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Canopy Growth (CGC): The Emperor Isn’t Wearing Any Clothes

support@smarteranalyst.com (Ben Mahaney)

By Gary Bourgeault

I think the gushing over Canopy Growth (CGC) may be gradually coming to an end, as the company attempts to position itself as an international and medical cannabis player, when in fact it’s heavily exposed to recreational pot, the weakest link under the cannabis umbrella.

Much of the positive sentiment toward the company is it did much of what the market expected of it, including receiving a big cash infusion and taking a dubious stake in Acreage Holdings, which will cost the company a hefty $3.4 billion if the U.S. ever legalizes recreational pot at the federal level.

The company is operating in a very traditional manner, which in the short term is of great benefit, and why it temporarily is the largest cannabis company by market cap. But as the domestic cannabis market begins to take shape and supply chain issues are resolved, it’s becoming apparent the company is going to struggle to keep up with its key competitor Aurora Cannabis, which for some time has reduced it long-term exposure to recreational cannabis, even though it has cost it short term sales.

Now that it’s obvious Aurora Cannabis has a superior business model, Canopy Growth is pulling out all stops to give the impression it’s matching Aurora in international and medical cannabis growth, even though it’s far behind it in both.

That’s going to be a problem when in the not-too-distant future recreational sales in Canada start to push up against a ceiling.

International markets and medical cannabis

Knowing the market is starting to look for the long-term growth associated with international cannabis markets and medical cannabis revenue, Canopy Growth provided an update on its international operations recently.

One of the things that looks impressive with a cursory glance is the declaration Canopy, after a string of deals, was now licensed to produce for over 35 million square feet. That includes properties across Africa, Europe and South America.

What’s troubling is when you read the fine print. For example, it states things like “only a portion of the cultivation area is in use,” “patient registrations have increased tenfold over the last year to more than 1,300 today,” and “Spectrum Therapeutics to its knowledge now owns one of the largest legal outdoor CBD cultivation sites on the continent of Africa, some of which is currently operational.”

It goes on in other sections of the press release to talk about integration of some of its units and in the process of developing plans to build other facilities.

The point is this is all presented in a way that gives the impression of rapid growth, and it is actually reflective of a lot of activity that has very little in the way of revenue or growth potential in the near term.

I would be okay with that, but even when looking at it all from a long-term perspective, I’m not convinced this will necessarily result in meaningful international growth and improved product mix for Canopy Growth.

My view is it’s just starting to learn about the international and medical cannabis markets and is struggling to catch up with market leader Aurora Cannabis, which I believe over the next two to three quarters is going to  surpass the performance of Canopy.

Consequently, its heavy exposure to recreational cannabis could start to hurt the company in a couple of quarters.

Recreational pot

As of the last quarter, recreational pot accounted for approximately 75 percent of Canopy’s sales. This is a strength and a weakness for the company. In the short term it’s a strength, as recreational pot sales are the major revenue driver for the overall cannabis sector at this time. This is one of the reasons Canopy has the appearance of being a market leader.

The weakness of being over exposed to recreational pot is it has long-term limitations because of the large amount of supply coming in the near future, and the eventual ceiling of demand that shouldn’t take long to discover in Canada.

The problem that must be solved is where sales growth will come from once it hits the Canadian adult-usage ceiling.

Again, I see this as a major reason for the fanfare surrounding the Acreage Holdings announcement. That isn’t to say it may not have value in the future if the deal actually is closed because of legalization in the U.S.

I am saying that it isn’t going to have any impact on the performance of Canopy Growth, other than giving the illusion it is aggressively advancing its long-term growth outlook, when in reality this is nothing more than a possible revenue stream.

On the other hand, if legalization were to come at all, and quicker than I think it will at this time, it would be a huge catalyst for Canopy on the recreational pot side of the market.

But as I said, I believe that future is farther off than most in the market think, if it ever comes.

Since federal legalization is probably far off, as the market absorbs that fact after a prolonged period of nothing happening, it will start to penalize Canopy Growth in a big way as it struggles to find other revenue streams outside of recreational pot.

Conclusion

I think Canopy Growth might be okay for a couple of quarters, depending on how its recreational sales in Canada do, but further out, it’s readily apparent it’s going to come under more pressure as Canadian demand for recreational pot is met.

This is why it’s scrambling to give the impression it has all sorts of potential for international and medical pot growth, and it appears it has done little more than entered into a bunch of partnerships that may or may not pan out.

A lot of Canopy bulls will continue to point out the cash infusion it received from Constellation Brands and its deal to acquire Acreage Holdings at some future date, along with its production capacity of about 500,000 kilograms a year, as reasons to continue to believe in the company.

But I haven’t seen the billions Canopy has had at its disposal being leveraged in ways that would propel it to a surge in sustainable growth. It really isn’t doing anything different than most of its competitors, and I think, it is attempting to copy Aurora Cannabis in what it’s doing in order to keep the wide differentiations between the two companies from being visible to investors.

Looking ahead, it’s not a certainty, but it’s possible Canopy Growth could enjoy a couple of decent quarters are rising recreational pot sales in Canada. It’s not a guarantee, but it is very probable.

After that I think the glaring weaknesses in Canopy’s business model are going to show, especially in light of Aurora Cannabis ramping up production at a much quicker and larger rate.

It is far ahead of Canopy in international exposure, and doesn’t have near the percentage of medical revenue Aurora has. I think that is going to stand out the next several quarters, and Canopy, if it can’t find real revenue streams, and not just promotional announcements with little in the way of numbers and potential, could start to get hammered over the next year or so.

I don’t see Canopy as a bad company, but I do see it has one that has positioned itself as a recreational cannabis producer, and even though it may retain its leadership as the most valuable cannabis company as measured by market cap, I see it rapidly eroding if it doesn’t get more of a sense of urgency in real execution and efficiencies with the properties it has, and the agreements it has entered into.

Potential is one thing, performance is another. Canopy Growth has a lot to prove outside of its recreational cannabis sales. The time is now to do so.

To read more on the nitty gritty of what’s going on in the rising cannabis industry, click here.

 

Disclosure: The author is Long Aurora stock

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