Five months after Canada legalized recreational marijuana, there's still plenty of reason to believe that marijuana stocks are in a bubble. Their prices have surged in 2019, returning to earlier heights they enjoyed before the crash that followed official legalization. Year-to-date, Canopy Growth (CGC +6.48%) is up 70%, Aurora Cannabis (ACB +2.91%) has doubled, and Cronos Group (CRON 0.38%) is up 108%. They are also delivering blowout growth, with Canopy's revenues up 268%, and Aurora clocking in with 345% top-line growth for most recent quarters.
However, while cannabis majors command market capitalizations north of $10 billion, real operating profits remain elusive as they continue investing in sustainable growth. For investors searching for an opportunity in the sector that isn't a loss-generating company with a lofty valuation, one appealing option emerges.
Image source: Getty Images.
An overlooked bargain
While darling Canopy Growth is valued at an ambitious $15.7 billion, it booked an operating loss of 157.2 million Canadian dollars in its fiscal third quarter. By contrast, its biggest investor, Constellation Brands (STZ +1.66%), looks like a downright bargain these days. Best known as Corona's distributor, the diversified alcohol company acquired 38% of Canopy last year, and now owns warrants it can use to purchase a majority stake.
Based on Canopy's current market cap, Constellation's stake is worth about $6 billion, or about 18.5% of the alcohol purveyor's current $32 billion valuation. Given that Constellation's P/E ratio is now 18.3, investors seem to be ignoring its stake in Canopy -- and its potential upside -- by treating the company like it's still a boring beer and wine operation.
In addition, Constellation is continuing to reorient itself toward growing premium markets like marijuana. In 2016, it divested its Canadian wine business, and now, it's in advanced talks to sell some of its low-end U.S. wine brands to E & J Gallo for up to $2 billion, according to CNBC. That deal could help the company fund further investments in cannabis, or it could put the proceeds toward paying down the debt it used to finance the $4 billion Canopy deal. This potential divestiture should also boost Constellation's growth -- management has acknowledged the wine segment was weighing down overall performance.
Check out the latest earnings call transcripts for Cronos Group and other companies we cover.
A strategic opportunity
Not only does Constellation offer investors cheap exposure to one of the biggest businesses in the cannabis sector, it also gives them the ability to profit from the strategic partnership between the two companies.
Constellation's $4 billion cash injection gave Canopy necessary capital for expansion and marketing. The young cannabis giant stands to benefit from the alcohol veteran's acumen in marketing, branding, distribution, and navigating complex regulatory environments. The two are also working on cannabis-infused beverages that will debut in Canada later this year. And Canopy's relationship with Constellation will give it a leg up in the U.S. if marijuana ever becomes legalized on the federal level.
The companies' partnership was on display in January when Canopy announced it would invest between $100 million and $150 million to open a hemp production facility in upstate New York near Constellation's headquarters. That move capitalizes on the recent legalization of hemp in the U.S., which brings cannabidiol (CBD), the non-psychoactive cannabis derivative, closer to full legalization. CBD, including in beverage form, has become popular among some consumers who use it to treat symptoms such as chronic pain, anxiety, and depression.
How the numbers add up
With revenues of about C$200 million over the last four quarters, Canopy trades at a sky-high price-to-sales ratio of 100, though outgoing Constellation CEO Rob Sands has said he expects Canopy to achieve a $1 billion revenue run rate in the next 18 months. Even if he's right, its P/S ratio would still be around 15 based on its current price. Given that operating profits are unlikely to be achieved in that time frame, the stock is at considerable risk for a pullback if an adverse event occurs like the market tanks, a recession hits, or if Canopy fails to deliver on expected growth.
Buying Constellation won't give investors total exposure to the growth of the marijuana market in the way buying pure-play Canopy would -- which means it has a smaller upside potential. But it eliminates nearly all the risk, given Constellation's current P/E of 18.3, and in an industry this green, a little safety isn't a bad idea. Backing out the contribution from value of its stake in Canopy, Constellation's P/E is more like 15 -- considerably cheaper than the market average -- and its ability to gain majority control of Canopy if it desires to gives investors additional upside, and a way to hedge their bets toward greater gains.
Constellation shares aren't about to rocket higher the way some pot stocks have, but they offer a great way for conservative investors to get exposure to the fast-growing marijuana market.
