Buy Cronos Stock Before It Surges Higher

seekingalpha08-21

Initiating coverage on Cronos stock with a "Strong Buy" rating.Cannabis industry tailwinds, conservative growth approach, and geographic expansion support Cronos' growth acceleration and EBITDA margin...

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Morsa Images/DigitalVision via Getty Images Initiating Coverage I am initiating coverage on Cronos (NASDAQ:CRON) stock with a “Strong Buy” rating and an investment horizon of 24 to 36 months. I believe that Cronos stock is undervalued and is poised for a breakout rally. This coverage discusses the reasons to be bullish on the cannabis stock, with a focus on the fundamentals and the growth acceleration catalysts. If we look at the price-action, Cronos stock has trended higher by 15% for year-to-date. In my view, the best part of the rally is due, and the stock is likely to remain in an uptrend. It’s worth noting that the cannabis stocks have gone through an extended period of depression. The reasons include regulatory headwinds, competition, over supply, and cash burn. However, the headwinds have waned and some of the best cannabis stocks are positioned to create value in the next few years. Cannabis Industry Tailwinds Before talking about Cronos, I would like to briefly discuss the industry factors that will support growth. The most important factor being a relatively friendly regulatory environment. Germany legalized cannabis in May 2024, and it’s likely that other European countries will follow suit. It’s worth noting that a 2021 study indicated that the legalization of cannabis in Germany can help in the creation of 27,000 jobs. Further, it “could bring the tax authorities a total of more than 4.7 billion euros per year.” Therefore, there are bigger incentives to legalize cannabis at a time when the European economy is struggling in terms of growth and job creation. In the U.S., legalization at the federal level remains elusive. However, research indicates that most Americans support the legalization of recreational cannabis. Further, it’s likely that cannabis will soon be reclassified as a Schedule III (less dangerous) drug. This might be the first step towards federal level legalization. It’s also worth noting that the global medicinal cannabis market is expected to grow at a CAGR of 21.8% between 2023 and 2030. This presents another big market opportunity for research-backed medicines. Overall, I am optimistic on the legalization scenario in the U.S. and Europe. As more countries adopt a friendlier approach, cannabis companies are likely to witness significant growth acceleration. Cronos Adopting a Conservative Growth Approach When a company has a robust cash buffer, it’s easy to get carried away and pursue aggressive organic and acquisition-driven growth. However, I like the fact that Cronos has remained conservative in the last 24 to 36 months. As of December 2022, Cronos reported cash and equivalents of $877 million. For the last financial year, the company’s cash buffer was $861 million. Further, as of Q2 2024, Cronos reported a cash buffer of $848 million. Clearly, the company has been conservative in utilizing its cash. It’s the right approach as Cronos waits for significant regulatory tailwinds before pursuing big expansion plans. I must add here that Cronos commands a market valuation of $938 million. A zero-debt balance sheet and a cash buffer that’s 90% of the market value is an indication of the extent of undervaluation. Another point to note is that in May 2023, Cronos decided to exit its existing U.S. operations. The company, however, reaffirmed that “U.S. will be one of the most important cannabis markets in the world.” The strategic exit has, however, supported the objective of cost-cutting and moving towards adjusted EBITDA breakeven. Overall, the markets might not have liked the conservative management approach. However, Cronos is ready with a strong war chest to significantly accelerate growth once industry tailwinds emerge. Broadening Geographic Presence While I talk about a conservative management, Cronos is gradually expanding its wings. For the last year, Cronos reported net revenue of $87.2 million. Of this, 74.2% of revenue was from Canada and 24.2% from Israel. Therefore, Cronos had limited geographic presence, and that’s one reason for relatively muted revenue growth. In September 2023, Cronos shipped its first order of bulk cannabis to Germany, with Cansativa Group being the distributor. The entry into Germany couldn’t have come at a better time, and I expect the country to be a growth driver. In January 2024, Cronos announced its entry into the Australian cannabis market. The