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5 Reasons Canopy Growth Still Isn't a Buy

By Sean Williams – May 12, 2020 at 7:21AM

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The biggest marijuana stock in the world by market cap has a long way to go before it becomes investment-worthy.

At one point early in 2019, there wasn't a hotter industry on the planet than cannabis. Canada had recently lifted the curtain on a decades-long marijuana prohibition, and there was hope that numerous states in the U.S. would consider legalizing recreational or medical pot. After generating $10.9 billion in worldwide legal sales in 2018, it looks like a sure thing that the pot industry would be bringing in at least $50 billion annually by 2030.

But over the past 13-plus months, the wheels have decisively fallen off the wagon. Between regulatory issues in Canada that have adversely affected supply, high taxes rates in the U.S. that have made it difficult for retailers to compete with black-market growers, and minimal access to nontraditional financing for all North American pot stocks, the marijuana industry has been a disaster.

A close-up of a flowering cannabis plant.

Image source: Getty Images.

The question investors are left to ask is, are these significantly reduced valuations a reason to buy? For some cannabis stocks, the answer may be yes. But for Canopy Growth (CGC 22.15%), the largest pot stock in the world by market cap, it remains wholly avoidable.

While Canopy has taken steps to better its business, including hiring a no-nonsense, cost-conscious CEO in David Klein, here are five reasons Canopy Growth isn't worth buying, even after a sizable pullback.

1. It's a long way from being profitable

Let's start with the basics, such as operating results actually mattering now in the cannabis space.

Klein's presence as CEO -- Klein was previously the Chief Financial Officer at alcohol giant Constellation Brands (STZ -1.45%) -- will certainly help Canopy Growth rein in many of the company's exorbitant expenses. In recent quarters, share-based compensation has been a killer for Canopy, but should be significantly reduced in fiscal 2021 (April 1, 2020 – March 31, 2021). Klein has also overseen the permanent closure of licensed greenhouses and multiple rounds of layoffs due to weaker-than-anticipated pot demand and the coronavirus disease 2019 (COVID-19) pandemic.

Yet even with these aggressive cost-cutting measures, Canopy is nowhere near turning the corner to profitability. Having such broad-reaching infrastructure also means that adjusting the puzzle pieces to match the current demand environment takes time. As a work in progress, I'm not looking for Canopy to have any shot at approaching recurring profitability until 2022, at the earliest.

Two businessman in suits shaking hands, as if in agreement.

Image source: Getty Images.

2. You're reading too much into the Constellation Brands deal

Next up, a lot of investors are reading too deeply into Constellation Brands' latest stake-upping move in Canopy Growth.

As a refresher, Constellation took an initial 9.9% stake in Canopy for about $190 million in October 2017, acquired a third of a $600 million Canadian convertible debt offering in June 2018, and made a $4 billion equity investment into Canopy in November 2018. Then, a little more than a week ago, Constellation exercised almost 18.9 million warrants to up its stake another 5.1% to 38.6%. This cost Constellation approximately CA$245 million. If every remaining warrant were exercised and its stake in the debenture fully converted, Constellation could own as much as 55.8% of Canopy Growth. 

Sounds pretty bullish, right? The thing is, these warrants were set to expire in just a few days. Having installed former CFO David Klein as CEO, Constellation had little choice but to execute these warrants to save face and offer support for Canopy's new leader. Allowing these warrants to expire would have raised red flags about Constellation Brands' faith in David Klein and its future as a partner in the cannabis industry. In short, this isn't as bullish an event as you might think. 

A person holding cannabis leaves in front of a globe of the Earth.

Image source: Getty Images.

3. International sales have been a disappointment

A third reason Canopy Growth is highly avoidable is the company's relatively anemic international sales.

Behind Aurora Cannabis, no pot stock has broader access beyond Canada than Canopy Growth. The expectation had been that production escalation would eventually lead to Canadian market saturation, followed by an export bonanza to overseas markets. With Canada having a leg up on international markets in setting up production facilities and arranging export licenses, Canopy should have had a clear path to a quick ramp-up in sales. However, with the exception of Germany, the company's international sales have been mediocre, at best.

In the fiscal third quarter (ended Dec. 31, 2019), Canopy Growth delivered CA$18.7 million in international medical marijuana sales, up a mere CA$0.6 million from the sequential quarter. Without a significant uptick in higher-margin overseas medical sales, Canopy Growth will remain relatively reliant on lower-margin dry cannabis in supply challenged Canadian markets.

Multiple clear jars packed with dried cannabis buds.

Image source: Getty Images.

4. A massive inventory writedown may await...

Perhaps the most under-the-radar reason why Canopy Growth should be avoided is the company's ballooning inventory.

At the end of calendar year 2019, Canopy Growth had CA$622.6 million in inventory, which was nearly as much as Aurora Cannabis, Aphria, Tilray, OrganiGram, and Cronos Group combined in their comparable December-ended quarter! Having some backlog of product is a good thing. However, when inventory levels balloon this much with few legal channels to move this product, it spells disaster.

Back in February, MKM Partners' covering analyst Bill Kirk noted that Canada's annual run-rate demand for the entire legal market was about 180,000 kilograms. Kirk estimated that if Canopy halted all of its growing operating and maintained its existing market share, it would take approximately 2.5 years for it deplete its inventory in Canada. In other words, there's the real possibility of a large inventory writedown in Canopy's future.

A person holding a magnifying glass over a company's balance sheet.

Image source: Getty Images.

5. ... Along with a goodwill writedown

Finally, since we're on the topic of writedowns, it's also plausible that Canopy Growth is going to have to take a hefty impairment charge following its acquisition binge in recent years.

When one company buys another, it's not uncommon for a premium to be paid above and beyond tangible assets. This premium is often recorded as goodwill, with the intent of the acquiring company to eventually recoup this premium through increased profitability from the acquired business over time. But in hindsight, the prices paid for acquisitions in the cannabis industry proved way too high.

At the end of calendar year 2019, Canopy Growth had CA$2.07 billion in goodwill, up from CA$1.54 billion just nine months prior. This CA$2.07 billion works out to 26% of the company's total assets, with the real likelihood that this percentage could grow as operating losses persist. Chances are that a substantive goodwill writedown will be needed at some point in the foreseeable future to clean up the company's balance sheet.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Constellation Brands and OrganiGram Holdings. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Canopy Growth Stock Quote
Canopy Growth
$3.75 (22.15%) $0.68
Constellation Brands, Inc. Stock Quote
Constellation Brands, Inc.
$232.52 (-1.45%) $-3.43

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