Fitch Ratings has downgraded the ratings for Canopy Growth Corporation and 11065220 Canada, Inc., including the Long-Term Issuer Default Rating (IDR) to 'CCC' from 'B-'.

The ratings downgrade reflects Canopy's significant market share losses in the Canadian market, given execution missteps and operating challenges with pivoting its cultivation strategy, which has resulted in weak operating results with an uncertain path to profitability and reduced liquidity. As a result, it is highly doubtful that Canopy can improve EBITDA trends to reach operating cash flow breakeven in fiscal 2025(March 31) as Fitch previously expected, and creates greater uncertainty around capital structure sustainability.

Fitch could take further negative rating actions if Canopy pursues a repayment/refinancing of the CAD600 million notes that Fitch considers a distress debt exchange per criteria, a lack of execution on the premiumization cultivation strategy, or Fitch's view that the strategic incentive for Constellation to support Canopy has lessened, as the current rating incorporates a one notch uplift from the stand-alone credit profile (SCP) at 'CCC-'.

Key Rating Drivers

Canadian Market Share Losses: 2021 Canadian cannabis retail sales grew by around 50% to CAD4 billion according to Statistics Canada. However, Canopy materially underperformed Fitch's and the company's own expectations of growth in line with or better than the market, with revenues in the Canadian cannabis channel decreasing by 10% in fiscal 2022 to CAD258 million. Canopy lost share in part due to its pivot away from the value segment.

Marketplace dynamics are challenging, including evolving consumer preferences and the competitive environment with significant pricing compression, particularly in the value segment that has caused material profitability pressures within the sector. Consequently, Canopy has recognized significant asset impairments. The industry has already experienced one cycle of production overexpansion and consolidation, as the sector matured following legalization in 2018.

In response to the operating challenges, Canopy announced restructuring actions that it expects to generate CAD100 million to CAD150 million in savings during the next 12 to 18 months, focusing on right-sizing cost structure, reducing cultivation costs and increasing efficiencies across the supply chain.

Consistent Cultivation Strategy Key: A key strategy to improve profitability, is a change in Canopy's 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. Canopy has several brands to leverage this strategy including DOJA, 7ACRES, Tweed and Deep Space. However, the transition in the genetics/cultivation strategy has been challenging, and has taken longer than expected to produce a consistent, higher-quality supply at commercial scale.

Fitch views Canopy's premiumization strategy and increased distribution for BioSteel as coherent. Nevertheless, there are still significant execution risks. The company believes it has 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 to service the marketplace. However, to increase market share and sustain top-line gains, Canopy will also need to drive retail velocities focused on budtender education and point-of-sale merchandising. BioSteel is also expected to materially increase distribution to more than 50,000 points by end of fiscal 2023 as the company invests in the brand.

Assessing Repayment Options: Canopy is assessing various options for the repayment of the upcoming July 2023 CAD600 million notes. Fitch believes Canopy's financing options have become more limited given the broad downturn in market conditions, with its own market cap declining to CAD1.8 billion from a peak of around CAD19 billion in early 2021 following US elections. Canopy's cash and short-term investments stands close to CAD1.4 billion at March 31, 2022. This compares to around CAD2.3 billion a year ago.

Fitch expects the company could seek options to preserve liquidity given ongoing high cash burn. As such, the company could pursue a notes repayment option that Fitch views as a distressed debt exchange.

Parent-Subsidiary Linkage: Canopy's ratings receive a one-notch uplift from its SCP due to the stake Constellation Brands, Inc. holds in the company. Constellation's investment totals CAD5.8 billion to date in the form of equity and convertible debentures. Constellation holds a 35.3% stake at May 26, 2022 with additional warrants to increase its stake.

Fitch believes a medium strategic linkage exists between the two companies given Canopy's portfolio adjacencies that could support moderate growth potential and reasonable financial value to Constellation's future group profile following U.S. federal legalization of THC. Canopy has leveraged some of Constellation's capabilities in support of its strategic initiatives with market research, product development, manufacturing, government relations and distribution capabilities including BioSteel.

Constellation holds four of seven board seats at Canopy, and several past senior Constellation executives hold key positions at Canopy. Fitch could revisit our views with the strategic linkage based on lack of execution with its premiumization strategy and/or lack of material US cannabis reform.

U.S. THC Optionality: Canopy has taken steps to bolster its competitive position with good optionality in the U.S. upon federal permissibility of THC, due to several delayed acquisition agreements. However, U.S. federal legalization timing is highly uncertain, with significant hurdles given Congressional inaction due to political uncertainties around differing party views on cannabis reforms.

