Why Cronos’ Entry Into U.S. CBD Market Could Be Overrated Over the Long Term


Cronos Group (CRON) got a nice boost from its upgrade from Underperform to Buy from Bank of America/Merrill Lynch analyst Christopher Carey, who also boosted his price target on the company from $13.00 to $20.00 per share.

The impetus behind upgrading the stock by two levels were comments by Cronos CEO Mike Gorenstein, who stated that the company was going to get aggressive with its launch of CBD in the U.S. He was very clear he meant by aggressive that it wasn’t going to be “that long of a way out.”

Partnership with Altria

Carey suggested in a research note that the partnership between Cronos and Altria Group Inc., which has a 45 percent stake in Cronos, was the “key to winning the U.S.”

Carey doesn’t think Cronos will use its C$2.4 billion cash to make an acquisition, rather he sees Cronos leveraging the distribution network of Altria – which has a presence in about 230,000 stores – launching its products in those locations.

He said the “potential to scale distribution nationally via Altria separates Cronos vs peers.”

I don’t have problems with what Carey concludes in general, but there is the fact that even if Cronos were to “win” the U.S. CBD market as it stands today, it represents only about $2 billion at this time. Taking into account the rapidly growing number of competitors in the space, even if it eventually gains decent share in the segment, it doesn’t represent in my view, something that will be a major gamechanger in near term.

The only way it could is if the company does get extremely aggressive with the cooperation of Altria, and takes an enormous amount of market share because of the huge number of potential outlets it could sell out of. The other problem is how much inventory does it really have on hand to make this a significant catalyst anytime soon? Even with its cash hoard, you can’t buy time with it in the sense of producing products faster, unless they invest in more facilities or enter into more partnerships to boost production rates.

Also, the U.S. CBD market is projected to grow to about $20 billion by 2022. That’s not bad, but the number of major players fighting for share will only increase during that time.

I’m not saying this isn’t going to give Cronos a nice boost, only that it needs to be tempered with the realities of doing business. If the company is able to leverage Altria’s distribution network, it will need a lot of product to fill up the huge number of outlets available to it.

The long term

As noted about, the size of the U.S. CBD market through 2022 is only projected to be at about $20 billion by 2022. That may seem like a lot, but when measuring it against the fast-growing medical cannabis market, it’s very small. There’s also the consistency associated with the medical cannabis market that is predictable over the long term. The CBD market is a relative unknown at this time, and can only be guessed at as to the growth potential.

Another uncertainty surrounding CBD is the current limitations it has in the U.S. concerning food additives, which is illegal for interstate commerce. That’s why the company is looking primarily at vape cartridges, sprays, tinctures and CBD creams to start with. How those breaks down on the demand side is probably fairly small.

Even now the company still carries a high valuation against its peers, and it seems to me it’ll not only have to generate more revenue once it goes after the U.S. CBD market, but a lot more revenue to justify its high valuation.

One of the issues there as I see it is the market has attributed a lot more value to companies that have been given a cash infusion, such as Cronos and Canopy Growth, even though the companies have had to give up a big part of their businesses in return. It remains to be seen whether or not having a lot of cash available where the cannabis market is at this time, is a positive for Cronos.

To me much of the positive is already priced in, which we’re seeing in the probable access to Altria’s distribution network. I say probable because it has yet to be confirmed that that is in fact the direction the company takes.

The next important thing, assuming it distributes through Altria, is how it deploys its cash going forward. That will be as important as the short-term bump Cronos gets from the current positive sentiment.

Once there is visibility concerning how Cronos is going to execute its aggressive strategy, there will almost certainly be another nice upward move in its share price, whether that finds a higher bottom or not will be determined by how the market views the long-term viability of its strategy.

Conclusion

Now that expectations have risen for Cronos Group, I do have concerns that once it launches it strategy, it could be disappointing because of the limited number of CBD products it will offer for sale. How much of the vape cartridges, sprays, tinctures and CBD creams market it’ll grab is uncertain, and of course how large it is, and how quickly it gain share.

While I agree the near-term bear thesis that had been in play has in general changed, but I’m not yet convinced it’s to the degree Carey thinks it is.

Even so, there will probably be a higher bottom for now until the details of the strategy are revealed, and further out, what the actual sales numbers end up being. For now, nothing has really changed other than management has said it’s going to get aggressive in its assault on the U.S. CBD market.

The assumptions are its access to Altria’s giant distribution network and its large cash holdings will combine to make this a significant catalyst. The questions remain concerning how big the market really is, how long it’ll take to roll out the products, and how the FDA treats CBD that is infused in food and drinks.

Until then, I’m going to hold off being overly optimistic, and maybe look for short-term positions in the stock that will surely be profitable from news that triggers upward moves in its share price.

Longer term, there’s too much uncertainty surrounding CBD in the U.S. to make a reasonable judgment on the size of the market. Once things are cleared up, then we’ll see the potential of the overall market if it includes being able to sell across state lines.

To read more on the nitty gritty of what’s going on in the rising cannabis industry, click here.

 

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