(Part 2 of 2)
In Part 1 of this article, I talk about how increasing market share for market share’s sake is one of the big mistakes made by “big cannabis.” Since many cannabis companies underlying operations were, for the most part, not profitable, all increasing market share accomplished was to exacerbate their losses. This lead to these companies diluting existing shareholders with more equity raises, or having to take on debt they couldn’t pay back since they were not actually profitable. This was probably the single biggest factor that caused the “big cannabis” stock bubble to pop. Investors found it hard to justify holding stock in companies that continually diluted their shares and weren’t producing profits.
Why did it take cannabis investors so long to learn this lesson? Well, on its face, it’s easy to be seduced by a strategy with the potential to produce 10x returns in a short time frame. Who doesn’t want to grow their company by an order of magnitude? I certainly would, and you probably do to. The problem with trying to “10x your company”, however, is that pursuing aggressive, non-organic growth is an expensive, and often risky, endeavor. Of course, pursuing growth and new “blue sky” opportunities is not necessarily a bad strategy. In many cases, it could be the best move your business will make. But pursuing aggressive growth, especially when fueled by acquisitions alone, can sometimes backfire.
The examples in the cannabis industry of companies that attempted to do this, then fell flat on their face, are almost too numerous to count. I could point to MedMen as an example, but that would simply be too easy as they are the posterchild of unsustainable growth, too much debt, and constant shareholder dilution. Instead, let’s look at another “big cannabis” company’s attempt to 10x their market. Initially, their growth strategy made sense, and they were able to become one of the largest cannabis companies in North America. Eventually, however, their pursuit of growth went too far and has lead to issues the company is currently struggling with to this day.
Canopy Growth: The Heady Days
If you purchased shares in Canopy Growth in 2016, you probably patted yourself on the back quite frequently. The share price of Canopy at the time was around $2.00, and by 2018 reached an all-time high of over $51 per share. The share price has since fallen to around $16 per share at the time this article was written. At first, Canopy’s growth strategy was the envy of the industry. As an early player in the market, they were able to capture new markets while other cannabis industry players were playing catch-up. But eventually this strategy, fueled by hungry capital markets willing to throw money at any cannabis growth opportunity, started to backfire.
Let’s start this story at the beginning. Canopy Growth, originally “Tweed Marijuana Inc”, was founded in 2013 in Ontario, Canada. The company started operations by repurposing a former Hershey’s chocolate factory for cannabis cultivation. It received one of the first medical cultivation licenses in Canada in 2014, and with hundreds of thousands of square feet of cultivation space to work with, was well positioned to carve out a dominant share in Canada’s burgeoning medical marijuana industry. At the beginning, margins were high as there were a limited amount of competitive cannabis cultivation licenses, meaning the company was able to obtain a high wholesale price for the marijuana it grew. The company soon merged with a competitor, changing its name to the one we know today–Canopy Growth.
At this point, pursuing growth opportunities made a lot of sense. It was sitting on a highly valuable, cash producing asset, and therefore had the capital to invest back into its operations. It reinvested its capital by significantly expanding its operations at the old Hershey plant, eventually acquiring the property in 2017, and it signed rapper Snoop Dogg to a sponsorship deal, helping to elevate its brand. At this point, the company seemed to have made all of the right moves, and its stock price began to explode. It traded at an obscene valuation, to the point that it seemed like the stock market had already priced in another “10x” growth cycle. The company felt the need to keep this momentum going, which it did with a series of acquisitions and market expansions. This is also the point where the company’s strategy went awry.
Canopy Growth: “Let’s Acquire Everything!”
When a stock increases in value by 10X, it can sometimes be a smart decision for a company to sell additional shares to raise money. Legacy investors, who bought the stock at a fraction of the new offering price, were likely happy to be diluted as long as the new capital was being used for accretive growth. Moreover, since the company was focused on cultivation, it made sense to expand its footprint in order to protect its long-term margin. It also made sense to expand beyond the Canadian market, which was a fraction of the size of the U.S. market. In short, the Company had significantly grown its market share and stock price, and the company and its shareholders seemed to think that they could continue to grow their market share and stock price through an aggressive growth strategy funded not by the company’s operations, but by bringing in new investors, including Alcohol giant Constellation Brands.
