- Canopy
Growth will reduce exposure to dilution and debt with the investment model
of the new company.
- The
business model of Canopy Rivers has one major flaw.
- The
way Canopy Rivers must be analyzed in order to understand its growth
potential.
Canopy Growth (NYSE: CGC) is near to
spinning off its new financial investment company called Canopy Rivers into a
publicly traded firm, which will pursue investment opportunities in the growing
cannabis sector.
With a business model that has done extremely well for
companies in other markets, if it is able to successfully leverage the model,
Canopy Rivers has the potential to grow larger than Canopy Growth in the years
ahead.
We’ll look at the business model and strategy of Canopy
Rivers, and use a highly successful company that uses a similar model in a
different industry as a baseline to measure its potential against.
Canopy Rivers is scheduled to start trading as (TSX.V: RIV)
on Thursday, September 20, 2018. My expectations are it’ll start trading over
the counter two to three weeks later.
What Canopy Rivers is
In July 2018, after raising $104 million and announcing it was close to
going public, the company provided this description of its business:
The Company is a unique investment and operating platform
structured to pursue investment opportunities in the emerging global cannabis
sector. The Company works collaboratively with Canopy Growth to identify
strategic counterparties seeking financial and/or operating support. The
Company has developed an investment ecosystem of complementary cannabis
operating companies that represent various segments of the value chain across
the emerging cannabis sector. As the portfolio continues to develop,
constituents will be provided with opportunities to work with Canopy Growth and
collaborate among themselves, which the Company believes will maximize value
for its shareholders and foster an environment of innovation, synergy and value
creation for the entire ecosystem.
Basically, how the deal will be made is Canopy Rivers will
make an offer for a desirable company competing in the cannabis space, taking a
partial stake in the business. Not only will it provide capital but its
management expertise as well.
Presumably, later on, if the investment pays off well, it’s
highly probable it could acquire entire companies. That’s not a certainty, but
it would have to be at least part of its strategy for the companies that
respond well to its investment and improved execution.
While I’ve seen some pundits gushing about the potential of
the new company, there is a major headwind we’ll get into that will determine
its long-term performance.
Strengths and weaknesses of the business model
We’ve already looked at the two strengths associated with
the business model of Canopy Rivers, which is to provide capital via taking a
position in a specific company and then providing its expertise to improve
operations and make it more competitive.
There is a third vital area that isn’t included in its
model, or at least it’s not observably present at this time, and I’m going to
use the highly successful Constellation Software as a baseline
to help identify and understand why it’s important to Canopy Rivers being an
extraordinary success.
For many years, Constellation Software has successfully
identified and acquired software companies that it has supplied capital and its
expertise to. What makes it different is it has targeted companies that compete
in niches or verticals that larger companies have no interest in acquiring because
of their relatively small size.
So, while providing capital and management expertise is
important, it’s not as important as finding companies to acquire that have very
little competition, which means they can be acquired cheaply and have few if
any peers. They perform well if they’re a big fish in a small pond.
Canopy Rivers can make acquisitions that can build its
production base, diversify products, and expand to different geographic areas.
The problem is any company can do the same that has enough capital and talent
in the cannabis industry. They don’t have to compete in the cannabis segment,
but if they have enough money, like some of the deep-pocketed tobacco, soft
drink, and beer companies do, this is an easily reproducible strategy.
Having said that, where Canopy Rivers could do well going
forward is it is looking to make investments in smaller, quality cannabis
companies that need a cash infusion. With the ongoing industry consolidation,
the companies with a lot more capital to offer aren’t going to look at tiny
companies that do little as an add-on to their much larger business.
In the case of Constellation Software, its business model
had a built-in moat, which was it acquired smaller software companies that
competed in a very narrow niche, such as waste disposal, local real estate,
medical, and a variety of other market segments.
The challenge for Canopy Rivers is even if it buys a
position in a significant number of cannabis firms, it hasn’t done much to
differentiate, which is the key to its long-term success. If its acquisitions
don’t create a defensible moat, then it’s doing nothing to keep from becoming a
commodity business.
