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Will Constellation Brands Acquire Canopy Growth Corporation?

By Sean Williams – Updated Aug 24, 2018 at 2:19PM

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Following a groundbreaking $3.8 billion equity investment, will the maker of Corona and Modelo buy the largest pot stock in the world?

Whether you realize or not, you'll bear witness to history in less than two months. On Oct. 17, 2018, Canada is set to become the first industrialized country in the world to legalize recreational marijuana. Overall, it'll be only the second country, other than Uruguay, to green-light adult-use pot.

As you may rightly have imagined, legalizing marijuana for adult consumption and via export to foreign countries where medical weed is legal is bound to lead to skyrocketing sales. Currently generating just a few hundred million dollars in annual sales, the legal cannabis industry in our neighbor to the north could see up to $5 billion in annual revenue within a matter of years. It's this surge in sales and the expectation for a lot of green in the bottom line that's lured investors in droves to marijuana stocks.

A brewer holding a pint of beer and closely examining it.

Image source: Getty Images.

Beer makers look to cannabis to brew growth

But it's not just Wall Street or investors who have their eye on the marijuana industry. Alcohol companies -- specifically, beer makers -- have been eyeing cannabis as sales have gone somewhat flat in North America. Cannabis-infused beverages, and other alternative products aside from simply the dried flower, offer a potentially intriguing means for beer companies to put some pep back in their step.

That's what made Constellation Brands' (STZ 2.01%) groundbreaking investment in Canopy Growth Corporation (CGC) in October 2017, and its subsequent larger equity stake last week, all the more important.

Constellation Brands, the maker of Corona and Modelo, initially purchased a 9.9% equity stake in Canopy Growth in late October for about $190 million. This was the first time a major alcohol company had made an investment in a pot stock, and it signaled the real possibility that alcohol companies would look to partner, or perhaps even acquire, marijuana businesses.

In June, Constellation Brands further solidified its positon by acquiring a third of the Canopy Growth's 600 million Canadian dollar convertible note offering (worth about $450 million). Though these notes could be treated as general debt that earns interest and is redeemed at a later date, it also allowed Constellation the option to convert its notes into more common stock, thus increasing its ownership stake in Canopy. 

Then, last week, Constellation Brands surprised Wall Street when it announced an additional $3.8 billion equity investment in Canopy Growth, which works out to 104.5 million shares of common stock. The price Constellation paid per share to up its ownership stake in Canopy Growth to 38% was a 51% premium to where Canopy had closed on the day prior to the equity stake announcement. Furthermore, the deal comes with 139.7 million in new warrants to be held by Constellation Brands. If exercised, it could up its stake in Canopy Growth to more than 50%.

Two businessmen shaking hands, as if in agreement.

Image source: Getty Images.

Will Constellation buy Canopy Growth Corp.?

While most folks are probably focused on Canopy Growth's coffers, which are soon to be boasting in excess of $4 billion in cash, or Constellation's partnership with Canopy in developing alternative cannabis products and bolstering its distribution and marketing channels to overseas markets, the bigger question has to be asked: Will Constellation acquire Canopy?

On the surface, an acquisition does appear somewhat likely. Constellation has made three separate investments in Canopy Growth in less than a year, and the size of its latest equity stake demonstrates its commitment to cannabis going forward.

Plus, Constellation's most recent quarterly report showed a 3.1% decline in U.S. shipment volume in its wine and spirits segment. Meanwhile, net sales for its beer segment rose 11%, with shipment volume rising by a healthy 8.6%. With solid demand for beer products, Constellation probably views a partnership with Canopy Growth as a means to further bolster this strength while offsetting weakness in wine and spirit sales. 

Similarly, Canopy Growth Corp.'s valuation of $8.4 billion (which includes a more than 50% run higher following the Constellation Brands equity stake announcement) isn't completely ludicrous. Assuming Constellation executes all of its existing warrants, purchasing the remainder of the company it doesn't already own wouldn't exactly put its balance sheet in dire straits.

A magnifying glass hovering over a balance sheet.

Image source: Getty Images.

An acquisition appears probable, but is at least two years out

However, I wouldn't look for Constellation to acquire Canopy Growth for at least two more years -- and there are two good reasons for the wait.

To begin with, the press release announcing the equity investment specifically states:

Constellation Brands remains committed to its investment grade rating and therefore, has no plans to engage in mergers, acquisitions or share repurchase activity until the company returns to its 3.5x leverage target, which is expected to occur within 18-24 months of deal closing. 

Constellation's equity investment, assuming it gains all the approvals needed to be completed, won't be finalized until October 2018. Then, once complete, an 18- to 24-month clock begins to tick to allow Constellation Brands the time to pay down debt with its operating cash flow. This would suggest that it's going to be a good 20 to 26 months before Constellation Brands' management team would even remotely consider acquiring its unowned stake in Canopy Growth.

The second reason is that Constellation Brands probably wants to take the time to ensure that the cannabis industry is all it's been cracked up to be. Sure, we've heard about pie-in-the-sky sales expectations, but it could be an entirely different story once adult-use marijuana hits recreational markets. There are serious concerns about the supply-and-demand outlook, as well as how successful the industry will be at luring consumers away from black-market channels. Even though the alternative cannabis products that the duo would be working on have higher-margin potential, there's no telling what sort of operating margins we could ultimately be talking about.

Cannabis leaves lying next to chocolate and a brownie.

Image source: Getty Images.

As the icing on the cake, it's also worth mentioning that the Canadian federal government hasn't yet approved the sale of many cannabis alternative products, such as edibles or cannabis-infused beverages. The expectation is that Parliament will bring the issue up for discussion next year and pass amendments allowing for the sale of edibles and beverages sooner rather than later.

Long story short, we're in a holding pattern. While I'm personally excited to see how this budding partnership will shake out, and I do see a growing possibility of a full-fledged buyout, the chance of a near-term buyout looks to be slim to none.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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