Cronos Group Inc.
Q3 2020 Earnings Call Transcript

Published: 5 Nov 2020

[Operator:]

Good morning. My name is Junica, and I will be your conference operator today. I would like to welcome everyone to the Cronos Group’s Third Quarter 2020 Earnings Conference Call. Today’s call is being recorded. At this time, I would like to turn the call over to Shayne Laidlaw, Investor Relations. Please go ahead.

[Shayne Laidlaw:]

Thank you, Junica, and thank you for joining us today to review Cronos Group’s third quarter 2020 financial and business performance. Today, I’m joined by our President and CEO, Kurt Schmidt; our Executive Chairman, Mike Gorenstein; our CFO, Jerry Barbato; and our EVP of Legal and Regulatory Affairs, Xiuming Shum. Cronos Group issued a news release announcing our financial results this morning, which are filed on our EDGAR and SEDAR profiles. This information, as well as the prepared remarks will also be posted on our Web site under Investor Relations.

[Mike Gorenstein:]

Thank you, Shayne, and good morning everyone. I'm proud to speak to you today as Cronos's Executive Chairman. As many of you know, after careful planning and thoughtful consideration, we expanded our leadership structure with the appointment of Kurt Schmidt as our new President and CEO in December. And I have transitioned to the Executive Chairman role, where I will lead the board and work with Kurt to continue to drive Cronos Group’s strategy going forward. I am incredibly confident that Kurt will help Cronos build on our strong track record of growth and lead us toward many more industry defining accomplishments. Kurt is a highly experienced consumer packaged goods executive with the expertise to push Cronos even further. During his three plus decade career, Kurt has built a track record of driving outstanding performance at some of the most respected global consumer goods companies, including Blue Buffalo, Nestle, Gerber, and Kraft Foods. He has demonstrated tremendous success partnering with founders and startups to accelerate growth, and we are excited to leverage his expertise as Cronos continued to expand.

[Kurt Schmidt:]

Thank you, Mike, and good morning, everyone. I hope everyone is staying safe and healthy during these turbulent times. It's rare in a career to be able to have the opportunity to join two fast paced growth companies with very high ceilings for expansion. I had my first shot with Blue Buffalo, which worked out very well and I think we have a similar opportunity here with Cronos Group to take it to the next level.

[Jerry Barbato:]

Thanks, Kurt and good morning, everyone. Turning to our financial results. The company reported consolidated net revenue in the third quarter of 2020 of $11.4 million, a 96% increase from the prior year period. Revenue growth year-over-year was driven primarily by the continued growth in the adult use Canadian cannabis market. The inclusion of Redwood financial results, our US hemp derived CBD business that was acquired in September of last year and the sale of PEACE NATURALS branded cannabis products to the Israeli medical market, partially offset by non-recurring wholesale revenue in the Canadian market in Q3 of 2019 and strategic price reductions on various adult use cannabis products in certain Canadian provinces in the third quarter of 2020. Consolidated gross loss for the third quarter of 2020 was $1.5 million, a $1.6 million decrease in losses from the third quarter of 2019. The improvement versus prior year was primarily driven by the increase in revenue and incremental gross profit contributions of the Redwood acquisition, offset by an increase in cost of sales, primarily driven by a higher volume of adult use sales and the associated third-party purchase flower and a decline in wholesale sales. Reported operating loss for the third quarter of 2020 was $41.2 million, representing $10.5 million increase in losses from the third quarter of 2019. The increase year over year was primarily driven by increased share based payments related to separation agreements with Redwood employees. Impacts from a full quarter of US segment results, increased G&A expenses, inclusive of review costs and costs related to the company's restatement of our 2019 interim financial statements, higher sales and marketing costs, primarily related to brand development and R&D spending, partially offset by the improvement in gross loss.

[Kurt Schmidt:]

Thank you, Jerry. Over the course of my first few months with Cronos, I've been encouraged by the talent throughout the organization. I look forward to bringing my experience and learnings gathered throughout my career and applying them to this industry as I help to make Cronos a long term leader in the cannabis space. Cronos is built on a foundation to drive full change in the industry. We’ll continue to lead an innovation while taking calculated risks to drive this industry forward responsibly. We have the team, leadership, organizational capabilities and the financial strength to be a leader in the cannabis industry. And I'm excited to be leading Cronos on this journey. With that, let's now open the lines for questions.

