Canopy Growth: Goliath Pivots

Summary

• Canopy had a better-than-expected quarter, but there is still large problems left over from previous management.
• Chief among these are huge cash burn and inventories.
• The entire industry has two regulatory issues: the slow rollout of retail in Ontario, and the uncertain pace of recreational legalization internationally.
• Canopy is still a company with a lot going for it, but there needs to be a restructuring to deal with the cold hard realities of the Canadian domestic market.
• There will be plenty of opportunities for short-term plays, but I still cannot recommend a long-term investment in any of the Canadian cannabis companies.

There Is Good News and Bad News

Chris Wimbush. Canopy's previous management was violating the First Law of Holes: when you are in a hole, stop digging.

This just reported quarter was a big one for the Canadian cannabis companies, and Canopy Growth (NASDAQ:CGC) in particular:

• The best news for Canopy and the entire industry is that their revenue grew to $137 million Canadian in the quarter, a record for them and the industry.
• The end of the quarter saw the beginning of new product formats, AKA Cannabis 2.0.
• But 2019 was the year that halcyon promise of the new industry finally met the cold, hard realities of the Canadian domestic market. It is a small country, and its largest province, Ontario, is moving very slowly on retail. Their biggest competition continues to be the untaxed illicit market.
• Put those last two together, and you get huge unsold inventories, with Canopy, as always, leading the way. At Q4 revenue levels, they had over a year of inventory at the end of the quarter.
• Canopy also had a leadership change that has tied them closer to their beverage benefactor, Constellation (STZ).
• The quarter saw a huge reduction in the administrative OpEx line, but cash flows from operations remained at -$189 million Canadian, or -$0.54 per share. These are both down sequentially around -6%, but that is not enough.
• Net cash is down to $1.7 billion Canadian, with $2.3 billion in cash and $558 million in debt. At their current operational cash flow burn rate, that gives them 12 quarters of cash, or through calendar Q4 2023. This is down from 14 quarters of cash, or through Q2 2024, at the end of the September quarter. Three months prior to that, they had 5 years of cash.

I call Canopy "Goliath" because they are very self-consciously going for the AB InBev (BUD) model of the giant conglomerate astride the globe. But previous management dug a deep hole of high cash burn and inventories. They have cut administrative costs considerably, and brought the revenue line up, and we'll dig into what happened there.

But those last two bullets is the challenge they face; Goliath does not pivot quickly.

I still can't recommend Canopy or any of the Canadian cannabis companies as a long-term investment. There are still too many challenges and things beyond their control. Foremost amongst these are the relatively small Canadian market upon which they must be dependent in the short term, and the added problem of slow retail rollout in Ontario. Canada remains the only country with broad legalization, and that doesn't look like it will be changing in the near term. For now, they must rely on the Canadian domestic market, and whatever they can squeeze out of international medical distribution.

But at least we are past the bubble phase:

Data by YCharts

Evaluating a Brand New Industry

Raw cannabis extract. Loonie for scale, and also to remind you that all dollars are Canadian. © 2020 Trading Places Research

Evaluating the performance of these companies just about a year into a brand new business is challenging to begin with, but when you add in the pace of acquisitions and one-time accounting events, normal analysis sort of flies out the window.

Complicating this is the manner of Canadian reporting which puts big inventory changes into the income statement (not on the balance sheet like the US) as "Fair Value Adjustments." Putting changes in inventory values into the income statement has a large effect on our usual measures of profitability of operations. There are also other incursions from what we would expect to be on the balance sheet to the income statement in Canadian reporting.

Which brings me to the concept of biological assets, which further complicates the picture. These are mothers, clones, and plants at various life-cycle stages. The value of these assets is literally changing daily, and that also shows up in the income statement. After harvest, it goes to inventory, but it becomes hard to put a value on it, as we have seen for finished product.

So the income statements are not as helpful as with most companies, and we will be focusing mostly on cash flow from operations as our primary earnings metric, since most of the big accounting anomalies come out in the wash there.

Additionally, the YoY and TTM numbers, which I tend to prefer, are still not relevant until next quarter, so we will be dealing with QoQ primarily.

