Alcoholic beverage maker Constellation Brands (STZ) has landed in hot water resulting from its bet on Canopy Growth (CGC), with the news sending the cannabis stock’s shares down 2% in the last three days.
The trouble started on August 15 when CGC reported a C$1.28 billion loss in its first fiscal quarter of 2020 as well as missed analyst estimates for revenue. This was followed by STZ’s disclosure that it expects to see a $54.8 million loss in its second quarter as a result of its investment in the cannabis company.
Despite CGC’s record smashing sales, CEO Mark Zekulin doesn’t foresee a profit for the next three to five years. This is bad news for 36% stake holder Constellation, with its total investment in Canopy coming in at more than $4 billion.
Constellation made its first $195 million investment in Canopy back in 2017 as it wanted to take a piece of the growing recreational marijuana market. It then increased its stake with another $3.8 billion investment the following year.
While this is surely enough to ward off some potential investors, Credit Suisse’s Kaumil Gajrawala maintains that STZ’s growth narrative remains just as strong even with the expected loss. Since the news broke, shares are actually up 2%.
Let’s take a closer look to find out why this analyst is still picking STZ.
Constellation’s Core Business is Solid
Gajrawala tells investors to focus on Constellation’s strong core business as opposed to its exposure from CGC. He adds that his prediction for STZ’s upside potential is derived from its beer and wine operations only, with no equity value being given to Canopy.
While the company is expecting a loss ahead of its second quarter earnings release on August 31, it remains a key player in the space thanks to a diverse beer and wine product portfolio. Its net sales in its last quarter gained 2% year-over-year to $2.1 billion. Beer sales alone increased 7% thanks to the strength of its Corona and Modelo brands.
The analyst also likes Constellation’s new strategy that involves shifting away from its smaller brands and instead focusing on its premium products. As part of these efforts, STZ announced that it signed an agreement with Heaven Hill Brands to divest Black Velvet Canadian Whisky for $266 million on August 12.
The company’s cash flow is also expected to improve from the sale of more than 30 of its wine brands to the E. & J. Gallo wine family for $1.7 billion.
CGC is Planting Seeds for Future Growth
Several recent positive developments could go a long way in calming investors’ CGC fears.
In July, the company decided to part ways with co-CEO Bruce Linton, a decision that some analysts believe was manufactured by Constellation’s management. “We view this change as a positive for Constellation shareholders as Mr. Linton’s entrepreneurial spirit struggled to reconcile with the world of consumer packaged goods,” Gajrawala argues.
With the company already controlling about 30% of Canada’s adult recreational cannabis market, it has maintained a commitment to growing this figure even further. Management cites its continued investment in production, retail and brand development leading up to the launch of its edibles in late-fall as steps towards profitability.
Not to mention Canopy continues to invest heavily in expanding its reach internationally. “Internationally we are now executing on the infrastructure we have spent the last several years building, with just under 1,000 kg or kg equivalents of dried flower, oil and softgel products exported from Canada since April 1, and domestic, commercial production now underway in Germany (C3), Denmark (Spectrum Therapeutics) and the United States (CBD only),” CEO Mark Zekulin stated.
The two-star analyst points out that it still has some facilities under construction as well as infrastructure that isn’t fully operational which don’t generate revenue yet. However, this is expected to change once they become fully functioning.
Based on all of the above factors, Gajrawala kept his Buy rating and $230 price target on STZ on August 26.
The Bottom Line
All in all, Wall Street is cautiously optimistic about STZ. It has a ‘Moderate Buy’ analyst consensus and $229 average price target, indicating 13% upside potential.
The same can also be said about Canopy. 10 Buy ratings vs 6 Holds received over the last three months adds up to a ‘Moderate Buy’ analyst consensus. Its $42 average price target suggests impressive upside potential of 73%.