The biggest question for Canopy Rivers is whether or not
there’s a large enough base of verticals within the cannabis to generate
significant numbers. In other words, if it takes a position in a targeted
company, does it have a number of other peers that can continue to compete
against it? Are there cannabis verticals that exist which provide products or
services that are in demand, but the market is small enough to be profitable,
but not large enough to attract larger buyers.
Then there is the fact there are a number of its peers that
could employ the same strategy. That has happened on the production and
distribution side already. That’s why I say the verticals in the industry are
what matter, and I’m not even sure enough exist that make the long-term growth
of Canopy Rivers sustainable.
Outside of cannabis production and sales, medical pot, and
hemp, there aren’t a lot of other verticals for Canopy Rivers to choose from in
the space. It could take a position in a company that helps others build
infrastructure and greenhouses, but again, that isn’t something that can’t be
easily done by competitors.
If Canopy Rivers and Canopy Growth can execute very well and
has the opportunity to make money from its investments on the picks and shovel
side of the business or make money from management fees, it could do very well.
There is, of course, also the potential of the companies it invests into grow
as well, providing more growth.
Is a moat possible with Cannabis Rivers?
If Cannabis Rivers is to build a moat, it would have to do
so in relation to the types of companies it invests in. The first thing to look
for would be the size of the investment in the companies, which as already
stated by Canopy Rivers, will be no higher than approximately $10 million. That
would mean few if any larger competitors would be interested in competing for
them because of their smaller size, which would drive up the price. Unless the
company was to change its strategy, this isn’t going to be an issue. With that
in mind, only its peers would be considered competition for taking a position
in these smaller cannabis firms.
The most important thing to consider in regard to the
potential for Cannabis Rivers to develop a moat would be the type of companies
it acquires. I’m looking for something different than production, which as
mentioned earlier is easy to replicate. Some considerations would be expanded
or improved distribution systems, approval for medical usage, and other things
in the industry that are difficult to reproduce.
Last, the one area it could take a big lead in that would be
hard for its competitors to copy would be to take positions in companies that
have high-quality leadership that it locks in through agreements. If it reaches
them before its competitors do, it could dry up the talent pool in the short
term, which would make it difficult for competitors to follow until the talent
pool in the market expands; that will take time.
Conclusion
Canopy Rivers is a company I want to like, and may even take
a position in it in the early months after it goes public. It is likely to
receive the benefit of its parent company Canopy Growth, and ride its coattails
for a period of time; although there are growing concerns about its rapid
increase in share price and market cap as well as the strong probability it’s
going to correct big in the near future.
The key to its long-term viability is whether or not
verticals emerge in the industry that provides defensible moats because of
their smaller size and lack of competitors. I don’t see much of that yet, but
it’s likely that more will emerge over time.
For investors interested in Canopy Rivers, that’s the key to
determining its future potential. If it takes positions in companies that
compete in a commodity segment of the cannabis sector, which is probably all of
them at this time, it’s only buying more revenue but not much in the way of
earnings.
Of course, revenue is important at this time, and I see that
as the main driver in the cannabis industry in the short term. But further out,
if verticals don’t emerge in the industry that has revenue and earnings growth
potential while being too small for larger players wanting to take a meaningful
position in the larger cannabis companies to take interest in, Canopy Rivers
will struggle to maintain sustainable growth on the top and bottom lines.
The positive for Canopy Growth is by using Canopy Rivers as
an investment arm, it allows it to grow via its 25 percent stake in the new
company, without diluting its share price by taking positions in other
companies, such as Aurora Cannabis has done.
That’s important because the market has punished Aurora
Cannabis because of the level of its dilution, and Canopy Growth is certainly
looking for ways to grow without having that same impact on its share price.
At this time, I think Canopy Rivers will be a positive for
Canopy Growth, but if it struggles to acquire companies that compete in
verticals with a moat, if they even exist in any meaningful numbers at this
time, it could eventually be a weight on its performance. On the other hand, if
it is successful in its acquisitions, this could be a huge growth catalyst for
both companies.
I could even see it being bigger than any other revenue
stream for Canopy Growth if Canopy Rivers is successful.
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