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Why I Just Bought Canopy Growth (TSX:WEED)

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By now, you’re probably well aware that Canopy Growth’s (TSX:WEED)(NYSE:CGC) last quarter was a major disappointment. Recreational cannabis sales came in well below estimates and signaled Canopy was losing market share in the face of rising competition.

Furthermore, margins completely eroded due to underutilization of production equipment combined with a revenue mix that weighed more towards lower-margin dried cannabis instead of higher-margin oils and gels. However, as disappointing as this quarter was, Canopy has not looked this attractive in months, and this sell-off will eventually prove to be a market overreaction.

Margin concerns should diminish with scale

One of the biggest concerns that came out of Q1 numbers were Canopy’s paltry gross margins, which came in at just 15%, deteriorating by 7% from the prior quarter. This, of course, bodes poorly for the company’s profitability and cash flow targets, which have been pushed back to fiscal 2022. However, to judge Canopy solely on profitability would be near sighted, as the empire of moving parts that was created under Bruce Linton’s tenure now requires time to be integrated into a unified sum.

As noted in the conference call, Canopy’s governing strategy is not to flood the market with product, but rather to become an international pharmaceutical powerhouse backed by clinical research while using their vertically integrated supply chain to introduce highly differentiated products on the recreational front — not just licensed, rehashed versions of products that consumers are already familiar with.

Once these products come online, we can anticipate Canopy to capture higher margins due to the value inherent within their differentiated and proprietary product offerings. Moreover, as Canopy ramps up production for Cannabis 2.0, we should see further applications of underutilized production assets and automation along the supply chain, leading to higher gross margins.

Market discounting key growth drivers

Although it can be argued that Canopy sold only about 8,000 kgs of cannabis in the last quarter and that it’s losing market share to rivals, I believe we’re too early in the game to make such inferences based on one quarter, especially as federal regulations have made branding and customer grouping wholly impossible. Furthermore, Canopy has unparalleled production scale and marketing resources thanks to Constellation Brands, and we should see it become the dominant player in the vapes, edibles, and CBD space — particularly since its extraction processes are vertically integrated, thus lowering chances of supply bottlenecks that other licensed producers might face.

Furthermore, Canopy is the only producer with optionality to expand into the lucrative U.S. market thanks to Acreage, and this could prove to be a major source of revenues once we have legalization south of the border.

Finally, given that Canopy has guided to $1 billion in annual revenues for fiscal 2020, the current share price reflects a valuation of 13 times forward sales, which is massively discounted from its usual 19 times forward sales. Therefore, even if my thesis of this quarter being a transitional one is incorrect, the stock’s current level provides enough cushion to make this an attractive investment.

And that is why I went long Canopy Growth.

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Fool contributor Victoria Matsepudra has shares of Canopy Growth Corp.

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