Canopy Growth Stock Suddenly Has Become a Turnaround Play

From a broad standpoint, the case for Canopy Growth (NYSE:CGC) stock has been relatively simple. Specifically, the argument has been that CGC stock offers the simplest way to play the cannabis boom, largely thanks to the multi-billion dollar investment in the company by Constellation Brands (NYSE:STZ,NYSE:STZ.B).

CGC Stock Suddenly Has Become a Turnaround Play
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That US$4 billion investment gave CGC a war chest it can use to capitalize on opportunities. The funds enable the company to execute acquisitions to build out its business, and it already has tied up with U.S. operator Acreage Holdings (OTCMKTS:ACRGF). Additionally, the cash  has enabled CGC to develop its distribution and processing capabilities.

In theory, Canopy can go wherever cannabis demand is growing. And bulls saw plenty of growth coming for the industry.

Canopy’s Outlook Has Deteriorated

That story now looks broken. The industry on the whole doesn’t look quite as healthy as optimists had hoped. Canopy appears to be losing market share in Canada. The combination has pressured Canopy Growth stock, which has fallen by half in a little over four months.

There’s a case to buy CGC stock after its decline, and indeed some investors have done just that in recent sessions. The long-term opportunity provided by Canopy Growth stock still looks reasonably intact. CGC even looks potentially cheap from the right angle. Its execution can, and perhaps should, improve.

But for the shares to rise, Canopy Growth is going to have to regain the confidence of investors. To do that, Canopy will need to improve itself, and it may need some external help as well.

CGC Stock Falls (Again) After Its Earnings

There are several reasons why Canopy Growth stock has steadily dropped since late April. For one, the entire sector has sold off.

Major cannabis plays like Cronos Group (NASDAQ:CRON), Hexo (NYSE:HEXO), and Aurora Cannabis (NYSE:ACB) all have dropped at least 19% in the last three months. Aphria (NYSE:APHA) posted probably the sector’s best earnings report this year and is up just 5% over the past quarter. However, it’s still  down about one-third from its April highs.

But that alone doesn’t explain the pressure on Canopy Growth stock. It’s been the worst performer among major marijuana stocks over the past three months, dropping 36%. And the company’s last two earnings reports have been a key factor in the decline of its shares.

In fiscal Q4, its cannabis revenue surprisingly declined quarter-over-quarter. In Q1, Canopy’s sales did rise compared with the previous quarter . But its revenue still missed expectations, and the company also booked a C$8 million reserve for customers’ returns of oil and softgel products.

Its gross margin of 15% seems far too low. Even excluding about 17 percentage  points of pressure from factories that were either underutilized or not yet producing, its 32% gross margin was notably weaker than its recent performances.

Two quarters don’t necessarily make a trend,  but they’ve been more than enough to worry investors. CGC’s revenue growth is slower than that of  its peers. Its margins and profitability have been disappointing. The company was  supposed to be the undisputed leader in cannabis, particularly in Canada. Its rivals are catching up in terms of revenue and Canopy, at least in the early going, is much less profitable than investors had hoped.

Industry Worries Add to the Pressure on Canopy Growth Stock

The issue is that Canopy’s earnings match some of the concerns facing the industry as a whole. The growth of recreational cannabis in Canada has been slowed by permitting backlogs, leading to much lower-than-expected overall sales.

Production continues to ramp across the sector, leading to worries about oversupply and pricing pressure. Canopy’s forecast of overly saturated oils and softgel markets  – which should be higher-margin products – augments those worries. So does a big price decrease by Tilray (NASDAQ:TLRY) the day before Canopy’s fiscal Q1 release.

The takeaway from Canopy earnings – and those of the sector – is that maybe this business isn’t quite as attractive as bulls had thought a few months ago. Cannabis companies’ long-term profit margins may be lower than expected. Movement on legalization outside of Canada has been modest. In Canada, the sheer number of players means “race to the bottom” pricing may pressure companies’ near-term results.

All told, worries are mounting. And with CGC, even net of cash, trading at something like eight times average fiscal 2020 revenue estimates, it’s not surprising that the stock has pulled back.

How CGC Stock Can Rebound

All that said, bulls can – and do – argue that the long-term outlook of CGC stock  really hasn’t changed all that much. Canopy still has its war chest, with US$1.5 billion of cash net of debt. Its production leads the industry. The weakness of its earnings per share isn’t a surprise; indeed, it’s part of the plan, as Canopy extends its capabilities in flower and  derivatives, and develops its supply chain.

Canopy is looking to redefine the vaping experience, as management detailed on the company’s Q1 conference call. It has a presence in the medical and pharmaceutical end markets. It’s entering the U.S. CBD market, and can participate in that market via Acreage when and if the federal government legalizes cannabis.

Even the company’s long-term financial targets remain intact, including guidance for EBITDA profitability (excluding some items)  in FY22. So what really has changed?

The answer is confidence, in terms of both Canopy itself and the industry as a whole. Clear market-share losses at this early stage are a real concern. So are potential price declines for cannabis flower, and weaker-than-expected demand for derivative products. Canopy is reiterating its targets, but investors are less likely to believe them.

Simple sector momentum no longer can carry Canopy Growth stock higher. The “easy” bull case of buying the leader in the space doesn’t make sense if investors worry the company won’t be the leader in the long-term. Canopy Growth – and the industry as a whole – need to answer key questions before investors can become confident in CGC again, and before CGC stock can rally.

As of this writing, Vince Martin has no positions in any securities mentioned.

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