Canopy Growth: 2 Years of Failures And Why You Should Avoid This

Canopy Growth $CGC reported earnings and I wanted to take a look at the company’s valuation.  Recently, there have been large surges in the prices of cannabis stocks and I am getting a lot of emails asking my thought on these matters.  With the so-called “Blue Wave”, a Democratically led Federal Government, the hopes of cannabis legalization have pushed stocks upwards.  And then there was a so-called Reddit surge which added to these price moves.

For a couple of years now Canopy Growth has been a bellwether of cannabis stocks.  They were injected with a significant amount of investment capital from Constellation Brands (STZ).  The amount was substantial; it was in the billions.  That was back in 2018 and that was the beginning of the cannabis craze for investors.  However, that was also very short-lived as profits from the sector never materialized.  Stocks in the sector dwindled starting in 2019 through 2020.

Given the current valuations, and after several years of handling a substantial investment opportunity, what are you getting from an investment in Canopy Growth; is Canopy Growth a good buy?

Some of the valuations I have seen lately with cannabis companies are starting to smell a lot like 2018 all over again with what would eventually turn out to be the cannabis crash of 2019. The Reddit moves I think merely exasperated stocks that have pushed up beyond their basic fundamentals.

I reviewed Canopy Growth back in November; the price was $22.00 and I was bullish.  Since then, the stock had more than doubled back up to $50.00 but has been sliding from that high.  One of the main drivers of cannabis stocks has been the November election and the Democratic victory.  I believe that the Feds are going to change the laws and I think it is likely to happen in the next 12 – 18 months, or thereabouts. Until that happens, and if that happens, companies still need to continue building their business foundations and push for revenues.

Normally, I stick to the smaller cannabis stocks simply because I think the larger cannabis stocks are all overvalued; Big companies get big headlines and big investment dollars push up prices… big.  I believe that may be the case yet again with Canopy.

Another reason I am looking at the bigger companies is that I have been asked to do a portfolio review of a reader’s cannabis investment portfolio.  The recent Reddit-induced price surges have warranted this individual to look at his portfolio and I am getting involved in that.  Canopy Growth is not part of his investment portfolio.  But, they are the so-called bellwether.

So, let’s look at this company to get a good understanding of the overall industry and the company at large.

The Cannabis Industry

Take a look at a few charts on cannabis and you will see that over the past few years the industry has been booming.  In Canada, where Canopy Growth has operations, the chart and subsequent numbers are impressive:

(Data Source: StatCan – Author’s Chart)

In October of 2019, Canada’s retail sales were ~$120M.  The past data point, 12 months later, has Canadian retail sales over $270M; more than double.  Canopy Growth has interest up in Canada so, keeping this in context will allow for an analysis to see how the company has kept pace with its competition.

Also, California gives us a pretty solid barometer for the United States during the past two years.  California, which had a healthy infrastructure for cannabis, legalized recreational cannabis in 2018.  As you can see from this chart, the overall tax take has moved upwards significantly during this time:

(Chart Source: California Dept. of Revenue – Author’s Chart)

I did an analysis here on Seeking Alpha where I looked at the State of California and its potential.  The entire United States’ retail sales numbers for cannabis is ~$15B.  California is currently at ~$4B.  In a few year’s time, California’s retail sales should be ~$15B, the entire country’s current volume.  I expect this to take about 5 – 7 years.  So, companies that are operating in this market have had an excellent opportunity to solidify a customer base with a solid foundation, being involved in the sharp increases seen above, and continue to expand into the future.

California has been legal for recreational cannabis all of 2 solid years.  The numbers are impressive with solid gains.  Companies involved in sales of cannabis during this time should be seeing the same type of revenue growth.

Canopy Growth Revenues

During the past two years, since Canopy Growth had their investment of several billion by Constellation Brands, here is what the revenue generated by the company over this period of time:

(Data Source: Canopy Growth – Author’s Chart)

As you can see from this chart, from December 2019 to December 2020, Canopy Growth moved from $95.3M to $119.9M in revenues.  That is a move of some $24.6M, or about 30% YoY growth.

