Cronos Group Inc. (CRON) is one of the hottest names in the pot stock space in 2019. The name experienced a major positive development in December 2018 when it announced tobacco giant Altria Group (MO) would be purchasing newly issued shares of CRON amounting to an approximately $1.8B USD investment. As CRON approaches earnings however, I want to remind market participants of something some seem to have forgotten as CRON has run into the stratosphere, up over 100% year-to-date.
The CRON-MO deal: A Major Part of the CRON Bull Thesis
On February 21, 2019, CRON notified the market that shareholders had voted to approve a $2.4B CAD investment from MO, a move that was largely expected based on the December 2018 announcement of this proposal. I believe MO has certain expertise which will be very useful to CRON. Most notably, MO has experience marketing products (tobacco) under restrictive conditions, doing its best to create and maintain branding despite a near outright ban on tobacco advertising. Similar restrictions apply to marketing of recreational cannabis in Canada.
The rules are extremely restrictive and I think we can liken them most to cigarette manufacturing... The packaging has to be very, very non-descript. - Retail expert Doug Stephens speaking to CTV about marketing and advertisement of recreational cannabis in Canada.
When we look at the Constellation Brands (STZ) and Canopy Growth Corporation (CGC) deal by comparison, advertising alcohol on TV and at sporting events (often via sponsorship) is still legal and commonplace. A THC containing beverage produced collaboratively between CGC and STZ might end up being one of the most difficult products STZ has ever tried to market because the restrictions on marketing and perhaps packaging will be greater than for alcoholic beverages.
The same can be said about the Tilray (TLRY) and Anheuser-Busch InBev (BUD) joint venture announced in December 2018, or the HEXO Corp. (HEXO) and Molson Coors Brewing Company (TAP) joint venture announced in August 2018. These alcohol companies do not normally market products that face such restrictions on advertising as a THC beverage might. An additional issue is that THC containing beverages are not yet legal in Canada and so the benefit to CGC, TLRY or HEXO from these collaborations in terms of product revenues is unlikely to be seen for a few more quarters at least.
CRON then has got itself a very valuable partner with MO and while initial details of MO's investment didn't come with the most extensive detail on what the two would actually be doing together, it seems MO's expertise is more likely to be of use sooner rather than later. Smokable cannabis products, for example dried flower, are already on the market and with the recent launch of legal adult recreation cannabis now is the time to launch products which establish a loyal customer base, branding is a key part of that.
The CRON-Ginkgo Bioworks Partnership
Another part of the bull thesis is CRON's partnership with Ginkgo Bioworks Inc, announced September 4, 2018. Ginkgo with funding from CRON may be able to develop a method that allows the company to produce large quantities of less studied cannabinoids (cannabinoids other than THC and CBD). Scientifically, this is quite exciting because many of these less studied cannabinoids occur at lower amounts in most strains of the cannabis plant. It would not be economical to harvest large amounts of the cannabis plant simply to extract a modest amount of a rare cannabinoid of interest. Putting genes for cannabinoid synthesis into yeast cells it should be possible to control exactly what cannabinoids are produced by those yeast cells.
Based on comments on the conference call on September 4, 2018, once Ginkgo produces the cannabinoids, CRON appears to intend to market them via the adult legal recreational route. The reference of The Cannabis Act suggests that. This would mean CRON will produce products which are available to all over the legal age in the relevant territory or province, which is the largest market available. CRON might also seek to make these products available as medical cannabis is or even one day run clinical trials on the cannabinoids, but CRON hasn't said much or anything about that at this stage.
I'm happy to report if you look through The Cannabis Act in Canada, that this method of production is allowed and all of these cannabinoids that we are targeting are cannabinoids that are found inside of the plant, they are the same exact molecules, it's not a synthetic analogue, these are phytocannabinoids. - Mike Gorenstein, CEO of CRON, September 4, 2018 conference call (approximately 12 minutes in).
The recreational route is already being used by some to market products with disclosed amounts of less commonly known cannabinoids. For example, a company called Green Revolution, which "thinks of itself as a high end nutraceutical company" sells a cannabis tincture in Washington State which is relatively high in cannabinol (CBN), although it does still contain THC and CBD.
