Part of cannabis and small business and retail
Top executives of Constellation Brands Inc., the U.S. maker of Corona beer and Robert Mondavi wine, gathered in early 2017 with a crucial objective: find the next big thing.
Constellation’s leadership team was looking for fresh ideas, so the executives brought in prominent futurist Faith Popcorn. She wasted little time. The marketing consultant, best known for identifying the massive shift in consumer behaviour that she dubbed “cocooning” – the trend that saw people opting to spend more time and money on home-based activities – told the Constellation bosses they would be “missing the boat” if they didn’t think about pot.
“’That’s going to be a very near-term major trend in the major markets,'” Bill Newlands, Constellation’s president and incoming chief executive, recalls Ms. Popcorn telling him and the other executives. “We kind of got our heads around the fact that she was right.”
For alcoholic-beverage companies such as Constellation, sales growth prospects don’t look great, industry analysts say. After years of moderate sales gains, the alcohol market in the United States is showing signs of slowing down.
For Constellation, the pot market seemed to open up opportunities beyond alcohol – in products such as cannabis-infused beverages and premium chocolates laced with weed.
The executives quickly assigned a team to study the cannabis sector and, soon afterward, hired management consultancy Bain & Co. to figure out the size of the business opportunity. Bain came back with a big number: US$200-billion globally within 15 years.
By October, 2017, Constellation announced it was investing $245-million in Canopy Growth Corp. – an almost 10-per-cent stake in the company, which is Canada’s top marijuana grower and one of the world’s largest. The purchase sparked a frenzy among investors, driving up the stock value of other cannabis firms as well. Less than a year later, Constellation upped the ante by pouring an eye-popping $5-billion into Canopy for 38 per cent of it – the single largest amount that a consumer products company has spent on a pot producer.
Predictions of how big the global weed market will become keep ballooning. Piper Jaffray analysts this month estimated it eventually could hit US$500-billion.
“Nobody knows the exact answer other than it’s going to be big,” Mr. Newlands says. “What we realized was the most efficient and effective way to win was to put everything behind Canopy.”
But Constellation’s leap of faith on an unproven sector has raised an array of questions among investors and industry watchers, fuelling uncertainty about the Canopy deal.
The investment establishes Constellation as a trailblazer in the nascent sector, but it also means the company will be among the first to have to untangle a web of industry regulations, many of which haven’t yet been tested. It also faces competition from other packaged-goods heavyweights that could jump into the cannabis fray – and shave profits – in a sector that is still illegal at the federal level in the crucial U.S. market.
Constellation shares have dropped about 25 per cent since the $5-billion Canopy deal was announced last August. On Jan. 9, investors got a shock when the alcoholic-beverages giant cut its profit forecast for the current fiscal year, partly due to the expected interest costs of about US$55-million tied to the Canopy transaction. Canopy would contribute to Constellation’s bottom line, company representatives assured investors, but not until fiscal 2021.
Some observers remain skeptical. “Quite simply, I think it was a bad move,” says Caroline Levy, an analyst at Macquarie Capital in New York. “They paid way too much money in an industry that’s going to be very competitive in the foreseeable future.”
“It’s a risky bet they’ve made, and I’m not sure they’re going to get financial returns from it,” adds Brian Madden, senior vice-president at Goodreid Investment Counsel, which has passed on investing in Constellation on behalf of Goodreid’s wealthy clients. “It’s not just a minor diversification – it’s a big bet they’ve made. I’d be wary of it.”
Others are taking a more cautious approach, dipping their toes in the water rather than committing resources on the scale Constellation has. Altria Group Inc. of Marlboro cigarette fame announced last month it is spending US$1.8-billion for a 45-per-cent stake in leading Canadian cannabis company Cronos Group Inc., while beer titan Anheuser-Busch InBev SA/NV paid US$100-million to set up a joint venture with pot producer Tilray Inc. of Nanaimo, B.C. Other consumer-goods companies, such as Coca-Cola Co., are doing their homework but, for now, staying on the sidelines.
Mr. Newlands, an alcoholic-beverage industry veteran who joined Constellation in 2015, doesn’t waver about the potential of the weed business or Canopy. “Our view going in after our assessment was that Canopy was the best player. They had the best management, best science, largest market share and a strong management team."
