Cronos Group Inc.
Q2 2019 Earnings Call Transcript

Published: 8 Aug 2019

[Operator:]

Good morning. My name is Sadie and I will be your conference operator today. I would like to welcome everyone to the Cronos Group Second Quarter and First Half 2019 Earnings Conference Call. Today’s call is being recorded. At this time, I would like to turn the call over to Anna Shlimak, Investor Relations. Please go ahead.

[Anna Shlimak:]

Thank you, Sadie, and thank you for joining us today to review Cronos Group second quarter and first half 2019 financial and business performance. I am joined by our Chairman, President and CEO, Mike Gorenstein; and our CFO, Jerry Barbato.

[Mike Gorenstein:]

Thank you, Anna, and good morning, everyone. In the second quarter, we continue to strengthen Cronos Group’s foundation for growth and success in both the near-term and long-term. We made strides on key initiatives, which will help us capitalize on the significant opportunities in the global cannabis industry for the benefit of our shareholders, partners, employees and consumers. I’ll go into more details on each of these shortly. But since our last call, we have acquired a state-of-the-art GMP compliant fermentation and manufacturing facility in Winnipeg, hired a Chief Innovation Officer with over 35 years of CPG experience, announced our entrance into the U.S. market through a leading hemp-derived CBD platform, and continued our supply chain expansion by securing third-party cannabis concentrate and co-manufacturing capabilities for our derivative product launch. For those listening, who may be unfamiliar with Cronos’ story I like to start each call by briefly reviewing the four key aspects of our strategy. At Cronos Group, we are establishing an efficient global supply chain. We are developing a diversified global sales and distribution network. We are creating a disruptive intellectual property. And we are growing a portfolio of ionic brands and products that resonate with consumers.

[Jerry Barbato:]

Thanks, Mike, and good morning, everyone. Both our press release and MD&A includes comparisons of our financials to the same period in 2018. As we shared last quarter, we believe the best way to evaluate our business and the industry is the comparison on a sequential quarter basis as comparisons to the prior year do not reflect the current operating or regulatory environment. I will focus the majority of my comments discussing the second quarter’s performance versus that of the first quarter of 2019. We continue to focus on measures that highlight the operating performance of the business, including adjusted EBITDA, net revenue, kilograms sold, average selling price and growth profit before fair value adjustment. Adjusted EBITDA removes the impact of items that may distort underlying business trends and results. We have included a reconciliation of the net income to adjusted EBITDA in our MD&A and our press release. Turning to Q2 results, the company reported net revenue of $10.2 million in the second quarter of 2019, a 58% increase from the first quarter. This increase is primarily due to increased sales in CBD oil, which carries no excise tax and increased sales of dry flower. The company reported an adjusted EBITDA loss of $17.8 million in the second quarter of 2019. The loss increased by 99% from the first quarter, as we continue to invest in infrastructure and capabilities to support future growth. The increased investments are primarily due to higher operating costs mainly sales and marketing, R&D and salaries and related hiring costs, partially offset by an increase in net revenue.

[Mike Gorenstein:]

Thanks, Jerry. In closing, we accomplished a lot to drive the business forward in the second quarter and have taken many steps to build our competencies across a range of product formats. We started the first half of the year by strengthening our capabilities in vaporizers, with the addition of Cronos Device Labs and pre-rolls with Altria’s assistance. In the second quarter, we strengthened our capabilities in other value-add categories like edibles with the addition of our new Chief Innovation Officer, who is an expert in food science. Subsequent to the quarter end, we expanded our expertise by adding additional product category capabilities which will now include skincare, cosmetics, and other hemp-derived consumer products with the announced acquisition of Redwood. We’re excited to continue the momentum as we set our sights on to the U.S. Our accomplishment this quarter continues to lay a strong foundation for Cronos Group and our business objectives. Let’s now open the line for questions.

[Operator:]

Our first question is from Andrew Carter from Stifel. Your line is open.

[Andrew Carter:]

First question is you suggested that your revenue will continue to accelerate from here. I guess, could you discuss kind of what the kind of opportunities are, the supply from Peace Naturals building force coming online, but also the demands from the second wave are kind of going to come into focus? Could you kind of discuss the impediments or opportunities here?

