Is a Big Tobacco-Marijuana Marriage on the Horizon?

The marijuana industry has had a pretty big year, and everyone has taken notice.

Even though pot stocks haven't performed as well as they have in recent years, the cannabis industry gained something far more important in 2018: validation. On Oct. 17, Canada lifted its nine-decade prohibition of recreational marijuana and opened the door to legal adult-use sales. Taking into account that it'll take a few years for the industry to expand its production capacity and lay the foundation for its international sales channels, we're likely looking at $5 billion or more in added annual sales in Canada by sometime in the early part of the next decade.

This sales potential is what's driven marijuana stocks notably higher since 2016, and it's what's recently caught the attention of a number of brand-name companies.

Beverage companies are drunk on marijuana's growth prospects

In August, the beverage industry announced two big-time deals with marijuana stocks. It began on Aug. 1, which is when Molson Coors Brewing Co. (NYSE: TAP) announced a 57.5%-to-42.5% joint venture with HEXO Corp. that will see the duo develop cannabis-infused beverages. Interestingly enough, most alternative forms of consumption aren't currently legal in Canada, with the exception of cannabis oils. Molson Coors and HEXO expect that to change in the summer of 2019, with Canada's Parliament set to discuss and (hopefully) approve new consumption options, including infused beverages and edibles.

An even grander deal was struck two weeks later, when the maker of Modelo and Corona beer, Constellation Brands (NYSE: STZ), agreed to purchase 104.5 million shares of Canopy Growth's (NYSE: CGC) stock at a greater-than-50% premium to its prior-day closing price. When the $4 billion deal closed, Constellation had taken a 37% stake in Canopy Growth. This was actually Constellation's third such investment in Canopy Growth, and it can eventually up its stake in the company to more than 50%. That makes this "partnership" about way more than just developing infused beverages. It's about Constellation's belief that the marijuana industry is a valid business model that would nicely complement its existing beverage portfolio.

Now it would appear that big tobacco has its sights set on the pot industry.

Turning over a new leaf

For those who many not recall, the very first tobacco-cannabis deal occurred back in late June, when U.K.-based Imperial Brands, the company behind the Winston and Kool cigarette brands, announced that it had made an undisclosed investment in Oxford Cannabinoid Technologies, which is aiming to develop cannabinoid therapies to treat select ailments.

For all intents and purposes, this was a baby step compared to what Constellation did in mid-August. However, it would now appear that U.S.-based Altria Group (NYSE: MO), known best for its premium Marlboro brand, may be readying for a leap forward.

As reported by Reuters on Monday, Dec. 3, Altria is in early stage discussions with cannabis grower Cronos Group (NASDAQ: CRON) to potentially buy the company. Much like Constellation's equity investment, this wouldn't be about a simple product development partnership. Rather, we're looking at Altria giving real significance to the validity of the cannabis business model. Not to mention, with the percentage of adult smokers in the U.S. hitting an all-time low in 2017, according to the Centers for Disease Control and Prevention, Altria has been consistently fighting weaker cigarette shipment volume with higher prices. This is a battle that won't end well for the company over the long run if it doesn't find new sales channels and/or alternative products.

Why Cronos Group?

So, why Cronos Group? While it's expected to be a top-10 producer by annual yield, Cronos isn't likely to threaten the nation's big five or six producers, leaving it stuck as an important yet nonmajor player. This would make Cronos Group a logical acquisition target to begin with.

Cronos Group is also devoting quite a lot of time and money to diversify its sales channels beyond just dried cannabis flower, which has been commoditized in a handful of legalized U.S. states, and will likely face a similar future in Canada. Cronos' September-announced deal with Ginkgo Bioworks is a testament to this. Cronos will gain exclusive access to Ginkgo's platform to create custom microorganisms for synthesizing cannabinoids. Cronos plans to use this platform to target eight cannabinoids, some of which are rare, to produce them at commercial scale. In other words, Cronos has its fingers in some high-margin alternative projects that Altria would probably appreciate.

Of course, it's important to note that the current talks between Altria and Cronos Group are in the early stages, and there's no guarantee that it'll result in a deal, per Reuters. Discussions are expected to continue for at least the next couple of weeks.

Altria had previously been in discussion with Aphria to take a small equity investment in the company, but those talks never amounted to anything more than chatter. It's possible that happens here, too.

It would be a pricey deal

While it's never a good idea to buy into a stock solely because you expect it to be purchased, I'm especially leery of Cronos Group given its already lofty valuation of $1.8 billion at the close on Monday, and nearly $2 billion in after-hours trading.

The thing is, Cronos Group is unlikely to produce a meaningful per-share profit anytime soon due to a number of major expenditures. These include the company's joint venture project (Cronos GrowCo) that'll see an 850,000-square-foot grow facility constructed, the need to get sales channels in place in international markets, and the ongoing push to diversify away from dried cannabis. When these higher costs are combined with Cronos' rising outstanding share count -- the result of a few bought-deal offerings -- it becomes apparent that this company will struggle to generate meaningful per-share profits.

At a $1.8 billion to $2 billion valuation, it could be a tough pill for any tobacco stock to swallow -- even one generating as much cash flow as Altria.

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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 Constellation Brands and Hexo. The Motley Fool has a disclosure policy.