Cronos Group (NASDAQ:CRON) is taking a different path than the rest of the cannabis industry. Long-term, that looks like a good thing for Cronos Group stock. It’s the short-term trading in CRON stock that looks like a potential problem.
To be sure, CRON stock already has lost more than half its value just since early March. And the stock did put in a bit of a bottom starting in late August, though a decline on Monday suggests the selling pressure might not yet be over.
That said, the problem for Cronos Group stock seems the same as I argued back in July: it’s the cannabis play for investors who worry that cannabis plays still look overvalued.
That doesn’t mean the long-term strategy will fail, of course. As one of those investors who long has questioned valuations in the sector, I see the Cronos stock strategy as particularly wise. But Q2 earnings last month further highlight the near-term issue: even if Cronos Group is right, CRON stock still lacks an immediate catalyst.
The Long-Term Strategy for Cronos Group Stock
One of the core principles of Cronos’ strategy is that producing cannabis is likely to be a narrowly profitable or even unprofitable endeavor. It’s copying the strategy of Altria Group (NYSE:MO), looking to build a network of contract producers instead of building out capacity itself.
Using that third-party supply, Cronos then plans to enter differentiated, value-added, and higher-margin markets. Its Cronos Device Labs focuses on designing new and improved vaporizer products. A research and development partnership looks to create new cultured cannabinoids. It’s looking to edibles and topicals as well.
As CEO Mike Gorenstein phrased it early in his prepared remarks on the Q2 conference call, “We have often discussed our view that in the mature market, capacity is a means to an end, not the key driver of value.”
That view makes sense. Prices in several regulated U.S. markets have crashed. Recent earnings from Tilray (NASDAQ:TLRY) showed a big, and worrisome, drop in average price per gram. Cannabis bears long have argued that production will be a capital-intensive and low-margin endeavor. In other words, not a great business — even if demand for legalized cannabis soars over the long haul.
The Near-Term Problem for CRON Stock
One issue for CRON stock is that the strategy goes against sector bulls. Investors who see a cannabis boom on the way are going to choose the likes of Canopy Growth (NYSE:CGC) and Aurora Cannabis (NYSE:ACB). Both companies have used acquisitions to build out production and worldwide reach.
But a new issue seems to have popped up after last month’s Q2 report. On the Q2 call, Cronos forecast that its Adjusted EBITDA loss would increase in the second half. Investments in branding and R&D are the key culprits.
That’s likely not what investors want to hear at the moment. Across the sector, worries about the bottom line seem to be offsetting any good news on the top line.
Cronos handily beat revenue estimates in its Q2 report — yet Cronos stock, after a brief pop, continued its downward trend. Cowen, a long-time CRON bull, lowered its price target to C$17 after earnings, citing worries about Cronos’ “path to profitability.”
If investors are going to choose a cannabis stock on profitability, CRON probably isn’t it, at least through the second half of this year. Those ‘value’ seekers might look to Aphria (NYSE:APHA), who is guiding for positive Adjusted EBITDA.
If investors want revenue, CRON similarly isn’t the choice. Its revenue and production numbers will look lower than peers. CEO Gorenstein himself admitted as such on the Q2 call. “Now, we understand that many investors are modeling cannabis companies off of their production capacity,” he told listeners. “However, our business model is not to be the farmer.”
In the short term, there’s yet another issue. The company’s focus on edibles and vaporizers means key revenue isn’t coming until 2020, as regulatory body Health Canada has been slow to approve cannabis derivatives. As such, in terms of both revenue and profits, Cronos looks like a 2020 story at best.
How to Play CRON Stock
For the next six months at least, whatever the fundamental metric, CRON stock is going to look less attractive than its peers. Neither its production nor its revenue is going to be as high as that of companies building out capacity. Its earnings, at least in Q3 and Q4, are going to stay negative. Revenue contributions from derivatives won’t come until next year.
And, at least for the moment, cannabis investors seem to be more focused on the fundamentals. That’s truthfully an odd focus to have. Regulated cannabis is a nascent market. Legalization of recreational marijuana will take years, if not decades, to play out worldwide.
It’s a doubly odd focus for investors to have when it comes to Cronos. The company has roughly US$1.5 billion in cash after its recent acquisition of U.S. CBD player Redwood. There’s almost no risk of bankruptcy unless Cronos decides to splurge big on an acquisition — something that seems highly unlikely given its strategy.
More broadly, this is a stock and a market that require patience. Investors right now don’t seem to have that patience. That likely goes double for CRON stock, whose markets will take longer to develop than those of peers moving to build out significant capacity.
Until that changes, Cronos Group stock, and the sector as a whole, are unlikely to rebound. After Q4 earnings in particular, it looks like a rebound in CRON is a ways off.
What can an investor do? Selling puts is a strategy only for investors who truly understand options trading, which can be risky. But premiums on CRON stock are reasonably high, leaving an investor with either attractive returns or the ability to own CRON below $10.
That aside, patience is likely wise here. The sector is struggling. Cronos is going to post losses in the next two quarters at least. The wisdom — or folly — of its strategy will take years to be proven. Until then, sideways trading might be the best investors can hope for. Of course, that sideways trading could be an opportunity, if treated correctly.
As of this writing, Vince Martin has no positions in any securities mentioned.
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