[Operator:]

And your first question comes on the line of John Zamparo of CIBC.

[John Zamparo:]

I was hoping you can give us a better understanding of the puts and takes on gross margin, and when you ultimately see that turning positive, either consolidated or by region? Thanks.

[Mike Gorenstein:]

I think you really got to separate those two between Canada and the US. So in the Canadian market, what you're seeing is continued price deflation across the Canadian cannabis market where a lot of the producers are lowering their net prices and offering larger format size offerings. We've done our own internal review and look at our brands and compared them against our competitive set by product type, and have lowered some of our prices different in each of the provinces, so quite strategic in nature. And as we continue to refine our global supply chain throughout 2020 and into 2021, we expect gross margins are going to continue to fluctuate as price and mix can change from quarter-to-quarter. In our US business, I think it's a little bit different. We've had a heightened promotional activity related to COVID. We've decreased that promotional activity in the third quarter. Margins did improve sequentially. And we remain confident in the long-term viability of this US CBD market. And I think the other thing that you saw was we had some premium pay as COVID started in the second quarter that was phased out over the third quarter. But I think you'll have the same situation where we've launched a new brand and you'll see continued fluctuation in the margins based on mix.

[Kurt Schmidt:]

Just add a point to that. I think what you're seeing is the deflationary pricing is really driven by the inventory situation. So I think that's something that people are working through. And I think once that alleviates, that's to me, a short-term problem versus anything that's long term.

[John Zamparo:]

And then my second question is more broad and it's more about your M&A strategy, and in particular on the US. We're still kind of unsettled on the election. But if there is a split between White House and Senate, maybe we don't get that transformational reform that you need to get cannabis off the Controlled Substances Act. So if that's the scenario, does that make you think differently about M&A, do you start maybe looking at other countries with more urgency, or do you maybe push the gas pedal a little more on CBD? Just would like to get your sense on how potential regulatory reform or forward lack of this changes your strategy in the next 12 to 18 months?

[Kurt Schmidt:]

I think on the first half, obviously, our balance sheet certainly provides us some flexibility. And regardless of the political changes in the US, the regulatory landscape is evolving and we're evaluating. I think one of the really important things about the changes we've done is elevating Mike to the Chairman role, as Mike focus, and he can speak to this, is going to be on our strategy with the US. And I can't think of a better person to have in this role, so to be able to guide us on this. So I think that's important and I think that’s important strategic market versus looking at alternative markets right now. So Mike, I don't know if you want to add anything.

[Mike Gorenstein:]

Exactly what Kurt saying, our focus and my focus has always been sort of the end game. Number one priority is US THC market we expect that’s the biggest profit pool. And looking at different scenarios and different structures for us, it's about how we enter not whether we enter and of course the regulatory environment will certainly dictate when and how that is but it's top of mind for us.

[Operator:]

Your next question comes from the line as Andrew Carter of Stifel.

[Andrew Carter:]

So I want to double click on that gross margin question because I think we all see the price competition on flower and understand you're kind of lowering your prices kind of to keep the gas in line. But what I'm unclear on is kind of the third party costs and you mentioned a lot of inventory. Is it an issue where the third party high quality flower costs are not decreasing at the same rate? I guess I would ask if that’s just for, are you upside down on prices? And how do you see that alleviating kind of like the high quality flower and being able to kind of get your supply chain in line to where you’ve had the cost to serve the Canadian adult use market?

[Mike Gorenstein:]

Yeah, I’ll let Jerry comment as well, but this pricing issue from a couple of quarters ago. So I think going forward, you're seeing better raw material pricing. But we still -- we've got this inventory from past so I see that alleviating itself as we move forward, as demand gets more in sync -- supply gets, excuse me, gets more in sync with demand side. Jerry?

[Jerry Barbato:]

Andrew, just to add a little bit more to that. We are seeing that our third party purchases, the price per gram is coming down even for the high quality high THC. But we do really have to separate that inventory based on flower and oil and where it's going and we use a weighted average cost. So that cost will go down over time. But like I talked about and Kurt has said, in the short run, there's just a lot of deflationary pressures in the Canadian market that we have to work through.

[Andrew Carter:]

And then second, I wanted to ask about Israel, because I think you reported 500,000 in sales outside of North America. So I wanted to understand, I think Israel is kind of, my estimate is about $250 million annualized market. What could that business look like for next year? And could Israel actually be a bigger driver of growth, essentially next year than Canada? Thanks.

