Constellation Brands Is Still The Safest Play In The Cannabis Space
In my previous article (July 7th), I argued that the safest way to benefit from exposure to the cannabis industry is through Constellation Brands (NYSE:STZ). The three months since then have proved this argument pretty well. Canopy Growth’s (CGC) stock plummeted by more than 40%, while Constellation Brands’ stock held tight. Constellation’s stock has shown exceptional stability, especially in light of the volatile August we have been through, and despite the expected loss the company has warned about for its equity-method investment in Canopy.
Data by YCharts
Today I reiterate my argument; an indirect exposure to the cannabis sector through Constellation Brands is the safest way to play cannabis. The sentiment in the cannabis sector is particularly negative at the moment, and we will probably see a change only towards the end of this calendar year when the second wave of cannabis products will hit shelves in Canada.
Another Summer of Beer Growth Overshadows The Disappointing Wine & Spirits Performance
Not surprisingly, Constellation’s second quarter, which concludes its results for June, July and August, is historically the strongest quarter of its beer sales. It wasn’t an easy summer for the company, as the hard seltzer craze (which we’ll talk about later) has attracted Millennials and directed its competition against the Corona brand family. And yet, despite only a modest 2% increase in net sales this following quarter, the beer business posted an impressive net sales increase of 7.4%, a gross profit increase of 8.3% and an operating income increase of 8.7%, all YoY. Beer net sales accounted for 70% of the company’s total net sales, with the Modelo and Corona brand families the foundations of this business.
In contrast, the wine and spirits business continues to disappoint, with a third consecutive quarterly decrease in all operational metrics YoY – net sales (-8.9%), gross profit (-13.2%) and operating income (-20.3%). Just to understand how much the beer business is the main source of profit for Constellation right now, you can look at the operating margin trend of both segments in recent quarters:
Source: Author’s process of Constellation Brands’ Financial Reports
In the long term, especially after the sale of lower-margin, lower-growth wine and spirits brands, the company expects the wine and spirits business to produce mid-single-digit net sales growth while migrating to an operating margin of 30%.
The Modifications of The Canopy Investment Are Ugly, But You Should Take Them With a Grain of Salt
Constellation recognized an equity loss of $484.4 million for the period April 1, 2019, through June 30, 2019, in its consolidated financial statements for the three months ended August 31, 2019 (there is a two-month lag). The bad news didn’t stop there. Constellation recognized another staggering loss of $839.1 million due to fair value adjustments of its related securities, making it more than a $1.3 billion loss in one quarter, just from Canopy.
Source: Constellation Brands’ Q2 FY-2020 Financial Reports
This is really ugly, it is, but investors must differentiate between the two types of losses. The $484.4 million loss is an equity loss, which results from Canopy’s results of operation. We shall recall that Canopy lost about C$1.28 billion between April and June 2019, and this loss resulted from a one-time non-cash charge on extinguishment of warrant liability of C$1.18B.
The $839.1 million loss is an unrealized loss from changes in the fair value of the Canopy securities (that are not part of the equity investment). The fair value of those securities is derived from Canopy’s share price, and as we have seen, Canopy’s share price has been in a free-fall mode in recent months. Once the pendulum swings to the other side, Constellation will recognize unrealized gains, probably at the same magnitude.
Some of you will probably be surprised, but overall the investment in Canopy is still profitable for Constellation, with an unrealized net gain of $768.9 million since its first investment in November 2017.
Source: Author’s process of Constellation Brands’ Financial Reports
It’s Time To Storm The Hard Seltzers Category
Bill Newlands, The CEO of the Constellation, announced during the earnings call following the financial results that the company will finally enter the hard seltzers booming category next spring (emphasis added):
We are very excited to announce that our new seltzer launch planned for next spring will be the next big innovation for the Corona brand family. […] We believe that seltzers are here to stay and will therefore accelerate the volume shift into category from the low-end to the high-end, where we are the market share leader. Corona hard seltzer will be introduced in four flavors, including tropical lime, mango, cherry and blackberry lime. The brand will weigh in at 90 calories with the 4.5 ABV with zero carbs and zero sugars. […] I can assure you that this will be a superior product with superior margin and profitability structure versus other competitors in the marketplace. […] We think this product is going to be a demonstrable winner in the category or we wouldn’t have launched it
Hard seltzer, a flavored malt beverage (NASDAQ:FMB), was probably the unofficial drink of summer 2019 (despite the simplicity of the drink; bubbly water that also has alcohol in it). Its attributes – low-alcohol (4.5-6% ALC/VOL), low calories, gluten-free and cheap price – made it a popular staple among millennials. Sales of hard seltzers have grown 193% over the past year, with 164% of that growth occurring in July alone, according to Nielsen.
