The marijuana industry projects as one of the fastest growing on the planet over the next decade. After generating $10.9 billion in global sales last year, the legal cannabis industry has the potential to expand to as much as $200 billion in yearly sales by 2030. That's an impressive growth rate we typically don't see reserved for "growing a plant."
But as investors, we also know that not every marijuana stock is going to be a winner. Even the brand-name pot stocks that have leaped to the front of the pack are not guaranteed to stay there.
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Take Canopy Growth (CGC +0.00%) as an example. It would appear to have all the hallmarks of a marijuana stock that investors would want to own. It has the largest cash position of any cannabis stock, thanks in part to an equity investment from Modelo and Corona beer maker Constellation Brands, has some of the top-known marijuana brands, and has clear global reach with its products.
Yet, there's also a laundry list of reasons why the largest marijuana stock in the world by market cap could see its share price dip below $20, if not lower, implying additional downside of greater than 20%.
1. Canadian supply issues are persistent
To begin with, all Canadian producers are contending with supply issues that are beyond their control. Regulatory agency Health Canada entered the year with more than 800 cultivation and sales licenses to review, which in many instances are taking months to more than a year to get to. Select provinces have also been slow to approve the licensing of physical dispensaries. These delays have kept producers from planting, processing, or selling their product. In Canopy's case, it's had the company's pot sales running in place for the past couple of quarters.
2. International sales are floundering
One of the under-the-radar problems with domestic supply issues is that they don't allow Canadian producers an opportunity to satisfy demand in foreign markets, either. With the exception of Aurora Cannabis, no other pot stock has as broad a global presence as Canopy Growth. Unfortunately, this international demand won't be met until domestic demand is satiated – and that could take years.
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3. Vape health concerns
In recent weeks, the U.S. Centers for Disease Control and Prevention has identified 530 cases of vape-related mysterious lung illnesses, eight of which have led to the death of the patient. This scare is concerning to Canopy for two reasons. First, derivatives are set to hit dispensary shelves in Canada in less than three months, which could lead to a weaker-than-expected sales launch. And secondly, Canopy Growth acquired popular vape device maker Storz & Bickel, giving it direct exposure to this scare.
4. Margins are anemic
Although cannabis margins haven't been great, Canopy's have been unworldly bad. In the most recent quarter, the company recorded a gross margin of 15%, which does take into account developing cultivation assets that aren't yet producing, as well as non-optimized production at certain facilities. Nevertheless, many of its peers have been producing a gross margin in the 30% to 60% range, which seems miles away for the aggressively spending Canopy.
5. Share-based compensation is climbing
Another component to Canopy's exceptionally poor operating performance is its ballooning share-based compensation. Now-former co-CEO Bruce Linton believed that keeping employees loyal was important to the long-term success of the company. As a result, he doled out long-term vesting stock to these employees, which has acted as a major drag on aggregate operating expenses. In the fiscal first quarter, share-based compensation soared to 87.4 million Canadian dollars from CA$31 million in the year-ago quarter.
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6. Canopy is losing a lot of money
Canopy Growth is also losing a jaw-dropping amount of money, regardless of whether or not you factor in one-time benefits and costs. The latest quarter featured a CA$1.18 billion loss on the one-time extinguishment of warrants tied to the aforementioned Constellation equity investment, as well as CA$229.2 million in operating expenses, relative to a gross profit of just CA$13.2 million, prior to fair-value adjustments on biological assets. This is a company that isn't anywhere near turning an operating profit, and may very well be one of the last major growers to do so.
7. Goodwill is on the rise
A pretty sizable red flag is that Canopy Growth's aggressive acquisition strategy has its goodwill on the rise. Goodwill is simply the amount one company pays for another, above and beyond tangible assets. Given that the company ended the fiscal first quarter with CA$1.93 billion in goodwill, it's looking likely that it's overpaid, at least in part, for many of the assets it's acquired. If Canopy isn't able to recoup a significant portion of this value in the quarters to come, it becomes increasingly likely that the company will take a sizable writedown on a portion of its goodwill.
8. Canopy's monstrous cash pile is shrinking
Since the calendar year began, one of the most attractive aspects of Canopy Growth has been the company's monstrous war chest. The CA$5 billion equity investment from Constellation Brands that closed in November, coupled with a CA$600 million convertible note offering in June 2018, pushed Canopy's cash and cash equivalents north of CA$4.9 billion by the end of 2018. But as of June 30, 2019, Canopy's cash pile was down to about CA$3.1 billion. With the company expected to continue losing money hand over fist, Canopy's once-vaunted downside protection is fading.
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9. No U.S. legalization anytime soon
Investors should also understand that, even though Canopy Growth is legally pushing into the U.S. hemp market and has agreed to acquire Acreage Holdings on a contingent-rights basis, legalization is unlikely to happen anytime soon in the United States. Real reform would require a party change in the Senate, which may not occur in the upcoming election. Without a federally legal U.S. market, Canopy's North American opportunity is more limited than folks probably realize.
10. There's no permanent CEO
Lastly, it's important to recognize that Canopy Growth has no permanent CEO following the early July firing of co-CEO Bruce Linton. Linton has long been viewed as Canopy's growth driver, meaning that his absence places the company's pretty defined long-term strategy into doubt. Certainly, the company's permanent CEO will focus on reducing expenses. The question will be whether or not this to-be-found permanent solution will lead Canopy Growth in a direction that will lift margins and market share.
For the time being, all signs point to weakness and the growing possibility that Canopy Growth's stock will fall below $20.
