This Canadian pot company was the first to impress customers with cannabis derivatives, so what went wrong?

Derivatives are additional recreational products that Canada legalized in October 2019 as part of "Cannabis 2.0" legalization. These products garnered a lot of consumers' attention. Thus, Canadian pot companies were eager to launch them. Canopy Growth (NASDAQ:CGC) was the one to jump at the opportunity. 

Canopy Growth had an early mover advantage in the Canadian medical cannabis market. It first started selling cannabis oil in the fourth quarter of fiscal 2016.

The company flourished, making many investors rich. However, soon regulatory holdups delayed the opening of legal stores in many parts of Canada, challenging the revenue growth. Canopy had high hopes from the recreational market. But now, years after Canada legalized these products, Canopy seems to be in worse shape than when it started. So what went wrong? Let's take a look.

Canopy's high-margin derivatives products aren't helping it rebound

In January 2020 (when these products were allowed to be launched in the market), Canopy introduced a line of high-margin derivatives. These included tetrahydrocannabinol (THC)-infused chocolate bars under its Tokyo and Tweed brands, cannabis-infused beverages under the Tweed, Quatreau, and Deep Space brands, and a line-up of vape pens and vape cartridges.

Its beverages, in particular, impressed customers. By the third quarter of fiscal 2021, Canopy had captured 34% market share in the beverages category, according to the management. In its recent second-quarter fiscal 2022 (ended Sept. 30, 2021), the company launched a few more varieties of edibles and its first-ever gummy products under the Deep Space brand.

Despite customers' good feedback, these products didn't generate enough revenue to bring in profits. Now, two years later, what was expected to drive Canopy Growth to success is not even helping it grow its revenue to achieve positive earnings before interest, tax, depreciation, and amortization (EBITDA).

Rather, revenue declined 3% year over year to 131 million Canadian dollars in fiscal Q1 2022. The company also saw a dip of 4% year over year to CA$58 million in total Canadian recreational cannabis sales (minus excise taxes) in the quarter. According to the management, supply challenges, rising competition, and shifting consumer preference during the quarter challenged recreational sales. 

Adjusted EBITDA losses also widened to CA$163 million, compared to CA$85 million in the year-ago quarter. Management stated that the decline in revenue and a negative 54% gross margin for the quarter were responsible for the increase in losses. Canopy expects to launch more innovative beverages into the market in fiscal 2022. It will be interesting to see if these can help revive its revenue growth.

High hopes in the U.S. market, but....

Canopy's products would get good exposure in the U.S. derivatives market, which is quite popular. Canopy even has strong partners like beverage giant Constellation Brands, multi-state operators Acreage Holdings (pending acquisition contingent to legalization), and TerrAscend to introduce these products in the market. The company also recently announced its plans to acquire Colorado-based Wana Brands, upon federal legalization. Canopy expects to have a stronghold in the edibles market through this acquisition, as Wana has a market presence in 12 states and is hoping to increase to 20 by the end of calendar 2022, according to management. 

Though Canopy has high hopes in the U.S. cannabis market, it is still a long shot. Besides, domestic multi-state players will be the first to benefit if and when legalization happens. The domestic companies are in a much better position (some of them are even profitable) to fuel their expansion plans in the U.S. market.

Is Canopy worth the risk?

Constellation's investment is keeping Canopy in safe waters for now. It ended the second quarter with cash and short-term investments of $2 billion. 

But until the company starts generating profits, more acquisitions and any expansion plans will keep burdening its balance sheet. Its peers Aurora Cannabis and Hexo are riding the same boat of declining revenues and rising losses.