Was CGC a Big Mistake for Constellation Brands?

Canopy Growth (CGC) (WEED) has seen dizzying ups and gloomy downs in 2019. The stock jumped up by 79.91% from $28.92 on January 2 to $52.03 on April 29. Since then, the company has lost 35.59%. Today, CGC is down YTD (year-to-date) by 30.59% on NYSE.

Previously, CGC had jumped up by 15.02% to $20.29 on November 21. The cannabis sector saw a short rally after House Judiciary Committee favored the MORE (Marijuana Opportunity Reinvestment and Expungement Act) bill. This is the first step in decriminalizing marijuana at the federal level in the US.

However, the bill may face multiple challenges in the Republican-controlled Senate. This awareness led to many prominent cannabis stocks, such as Aurora Cannabis (ACB), Cronos Group (CRON), CGC, Hexo Inc (HEXO), and Aphria (APHA), to lose most of the gains within a few days.

In October 2017, Constellation Brands (STZ) bought a 9.9% stake in CGC for $245 million Canadian dollars. In November 2018, STZ upped its stake in CGC to 38% for an investment of $5 billion Canadian dollars.

Has CGC proved to be a big mistake for Constellation Brands? Let’s try to uncover the answers in the company’s latest news releases and financial results.

STZ seems to be losing hope about CGC. On November 22, as reported in a regulatory filing, Constellation Brands announced that it will not be making any additional cash investments in CGC.

Currently, STZ holds warrants in CGC, with an exercise price of $12.98 Canadian dollars per warrant and set to expire on May 1, 2020. Also, the company has CGC’s Trance A warrants, which will expire on November 1, 2023. STZ will be exercising these warrants only after assessing their prospects just prior to expiration.

The company believes CGC to have sufficient capital, considering the $2.7 billion cash and marketable securities on its balance sheet as of September 30. STZ has guided for $2.2 billion of operating cash flow in fiscal 2020. However, the company prioritized returning $4.5 billion in cash to shareholders over additional investments in CGC.

On November 29, as reported by MarketWatch, MKM Partners analyst Bill Kirk explained why CGC may not become profitable on a per-share basis by fiscal 2022. The analyst highlighted challenges, such as the need for ongoing investment to target future growth opportunities in the face of increasing pricing pressures due to demand-supply mismatch. In this backdrop, CGC’s revenues failed to keep pace with expectations. This has resulted in higher-than-anticipated losses.

Also, Kirk highlighted the uncertainty surrounding brand differentiation in the cannabis sector as another challenge for CGC. He also highlighted challenges arising from the company’s excessive executive compensation policy and high inventory levels. However, he believes CGC can benefit from increased R&D (research and development) spending in future years.

On November 21, Mad Money host Jim Cramer expressed disappointment for the future growth prospects of the entire cannabis sector. He claims to have mistaken the industry as an “incredible opportunity.” He even asked investors to reduce their exposure to the cannabis sector. Canopy Growth, once a Jim Cramer favorite, is no longer in the hedge fund manager’s good books.

In its second-quarter earnings, Constellation Brands reported a comparable basis EPS of $2.72. This included $0.20 per share equity losses associated with Canopy Growth. The company reported losses of $484.4 million as its share of CGC’s equity losses and related activities. However, STZ reported a $1.2 billion gain associated with the recent modification of CGC’s warrants in the second quarter.

Since November 2017, STZ has reported $757 million unrealized net gain related to CGC. However, in the second quarter, the company had to reduce the fair value of CGC investments by $839 million.

Also, STZ has guided for fiscal 2020 reported basis EPS of $0.55—$0.75. This includes the impact of the earnings and other activities of Canopy Growth. Excluding CGC impact, Constellation Brands has guided for fiscal 2020 comparable basis EPS of $9.00—$9.20.

On November 28, Canopy Growth outlined its Cannabis 2.0 strategy. The company detailed its strategy for cannabis-infused beverages. The drink will be available across flavors, sizes, and potencies. To that effect, CGC has developed a proprietary process that can distill a clear liquid from the whole flower cannabis. This liquid is the active ingredient for THC- and CBD-based beverages.

On November 22, the company got an operating and storage license for its 150,000-square-foot beverage facility at Smiths Falls. The company started manufacturing cannabis-based beverages at this facility on November 25. The company plans to make 11 beverages based on Distilled Cannabis during the first wave of production. So, the company plans to gradually increase its beverage portfolio.