Shares of Canadian cannabis leader Canopy Growth (NYSE:CGC) have had a really strong 2019 so far for two big reasons. First, the global cannabis market has demonstrated upward progress through continued strong sales momentum and important legal developments. These factors imply a multi-hundred-billion-dollar market one day, raising prospects for CGC stock.
Second, Canopy has continued to dominate the Canadian cannabis market. They’ve also made strategic acquisitions and investments to similarly dominate the U.S. cannabis market (once it’s fully legal). That could represent another surge for Canopy Growth stock.
Consequently, it has become increasingly clear through the first half of 2019 that Canopy projects as the leader in a potentially massive market one day. As this bull thesis has gained visibility and traction, Canopy stock has rallied. Year-to-date, shares are up 50%.
But, the CGC stock price has also plunged 25% over the past month. Why? Because Canopy reported sub-par fourth-quarter 2019 numbers which challenge that aforementioned bull thesis.
Investors would be wise to ignore these near-term growing pains. This is a necessary, natural, and healthy reset in Canopy Growth stock. From here, shares should trade higher into the end of the year, and do so over a longer-term framework. Why? For five big reasons, which I outline below:
The Cannabis Market Will Be Huge
First, several experts project a massive spike in the cannabis market.
Despite its federally illegal status, cannabis is already a widely used drug. Indeed, current consumption trends indicate that not only has cannabis consumption risen dramatically over the past three decades, but cannabis products are now almost as widely consumed as alcoholic beverages among U.S. high school students. The global alcoholic beverage market measures well north of $1 trillion. Thus, it is reasonable to assume that, once legal, the cannabis market will eventually reach hundreds of billions of dollars.
Stifel recently pegged that market at roughly $200 billion in the next decade. You don’t have to be a mathematician to recognize the associated potential for Canopy stock.
Canopy Growth Stock Projects as the Leader in a Burgeoning Market
Second, Canopy Growth projects as the leader in that $200 billion global cannabis market.
Right now, Canopy is the unparalleled leader in the Canadian cannabis market, with over $70 million in revenue last quarter. That’s on approximately 10,000 kilograms of cannabis sold. The next biggest player is Aurora (NYSE:ACB), and their revenue base last quarter was below $50 million. Thus, Canopy is substantially larger than everyone else in the Canadian market.
Further, Canopy is loaded up with a $4 billion cash investment from Constellation Brands (NYSE:STZ). This influx gives the company ample resources to expand reach and market share through acquisitions and investments. This is exactly what Canopy has done, including making major investments into the U.S. market. Should legalization happen here, the CGC stock price is primed to explode higher.
These investments and acquisitions will continue. As they do, Canopy will maintain its leadership position as the global cannabis market expands and matures. This could spark a second major bull run in Canopy Growth stock.
Long-Term Fundamentals Support the Present Valuation
Assuming Canopy becomes the leader of the $200 billion cannabis market in 10 to 15 years, then CGC stock is presently undervalued relative to its long-term profit growth potential.
Of that $200 billion market, Canopy will likely control somewhere around 10%. That implies $20 billion in revenues. Gross margins should scale toward 50% while the opex rate should fall back toward 20%. That implies operating margins of 30%, which is roughly equivalent to operating margins at major alcoholic beverage companies today. On $20 billion in revenue, that infers $4 billion in operating profits. Taking out 20% for taxes, that equates to roughly $3.2 billion in net profits.
Based on a market-average 16 multiple, that suggests a long-term valuation target for CGC stock of over $50 billion. Let’s assume it takes around 12.5 years to get there. Using a 10% discount rate, that equates to a fundamentally supported present valuation for CGC stock of roughly $15.5 billion.
Canopy’s current market capitalization is under $14 billion. Thus, under realistic long-term growth assumptions, CGC stock is slightly undervalued today.
Strong Technical Support at $40 for Canopy Stock
The CGC stock price presently trades right around a buck above the $40 level. Moreover, shares have demonstrated this psychological marker as a key technical support line.
In early April, early June, and late June of this year, Canopy Growth stock fell to levels right around $40. Each time, shares showed significant support around the $40 level, and proceeded to bounce.
The explanation for this support? Investors, while cautious on the near-term growth picture, are still bullish on the long-term growth potential. As such, they’re not necessarily buyers with the CGC stock price above $50. However, they also don’t want to sell it down at $40.
This dynamic should persist for the foreseeable future, meaning $40 should represent solid support for the next several months. Therefore, with CGC stock presently trading at that level today, now looks like a good time to buy the dip.
The Fundamentals Will Improve in the Second Half
Two major headwinds have weighed on Canopy Growth stock over the past month: slowing growth and compressing margins. Both these trends will reverse course in the back half of 2019.
With respect to slowing growth, international regulatory patterns suggest Canada will legalize edibles, extracts, and topicals in the second half. That should provide a boost to legal cannabis demand across the entire Canadian market. Because Canopy is the leader in that market, the company will naturally benefit from that boost, accelerating growth trends.
On the margin front, gross margins have been pressured for several quarters because Canopy is building out production and capacity. Such production build-out won’t last forever. Indeed, it’s supposed to start fading later this year. Plus, management expects margins to meaningfully improve throughout the rest of the year. Helping margins will also be the sale of higher-ticket edibles, extracts, and topicals.
Overall, revenue growth should re-accelerate in the back-half of 2019 while gross margins should start expanding. That dynamic represents a reversal from the current trend. This should ultimately inspire a nice second-half rally in Canopy Growth stock.
Bottom Line on CGC Stock
Canopy Growth projects as the leader in a $200 billion-plus global cannabis market one day. Given that long-term growth potential, CGC stock is an investment you want to own for the long haul.
Thus, the strategy here is simple. Buy on weakness and hold out for the coming massive wave.
As of this writing, Luke Lango was long CGC and ACB.
