If you asked any cannabis industry expert six months ago which pot stocks were good investments, Canopy Growth (NYSE: CGC) would definitely have topped many of their lists. The world's largest cannabis producer had signed impressive partnerships with established companies including Constellation Brands (NYSE: STZ). Canopy seemed to have everything going for it.
Yet during the past couple of months, everything appears to have turned around. Canopy shares fell by 51.7% after hitting a high point in May. Bruce Linton, the company's longtime CEO and co-founder, was fired suddenly in July. By the time the company released its quarterly financials in mid-August, shareholders were shocked by a $1.4 billion loss. Its market cap today stands at just $8.52 billion, and while Canopy is still looking to appoint a new CEO in the months to come, Mark Zekulin is currently filling the role until a replacement is found.
As analysts proceed to reevaluate the stock in light of this news, investors are faced with a conundrum. Is this recent loss in stock price a good buying opportunity, or just the beginning of a lengthy decline?
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The obvious problem
It's worth noting that other major cannabis stocks have recovered from drastic declines in the past. Investors recall the incident with Aphria (NYSE: APHA) in late 2018, where shares plunged substantially after reports from short-sellers claimed it drastically overpaid for its Latin American acquisitions. While many thought that Aphria might get bought out by other rivals during this time, the fundamental strength of its assets in Canada was strong enough to justify a bounce back in the company's stock price.
However, Canopy Growth's situation is a little different because the underlying problems behind this decline are harder to fix. Skimming over its financial results, one quickly spots a few issues. The first of which is the $1.4 billion decline in cash and cash equivalents during just one quarter. That leaves only $3.14 billion, a sizable sum nonetheless, but it won't last long if management doesn't slow down with its expenditures. However, this might be the least of the company's problems, as closer inspection shows that around $826 million of the $1.4 billion loss came from M&A activity. If Canopy's management wants to, it could drastically cut back on next quarter's losses by dialing down on M&A activity, especially with some of the more expensive acquisitions.
The real problem
The bigger problem lies elsewhere. EBITDA came in with a loss of $92 million, more than four times the loss of $22.5 million EBITDA reported the same time last year. Investors in the cannabis sector are getting tired of companies simply reporting revenue growth. Instead, they're looking for signs of profitability, something that Canopy Growth hasn't been able to provide.
The key issue comes down to pricing. Canopy reported it was charging $7.56 per gram, a significant decline from the $8.94 per gram the same time last year. While pricing for Canopy's medical cannabis remains strong, the real weakness comes from recreational marijuana, which Canopy is selling for just $6.35 per gram, down from the $7.28 per gram in the previous quarter. Considering that recreational use of marijuana is expected to increase exponentially over the coming years, a decline in what the company is able to charge is worrying.
To make matters worse, the outlook for other products might not be so optimistic. While cannabinoid (CBD) oils and gels have higher profit margins than dried flower, Canopy recently warned investors about a potential oversupply problem on the horizon. While this risk is blamed on inefficient retailers in Canadian provinces, it could mean that previous forecasts have been far too bullish and companies that have been aggressively expanding into this area – like Canopy – will take a financial loss as they struggle to sell off an oversupply of CBD products.
What should investors do?
While it seems that the company is in for a bumpy ride for the short-term, as long as Canopy's management keeps a good grip on the business, it should be able to weather out the storm over a multi-year period. Losses in the upcoming quarter will likely be far lower, if only due to the recent shareholder backlash at these M&A expenditures. While shrinking profit margins are a problem, the ongoing growth in the cannabis market both in Canada and the U.S. should help lift Canopy back to previous highs.
Linton recently said in an interview about Canopy's stock that "a 52-week low is a good thing, right, if you're trying to buy. It's bad to sell," as he announced he was buying up more shares in the company. While it might be a good time to buy and hold, investors should understand that it might take a while for the stock to return to a more appropriate price point.
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