TLRY - Canopy Growth: Willing To Risk Everything For The USA

Summary

• Canopy Growth Corporation, once the darling of the cannabis sector, has seen its stock round trip back to 2018 levels.
• Canopy Growth has announced intentions to consolidate its U.S. assets through the formation of a holding company.
• That may lead to a delisting of Canopy Growth Corporation stock from the Nasdaq exchange.
• Canopy continues to burn cash and may have to raise cash from a secondary offering.

Canopy Growth Corporation ( CGC ) was once known as “the” cannabis stock to buy to take advantage of the promising sector. After many years of steep losses, it appears that investors have finally given up on the stock, as it is now trading near where it did prior to cannabis legalization in Canada. CGC has announced intentions to consolidate its U.S. operations into a new holding company, a move that may reinvigorate interest in the name. Beverage line BioSteel has also sustained rapid growth, but as has been very common over the past few years, investors must wait for management to finally execute against their promises.

CGC Stock Price

Before Canada legalized cannabis in late 2018, Canopy Growth Corporation was just an unknown medical cannabis operator. Then CGC soared above $50 per share as investors grew optimistic regarding its potential to become a dominant cannabis operator globally. After a volatile ride, Canopy Growth is now back to where it all started.

I last covered Canopy Growth Corporation in August, where I rated it a buy though noted my preference for the stocks of U.S. operators. CGC remains highly risky here, though its valuation can still work out in bullish scenarios.

CGC Stock Key Metrics

Canopy Growth Corporation’s latest quarter was a mixed bag. Net revenue declined 10% YOY, but adjusted gross margin jumped dramatically, from negative 52% to positive 10%, as the company moved beyond inventory issues. The adjusted EBITDA loss also improved 52%, but the free cash flow ("FCF") loss widened. Cash and marketable securities declined 42% YOY, to $1.1 billion.

While CGC is mostly thought of as a cannabis company, it actually is showing great weakness at its cannabis operations based on negative growth and poor gross margins and is instead bolstered by strength in its beverage line BioSteel.

On the conference call , management noted that their acquisition of a manufacturing facility in Virginia may help boost BioSteel gross margins even further as they would be able to eliminate co-packing costs.

The company’s overall adjusted gross margin of 10% was the highest since three quarters back and a sizable improvement over the prior year. CGC still needs to prove that it can generate positive unit-level economics on a consistent basis.

BioSteel showed 299% growth as the company benefited from its distribution agreement with Walmart ( WMT ). BioSteel ironically is the main bright light for the company.

CGC continued to burn cash, which has been a common trend.

I expect many investors are focusing less on quarterly results and more on the company’s significant announcement regarding their U.S. investments. CGC intends to consolidate its U.S. assets into a holding company, which would trigger full ownership of those U.S. investments.

Such an initiative makes sense considering that the United States remains a far more promising opportunity for cannabis than Canada. CGC’s previous hype was arguably mainly centered around its potential to penetrate the United States. CGC’s various assets span a national footprint.

Consolidating these assets would significantly alter their reported financials as they would then derive nearly half of revenue from the United States.

As a refresher, CGC’s main assets are in the multi-state operator ("MSO") Acreage, vape company Jetty Extracts, and edibles company Wana Brands. CGC also owns a significant stake in the MSO TerrAscend Corp. ( TRSSF ).

CGC expects to begin this process over the next 2 quarters, first triggering 100% ownership of Jetty and Wana, and lastly acquiring the entirety of Acreage.

It may not be so easy, however, as the company later warned that the formation of this US holding company may lead to a delisting of the stock from the Nasdaq exchange.

On the conference call, management noted that while the TSX is supportive of the new structure, Nasdaq has objected to consolidating Canopy USA into their financial results. Management noted that they “don’t require their approval of the transaction per se.”

It's also important to understand that there is no imminent risk to our listing on NASDAQ and we're continuing to engage in constructive dialogues with NASDAQ to really ensure that we are in compliance with their rules and regulations and general policies. Now even in the event that NASDAQ continues with its objection to the consolidation, there are a number of potential paths and that really includes, NASDAQ may accept the heightened level of disclosure for the USA assets. We could also appeal a decision by NASDAQ to delist our shares as we get to that point. So I just want to remind people that there's a lot of things that have to happen in the next few months. And certainly, we'll share more details with people as we get more updates.

Management also stated:

So we will continue to work with NASDAQ. We'll continue to have dialogues with them – with them to make sure that we can come to a constructive decision, but if you think about our primary motivation for Canopy USA, it is really about value creation. And so that's really where we have our eyes set on.

That commentary seems to imply a willingness to accept a delisting of the stock from major exchanges if it came down to it, but such a decision seems misguided considering that it is arguably the major exchange listing that has allowed CGC to command a significant premium to U.S. MSO peers.

Is CGC Stock A Buy, Sell, or Hold?

At recent prices, CGC trades right around the middle of the pack in terms of EV/S relative to Canadian peers Aurora Cannabis ( ACB ), Cronos ( CRON ), and Tilray ( TLRY ). I note that TLRY is the only name which has consistently generated positive adjusted EBITDA.

But CGC still trades at a large premium relative to U.S. MSOs like Green Thumb ( GTBIF ), Trulieve ( TCNNF ), and Verano ( VRNOF ) as the U.S. MSOs have consistently generated robust adjusted EBITDA margins.

Based on what I heard on the conference call, it was not entirely clear if management was still committed to delivering positive adjusted EBITDA by FY2024.

Management’s commentary that their “balance sheet remains strong with CAD1.1 billion of cash at hand at the end of Q2 and $2 billion of base shelf available” seems to imply that a secondary offering may be coming soon. That shouldn’t surprise investors considering that the net cash position has all but disappeared and the company continues to rapidly burn cash.

Management has stated that they view it “important to have a self-sustaining Canada business, while [they] really scale growth in the US.”

Trading at around 3.3x sales, the stock is more expensive than that of the U.S. MSOs but still cheap enough to provide some alpha in a bullish scenario. Assuming 15% long term net margins, 15% long term growth, and a 1.5x price to earnings growth ratio ("PEG ratio"), I could see CGC trading at 3.4x sales. If CGC can start to show growth in its Canadian operations, then it may be able to deliver double-digit forward returns. In previous reports, I have rated CGC as “buyable” but noted that I had no position and was instead focused on the stocks of U.S. MSOs. Today I am going to differ from that evaluation and rate CGC as an avoid. CGC has had more than enough time to turn things around but continues to burn cash rapidly. I expect CGC to end the next 12 months with a significant net debt position, which may be risky considering the rising interest rate environment. I also expect CGC to continue diluting shareholders with a sizable secondary offering appearing imminent.

It is worth noting that company insiders own astonishingly little of the stock.

Their compensation even exceeds their total stock ownership.

While Canopy Growth Corporation may bounce at any moment, this is the kind of environment in which such bounces are far less likely. Investors looking to invest in the U.S. cannabis are likely to find better success investing directly in the stocks of U.S. cannabis operators. As discussed with subscribers to Cannabis Growth Portfolio, President Biden’s changing shift on cannabis reform may be a crucial catalyst for the industry. I continue to view higher-quality MSOs and certain ancillary stocks to be the best way to position long term . CGC looks very risky here, and if it really does lose its Nasdaq listing, then it may lose any reason for preference over cheaper U.S. peers.

For further details see: