Jefferies Financial (NYSE:JEF) analyst Owen Bennett downgraded Canopy Growth (NYSE:CGC) on Oct. 11 from a “buy” rating to “underperform,” while also cutting the target price from C$77 to C$25, a major blow to one of Canada’s leading cannabis companies.
The analyst based his downgrade on a trio of factors: weak margins and a lack of profits, no near-term catalysts, and “question marks” surrounding the future success of cannabis-infused drinks.
“With a number of negative headlines impacting the sector the last 6 months, and still with little sign of profitability, the sector has seen greater risk/volatility priced in,” Bennett and fellow analyst Ryan Tomkins wrote in a note to clients.
With Canopy Growth stock down 43% over the past three months, it’s easy to see why so many professionals are recommending clients stay on the sidelines. While it’s understandable, five years from now, the idea that you could buy CGC stock for $18 will be unfathomable. Here are seven reasons why.
1. CGC Getting a New CEO
It has been three months since former co-CEO and CGC co-founder Bruce Linton was relieved of his duties. Since then, in consultation with its largest shareholder Constellation Brands (NYSE:STZ), Canopy has been searching far and wide for the right person to take it to the next level.
At the company’s annual meeting in September, interim Chairman John Bell indicated it would name Linton’s successor by the end of the calendar year. Current CEO Mark Zekulin, who will step down once a successor is named, says they have attracted interest from several industries including pharmaceuticals, consumer packaged goods, and alcoholic beverages.
The hiring of a new CEO should bring some stability to Canopy’s stock price. In August, I suggested three possible candidates that would make great CEOs. All of them might be a little too expensive for Canopy at this stage in its development. However, one can dream, right?
2. Cannabis-Infused Drinks Are Coming
The analysts at Jefferies might have some doubts about the cannabis-infused drinks market, but I sure don’t. That’s especially true after Canopy announced on Oct. 2 that it had acquired a 72% stake in Toronto-based sports nutrition company BioSteel Sports Nutrition, whose customers include 70% of the teams in North America’s four major sports leagues.
It’s a brilliant deal because it could stand on its own without the CBD and cannabis connection. However, once Canopy and Constellation lend their experience to BioSteel, you can bet that the kind of drinks it produces in the future will be attractive to both athletes and regular folk.
“BioSteel co-founder and co-CEO Michael Cammalleri is a CBD user. He understands the acceptance of CBD-based products by both professional sports leagues and consumers is changing for the positive as people realize these products provide more effective pain relief while minimizing the negative effects of prescription painkillers,” I wrote Oct. 4.
Canopy and Constellation can take BioSteel to the next level.
3. Retail Stores
It’s no secret that the rollout of cannabis retail stores across Canada has been a slow, arduous process. Especially in Ontario where the Ford and Wynne governments totally fumbled the ball.
In mid-September, the province of Alberta had granted 283 licenses to brick-and-mortar retail. Calgary, with 1.3 million people, had 57 retail cannabis stores compared to five in the city of Toronto.
Five cannabis shops for a population three times Calgary’s. Ridiculous.
“We need more. We need to be much more on a par with Alberta than where we are in Ontario now and we’re getting at that. There’s gonna be another 50 that come online sometime this year but that would bring us to 75 which is just not enough to serve the population we have in Ontario,” stated Business of Cannabis co-founder Jay Rosenthal.
The good news, if you’re a CGC shareholder, is that it leaves a lot of opportunities for the company to go direct to the consumer in its home market of Ontario.
Currently, Canopy’s Tokyo Smoke banner has 10 stores open (one in Alberta, five in Manitoba, and four in Ontario) with more to come. In addition, the company’s Tweed brand has 20 stores (six in Newfoundland, seven in Saskatchewan, two in Ontario, and five in Manitoba).
That means Canopy has 30 stores open out of several hundred across the country with many more to come in the next 12-24 months. According to data gathered over the past year, provinces with more brick-and-mortar stores such as British Columbia and Alberta experienced sales per capita 2.5 times the sales of provinces with very few stores.
