Marijuana companies are popular for one obvious reason: The market for marijuana is one the quickest growing markets in the world, sporting a compound annual growth rate (CAGR) of 28.02% between 2020 and 2025. In recent years, popular Canadian pot companies have started to capitalize on the U.S. cannabis market, which is expected to grow at its own CAGR of 17% until 2025, according to New Frontier Data. Although marijuana is still a Schedule 1 drug under U.S. federal law, which is defined as a drug, substance, or chemical with no currently accepted medical use and a high potential for abuse, Canadian companies are hoping to expand consumer bases in U.S. state markets where marijuana is legal.
Toronto-based Cronos Group (NASDAQ:CRON) is one company extending its reach. Its deal with the maker of Marlboro and Black & Mild brands, Altria Group (NYSE:MO), fascinated investors last year. But is Cronos reaping real benefits from the deal? There are three things that investors should be aware of before buying this stock, which are inhibiting Cronos' growth.
Revenue is overshadowed by costs
Revenue for Canadian marijuana companies took a major hit last year after regulatory holdups caused delays in the openings of legal stores. This caused consumers to turn to the black market, which offers cannabis products at cheaper prices. However, this year, the pandemic caused consumers to purchase pot like any other consumer staple product -- often and at regular, consistent prices. Revenues for U.S. cannabis companies have skyrocketed, and states including Colorado and California have seen record monthly revenues for legal cannabis sales. No doubt, Canadian companies have also seen a surge in sales amid the pandemic, but their growth is comparably modest, in part because the pandemic did its part in delaying legal store openings in 2020.
Surprisingly, Cronos, which boasts a market cap of $1.8 billion, higher than Canadian peer Aphria's (NASDAQ:APHA) cap of $1.3 billion, saw mellow revenue growth this year. But for the full fiscal year 2020, Aphria saw a stunning jump of 129% year over year to 543.3 million Canadian dollars. Meanwhile, Cronos only earned net revenue of $8.4 million in the first quarter and $9.9 million in the second quarter of fiscal 2020, bringing the total to $18.3 million for the first six months (ended June 30).
So Cronos is still growing revenue, including in its recent second quarter, but why is there such a drastic difference in growth from its Canadian cousin? It could because Aphria has a wider network, offering a range of medical and recreational cannabis products in Germany, Italy, Malta, Colombia, and Argentina. The company stated in its management, discussion, and analysis report that it maintains supply agreements for recreational cannabis with all Canadian provinces and the Yukon Territory, which allows it access to 99.8% of Canadians. Despite its international reach, Aphria's focus is still on its core Canadian market, which drives revenue growth.
In addition to dragging revenues, Cronos' costs surged in Q2 driven by higher selling, general, and administrative (SG&A) and research and development (R&D) expenses. The jump in operating expenses led to a rise in adjusted operating loss to $31 million, up $14 million from the year-ago period. Management said that an increase in the workforce to support the company's growth strategy pushed the expenses higher, but its revenue numbers don't reflect that growth. Cronos also had to reinstate items in the first three quarters of fiscal 2019, which cut off $7.6 million from its revenue for two of the quarters. Readjustments like these make investors skeptical.
Hopes for the U.S. vape market are fading
When vaporizers first hit the market in the U.S., demand was high. But things took an ugly turn when news on the dangers of vaping hit the market in 2018. The Centers for Disease Control and Prevention (CDC) identified illicit market vape products that contained vitamin E acetate, which caused a new disease called "e-cigarette or vaping product use-associated lung injury," or EVALI. As of Feb. 18, 2,807 hospitalized EVALI cases or deaths had been reported to the CDC from all 50 states. Now, as COVID-19 sweeps across the country, consumer uncertainty about vape products and their effects coupled with the coronavirus, which can affect the lungs, has heightened. This dynamic spells trouble for Cronos' business through its new partner, Altria.
Though many cannabis companies try to ensure that their legal products are of high quality, the effect on the market is evident through Cronos' underwhelming sales so far in 2020. The U.S. market contributed to just 22% of Cronos' net revenue in the second quarter, earned purely from cannabis extracts.
Cronos is still working towards a competitive advantage
Cronos' 36% year-over-year rise in R&D costs to $3.6 million in Q2 appears acceptable given its involvement in an innovative process of producing cannabinoids more cheaply and efficiently via biosynthesis. Cronos, along with its partner Ginkgo Bioworks, successfully fermented one cannabinoid by biosynthesis in the first quarter. In the second-quarter earnings call, management stated the company is on "schedule to produce fermented cannabinoids at commercial scale in September 2021."
Once commercialized, it could give Cronos a competitive advantage, or an "economic moat." As coined and popularized by Warren Buffett, an economic moat implies a company's capability to sustain a competitive advantage over its peers and protect its long-term profitability and market share.
An economic moat not only helps a company enjoy sustainable earnings, but also helps it stand out in front of consumers. This advantage could help Cronos catch up to its peers in terms of revenue and (hopefully) achieve profitability. Investors should keep an eye on Cronos' plans to bring the product to market.
Hold on for now
Besides vaporizers, Cronos hasn't launched any other derivatives products, which could be one of the reasons for the lower revenue numbers. Meanwhile, peer Canopy Growth (NASDAQ:CGC) has offered a wide range of cannabis-infused beverages and chocolates in addition to vape products. Canopy Growth has seen solid sales growth in response. Aphria also has innovative derivatives products in its pipeline.
Cronos' delay in launching derivatives might prove detrimental for its growth, as its peers are already ramping up production. Shares of Cronos have sunk 33%, compared to the industry benchmark Horizons Marijuana Life Sciences ETF's decline of 36%. Aphria, on the other hand, has slumped 18% over the same period.
Investors should wait to have a clear picture from the management about Cronos' growth strategies and expansion plans before picking this cannabis stock.