Cronos Group Could Be the Bargain of a Lifetime

Cronos Group (NASDAQ: CRON), Canada's third-largest pot company by market capitalization, has suddenly turned into a black sheep. In effect, the company's shares have shed 24% of their value since hitting a high-water mark last March following the closure of its $1.8 billion deal with Malboro-maker Altria (NYSE: MO).

Wall Street's abrupt change of heart centers around the juxtaposition between Cronos' lower-tier peak production capacity of around 120,000 kilograms per year and its sky-high valuation. In short, Cronos' lower-rung production capacity has caused the company to lag behind the industry leaders from a revenue generation standpoint. Worse still, this trend isn't expected to change anytime soon. Cronos' stock, as a result, is now trading at an astronomical forward-looking (2020) price-to-sales ratio of 53.7.

This rather unappealing near-term outlook, though, is far from the full story. Cronos, in fact, sports an extremely compelling long-term value proposition that arguably makes its shares a downright bargain at current levels. Here's what investors might be missing about this underappreciated pot stock.

How Cronos is unique

One of the biggest problems facing the pioneers of this rapidly developing space is the issue of how to build a viable economic moat. Pot, after all, is fairly easy to grow, there is a thriving black market that's stripping tons of value out of the legal space, and there are literally thousands of brands already competing for market share in Canada and the United States.

Canada's top cannabis companies, in kind, have largely turned their attention to medically oriented cannabis brands and/or derivative products like beverages and edibles as a way to dig some form of a competitive moat. Peak production capacity has thus become a closely watched metric among marijuana investors. The reason being is that higher production capacities allow companies to meet the demand of the high-volume recreational space, while also enabling the expansion into more profitable channels that can be defended in some fashion (branding, patent protection, etc.).

Wall Street has thus shown a clear preference of late for companies with elite production outputs such as Aurora Cannabis (NYSE: ACB) and Canopy Growth (NYSE: CGC). Driving this point home, shares of Aurora and Canopy have both outperformed Cronos' stock this year:

Cronos, by contrast, has taken an entirely different path to create value for its shareholders -- a fact that the market seems to have missed. Digging into the details, Cronos has openly stated that it doesn't want to to be a farmer like either Aurora or Canopy. Instead, the company intends to create value by building a highly efficient supply chain and developing innovative products. Its tie-up with Altria and partnerships with MedMen Enterprises (NASDAQOTH: MMNFF) and Ginkgo Bioworks are central to this plan.

A supply chain moat

Altria has been slowly collecting patents around vaporizer technology -- many of which seem to have a cannabis component -- since 2013. This formidable patent wall could force other cannabis companies to either license the technology at a hefty premium or avoid this rapidly growing market segment altogether.

What's the connection between Altria's vape patents and its cannabis collaboration with Cronos? Cronos has an agreement with Ginkgo that seems to dovetail nicely with Altria's patented vaporizer tech. Cronos and Ginkgo are using genetically modified yeast to produce a wide range of cannabinoids at commercial scale. These synthetically derived cannabinoids, in turn, might provide the raw material for a wide range of high-end vape products.

Going one step further, these premium vape products would be an absolutely perfect fit for MedMen's upscale dispensaries in Canada and elsewhere. The take-home point is that Altria and Cronos are marshaling their collective expertise to create a unique end-user experience -- one that should culminate in a nearly insurmountable competitive moat in the high-end portion of the market.

Now, on the mass market side of the equation, Altria and Cronos are probably going to turn to contract farmers to quickly ratchet up production following the end of prohibition in the United States. Keeping with this theme, Altria already has the pre-roll infrastructure in place to meet the demand of the mass market. Wall Street, therefore, seems to be making a mountain of a molehill over Cronos' lower-tier production capacity. Altria should be able to convince a large swath of its contract tobacco farmers to switch to cannabis once federal law permits.

The downside is that Cronos' enormous value proposition is largely predicated upon the end of prohibition in the United States. While the political winds seem to favor a change in the law soon, there's no telling how this long-winded legislative process will play out.

Is Cronos a buy?

On paper, Cronos looks like a stock to avoid right now. The company's quarterly sales have paled in comparison to those of Aurora and Canopy in the first two quarters since Canada legalized adult-use recreational marijuana and management doesn't even seem interested in catching up to these top dogs from a production standpoint.

But Cronos has laid a solid foundation for the future with its trio of partnerships with Altria, Ginkgo, and MedMen. In 10 years' time, Cronos seems to have carved a path toward dominating the cannabis oil and vape market segments -- and Altria's massive infrastructure may also make it the market share leader for pre-rolls as well.

Bottom line: Investors may want to look past Cronos' anemic quarterly results. The company is essentially Altria's research and development wing for cannabis and the duo is squarely focused on building a product portfolio that outshines the competition. So, yes, Cronos' stock may indeed be an outstanding bargain for long-term-oriented investors -- that is, if all the pieces of the puzzle fall into place.

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George Budwell has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.