CGC - Constellation Brands: The Uncertain Road Ahead After Failed Diversification In Cannabis

2024-01-08 21:52:36 ET

Summary

• Constellation Brands' bet in the cannabis industry has not paid off, leading to uncertain future growth.
• The company's investment in Canopy Growth Corporation has resulted in a significant loss of value.
• Constellation Brands' current valuation is expensive compared to peers in the alcohol sector and other slow-growing industries.

Known for its Corona brand, generating solid free cash flow at over $2 billion on an annual basis, Constellation Brands, Inc. (NYSE: STZ) is regarded as one of the largest players in the alcohol sector. However, Constellation Brands' bet in the cannabis industry didn't pay off to diversify itself from the alcohol sector. As a result, Constellation Brands' future growth trajectory is increasingly uncertain. The current valuation of $45 billion in market capitalization (28.75 times earnings) is quite expensive, especially comparing to companies such as British American Tobacco ("BAT"). BAT trades at 6.17 times earnings and has a more clear path to diversify its dependence on the tobacco sector through its partnership with Organigram. As a result, I recommend a "Hold" rating for Constellation Brands, which is consistent with Quant Rating.

Introduction

Constellation Brands was founded by Marvin Sands in 1945, mainly in the wine and spirits business. Prior to 2012, Constellation Brands was growing but remained a fairly small-sized business. Rob Sands, Marvin's son, became CEO at Constellation Brands in 2007. With his legal background and years of experience working at the family business, Rob was ready to start transforming Constellation Brands. At the time, Constellation Brands had a market capitalization of about $5 billion .

In June 2013, Constellation Brands completed a historical acquisition of Grupo Modelo's U.S. beer business from Anheuser-Busch InBev for approximately $4.75 billion, doubling its size. This deal provided Constellation Brands full ownership of the Piedras Negras brewery in Mexico and the exclusive rights to import, market, and sell Corona and the Modelo brands in the United States. From there on, carrying the growth trend in the beer sector, especially in the premium beer segment, Constellation Brands was on the run. Its market value went from $6 billion prior to the acquisition of Grupo Modelo to $49 billion at its peak in July 2023.

Investment in Canopy

However, while the $5 billion acquisition of Grupo Modelo paid off helping the business generate over $2 billion in operational cash flow every year, the $5 billion investment in Canopy Growth Corporation ("Canopy") performed terribly.

It was a bold and strategically sound move to diversify beyond the alcohol industry which is experiencing slower growth rate. It is forecasted that the alcohol industry will only grow at about 3.8% per year from 2024 to 2028. At the same time, the legal cannabis sector in North America alone is expected to grow at a rate of 15% per year. Specifically, to some extent, the rise of legal cannabis industry may directly lead to decline in alcohol consumption. An analysis estimated that each dollar of legal medical cannabis sold was associated with an average alcohol sales decrease of roughly $0.74 to $0.84. The analysis suggested that cannabis was an economic substitute for alcohol in Canada and that Canada's 2017–2018 alcohol sales were roughly 1.8% lower than they would have been without legal medical cannabis.

Similar to how British American Tobacco invested in Organigram to diversify beyond the stagnating tobacco industry, Constellation Brands made the bold move to invest in Canopy (initial ownership of 10%) in 2017, which at the time was the top cannabis producer in the world by a wide margin. Through follow-on investments, Constellation Brands in total held over 38% equity stake in Canopy and invested over $5 billion. This looked like a fantastic investment putting Constellation Brands on another fast track with another decade of hyper growth.

Canopy's Free Fall

At the peak, Canopy was trading at $511 per share in January 2021, which led Constellation Brands to value the equity stake in Canopy at around $3 billion. Since then, Canopy's share price has been free falling to $6.38 per share as of January 5, 2024, losing a whopping 99% of its value. From having $5 billion cash on hand, Canopy had to raise additional capital of $70 million in September 2023 to sustain itself. Several factors contributed to this such as:

• industry oversupply and overtaxation
• sustained competition of illicit market
• mismanagement and misallocation of capital
• lack of understanding of cannabis in terms of quality by management team

Unfortunately, this may not even be the end of the nightmare for Canopy. I will perform a more detailed analysis on Canopy at another time. In summary, Canopy is still not cash flow positive and is consuming almost $70 million in cash every quarter. As of September 30, 2023, Canopy had $270 million cash on hand, just enough to cover its operational cash flow need for the coming quarter and current liabilities. It is still quite far from when one can expect Canopy to be cash flow positive.

