Aurora Cannabis: Death Spiral Financing In Disguise, Longs Beware

  • Aurora Cannabis is equitizing convertible debt due in four months in a death spiral-like transaction.
  • Aurora faces potential of virtually unlimited dilution.
  • That Aurora, one of the largest and most liquid cannabis companies was unable to obtain better financing options should signal caution in the cannabis sector.
  • Based on set-up, stock should fall this week, until the convert is equitized.

On Thursday, November 14, Aurora Cannabis (NYSE: ACB) quietly issued a press release alongside its earnings release. In the press release, Aurora announced the equitization of CAD $230M of convertible debt (with an original exercise price now far out-of-the-money) in a classic “death spiral” structure. The fact that Aurora was forced into this extremely dilutive option should signal caution in the cannabis sector.

From Investopedia: “Death Spiral is a term applied to a type of convertible debt that stimulates an ever-increasing number of shares, leading to steep stock price drops. The convertible bond, unlike a conventional convertible one, converts into a fixed value instead of a fixed number of shares. If this bond is converted into stock, the price of the stock tends to drop due to the increased supply of shares. This, in turn, encourages more conversion because the convertible debt owners can obtain — and then sell — even more shares of the stock with the fixed value feature. Theoretically, the death spiral can end with the stock at or near a zero dollar value.

Management was vague about the true mechanism of the repayment of the 2020 debenture. They pitched it as a measure to “strengthen” the balance sheet, when in fact it exposes shareholders to the potential of virtually unlimited dilution. While Aurora shares are down ~30% since the announcement, the potential downside is even lower given how punitive this repayment structure could be for existing shareholders.

It appears that a few sophisticated hedge funds have negotiated this repayment structure which allows them to hedge out the debenture without needing to borrow shares, meaning they can begin selling the approximately 80M shares that would be needed to hedge the entire $230M debenture issue. Note the 80M shares figure assumes the share price stays at the current $3 CAD over the next 5 trading days – but this number could increase significantly if the share price were to drop in a meaningful way.

The supplemental indenture filing reveals a very deliberate structure that allows holders to lock in gains by hedging out shares of ACB over the course of this week. The debenture holders have cleverly negotiated a two-part repayment: the first, based on the average daily VWAP from November 18 and 19, is paid in shares on November 20. This is extremely advantageous as it allows the funds to receive shares in a standard T+2 settlement, thus obviating the need to borrow shares. The second part of the repayment is based on the VWAP over the whole week (November 18 to November 22) and paid in shares on November 25. The staggered repayments allow holders to begin hedging or shorting this week without the need for borrow.

It’s a vicious cycle: the lower the price of ACB, the more the debenture holders need to hedge. The more they hedge, the lower the price goes. The below table outlines the dilution that ACB will suffer under various price scenarios. All references below are in CAD.

Investors Should Avoid Aurora Shares

While the financing structure will be a significant technical headwind into November 25, shares could find support if the broad cannabis sector experiences a sharp rally or short squeeze. However, the effects on ACB shares would likely be outweighed by convertible hedging and additional shorting given the size of the issue and the stock’s liquidity.

The takeaway is that there will likely be continued heavy selling pressure on ACB stock throughout this week as hedge funds who own the 2020 debentures scramble to hedge out their exposure and lock in gains. Given this, we recommend investors avoid Aurora stock or reduce their holdings until the convertible is equitized.