By Kris Rosemann
The Growing Pot Market
As the number of states legalizing recreational marijuana continues to grow, investor interest in the space continues to rise and the public stigma around the substance continues to fall. According to a recent RBC note, roughly 83% of Americans believe marijuana should be legal in some capacity, suggesting further decriminalization and/or outright legalization is likely to take place in coming years, a notion supported by Canada’s recent nationwide legalization.
RBC also estimates that legal marijuana sales in the US will grow at a 17% compound annual growth rate over the next decade to approximately $47 billion in legal annual sales. Current recreational sales of marijuana in the US, both legal and illegal, are estimated at roughly $50 billion per year, a figure that is already nipping at the heels of spirits ($58 billion) and wine ($65 billion) without the benefit of legal, nationwide distribution capabilities. Marijuana concentrates and edibles are helping drive the growth potential of the space as users prefer such consumptions methods over the plain flower, and providing companies continue to pump out the higher-margin products. In Colorado, where recreational use has been legal for several years, plain flower sales have fallen to 46% of total sales as of the fourth quarter of 2017 from 70% in the first quarter of 2014.
Alcoholic beverage company Constellations Brands (STZ) has captured investor interest in the marijuana space as it continues to grow its exposure via an expanding partnership with Canopy Growth (CGC), a leading cannabis company. Constellation recently raised its ownership stake in Canopy Growth to 38%, which will provide Canopy with ~$4 billion in new capital to solidify its leading position in the industry and give Constellation access to the growth potential of Canopy without adding significant financial leverage and maintaining a reasonable level of risk management. Scotts Miracle-Gro (SMG) has faced challenges in its own cannabis growing subsidiary, Hawthorne Gardening, which it does not expect to meet internal growth targets for the foreseeable future. Management cited difficult negotiation processes and an inability to reach synergy targets related to a recent acquisition as the key causes for the headaches.
Scotts Miracle-Gro’s issues are an important reminder that the path to nationwide recreational legalization of marijuana remains chock-full of uncertainty. While it may very well be true that legalization will ramp in coming years, regulation and political uncertainty should not be discounted, and the process will not be all flowers. The legal cannabis space certainly holds intriguing long-term investment potential, but investors would be remiss to believe that unfettered growth is in the cards for the industry.
PepsiCo Gets into Home Beverage Systems
Global beverage and snacks giant PepsiCo (PEP) has agreed to acquire SodaStream (SODA), an Israel-based maker of home beverage carbonation systems, for $3.2 billion in cash. Though the investment is a rather minor one for a company of PepsiCo’s size, we think the company overpaid for SodaStream as the purchase price comes out to $144 per share, which is significantly higher than our prior fair value estimate of $87 per share. Nevertheless, SodaStream brings additional growth opportunity, as well as a strong presence in Western Europe. Europe accounts for approximately 60% of SodaStream’s sales, and its household penetration rates there (16% in Sweden, 8%-10% in some European markets and Israel, Australia, and New Zealand) are far higher than in the US (1.4%).
SodaStream’s recent growth has been fueled in large part by its transition to a sparkling water company, and though its offerings include a variety of sugared and non-sugared flavor options, unflavored sparkling water has been a key driver, according to Moody’s. Such a trend bodes well for PepsiCo’s plans to grow its presence in non-sugared beverages as consumers in developed economies become increasingly health conscious and certain major cities consider and/or implement sugar taxes. SodaStream’s environment-friendly operating system should also fit nicely into PepsiCo’s sustainability initiatives.
PepsiCo’s massive distribution capabilities should help boost SodaStream’s growth—the company has tuned in double-digit sales growth in ten consecutive quarters as of the second quarter of 2018. SodaStream has showcased the profit potential of its business as it scales–the company’s operating margin has expanded to 15% from 4% over the past three years. Given the size of the deal, we think it brings a somewhat lower level of financial risk for PepsiCo with notable upside potential as consumers continue to prioritize convenience and shopping from home. Some critics believe making carbonated drinks at home is not as convenient as it may appear given the time it takes to make a beverage compared to buying a 12-pack of ready-to-drink cans.
All things considered, we like the deal for both sides, though PepsiCo may not have gotten as attractive a price as it could have. Synergies will be limited as SodaStream will continue to operate as an independent business, but Moody’s estimates that PepsiCo’s net leverage ratio will be 2.3x at the end of 2018 as compared to 2.1x prior to the deal. The company’s extremely shareholder-friendly management team might consider curtailing dividend growth or its robust share repurchase practices if financial leverage becomes an issue. The company expects free cash flow generation to be ~$6 billion in 2018 with planned dividend payments of ~$5 billion and share repurchases of ~$2 billion. Near-term income investors may want to keep an eye on the tight cash flow coverage, but we don’t expect a significant impact on the health of the payout to turn materially negative following the deal, which brings long-term growth potential.
Broker Price War May Just Be Beginning
It is no secret that passive investing continues to proliferate, and as a result, buyers of index funds and ETFs are becoming increasingly cost-conscious. Fidelity Investments beat its other low-cost competitors to the “free market exposure” punch as it now offers two core index funds with no management fee, and Vanguard recently made headlines with its plans to offer free trading on more than 1,800 ETFs. J.P. Morgan (JPM) recently rolled out an app that allows for free trading, too, with J.P. Morgan CEO Jamie Dimon pointing to Amazon Prime as its inspiration, according to CNBC. We can only expect more and more brokers to follow suit as the price war rages on.
Critics of Vanguard’s move suggest the company’s free ETF trading policies will encourage short-term decision making on the part of the investor, which might be exacerbated by the market’s recent return to volatility but seems to fly in the face of the concept of passive investing. Though such concerns should not be ignored, investors are the winners in the fee war for obvious reasons. However, making indiscriminate buying of a large basket of companies even more accessible means that the proliferation of investing not backed by fundamental research and price-to-fair value considerations could accelerate as other companies follow Vanguard’s lead.
We applaud brokers working to reduce fees for consumers, but we continue to be wary of the aforementioned proliferation, especially when it is coupled with an incentive to execute more trades with fewer consequences. Eliminating management fees on index funds, as in the case of Fidelity, makes the most sense and is a huge win for the industry, in our opinion, as we don’t think investors should be charged a fee just to gain expose to a broad swath of the market. We expect more asset managers to follow Fidelity’s lead in this regard, and we think the pressure on brokerage commissions from Vanguard and J.P. Morgan, in particular, is a notable negative for the profitability of online brokerages over the long haul.
Related: AMTD, SCHW, ETFC, IBKR
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Kris Rosemann 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.