In addition, it is uncertain whether Canopy could exercise rights to full control prior to U.S. federal legalization of THC in the event Congress passes a bill around potential federal banking reforms. Thus, while these entities generate around USD500 million in revenue and more than USD100 million in EBITDA, Canopy's financial profile does not currently benefit from these investments.

Derivation Summary

Canopy's 'CCC' rating reflects the significant market share losses in the Canadian market given execution missteps and challenges with pivoting its cultivation strategy, which has resulted in weak operating results with an uncertain path to profitability and reduced liquidity. As a result, Canopy has pursued actions to right-size cost structure, improve efficiencies, and is in the midst of pivoting its genetics and cultivation strategy away from value to the premium and mainstream segments that has been slower than expected.

The rating also considers Canopy's position as a scaled Canadian licensed producer with an extensive cannabis portfolio in the medical and recreational market with leading premium market shares, significant licensed cultivation and production operations, portfolio of related CPG brands, and a pathway to a potentially much larger U.S. THC market upon federal permissibility of THC or at Canopy's discretion due to several delayed acquisition agreements.

The company has approximately CAD1.4 billion in cash, cash equivalents and short-term investments. Constellation's equity stake and strategic partnership meaningfully expands Canopy's capabilities while also presenting another potential source of capital. Canopy's ratings receive a one-notch uplift from its 'CCC-' SCP due to Constellation's minority interest in the company.

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 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. FCF has remained consistently negative but has improved over the past year. However, 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-' Issuer Default Rating (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, with whom 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 proforma 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;

Bolt-on M/A transaction structured similar to Jetty Extracts targeting the U.S. THC market utilizing structured investments prior to federal permissibility;

Successful repayment/refinancing of convertible notes maturity;

Forecast does not assume any changes in US Cannabis laws regarding federal THC permissibility or federal banking reforms.

RATING SENSITIVITIES

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

Good execution with on-going 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 an agreement with convertible bondholders that could be classified as a Distress Debt Exchange Rating per Fitch's Criteria;

Lack of execution on premiumization strategy and profitability improvement that is materially lower than expectations of Canopy reaching EBITDA positive in fiscal 2024 excluding investments in BioSteel and U.S. THC that raises concerns about the sustainability of its capital structure;

A material adverse change in the strategic relationship with Constellation or Fitch's assessment that the moderate strategic linkage between Constellation and Canopy has weakened.

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 current market conditions have eroded Canopy's liquidity position and could hamper its ability to access additional capital. Cash, cash equivalents and short-term investments totalled CAD1.4 billion at the end of fiscal 2022. This compares to around CAD2.3 billion for fiscal 2021.

Canopy's liquidity was supplemented in March 2021 with a USD750 million senior secured term loan facility due 2026. The company also has a USD500 million accordion feature on the term loan facility. Fitch does not assume Canopy will draw on the accordion as the company reviews alternatives to repay/refinance the CAD600 million convertible notes. The term loan facility has a minimum liquidity covenant of USD200 million.

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 on 6.0x multiple applied to the stressed EBITDA) to determine the waterfall recoveries.

The 6.0x 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 6.0x for Canopy considers Canopy's brands and Constellation's current operational and financial support. Fitch also 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 $1.1 billion, Fitch assumes a going concern EBITDA of around CAD100 million valued at a 6x multiple. 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 and other of roughly CAD500 million that considers the delayed acquisition agreements.

In deriving a liquidation value of the assets for around CAD1.4 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 value of around CAD800 million for Storz & Bickel, BioSteel, Thisworks and the delayed acquisition agreements for Wana Brands, Jetty Extracts, Acreage and TerrAscend.

Fitch assumes borrowings under the USD750 million Term Loan and no borrowings on the USD500 million accordion. Given the roughly CAD1.4 billion in EV and 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

Fair value of debt adjusted 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 and CBD 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 Germany, 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

RATING ACTIONS

Entity / Debt

Rating

Recovery

Prior

11065220 Canada, Inc.

LT IDR

CCC

Downgrade

B-

senior secured

LT

B

Downgrade

RR1

BB-

Canopy Growth Corporation

LT IDR

CCC

Downgrade

B-

senior secured

LT

B

Downgrade

RR1

BB-

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VIEW ADDITIONAL RATING DETAILS

Additional information is available on www.fitchratings.com

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