In this article, I will outline some of the trends in the cannabis industry. As such, it is likely that industry leader Canopy Growth (CGC) will continue to have a growing business in the coming years as cannabis gains popularity, research increases on CBD, and the US federal government potentially legalizes marijuana.
Cannabidiol, a key cannabis extract also known as CBD, has become an increasingly popular consumer trend in recent years. It can be found in products in prominent retailers like Walgreens (NASDAQ:WBA) and CVS (NYSE:CVS) and has an ever-increasing amount of celebrity endorsements. Proponents claim that it can be used as a remedy for anxiety, cancer, seizures, inflammation, neurodegenerative disorders, pain relief, depression, post-traumatic stress disorder, restless sleep, among other things, as it has biological activity modulating the body’s endocannabinoid system. CBD is also pitched as a way to reduce opioid and cigarette use. If true, all these claims would make CBD’s demand sound reasonable or even too low, as CBD has only recently begun to gain widespread popularity.
What is CBD?
CBD is a chemical found in the cannabis plant (whether it be marijuana or hemp), and is its second-most notable chemically extractable component. Unlike cannabis’ largest component (THC), CBD does not have the same psychoactive effect: meaning a user would not get a “high.” In fact, CBD is used in THC CBD medical marijuana to attenuate the THC effects – CBD partially blocks THC’s effects in the body’s brain and central nervous system as it is an allosteric modulator of the CB1 receptor, which THC interacts with.
CBD can be used in a variety of ways; it can be inhaled, applied as a topical, or ingested. According to the World Health Organization, CBD carries little to no risk of addiction in humans. Despite this, it is not as if CBD carries no risk at all. It has some side effects, according to the Mayo Clinic, although they are usually minor. On a scientific level, claims of CBD’s efficacy have not necessarily met the burden of evidence to be taken seriously, outside of its uses for epilepsy in Lennox-Gastaut syndrome and Dravet syndrome patients, for which the FDA approved GW Pharmaceuticals’ (GWPH) Epidiolex in 2018. Perhaps one day CBD use will be more widespread, but for now, current evidence of clinical success often remains on the animal (preclinical) level, indicating that claims might be either false, exaggerated, or premature, as much more research needs to be done in order to back up those claims.
The global CBD market in 2018 was estimated to be $4.6B. Grand View Research Inc. projects a 22.2% compound annual growth rate (CAGR) until 2025 when the market will reach $23.6B. This rapid growth rate is attributed to a variety of factors, including increasing awareness of CBD’s advertised benefits, increasing availability in mainstream wellness retailers, expansion of CBD applications to new areas, and the potential legalization that will help cultivate the industry and make it ubiquitous (especially in the United States). In fact, the House of Representatives is expected to vote on a historic cannabis bill next month, which would “federally de-schedule cannabis, expunge the records of those with prior marijuana convictions and impose a federal five percent tax on sales, revenue from which would be reinvested in communities most impacted by the drug war.” The anticipated growth of the topical CBD industry is even more impressive than the CBD sector as a whole, as topical CBD is expected to become a $1.7B industry by 2025, reflecting a 32.9% CAGR. However, for now, the industry has constraints, mainly legal ones.
The legality of CBD in America can be confusing. Cannabis is listed as a Schedule 1 drug by the Food & Drug Administration (FDA) and as such is illegal on the federal level. The passage of the 2018 Farm Bill made hemp and hemp-based CBD legal on the federal level. The Food & Drug Administration is currently formulating rules for governing the CBD industry. As of yet, mentioned above, only one epilepsy drug (Epidiolex) has been formally approved for medical use. Technically, this makes all other health claims about CBD as a drug not legal (as of yet). In practice, this is not so significant since enforcement for rule-breakers is quite limited. What makes cannabis governance even more complex is that different states have different laws regarding the legality of CBD. For example, in some states, it is completely legal, and in others it is illegal. In addition, if CBD is made from marijuana (or has greater than 0.3% THC) it is illegal on the federal level, but still subject to different rules on the state level.
