Constellation Brands is currently awaiting regulatory approval to increase its stake from ~10% to 38% in Canopy Growth, Canada's premier legal cannabis manufacturer.

Due to the uncertainty as to how this industry will evolve, I am reluctant to take a direct position in any cannabis producer. I do, however, wish to have some exposure to this industry to benefit from any potential upside. I have, therefore, decided to gain exposure through Constellation Brands by employing the use of a bullish option strategy.

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 15^th, 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 14^th. 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.

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