The Most Hated Pot Stock Received a Rare Upgrade but Is Still Grossly Overvalued

Sean Williams, The Motley Fool - finance.yahoo.com Posted 5 years ago
image

The cannabis industry has a real shot at becoming one of the greatest growth stories of our generation. The sales are certainly there, with tens of billions of dollars being generated in the black market each year. If a steady portion of these illicit sales are moved into legal channels, and legalized countries and states continue to grow organically, the global weed industry could easily surpass $50 billion in annual sales in a decade, according to Wall Street estimates.

As a whole, analysts on Wall Street view most pot stocks favorably. This really shouldn't surprise anyone since Wall Street typically favors high-growth industries, and generally has a buy bias relative to a sell bias on the companies that it covers.

View photos
A hand writing with a pen and circling the word buy underneath a dip in a stock chart.
More

Image source: Getty Images.

Say what? A Wall Street firm actually upgraded Cronos Group?

There is, however, one marijuana stock that rightly deserves the title of most hated on Wall Street: Cronos Group (NASDAQ: CRON). Cronos Group entered the week with four separate Wall Street firms rating the company with the equivalent of a sell. In fact, Cronos had accumulated more sell ratings than every other pot stock, combined!

But things changed this past Wednesday. In an exceptionally rare move, Bank of America covering analyst Christopher Carey, the same analyst who has called for $166 billion in peak industry sales for cannabis, and has labeled HEXO as his and his firm's top pick, offered a double upgrade to Cronos, moving it to buy all the way from a rating of underperform. Carey also upped Cronos Group's price target to $20 from $13, implying that the company has 39% upside, based on its closing price of $14.42 a share on Tuesday, June 4. 

Said Carey in his note to investors:

While clearly a high multiple even vs. peers, following recent mgmt [management] comments, we have improved confidence CRON is near announcing its launch, in our view a significant catalyst: (1) improving near-term visibility in the largest market for cannabis derived compounds in the world, (2) CRON beginning to flex its near group-leading balance sheet (C$2.4 bn in cash [2.4 billion Canadian dollars]) and partnerships (Altria) to begin a transformation we see creating a vastly different co. in the years ahead.

For those who may not be closely following Cronos Group, much of its 2019 rally comes on the heels of a now-closed $1.8 billion equity investment (that's U.S. dollars) from tobacco giant Altria (NYSE: MO). The deal gave Altria a 45% nondiluted stake in Cronos. Altria also received warrants that, if exercised in the future, could up its stake to as much as 55%. Aside from the possibility of Altria simply buying out Cronos Group, the expectation is that the two will work on vape products throughout North America, with Altria's deep pockets, as well as branding and marketing expertise, proving invaluable to the partnership.

As for Cronos Group, the addition of $1.8 billion in cash -- it had less than $25 million in cash on hand as of the end of 2018 -- gives the company ample leverage to execute on its long-term strategy, which may include added production, international expansion, and a move to further diversify its product portfolio by adding high-margin derivatives.

View photos
An up-close view of a flowering cannabis plant growing indoors.
More
Story continues

Image source: Getty Images.

Upgrade aside, Cronos Group is still the most overvalued pot stock

Although Carey makes the case that Cronos Group is turning the corner, I remain unconvinced. Having referred to Cronos as "the most overvalued marijuana stock" in January, as well as following its fourth- and first-quarter operating results, I'm standing by my assertion that just about any other marijuana stock has more to offer.

The biggest problem with Cronos Group is that, in many aspects, it's not a top-10 cannabis player. It currently slides in as Canada's No. 9 producer if we focus on individual companies. But if we consider the Pure Sunfarms joint venture between Emerald Health Therapeutics and Village Farms International, as well as Auxly Cannabis Group's licensing operations, Cronos Group is no better than 11th in terms of peak retail sales potential with its 117,500 kilos of maximum output.

And, if we really want to get technical, its largest facility, the 850,000-square-foot joint venture capable of 70,000 kilos of yearly output, is only half-owned by Cronos, with the remainder owned by a group of investors. That means Cronos Group's wholly owned production is more like 82,500 kilos a year, which doesn't even make it a major grower.

To build on its production deficiencies, rivals Canopy Growth, Aphria, OrganiGram Holdings (NASDAQ: OGI), and CannTrust Holdings (NYSE: CTST), have secured supply deals with all of Canada's provinces, thereby locking in some degree of predictable annual supply and cash flow. Cronos Group is nowhere near having a deal with every Canadian province.

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

Image source: Getty Images.

It hasn't exactly lit things up from an international expansion perspective, either. With the exception of having a distribution presence in Germany and Poland, and very modest production capabilities in Israel an Australia, Cronos substantially lags its peers in external sales channels. The aforementioned Canopy Growth has a presence in around a dozen countries worldwide, while Aurora Cannabis has a production or distribution presence in 24 nations, including Canada.

If you peel back the $1.8 billion in cash and Altria partnership, it's difficult to see a scenario where Cronos Group's assets fetch more than a roughly $1 billion valuation. After all, you can buy 200,000 to 300,000 kilos of diversified production from CannTrust right now for less than $800 million in market, or gobble up OrganiGram, which is yielding more than twice the industry average on the basis of square footage with its 113,000 kilos (nearly the same peak output as Cronos) for $1.1 billion in market cap. Cronos, on the other hand, looks to offer a slightly below-average yield per square foot.

Even placing a modest premium on its partnership with Altria, and taking into account the eventual depletion of its cash pile as it's put to work, it's tough to make a case that Cronos is worth much more than $2.8 billion to $3.3 billion. But, following Bank of America's upgrade, Cronos sits firm at a $5.3 billion market cap.

Whether it's CannTrust, OrganiGram, Aurora, Canopy, or any host of marijuana stocks, you could throw a dart and come up with a more attractive marijuana stock at the moment than Cronos Group. Suffice it to say, this is one upgrade I don't agree with.

More From The Motley Fool

  • Beginner's Guide to Investing in Marijuana Stocks
  • Marijuana Stocks Are Overhyped: 10 Better Buys for You Now
  • Your 2019 Guide to Investing in Marijuana Stocks

Sean Williams owns shares of Bank of America and CannTrust Holdings Inc. The Motley Fool recommends Auxly Cannabis Group, CannTrust Holdings Inc, HEXO., and OrganiGram Holdings. The Motley Fool has a disclosure policy.