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Wall Street Is Finally Wising Up on Cronos Group

By Sean Williams – Updated Apr 1, 2019 at 10:26AM

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Three downgrades following a subpar fourth-quarter earnings report suggest the tide is shifting for this popular pot stock.

Big things are happening with the legal marijuana industry, and according to Wall Street cheerleader Cowen Group, the global cannabis industry has a real shot to hit $75 billion in annual sales by 2030, potentially surpassing global soda sales. This strong growth forecast -- global sales were "only" $12.2 billion in 2018 -- is what has lit a fire under pot stocks in recent years.

But, as we all know as investors, not every stock in a high-growth industry is going to be a winner. Although it's very difficult to pinpoint what stocks within the pot industry are poised to thrive, one such name that's been pedal to the metal in recent months is Cronos Group (CRON -2.55%).

A person holding cannabis leaves in their cupped hands.

Image source: Getty Images.

Here's why Cronos has been on a tear

Shares of the company have more than tripled since July 2018. Over the past nine months:

  • Cronos Group entered into a joint venture with a group of investors to develop an 850,000-square-foot grow facility capable of producing 70,000 kilos annually at its peak.
  • The company formed a partnership with Ginkgo Bioworks that could be worth up to $100 million. Cronos will gain access to Ginkgo's microorganism platform, which will allow it to use yeast strains to produce targeted cannabinoids (some of which are rare) at commercial scale.
  • It closed on a $1.8 billion equity investment from tobacco giant Altria (MO 0.83%), which now holds a 45% stake in Cronos, with the option to exercise warrants and lift its stake to 55%. Meanwhile, Cronos now has more than $1.8 billion in cash to execute on its global strategy.

Landing Altria was by far the biggest catalyst for Cronos, with the deal placing a number of Altria executives on its board, and -- more important -- giving it access to Altria's genius in marketing and product development.

But as we witnessed last week when Cronos Group delivered its highly anticipated fourth-quarter and full-year operating results, sometimes the results simply can't match the hype.

A businessman in a black suit touching the quarterly report icon on a digital screen.

Image source: Getty Images.

Cronos dishes on a pretty dismal quarter

For the fourth quarter and full year, Cronos wound up reporting 248% and 285% sales growth, respectively. Unfortunately, on a nominal basis, this only worked out to $5.6 million Canadian ($4.2 million) and CA$15.7 million, respectively. That's not much in the way of sales for a cannabis grower that went into its report with a nearly $3.8 billion market cap. 

Cronos Group's production updates also suggest that most of its projects won't be complete until mid to late 2019. This is a company that's slated to produce only about 120,000 kilograms of weed at its peak, which is perhaps good enough to be the eighth-largest grower in Canada. Combine this with management commentary alluding to multifaceted supply shortages throughout Canada, and it's tough to see how things will improve for the company anytime soon.

In the interim, operating losses continued. Operating expenses wound up more than tripling to CA$29.4 million, pushing its operating loss, sans fair-value adjustments of biological assets, up almost tenfold to CA$21 million in 2018. This may not be as big of an operating loss as peers like Canopy Growth, but Cronos' business model is far less complex than Canopy's.

All told, it confirmed to yours truly that Cronos is indeed the most overvalued of all pot stocks.

A businessman in a suit pressing the sell button on a digital board.

Image source: Getty Images.

Wall Street finally throws in the towel on Cronos Group

Interestingly enough, though, Wall Street had -- until Cronos' fourth-quarter report -- remained relatively bullish on the company. But after those dismal fourth-quarter operating results, it appears that Wall Street is finally wising up.

Subsequent to the earnings release, Cronos received three separate downgrades in less than 24 hours. In no particular order:

  • PI Financial covering analyst Jason Zandberg maintained his firm's price target of CA$24, but lowered his rating on Cronos to neutral from buy following operating results that were substantially lower than what he had forecast for the fourth quarter.
  • Cormark Securities covering analyst Jesse Pytlak wound up modestly increasing his firm's price target on Cronos to CA$25, but lowered his rating on the company to market perform from speculative buy.
  • Canaccord Genuity covering analyst Matt Bottomley downgraded his firm's rating on Cronos to sell from hold, noting a "soft start" to Canadian recreational marijuana and Cronos's lofty valuation.

These three downgrades follow two additional sell ratings that were already in place from BMO Capital Markets and Jefferies, as well as a hold rating from industry booster Cowen Group. In other words, Cronos is the only pot stock to have three sell ratings and multiple equivalents of a hold rating. Not even the ever-bullish Wall Street believes Cronos is worth the $3.3 billion market cap it closed at on Wednesday, March 27.

A person holding cannabis leaves in front of a globe of the Earth.

Image source: Getty Images.

Cronos Group has some serious catching up to do

In my view, the only factor holding Cronos above a $3 billion market cap at this point is its cash position and the hope that Altria will eventually just buy what it doesn't already own of the company. Of course, if your investing thesis relies on hope, you're doing something wrong.

It's pretty evident from Cronos Group's report that it's a production laggard, and that it's not done nearly enough to push into international markets. A small production presence in Israel and Australia, along with distribution agreements in Poland and Germany, simply isn't enough. When domestic oversupply does become an issue (likely within two years), the company could struggle to offload its dried cannabis flower without ample external sales channels. In plainer English, this could lead to a pretty significant deterioration of the company's margins.

Cronos should be thrilled that it now has $1.8 billion in cash to work with, because there's a really good chance it'll need this capital to acquire additional production and push into new markets. This is a company with a lot of catching up to do, and investors would be wise to remain on the sidelines in the meantime.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Cronos Group Inc. Stock Quote
Cronos Group Inc.
CRON
$3.05 (-2.55%) $0.08
Altria Group Stock Quote
Altria Group
MO
$45.11 (0.83%) $0.37

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