For years, cannabis stocks have been practically unstoppable, and their robust long-term growth prospects were to thank for their outperformance. Depending on your preferred source, the global pot industry could see sales soar from $3.4 billion in 2014, to anywhere from $50 billion to $200 billion by the end of the next decade. That's more than enough growth to get the attention of Wall Street and investors.
Unfortunately, next-big-thing investments tend to have a fairly common Achilles' heel. Namely, that they're fundamentally flawed in their early stages and typically nowhere near profitable. Even though Canada legalized recreational marijuana in October, and numerous U.S. states have given the OK to medical and/or adult-use weed, most pot stocks are still losing money. Eventually, this becomes a problem for companies with soaring valuations.
Last week, Canopy Growth (NYSE:CGC), the largest cannabis stock in the world by market cap, reported its highly anticipated first-quarter operating results and, not surprisingly, it wasn't well-received by investors. While you may have heard some tidbits of information surrounding the company's report, the following five figures are what truly sum up just how bad it was.
1. Sales are running in place
The headline figure that really freaked out Wall Street was that Canopy Growth's sales missed the consensus forecast of around 109 million Canadian dollars (that's in gross revenue, which doesn't include excise taxes paid). In the fiscal first quarter, the company wound up reporting CA$103.4 million in gross sales, or CA$90.5 million after excise taxes were factored in. By comparison, Canopy delivered CA$94.1 million in net sales in the sequential fourth quarter, meaning it suffered through a sequential revenue decline, which should be unheard of in the rapidly expanding pot industry.
Of course, things reversed a bit from the sales sluggishness the company experienced in the fourth quarter. For example, the fourth quarter saw Canopy report a decline in cannabis revenue from the sequential third quarter. That didn't happen in the first quarter, where cannabis net revenue hit CA$71.7 million, which is higher than the CA$68.9 million in net cannabis sales in Q4 2019. Mind you, I'm not suggesting that Wall Street should be pleased with this minimal sequential net cannabis sales growth. However, it's important to recognize that this wasn't the reason the company's sales reversed course.
Rather, the culprit looks to be revenue in the company's "Other" segment, which includes vaporizer accessories company Storz & Bickel, as well as extraction services and clinical partnerships. Even though "Other" segment revenue rose nearly 1,500% year-over-year, the CA$18.8 million Canopy reported in Q1 2020 was notably lower than the CA$24.2 million generated in the sequential fourth quarter. This is why Canopy suffered a sequential sales decline.
2. Gross margin is among the industry's worst
What might be even more disappointing than Canopy Growth's sequential sales going in reverse is the company's anemic gross margin, which came in at 15% in the fiscal first quarter (CA$13.17 million in gross profit on CA$90.48 million in net sales). For major pot companies, I'd opine that this will be the low-water mark for the industry in this round of earnings reports.
Part of the reason Canopy's margins are so terrible is due to the fact that it's still completing construction, and working on the ramp-up of production, at many of its grow farms. Even if these grow farms aren't producing or are underutilized they're still incorporated into cost of sales, which adversely impacts the company's gross margin.
Canopy Growth also announced the need to even out its inventory during the fiscal first quarter, resulting in the company selling considerably more dried flower relative to cannabis oils and softgel capsules. The issue being that dried flower offers considerably lower margins than derivative products, such as oils and softgels.
Canopy Growth does note in its earnings release that it's been ramping up toward the expected launch of derivative products, such as edibles and infused beverages, later this year. But that won't cover up the fact that its gross margin in the first quarter was much worse than the 22% gross margin reported in the sequential fourth quarter.
3. An oil and softgel oversupply?
Most folks were probably stunned by Canopy's massive first-quarter loss, which featured a CA$1.18 billion loss from the extinguishment of warrants held by Constellation Brands. This increased the company's net loss to CA$1.28 billion, or close to CA$4 per share. However, it's CA$6.4 million in future returns that's an even more looming figure.
You see, in Canopy's discussion of what type of product was sold during the first quarter, the company notes the following (taken directly from the press release):
During Q1 2020, we evaluated the form, strain, and estimated on-hand provincial and territorial inventory levels against the recent demand and sales trends that have been observed in the recreational market to ensure we make adjustments to our supply chain based on the purchasing preferences of recreational consumers. As a result of this evaluation, we believe that the risk of an over-supply of certain oil and softgel formats may exist in certain markets due, in part, to incomplete retail platforms in most provinces. Based on this assessment, we have estimated variable consideration that may result from rights of return in the amount of [CA]$8 million dollars in gross revenue, which corresponds to estimated future returns of [CA]$6.4 million, net of excise tax, and the estimated return amount has been reflected in net revenue.
In other words, the slow rollout of dispensary licenses in select provinces is seriously constraining Canopy's ability to grow its high-margin sales, and, more important, the company foresaw the possibility of a softgel capsule and oil oversupply as a result. Oversupply of derivative products this early in the game is almost unbelievable.
4. Share-based compensation goes through the roof
The fact is that every expense is rising for Canopy Growth right now. Sales and marketing costs, research and development expenses, acquisition expenditures, general and administrative costs... you name it... it's all gone up on a year-over-year basis. But the biggest eyesore continues to be the company's share-based compensation.
Although Canopy Growth does issue shares based on certain acquisition-based milestones, this only amounted to CA$10.3 million in Q1 2020 costs, up from CA$7.1 million in the year-ago quarter. The real culprit was the CA$77.1 million in share-based compensation tied to long-vesting options granted to employees. The company's employee count has grown from about 1,400 at the end of June 2018 to approximately 3,850 one year later.
On one hand, giving employees stock options is a means of retaining talent for the long-term, as well as pushing everyone on the team to strive for success. The idea being that if employees have a vested interest in the success of the company, they'll work harder, or make decisions that benefit the company they work for over the long run.
On the other hand, these granted stock options are just killing Canopy and its shareholders by driving expenses through the roof. In the latest quarter, CA$87.3 million out of CA$229.2 million in expenses was some form of share-based compensation. Comparatively, the company's gross margin was CA$13.2 million. Had it not been for a CA$92.9 million fair-value adjustment benefit on biological assets, the company's operating loss would have been well over CA$200 million, not including its warrant extinguishment.
5. A writedown waiting to happen
Last, but not least, Canopy Growth's balance sheet looks to be a writedown waiting to happen.
When one company buys another, it's not uncommon for the acquiring company to recognize goodwill once the deal is complete. Goodwill is the premium paid for the acquired company, above and beyond tangible assets. Since the marijuana industry is so nascent, it's really difficult to accurately value what's being purchased, which has left most major acquirers lugging around a lot of goodwill. In Canopy's case, its goodwill rose by more than CA$387 million to CA$1.93 billion by the end of June 2019.
Ideally, a company would like to be able to recoup this goodwill by developing the assets it purchased, as well as monetizing whatever intellectual property or patents that were acquired. Unfortunately, goodwill isn't something that businesses can always recover, which is what leads to businesses taking a writedown. A writedown is pretty much an admission that a company overpaid for assets that it acquired.
In Canopy's case, its CA$1.93 billion in goodwill now makes up more than 22% of the company's total assets. With Canopy aggressively utilizing its cash to expand into new markets and supplement its supply chain, it's not out of the question that its total assets decline in value as its cash is used. This suggests the possibility that goodwill will grow into a larger percentage of total assets, making it more likely that a writedown is undertaken at some point in the future.
Suffice it to say that Canopy's fiscal first-quarter report was not impressive, albeit you may have missed the truly terrifying aspects of it if you just focused on the headline numbers.