Effective May 31, 2023, Constellation Brands removed Canopy as a reporting segment. While Constellation Brands has reduced the value of its equity investment in Canopy, as of November 30, 2023, Constellation Brands still held a $70 million debt due from Canopy and held the Canopy equity investment at a value of $142 million based on Canopy's quoted share price on May 31, 2023. If Canopy is not able to turn around, the $70 million debt and $142 million equity investment are both at risk as well in the near future, which will reduce Constellation Brands' total assets by another $212 million wiping the increase in assets since February 28, 2023. As of January 5, 2024, Canopy's share price declined another 40% from $11.40 as of May 31, 2023 to $6.38 per share.

As a result, Canopy's performance may continue to impact negatively on Constellation Brands.

Q3 2024 Financial Update (Earnings Released On January 5, 2024)

• Net sales increased by 1% compared to the same quarter in prior year mainly driven by the beer segment (4% growth in beer segment with 8% decline in the wine and spirits segment). This reflected again the slow growth rate in the alcohol sector, especially considering the inflationary environment we are in.
• Operating income increased by 7% compared to the same quarter in prior year, demonstrating the effectiveness of Constellation Brands' cost-saving initiatives. It is comforting to investors that the management team is actively seeking ways to manage through the challenging period.
• Net cash provided by operations for the nine months ended November 30, 2023, was $2.3 billion.
• Total assets increased to $25 billion as of November 30, 2023, from $24.7 billion as of February 28, 2023

Valuation

The current valuation of Constellation Brands is $45 billion in market capitalization (28.75 times earnings or 28 times cash flow from operations or 5 times equity). The valuation seems very rich even when compared to peers in the alcohol sector. For example, Diageo (DEO) only trades at a PE ratio of 17 as of January 5, 2024. When looking outside the alcohol sector, companies in other slow-growing sectors present an interesting picture. For example, British American Tobacco (NYSE: BTI) only trades at a PE ratio of 6.17 while it has a more clear path to diversify its dependence on the tobacco sector through its partnership with Organigram. As a result, I believe that Constellation Brands' value is close to 20 times earnings, which puts it at about $30 billion in market capitalization.

Other Risk Factor

Other than the risk mentioned above that Constellation Brands is in a slow-growing industry without a clear path of diversification, Constellation Brands has been facing another fierce issue. Constellation Brands' bright spot currently is the assets acquired from Grupo Modelo (the exclusive rights to import, market and distribute Corona and Modelo branded products in the U.S.). However, Anheuser-Busch InBev asserts that the exclusive right is only for beer, which doesn't include other similar products such as Hard Seltzer. The legal proceeding is still ongoing since 2021. Not only it causes Constellation Brands to incur expensive legal costs draining its resources against one of its largest competitors, it prevents Constellation Brands from capitalizing on the growth potential in products such as Hard Seltzer fully realizing the value of Corona and Modelo brands. In addition, while the lawsuit is only around Hard Seltzer and Modelo Ranch Water products, it is not impossible that the lawsuit may extend to other products such as non-alcoholic beer.

Forward Insights

Going forward, Constellation Brands may continue generating free cash flow but likely at a declining pace until it finds its way of diversification and clarity over Corona and Modelo brands. It is prudent for interested investors to closely monitor whether Canopy can turn around and become a contributor to Constellation Brands' bottom line in addition to providing the diversification Constellation Brands urgently needs. In addition, investors should pay close attention to the legal proceedings with Anheuser-Busch InBev and assess what is the growth potential of Constellation Brands' Corona and Modelo brands.

Conclusion

Despite its solid foundation in the alcohol industry with strong free cash flow generation and the well-known Corona brand, Constellation Brands faces a series of challenges that cloud its future growth trajectory. These challenges include the company's disappointing investment in Canopy, slow growth in beer, wine, and spirits segments, and an ongoing legal battle over its right to use the Corona and Modelo brand names for products like Hard Seltzer. With a market capitalization significantly higher than peers, the current valuation appears rich. As a result, Constellation Brands warrants a cautious "Hold" rating, reflecting the uncertainties ahead.

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