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This Marijuana Producer Just Got Slapped in the Face

By Cory Renauer - May 1, 2018 at 5:04PM

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Cronos Group's independent accountant recently raised the concern that it's at risk of bankruptcy.

Canadian marijuana producer Cronos Group (CRON -4.09%) booked 636% more sales in 2017 than in 2016, and its expectations for future cannabis sales range from good to amazing. With this in mind, you might be a little surprised to know the independent accountant who signed off on the company's 2017 financial report left a disturbing note. In short, the auditor highlighted a chance the company won't be able to meet its financial obligations.

When the only independent accountants who have had full access to a company's books offer anything beyond the standard boilerplate, it pays to understand why. Although Cronos is much further from bankruptcy than its auditor's note suggests, a deeper look at last year's results -- in context -- paints a disturbing picture. 

Shocked woman looking at her computer.

Image source: Getty Images.

Nothing too unusual here

Auditor statements are generally dull affairs limited to an opinion of whether the results are accurate, rather than attempting to offer opinions on the health of a business. But in this case specifically, the auditor drew attention to last year's negative cash flows and the fact that -- if they continued -- the company might not be able to continue as a going concern.

While the auditor's note was a bit odd, there's nothing unusual about a company losing money while investing in its own future. The entire biotechnology industry relies on shareholders financing operations that produce losses for years on end. Cronos isn't waiting for a clinical trial result, but proposed legalization of recreational cannabis throughout Canada is expected to drive the company's sales into the stratosphere in the near future.

Didn't Cronos Group Inc. report a profit?

The auditor's note is a real head-scratcher if you look solely at the headline figures from 2017. Product sales soared, and the company actually reported a slim $1.9 million profit. That hardly seems like a company in danger of bankruptcy.

Here's the issue: A production glut that could get a lot worse has already hammered profit margins into the dirt. The company is booking more sales, but its production costs as a percentage of those sales rose from 64% in 2016 to 98% in 2017. Cronos doesn't sell marijuana in the U.S., but the trend in spot prices since several states legalized recreational weed should be downright frightening to shareholders. Over the past year alone, the average price paid for a pound of cannabis in the States fell 20% from $1,648 to $1,313, according to Cannabis Benchmarks

Medical marijuana generally commands a significant premium in U.S. states where it's not legally available for recreational use. That doesn't necessarily mean Canadian prices will plunge when legal recreational sales begin (assuming all goes as planned) later this year, but it doesn't bode well for a company that's already struggling to sell marijuana at a profit.

Indoor marijuana growing operation.

Image source: Getty Images.

Looking ahead

The auditor cited negative cash flows of $4.3 million last year as the main reason to doubt the company's ability to continue as a going concern. The statement seems a bit silly when you consider the company raised $113 million in a secondary share offering earlier this year. At the very least, Cronos has some time to boost profitability.

There's also the possibility that enormous capacity expansions might lower Cronos Group's production costs enough for it to squeeze out a gross profit in the quarters ahead. After all, margins haven't been flattened across the industry. When the company's largest competitor, Canopy Growth Corp. reported fourth-quarter results, production costs came in at a manageable 42% of sales.

A big cash cushion should give Cronos a few years of breathing room, but I'd be awfully nervous about holding any shares of the stock right now. The company's recent $1.1 billion market cap is an awfully high perch to fall from if investors get nervous about plunging cannabis prices. 

Unfortunately, an epic supply glut will give those shareholders plenty to worry about later this year. Cronos intends to open the world's largest purpose-built cannabis production facility this summer, and its Canadian peers are barreling toward mind-boggling production gains as well. The slap in the face its auditor delivered may have been over-dramatic, but I'd steer clear of this marijuana stock until the company can show signs of sustainable profitability.

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