Two Key Reasons Not to Buy the Dip in Canopy Growth Stock

Cannabis bulls no doubt are tempted by CGC, but there are two important reasons to stay away

The bubble in Canopy Growth (NYSE:CGC) stock has burst. And, in retrospect, it certainly looks like a bubble. Canopy Growth stock now is down 62% from its 52-week high. A recent bounce already may be fading after a 5% decline on Tuesday.

Two Key Reasons Not to Buy the Dip in CGC Stock
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Certainly, CGC bulls would take exception to calling the stock a “bubble.” Many cannabis investors see the sector-wide selloff as dramatically overdone, and due to short-term factors.

Notably, performance in Canada, the key market for Canopy and the legal industry as a whole, has disappointed. But a regulatory backlog is at least partly to blame. The long-term outlook for recreational and medicinal marijuana worldwide remains bullish. Cannabis bulls see short-term (and short-sighted) concerns driving the recent selloff.

Meanwhile, Canopy Growth still can capitalize on that opportunity. The company retains a billion-dollar war chest thanks to last year’s investment by Constellation Brands (NYSE:STZ). Its global reach is matched only by rival Aurora Cannabis (NYSE:ACB). To put it simply, bulls still believe cannabis will be big business. And Canopy Growth, near-term stumbles aside, still is in prime position to benefit.

But increasingly the huge gains in cannabis stocks last year — driven precisely by Constellation’s $4 billion investment in CGC stock and warrants — in fact look like a bubble. That in turn weakens the case for buying Canopy Growth stock on the dip.

CGC stock, at something like 7 times next year’s revenue backing out net cash, isn’t cheap. And in that context, there are two big problems with arguing that CGC shares indeed are “cheap” simply because the stock has fallen so sharply.

Revenue, Profits and Canopy Growth Stock

There’s an increasingly obvious problem with the argument that legal cannabis will be “big.” Revenue is not the same as profit.

As James Brumley presciently noted back in April, cannabis largely is a commodity. To be sure, different strains have different effects, and therefore can target different consumer bases. But producing legal cannabis is not going to be a business with substantial profit margins.

That’s already become evident in Canada. And regulatory issues aren’t necessarily to blame. Cannabis in Canada simply is oversupplied. Similar problems led to plunging prices in U.S. state-level markets like Oregon and Washington state. The legalized market in Oregon, at the beginning of this year, had six years’ worth of unsold cannabis.

Ironically, Canopy itself has been aware of this problem. Former CEO Bruce Linton, who was pushed out this summer, said as much at the time of the Constellation investment. Linton told CNBC last August that “by 2020 or 2021, there will be too much cannabis produced” in Canada. That prediction already looks optimistic.

As a result, Canopy is looking toward higher-margin segments of the market. It’s aiming to be a leader in vaping. It acquired retailer Hiku Brands last year.

But it’s not as if it has any of those markets to itself. Competition is intense across the entire industry. That’s going to pressure margins for years to come even in more attractive businesses. Meanwhile, Canopy has invested heavily in production — and seen disappointing gross margins as a result.

Canopy is going to sell literally tons of cannabis in the coming years. It hasn’t convinced investors it can do so profitably.

The Dot-Com Bubble Problem for CGC Stock

That issue leads to the second problem for CGC stock. Just because an industry is going to grow doesn’t mean that all of its stocks will benefit.

This should be the lesson from the late 1990’s dot-com bubble. The bubble didn’t happen because investors were wrong about the transformative power of the internet. Financial projections certainly were optimistic: Adoption rates for e-commerce, for instance, were badly overestimated.

But the internet, for better or for worse, wasn’t a fad. It’s changed almost every aspect of our daily experiences (including investing). Despite that fact, the bubble burst because investors made two mistakes. They ignored valuations and they assumed that every company even tangentially related to the internet would be a winner.

It’s impossible not to see a repeat in cannabis trading during the rallies last year and early in 2019. As I wrote last year, CGC stock traded at a dot-com-era valuation. Revenue-based multiples in the sector assumed that all companies in the industry would make enormous profits.

To be sure, the cannabis boom wasn’t as crazy, or as widely bought, as the internet bubble. Having worked in the industry in the late 1990s, I’d argue nothing in my lifetime will ever quite compare. Still, there are echoes of that bubble in the frenzied buying last year of any stock with any cannabis exposure at all — and in the headlong rush into CGC stock.

Buying the Dip

Admittedly, after the sector-wide selloff, investors can point to dot-com stocks as supporting the bull case. After all, Amazon (NASDAQ:AMZN) was a good investment even at 1999 peaks above $100. It was the buy of a lifetime at $6 in 2001.

But AMZN stock doesn’t necessarily prove the case for CGC stock. Amazon.com, in 2001, was just an online bookseller. It wasn’t anything like the behemoth we now know it to be. And while investors could have made money on eBay (NASDAQ:EBAY) or even Yahoo!, they also could have lost even more money on busted names like Nortel Networks, Global Crossing or InfoSpace.

Indeed, it’s not a coincidence that so many fiber companies went bust after the bubble burst. Fiber proved to be a capital-intensive industry — and the hoped-for returns on that capital never materialized. A similar worry has to plague any production-heavy cannabis play, including CGC stock.

Admittedly, Canopy Growth’s cash hoard suggests minimal risk of bankruptcy. And the company is returning to a focus on core businesses. But that doesn’t in turn mean that a market capitalization still above $7 billion is cheap. Execution has been poor, as I wrote last month. Margin concerns are real. Expectations for the industry have to come down, and the pace of legalization outside Canada has been close to zero.

In that context, buying the dip here looks dangerous — and based on a still-flimsy bull case. Investors bid up cannabis stocks on a simplistic argument that the industry would be huge. Some are buying it on an equally shallow argument that the worst is over. Neither necessarily is true, which means the worst may not be over for Canopy Growth stock.

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


Article printed from InvestorPlace Media, https://investorplace.com/2019/10/two-key-reasons-buy-dip-cgc-stock/.

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