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2 Pot Stocks Expected to Fall at Least 25%, According to This Wall Street Firm

Sean Williams, The Motley Fool

The marijuana industry is growing at a blistering pace, and it's led to rapid appreciation in most marijuana stocks. With the exception of the fourth quarter, pot stocks have been mostly unstoppable since the beginning of 2016. In January alone, 15 marijuana stocks rose by no less than 50%.

The impetus for this rally is the legalization of recreational cannabis in Canada this past October; ongoing state-level legalizations in the U.S.; a growing expectation that Mexico may give the OK to adult-use weed in 2019; and the passage of the Farm Bill in December, which gives the green light to hemp and hemp-based cannabidiol products in the United States.

A businessman in a suit pressing the sell button on a digital board.

Image source: Getty Images.

These marijuana stocks just received the dreaded sell rating

But despite lofty sales growth targets for the pot industry, we as investors have seen this act play out before, and we know that not every company within a rapidly growing industry can be a winner. Earlier this week, investment bank Jefferies initiated coverage on nine pot stocks, anointing five with a buy recommendation and two with a hold recommendation, and giving two more the dreaded sell recommendation.

What's particularly notable about these sell recommendations is that Jefferies doesn't just see modest downside possible. Owen Bennett, the covering analyst, is modeling a target price that's at least 25% lower than where these two pot stocks closed on Tuesday, Feb. 26. Let's dig a bit deeper into these two marijuana stocks that Jefferies doesn't care for.

Cronos Group: $12.93 target price, representing potential downside of 40%

This target price might come as a bit of a shock given that Cronos Group (NASDAQ: CRON) is a Wall Street darling. The bulk of its recent gains have come since December, when tobacco giant Altria (NYSE: MO) announced that it'd be taking a $1.8 billion equity stake in the company, which has yet to close. When it does close, Altria will own approximately 45% of Cronos Group, with warrants being issued giving it the option of upping its stake to 55%. Needless to say, between product development opportunities with Altria (e.g., vape products) and the growing possibility of an outright buyout, investors in Cronos are clearly excited.

But there are a number of reasons to temper that enthusiasm, as evidenced by Jefferies' target price of less than $13 per share. To begin with, Cronos Group simply isn't producing like a major player, despite having a major player price tag. Between Cronos' July announced joint venture, its maximum annual output at Peace Naturals, and a few smaller domestic and international grow sites, its roughly 120,000 kilos in peak production isn't all that impressive. Investors can pick up growers yielding 100,000 kilos or more for less than a quarter of Cronos' market cap.

A person holding cannabis leaves in front of a globe of the Earth.

Image source: Getty Images.

This is also a company that hasn't impressed with regard to its international expansion strategy. Although it does have a presence in Australia and Israel, Cronos Group is lagging growers like Aurora Cannabis and Canopy Growth that have a presence in two dozen, and more than one dozen, respective countries. International markets are especially important, given the expectation that dried cannabis flower will be overproduced and commoditized in Canada within a few years. These foreign outlets will serve as channels for domestic producers to offload their excess supply. Cronos is simply not well prepared right now for this potential scenario.

Then there's Cronos Group's bottom line, which isn't expected to yield much in the way of profits in 2019 or 2020. The company's forward price-to-earnings ratio of more than 450 is enough to make any fundamentally focused investor cringe. There is a reason I've labeled Cronos Group as the most overvalued pot stock, and I believe Jefferies is right on the money with its sell recommendation.

HEXO: $4.26 target price, representing potential downside of 25%

What's perhaps more surprising than a Wall Street firm finally seeing Cronos Group as grossly overvalued is that Jefferies chose Quebec-based HEXO (NYSEMKT: HEXO) as the other pot stock to anoint with a sell rating.

Why rain on HEXO's parade, you ask? Part of the reason could be the company's game-changing joint venture with Molson Coors Brewing (NYSE: TAP), which was announced in early August. HEXO was cheered by Wall Street for landing a brand-name partner despite not being on most investors' radars at the time. Molson Coors and HEXO's joint venture, known as Truss, is expected to begin selling nonalcoholic cannabis-infused beverages by this coming fall.

A cannabis leaf floating atop carbonation in a glass, with cannabis leaves to the right of the glass.

Image source: Getty Images.

However, the market for infused beverages has changed quite a bit in a relatively short time frame. We've witnessed a number of new entrants into the space. And while having a top-tier marketer like Molson Coors in its corner will help, it's unclear just how much of a needle mover infused beverages will be for either party.

Another concern has been the supply shortages and regulatory red tape that Canada has dealt with in the early going. In one corner, growers are still in the process of ramping up their capacity, and they may not be finished upping production for a few more years. In the other corner, Health Canada has been bogged down by cultivation license applications and sales permits. Without these licenses and permits, growers are forced to sit idle or hang onto their harvest. As a result, we've witnessed profit projections falling rapidly throughout the industry, and HEXO is no exception. Over the past three months, Wall Street's 2020 consensus EPS for the company has declined by more than 50%, with its forward P/E now moving north of 50.

Unlike Cronos Group, I'm not as much a fan of Jefferies' sell call when it comes to HEXO. But given the challenges facing the industry, I do understand why pessimists might be leery at this point.

One thing is for sure: Jefferies probably won't be the last Wall Street firm to initiate pot stocks with a less-than-stellar recommendation.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of Molson Coors Brewing. The Motley Fool recommends HEXO. The Motley Fool has a disclosure policy.