Yesterday, Cronos Group (CRON +1.79%) fell by nearly 10% after a slew of downgrades from top firms like Canaccord Genuity. Analysts are reportedly turning bearish on the stock in response to the company's uninspiring 2018 fourth-quarter and full-year earnings release earlier this week.
The short story is that Wall Street thinks investors are putting too much stock into Cronos' partnership with American tobacco giant Altria Group (MO 1.19%), especially since the company isn't well positioned in the Canadian adult-use market and international cannabis sales could take years to ramp up.
Image source: Getty Images.
Are analysts missing the bigger picture with this mid-cap pot stock? Or should investors take these downgrades as a sign of things to come? Let's dig deeper to solve this riddle.
Bulls vs. bears
Wall Street has a strong case against Cronos Group. The company sports one of the highest valuations within its immediate peer group, but also one of the lowest forward-looking production outputs.
| Company | Projected 2020 Price-to-Sales Ratio | Estimated Peak Annual Production Capacity (kgs) |
|---|---|---|
| Aphria | 5.3 | 255,000 |
| Aurora Cannabis | 13.4 | 700,000 |
| Canopy Growth | 14.8 | > 500,000 |
| Cronos Group | 18.4 | 120,000 |
| HEXO | 3.4 | 150,000 |
| Tilray | 19.1 | > 200,000 |
Cronos has been countering these criticisms by claiming that Wall Street simply isn't seeing the forest for the trees. In short, the company's core business strategy is to capitalize on key value-added areas in order to build a viable economic moat -- instead of competing on sheer production volume.
Turning to the specifics, Cronos is banking on its partnership with Altria to maximize the efficiency of its supply chain. By doing so, the company's goal is to ratchet up its gross margins on value-added products like world-class pre-rolls and customized cannabis vaporizers. This move seems particularly wise, given that Altria has a proven track record at maximizing its supply chain, as well as building iconic brands like Marlboro.
Cronos' strategic decision to focus mainly on the end-user portion of the supply chain and to look toward international markets as the main growth opportunities could pay off big down the road. The downside to this approach, though, is that the step-wise fashion in which the legal U.S. cannabis space has evolved has led to a highly fragmented marketplace, as well as a messy legal landscape at the state level. Altria and Cronos thus have a lot of work to do to consolidate this high-value marketplace -- and an enormous amount of entrenched competition to overcome as well.
Check out the latest earnings call transcripts for Cronos Group and Altria Group.
Is this dip a buying opportunity?
If you're buying shares of Cronos at these levels, you're gonna have to look toward what the company could become within the next few years, not what it is right now. After all, Cronos is a flat-out laggard in the Canadian cannabis space, with a bloated valuation to boot. But this imaginative approach toward investing is without question a risky proposition.
While the U.S. is indeed starting to lead toward ending federal prohibition on cannabis, Altria and Cronos won't immediately cash in once this key market opens up. The duo will undoubtedly have to deal with numerous logistical and legal headwinds in differing jurisdictions, as each state overhauls its marijuana policies in accordance with the new law of the land. This process could take years to smooth out.
Viewed this way, Cronos' sharp pullback this week probably doesn't represent a great buying opportunity. Legal cannabis does present an impressive commercial opportunity, but most of this latent value will probably take several years to materialize.
