Early investors in Canada’s legalized marijuana market have been having a horrible year. Investor sentiment in the sector seems to have moved from exuberance to utter dismay within just a few months. Cannabis companies have shed billions in value while heads have rolled at the top.
Perhaps the biggest loser this year in absolute dollar terms has been the nation’s top producer Canopy Growth (TSX:WEED)(NYSE:CGC). Canopy has lost a fifth of its market value since the start of the year and more than half its value since April alone.
Investors are worried, and with good reason — Canopy is burning through cash at a relentless pace, and it could soon find itself in a difficult cash flow position. The company isn’t going out of business, of course, but it may soon have to make some difficult choices with less-than-ideal repercussions for investors.
What makes Canopy stand out from its closest rivals are its resources. Ever since Constellation Brands bought a hefty stake and infused $5 billion (US$4 billion) in the company, the team has had more cash to deploy in expanding production and distribution than any other legal marijuana company in the country.
Constellation’s team must have assumed that these billions would suffice until the company reached profitability, but now investors seem worried that even $5 billion in cash won’t be enough.
According to the latest quarterly report, the company’s lost $1.28 billion. Cash flow, meanwhile, was negative $660 million for the quarter. At that pace, the company will run out of its cash hoard (currently worth $3.18 billion) in fewer than two years or so.
However, analysts don’t expect the company to report positive EBITDA (earnings before interest, taxes, depreciation, and amortization) until fiscal year 2022 or positive earnings until fiscal 2025 or later.
A slowing pace of revenue growth doesn’t seem to be inspiring any confidence either.
At this point, it wouldn’t be wise for the company to cut back on cash flow for investments or operations. Instead, the only option is financing.
This means Canopy could soon have to make a difficult decision about raising more funds through issuing equity or debt. Issuing more shares on the open market or getting a strategic investor (perhaps Constellation Brands again) to infuse fresh capital could cause stock dilution for retail shareholders.
Meanwhile, raising debt will add to the company’s risk profile and interest payments will strain the cash flow even further. Since Canopy’s debt-to-equity ratio is currently 37%, I believe the team is more likely to issue debt rather than equity over the next few years.
However, investors seem to have already priced in these difficult choices. The stock is currently trading at 1.8 times book value per share, or three times cash per share. On a risk-adjusted basis, I would say that price is fair.
At its current pace of cash flow, Canopy may have to raise more capital over the next few years before its operations become profitable. The choice between issuing debt or equity could add dilution or risk for current shareholders. However, these risks now seem to be priced in.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Vishesh Raisinghani has no position in any of the stocks mentioned.