The silver lining behind Canopy Growth’s October swoon

Cannabis leaves of a plant on a dark background

This article was originally published on Fool.com

Investor interest in marijuana stocks reached a fever pitch as summer turned to fall, and the Oct. 17 legalization of recreational marijuana in Canada was a milestone event for the budding cannabis industry. Yet in what many market watchers referred to as a sell-the-news event, marijuana stocks retreated in the last half of October, and Canopy Growth (NYSE:CGC) finished the month with losses of 19%.

For those who had hoped that Canopy Growth’s stock would be a straight-up pathway to riches, October’s performance for the cannabis leader brought a cold dose of realism to their dreams. Yet in one way, there’s a silver lining to Canopy’s swoon, as it’ll make sure that key investment partner Constellation Brands (NYSE:STZ) remains dedicated to fostering the cannabis company’s growth and aligns shareholders’ interests with its own.

Worker wearing Tweed uniform, gloves, and hairnet working on cannabis plant.

IMAGE SOURCE: CANOPY GROWTH.

Too far too fast

Constellation Brands has put more money into the marijuana industry than any other major mainstream company, supplementing a modest $190 million purchase of a 10% stake in the company in late 2017 with a massive investment of nearly $4 billion in August. Canopy investors at the time saw the move as reflecting the huge potential of the cannabis industry, and they were pleased that Constellation recognized its own ability to profit from Canopy’s growth. The marijuana company’s stock immediately roared higher, pushing out of the $20s to rise as high as the mid-$50s on several occasions in September and October.

However, the potential problem for new investors looking at paying those high prices for Canopy stock was that the structure of the Constellation investment created a potential conflict. In addition to paying 48.60 Canadian dollars per share for Canopy stock in August — roughly $37 per share in U.S. dollars — Constellation also got warrants to purchase additional shares of the marijuana company’s stock in the future. For the bulk of the warrants, Constellation got the right to pay CA$50.40 per share — or about US$38.50 — for up to 88.5 million additional shares of Canopy.

What that meant for investors was that as Canopy’s share price was soaring, the potential for future dilution was increasing. With the stock in the mid-$50s, would-be buyers had to deal with the prospect that Constellation would be able to pay roughly $16.50 per share less to take what would amount to a controlling stake in Canopy. And even though some of Constellation’s warrants were set to reflect the market price of the stock at the time it wanted to exercise them, the amount of dilution from the majority of Constellation’s warrants was an impediment.

A better place

Now, though, Canopy’s stock price aligns the interests of new shareholders with Constellation’s interests. At roughly $36.50 per share currently, Canopy’s stock price is low enough that it wouldn’t make sense for Constellation to exercise most of its warrants. Although that doesn’t eliminate the threat of potential future dilution, it does put those looking at Canopy stock for the first time on a more even footing with existing shareholders, including the beer giant.

Moreover, none of the decline in Canopy’s stock really came from any significant change in the company’s fundamental prospects. Canopy still has a commanding lead in cannabis production capacity, and it’s moving forward with plans to boost its output even further. The strength of the Tweed brand remains important for its long-term efforts to build market share, and exposure to international markets will make it easier for Canopy to take advantage of the trend toward legalization globally. As the market for cannabinoid-containing beverages keeps developing, opportunities for Constellation and Canopy to work together will likely broaden.

A price to keep in mind

Investors shouldn’t necessarily anchor on the exercise price of Constellation’s warrants as a firm line in the sand. The value of the warrants doesn’t go to zero just because the stock falls below the exercise price, as the three-year time span on the warrants gives Constellation the ability to profit from share-price gains even without directly owning shares.

However, for those looking at Canopy Growth stock for the first time, the fact that prices have fallen back to levels that Constellation contemplated as offering a reasonable opportunity for future investment is encouraging. Marijuana stock volatility isn’t likely to go away anytime soon, but smart investors interested in the space can take advantage of downward moves when they come to take a closer look at stocks like Canopy Growth.

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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool US recommends Constellation Brands. The Motley Fool has a disclosure policy.

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