Fitch Ratings has downgraded the Long-Term Issuer Default Ratings (IDR) for Canopy Growth Corporation (Canopy) and 11065220 Canada Inc. to 'RD' from 'CCC-' reflecting the agreements with certain convertible noteholders that exchanged debt for common shares.

Subsequently, Fitch has reassessed and upgraded the IDRs to 'CCC-' post completion of the exchange. Fitch has also downgraded the ratings for the senior secured term loan facility at Canopy and the co-issuer, 11065220 Canada, Inc. to 'CCC+'/'RR2' from 'B-'/'RR1'.

The post-exchange IDR of 'CCC-' reflects Canopy's current liquidity position including actions taken to reduce the high cash burn rates and recent asset sales and the uncertain path to profitability due to executional risks around its operating strategies. Fitch could take further negative rating actions if Canopy pursues actions that Fitch considers a distressed debt exchange per its criteria or the liquidity headroom becomes further diminished.

Key Rating Drivers

Agreement Constitutes a DDE: Canopy entered into privately negotiated exchange agreements with certain noteholders that cancels CAD12.5 million of the convertible notes due July 15, 2023 for a cash payment of the unpaid and accrued interest and the issuance of approximately 24.3 million Canopy common shares. Fitch views the execution of this transaction as a DDE under its criteria.

When considering whether the transaction should be classified as a DDE, Fitch expects both of the following to apply: the transaction imposes a material reduction in terms compared with the original contractual terms; and it is conducted to avoid bankruptcy, similar insolvency or intervention proceedings, or a traditional payment default. Fitch believes this satisfies both prongs of its test including a material reduction in terms due to the equitization of the notes held by the holders.

Constrained Liquidity: Canopy's cash and short-term investments were CAD783 million at March 31, 2023. Adjusting for payments made following year-end close, including the repayment USD93.75 million of Canopy's term loan at a 7% discount, cash and short-term investments were around CAD666 million per management's earnings call. Absent any further agreements with remaining 2023 noteholders, Fitch anticipates Canopy would repay the remaining notes outstanding of approximately CAD225 million.

While Canopy is expected to reduce operating FCF deficits given announced cost reduction initiatives, including several measures to reduce the cash burn related to brand building and operational plans around BioSteel, operating deficits could remain material in FY2024 at around CAD300 million. This compares with around CAD600 million annually the past three years.

Since April 1, 2023, Canopy has sold five facilities for proceeds of CAD81 million and expects to realize up to CAD150 million in total proceeds from facility divestitures by Sept. 30, 2023. Under provisions of the term loan agreement, 50% of proceeds will be used to paydown outstanding amounts of the term loan. Canopy continues to assess additional strategic options to supplement liquidity and reduce cash operating deficits. Canopy's financial statements for year-end FY2023 contain a statement by its auditors expressing uncertainty regarding the ability to continue as a going concern.

Canadian Operations Challenged: Given the ongoing structural issues within the Canadian cannabis marketplace, challenges with operating strategies and uncertain path to profitability, Canopy announced further restructurings in February 2023 to move to an asset-light, third-party sourcing model that includes the closure of the Smiths Falls cultivation facility and significant headcount reductions across the business.

Cost initiatives. including actions announced in April 2022 have reduced expenses by a combined CAD125 million through the end of FY2023. Canopy expects remaining initiatives could reduce annual expenses between CAD240 to CAD310 million in total. Canopy anticipates these actions will result in breakeven to positive EBITDA in all businesses, with the exception of BioSteel by the end of FY2024.

U.S. Transaction Subject to Risk: In October 2022, Canopy announced the creation of a new U.S.-domiciled holding company, Canopy USA, LLC (CUSA), that holds the company's conditional 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 has filed a revised proxy statement as the previous CUSA structure was not in compliance with NASDAQ's listing rules. Presently, little clarity exists around Canopy's timeline to move forward with this organizational structure, including the successful completion of the proxy review and timing for the shareholder vote.

As contemplated, Canopy would not directly own any of the U.S. cannabis assets and would hold the non-voting and non-participating shares in CUSA. CUSA 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. assets including THC that are federally illegal and whether that increases rating concerns.

Parent-Subsidiary Linkage: Fitch's ratings for Canopy do not assume any ratings support from the strategic linkage between Constellation and the company. In connection with the proposed transactions announced by Canopy in October 2022, 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 would be terminated, Constellation will no longer have board rights or approval rights over certain transactions, and any restrictive covenants previously agreed upon between the parties will terminate. Across Canopy's corporate structure, Fitch equalizes the IDRs.

Derivation Summary

Canopy is rated lower than Legends Hospitality Holding Company, LLC (B-/Stable) and GPS Hospitality Holding Company LLC. (CCC+).

