3 Reasons Big Tobacco and Marijuana Partnerships Are Imminent

The green rush is in full force. Beginning in less than six weeks, recreational marijuana will be completely legal in Canada. Aside from Canada becoming the first developed country in the world, and second overall, to wave the proverbial green flag on adult-use weed, this move could also generate upwards of $5 billion in added annual revenue once the industry is running on all cylinders.

Dealmaking ramps up as legalization inches closer

Legalizing weed in our neighbor to the north has also spurred a lot of dealmaking activity both outside and within the cannabis industry. Within the industry, leading producer Aurora Cannabis, which is expected to yield 570,000 kilograms a year once fully operational, acquired CanniMed Therapeutics and Ontario-based MedReleaf for $852 million and approximately $2.5 billion, respectively.

But what's happening outside the industry is what has investors' full attention. Last month, we witnessed two major partnerships take place between Big Alcohol and the cannabis industry. On Aug. 1, Molson Coors Brewing announced the formation of a 57.5%-42.5% joint venture with HEXO Corp (previously known as Hydropothecary Corp) to develop nonalcoholic, cannabis-infused beverages. Interestingly enough, infused beverages won't be legal come Oct. 17, although Canada's Parliament is expected to discuss, and likely broaden, what forms of consumption are legal next year.

Making even bigger headlines was Constellation Brands' (NYSE: STZ) $3.8 billion equity investment in Canopy Growth Corp (NYSE: CGC) at a 51% premium to its prior-day closing price on Aug. 15. This was actually the third time the maker of the Corona and Modelo beer brands had invested in Canopy Growth. Aside from just product innovation, Constellation should be able to offer its marketing and international expansion expertise to Canopy Growth, while Canopy will be able to offer its insight into the cannabis industry to Constellation Brands.

A Big Tobacco-marijuana marriage appears inevitable

Though most investors have wondered what alcohol company could be next -- rumor has it that Diageo is looking for a cannabis partner -- they might be overlooking the next-most logical entrant into the cannabis space: Big Tobacco.

Here are three reasons a Big Tobacco-marijuana partnership appears inevitable.

1. Key tobacco metrics are declining in developed markets

The biggest impetus for Big Tobacco to seek out a partnership or investment opportunity with the marijuana industry is declining usage and shipment volume in developed markets. Within the U.S., the percentage of U.S. adults smoking cigarettes has declined from around 42% in the mid-1960s to just 15.5% as of 2016. The industry is also facing marketing, advertising, and branding restrictions in key developed markets around the globe.

For example, Altria (NYSE: MO), which is best known for its premium Marlboro brand in the U.S., reported a 6.3% sales decline in smokable products during the second quarter of 2018, as well as a 3.7% decline through the first half of the year. Overall, Altria's smokable domestic shipment volume wound up plunging 10.8%.

Meanwhile, Philip Morris International (NYSE: PM), which operates in more than 180 countries around the world, not including the U.S., saw its total cigarette shipment volume fall by 1.5% in the second quarter, and 3.3% through the first half of the year. In fact, with the exception of its Fortune and Dji Sam Soe brands, every other cigarette brand has delivered a volume decline during the first half of 2018.

2. Big Tobacco has more than enough capital to make a deal happen

Another good reason to believe a deal should happen between Big Tobacco and cannabis is that Big Tobacco has more than enough cash on hand, and operating cash flow, to make it happen.

Despite the fact that volume has been in constant decline for Altria and more recently Philip Morris, both tobacco companies offer incredible pricing power as a result of nicotine's addictive nature. For instance, even though Philip Morris experienced a 3.3% slide in cigarette shipments during the first half of the year, it still managed to grow revenue by 8.3%, if you exclude the benefit of currency movements. Being able to pass along price hikes to consumers has long been a means to higher sales and profitability for tobacco stocks.

But the thing is, Big Tobacco also needs to innovate and find new ways to grow. For as long as this investor can recall, Altria and Philip Morris have paid out enormous dividends to lure in long-term investors. Yet, these companies are still generating a lot of annual operating cash flow. Altria has averaged about $5 billion annually over the past five years, with Philip Morris generating closer to $8.5 billion over the same time frame. That's more than enough to divert some of this cash flow to an investment or joint venture in the cannabis industry.

3. It's a logical product evolution

Finally, Big Tobacco partnering with the marijuana industry would be a logical evolution of where the tobacco industry is already headed.

Earlier this decade, the introduction of electronic cigarettes were all the rage. More recently, heated tobacco units, such as Philip Morris' iQOS device, have been garnering attention. The point being that Big Tobacco has been working on ways to lessen its reliance on traditional dried tobacco for years, and what the cannabis industry is trying to accomplish would be complementary to the tobacco industry's goals.

For example, assuming the Canadian federal government approves new forms of consumption in 2019, beyond just dried cannabis and cannabis oils, vaporized cannabis cartridges could be used in existing devices that consumers have been using for vape products, or perhaps even with heated tobacco units. It would be a relatively seamless transition for both the tobacco and cannabis industries, and should be beneficial to both.

And the winner is...?

So, which lucky marijuana stock is going to snag a partnership with Big Tobacco? While no one knows the answer to that with any certainty, I'd surmise that Aphria (NASDAQOTH: APHQF) has the best shot for two reasons.

First, it's a matter of market and existing deals. Some of Aphria's peers, such as Canopy Growth, have already landed a major partnership. And while it's not out of the question that Canopy Growth finds new partners beyond Constellation Brands, it's going to be busy plotting with Constellation and expanding its international infrastructure to take on too much else.

Aphria, on the other hand, has no major partners as of yet and, unlike Aurora Cannabis, isn't going all in on the medical cannabis market, which should appeal to Big Tobacco. Also, with 255,000 kilograms of peak annual pot production and a sales pathway to a dozen countries, Aphria checks off a lot of boxes that would make it an attractive partner for Big Tobacco.

The second reason would be that Aphria already has vaporized cartridges with tetrahydrocannabinol (THC) of the sativa or indica variety, or a combination of THC and cannabidiol (CBD), on the market in Florida. There would be virtually no innovative lag time if Aphria were to partner with Big Tobacco.

In short, I'm counting on Big Tobacco to aggressively seek deals with cannabis companies (possibly Aphria) in the not-so-distant future.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of Molson Coors Brewing. The Motley Fool recommends Diageo. The Motley Fool has a disclosure policy.