If you want some background on cannabis cultivation, product trends and a broad review of the Canadian landscape, that's here.

A Quick Rundown of Goliath

My promise to you, as always, is that there will be no weed puns in this article. © 2020 Trading Places Research.

Canopy started calendar 2019 with just under $5 billion in cash, and finished with $2.3 billion. It is the company most self-consciously going for the AB InBev model, and about a billion of that went into acquisitions and related costs, in addition to very high CapEx and R&D lines.

They have invested heavily in a fully vertically integrated Canadian operation from production to retail. They are pursuing recreational, medical, and CBD products wherever the regulatory environment allows. They are also the most aggressive in developing new products and formats, and they are very focused on brand development as well.

These are all good things, and fit into my preferred model here. But they are paying far too high a cost to do it, when the Canadian market remains relatively small, and big international regulatory changes are not on the short-term horizon. In short, they moved too fast and dug themselves a hole.

But what did they get for all those loonies?

• A vertically integrated Canadian operation that can also supply medical products to five European countries, five South American countries, Australia, and South Africa. Did I mention Jamaica? Of course, Jamaica.
• They have 22 owned stores in Canada, and 6 more independently operated under their Tokyo Smoke and Tweed brands. Crucially, none of these are in the largest market, Ontario, or the most developed market, Alberta. Getting new stores into Ontario once they loosen up the regulations will be key.
• A portfolio of brands led by Tweed, Tokyo Smoke and Spectrum Therapeutics. They also have DOJA, a high-end British Columbia brand, and Twd., their low-cost Tweed offshoot. There's also Van de Pop, marketed towards women. They also have brands in edibles, drinkables and topicals.
• 130 issued patents and another 350 pending (there is double counting across countries in there). This will be key if the Cannabis 2.0 market takes off the way they hope.
• Partnership with DNA Genetics, a longtime pre-legalization leader in breeding.
• Partnership with Constellation, and also beverage and topicals acquisitions.
• Two nice German assets: C3, a producer of pharmaceutical CBD, and Storz & Bickel, manufacturers of high-end dried flower vaporizers, AKA "The Mercedes of Vapes."
• A Danish greenhouse for medical production.
• Outdoor growing facilities in Columbia (1.26 sq km) and Lesotho (0.2 sq km)
• A toehold in US CBD hemp farming.
• Partnerships with Drake, Snoop Dogg and Seth Rogen, who have their own brands.
• The Acreage Holdings deal.

The Acreage deal is the most interesting part of this. Acreage is a New York company that runs a pretty well-integrated operation in 20 states. Canopy gave them $300 million USD for call options to merge the companies through a stock swap "at such time as the occurrence or waiver of changes in United States federal law to permit the general cultivation, distribution, and possession of marijuana or to remove the regulation of such activities from the federal laws of the United States." Canopy is required to make the transaction, so long as the regulatory changes happen before 2026.

There's a bunch of wiggle-room in that quote, but the combined entity would instantly be a North American giant with a lot of room to run. Importantly, it protects Canopy in that early US-legalization period, where the danger to the Canadians is getting swamped by larger US firms once they have access to capital markets.

They paid a lot, and they got a lot, but it looks like too much, and number one on the list is too much Canadian production, which is where those bloated inventories come from.

New Management

New CEO David Klein, sporting Weed Industry Business Casual. He has a lot to think about in the next 90 days. Canopy publicity photo.

New CEO David Klein was already on the board and came from Constellation, so this has deepened the ties. This has led to much speculation that there will eventually be a merger here. He is still very fresh to the job, but not new to Canopy. He has identified four priorities:

1. Brand development.
2. "Focus and discipline."
3. "Right-sizing." Here come the layoffs and asset sales.
4. Stop overpromising like previous management and regain credibility.

Klein said he's going to take the next 90 days before announcing anything big on items 2 and 3, but I think the writing is on the wall. Previous management overbuilt, overhired and overproduced, and new management is going to have to clean that up without hollowing out the company. That is a huge hill to climb, and every decision is crucial.

