This note was researched and co-authored by Stepan Lavrouk, director of research at Atreides Capital LLC.
The legal cannabis sector is a booming industry that has swept up many an investor. As with all nascent growth spaces, it is important to separate the wheat from the chaff when it comes to looking for value. In this research note, we will be examining whether Cronos (CRON) more closely represents the former or the latter.
Cronos, a Canadian recreational marijuana company, recently inked a deal with tobacco giant Altria (MO) and seems well-poised to continue to grow and consolidate its market. However, it posted a loss in the previous quarter. So is there value in this stock or is it all hype? Let’s discuss.
Financial Review
Last month, Cronos reported earnings for the third quarter of its fiscal year 2018, demonstrating some impressive growth. The stock is currently trading at around $11.50 per share and has a market capitalization of $2.08 billion. Revenue was up 186% year-on-year and almost 11% on the quarter. Kilograms sold increased 213% year-on-year.
On the other hand, the company posted a $5.5 million loss in Q3, compared with a profitable third quarter in 2017. This was driven primarily by increases in operating expenses, which ballooned 242% year-on-year. While this may worry investors, a key factor behind rising costs was investment in expanding production capacity.
Cronos recently completed Building 4 at its Ontario facility, adding 286,000 square feet of indoor growing space, with the first harvest expected by the end of 2018. This should have considerable positive impacts on Cronos’ financials in 2019 – and beyond.
Benefits of the Altria Deal
As mentioned at the start of this note, Cronos was recently selected by Altria to help it enter the cannabis market. Partnering with the tobacco giant sets Cronos apart and may offer it profound advantages as the industry evolves and other Big Tobacco concerns enter the fray. Altria is making its debut in cannabis through Cronos, having purchased a 45% stake in the company for around $1.8 billion, with warrants to increase that stake to 55% over the next four years. Additionally, Altria now controls the board of directors, with four of the seven seats.
The benefits of this deal are threefold. Firstly, the infusion of capital on its own will go a long way towards enabling Cronos to increase its worldwide reach (more on this later).
Secondly, Atria’s extensive experience in navigating complex legislative and regulatory environments will prove to be invaluable to a young company dealing with similar hurdles. This will bring down regulatory costs.
Thirdly, the deal marks Cronos as a quality producer, which should boost investor confidence and make raising additional capital much easier. That said, the Altria cash should keep the business well-funded for the foreseeable future, decreasing the probability of stock dilution.
Expanding Reach
The Canadian cannabis market is expected to generate around $5.6 billion in sales next year. The US market is estimated to grow to $146.4 billion by 2025, as the number of states legalising marijuana grows. Further afield, Cronos has supply deals in Germany (expected to be the fastest-growing market over the next four years) and Poland. Cronos also has arrangements in Australia, Israel and South America.
Obviously, not all of these ventures will be home runs, but the sheer number of joint ventures and supply agreements makes Cronos stand out in a market with so many smaller companies.
In September, Cronos made another major move forward, announcing a partnership with Ginkgo Bioworks with the stated aim of producing cannabinoids from genetically engineered yeast strains, at a substantial discount to the current cost of production. This could have profound effects on the industry as a whole and represents a potential (but as yet uncertain) value driver for the young cannabis concern.
Investor’s Eye View
Overall, Cronos represents an exciting play in a growing sector. True, there is likely to be some price swings in the short-term, as states establish appropriate regulatory frameworks for the sale and consumption of cannabis. But these are short-to-medium-term problems. What is undeniable is that this industry is here to stay, and investors looking for exposure could do a lot worse than Cronos. It has built important international networks, established a critical partnership with a Big Tobacco concern, and is working to push the bounds of industry innovation.
With market interest running hot in the cannabis sector, it is hard to find any pot stock that looks cheap. But Cronos looks like a company – and stock – with comparatively solid staying power.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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