Canopy Growth: Take A Breath Before You Jump In

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About: Canopy Growth Corporation (CGC)
by: One Guy and a Calculator
Summary

Canopy Growth is positioned in a rapidly growing industry.

But the company is clearly overvalued.

Market forces will hinder CGC's revenue and earnings growth.

Summary

Canopy Growth (CGC) is primarily engaged in production and distribution of dried flower, oil and soft gel capsules both in North America and increasingly overseas. They have ridden a wave of excitement and stock price increases with every state that decriminalizes and legalizes cannabis. Canada as well, has fully legalized cannabis for recreational consumption, as is well known. The excitement that everyone was feeling might be slowly fading away. The former chairman and co-CEO Bruce Linton, was recently fired after managing to record a $ 1.28 billion USD loss on $ 90 million USD of revenue in the last quarter, ending June 30th.

Source: Yahoo Finance

The other important point worth mentioning is that revenue has also decreased from the previous quarter of $ 94 million. This is important to mention because right now weed sales should be booming, but for Canopy Growth their revenue is effectively flat. Their revenue and loss was worse than analyst had anticipated. It was estimated the company would record a loss of 70 cents/share on $107 million in sales. Last quarter’s loss per share was $3.70; clearly a big difference from what was projected.

Valuation

How do we value something that is losing buckets of cash, but situated in a growing industry, yet facing multiple competitors? Discounted cash flows will not work, it’s all going to be pure speculation. We have to look at sales ratios with similar companies. Drinking for a long time has been a popular way to relax and unwind; which is a similar motive for smoking weed. This is why I will look at price to sales ratios from some of the biggest beverage companies to gauge relative value.

Average P/S for the beverage group is 3.79.

Source: Yahoo Finance

Using lasts quarter’s revenue of $90.5M x 4, we get $362M of revenue over the next 4 quarters. I’m just using $90.5M because I can’t assume its going to increase since there is already a drop in revenue from the previous quarter.

Current market cap is $8.43 B and their extrapolated revenue of $0.362B gives us a P/S of 23.28. For the P/S ratio to approach their peers it would need to increase to $2.2B (8.43B market cap / 2.2 B revenue =3.79). I don’t see this happening any time in the near future.

That means for it to approach $2.2B, revenue would need to increase by +6 times. Even if revenue were to double or triple right now, Canopy Growth would still be overpriced based on the P/S multiple. No doubt this company and the cannabis sector will grow (pardon the pun), but I think there is still too much hype and exuberance in the sector.

Lets do a quick napkin calculation to see how much a reasonable price of the stock would be if the revenue just tripled. I’ll just quickly use whole numbers for this.

  • Currently there are 347 million shares outstanding.
  • Last quarter’s revenue was 90 million
  • Over the next 4 quarters if the revenue were to triple the revenue would be $90M x 4 x 3 = $1080 million, or $3.11 Rev/share.

Based on the peer P/S ratio of 3.79 we get a price of $11.79 (3.79 x 3.11). As of the writing of this article, I’m seeing the price fluctuate around $27 USD.

The valuation is a important point because I’m asking for the revenue to just triple for us to get up to a reasonable price of $11.79. On top of that after the revenue just triples, the value of the stock is still less than half of what it’s currently trading at.

Quality of Managers

Current CEO Mark Zekulin, has been with the company since its inception. He is well educated and has served in an advisory capacity to different companies over the years. The focus that has been laid out in the MD&A is fairly straight forward and is to be expected. In the MD&A, it lays out their direction of pursuing opportunities globally, looking for partnerships to expand their growing and cultivation efforts. They are also looking to get into infused beverages, pain and anxiety therapies; which I feel will be a large market in the future. They are also looking to profit from any patents that have developed.

Industry Prospects

According to Grand View Research the market for cannabis is expected to grow to USD 66 billion by the year 2025. The market size translates to a CAGR of 23%. This is a healthy growth rate for sure. No doubt that opening up markets to legal weed will make weed more socially acceptable for recreational and medical purposes. There are many anecdotal reports that now older patients are asking their doctors for cannabis for various ailments.

Insider buying/selling

Recently after his firing, ex co-CEO Bruce Linton purchases more shares of CGC, although the amount is undisclosed. The other officers of Canopy growth seem to be just cashing in with their option exercises as can be seen below.

(Source: Canadianinsider.com)

Overall, I don’t see any positive or negative signals from insider activity.

Positives for Canopy Growth

  • Generally, countries are becoming more open to the possibility of decriminalizing or legalizing weed for both recreational and/or medical purposes. The legalization of weed will help its consumption become more socially acceptable for more people to use, which will increase the consumer base.
  • Canopy Growth has some well known brands in Canada and globally like Tokyo Smoke, Tweed and Spectrum.
  • In Canada the market for edibles and infused beverages will be made legal at the end of 2019.“Canada could see as many as 3 million new consumers enter the cannabis market due to legalization and availability of edibles, extracts and topicals”(Newswire).
  • Europe is also opening up to more medical cannabis.
  • CGC continues their push into medical with the acquisition of Storz & Bickel GmbH and its related intellectual property. Storz is a leader in the design and manufacturing of vaporizers which have been approved for medical purposes.
  • Canopy Growth has 111 patents issued as of August 14 2019. Their patents cover cannabis infused beverage production, plant genetics, and cannabis delivery technology. They have 60 clinical trials in the planning phase, ongoing, or which have been completed. These trials include “sleep, pain and anxiety treatment”(MD&A June 30 2019)

Negatives for Canopy Growth

  • Still a lot of competition left from the black market. With all the tax and regulation we see applied to the marijuana market it’s no wonder that legal weed has a hard time matching the price point of illegal weed. On top of the price point, you have many people that have developed a personal/business relationship with their current dealers which they plan on keeping. In Canada after legalization 40% still buy from the black market.
  • Barriers to entry are very low for growers and suppliers! For example in California’s Monterey County there were 180 rose growers in greenhouses along the highway. Today most of the rose growers are all gone; they have shifted their growing operations to marijuana. The roses are now being grown in cheaper locations like Columbia. But there are companies like Grupo Flor that are already looking to shift weed production to Columbia to be more cost competitive. “Most Canadian companies nurse the long-term hope of getting their production costs below two Canadian dollars per gram of cannabis. Colombian producers say their costs will start well below 50 cents a gram—and go down from there.”(Barrons)
  • Switching costs are very low. You can go from one producer to another with ease.
  • Branding/marketing is hindered. In Canada marketing and branding is very strict. The rules around marketing in Canada have been described by the government as “no excitement, no glamour, no fun“(Globe and Mail). In the same Globe and Mail article, “when Brightfield Group, a Chicago-based research firm, asked Canadian cannabis users about the brands they bought, almost one-quarter of those surveyed were not sure”. In a recent Bloomberg article that looked at this same issue found, “Google prohibits marijuana ads, has kicked some weed sellers off Instagram. Earlier in January CBS declined to air a commercial touting the benefits of medical marijuana during the Super Bowl”. These are not small issues that have no effect on the revenue of a company. When we have a product that is very much looked at as a commodity, there needs to be a way to stick out-and that’s marketing and branding. Currently, marketing and branding have material restrictions.

Recommendation

The industry will grow as a whole there is no doubt about that. The more places that legalize it, make it more socially acceptable to the general populace. From an investment perspective, barriers to entry are low, switching costs are low, branding is weak, and in many places people are able to grow it themselves. On top of all this, the black market is still alive and well. I would hold off in investing at the moment.

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.