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3 Reasons to Wait on Cannabis Favorite Cronos Group

By Sean Williams – Jun 25, 2019 at 8:51AM

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Despite being a top-performing pot stock since 2016, Cronos Group still has a lot to prove to Wall Street and investors.

By now, it's become no secret that legal marijuana offers a potentially once-in-a-generation growth opportunity for investors. After global cannabis sales nearly hit $11 billion in 2018, according to the newest "State of the Legal Cannabis Markets" report from Arcview Market Research and BDS Analytics, they're expected to soar to north of $40 billion by 2024, representing a compound annual growth rate of almost 25%.

If these various growth forecasts prove accurate and we do see relatively steady double-digit growth rates worldwide in the pot industry over the next 5 to 10 years, there's little doubt that a number of marijuana stocks will come out as winners.

A flowering cannabis plant growing in a hybrid greenhouse.

Image source: Getty Images.

Cronos Group has left other pot stocks in the dust

Early investors in the marijuana industry have placed their bets and anointed Cronos Group (CRON 3.28%) as one of the must-own stocks of the industry. Since the beginning of 2016, Cronos has been a top performer, with gains totaling roughly 6,600% for those who've been willing to brave the wild vacillations that come with owning pot stocks.

Cronos Group really flew to the top of the pack after announcing in early December that Altria would be taking a 45% nondiluted equity stake in the company. In return, Cronos received $1.8 billion in cash upon closing of the investment in mid-March. The belief here is that Altria will work with Cronos to create unique vape products throughout North America. And as for Cronos, there's the reality that it can use its newfound fortune to make complementary acquisitions, boost capacity, broaden its product portfolio, and build up its existing brands. Prior to this deal announcement, Cronos had less than $25 million in cash on its books.

This is also a company with a large focus on the high-margin cannabinoid derivatives market. By derivatives I mean products that aren't dried cannabis flower, such as oils. Cronos struck a deal worth up to $100 million with Ginkgo Bioworks last September that'll allow it access to Ginkgo's proprietary microorganism platform. In return, Cronos Group will utilize yeast strains capable of producing eight targeted cannabinoids, some of which are rare, at commercial scale. This focus on derivatives has been one of the primary selling points of Cronos Group's stock.

Four vials of cannabidiol oil lined up on a counter.

Image source: Getty Images.

Three reasons to keep your distance from Cronos Group

But as I've suggested numerous times before, this is a stock that has a lot to prove to Wall Street and investors. Here are three good reasons, even with a focus on high-margin cannabis derivatives, you should hold off on investing in Cronos Group.

1. Cronos Group's valuation implies a flawless derivatives launch, which is unlikely

To begin with, the company's market cap of $5.5 billion appears extremely lofty and assumes that the upcoming launch of derivatives in Canada will go off without a hitch. For those unaware, Health Canada has announced its intention to legalize a plethora of new cannabis consumption options by no later than mid-October. This launch of high-margin products is generating as much buzz within the investment community as the initial launch of recreational marijuana did in Canada on Oct. 17, 2018.

But here's the problem: It's unclear if the supply chain issues that have caused major marijuana shortages in Canada will be resolved by the time mid-October rolls around. A massive backlog of cultivation applications with Health Canada, along with shortages of compliant packaging, have ensured that it'll take many more months, if not years, before marijuana supply can satisfy domestic demand.

Health Canada has announced changes to its cultivation license application procedure that should help expedite reviews. Going forward, only growers with completed cultivation facilities will be allowed to submit licensing applications. Nevertheless, it's unlikely that Canada will be able to work through such rampant supply issues (for dried cannabis or derivatives) in such short order. That bodes poorly for Cronos Group's chances of a flawless derivatives launch.

Two miniature shopping carts, with one containing a cannabis flower and the other holding vials of cannabidiol oils.

Image source: Getty Images.

2. Competition in the derivatives space will be fierce

Another overlooked problem is that while derivatives are high margin relative to dried cannabis, the competition in the derivatives space will be fierce. Even with Ginkgo Bioworks in its corner, Cronos Group is just one bee in a very busy hive that's looking to take advantage of alternative consumption options.

For instance, Cronos Group announced earlier this month that it plans to enter the U.S. cannabidiol (CBD) market within the next year. CBD is the nonpsychoactive cannabinoid that's best known for its perceived medical benefits. The Brightfield Group has projected that CBD sales in the U.S. could grow from a mere $591 million in 2018 to as much as $22 billion by 2022, representing a compound annual growth rate of 147%. What company wouldn't want a piece of that pie?

However, six of Cronos Group's major-producing peers have already announced their entrance into the U.S. CBD/hemp market via partnerships, joint ventures, or an organic push into the U.S. market. Thus, Cronos would be entering the lucrative U.S. CBD space well behind much of its competition. And this doesn't even take into account the CBD-focused hemp players, such as Charlotte's Web, or the general retail stores, like Kroger and gas station convenience stores, that could be carrying CBD topicals, oils, or capsules. The competition in this space will be fierce, and Cronos bulls are overlooking this point.

A hundred-dollar bill on fire atop a stove burner.

Image source: Getty Images.

3. The tangibles: Losing money and minimal overseas presence

Lastly, Cronos Group's more tangible figures don't offer a lot of promise.

In terms of production, Cronos Group currently slots in as perhaps the ninth-largest individual producer by peak annual output. However, if we were to add in cannabis royalty companies and joint ventures, it slides out of the top 10 altogether. Thus, it leaves a lot to be desired on the production front, even if its focus is on cannabinoid production.

This is also a company with a relatively limited overseas presence. Whereas a number of Cronos Group's largest peers have representation in around 12 or more countries worldwide (including Canada), you only need one hand to count Cronos Group's overseas outlets. This could be troublesome if and when dried flower oversupply rears its head in Canada.

Perhaps most important, Cronos Group has been losing money on an operating basis and may continue to do so for the foreseeable future. If we remove one-time benefits and costs, along with fair-value adjustments on biological assets, from the equation, Cronos Group looks to be the priciest of its peers on a forward sales basis, as well as when factoring in the possibility of ongoing operating losses.

It's for all these reasons that Cronos Group should be left out of investors' portfolios.

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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