[Jerry Barbato:]

Yeah. So I think as Peace Naturals comes online, we’ll have more production capacity. And as also we talked about, we’re building a third-party supply, so we’re buying from third-parties, which is what’s leading to the building of our inventory for the derivative launch in Q4. So I know that’s been delayed a little bit by Health Canada. So we would expect that in the end of the fourth quarter and beginning of Q1, you’ll see a larger launch in these derivative product markets.

[Andrew Carter:]

Okay. And then, kind of the second point to that, kind of now that we know what the kind of the Health Canada guidance will be for the second wave market, what is your outlook for the sub-segments overall? Obviously, Cronos is making a big commitment to the vapor category. How quick do you think approvals will happen and you will have products on shelf? You just mentioned end of the year. But what are kind of the risks of any delays or anything like that?

[Mike Gorenstein:]

Yeah, for us, I think we’re most excited about the vaporizer category, but believe that as regulations evolve and we get clarity that edibles and topicals will also be very important categories. Because of the timing of the 60 days being in December, there certainly could be a push between falling in late in Q4 versus the beginning of Q1. It’s always tough to predict, but we don’t expect any big delays, certainly a week or two you could push it through between the quarters. But overall, we think we should see accelerated demand as derivative products come online. I think it’s also easier to differentiate as we get into further categories where device technology starts to play a key role in marketing. So we’re very excited for 2.0 to start.

[Andrew Carter:]

Thanks, I’ll pass it on.

[Operator:]

Our next question is from Tamy Chen from BMO Capital Markets. Your line is open.

[Tamy Chen:]

Yeah, thanks. Hi, everyone. First question is on the guidance you gave for adjusted EBITDA over the rest of this year. I’m just wondering, I just want to get a better understanding, given that Cronos has a more asset-light model and you’ve got some contract manufacturing, for example with Heritage on the vaporizer side, I’m just wondering like what are the key areas that you do need to ratchet and increase the spending on that would weigh on your adjusted EBITDA?

[Jerry Barbato:]

Yeah, so I think, we talked about in our prepared remarks, it’s really the investments behind R&D and the increased headcount to prepare ourselves for future growth, as well as we prepare for these derivative product launches is really our increase in marketing spend.

[Tamy Chen:]

So you expecting that on the marketing side there will be more flexibility in terms of regulations, so you’ll be able to increase your marketing opportunities for the value-add products?

[Mike Gorenstein:]

I think when we look at marketing spend and regulations, as a company, we continue to grow. It’s not just focused on opportunities in Canada. So we think there is more flexibility for marketing in the U.S. or in other markets for CBD based products. And so, while we do think there is still some opportunity for marketing in Canada, we think that other countries will certainly contribute to the opportunities that we’re seeing for building brands.

[Tamy Chen:]

Got it. And my follow-up is, on the B4 facility, in terms of the processing, so everything post-harvest between the drying, the packaging, et cetera, for existing products, primarily the dry flower and the pre-rolls, I’m just wondering, has the processing capacity at the facility, is that ramping up concurrently to be able to handle and take on all the harvest that are eventually going to come from B4 or could that potentially still remain a bit of a bottleneck despite ramp on cultivation?

[Mike Gorenstein:]

No, I think that’s certainly ramping up. And I think one of the things we talked about as an existing category, but we actually think of something where it’s a big opportunity and we’re putting a lot of resources towards in R&D is pre-rolls. So there is significant expertise that we have from Altria and we do see that as something that will rapidly increase throughput and a value-add category that, while it exists today, we think the formats and the consistency and quality we’ll be able to provide will be different than what’s on the market right now.

[Tamy Chen:]

Okay, that’s it from me. Thanks.

[Operator:]

Next we have John Zamparo from CIBC. Your line is open.

[John Zamparo:]

Thanks, good morning. I wanted to ask about the Redwood deal, maybe a two-part question. First, can you talk about your priorities in terms of expanding the point of distribution and is that a brand you take to Canada or Europe? And then secondly, is there any plan to have that brand interact with the research you’re doing with Technion? Or are those meant to be a standalone assets?