Facing an increasingly competitive cultivation market in Canada, the company sought to expand its cultivation capacity in Canada to protect its market share, and expand it did. The company hoped that its new cultivation facilities would protect its Canadian cultivation operations in an increasingly competitive market, but the problem was that the new cultivation facilities weren’t really that profitable given the increasingly competitive Canadian market.
By late 2017, many commentators and industry insiders were suggesting that Canada already had enough cultivation capacity to serve the entire Canadian marijuana market. Yet, Canopy continued to build more facilities, hoping to squeeze out its competitors with massive production. In 2018, the company opened two new “mega” greenhouses in Canada with a combined total of 3 Million square feet of new production space in anticipation of Canada legalizing recreational marijuana. Unsurprisingly, in just two short years, these two “mega” greenhouses were closed down due to the Canadian cannabis market being overwhelmed with supply.
As we have observed in this blog, in the beginning, growers are generally the most profitable part of the industry. Since it’s the beginning, there isn’t as much competition, meaning the wholesale price, and margins, remain high. However, as the market matures, and more and more growers come online, the wholesale prices drop and margins start to squeeze. Canopy could have used the money it was generating from cultivation and new investors to invest more in vertical integration, or in cultivation facilities in the new markets that were popping up in the U.S. Instead, it invested more in the already saturated Canadian market because it was worried about protecting its market share.
Cultivation facilities of the size Canopy Growth was building can cost hundreds of millions of dollars, but Canopy, sitting on a pile of investor cash, didn’t seem to care. Raising money from capital markets seemed like a consistent source of growth capital, and the company probably assumed it wasn’t going to go away anytime soon. If the company had taken a more disciplined strategy and not invested in more grow facilities in an increasingly saturated Canadian market, it would be sitting on a lot more cash today, which could be used in other new North American markets, where they could have gotten a better return on investment. Instead, it sought market share in the Canadian market seemingly for market shares sake, instead of focusing on maximizing the value of its existing operations. In the process, it burned through cash at a startling rate.
The over-expansion in the Canadian cultivation market wasn’t the only mistake the company made in its aggressive growth strategy. The company sought to take its newly raised cash to dominate, quite literally, the entire world of cannabis, while ignoring more grounded organic growth opportunities in its own backyard. It’s hard to put all of the blame on Canopy’s management, they were just doing what their investors wanted them to do—growth at all costs. The idea at the time was that this was a land grab situation, and it would be stupid to not invest every dollar available to the company to plant as many flags as possible. Thinking the window was closing on this opportunity, it decided to grow as quickly as possible, meaning growth by acquisition rather than slower-moving, but sustainable organic growth.
Focusing on expanding by acquisition, Canopy began to overpay for other company’s brands and facilities, rather than develop and strengthen their own branding. For example, in 2018, Canopy acquired Hiku and its Tokyo Smoke brand for a whopping $600 Million in stock. Hiku only operated 6 branded Tokyo Smoke retail facilities and small number of other branded facilities. Think about that for a second. Canopy had one of the most prominent cannabis brands at the time in “Tweed”. Rather than invest in further developing its own brand, or creating a new complimentary brand to Tweed, it decided instead to spend $600 Million acquiring the Tokyo Smoke brand and a handful of other lesser-known brands. Why seek strategic investment with one of the biggest alcohol brands in the world if you are going to simply overpay for the brands of lesser well-known cannabis competitors?
This land grab mentality also led the company to engage in a number of poorly executed international expansions and acquisitions. Rather than develop its North American presence organically, the company yet again sought to expand into the North American market by acquisition. In 2019, it sought to acquire Acreage Holdings, a deal that is expected to close when the U.S. officially legalizes marijuana. At the time of writing, shares in Acreage Holdings traded at approximately half of the price Canopy agreed to pay. This same mentality carried over into acquisitions outside of North America, from South Africa to Colombia. In South Africa, Canopy practically gave away its operations, while in Colombia Canopy recently announced that it was shutting down its cultivation operations.
