This was supposed to be the year that marijuana stocks really put themselves on investors' radars. Canada had become the first industrialized country in the modern era to legalize the consumption and sale of recreational cannabis in October 2018, and derivative pot products were set to hit dispensary shelves just a year later. Everything looked right for cannabis stocks to push toward profitability by year's end.
Yet, here we are just two weeks from the end of 2019, and pot stocks are a disaster. A combination of supply issues to our north and high tax rates in the U.S. has kept cannabis stocks from shining. And the result is some poor performances from very popular pot stocks.
Cronos Group (CRON 5.51%), the ninth-most-held stock on online investment app Robinhood, has lost 36% of its value in 2019, through this past weekend, and two-thirds of its value since the first week of March. With such a significant decline on the books this year, you might be wondering if this represents an intriguing buying opportunity. Before answering that question, let's take a good look at the reasons to buy and avoid Cronos, then weigh in on whether or not it'd be a good fit for cannabis investors moving forward.
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The buy thesis
One of the biggest catalysts for Cronos Group, and really the entire Canadian cannabis industry as a whole, is the official launch of derivative products this week. Derivatives are non-dried-flower products, such as vapes, infused beverages, edibles, topicals, tinctures, and concentrates. Because derivatives bear higher price points and margins than traditional dried flower, this launch is what's expected to significantly improve the operating margins of marijuana stocks. As you'll see in the next point, Cronos is heavily levered to derivatives, perhaps more so than its peers.
Another reason to consider Cronos Group an intriguing buy is the company's close tie-in with tobacco giant Altria Group (MO 0.85%). Following a $1.8 billion equity investment from Altria that closed in March, it became abundantly clear that Altria would be leaned on for its marketing and product development expertise to help Cronos develop a line of vape products. Not only does Altria want to diversify away from tobacco, which has seen declining cigarette shipment volumes in the U.S., but it also wants to take advantage of what should be the top-selling form of derivatives (vapes). Altria's expertise in launching vice brands should give Cronos a leg up on its competition.
Building off of this point, Cronos is also swimming in cash following this equity investment. At the end of the third quarter, Cronos had around $1.5 billion in cash, cash equivalents, and short-term investments at its disposal. As of this past weekend, its cash position comprised around 60% of its market cap. Presumably, this cash acts as something of a downside buffer for Cronos Group's stock, as well as gives it more financial flexibility than many of its peers.
Sounds like a slam-dunk buy, right? Well, there's another side to this story.
Image source: Getty Images.
The avoid thesis
One of the top reasons to keep your distance from a company like Cronos (and a number of Canadian pot stocks in general) is the strong probability of ongoing supply issues in Canada. Regulatory agency Health Canada has struggled to approve licensing applications in a timely manner, while Ontario, the most-populous province in the country, had only two dozen retail stores open on the one-year anniversary of adult-use sales commencing. Translation: Canada has been a breeding ground for the black market. Unfortunately, these supply issues will take some time to resolve, which means the launch of derivatives will be plagued by the same problems dried cannabis has contended with.
Investors might also consider avoiding Cronos Group because it's significantly lagged its competition in the production department. Putting aside Canada's aforementioned supply issues, Cronos has only the Peace Naturals campus, with its 40,000 kilos of peak output, at its disposal until the joint venture Cronos GrowCo project is complete. This is why, in spite of Cronos Group's larger market cap, its revenue has trailed pot growers with significantly smaller market caps.
To add, even though Cronos has been wildly profitable through the first nine months of 2019, the company's profits are solely the result of derivative liability revaluations (i.e., warrants tied to the Altria equity investment). If these revaluations are stripped from the equation, along with fair-value adjustments, we'd see that Cronos Group is nowhere near the point of operating profitability.
Lastly, there's the very real possibility that the company's vape sales struggle out of the gate due to the recent vaping health scare in the United States. According to the Centers for Disease Control and Prevention (CDC), over 2,400 cases of e-cigarette, or vaping, product use-associated lung injury (EVALI) have been reported, leading to 52 deaths, as of Dec. 12. The CDC update notes that EVALI looks to be caused by vitamin E acetate, mostly found in black-market products. Whereas this research is ongoing in the U.S., the CDC's recommendation that consumers not vape liquids containing tetrahydrocannabinol (THC), the cannabinoid that gets users high, could put a serious damper on vape sales throughout North America.
Image source: Getty Images.
The verdict
Now that we've had a chance to weigh both sides, let's return back to the initial question at hand: With Cronos Group down 36% year to date, is this decline a buying opportunity?
My answer is no, it's not.
While I can appreciate the company's healthy cash position, focus on high-margin derivatives, and enviable partnership with Altria, there aren't enough catalysts to outweigh the risks that lie ahead.
The biggest issue is that Cronos hasn't demonstrated that it has a clear path to near-term recurring operating profits. With supply issues expected to continue for some time in Canada, the company's top-line growth will likely be more subdued than Wall Street realizes. Considering that operating results actually matter now, this paints the company's income statements in a bad light.
Furthermore, Cronos' need to diversify its product line and support its supply chain could mean that the company's cash hoard continues to dwindle over time. Thus, the perceived downside buffer provided by the company's cash on hand might be less impressive than first thought.
It's possible that Cronos proves me wrong and leans on these higher-margin products to deliver better-than-expected operating results in 2020, but I'm not counting on it. For now, it remains a popular pot stock to avoid.