The challenges Klein will face in the next 90 days:

• Continuing to grow sales in a tough environment.
• Figuring out which are the core market segments they want to play in, and which ones they should abandon.
• Figuring out which assets are underperforming, and what the sale possibilities are.
• Figuring out what to do with their bloated inventories.

Reducing administrative costs by $20 million in the quarter is a good start. But unless sales grow rapidly from the Cannabis 2.0 launch, and I am skeptical that can happen in the short term, they will require some restructuring. This will likely include layoffs like we have already seen at Aurora (ACB) and Tilray (TLRY), and asset sales are on the table. Klein admitted to Reuters that they have a tough row to hoe here as, "There's not a lot of market demand for cannabis production facilities."

Revenue

© 2020 Trading Places Research

This is of course an important early indicator for any new industry, especially one with a still-thriving black market as competition. Canopy blew out their own previous top quarter, and also beat Aphria's (APHA) August quarter industry record by 7%. They showed nice sequential growth everywhere.

Their QoQ numbers are a bit misleading. Last quarter was a bit of a disaster, with a $33 million charge to revenues for pricing adjustments and returns, and the end result was negative gross margins. The biggest driver here was that they badly overestimated the demand for softgels based on the California and Colorado markets, and inventories there jumped, and prices fell.

• If we pull out the $33 million, revenue was up 14% sequentially.
• In the recreational wholesale market, where that $33 million charge was, revenue was up 8% without the charge included. The company attributes this to new retail openings across the country, 140 stores in the quarter.
• They had some store openings of their own in the quarter, but the 16% jump in recreational retail was primarily due to the 11% rise in same-store sales.
• They saw only small increases in medical cannabis sales, both domestically and internationally. I believe that the big growth opportunities lie in recreational, not medical.
• They also got a nice seasonal bump from Storz & Bickel. Their products are expensive, so they make a great Christmas gift for the right person.
• Cannabis 2.0 products did not have any effect on revenues in the quarter, as the launch was limited, and very late in the quarter.

My conclusion here is the same as it has been: the big near term issues remain expanding retail, and converting recreational consumers from the black market to legal sales through convenience and quality product, brands, and new formats.

Inventory and Cash Burn Remain Problems

So first of all, we are not going to run out of cash.

That quote is from David Klein, answering his first-ever analyst question on the earnings call. An inauspicious beginning.

Starting with inventories, they have ballooned for everyone in the industry except for Aphria, who was actually having trouble filling their channels as of last November. But Canopy has been the biggest offender here, overproducing and underselling very badly in the initial launch of legalization.

Company filings and morningstar.ca. The revenue charge in the September quarter has been excluded from the inventory-sales ratio calculation.

With the onloading of new Cannabis 2.0 products coming in the quarter, I didn't expect them to solve the problem, but I also did not expect that it would get worse. At Q4 revenue's run rate, up considerably, they still had over a year of inventory at the end of December. Previous management has really put them in a bind here.

They will have to grow sales rapidly if they want to avoid inventory charges down the road. Since these show up in the income statements in Canada, if they are going to do this, I expect them to wait until the switch to US GAAP reporting first, where these will show up on the balance sheet. They have more room for it there with a current ratio still at 8.4.

Turning to their cash burn, they went through $469 million in the quarter, $189 million from operations. This needs to stop:

Company filings and morningstar.ca.

They have only taken the first small steps towards correcting this. David Klein has a lot of tough decisions in the next 90 days.

Branding

Branding has been around in the illicit cannabis market for decades already under the "strain" rubric. But without enforceable trademarks, this just led to chaos and copycats. Now in Canada, we see the first real modern attempts at forming brands for cannabis, with all the power of marketing MBAs behind it. Like with all consumer packaged goods, branding will be key in the long haul.

Some early trends in the Canadian recreational market:

• Dried flower, AKA weed, still dominates over newer formats, but the hope is for much higher margin Cannabis 2.0 products to begin to take over.
• Within recreational weed, we see a bifurcation like brewing, with less expensive brands like Canopy's Twd. doing well, and top-end brands like Aphria's Broken Coast and Aurora's San Rafael '71 also doing well. It looks like the middle is sagging.
• Preroll is emerging as a very popular format. Convenient formats seem like winners in the legal market.

