As the market absorbed the Canopy Growth (CGC) March quarterly results, the stock continues to stumble. The cannabis company announcing the license approval of a 7 million sq. ft. planting area isn’t going to help the stock. The market already has substantial questions regarding margins and a flood of new supply isn’t going to help investors obtain comfort that the executive team knows when to stop growing production for a struggling market.
Big Supply Increase
Canopy Growth just reported a quarter where cannabis sales actually declined and gross margins crashed. Naturally, the company announced a massive ramp in production from new cultivation obtaining approval hit the stock sending Canopy Growth to a low around $38.50.
On Monday, the company announced the new license from Health Canada for an outdoor growing space in northern Saskatchewan. The company has already started planting a 160 acres cultivation space that will add to the production that was already forecasted to double sequentially to 34,000 kg in the June quarter.
The market already knows that CannTrust (CTST) has started focusing on outdoor growing space. The small cannabis company has forecasted anywhere from 1,000 to 2,000 kgs of cannabis flower production per acre.
A similar situation would suggest that Canopy Growth could generate at least 160,000 kgs from this new cannabis planting space. The company might even top 300,000 kgs as productivity is increased in future years.
The scary part here is that with limited capital other than general farming equipment and the cost of land, Canopy Growth and CannTrust have quickly brought online cannabis production that could combined top 500,000 kg in annual production by next year.
Scary Margins
Canopy Growth dipped to $38.50 in early trading this week due to the additional fears over weak margins. The company generated a meager 22% gross margin in FQ4 despite the substantial net revenue growth of 313%.
The company forecast that gross margins would return to the 40% range by the end of the fiscal year, but CEO Bruce Lipton appeared to hedge those bets. The problem here is that the company is already on the bleeding edge of these developing global cannabis markets and a 40% gross margin leaves Canopy Growth with substantial losses.
Even if revenues soar 150% to C$250 million quarterly, Canopy Growth would only generate C$100 million in quarterly gross profit. The company already spends far in excess of that amount on operating expenses and the vape and edibles market won’t even ramp up until the end of 2019.
Even more concern were the statements of the CEO on the earnings call that the company isn’t worried about competitors that are bringing on substantial supply.
This lack of market recognition is what leads Canopy Growth to load up on more production. The worst-case scenario is that the cannabis industry giant overlooks these smaller players and cannabis prices collapse causing gross margins to fail to reach meager goals of 40%.
Takeaway
The key investor takeaway is that Canopy Growth remains too richly valued considering the substantial losses and the total disregard for operating profitably. Over the course of the next few months, the cannabis industry will bring on substantial supply that the market can’t support. Any pricing pressures that hit expected margin gains will hit the stock rather hard until the company shows some discipline with forecasting future supply growth.
To read more on the nitty gritty of what’s going on in the rising cannabis industry, click here.
Disclosure: No position.
