Description

We believe the Canadian marijuana stocks are in a bubble.  Current valuation levels are completely out of whack with reality, the near-term data points are terrible, the long-term prospects are likely even worse, and the Canadian cultivators will be at a major competitive disadvantage as the global trend toward legalization continues.  Easy money chasing the marijuana boom has led to aggressive capacity expansions that will eventually dwarf demand, and we are therefore skeptical the market will ever generate a sustainable, meaningful profit.  It is quite probable in our view that the stocks of all the major players gradually slide into oblivion.  Given its enormous market cap, struggles with profitability and prospects for market share losses, we recommend shorting Canopy Growth.  Also, it is the stock with the best availability of borrow, typically at a reasonable cost.

Company Description

Canopy Growth is the largest producer of medical and recreational marijuana in Canada with roughly 35% current market share.  Just three years ago, the company had a market cap of C$300 million.  Today, the market cap is C$17 billion.  Stocks of all Canadian cannabis cultivators have soared in recent years on hopes that these companies would mint money once recreational cannabis was legalized in Canada.  Canopy has always had a halo around it due to its relatively larger size, supposed “best in class” management and the backing of U.S. beer and wine company Constellation Brands that made a sizeable investment in the company last year.

The Near Term

Health Canada releases monthly supply and demand data for the cannabis industry, which reveals that the industry is off to a very slow start (likely because the black market continues to thrive).  Using the latest April sales data, the entire industry is run-rating at only ~C$750mm of annual net revenue, a fraction of original market expectations.  While the province of Ontario is still in the midst of a rollout and edibles are yet to be available in the market, it is nearly impossible to see how the market can even come close to justifying the market caps assigned to the top Canadian cultivators (top public players have a combined market cap of close to C$50bn).

We initially thought the major producers would enjoy a window of excess profits after legalization before additional supply hit the market, but the largest Canadian cultivators have massively disappointed on sales and posted significant operating losses in the past two quarters.  In the most recent quarter ended March 31, 2019, Canopy reported adjusted EBITDA of negative C$98mm, actually a worse result than the fourth quarter of 2018.  On the earnings call, the company indicated it will not have positive EBITDA in the Canadian market until FY2021.

The Long Term

We do not believe it is going to get any better from here.  While demand will continue to ramp in the coming quarters due to a continued retail rollout in Ontario and the addition of edible products, we think supply is on the verge of dwarfing this eventual demand.  Based on the announced capacity of just the public players, the market is likely to be three to five times oversupplied in a few years.  Marijuana is no different than any other crop or commodity, and when supply vastly exceeds demand, prices crash.  For example, in Washington, Oregon and California, pricing has fallen by ~40% in the past eighteen months as product flooded the market, with dry flower prices now just a small fraction of what the Canadian producers currently charge.

International Markets are a Threat, not an Opportunity

We believe it is rather obvious that the Canadian market is doomed, and the larger producers have already started to talk down prospects for the market (just months after legalization), and they are now starting to divert investor interest to international opportunities.

Let’s be clear:  if marijuana ever became a legal, global product, the Canadian cultivators are screwed.  Canada is one of the last places on earth you would ever choose to grow marijuana with freezing cold temperatures, high energy costs and limited daily sunlight.  You can actually grow for just 10% of the Canadian cost in South America.  These companies exist simply because of a competitive umbrella afforded to them by the Canadian government.

What about Constellation Brands?

In 2018, U.S. beer and wine company Constellation Brands made a large investment in Canopy that generated a lot of enthusiasm around the stock and seemed to “validate” the bull case.  We thought it was an epically stupid deal at the time and that is now becoming rather clear.  Shortly after the deal was announced, Constellation Brands’ CEO Rob Sands announced that he will step down as CEO in March 2019.  On the latest earnings call, Constellation Brands’ new CEO, Bill Newlands, commented that they “were not pleased with Canopy’s recent reported year-end results.”  Just two weeks ago, Canopy’s CEO Bruce Linton was fired.  Recall, Canopy’s “best in class” management was always a key selling point for the stock (and specifically highlighted by Constellation as a key consideration for their investment)… and now the CEO was fired.

With both CEOs now gone, it is unclear what the future holds for the partnership between the two firms.  As Canopy continues to spend the money it received from Constellation on aggressive expansion plans and silly, overpriced acquisitions, the company’s cash balance drops lower and lower every quarter. 

While we don’t have an explicit price target, we think it is likely the stock will eventually grind its way towards zero.

Catalyst

·         Price / gram declines due to increasing competition

·         Continued poor execution with lack of margin improvements

·         Year-over-year comparisons get challenging starting in Q4 2019