It's hard to judge from 10,000 feet since we are very much in the early stages here, but it seems to me that the brand leaders so far are Canopy and Aphria. Beginning with the later, Aphria brands are really gaining popularity on the high end, as judged by Lift.co's (OTC:LFCOF) user reviews. Other standouts there are San Rafael '71, and Supreme's (OTCQX:SPRWF) 7ACRES. Lift has been running awards for 6 years now, and Aphria is really dominating these:

Canadian Cannabis Awards. I have annotated each winner with the ticker of the public company who owns them. Redecan is private.

The first two rows are the important ones, and Aphria in purple is really doing well here, along with Aurora and OrganiGram (OGI). Canopy only shows up well in the sprays and capsules, and these formats have sold poorly.

But Canopy continues to be the leader in recreational cannabis sales, so they must be doing something right on the branding end, even if that is something as mundane as channel stuffing. David Klein kept calling out the high and low ends of the market. CFO Mike Lee estimated that 40% of the market is for premium product, and 30% for the low end, which doesn't leave a large middle. They weren't much more detailed than this, but they called out their budget brand, Twd., a few times, so I have to assume this is where they are seeing brand strength.

So it looks like the very early winners in the branding war are:

• High End: Broken Coast (Aphria), San Rafael '71 (Aurora), Edison (OrganiGram), Soleil (Aphria), RIFF (Aphria)
• The Bud Light Segment: Twd. (Canopy), Good Supply (Aphria)

To be frank, Canopy could use some consolidation here:

Canopy graphic

Nine "Core" brands seem like too many for this stage, and I'm wondering if they consolidate this at some point.

I haven't been up to The North since early legalization days, and much has changed on the retail and branding fronts. After there's been some time for Cannabis 2.0 products to get on shelves, and it thaws a bit up there, I intend to get to Alberta, which has the most mature retail market in Canada. This is the good research.

Not quite there yet. weather.com

Cannabis 2.0

"Cannabis 2.0" is a marketing term, so it is a bit in the eye of the beholder, but generally it refers to new product formats that don't involve smoke and ash:

• Edibles
• Beverages
• Oils which can be eaten or vaporized
• Topicals, with an emphasis on CBD preparations here

The key to all this is extraction technology, and strains that are bred expressly for this. The goal is to create colorless, flavorless, scentless distillates at the lowest cost that can be used in a variety of ways. This is the Hard Seltzer Model. Hard seltzer is grain alcohol, carbonated water, and flavoring. Cannabis 2.0 is an attempt to replicate and expand that.

No one is hotter on this than Canopy.

• Their headquarters is the old Hershey's chocolate factory in Smith Falls, Ontario, which is licensed for chocolate production. They have a partnership with a high-end chocolate company, Hummingbird, for recipes and production here, and products under the Tokyo Smoke, Tweed and Bean & Bud brands.
• Their biggest partnership is with beverage giant Constellation, and that's where David Klein came from. The brands here are Tweed, Quatreau, Houseplant (Seth Rogen's company) and Deep Space. They also own a sports drink company, BioSteel. Unlike edibles, oils and vapes, this category is really something new.
• Though they overestimated demand badly, Canopy's lead in extraction is shown by the relative strength of their oil capsules. They have oil vape cartridges in the Tweed, Van der Pop and Twd. brands, as well their proprietary JUJU battery system, and single use JUJU Joints. I think the later will be popular.
• Their topicals investment is This Works, a 15-year old British topicals company.

Many of Canopy's patents deal with extraction and they are hoping to take the lead here, and also with the end-use products where they are being really aggressive. Unsurprisingly considering the Constellation ties, they are moving hard on beverages, despite a delay in the general release here. David Klein:

Leveraging considerable intellectual property, Canopy has formulated a range of beverages that I believe will delight our consumers…

To add some color here a few weeks ago, myself and other board members tasted live versions of our cannabis beverages. After the tasting, a fellow board member sent me a text, the text read simply "Game Changer." I share that opinion. In our view, we truly have a unique and differentiated beverage which based on our competitive tasting, you can't find anywhere. We also see our cannabis beverage as truly disruptive and the best vehicle to attract new consumers to the cannabis market.

