A big knock against investing in marijuana stocks has been valuation. However, the decision by Constellation Brands (NYSE:STZ) to pay up for a 10% stake in Canopy Growth (NYSE:CGC) suggests share prices for marijuana stocks may not be as crazy as they seem. Is it too late to buy these stocks, or is it just getting interesting?
What's going on
Canopy Growth is Canada's largest marijuana stock by market cap and trades for more than 20 times its sales over the past 12 months. Even so, the wine, beer, and spirits Goliath, Constellation Brands, forked out $245 million Canadian to get its hands on nearly a 10% equity ownership stake. It also acquired warrants that can allow it to buy up even more shares in Canopy Growth in the future.
The deal provides Canopy Growth with a deep-pocketed minority stakeholder with extensive regulatory, production, distribution, and marketing experience. In the past year alone, Constellation Brands sales have clocked in at nearly $8 billion, thanks to fast-growing craft-brew brands, including Ballast Point and Funky Buddha.
On Constellation Brands' side of the ledger, the investment is in keeping with past investments that have insulated it against the risk of declining sales because of consumers' changing tastes. Specifically, acquiring minority ownership of Canopy Growth helps protect it against the risk of declining alcohol demand tied to legalizing marijuana.
Certainly, there's an opportunity for Constellation Brands to infuse its existing products with cannabidiol to drive sales, too, but I think this investment is more about helping the company profit from a shift to buds from suds. The risk of a drop-off in alcohol use shouldn't be ignored. Cowen & Co. research shows that, for seven years, alcohol use has been declining, while marijuana use has been increasing among 18 to 25 year olds. Since marijuana's psychoactive cannabinoid THC doesn't always play nicely with alcohol, a drop-off in alcohol consumption in this population could indicate that legalizing marijuana in the U.S. may crimp future demand for Constellation Brands' beer, wine, and spirits.
Of course, Constellation Brands' investment in Canopy Growth isn't just about what could happen in the future with marijuana in America. The deal also gives Constellation Brands immediate exposure to the fast-growing Canadian marijuana market. In Canada, marijuana use has been climbing rapidly over the past few years following Health Canada's decision to begin issuing licenses in 2014.
Perhaps no company has benefited more from Canada's growing marijuana industry than Canopy Growth. Over the past 18 months, it's been raising money from investors to acquire competitors, including Mettrum, and invest in marijuana production and distribution. As a result, its sales have marched significantly higher and its cost of production and distribution has fallen.
The company hasn't updated investors with its most recently quarterly results -- that will happen on November 14 -- but fiscal first-quarter sales skyrocketed 127.4% year over year, to $15.87 million Canadian, as the company sold 86% more kilogram and kilogram equivalents of marijuana than it did in the same quarter one year ago. The average price per gram improved to $7.96 per gram from $7.09 per gram year over year, and the weighted average cost per gram of cultivation to harvest and post-harvest costs, not including shipping and fulfillment, fell to $1.28 per gram from $1.64 per gram one year ago.
The revenue growth lifted the company's sales over the past 12 months to nearly $37 million Canadian.
Cross out the one-time items, and Canopy Growth's gross margin ticked up to 66% in the quarter from 60% last year. High operating expenses because of its investments means Canopy Growth's not turning a profit yet, but it's making smart decisions that could pay off handsomely if Canada's plans to legalize recreational marijuana go off without a hitch in 2018.
Constellation Brands' investment in Canopy Growth could spark interest from other big companies to take the leap and ink deals. No company is saying yet that they'll be following suit, but an argument can be made that other beer, wine, and spirits companies could be on the hunt. Tobacco companies could also be interested.
It's anyone's guess what marijuana stocks these companies would target, but they'll probably limit their interest to best-in-breed players. If so, they could come knocking on Aphria's (NASDAQOTH:APHQF) door.
Like Canopy Growth, Aphria's management team is solid and they've been making investments so that they can be a significant player in Canada's cannabis market, too. With sales of $16.8 million Canadian over the last 12 months, Aphria is smaller than Canopy Growth, but it's still in a good position to tap into booming marijuana demand.
Overall, marijuana stock prices value these companies at a premium already, but Constellation Brands' decision to invest in Canopy Growth suggests the long-term opportunity may be big enough to justify the short-term risk of a sell-off.
Todd Campbell has no position in any of the stocks mentioned. His clients may have positions in the companies mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.