Fitch Downgrade Canopy to ‘CCC-‘

Here’s thair latest analysis

 

RATING ACTION COMMENTARY

Fitch Downgrades Canopy Growth Corporation to ‘CCC-‘

Fri 28 Oct, 2022 – 12:07 ET

Fitch Ratings – Chicago – 28 Oct 2022: Fitch Ratings has downgraded the Long-Term Issuer Default Ratings (IDRs) for Canopy Growth Corporation (Canopy) and 11065220 Canada Inc. to ‘CCC-‘ from ‘CCC’. Fitch has also downgraded the senior secured term loan facility to ‘B-/RR1’ from ‘B’/’RR1’.

The downgrade reflects Fitch’s view that the strategic linkage between Constellation Brands, Inc. (Constellation) and Canopy has materially diminished. Previously, Canopy’s ratings reflected a one-notch uplift from its standalone credit profile of ‘CCC-‘.

Fitch could take further negative rating actions if Canopy pursues a repayment/refinancing of the remaining 2023 notes that Fitch considers a distressed debt exchange (DDE) per our criteria, if liquidity appears constrained such that a default is probable, or if the company does not successfully execute their premiumization cultivation strategy.

KEY RATING DRIVERS

Debt Repayment Expected: Canopy entered into agreements with certain lenders under its term loan credit agreement to amend terms and tender for USD187.5 million of the principal amount outstanding at a discounted price of USD930 per USD1,000 or USD174.375 million. The repayment will be made in two equal payments with the first payment in early November 2022 and the second payment in mid-April 2023. Fitch does not view this as a DDE because it does not satisfy the two-pronged test under our criteria.

Canopy also intends, if shareholders approve the creation of the exchangeable shares, to negotiate an exchange agreement with Greenstar Canada Investment Limited Partnership, a subsidiary of Constellation, to purchase for cancellation up to CAD100 million principal amount of senior convertible notes in exchange for stock. Fitch could view this potential exchange agreement as a DDE.

Reduced Liquidity: If the two capital structure transactions are completed, this would reduce the overall debt in Canopy’s capital structure by approximately 27% and reduce annualized interest expense by around USD26 million. However, Canopy’s cash position would be further reduced. Cash, cash equivalents and short-term investments total CAD1.2 billion at the end of fiscal 1Q23 (June). This compares with approximately CAD2.3 billion for fiscal 2021. Canopy used USD297.5 million in connection with the Wana transaction in late 2021.

Parent-Subsidiary Linkage: Fitch believes the strategic linkage between Constellation and Canopy has materially diminished. As such, Canopy’s ratings no longer benefit from a one-notch uplift from its standalone credit profile. In connection with the proposed transactions recently announced by Canopy, assuming approval and adoption of certain amendment proposals including the special resolution authorizing an amendment to create a new class of non-voting Canopy exchangeable shares, Constellation has expressed its current intention to convert all of its common Canopy shares into exchangeable shares.

As part of this conversion, all commercial agreements between Canopy and Constellation will be terminated, Constellation will no longer have board rights or approval rights over certain transactions, and any restrictive covenants previously agreed between the parties will terminate. Across Canopy’s corporate structure, Fitch’s equalizes the IDRs.

U.S. Transaction Subject to Risk: Canopy announced the creation of a new U.S.-domiciled holding company, Canopy USA, LLC, that is expected to hold the company’s U.S. cannabis investments. This could enable it to exercise rights to acquire Acreage Holdings, Inc., Mountain High Products, LLC, Wana Wellness, LLC and The Cima Group, LLC (Wana), and Lemurian, Inc. (Jetty). Fitch believes the transaction, as proposed, is subject to material execution risks including regulatory, shareholder and exchange approval. Canopy’s credit agreement contains affirmative covenants to comply with all policies and listing requirements of public securities exchanges. A failure to remain listed on at least one exchange would be a condition for an event of default. The Toronto Stock Exchange has made public comments supporting the new structure while the Nasdaq has proposed that such consolidation is impermissible under its general policies.

If Canopy receives approval from all parties, it expects to close all the transactions by the second half of fiscal 2024. As contemplated, Canopy would not directly own any of the U.S. assets and would hold the non-voting and non-participating shares in Canopy USA, which would consolidate Canopy USA’s financials under U.S. GAAP accounting. Canopy USA will also need to maintain funding separate from Canopy and will likely be reliant on other external avenues to fund strategic initiatives. Fitch will continue to review Canopy’s corporate structure and exposure to U.S. THC assets that are federally illegal and whether that increases rating concerns.

