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Will Canopy Growth’s Spin-Off Canopy Rivers Be A Powerful Growth Engine?

  • 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.

Authored by Gary Bourgeault of Seeking Alpha

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