The Ripple Effect of Canopy Growth's Move From Indoor Growing

This week Canopy Growth (CGC) stunned the market when the company announced it was closing two indoor grow facilities. At the beginning of legalization, the industry was in a race to build as much indoor grow acreage as possible. Companies touted potential grow square footage as a reason for investors to buy into their story. That key selling point has been tossed away and could have a ripple effect over the ancillary indoor grow sector.

It wasn't a complete surprise. As these companies were trying to one up each other with square footage boasts, there were plenty of market watchers who pointed out that the demand could never meet that supply. Canada only has so many residents and according to Statista total market sales for Canadian cannabis are less than the state of California. Cowen & Co. analyst Vivien Azer reduced her estimates by 32% to C$3.5 billion for 2020 for expected adult-use cannabis sales.

The response from Canopy and others was that they would be able to sell into international markets in addition to its domestic market. This has required significant investment with little to show in revenue. Azer noted in a September report that Canadian companies that have had an international focus have had worse EBITDA losses than Canadian companies focused only on a domestic market.

The problem with that plan is that international cannabis consumption is nowhere near the levels of North America. Europe continues to have stigma issues and there are as many if not more restrictions where legalized cannabis is available. There is product being exported, but it isn't at an amount that can make a significant differences or requires acres of plants.

Beyond this sales argument, it's just plain cheaper to grow outside. It costs roughly between three cents to 20 cents per gram of cannabis for an outdoor grow. An indoor grow costs between 90 cents and $2.00. Canopy may have been the first to admit such a massive mistake, but it may not be the last. This could have a long lasting effect on the ancillary sector for indoor growing.

Turning Off The Lights

Health Canada released statistics in January stating that it has licensed roughly 13 million square feet of indoor cannabis cultivation (including greenhouse), versus 19.9 million square feet approved for outdoor growing. This is a huge shift in a country that doesn't have a large growing season.

As the cannabis companies went on a building binge, the indoor growing sector blossomed along with it. Software was developed in order to get the most yields from plants by controlling lights and watering. Lights were created to use the least amount of energy possible and also to increase yields. Modular building units, movable tables and more were fueling the growth of this sector. While much of this technology can be used to grow products other than cannabis, the main focus has been on cannabis.

The recent MJ Biz conference held in December in Las Vegas has one of its biggest trade show floor yet, and with 1,300 exhibitors. These weren't just indoor growing companies, but they were heavily represented. Brandy Keen, co-founder and senior technical advisor for Surna, a manufacturer of lighting and environmental control systems in Boulder, Colorado said during an MJ Biz con session, "Anyone who has built a cultivation facility knows that the building is the cheap part. The infrastructure is more expensive."

Indoor Grow Companies

Of course it's too soon to call for a slowdown in indoor growing. Regulations and requirements for medical marijuana can be much stricter than recreational marijuana. Also, many municipalities don't want acres of cannabis growing nearby and outdoor grows are hard to police. Just look at California's illicit market problem and the abundance of illegal outdoor grows. So, there is an argument to be made for indoor grow facilities. However, companies can't exist without profits and if outdoor growing is the difference between operating and bankruptcy, then outdoor growing will begin to thrive.

Here are just a few of the companies that could ultimately be hurt by this trend.

• The currently solid GrowGeneration (GRWG) is solely focused on selling hydroponic equipment. This company has been one of the few in the industry to consistently deliver solid quarterly results. It not only sells to small growers, but industrial size companies as well. GrowGeneration has been growing itself by acquiring smaller local businesses. The company will certainly lobby against outdoor growing of cannabis.
• Scotts Miracle-Gro (SMG) has also placed a big bet on hydroponics with its Hawthorne division. Hawthorne is all in for indoor farming with lighting solutions, nutrients and soil options. The stock is trading at $115 not too far from its 52-week of $125. Like GrowGen, this is a strong indoor grow company at this time. Scotts has predicted that it could deliver annual sales of $600 million from more than 1,800 hydroponic retail stores in North America. In fact in 2019, Hawthorne's sales rose by 95%, to $671 million. This is only a portion of the company's overall $3.2 billion in sales, but it's worth keeping an eye on if indoor grows begin to lose favor.
• Innovative Industrial Properties (IIPR) is also flying high for now. The cannabis industry REIT has been reaping the rewards of cannabis companies strapped for cash and selling off their real estate assets. The cannabis producers saw this as a win win. Sell the building, get cash in the bank and then just pay rent for the indoor grow facility. What happens though if Canopy's decision starts to spread throughout the industry? Will companies decide that the rent is too high and leave? Further down the road this could leave IIPR with loads of indoor grow facilities that become abandoned.

It could be too soon to call for the scaling back of indoor grows, but if it does happen investors should be aware of the companies that could be directly impacted. These are just a few names and doesn't even take into account the millions invested in smaller private companies that make lighting systems, software for indoor growing facilities, movable tables, modular indoor growing units, and so on. These smaller companies would probably be hurt the most. No doubt the debate between indoor and outdoor will continue, but there is no argument over which is cheaper.

At the time of publication, Debra Borchardt had no position in the securities mentioned.