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Cronos Group Is a Mess, and Its Third-Quarter Report Proves It

By Sean Williams - Nov 15, 2019 at 7:21AM

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Here are five less-than-obvious reasons Cronos Group's operating results are a major disappointment.

The big day finally arrived on Tuesday, Nov. 12, before the opening bell. Cronos Group ( CRON -5.46% ), one of the most popular cannabis stocks in the world, reported its third-quarter operating results. And while Wall Street considered the report a relative non-event, based on the modest move lower in the company's stock, it solidified the idea that the company is a total mess.

Before I dig into the five reasons Cronos Group is a disaster, let's have a look at the company's headline numbers.

A clear jar that's packed with dried cannabis buds that's lying atop a fanned pile of twenty dollar bills.

Image source: Getty Images.

For the quarter, Cronos generated 13.39 million Canadian dollars in gross sales and CA$12.7 million, on the dot, after excise taxes were subtracted. While this was a double-digit percentage improvement from the sequential second quarter, it fell well short of the CA$14.1 million that Wall Street had expected. (Note: Wall Street's revenue projections are often for gross revenue, not net sales.)

However, Cronos generated CA$788 million in quarterly profit, which was entirely the result of a positive gain of CA$835.1 million recognized from the revaluation of derivative liabilities tied to warrants owned by Altria Group. This is the third consecutive quarter that derivative liability revaluations have led to a huge bottom-line profit, all while Cronos Group's actual operations continue to lose money. Stripping out every single one-time benefit, cost, and fair-value adjustment reveals a gross profit of CA$5.3 million and operating expenses of CA$34.8 million.

These are the figures that most folks are aware of. Now, here's a deeper look at the five things Cronos reported or said that should have investors absolutely terrified.

A cannabis leaf laid within the outline of the Canadian flag's red maple leaf, with rolled joints and a cannabis bud to the left of the flag.

Image source: Getty Images.

1. Cronos Group's net sales price per gram plunged in Q3

One of the most front-and-center surprises of Cronos Group's third-quarter report was the absolute plunge in what the company received for its product on a per-gram basis. Statistics Canada data showed a modest decline in legal per-gram prices during the third quarter, but Cronos delivered a 48% year-over-year decline in net per-gram pot prices to CA$3.75. This decline dwarfed the 31% drop in year-over-year cost of sales per gram before fair-value adjustments.

The company noted that increasing supply and a shortage of legal channels in which to sell its product are the reasons its per-gram sales price plunged. The inability of certain provinces to effectively roll out physical dispensaries, coupled with new supply reaching the market, has created an environment of oversupply, despite a reasonably small percentage of legal demand actually being met.

Four vials of cannabidiol-rich liquid lined up on a counter.

Image source: Getty Images.

2. Extract sales fell off a cliff

Another shocker was Cronos Group's financials showing that extract sales comprised just 9% of total revenue, down from 29% in the year-ago quarter. This is particularly noteworthy given that extracts produce significantly higher margins than traditional dried cannabis flower, which, as noted, can be oversupplied and commoditized. This lack of extract sales is yet another reason the company's net product revenue per gram plunged so much from the previous year.

Admittedly, extract sales have been limited to just oils until recently. Cronos should see its net product revenue per gram sold rise in the quarters to come, once derivatives hit dispensary shelves in December. But understand that derivatives will be subject to the same supply issues that have plagued the dried flower market since sales began on Oct. 17, 2018.

A vape pen next to a vial of liquid and neatly arranged dried cannabis flower.

Image source: Getty Images.

3. The company is "aligning" Peace Naturals to meet current market conditions

Thirdly, it's worth noting that Cronos Group "has undertaken certain initiatives to better align with its evolving business and strategic pillars." This might sound like a plan designed to bolster growth, but it's a fancy way of saying that Cronos Group is forgoing some of its cultivation space in order to focus on higher margin products and reduce its rising expenses. As noted in the press release:

Certain facilities at the Peace Naturals Campus will be partially repurposed from cultivation to provide for additional R&D [research and development] activities, production and manufacturing of derivative products, and will allow for increased vault and warehousing capabilities. In addition, certain facilities at the Peace Naturals Campus will transition to R&D areas focused on new technologies for value-added product manufacturing.

Mind you, I'm not chastising Cronos for this move, as the company does need to reduce its suddenly rising costs. But this statement is a roundabout admission that its only major growing facility is having its output cut because of weak cannabis market conditions in Canada. That's not a statement investors should overlook.

Flowering cannabis plants growing in a large indoor cultivation facility.

Image source: Getty Images.

4. Cronos GrowCo is a long way from contributing

The company also provided an update on what could be its eventual flagship grow site, Cronos GrowCo.

GrowCo, as it's known, is a joint venture between Cronos and a group of investors and is expected to yield as much as 70,000 kilos annually, when at full operating capacity. When the joint venture was founded in mid-2018, the expectation was completion in 2019 with a quick ramp up in production, but the latest update in Cronos' third-quarter report suggests otherwise.

According to the press release, construction on GrowCo won't be complete until the current calendar-year quarter, with cultivation coming online in phases during the second half of 2020. Though this slow-stepped production at GrowCo makes sense, given the oversupply Cronos is contending with, it also means that this potential flagship facility is going to be dead weight for even longer than expected. There's no longer any question that Cronos Group isn't a major cannabis player.

A magnifying glass being held over a balance sheet.

Image source: Getty Images.

5. Holy goodwill, Batman

Last but not least, Cronos Group completed its acquisition of privately held Redwood Holdings during the quarter for $300 million (that's U.S.). This purchase is designed to facilitate Cronos' push into the U.S., with Redwood owning the Lord Jones brand of cannabidiol-based beauty products.

However, a quick look at the company's balance sheet shows that it has now recognized CA$284.2 million ($214.8 million) in goodwill, up from CA$1.8 million at the beginning of the year. This suggests that around 72% of the Redwood deal is currently being recognized as "premium." In other words, Cronos may have grossly overpaid for its acquisition of the Lord Jones brand.

Even though Cronos continues to sport a healthy cash balance and has fallen well off of its all-time high, there remain few reasons, if any, for investors to be excited about its near- and intermediate-term growth prospects. This company is a mess, and investors would be wise to keep their distance.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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