This is a big year of transformation for the marijuana industry. After thriving for years on promises, Wall Street and investors are now ready to see results. With Canada having legalized recreational marijuana, and more than 40 countries worldwide giving the green light to medical marijuana, sales and profits actually matter for marijuana stocks.
One highly popular pot stock that's come into focus as this transition takes place is Ontario-based Cronos Group (NASDAQ:CRON).
What's next for cash-rich Cronos Group?
Cronos really began turning heads in early December when it secured a $1.8 billion equity investment from tobacco company Altria. The deal, which closed in March, gives Altria a 45% nondiluted stake in the company, with certain anti-dilution rights built in. The expectation is that Altria will work with Cronos on a host of new products, including vapes, to reignite growth in a product portfolio that's been struggling with declining U.S. tobacco cigarette shipments for years.
The bigger news for Cronos is that it catapulted from less than $25 million in cash and cash equivalents at the end of 2018 to having $1.8 billion in cash on its balance sheet by the end of March. How the company will put this capital to work is what Wall Street and investors are eager to see.
To be clear, Cronos Group has a number of deficiencies, at least relative to its $5.1 billion market cap. It's technically not even a top-10 producer and retailer of cannabis, and it's watched four other companies beat it to the punch when it comes to securing supply deals throughout Canada. It has glaring needs up and down its supply chain, but plenty of cash to tackle various problems.
CannTrust looks to be a reasonable production-boosting acquisition target
Roughly six weeks ago, I opined that Cronos Group could consider using its capital to acquire additional production. With 117,500 kilos in peak annual output forecast by the company, it isn't exactly a major player like its peers -- and that could be a problem if it wants to land lucrative long-term supply deals and expand into foreign markets.
Ultimately, I viewed CannTrust Holdings (NYSE:CTST), which is also Ontario-based, as the best bang for Cronos' buck, hypothetically speaking.
At a little more than $800 million in market cap, CannTrust should be easily acquirable in a cash-and-stock deal without breaking Cronos Group's bank. In return, Cronos Group would get a company with around 100,000 kilos of hydroponic growing capacity and another 100,000 kilos to 200,000 kilos of outdoor grow potential. That's 200,000 to 300,000 kilos in annual run-rate potential by as soon as the midpoint of 2020, which would make CannTrust a top-five, or perhaps even top-three, producer by peak output in Canada. When combined with Cronos Group's capacity, the combined company would be the clear No. 3 producer, behind only Aurora Cannabis and Canopy Growth.
Furthermore, CannTrust's access to cheap sources of water and electricity make its flagship hydroponic facility in Niagara, and its much smaller Vaughan facility, excellent candidates to deliver below-industry-average production costs on a per-gram basis.
It's also worth mentioning that CannTrust is one of the four growers with supply deals in all of Canada's provinces, meaning an acquisition would give Cronos immediate access to all domestic markets.
Valens GroWorks could be a logical buyout target, too
About a month after suggesting that CannTrust would make sense as a means for Cronos Group to bolster its production capacity, I took a separate route and offered up the idea that, since Cronos has fallen so far behind its peers on peak output, it could abandon trying to become a major producer and instead focus solely on the burgeoning derivatives market by acquiring small-cap Valens GroWorks (NASDAQOTH:VGWCF).
Although it's an under-the-radar ancillary stock in the pot industry, Valens GroWorks is now the largest third-party provider of extraction services. That means it's signing plenty of deals with big-name marijuana producers to take cannabis and hemp biomass and deliver resins and distillates that these growers can use to make higher-margin derivative products (e.g., oils, topicals, edibles, beverages, and concentrates).
Recently, Valens signed its most noteworthy deal to date: A two-year agreement with Quebec-based HEXO. HEXO will supply a minimum of 30,000 kilos of cannabis and hemp biomass in year one, and 50,000 kilos combined in year two, for extraction purposes.
Cronos Group already has a deal in place worth up to $100 million with Ginkgo Bioworks that it'll give it access to Ginkgo's microorganism platform. This platform should allow Cronos to develop yeast strains capable of targeted cannabinoid production at commercial scale (and for a low cost). Essentially, buying Valens would make Cronos a pretty indispensable extraction middleman.
Why not both?
But here's my newest crazy thought: Why not buy both companies? Even at a 50% premium for both -- a roughly $1.7 billion combined value -- Cronos would still have plenty of cash left (more than $900 million) if it conducted these purchases as half-cash, half-stock deals.
As noted, CannTrust is a logical buy for a number of reasons. It provides some of the best bang for the buck in terms of peak output, and also being located in Ontario is a feather in the cap for a potential deal. But the key here is CannTrust's outdoor growing potential.
When CannTrust reported its fourth-quarter operating results in late March, it introduced the idea of acquiring 200 acres of land for outdoor growing. Management then noted that most of this cannabis would likely be used for extraction purposes, yielding considerably higher-margin derivative products instead of lower-margin dried flower. If Cronos were to acquire CannTrust for its production and Valens GroWorks for its extraction potential, it would be able to internalize its extraction costs, making it a reasonably low-cost grower, thrust itself into the top-three among producers, and easily become the largest extraction services provider. In my estimation, it could do all this by utilizing maybe half of its cash hoard (and that's assuming a 50-50 cash-and-stock deal for both companies at a 50% premium).
Now, as I've mentioned previously, just because I think it would be a smart idea doesn't mean there's been a shred of evidence to suggest that Cronos Group's management team is even thinking about an acquisition at the moment, let alone of the two marijuana stocks mentioned here. This is pure opinion on my part. But given the synergies that could be realized by combining this trio of companies, it's a crazy-enough idea to work, in my view.