New year, clean slate: That's the thesis for most marijuana stock investors following the drubbing they took in 2019.
Last year was expected to represent a major leap forward for cannabis stocks, with Canada allowing derivatives to reach dispensary shelves, and a number of U.S. states forecast to legalize adult-use weed. But very little of what was expected at the beginning of the year went according to plan. When the curtain closed on 2019, most marijuana stocks wound up losing money, and Canadian weed sales fell significantly short of expectations.
The question is, does the substantive decline in pot stocks over the past nine months represent an intriguing buying opportunity? Investors are probably asking that right now of pot stock Cronos Group (CRON -3.97%), which ended the year about 40% lower, and nearly 75% below its closing high, which was set in early March.
But does this make Cronos Group a buy in 2020?
Unfortunately, dear optimists, the answer to that question remains a firm no.
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Cronos isn't a lost cause...
I'll admit, there are three factors working in Cronos Group's favor. First, it has a boatload of cash stemming from Altria Group's (MO 0.28%) $1.8 billion equity investment in the company. The deal, which closed in March, gave Altria a 45% stake in Cronos and, in turn, supplied Cronos Group with plenty of cash to expand domestically and internationally.
Second (but to build off the first point), Altria is an excellent company to have in Cronos' corner. As a 45% stakeholder, Altria is incentivized to help Cronos Group launch its line of derivative pot products, such as vapes. Altria has keen knowledge of how to market and brand vice products to consumers and will be invaluable in helping Cronos gobble up early stage market share.
Third, there's the aforementioned launch of cannabis derivatives, which happened a little more than two weeks ago. Derivatives are a much higher-margin product than traditional dried cannabis flower, which should result in an improved bottom line throughout the industry.
However, none of these factors outweighs the issues Cronos will contend with in 2020.
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...But it's not a pot stock to buy in 2020
Although not company-specific, Cronos Group will be dealing with ongoing supply issues for much of the year. As an example, Canada's most populous province, Ontario, had just 24 open dispensaries on Oct. 17, 2019, the one-year anniversary of adult-use sales commencing. That's one store for every 604,000 people in the province. The supply channels needed to efficiently move product (including derivatives) from growers to consumers just don't exist at the moment, and they'll continue to be a work in progress throughout 2020. This means the Canadian black market will continue to thrive at the expense of legal growers like Cronos Group.
Another important point is that Cronos Group isn't the major player that its market cap implied it was. The company's only reasonably sized grow farm is Peace Naturals, which is capable of 40,000 kilos annually at its peak, with its joint-venture grow farm capable of 70,000 kilos a year not expected to be producing until the latter half of 2020. The point is, Cronos isn't a major grower, and that could leave it on the outside looking in when it comes to wholesale supply agreements with provinces. Furthermore, it might also create the need to purchase wholesale cannabis down the line to make up for its own lack of production. This would ultimately be a margin killer (just ask Tilray's shareholders).
Cronos Group is also losing money on an operating basis, and should continue to do so in 2020. Even though the company has produced a number of huge per-share profits in 2019, this was solely a result of revaluing derivative liabilities (i.e., warrants) tied to its equity investment with Altria. If we get past the frosting, we see a business with considerably smaller sales than its similarly sized peers and ongoing operating losses. With Wall Street now focused on profits in the cannabis industry, Cronos' one-time-benefit-laden reports won't pass muster.
Image source: Getty Images.
What needs to happen for Cronos Group to rebound
But just because Cronos Group isn't a pot stock to buy doesn't mean it's not worth keeping an eye on. After all, the company is only valued at roughly $740 million more than its cash and short-term investments on hand. If a couple of things go its way, it might be worth a closer look.
Perhaps the most important resolution needed is a more efficient pathway for cannabis products to reach consumers. Ontario, for instance, is shelving its lottery system in favor of a more traditional licensing program for dispensaries. The goal will be to approve about 20 retail stores per month, leading to 250 new locations being opened in 2020. While this would be 10 times as many stores as the province had in October, there would still be a way to go before Ontario is anywhere near retail saturation. If these store openings happen on time, or even ahead of schedule, Cronos could begin to see a real improvement in its bottom line.
It will also have to be mindful of its costs and marketing. The U.S. is fresh off a vape-related health scare, so Cronos is going to have to work closely with Altria to safely navigate a launch of vape products in Canada. Cronos has also already repurposed some of its cultivation space at Peace Naturals for derivatives research and production, but additional cost-cutting may prove necessary to improve operating cash flow as the year moves on.
There's no denying that Cronos Group is one of the most popular pot stocks on the planet. But popularity is not a guarantee of profitability, and investors would be wise to keep their distance in the meantime.
