Constellation Brands (STZ) stock price weakness is a function of the downdraft in the general market, cessation of its buyback program and the devastation taking place in the cannabis sector. STZ’s stock price could come under even more downward pressure when it reports its Q3 results in a few weeks. STZ is likely to report a significant loss for its Q3 ended November 30, 2018 primarily because of the decline in the market price of Canopy Growth (CGC) stock.
History of Constellation Brands Investment in Canopy Growth
Constellation Brands (STZ) made an initial $191.3 million investment in Canopy Growth Corporation (CGC) in November 2017 by purchasing 18,876,901 shares at $12.9783 per share. At that time it also received options to acquire an additional 18,876,901 shares at the same price exercisable in two equal tranches on August 1, 2018 and August 1, 2019.
On June 20, 2018 STZ injected additional funds into CGC by purchasing $200 million of the $600 million in 4.25% Convertible Senior Notes due 2023 that were issued by Canopy. These notes can be converted into CGC common stock at the ratio of 23.7431 shares per $1,000 in par value.
On November 1, 2018 STZ acquired an additional 104,500,000 newly issued common shares of CGC plus warrants to purchase 139,745,453 common shares for an aggregate purchase price of approximately $4 billion or $38.40 per common share. The warrants are divided into 88,472,861 Tranche A Warrants that are immediately exercisable at a price of $39.70 and 51,272,592 Tranche B Warrants that are exercisable at a price equal to its 5 day volume weighted average price (VWAP) immediately prior to exercise. The Tranche B warrants can only be converted into common shares after all the Tranche A Warrants have been exercised. All these CGC Warrants expire on November 1, 2021. If Constellation exercised all its options and warrants it would own more than 50% of Canopy Growth.
The $4 billion investment by Constellation is viewed by some as an “all-in bet,” since on August 31, 2018 STZ was showing only $206 million in cash and equivalents on its balance sheet. It financed this purchase entirely with borrowed money as follows: (1) $350 million Commercial Paper, (2) $500 million 3-year term loan, (3) $1 billion 5-year term loan, (4) $650 million Senior Floating Rate Notes at 3 month LIBOR + 70 basis points due November 15, 2021, (5) $500 million 4.4% Senior Notes due November 15, 2025, (6) $500 million 4.65% Senior Notes due November 15, 2028, (7) $500 million 5.25% Senior Notes due November 15, 2048. These borrowings caused Constellation’s debt to equity ratio to rise from 86% to 120%. The current weighted average rate of this $4 billion is about 4.8% which equates to annual interest payments of $192 million or $16 million per month.
Per FASB rules, STZ accounts for its investments in CGC on its income statement by recognizing any increase in market value of CGC as “income from unconsolidated investments.” STZ arrives at market value by multiplying the closing price of CGC stock by the number of shares it owns and adding to that the theoretical, intrinsic value of its options and warrants calculated by applying the Black-Scholes Model. Changes in the recognized value of CGC, net of taxes, flow through to STZ’s equity.
From the date of its original investment through August 31, 2018, STZ recognized $1.361 billion in unrealized income from its investments in CGC by recognizing $464.3 million in income for its 2018 fiscal year ended February 28, 2018 and an additional $896.9 million for the six months ended August 31, 2018. This significant unrealized income occurred because the price of CGC rose above STZ’s cost basis and/or above the value recorded in the prior quarter. On February 28, 2018 CGC closed at $21.32 and on August 31, 2018 it closed at $45.72. The latter price was above the prices STZ paid for any of its CGC common shares and the options and warrants exercise prices.
Given the above information, STZ is about to report sharply negative results for its fiscal 2019 Q3 ended November 30, 2018. The market value of its 18,876,901 CGC shares will decline by $12.17/share ($45.72-$33.55) or $229,731,885, while the market value of its 104,500,000 shares will decline by $4.73/share ($38.28-$33.55) or $494,285,000. These two investments alone should therefore show a combined “loss from unconsolidated investments” of $724,016,885. Application of the Black-Scholes Model will also cause significant losses on the outstanding options and warrants, because they will not be as potentially lucrative. Additionally, as previously stated, Constellation will incur a significant increase in interest expense of about $16 million.
At best, Constellation will report that it broke even in Q3. It is more likely that they will report a loss of about $1 per diluted share on 190 million shares. The recent weakness in Constellation and Canopy stocks suggest that Q3 results may already be reflected in their stock prices. Going forward investors will need to be pay attention to STZ beer, wine and spirits business as well as Canopy Growth’s business since both can dramatically affect reported earnings.
Constellation’s highly regarded management realized that earnings would become volatile as a result of the Canopy investment. In the 10-K for 2018 they downplayed the $464.3 million reported in “income from unconsolidated investments” and stated, ““We expect the fair value of these investments to continue to be volatile in future periods.”
Investors should expect STZ management to focus their remarks on operating earnings as a truer measure of how well Constellation is performing. In effect, they will take a page out of Warren Buffett’s playbook, because he has faced the same problem for the past few years and has told people to ignore Berkshire’s gains and losses from unconsolidated investments.
Constellation, however, does not have the diversified investment portfolio of Berkshire. Instead, it has leveraged its balance sheet and concentrated its investment to gain effective control of the leading company in an emerging sector that is viewed as a direct threat to its beer, wine and spirits business.
The wisdom of Constellation’s aggressive move into the cannabis sector will depend on Canopy Growth becoming a consistently profitable company with positive, free cash flow in the next 12 months. This will be a challenge, because for the 9 months ended September 30, 2018 Canopy reported a net loss of about $350 million and, coincidently, negative cash flow (excluding financing) of about $350 million.
Disclosure: I am/we are long CGC. 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.