Canopy Growth Stock: Should CGC Investors Err on the Side of Caution?

As CGC stock price loses momentum, it is just too bumpy to consider buying right now

Investors in the cannabis sector are well aware of how volatile the stock price of Canada-based Canopy Growth (NYSE:CGC) and its peers can be. They were not impressed with CGC’s fourth-quarter results for the three months ended March 31, 2019, as shares dipped below $40 following the report’s release in June.

Canopy Growth Stock: Should CGC Investors Err on the Side of Caution?
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Now that the CGC earnings season is behind us, let’s look at what may be next for Canopy Growth stock, particularly within the context of marijuana legalization in Canada and the U.S.

Canada Was the First G7 Nation to Legalize Marijuana

Canada stepped into the spotlight in 2018 when it passed the Cannabis Act and became the first Group of Seven (G7) country to decriminalize the use of marijuana for medical and recreational purposes. The G7 consists of Canada, France, Germany, Italy, Japan, the United Kingdom and the United States. It represents almost 60% of global net wealth.

The general public does not know the difference between cannabis, marijuana, and hemp very well. Therefore people often use the three terms interchangeably.

In short, cannabis is the botanical name of the plant species. The plant has different strains, one of which is hemp, and the other which is marijuana. This is why hemp and marijuana are sometimes referred to as “cousins.”

Industrial hemp has naturally high levels of cannabidiol (CBD) and low levels of tetrahydrocannabinol (THC). Marijuana has high levels of THC and lower levels of CBD.

THC is the crystalline compound behind the “high” from smoking marijuana. CBD does not have the psychoactive properties of marijuana and is used by consumers seeking relief from physical pain. Hemp cannot contain more than 0.3% of the psychoactive ingredient THC.

There is a high degree of social stigma surrounding the use of cannabis for both medical and recreational purposes.

Canadian Provinces Hold Veto Power

Canada is also the second country in the world, after Uruguay, to legalize recreational marijuana at the federal level. The legal age is set at 18 years.

However, individual Canadian provinces can still ban recreational use; yet, residents across Canada can order cannabis online from a government-run website.

Therefore, the need for illegal purchases by consumers disappear and the Canadian government can generate revenue through an excise tax of 10% or C$1 per gram (whichever is higher) of which 75% goes the provinces.

There is also a provincial sales tax, ranging from 5% to 15%. Cannabis cultivators and manufacturers are required to obtain a licence from the Canada Revenue Agency (CRA). Since legalization, Canadian regulators have been granting operational licences continuously.

Canopy Growth Has Become One of the First Green Pioneers in Canada

Over the past year, Canada has witnessed a wave of innovation and entrepreneurship. Canopy Growth became the first federally regulated, licensed and publicly traded cannabis producer in the country and started trading on the Toronto Stock Exchange (TSE) in 2016.

Since completing a dual listing at the New York Stock Exchange (NYSE) in May 2018, CGC stock has attained a market cap of $14 billion and become a diversified cannabis and hemp company with the largest market cap. The group has a wide range of brands ranging from medical marijuana to premium strains of weed.

In Aug. 2018, when the alcoholic beverages giant Constellation Brands (NYSE:STZ) announced a $4 billion investment into CGC, Wall Street took notice and shareholders rejoiced. STZ now holds a 38% stake in the company.

Since being listed in the NYSE, the number of funds that own CGC stock have been going up. Some of the institutional owners include The Vanguard GroupBank of Montreal (NYSE:BMO), and Morgan Stanley (NYSE:MS).

CGC stock’s main competitors include Aurora Cannabis (NYSE:ACB), Tilray (NASDAQ:TLRY) and Cronos Group (NASDAQ:CRON), all Canada-based companies.

Canadian Weed Industry at Present

The recent earnings reports from CGC as well as its peers are important in gauging the health of the industry, as not everyone is convinced that Canadian recreational pot sales will remain strong. Many investors are worried that the initial hype surrounding the industry could be decreasing.

Since legalization in October 2018, Canadian sales numbers have been muted without any signs of increasing. In 2019, the total cannabis market in Canada, including both legal and illegal recreational and medical sales, is expected to be around C$7.2 billion. About half of it is likely to come from legal sales.

Analysts note that sales from the black market in Canada have been slowly shifting to legal online sales, i.e., to the retail sites of CGC and other major companies in the industry. If the trend continues, then the market expects Canopy Growth stock’s sales to increase further.

However, illegal dealers have been fighting back by lowering prices to keep their market share.

