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Morningstar | Constellation Brands Pays a Premium to Enhance Its Presence in the Budding Cannabis Category

We're not anticipating a material change to our $199 fair value estimate for narrow-moat Constellation Brands after evaluating its increased equity stake in Canopy Growth, a leading cannabis firm. Constellation had taken a nearly 10% ownership stake in Canopy in October 2017 for CAD $245 million and now plans to raise its stake to roughly 38% ownership for around CAD $5 billion, or a 38% premium to Canopy's five-day volume weighted average price. The transaction is expected to close in October, and will also provide warrants that, if exercised, would lift Constellation's ownership to more than 50% in the three years after closing.

Shares pulled back by a mid-single-digit percentage on the announcement, and we suspect this reaction was due to concerns around capital allocation, given the lofty premium paid for shares and higher risk inherent to the cannabis space (which is not legal on a federal level in the U.S.) relative to Constellation's core beer and wine portfolio. While we concur that the price paid was excessive, we remain constructive on the longer-term opportunities this investment could yield and appreciate the firm's efforts to be an early mover into this developing category. Further the deal will allow Constellation to nominate four directors to Canopy's seven-member board; we'd expect this increased control to come at a premium. We're reiterating our longer-term outlook for the company, which incorporates around 6% revenue growth and mid-30s operating margin on average over our forecast. While shares are now trading in line with our valuation, we'd suggest investors wait for a wider margin of safety.

Recreational cannabis is set to be legalized in Canada (where Canopy is based) in October, and Canopy's management estimates that it is the top licensed producer in the region based on supply agreement awards, with a 36% share of all business awarded to date in the country. While products like flowers and oils will come to market initially, the Canadian government has suggested that value-added recreational cannabis products (including beverages) will be permitted within a year of legalization. However, both firms have emphasized that they will not participate in the U.S. market while cannabis remains illegal on a federal level. In our view, the uncertainty around the path to decriminalization in its home market remains the chief risk facing Constellation's investment in this space.

We contend that Constellation will be able to leverage Canopy's entrenched distribution relationships, intellectual property, and research and development capabilities (including investments in clinical trials) to expand into the cannabis beverage category as a growing number of countries permit medicinal and recreational uses. From our perspective, the specialized knowledge and scale needed to produce and distribute cannabis (and related products like oils) would be challenging for a new entrant to replicate. As such, we contend that Constellation's partnership with Canopy should allow it to more easily gain traction with cannabis than if it were to develop this capability internally. While the extent to which recreational cannabis could cannibalize Constellation's core beer (above 60% of sales) portfolio remains to be seen, we portend that cannabis beverages could be used in conjunction with alcoholic ones in off-premises settings.

Constellation Brands expects to finance the deal with a combination of senior notes and term loans and plans to suspend further mergers, acquisitions, or share repurchases until its 3.5 times leverage target is restored (management expects this to occur within 18 to 24 months of the close). We're not overly concerned about this degree of leverage, given the firm's robust free cash flows (around 13% of sales in fiscal 2018) and historical ability to operate with elevated levels of debt on its balance sheet. As evidence, debt/adjusted EBITDA stood above 5 times in fiscal 2014, after the firm acquired the outstanding stake in its beer joint venture. We expect debt/adjusted EBITDA to tick up above 4 times in fiscal 2019, before trending down toward 3.6 times by fiscal 2021.

While Canopy is still operating at a loss, management expects the deal to benefit its diluted earnings per share by fiscal 2021. We expect the contribution from equity investments to remain a relatively minor portion of the company's outlook longer term, remaining at a low-single digit percentage of revenue, but we posit that the firm could increase its investment in or potentially even acquire Canopy (provided its leverage target is met) longer term, particularly if cannabis were decriminalized in the U.S. on a federal level.