• Ted Ohashi

Why Constellation's investment in Canopy Growth is important

Canopy Growth (#TSX: $WEED #NYSE: $CGC) with the support of Constellation Brands (#NYSE: $STZ and $STZ.B) are once again leading the Canadian cannabis parade. Recall the blockbuster announcement on October 30, 2017 in which STZ took a 9.9% position in WEED with an ability to increase that holding to 20%. We believe this triggered the massive rally that carried cannabis stocks to new highs in a 55.9% rally as measured by the Let’s Toke Business Marijuana Composite Index. This was particularly important because it was the first significant cross-industry investment into the Canadian cannabis sector.

This most recent transaction could trigger a 2018 rally in the cannabis stock sector.

In actual fact, however, the first transaction was more like an engagement and everyone knows not all engagements end in marriage. It wouldn’t be the first time someone said I do then didn’t. That transaction did, however, discourage other prospective suitors for Canopy’s hand without preventing an aggressive paramour from making a last ditch effort. To the extent there was a lack of total commitment, it probably existed on both sides. Constellation had made the decision it wanted to enter the cannabis industry and saw Canopy as a potentially great partner. Canopy probably wanted an association with a major but couldn’t be absolutely sure Constellation was the one.

The nature of the latest transaction, however, suggests both sides are now fully committed. Constellation will acquire 104.5 million additional shares directly from Canopy at C$48.60 per share and will then have 38% ownership after exercise of existing warrants. The price being paid is a 37.9% premium to WEED’s 5-day volume weighted average price (VWAP) of the common shares on the Toronto Stock Exchange and a 51.2% premium to the closing price on August 14, 2018. STZ will also receive 139.7 million three-year warrants to buy additional Canopy shares: 88.5 million exercisable at a price of C$50.40 per share, a 43.0% premium to VWAP and 51.3 million exercisable at the VWAP at the time of exercise. Canopy will receive approximately C$5 billion cash immediately and the exercise of all new and existing warrants would give STZ over 50% ownership of WEED and provide WEED with at least an additional C$4.5 billion cash. (read full press release here)

We think this is an important transaction for investors because:

(a) The Chief Executive Officer of Constellation Brands Rob Sands said, “Through this investment, we are selecting Canopy Growth as our exclusive global cannabis partner.” Constellation Brands is a credible, Fortune 500 company so this commitment is meaningful.

(a) The initial cash infusion from this transaction should cover Canopy’s needs for the foreseeable future. Unlike other major financings, this has the advantage not sucking $5 billion of cannabis stock buying power out of the market.

(b) It is not lost on us that Bruce Linton, CEO of Canopy, referred to the cash injection as “rocket fuel” to “expand internationally.” Linton also said international meant the United States, Europe and Latin America. But Constellation and Canopy both stressed they would not go into a market unless cannabis was legal at all levels. This excludes American growers at this time although it leaves them open to nibble around the edges.

(c) A quick calculation indicates that if Constellation follows through to a 50%+ ownership of Canopy, they will have paid C$10 to C$12 billion for their 50% interest. Given there is a premium paid for a controlling interest, this still suggests Constellation views Canopy’s value to be in the C$20 billion plus range.

(d) In making the investment, Constellation expressed the view that Canopy would be accretive to earnings in 2021. It is reasonable to assume that Fortune 500 companies do not spend C$5 to C$10 billion without having thought about it carefully. For example, Constellation was advised by Goldman Sachs and financing was provided by Bank of American Merrill Lynch.

(e) As happened after the initial investment around 10 months ago, the latest Constellation/Canopy transaction could result in another broad reassessment of stock market valuations. It seems Constellation believes Canopy is worth around triple the market cap it was trading for on the financial markets. Above average investment returns may not be over for Canopy shareholders by a long shot.

(f) Accepting that Constellation is an aggressive, early adopter, we think this move indicates it will not be that long before other majors in the alcoholic beverage, pharmaceutical and tobacco industries make their move into cannabis. Although their focus will be on larger cannabis companies, we think there will be some appetite for larger potential growth as well.

(g) Linton also said and not for the first time that price weakness in the cannabis plant is only a problem if you are dealing with a commodity. This implies Canopy will stress cannabis based products that offer higher profit margins and marketing capabilities which is where Constellation’s expertise comes in.

(h) Wednesday’s events once again demonstrate the value of diversification into the cannabis stocks. On a day when the Canadian Cannabis Composite Index was up 287.86 points or 12.7%, the Dow Jones Industrials fell 137.51 points or 0.5% and the S&P/TSX Composite declined 182.2 points or 1.1%.

Here is a summary from Canopy Growth Chief Executive Officer Bruce Linton’s BNN Bloomberg interview shortly after the news broke on Constellation. We have selected seven Bruce Linton sound bites that tell you all you need to know to invest in cannabis.

Why Constellation? “We know these guys well….They get that this is a medical business and a consumer packaged goods business and that you have to do both or else you lose.”

What’s Next for Canopy/Constellation? “…if you’re saying 'Well I think I should sell Canopy stock and buy a few of these other companies because they’re going to buy them,' that might not work out. But if there are global business opportunities, that’s where we’re going.”

Why Global? "We’re in 11 countries on five continents….my target addressable market is probably somewhere north of 20 times the number of people who are in Canada. We want to be at the front of all that."

Why Hurry?The reason we wanted the cash now is because…Canada is being copied but it’s not…one country after another….about 29 countries are saying, 'We should do the same thing.'”

Who Will Be Your Competition? "The competition…are going to be big, big alcohol and big, big pharma….what I want to make sure is that we are partnered up and going fast early…..”

Canada’s Investment Outlook? "The problem…is that there’s far more companies then there are businesses….There’s going to be two or three companies that are decent….The rest, there won’t be consolidation, there’s going to be disintegration.”

And Canopy? "…the company that people look at and say, 'Okay, I might own four cannabis stocks…half my money’s going to Canopy and the other ones are going to funny little side bets, and hope they work out.'"

(see full interview here)

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