Altria Group Inc., the U.S. maker of Marlboros, made a $1.8 billion investment in a Canadian pot company Friday based on a simple premise: Cannabis is growing fast, and cigarettes are not.
Altria has agreed to take a 45 percent stake in Toronto-based marijuana producer Cronos Group Inc., marking a major tobacco company's first foray into cannabis. Altria has the option to gain majority control in the future.
With U.S. smoking rates falling fast, Richmond, Virginia-based Altria is under pressure to find new avenues to expand revenue. Marijuana, while still illegal on the federal level in the U.S., is now allowed in an increasing number of states, while Canada now represents a large laboratory for the nascent industry.
"We believe cannabis is an excellent strategic fit for tobacco," Jefferies analyst Owen Bennett said in a research note earlier this week. It's a logical fit, because "big tobacco knows how to cultivate crop, knows how to deal with regulators, they are at the forefront of vaporization technology, and they also arguably have less reputational risk than other fast-moving consumer goods," he said.
It's clear Altria has reassessed its competitive position. It also announced Friday that it will discontinue two of its next-generation tobacco products and its oral nicotine-containing ones to focus on "more compelling reduced-risk tobacco product opportunities." The company attributed this to regulatory restrictions and lack of financial prospects for those products.
Altria shares rose as much as 3.2 percent to $56.14 on Friday. Its stock had fallen 24 percent this year through Thursday's close -- illustrating how investors had become pessimistic about the company's future amid rising regulations and taxes on tobacco.
Cronos shares, meanwhile, surged as much as 33 percent to $13.95 in New York. Altria's offer of C$16.25 a share represents a 16 percent premium from Thursday's closing price. Peers in the marijuana sector also gained, with Aurora Cannabis Inc. rising as much as 11 percent, Aphria Inc. adding 14 percent, Canopy Growth Corp. rising 7.3 percent and Tilray Inc. gaining 4.8 percent.
The deal will expand Cronos' board from five to seven seats, with Altria getting a total of four of them.
Cowen analyst Vivien Azer said it's not surprising that Altria opted for a pathway to a majority control of Cronos. Altria is paying 25 times forward sales, she said, and in her view, Altria is "buying their way out of a bind" after almost two decades of volume decline for U.S. cigarettes, and a challenging 2018 for e-cigarettes.
Cronos CEO Mike Gorenstein said the partnership with Altria doesn't limit the cannabis firm from engaging with other strategic partners. "In fact, we think this partnership makes us collectively a more attractive partner" for other potential investors, Gorenstein said on a conference call Friday. The most attractive piece of the partnership is Altria's experience dealing with regulatory agencies, he said.
Altria currently has been grappling with a Food and Drug Administration that's intent on strengthening restrictions on some of the vaping products that have caught on with younger users.
Philip Morris International Inc., which was spun off from Altria and sells the Marlboro brand internationally, has been trying to get U.S. approval for Altria to market its IQOS device. Separately, it has asked for regulatory permission to say the device carries a lower health risk than regular tobacco products.
Cronos's Gorenstein said his company and Altria agree that developing brands and intellectual property is more valuable than growing plants and should be the focus going forward.
"When we were strategically planning how we would enter cannabis years ago, one of the companies that we looked at and had a lot of respect and admiration for was Altria," he said. "It's worth noting that Altria does not grow their own tobacco. We think that model of growing your own plants is very difficult to scale and to execute well. That was something we're very aligned with."