Now That the Pot Stock Bubble Has Popped, Should You Buy Cronos Stock?

CRON stock - Now That the Pot Stock Bubble Has Popped, Should You Buy Cronos Stock?

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Once the highest-flying stocks in the market, pot stocks have cooled significantly ever since the nationwide roll-out of legal cannabis in Canada on Oct. 17. At that time, pot stocks were trading near all-time highs. Ever since, every notable pot stock has dropped more than 20%, with Canopy Growth (NYSE:CGC) and Aurora (NYSE:ACB) down 37% and 45%, respectively. But there’s one pot stock that has weathered this recent selloff better than the rest — Cronos Group (NASDAQ:CRON) stock.

CRON stock is down “just” 21% since Oct. 17, and is “just” 40% off its all-time highs. Granted, it’s far from a stellar performance, but it’s far and away the best among the big four pot stocks, which include Cronos, Canopy, Aurora and Tilray (NASDAQ:TLRY).

The average loss in that group (ex-Cronos) since Oct. 17 is more than 35%, while the average drop from all-time highs is nearly 50%! Cronos is performing significantly better.

Why? Because CRON stock was relatively less expensive than its peers, so when the pot stock bubble burst (and make no mistake, it has burst), CRON stock fell the least.

That’s a good thing.

It might make some contrarian investors bullish on buying the dip in CRON stock.

But patience is the name of the game here. Right now doesn’t look like the best time to buy the dip in CRON stock. There is a pathway for this company to be worth significantly more in five-plus years. That pathway lacks clarity at the moment. Until Cronos finds more clarity, it is best to wait on the sidelines.

The Pot Bubble Has Burst

Even the most bullish pot stock investors need to understand this: the pot bubble has burst. These were once the highest-flying stocks in the market. Now, they have all dropped 40% or more over the past two months.

This bubble bursting has to do with a lot of things. For starter’s, the valuations at the peak were unsustainable. We are talking about Tilray being valued at $20 billion despite having just $10 million in revenues last quarter. That is the definition of too much hype and not enough fundamental support.

Also, the legal rollout of cannabis in Canada wasn’t very smooth. Demand was there but supply wasn’t.

Persistent supply shortages somewhat diluted the excitement of what was supposed to be a huge catalyst. Buyers turned to the black market, and the early bump for legal producers wasn’t as big as expected.

There were also recent quarterly numbers from the major pot producers that, while good, weren’t good enough. The common trend across the industry is that revenues and kilograms sold both grew by over 100% last quarter. That is strong. But, considering that these companies were growing from really small bases and were sporting huge valuations, investors wanted more.

Taken together: unsustainable valuations, a bumpy Canadian roll-out and slower-than-expected growth are to blame for the pot bubble bursting.

Going forward, these risks won’t go away. Valuations are still big relative to today’s revenue numbers. Supply shortages are still a problem in Canada. And until the big four marijuana companies report earnings again, the last thing investors have to hang their hat on is slower than expected growth last quarter.

Because these risks won’t go away any time soon, the near-term outlook for CRON stock is unfavorable.

Cronos Could Be Worth $3 Billion or More

Having said that, there is an opportunity for CRON stock to more than double over the long run.

At this point in time, Cronos advertises itself as a global cannabis player. This isn’t false advertising. The company does have a global presence with distribution in Poland and Germany, and growing capacity in Australia, Israel, and Colombia. But at this point in time, considering the lack of certainty on how global cannabis markets will develop, the safest way to value CRON stock is through the Canadian business alone.

The recreational cannabis market measured $6 billion in 2017. Inevitably, that number will grow as legalization prompts new people to try cannabis (read this story about first-timer Genevieve Despres). Thus, most estimates peg Canada’s recreational cannabis growing to anywhere between $6 billion and $9 billion over the next several years. Meanwhile, the medical cannabis market is projected to be a $3 billion annual revenue market in Canada. Thus, between the medical and recreational markets, we are talking about roughly a $10 billion annual revenue opportunity in Canada.

How much of that will Cronos grab? Not much. Among the four biggest pot stocks, Cronos is by far the smallest in terms of revenue reported last quarter and current and planned production capacity. Thus, Cronos doesn’t project to be a big player in this market. Rather, at scale, we are talking about maybe 5% to 10% market share for Cronos.

At those levels, Cronos could reasonably reach $750 million in revenues at scale. Assuming fairly normal 35% operating margins and a 20% tax rate, that should flow into $210 million in net profits. A market average 16 multiple on that implies a future market cap in excess of $3.3 billion, versus a present market cap of $1.5 billion.

As such, CRON stock could more than double in the long run. But, in the long run, I’m talking anywhere between five and ten years. During that stretch, a lot can and will change about the competitive and legal landscapes in the cannabis industry.

All those potential changes create a significant lack of clarity for CRON stock to potentially double at scale. So long as this pathway remains clouded, it will be tough for CRON stock to rally.

Bottom Line on CRON Stock

The unfortunate reality of the cannabis industry is that at current valuations, the industry will produce a lot more long-term losers than winners. Thus, while CRON stock could potentially double over the next several years, the pathway to realizing that potential lacks clarity. So long as this remains true, buying the dip in CRON stock is unnecessarily risky.

As of this writing, Luke Lango was long CGC stock.

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