Summary

  • Constellation Brands is awaiting regulatory approvals to increase its ownership in Canopy Growth to 38% from ~10% in an effort to capitalize on opportunities in the cannabis industry.
  • The cannabis industry is Canada is undergoing a significant transformation and other major liquor companies are / will enter this space.
  • I am reluctant to invest directly in Canadian cannabis companies as I do not know which companies will survive the inevitable market shake-out.
  • I have decided to employ the use of a bullish option strategy on a well established liquor company which generated ~$7.6B in revenue in fiscal 2018 in order to gain exposure to the cannabis industry.

NOTE: Constellation Brands has two classes of shares. This article refers solely to the Class A shares as the Class B shares are very thinly traded.

This option strategy means investors are employing the use of leverage, and therefore, it is not suitable for all investors.

Introduction

In my October 15, 2017 article I indicated I liked Constellation Brands’ (NYSE: STZ) long-term prospects but I was reluctant to initiate a position because I felt the stock was somewhat expensive.

Subsequent to that article, STZ’s stock price has experienced some volatility. Furthermore, it has certainly had its share of press coverage given its exposure to the cannabis industry through its investment in Canopy Growth (NYSE: CGC).

As recently as August 15th, STZ announced a significant expansion of its strategic partnership with CGC to position CGC as the global leader in cannabis production, branding, intellectual property and retailing. The $4B transaction is subject to customary closing conditions, including Canopy shareholder approval and applicable Canadian government and regulatory approvals, and is expected to close by the end of October 2018. In addition, STZ will also receive additional warrants of CGC that, if exercised, would provide for at least an additional CAD $4.5B to CGC.

News of this impending transaction has resulted in a ~$17 jump in CGC’s stock price subsequent to August 14th. STZ’s stock price, however, has pulled back ~$14 thus reducing some of the ‘frothiness’ in STZ’s stock.

I think this strategic partnership offers STZ significant growth potential but I honestly have no idea how the industry will shake out since there are other large players in the liquor industry (eg. Molson Coors Brewing Co.  (NYSE: TAP), Anheuser-Busch InBev SA/NV (NYSE: BUD), and Diageo (NYSE: DEO) who have either formed or are looking to form strategic partnerships with cannabis companies.

STZ has paid a ridiculously high multiple to increase its stake in CGC from just under 10% to 38%. This is attributed to expectations that marijuana sales will surge once cannabis is fully legalized in Canada.

In addition to not knowing which, and how many, other liquor companies will enter the cannabis industry, I am concerned we could initially see a marginal increase in usage but there will be a surge in the number of suppliers which may drive down cannabis prices (the old law of supply and demand story).

Furthermore, I think many investors are under the assumption that liquor companies will be able to begin selling cannabis infused liquor once it is legalized October 17, 2018. This is not the case as the impending legalization initially excludes cannabis infused liquor.

I am also skeptical that consumers will be able to differentiate between cannabis produced by CGC versus other suppliers.

I also recognize there are mid-term elections in the US in November and the outcome of the elections could result in increased market volatility.

There will be some shake out within this industry over the next several months / few years but I think STZ / CGC will end up being a formidable player. In my opinion, however, there are far too many uncertainties at this point in time for my liking and I would prefer to be cautious with any investment that is cannabis related. I do, however, I want the opportunity to participate in potential upside; I am of the opinion STZ will rise in value over the next few months.

Rather than purchase STZ shares outright thus requiring a significant cash outlay, I have decided to employ the use of options which allows me to gain exposure to STZ / cannabis without having to lay out a significant amount of cash up front.

There is certainly a downside risk to the strategy I have employed but I have calculated my risk of potential loss in a scenario where STZ’s shares tumble below its 52-week low of ~$195.96; I am prepared to accept the downside risk.

Business Overview

STZ was incorporated in December 1972 as the successor to a business founded in 1945. It is an international producer and marketer of beer, wine and spirits with operations in the U.S., Mexico, New Zealand, Italy, and Canada and it has in excess of 100 brands in its portfolio.

In the U.S., STZ is the largest multi-category supplier (beer, wine and spirits) of beverage alcohol, the 3rd largest beer company, and it is also one of the world’s leading premium wine companies.

There is certainly no denying that long-term STZ shareholders have been amply rewarded as evidenced by the following graphs.

STZ - 20 year return vs S&P500

Source: Tickertech

Additional information can be found here and in the Q1 FY2019 Investor Presentation. Pages 5 – 11 in the Q1 FY2019 presentation explains STZ’s rationale for investing in CGC and the global potential of the cannabis industry.

Q1 FY2019 Results and Outlook

STZ’s Q1 FY2019 results and outlook for the current fiscal year can be accessed here. Please note that these financial statements are as at May 31, 2018 which is prior to STZ’s additional multi-billion investment in CGC. Should all appropriate approvals be received and the additional CGC transaction close as anticipated by the end of October 2018, investors can expect the level of Goodwill and Intangible assets carried on STZ’s books as at the end of Q3 FY2019 to be considerably higher than that reported as at the end of Q1.

