There are drug deals and then there's Constellation Brands' (NYSE: STZ) massive investment in Canopy Growth Corporation (NYSE: CGC), the Canadian marijuana grower.
Constellation Brands, best known as the U.S. distributor of Corona and other Modelo Group beers, made headlines last week when it said it would invest $4 billion in Canopy Growth, giving it a 38% total stake in the company. The deal follows an initial investment last October of about $200 million for a 9.9% equity position in the company.
The transaction was the largest ever in the cannabis industry, as Constellation CEO Rob Sands explained:
Through this investment, we are selecting Canopy Growth as our exclusive global cannabis partner. Over the past year, we've come to better understand the cannabis market, the tremendous growth opportunity it presents, and Canopy's market-leading capabilities in this space. We look forward to supporting Canopy as they extend their recognized global leadership position in the medical and recreational cannabis space.
Investors, however, weren't buying it. The market pooh-poohed the move, sending Constellation shares down 6.1%, as analysts seemed to believe that the diversified alcohol company had overpaid for a stake in the cannabis grower. Canopy stock, meanwhile, rocketed higher, gaining 30% as Constellation said it would pay a 37.9% premium over the five-day volume-weighted average price of the shares on the Toronto Stock Exchange.
Based on the sell-off in Constellation shares, investors think it's a bad move. I disagree, though. Here's why:
Image source: Getty Images.
1. The opportunity in cannabis is huge and still underappreciated
No one knows how big the global cannabis market will be. That will depend on legalization trends, medical research, and consumer tastes, but there is clearly enormous potential for it.
According to Arcview Market Research, illegal marijuana sales topped $46.4 billion in 2016 in the U.S. That's approximately $150 per American on an illegal substance, and that's at a time when recreational marijuana was already legal in multiple states.
Alcohol sales, by comparison, are about $223 billion a year in the U.S., and cigarette sales in the U.S. totaled $93.4 billion in 2016. Pot sales in Colorado last year reached $1.5 billion. Extrapolating that number for the entire country would mean a national marijuana market could generate about $85 billion annually, a market size comparable to that of tobacco. With some momentum and the legalization of venues like hash bars or marijuana cafes, it could potentially grow to the size of the alcohol market.
However, marijuana stocks are worth much less than those of tobacco or alcohol companies. The chart below compares some of the biggest companies in each sector.
|Philip Morris International||Tobacco||$132.2 billion|
|British American Tobacco||Tobacco||$117.6 billion|
|Constellation Brands||Alcohol||$39 billion|
|Canopy Growth||Cannabis||$7.5 billion|
|Aurora Cannabis||Cannabis||$4.76 billion|
|GW Pharmaceuticals||Cannabis||$3.84 billion|
Source: Yahoo! Finance.
As you can see, the size of major publicly traded alcohol and tobacco companies dwarfs that of the biggest marijuana stocks. That makes sense, of course, as the pot purveyors have barely any business currently. But if legalization plays out the way many expect, it's reasonable to believe the top three marijuana companies will eventually have a combined market value of more than $350 billion, just like they do in alcohol and tobacco.
2. Marijuana will eventually be legalized in the U.S. -- probably
Again, no one knows when or even if marijuana will become legal in all of the U.S., but the momentum for its eventual legalization has become overwhelming.
Recreational pot is now legal in nine states plus the District of Columbia, and medical marijuana is legal in another 21.
According to the Pew Research Center, 61% of Americans believe the drug should be legalized, and that group has grown phenomenally in recent years, doubling from 31% in 2000. Not surprisingly, among younger Americans, legalization is even more popular. Seventy percent of millennials favor legalizing the drug, and 66% of Gen Xers agree. In other words, support for legalization should naturally grow as the younger population ages. A Gallup poll even found that a majority of Republicans support legalization.
Momentum for legalization is building in other arenas of government as well. New York City, for example, is taking steps toward decriminalizing the drug, in part because of the disproportionate enforcement of the law against African-Americans and Hispanics and the high incarceration rates it leads to. Marijuana arrests outnumber those for all violent crimes nationally, including murder, rape, aggravated assault, and robbery.
Even the Drug Enforcement Administration is relaxing its restrictions on the amount of pot that can be grown for research, increasing the total cap from 1,000 pounds this year to 5,400 pounds next year.
Finally, recreational pot is going to become legal in Canada this October. If legalization goes well north of the border, pressure will mount to follow suit domestically, especially as the move will likely boost the marijuana black market in the U.S. as well as draw American pot tourists to Canada.
3. Management has proven its capability
Constellation stock has risen more than 800% over the last decade, an astonishing gain in a low-growth market like alcohol. That surge was largely due to the acquisition of the American distribution rights to the Modelo Group beers (and management's subsequent ability to grow sales and profits of those beers), but the company has also made several other moves to rearrange its portfolio to orient it toward growth.
Investing in marijuana and specifically, a market leader like Canopy Growth looks smart, as the pot grower will benefit from Constellation's marketing and distribution acumen. There's also the promise of a marijuana beverage being developed between the two, as marijuana edibles have boomed since legalization in various states. Plus, with $4 billion to play with just when the Canadian market of 36 million people is opening up, Canopy is getting a huge cash infusion at just the right time. Notably, Canopy signaled in the deal's press release that it was done expanding capacity for the time being, but it can use the money for things like marketing, distribution, research, and new products, as well as future expansion.
Whether Constellation overpaid in the Canopy deal is a fair question, but the Corona distributor also gained warrants that will give it a majority stake in Canopy if it chooses to exercise them. In other words, the company would control a leading cannabis grower as well as popular brands across beer, wine, and liquor -- a powerful combination.
There's huge potential growth in marijuana, and it should gain momentum with Canadian legalization. With this $4 billion deal, Constellation has put itself in the driver's seat in another new growth market.
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