[Kurt Schmidt:]

We're really positive on Israel. I mean it's early stages yet. But the patient count continues to grow. So we see that growing at a pretty good clip. And then we are positioned very well there. We've just received our certifications required for cultivation and production, and marketing of dry flower, pre rolls and oil drops in Israel. And we're now selling dried flower and oils in the PEACE NATURALS brands, which has been well received. So we're really bullish on the market. I don't want to get into where I see how big it will get. The one thing about this industry I learned is estimates are forecasting is not an easy thing to do. But we like where it's going. We like where the legal environment is going. We like the active nature of the Israeli government in the industry and support. So I think this is a very good opportunity and we have a very good organization on the ground.

[Andrew Carter:]

Thanks. I'll pass it on.

[Mike Gorenstein:]

Just to lay on that, I'll say directionally things are extremely positive in Israel. So you're seeing great momentum, not just in the medical market but also in regulatory progress. So I think in the framework we have today, there's a great growth opportunity but part of what Kurt spoke about why its forecasting so hard if CBD is descheduled or if adult use opens up, that certainly makes it exponentially larger growth opportunity.

[Operator:]

Your next question or comment comes from the line as the Vivien Azer of Cowen.

[Vivien Azer:]

So my first question is a follow up to one of the earlier questions. Just a clarifying peak, if you will, Mike, I think for you. What was your base case expectation assuming a blue wave? Because certainly like our house you was not a descheduled even if the Democrats took the Senate in the White House? So I'm curious whether you guys share that opinion or if you’re little more more optimistic?

[Mike Gorenstein:]

Well, I think that’s a timing issue. I think that one of the important things and I've always maintained this was getting past the election and allowing from just a political process perspective, everyone to sit down and look at what's the best way to put in regulations and put in policies, whether that's a stimulus or building up industries that can help rebuild some of what the economy lost over the last year. And it's very difficult to do that when you're in an election year. So for us, it wasn't an -- if something happen immediately after I think that always sound better than what the actual practice is. But getting past the election was a big catalyst regardless of who won, blue waves split and I think we'll see that starting with stimulus. And I think the cannabis you see with the ballot initiatives, whether it's red or blue, where the popular opinion is, you see the need for jobs, we need tax revenue, we need social justice reform and there is just a very simple and elegant solution and that is advancing cannabis legislation.

[Kurt Schmidt:]

And the other good part about this company is our group in Washington is very much engaged on these issues. So we're very confident that we'll be able to see the directions possibly it can go.

[Vivien Azer:]

And my actual question is about the strategic pricing adjustments that were made in the quarter. Can you expand on that a little bit? And in particular, I'm curious about how you guys were thinking about the magnitude of those pricing adjustments and what you were using as a reference point, was it competitive pricing, managing price caps, price elasticities, price caps relative to the illicit market? Any incremental color would be helpful. Thank you.

[Jerry Barbato:]

What I would say, as it's typical of most CPG companies, we perform a regular strategic review of the landscape and look at differentiation amongst our brands, both COVE and Spinach, by product format and price point. And during that we found that we wanted to better align our pricing versus our desired competitive set. So we adjusted to better fit into the group for our respective brands. The pricing adjustments have only been in place for a few months and we have some early positive results, but we'll continue to evaluate the situation and adjust as we see fit.

[Operator:]

And next question comes from the line of line of Rahul Sarugaser of Raymond James.

[Rahul Sarugaser:]

So I guess my first question is really around the Lord Jones and Happy Dance and Jerry, relative to the fact that I'm super happy with the ramp CBD products. So given that the US market for CBD relatively disaggregated, most of the products are out there for really kind of these cottage industry brands. So what is your strategy to really drive differentiation or what I assume are your big brands versus these cottage industry brands, and when can we start to see sort of an inflection point in that US revenue?

[Kurt Schmidt:]

I think fundamentally, we believe in our brands. I think Lord Jones, we're not happy with the results, obviously, the past quarter. But we feel confident we have the right plans to correct that. We're really focused on the branding and the branding experience. Obviously, COVID has hit the CBD sector heavier than on the THC side. We have an innovation -- we're building an innovation funnel. We're looking at our marketing mix model to make sure we're hitting the right touch points. And Happy Dance, we're very excited about. It's in early days. But that launch was very exciting and well executed. And the beginning -- we're in the early innings but it has really been positive momentum and we're going to carry that forward.

