Bring-me-down Bruce

Photo mashup of a gap-toothed magazine cover fixture with a certain boyish charm who lost his job this past week... and MAD Magazine's Alfred E. Neuman.

Mixed feelings in the Cannasphere following the ousting of Canopy Growth Corp. (NYSE:CGC)(TSX:WEED) co-CEO Bruce Linton, following a lackluster quarter. Few argue that he ought to be left to continue, but both his peers and the media that Linton so skillfully used to manifest Canopy’s position at the top was gripped with an instant nostalgia for the Linton era.

Linton’s stewardship of Canopy set the tone for what it took to make a company succeed in the marijuana business. He understood before most that he was actually in the capital markets business, and that the potential for Canopy to be a high-margin money machine had to be sold in the short term if it were ever to be built in the long term. Once that sort of thing starts working, why stop? Canopy was number one in production early by virtue of being first, and Linton used the capital markets to make damned sure they stayed that way. His 2016 acquisition of Mettrum kicked off a feedback loop of production and infrastructure allowing for the ability to finance the creation or purchase of more production infrastructure until, evidently, the people handling the finance started asking questions about the production infrastructure, forcing an agonizing reappraisal of the situation.

The Big Number

Bruce Linton belongs in the stock promoter Hall of Fame for laying a golden handcuff on Constellation Brands (NYSE:STZ) in an all cash deal for a majority stake in WEED back in 2018, but it’s doubtful that he would have been able to pull it off if he wasn’t selling a seemingly insurmountable lead. Constellation was (and is) a multi-billion dollar company. They did $8 billion in sales last year. None of the smaller more efficient cannabis companies with a chance at being number one are any use to big liquor. If they’re in cannabis, they want the biggest, surest thing there is. Constellation bought into Linton’s 2018 Canopy because it was ready to track the industry’s growth while using their cash to maintain or increase their lead through blunt-force trauma. Trying to hang on to first place with stunts while the core falls apart isn’t their idea of leadership.

But it isn’t immediately clear that Constellation has a plan beyond “please stop burning our money.” In a paradox fit for the cannabis boom, the industry’s sales leader is suddenly a turnaround story. The new management will inherit something that, in the custom auto world, is called a “basket case.” It’s all there, most of it works, but you’re going to have to get it all together before you figure out if it really runs and how it runs. Something will probably break, you’ll need something you didn’t realize. The board of directors is going to want someone with an inclination towards wrenching the build together, instead of just buying more high-performance (?) parts to sit on the shelf in the garage.

There’s a trade in here

Bloomberg’s Kristine Owram, who has been covering Canopy as long as anyone, rounded up a few analysts who all framed this change as a desire by an STZ-controlled board to make their investment one that makes money, instead of losing it, and that’s a safe bet, but the analysts quoted betray a potentially unreasonable expectation among street types that it will improve in the near term. Fundamental Hype has a dim outlook on Canopy’s near term prospects for one core reason that comes in two parts:

a) Canopy’s infrastructure is suspect

We ran this excerpt from the last MD&A in our June 30 overview of their latest filings, and continue to consider it cause for alarm.

… facilities which were not yet fully cultivating or had unutilized capacity, includ[ed] the Delta greenhouse, a number of zones at the Aldergrove greenhouse, the Mirabel greenhouse which was in a pilot phase for the majority of the fiscal year, and the greenhouse in Fredericton, New Brunswick which was in a start-up phase.

– Canopy Growth Corp Year End MD&A, for the period ending March 31, 2019

The pattern established by their sales and inventory reporting suggests that the big cannabis sales and cannabis sales revenue numbers they printed in the December quarter were the result of having burned through a stockpile. That causes us to question whether or not they’re able to fill the channels, especially if all their rooms are beat up. Canopy doesn’t say how much of their unit sales start out as wholesale purchases from other LPs, but we’re starting to expect that it’s a significant portion because:

b) Canopy won’t tell us their margin on cannabis products.

