Canopy Growth Stock Is a Bet on a U.S. Market Which May Not Arrive

© Source: Shutterstock A close-up shot of hands holding a grinder with cannabis buds in the background representing aurora stock.

Cannabis stocks are hot again, and industry leader Canopy Growth (NASDAQ:CGC) has benefited. Before a 5% pullback on Wednesday, CGC stock had better than doubled in a little over two months. Even with the one-day weakness, shares are up 37% year-to-date.

© Provided by InvestorPlace A close-up shot of hands holding a grinder with cannabis buds in the background representing aurora stock.

It’s been a long time coming. The sector as a whole topped out back in March of 2019, when CGC briefly cleared $50. Since then, consistently disappointing results in Canada, as well as a lack of movement elsewhere in the world, have undercut sentiment. In fact, the 40%-plus decline in CGC stock from its March 2019 peak is relatively minimal compared to a 90%-plus plunge for Aurora Cannabis (NYSE:ACB) and an 85% fall for Hexo (NYSE:HEXO), to name just two struggling rivals.

But sentiment has turned, at least for now. And it’s U.S. politics that appear to be the catalyst. Positive results in the November elections along with long-awaited movement at the federal level are sparking hopes of full legalization. Canopy, more so than perhaps any other Canadian producer, would be a big winner in that scenario.

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The problem after the rally, however, is that the case for Canopy stock and the sector as a whole increasingly rests on that U.S. market. We’ve seen enough, or at least close to enough, to believe that other regulated markets (whether recreational or medical) simply do not and cannot offer the profits required to support even current valuations.

That leaves CGC stock vulnerable to sentiment toward U.S. legalization. Of late, that’s been a plus for the stock. At some point, that’s likely to change.

The Turnaround Begins

There is a sense that Canopy itself is in the middle of a potentially successful turnaround. That sense isn’t completely wrong.

Canopy brought in David Klein from shareholder Constellation Brands (NYSE:STZ,NYSE:STZ.B) to improve execution. He’s done so. Layoffs have significantly lowered operating expenses and cash burn. Production has been rationalized, with Canopy this week announcing the closure of more production facilities.

Canopy, like so many other Canadian producers, simply overshot. The demand in Canada and elsewhere was not there to support the vast amount of production capacity put into place. Significant oversupply led to a lack of pricing power and crushed profit margins. The company at least is taking steps to try and fix that problem.

Meanwhile, Canopy still is investing behind its business, as it should. CBD (cannabidiol) products have been launched in Canada and the U.S. According to Canopy’s fiscal second quarter earnings release last month, the company is gaining market share, with a 200 basis point improvement in Q2 to 15.5% from 13.5% the quarter before.

Indeed, revenue in the quarter was an all-time record for Canopy. That growth came with lower spending, as Adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) loss narrowed sharply year-over-year. Operating expenses declined 19% y-o-y, while gross margin expanded signficantly.

As I wrote at the beginning of the year, the hope coming into 2020 was that Klein would make Canopy Growth a better company. It certainly seems like he’s succeeding. The market is responding as such: CGC stock rallied almost 5% after earnings.

Is It Enough?

And yet there’s a real question as to whether ‘better’ is good enough. Taking a step back and reviewing the Q2 report, it’s hard to answer in the affirmative.

Revenue did grow. Adjusted EBITDA loss did narrow. But the quarter remains something close to a disaster.

Canopy generated 135 million CAD in revenue. Adjusted EBITDA was negative 85.7 million CAD. Canopy, using the most favorable possible profit metric, still lost 63 cents for every dollar in sales. Free cash flow burn, at over 190 million CAD, dwarfed revenue.

Yes, the Canadian market is relatively new. But it’s not that new. “Cannabis 2.0” products have been rolled out. Retail stores have opened after regulatory bottlenecks slowed capacity. There should be a way to at least near profitability in this market. Canopy is nowhere close.

The rest of the world isn’t contributing enough, either. International medical revenue actually declined 3% year-over-year.

And so it’s exceedingly difficult to see how this business, outside of the U.S., can support a market capitalization now back over $10 billion. Net cash of 1.2 billion CAD (roughly $940 million) obviously isn’t enough. The profits required to support that valuation have to come somewhere, and it’s hard to see that ‘somewhere’ being anywhere but the U.S.

The U.S. and CGC Stock

Now, if the U.S. does come around, Canopy has a huge opportunity. The likes of Aurora are hamstrung by balance sheet problems. Canopy has a deal with Acreage Holdings (OTCMKTS:ACRHF) that could provide for almost-instant access to a federally regulated American market.

But there are two core reasons for caution. The first is that Canopy isn’t necessarily just going to waltz in and take market share. Existing multi-state operators like Trulieve Cannabis (OTCMKTS:TCNNF) already have strong presences and valuable brands.

The second is that federal legalization is not a slam dunk. And it’s legalization, not just decriminalization, that almost certainly would be required for a company like Canopy to have the needed access to financial and other resources.

The U.S. House of Representatives did vote on cannabis decriminalization last week, but it was largely a symbolic vote. Republicans in the Senate still likely have enough power to block any legislation, and Joe Biden has said that he does not support full legalization.

State-level elections did provide some support for legalization and decriminalization — but, again, that’s not enough. Canopy needs movement at the federal level to enter the U.S. And it needs to enter the U.S. to create the profits needed to move CGC stock higher.

That entry could still be many, many years off. And when investors realize that fact, the rally in CGC stock is likely to reverse.

On the date of publication, Vince Martin did not have (either directly or indirectly) any positions in the securities mentioned in this article. 

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