Many market watchers are also expressing concern that the Canadian market is currently running the risk of being oversupplied. Is all this capacity truly needed, given that export volumes are not expected to meaningfully offset oversupply, either? Canopy Growth harvests more than what it sells, resulting in higher inventory balances for the company.

Simple economics tells us that a supply glut would eventually drive down the price of marijuana along with CGC’s and its peers’ margins.

In other words, the legalized marijuana industry is still in its infancy in Canada and almost non-existent globally. Leaders like Canopy Growth are likely to become the first ones to be positively affected by major North American or global developments that may boost the sales and use of recreational or medicinal marijuana. But they could also be hit hard if fears of oversupply come to fruition.

Legalization Developments in the U.S.

In December 2018, the U.S. Congress passed the Farm Bill legalizing hemp and CBD, which President Donald Trump later signed into law.

Because hemp is now an ordinary agricultural commodity in the U.S., farmers can apply for federal hemp cultivation permits. In January, Canopy Growth announced that it obtained a license to process and produce hemp products in New York State.  It will establish a hemp industrial park for extraction and product manufacturing. CGC’s operational investment will be between $100 million and $150 million.

Although it is too soon to predict how the legal hemp production in the U.S. will affect CGC stock’s bottom line, analysts believe the partnership between Canopy Growth and Constellation Brands is the area to watch. The two are currently developing cannabis-infused beverages for Canada, where experts believe such drinks will be legal by 2020.

Canopy Growth could decide to enter the U.S. CBD-infused drink market with a wellness beverage. Some industry watchers are expecting big developments and numbers in this niche market, like reaching $260 million in a few years in the U.S. alone.

Wall Street believes CGC and its peers will seize upon the market expansion opportunities that legalized hemp provides. However, it will probably be several quarters before the investments would pay off and turn into profits.

Will the U.S. Legalize Marijuana at the Federal Level?

At the federal level, marijuana is still illegal in the United States and remains a Schedule I drug. However, at the state level, the legal status of marijuana depends on the laws of the individual state.

Legalization allows for both individual marijuana possession as well as the legal production and sale of the drug. Legalization can happen in two categories: the legalization of recreational marijuana or the legalization of medical cannabis.

As both recreational and medicinal use are becoming more widely accepted, the number of U.S. states that have legalized it has increased. Medical cannabis is now legal in 33 states and the District of Columbia.

Recreational marijuana is legal in 11 states, i.e., individuals require no prescription to use marijuana in these jurisdictions. In 2012, Colorado was one of the first states to legalize recreational marijuana. Illinois is the most recent addition to the list.

The “Big Four” states, i.e., California, Colorado, Oregon, and Washington, have the majority of legal recreational cannabis sales.

It is important to underline that none of the Canadian cannabis stocks have done any business in these pot-friendly U.S. states, as the listing requirements at the NYSE as well as at the TSE bar companies from engaging in commercial activities in countries where they would be breaking the law.

It would not be wrong to assume that if the U.S. federal legalization of marijuana occurs, it could create a rush by Canadian firms that have been previously unable to enter the U.S. market. The U.S. could become the largest marijuana market globally if legalization happened at the federal level.

U.S. marijuana sales could easily reach $75 billion by 2030.  Investors are hoping that Canopy Growth would have a first-mover advantage in such a scenario.

How Does Canopy Growth Make Money?

Since the company went public, investors have been enamored with CGC stock. Following Canadian legalization, the company initially became a darling among investors partly because it already had operations up and running, with several facilities creating products for Canada as well as about a dozen other countries.

As a result, many investors became rather optimistic about the prospects for the cannabis industry and specifically for Canopy Growth stock.

In 2019, global legal cannabis spending is expected to reach almost $17 billion, a year-over-year (YoY) increase of over 35%. Canopy Growth, which aims to capture an important part of this growth, has three key target markets:

  • Canadian Consumer (i.e., retail recreational)
  • Canadian Medical
  • International Medical

In general, of these three areas, Canadian retail recreational is the most important one for the industry. Similarly, in the U.S., only about 20% of sales come from the medical side.

Sales to the Canadian recreational cannabis market generate most of CGC’s growth. Yet the company remains one of the leaders in the medical cannabis segment. However, Canada’s second-largest cultivator, Aurora Cannabis, which stands out as a low-cost operator, is regarded as a leader in the medical cannabis segment as well.

Canopy Growth currently has operations in over a dozen countries in five continents. In the long run, CGC’s investments in these overseas markets are likely to give it a head start globally, too. However, the details about the worldwide operations are somewhat sketchy as they do not yet contribute to revenues very much.

