Roughly a month ago, I cautioned that while cannabis name Canopy Growth (NYSE:CGC) may have been an indirect winner on Election Day, CGC stock was still held hostage by sentiment. Hype was the foundation for the stock’s bullishness earlier in the year, but once the hype fades — and it always does — you’re often left with a disconnect between the stock’s value and its price.
We just caught a glimpse of how this vulnerability can prove problematic. Macquarie downgraded Constellation Brands (NYSE:STZ) late last week almost entirely because of its sizeable investment in Canopy Growth. The beer, wine and spirits company bought $4 billion worth of CGC stock in April, setting the stage for product-development partnerships, but loading it with what could be a losing equity stake.
It’s a problem, simply because Macquarie’s STZ stock analyst didn’t pull any punches about CGC’s weaknesses. Rather, Macquarie just made it easier for other analysts to also voice concerns.
What She Said
As the old adage goes, if you live by the sword, you die by the sword.
Clearly, there are no sword fights when it comes to the stock market (at least not yet), but the point is still a valid one. When hype and hysteria get too far out in front of actual results and plausible profits, when that pendulum swings back in the other direction, it can hurt.
CGC stock has actually held up pretty well against the criticism, all things considered. But with the first downgrade on the books, it becomes much easier for other analysts to express similar doubts about the future value of Constellation’s investment.
Macquarie analyst Caroline Levy’s exact words were, “Brand-building will be costly and unpredictable. It thus seems difficult to see any near-term profits for Canopy and possibly subpar returns for many years, if it continues to prioritize sales growth and market share.” Levy went on to concede “Branding will be key to unlocking value in cannabis business,” but added “the winners are far from clear.”
Those other winners could include rivals like Aurora Cannabis (NYSE:ACB) and Tilray (NASDAQ:TLRY), though the race has only just begun. Any player could come out a winner, including one that’s yet to go public or even start up.
In a vacuum, Levy’s comments in and of themselves wouldn’t be damning.
They weren’t offered in a vacuum though. They were delivered in an environment that’s over-rewarded pot stocks to investors with relatively short attention spans. In that environment, a comment like “It thus seems difficult to see any near-term profits for Canopy and possibly subpar returns for many years” could be something that gnaws at investors, chipping away at the fragile foundation under CGC stock. Nobody will see it buckling, if that’s what’s in the cards, until it’s too late.
The comments also lets other less-daring pros start to weigh in against a relatively underfollowed Canopy Growth stock.
On the Other Hand…
The great irony and frustration for current and prospective owners of CGC stock is that the cannabis movement isn’t a mere fad that will fade away like pet rocks or Cabbage Patch Kids. Marijuana has been around, and in use, for ages despite its illegality. If it was going to evaporate, it would have done so by now. Indeed, researchers have only scratched the surface of the use of cannabidiol as a legitimate medicine. Marijuana, in one form or another, looks to be the best solution to the opioid epidemic.
Putting some quantitative data to the qualitative idea, the global cannabis market now stands at almost $200 billion… much of that being illicit. As new, non-psychedelic uses are created though, the market size could expand tremendously.
That’s where Constellation and Canopy say they aim to meet up, looking to develop cannabis-infused beverages.
Levy even acknowledged, “After attending the recent 27,000-person-strong MJBiz Conference in Vegas, we believe the market for cannabis and hemp products will indeed be extremely large; the U.S. is likely to decriminalize cannabis in the not-too distant future, potentially opening up a huge market.”
Bottom Line for CGC Stock
There’s the rub, and challenge, for interested investors.
The rise of legalized cannabis will probably drag some of these players out of the red and into the black. But, if Levy’s worry that Canopy Growth could drive “subpar returns for many years, if it continues to prioritize sales growth and market share” ends up being on-target, it’s unlikely the market will continue to indefinitely hold onto a stock that’s trading at 165 times its trailing sales while waiting for profitability that may never actually materialize. Once marijuana is proven as a viable, sustainable, profitable business model, bigger and better-funded competition will crawl out of the woodwork, making cannabis a commodity.
And that’s 165 times sales, to be clear — not earnings. For perspective, the marketwide average P/S ratio usually between 2.5 and 3.0.
Only time will tell, but it’s not like we’ve not seen these kinds of hype-driven stories derailed before. Blue Apron Holdings (NYSE:APRN) and Fitbit (NYSE:FIT) come to mind.
Yes, hype has set bar has been set uncomfortably high for Canopy Growth stock. Even the best of growth outcomes for the next few quarters may look and feel like a relative disappointment. In the meantime, more warnings like Levy’s will only serve to underscore how risky any level of investment is in Canopy and its peers.
But Constellation’s $4 billion investment? Remember, Constellation gets a certain level of control and locks up future product developments with its stake, which first and foremost serves Constellation and its shareholders. It doesn’t need Canopy Growth to be profitable to make a profit on its relationship with the budding marijuana company.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can follow him on Twitter, at @jbrumley.
