What The Future Holds For Canopy Growth Corp.

 source: new cannabis ventures

The short- and long-term future of Canopy Growth Corp. (OTCPK:TWMJF) looks very strong, as demand for legal and recreational cannabis grows, and public opinion continues to move toward more receptive of the drug.

With California allowing non-medical use of marijuana beginning January 1, 2018, and Canada set to vote on allowing recreational use nationwide by July, 2018, Canopy is best positioned to meet the explosion in legal demand that will immediately emerge.

Another positive catalyst for Canopy is the decision by Attorney General Jeff Sessions to fight the legalization of the marijuana industry. I don’t think he’ll be successful in the long-term, and he may even lose his job over it if he focuses on that rather than the immigration issues that were a primary reason for Donald Trump winning the presidency.

What this has done for Canopy and other Canadian growers is allow them to better establish themselves for the inevitable legalization of marijuana in most, if not all U.S. states.

In its latest earnings report the company said it had growing capacity of about 2.4 million square feet under construction, and the option to acquire another 1.7 million square feet in British Columbia, which it recently decided to exercise. It also continues to engage in an aggressive acquisition strategy that will continue to grow its square footage out.

In its annual update the company said it now has 5.6 million total square footage in seven Canadian provinces.

Assuming Canada does legalize marijuana for adult use, Canopy is in position to take up to 20 percent of overall market share, based upon its production capacity.

The rising tide of legal demand will raise all cannabis ships in the short term, but Canopy should be the market leader on the production side of the business once the fundamentals come into play.

In 2017 Canopy rewarded shareholders with a return of 247 percent. If Canada legalizes and more U.S. states do the same, it’s probably going to do even better in 2018.

On the other hand, if for some reason Canada were to decline to legalize marijuana, the company would get crushed. But it would still survive because of demand for medical marijuana, albeit at a more modest size than is being anticipated at this time.

Latest earnings

In its latest earnings report Canopy reported earnings of $17.6 million in the second quarter, an increase sequentially of 11 percent, and up 107 percent year over year.

For the six-month period ended September 30th, revenue came in at $33.4 million, up 115 percent over the $15.5 million in revenue generated during the same reporting period the year before.

Overall grams sold in the quarter totaled 2,020 kilograms and kilogram equivalents for an average of $7.99 per gram, an increase from the 1,169 kilograms and kilogram equivalents sold in the same quarter of 2016 at an average of $7.01 per gram. In the quarter Softgel caps accounted for 18 percent of revenue.

The higher average price is attributed to a better mix of oil products, which included the Softgel caps.

As of the last quarter, about 3,850 kilograms were sold for an average of $7.98 per gram, against the 2,153 kilograms sold at a price of $7.05 per kilogram during the same reporting period last year.

The company lowered the average weighted cost per gram in the quarter, cutting it from $0.99 last year to $0.72. Most of that was as a result of improved operating efficiencies from the 12 grow rooms it added at Smith Falls. It has been able to cut costs per gram to point of harvest for five straight quarters.

On the post-harvest side, weighted average costs dropped to $0.53 from $0.71 in the quarter, a decline of 25 percent. Those improvements included Softgel capsules and cannabis oils. Better efficiency in regard to oil extraction was the stated reason for the improvement.

The primary reason for the improvement in efficiencies was the CO2 Super Critical extraction machine Canopy has custom built for it. It was put into play at the end of the first quarter. That suggests the efficiencies are sustainable going forward.

Gross margin in the quarter was down, but that appears to be a temporary situation, based upon write down of $700,000 inventory and discontinuation of product lines, and another $400,000 charge associated with idle operations at its Creemore location as it was being reset by the company.

The one-off costs of those effects were $1.8 million. Without them “fair value impacts and costs sales would have been $11.9 million or 68% of revenue,” as compared with the $10.1 million or 57 percent of sales in the quarter. That aligns closer with the year-to-date gross margins of 67 percent of revenue. It should return to those numbers in the current quarter and the near-term future.

