Cronos Stock Gets Closer to Being a Buy, but It’s Not There Yet

Cronos stock is well-positioned for the new reality of cannabis

One of the ironies of the long decline in Cronos Group (NASDAQ:CRON) is that management actually seems to have been mostly correct so far. Unfortunately, it’s done little for Cronos stock so far, which is down 72% from its 52-week high.

Cronos Stock Gets Closer to Being a Buy, but It's Not There Yet
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Those declines have come amid a broad sell-off in cannabis stocks. That sell-off has been driven by significant oversupply, and plunging selling prices, in the Canadian market. That in turn suggests sharply lower earnings potential for companies that have aggressively built out their production capacity.

But Cronos isn’t one of those companies. As CEO Mike Gorenstein put it on his company’s second-quarter conference call in August, “Our business model is not to be the farmer.”

Cronos is following the example of Altria (NYSE:MO), which owns a large stake in the company. Altria doesn’t grow tobacco but is the most profitable tobacco company in the world.

That strategy seems particularly wise at the moment. Meanwhile, Cronos is sitting on a cash hoard at a time when fears of bankruptcy are rising across the space. So far, investors haven’t given Cronos any credit for those positive attributes, and that might not change any time soon. But it likely will at some point.

The Oversupply Problem

Industry-wide pricing pressure makes it obvious that Canadian cannabis companies have overbuilt production capacity. For Cronos, the average selling price in the third quarter declined 28% from second-quarter levels and was nearly halved from year-prior levels.

Other cannabis producers saw similar pressure. Tilray (NASDAQ:TLRY) saw roughly the same trend, though Aurora Cannabis (NYSE:ACB) did manage to keep prices relatively stable. Canopy Growth (NYSE:CGC) said on its earnings call that it would cut prices on softgels and oils, while an analyst on that call pointed to licensed producers in Canada “becoming more aggressive” on flower pricing as well.

This really shouldn’t be a surprise. Legalized recreational markets in the U.S. have had their own oversupply problems, with Oregon a notable example. In Canada, meanwhile, the news is unlikely to get better.

As Will Ashworth pointed out on this site back in August, the Canadian market is estimated to need roughly 1 million kilograms of cannabis. There is as many as 3 million kilograms’ worth of supply online or on the way.

This is a huge problem for large-scale producers who are going to see harvests potentially go to waste and lower prices on what they can sell. Put another way, marijuana in legalized markets is going to become a commodity, just as skeptics have argued. And selling a commodity usually is a highly competitive and low margin business.

Cronos Stock and Oversupply

But, again, Cronos largely saw this coming. It’s not a large producer of cannabis. It’s already cutting back on production capacity, shifting cultivation assets at its Peace Naturals Campus to R&D and warehousing. Cronos will buy at least some of the cannabis it needs from third-party producers, instead of growing its own.

Going forward, Cronos is focusing on derivatives. Thanks to its Redwood acquisition, Cronos can become a significant player in the U.S. CBD (cannabinoid oil) market. In Canada, the company is aiming to be a major player in the so-called “Cannabis 2.0” products like beverages, edibles, and vapes.

And so Cronos Group may well benefit from plunging wholesale prices. It doesn’t have massive grow rooms that require the company to either use those assets at inferior margins or leave them idle. Rather, it can buy flower cheap at wholesale prices and, at least in theory, convert that flower to higher-priced, higher-profit derivatives.

The Balance Sheet Edge for Cronos Stock

The decision not to build out production capacity has positioned Cronos well in another sense. The company’s balance sheet is rock solid.

Thanks to its Altria investment, Cronos closed its third quarter with roughly CAD$2 billion ($1.5 billion U.S.) in cash — and no debt. And its cash burn rate is much lower than that of other cannabis companies; as an analyst noted on the Q3 call, Q3 numbers suggest the company has 41 quarters’ worth of cash left.

That’s not the case for other producers. Aurora just diluted its shareholders once again, the only way it could manage a problematic convertible bond that was due in March. Hexo (NYSE:HEXO) has a cash burn problem. Many smaller cannabis companies no doubt will struggle to adjust to the new normal of lower pricing.

As Gorenstein put it on the Q3 call, “the focus is going to quickly shift to survival” in the industry. And some companies simply may not survive.

There are going to be assets available on the cheap, whether from companies trying to salvage some sort of value for their shareholders or via a restructuring process. Cronos, moreso than perhaps any other cannabis company save Canopy, is best-positioned to capture some of those assets, potentially at a sharp discount to their cost.

The Story Behind Cronos Group Stock

Again, it looks like Cronos’ decision not to chase production was wise, though that decision has done nothing to help CRON stock so far.

Part of the issue has been the narrative behind CRON. The stock never has had a compelling story. In fact, as I wrote earlier this year, the best argument for CRON stock was that it was the pot stock for investors who believed pot stocks were overvalued. Unsurprisingly, that hasn’t been a case that has drawn many buyers.

But plunging stock prices and plunging cannabis prices themselves are changing that fact. A narrative for Cronos Group stock is emerging. It’s the cannabis company that isn’t going bankrupt. It’s the company with the most flexibility in adapting to the new normal.

Cronos can try to ramp spending behind derivatives as it competes against rivals who may be watching every penny. It should benefit from oversupply in a way that few Canadian companies can. The combination of Altria’s distribution capabilities plus the Lord Jones brand acquired in the Redwood deal, make the company a strong player in CBD in the U.S.

And Cronos Group, backing out that cash, now has an enterprise value below $1 billion. Suddenly, if thanks only to the plunge across the sector, there is a story behind CRON stock. Increasingly, it looks like the stock for investors who believe in the long-term opportunity in cannabis — and in a short-term disruption that may well benefit Cronos.

The Bottom Line on Cronos Stock

All that said, I’m not rushing in to buy Cronos stock just yet. There is an opportunity here, but Cronos still needs to capitalize. It has to win in a U.S. CBD market that already is quite crowded. I’m personally not sold on the long-term viability of the CBD market, either, given the lack of proof of efficacy and widespread questions about dosing. It has to spend its capital wisely.

Meanwhile, $1 billion might sound cheap in a sector where multiple companies had much higher valuations just months ago. But Cronos still is a company that generated just 12 million CAD in revenue in its most recent quarter.

Obviously, lower production leads to lower revenue relative to other publicly traded cannabis companies. Still, Cronos is years from profitability and trades at a sky-high multiple to even 2020 and 2021 revenue.

More broadly, I’m not convinced that the sell-off in cannabis stocks, and Cronos stock, is over. Fundamentally and technically, there’s still little evidence of a bottom, even with some signs of life in recent trading.

All that said, CRON stock at the least is intriguing if for no other reason that it finally has a real narrative behind it. The current cannabis environment is not what investors believed it would be — but it’s roughly what Cronos management expected. If they’re as correct going forward as they have been in 2019, CRON stock has big upside from current prices.

As of this writing, Vince Martin has no positions in any securities mentioned.


Article printed from InvestorPlace Media, https://investorplace.com/2019/11/cronos-stock-closer-to-buy/.

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