Canopy Growth is investing heavily in production, fulfillment, marketing and general administration, as well as in international operations. Fiscal 2019 has seen Canopy harvest 46,927 kilograms for fiscal 2019, more than double the 22,513 kilograms produced a year earlier. Management has been constantly emphasizing that the company is getting ready for the legalization of cannabis edibles in Canada, expected in a few months.

CGC Stock’s Q4 Earnings Raised Concern

In the June 21 quarterly report, analysts paid special attention to the sales figures and the level of operational loss. The results showed declining cannabis sales and plummeting gross margin.

Its gross recreational cannabis sales of C$68.9 million was nearly 4% lower than a quarter ago.

Analysts were concerned to see that CGC’s Canadian medical cannabis sales in Q4 declined to C$11.6 million, a 41% decrease from Q3. There was a similar decline in Canopy Growth’s international medical cannabis Q4 revenue of C$1.6 million, which meant a 25% YoY decrease.

In total, Canopy Growth’s revenue net of excise taxes came in at C$94 million, or 13% higher than last quarter and a 312% jump YoY. Analyst revenue estimate had been US$93.7 million.

This revenue increase was actually due to non-cannabis sales. The main driver was the acquisition of Germany-based vaporizer maker Storz & Bickel. Without this ancillary revenue contribution, Canopy Growth’s quarterly revenue would have been C$70 million, a 16% decline from the previous quarter.

Investors are now seriously questioning whether CGC and its peers can achieve much growth in revenue in this subdued Canadian cannabis market.

Wall Street is also concerned about the declining gross margin which now stands at 16%. That number was below the expectation of 24%. As further comparison, CGC’s gross margin in Q1 2019 was over 40% and the gross margin reported by its main rival Aurora Cannabis is about 55%.

The group’s net loss increased on the back of expanded investments. Q4 results showed a net loss of C$323.4 million, or C$0.98 per share. Last years’s comparable numbers were a net loss of C$54.4 million, or C$0.31 per share.

The group’s fiscal 2019 net loss has ballooned to C$670 million; it stood at C$54 million a year earlier.

Considering Canopy Growth’s expansion plans both in Canada and overseas, its bottom line results could get a lot worse before they get better. Is CGC’s business model sustainable?

Following the report, CGC stock dropped 8% to below $40. But over the past few trading sessions it has recovered some of its losses.

High Industry Valuations

As CGC’s numbers did not come out as high as expected, there are questions regarding the valuation of Canopy Growth stock and the cash-intensive industry as a whole.

Like its peers, CGC has high operating expenses. The red ink at the bottom of its income statement, quarter after quarter, is becoming a worry for shareholders. If the international cannabis market does not grow as expected, then Canopy Growth’s stock price could experience further selling pressure.

Investors are beginning to get concerned about how increased spending is reducing earnings and cash flow numbers. So far, cannabis stocks have been largely driven by hype and publicity, such as the investment by Constellation Brands in CGC.

Many analysts are concerned that the valuations in this new consumer market are extremely high, that most of the cannabis stocks are going through cash fast and that many are not likely to achieve profitability in the near future. Have the share prices for most marijuana companies gotten ahead of themselves?

In January, CEO Bruce Linton said that Canopy Growth did not plan to acquire any more Canadian cannabis assets. The company is possibly regarding the growth levels in Canada as not enough for such ambitious expansion plans.

If further growth doesn’t come from the rest of the world, Wall Street is likely to start devaluing most of these pot companies substantially. Thus, if there were legal issues regarding legalization of marijuana at the federal level, the industry would take a hit.

One important benefit of the investment by STZ, which now has a 38% interest in CGC, is that Canopy Growth has the financial muscle to pursue acquisitions and invest in research and development (R&D) to grow its production space. However, not all potential deals are likely to benefit CGC shareholders immediately.

For example, the group has an agreement in place to acquire U.S.-based Acreage Holdings (OTCMKTS:ACRGF) for $3.4 billion. This acquisition can only happen if cannabis is legalized federally in the U.S. Should investors give Canopy Growth a blank check for an open-dated deal?

Can investors regard the current concerns as hiccups in a growing industry, or are there enough signs that cannabis stocks could be in a bubble?

Shorter-Term Technical Analysis of CGC Stock

Year-to-date, Canopy Growth shares are up over 48%. Since late April, however, there has been selling pressure on CGC stock.

Investors who look at the CGC stock chart may be raising their eyebrows, as the stock is currently down from a 2019-high $52.74 reached on Apr. 29, to the low $40’s.

