Since 2016, the landscape of the Canadian cannabis has changed, and Licensed Producers (LPs) seem to care more about operating profitably than it did in prior years.
Back in 2016, many Canadian LPs such as Canopy Growth Corporation (TSX: WEED) (NASDAQ: CGC) were being valued on funded capacity. When we first learned that leading broker-dealers were valuing companies on funded capacity, we became concerned with how Canadian LPs were being valued. Funded capacity refers to the amount of cannabis that can be produced on a square footage basis and is based on the amount of cash that it has on hand.
The reason why we found this valuation metric to be absurd is due to lack of analysis that was used to come up with it. The metric does not take any delays, mistakes or miscalculations into account and assumes that construction will not face any issues or incur any additional costs.
Although all Canadian LPs failed to successfully reach their respective funded capacity, we believe that the failures have proved to be beneficial for the long-term opportunity. Since 2019, we have noticed a trend with Canadian LPs which are closing facilities and decreasing the potential amount of cannabis that can be produced.
From Aurora Cannabis (ACB.TO) (ACB) to HEXO Corporation (HEXO.TO) (HEXO), this is a trend that is playing out for leading Canadian LPs. Besides for these two operators, Canopy Growth Corporation (TSX: WEED) (NASDAQ: CGC) has been highly focused on cutting costs by closing facilities and right sizing the business.
Closing Facilities Should Lower Expenses and Lead to Margin Expansion
Earlier this week, Canopy Growth announced a series of operational changes to its Canadian platform that are designed to streamline operations and lead to margin appreciation. As part of the restructuring process, Canopy Growth will cease operations at: St. John’s, Newfoundland and Labrador; Fredericton, New Brunswick; Edmonton, Alberta; Bowmanville, Ontario.
Canopy Growth also reported to be closing down the outdoor cannabis cultivation operation in Saskatchewan and this is a trend that caught our attention. Last year, the company’s outdoor cultivation operation did not meet expectations and we are not surprised by the decision due to the amount of cultivation assets that it has in various low-cost international markets.
As a result of the closures, Canopy Growth expects to incur pre-tax charges in the range of approx. $350 million to $400 million. This amount consists of approx. $320 million of non-cash asset impairments that are related to the closure of production facilities in the third quarter. The remaining charges are cash charges that are primarily attributable to employee severance, contract and existing obligation terminations, outside services, and shutdown related costs.
Most of these impairment charges are expected to be recorded in the fiscal third and fourth quarter (for the period that ends on March 31, 2021). Going forward, Canopy Growth expects the closures to result in annual cost savings of more than $50 million and we find this to be significant. We believe the management team has the expertise that is required to execute on this initiative and will monitor how company fundamental change over the next year.
During Canopy Growth’s second-quarter earnings call, the management team said that the closing of additional facilities would play an important role the company’s previously announced plan to save approx. $150 million to $200 million and accelerate its path to profitability.
Remaining Facilities are Expected to Satisfy Consumer Demand
Canopy Growth CEO David Klein said that he is confident that the remaining cultivation facilities will be able to produce the quantity and quality of cannabis that is required to meet current and future demand.
These changes are part of a much larger strategy that was highlighted by the management team in the second quarter earnings call. These decisions are the partial outcome of an ongoing end-to-end review that looks at people, process, technology, and infrastructure.
If the management team’s estimates are correct, Canopy Growth expects to save approx. $350 million to $400 million of estimated total pre-tax charges in the third and fourth quarter (fiscal year 2021). These expectations are preliminary, unaudited, and are subject to change ahead of the company’s next quarterly and annual earnings report.
Closures Represent a Large Chunk of Canopy Growth’s Capacity
This is not the first time that Canopy Growth has closed facilities so far this year and this is a trend that we will be following in 2021. The production facilities that were most recently closed represented approx. 17% of Canopy Growth’s enclosed Canadian footprint and 100% of its Canadian outdoor production footprint.
Earlier this year, Canopy Growth closed facilities in Aldergrove and Delta, British Columbia. At the time of this announcement, the company stated that it no longer plans to build a third greenhouse in Niagara, Ontario. At the time of the announcement, the management team said that these closures were part of a strategy to align supply and demand while improving production efficiencies.
The greenhouses that Canopy Growth closed in British Columbia accounted for approx. 3 million square feet of licensed production space that was put into commission in February 2018. When Canopy Growth announced the closing of facilities, the market seemed to be caught by surprise and we will monitor how it responds to the most recent closures.
Positioned to be a Long-Term Leader
With almost $2 billion of cash on the balance sheet, Canopy Growth is well positioned to survive the current market environment. We believe the management team has taken a strategic approach to improve profitability and maximize efficiencies.
Despite the recent facility closures in Canada and in international markets (Latin America and South Africa), Canopy Growth is still considered to be a leading play on the global cannabis market. We believe the management team is taking the business down a path to profitability and will monitor how fundamentals improve in 2021.
During the last quarter, Canopy Growth has been trending higher and the stock has rallied more than 80% off its late September lows. So far this week, Canopy Growth has been under considerable pressure and the stock has come off its recent highs. During this time, momentum has been trending to downside and this is a metric that we are closely monitoring to better under the direction the stock is heading.
Over the next year, we expect Canopy Growth to report impressive improvements on the top and the bottom-line. As a result of the facility closures, the company is expected to substantially lower its cash burn and we will continue to closely follow the opportunity.