Canopy Growth – Everything's Gonna Be Alright

The World's largest cannabis company – Canopy Growth – delivered a pretty poor set of quarterly results, and with Bruce Linton no longer at the helm, investors are asking…now what?

 

As Highlander famously said, "there can be only one", and this has always been Canopy Growth. The global behemoth was founded in the small town of Tweed—where the abandoned Hershey's chocolate factory stood barren—before the vision and drive of one man, Bruce Linton, grew it into a $15 billion dollar business in only 5 years.

But, no matter how big they are, the fable of David and Goliath tells us that the right hit at the right time can topple even the greatest. In this case, Bruce Linton, the founder, visionary, and global commercial rock star, was fired. Gone, immediately. 

No one fires their CEO when they are kicking ass. If a CEO is fired straight after a quarter, then it stands to reason, that the coming quarter is not going to be much better. This was off the back of a pretty average Q1 for Canopy, where losses and burn grew ever larger by the quarter. Constellation had simply had enough. 

The markets were rocked by the termination of Bruce Linton, and the share price subsequently softened. Then usual suspects started making noise about a pretty bad looking Q1 in the Twittersphere. And now that the results are in, it's what my grandmother always swore. If there's smoke, there's a fire son.

 

Q1 2020…and shares fall 11%

On the 14th August, Canopy Growth released earnings for the first quarter of their fiscal 2020. The company reported a sequential decline in revenue, a $1.3 billion loss, and a marginal improvement in adjusted EBITDA. Bottom line, not good at all.

Canopy Growth Recreational Cannabis
Source: Company Filings

Canopy Growth's net revenue also declined 4% QoQ to $90 million. Not only is this a decline when almost everyone else is showing an increase, but it is now behind Aurora's $100-107 million guidance. If you remove the revenue of the recently acquired C3 in Germany, then the decline of 13% QoQ becomes even worse.

Previously, Canopy had quickly established themselves as the recreational market leader in Canada. However, sales in this current quarter were flattered by higher pricing on the medical cannabis side of the business, whereas its recreational sales came in at $6.35 per gram, nearly a dollar lower than just one quarter ago.

The decline in revenue is glaringly obvious. Canopy clearly misunderstood the level of demand in the Canadian recreational cannabis market. Basically, they banked on high demand for recreational oils and capsules. But these were low potency oils and capsules, and the market never took to them at all. As a result, Canopy is taking an $8 million hit, and expects a significant amount of their previously-sold product to be returned, unsold.

Canopy Growth Recreational Cannabis
Source: Company Filings

Canopy Growth came into the quarter with the worst margin of any of the Canadian LP's and left in even worse shape. This quarter's margin dropped to an all-time low of 15%. To put this in perspective, most of the major producers are above 50%, with only Tilray's margin being comparable, but then they both buy and sell cannabis at wholesale.

One big win from the quarter was their harvest. Canopy Growth recorded its largest-ever cannabis harvest in the June quarter. Nearly 41,000kg harvested, up 323% from the 9,685kg harvested one year earlier.  Good news for investors is that over 70% of this harvest is graded as "high THC" strains, which sell very well. 

This was a huge decline in sales, but with a massive increase in premium inventory they should have significant future revenue potential. Investors could expect higher sales in the coming quarters.

Operating costs for the quarter declined 6% QoQ to $229 million. Although we applaud the decline, make no mistake about it, it's still way higher than the revenue, meaning profitability is still a way off.

 

Canopy Growth Recreational Cannabis
Source: Company Q1 FY20 Financial Statement.

 

A $1.2 Billion decision!?

Canopy Growth's income statement contains a $1.176 billion charge for "loss on extinguishment of warrants." Essentially, when Constellation Brands invested $5 billion into Canopy last August, part of the deal was that Constellation was given warrants, allowing them to purchase up to 55% of the business for an additional $5 billion. When Canopy made the decision to acquire Acreage in April this year, the all-stock deal would lead to dilution for Constellation , and thus their warrants needed to be renegotiated.

Bottom line, Canopy Growth has agreed to use about one-third of the proceeds from Constellation's warrants for a share buyback. It is an accounting fix and no money will ever actually be paid. This non-operating loss led to Canopy's $123 million operating loss, which would eventually become a $1.3 billion net loss. Despite this—and the cash payments to acquire C3 and Acreage Holdings—Canopy still has $3.1 billion in cash on hand.

 

Disclaimer: Past performance is not an indicator of future performance.

Haven't you heard?

Canopy Growth revealed that, despite posting strong sales and volume growth in the first quarter of its new fiscal year, it's still been unable to generate a profit. In fact, following Aurora's guidance of their upcoming results, Canopy has finally been knocked off the #1 ranking. It was never going to be a great quarter. Bruce Linton is no ordinary CEO, and for Constellation to fire him, and that fast, always meant the next couple of quarters were going to be, well, harsh.

But one would be naive to think that the next quarter is going to be that much better. Yes, they have significantly increased their harvest, and high THC strains should drive higher revenue, but it's the profitability that is going to be the short-term Achilles heel.

For a while now, Aurora has been spruiking guidance of a positive EBITDA by the end of the next quarter. Albeit, we do not think they will actually achieve it (without funky accounting and adjustments), the fact remains they will probably come reasonably close, and herein lies the point.

Canopy Growth Recreational Cannabis
Source: Company Filings

Canopy needs to address the burn, and do it immediately. They have more than enough cash in the bank and are dominant in many areas of many markets. But falling revenue, industry-low margins, and global growth are all burning cash in staggering amounts, and Canopy needs to tighten the ship and start looking to drive operating leverage if it's to ever turn a profit. And apparently—according to some—profit is making a comeback.

But there are most certainly good things to come. Acreage talking about Tweed in the US, Canadian edibles and extracts around the corner, and a new super-CEO (one would think) on the horizon, all lead us to believe that this will be a short term blip on the radar for Canopy.

If like us you're long-term on Canopy Growth, then take advantage of these buying opportunities. Because in this case—with their global brand, backing and base—we think Bob said it best.

 

Mark Bernberg
Mark Bernberg

Mark Bernberg is a long-time cannabis investing enthusiast and founder of The Green Fund, Asia Pacific's preeminent media house, positioned at the forefront of the global cannabis industry.

Leave a Reply

Your email address will not be published. Required fields are marked *