In other words, Canopy Growth shares have lost more than a third of their value since late April. The downtrend since this spring is a stark reminder that CGC’s all-time high of $$59.25 from Oct. 2018 is now in the rear-view mirror.

Those who bought at the high might not be too happy, but investors who had the courage to step in at the end of 2018 when CGC stock saw $25.26 are still in pretty good shape. If you are an investor with paper profits, should you consider locking in some of those gains now?

At present, the short-term technical charts, especially the trend lines and support and resistance levels, are telling investors to exercise caution.

Although Canopy Growth stock’s momentum indicators, which describe the speed at which prices move over a given time period, are currently in oversold territory, they can stay oversold for quite a long time, especially when the overall trend is down.

CGC stock’s short-term technical chart looks weak, pointing to the possibility for more downside around the corner. Expect nearer-term trading to be choppy at best.

If there is any broader market weakness in Canadian stocks, say due to market worries over U.S.-China trade wars, Canopy Growth share price may be further adversely affected.

At this point, bears are in control. Therefore CGC shares will need a catalyst to make them attractive in the eyes of long-term investors, who are probably still skeptical about the near-term prospects for the company.

If you are considering investing in Canopy Growth, you may want to start building a position between the $27 to $32 levels, and expect to hold the stock for several years. In the meantime, expect a lot of volatility in CGC share price.

Other Ways for Investors to Participate in the Industry

Risk and return go together when it comes to investing. Where there is a potential return, there is also a potential loss. And different investors have different financial goals and risk tolerances.

For more risk-averse investors, cannabis stocks may not be appealing because of their high-risk levels and volatility. However, investors who are able to take on more risk might be comfortable buying into marijuana stocks such as CGC.

Investors who do not want to take on the company-specific risks associated with investing in individual stocks, may consider alternative ways to participate in the industry.

Our readers may be interested to know that a 2018-report by the United Nations (UN) revealed that Britain is the biggest producer and exporter of legal cannabis in the world. In 2016, the UK produced 95 tonnes of marijuana and exported 2.1 tonnes.

Virtually all of that is through exporting one drug, Sativex, produced by UK-based GW Pharmaceuticals (NASDAQ:GWPH), a leading cannabinoid-focused biotech company. In 1998, the company obtained a unique domestic licence in the UK to cultivate cannabis seeds.

GWPH now produces Sativex to treat spasms in multiple sclerosis patients.  Last year the company obtained U.S. regulatory approval of its CBD drug Epidiolex for the treatment of epilepsy.

GW Pharmaceutical’s share price has gone from about $10 in 2013 to an all-time high of $196 in May 2019. Currently it is hovering around $165. A biotech company such as GWPH is a secondary way to invest in the CBD market.

Exchange-trades funds (ETFs) also offer an alternative opportunity to buy into the shares of Canopy Growth and its peers. These ETFs provide more diversification than buying into the CGC stock by itself. The following ETFs may be of interest to potential investors:

  • ETFMG Alternative Harvest ETF (NYSEArca:MJ)
  • AdvisorShares Pure Cannabis ETF (NYSEARCA:YOLO)
  • AdvisorShares Vice ETF (NYSEARCA:ACT)

Investing in cannabis-related ETFs would enable investors to take a long-term view on a growth industry that is likely to reach tens of billions globally in a decade or two.

Finally, in order to have more limited exposure to the volatility in the industry, investors could also consider buying stocks companies with a core business outside the cannabis industry. An example would be buying Constellation Brands, which already has about 38% ownership of CGC stock.

The Bottom Line on CGC Stock

In 2018, the marijuana industry gained validation in Canada. So far, Canopy Growth has been one of the main beneficiaries of the legal developments in Canada. However there is still a lot of confusing hype surrounding the U.S. market potential for industry leaders like CGC.

Investors may have to wait until the earnings reports of CGC’s peers are released in the coming weeks to have a better view on the developments in the industry as they affect these marijuana stocks.

For Canopy Growth stock, it may be a long and choppy journey back to the all-time high of $59.25, as rich valuations in this commodity-based consumer market could take a hit in the coming months.

There might also be profit-taking and investor uncertainty about the general markets as well as the weed industry. As we move along the second half of the year, could investors become more risk-averse and shy away from these high-growth yet potentially risky stocks for their portfolios?

If you are not yet a shareholder of CGC stock, you may want to wait on the sidelines in the coming weeks until you are able to do more due diligence on Canopy Growth, considering both the bull and bear arguments.

If you already own CGC shares, you may consider hedging your position with at-the-money (ATM) covered calls with July 19 or August 16 expiry.

As of this writing, Tezcan Gecgil did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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