“There were going to be some constraints in the near term around legalities,” he says, adding: “You don’t often see businesses that are in their early stages that people view as being 200 [billion dollars] or 500 [billion dollars] or whatever number you choose. This is truly a unique scenario that most of us won’t see in our lifetimes.”
Meeting of the minds
Canopy co-CEO Bruce Linton had been quietly searching for a major alcoholic-beverage player to team up with in 2016 – and had already been flatly rejected by one of those companies, he says, declining to name it.
He remembers reading that November that Constellation CEO Rob Sands was thinking about the company getting involved in marijuana. Mr. Linton reached out on LinkedIn to a Constellation business development official, who has since moved over to Canopy’s team. By the time Constellation started to seriously study the sector in 2017, Mr. Linton had already connected with some of the beverage company’s employees.
When he finally met Mr. Sands, Mr. Linton and his team had been working for a couple of years on a cannabis-laced beverage, he says. “We didn’t disclose that in the process of trying to create the relationship because in the event that we didn’t have the relationship, it wouldn’t have been very good to tell them what we had.”
Still, the Constellation executives liked what they did hear. While it is a leader in the alcoholic-beverage industry, with more than US$6-billion in annual sales, Constellation’s performance has been fairly volatile, driven by inconsistent sales and profit growth, says analyst Wendy Nicholson at Citigroup in New York.
The volatility reflects the effects of multiple acquisitions, divestitures and restructurings over the years, she says. For example, in 2006 Constellation took over Vincor International, Canada’s largest wine producer, whose brands included Jackson-Triggs and Inniskilin, but a decade later sold the division to the Ontario Teachers' Pension Plan in a bid to focus on upscale, higher-margin products. In 2013, it acquired the coveted Modelo and Corona beers in another deal.
But that industry faces slowing growth in the United States, with the beer category suffering the most (although beer remains a healthy part of Constellation’s business). Over all, U.S. sales of alcoholic drinks are expected to pick up just 0.3 per cent annually from 2017 to 2022, reaching 30.9 billion litres – just half the 0.6-per-cent annual lift from 2012 to 2017, according to researcher Euromonitor International.
Constellation generally has outperformed the market, helped by its strategy of concentrating on faster-growing premium brands. But its wine and spirits division has been pinched by weakness in its lower-end lines, which the company is trying to sell. To accelerate the turnaround, Mr. Newlands has personally stepped in to temporarily head that division. And while its beer business is doing well, that industry category as a whole is under pressure. “If demand in [Constellation’s] beer business slows at all, we believe questions on the need for the Canopy investment will come more in focus,” warns Bill Chappell, an analyst at SunTrust Robinson Humphrey in Atlanta, Ga.
Still, Mr. Newlands says Constellation is embarking on its cannabis strategy to find ways to boost revenues, not to replace declining sales in its core business. Analysts point to the threat of cannabis sales eventually swallowing some alcoholic-beverage business. But Mr. Newlands says that even in U.S. states where marijuana is legal, Constellation has seen no drop in sales.
Nevertheless, if at some point its alcoholic-drinks business is squeezed by that of marijuana, the company will be able to capitalize on its Canopy investment, he adds.
Industry watchers agree, saying the Canopy stake is a hedge against an increasingly sluggish beer, wine and spirits market. Mr. Newlands is “investing as if he’s trying to react to the risk that exists to his business,” says Michael Lavery, an analyst at Piper Jaffray.
When it closed its initial deal for a 10-per-cent stake in Canopy in November, 2017, Constellation set up a test lab – dubbed Greenstar – in a historic building in Toronto’s trendy east-end Distillery District to develop cannabis-infused beverages with Canopy. Those drinks and other edibles are expected to be legal in Canada by this fall.
And there’s a lot of room for improvement: Most of the existing beverage products in the market are “terrible,” Mr. Linton says, and have fared poorly. They’re typically opaque and brightly hued, take at least 40 minutes to have an effect on drinkers and can “ruin” them for four hours, he says.
