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Canopy Growth (CGC) announced that it will acquire another Canadian licensed producer Supreme Cannabis (OTCQX:SPRWF) for $435M while paying a whopping 66% premium for the small asset. The market didn't like the deal and sent Canopy shares down 5% on the day, wiping out ~$750M of its market value. We also think the deal could be viewed negatively given the large premium paid and the confusing signal it sends to investors about Canopy's priority and ability to execute organic growth initiatives. We continue to view Canopy shares as highly speculative given lofty valuation.
Poor Track Record
Canopy's track record in M&A has been mixed given it overpaid for many acquisitions, most notably its two large Canadian deals. We have published detailed analyses on why we think Canopy overpaid for its $600M Hiku acquisition and wasted another $500M on two B.C. Tweed greenhouses. Canopy only got a brand from the Hiku deal and it also recently announced the shutdown of those B.C. greenhouses after suffering heavy losses and operational issues including a major fire, resulting in a total wipeout of value from this investment. We think a big part of these two difficult acquisitions has to do with Canopy's shifting strategy in Canada. As the early leader and the best-capitalized player, Canopy decided to spend money on cultivation and retail brands which turned out to be less valuable parts of the industry. Industry-wide cultivation capacity far surpassed demand which led to massive oversupply and a wave of failure across cannabis greenhouses. Further, most of the Canadian provinces placed heavy restrictions on vertical integration.
Now that Canopy has had its new management team for over a year now, we were a little surprised that it decided to spend large sums on a local producer instead of building out its own operations. Canopy was one of the earliest and largest LP in Canada with millions of sq. ft. in cultivation capacity. It decided to sell most of its large-scale greenhouses and scale back operations only to turn around and acquire another cultivation-focused LP. Although Canopy tries to position Supreme as a premium flower producer, Supreme reported an average selling price of only $4.24/gram from recreational and $2.22/gram from wholesale channels. These are not premium numbers and they are pretty close to other diversified LP such as Aphria (APHA).
Acquiring Supreme
Canopy shares on the TSX closed down 5.3% at $35.75 the day it announced the deal, which implies an offer price of $0.42 for each Supreme share based on the exchange ratio of 0.01165872 plus $0.0001 in cash. The market clearly did not like the deal at first and we think there are few potential reasons. First of all, as we discussed above, Canopy seems to be going back and forth on its Canadian strategy, and investors are likely frustrated with its decision to shut down its multi-billion greenhouses while paying a hefty premium to acquire another local producer. Secondly, Supreme is an asset that has been struggling for most of the last two years. The business has seen improvements on both the top-line and profitability last quarter but it remains early days. At least the deal will be accretive technically because Canopy is highly unprofitable! Lastly, the deal signals that the Canopy team likely has a limited number of near-term opportunities in the U.S. because it could find time to work on this Canadian deal. Investors would prefer Canopy to spend time on ways to make money in the U.S. but instead was given another Canadian deal. The Canadian market has been challenging since the beginning of legalization; oversupply and price compression continue with no relief in sight. Meanwhile, the U.S. market is booming with MSOs reporting record revenue growth and profitability. People could likely infer that Canopy sees limited activities in the U.S. and European market for itself and decided to focus on Canada.
(Source: Author)
Canopy shares experienced a strong rally in the last 12 months as cannabis stocks benefited from Democrat's Senate win. However, Canadian LPs were clearly overheated because they are less likely to benefit from any near-term legislative changes in the U.S. which will probably focus on banking and capital markets access. We think the timing for Canadian LPs to enter the U.S. market is remote given Biden's opposition to federal legalization. Supreme didn't even benefit from the initial surge as its relevance dwindled and investors lost interest in small-cap Canadian players given the challenging industry backdrop and poor outlook. There has been a visible trend of large Canadian LPs losing market share to smaller players. Canopy's cannabis sales have not increased during the last 12 months while Canada-wide cannabis sales doubled during 2020, indicating a material loss of market share for Canopy.
(Source: Bloomberg)
Looking Ahead
In summary, we think Canopy's acquisition of Supreme appears to be defensive given its significant loss of market share in the Canadian market last year. Supreme struggled operationally and underwent balance sheet restructuring before this deal but the headline price and significant premium still raised questions about whether Canopy overpaid. Overall we view the deal as negative for Canopy because Canada is an unattractive market for capital deployment and the transaction signals Canopy's inability to execute on growth strategy organically. For Canopy, shareholders would prefer to see management create value by executing instead of buying, especially given its poor acquisition track record. We remain Negative on Canopy shares given its high valuation at 30x EV/Sales and lack of paths to profitability. We think Supreme shareholders got a great deal to exit.