We’re going to crack the code about the warrant situation between Canopy Growth and Constellation Brands…

The latest earnings report from Canopy Growth Corp. (NYSE: CGC) did not inspire confidence.

It wasn’t as bad as most people believed, but there were some issues that could have been addressed better.

There were some strategic mishaps, and executives running the show could have taken more responsibility for what went wrong.

In fact, one of our members had a comment about that.

Aimee S. said: “Growing pains for companies like Canopy are not unusual. What bothers me is that it did not take responsibility for its mistake and, from what you said, it’s unclear if Canopy has adjusted its strategy.”

Aimee, you just said exactly what I told Canopy’s investor relations staff after their call. The good news is that the company has adjusted its strategy – in addition to taking a reserve for returns, Canopy shipped very little oil or gel-cap product during the quarter that just finished so that stores could run down their inventories.

The bad news is that on the earnings call, the executives made it seem like a pretty serious marketing error was just one of those things that happens from time-to-time.

I communicated our shared concern to Canopy’s management.

I also received a question about Constellation Brands’ investment in Canopy that I want to address right now…

The Connection between Canopy and Constellation Brands

In the earnings report for Canopy, I know you may have heard about the warrants connected to Constellation Brands (NYSE: STZ).

Let me try to remove the financial jargon as much as possible and tell you what you need to know.

Raymond C. asks: “Hi Greg, could you please explain the warrants that were extinguished by Constellation when the Canopy earnings were announced. It seemed like a huge amount of U.S. dollars. How did that affect earnings, and how does that affect things going forward? Thanks!”

Hi, Raymond, this is a really good question. However, after reading the answer, you may wish you hadn’t asked it!

It requires a bit of an explanation, so I hope you don’t mind that I want my answer to be as thorough as possible.

The short answer is that this is all accounting flimflam, and it will not affect the company at all. The longer answer requires some accounting explanations.

There’s one big question here: How does a company account for warrants it has awarded to an outside party?

When Constellation made its big investment in Canopy, part of the deal was that Canopy gave a huge slug of warrants to Constellation. One group of them allowed Constellation to buy 88.5 million shares at a fixed price of $50.40 per share, as long as Constellation acted before November 1, 2021. The other warrants allowed Constellation to buy another 51.3 million shares at whatever Canopy’s stock price is when Constellation exercises them.

It’s important to note that Constellation can only trigger the second warrants if it has already triggered the first set.

As part of getting Constellation’s permission to buy Acreage Holdings (CSE: ACRG, OTC: ACRGF), Canopy extended the deadline on all the warrants. It also split the second set of warrants into two subsets. The first subset replaced the flexible price on the old warrants with a fixed price of $76.68 per share. The second subset is still for whatever the share price is at the time Constellation triggers them.

Now, let’s take a look at how that is accounted for on the balance sheet.

Under international accounting rules (Canopy uses international rules, which differ from U.S. rules), the warrants with a fixed price are entered in the equity account of the company using a complex formula to decide how much to add to equity.

The warrants with a variable price are considered a contingent liability.

So, when Canopy replaced some of the variable-price warrants with fixed priced warrants, it had to calculate the value of the “equity” it issued in the new warrants and compare it to the liability it had recorded for the old ones. The value of the new warrants exceeded the value of the old ones (which Canopy had recorded as zero) by $1,176,350, which was the charge Canopy took.

That leads to another important question: How is a warrant to acquire shares at $76.68 per share so valuable when the stock’s current price is much lower?

The answer is that Canopy’s stock price is volatile, and the warrants don’t expire for a long time. I still believe Canopy is a long-term hold. But after learning about volatility, what most investors have been doing next is seeking out more information about Cannabis Lots.

That’s one potential way to profit, no matter if stock prices are headed up or going down.

Volatility and time are two of the inputs into that complex formula I mentioned above. Combine that high volatility with the long term of the warrants – over seven years – and the warrants have a lot of value. It’s ironic that the change resulted in a charge to earnings.

If Constellation exercises those warrants, it will mean that the stock has tripled from its current price.

That would make shareholders very happy.

I hope you enjoy your long weekend, and I’ll talk to you soon.

Take care,

Greg Miller

Executive Director, National Institute for Cannabis Investors