Investments in cannabis companies have ramped higher in the past few years. Investors now have access to a variety of cannabis-related companies, as products containing cannabis have reached greater social and legal acceptance in North America and around the world.
Multiple large companies whose business models are not related to marijuana have invested in this booming adjacent category as a way to gain exposure to a major growth theme. By extension, this gives investors exposure to cannabis through a company’s investments. You can see the full list of marijuana stocks here.
One such example is Constellation Brands (STZ). The spirit, wine, and beer maker spent $4 billion last year to buy a 38% stake in cannabis company Canopy Growth (CGC). In addition, Constellation has warrants that could raise its current stake up to 50%, should the warrants be exercised.
This sort of ownership position gives investors a unique opportunity to own a well-established and highly-profitable beverage producer that also has very significant exposure to cannabis products. Constellation Brands stock appears to be slightly overvalued today, but could prove to earn its premium valuation if its growth investments pay off.
Company Background and Recent Financial Results
Constellation Brands was founded in 1945 and in the 74 years since, it has grown into a global maker of a wide variety of beers, wines, and spirits. Indeed, Constellation counts more than 100 brands in its stable of beverages worldwide, including Corona, Modelo Especial, Pacifico, Robert Mondavi, Black Box, Casa Noble Tequila, and SVEDKA Vodka.
Constellation produces just under $8 billion in revenue annually and has a market capitalization of $39 billion today.
Constellation reported Q1 earnings on 6/28/19 and results were somewhat mixed. Total revenue was up 2% to $2.1 billion as beer gained 7.4% year-over-year, offsetting weakness in other parts of the business.
Headline earnings-per-share came in at -$1.30 in Q1, however, the entirety of the decline was due to a writedown in the fair value of the company’s investment in Canopy Growth. Excluding this, earnings-per-share would have been flat to last year’s comparable period at $2.21.
Despite what was a relatively weak Q1, Constellation boosted its full-year outlook and expects to see $8.65 to $8.95 in earnings-per-share this year on continued strength in beer sales.
After starting the year very strongly, Canopy Growth shares have fallen by more than a third since the end of April. Given Constellation’s enormous stake in the company, that is hurting not only Canopy shareholders, but Constellation as well.
Canopy’s co-founder, Bruce Linton, stepped down as co-CEO in early July. This was a quite unexpected development and there is intense speculation that Constellation was responsible for Linton’s departure. Indeed, Linton has since claimed he was fired, and that he didn’t resign. Whether these rumors are true or not, this turmoil has caused some angst for investors in both stocks.
Constellation should hold up well during the next recession, as it did during the last one. Indeed, earnings fell slightly during the Great Recession, but its recession-resistant products performed well before, during, and after the downturn. We see its investment in Canopy as potentially reducing some of that safety given that cannabis companies weren’t generally publicly-traded during the last recession. Thus, we don’t really know how those companies’ earnings will behave. Given Constellation’s significant exposure to this industry, we are a bit more cautious.
We see $8.80 in earnings-per-share for this year for Constellation, the midpoint of its updated guidance. We weren’t particularly impressed with Q1 results, but management sees beer sales as good enough to carry the weaker portions of the business. And of course, the company’s stake in Canopy is a wildcard given the relative volatility of that stock.
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We see Constellation producing 8% annual earnings growth in the coming years as the company’s growth rate should slow from recent rates. Constellation saw earnings-per-share expand by 19% annually in the past decade as revenue doubled, and profit margin more than doubled from 9.5% to 23% of revenue. Given the very high base of revenue and margins, we see further growth as more challenging. We suspect this is at least part of the reason why the company owns such a large portion of Canopy.
Constellation’s beer brands are performing very well at the moment, but its wine brands and spirits are lagging somewhat. Constellation is trying to build scale in the craft beer market and the strategy is working, but we note that wine and spirit sales would need to pick up materially to improve on our 8% growth estimate.
Of course, much of this depends upon how well Canopy performs given that more than 10% of Constellation’s market capitalization is tied up in its position in the cannabis company. Constellation has noted recently how it is disappointed in Canopy’s progress on the growth front, but with Constellation having several board seats, investors would do well to monitor progress in the coming quarters.
Valuation and Total Returns
At $201, Constellation trades for 22.8 times our earnings estimate for this year of $8.80. The company’s average price-to-earnings ratio over the past decade is 17, but we assess fair value at 18 times earnings. Still, that means the stock is meaningfully overvalued today, and that implies a mid-single digit headwind to total returns in the coming years.
While we believe Constellation’s growth outlook is largely intact, we view the stock as somewhat overvalued, given that it is trading above its historical average.
Total projected returns for Constellation consist of the following:
- 8% earnings-per-share growth.
- 5% dividend yield.
- 6% multiple contraction.
In total, we see just ~5% total projected annual returns for Constellation over the next five years. This shows the potential impact of buying an overvalued stock. It is a difficult task for a company to grow at a fast enough rate to justify its lofty valuation, which adds an element of risk. The meager dividend yield isn’t enough to boost the stock’s returns as more than half of the company’s projected earnings growth would be potentially offset by multiple contraction.
Investors looking for exposure to the marijuana industry can get that exposure in a variety of ways. If direct ownership of a cannabis company is deemed too risky, investors can buy a stake in Constellation and get indirect ownership of one of the largest cannabis companies on the market.
We think Constellation’s growth outlook is robust on its own and while Canopy introduces new risks, it also introduces the potential for outsized growth down the road. Still, given the relatively expensive valuation Constellation sports today, we see the stock as a hold on the basis of valuation. Growth investors may view the stock more attractively, given the company’s exposure to an emerging growth category in the form of marijuana.