Canopy Growth Management Are High On Their Own Supply

2019/05/09

“The stock market is filled with individuals who know the price of everything, but the value of nothing.” —Philip Fisher

 

Back in December 2016 we wrote an article about weed companies entitled “The Green Rush Bubble” reasoning that stocks in the cannabis industry are overvalued. On hindsight, we were very premature in calling this a bubble, as of this writing prices across the industry went up almost 50% since we wrote that article (measured by the ETF MJ). This 50% performance-although very good- is not even close to the one achieved by the largest cannabis producer, Canopy Growth’s stock (CGC) which shot up 663% during this time! Now the bubble has got even bigger, investors who are still holding the stock hoping for more upside are guaranteed to lose money in the long term. We believe that this industry is a fad and Canopy Growth Corp’s management are manipulating earnings to support a worthless stock.

 

Let us explain …

 

A rookie analyst would notice that Canopy’s financials are full of red flags. Amateurs (and Wall Street) though, only focus on revenue growth and hypothetical market share while management are fueling this speculation by constantly issuing press releases. Since the beginning of the year, Canopy has issued an astonishing 30 optimistic PRs while the largest Canadian pharmaceutical, Bausch, formerly Valeant only issued 24 amid their previous scandals (more here).

The hype is around revenue growth and market share. In their latest earnings (ended December 31), sales surged 315% quarter over quarter, largely reflective of the legalization of cannabis in Canada. However, accounts receivable and prepaid assets have been rising at an alarming rate faster than revenue:

When a company’s accounts receivables are growing faster than sales, that indicates that the company is booking revenues before the proper time, which is one of the most common practices within the universe of manipulation. Future sales are simply recognized early, inflating earnings.

 

Another red flag on the balance sheet is the prepaid assets entries. Prepaids have been growing at an alarming rate with no explanation in the notes to the financials as to the reason behind such inflated numbers. This old trick of manipulation allows management to set up a deferred asset instead of reporting it as expense, boosting current earnings.

In 2004, Bristol-Myers Squibb, was investigated by the Securities and Exchange commission for perpetrating a fraudulent earnings management scheme by, among other things, selling excessive amounts of pharmaceutical products to its wholesalers ahead of demand, improperly recognizing revenue from $1.5 billion of such sales to its two largest wholesalers and using “cookie jar” reserves to meet its internal sales and earnings targets and analysts’ earnings estimates.

 

The company settled with the SEC to pay $150 million and perform numerous remedial undertakings, including the appointment of an independent adviser to review and monitor its accounting practices, financial reporting and internal controls.

  

Growth for the sake of it does not translate to profits for investors, since its inception, Canopy Growth has never posted a profit nor it has any plans to achieve profitability in the future as per the risk section on their FY18 MD&A “The Company has a history of losses, may incur significant losses in the future and may not achieve or maintain profitability.” Yet the company is funding its operations, financing acquisitions, and paying out lavish bonuses to management by issuing common stock. As the following graphs show:

 

CGC shares outstanding

It should be a red flag when management team is busy touting the stock on road shows instead of running the business. Among the 17 analysts covering it, only 1 has an underperform rating! Jim Cramer, the CNBC guru is an advocate of the company without doing any due diligence as he states “I will only recommend Canopy Growth […] I have spent a lot of time with Canopy. I have had many lunches and meetings and interviews with Bruce Linton, the chairman, co-CEO and co-founder of Canopy, which is attempting to be the dominant seller of both recreational cannabis and medical cannabis […] In truth, though, the real reason I like it is because Constellation Brands has done the due diligence for me.” (Link here).

 

Constellation Brands hasn’t done any due diligence, they bought a stake because of FOMO (Fear Of Missing Out), same fear that triggered the $165 billion merger between AOL and Time Warner during the dot-com bubble, only to see the combined company post a loss of $99 billion when the bubble burst a few years later. This “investment” in Canopy is not based on any rationality. After all, Canopy is a commodity company, with negative working capital, that keeps losing money and has no plans to achieve profitability.

 

During the last quarter (December 31), while analysts are cheering for the record revenue of $62.8 million, SG&A expenses also hit a record $117.14 million (higher than revenue!). Management explains in the MD&A “G&A expenses also included higher employee compensation costs due to increased staff levels, necessary use of consultants and advisory services”. In other words, the more the company expands the higher these costs will be.

Which leads us to management salaries …

The company is run for the benefit of management with no consideration to shareholders. During last quarter (December 31), the company granted $47.33 million in stock options to management, consultants, employees and others. A ludicrous amount (75% of sales!). For every dollar of weed sold, insiders will pocket 75 cents!

Things get more interesting in the “Transactions with Related Parties” section of the Financial statements (These pages are unavailable on the company’s website, we had them printed before they were taken down).

This section is just another way of saying self-dealing, which is when a company does business with its insiders. Transactions with Related Parties is a hornet’s nest of potential problems.

 

• The company acquired the entire building and land, known as 1 Hershey Drive, Smiths Falls, Ontario, from Tweed Hershey which was related through common ownership (the CEO and chairman is a significant shareholder of the lessor).

• The company leases premises for the two Bedrocan facilities in Toronto from a company controlled by a director of Canopy Growth Corporation.

• In addition to the leased premises, consulting services of $159,000 was also provided to the company.

• The company leases premises for the Mettrum Hempworks Inc. production facility located in Barrie, Ontario from and employee and shareholder of the company.

