Cronos Group: Bubbles And Smoke - 18 minutes read

Cronos Group: Bubbles And Smoke - Cronos Group Inc. (NASDAQ:CRON)

Cronos Group has been a favourite among retail investors since the $2.4 Billion investment from tobacco giant Altria, which works out to a 45% non-diluted stake in the company.

It would seem that CRON's near-term production plans will not generate a strong enough free cash flow yield in the next 5 years to warrant the $20/share price.

The company would have to grow revenue an astounding 119x from its current Q1 2019 annualized revenue at $26MM just to trade in line with the S&P/TSX average P/S of ~2x.

We estimate the intrinsic value of CRON at $4.36/share, using the production plans as a guide and reasonable CAPEX and cost assumptions.

Cronos Group (NASDAQ:CRON) has been a favourite among retail investors since the $2.4 billion investment from tobacco giant Altria (MO), which works out to a 45% non-diluted stake in the company. The idea being that Altria will either buy the company outright at some point in the future, putting a floor under its valuation, or turn CRON a success by helping to develop vape products for when derivative products launch in Canada.

Unlike its main competitors Canopy (OTC:CGC) and Aurora (OTC:ACB), it trails them from a production perspective. CRON intends to be more of a cannabinoid company, with a predominant focus on derivative production, such as cannabinoid oils at commercial scale. But that still doesn't mask the fact that its planned annual production of 117,500 kg output doesn't even place it among the top 10 retailers of marijuana. For example, CGC had sold almost ~30,000 kg at their 2019 FYE relative to CRON which had sold 2.7 kg at 2018 FYE and only 1.1 kg in Q1 2019. To their credit, their gross margins are about in line with their counterpart CGC. Canopy is also more aggressive in its assumptions in converting dried flowers to oils as it assumes 8 ml/gram, whereas CRON assumes 4 ml/gram.

Another couple of things to like at a quick glance is that CGC's share-based compensation was 111% of revenue as per the 2019 Q4 report, which is a major red flag, as having such important levels of compensation related to M&A activity could lead managers to pay more attention to acquisition milestones rather than the long-term profitability of the firm. CRON is a mere 25% at 2018 FYE. Goodwill is 21% of CGC's total assets due to major acquisitions purchased at premiums to fair value. CRON has goodwill at less than 1%.

In January 2019, the company entered into a credit agreement with Canadian Imperial Bank of Commerce (NYSE:CM), as an administrative agent and lender, and the Bank of Montreal (NYSE:BMO), as a lender, in respect of a $65.0 million secured non-revolving term loan credit facility. In connection with closing the Credit Facility, the company used funds available under the Credit Facility to fully repay the Romspen Construction Loan. In March 2019, the Credit Facility was repaid in full by the company with a portion of the proceeds from the Altria Investment, indicating the company makes very modest use of leverage.

The purpose of this article is to determine the intrinsic value of CRON as full capacity is utilized with their current and planned production facilities utilizing an enterprise cash flow DCF valuation model for which the various components will be discussed first.

Although CRON is well below its planned production capacity as its Q1 2019 annualized production only amounted to 4.4 kg, which is well below even its current existing capacity of 40 kg. However, at an average selling price of $5.75 (about in line with its historical price), that will yield ~ $673MM in annual revenue, nearly 42x its current revenue at $16MM.

We assume Peace Naturals Building reaches 10,000 kg by 2019 YE, doubles to 20,000 at 2020, and reaches full capacity at 2021 YE, which is conservative as the company expects all flower rooms to be populated in the first half of 2019 and, thereafter, anticipates further improvements in yields toward full run-rate capacity as a result of increasing efficiencies over time. We assume Peace Natural Greenhouse and OGBC reach full capacity by YE.

The company anticipates that construction of the Cronos Israel greenhouse to be complete in the first half of 2019, and construction of the manufacturing facility will be complete in the second half of 2019. Therefore, we expect full utilization by 2020 FYE.