One of Canopy’s beverages is called Tweed & Tonic, a nod to the Tweed brand that Canopy has established for its stores and products. The beverage contains a much lower dose of cannabis than others on the market – two to 2.5 milligrams, compared with 10 mg – Mr. Linton says, but it takes just seven to 12 minutes for drinkers to feel the “onset” of the high. The Canopy product is a clear liquid that comes in lemon and other flavours and has zero calories, making it an attractive alternative to alcohol, he says.
Greenstar studied branding opportunities, taste and texture possibilities and consumer attitudes on weed, Mr. Newlands says. “Like in any sort of new product development, one of the things the consumer worries about is: ‘What is it? How do I know what it is? What kind of expectation do I have when I take it? What’s the response that I would get?' This is where brands and trust and authenticity become critical elements.”
Consumers also crave consistency of flavour and intensity in their cannabis products, company research found. To help in this critical area, Constellation sent Greenstar its expert from its sensory lab, who had worked for years on the taste profile of alcoholic drinks. “This is some of the capabilities that we can help Canopy with,” Mr. Newlands says.
For instance, cannabis can be bitter, so Greenstar worked on minimizing that taste, he says. Constellation also brought its analytics, product development, marketing and branding know-how to the team and went so far as nailing trademarks for some new products.
Branding will become increasingly important in the pot sector as the price of weed declines, shifting the spotlight to higher-margin cannabis-laced edibles such as energy drinks and chocolates, observers say. Six out of 10 cannabis customers will likely consume edibles, a 2018 Deloitte study predicts.
Greenstar operated for a year but, by last November, Constellation shifted the work to Canopy in a bid to step up collaboration between the two companies, Mr. Newlands says. The team moved to bigger offices above a store in Toronto’s hip Queen Street West area, although even that space is now getting crowded, Mr. Linton says. “Greenstar was the first phase of the rocket,” he says, adding it put Constellation “right in the game … it enabled them to get much more comfortable with the topic.”
As Mr. Newlands puts it, ConstelIation’s 10-per-cent stake in Canopy “was a little getting-to-know-you time, if you will,” giving the Victor, N.Y.-based company the confidence to raise its holding.
Meanwhile, Canopy is gearing up for its foray into the cannabis drink market. It’s building a bottling plant at its head office in Smiths Falls, Ont., the site of a former Hershey’s chocolate factory. Last fall, it installed new equipment and moved in chocolate-maker Hummingbird, which will produce its premium products there – without cannabis but with Tweed stamped on them. The initiative is helping lure more people to tour the Canopy property, raising the cannabis grower’s profile and trumpeting its name, Mr. Linton says. Eventually Canopy plans to take back the space and produce its own cannabis-infused chocolate, he says.
Once other markets approve the sale of cannabis-infused beverages, Constellation could help distribute them for Canopy, he says. “What we invent and create in Canada probably will work in other jurisdictions if and when we can sell it there.”
Constellation today is a far cry from its humble beginnings in 1945 as a bulk-wine seller to bottlers, founded by 21-year-old Marvin Sands in upstate New York. Over the years, he broadened the distribution, introduced his own Richard’s Wild Irish Rose label and, by 1973, took the company public as Canandaigua Wine Co. Inc., growing by acquisitions.
By the time his son Richard became CEO seven years later, the company had expanded into imported beers and spirits through more takeovers. Canandaigua moved into premium wines in 1999, changing its name to Constellation a year later to reflect its wider array of products. Richard’s brother Rob stepped in as CEO in 2007, but will soon hand the torch to Mr. Newlands, the first outsider to take the helm.
When Constellation’s executives invited Ms. Popcorn to speak to them two years ago, they were looking for inspiration from the “outside-the-box thinker,” Mr. Newlands says. They initially were reflecting on what they should be doing to shore up their alcoholic-beverage business but perked up when the conversation turned to cannabis.
“Our group collectively, our CEO Rob Sands, was very active in giving this consideration,” Mr. Newlands says. “The consumer sentiment was going very directly to legalization of marijuana and all the components thereof.”
Ms. Popcorn views it as an investment in the future, calling it in an e-mail “one of the biggest movements of our time.”
“It’s clear that marijuana, once legalized, is positioned to be a disruptor," she wrote in industry publication Food and Drink about a year ago. “Millennials would rather smoke weed than down a brew and we expect Generation Z to stay on that preference path.”