Since Green Revolution's Finest Cannabis Tincture isn't an FDA approved drug, the company is limited in the way it can market the drug and the claims it can make about it. You won't find drug reps in doctors offices marketing the tincture for sleep as might be the case with drug reps marketing a newly FDA approved drug for insomnia. Still if CRON could produce high purity rare cannabinoids it might have some marketing advantage in the recreational and medical cannabis space as others might not be able to produce these rare cannabinoids in a cost-effective manner or at any feasible scale to launch a marketable product.
Cronos Group will fund certain R&D and foundry expenses expected to be approximately US$22 million subject to the achievement of certain milestones. In addition, upon Ginkgo’s demonstration that the microorganisms are capable of producing the target cannabinoids above a minimum productivity level, Cronos Group will issue up to approximately 14.7 million common shares in the aggregate... - September 4, 2018, press release from CRON.
The problem is that CRON has not even produced these cannabinoids at scale, yet let alone launched a product and so any impact to product sales is a while away. Meanwhile CRON will be bearing the cost of some of Ginkgo's R&D and will award equity should Ginkgo reach development milestones.
Did CRON do enough heading into October 17?
Heading into the launch of legal adult recreation cannabis in Canada on October 17, 2018, a number of Canadian cannabis producers began discussing some of the supply agreements they had set up or purchase orders they had received. CRON was one such company, but unlike several of the other big names, CRON's press releases seemed a little light on detail regarding the size of these purchase orders or supply agreements.
The absence of details on the size of these supply agreements provided some of the rationale for a short report from Citron Research, released August 30, 2018, which noted that CGC and TLRY had provided more concrete numbers in their disclosure of their own supply agreements. The numbers from CGC certainly sounded impressive. When CGC reported Q1 Fiscal 2019 earnings on August 14, 2018, the company noted it had secured a sizeable proportion of committed supply agreement volume.
With an estimated 36% of the total supply committed to date [over 67,000 kg annualized] to the provinces and territories, we have secured by far the deepest channel into the Canadian recreational cannabis market. - Bruce Linton, Chairman and Co-CEO of CGC, August 14, 2018.
CGC started throwing around a number of 70,000 kg shortly following that. APHA noted the total extent of its supply agreements on September 20, 2018, but only in terms of the number of provinces (all ten) and territories (one, The Yukon) and not in terms of kilograms. Aurora Cannabis Inc. (ACB), Aphria Inc. (APHA), CGC and TLRY are compared to CRON overall in Table 1 below. Examining the table, it doesn't exactly look like CRON prepared as well as other talked about Canadian cannabis producers.
Table 1: Data concerning the size of supply agreements for select Canadian cannabis producers and relevant dates (2018 unless specified otherwise) of the press release from which any numbers are derived. Amounts in kilograms are based on noted one-year supply unless specified otherwise. ND, not disclosed. Blank cells mean no press release was identified, but in some cases, an agreement or memorandum of understanding can be inferred. Aphria Inc. notes an agreement with every province suggesting agreements in Newfoundland and Labrador, for example. Source: Relevant press releases, table produced by Biotech Beast.
25,000 kg (first 6 months)
870 kg opening order
15,000 kg minimum (first 6 months)
5000 kg minimum
up to 2700 kg
up to 6500 kg
“up to 3,000 kg of cannabis and up to 4,000 litres of cannabis oil ”
Sep 15 2017
Newfoundland and Labrador
“The first purchase orders are intended to secure 3.75 million grams. The NSLC anticipates it will order in the range of 15 million grams in the first year.”
500 kg minimum
Prince Edward Island
1000 kg minimum
5000 kg minimum plus 8000 kg minimum (MedReleaf)
Up to 12,000 kg
900 kg (over 3 years)
Following the Citron short report, the CEO and Chairman of CRON, Michael Gorenstein, took to CNBC to respond to the accusations. The CEO did note that Ontario forbids producers from providing a size of their supply agreements and noted further Ontario did not give volume allocations anyway.