Credit Ratings 

STZ’s long-term unsecured credit rating was upgraded by Moody’s to Baa3 from Ba1 in January 2017 and its Baa3 rating was reaffirmed August 15, 2018. This rating is the lowest tier within the investment grade category.

S&P Global has accorded a BBB long-term unsecured credit rating as at April 2018. This rating is one notch higher than that accorded by Moody’s.

Both ratings are currently acceptable from my perspective.

Valuation

STZ’s current mean adjusted EPS estimate for FY2019 from 20 analysts is $9.46 with the low and high estimates being $8.93 and $9.94. At the time of my October 15, 2017 article, 19 analysts had a mean estimate of $9.23 for FY2019 with the low and high estimates being $8.25 and $9.67.

Using the current stock price of ~$207.50 and the mean EPS estimate of $9.46, we arrive at a forward adjusted PE of ~21.93 which is lower than PE levels in the mid and upper 20s reported in FY2014 – FY2018.

STZ’s current valuation appears to be reasonable from my perspective.

With cannabis slated to be legalized in Canada on October 17, 2018, it is highly likely CGC’s FY2019 results will be materially different from those reported for FY2018 (ie. CDN $78 million in annual revenue with a sizable net loss). I am of the opinion that the legalization of marijuana will have a material positive impact to CGC’s business (as well as STZ). The extent to which STZ’s earnings will be impacted and by when, however, are far too difficult for me to accurately predict.

I do not expect any material benefit from STZ’s investment in CGC to be reflected in STZ’s FYE2019 financial statements. Given that CGC will likely be in hyper-growth mode once cannabis is legalized in Canada, I strongly suspect free cash flow will be negative or negligible over the next few years.

Since there is considerable uncertainty surrounding STZ’s investment in CGC, I wish to restrict my initial investment and have employed the option strategy reflected below.

Dividends

STZ’s brief dividend history can be found here.

STZ’s quarterly dividend is insignificant from an overall investment perspective. The current $0.74/quarterly dividend ($2.96/year) provides a dividend yield of ~1.42% based on a ~$208 stock price.

Since I will not own the underlying security and will not collect any quarterly dividend I am dispensing with any further review on this matter.

Share Purchase

If I were to acquire 200 shares of STZ I would need to invest ~$208 x 200 = $41,600 (excludes fees). As an owner of the shares I would collect a quarterly dividend of $148.

Let’s see what happens when January 18, 2019 rolls around.

If I purchase 200 STZ shares @ ~$208 and STZ is trading at $210 then I am ahead $400 (($210 - $208) x 200 shares).

If I purchase 200 STZ shares @ ~$208 and STZ is trading at $190 then I am down $3,600 (($208 - $190) x 200 shares).

By owning the shares, I have not truly ‘lost’ any money unless I was to sell my shares at below my purchase price. The advantage of owning the shares outright is that I can afford to be patient and to hope my STZ shares eventually rise in value.

Option Strategy

This is the trade I have initiated.

Buy 2 January 18, 2019 $190 Call contracts @ $25.60/share = $5,120 outlay which means my breakeven price is $215.60 ($190 + $25.60).

If the shares were to plunge to $160 by expiry, for example, I would not exercise my option so I would just be out $5,120 whereas if I had purchased 200 shares at $208 I would be down $9,600 (($208 - $160)) x 200 shares).

Through the use of this option strategy, I can close out my position and recover a little bit of money if I think the shares are highly likely to trade below my breakeven come January 18, 2019.

Now, this is a Bullish option strategy so if the shares rise in value then I stand to benefit.

Let’s say the shares are trading above my $215.60 breakeven. I can decide whether I want to exercise my option and to acquire the shares. If the shares are trading at $220 I would buy 200 shares at $190 for a total of $38,000. I would add to this the cost of my options ($5,120) thus giving me a total cost of $43,120. The shares, however, are worth $44,000 ($220 x 200) for a gain of $880.

I shelled out $5,120 and am earning an $880 profit which is a ~17% return on my money over a 5 month period.

Final Thoughts

There are various bullish option strategies which can be employed in order to benefit from any potential upside to a particular investment. Investors should, however, be cognizant that the use of options means you do not own the underlying security so you do not have the luxury of being patient and waiting for a stock to bounce back where the stock price has gone against you; the expiration of time goes against option buyers whereas the expiration of time favors option sellers.

The reason I have decided to employ an option strategy with STZ is that there are so many uncertainties out there and the level of volatility with this stock is such that I am not prepared to commit a sizable amount of money. I am essentially committing a small amount in an effort to potentially benefit from the market euphoria surrounding the cannabis industry while limiting my downside.

As noted at the beginning of this article, this strategy is not suitable for all investors. In addition, your broker must approve you for options trading and there are various levels at which you can be approved. Depending on the level at which you are approved will determine what option strategies you can employ.

I hope you enjoyed this post and I wish you much success on your journey to financial freedom.

Thanks for reading!

Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected]

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I have purchased 2 STZ Call options expiring January 18, 2019.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.