For about a year, Canopy Growth (CGC -3.01%) has been playing with the big boys, so to speak. Despite operating in a still nascent industry, Canopy Growth has been the only cannabis stock to consistently possess a market cap in excess of $10 billion.
The company's success has a lot to do with its impressive balance sheet. Aside from raising 600 million Canadian dollars in a June 2018 convertible note offering, the bulk of Canopy's cash pile derives from a $4 billion equity investment it received from Modelo and Corona beer maker Constellation Brands in November 2018. The deal, which gave Constellation a 37% equity stake in the company, is ultimately what's given Canopy the capital to make acquisitions and expand into new markets.
At the moment, Canopy Growth is likely second in terms of peak production and international reach, trailing only Aurora Cannabis, but easily has the best known brands in the world.
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One Wall Street firm just reduced Canopy's price target by the equivalent of $6.6 billion in market cap
But the party came to an end in August, with Canopy losing its large-cap status following a weaker-than-expected fiscal first-quarter report.
And it's not just that Canopy's valuation has taken a hit. Wall Street is beginning to lose faith in the industry's brand-name pot stock. Both MKM Partners and Oppenheimer recently initiated coverage on Canopy with a perform rating (the equivalent of a hold), while another Wall Street firm decided it was time to take their scissors to previous projections and absolutely slashed Canopy's price target.
Last week, Bank of America/Merrill Lynch covering analyst Christopher Carey, who's been bullish on Canopy Growth for quite some time, reduced his rating on the company to neutral and wound up slashing his price target by 41% to $27 from $46. In market cap terms, this is a reduction of $6.6 billion.
According to Carey, Canopy Growth should remain a long-term leader in the pot industry, but he foresees multiple growth headwinds in the second half of this year. B of A/Merrill wound up reducing its forecasted multiple on Canopy from 20 times enterprise value-to-sales to just 10 times EV-to-sales.
Carey also notes that near-term health concerns about vaping could wind up impacting companies like Canopy Growth. The Centers for Disease Control and Prevention had 805 cases of confirmed or probable vape-related lung illnesses as of last week, including 12 patient deaths. Without any certainty as to what's causing these illnesses, it could have a negative impact on the upcoming launch of derivative products (including vapes) in mid-December in Canada.
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The bullish thesis has left the building
With Wall Street changing face on Canopy Growth, it's time for investors to come to terms with the fact that the bullish these on the biggest pot stock in the world has left the building. In other words, having a lot of cash on a company's balance sheet and operating in more than a dozen countries worldwide doesn't make the company a buy.
To begin with, Canopy Growth is losing money at an extraordinary rate, and it doesn't look as if it'll slow anytime soon. On top of capacity expansion expenses, Canopy's costs have shot higher because of share-based compensation. Prior to being fired as co-CEO, cannabis visionary Bruce Linton handed out a lot of long-term vesting stock to his employees in order to keep them loyal to the company. Unfortunately, this type of compensation has ballooned in recent years, substantially pushing up operating expenses for the company. As things stand now, Canopy Growth may not have a shot at recurring profitability until 2022, at the earliest.
To build on this previous point, I don't think investors have really wrapped their hands around Linton's firing. Linton was the guiding force for Canopy Growth and was responsible for building up its Tweed brand, as well as securing its massive equity investment from Constellation Brands. Without Linton, and with the current CEO, and former co-CEO, Mark Zekulin expected to step down once a permanent replacement is found, it's unclear what direction the company will head next. That's a lot of uncertainty for a company sporting an $8.6 billion market cap.
Canopy Growth is also lugging around an unsightly amount of goodwill. Goodwill is simply the amount of premium that Canopy paid for its acquisitions above and beyond tangible assets. While it's not uncommon to recognize goodwill following a transaction, ballooning goodwill throughout the industry suggests that pot stocks have grossly overpaid for their acquisitions. In Canopy's case, it's sporting CA$1.93 billion in goodwill, which looks like a writedown just waiting to happen.
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Finally, it's worth pointing out that Canopy Growth's superior production and international presence mean very little in the early going when supply issues remain persistent in Canada. Issues at Health Canada and within select provinces are liable to take many quarters to work through, which means little chance of Canopy Growth being able to demonstrate its production superiority in its domestic market.
Making matters worse, international market sales aren't going to pick up until domestic demand is satiated, which, as noted, will take time. Canopy is essentially stuck between a rock and hard place in what should be a high-growth industry. It has no immediate entry into the U.S. pot market, and the launch of dried cannabis in Canada has been subdued by supply issues.
Suffice it to say that being a brand-name stock can only take a company so far. It's time for investors to admit that Canopy Growth's luster has officially worn off.
