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Constellation Sets Optimistic Tone, Outlines Cannabis Opportunity

publication date: Oct 4, 2018
author/source: Brian Nelson, CFA

Image Source: Constellation Brands

The producer of beer, wine and spirits reported excellent second quarter fiscal 2019 results and described cannabis as a “once-a-century disruptive market transition.” Without a doubt, the opportunity in cannabis looks tremendous, but the landscape is fast-evolving. We think Constellation will be a long-term winner in the space, but outsize profits in cannabis may be tough to come by initially.

By Brian Nelson, CFA

Constellation Brands (STZ) reported solid second quarter fiscal 2019 results October 4 that showed a very healthy and growing business. Net sales advanced 10%, while operating income increased 9% on a comparable basis. The company raised its fiscal 2019 earnings per share outlook to $14.10-$14.25 on a reported basis (was $11.47 in fiscal 2018) and $9.60-$9.75 on a comparable basis (was $8.70 in fiscal 2018). Management is targeting fiscal 2019 operating cash flow of ~$2.45 billion with a free cash flow projection in the range of $1.2-$1.3 billion in the year, a combination that should continue to facilitate share buybacks, which totaled 1.9 million shares during the fiscal second quarter.

As one of the key growth contributors in the US alcoholic beverage market, Constellation is experiencing consumer interest across the super-premium segment of its wine portfolio (Meiomi, Kim Crawford, Simi, and Prisoner). The company’s Modelo and Corona brands also are performing well, and Constellation’s beer business generated a record operating margin in the period of 41.3%, an advance of 10 basis points. Most of the operating-margin improvement was driven by a better mix and more favorable pricing as higher transportation costs and competitive-marketing spend continue to be headwinds. Constellation continues to invest in brand awareness for the launch of Corona Premier and Corona Familiar.

While its alcohol business is on solid ground and its fundamental performance remains solid, Constellation jumped at the opportunity to take a big step into the cannabis business. Its pending $4 billion acquisition of Canopy Growth (CGC) has provided considerable market backing for the optimistic sentiment regarding cannabis stocks, and many smaller players in the space have been experiencing unprecedented volatility, including one of the most-watched moves in Tilray (TLRY) recently. Constellation’s Canopy deal will add another $4 billion in debt to a balance sheet that already has a long-term debt load of nearly $10 billion, as of August 2018. The company will have to continue to generate copious amounts of free cash flow and perhaps slow buybacks to deleverage in the future, in our view.

Profits in the cannabis will be hard to come by initially, but Constellation expects global markets to generate more than $200 billion in retail revenue before 2035. Cannabis may be a great fit for an alcoholic-beverage company in that management has had to deal with various regulatory and licensing issues in the making and selling of alcohol, but there are still considerable risks, particularly on the political front. The US has not been perfect with its proposed legislation, and we have the repeal of Prohibition as one important precedent. It remains to be seen how the political environment ebbs and flows with cannabis, but what may look like a great opportunity today could turn into a dud in the years ahead. Regardless, the change in attitudes toward cannabis in recent years has been notable.

From vaping to edibles/beverages to cannabis-based medical treatments, the product line-up is long and growing, and innovation will almost certainly bring more to consider for consumers. Canopy is one of the most entrenched players, too, holding roughly 36% share of all supply contracts in Canada and boasting the largest licensed domestic production capacity in the country, capacity that is expected to double in the coming year or so. As of right now, Constellation believes estimated US sales of cannabis are already at $50 billion, almost on part with that of spirits and wine. We think the market is a bit ahead of itself with Constellation’s share price, with the high end of our fair value estimate range about where shares are currently trading, but for those looking for lower-risk exposure to the cannabis end market, Constellation could make sense.

What Might Be the Best Risk-Adjusted Way To Consider Cannabis Exposure?

There's a lot of hype with cannabis stocks these days, and we fear many of the smaller players may not live up to it, or at least they may experience strong run-ups and then face considerable pressure, similar to the Tilray story. We wanted to share the Constellation update because it sizes up the fundamental long-term opportunity in cannabis fairly well, with an overlay of the long-term policy risks of cannabis that may be overlooked, even though the change in attitudes toward cannabis in recent years has been positive. What many may believe will be acceptable may eventually not materialize, or at least not in the magnitude of expectations. The regulatory environment can be highly punitive.

All in, sizing up the long-term cannabis opportunity given policy risks and then shaking out who will have the corresponding market share across verticals will be an inexact science so early in the adoption curve, particularly as many of the smaller companies may be money-losing endeavors, with perhaps their biggest promise in coming years being speculative potential of a buyout from a larger company. Whether that buyout materializes and at what price adds yet another degree of uncertainty to any one small industry player.

Some of the ways that investors may be playing the space, too, is through more diversified ETFs. Picking fundamental winners and losers in cannabis may be a difficult task and expecting a buyout as a central part of anyone's thesis may not be a great risk-adjusted way to consider investing in the space, as many buyouts may not come to fruition. However, a basket of marijuana stocks may collectively benefit from buyouts in the space, as a "rising tide lifts all boats" dynamic occurs.

There are a variety of marijuana ETFs, too (and probably more to come), including Horizons Marijuana Life Sciences (HMMJ) -- see here -- Horizons Junior Marijuana Growers (HMJR) -- see here -- and ETFMG Alternative Harvest (MJ) -- see here. The companies within these ETFs may be a great source for idea generation within the space, and the ETFs themselves may yet be another diversified way to consider playing the space without taking the outsize risk of any one entity.

Beverages - Alcoholic: BF.B, BUD, DEO, FMX, SAM, STZ, TAP



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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.

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