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Another Week, Another Rally for Canopy Growth Corp. (TSX:WEED)

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It’s another week, and Canopy Growth Corp. (TSX:WEED)(NYSE:CGC) is having another massive rally. Trading at just $32 at the start of August, Canopy shares are now up over 100% at $68.83. Clearly, investors are optimistic about this company’s future. A recent article opined that Canopy shares may go as high as $100. And in fact, since August, the shares have made heady progress toward that milestone.

The question is, how long can this rally go on?

To answer this question, we need to look at the reasons behind the rally.

Positive investor sentiment

Canopy is currently receiving a groundswell of investor support driven by two developments: the Constellation Brands Inc. (NYSE:STZ) investment and the legalization of recreational cannabis in Canada. The Constellation investment was announced in August and brings with it some immediate benefits to Canopy, such as $4.5 billion in cash. Legalization is coming on October 17 and may benefit Canopy by increasing its sales.

I’ve made no bones about my skepticism regarding legalization. As I wrote in a recent article, I think there’s a good chance that legalization could drive cannabis prices down. To be clear, there’s no doubt that legalization will increase cannabis sales. Canopy has already signed supply contracts with the Ontario Cannabis Store (OCS), among others.

However, the problem Canopy faces is not revenue but bottom-line earnings. The company lost $90 million on $26 million in earnings last quarter. Simply ramping up sales will not erase that loss–especially not if legalization results in downward pressure on prices. In fact, the losses may grow larger if the cost of revenue can’t be kept under control.

Nonetheless, investors remain optimistic about October 17. In the short term, that will probably contribute to continued growth in Canopy shares, as the consensus is that increased sales will be a boon to the company.

The Constellation partnership

Of the two factors driving the Canopy rally, the Constellation investment is (in my judgment) the more promising one.

When Constellation announced its first Canopy investment in 2017, company representatives said they were interested in developing a cannabis-infused alcoholic beverage. This would be a novel product category that may command higher prices and result in higher profit margins than raw cannabis flower and extracts (Canopy’s two main product lines).

The alcoholic beverage market is highly differentiated, with certain brands commanding higher prices than others by the strength of their name alone. A cannabis-infused Corona (for example) might prove more profitable than the relatively generic cannabis products Canopy currently supplies.

Another upside to the Constellation investment is the potential for a full-fledged buyout. The agreement between the two companies lets Constellation appoint four of Canopy’s board members and includes warrants for upping its stake to 50%. If Constellation does pursue a full-fledged buyout of Canopy, it will likely be at a premium relative to the market value of Canopy shares (as is the norm in such acquisitions). And in that scenario, Canopy investors will benefit immensely.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Andrew Button has no position in any of the stocks mentioned.

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