Marijuana stocks can seemingly do no wrong lately, and it's not hard to see why. Since October, we've seen Canada legalize recreational marijuana, had a handful of U.S. states approve medical or recreational weed during midterm elections in November, witnessed President Trump sign the Farm Bill into law, and heard of rumors that Mexico may choose to legalize recreational marijuana in 2019. Not shockingly, the first-ever marijuana exchange-traded fund in Canada, the Horizons Marijuana Life Sciences ETF, is up more than 50% this year.
But even with rapid global sales growth of up to 38% expected in 2019, not all pot stock valuations make sense. While yours truly has been critical of mid- and large-cap marijuana stock valuations in recent months, no company has stood out as more overvalued recently than Cronos Group (NASDAQ:CRON) -- this year's top-performing pot stock.
However, just because I view Cronos Group as a stock worth avoiding now, it doesn't mean I don't see value in the business or the stock. There is a share price at which I believe Cronos Group becomes attractive to investors. But before I divulge that price point, let me walk you through my thought process from both the buy and sell sides of things.
The Cronos Group buy thesis
Make no mistake about it, the clearest reason to be excited about Cronos Group is the $1.8 billion equity investment from tobacco giant Altria (NYSE:MO), announced in early December. Altria, which has faced years of declining cigarette demand in the U.S., is looking for ways to reignite growth, without having to continuously raise tobacco prices. By taking a 45% equity stake in Cronos Group, Altria is getting its foot in the door in the high-growth cannabis industry.
Furthermore, Altria's equity stake in Cronos Group, which has yet to close, comes with warrants that could be exercised at a later date. If Altria were to exercise all the warrants it'll be receiving, it could become a majority stakeholder (55%) in Cronos. Given its $3.6 billion market cap, Cronos could easily be gobbled up by Altria and its still-substantial free cash flow. Thus, premium is being paid to the likelihood that Altria will eventually buy the remainder of Cronos Group that it doesn't already own.
On the flip side, once the deal closes, Cronos Group will have north of $1.8 billion in cash on hand to execute on its long-term strategy. No longer having to worry about raising capital, Cronos will be focused on expanding internationally, diversifying its product portfolio to feature high-margin items, and growing its production capacity. This also means that dilution becomes less of a concern, with the company not having to turn to bought-deal offerings to raise capital.
Partnerships are another key selling point for Cronos Group. In September, it and Ginkgo Bioworks entered into a deal that'll cost Cronos up to $100 million. It will, however, give Cronos access to Ginkgo's microorganism development platform. This platform should allow for the creation of yeast strains capable of producing eight types of cannabinoids. These cannabinoids, some of which are rare, could be produced at commercial scale, presumably for a cheaper cost than traditional extraction methods.
Why avoiding Cronos Group makes sense
On the other hand, there are also a number of reasons why this $3.6 billion valuation (soon to be $5.4 billion once the Altria deal closes) makes little sense.
To begin with, Cronos' production isn't all that impressive, relative to its market cap. The top three projected growers -- Aurora Cannabis, Canopy Growth, and Aphria -- are on track for 700,000 kilos, 500,000 kilos, and 255,000 kilos, respectively, at peak production in my estimate. Aurora, Canopy Growth, and Aphria carry respective market caps of $7.2 billion, $15 billion, and $2.4 billion (albeit Aphria has had a crisis of confidence with management of late).
By comparison, Cronos Group should net 70,000 kilos from its joint venture, 40,000 kilos from Peace Naturals, about 7,000 combined kilos from its international grow farms, and some smaller amounts from other grow sites. That's squeezing every last drop of blood from the proverbial turnip for maybe 120,000 kilograms of peak annual production. Investors could purchase about a half dozen other pot stocks that should net between 100,000 kilos and 138,000 kilos at their peak for anywhere from a third to a tenth of Cronos' post-Altria investment market cap (i.e., $5.4 billion).
Cronos Group has also done a pretty poor job of moving into overseas markets like its peers. As we've witnessed from recreationally legal states in the U.S., dried cannabis flower has a tendency to be oversupplied and commoditized over time. By the early part of the next decade, it wouldn't be surprising if domestic Canadian supply far outpaced demand, leading domestic growers to seek foreign outlets to sell their excess supply. Aurora Cannabis is nearing a presence in two dozen countries, whereas Canopy Growth has a presence in more than a dozen foreign markets. As for Cronos, it's made little foreign impression beyond Israel and Australia, which could threaten its margins if dried flower oversupply does hit, as expected.
Lastly, with marijuana now legal to our north, fundamentals and earnings reports actually matter now. Even though Cronos Group is receiving a very welcome cash infusion from Altria, and the duo may work on joint products (pun intended) in the future, the company isn't expected to generate much in the way of profits anytime soon. The four analysts covering Cronos are calling for just CA$0.06 per share (that's six cents in Canadian dollars) for fiscal 2019, and it's unclear if that includes a number of one-time benefits that have been helping pot stocks like Cronos Group. Even assuming Cronos Group is profitable, which is far from a guarantee, its forward price-to-earnings ratio might be north of 400!
Here's the price at which Cronos Group offers real value to investors
Now that you've heard both sides of the argument, I can walk you through the share price at which I feel Cronos Group offers value, which for me is $9 per share. And yes, I'm aware that this is 55% lower than where Cronos is currently trading, which also backs up my thesis of the company as being the most overvalued pot stock.
Just how the heck did I pull $9 out of the hat? Well, on the positive side, I'm factoring in that about a third of the postinvestment market cap of this company will be in cash. Of course, Cronos Group will be actively using this capital to hopefully expand overseas and make complementary acquisitions. Thus, this $1.8 billion in cash might be more like $1 billion in 12 to 18 months.
I'm also counting on Cronos Group to focus on higher-margin products and medical cannabis patients. Its partnership with Ginkgo is a good example of the company aiming for high-margin sales.
Then again, Cronos Group will probably be lucky to turn a profit in 2019, and it's unlikely to even cross $100 million in annual sales until fiscal 2020. That's a lot of premium that investors are giving a company with a triple-digit forward price-to-earnings ratio.
Ultimately, a share price of $9, post-Altria deal closing, assumes a forward cash value of around $1 billion and assigns a value of an additional $1.4 billion to $1.5 billion to its 120,000-kilo production, its high-margin cannabinoid output with Ginkgo, and the intangible value that a name like Altria brings to the table. While still not traditionally cheap, a $9 share price would likely give Cronos a PEG ratio less than 2, which could offer modest upside and represent a potentially attractive entry point for investors.