[Rahul Sarugaser:]

And then so my follow-up would be around the fermentation. So we're now three quarters from what you projecting in terms of Cronos' first products coming from the fermentation facility. Are you on track with that? Are there specific product formats that we should be thinking about? And how is Cronos planning on plugging these products into the Canadian market versus the US market given the different regulatory paradigms of cannabinoids beyond CBD in each of these markets?

[Kurt Schmidt:]

Yeah, we are on track. We're getting close. We think that we'll be producing our first CBDA product, which exhibit similar characteristics to CBD. And we're going to be -- our target has and remains to produce fermented cannabinoids at commercial scale in September of 2021. And after that, we're going to follow with the fermented cannabinoids to be utilized in finished products. Obviously, Canada first, but we'll have to figure out the regulatory environment. But this is a key strategic underpinning. And so we're looking forward to that and we will -- we are on track and you should start to see that at the end September of '21.

[Mike Gorenstein:]

And just to follow-up on that, I think it's important to reiterate that we do see the, from a supply chain perspective, fungibility. So when we think about the derivative products and how we'll use the fermented cannabinoids, it doesn't necessarily have to be a completely new product format. That product format without showing our hand on our 2.0 product pipeline, that product could be something that you see before. We're using fermented cannabinoids, it could be something that’s launched later. We see it as something that we can fully integrate in our supply chain. And on the US side, I would say that the main division that we will be thinking of is whether or not the cannabinoid we're thinking of is subject to the Controlled Substance Act or not. So you know some of those cannabinoids, THC, THCB, we think would be but of course CBD, CBG we think would not be.

[Operator:]

Your next question comes from Tamy Chen of BMO Capital Markets.

[Tamy Chen:]

Most of my questions have been answered, so I just have one. I'm just curious at this point relative to some of your peers in Canada, you do have a smaller presence. So I'm just curious if at this point you are seeing anything interesting emerge in that market to invest more in or to acquire?

[Kurt Schmidt:]

We believe in the brands we have and the brands, you know, I think about performance -- Spinach for example, we think we have a lot of runway and the growth in our brands and we'll be driving it through in market presence and the innovation funnel we have. I'm not really going to speak to M&A. I'm not going to speak that on the phone but we always look for opportunities. And if something makes sense for us and it fits with what we're trying to do we have the capability to do.

[Operator:]

And your next question comes from the line of Graham Kiebler of Eight Capital.

[Patrick Sullivan:]

Thanks for taking the question. This is actually Patrick Sullivan on the line for Graham. Most of mine have been answered already, but I guess just want to touch on the CBD side of business again. You said you guys were refreshing. So the marketing campaign and with kind of direct inputs. I'm wondering if you could just elaborate on that a little bit more. What exactly in these strategies are you trying, or what are some of the things that are in the pipeline for that? Thank you.

[Kurt Schmidt:]

I think it's just accelerating what the team has been working on. So again, that will be, you know, marketing investments side, it'll be distribution side and it'll will be innovation side as we lay out the innovation funnel, which will be an important piece. And you'll see that develop over the next 12 months.

[Operator:]

And your final question comes from the line of Bill Kirk of MKM Partners.

[Bill Kirk:]

Thanks for taking the question. Mine relates to reporting adjustments just to clarify some things. Was the US separation equity comp adjusted out of the US segment adjusted operating loss? To me it doesn't appear so but then I see the share base comp adjustment to consolidated EBITDA. So I guess can you help me understand how that US separation comp was treated in the adjustments segment number versus the adjusted consolidated EBITDA number?

[Jerry Barbato:]

No, we did not adjust it out. So it's included in that adjusted operating loss in the US segment. And we have it to be consistent we adjust share based comp out of our adjusted EBITDA number.

[Bill Kirk:]

So not adjusted to segment but adjusted to consolidated?

[Jerry Barbato:]

Adjusted to the consolidated EBITDA number. Yes.

[Operator:]

And there are no further questions in queue. Do we have any additional closing remarks.

[Kurt Schmidt:]

No. Just thanks everybody and I look forward to working with all of you in the future.

[Operator:]

This concludes today's conference call. You may now disconnect.