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2019-08-14 22:17:48

Welcome to our Cannabis Earnings series where we break down the latest earnings to help you focus on the most important topics.

Introduction

Cronos (CRON) reported its 2019 Q2 results last week and the stock tanked amid cautious near-term financial outlook. The stock remains the most expensive large-cap cannabis stock in Canada supported by Altria's $2.4 billion investment. We remain cautious on the stock due to its elevated valuation but see enhanced growth opportunities after its entry into the U.S. CBD market.

(All amounts in C$)

2019 Q2 Review

Cronos reported 2019 Q2 results last week which showed net revenue reaching $10 million for the first time, representing an increase of 58% from Q1. Most of the increase last quarter was due to higher sales of CBD oil and dried flowers. Cannabis oil sales accounted for 20% of the total sales last quarter; gross margin remained stable at a comfortable 53%.

(Source: Public Filings)

Cronos sold 1,584 kg of cannabis during the quarter at an average price of $6.44 per gram. The increase was driven by CBD oil sales that had no excise taxes. However, cost of sales increased from $2.69 in Q1 to $3.01 per gram due to higher processing costs. The higher production costs are unlikely to drop meaningfully anytime soon due to Cronos' limited scale.

(Source: Public Filings)

Cronos has limited cultivation assets that are currently operational in Canada. Due to its reluctance to invest in Canada, Cronos only has limited capacity in Canada which hampered its near-term sales and production. Its Peace Naturals Buildings 4 became fully licensed and populated in May 2019 but its GrowCo won't reach full-capacity until 2020 2H. We liked GrowCo as the 50/50 JV is cost-efficient and provides much-needed cannabis production capacity in the medium term. However, the company should have made the move much earlier as it would be two years into legalization by the time the greenhouse is fully ramped up.

(Source: Investor Deck)

The U.S. CBD Opportunity

Cronos announced a US$300 million acquisition of Redwood which owns the popular CBD brand, Lord Jones. The company acquired an established CBD brand that has deep distribution partnerships including being the first CBD brand to become available at Sephora. Lord Jones was only founded in 2017 and offers skincare, bath, and candies using hemp-derived CBD. We view this deal as the first foray into the U.S. cannabis market by Cronos which is bullish for its financial outlook in the near-term. It was not disclosed how much revenue and earnings did Redwood generate in the past but we expect Cronos to see much higher sales out of its U.S. operation than its Canadian division currently does. The U.S. CBD market is experiencing a boom as major retailers begin carrying popular CBD brands such as Charlotte's Web and CV Sciences. However, we still see incremental opportunities for others such as Lord Jones as consumers are just beginning to embrace this new product category.

(Source: Company Website)

Cronos is uniquely-positioned within the cannabis industry by having over $2 billion of cash available for deployment. It also has the ability to leverage Altria's capabilities in many functions which will become highly relevant as it tries to expand its newly-acquired U.S. CBD brand. We see Cronos aggressively pursue growth through expanded distribution and product offerings. Altria could provide support in areas such as sales and marketing, vendor relationships, and manufacturing.

The company also established an R&D center in Israel this May which will focus on vaporizer development. We think Altria could potentially provide guidance given its investment in Juul, the world's most popular vaporizer brand. We believe Cronos will focus on producing vape products in time for the second wave of legalization in Canada.

Looking Ahead

Cronos currently trade at 161x EV/Sales based on the latest quarter which is the highest among large and mid-cap stocks. The company was one of the first Canadian companies to report earnings but its domestic business is also one of the smallest. Cronos management has repeatedly told investors that its focus is on cultured cannabinoids and the U.S. CBD market, instead of the Canadian market. Thus, we see Cronos accelerate its capital deployment in the U.S. as more acquisitions are needed to boost its presence in the fast-growing market. We also expect the company to make significant progress on biological manufacturing based on the ongoing work with Ginkgo Bioworks.

However, the valuation of Cronos is prohibitively high and we would not recommend investors taking a position in the company now. We remain Neutral on the stock as its $2 billion cash pile provides unmatched dry powder and access to new growth opportunities. However, without a clear path to financial success, we believe investing in Cronos is highly speculative at this point.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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