[Mike Gorenstein:]

Sure. That’s a great question. I think first for Redwood, I mean, we would highlight that Lord Jones is the first of a pipeline of brands that we’ve been able to review the brand architecture and we’re very excited about. And I think the different brands will have different points of distributions. We’re looking at much different consumer need states that are being addressed in different occasions. So we do see Lord Jones is something where the distribution channels will continue to expand, but staying in similar retail outlets like Sephora, SoulCycle, a lot of great opportunities for continuing to build that community. We’re very, very excited about everything that Rob and Cindy have built there and looking forward to continuing to help them advance their mission globally. It’s too early to speculate, I think, on specific markets as far as which countries we bring the brand to. We do see significant opportunity in Europe. But ultimately, whether it’s one country or the other will just depend on what we think is best for the brand.

[John Zamparo:]

Okay. Understood. And then, sticking with that subject, can you talk about FDA regulations and how you’re thinking those evolve in the next 6 to 12 months and how you feel your products are compliant with their requirements? Thanks.

[Mike Gorenstein:]

Yeah, as you know the CBD industry is growing, changing and evolving pretty real time. And so independent of how the landscape continues to develop, we’re very confident that CBD will have a place for the industry. And really our focus is just positioning ourselves for our success as the process unfolds. We think partnering with Redwood puts our company at the forefront of many exciting opportunities. And we’re committed to continuing to lead as a responsible player, and our focus will be on quality, consistency, and marketing responsibly. And we think that we have got expertise that we are able to leverage that will allow us to do that and make sure that we end up in a place where we are all very happy with the long-term sustainable industry.

[John Zamparo:]

Okay. That’s great. That’s all for me. Thank you.

[Operator:]

Next, we have Vivien Azer from Cowen and Company. Your line is open.

[Vivien Azer:]

Hi, good morning.

[Mike Gorenstein:]

Hey, good morning.

[Vivien Azer:]

So very meaningful revenue beat relative to our expectations as well as consensus. And given the magnitude of that beat, I was a little bit surprised to see the inflation in terms of cost of goods sold. So I was hoping that you could expand on that a little bit and perhaps comment whether the increased sales of CBD oil that you called out was a factor in that? Thanks.

[Jerry Barbato:]

So good question, Vivien. As we continue to optimize our production methods at Peace Naturals and source third-party biomass, we anticipate there will be some variability from quarter-over-quarter in our unit costs, and we feel that these results are best judged over a longer time horizon. We can have quarter-to-quarter variability as we are still in the process of bringing our B4 online, which is our largest facility at Peace Naturals, and dialing inefficiencies. But we expect unit cost to decrease over time as we work towards, getting towards the steady state.

[Vivien Azer:]

And would you be willing to put out a target in terms of what you think the right optimized COGS program would look like?

[Jerry Barbato:]

Not at this time. One of the things to think about is, as we continue to source from third parties and as we see the price come down over time that will have a meaningful impact on our COGS.

[Vivien Azer:]

Understood. Thanks.

[Operator:]

Our next question is from Chris Carey from Bank of America Merrill Lynch. Your line is open.

[Christopher Carey:]

Hi, good morning.

[Mike Gorenstein:]

Hey, good morning.

[Christopher Carey:]

So I think your comment is well taken on focusing on the higher margin areas of the value chain for the longer-term, and how you are setting up the supply chain to position for that, right. So I guess, on that front, securing more third-party supply and co-packing at Canada. Are you starting to see some more favorable pricing in the wholesale channel? Or is this just a natural evolution of your business model to have a mix of owned and outsourced capacity? And then related on the supply chain front for U.S. CBD, right, the Lord Jones gives you that prestige channel access, but how do you think your supply chain is set up right now to capitalize on the bigger mass convenience store opportunity?

