How do you justify the renewed interest in cannabis stocks?
The announcement that Constellation Brands (NYSE: STZ) plans to invest an additional CAN $5 billion into Canopy Growth (NYSE: CGC) was one of those headline dominating events. In a way that’s a good thing because Canopy also reported its first quarter results a few trading hours earlier. Revenues were $25.9 million and the adjusted net loss after taxes was $90.8 million. As the cannabis stocks had been in a relatively prolonged downtrend immediately prior, we believe without the STZ news, we’d be talking about how low CGC and the other cannabis stocks could to.
For the past few months, cannabis investors had been focussing more and more on how revenues and income were going to justify the lofty valuations in the cannabis group. And they didn’t like the answers they were coming up with. If can edit Canopy CEO Bruce Linton’s comment, “There are more companies than businesses.” In other words, under the most optimistic assessments for the cannabis industry in Canada, there isn’t enough room at the trough to feed all the little piggies.
Today, of course, the investor agenda has changed. Now we’re thinking instead about a revitalized cannabis sector and how high stock prices might go. It was a public relations coupe that even President Trump would have admired. But unlike politicians who take your mind off a troubling matter by giving you something even more bothersome to worry about, the critical question is “What’s changed to justify the renewed interest in cannabis stocks?” There has to be a satisfactory answer to this question or else all the unbridled optimism of the past week and a half is not justified. We think there is and here’s why.
$5 billion is a lot of money: the Canadian cannabis industry has been in a fund raising “arms race” for the past year or so. Companies have sought to “out-raise” competitors by announcing the largest financing, biggest bought deal, largest Initial Public Offering, and so on. For the time being, the arms race is over. It will be some time before anyone steps forward with a financing that tops Canopy.
The $5 billion raised didn’t come out of the “market”: as this arms race evolved, we have commented regularly that it is one explanation for the lackluster performance in the cannabis stocks. Each financing extracted funds that would have otherwise gone into buying cannabis stocks on the market. In this case, however, these are not dollars that were earmarked for investment in a variety of cannabis stocks.
The $5 billion raised the market cap bar for the industry: cannabis analysts and investors had been actively debating whether Canopy or Aurora or Aphria were really worth the valuations given them by the investment community. Based on the stock performance of the “big three” over the previous few months, investors were concluding more to the negative. Then along comes STZ that pays $5 billion in addition to the $.5 billion they paid last Halloween to increase their holding in Canopy from around 10% to around 38%. That kitchen arithmetic says STZ figured CGC overall is worth over $15 billion and to take control would imply a valuation of over $20 billion. On the back of my napkin, that means the big three were potentially undervalued by a factor of two to four times.
The Constellation valuation carries some weight: STZ is a Fortune 500 company and as a group, these companies throw nickels around manhole covers. And even when they have decided to spend some capital, they carefully cover their backsides. For example, Constellation was advised by Goldman Sachs which means in the file at head office there is a letter from an expert at Goldman that says the price being paid is fair and reasonable. Finally, Bank of America Merrill Lynch is lending STZ the money to pay Canopy. So the deal has credibility.
It shortens the time line: just prior to the Constellation announcement, the consensus among the investment community was that a move by big pharma, big beverage or big tobacco was at least a year away. These are typically slow moving behemoths that believe although the early bird gets the worm, the second mouse gets the cheese. But as they look at the world cannabis landscape today, the leader is taken. There is increased pressure to move. It may not be a year before we hear of the next blockbuster agreement.
What will Canopy NOT do with $5 billion? We think that is reasonably clear. They will not be acquiring grow facilities in Canada and perhaps not even cannabis related businesses in Canada. Canopy has said for some time that regarding “build or buy,” they have concluded buying grow facilities in Canada is too costly so they prefer to build.
What will Canopy do with $5 billion? Again the answer is fairly clear and totally consistent with what Canopy has been saying for around a year. To paraphrase what Linton said in a BNN interview there are 29 countries using the Canadian model for cannabis and they are looking at it all at the same time. Canopy wants to be on the leading edge of that international opportunity and the money will allow them to do it.
What does international mean? Generally speaking for Canopy it means the United States, Europe and Latin America. Canopy has said all along they won’t be in the U.S. cannabis industry until it is legal at all levels and they see signs that the timeline is shrinking. In the meantime, Linton did say that didn’t mean they would be sitting still saying the acquisition of a greenhouse that is growing tomatoes would be fine and down the road it could be converted to growing cannabis.
What will investors focus on now if not sales and income? We think the focus will shift to Canopy Growth and their move into international markets.
Think of the 5 W’s: why, where, what, who and when:
Why? Linton sees twenty times the growth potential internationally compared to Canada.
Where? has been narrowed down to the U.S., Europe and Latin America and, until cannabis scheduling changes, U.S. involvement will come slower but if regulations change, the action will be explosive.
What? is a little open ended. We think Linton has dropped enough clues along the way to conclude they will emphasize medical cannabis. But beyond that we will simply have to pay attention.
Who? is hard to pin down, however, based on what they have done in Canada, we think Canopy will tend to stick to quality and value. They will not buy their way into markets for the sake of being there.
When? we think starting immediately.
Conclusion: we believe investor attention will shift away from sales and earnings to event driven markets again. However, what we know for sure is the stock prices can outrace corporate development and investor expectations can outdo either of them. Right now and for the time being, investors appear to be taking Linton’s comment about “rocket fuel” literally. We mustn’t ever forget, this is the stock market and as Henry Poor (of Standard & Poors) and/or John D. Rockefeller (Standard Oil) was to have said well over a century ago, “stock prices will fluctuate.”
We are in the trading phase of the bull market so the appropriate strategy is buy on weakness and sell more on strength raising cash as we go. This is what we believe is appropriate for portfolios now and what Ted Ohashi will strive to do in The Cannabis Report Model Portfolio.