Execution Risk with Cultivation Strategy: Canopy has lost significant market share in the Canadian market due to its transition from low-margin value flower, execution missteps and challenges with pivoting its cultivation strategy. This has delayed production of a consistent, higher-quality supply at commercial scale and generated weak operating results with an uncertain path to profitability. Canopy hopes to counter these issues with a change in its genetics and cultivation strategy to higher quality cannabis with the right attributes (i.e. higher THC, single-strain, good terpenes) for the premium and mainstream flower, pre-rolls, edible and vape markets, while using the value segment as an outlet strategy.

Fitch views Canopy’s premiumization strategy and increased distribution plans for BioSteel as reasonable, but there are still significant execution risks. The company believes it made material progress with its strategy given growth and positive mix shift during 4Q22 and expects to have 100% of internally sourced cannabis available for 2H23, supplemented by partnerships with craft growers of selective strains. However, Canopy will also need to drive retail velocities focused on budtender education and point-of-sale merchandising. BioSteel plans to materially increase distribution to more than 50,000 points by FYE 2023 as the company invests in the brand.

DERIVATION SUMMARY

Canopy is rated lower than Legends Hospitality Holding Company, LLC (B-/Stable); Knowlton Development Corporation Inc. (KDC, B-/Stable); and WeWork Companies LLC (CCC+).

Legends’ rating reflects the ongoing recovery of the company’s financial metrics following pandemic-related disruptions to its business model, which drove Fitch-calculated EBITDA negative in 2020, with Fitch expecting leverage to return to the low-7x in 2022 and FCF approaching neutral in 2023.

WeWork’s ‘CCC+’ IDR reflects Fitch’s view that the business model appears viable exiting the coronavirus pandemic having right sized its footprint and cost structure. The company’s FCF outlook is subject to risks and uncertainties, particularly to the extent office demand is structurally weak over the medium term. WeWork’s financial policy while supportive of providing needed liquidity may not be sufficient in the medium term to protect creditors.

KDC’s ‘B-‘ IDR reflects KDC’s status as a global leader in custom formulation, packaging and manufacturing solutions for beauty, personal care and home care brands, supported by a diverse product portfolio and customer base, ranging from blue-chip names to “indie” brands, which the company typically maintains long-term relationships.

Fitch expects KDC’s broadening platform, including the recent Aerofil acquisition, and investment in R&D will enable the company to sustain modest organic revenue growth over the long term. While the recent strategic investment by KKR affords the company significant financial flexibility in the near term, the ratings are constrained by KDC’s highly acquisitive strategy, which Fitch expects could result in debt/EBITDA trending in the 7.0x range over time, up from around 6.0x today pro forma for the KKR investment.

KEY ASSUMPTIONS

Fitch’s Key Assumptions Within the Rating Case for the Issuer:

–Revenue increase of approximately 8% in fiscal 2023 to mid-CAD500 million range supported by successful execution on the genetics cultivation strategy reflecting increased premium and mainstream market shares, increased distribution of BioSteel and volume growth in Storz and Bickel products. Growth in fiscal 2024 to around CAD 700 million driven by similar factors;

–EBITDA deficit in the mid CAD200 million range versus negative CAD410 million in fiscal 2022, reflecting improved operating leverage supported by top-line growth, margin/mix benefits from premiumization strategy and efficiency cost savings initiatives. EBITDA deficit narrowing but remaining negative through fiscal 2025;

–Capital spending of around CAD 50 million;

–FCF deficit of close to CAD500 million in fiscal 2023, decreasing to around CAD250 million in fiscal 2024;

–Successful repayment/refinancing of convertible notes maturity;

–The forecast does not assume any changes contemplated resulting from Canopy’s recent announcement.

 

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

–Good execution with ongoing strategic initiatives that results in greater clarity around a pathway to profitability that generates positive EBITDA, significant reduction in operating deficits and improved liquidity to fund ongoing operations and necessary investments over the next 24 to 36 months;

–Positive changes in the regulatory environment.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

–Canopy enters into a debt restructuring that could be classified as a DDE per Fitch’s criteria including an equity-like exchange with convertible bondholders;

–If liquidity appears constrained such that a default appears probable;

–Lack of execution on premiumization strategy and profitability improvement that is materially lower than expectations of Canopy reaching EBITDA positive in fiscal 2024 that raises concerns about the sustainability of its capital structure.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

LIQUIDITY AND DEBT STRUCTURE

High Cash Burn, Weakening Liquidity: The ongoing cash burn and M&A strategy, combined with market conditions, have eroded Canopy’s liquidity position and could hamper its ability to access additional capital. Cash, cash equivalents and short-term investments totaled CAD1.2 billion at the end of fiscal 1Q23. This compares with approximately CAD1.4 billion and CAD2.3 billion for fiscal YE 2022 and 2021, respectively.

