Rumors are swirling that big-cap consumer goods companies are interested in investing in marijuana stocks following Constellation Brands' (NYSE:STZ) decision to acquire over one-third of Canopy Growth (NYSE:CGC) earlier this year. Coca-Cola (NYSE:KO) was reportedly considering an investment in Aurora Cannabis (NYSE:ACB) last month, and there are reports today that tobacco kingpin Altria Group (NYSE:MO) would like to partner with Aphria Inc. (NASDAQOTH:APHQF). Is big tobacco about to cozy up to cannabis?
Why Aphria could be in Altria's sights
With 255,000 kilograms of capacity next year, Aphria is the third-biggest Canadian marijuana stock by annual marijuana production behind Aurora Cannabis, which has 570,000 kilograms of funded capacity, and Canopy Growth, which is on track for over 500,000 kilograms of capacity in 2019.
Although it's not as big as Aurora and Canopy Growth, Aphria is carving out an important niche as Canada's leading low-cost producer. Broadacre cultivation is cheapest, but Canada's unforgiving climate makes growing outdoors less enticing. Instead, Aphria focuses on greenhouses, which are far less expensive to operate than indoor facilities. According to a 2016 study conducted by Deloitte for the Australian cannabis market, it can cost $888, $1,539, and $1,909 per kilogram of dried flower to produce marijuana using broadacre, greenhouse, and indoor cultivation, respectively.
In addition to being on track to have over 95% of its marijuana production in greenhouses, Aphria's also at the forefront of implementing cost-saving automation in its facilities to drive costs down even more. Labor can represent up to 50% of the expense of operating a greenhouse, so automating nutrients, cuttings, de-budding, trimming, and waste disposal is key to boosting margin. Furthermore, Aphria's installing a power co-generation plant to save on its electricity costs and its implementing a water recycling system to lower its water bill.
The cost-forward approach at Aphria is already translating into enviable gross margins. Its gross margin was 75.6% last fiscal year, excluding fair-value adjustments due to inventory changes, and that's nicely better than Aurora Cannabis' 65% gross margin last fiscal year and Canopy Growth's 43% gross margin last quarter. While Aurora is attempting to lower its per-gram production costs to $1 or below by building out its own high-tech greenhouses, Aphria is already there. Last quarter, its production costs minus packaging and amortization were $0.95 per gram.
If we assume that the real money to be made in marketing marijuana will come from consumer goods, rather than marijuana as a commodity, then the consumer goods company that has the lowest all-in costs should have a compelling advantage over their competitors. In this respect, Aphria is undeniably attractive.
What can Altria offer?
Marketing and distribution know-how was one big reason why Canopy Growth agreed to partner with Constellation Brands and, undeniably, few consumer goods companies have the marketing and distribution experience of Altria.
Its Marlboro brand is one of the most famous brands in history. It also markets the well-known smokeless tobacco brands Copenhagen and Skoal, and it's in the midst of establishing Nu Mark's MarkTen as a leader in e-vapor. Additionally, it markets a stable of wine brands, including Chateau Ste. Michelle, and it holds a roughly 10% equity investment in AB InBev, which owns the Anheuser-Busch beer lineup, including Budweiser.
Money is another big reason why Canopy Growth teamed up with Constellation Brands and, arguably, Altria's pockets are even deeper.
In exchange for a 38% equity interest in Canopy Growth, the beer, wine, and spirits company paid roughly $4 billion. It ended up with a big stake in Canopy, and Canopy got an important influx of cash to help it execute on its plans to win Canada's fast-growing marijuana market and explore opportunities in other countries considering legalization.
Altria wouldn't have any trouble funding a similar deal. It hauled in $9.5 billion in revenue during the first six months of this year, excluding excise taxes, and over the past 12 months, its net income exceeded $10 billion. Last quarter, it spent $1.3 billion on dividends and $437 million on share repurchases alone. Undoubtedly, it has the financial flexibility to make a big bet on Aphria or some other marijuana company.
What to watch next
Though Aphria could go it alone in the marijuana marketplace, there are advantages to teaming up with a company like Altria, including insight into how to best navigate regulatory complexity. That regulatory know-how could be particularly important if the U.S. government ends marijuana prohibition federally someday.
Aphria reported after the closing bell today that it doesn't have any agreement in place with anyone, but it also said that it engages in talks from time to time. It's anyone's guess if those talks include Altria, but I think a good argument could be made that such a partnership would be a long-term win. Given the M&A chatter, I imagine all eyes will be watching Aphria's quarterly conference call on Oct. 12 for clues to if a deal could be on deck.
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.