[Mike Gorenstein:]

Sure. So first in Canada, we are starting to see more favorable pricing, and given the emphasis of capital deployment in Canada has historically been around capacity, we do expect to see that accelerate. So our view and our approach is really been to make sure that in any market, we’re focusing on capturing demand making sure that we build a relationship with consumer, and as that investment capacity leads to much more supply, we feel that will be very well positioned to optimize margins. In the U.S., we feel that we’re in a very good position as far as supply chain, and similarly we think focusing on the demand side is the priority in making sure that we have the highest quality products, that we have a supply chain, that we can provide transparency and make sure that we have quality consistent products. We feel that we have that today, but we certainly will make sure to continue optimizing costs and I would note that we have network of contract farmers, then we have a lot of R&D that we’ve been doing at Cronos that can help optimize that supply chain. And I think that, there is kind of two things that we look at, continuing to build out the brand and build that community. And then also on the other side, optimizing margins with different technologies, whether that’s the work we’re doing with Ginkgo, whether that’s genetic breeding or other investments in automation throughput and packaging. And while we feel like it’s underappreciated and not often discussed, we do think that efficiencies and distribution and costs is a very, very important thing and an advantage it will have.

[Christopher Carey:]

Okay. Thanks. And then just for the follow-up, the quarter showed good progress on the legacy Canada business, which is good to see and important to see, and it sounds like that trend will continue with Peace Naturals getting licensing and you’re securing more supply, right. But bigger picture, right, the opportunity is so much larger than what this quarter’s results would reflect, right. And so, when you think about the next year and namely kind of the U.S. market with CBD and potentially even devices, how does your geographic mix from a sales standpoint look over the next one to two years?

[Mike Gorenstein:]

Sure. I think, it’s probably too early to speculate on exactly how quickly the European market will unfold for CBD. So while we see a lot of opportunity and it’s exciting, I don’t think we have the same clarity we do as far as the Canadian market or the U.S. So that’s a big initiative. But I think it’s fair to estimate that the U.S. CBD market will likely be the largest contributor over the next year or two.

[Christopher Carey:]

Very helpful. Thank you very much.

[Mike Gorenstein:]

Thank you.

[Operator:]

Next, we have Graeme Kreindler from Eight Capital. Your line is open.

[Graeme Kreindler:]

Good morning. Thanks for taking my questions. I just wanted to follow-up in terms of the average price per gram sold, it steadily increased over the past couple of quarters, and tying that in with the comments before about sourcing more supply on third-party. I was just curious in terms of Cronos’ strategy today seems to be achieving premium pricing. What’s gone into that and how is that expected to trend over time?

[Jerry Barbato:]

Yeah. So I think we really can’t read a lot into quarter-over-quarter, I know, that it’s increasing today and it’s really driven by product mix, as well as you’ve seen a steady increase in CBD sales, which carry no excise tax.

[Mike Gorenstein:]

And I think, one of the things to think about as we start getting in different products that costs of biomass by weight isn’t necessarily representative of what the actual cost and value driver is. It’s really focused on cannabinoid. So one of the reasons that we think that cost can start to get tricky, if you measure it by flower is that when you think about using fermentation, where you’re getting cannabinoids that aren’t coming from the weight of flower, but also, just the simple example of comparing a flower that’s $1 a gram, it has 10% cannabinoid content versus flower that’s $2 a gram, but has 30% cannabinoid content. The actual input costs into derivative products is more favorable on the latter, even though the price per gram of biomass is actually higher than the former.

[Graeme Kreindler:]

Okay. And just as a follow-up to that with respect to fermentation. You mentioned that the fermentation facility has some activities that are going to be winding down towards the end of the fourth quarter, but is there any sort of target at this point in time in terms of when that might go operational as well as the expected CapEx budgets if you, I guess, retrofitted for your need?

[Jerry Barbato:]

Sure. So because we need a cannabis specific license, we actually thought that it was a really great opportunity to minimize our spend, but also provide a good opportunity for Apotex. So the ability to close the transaction apply for license as well the Apotex employees continue to work for Apotex and wind down opportunities, it’s something that just cost savings for us and afford them flexibility. So we thought that that was a really good way for both of us to create value. We don’t have any specific targets that we’re ready to discuss yet, but we do see that the most important near-term opportunity is being able to focus on what that downstream processing will be, which gives us the model to scale and optimize downstream processing. So while there’s fermentation, once you actually get the fermented broth, understanding at a separate and isolated is something that we want to make sure that we develop the right technical specifications for us, so that we have a model and a blueprint as we move into commercial activity.

[Graeme Kreindler:]

Got it. And just to clarify, once the transaction is closed, there is going to be no further involvement from Apotex in that facility. Is that correct?

