Constellation Brands Must Exercise Warrants to Keep Canopy Growth Alive

Canopy Growth (NYSE:CGC) just received a lifeline from Constellation Brands (NYSE:STZ, NYSE:STZ.B). The latter company exercised some of its warrants to buy CGC stock at a discount from its present price.

CGC stock

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This both provided cash to Canopy Growth and increased Constellation Brands’ stake in CGC.

Constellation Brands raised its stake in Canopy Growth by 5.1% to 38.6%. It also provided 245 million CAD to Canopy. Given that Canopy is still burning cash, the investment helps alleviate the cash drain.

Cash Burn Issues Plague CGC Stock

For example, as of Dec. 31, 2019, Canopy Growth had 1.6 billion CAD in cash and 706 million CAD in marketable securities. This totals 2.3 billion CAD. Moreover, this represents just 29% of its market value.

The problem with Canopy is that it is still burning cash. Its cannabis and related product operations have still not turned cash-flow positive.

For example, on March 31, 2019, the company had 4.5 billion CAD in cash and securities. So, over the next three quarters, the company burned through 2.2 billion CAD in cash.

The company is expected to report its fiscal fourth-quarter earnings sometime by mid-June. I suspect it will show a higher cash burn than last quarter, when it burned 360 million CAD. I assume it will be between 500 million CAD and 600 million CAD.

That would lower the company’s liquidity to 1.8 billion CAD or so. Enter then Constellation Brands’ exercise of warrants for 245 million CAD. That increases the company’s liquidity to 2 billion CAD.

In other words, Canopy likely burnt through more than 2.5 billion CAD for the year ending March 31, 2020. But it has just 2 billion CAD left — or less than one year of liquidity.

All Is Not Lost for Canopy Growth

Canopy just launched its new cannabis-infused beverage line. This may help create extra demand for its products. But, don’t hold your breath. So far none of the cannabis companies that are public, especially the higher-priced stocks like Canopy, have figured out how to run their operations profitably.

Constellation Brands has the ability to infuse more cash into Canopy. It owns 139.745 million warrants to purchase CGC stock. The exercise of these warrants will provide additional cash for Canopy Growth.

Different Warrant Tranches

However, there is a problem with the warrants. The original announcement filed with the U.S. Securities and Exchange Commission indicates that there are two tranches of the warrants. The Tranche A warrants, comprising 88.5 million rights to buy shares, have an exercise price of 50.40 CAD per share.

This is significantly higher than the existing price of 24.04 CAD. So, these warrants are useless. Constellation Brands would never exercise them. It could just go in the stock market and buy those shares directly. It would cost Constellation Brands 2.1 billion CAD. But, again the problem is Canopy would not receive that money since the market proceeds would go to a public seller.

Now, the Tranche B warrants, comprising 51.3 million rights to buy CGC stock, are market-price based. The only requirement is that the exercise price is set at the “five-day volume weighted average trading price of the Common Shares on the TSX at the time of exercise.”

So, on May 1, Constellation Brands used up 18.9 million of these Tranche B warrants. The five-day weighted average price was 12.99 CAD per share. Therefore, that leaves another 32.4 million warrants it can use. At today’s price, these would provide Canopy another 778.8 million CAD.

Constellation’s Lifeline Has a Limit

The Tranche B warrants, if exercised, would raise Canopy’s cash balance to just 2.8 billion CAD. Remember above we estimated Canopy probably burnt through 2.5 billion CAD in the year?

Therefore, this additional 778.8 million CAD, if exercised and added to the 2 billion CAD cash at Canopy, would give it a little more than one year of liquidity.

I have thought about whether Constellation Brands would make this investment. If it is going to do so, it will wait for a bargain price. Somehow it paid just under 13 CAD per share, even though the market price is almost twice that today.

Constellation Brands seriously overpaid for its original investment in Canopy. On Nov. 1, 2018, it paid 5.1 billion CAD at a price of 48.60 CAD per share for 104.5 million shares. That investment is now worth less than half that amount, or 2.5 billion CAD.

So you can see adding on another 275 million CAD at 13 CAD per share helps reduce their average cost a bit. But will the company really exercise the remaining warrants and pay another 778.8 million?

The Bottom Line

One good thing for Canopy is that there is a time limit. Constellation Brands has until Nov. 1, 2021. That is when the warrants expire. If CGC stock will be higher before then, Constellation Brands may have to exercise those warrants within the next six-to-nine months.

However, I suspect the following is true: Canopy will probably have to start showing a pathway to positive free cash flow before Constellation Brands makes another investment.

As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide, which you can review here.

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