Cronos Stock Just Raised a Massive Red Flag

Cronos Group (NASDAQ:CRON) stock rallied 12% on Wednesday just two days after the company filed a document with the U.S. Securities and Exchange Commission addressing its delayed earnings report. Cronos initially said it would report earnings on Feb. 27. The company said on Monday that it is extending its filing deadline by 15 days while its board of directors conducts an audit of the company’s financials.

Cronos Stock Just Raised a Massive Red Flag

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Fair or not, cannabis stocks are fighting an uphill battle with many retail investors questioning them to prove their businesses are legitimate. Investors hesitant to dip their toes in the water are likely hypersensitive to any news of financial inconsistencies.

The market doesn’t seem particularly concerned with the impact the audit’s outcome could have on Cronos stock. However, investors should anticipate Cronos will potentially restate earnings and/or revenue numbers going back several quarters.

The Audit

In its filing on Monday, Cronos management said its internal Audit Committee is working with outside forensic accountants to conduct a review of “several bulk resin purchases and sales of products through the wholesale channel and the appropriateness of the recognition of revenue from those transactions.”

Like any legal language, that characterization is extremely opaque. Cronos said it plans to release its quarterly and full-year earnings reports “promptly.” It also said there is no guarantee the reports will be ready by the end of the two-week extension.

The problem with situations like these is that they leave investors almost completely in the dark. The one thing investors know is that somebody within the company raised questions about Cronos’ finances. I’m guessing that if those questions weren’t credible, there would be no audit.

So now investors must wonder just how “inappropriate” the company’s reported revenues are and how far back the issue stems.

The Bull Case for Cronos Stock

I have previously been relatively bullish on Cronos stock. The thing I liked the most about the company is its strong balance sheet, a rarity among cannabis stocks.

Bank of America analyst Christopher Carey says he is still bullish on the stock. However, he cut his price target by 15% as a result of the uncertainty the audit news has created. He said the audit news is “unfortunate,” and the company has questions it needs to address. But Cronos’ cash position and financial backing from Altria (NYSE:MO) makes it one of the top investments in the cannabis space.

“We see Cronos as one of the more compelling fundamental stories in cannabis, reflecting the second strongest balance sheet in the sector (post Altria investment) and a forward-thinking strategy (cannabinoid development platform),” Carey says.

Carey maintains his “buy” rating, and his new price target is $8.24.

The Bear Case

Until the audit issue is resolved, it’s unlikely that the stock will outperform its peers. Carey said Cronos has the second-best balance sheet in the group. The company with the best balance sheet is Canopy Growth Corp (NYSE:CGC).

In the past month, CGC stock is down 20% overall and CRON stock is down 19.7%. Assuming you are a long-term investor looking to buy a cannabis stock with a strong balance sheet and a major financial backer. Why would you choose Cronos over Canopy and its investor Constellation Brands (NYSE:STZ) right now? One company has an ongoing audit of its financials and the other one doesn’t.

Stifel analyst W. Andrew Carter downgraded Cronos stock from “buy” to “hold” following the audit announcement. He likes the stock in the long-term, but said he will stay on the sidelines until the audit is complete.

“We find the outlook for the shares difficult to analyze at this point given the investigation and given the lack of SEC filings at least in the short run,” Carter says.

Carter says the stock will underperform until the issue is resolved, and investors will need to be patient.

“While we believe the organization is aggressively pursuing this [15-day] deadline, we do not believe the company will meet the extension which suggests the company will be required to submit a plan of action and comply with a 180 day deadline imposed by NASDAQ,” he says.

How to Play It

In other words, 180 days is three months. Investors may not get a resolution for quite a while. In the meantime, the stock likely won’t get too much bullish momentum. I’m honestly surprised it has bounced back so quickly from the audit news. I wouldn’t be surprised if it drifts back lower in the coming weeks unless the issue is resolved.

At this point, I’d recommend investors switch to Canopy Growth stock for the time being. The two companies essentially represent the same cannabis bull thesis, but Canopy has a lot less near-term risk.

Wayne Duggan has been a U.S. News & World Report Investing contributor since 2016 and is a staff writer at Benzinga, where he has written more than 7,000 articles. Mr. Duggan is the author of the book “Beating Wall Street With Common Sense,” which focuses on investing psychology and practical strategies to outperform the stock market. As of this writing, Wayne Duggan does not hold a position in any of the aforementioned securities.

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