Battered Canopy Growth Stock Could Reach New Lows

Thomas Niel

Mon, Sep 23, 2019, 12:20 PM

MKM Partners’s Bill Kirk is bearish on the whole pot space in general. As he puts it, “Don’t smoke the Kool-Aid.” While he rates CGC stock at “neutral,” he has concerns over the company’s use of share-based compensation. Canopy’s cumulative share-based compensation is nearly 100% of its cumulative revenues. His other concerns include excess pot inventories. Last quarter CGC grew four times the amount of cannabis it sold.

If you have read my prior CGC analysis, you know I have similar thoughts on Canopy Growth stock. But could the company be in better shape than its peers? Or will Canopy Growth stock continue to reach new lows? Let’s take a look at recent development, and see if the story has changed with CGC.

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Edibles Could Be a Saving Grace for CGC

Cannabis bears may view excess inventory and falling prices as reasons not to buy. But they could be too focused on the short term. Cannabis 2.0, which encompasses edibles and infused beverages, is just around the corner. These new products will hit Canadian shelves in December.

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These high-margin processed cannabis products could be a cash cow for the Canadian pot space. Selling the marijuana you smoke is a commodity business. As I have discussed in my Hexo (NYSE:HEXO) analysis, a pivot to cannabis-infused products is the best pathway to profitability. While in the past I have criticized CGC’s partnership with Constellation Brands (NYSE:STZ) as dilutive, the cannabis sphere needs deep-pocketed consumer products companies to profitably roll out branded products.

But Canopy’s long-term strategy is no slam dunk. High competition and too much money spent chasing limited opportunities will make it hard for CGC to profit. In the meantime, the company will hemorrhage cash as it scales into a major pot player. Investors are aware of this cash burn, but may be too optimistic about the profitability point.

Bill Kirk believes Canopy will not reach positive free cash flow until 2026, and this may be one of the more optimistic calls. Another analyst, Oppenheimer’s Rupesh Parikh, highlighted greater cash burn concerns in his initiating coverage. Parikh believes Canopy could lose more than $500 million over the next two fiscal years (CGC’s fiscal year ends in March). With this in mind, the company may face greater risks than the share price reflects. Let’s take a look at CGC’s valuation, and see how it stacks up to peers.

Upside Is Priced into Canopy Growth Stock

Like other marijuana stocks, CGC is richly valued. The company trades at a trailing enterprise value/sales ratio of 37.3. This is a premium to Aurora Cannabis’s (NYSE:ACB) EV/Sales of 28.6. Smaller competitor Aphria (NYSE:APHA) trades at an even lower valuation (EV/Sales of 8.6). But Canopy is not the most overvalued pot stock. Hexo trades at an EV/Sales of 41. Cronos (NASDAQ:CRON) trades at a staggering EV/Sales ratio of 85.2.

CGC stock is certainly not a value play. High expectations continue to be priced into shares. Investors who bought in at the start of the marijuana legalization trend have won big. But anyone entering the space today must pay through the nose. Paying a premium today for opportunity tomorrow is not always a bad deal. However, for the pot stocks, it seems to be too much of a bubble environment to make a smart investment.

Legalized marijuana will be a big business, but expectations may exceed reality. There could be a time down the road where cannabis stocks are a screaming buy. While investors have started to make their exodus, it is definitely too early to call a bottom.

Seek Better Pot Plays Elsewhere

I remain highly bearish on CGC and most of the other cannabis stocks. Valuations are too high, catalysts are priced in — and all that jazz. But what if you want to gain exposure to marijuana stocks today? Other names in the pot space may offer better value. While Hexo has headwinds of its own, the company may be nimble enough to profit from the infused products niche. The relatively low valuation of Aphria may make it a speculative buy.

But in the case of Canopy Growth, there are too many red flags. Trying to become the top dog in a growing industry can pay off big, but it could also lead to ruin. CGC remains an opportunity with too much risk and not enough upside. Take a look at the cheaper pot stocks, but continue to avoid CGC stock.

As of this writing, Thomas Niel did not hold a position in any of the aforementioned securities