• The company currently has a loan payable to a director of the company for the amount of $169,000 at 10% interest rates.

• The company entered into a lease for the Vert and Hemp.CA properties with a shareholder of Hemp.CA who was an employee of Canopy, the lease to expire in 2036 with two automatic renewal terms of 10 years each.

• Bedrocan (a subsidiary of the company) leases its operating facility at 16 Upton Road, Toronto, Ontario and 43 Upton Road Toronto, Ontario from Goldman Ltd. Murray Goldman, a director of the Corporation, is an officer, director and holds a majority interest in Goldman Ltd.

• Furthermore, there is a $2,000,000 loan to Bedrocan at 10% per annum and is payable over a period ending July 1, 2024. Plus, monthly rent of approximately $27,100.

$ Amounts in CAD

 

It’s obvious that these transactions create a conflict of interest, such transactions with management and employees constitute an apparent red flag (remember Enron?). No corruption act can exist without a conflict of interest.

 

In all corporate boards, the CEO has a base salary plus stock options as a bonus for achieving some operational metrics. In the case of Canopy, the CEO’s compensation is beyond logic.


The Proxy statement or Management Information Circular as it’s called in Canada sheds more lights on the executives’ outrageous compensation (the following amounts in CAD).

 

• The Corporation shall pay to HBAM (the CEO’s holding company) a monthly fee of $16,667.

• Plus, a car allowance in the amount of $1,500 per month.

• HBAM is also eligible for an annual short-term incentive bonus of up to $300,000.

• The Corporation agreed to grant HBAM $200,000 of RSUs, upon establishing such long-term RSU incentive plan.

• HBAM is further eligible to receive equity or equity-based compensation granted by the Board of Directors of the Corporation from time to time.

• The Consulting Fee was increased to $25,000 per month effective April 1, 2018.

 

Here is a summary of the executives’ compensation. The table does not include over $35 million of In-the-money stock options:

Meanwhile, the Compensation committee and the Audit committee are held by the same directors (no wonder there is no independence nor oversight in this board) while their compensation is excessive as well.

For comparison, Berkshire Hathaway, 5th largest company in the US pays its directors between $3,300 and $7,300, depending on which committee they sit on.

But wait … There’s more:

 

An excerpt from the latest MD&A document: “in the event that executive officers employment agreements were terminated by the Company, […], the CEO is entitled to a severance amount equal to nine months of compensation based on the monthly contract work fee of $300,000 in aggregate and all other Executive officers are entitled to a severance amount equal to at least thirty four week’s annual base salary and in some cases, inclusive of their annual bonus.”

 

Another worrying sign is the accuracy of the numbers being reported, under Internal Controls Over Financial Reporting section on the MD&D the company states “As of March 31, 2018, the Company did not maintain effective internal controls over Corporate-wide EUC spreadsheets, the accounting complexities encountered in the financial reporting relies on equally complex spreadsheets. […] Because of the material weakness described above, management concluded that the Company’s internal controls over financial reporting were not effective as at March 31, 2018. Accordingly, a reasonable possibility exists that material misstatements in the Company’s financial statements will not be prevented or detected on a timely basis”. Such incident happened less than a week after posting quarterly earnings, the company has had to issue a correction of their EBITDA metric. The nine-month adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) figure should have been a loss of $155.2 CAD million instead of the incorrectly stated $69.0 CAD million!

 

The Cannabis Act
 

While everyone is ecstatic about the cannabis legalization in Canada, and Canopy’s potential market share of this industry, one should at least understand what this bill entails.

 

The Act allows:

 

• purchasing limited amounts of fresh cannabis, dried cannabis, cannabis oil, cannabis seeds, or cannabis plants from retailers authorized by the provinces and territories;

• possessing of up to 30 grams of dried legal cannabis or equivalent in non-dried form in public;

• consuming of cannabis in locations authorized by local jurisdictions;

• growing up to four cannabis plants per household for personal use;

• sharing up to 30 grams of dried cannabis or equivalent with other adults;

• making legal cannabis-containing products at home, such as food and drinks, provided that dangerous organic solvents are not used in making them.

 

The Act prohibits:

 

• products, promotions, and packaging and labelling that are appealing to youth;

• the sale of cannabis through self-service displays or vending machines;

• promotion of cannabis, except in narrow circumstances where the promotion could not be seen by a young person; and

• false, misleading or deceptive advertising, sponsorships, testimonials and endorsements or other forms of promotion that could entice young people to use cannabis.

 


In short, Canopy Growth and its peers are in a highly regulated commodity type business, very competitive (black market), with no barriers to entry (you can grow your own plants at home, legally) and cannot differentiate their products through branding or marketing. Management are incompetent at best (who loses money selling drugs?), and in order to keep analysts hyping its stock, Canopy Growth keeps issuing press releases (collaboration with Martha Stewart as an example), buying other companies in the cannabis industry at a very high valuations, issuing more shares to fund such acquisitions and pay insiders very handsomely. As Warren Buffet said, time is the friend of the wonderful business, the enemy of the mediocre. Time will tell when Canopy’s stock will come crashing down. If you can’t see this, you’ll probably be left holding the bag!



Disclosure: Lembirik Group is not holding any position in this company nor do we have any position in this industry.



Sid-El Mehdi Lembirik
Managing Partner
Lembirik Group, LLC