company shipped cannabis flower to Vitura Health Limited. The medicinal cannabis market in Australia is estimated at $186 million, and Cronos seems positioned to benefit. Additionally, in May 2024, Cronos announced entry into the U.K. market in the medicinal cannabis business. It’s worth noting that Cronos owns a 50% stake in Cronos Growing Company (GrowCo). The latter is a cannabis cultivation company. In June, Cronos announced an investment of $51 million (through a secured non-revolving credit facility) in GrowCo. The investment will help in supporting the “increased global market demand for high-quality cannabis flower.” With entry into new countries and a strategic investment, Cronos is positioned to accelerate revenue growth. This will translate into positive price-action. Growth Acceleration and EBITDA Margin Improvement For Q1 2023, Cronos had reported revenue de-growth of 20% on a year-on-year basis to $20.1 million. However, there was gradual improvement and for Q4 2023, Cronos reported revenue growth of 9% on a year-on-year basis. The trend in the current year has been encouraging. In the most recent quarter (Q2 2024), Cronos reported revenue growth of 46% on a year-on-year basis to $27.8 million. Expansion in new markets has supported top-line growth, and I expect healthy numbers to sustain in the coming quarters. It’s worth noting that the strategic decision to exit U.S. last year was a part of the cost-cutting efforts. That’s yielding results. For the first six months of 2024, Cronos reported an EBITDA loss of $21.7 million, as compared to an EBITDA loss of $31.6 million in the prior year comparable period. There are two factors that will continue to support EBITDA margin expansion. First, the company’s cost-cutting efforts. Cronos has guided for operating expense savings target of $5 to $10 million on a standalone basis in 2024. Further, robust revenue growth will be associated with operating leverage. Given the narrowing of EBITDA level losses, I am of the view that Cronos is likely to achieve adjusted EBITDA breakeven in the second half of 2025. This is a key stock upside catalyst as it would imply further improvement in fundamentals. Further, considering the total addressable market, it’s likely that EBITDA margin expansion will sustain beyond 2025. Risk Factors The biggest risk to the bullish thesis is regulatory headwinds. It seems that countries are increasingly willing to change their stance on cannabis. However, any delay in legalization will continue to impact growth. Having said that, even without federal level legalization, the U.S. cannabis market is expected to be worth $71 billion by 2030. Similarly, Curaleaf Holdings (OTCPK:CURLF) estimates that the European cannabis market is likely to be worth $246 billion. Another risk that industry players face is competition and oversupply. This has translated into an inventory glut for cannabis flowers. The company’s President and CEO, Mike Gorenstein, however, makes an important point. That there is “a difference between available cannabis inventory and available inventory that's sellable as quality flower.” While there is a glut of the former, there is a shortage of high quality. With additional investment in GrowCo, the target is to meet the increasing demand for quality. Another factor to note is that Cronos has a strong balance sheet and the backing of Altria (MO). Even amidst intense competition, the company is well positioned to survive and grow. I further believe that the industry will see consolidation in the next few years. Fundamentally strong companies like Cronos will benefit from the consolidation. Concluding Views Cronos stock has witnessed an extended period of price and time correction. However, in the last 12 months, the stock has delivered positive returns of 35%. This is an indication of the point that the cannabis stock has bottomed out. Further, the rally has been backed by positive business and financial developments. With Cronos pursuing geographic expansion, I am optimistic on the growth front coupled with the likelihood of continued improvement in EBITDA margin. A strong cash buffer is a big positive and can be potentially utilized for acquisitions once regulatory headwinds wane. It’s also worth noting that Cronos has a presence in the recreational as well as medicinal cannabis business. The recent entry into Germany, Australia, and the U.K. has been in the medicinal cannabis segment. Therefore, there is a big addressable market and provides headroom for healthy growth in the next five years.  Given these positives, I consider Cronos stock as a “Strong Buy” at current levels of $2.4. 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