In February 2018, the company announced a strategic joint venture, Cronos Australia Pty. Ltd. ("Cronos Australia"), with NewSouthern Capital Pty. Ltd. ("NewSouthern") for the research, production, manufacture, and distribution of medical cannabis. Each of the company and NewSouthern owns a 50% equity interest in Cronos Australia and has equal representation on the board of directors of Cronos Australia. The company believes that Cronos Australia will serve as its hub for Australia, New Zealand, and South East Asia, bolstering the company's supply capabilities and distribution network in the Australia and Asia-Pacific region. In February 2018, Cronos Australia was granted a medicinal cannabis cultivation license and a medicinal cannabis research license, by the Australian Therapeutic Goods Administration and the Office of Drug Control (the "ODC"). In June 2018, Cronos Australia was granted a medicinal cannabis manufacture license by the Australian ODC. This is the final license necessary for domestic production in Australia, which includes the medicinal cannabis cultivation license and research license. Cronos Australia has also received an import license from the ODC, together with all necessary permits, to import Peace Naturals TM branded products for sale in the Australian medical market, while construction of the Cronos Australia production facility is being completed. Arrangements for imports are in progress. Cronos Australia has also received an export license from the ODC to export certain medical cannabis products, subject to receipt of all necessary permits. We assume utilization by 2021.

In July 2018, the company entered into a strategic joint venture with a group of investors led by Bert Mucci (the "Greenhouse Partners"), a leading Canadian large-scale greenhouse operator. Each of the company and the Greenhouse Partners owns a 50% equity interest in the joint venture, Cronos Growing Company Inc. ("Cronos GrowCo"), and has equal representation on the board of directors of Cronos GrowCo. Cronos GrowCo is constructing an 850,000 sq. ft. purpose-built, GMP-standard greenhouse on approximately 100 acres of land acquired by Cronos GrowCo in Kingsville, Ontario. Once fully operational, the greenhouse is expected to produce up to 70,000 kilograms of cannabis annually. Construction of the greenhouse has commenced. The company expects to complete the superstructure of the greenhouse in the second half of 2019 and expects the greenhouse to become operational in phases in 2020. We, therefore, assume 50% utilization by 2020 FYE, then full utilization from 2021 onward.

After all planned production is realized, we assume modest growth in production at 10% for the next 5 years.

We assume a $5.75/gram selling price in line with the historical average. Granted, it will likely decline over time as more competition enters the space.

Now, we have only discussed the supply side here about the demand side. Will the cannabis products be bought? There is reason to believe it will via the Cura Supply Agreement. Cura Cannabis Solutions is a vertically integrated cannabis operator that has signed a five year take-or-pay supply agreement to purchase a minimum of 20,000 kilograms of cannabis per annum from Cronos GrowCo, commencing after Cura receives its production and sales licenses from Health Canada.

In October 2017, the company announced its strategic partnership and five-year exclusive distribution agreement with G. Pohl-Boskamp GmbH & Co., an international European pharmaceutical manufacturer and distributor with a German distribution network of pharmacies, to distribute Peace Naturals branded cannabis products within the German medical market.

In June 2018, CRON entered into a strategic distribution partnership with Delfarma Sp. Zo.o. Delfarma is a pharmaceutical wholesaler with a distribution network of over 5,000 pharmacies and more than 200 hospitals that collectively reaches approximately 40% of the Polish domestic market. Under the five-year exclusive distribution agreement, CRON will supply Peace Naturals branded cannabis products to Delfarma for distribution within the Polish medical market. The company and Delfarma are currently in the process of obtaining the necessary regulatory approvals to sell cannabis products in Poland.

We use a cost of $2.70/gram to estimate gross margins before adjustments to fair value and assume a 5% decline rate over the next 5 years as this will be essential to be successful with their business model as they are largely a "price-taking firm." The cost will stay level after 5 years into perpetuity.

We ignore the effects of unrealized gains on changes in fair value of biological assets as they do not contribute to cash flow and are quite frankly a ridiculous accounting tool that IFRS needs to rectify as they artificially inflate gross margins and earnings.

Sales & marketing accounted for 14%, 26%, and 23% of revenues at 2017 FYE, 2018 FYE, and Q1 2019, respectively. Granted, these costs have been ramped up in anticipation of legalization (i.e. packaging to make their products more visually appealing). Cronos Group's spending in this area has been a lot more moderate than Canopy which spent 77% of revenue on this at 2019 FYE. We make the assumption that it will be in line with the previous year at 26% of revenue for the next two years, then a more moderate 10% into perpetuity as they gain brand recognition.

Sales & Marketing accounted for 0%, 24%, and 24% of revenues at 2017 FYE, 2018 FYE, and Q1 2019, respectively. R&D expenses will be 24% of sales until 2020 FYE, then be 5% into perpetuity, as CRON develops novel IP regarding plant genetics and growing patterns.

