Losses Are Narrowing for Canopy, but Significant Dilution Risk Remains for Existing Shareholders

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Canopy Growth grows and sells cannabis products primarily in Canada, which accounts for roughly 60% of sales. Unfortunately, the Canadian market is overloaded with too many licensed producers, leading to tough price competition and a stubbornly robust illicit market, so Canopy has yet to reach profitability. We forecast mid-single-digit growth over the next decade for the Canadian market, driven by the conversion of illicit consumers into the legal market. We expect competition to ease as continued industry losses drive consolidation.

The international medical market is more attractive and profitable, as strict regulations limit the number of competitors. But it's a small contributor at just roughly 10% of net sales in fiscal 2023. We forecast high-single-digit growth as more medical cannabis legalization expands to new markets and more patients.

The company has diversified into non-THC products like its BioSteel sports drink in an attempt to get to profitability faster, but we see few synergies across these businesses. Additionally, although they add to Canopy's top line and potentially help it leverage over fixed costs in a path to profitability, it's unclear how much of the bloated fixed costs come from selling the disparate products.

Much of Canopy's cash hoard came from the prior investment by Constellation Brands, which has since appeared to take a step back as it has relinquished options to expand its ownership of 38.6%. Though much of that has gone to fund the continued operating losses, Canopy has also used it to acquire rights to U.S. assets Acreage, Wana Brands, Jetty, and a stake in TerrAscend. But the lack of progress on changing U.S. federal prohibition has largely left these assets stranded. 

Canopy plans to execute its options and merge the assets into a single holding company, Canopy USA. To avoid risking its own listing on the Nasdaq exchange, Canopy will have no direct operating relationship nor will it consolidate Canopy USA's financials into its own. We think this increases the difficulty of estimating the value from the U.S. assets, although we think the eventual easing of federal prohibition will allow it to integrate Canopy USA eventually.

Business Strategy & Outlook

We assign Canopy a no-moat rating. Although there appear to be a few potential sources of competitive advantage through intangible assets and cost advantage, we see several barriers that prevent Canopy from earning an economic moat. We believe the most likely moat source would come in the form of intangibles stemming from regulation.

Cultivators and dispensaries require government licenses to operate in every market where recreational and/or medical cannabis is legalized. As a result, companies with licenses could be protected from outside competition, helping establish pricing power. However, this only holds true if limited licenses are issued. The number of licensed producers in Canada has exceeded legal-market demand, weakening the potential competitive advantage and driving price competition.

Additionally, we see a few challenges to achieving economic profitability for Canopy. First, given that the cannabis industry remains in the growth stage, investment has outpaced earnings, so profitability remains years away. Although we expect returns to improve as the industry matures, a severe threat of material value destruction remains in the near term.

Second, we see governments and the illicit market squeezing cannabis cultivators and dispensaries, challenging consistent positive economic profit generation. With governments on national, state, and local levels reeling from budget problems, the emergence of cannabis as a legal product has come to be viewed as a funding panacea. For example, Washington state has implemented a 37% tax rate on recreational cannabis. 

All else equal, on the other end of the value chain, consumers would likely bear any government tax increase, similar to the cigarette market. However, the existence of a large and accessible illicit market has effectively served as a price ceiling. High legal taxes have effectively made legal market prices higher, hurting demand.

Lastly, we think Canadian-licensed producers focused on cultivating and selling cannabis—like Canopy—have the least leverage against the government and consumers. The cultivation parts of value chains in other industries rarely have moats, and we see little reason cannabis would be different.

Potentially offsetting the challenge of generating economic profit from regulation intangibles, we think that the creation of brand intangibles would help cannabis companies pass the increased cost to consumers, thus protecting their own economic profit. Alcohol and cigarettes are typically highly taxed, but some producers of these products have established strong enough differentiation and brand intangibles that consumers are willing to pay price premiums.

However, nearly every cannabis producer wants to create a brand intangible asset, creating heavy competition. Additionally, Canadian regulation restricts packaging design (limiting visual differentiation), direct contact between the company and dispensary workers (limiting potential strengthening of the sales channel relationship), and advertising to venues in which only adults will be present (limiting ability to capture mind share outside of the dispensary). As evidence that brands are struggling to emerge in Canada, market share has largely been driven by value brands.

We think it would be unlikely for Canopy to establish a cost advantage. Given the climate, most cannabis in Canada is grown either in greenhouses or indoors. Although this allows for higher-quality cannabis to be grown, these methods also cost much more because of the required lighting (for indoors) and climate control. Additionally, advantages in greenhouse and indoors can be much more easily imitated than geographic advantages that may be present in outdoor cultivation.

Lastly, we think Canopy's non-THC businesses also have no moat. Sports drinks, skincare, CBD, and the other products are all heavily competitive and have large, established brands. It will be difficult to see any brand advantage emerge that is defensible and lasting.

None

Economic Moat

Canopy Growth

Canopy Growth Corp. engages in the production and sale of medical cannabis. The firm operates through the following segments: Global Cannabis and Other Consumer Products. The Global Cannabis segment encompasses the production, distribution and sale of a diverse range of cannabis and cannabinoid-based consumer products in Canada and internationally pursuant to applicable international and domestic legislation, regulations and permits. The Other Consumer Products segment encompasses the production, distribution and sale of consumer products by Storz & Bickel, This Works, BioSteel, and other ancillary revenue sources. It focuses on the treatment of chronic pain, seizures, muscle spasms, nausea, and loss of appetite. The company was founded by Bruce Linton on August 5, 2009 and is headquartered in Smith Falls, Canada.

Earnings data Q2 2023

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Canopy Growth Corp. engages in the production, distribution, and sale of cannabis and cannabinoid-based products for both adult-use and medical purposes. The firm operates through the following segments: Canada Cannabis, Rest-of-world Cannabis, Storz and Bickel, BioSteel, This Works, and Other. The Canada Cannabis segment includes the production, distribution, and sale of cannabis, hemp, and cannabis products in Canada. The Rest-of-world Cannabis segment focuses on production and sale of cannabis, hemp, and cannabis products internationally. The Storz and Bickel segment produces and sells vaporizers. The BioSteel segment refers to the sale of consumer packaged goods including sports nutrition beverages, hydration mixes, proteins, and other specialty nutrition products. The This Works segment includes the production and sale of beauty, skincare, wellness, and sleep products, some of which have been blended with hemp-derived CBD isolate. The company was founded by Bruce Linton on August 5, 2009 and is headquartered in Smith Falls, Canada.

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