Canopy Growth: The Undervalued Argument Of A Dominant Pot Stock

|
About: Canopy Growth Corporation (CGC)
by: D. H. Taylor
Summary

Thursday's financial release for Canopy Growth will show sales numbers for the first quarter of legalized adult-use cannabis in Canada, a period where the country ran out of product.

Canada is likely to fall well short of supply considering the amount available for the biggest producers to supply over the medium term.

Canopy will have a large infusion of capital and will be able to use that capital to expand in a segment that has limited supply.

Canopy Growth (CGC) is sitting at prices where not long ago the floor fell out beneath them. The stock peaked at $59.25 in October and then proceeded on a sharp move downward to $25.00, a 57.8% loss of value. I not only wrote about how the stock was so overvalued that it was irrational, but I also rode the move downward in a short position. The stock has moved back up to levels that once again call into question the valuation. With the stock entering these levels again, I have gotten queries from my regular readers pointing out my previous position as they wanted to know my thoughts going into the financial release on Thursday.

The short version is that I believe Canopy Growth will post lower-than-expected results and likely the stock will move down from this. The long answer is much more complicated than that and any volatility will be a significant buying opportunity for Canopy. I believe that the country of Canada is likely to be low on supply of cannabis for a long time to come; something that Canopy will profit from handsomely.

Here is a look at recent activity on Canopy Growth's stock:

Canopy Growth Stock: CGC

My expectations are smaller than your expectations

This is the infancy of legal cannabis in Canada. Do not expect full-throttle production and sales from any of the companies over the next 2-3 quarters while the country ramps up. That being said, however, there is some context to give a potential investor some guidance: The State of Colorado.

The demographics of Colorado and Cannabis are about the same when it comes to the number of people who consume the substance. About 16.5% of the general population in Colorado consume cannabis on some amount of regularity which is termed by the State of Colorado to be at least 1-2 times per month. For Canada, where adult-use is just now legalized, the numbers are strikingly similar where the statistic hits about 14%.

As it turns out, usage in Colorado has moved upwards from initial numbers to the 16.5% it is now. The reason is simple: It's everywhere and everybody is doing it, so why not? As a resident of both Colorado and California, I see this play out all the time at parties, concerts, or wherever. People who ordinarily may not go out and purchase cannabis on their own are offered a hit and take it. Congratulations to them, they just became a data point in a larger statistic.

Here is a breakdown of the growth of Cannabis in Colorado. First, there are 6.5 times more Canadians than Coloradans (36.7M versus 5.6M). So, multiply these numbers by 6.5 and you should get a good metric for Canadian cannabis sales:

Calendar Year Total Marijuana Sales Total to Date
2014 $683,523,739 $683,523,739
2015 $995,591,255 $1,679,114,994
2016 $1,307,203,473 $2,986,318,467
2017 $1,507,702,219 $4,494,020,686
2018 (Jan - Nov) $1,410,946,626 $5,904,967,312

At the end of 2014, the wholesale price of cannabis in Colorado was roughly $1,775.00 per pound, or ~$4.00 per gram (16 oz. per pound with 28.35 grams per ounce). At that rate, with $683M annual sales, about 170M grams were solid in Colorado.

Given the numbers above, we can multiply by 6.5 to get the rough equivalent, then divide by four and that should give the approximate quarterly sales volume of Canadian adult-use sales. I expect there to be about 275M grams of cannabis per quarter sold in Canada with a dollar volume of approximately $1.95B. There are multiple companies that will be cashing in on this sales volume but, I can expect Canopy Growth to participate in a big chunk of that.

There's just one caveat to this data, however. In Colorado, private enterprise is pretty much in charge of the entire process. In Canada, the government has been injected into the supply process. This may, or may not, have been the catalyst of the country running out of cannabis in the first week of legal adult-use sales.

As it turns out, on day one of legal, adult-use cannabis sales in Canada sales were far more robust than originally predicted. Provincially regulated/owned stores had sales anywhere from 5,000 - 30,000 orders. For example, the Province of British Columbia, with only one store open, received 795 orders in person while their online store received 9,137 orders (British Columbia has a population of 4.9 million, nearly that of Colorado and yet there was only one store open in the entire province).