Although this is an increase, as far as I am concerned, this is a below-average move that pails in comparison to the overall growth rates seen in the United States and Canada during the very same time.  Keep in mind, Canopy Growth operates in these areas – as well as getting involved in other international endeavors.

So, while these countries were printing much higher growth rates, the most well-funded company in the sector could not replicate what was going on within these markets.

Mind you, the data above from Canada are the result of every single operator in Canada, as well the same with California.  So, there are companies that are participating in the growth of cannabis that has driven the retail numbers as high as they are.

Canopy Growth Gross Margins and Operating Efficiencies

Revenues are one thing.  The next thing for me is to look at what management has done with the revenues they have earned.

Here is a look at gross margins:

(Data Source: Canopy Growth – Author’s Chart)

When I evaluate management, I do not sit in my office pretending to have a crystal ball and say what a future addition to the management team will do for a specific company.  I look at numbers and charts.  If I can look at numbers and see trends then I can reasonably look at a trend and say that this particular trend may, or may not continue.

In the case of gross margins for Canopy Growth, I can reasonably say two things: the margin rate is well below average and simultaneously lacks consistency.

If a company consistently prints numbers that are either steady or increasing/decreasing, then from an analytical perspective I can reasonably determine what a company may continue to do so.

Over the past many months I have gone through an entire slew of cannabis companies to see if they are good investments.  With the numbers I see in gross margins, from the companies that are being consistent and printing solid revenue growth and margins, I have seen levels coming in around the mid-50s to lower 60s on a percentage basis.  I was nearly in shock at how low these gross margins are for Canopy Growth.  This is well below what I see as a solid figure.

Considering that Canopy Growth has been sitting on billions in investment dollars to put to work, and they have had two years to do so, I would expect far better results.

But, margins from sales are just a small part of the equation.  Effectively employing individuals to work to produce the products is another part of the equation.

As it turns out, it does not get any better from a cost perspective.  Here are operating efficiencies:

(Data Source: Canopy Growth – Author’s Chart)

For those not entirely in the know, gross margins would be the difference earned from the total sale of the product to the material costs of making the product.  Labor and other variables are then subtracted from what is remaining to determine profits.  Operating efficiencies need to be smaller than the number in the gross margins.

Let me break this down for those not entirely savvy in this:

If you sell a product for $100.00 you then figure out your gross margins by subtracting material costs.  The high-end gross margins I have seen are roughly in the low 60s on a percentage basis – you want this number as high as possible.  For this example, let’s say it is 60%.  Your costs would be $40.00 for that product, leaving you the 60% in margins, or in this simplistic explanation, $60.00.

Then, you would subtract labor costs from the total revenues.  This number you want as low as you can get.  Generally, they hit around 40%.  I have seen some terrific eye-popping numbers (Check out C21 Investments (CXXIF), a company that I fell in love with immediately, with efficiencies coming in ~27.5%).  If numbers for efficiencies hit 40%, or in this case, $40.00, management would be left with 20%, or $20.00.  This is gross profits from which other expenses such as loans are paid from.

But, in the case of Canopy Growth, their operating efficiencies are higher than the cost of their products.  And, the latest 114% is the best they have done so far.

Canopy Growth Net Revenue

Canopy Growth made many deals over the course of the past few years from which some were profitable and some were not.

Here is a look at net income:

(Data Source: Canopy Growth – Author’s Chart)

There were charge-offs in the latest releases.  But, that is not even anything I would want to think about at this point.

I’m still stuck on the simple math that a company produces a product, sells the product, and then has margins left over for net incomes.  In the case of a company that is the most well-funded within the industry, they can’t even employ labor in a manner that will get them to profitability simply because they are employing too much labor and other expenses during the process.  Net revenue is what is leftover from margins and costs.  Those two metrics are so far below average that any analysis of when they will get to net earnings positive is a long, long way off.

Canopy Growth Book Value

As a cannabis investor, I approach analysis from two angles and try and marry the concepts as best I can.  The two angles are value investing and growth investing.  On the one hand, as a growth investor, it is management’s job to take advantage of opportunities within a growing industry.  Look again up at the charts I have shown on retail sales for Canada and California; cannabis is a booming industry.  So, any investments should marry the future opportunity with the present position of a company.

