We have probably all been there. It might have a been sudden drop or a slow and systematic decline in the stock price due to a black swan event or poor earnings report. You might have averaged down because you thought the market was crazy to discount your holding. “This is a fire sale”, you thought, “I'm backing up the truck”. Weeks turned into days, which turned into months and a year later you are still berating yourself for making the initial investment. Even the best investors have been bagholders at least once in their investing journey.
Bagholding is in itself an art form. It requires the perfect balance of patience, time, hope, and opportunity. All these factors have to be in alignment for the bagholder to either exit their position or stomach the loss and move on. While earlier investors in Canopy Growth (CGC) have a significant margin of safety (as well as substantial capital gains) later investors are likely to become unwilling bagholders as the expectations built into Canopy's current valuation are unlikely to materialize over the coming years.
Canopy's capital gains are firmly behind us, I also think the company now faces insurmountable hurdles stemming from the structurally hostile nature of the Canadian recreational cannabis market, its heartland. The move to acquire the rights to acquire Acreage is one of desperation. It amounts to browsing for a new property while your home is burning down, and will add more frothiness to an already egregiously overvalued stock. Canopy’s $4 billion cash war chest now faces quarter over quarter raids from the bad decision making and questionable conglomerate strategy of its management team.
Dots On A Map Does Not Mean Financial Viability
Last year, I wrote an article about how Canopy's supposed geographical exposure amounted to nothing more than dots on a map, as the majority of its revenue still comes from Canada. Even with the acquisition of the ability to acquire Acreage, this fact will remain until early 2021 at the very earliest.
However, and a key risk for any Canadian cannabis bears, is that when euphoric expectations have replaced financial analysis, dots on a map very well means more to bulls than underperforming revenue growth (versus analyst estimates), declining gross margins, and an expansionary negative free cash flow profile.
Conducting analysis to make an investment decision within the cannabis space is to throw away everything you learned in your Finance 101 courses. Instead, embrace excessive PR Newswires, investments or partnerships seemingly made every day, and blue-sky thinking. Grasping this fundamental tenet allows for the fine tuning of an investment strategy into the cannabis space.
Following the investment into Acreage (OTCQX:ACRGF), Canopy gains a foothold into the United States, the most important cannabis market in the world. Crucially, and perhaps, the underlying reason for the right to buy acquisition is Canopy gains a raison d'etre for continued shareholder bullishness in its stock following the continued deterioration in its home market.
Escalators Do Not Go To The Sky
It's quite interesting to read some of the passionate bullish commentary around canopy growth prophesying a stock that will "easily triple" from its current $45 level. At $135, Canopy Growth would have a $45 billion valuation. The financials required to support such a valuation is far beyond what can be realized by Canopy Growth.
Chart created from SEC filings
Gross profit margins, the important demarcation of a commodity versus a differentiated product fell to 15% during Canopy's last reported quarter. This worrying trend is before anticipated oversupply of cannabis in Canada.
Chart created from SEC filings
Quite worrying is data from Health Canada show that there is already excess cannabis supply. BNN Bloomberg report Canadians buying "about 6,671 kilograms of cannabis in February, down about nine percent from the prior month". But the total amount of inventory of finished and unfinished dried cannabis held by cultivators, processors, distributors, and retailers totaled "144,470 kilograms in February – approximately 21.7 times the amount of total sales in the month".
This is bad and dispels what has been consistent statements from LPs that there is a supply issue in Canada. The impact of this on per gram metrics has been pronounced.
Average sales price per gram has fallen by 12.3% to $7.33 from $8.36. I expect this declining trend to accelerate as oversupply issues continued to force the market prices down.
There is no near term catalyst that will stop the continued outward shift in supply from S to S1, and from S1 to an even more rightward S2. Cannabis edibles have been touted as a potential savior from the total collapse in the Canadian cannabis market, but time will tell.
Canopy Growth now faces at least two years, eight quarters, of continued cash burn and declining gross margins. I estimate gross margins for the next quarter will have likely fallen to single digits, with negative free cash flow at $190 million, consistent with their last reported quarter.
My bearish stance is founded on an assumption that Canopy's historical losses (FCF) are reflective of the intrinsic nature of the industry it operates in. The average selling price per gram, as well as the rising cash costs, mirror what one would expect of a farmer of an agricultural commodity.
The Next Generation Of Bagholders
Canopy Growth currently trades on high expectations of total world cannabis domination. It the company ascends to meet these expectations then bagholders should be crossed out from the title and replaced with moderate wealth. However, if the company's future earnings reports continue to reflect its suboptimal historical past then these expectations of wealth will regress to hopes of recovery.
Fundamentally, Canopy Growth is a $16 billion company with comparatively minuscule sales and a ramping negative cash flow profile. A company where shareholders expect it to at base minimum double over the next year.
Against this backdrop, the question of how much upside is left springs up. But as we have seen from history, the financials do not matter within the cannabis space. Canopy simply has to announce a partnership deal with yet another celebrity (I'd recommend Kanye) for the stock to gain a billion in market cap. But while escalators go up, they do not go to the sky. And this is why bubbles eventually burst. Positive coverage of the acquisition will likely push the company's stock price above $50 in the next few days, followed on by a plethora of newswires announcing deals largely immaterial to their financial standing. As soon as this happens I am short.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.