In just 43 days, Canada will make history. Following the passage of the Cannabis Act in June, recreational marijuana is set to become legal for adult-use in our neighbor to the north. While around 30 countries worldwide have given the green light to medical weed, Canada’s becomes only the second country total, and first industrialized nation, to approve the sale of recreational cannabis.
When dispensaries open for business on Oct. 17, the expectation is that demand will be high — and that pun is fully intended. Once fully ramped up, the industry could be generating upwards of $5 billion in added annual revenue, atop what it was already bringing in from domestic medical pot sales and via exports to foreign countries where medical marijuana is legal. It’s this expectation of big dollar figures that’s sent marijuana stock valuations into the stratosphere.
Leading the group is none other than Canopy Growth Corp. (NYSE: CGC), which became the first pure-play pot stock to carry a large-cap valuation last week (traditionally defined as a market cap of $10 billion or higher). The question is, with recreational weed still yet to launch, can Canopy Growth hold on to its $10 billion market cap, or even build on its valuation, in the months and years that lie ahead? Let’s take a pro-versus-con look.
Pro: Yes, Canopy Growth can maintain or build on its $10 billion market cap
Probably the biggest catalyst working in favor of Canopy keeping or building on its large-cap valuation is its deepening relationship with alcohol giant Constellation Brands (NYSE: STZ), which is perhaps best known for its Corona and Modelo beer brands.
In late October 2017, Constellation took a 9.9% equity stake in Canopy for what amounted to about $190 million at the time. This investment has since compounded many times over. In June, Constellation took the opportunity to grab a third of Canopy’s CA$600 million convertible note offering, which gives Constellation the option of converting its notes to more shares of Canopy stock, thereby increasing its stake. And more recently, before the opening bell on Aug. 15, we learned that it was taking a $3.8 billion equity stake in Canopy, raising its aggregate stake to 38%. Along with the 139.7 million warrants that will be issued upon closing, it will give Constellation Brands an opportunity to become a majority stakeholder in the company.
The tie-up between Constellation and Canopy is about more than just a few products. Constellation’s willingness to invest over $4 billion in Canopy suggests that it truly believes cannabis is a long-term growth driver. Likewise, it’s pretty evident that Canopy’s management believes Constellation’s global breadth and marketing expertise could come in handy.
Secondly, it’s arguable that no cannabis company has the infrastructure in place that Canopy Growth does. It already has 2.4 million square feet of licensed growing capacity, and appears to be on its way to 5.6 million square feet in aggregate grow space. When fully licensed, it’ll likely slide in as the nation’s No. 1 or No. 2 grower, with somewhere in the neighborhood of 500,000 kilograms of annual capacity. Canopy also has access to numerous international markets, and is able to sell its weed through multiple channels, including privately owned physical stores and online sales.
And thirdly, Canopy Growth has a broadening selection of pot products beyond just dried cannabis, as well as the most recognized brand throughout all of Canada: Tweed. Though much focus has been placed on dried marijuana, it’s shown to be an easily commoditized product in Colorado, Washington, and Oregon. Therefore, Canopy’s push toward oils, and more specifically its softgel capsules, demonstrates the importance of brand building and product differentiation.
In other words, it would appear to have the tools to command one heck of a premium valuation.
Con: No chance! Canopy Growth has a nosebleed valuation and is primed to fall
Then again, there are a number of reasons to believe that Canopy Growth’s valuation could be in bubble territory.
One of the prime concerns with legalization in Canada is that Wall Street, and the marijuana growers themselves, have absolutely no clue what the supply and-demand outlook is going to look like. Sure, we know that demand will be strong out of the gate, but we really don’t know where Canada’s domestic annual demand will settle at once the initial euphoria wears off.
Building on this point, we witnessed growers expanding their capacity without restraint during the first half of 2018. After beginning the year with an aggregate expectation that pot growers may not even hit 1 million kilograms of production when fully operational, I’m now fairly confident that annual production will top 3 million kilograms by 2020. Based on estimates from Health Canada, this could work out to a 2-million-kilogram annual oversupply. Though foreign markets are expected to gobble up this oversupply, it remains to be seen if that happens. Foreign market grow industries may be nascent now, but that could change by the time 2020 rolls around.
Another concern with Canopy Growth is the company’s bottom line. Even though sales are expected to grow by triple digits in each of the next two years, there’s no guarantee that Canopy will generate a profit. Even with more than $4 billion in cash in its coffers (once the equity investment from Constellation closes), the company will be spending big bucks on expanding internationally, and it could be some time before these expenditures translate into positive bottom-line results. Will investors be willing to wait for Canopy Growth’s fundamentals to make sense? That isn’t guaranteed.
Finally, investors have to take into account the possibility that share dilution will continue to wreak havoc on Canopy Growth, and marijuana stocks as a whole. Prior to the passage of the Cannabis Act, the only regular means to access capital for most pot stocks was through bought-deal offerings, whereby common stock, convertible notes, stock options, and/or warrants were sold.
For Canopy, its outstanding share count in Canada ballooned to just over 200 million shares at the end of the second quarter from almost 164 million at the end of Q2 2017. But keep in mind that it issued CA$600 million in convertible notes in June, and has agreed to hand over 139.7 million in warrants to Constellation Brands. These share issuances can weigh down the value of existing shares, as well as reduce earnings per share potential.
If my arm were twisted and I was forced to choose, I’d suggest that Canopy Growth has a far better chance of pulling back well below $10 billion in market cap as Wall Street and investors await genuine bottom-line improvement and a clear supply and-demand outlook.
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