Constellation's Move Into Cannabis Looks Interesting

David Zanoni

Summary

Constellation’s stake in Canopy could produce some innovative products.

This could create a new avenue of growth for Constellation.

Constellation’s valuation and growth are evaluated.

Constellation Brand's (STZ) recent announcement that the company acquired a 9.9% stake in Canada-based Canopy Growth (OTCPK:TWMJF) is an interesting development. Canopy Growth is a provider of medicinal cannabis products. Constellation's relationship with Canopy is likely to help create a new line of products.

Since Constellation is a beverage company, it would be natural for these companies to work together to produce cannabis-infused beverages. Canopy would provide their marijuana-producing techniques, while Constellation focuses on incorporating the cannabis into a beverage.

The company indicated that they will only sell marijuana-based products in countries where it is fully legal at all government levels. Constellation is likely to roll out cannabis-based products in Canada, where the country plans on legalizing the possession of small quantities on July 1, 2018.

 

Constellation is likely to grow the cannabis-based business steadily over time. Canada looks like the starting point with legalization coming next year and since Canopy is located in the country. Canada can act as a testing ground for further expansion.

There are other countries that have legalized the use of cannabis where Constellation could market their marijuana-based products. For example, Colombia legalized the possession of up to 22 grams for personal use. It is also possible that Constellation could attempt to sell in the Netherlands, where up to 5 grams of cannabis possession is legal in coffee shops. The company could also market to: South Africa, Spain, and Uruguay, where possession is legal.

The United States represents a strong region of future growth potential if cannabis is legalized at the federal level. Constellation indicated that they won't attempt to sell cannabis-based products unless it is legal at all government levels. So, it would have to be legalized at the federal government level to see these products from Constellation in the United States.

Even without the United States, Constellation has 5 countries to market to in the near term. Others including the United States could be added if legalization occurs. In the meantime, Constellation will continue to market its alcohol-based products in the United States and in other countries where cannabis is not fully legalized.

Constellation's Valuation

Although Constellation [forward PE of 23] trades above the S&P 500 (SPY) [forward PE of 19], the stock is fairly valued as compared to the brewing and winery/distillers industries. Both industries are trading at about 23X next year's expected earnings.

Here's how some of the individual large-cap peers are valued:

Brown-Forman (NYSE:BF.A) (NYSE:BF.B), the producer of Jack Daniels beverages, is trading with a forward PE of 27. Anheuser Busch Inbev (BUD) is trading slightly above Constellation with a forward PE of 24. Diageo (DEO), the producer of Guinness, Baileys, Captain Morgan, etc. is trading with a forward PE of 19.5.

With Constellation trading at the industry average, I see the stock as fairly valued. From here, the stock should be able to grow about in-line with earnings growth. Constellation is expected to grow earnings at nearly 24% in FY18 and 10% in FY19. However, a new beverage on the market in FY19, could cause the estimate of 10% EPS growth to be revised higher. So, we'll have to see how things progress with the Canopy partnership.

Since the forward PE is based on the EPS estimate of $9.23 for FY19, the stock could be valued lower than what the current forward PE is showing. The reason for that is because there could be EPS revisions for FY19 in the future when there is more clarity on when the new cannabis beverages will hit the market and how well they sell. This is something that most investors might not be seeing.

The United States represents a strong region of future growth potential if cannabis is legalized at the federal level. Constellation indicated that they won't attempt to sell cannabis-based products unless it is legal at all government levels. So, it would have to be legalized at the federal government level to see these products from Constellation in the United States.

Even without the United States, Constellation has 5 countries to market to in the near term. Others including the United States could be added if legalization occurs. In the meantime, Constellation will continue to market its alcohol-based products in the United States and in other countries where cannabis is not fully legalized.

Outlook for Constellation

I think the company made a wise strategic move to purchase a stake in Canopy to explore cannabis-based products. Cannabis-based beverages could be a key new source of growth for Constellation for many years. Constellation has Canada as a region to begin selling a new cannabis-based beverage.

The company can grow into other countries where cannabis is already legalized.

Further growth may occur if additional countries such as the United States legalize the use of cannabis at the federal level. It is estimated that the marijuana industry could be bigger than the NFL in terms of annual revenue if it was legalized at the federal level. The unregulated cannabis industry is estimated to be worth $100 to $200 billion, while the NFL made $9 billion in revenue in 2016. So, you can see the total market sales potential if it was legalized at the federal level. The legal cannabis industry is already worth $8 billion to $10 billion, about on par with NFL revenue.

Constellation is likely to benefit from the Canadian market, where legalization begins July 1, 2018. The estimated market size in Canada for cannabis is $22.6 billion according to Deloitte. 

If Constellation captures just a half a percent of that with cannabis-infused drinks, they could make $113 million (1.5% of expected FY19 revenue). So, that would be a good starting point, which can be scaled up as the company expands into legalized countries and as legalization continues to grow in other countries.

I expect Constellation to get a cannabis-based product to the market within FY19. The company has expertise in producing beverages. They just need to develop a new formula incorporating cannabis.

Sales of a new cannabis-based product is not priced into current earnings estimates of 10% growth for FY19. Therefore, I would expect a new exciting product such as a cannabis-infused drink to lead to positive earnings revisions for FY19. As a result, the stock is likely to outperform the S&P 500, which is expected to grow earnings at about 10% next year.