Source: Nielsen, May 2019
The hard seltzers category, currently worth $550 million, could reach $2.5 billion by 2021, according to a recent note by UBS. With a market forecast of such magnitude, Constellation just can’t behind. Currently, the dominant brand in the category, with a market share of more than 50%, is White Claw, which belongs to the private company Mark Anthony Group. To understand how dominant this brand is – at $212.1 million in dollar sales through June 23, White Claw has already surpassed its entire IRI sales from 2018 of $196.7 million, accounting for 55.5% of the dollar share for the week of the Fourth of July. The second dominant brand in the category is Truly, which belongs to the Boston Beer Company (SAM). The third dominant brand in the category, with a significantly smaller market share, is Bon & Viv, which was acquired in 2016 by Anheuser-Busch (BUD).
Source: Yahoo Finance
It’s worth mentioning that Constellation has already had a seltzer, called SVEDKA Spiked Premium Seltzer based on the famous vodka, but it didn’t resonate with consumers very well. According to David Klein, Constellation’s CFO, the brand proposition of this seltzer was just wrong.
In my previous article, I mentioned under the Ifka Mistabra (risks to consider) paragraph that it will be interesting to see how the Corona Refresca brand and the entire Corona family will compete with the hard seltzers, especially during the summer. The week of the Fourth of July gave us a great showcase for the competition between the Corona’s and the hard seltzers, and judging from Nielsen’s data, the hard seltzers seem to have got the upper hand (one should note Constellation’s Modelo Especial, which still gives a serious fight to the seltzers).
Nielsen’s list of top growth brands for the week of the Fourth of July, 2019:
Source: brewbound. ** the Cape Line beverage is branded as ‘sparkling cocktail’ and not as ‘hard seltzer’, but its ingredients list is about the same as the hard seltzer’s one.
Constellation’s seltzer is going to be slightly different from the existing ones and as it seems, has an advantage in every so-called “wellness criteria” that has made the seltzers so popular; less calories, less carbs, and less sugar.
| 12oz | Corona Hard Seltzer | White Claw | Truly | Bon & Viv |
| ABV | 4.5% | 5% | 5% | 4.5% |
| Calories | 90 | 100 | 100 | 90 |
| Carbs | 0g | 2g | 2g | 2g |
| Sugar | 0g | 2g | 1g | 0g |
Source: White Claw, Truly, Bon & Viv.
Another interesting development, starting this December, will occur when Canopy unveils its portfolio of value-added higher-margin products in various form factors, including drinks, edibles and bake. Will we finally see a beverage that is the result of a collaboration between Constellation and Canopy? Perhaps a clue could be found in an interview given by Canopy’s interim CEO Mark Zekulin to Jim Cramer’s Mad Money a few weeks ago (emphasis added):
Talking about the beverages is actually a perfect example of the collaboration we have with Constellation. You are right, seltzers are the biggest thing in the US right now, and you know, around the world. Stop and think about the cannabis beverage opportunity, we have an opportunity to create a precisely dosed product that gives people a reliable experience that we can relate to the experience they know with a seltzer or a beer or an alcoholic beverage. We can put it in, that form factor they are familiar with, and to your point, we can make it taste good and then we can take away some of the bad points alcohol; hangover, calories and all that kind of staff. This is an incredibly compelling opportunity and we are excited to to make that taste good, put a ‘TWEED’ brand on it and bring it to market.
Over 97% of Constellation’s revenue is generated within the United States, but the company also operates in Canada. In fiscal-year 2019 (ended February 28, 2019), approximately 2.7% of the company’s revenue was generated from what the company calls ‘Non-U.S. Region’, which is primarily Canada. In addition, the company has one distillery in Lethbridge, Alberta for the wine and spirits business. Constellation’s direct operation in Canada is pretty small, but in this way, it will have the opportunity, starting this December (when the second wave of cannabis products will hit shelves), to launch cannabis-based beverages in Canada and test their popularity among Canadian consumers.
