Canopy Growth (CGC) has been on a downward spiral lately, with part of it being the result of growing negative sentiment in the cannabis industry, and partly because of its own disappointing performance, where it has under performed on revenue and growth toward profitability on a sequential basis. In a recent note from Bank of America analyst Christopher Carey, he pointed out the temporary weakness in the Canadian market that will have a detrimental impact on the performance of the company, resulting in it downgrading the stock and lowering its price target. Carey believes expectations for Canopy Growth remain too high; I agree with that assessment at this time.
The Canadian market
Whether it’s Canopy Growth or another Canadian-based cannabis company, a major issue in Canada is outside their control, which is the snails pace at which retail outlets are receiving their licenses, and the prior weak due diligence Health Canada performed on prospective licensees. To this day a number of those that have received licenses haven’t even started building their stores.
That, along with relative few licenses, means demand from customers isn’t being met, and that has pushed them toward the black market. That is expected to significantly change in the second half of 2019, but for now, it remains an issue.
The city of Toronto and province of Ontario have had the most negative impact on the Canadian cannabis sector, because until recently, Toronto itself only have 5 retail outlets for consumers to buy cannabis from. That’s important because Ontario is by far the largest Canadian market.
At a time when there should be hundreds of retail outlets to buy from, it’s still only in the low double-digits in that region.
Carey said in a note to clients that there is currently approximately “3 and a half months of flower inventory in the channel in Canada and eight and a half months of oil.”
With the slow roll out of stores, and existing stores reporting slow sales, the analyst concludes it’ll take time to work through the existing inventory. This isn’t because of weak demand, but because of a lack of retail outlets to sell in.
While derivatives should eventually boost sales after being approved of in Canada in October, the fact is sales won’t start until the latter part of December 2019, which means the first real impact it’ll have on Canopy Growth won’t be until after the first calendar quarter of 2020.
Lack of positive catalysts
In the short term, I see more pain for Canopy Growth. It has committed to buying the rights of Acreage Holdings as its major entry point into the U.S. market. Unfortunately, there is little chance the U.S. will legalize pot at the federal level.
The major policy of the Trump administration concerning cannabis is to allow the states to make up their own minds on the legalization issue. It is more likely that all the individual states will legalize marijuana medically or recreationally, than it is to be legalized federally.
If I’m correct in my outlook, it means Canopy Growth is going to sit on Acreage Holdings for a long time without getting any benefit from the proposed deal.
At the same time, it lags behind major competitor Aurora Cannabis (ACB), which by far as the largest global footprint, with a presence in 25 countries.
That means Canopy is more reliant on the U.S. market than Aurora is, even as Canopy continues to underperform in the Canadian market.
There are no visible catalysts that will change Canopy Growth’s performance in the near term that I can see. For that reason I think there will be more pain in the short term.
It remains to be seen how much impact derivative sales will have on the company in the first calendar quarter of 2020, but if it is able to do well, it could surprise to the upside.
One potential positive catalyst will be when it finally appoints a new CEO. The management record and style of that person will be important as to whether or not the company gets a sustainable boost from the hire. That will also provide more clarity concerning Constellation Brands assertion it needed a new CEO for its growth strategy of the future.
Finally, Canopy Growth and others in the Canadian cannabis market could get a general boost if market sentiment changes there, and licensed retailers are operational at a much higher number than they are now. That will result in higher sales.
The combination of an increase in retail outlets and meaningful derivative sales could change the performance of the company to the better over the next couple of quarters. As for the U.S., I don’t think investors should include that in their models at this time because it’s going to be a long time, if ever, before cannabis is legalized at the federal level in the U.S.
My conclusion on Canopy Growth remains the same. It’s going to be a decent company over the long term, probably settling into the lower level of the top tier of cannabis producers in the world over time.
What would change that thesis is if the U.S. were to legalize pot and it gained access to the U.S. market via Acreage Holdings. If that were to happen, it would be a real game changer for Canopy Growth.
Unsurprisingly, investor sentiment is very negative, with individual portfolios in the TipRanks database showing a net pullback from CGC.
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