The USD750 million senior secured term loan facility due 2026 supplemented Canopy’s liquidity in March 2021. Canopy entered into agreements with certain lenders under its term loan credit agreement to tender for USD187.5 million of the principal amount outstanding at a discounted price of USD930 per USD1,000 or USD174.375 million.

This repayment, while reducing debt and annual interest payments, will further weaken Canopy’s liquidity position. Additionally, as part of the credit agreement amendment, the USD500 million accordion feature on the term loan facility was terminated and a new CAD100 million delayed draw term loan was added. The amended term loan facility amended certain terms including the minimum liquidity covenant reduced to USD100 million, a decrease from USD200 million.

The previous exchange of the senior convertible notes in July 2022 only partially addresses the 2023 maturity, with CAD337 million still outstanding, of which Constellation holds CAD100 million. Fitch anticipates Canopy will continue to assess options ahead of the maturity for repayment of the remaining outstanding notes and could pursue further repayment options that Fitch views as a DDE.

Recovery Considerations

For issuers with IDRs at ‘B+’ and below, Fitch performs a recovery analysis for each class of obligations. Issue ratings are derived from the IDR and the relevant Recovery Rating (RR) and notching based on expected recoveries in a distressed scenario. Fitch takes the higher of liquidation value or enterprise value (EV, based multiple applied to the stressed EBITDA) to determine the waterfall recoveries.

The 5.5x for Canopy considers historical bankruptcy exit multiples for CPG companies ranging from 4.0x to 10.0x, with a median reorganization multiple of 6.3x. The multiple for Canopy also considers Canopy’s brands. Fitch considers the value accorded to the agreements to purchase interests for Wana, Jetty Extracts, Acreage Holdings and TerrAscend Corporation which has been stressed from current levels.

For Canopy, the recovery of the USD750 million term loan is based on liquidation value of the assets rather than a going concern enterprise value. To derive the going concern enterprise value of roughly CAD1 billion, Fitch assumes a going concern EBITDA of around CAD100 million. This assumes (i) an estimated normalized post-restructuring revenue of around CAD775 million, which currently aligns with the midpoint of Fitch’s fiscal 2024 and 2025 forecasts with more than half of revenue projected to come from global cannabis revenues, and the remaining portion from U.S. CPG brands (including BioSteel, Storz & Bickel), (ii) EBITDA margins of 12% and (iii) additional value from affiliates, minority interests that considers the delayed acquisition agreements.

In deriving a liquidation value of the assets for around CAD1.2 billion, Fitch considered the liquidation value of inventory, receivables, and net property, plant and equipment assumed at the end of fiscal 2022, and applied various advance rates. Fitch also considered liquidation values for Storz & Bickel, BioSteel, Thisworks and the delayed acquisition agreements for Wana Brands, Jetty Extracts, Acreage and TerrAscend.

Following a 10% reduction for administrative claims, the recovery analysis for the term loan results in a recovery corresponding to ‘B-‘/’RR1’.

ISSUER PROFILE

Canopy is a leading global diversified cannabis and hemp company based in Canada that primarily produces, distributes and sells recreational and medical cannabis and hemp-based products. Canopy offers a large portfolio of branded cannabis and CBD product offerings, cannabis vaporizers and non-cannabis consumer packaged goods.

 

SUMMARY OF FINANCIAL ADJUSTMENTS

Fitch adjusted the fair value of debt to reflect debt amount payable on maturity, stock-based compensation, transactions expenses, impairments and restructuring costs.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG CONSIDERATIONS

Canopy Growth Corporation has an ESG Relevance Score of ‘4’ [+] for Exposure to Social Impacts. This is due to Canopy’s core business focusing on a portfolio of cannabis product offerings benefits from shifting consumer preferences toward recreational, medicinal and health/wellness usage, and ongoing legalization that is in various stages in Canada, the U.S. and other international markets, which has a positive impact on the credit profile, and is relevant to the ratings in conjunction with other factors.

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of ‘3’. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch’s ESG Relevance Scores, visit www.fitchratings.com/esg.

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