Ready or not, we're entering the heart of earnings season for the cannabis industry. Although "earnings season" never truly ends, the next couple of weeks will feature the quarterly operating results of North America's biggest pot stocks.
On Thursday, Aug. 8, before the opening bell, Cronos Group (CRON +0.80%), the third-largest Canadian marijuana stock by market cap, delivered its much-anticipated second-quarter results. Suffice it to say, Wall Street was surprised by the profit Cronos generated, as well as the tripling in year-over-year sales. But dig into the company's report beyond the headline figures, and there's not much to like.
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Here's what went right for Cronos Group in the second quarter
Let's begin with the basics. For the quarter, Cronos Group wound up reporting 10.78 million Canadian dollars in gross sales, with excise taxes paid on recreational weed removing CA$0.55 million, leaving CA$10.24 million in net sales (when rounded). With Wall Street typically focusing on gross revenue, the CA$10.78 million Cronos produced in Q2 blew past the consensus estimate on Wall Street of CA$5.6 million. The company attributed its 58% sequential quarterly cannabis revenue growth on demand in the adult-use market, as well as increased production.
Furthermore, the company reported comprehensive income (I'll get into more detail a little bit later about what this entails) of almost CA$251 million, working out to a diluted profit per share of CA$0.22. By comparison, Wall Street had been forecasting a loss per share of CA$0.02 for Cronos. This is the second consecutive quarter that Cronos was expected to produce a loss but instead wound up blowing Wall Street's forecasts out of the water with a huge profit.
On top of these headline figures, the company continues to make headway in the derivatives market. Subsequent to the end of the quarter, it closed its acquisition of an 84,000-square-foot fermentation and manufacturing facility in Winnipeg, Manitoba, from Apotex Fermentation, and also announced the $300 million (that's U.S.) acquisition of Redwood Holdings to establish a presence in the U.S. cannabidiol (CBD) market. CBD, the nonpsychoactive cannabinoid best known for its perceived medical benefits, projects to grow at greater than 100% per year on a compound annual basis through 2023. Since derivative products, such as edibles and vapes, have considerably higher margins than traditional dried cannabis flower, they're expected to be Cronos Group's ticket to big profits.
Furthermore, Cronos Group has worked out a number of agreements with third-party providers for extraction and/or concentrate supply, further cementing the company as a hopeful leader in the derivatives market.
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This is why Cronos Group's Q2 report is far from impressive
But dig below the surface and you'll note that many of Cronos' income statement improvements weren't anywhere near as impressive as they sound.
Let's begin with Cronos Group's top line, which featured 202% year-over-year sales growth. This sounds fantastic... until you see that gross margin actually dropped 10 percentage points from the prior-year period (53% in Q2 2019 vs. 63% in Q2 2018), before fair-value adjustments on biological assets are taken into account. Also, high-margin extract sales as a percentage of total revenue ticked higher by a meager 1 percentage point to 20% from 19% year over year. Despite calling itself a cannabinoid company, Cronos remains, for the time being, heavily reliant on dried cannabis flower relative to cannabis oils and other currently legalized derivatives in Canada.
I believe it's also worth mentioning just how far behind its peers Cronos is in terms of production. Despite the company reporting a 232% increase in kilograms sold in the second quarter from the prior-year period, the 1,584 kilos sold substantially lags Aurora Cannabis, which projects to have production available for sale of between 25,000 kilos and 30,000 kilos in its soon-to-be-reported quarter. Mind you, Cronos and Aurora Cannabis have respective market caps of $5 billion and $7.2 billion, yet their production figures show they're nowhere near this close in terms of real-world production.
Moving to Cronos Group's bottom line, we see that the company benefited from both a fair-value adjustment on biological assets, which added CA$0.47 million to gross profit, as well as a massive revaluation of its derivative liabilities -- i.e., warrants given to Altria as part of its $1.8 billion equity investment into Cronos that closed in mid-March. The gain on derivative liabilities totaled CA$263.9 million in the second quarter, and follows a greater-than-CA$436 million gain recognized in the first quarter. Without these one-time gains, Cronos Group doesn't even come close to making money.
Removing the company's fair-value adjustments, derivative liabilities, and other one-time costs and benefits, Cronos Group produced a gross profit of CA$5.48 million. Comparatively, operating expenses equaled CA$26.29 million, representing a roughly 349% increase from the prior-year period. While it is a positive that share-based compensation only doubled from the prior-year period (a number of Cronos Group's peers have been ravaged by high share-based compensation expenses), general and administrative costs rose by an unsightly 260%. This works out to an operating loss (without fair-value adjustments) of closer to CA$20.8 million. That's a far cry from the nearly CA$251 million headline profit that Cronos Group announced in its Q2 report.
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A lot to prove
Based on what I've seen from Cronos Group's operating results, the company has a lot to prove to Wall Street. Even though it's focused on being a cannabinoid company, Cronos has to demonstrate that it can close the vast production gap between it and its peers -- at least if it has any hope of maintaining its lofty $5 billion market cap.
Cronos Group will also likely need to work through the same supply issues that have plagued the Canadian industry since recreational weed sales launched on Oct. 17, 2018. Regulatory agency Health Canada has introduced policy changes designed to help it work through its huge backlog of cultivation, processing, and sales licensing applications, but it's probably going to take months, or many quarters, before significant progress is made. When combined with compliant packaging shortages, it's looking unlikely that supply issues in the adult-use market will be resolved before a broader spectrum of derivative products make their debut in mid-December.
The one thing Cronos Group does have working in its favor is its abundant cash pile, thanks to Altria's equity investment. The company ended its most recent quarter with CA$1.58 billion in cash and cash equivalents, as well as CA$744.9 million in short-term investments. Combined, this is CA$2.32 billion (about $1.76 billion) in accessible capital, or 35% of Cronos Group's current market cap. That should help provide a downside buffer for the company's stock.
Nevertheless, Cronos Group looks to face an uphill battle with no clear signs that it'll be profitable on an operating basis, without the help of one-time benefits, anytime soon. That makes it potentially avoidable for investors.