From a value investment, I want to see that management is continuously improving the company’s situation with prudent investment practices.

Here is a look at the book value of Canopy Growth:

(Data Source: Canopy Growth – Author’s Chart)

I have highlighted book value within the cannabis industry and a long listing of cannabis stocks.  In that one article, I had wanted to show which companies were trading at the best book value.  Some dismissed book value as being nonsensical.

Warren Buffett looks at book value… So do I.

Book value could be looked at as a “fire sale” approach to what a company would be worth if management were to sell everything off.  In the case of Canopy Growth, the $8 is about 25% of the actual value of the stock.

When you start looking at the bigger picture, you start putting the pieces together and see that Canopy Growth is significantly overvalued with few future prospects.

Revenues, although they have moved higher, are not increasing in pace with the rest of the industry.  Canopy Growth is the single most well-capitalized cannabis company there is.  Yet, they have not been able to string together nearly the revenue growth of some of their smallest competitors that are the aggregate result of the charts above pushing higher and higher.  Canopy Growth is getting their butts whooped by far smaller companies.

Then, there are the margin issues.  Canopy Growth is far below numbers I consistently see in my analysis of the many companies I have looked at in the cannabis sector.  Gross margins should be pushing upwards around 60% with operating efficiencies pushing numbers in the lower 30%.  Canopy Growth is nowhere near these numbers.  Nor do they look like they are just on the cusp of hitting these numbers.  There is no need to even bring up net earnings since Canopy management can’t even get the first parts of the math correct.

CGC Stock

$CGC stock has been at levels we are now looking at previously:

(Chart Source: Trading View)

I had gone bearish on CGC back in late 2018 and early 2019 when the stock first hit the $52.00 level.  That turned out to be a prescient call.  Now, we are seeing some of the same levels but what I might start thinking as far worse fundamentals.

Canopy Growth is losing money.  Consistently.  And, their metrics do not add up to any turnaround any time soon.  The recent Reddit-induced surge may have been a gift horse.

Is Canopy Growth A Good Buy?

No.

That’s the short answer and the longer answer is far worse.

What would you pay to lose money?  Canopy Growth’s prospects of making consistent money look dim, at best.  The one thing they have working in their favor is the cash they are sitting on from an investment from 2 years ago; which largely has not seen a return on investment and has been dwindling since:

  • Gross margins are significantly below average;
  • Operating efficiencies are significantly above product sales numbers;
  • Book value is well below current value without requisite growth rates to compensate;
  • Their cash position is continually declining, albeit still substantial.

This is the so-called bellwether company for the cannabis industry.  Recent news regarding the Blue Wave has pushed cannabis stocks upward in the anticipation of new legalization across the nation.  Great.

Here is the thing, however: I would expect that the most well-capitalized cannabis company should be able to turn a consistent profit in a much smaller market before they were to consider expanding across the nation.  After all, they aren’t profitable with Canada being fully legal, what makes this new scenario any different?

With cannabis, the idea of churning out large quantities of cannabis means a focus on high volumes, and likely, low quality.  The entire industry is reeling from that from back in 2018 and I am finding plenty of company reports that show other companies switching from producing lower quality cannabis to more premium products.  So, economies-of-scale are not the answer to Canopy Growth’s woes with the potential future legalization of cannabis across the United States.

Canopy Growth needs to focus on a plan forward that produces high margin results on a lower cost basis.  Smaller competitors are doing just this and are expanding and turning a profit, or getting close to doing so.  Why can’t the most well-capitalized company in the industry?

Canopy Growth gets a lot of high-profile news and this draws in a lot of investment dollars.  But, is that necessarily a good thing?  If Canopy Growth’s stock price were significantly lower, it might be a growth opportunity.  However, the stock has been pushed upwards beyond reasonable valuations.

I am going neutral on Canopy simply because the value of the company is far lower.  However, investors may still be drawn into a high-profile stock such as this and that may elevate the stock at these levels.

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