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Canopy Growth Is the Gold Standard in Cannabis

Canopy Growth (NYSE:CGC) stock is down 28% in the past three months, significantly underperforming the overall S&P 500. The most recent negative cannabis headlines include worse-than-expected first-quarter numbers from Tilray (NASDAQ:TLRY) and news of two more executive departures at Canopy.

The More CGC Stock Flounders, the Less Constellation Can Handle It
Source: Shutterstock

I honestly have no idea if Canopy’s business will get better, worse or stay the same over the next few months. However, I don’t see any indication that Canopy’s long-term outlook has fundamentally changed in the past three months. The near term will likely be challenging for Canopy, the cannabis space and the entire S&P 500. But Canopy remains the top dog among legal Canadian cannabis producers.

Warrants Executed

In the past, I’ve argued that Canopy is a potential buyout target. Minority investor Constellation Brands (NYSE:STZ) has replaced Canopy’s CEO with its own former CFO. I suspected this transition may be part of Constellation’s long-term plan to clean up Canopy’s business and dress it up in anticipation of a full buyout sometime down the line. If Constellation wants its shareholders to approve a takeover, it needs Canopy’s business as efficient as ever.

The Covid-19 chaos may have deterred an outright Constellation buyout for now. But Constellation didn’t blink at exercising warrants worth approximately $173 million earlier this month. The warrants expanded Constellation’s ownership stake in Canopy to around 38.6%.

Cantor Fitzgerald analyst Pablo Zuanic says he wasn’t surprised by Constellation’s decision to exercise its warrants.

“We think STZ sees Canopy Growth at least as a strategic investment (this should be obvious, given senior leadership at Canopy has come from STZ), and not just as a financial investment,” Zuanic stated in a note to investors.

If Constellation didn’t see CGC stock as a strategic long-term investment, it had no obligation to exercise those warrants. Yet it chose to do so during the middle of one of the most uncertain times for its business in the past two decades. That decision speaks volumes about how Constellation views Canopy in the long term.

Why a Buyout May Be Off the Table

In other recent CGC stock news, the company made the decision last month to significantly cut international operations. The idea behind the cuts was seemingly to reduce cash burn and focus on its core North American business in the near term. I’m sure that decision came from the very top, former Constellation CFO and current Canopy CEO David Klein.

Morningstar analyst Kristoffer Inton says an international pullback makes perfect sense given Klein’s priorities.

“The decision to shutter some international developments fit his strategic effort to optimize the company’s cost structure and reduce its cash burn,” Kristoffer says.

He has a “buy” rating and $45 fair value estimate for CGC stock, suggesting roughly 200% upside from current levels.

Zuanic isn’t nearly as optimistic given his “neutral” rating and $17.71 price target. However, he says Constellation would likely love to completely buy out Canopy. Unfortunately, its hands may be tied due to the recent downturn. Zuanic estimates it would take about $3.7 billion for Constellation to buy the remaining shares of CGC stock.

Zuanic estimates Constellation will generate about $7 billion in free cash flow through 2023 but has committed $4.5 billion of that to shareholder returns. By 2023, he estimates Constellation’s net debt will be $8.5 billion.

“Other than raising new equity at some point and or breaking its commitment to return $4.5B to shareholders, STZ appears unlikely to buy [Canopy] in the coming years,” Zuanic says.

How to Play CGC Stock

Nobody saw this Covid-19 disruption coming. But cannabis investors should make peace with the fact that the next several years will likely be a lot like the past several years. Expect the unexpected. Expect volatility. Anticipate regulatory and political headline risk. Expect both negative and positive academic research data. Expect U.S. pharmaceutical companies to fight U.S. legalization as if their lives depend on it. Prepare for Wall Street upgrades and downgrades. But don’t lose sight of the long-term thesis for CGC stock.

At the end of the day, if you believe cannabis legalization and consumption is on the rise worldwide, CGC stock should be the first shares you buy. To me, the fact that CGC stock is down 66% from a year ago says more about how ridiculous near-term expectations were a year ago than it does about the long-term outlook for Canopy today.

Constellation just upped its ownership stake in the middle of the biggest economics crisis in at least the past decade. Constellation might even buy out Canopy completely if it had the means to do so. Until something changes, CGC stock is the gold standard in Canadian cannabis. If you’re bullish on cannabis in the long-term, you must be a Canopy bull as well.

Wayne Duggan has been a U.S. News & World Report Investing contributor since 2016 and is a staff writer at Benzinga, where he has written more than 7,000 articles. Mr. Duggan is the author of the book “Beating Wall Street With Common Sense,” which focuses on investing psychology and practical strategies to outperform the stock market. As of this writing, Wayne Duggan was long CGC stock.

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