When the year began, expectations for the cannabis industry were off the charts -- and the performance of pot stocks during the first quarter confirmed it. The Horizons Marijuana Life Sciences ETF, the first cannabis-focused exchange-traded fund, galloped higher by more than 50% in the first quarter, with over a dozen popular cannabis stocks gaining in excess of 70%. With Canada having legalized recreational marijuana in October 2018 and the U.S. seemingly adding new legalized states each year, the sky looked to be the limit.
Little did investors know that the "sky" had a low-hanging glass ceiling.
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One of the most popular marijuana stocks has a new fan on Wall Street
Since the end of the first quarter, marijuana stocks have been pummeled, with a capital "P." Most are down in excess of 50%, with the largest pot stock in the world, Canopy Growth (CGC -1.59%), losing more than $10 billion in market cap and close to 70% of its share price since finding its highs earlier this year. But this decline has some analysts on Wall Street considering cannabis stocks a good value.
Last week, on Wednesday, Nov. 20, Bank of America/Merrill Lynch covering analyst Christopher Carey upgraded Canopy Growth to buy from neutral and set a 24 Canadian dollar price target ($18.04). Interestingly enough, Carey and his team at BofA/Merrill Lynch had cut Canopy from buy to neutral less than two months prior, while setting a CA$27 target.
In the research note released to clients, Carey stated that Canopy Growth's stock had dropped 38% since issuing the downgrade on Sept. 27. Since then, valuations have become more reasonable, with sales estimates coming down and becoming achievable, if not beatable. BofA also points out that inventory levels are becoming leaner, which may help to alleviate early stage oversupply and pricing pressure concerns.
Even with Canopy's valuation significantly reduced, it remains the largest marijuana stock by a mile, and is clearly one of the most popular among investors. But just because one Wall Street analyst sees greener days ahead does not mean this stock is worth buying.
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This Wall Street buy recommendation is very premature
For one, there doesn't seem to be much hope of Canada's supply problems resolving anytime soon. Health Canada has changed its cultivation application process to hopefully approve more growing licenses, but is still contending with a huge backlog of cultivation, processing, and sales license applications.
The bigger worry on the supply front for Canopy is that certain provinces haven't done a very good job of providing sales channels for legal weed. Ontario, a province of 14.5 million people (nearly 40% of Canada's population), had just two dozen open retail locations a full year after the launch of recreational marijuana. That's simply not going to cut it, and it's creating an odd situation whereby growers are facing oversupply, yet most consumer demand is still being met by black-market producers. It's already difficult to drive out black-market producers with legal product facing an excise tax, but it's considerably tougher when regulatory agencies are slow-stepping the rollout of dried cannabis flower and derivatives.
Another issue for Canopy Growth is that the company's aggressive overseas investments aren't anywhere near a point where they're going to pay dividends. Health Canada is counting on growers to satisfy domestic demand before shipping substantial amounts of cannabis to overseas markets, and Canadian supply issues are unlikely to be resolved for a while. Also, a number of overseas countries are still in the process of establishing their medical marijuana regulations, suggesting that they're nowhere near the point of accepting bulk imports from Canopy.
The company's share-based compensation is also a major liability. Now-former co-CEO Bruce Linton strongly believed that providing long-term vesting stock and options to employees would keep them loyal to the company. However, this issued stock has caused Canopy's expensing to go through the roof. In fact, the latest quarter featured net sales for the company that were lower than just its share-based compensation. Canopy Growth's free-spending ways are liable to keep it losing money possibly into fiscal 2022.
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It's also worth mentioning that Canopy Growth is without anyone to truly steer the ship. With longtime company visionary Linton getting the heave-ho in early July and current CEO Mark Zekulin, who was co-CEO with Linton, stepping down once a permanent CEO solution is found, the long-term strategy for Canopy Growth remains clouded, at best.
I'd also be remiss if I didn't mention the time bomb on the company's balance sheet: its growing goodwill. With acquisitions representing a key part of Canopy's expansion strategy, it's become pretty evident in recent months that Canopy likely overpaid for the businesses it has acquired... by a lot. The CA$1.91 billion in goodwill currently on its balance sheet accounts for 23% of total assets, and this is a percentage that just keeps growing as the company's cash dwindles and losses grow. It's looking likely that a pretty sizable writedown -- one that would dwarf Canopy's fiscal second-quarter inventory writedown -- is in the offing.
Look, I understand that Canopy Growth has strong branding and hasn't struggled with licensing wait times like a number of its peers. However, recency bias is likely tugging at investors' heartstrings and clouding their judgment. In other words, just because Canopy has fallen from north of $50 into the teens, it doesn't make the company a good value. The argument could just as easily be made that Canopy never deserved a $17 billion market cap in the first place.
With the company's cash continuing to shrink, a writedown looming (in my view), and Canopy expected to lose money for years to come, it remains a cannabis stock to avoid, regardless of what Wall Street says.
