For years, marijuana has been Wall Street's hottest investment opportunity. Wall Street projections have suggested that worldwide weed sales could grow somewhere between fivefold and 18-fold over the next decade, with the loftiest estimate implying that $200 billion in annual global sales may be possible. These estimates, along with the sheer size of the black market, have proven to be more than enough to get investors, and cannabis companies, excited about the future.
Beginning in 2018, merger and acquisition (M&A) activity, and outside investment into the North American marijuana industry, really began to pick up. We started to see M&A deals among Canadian growers, followed by combinations of U.S.-focused multistate operators. We even had brand-name businesses drop quite a bit of green into the cannabis space.
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For example, in August 2018, Constellation Brands, the alcohol producer behind such names as Corona and Modelo, announced that it would be taking a $4 billion equity investment in Canopy Growth, the largest pot stock in the world. Then, in December 2018, tobacco giant Altria Group (MO 0.80%) announced plans to invest $1.8 billion into Cronos Group (CRON 0.20%).
Unfortunately, investments don't always pan out as planned, as Altria shareholders have found out in recent months.
An equity investment made sense for both companies
Altria and Cronos looked to have a good thing when Altria's equity investment closed in mid-March. When the deal finalized, Altria owned a 45% equity stake in Cronos Group, with the option of upping its stake by an additional 10 percentage points to 55% via warrants that were also granted. But what was important here is that each company gained access to what they sorely needed.
For Altria, this was an opportunity to reignite top-line growth. U.S. adult cigarette smoking rates hit an all-time low in 2017, according to data from the Centers for Disease Control and Prevention, and they're trending even lower. The dangers of smoking tobacco have caused consumers to rethink their nicotine consumption, with users choosing other options, such as vaping, over traditional tobacco cigarettes. That's a big problem for Altria, which has simply chosen to increase its prices at this point to combat the shipment volume slowdown.
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Altria's investment into Cronos was designed to give it access to the high-growth Canadian/North American cannabis market, and presumably allow it to aid Cronos in the rollout of vape products containing targeted cannabinoids. Investment firm Cowen Group predicted in March that vapes would be the top-selling cannabis derivative in the U.S. market, and would trail only dried cannabis flower in aggregate annual sales.
Then, there's Cronos Group, which desperately needed a cash infusion. Prior to the closing of the deal, Cronos had less than $25 million in cash left, yet had aggressive plans to enter the U.S. and other overseas markets, as well as the desire to expand inorganically. Altria made this possible by handing over $1.8 billion in cash in exchange for a 45% stake. Without this cash, Cronos' $300 million acquisition of Redwood Holdings, owner of the Lord Jones brand of cannabidiol-based beauty products, probably wouldn't have been possible.
Altria has lost quite a bit on its investment in Cronos
However, this investment hasn't exactly worked out for Altria -- at least not yet. Cronos' share price has tumbled by two-thirds since the equity investment was finalized. Based on the $1.8 billion Altria invested into Cronos, the company is currently sitting on a paper (unrealized) loss of $731 million, as of Nov. 25.
Regulatory and procedural issues in Canada have, by far, been the biggest issue for Cronos, along with the rest of its peers. Health Canada, which is tasked with overseeing the licensing process of the pot industry, has been exceptionally slow to approve growing and sales licenses.
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To add, select provinces have done a poor of job of approving licensed retailers. Ontario, for instance, has about one open dispensary for every 604,200 people in the province. That's insanely low, and it's effectively driven consumers to the black market, if they weren't already purchasing from illicit producers.
Both Health Canada's licensing backlog and the slow-stepped dispensary rollout in Ontario are fixable, but these issues will take numerous quarters to sort out. That's left the Canadian weed industry in a precarious situation, whereby some growers are contending with oversupply, yet the bulk of market demand still isn't being met by legal-channel product.
It also hasn't helped that Cronos Group continues to lose money on an operating basis, if fair-value adjustments on biological assets and derivative liability revaluations are stripped from the equation. Earnings actually matter now with pot stocks, and Cronos hasn't been able to step over the bar as of yet.
Crazy idea: Altria might just buy Cronos Group
Yet, in spite of Cronos Group's struggles, it might actually make sense for Altria to consider making a bid for the entire company. At this point, $1.25 billion in market cap is what Altria doesn't own of Cronos, which represents what Altria generates in levered free cash flow in two months. In other words, Altria has more than enough capital to throw at the wall to see what sticks.
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There's also little doubt that the marijuana industry has the potential to be huge many years down the line. The sheer dollar amount of sales being conducted in the black market each year serves as a reminder of just how big the legal pot market could be. With tobacco sales struggling, it only makes for Cronos Group to consider alternative vice products.
But the biggest dangling carrot of all might just be the ability to recoup a significant portion of its original equity investment. Think about this for a moment: Cronos Group still had $1.5 billion in cash, cash equivalents, and short-term investments, as of the end of the latest quarter. Even if Altria acquired the remaining shares of Cronos, based on its Nov. 25 closing price, at a 20% premium to the close, it would get the remaining shares for free given the $1.5 billion in cash currently sitting in the company's coffers.
The only question at this point is, does Altria want the hassle of owning a cannabis company? And that's an answer I don't have.