G&A accounted for 160%, 110%, and 149% of revenues at 2017 FYE, 2018 FYE, and Q1 2019, respectively. This is due to the regulatory framework surrounding the legalization of cannabis in Canada and other countries in which it operates. These expenses are linked not only to internal expenses but also to compensate operations consultants, compliance advisors as well as normal operating expenditures linked to CRON's facilities. That being said, G&A expenses also include overhead linked to production sites, which will always be a factor. Considering CRON has expanded its total production capacity almost 5-fold since 2017 FYE, with considerable expansion plans down the pipeline, a substantial increase in expenditures would be advisable. We assume that G&A expenses will be 150% of revenue for 2019, 100% for 2020, then decline to 10% of revenue into perpetuity. Forecasting R&D expense using a historical average percentage of sales would lead to ridiculously high expenditures as well.

This, like sales & marketing expense, will also need to come down at some point as spending at this level is not sustainable.

Net Working Capital (NWC) is the difference between the current assets and current liabilities of a company. This is a measure of financial performance for the firm as it allows us to observe the company's short-term financial health. A positive NWC indicates the company's ability to pay short-term liabilities with its current assets.

NWC also includes cash and cash equivalents. This poses a problem for CRON as the company has recently closed a $2.4 Billion deal with Altria (MO), most of which has remained in cash. It is a safe bet to assume that these cash reserves are earmarked for M&A activity and capital expenditures down the road. So, the changes in cash reserves will skew NWC significantly, which poses a problem for financial modelling. We assume NWC grows as a proportion of sales going forward and cash inflows resulting from changes in capital structure i.e. stock sales, or debt financing are not to be included.

The largest driver of NWC other than cash is inventory. Historically, CRON has had NWC far superior to their sales due to holding large inventories, since they would have to keep large amounts of product on hand as the medical market is much more fragmented and individual sales are quite small, making it harder to plan and organize production. In the new era of recreational cannabis, it will be possible to hold less inventory as they can better organize their production, thanks to large regular purchase orders. Given that the expected life cycle of cannabis plants is 3-5 months, you can have 2-4 harvests per year. And, the higher the harvest frequency, the more easily you can justify having lower inventory levels. Thanks to recent acquisitions that have expanded their production capacity, they will have enough capacity and space to be able to stage production runs to ensure continuous harvesting throughout the year. Therefore, we assume NWC grows at one quarter the rate of sales growth.

CAPEX is one of the most difficult things to model but one of the most important as it is such a key aspect to CRON's growth strategy. In the first nine months of the 2019 fiscal year, CRON spent ~$125MM on acquisitions. Much of these proceeds went towards construction of the Cronos Australia, Cronos Israel, Building 4 of the Peace Naturals facilities. As of March 2019, the company entered in a strategic partnership with Altria. At closing, the company issued to certain wholly-owned subsidiaries of Altria common shares of the company and one warrant, which may be exercised in part or in full on or before March 8, 2023. The value of the investment currently sits on the balance sheet in cash and short-term marketable securities as of Q1 2019.

As per the 2018 FYE MD&A, the company intends to spend approximately $18.8M for sure in CAPEX on finishing construction of Cronos Australia, Phase 1 of Cronos Israel, and Building 4 of Peace Naturals. This works out to 33% of Q1 2019 annualized revenue at $26MM ($6.5MM * 4). We assume that CAPEX will be 33% of revenue for the next two years, then fall to 10% in perpetuity.

Since the company has very little in the way of operating or term debt in their capital structure, we assume a WACC closer to equity market returns at 10%.

We assume a 2% free cash flow growth rate terminal value (about in line with the alcohol and tobacco industries).

Below is a summary of the assumptions that were made in this analysis, the free cash flow estimates, and the valuation.

(Figures except percentages are in thousands)

(Figures except per/share are in thousands)

What most interesting is that using our reasonable assumptions, once full planned production capacity is reached free cash flow will only be $128M annually, which is a 3-year forward-looking free cash flow yield of only 2% at the current $20/share. Also, approximately 91% of the estimated EV comes from our assumptions about the terminal growth, which are actually shaky at best due to the lack of information about how the cannabis market will look in 5-10 years. But the immediate prospects of CRON do not warrant the current $20/share or anywhere close.

What is more perplexing is that with the current P/S multiple of 193x, the company would have to grow revenue an astounding 119x from its current Q1 2019 annualized revenue at $26MM just to trade in line with the S&P/TSX average P/S of ~2x, which the company looks nowhere close to doing.

It would seem that CRON's near-term production plans will not generate a strong enough free cash flow yield in the next 5 years, given their current production plans to warrant the $6 Billion market capitalization. Essentially, the likely revenue will only likely be barely sufficient to cover the currently high CAPEX, SG&A, and G&A expenses.

Disclosure: I am/we are short CRON. 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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