Established companies have the advantage of basking in a halo of trustworthiness to counter any stigma that may still be tied to weed, she says. But she also acknowledges that corporate early adopters could face massive pushback. “It’s going to take vision and guts," she says. “Now is the time to act.”
Spiros Malandrakis, head of alcoholic drinks research at Euromonitor in London, says it would be “extremely risky” for Constellation or any of its rivals not to embark on a cannabis strategy. “Yes it is a big gamble, but the downside risk of not getting into it is far too big to ignore.”
He compares it to the big beer companies missing out on the craft brewing wave a decade ago and then jumping on the bandwagon late in the game. “That was a huge mistake.”
The rising demand from millennials and Generation Z for low- and non-alcoholic drinks – and alcoholic-beverage companies responding by producing more of those beverages – is a signal of the shifting tides, he says. It’s a clue that cannabis-infused drinks will be embraced by a younger demographic as an alternative to alcoholic beverages, he says.
"I would be far more worried if I were a long-term investor if one of the major companies had decided to just ignore the issue,” he says. “For short-term investors and their shares, I’m sure there will be much more volatility to come, because this is all new. It’s going to continue to be a roller coaster.”
John Anderson, portfolio manager for Franklin Equity Group in San Mateo, Calif., which holds more than a million Constellation shares, has confidence in the company’s long-term cannabis play – although he recognizes the short-term hurdles.
“The core business is operating well – it’s operating better than almost any other consumer-product-type business,” Mr. Anderson says. “It’s not something we want to dump at this point at least.”
Still, concerns about Constellation’s big bet persist. Investors have a hard time evaluating whether it overpaid for Canopy, Mr. Anderson says. “The stock has been punished because of the deal.”
Other uncertainties linger. In Canada, pot stores have been forced to close temporarily after Ottawa legalized recreational marijuana in October because of product shortages.
In the key Ontario market, only 25 licences are being issued through a lottery for April 1 openings. So far, Canopy’s Tweed stores seem to be shut out along with many others. The province allows licensed producers to have a single store, according to Canopy’s interpretation of the rules, a spokesman says.
Cannabis regulations severely restrict marketing and brand promotions, limiting companies’ ability to promote their products. A web of rules also slows down licence approvals for everything from production to retailing. (Even so, alcoholic-beverage companies such as Constellation are adept at working with regulators and familiar with those challenges.)
In the United States, cannabis remains illegal under federal law, even though 10 states have permitted recreational pot. Meanwhile, it takes time to get grower licences state by state, says Macquarie’s Ms. Levy. She foresees few barriers to entering the cannabis field and rising competition from players in the soft drink, alcohol, tobacco and pharmaceutical fields – all of whom also have deep pockets and marketing prowess, she says. “We see it taking many years and big investments before the brand leaders emerge,” she says.
AB InBev, for its part, has seen its shares in steady decline over the past several years amid slowing sales and changing consumer tastes. But the maker of Budweiser beer has much less at stake in its pot deal, having merely partnered with Tilray to research marijuana-infused drinks rather than investing in the cannabis firm.
Mr. Newlands agrees there are a lot of unknowns and uncertainties, but he is convinced that diving into the cannabis business is a once-in-a-lifetime opportunity.
Canopy is committed to reaching $1-billion in sales within 18 months, he notes. Once it performs to expectations, including generating operating profit margins on par with those of the better consumer-product companies – about 30 per cent of sales – the market will reward Constellation, he says.
Constellation effectively created “a war chest” for Canopy to build its global leadership position in cannabis “for a long time to come,” he says. Already it has used the proceeds to make acquisitions in strategic areas such as a research firm specializing in cannabidiol, or CBD, a non-psychoactive cannabis compound that has been touted as having significant medical benefits. U.S. legislative reforms last year legalized the production of industrial hemp, including CBD, a first step to opening the way for companies such as Constellation and Canopy to produce beverages and foods infused with CBD and flagged as wellness items.
By late 2021, Constellation has the option to raise its stake in Canopy to a majority position, although Mr. Newlands isn’t ready to make any further investments until the cannabis producer delivers on its commitments.
He’s a believer – but doesn’t have all the answers to how the cannabis market and laws will evolve and shift. “It’s tough to tell at this point,” he says.