Why Cronos Group Is Overvalued Right Now

The majority of cannabis stocks have seen their shares plummet over the past few months, eradicating most of the earlier gains seen in the first quarter of 2019. While many of these companies have become viable investment opportunities now that they're trading at lower prices, there is still a handful of stocks I wouldn't recommend touching until they fall much further.

One of these companies is Cronos Group (CRON -1.66%). The company has recently overtaken Tilray (TLRY) as the third-largest cannabis company by market cap, behind only Aurora Cannabis (ACB -1.15%) and Canopy Growth (CGC 1.28%).

The story behind Cronos Group, which is worth $4.04 billion right now, is one that reflects the investor overexcitement surrounding the cannabis sector ahead of Canada's legalization last year. Back in 2018, Cronos Group had reached such a high valuation that it was seen as overpriced even by industry experts who were otherwise highly optimistic about the cannabis industry's growth potential.

Fast forward to 2019, and Cronos has seen its stock decline substantially. However, I think there's still a strong case to be made that Cronos remains overvalued even after falling 50.7% over the past six months.

IMAGE SOURCE: GETTY IMAGES.

Looking at the financials

Taking a brief look at the company's recent quarterly results, net revenue had reached just $10 million, a 58% increase from Q1 2019 but still an extremely small figure overall. Margins remain high, sitting at 53% overall, while its average selling price remains at a comfortable $6.44 per gram. Unlike other producers, Cronos has very few assets in Canada; instead, it has focused on expanding in the U.S. One of the more recent developments in this trend includes the $300 million acquisition of Redwood, owner of the well-known Lord Jones CBD brand.

At the same time, Cronos is working on developing a system that would produce cannabinoids via biosynthesis as opposed to regular cultivation. Instead of growing cannabis regularly, biosynthesizing these compounds with yeast can significantly reduce the cost of production. For regular cannabis, Cronos' cost of sales increased from $2.69 to $3.01 per gram between Q1 and Q2 2019, due mainly to higher processing costs.

This paints the picture of Cronos as a unique Canadian large-cap cannabis producer that has stayed away from the domestic market to instead focus on building international business, predominantly in the U.S. Sitting at a very comfortable $2 billion in cash, Cronos has plenty of financial room to pursue further acquisitions in the U.S. should it wish to do so.

Besides the low revenue figures, none of this seems particularly alarming from a financial standpoint in and of itself. The problem many investors have is that there's no real justification for its needlessly excessive valuation.

Cronos Group is trading at 114.6 times enterprise value to sales based on its recent quarterly financial data. This makes it one of the most expensive cannabis stocks on the market. In comparison, all of Cronos' rival large-cap pot stocks are trading at much lower multiples. Canopy Growth and Aurora, both of which are significantly larger in market cap in comparison to Cronos, are trading at EV/sales (enterprise value to sales) multiples of 25.4 and 26.5, respectively. Aphria (APHA), with a $1.4 billion market cap which is just over a third of Cronos', is trading at an EV/sales ratio of only 7.3 and has reported drastically higher revenues.

Here's a comparison of major cannabis producers by market cap, EV/sales, and revenue.

Data Source: MarketWatch.

History of overvalued pot stocks

With relatively little to justify these high valuations, why would Cronos trade so high in the first place? Back in late 2018, Altria (MO 1.91%) announced a $1.8 billion investment in Cronos, something that drastically elevated its perceived attractiveness to investors. In two months, shares of Cronos more than doubled from $11.54 to $21.92, despite relatively little changing from a fundamental perspective.

In fact, the story behind Cronos Group resembles the tale of another major cannabis producer. Tilray was also trading at an extraordinarily high multiple earlier this year, sitting around 52.8 EV/sales in January, much higher than both Canopy and Aurora despite very little in terms of revenue. Since then, Tilray's stock has fallen by a drastic 63.2% as well. The difference between Tilray and Cronos now, however, is that Tilray is currently trading at a much more reasonable multiple, only 25.9 times EV/sales in comparison to Cronos' 114.6. Viewing Tilray as a case study, it's not difficult to imagine Cronos Group suffering a similar fate, with share prices falling anywhere from 50% to as much as 80% under the right circumstances.

What's in store for Cronos?

Overall, I think there's little reason for Cronos to remain so expensive when other overvalued cannabis stocks have collapsed to more reasonable levels. The company's $2 billion in cash is definitely a selling point for many experts and is likely a big reason so many Wall Street analysts give the stock a hold rating as opposed to an outright sell. However, I think that Cronos' high trading price is a liability for the company's stock, which makes me uncomfortable recommending it to investors. Wait until prices fall and key financial metrics fall in line with those of other large-cap pot stocks before considering the company.