Investors routinely ask if they should be buying marijuana stocks. No investor wants to miss out on a timely opportunity for juicy returns. After all, U.S. federal decriminalization could be in sight depending on several political factors, and lots of market watchers expect such a policy change to catalyze pot stock prices.
Many states have already legalized cannabis for medical and recreational purposes, which has been a boon to multistate operators that can sell cannabis there. But what does U.S. decriminalization of pot mean for marijuana giants north of the border, namely Canopy Growth (CGC -4.62%), which has a deal in place to merge with Acreage Holdings (ACRGF) that's contingent on full federal legalization of cannabis?
First, it's important to understand the difference between the more likely decriminalization policy and the much more remote possibility of full federal legalization in the U.S. Decriminalization means little to overall pot demand and consumption of cannabis.
The recent MORE bill passed by the House of Representatives seeks to expand financial services to cannabis businesses and expunge the criminal records of those convicted of certain marijuana-based offenses. To become law, this bill will need to gain traction in the Senate, which is not a sure thing.
For investors, only federal legalization of marijuana in the U.S. would be a total game-changer. So, for those expecting the U.S. under President-elect Joe Biden to follow through on his promises to decriminalize cannabis, is Canopy Growth a buy?
Is 2021 a turnaround year for Canopy?
Canadian marijuana producer Canopy Growth tends to hog the pot sector's headlines, but it was especially interesting to investors in January 2020 when alcohol giant Constellation Brands' (STZ -0.48%) CFO David Klein took over as Canopy's CEO. Subsequently, in May, Constellation Brands increased its equity position in Canopy to 39% -- tying the fates of the two companies more closely together.
Klein is completing his first year at the helm of Canopy and has been very active in driving change. Recent announcements include the closure of several production facilities to reduce expenses and production capacity, the introduction of a line of wellness products called Martha Stewart CBD which is sold by The Vitamin Shoppe, and the divestiture of subsidiary Canopy Rivers.
These initiatives should help stabilize the business, and it's clear that Klein is executing a strategy to drive growth and streamline operations.
Commitment to achieving profitability
On the last earnings call, Klein said: "We remain committed to delivering at least 40% gross margin over time. And in support of achieving this target, we are nearing completion of the operations and supply chain review that we began in Q1."
Why is there a need to reduce production capacity in a growing market? It appears that Klein is right-sizing the company to drive the business strategy and to prepare the company to grow more efficiently in the next 10 years. Some of these business changes are difficult for employees to understand, as evidenced by the mediocre Glassdoor CEO approval rating of 71%.
Canopy Growth has a $9.2 billion market cap, revenue of $358 million trailing 12-months, and revenue growth rate of 38.7%. In the latest quarter, revenue grew 77% year over year, and with the reduction of production capacity, expenses should drop and put the company on a solid footing.
However, to date, operating expenses have remained relatively flat for the past two quarters, so the proof of expense reduction is yet to come. If Canopy can demonstrate that it's on a pathway to profitability, that will catalyze its stock price higher.
The other significant driver of stock price will be the legalization of marijuana in the U.S. Canopy is already prepared to grow with the advent of U.S. legalization, with the right to purchase Acreage Holdings. That deal is contingent on the U.S. federal government legalizing marijuana.
Negative cash flow should remain a concern for investors, as Canopy Growth is not yet profitable. The big question is whether the company will be a large player in cannabis globally. The probability of success is reasonable given Klein's financial acumen and experience, the backing of Constellation Brands, and the expected eventual federal legalization by the U.S. government.
To buy or not to buy?
Any prudent investment in Canopy Growth calls for a long time horizon and the patience for inevitable volatility. Canopy's stock mirrored the S&P 500 in the past 12 months -- up 16.8% versus the S&P 500 at 16.3%. Yet, the stock has done poorly compared to the S&P 500 over three years, with the S&P 500 outperforming Canopy by 36%.
Investors looking to add cannabis exposure to their portfolios would do well to consider buying Canopy Growth stock. Still, a more effective approach would be to add a second and even a third pot stock to round out a diversified cannabis position, perhaps adding stocks of strong U.S. multistate operators like Trulieve or Curaleaf. For investors with a long outlook and an appetite for risk, marijuana stocks are an essential, but small, part of their overall portfolios.