Canopy Has Global Potential Amid Foggy U.S. Market
The cannabis company took a hit on Q2 earnings, but consumer demand is expected to increase.
On Nov. 14, Canopy (CGC) reported second-quarter results highlighted by product mix challenges due to an unexpected and dramatic hit to revenue and profits. After overproducing oil and softgel for the Canadian recreational market, the company had to accept returns and price reductions that led to a CAD 33 million restructuring charge. Management also scaled back its previous goal of CAD 250 million in net revenue in the fourth quarter of fiscal 2020 because of insufficient points of retail sales in the near term. We always questioned the wisdom of setting a target when provincial governments' slow rollout of stores has held back the industry, so the retraction makes sense to us. We maintain our no-moat rating.
We view the announced restructuring charge as a disconnect between the cannabis forms Canopy produced and those that customers wanted, and not reflective of oversupply of cannabis in general. Kilogram equivalents sold increased 397% year over year to 10,913 kilograms, which the Canadian recreational market and international medical market boosted. Furthermore, the business-to-consumer retail channel saw sequential growth of 24% from the first fiscal-year quarter. As cannabis 2.0 rolls out and more consumer-packaged goods will be available for sale, customer demand is expected to increase for these new cannabis products.
Additionally, Cronos (CRON) and Tilray (TLRY), which have already reported earnings this quarter, had no similar restructuring charges. We think they didn't have such a dramatic mismatch between forms produced and demanded, which Canopy blamed on the lack of Canadian data during initial production plans. While it will take several months or more to correct its production and inventory to market preferences, we see the issue as ultimately surmountable.
The restructuring charge marred Canopy's results, as revenue declined 15% sequentially from the prior quarter to CAD 76 million, largely because of the charge. Gross margin before fair value adjustments was negative 13% for the quarter. When adjusted for the restructuring charge and underutilized facilities, gross revenue grew 6% and gross margin would have been 38%. Although the charge significantly affected revenue and gross margins for the quarter, we consider it a temporary headwind. The company continues to be well positioned for dramatic growth in Canadian, U.S., and international cannabis markets.
Canopy is currently trading roughly 65% below our fair value estimate, as the lack of profitability and the uncertainty related to the restructuring charge have weighed on the market price. However, while there have been a lot of unexpected speed bumps, we think it would be misguided to focus on profitability this early in the company's and industry's evolution. We continue to think that the seeds for long-term value are present. With a normalized gross margin of roughly 40%, continued demand growth that will be fueled by cannabis 2.0 products, and the help of Constellation Brands (STZ), which owns 37% of Canopy. We see Constellation's investment as supportive of Canopy's focus on developing branded cannabis consumer products.
Global Market Looks Lucrative
Canopy Growth grows and sells cannabis products primarily in Canada, which accounts for roughly 80%-90% of gross sales. Although historically focused on medical cannabis in Canada, Canopy has pivoted to recreational sales after legalization in 2018. Recreational cannabis now accounts for roughly 70% of gross sales. Although we expect the medical market to shrink because of recreational legalization, we forecast roughly 20% average annual growth for the entire Canadian market through 2030, driven by the conversion of black-market consumers into the legal market and new cannabis consumers. Canopy also exports medical cannabis globally. The global market looks lucrative, given higher realized prices and growing acceptance of cannabis' medical benefits. However, exporters must follow strict regulations to enter markets, protecting early entrants like Canopy. Partially offsetting the global markets' potential for Canadian producers are threats of future production from countries with cheaper labor--the single largest cost. Canopy's efforts to expand production into countries like Colombia and Lesotho should offset its cost-disadvantaged Canadian production. We forecast around 20% average annual growth through 2030.
Canopy Betting on Federal U.S. Legalization
Besides hemp, Canadian companies typically have no U.S. operations, given legal limitations. However, in April 2019, Canopy reached a deal to acquire Acreage Holdings, a U.S. cannabis company, immediately upon federal legalization. We thought Canopy paid a good price and acquired an attractive option for an accelerated entry into the U.S. The U.S. market is murky, with some states legalizing recreational or medical cannabis while it remains illegal federally. We expect that federal law will be changed to recognize states' choices on legality within their borders. Based on our state-by-state analysis of cannabis legalization, we forecast nearly 25% average annual growth for the U.S. recreational market and nearly 15% for the medical market through 2030. Regulation around supply can also significantly shape free cash flow generation. Businesses must be licensed by governments to operate cultivation facilities and dispensaries, with licenses specifying production levels. However, governments have at times expanded too slowly or too quickly. In Ontario's early months of legalization, dispensary licenses were distributed slowly, leading to multiple-hour wait times for potential customers. Oregon has faced the opposite problem, as an excessive amount of cultivation licenses has led to market oversupply, driving cannabis prices lower.
Another risk is the black market. Years of government efforts have done little to stem illegal cannabis, but a change to the ease of accessing black-market supply could have a significant impact on the pricing power, thus the profitability of legal cannabis companies. In addition to the operational risks Canopy faces, it also faces financial risk. As the company has yet to generate positive free cash flow, it will continue to rely on outside capital raises, especially as it expands production to meet growing demand. Although historically focused on medical cannabis in Canada, Canopy has pivoted to recreational sales after legalization in 2018. Recreational cannabis now accounts for roughly 70% of gross sales. Canopy also exports medical cannabis globally. The global market looks lucrative, given higher realized prices and growing acceptance of cannabis' medical benefits. Exporters must pass strict regulations to enter markets, protecting early entrants like Canopy. Partially offsetting the global markets' potential for Canadian producers are threats of future production from countries with cheaper labor--the single largest cost. Canopy's efforts to expand production into countries like Colombia and Lesotho should offset its cost-disadvantaged Canadian production. We forecast around 20% average annual growth through 2030.
Kristoffer Inton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.