Cronos Group: An Intriguing Value Opportunity (NASDAQ:CRON)

ArtistGNDphotography As a multinational cannabis business, Cronos Group Inc. (NASDAQ:CRON) operates across four continents, with its home market of Canada anchoring most of its operations. Outside of Canada, where it competes in the recreational segment, its focus is on medicinal cannabis, which enables it to compete in lucrative markets like Germany and the U.K. Aside from its marijuana brand called Spinach, its other two main brands, Peace Naturals and Lord Jones, aren’t particularly well known yet. The company’s steady growth, increasing operational efficiency, and cheap valuation in recent times mean that it is likely to be an attractive opportunity for buying and holding for a period of several years or longer. But, as shown by its quitting the U.S. market for hemp-derived CBD in Q2 of 2023 and unsuccessfully attempting to sell off one of its cultivation facilities in Canada, Cronos’ positioning today is unlikely to be the same in a couple of years, and it might even be unrecognizable. At the same time, while it has ample resources to succeed in its current strategic priorities, it faces a few significant risks, some of which are unusual for its industry, and all of which are beyond its control. Let’s begin by analyzing its growth characteristics and plans. Growth Prospects Per its Q1 earnings report, Cronos is currently experiencing relatively rapid revenue growth. Its sales for the period were $25.3 million, a gain of 30% more than a year prior. Nonetheless, that pace is actually lower than the company’s quarterly average over the last five years: Data by YCharts Competing in two markets in particular is driving the additional revenue: Canada, and Israel. Its Spinach brand held a market share of 14.4% in the edibles segment in Q1, down from 15.3% a year prior, marking increasing competitive headwinds while retaining its status as one of the Canadian market’s leaders in the category. The brand is also one of the leading choices for the dry flower segment, holding a share of 6.5%, down slightly from 6.9% a quarter prior. In total, sales to Canada were worth $18.8 million when adjusted for currency impacts. Cronos’ Israel operations brought in 27% more revenue than in the same quarter last year, arriving at $6.6 million on a currency exchange-adjusted basis. Its successful dried flower segment was responsible for driving most of the growth. Importantly, the fact that Cronos is competing favorably in the highly competitive dried flower segment in more than one of its major markets indicates that its ongoing efforts to develop better and more appealing strains of cannabis relative to consumers’ preferences are working as intended. Thus, there is likely more growth on the way in the Canadian and Israeli markets, as well as in Germany, where it is already a major supplier of Canasativa GmbH, a medicinal distributor to pharmacies in the country. Cronos Group Investor Presentation But over the next few quarters, the growth centers are likely to change regardless of its recent progress. This year, it also entered the U.K. as well as the Australian medicinal marijuana markets. There hasn’t yet been enough time since launching for it to report a full quarter’s worth of financial information with the proceeds from either operation, though that will soon change. Beyond those markets, it also has exposure to the U.S. cannabis market via a 5.9% stake valued at $25.7 million in PharmaCann, a private multi-state operator (MSO). It also has the option to acquire a 10.5% stake in that business for a total consideration of around $110.4 million in the event of federal cannabis legalization in the U.S. But, as the prospects of full legalization even occurring are in flux as of right now, the U.S. can’t be considered as an earnings driver just yet. Overall, the growth outlook is favorable for Cronos in the near term. While it may struggle to gain ground against other producers in Canada in terms of market share, the fact that it’s able to keep growing the top line under relatively saturated cannabis market conditions suggests that it is well into the process of building brand loyalty and brand awareness among consumers. In the long term, if those efforts are successful, it could become a competitive advantage in the form of a moat, which would protect its margins. Efficiency Is Increasing Currently, Cronos isn’t operationally profitable, though it has made significant steps towards reducing its losses by implementing cost cuts. Management plans to slash between $5 million to $10 million in selling, general, and administrative (SG&A) and research and development (R&D) expenses this year. Given its operating losses of $15.9 million in Q1, those savings could potentially bring the business within striking distance of operating profits by the start of 2025. There’s reason to believe that management’s plan will pay off for shareholders. Specifically, the past three years of expense-cutting and cost discipline have been overwhelmingly successful, and they haven’t caused the company to lose out on growth: Data by YCharts That should also give investors a measure of confidence that the ongoing attempts to enter new markets and expand in existing ones will not lead to spiraling costs that destroy value. Another point in Cronos’ favor is that its balance sheet looks rock solid, especially in comparison to its peers. It has zero in the way of long-term debt, and $855.1 million in cash, equivalents, and short-term investments. Therefore, it has more than enough resources on hand to acquire promising companies in any of its target markets, and it can likely comfortably enter another market or two as well. Be Aware Of These Risks Cronos’ multinational status exposes it to several risks or impediments. As it’s spread across a handful of countries, it needs to deal with many different sets of regulations and laws, thereby incurring higher legal costs than players that only compete in one market. In places where cannabis laws are actively changing, like in Germany, which appears to be in the process of relaxing some of its rules, the changes could very well lead to having access to a larger addressable market. On the other hand, as access to participating in marijuana markets is tightly controlled in Germany, shifting regulations could easily destroy the company’s privileged position and allow competitors to gain ground more readily than before. The base case for Germany is for the ongoing shift to moderately benefit producers like Cronos, but it is not at all guaranteed presently. Separately from legal risks, of particular concern are Cronos’ operations in Israel, which constitute a significant portion of its revenue. As stated by management, “The extent to which the Middle East Conflict may impact the Company’s personnel, business and activities will depend on future developments, which remain highly uncertain and cannot be predicted.” However, as Cronos’ Israeli subsidiary cultivates cannabis for the purpose of sale to the domestic medicinal market rather than for distribution elsewhere, the risks associated with the potential interruption of imports or exports are not considerable. Cronos Investor Presentation Finally, there is also the risk that the company does not manage to ever become profitable due to persistent difficulty in driving down its costs. At present, it does not appear that this risk will come to pass, though marijuana companies are notoriously inconsistent, so don’t underweight the chances. The Valuation Is Appealing While the risks facing Cronos currently should give investors pause, the stock’s valuation can be interpreted as a green light for investment. Here’s how it compares to its competitors: Data by YCharts Its enterprise value-to-revenue (EV/R) multiple is surprisingly low, as is its price-to-book (P/B) ratio. Such a low EV/R ratio would under normal conditions suggest a business with a tremendous debt load or ghastly growth prospects. Similarly, a P/B of less than 1 is usually reserved for deeply unprofitable operations that are actively destroying value and mismanaging assets without a road towards recovery. Neither of those explanations fits the Cronos of today, though it is unprofitable, as mentioned before. Therefore, it is likely that this stock is significantly undervalued. Positive catalysts, like favorable changes to regulations in its markets, could well lead to the value gap starting to close in the near term. Next Steps Starting a position in Cronos could be a smart move presently, with the understanding that investors will likely need to hold on to their shares for at least a few years to see worthwhile returns. The company’s growth and profitability trajectories thus far, as well as its current growth and efficiency campaigns, point to the Cronos of tomorrow being one of the leading multinational operators. Likewise, its undervalued shares provide investors with a margin of safety and an opportunity for a good return on the risk.

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