Last year was supposed to when the marijuana industry proved skeptics wrong and demonstrated that it could be a profitable industry. For the most part, this vision fell flat on its face.
In Canada, supply issues remained persistent throughout the year, keeping legal product off dispensary shelves and fueling an already resilient black market. Meanwhile, in the U.S., high tax rates in select states (looking at you, California) made it virtually impossible for legal growers to compete with illicit production. The end result was weaker-than-expected legal weed sales throughout much of North America and steep declines in market valuation for most marijuana stocks.
The thing is, with cannabis stocks losing so much in 2019, some investors are genuinely wondering whether 2020 is the time to buy pot stocks. One name that's certain to come to mind is Canopy Growth (CGC -3.01%), the largest marijuana stock by market cap. In 2019, Canopy Growth lost about 27% of its value and shed around $10 billion in market cap from its closing high for the year.
But is Canopy Growth a pot stock you should be buying in 2020? The answer is probably going to disappoint you.
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Canopy Growth looks like a buy -- on paper
On one hand, Canopy Growth does seem to offer a number of advantages -- on paper. It has 10 cultivation facilities that are fully capable of more than 500,000 kilos, combined, of peak annual output. This substantive production is a big reason the company wound up securing more than 70,000 kilos of supply agreements in total with all of Canada's provinces. And Canopy Growth's Tweed is arguably the most recognized cannabis brand in Canada.
The company has also done a seemingly bang-up job of pushing into overseas markets. Including Canada, it has an export, production, research, or partnership presence in 17 countries. If and when dried flower becomes oversupplied, these foreign countries could provide invaluable sales channels to offload excess product.
But the real envy surrounds Canopy Growth's cash position. In November 2018, Canopy closed a $4 billion equity investment from Modelo and Corona beer-maker Constellation Brands (STZ 0.06%). The investment gave Constellation a 37% stake in Canopy and further diversified its future revenue channels within the vice space. For Canopy, it gave the company ample cash to make acquisitions, hire, and expand the company's existing operations.
Top-tier production, international expansion, and plenty of cash on hand -- sounds like a buy, right? Unfortunately, that's not the case.
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A fundamental disaster that should be avoided in 2020
Canopy Growth may be a well-known and popular pot stock, but popularity isn't going to do a darn thing for the financial mess this company has gotten itself into.
For one, regulatory issues have done Canopy (and the entire industry) no favors. Although the company hasn't had any issues getting cultivation and sales licenses for its facilities, it's been walloped by licensing issues in certain provinces. Ontario, for example, is Canada's largest province by population, yet it only had 24 open dispensaries as of the one-year anniversary of the commencement of recreational weed sales. That's only one store open per 604,000 people, and it's created a massive supply bottleneck in the region. Though Ontario is (thankfully) abandoning its lottery system for retail licenses in 2020, it's going to be some time before the cannabis supply chain improves.
This is also a company that's been losing a staggering amount of money. In just the fiscal second quarter alone, Canopy's loss from operations totaled $265.8 million Canadian, with CA$388.9 million in losses through the first six months of fiscal 2020. While hiring a boatload of new employees has pushed costs higher, the real kick in the pants has been skyrocketing share-based compensation.
Now-former co-CEO Bruce Linton believed that giving long-term vesting stock to employees was the best way to motivate them and keep them loyal. However, it's ballooned Canopy's costs so much that share-based compensation was higher than the company's net sales in Q2 2020. This makes profitability a distant hope for the company at the moment.
Furthermore, Canopy's balance sheet isn't as pristine as its CA$2.7 billion in cash, cash equivalents, and marketable securities would imply. That's because, in addition to whittling away at its cash pile due to ongoing operating losses, it also seems to have grossly overpaid for its acquisitions. The company's CA$1.91 billion in goodwill represents 23% of total assets and is climbing. This looks to be a writedown just waiting to happen.
Lastly, Canopy is welcoming a new CEO in January. While I have no doubt David Klein, Constellation Brands' soon-to-be former chief financial officer and new Canopy CEO, will handle some serious belt-tightening, he ultimately has no experience in the cannabis industry and puts the company's previous long-term strategy into doubt.
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What needs to happen for Canopy Growth to be worth buying?
Just because this company has been an absolute mess of late doesn't mean you can't add it to your watch list for future evaluation. As noted, it has a number of positives on paper but would need a lot to go right before becoming a buy for investors.
First, there would need to be some serious improvement of Canopy's income statement. This starts with serious cost-cutting, as well as supply-chain resolutions. Ontario should be able to open roughly 250 new dispensaries this year, which is a good start to pressuring the black market and giving consumers access to legal-channel product. Canopy doesn't have to be profitable on a recurring basis to be taken seriously as an investment, but it can't be on track for close to CA$800 million in operating losses, either.
Secondly, the company would probably have to clean up its balance sheet a bit. On top of reducing its net-cash outflow, Canopy would likely have to admit that it overpaid for a number of its acquisitions and take a writedown to clean the slate, so to speak. Make no mistake about it: A writedown would not be well-received but a smart move for the long run.
Lastly, Canopy will need a much better showing in international markets. The company should begin to realize hemp-processing revenue from its New York processing plant later this calendar year, and will hopefully see an uptick in European medical marijuana sales as more EU countries establish medical pot regulations and commence imports.
It's not an impossible hill to climb for Canopy Growth, but it's not a stock you'll want to own in 2020.
