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Hold off Buying CGC Stock Ahead of This Week’s Earnings Report

CGC stock will suffer from industry-wide headwinds for the foreseeable future

Canada-based Canopy Growth (NYSE:CGC) stock is expected to release Q2 FY20 financial results later this week. CGC stock, which is an industry bellwether has been falling fast since April, leading to much investor disappointment.

Hold off Buying CGC Stock Ahead of This Week's Earnings Report
Source: Shutterstock

Year-to-date, the share price is down about 29% as pot stocks have not been favored investments throughout most of the year. Now that the Canopy Growth earnings season is upon us, investors are wondering as to what may be next for the stock price.

CGC continues to run large operational losses and its share price may not reach its previous highs any time soon. Let’s now look at the company’s fundamentals as well as the stock price to discuss why Canopy’s problems may not be over any time soon.

Expectations for Canopy Growth’s Q2 Results

So far in 2019, most marijuana stocks have taken a dive on repeated earnings misses. Similarly, when CGC reported Q1 earnings on Aug. 14, it missed analyst expectations. The next day, CGC stock dropped over 10% to below $30.

In Q1, Canopy Growth’s net revenue came at CAD$90.5 million, a downside surprise of almost 20%. Analysts have been increasingly concerned that these pot companies somehow feel free to spend investor and partnership money like there is no tomorrow. CGC’s net loss hit an eye-popping CAD$3.70 per share. Analysts were expecting CAD$ 0.38.

Costs also ballooned, as total operating expenses rose 73% to over CAD$229 million. In short, its Q1 results showed declining cannabis sales and plummeting gross margin. Hence, the dramatic loss in Canopy stock.

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 truly sustainable? Will management be able to achieve cost control and revenue maximization?

When the company reports Q2 earnings, the Street is likely to pay special attention to Canopy Growth’s sales figures and the level of operational loss as well as free cash flow. Any further negativity is likely to put CGC stock under considerable pressure.

Cannabis Is an Agricultural Commodity

It is important for investors to remember that marijuana is a capital-intensive crop. Producers like Canopy are effectively agricultural producers of a commodity vulnerable to traditional agricultural demand and supply issues.

More than 260 million adults worldwide consume cannabis at least once per year. Canopy Growth, which aims to capture an important part of this market, has three key target segments: Canadian consumer (i.e., retail recreational), Canadian medical, and international medical.

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

In Q1, 60% of CGC’s revenue, or about CAD$61 million, came from recreational sales. However, this number meant an 11% decline on a quarterly sequential basis.

Statistics Canada has just released the quarterly National Cannabis Survey which shows that Canada is still a relatively small market. According to the report, “[f]rom mid-August to mid-September, nearly 5.2 million or 17% of Canadians aged 15 and older reported using cannabis in the previous three months. This was unchanged from one year earlier (before legalization).”

A study by Deloitte estimates the Canadian market for legal recreational and medical cannabis to be worth CAD$2.6 billion to CAD$6.13 billion overall.

On the other hand, the black market is still thriving in Canada, i.e., the transition from an illegal market to a legal one is rather slow. One of the most important reasons for this sluggish move to legality is price.

For Q3, the average cost of a gram of legal cannabis was CAD$10.23 CAD, compared to CAD$5.59 for illegal weed. This big price gap between legal and illicit marijuana is quite a concern for stocks like CGC.

Therefore, it might simply be too optimistic to expect sales numbers to improve unless the market for the commodity grows considerably.

Wall Street is now seriously questioning whether Canopy Growth stock and its peers can achieve much growth in revenue in this subdued Canadian cannabis market.

Other Concerns About Canopy Growth Stock

Analysts highlight that valuations in this new consumer market are extremely high. CGC stock’s price-to-sales ratio of about 30.1x. Even some of the most-hyped technology or fintech stocks do not have such high ratios. It may be hard to believe that about a year ago Canopy was trading at 160-times sales! To put the metric into another perspective, the S&P 500’s average P/S ratio is 2.2x.

Additionally, sector players are burning through cash rapidly. Many of our readers would be aware of the fact that in Aug. 2108, the alcoholic beverages giant Constellation Brands (NYSE:STZ) announced a $4 billion investment into CGC.

Understandably, Wall Street took notice and shareholders rejoiced. STZ now holds a 38% stake in the company. Yet despite this important amount of cash injection into the group, Canopy’s management has had a host of cash flow issues, in part due to increasing investments.

We have to underline that CGC is not all unique in that respect; most other cannabis stocks have continuous cash management problems as they seem to spend a lot of cash to make some money.

Indeed many of these pot-based securities, including CGC stock, are not likely to achieve profitability in the near future. That suggests that the industry stocks have gotten ahead of themselves.

Furthermore, Canopy and its peers must follow a host of Canadian regulations. Therefore, cannabis production requires significant infrastructure and regulatory costs. For example, earlier in July, Health Canada, the national regulator, has — due to “unauthorized activities” — revoked Agrima Botanicals’ producer and dealer licenses.

Similarly, Health Canada put a hold on CannTrust (NYSE:CTST) for unlicensed growing. Therefore, non-compliance issues may haunt CGC stock and its peers in future months.

Indeed, in October, it was reported that CGC and “and a Nevada-based hemp producer are suing each other in rival federal cases over a bad crop and allegations of missed payments and misspent advances.” Although details of the case are sketchy and the end result may not necessarily hurt Canopy Growth, this development is another example of the growing pains in the industry.

Where CGC Stock Price Is Now

In 2018, many investors regarded Canopy Growth stock as synonymous with the growth of the legalized marijuana industry. Early shareholders have gained considerable wealth investing in CGC stock. But more recent investors have lost money as they placed their bets on the growth of these pot stocks.

CGC stock is currently down from a 2019 high of $52.74 reached on April 29, to around $20. The downtrend since this spring is a stark reminder that CGC’s all-time high of $59.25 from October 2018 is now in the rear-view mirror.

If you’re an investor with any paper profits left, you may want to lock in some profits here.

Presently, the short-term technical charts, especially the trend lines and support and resistance levels, are telling investors to exercise caution. Expect nearer-term trading to be choppy at best.

At this point, bears are in control. Therefore, CGC stock will need a catalyst to make it attractive in the eyes of long-term investors. Indeed, they’re probably still skeptical about the nearer-term prospects for the company.

If you’re considering investing in CGC stock, you may want to start building a position between the $14 to $16 levels. Then, expect to hold the position for several years. In the meantime, expect a lot of volatility in the CGC stock price.

The Bottom Line on CGC Stock

Initially, especially around the time of legalization in Canada in October 2018, most cannabis stocks moved in tandem and went up. However, 2019 has so far been a different story.

As companies report earnings, Wall Street is better able to gauge the fundamentals of these stocks. And investors have been increasingly noticing that fundamental numbers are not adding up to the headline stories. Thus they are not shy to penalize those that do not make the cut.

Quarterly performances of companies like Canopy Growth also give analysts important clues as to how the Canadian and international demand and supply equation is evolving. Going forward, investors may have to wait months until better news regarding the industry hits the news wires.

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

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


Article printed from InvestorPlace Media, https://investorplace.com/2019/11/hold-off-buying-cgc-stock-earnings/.

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