Vertical integration will make Canopy shareholders money over the long haul.
Some experts believe that Bruce Linton was shown the door because of the losses that piled up under his watch.
“The magnitude of losses for [Canopy] has expanded far more than we had expected, and while we commend Linton for his vision in establishing the world’s leading cannabis company, we believe new leadership will be a welcome change,” Cowen analyst Vivien Azer wrote in a note to clients after Linton’s departure in July.
It’s easy to assume Constellation Brands CEO Bill Newlands had Linton fired because of his free-spending ways — Linton paid $600 million in Canopy stock for Hiku, the parent of Tokyo Smoke — but the reality is that Canopy needed a CEO with a lot more experience at running a global company that Linton had.
Great entrepreneur. Not-so-great operator.
As for profits, Oppenheimer analyst Rupesh Parikh believes Canopy will lose more than $500 million in fiscal 2020 and 2021. Now that Constellation CFO David Klein’s been named CGC’s chairman, you can bet the company will figure out how to spend money wisely.
If you build it, the profits will come.
5. Strong Balance Sheet
At the end of June, Canopy had net cash of $2.3 billion, 33% less than it had at the end of March. That’s the bad news. The good news is that it’s probably got 2-3 years of cash to burn before it runs out of money.
In the meantime, CGC has the rollout of edibles and cannabis-infused drinks to keep it busy over the next 12 months, not to mention the many other projects it’s working on including lobbying the U.S. federal government to legalize cannabis so it can buy Acreage Holdings (OTCMKTS:ACRGF) for $3.4 billion.
“Canopy is well positioned in the sector,” Piper Jaffray analyst Michael Lavery told Barron’s in early October. “Canopy’s strong balance sheet is an advantage vs. competitors.”
6. U.S. Legalization
As I said in the previous slide, Canopy has a standing order to buy Acreage, a U.S. multi-state operator with licenses in 20 states, 87 dispensaries, and 22 cultivation and processing sites. But it won’t happen if the U.S. federal government doesn’t legalize cannabis by the summer of 2026.
Canopy paid $300 million to Acreage shareholders as a sign of good faith. Now it must work with the U.S. company to convince whoever the president is at the time to open the floodgates.
Given the U.S. cannabis scene seems to be overtaking the Canadian industry, I find it hard to believe the powers that be will be able to resist the tax revenue pot will generate across the entire American landscape.
It’s quite possible that a decade from now, Bruce Linton’s legacy at Canopy will be the Acreage deal. Here’s what I had to say about Canopy in September:
“I believe that Canopy Growth is one of the best Canadian cannabis stocks available. However, to become a global player, it needs to be a part of the U.S. marketplace. The Acreage deal makes that a reality,” I wrote. “Federal legalization is coming, but it can’t get here fast enough.”
7. Black Market Concerns
There’s no question, at least in the first year of Canadian legalization, that the big players and their massive supply agreements have done little to put a dent in the cannabis black market. Factors for this include product shortages, few retail stores, high retail prices, poor quality, and a combination of the above.
“I don’t think we’ve had an impact on the black market at all,” said Trevor Fencott, chief executive of cannabis retail chain Fire & Flower Cannabis Co. “The customers we are seeing now are not price sensitive. I think they are brand new to the industry, don’t buy from the black market and that’s why they are willing to pay such high prices.”
Statistics Canada has found that the average price of a legal gram of cannabis in the third quarter was C$10.23, 83% higher than the same gram at an illegal dealer. As Fire & Flower’s CEO suggests, Canadian cannabis companies have to work a lot harder if they want to take away the black market advantage.
The fact that Canopy Growth is positioning itself to be a big player in the direct-to-consumer market, the next 2-3 years should see it win over some of the illegal sales as more of its own and other retailers’ shops open for business.
If the black market wasn’t so big, I’d be really concerned about the upside potential of the Canadian cannabis market. However, like the liquor business, when price, quality, and availability is equal, people will always choose legal over illegal. It’s human nature.
At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.