This is the big tell. WEED has always had lower margin than their peers, and it was largely excused because of their lead in volume and market share. But this past period, they purposely gave us the metrics in a way that made calculating their cannabis product margin impossible. They didn’t do that because it looked good, and declining margin would be consistent with their flower being bought instead of made. We note that they had twice as much oil as bud in inventory in September, 2018, before they took that metric away. When the dust settles on this HR move, Canopy will be in the process of sorting itself out. We’re going to pencil Canopy in for a regression in unit sales in Q2.

If those cultivation assets seemed like they would be moving in the right direction any time soon, Constellation may have shown more patience. The cultivation infrastructure not yet being dialed-in while the competition has closed to within striking distance isn’t what Constellation signed up for. Coming up on the one year anniversary of the deal that gave them a majority stake in the company for US$4 billion, the grand future that Linton sold them is still a dream, and they aren’t in the perpetual dream building business. Not if it means spending time at #2.

A chart of quarter over quarter unit sales shows Canopy’s strong lead eroding slowly at first… then all at once.

There’s only so much goodwill…

One can also imagine the new team failing to see the enormous potential in all the great assets that Linton parked on the balance sheet, and an aggressive turnaround team may want to get those write offs over with sooner rather than later. $1.3 billion of the $1.5 billion in goodwill on Canopy’s books was put there within the past year, $539 million worth of it from the deal with Hiku. We had Hiku’s value mostly contained within its “brands.” There’s a further $464 million in goodwill between R&D subsidiaries Canopy Health Innovations and ebbu, $117 million wrapped up in German vape maker Storz and Bickell, $93 million in a Saskatchewan extraction operation, and $16.7 million in Colombian and Lesothonian (Lesotholese?) assets.

There’s no telling what the new team will consider worth keeping around and what they won’t, and a write down would certainly hurt the equity value in the near term, but STZ isn’t here for a trade. They’re married to this thing, and need to get it right.

Chart courtesy stockwatch.com

How we’re playing it

When we wrote their last earnings up, Canopy’s ever-present puncher’s chance kept us from betting against it. Without Bruce Linton around to cook up a reason for a rally, we’re ready to call it: it’s going to get worse before it gets better for WEED.

Between better companies being available for much cheaper, and new, more conservative management staring down $1.5 billion in goodwill (NOT including a commitment to buy Acreage Holdings (CSE:ACRG), on which our outlook is bearish), we’re short Canopy via puts, but won’t set a downward target price until we get a handle on the news climate in the post-Linton era.

Canopy’s status as #1 doesn’t figure to last. As we reported last week, their March quarter unit sales only beat closest competitor Aurora Cannabis (NYSE:ACB)(TSX:ACB) by 146 kilos. Organigram (TSX.V:OGI)(NASDAQ:OGI) sold about half as much as Canopy did in their most recent quarter, and has an enterprise value less than one tenth the size of Canopy’s enterprise value.

 

We were just thinking out loud on twitter when we cooked up the idea for a pairs trade with OGI, but have since talked ourselves into it. If the trend in the sector moves away from future growth and towards operator efficiency, then OGI is the play. It should out-perform. We’re about even on our OGI position, added to it Friday. Organigram announced a Monday AM reporting of their Q2 earnings for the period ending in May, telegraphing that they think the numbers are strong. The market may well have its own ideas.

Fundamental Hype reminds readers that it is a blog about markets and financial media so, in terms of financial advice, this might as well be a Wendy’s drive thru. We recommend talking to a qualified advisor before making any kind of investment in anything at all. If you just want to chit-chat about the markets, you can talk to us in the comments.

BONUS CHART

Aurora and Tilray are the only companies consistently north of the growth equator. Organigram has shown the largest growth for two quarters running.

 

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About Braden Maccke 60 Articles
Founder and Editor in Chief at Fundamental Hype, a blog about venture stage finance and the media that supports it.

2 Comments

  1. No mention of the illegal seizure from back in 2013? Seems like a lot of people forgot about that or might not know about that. Liberals and even the former head of the RCMP got rich from TWEED (now WEED). No press release because of fear it would hurt the stock…. now all other companies are being set on fire due to HC standards and not following the rules.

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