- Canopy Growth has been hunkering down to survive the latest rout caused by COVID-19.
- The company has shut down its largest greenhouses, fired hundreds of workers, and scaled back from several international markets.
- We believe these are just the beginning of a long-term retreat and will lead to a much smaller and focused company under the new CEO.
- Investors should remain on the sidelines until things clear up and a new strategy is formed by the new management team.
Canopy Growth (NASDAQ:CGC) is the problem child that Constellation Brands (STZ) is desperately trying to find a way to bring it back on track even as Constellation exercised 19 million warrants on May 1 to increase its stake in the world's largest public cannabis company to 39%. Canopy's new CEO came from Constellation and he is taking aggressive actions to scale back redundant operations and cut back operational costs. With the challenging market conditions caused by COVID-19 likely to persist into the rest of 2020 and beyond, we think it is prudent for Canopy to hunker down. We are Neutral on Canopy as the cannabis sector is facing a double whammy of pandemic and investor apathy after an already disappointing 2019. We fully expect Canopy to lead the pack when it comes to recovery, but there remains limited near-term visibility at this juncture.
(All amounts in C$)
Constellation Doubling Down
In May, Constellation exercised 19 million warrants to acquire $245 million of additional Canopy shares at $12.98 per share. These warrants were issued when Constellation made its initial investment in Canopy in 2017 and had the same exercise price as it paid in that deal. After the latest purchase, Constellation owns 142 million shares, another 139 million warrants, and $200 million of convertible senior notes of Canopy. Clearly, Canopy is becoming too large to discard at this point for Constellation. Before the latest warrant exercise, Constellation already invested twice in Canopy:
- October 30, 2017: Constellation announced its initial investment in Canopy whereby it acquired 9.9% for $245 million at $13.0 per share; the same number of warrants were issued at the same price.
- August 15, 2018: Constellation announced another ~$5 billion investment whereby it acquired 104.5 million shares of Canopy at $48.60 per share, a 51.2% premium to Canopy's closing price; Constellation also acquired 139.7 million warrants exercisable at $50.40.
The initial investment in 2017 was instrumental in kickstarting an investor frenzy in cannabis stocks that lasted through early 2019 before everything came crashing down. The second investment in 2018 was much larger and solidified the financial linkage between both companies. However, things have gotten much harder as several years of underperformance at Canopy is making Constellation investors nervous. While it is important to keep in mind that despite the challenging outlook for Canopy, the investment remains a relatively manageable portion of Constellation's overall business which has a market cap of US$32 billion. Nevertheless, with close to US$5 billion of cash sunk into its cannabis bet already, we think Constellation is eager to manage the investment to avoid further losses and salvage as much of its capital as possible in the long term.
An important implication for Canopy shareholders and the company is that Constellation will push to improve Canopy's near-term performance and avoid risky bets. The first step was the appointment of its own veteran David Klein in December 2019 as Canopy's new CEO, replacing founder Bruce Linton. In April 2020, the company announced a slew of downsizing actions to roll back many actions took by the previous management team. We think this is the beginning of a tough period for Canopy as it walks back many side bets and previous strategic mistakes to focus on becoming a self-sustaining company one day.
Cash Is King
It is never more true than this time that cash could make or break a cannabis company's prospect. In 2020 so far, both Canopy and Cronos (CRON) have managed to outperform the popular Horizons Marijuana ETF (HMLSF) and other Canada-based large-cap cannabis operators with their billions of cash from corporate sponsors. We think investors are growing ever more bearish on the sector as a whole and most expect the weaker and financially fragile players to be eliminated in due course. Aurora (ACB) and Tilray (TLRY) are two of those weak players that will likely face continued headwinds both operationally and from investors.
Despite the large cash balance, Canopy is urgently in need of strategic retooling to avoid running out of cash. Although Constellation has put in almost $5 billion of cash, Canopy only had $2.2 billion left at the end of 2019. Meanwhile, the company continues to burn through millions of cash each day as its sales are far from enough to pay for its expenses. For example, Canopy spent $150 million on SG&A during the last three months of 2019 while it only generated net sales of $124 million and gross profit of $42 million. In the two strategic overhauls announced in March and April, Canopy made the following adjustments to its global operations:
- Shutdown the indoor facility in Yorkton, SK and its two largest greenhouses in British Columbia totaling 3.1 million sq ft
- Scrap plans for another greenhouse in Niagara
- Exiting its African business
- Cease farming operations in Colombia and the United States
- Eliminate ~1,000 positions across multiple functions
- Incur pre-tax charges of $700-800 million
Clearly, Canopy realized that its expensive greenhouses are nothing but redundant under the oversupplied market in Canada. We have repeatedly predicted that the Canadian market will become oversupplied years ago and we even warned investors of the extremely poor decision to purchase the two B.C. greenhouses for $500 million in our analysis "BC Tweed Buyout Is A Ticking Time Bomb". With the largest production footprint eliminated in Canada, it is clear that the company will focus on an asset-light strategy by utilizing outdoor cultivation and third-party purchases to cut costs and improve margins. However, we think the recent announcement is not enough and Canopy needs to further downsize to even have a chance of becoming profitable. We expect Canopy to eliminate a large number of its workforce and slash discretionary spending in the coming months as it tries to cut back on its $150 million quarterly SG&A expense. To improve profitability, there are only two ways: either improve sales or cut costs. Given Canopy has so far failed to increase sales fast enough, it is logical to continue downsizing and scaling back sporadic bets made by the previous management.
We think Canopy is one of the most defensive cannabis stocks given its fortress balance sheet and sponsorship from alcohol and beverage giant Constellation Brands. However, the company has spent billions on bets that are now being slowly unpicked by the new CEO in his bid to restore financial discipline and stem cash bleedings. We think the recent downsizing is just the beginning of a period of tightening that will see Canopy becoming a smaller, leaner, and less diversified company. Instead, the company will likely focus on divesting capital-intensive farming operations and developing consumer products and brands to mimic the strategy in other consumer products industries. We expect the market condition to remain tough for Canopy and investors could await better entry opportunities. When Constellation exercised its warrants last week, Canopy's shares failed to rally as it typically did in the past on similar actions that speak to the growing investor apathy towards the cannabis sector after a painful 2019 and 2020 thus far. Given that Canopy will remain in its downsizing and cost-cutting mode for the next little while, we think investors should stay on the sidelines until a new strategic plan is clearly laid out.
This article was written by
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