What a difference a month makes. Following what was generally a rough 2018 for marijuana stocks, the industry collectively soared in January. The Horizons Marijuana Life Sciences ETF, a basket of about four dozen pot stocks with varied weightings, skyrocketed by more than 47% last month. That's incredible, no matter how you slice it.
This Wall Street darling is blazing hot
One of the top-performing marijuana stocks in January was Wall Street darling Cronos Group (CRON 3.60%), which galloped higher by roughly 90%. Cronos, which has been lauded as a top or near-top pick by a handful of industry pundits and Wall Street investment firms, has benefited from a number of partnerships landed in the second half of 2018.
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It began in September, when Cronos announced that it was entering a deal worth up to $100 million with Ginkgo Bioworks to utilize Ginkgo's proprietary organism design technology to create yeast strains capable of commercial cannabinoid production. Cronos aims to produce eight cannabinoids, some of which are rare, at commercial scale and, presumably, at a much lower cost than with traditional extraction techniques. Since alternative cannabis products typically have much higher price points and margins than dried cannabis flower, this move was seen as a way for Cronos to boost its long-term operating margins.
Then, in early December, tobacco giant Altria (MO -0.37%) announced a $1.8 billion equity investment in Cronos that'll give it a 45% equity stake in the company. Along with the warrants Altria will be receiving, assuming closure of the investment, it could up its stake in the company to 55%. With tobacco cigarette shipment volumes falling precipitously in the United States, Altria is presumably expecting to work with Cronos on cannabis vape products or pre-rolled joints at some point in the future. Additionally, with the company taking a 45% equity stake, Altria clearly believes in the long-term growth prospects of the weed industry.
As the icing on the cake, Cronos Group will likely slot in as a top-10 producer with around 120,000 kilograms of annual peak estimated production, 70,000 kilos of which will derive from its joint venture Cronos GrowCo facility, and 40,000 kilos of which should come from Peace Naturals. The remainder will come from smaller domestic grow sites and overseas facilities.
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Here's what would make "the most overvalued pot stock" a buy
But as I pointed out recently, there are also a lot of reasons to dislike Cronos Group here. In fact, I went so far as to call it the "most overvalued marijuana stock" right now. The thing is, I'm not averse to changing my opinion on any marijuana stock. If Cronos Group were to tackle three specific deficiencies, I'd reconsider it as a possible pot stock to buy.
1. Notably improve output
The first issue with Cronos Group is its peak production. Generating as much as 120,000 kilograms a year might sound more than sufficient, but for a company sporting the market cap that Cronos does, it's pretty low.
Assuming Altria's equity investment is approved, the company would have a market cap of $5.3 billion. How expensive is that relative to 120,000 kilograms of production? As an example, investors could go out and purchase shares in HEXO, CannTrust Holdings, or OrganiGram Holdings, which each have peak production potential of 108,000 kilograms, 100,000 kilograms-plus, and 113,000 kilograms, based on the projections of their respective management teams. Their respective market caps are $1.16 billion for HEXO, $805 million for CannTrust, and $739 million for OrganiGram. Even subtracting Cronos' cash on hand, a market cap of $3.5 billion for around 120,000 kilograms of production is ridiculously expensive.
What I'd like to see is Cronos use its soon-to-be $1.8 billion in cash on hand as a means to acquire new production or to kick off another organic build, as it did with its joint venture partners via Cronos GrowCo. A market cap this large should be capable of delivering around 200,000 kilos a year, at minimum, in my opinion.
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2. Focus on international expansion
Secondly, it's time that Cronos Group stopped lagging its peers by focusing on international markets. Whereas Aurora Cannabis, the projected largest producer in Canada, has its fingers in about two dozen countries worldwide, Cronos has hardly made a footprint outside of Canada. With the exception of 2,000 kilos of capacity in Australia, 5,000 kilos of capacity in Israel, and distribution in Germany and Poland, there isn't much international activity to speak of.
The reason the international markets hold so much importance is the fear of domestic oversupply. Though Canada is currently contending with cannabis shortages, part of which is the result of regulatory red tape tied to Health Canada, it won't stay this way for long. Health Canada estimates that Canadian marijuana demand will hit approximately 1 million kilos a year, with provincial reports estimating this figure as closer to 800,000 kilos. However, I expect peak production to total well beyond 3 million kilos within a few years. This extra supply has to go somewhere, and overseas markets are the answer. Growers that fail to focus on international expansion run the risk of seeing their margins deteriorate from dried flower oversupply.
Although I don't have a specific country or region in mind, Cronos needs to demonstrate that it's serious about expanding its international presence. The capital it'll receive from Altria should help it lay the groundwork needed to be successful in overseas markets.
Image source: Getty Images.
3. Produce a meaningful per-share profit
Finally, following the legalization of recreational pot in Canada, promises are no longer sufficient to drive marijuana stock valuations higher. Operating results actually matter now; and more specifically it's time for pot stocks like Cronos Group to demonstrate genuine bottom-line improvement.
For what it's worth, Wall Street is expecting Cronos to be profitable in fiscal 2019, with the consensus estimate calling for nearly 400% sales growth to 87 million Canadian dollars and CA$0.06 per share in full-year profit. But as things stand now, this places the company at a forward price-to-earnings ratio of almost 430. That's not going to attract any fundamentally focused investors.
Making matters worse, the Altria equity investment will result in more shares being issued, leading to a big increase in the company's outstanding share count. As Cronos' outstanding share count rises, its earnings per share will be adversely impacted. It's unclear if Wall Street's consensus is currently factoring this into the 2019 full-year EPS projections.
In order for me to change my view on Cronos Group, the company is going to have to make significant progress on the profitability front. A triple-digit price-to-earnings ratio simply won't cut it.
Check out the latest Cronos earnings call transcript.
