Canopy Growth (NYSE:CGC) is arguably the premier name among marijuana stocks. Not only did it validate the entire marijuana movement in August of last year when Constellation Brands (NYSE:STZ) became a major shareholder, CGC stock is the top-performing cannabis name in recent months. Canopy Growth stock is rallying again too, on the verge of rivaling last year’s peak level.
Be wary of jumping on board this rising rocket, though. Even if CGC stock is currently advancing, the euphoria is wearing off … and the same thing that’s made Canopy Growth stock so compelling may end up being the very thing that upending it.
Of course, the industry-wide undertow isn’t helping to bolster the bullish argument either.
The concept is simple enough. The legalization of marijuana in Canada and certain parts of the United States has created an instant market for outfits that can supply it. Investors plugged in, putting names like Cronos Group (NASDAQ:CRON), Tilray (NASDAQ:TLRY) and Canopy Growth under a spotlight so intense, no one could have expected it just a couple of years ago.
As was the case with the dot-com companies in the late-90s, housing in 2007, gold in 2011, oil in 2014 — and the many more manias that have come and gone in the past couple of decades — excited investors looked past the fact that these businesses eventually have to turn a profit.
Most pot stocks aren’t profitable, and Canopy Growth most definitely isn’t. CGC logged an operating loss of $157 million on net revenues of $83 million in its most recently reported quarter. The top line nearly quadrupled, but gross margins fell by a quarter. Operating expenses almost quadrupled as well.
CGC stock backers will argue — and correctly so — that an organization has to spend money to make money. To that end, Canopy Growth has made nine major purchases within the past several months; gross margins and operating profits generally don’t fully reflect the cost of acquisitions.
More than that, it’s spending big at a time when the legal pot market is already running into a headwind.
Costs Rising, Prices and Demand Falling
The string of operating losses in the midst of what’s largely been seen as a marijuana revolution is illuminating. It highlights a stark reality that many investors refused to consider … that is, while the cost of growing cannabis varies, so does the market price. The law of supply and demand dictates the greater the supply, the lower the price.
This is precisely, albeit modestly, what we’ve seen take shape in recent months, with more of the same on the way. Canopy Growth’s average selling price per gram $7.33 per gram (Canadian) was down 12% year-over-year. Cannabis Benchmarks forecasts that cannabis prices will continue to dwindle, losing roughly another 8% of its current value by October.
Once a black-market plant that couldn’t be grown in bulk, marijuana is now a commodity, and given time will decline in value to its lowest sustainable price that will be dictated by major farming operations.
At the same time the price of cannabis is being commoditized, Canopy Growth faces a steep cost-cutting hill.
Cowen analyst Vivien Azer explained following February’s Q3 earnings report:
“While industry disclosure around gross margin can vary from company to company, for Canopy, cash cost of goods sold per gram of $5.11 looks to be meaningfully higher than its peers, having climbed 15 percent sequentially.”
Underscoring Canopy Growth’s cost red flags is Tilray’s similar rise in costs a quarter ago. The kicker: While all the rage in October of last year when Canada legalized recreational marijuana, cannabis sales in Canada fell — sequentially — in January and then again in February.
The buzz, no pun intended, appears to be wearing off as cannabis becomes ‘just another business.’
Bottom Line for CGC Stock, Others
Last year was a splashy one for marijuana stocks. Investors may not remain as stoked this year, as reality starts to set in. That’s not inherently a clarion call to shed any and all positions in CGC stock and never return to it (although Canopy Growth stock is overbought and ripe for profit-taking).
Marijuana is a real product with real demand, and legalization in the United States is almost an inevitability. Canopy Growth can find a place in the future of the business, even if only as a subsidiary of a bigger, industrialized ag player.
Between now and then though, these companies face a challenge they’ve not faced before … they’re going to have to prove that all the heavy spending will bear fruit and that they didn’t overstate the profit potential of cannabis. This is especially true of Canopy.
Given the current pricing and cost trends, that’s not going to be easy to do.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can learn more about James at his site, jamesbrumley.com, or follow him on Twitter, at @jbrumley.