Legends' B-/Stable rating reflects its modest scale, high adjusted leverage in the 7x area and minimal FCF. The rating is supported by the company's strong liquidity and its unique position as a fully integrated provider of hospitality services for professional and college sports teams, live entertainment venues, and attractions. While the pandemic substantially disrupted the company's operations, new business has driven strong growth in revenues, which significantly exceed pre-pandemic levels. EBITDA margins remain depressed due to high inflation and the lower-margin nature of contracts Legends has recently entered into, but Fitch expects continued margin recovery and new contract wins will support EBITDA growth over the longer term.

GPS Hospitality's 'CCC+' rating reflects Fitch's view of a stabilization in sales and improved operating performance following an extended period of sales decline and margin contraction, driven by wage and commodity inflation, notably at the primary brand Burger King. The improvement in earnings is supported by increased core capabilities through new kitchen equipment, outdoor digital menus, new menu offerings, as well as enhanced recruiting platforms that have helped alleviate staffing challenges. The rating is constrained by the company's small scale with expected revenues and EBITDA of $690 million and $35 million in 2023, respectively, resulting in high leverage of around 9x.

Key Assumptions

Revenue declining in the low single digits in FY2024, assuming Canadian cannabis quarterly run rate of around CAD40 million and mid-single digit decline in consumer products revenues with declines in BioSteel reflecting recent actions to reposition the brand in North America offset partially by growth in Storz and Bickel. Revenue growth in low double digits in FY2025, reflecting Canadian cannabis quarterly run rate of around CAD50 million;

EBITDA deficit in the mid-to-upper CAD100 million range in FY2024 versus negative CAD353 million in FY2023, reflecting cost take-out initiatives. In FY2025, EBITDA deficit decreasing to around breakeven driven by cost savings and strategic operating initiatives;

Cash interest costs in the CAD120 million range in FY2024, decreasing to the low CAD100 million range in FY2025. Interest rate assumption based on SFOR forward curve;

Capital spending of about 12 million in FY2024 and FY2025;

FCF deficit around CAD300 million in FY2024, decreasing to the CAD100 million range in FY2025.

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.

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;

Further reduction in liquidity headroom such that a default appears probable;

Lack of profitability improvement that increases concerns around 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

Ongoing Cash Burn, Weakening Liquidity: The ongoing cash burn combined with market conditions have eroded Canopy's liquidity position and hamper its ability to access additional capital. Cash, cash equivalents and unrestricted short-term investments totaled CAD783 million at year-end 2023. This compares with approximately CAD1.4 billion and CAD2.3 billion for FY2022 and FY2021, respectively. In October 2021, Canopy agreed to acquire Wana for a cash payment of USD297.5 million.

To supplement liquidity during 2023, Canopy entered into an agreement during February 2023 with an institutional investor to purchase up to USD150 million aggregate principal amount of senior unsecured convertible debentures with USD100 million sold on Feb. 21, 2023.

In April 2023, Canopy refinanced CAD100 million of the 4.25% unsecured notes due in July 2023 held by Greenstar Canada Investment Limited Partnership, a wholly-owned subsidiary of Constellation Brands, Inc. that extended the maturity date to Dec. 31, 2024. Absent any further agreements with remaining 2023 noteholders, Fitch anticipates Canopy would repay the remaining notes outstanding of approximate CAD225 million in cash.

Capital Structure: Canopy's USD750 million senior secured term loan facility matures in 2026. Canopy announced an agreement with certain lenders under its term loan credit agreement in October 2022 to tender for USD187.5 million of the principal amount outstanding at a discounted price of USD930 per USD1,000 or USD174.375 million. Canopy completed the second repayment in April 2023. The term loan contains a minimum liquidity covenant of USD100 million.

Recovery Considerations

For issuers with IDRs of '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 5.0x 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 multiple for Canopy also considers Canopy's brands. Fitch considers the value accorded to the agreements to purchase interests for Wana, Jetty Extracts, and Acreage Holdings which has been stressed from current levels.

In deriving a liquidation value of the assets, Fitch considered the liquidation value of inventory, receivables, and net property, plant and equipment and applied various advance rates. Fitch also considered liquidation values for Storz & Bickel, BioSteel, and thisworks, and valuations for Wana Brands, Jetty Extracts, Acreage, TerrAscend, and other assets. Fitch determined the liquidation value to be roughly CAD700 million. Thus, the recovery for Canopy is based on liquidation value of the assets rather than a going concern enterprise value.

The initial USD750 million term loan has been reduced by USD187.5 million pursuant to the October 24, 2022 agreement with lenders. Following a 10% reduction for administrative claims, the recovery analysis for the term loan results in a recovery corresponding to 'CCC+'/'RR2'.

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 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

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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