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Canopy Growth: Time To Hold ‘Em Or Time To Fold ‘Em?

Source: Seeking Alpha

Canopy Growth (CGC), one of the leading cannabis-producing companies in the world, has been soaring for some time, as the market focuses on the growth potential of medical cannabis and recreational pot.

The volatility of the stock has provided a lot of opportunities for traders over the last couple of years, but now that there is more clarity and visibility in the market than in the past, the question arises on whether or not it is time to take a position in Canopy Growth for the long term, or if it’s time to take profits and look to other market sectors for growth.

Canadian supply shortage

It has been clear for a while that even with the rapid advance of production capacity in Canada, that suppliers will struggle to provide enough recreational cannabis in the near term for Canadian users.

An upcoming release of a study by researchers from C.D. Howe Institute and the University of Waterloo have found that while expected demand for marijuana in Canada over the next year will be 610 tons, in the first year after legalization, suppliers may be only able to produce approximately 210 tons. Supply in the fourth quarter is estimated to reach about 146.13 tons, according to the report.

There are a couple of things to consider here for Canopy Growth in particular, and the overall Canadian pot industry in general. The first is if the market can’t come close to meeting demand, will Health Canada allow to remove barriers that slow down the application and approval process. Second is if it does, will that result in much higher sales from Canopy in the near term than expected.

In the case of the latter, another question arising is the decisions made by consumers in regard to whether or not they continue to look to the black market for supply. That could happen in the short term if they can’t secure product.

The report states that the black market in Canada provides about 380 tons of cannabis, valued at a minimum of $2.5 billion over the first year after recreational cannabis is legalized.

Since there are hundreds of millions in tax revenue at stake, my thought is it’s highly probable that Health Canada may expedite the approval process to secure more tax revenue in the short term. If that’s the case, that could be a benefit to Canopy Growth as it ramps up production.

If licensing restrictions are loosened up, Canopy could benefit from licensing its brand in order to serve a larger market. This is especially true in Ontario, which is the most attractive and populous market in Canada.

Depending on the response of the Provinces to the expected shortfall, this could be a revenue windfall the market isn’t pricing in at this time, assuming that is how it plays out.

Another factor is whether or not Canada quickly clamps down on black market production, or allows it to remain in play until suppliers are able to meet demand.

I think it could be somewhat loose in the first couple of months after legalization, and as production capacity increases, they’ll come down hard and heavy on the black market in order to generate the expected tax revenue, which of course is the purpose behind legalization in the first place.

There is no doubt Canopy Growth will be a major beneficiary in the long term. What remains to be seen is if there is a surprise in the short term because the licensing process is streamlined in order to boost supply quicker.

While not the major focus of this article, cannabis investors should take into account the short-term potential of smaller producers that will, in my opinion, for six months to a year, enjoy a period of cannabis demand that will drive growth. Once the major players build out their capacity, that is likely to change quickly.

It’s also why the marijuana industry will continue to consolidate as supply starts to meet demand.

Finally, concerning supply and demand in the near term, it’s possible the price per gram will reach the upper end of what the Canadian government is looking for as a result of the expected shortage. That would mean about C$10.00 per gram.

It’s important to note that other markets, such as Germany, don’t have the same restrictions. Consequently, in the last quarter, the average price per gram sold in Germany was $13.62.

Looking at the long term

What I want to talk about primarily in this article is changing the way to view Canopy Growth in light of the visibility of its existing licenses and production capabilities. That of course will undoubtedly continue to change going forward, but the principles guiding the growth trajectory of the company should remain in play.

I believe investors can safely start to view Canopy Growth as a solid long-term play in the cannabis sector. It’s not probable that it’ll come close to its past rapid rise in value, even though over the years ahead I expect to continue to climb in value nicely.

What’s important to me is even though the share price will continue to be volatile, I think it’s coming close to the time we can set and forget the stock for some time, ignoring the price swings. Since I don’t see the amount of risk going forward being near what it was in the past, it’s apparent to me that increased demand and the potential production capacity Canopy has as it is today, means revenue growth will continue on well into the future.

The hefty investment of Constellation in Canopy will be used to boost its “global leadership position in the cannabis industry by building or acquiring key assets needed to establish global scale.”

Revenue in the last reporting period was $25.9 million, up 14 percent over the prior quarter, and 63 percent year over year. Of interest is Germany accounted for $3.4 million of the total in the quarter.

The company sold 2,695 kilograms in the first fiscal quarter, averaging $8.94 per gram. I think that could rise higher over the next half because of the inability for the market to meet demand during that period of time. Last year in the same reporting period the average price per gram sold was $7.96.

In the quarters ahead, the company stated it expects “the amount of cannabis harvested to increase significantly…”

In preparation for the legalization of recreational pot and growing demand for medical cannabis, Canopy Growth said it had inventory of about 19,721 kilograms of dried cannabis, 14,895 liters of cannabis oils and 1,055 kilograms of soft-gel capsules.

When asked about allocation of capital, Bruce Linton said concerning its “current target acquisition list, it exceeds $1 billion for international… non-cultivation assets,” adding that company knows the “list will grow.”

My thesis

My outlook for Canopy Growth is revenue will be the determining factor in its performance in the near and midterm, and that means it should continue its upward trajectory for a long period of time.

What happens with fast-growing sectors is the market in general, primarily looks at revenue growth in the early years, and over time starts to look for earnings. This is why even though some analysts and pundits point to overvaluation with Canopy Growth, it has had little effect on the value of the stock at this time.

Most investors understand you have to sacrifice earnings in order to grow in the early years, and that is the case with Canopy. Its major competitors are participating in similar strategies; it’s the nature of any market in fast-growing, relatively new industries.

What’s changing for Canopy Growth is it has secured enough licenses to compete in Canada and other places around the world, and with significant production capacity, it is positioned well for the ongoing growth in this burgeoning sector.

At this time, the company has more than 3.2 million square feet in capacity.

Conclusion

Canopy Growth has passed through what I consider its most volatile stage of growth, and with cannabis demand about to soar even more, I see it starting to grow at a more measured pace.

The reason I don’t see the rise in demand having a more volatile effect on Canopy than in the past is because it has many elements in place to meet that demand without having a detrimental impact on the performance of the company.

While there will be ongoing volatility and some corrections, without a doubt, I see them leveling off in the future. The challenge now is for shareholders and investors to consider holding for the longer term; not getting scared off by temporary movements in the share price. That’s not only on the low side of the price but on the upside as well.

It’ll be tempting to sell if prices drop quickly, and the same if prices jump.

I think the stock is entering into a period of tempered growth, and investors should start looking at holding for the long term because there is no doubt in my mind the company is going to continue to move up in price, no matter what happens in the short term.

At this time looking for pullbacks isn’t likely to add much value over the long haul. Sure, a big correction would give a better starting point, but I think corrections aren’t going to be as wide going forward than they have been in the past. In other words, volatility, while remaining, is going to start leveling in my view. If I’m correct, it means trading Canopy isn’t going to be as profitable as it has been. To move in and out of the stock isn’t going to provide the returns that have been enjoyed over the last few years.

For that reason and the long-term potential of Canopy Growth, I think it’s time to start looking at taking or adding to a position in the company and letting it ride.

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.

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