Don’t Buy Into Cronos Stock Just Yet

CRON stock - Don’t Buy Into Cronos Stock Just Yet

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Weed is finally legal in Canada. That is big news for pot stocks. Names like Cronos (NASDAQ:CRON), Tilray (NASDAQ:TLRY) and Canopy Growth (NYSE:CGC) all rallied big into this event as it was widely perceived as the biggest legal breakthrough yet in the still nascent cannabis narrative. Yet, the legalization of weed in Canada has become a “sell the news” event for pot stocks. On Oct. 17 — the day weed became legal — pot stocks dropped. As of writing, CRON stock is down 7% from Tuesday’s adjusted close. TLRY stock is down 6%, too, while CGC stock is down 4%.

The writing was on the wall for this to happen. Pot stocks were jumping to “priced for perfection” valuation levels in anticipation of this catalyst. When you have an unprecedented roll-out like the one happening right now in Canada, it is a guarantee that you won’t get perfection. There will be supply chain hiccups, demand issues, consumer confusion and logistics headaches.

All of that will contribute to a bumpy first few weeks of legal weed in Canada, and those bumpy first few weeks will likely cause turbulence in pot stocks. As such, I’m avoiding adding to my cannabis positions at the current moment. The long-term growth potential is promising. The next few weeks, however, promise to be bumpy.

Eventually, those operational hiccups will subside, and this bumpy ride will smooth out. That is when buying the dip in pot stocks will become the smart move. While I’ve voiced my bullishness on CGC stock before (and it remains my favorite in the sector), another pot stock that is worth considering in a few weeks once things smooth out is CRON stock.

Pot Stock Valuations Make Sense Long-Term

There has been a lot of talk about extended valuations in the cannabis space. I agree the valuations are big right now. But, the cannabis market projects to be huge, and if you consider the long-term growth potential of this market globally, then current pot stock valuations start to make sense.

There are two important things here. One, global legalization of marijuana isn’t a matter of “if.” It’s a matter of “when.” Two, when fully legalized, the marijuana market could be as big as, and will likely be bigger than, the global alcoholic beverage market.

On the first point, global regulation of marijuana is currently one giant mess. It is tough to follow and highly fragmented. There is one important trend to note, though. In 2001, two countries were exploring cannabis legalization. In 2014, that number grew to five. Now, that number stands at over 25. In other words, whereas it took 13 years to add three countries to the marijuana legalization docket, that docket is now adding more than five countries per year. Thus, cannabis legalization is accelerating globally, and if this trend persists, we are looking at largely global cannabis legalization in the not-too-distant future.

On the second point, marijuana is just as popular among consumers as alcohol. Roughly 33% of U.S. high school seniors drink on a monthly basis. That rate is down big from 50%-plus in the early 1990s. Meanwhile, roughly 23% of high school seniors use marijuana on a monthly basis. That rate is up big from under 15% in the early 1990s. If current trends persist, marijuana and alcohol consumption rates among high school seniors should be roughly equivalent in five-plus years.

The U.S. alcohol market measured $120 billion in revenues in 2016. The U.S. cannabis market measured under $10 billion in revenues last year. Given current consumption trends, I reasonably see the U.S. recreational cannabis market going from under $10 billion to over $120 billion over the next decade. That’s just the U.S. — and just recreational marijuana. If you consider all other aspects of this burgeoning industry, you are easily talking about a $200 billion-plus market within a decade.

In a $200 billion-plus market, you will have a handful of players with $5 billion-plus in revenues. Assuming fairly normal operating margins of 35% and a 20% tax rate, that $5 billion in revenues should flow into $1.4 billion in profits. Throw an average 20 multiple on that. You are talking about a $28 billion valuation in a decade. Discount that back by 10% per year. You arrive at a present value of over $10 billion.

Cronos Stock Is Attractively Valued

In the grand scheme of things, valuations for pot stocks in the $10 billion range seem reasonable, if the company projects to be a leader in the cannabis space over the next decade. CRON stock has a market cap of just $2 billion, versus $10 billion-plus at both TLRY and CGC. Thus, right off the bat, CRON stock seems to be more attractively valued than its peers.

A big reason for the lower valuation is lower production capacity. CRON has planned production capacity of roughly 1.2 million square feet, versus 3.8 million square feet for TLRY and 5.6 million for CGC. TLRY has a $14 billion market cap. CGC has a $10.5 billion market cap. Thus, market cap per square foot of planned production is about $3,700 at TLRY and $1,875 at CGC. At CRON, it is just $1,700, yet another sign that this stock is attractively valued relative to peers.

When you look at the fundamentals, Cronos doesn’t presently project to be as big a player in this space as TLRY or CGC, given lower production capacity and a narrower product portfolio. But, the relatively discounted valuation seems to account for this, and then some.

As such, once pot stocks stabilize from recent volatility due to bumpiness in the national legalization of weed in Canada, CRON stock could be a buy. I still think CGC stock is the best in class, but CRON stock offers relative valuation upside that is quite attractive.

Bottom Line on CRON Stock

Pot stocks will be choppy over the next few weeks. But, once that choppiness fades, CRON stock could morph into an attractive investment.

As of this writing, Luke Lango was long CGC. 

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