Canopy Growth (NYSE:CGC) recently announced earnings, and while they were far from an unqualified triumph, they did come in well ahead of expectations. This, not surprisingly, sparked a rally in CGC stock.
The marijuana sector has reached such a low point as far as sentiment goes that companies are beating analysts’ outlooks with even modest results.
While beating analyst expectations is a first good step, Canopy Growth still has huge issues to overcome. I see some traders suggesting that the worst is over for beaten-up marijuana stocks like Canopy, and that may be true to an extent, but don’t mistake the recent earnings report for the start of a rapid recovery either.
Earnings Improve a Bit
Looking at Canopy’s most recent earnings result, you can see some clear signs of optimism. Gross revenues grew 15% versus the previous quarter and 39% versus the same quarter of 2019, and business to business revenues increased 8% as 140 new retail stores came online. This, over the long haul, will be key to helping Canopy turn things around.
The company also made progress on the cost side. Operating expenses dropped 14%, which is at first glance seems tremendous. However, take a closer look and you’ll see that a large portion of this “cost savings” was due to the company spending less on shareholder compensation.
Put simply, because Canopy’s stock price went down, it cost them less to give stock benefits to their employees. This is, needless to say, not the most optimal way of reducing expenses. Though to Canopy’s credit, they also cut overhead expenses as well, and much more is coming on that front.
More Cuts Ahead
Canopy’s David Klein made it clear in discussing the quarterly results that Canopy will be launching a huge strategic overhaul. Klein said that its his responsibility to create a “very visible path to profitability.”
To do that, Canopy will align its resources to the market “as it exists today” rather than planning for growth that may or may not come many years out into the future. That’s a big change from Canopy’s past “build it and they will come” philosophy which led to ruinous losses and the fallout with key backer Constellation (NYSE:STZ).
To that end, Klein said that Canopy will begin taking “initial steps” to shrink the company’s overhead costs over the next 90 days. Make no mistake, it won’t be a one-quarter fix to turn Canopy into a lean mean machine. This will be a process that is likely to drag out through most or all of 2020.
Long Way to Neutral
The core issue at the heart of Canopy’s problems is that they simply have way too much inventory – around a year’s worth, in fact. Canopy, and other marijuana players, built far too much production capacity before it was needed.
Some of this blame falls on Canada. Ontario in particular bungled the roll-out of retail stores. The black market remains a vibrant competitor to Canopy and other legal firms, but these companies also assumed way too much would go to plan in a new industry where there would be bumps along the way.
As a result, Canopy has tons and tons of excess inventory that will take ages to sell. Thus, the natural reaction is to cut costs to the bone. But if they fire too many employees and cut-back too much, they risk wrecking the company’s morale and brand image. It will be a tricky balancing act for Klein to find the right level between spending too much money and gutting the business.
For as much trouble as Constellation’s involvement in Canopy has caused, at least Canopy still has a ton of money. As of this most recent quarter, Canopy now has $1.7 billion CAD of net cash left, after netting out debt. That is impressive, but slightly less so after realizing that the company is consuming nearly $200 million CAD per quarter via its negative operating cash flow.
CGC Stock Verdict
You can make a case for CGCstock after this most recent earnings report. In fact, our Matt McCall recently made the case that Canopy is attractive for long-term investors here. He cited management’s disciplined cost-cutting efforts and industry leadership.
And, over a long enough time horizon, McCall’s bullish thesis could certainly play out. Over the next, say, six months, however, I don’t think you’ll miss anything if you don’t own CGC stock. As the old adage goes, it’s difficult to cut your way to prosperity.
At the end of the day, Canopy has a revenue problem. Canopy is still generating roughly $500 million CAD in sales per year. Meanwhile, the market capitalization is up near $8 billion.
The market simply isn’t going to support a 20x price/sales ratio for a company running massive losses in a market that needs to consolidate further. Canopy may have stopped the bleeding, but it’s not yet a buy.
Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek. At the time of this writing, he held no positions in any of the aforementioned securities.