The numbers are striking - they also underscore how far off government predictions were for sales numbers and by consequence the inability to be stocked properly. I considered some off-hand musings that maybe Canada just got some really great publicity for their new industry, sort of like how Facebook got some of its best publicity from the movie The Social Network.

Since the sales data for Canopy is going to be the first quarter with the newly legalized adult-use sales data, as I said at the beginning of this article, I expect these numbers to miss expectations. But eventually, I do expect the numbers from Colorado and Canada to start to correlate with each other and from that normal growth rates can be expected.

What is Canopy Worth

Canopy Growth can be a bit shy on braggadocio when it comes to how much they can produce. But through a bit of work, we believe their capabilities are about 560,000 kg. per year of production. The current wholesale value of cannabis is $5.20 per gram. At that rate, revenues for the company would be $2.9 billion. Through all of my research within the industry, I have found net margins to run about 17%. And, if you take a value approach with a growth industry such as cannabis, a 20-times multiple - the all-time average of the entire market is about 17.5-times but is currently running high at 29-times - then the company should be worth about $9.9 billion. It is currently valued at about $16.5 billion with its stock price at $45.50.

The $4 billion gorilla in the room

I have debated a few issues with a multitude of individuals regarding the value of Canopy Growth. The deal with Constellation Brands closed on November 1st, and this now puts some $4B into Canopy's coffers. Effectively, that $4B is baked into the price of Canopy. I generously value the revenue potential for the company at $9.9B and will add in the $4B on top of that getting to $13.9B. The stock is still off by about $2.6B, or ~20%.

This is where the philosophical debate begins, and did begin with another investor in the industry. The question becomes, what can Canopy do with the extra funds to get to the point that the stock will then be valued appropriately? My knee-jerk reaction was to say to "invest in cannabis". As simplistic as it sounds, that is a good business strategy and exactly why Constellation Brands invested in Canopy Growth and continues to support this.

Take a look at the revenue numbers above for Colorado. The first year was approximately $700 million in revenue. After three years, that revenue more than doubled.

If Canopy Growth were to have their "560K kg. production house" in order, then the ability to produce the revenue projections will mean they can be profitable and then can return the true value to shareholders. Given that, could they not then invest in larger production capabilities? Absolutely.

Take a better look at the Colorado numbers above. Right now, there appear to be about 1.5 million kilograms production capabilities in Canada coming online very quickly; that is 1.5B grams, this is about what the country needs the first year. When you do the math on how much Canada is likely to consume in the second year - given the linear relationship between Canada and Colorado - the country is going to fall short of supplying the demand.

Colorado consumed approximately 45% more cannabis in the second year of legalization. Right now, the biggest Canadian producers are going to be coming online with their big projects throughout this year and those totals are for the 1.5M kilograms. These companies are going to have to start adding in 50% more capabilities immediately in order to maintain the same growth rate.

What is the single most basic economic tenet of supply and demand when it comes to not enough supply? Price must go higher. Then, entrants will start to provide more supple. I expect that shortages in Canada are going to continue throughout the country and because of that prices will likely rise. This would be excellent for a company doing business in Canada.

But, Canopy Growth has something that is just about to show up in their financial records: $4 billion in cash. Remember, the deal was just closed with Constellation Brands and the transaction is about to be completed. Canopy now has the ability to start expanding in an industry that is limited in supply. And, if the supply constraints push prices higher then revenues will increase along with this demand.

I am looking at a much broader picture and I believe that Canopy has the ability to capitalize on this potential situation. I will be keeping a close eye on the government's data to see how closely they correlate with Colorado's. This is key and something that I think will be a process but will likely play out. However, I do stress that this is not a guarantee. There are a lot of correlations between what I see in Colorado and Canada. But, it is no guarantee that it will all play out.

In the meantime, I expect that the prices should start to edge higher for cannabis on the wholesale level and I will be watching for this closely. And, I expect that eventually, Canopy Growth will show these kinds of results in their financial releases. However, I do not expect that these numbers will show up this Thursday.

Trading on Thursday may be volatile from the financial release. But, eventually, there is a lot of potential with this company and others in the industry.

Disclosure: I am/we are long CGC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.