If You Must Invest in a Pot Stock, Cronos May be the One (NASDAQ:CRON)

Cronos Group NASDAQ: CRON kicked off the earnings season for cannabis stocks by posting a narrow profit but with revenue that came in slightly below expectations. The company generated $1.9 million more revenue than in the second quarter. However, CRON posted a CA$6.2 million greater loss in EBITDA in the second quarter.

After rising nearly 5% on the news, the stock has given back all those gains and was trading down in mid-afternoon trading.

Bill Kirk, an analyst for MKM, said “We continue to struggle with the profitability for the industry. With inventory levels too high and absolute and relative pricing pressures, we don’t see a near-term industry catalyst for improved profitability.”

Cannabis stocks have come down to earth

To say it’s been a difficult year for marijuana stocks would be an understatement. After a meteoric rise in 2018 based on nothing more than future potential, pot stocks have come crashing back to reality. Investors are now demanding to see a path to profit.

The fundamental problem is supply and demand. In this case, the market is amply supplied, but there is not enough demand due to a lack of market access. Even though the Canadian market is now open for business for both medicinal and recreational use, many of the leading cannabis companies know that the market won’t really open up until the U.S. market opens up.

Investors and analysts see this as well. And this is causing many investors to stay away from all cannabis stocks. But this strategy assumes that all cannabis companies are equal.

In the case of Cronos, I don’t think that’s true.

Cronos is playing a different game than other cannabis stocks

An overriding tendency within the cannabis sector is to look at all companies the same way. But while some companies like Canopy Growth NYSE: CGC and Aurora Cannabis NYSE: ACB are relying on production capacity to carry them to profit, Cronos is taking a different approach.

In August, Cronos completed its acquisition of four subsidiaries of Redwood Holding Group. Redwood is the owner of the Lord Jones brand which entered CRON’s profit and loss account on Sept. 5.  This is one part of what can be called an asset-light approach to growth. Cronos is not seeking to become the largest producer. Rather they are concentrating on building a network of co-manufacturing joint ventures and partners to carve out specific niches in the cannabis sector.

The acquisition of Redwood is the company’s first foray into the U.S. marijuana market and continues the company’s focus on the growing demand for CBD-based beauty products.

Producing cannabis through biosynthesis

Another example of how Cronos is taking a different approach to the cannabis market is its partnership with the bioengineering company Gingko Bioworks. Cronos entered this partnership in 2018. If all goes according to plan, CRON will be able to reduce the cost of cannabis production. And, they will also be well-positioned to product “minor cannabinoids” on a large scale. One such product is Tetrahydrocannbivarin (THVC) which has a number of health benefits including an ability to suppress appetite which is not a benefit in THC or CBD.

Gaining a foothold in the Canadian derivatives market

With recreational usage of marijuana now legal throughout all of Canada, it is opening up a large derivative market. This includes products such as vaping pens, edibles, and topicals. While the vaping industry is currently under fire, and with good reason, in the long term tighter regulation will benefit the cannabis companies that are trying to ensure delivery of products that meet regulatory guidelines. Cronos has a relatively small place at the table right now, but with agreements in place with third-party suppliers, they will remain a presence.

Cronos is not diluting their share price through acquisition

The standard practice that many cannabis companies use to finance their acquisitions is the secondary stock offering. This is a common accounting tactic used with real estate investment trusts (REITs). But a REIT is obligated to pay out a dividend so shareholders don’t lose value. That’s not the case with cannabis stocks. With every secondary offering, they dilute the value of existing shares.

Cronos, by contrast, paid for most of its Redwood acquisition with cash. Some of which they received from Altria (NYSE:MO) which made a $1.8 billion investment in Cronos Group in 2018. Shareholders may quibble with the purchase price of $300 million that was anywhere from 75 to 100 times earnings. However, Cronos’ long-term debt remains very low compared to a company such as Canopy Growth.

Cronos has a compelling story that goes beyond cannabis

The question is whether investors have tuned out of the cannabis market entirely. If they haven’t than CRON stock is worth a look not just as a cannabis company, but as a small-cap growth company that is taking an innovative approach.

In a world of unicorns, Cronos is attempting to raise its market share through repeatable revenue and share price appreciation, not by fuzzy math and accounting maneuvers.