To be fair, the company did make a couple smart moves in this time, and it did try to vertically integrate its Canadian operations organically though it ran into regulatory roadblocks. But the fact remains that by 2020, Canopy had spent a whopping $2.7 Billion in acquisitions. Canopy’s massive war chest has since dwindled, and it continues to lose significant money each quarter as its operations are not profitable by a long shot. Had the company taken a more disciplined approach, it would now be in a position to strategically buy assets at low valuations. It could have spent a fraction of that money organically obtaining licenses in the lucrative U.S. market, where a handful of big cannabis players have managed to achieve profitable operations, rather than focus on pie-in-the-sky international markets. If it did so, it would have more cash on hand, high margins, and may have even been profitable like some of its U.S. focused competitors.
What’s Next for Canopy?
Canopy remains the biggest cannabis company in the world by market capitalization, but it is hard to think the company didn’t squander its opportunity to become a true global giant generating billions in revenue and hundreds of millions in free cash flow. The mistake it made, and the mistake I’ve seen many other smaller cannabis companies make, is they tried to grow too fast. They focused too much on acquisitions over organic growth, and in the Canadian market, aggressively tried to grow its market share without taking into account margins and profitability. At the same time, it ignored organic growth opportunities in its own back yard—the U.S.
In short, Canopy suffered from the mistaken belief that it had a limited time to claim as much market share as it could, because the industry would soon solidify much the way the alcohol market has. The problem with this logic is that it took DECADES for the alcohol industry to solidify, and the cannabis industry is still in its nascent stage. Canopy’s management didn’t realize they had plenty of time to grow organically rather than through acquisition. If the company had taken a more disciplined approach, rather than trying to take over the entire world of cannabis, it may very well be profitable today. It also may very well have been sitting on a pile of cash that could be used as part of a disciplined acquisition strategy. Instead, it spent money on acquisitions like a drunken sailor, and we will never know what its true potential would have been.
Canopy is currently trying to turn itself around, and has seemed to recognize its previous mistakes. It brought on a new CEO who has focused on streamlining operations. Canopy is shedding itself of unproductive assets and cutting the proverbial fat, including stopping construction or halting operations on its expensive new Canadian cultivation facilities and ridding itself of many of its unproductive international assets. Only time will tell whether Canopy can turn itself around into a profitable, sustainable operation.
Lessons for Small Cannabis
While many of the big cannabis companies made this same mistake, some smaller and micro cannabis companies have been able to grow through a disciplined acquisition and licensing strategy. The key to this strategy is simple, have patience, and don’t force opportunities. When advising cannabis business clients, I like to use the analogy of acting like an alligator. Now before you think I’m crazy, hear me out. An alligator is an incredibly patient hunter, and also an opportunist. They may patiently observe their prey for hours before waiting for the perfect time to attack. That’s exactly the type of mentality you need to have in the cannabis industry when it comes to acquisitions.
The problem with being patient is that it is much easier said than done. In the Michigan market, it took two years for reasonably priced dispensary opportunities to present themselves. During this time, many thought that it may never happen, that overpaying for dispensaries was simply what you had to do in this market. Some dispensaries were sold for north of $10 Million, many of which artificially increased their revenue through low margin sales in an attempt to justify a lofty valuation.
Like the Canopy example above, many companies fell into the trap of overpaying for dispensaries in an attempt to grab market share. They were afraid of missing out. A few, however, were a bit more patient. These companies developed their own opportunities organically while the mad rush to acquire operating dispensaries was happening, only to switch over to an acquisition strategy when the market for dispensaries tanked and good opportunities presented themselves. They were willing to lie in wait for years for the right acquisitions to line up, and when they did, like an alligator, they quickly pounced on them. I’m sure there are hundreds of more examples of smaller cannabis companies waiting for the right opportunity to come along before making an acquisition.
Discipline is a trait that is not common in this industry at the moment, despite it being incredibly valuable. Eventually, it will be more prevalent as the disciplined companies continue to not just survive, but thrive, and eventually overtake their larger, less disciplined competitors. However, it will take time to do so, as markets start to mature and capital discipline is gradually instilled in the industry and the undisciplined companies get shaken out. In the meantime, don’t be afraid to pass on an acquisition opportunity. Oftentimes the best business decision you can make is to simply do nothing, and like an alligator, lay in wait for the right opportunity to present itself.