Costs per gram on the shipping and fulfillment side did jump from $1.01 to $1.48 year-over-year. According to Canopy, the increase was from “higher investments in packaging, delivery and overall experience excellence since last year.”

It sees this as a way to differentiate from competitors by improving customer experience. This does make sense in light of the path Amazon (NASDAQ:AMZN) has taken in that regard, which is one of the reasons why it is able to keep adding customers to its Amazon Prime subscription service.

Customer growth and costs

Canopy has significantly increased the size of its customer base from last year in September, with it growing from 24,000 to 63,000 as of the end of the reporting period.

Expenses associated with customer acquisition year-to-date are $14 million, or 42 percent of revenue, against the $5.2 million, or 33 percent of revenue for the prior six-month period of last year.

For the quarter, sales and marketing expenses were $7.6 million, or 43 percent of revenue. The most important part of those costs in my view were investments “made in staffing and resourcing the marketing and sales functions needed in coming regulated recreational and international markets.” What that suggests is the company sees global markets it can gain market share in. These are preparations to meet the expected soaring demand.

As for its ability to continue to fund customer growth, the company balance sheet looks solid.

At the end of the quarter it had cash equivalents was $108.2 million, up $6.4 million over the last year.

Where Canopy will have to balance things is in regard to its growth model and customer acquisition. It is noted for growth by acquisitions, and during 2018 it may have opportunities it may never have again: acceptance of cannabis may provide the opportunity to grab market share, and with its significant production square footage, to hold on to it in the years ahead.

Allocation of capital across marketing and acquisition channels will have to be done right in order to take full advantage of what 2018 has the potential to bring.

Concerning existing inventory, as of September 30th it stood at “$73.3 million, up from $46 million at March 31 and the biological assets were $23.5 million, up from $14.7 million at the end of last fiscal year.” Combined they’re valued at about $97 million, up from $60.7 million at the end of 2016.

The mix was “12,064 kilograms of dry cannabis and 2,683 liters of cannabis oils.”

Of that, 5,032 kilograms were available for immediate sale, waiting approval for sale, in the process of finishing. A little of 7,000 kilos “of extract-grade cannabis held for conversion to salable oils and capsules.”

Conclusion

Canada is poised to make recreational marijuana use legal in the country, and 29 states already have some form of marijuana legalized, with 8 of them including recreational marijuana. There are another 15 states that are looking to legalize marijuana in some form in the near future.

I see this continuing because the boost in local economies and increase in taxes is a combination that will keep the impetus for acceptance growing. And this is just in North America I’m talking about. This has already spread to other areas of the world, and will continue to grow in acceptance in some form.

If Canada goes through with recreational legalization, Canopy will soar in value. If it doesn’t, it’ll retrace its price movement – although over time it would still be a viable growth business in the medical marijuana segment of the market.

Canopy definitely will take the largest hit of cannabis producers if Canada surprises the market and doesn’t legalize recreational marijuana. On the other hand, it’ll also receive the biggest reward on the production side of the business.

With decent inventory levels and the size of its capacity, Canopy has positioned itself as a market leader, and it will be looked upon as the company that has the most potential to meet market demand in significant amounts.

About a year ago Canopy acquired Mettrum Health, which greatly increased its medical marijuana customer base. If recreational marijuana is legalized in Canada, it not only will have the available inventory to help meet the immediate demand; it will also have the balance sheet to make some rapid acquisitions if it has to in order to prepare from the expected soaring demand.

At this time, if you’re interested in having exposure to cannabis, Canopy would be a good foundational base to work from, allocating to it the highest percentage of your capital allocated to the sector. From there, adding some complementary producers to the mix would be a good way to take advantage of the burgeoning market.

Not a subject of this article, but keep in mind the companies providing the tools to Canopy and other producers are great investments as will, with many of them residing in the U.S.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.