When we have had actual concrete guaranteed purchase orders like a supply agreement we have with Cura, which is the largest guaranteed supply agreement with a minimum of 20,000 kg, take-or-pay, we disclose and give that information. But we always air on the side of caution, being very conservative and that's something we've made sure to do here, we'll list where we're distributing product but ultimately it is going to be a function of sales velocity. - Michael Gorenstein, CRON chairman and CEO on CNBC, September 2018.
Regarding the other provinces, I note that other companies in Table 1 also don't seem to specify numbers a lot of the time but every company other than CRON managed to come up with some sort of number for at least two provinces/territories. I think the bear argument relates more to the number of provinces/territories with which CRON note agreements rather than the absence of any numbers on the kilograms of cannabis the company intends to supply.
Heading into the October 17 launch of adult legal recreational cannabis, CRON appeared to be missing agreements in key territories such as Alberta and Quebec. Based on the three months of retail sales data available to date, those two territories now appear to be the biggest markets within Canada (Figure 3). It is worth noting at the launch, Ontario, with which CRON did have an agreement, appears to have been the biggest market, but that trend didn't hold up.
It might be fine that CRON would fail to secure supply agreements in all the relevant provinces if the company shared a valuation with some of the medium-sized Canadian cannabis producers, but right now, the company trades like one of the big names.
CRON Trades Like A Big Player
Based on a December 2018 presentation from CRON, there would be 324.9M shares outstanding following the close of the CRON-MO deal. Based on a price of $21.42 on February 26 at 12:00 pm (the time of writing), that implies a market cap of $6.96B USD. Now the company notes that cash, not factoring in transaction costs, would be ~$2.45B CAD following the close of the CRON-MO deal ($1.86B USD). CRON's debt is fairly negligible in the context of these numbers so we can be generous again and calculate an enterprise value of $5.09B USD for CRON. This seems pretty rich for a company that reported $3.76M CAD in revenues for the quarter ending September 30, 2018.
A recent comparison of the valuation of CRON, CGC, TLRY, APHA and ACB by SA contributor Cornerstone Investments noted that CRON had surpassed TLRY as the most expensive cannabis stock. That was when TLRY traded at $93.26 and CRON at $19.70. TLRY is cheaper now and CRON more expensive, making the valuation of CRON look even more ridiculous compared to its peers.
Potential For Short-biased Trades
When CRON reports earnings for the quarter ending December 31, 2018, the market will get a timely reminder of how CRON operates like a small player, even though it trades like a big player in the Canadian cannabis stock space. The company does not look set to report earnings which match up to the likes of other big players despite the valuation suggesting CRON is part of that family. CRON has not currently reported a date for earnings however.
A short is a possibility heading into earnings but I can think of a better trade using options called a bear call spread. That trade can be opened by buying and selling a pair of calls that are out-of-the-money. In that case, if CRON fails to report earnings before the calls expire, then the trader will likely win out unless some other catalyst spurs upside in the stock. Even then the maximum loss is capped, unlike with shorting. Traders might also like to buy puts as an alternative means of betting against CRON. In that case, I encourage traders to look at options with expiries further in the future as quite a bit of extra time can often be had for only slightly more premium. This might occur because options with near-dated expiry have been bid up as traders and investors look to make short-term bets on volatile talked about stocks like CRON.
The risk with all these trades is that CRON surprises and reports earnings that justify its valuation, or another positive event occurs while the short-biased trade is open.
CRON does have an exciting partner with MO and the deal with Ginkgo that one day might lead the company to become a major player in terms of revenues from cannabis products and cannabinoids. Near term however, CRON is going to have to report how much cannabis it is selling and the market will likely focus on that. Tabulating the supply agreements the big names set up heading into October 17, it appears CRON was not prepared like ACB, APHA, CGC or TLRY.
This is despite the fact that CRON trades at a rich valuation, something that should really be afforded to a company that has nailed the launch. Confirmation that CRON did not nail the launch will likely cause the market to reconsider the current valuation and the stock will sell-off.