Since there is no coherent federal policy on hemp-based CBD, the market is largely unregulated. This makes for a poor consumer experience, as many products have been found to not contain pure CBD or have too high THC levels. This poor product regulation coupled with the presence of CBD’s baffling legal status, particularly, holds back CBD, especially in the edible portion of the sector. The CBD industry would likely grow if given new federal guidelines outlining the legal status of CBD, whether it be handed down from Congress or the FDA. Since Republicans typically are much less inclined to liberalize cannabis and cannabis derivative use, the fact that Democrats are currently favored to win the Presidency and perhaps the Senate this November (according to the current polling averages) should make the CBD industry even more hopeful for potential welcomed changes.
Ready for Prime-Time
What companies are well-positioned to capitalize on the current industry environment and potential changing outlook?
Canopy Growth is a global industry leader in CBD production and distribution with a current market cap of over $6 billion. However, Charlotte’s Web Holdings, Inc. (OTCQX:CWBHF) claims to be the #1 brand by market share; it has more than twenty-one thousand retail locations in the United States. Unlike many other cannabis companies, it only makes CBD products. Its sales have been e-commerce focused, which should allow it to hold up well in the current COVID-19 environment and beyond. The company has not yet announced Q2 results, but there are reasons to be optimistic. A similar, albeit much smaller, company cbdMD (YCBD) which is also CBD and e-commerce focused recently reported record-high sales in Q2. This combined with its recent purchase of Abacus Health Products Inc. (OTCQB:ABAHF), an over-the-counter topical CBD company, gives it significant growth potential.
Curaleaf Holdings, Inc. (OTCPK:CURLF) is a vertically integrated U.S. cannabis company and the “largest national retail dispensary brand.” It has a large variety of CBD products ranging from oil drops to creams. It has had an impressive year, so far. The company’s Q2 revenue has increased by 142% YOY while adjusted EBITDA increased by 534% YOY. Due to this growth, it has become the largest cannabis company by sales worldwide. It has a strategy of aggressive acquisitions. In the past year, it has bought 15 companies despite industry M&A declining during this period. By building out this vast infrastructure it is well poised to compete in the future, especially if current regulations are clarified or loosened. There is clearly a lot of activity in the cannabis industry.
Canopy Growth Strengthens Its Positioning
Canopy Growth is well positioned for these potential industry tailwinds. The company has been under pressure over the last year to decrease its expenses in an effort to become profitable, not simply the first to market. While revenues are growing rapidly, the company laid off hundreds of employees over the last year and ceased certain operations that were not necessarily its best.
Regardless, Canopy’s overall revenues rose 22% year over year, with significant outperformance (70-90% revenue growth) outside Canadian medical and recreational markets. With the rollout of cannabis 2.0 (edible/ingestible cannabis) products, which could be a market with high margins similar to alcoholic beverages due to similar social dynamics, Canopy’s cannabis beverage products, as well as strong global growth, Canopy seems to be moving in the right direction as a global cannabis market leader.
Source: Canopy Growth Q1 2021 (August 10th, 2020) Earnings Presentation
These moves Canopy Growth has recently taken have moved it much closer to a free-cash-flow positive state, with FCF improving about 50% (half as cash-flow negative) year over year. With gross margins improving (although fluctuating) over time and total cash of about $2 billion, Canopy has ample time to rapidly grow its revenues before it becomes profitable.
Source: Canopy Growth Q1 2021 (August 10th, 2020) Earnings Presentation
Canopy Growth’s strong balance sheet, strong revenue growth, business resizing, and overall market leadership and diversified cannabis revenue streams should position it well to succeed, both practically and as an investment. After all, leading alcoholic beverage companies such as Constellation Brands (STZ) and beverage companies such as Coca-Cola (KO) have been phenomenal long-term investments.
As for a valuation, investors may be wary to pay ~12x TTM revenues for a company such as Canopy. However, barring the recent COVID-19 pandemic, revenues had grown from about $12.7 million CDN in FY’16 to ~$440 million CDN in FY’20. With global revenues still growing ~22% over last year’s quarter and net revenues up 76% in FY’20 versus FY’19, Canopy’s growth trends are still intact. If Canopy can resume its growth trajectory in the coming months or years, its valuation could spike higher. If growth slows substantially, the stock may be overvalued or fairly valued.
The industry is in a favorable position with recent and potential future legislation only brightening its outlook. However, will lower barriers to entry and increased legality of cannabis products allow for more competition to arise, increasing supply and decreasing pricing power? Or will demand growth outpace this increased supply and competition? It will be interesting to see if cannabis producer and distributor margins expand or contract.
#Investors. Take. Note.#
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.