Cronos: Lack Of Capacity To Limit Near-Term Growth

Written by: Cornerstone Investments – Seeking Alpha

Introduction

Cronos (CRON) reported its 2019 Q1 results and investors dumped the stock sending its shares down 7.1% for the week. Before Altria made its investments into Cronos, we had told our readers that Cronos is one of the weaker large-cap players in Canada. As Cronos reported disappointing results again last week, we think investors should embrace for a period of slow growth. However, potential M&A catalysts are made possible by Altria’s C$2.4 billion investment but timing is impossible to predict. We remain cautious on the stock due to its sky-high valuation and weak financial outlook.

(All amounts in C$)

2019 Q1 Review

Cronos reported its 2019 Q1 results last week which painted a picture of Canada’s third-largest cannabis company struggling in the domestic market. Cronos reported 2019 Q1 revenue of $6.5 million which increased only 16% from last quarter. Gross margin increased slightly to 54% which is within the range and has a small impact on profitability due to the small revenue base. Despite the top-line growth, Cronos remains a small participant within the Canadian legal market considering its large market cap.

 

(Source: Public Information)

Cronos sold 1,111 kg of cannabis which is barely unchanged from last quarter. The lack of volume growth is a direct result of the limited capacity Cronos operates in Canada. Average selling prices remained largely unchanged as Cronos made little progress in its operations last quarter. Given how disappointing its performance has been so far, we think the lack of progress and improvement is a major concern for investors.

(Source: Public Information)

The reason why Cronos has made little progress in the last quarter is the inherent limitation within its production capability in Canada. The company’s main growing asset in Canada is its Peace Naturals campus in Ontario. Phase 1 to 3 of the facility only has a combined annual capacity of 5,000 kg whereby the Phase 4 expansion will bring on 33,500 kg of annual capacity once completed. However, Cronos is still not fully licensed for its Phase 4 expansion let alone fully ramped up in terms of production. As a result, Cronos was most likely operating at an annualized capacity of closer to 6,500 kg for 2019 Q1.

(Source: Past Investor Presentation)

 

As we noted in our analysis after Altria (MO) announced its investment in Cronos “Altria’s $1.8 Billion Bet On Cronos Is Both Risky And Expensive“, we think growing cannabis was never the focus for both Cronos and Altria. As Cronos CEO said on the latest earnings call:

Like Altria, we believe that the best way to create value to the supply chain is by working with contracts farmers and not being farmers ourselves. This belief is why we are working to expand our production footprint globally by setting up co-manufacturing with agricultural partners, and we believe in the future, Altria can be helpful in these efforts given its own agricultural relationships.

As a result of the lack of near-term capacity, we think there are very few financial catalysts for Cronos in the next few quarters. Without a significant increase in capacity, volumes and revenue will continue to stay subdued. Even if Phase 4 is completed, we think the capacity will not compare favorably with other top players in Canada. The industry is dominated by two large producers, Canopy (CGC) and Aurora (ACB), and Cronos is only in the middle of the pack along with much smaller peers. Importantly, much of Cronos’ future capacity hinges on its 50/50 GrowCo joint venture with a Canadian farming group which accounts for 70,000 kg of future capacity. We think GrowCo likely won’t begin producing until the end of 2019.

(Source: Public Information)

Valuation and Trading

Cronos shares have recently come off its all-time high as investors had few reasons to cheer after consecutive quarters of weak financials. While the Altria investment brought unquantifiable benefits to the company in terms of recognition and $2.4 billion of cash, we think short-term investor sentiment will continue to be dominated by headline financial performance.

 

(Source: TSX)

Cronos is the third largest cannabis company in Canada by market cap and is the most expensive stock among the top 10 companies. The company trades at 189x EV/Revenue which is much higher than most of its peers. Both Canopy and Aurora trade in the 55-60x range and even Tilray (TLRY), the infamous bubbly cannabis stock, only trade at 81x. Cronos is no doubt very expensive compared to all its large-cap peers even after its recent drop.

(Source: Public Information)

Looking Ahead

We think Cronos is facing several near-term operational challenges that will limit its financial performance. Although the company deemphasizes in-house cultivation, the immediate consequence is that Cronos has reported and most likely will continue to report inferior financial performances compared to its peers. We don’t see its financial performance improve materially in 2019 as new capacities won’t come online until the end of this year.

However, one potential catalyst for the stock is its $2.4 billion cash from the Altria acquisition. Before the investment was announced, we noted that Cronos was at the brink of facing severe liquidity issues as cash balance dwindled. However, Cronos now has the second largest cash balance after Canopy Growth and is well-positioned to pursue large-scale transformational M&A in the near-term. A very likely deal would be an acquisition of a major U.S. MSO similar to the structure used by Canopy to acquire Acreage (OTCQX:ACRGF). We think the market would react positively if Cronos enters the U.S. market given the attractive growth profile relative to Canada.

 

Overall, we maintain our cautious view on Cronos given its elevated valuation compared to some of the best operations in the industry (Canopy, HEXO, OrganiGram). Altria’s $2.4 billion cash infusion provided possibilities but it is inherently difficult to invest based on M&A speculations.

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.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.