In other words, we believe it will do more to recruit new consumers than any other product format in our industry, creating new consumption occasions and a whole new industry. Just think about how big hard seltzer in the U.S. became in just three years. [emphasis added]

From their latest filing:

We believe that cannabis-infused beverages that offer sophisticated taste and dose control with a rapid onset and shorter duration can be tailored to meet specific outcomes across a variety of consumption occasions, while avoiding such things as weight gain, "hangover" effects, and interactions with traditional pharmaceutical medications. While our products will contain THC, CBD, or a combination of the two up to the limit of 10 milligrams of THC per package, in accordance with the regulations under the Cannabis Act, we believe a standard serving of 2 milligrams of THC is ideal for consumers and allows for more control for the user, and therefore most of our cannabis-infused beverages will be available at this potency. [emphasis added]

Two milligrams is a very small dosage, so that will not be that appealing to long time users, but they are clearly looking to go at new consumers who want a light, short-lived effect - something to have fun with, but be sober by the time you have to drive home. They think there is a very broad market here.

If successful, there are a lot of benefits to Canopy

• There is no competition from the illicit market, still the number one competitor in Canada.
• Constellation gives them a huge advantage, both in product development and eventually distribution.
• Most importantly, the small dosage means that margins are very high on these beverages.

Canopy has bet a lot on all this, and a big success here could really turn things around, but I remain skeptical. The small dosage is likely the correct choice; there are too many problems with new users overdosing on edibles, which is too easy to do. Not to mention those margins.

But I also wonder where new users are going to get these beverages. Klein called out hard seltzer, and that is the model here. But hard seltzer showed up in supermarkets and convenience stores where people were already shopping for alcohol and other stuff, right next to the beer. When they went out to bars, they were greeted by promotional materials. Trying it didn't require much effort. Even Mrs. TPR brought home a 12-pack, the remnants of which still reside in the back of the fridge.

But these new cannabis beverages will not be in supermarkets or bars. New users may still be too intimidated to walk into a cannabis store, and finding retail remains a chore in much of the country. This may eventually prove to be a popular format, but I don't think it will happen fast enough to fill that giant hole previous management dug. There is no silver bullet.

In the other Cannabis 2.0 categories, they will see much more competition. That, as always, will come down to price, quality, and customer satisfaction.

Conclusions and Recommendations

© 2020 Trading Places Research

We are beyond the bubble phase, and management has gotten some of the numbers moving in the right direction, but there are still too many regulatory issues for Canopy and the whole industry that are beyond their control. Foremost amongst these:

• The slow rollout of retail in Canada, with the largest province really dragging their feet.
• The uncertain pace of recreational legalization internationally.

Canopy has additional issues on top of that: giant loses and inventories. They are hoping Cannabis 2.0 is a "game changer," and it may indeed be in the medium and longer term. But I remain skeptical of its short-term benefits to their bottom line, and it certainly won't be big enough to fill that hole that previous management dug.

But Canopy is still a company with very important strengths:

• Despite the cash burn, they still have $2.3 billion left.
• Though they have to trim back, in my opinion they have a great portfolio of assets.
• Selling a lot of weed in the quarter is a good thing. Let's see if they can keep it up.

There will be plenty of price action as there has been, so there are plenty of opportunities for short-term trading for those of you who like that sort of thing. In my opinion, the next big event on the calendar right now is Aphria's reporting in about two months.

But I can't recommend Canopy or any of the others yet for a long-term investment. There is too much up in the air with regulations and within Canopy. Original management decided to run a 10K, when this race is starting to look more like a marathon or an ultramarathon. They need to downshift, and it's very hard to predict how that plays out.

But I have not given up on Canopy; far from it. They still have very important strengths, and if they can reorganize for the realities they find themselves in, they can still be a powerhouse. Having Constellation at their back does not hurt.

But this has to stop:

Company filings and morningstar.ca.

And this has to stop:

Company filings and morningstar.ca.

Disclosure: I am/we are long APHA. 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.