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This Just In: Cronos Group Stock Upgraded

Rich Smith, The Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Canadian cannabis stock Cronos Group (NASDAQ: CRON) has had a fabulous year, surging more than 100% in value as Canada's legal marijuana rollout proceeds and hopes for similar legalization in the U.S. gain momentum. As of today, Cronos boasts the third-largest market capitalization among Canadian pot stocks -- and one banker thinks it could do even better than that.

Early this morning, analysts at Merrill Lynch announced they are reversing their opinion on Cronos, and upgrading the shares all the way from underperform to buy, with a new price target of $20. Is this a good idea, though?

Let's find out.

Marijuana plants

Image source: Getty Images.

Reasons not to like Cronos today

As my fellow Fool.com contributor George Budwell has pointed out, "On paper, Cronos looks like a stock to avoid right now. The company's quarterly sales have paled in comparison to those of Aurora and Canopy in the first two quarters since Canada legalized adult-use recreational marijuana and management doesn't even seem interested in catching up to these top dogs from a production standpoint."

Over the last 12 months, Cronos made a paltry $14.4 million in sales -- almost entirely limited to within Canada. (According to data from S&P Global Market Intelligence, 93% of the company's revenue comes from Canadian sales.) Its operations earn no profits, and Cronos is burning cash at the rate of $100 million a year.

Despite all this, Cronos carries a market cap of $5.35 billion and a valuation of more than 370 times sales, let alone earnings.

Reasons to love Cronos tomorrow

Merrill Lynch deadpans in a note covered on StreetInsider.com (subscription required) that this looks like "a high multiple." Even assuming a ramp in production and sales, and giving Cronos credit for the large amount of cash on its balance sheet, Merrill is forced to admit shares sell for a sky-high enterprise valuation of 62 times 2020 sales. Regardless, the banker is telling investors to buy Cronos today despite that high price.

Why?

Not to put too fine a point on it, but Merrill Lynch argues that the reason to buy is that the Cronos we see today will hardly be recognizable by the time tomorrow (figuratively speaking) rolls around.

Cronos' alliance with Altria, combined with its ability to "flex" the $1.8 billion in cash on its balance sheet to expand production and make new deals to grow its influence, are the start of a "transformation" that will result in "a vastly different co. in the years ahead," says Merrill Lynch.

Moreover, currently, Cronos is an almost entirely domestic Canadian company. However, the analyst believes that it's close to announcing a launch of cannabidiol (CBD) products for sale in the U.S. as well, the success of which will yield "improving near-term visibility in the largest market for cannabis derived compounds in the world."

This will be a "significant catalyst" for Cronos stock, predicts the analyst. "As this process accelerates," Merrill Lynch says, arguments against the company based on its high valuation, low production volumes, or both, may become "increasingly untenable."

What it means to investors

And yet, optimistic as this assessment sounds, I have to say that it's awfully short on hard numbers, and awfully long on hope (or hype?). What Merrill Lynch is arguing, it seems to me, is that the primary reason to buy Cronos is because it will soon look nothing at all like the stock that it actually is today!

Granted, there are reasons to be optimistic about Cronos. Entry into the legal U.S. CBD market offers a near-term prospect for growing sales. Longer term, as Budwell argues in his column, "Altria and Cronos are probably going to turn to contract farmers to quickly ratchet up production following the end of prohibition in the United States," and "Altria should be able to convince a large swath of its contract tobacco farmers to switch to cannabis once federal law permits," and therefore Cronos' relatively low production rates will not be an issue.

These hypothetical farmers will be switching to the cultivation of a new form of agriculture, however, and one they're not familiar with farming -- all while competing against massive, integrated production operations run by Cronos' Canadian rivals Aurora Cannabis and Canopy Growth just across the border that could have several years' experience in farming marijuana by that time. It's far from a sure thing that a contract-farming model will produce the kinds of profit margins necessary to bring Cronos' valuation down to reasonable, investable levels.

Nevertheless, this appears to be the bet Merrill Lynch is making. Investors who have bid up Cronos stock over 10% today on the upgrade had better hope the analyst is right.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.