The marijuana industry is budding before our eyes, and exactly seven weeks from today, we'll see recreational weed go on sale in our neighbor to the north. When the proverbial green flag waves, it could open the door to billions of dollars in added annual revenue once the industry is fully ramped up.
With the Cannabis Act now passed and legalization around the corner, the time for promises is waning, and investors are going to be looking for pot stocks to deliver on their previous promises of growth and brand building. One such company that investors have been particularly keen on is Ontario-based Cronos Group (CRON 4.66%), which, at a market cap of $1.8 billion, is among the largest publicly traded marijuana stocks.
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Everything you need to know about Cronos Group's second-quarter report
It just so happens that the first pot stock to have uplisted from the over-the-counter exchange to a reputable U.S. exchange reported its second-quarter operating results roughly two weeks ago. Now that the euphoria surrounding Constellation Brands's big equity stake in Canopy Growth Corp. is wearing off a bit, let's take a closer look at the eight things you should know about Cronos Group's Q2 operating results.
1. A growing reliance on high-margin oils in the early going
While most of the focus on Cronos's Q2 report was likely on the company's 428% increase in year-over-year sales to 3.39 million Canadian dollars (US$2.6 million), it was the composition of those sales that was much more impressive. In particular, 19% of aggregate revenue was the result of cannabis oil sales, after recording no oil sales in the year-ago quarter. Cannabis oil might be targeted at a smaller pool of patients and consumers than dried cannabis, but it's a significantly higher-margin product than the dried flower. Assuming Cronos Group pushes for oils to be a notable component of future sales, its margins have an opportunity to outpace its peers.
2. Inventory is building
Although the Canadian government feels confident that growers will be able to meet domestic demand once Oct. 17 rolls around, there's a good chance that we'll witness an initial shortage. That's because growers like Cronos are still in the process of expanding their production capacity. However, Cronos did end the quarter with more than triple the value of oils it had in inventory as of Dec. 31, 2017 (inclusive of finished goods and work in process), with dried cannabis inventory growing by 39% over the same time period. Having a solid inventory is an important step to meeting initial demand and brand building.
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3. Its international push is on track
The legalization of marijuana in Canada is about more than just the domestic market. Cronos is also looking overseas to foreign markets that have legalized medical weed. During the quarter, the company's Cronos Australia subsidiary was granted a medical cannabis manufacturing license. Also, it forged a strategic distribution partnership with pharmaceutical wholesaler Delfarma, which has the potential to reach about 40% of the domestic Polish market.
4. Announced a major take-or-pay agreement
A major positive subsequent to the end of the second quarter was the announcement from Cronos that it had landed its biggest supply deal to date. On Aug. 9, Cronos announced that it and Cura Select Canada had entered into a five-year take-or-pay agreement that'll see Cronos supply a minimum of 20,000 kilograms of cannabis annually to Cura. Cura, in turn, will build a state-of-the-art extraction facility on a parcel of land owned by Original BC and use the product it purchases from Cronos to develop cannabis-based and cannabidiol-based oils.
5. Potentially doubled production capacity
Unlike a number of its peers, Cronos Group hasn't exactly been forthcoming with an aggregate peak production estimate for its owned properties. It did, however, announce a 50-50 joint venture with a group of investors (known as Cronos GrowCo) to build an 850,000-square-foot facility in Ontario that'll be capable of 70,000 kilograms of peak production. My own estimate prior to this joint-venture announcement was that Cronos Group was on track for around 70,000 kilograms in annual production. Thus, its strategic partnership essentially doubles its peak annual production.
6. Bolstered its cash position
During the second quarter, Cronos Group completed a bought-deal offering that wound up raising CA$100 million in gross proceeds. With the company spending heavily on capacity expansion, it ended the second quarter with CA$89.6 million in cash. This should prove to be more than enough to finish constructing its existing facilities and focus on its brand-building efforts.
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7. Generated a Q2 profit, with a big asterisk
Then again, this was far from a perfect quarter. Even though Cronos Group's net income soared 316% to CA$723,000, which worked out to nil (CA$0.00) on a per-share basis, the company's profit comes with a pretty notable asterisk. Namely, there was a favorable adjustment in the fair value of its biological assets and inventory sold in Q2 that amounted to CA$4.21 million. Without this fair-value adjustment, a more than doubling in general and administrative expenses and share-based payments, and a quadrupling in sales and marketing expenses would have resulted in another loss for Cronos Group.
8. Continues to dilute investors
Lastly, like most pot stocks in need of capital, Cronos Group has been busy diluting shareholders with bought-deal offerings. A bought-deal offering involves the sale of common stock, convertible debentures, stock options, and/or warrants in order to raise capital. After having 133.1 million shares outstanding in Canada as of the end of Q2 2017, it now has nearly 177 million shares outstanding. Further, Cronos had 27.2 million warrants and nearly 12.9 million stock options outstanding at the end of the quarter. In other words, dilution will continue to wreak havoc on investors and weigh down any chance of the company producing a meaningful per-share profit.
While I'd strongly advocate waiting on the sidelines with virtually all pot stocks and allowing them to prove their worth to Wall Street, I'm particularly averse to Cronos Group given its relatively small expected per-share profit for 2019, as well as its valuation in comparison to its peak annual production potential. It remains a marijuana stock I wouldn't buy.