First Share Buyback Since The Big Investment In Canopy
In January 2018, the company’s board of directors authorized a repurchase plan of up to $3 billion of shares. The last time the company repurchased its shares was in the summer of 2018, before of the leveraged investment in Canopy. Since then, the company has halted its repurchase program, but over the last quarter repurchased $50 million of its stock, at an average price of $188 a share. It’s a small amount, and the company still has about $2 billion left for buybacks according to its plan. David Klein, Constellation’s CFO, has addressed the buyback program during the latest earnings call as well (emphasis added):
We’ve reduced our net debt level by more than $650 million since the end of fiscal ‘19. This allowed us to opportunistically repurchase $50 million worth of stock during the quarter. In closing, I’d like to reiterate, we are committed to returning $4.5 billion to shareholders from fiscal ‘20 through fiscal ‘22. The share repurchases we’ve made during the quarter reflect the confidence we have in our long-term business model.
Constellation currently expects to close by the end of FY-2020 (which ends on February 28, 2020) the sale of lower-margin, lower-growth wine and spirits brands, plus the sale of its Black Velvet Canadian Whisky business. According to the company, the net cash proceeds from both sales (about $1.7 billion) will be used primarily to reduce debt, which currently stands at $12.9 billion (the first time since the big investment in Canopy that it’s below $13 billion). Reducing the debt will allow the company to reduce its leverage ratio (aiming to reach a leverage ratio of 3.5x) and eventually get back on track with its buybacks.
Conclusion
In recent months, thousands of cannabis investors have been left heartbroken. The vast majority of cannabis stocks will need to double in value before investors will break even. In such a volatile market that we are in at the moment, investors seem to be no longer pricing in cannabis dreams, they want to see results in the short term as well. Cannabis companies appear to be failing to deliver such results so quickly, as this is an industry that is still developing and building itself, and will therefore continue to burn cash (e.g. Canopy), dilute its investors (e.g. Aurora), or get into trouble with the regulators (e.g. CannTrust). In such times, the solid investor should play safe, and as I see it, the safest play in the cannabis industry right now, or the perfect “call option”, is through Constellation Brands. The company’s dominance in the beer business, which should be recession-proof, should the United States enter into one, and its experience with the regulators, might provide the safest play for investors who look for exposure in the cannabis space.
And if after my previous article someone has still not been convinced that Constellation is a safer play than Altria (MO) (which has 45% equity interest in Cronos), than I’m pretty sure the past two months have proved this point; without getting deep into Altria’s issues, I can say that Altria is being treated on Wall Street like it’s public enemy number one, and Constellation isn’t.
Data by YCharts
Ifka Mistabra – Risks To Consider
The source of the phrase “Ifka Mistabra” is in Aramaic, meaning “On the Contrary”. As for Constellation Brands, there are a number of risks that are important to consider:
- The ability of Canopy Growth to achieve its business objectives is contingent, in part, upon the legality of the cannabis industry. The laws and regulations governing medical and recreational cannabis are still developing, including in ways that Constellation Brands may not foresee. Any amendment to or replacement of existing laws to make them more onerous could have a material adverse effect on Canopy’s business, liquidity, financial condition and results of operations. Were that to occur, Constellation may not be able to recover the value of its investments in Canopy.
- The value of the warrants and the convertible debt Constellation holds in Canopy is subject to the volatility of the market price of Canopy’s common stock. This subjects Constellation’s financial results to volatility. That volatility may continue in the future and may also be subject to wide fluctuations in response to many factors beyond the control of Canopy, or of Constellation Brands.
- Market volatility is likely to continue in the coming months. The VIX Index seems like it wants to reach 20 more than 10, and we have a number of events that we don’t know to where will they lead the global economy and how will they end: Brexit, more China-US trade talks, more tariffs, and one ongoing fear from recession. Any of the aforementioned events, together and separately, can have an adverse effect on the stock market, and on Constellation Brands as well, without any exception. We all remember what happened in the fourth quarter of last year.
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Disclosure: I am/we are long STZ, CGC, MO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am also Long ACB, CTST.
Investors are required and expected to do their own due diligence and research prior to any investment. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions.
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