[Mike Gorenstein:]

Yeah, so the transaction has closed. We would be hiring employees that worked for Apotex, but not with Apotex Corporate, so it wouldn’t be…

[Graeme Kreindler:]

Understood.

[Mike Gorenstein:]

…yeah.

[Graeme Kreindler:]

Okay. Thank you.

[Operator:]

Our next question is from Michael Lavery from Piper Jaffray. Your line is open.

[Michael Lavery:]

Good morning. Thank you.

[Mike Gorenstein:]

Good morning.

[Michael Lavery:]

I just wanted to clarify one thing from – a question on pricing. You said you expect it to improve going forward. Is that for you as a buyer or your net realized selling price – and obviously, there is a mix component there versus the – trying to get at some of what the commodity price expectations are. What do you expect looking ahead on U.S., buying flower, in terms of how that market looks?

[Mike Gorenstein:]

Yeah, I think as far as buying flower, we do expect that as capacity continues to increase that it will mean that we’re able to source for lower prices. So I think that comment was specific to being able to get input that we then can use ingredients and value-add products. And a lot of the investments that we’re making is in being able to take that third-party product, make sure that we’re sourcing the right product, making sure we’re procuring some of the high quality as far as inputs, and then formulating it and standardizing to have the value-add products where we then think on the demand side, we would still have pricing power and potentially increased pricing power as we move into things like vaporizers. But we don’t necessarily – we’re not referring to dried flower as a category, just using flower as an input and then the output of the actual packaged product.

[Michael Lavery:]

That’s helpful clarification. Thank you. And then just on vaporizers, can you give us a sense? We know, obviously, the Health Canada timing. But do you have a sense of how you align with that and what we should expect in terms of pacing? And then just in terms of differentiation, can you give a little sense of what illicit for something like vaporizers may look like? Is there much of a market there and how would you – how might you stand out relative to what’s out there today?

[Mike Gorenstein:]

Sure. So we’re ready for whenever we’re able to launch, whenever the approvals come and we expect that late December, again could slip to early January, depending on how many submissions go in. We think early on the two key differentiators are going to be certainly the formulations, being able to provide something that’s consistent, that delivers the desired effect, and then ultimately, has a good flavor profile and overall experience. And I think the most important one is safety. So there is significant work that we’ve done on making sure that the devices are safe, that we’re using the highest quality materials from a supply chain perspective, having boots on the ground to make sure that we’re auditing everything that comes over, and also what the interaction is between the formulations and those devices. So I think that’s a big differentiator, not only among us versus peers, but especially against the illicit market. And as far as illicit market, while we think that there are certainly robust vaporizers out there as far as quantity, we don’t expect, from a technology perspective – as we continue to iterate that there is likely going to be much competition. In terms of innovation, we think it’s more about pricing and would probably be something that you see competition in the value category versus more mainstream and premium.

[Michael Lavery:]

Okay. Thank you very much.

[Operator:]

Our question is from Jesse Pytlak from Cormark. You may ask your question.

[Jesse Pytlak:]

Hey, good morning, guys. Just coming back to the commentary on the adjusted EBITDA outlook for the back-half of the year, is there any type of kind of commentary or guidance you can provide in sense of just how aggressively that will kind of change versus the first-half result?

[Mike Gorenstein:]

Yeah, I think as always this will depend on some of the market opportunities. So how things open up, but nothing specific as far as guidance targets at this time?

[Jesse Pytlak:]

Okay. That’s fair. And then, just coming back to the fermentation facility with respect to licensing, are there any type of unique or kind of special classes of licenses that you would need that would be outside of the typical cannabis licenses in Canada?

[Mike Gorenstein:]

No, it’s considered a processing license. So it’s actually called out in C-45. It would be similar to an extraction license.

[Jesse Pytlak:]

Okay. That’s all from me. Thank you.

[Operator:]

This brings to the end of the Q&A session of today’s call. I will turn the call over to Mike for closing remarks.

[Mike Gorenstein:]

Thanks, everyone, and have a great day.

[Operator:]

Ladies and gentlemen, this concludes today’s conference. And thank you for your participation. Have a wonderful day. You may now disconnect.