Cronos Refutes The Shorts With A Focus On Science

Summary

  • Cronos has been put under some pressure from a prominent short thesis.
  • Cronos CEO took to CNBC to respond to those criticisms of his company and did so very effectively.
  • Cronos deal with Gingko could lead to Cronos having cost advantages in what is potentially the most lucrative segment in cannabis.
  • All cannabis investments are risky and investors should be cautious.

Last week, Cronos was subject to some criticism from notable short-seller Andrew Left. Shares fell rather heavily on the day but have since bounced back and are up a remarkable 96% since August 14.

In an interview, Cronos CEO Michael Gorenstein focused attention on Cronos’ deal with Gingko Bioworks to develop innovative ways to cheaply produce pure cannabinoids in large quantity.

That response effectively answers Citron’s criticisms regarding R&D spend, with the deal including $22 million in R&D spending and potentially up to $100 million in rewards on meeting certain milestones: a hefty amount of R&D spending.

Being able to produce cannabinoids at the costs in the deal – under $1,000/kg – would be huge for Cronos and give it an advantage in the value-added segment, which is likely to be the most lucrative segment in cannabis. However, there are also risks, since there is no guarantee that Gingko will be successful in its research, nor that competitors wouldn’t also find similar (or better) techniques for producing cannabinoids.

Based on a comparison with peers, I find Cronos to be expensive on an enterprise value-per-production basis, although in line with major peers on an enterprise value-per-supply basis. The latter is a rough metric at this point, since each company has not announced quantities from 2-4 provinces (the number of excluded provinces noted in italics in the chart above).

Cronos offers an attractive option to investors who believe in what Cronos’ management is doing and their focus on value-added products. I do not own Cronos at this time, but I would consider purchasing shares on a pullback. Until such a pullback, I am neutral on the company.

Criticism

Last week, Citron research released a short thesis on Cronos that shook – at least for a day – the cannabis market. Cronos shares fell 30% on the day, although they have rebounded from most of this decline, finishing at $12.20 in after-hours trading on September 4, only 4% down from their close prior to Citron’s publication.

Citron’s thesis sets a price target of $3.50/share for the stock. Citron asserts that Cronos has failed to disclosure the quantities in their supply agreements, perhaps due to the low size of those agreements. Citron also discusses Cronos’ low sales totals to date (medical sales since recreational cannabis is illegal until October 17).

Citron also lamented Cronos’ lack of R&D spending ($1 million over the last year) despite management’s discussions assertion that:

“Cronos seeks to build the world most innovative cannabinoid platform using different plant genetic and production methodologies to develop a portfolio of cannabinoid and terpene recipes that delivered differentiated psychoactive effects and therapeutic benefits.”
Cronos Q2/18 CC

Citron further lamented a history of product recalls, one due to mislabeling and another due to use of a particular pesticide. Citron also questioned Cronos’ valuation compared to Canopy Growth (CGC), suggesting that Citron trades at higher multiples despite Canopy’s $3.8 billion deal with Constellation (STZ).

CNBC & The Gingko Deal

Both parties – Citron’s Andrew Left and Cronos CEO Michael Gorenstein – have taken to CNBC to defend their positions. I encourage readers to watch Michael Gorenstein’s interview. His performance was strong and is a primary reason why shares are up 9.4% after hours.

Michael Gorenstein did not discuss Citron’s valuation of Cronos, although he did smile at the mention of a $3.50 target price.

Instead, Gorenstein focused the narrative on Cronos’ announcement of a partnership with Ginkgo Bioworks to produce cultured cannabinoids:

“By transferring the DNA sequences for cannabinoid production into yeast, Ginkgo expects to develop strains that produce cultured cannabinoids at high quality and purity in a process similar to brewing beer in a microbrewery. In addition to allowing for the efficient and scalable production of cannabinoids, the use of Ginkgo’s platform is expected to unlock access to potentially medically-important and valuable cannabinoids that are present only in low quantities in the plant.”
Press release, September 4, 2018

During his CNBC interview, Gorenstein likened cannabis to oranges (at ~7:04), THC to vitamin C, and said that these processes could be the steps to unlocking value-added vitamin C-based products like Airborne, Emergency or vitamin C tablets. Rather than simply squeezing juice from the orange, so to speak, working with Ginkgo will potentially allow Cronos to be able to get the cannabinoids it wants to use – those that are most effective for any given purpose – in the most efficient and cost-effective way.

“Under the exclusive partnership, Ginkgo will work with Cronos Group on research and development of microorganisms capable of producing certain target cannabinoids in a scalable and highly efficient manner. Cronos Group will fund certain R&D and foundry expenses expected to be approximately US$22 million subject to the achievement of certain milestones. In addition, upon Ginkgo’s demonstration that the microorganisms are capable of producing the target cannabinoids above a minimum productivity level, Cronos Group will issue up to approximately 14.7 million common shares in the aggregate, in accordance with the milestone allocations described below. The common shares allocated were based on the 60-day VWAP for Cronos Group common stock of US$6.81 as of July 17, 2018, when the letter of intent was executed by both parties. The transaction had an aggregate value of US$100 million assuming all milestones are met. Tranches of these common shares will be issued once each of the target cannabinoids can be produced for less than US$1,000 per kilogram of pure cannabinoid at a scale of greater than 200 liters as follows: THC(A), 20%; CBD(A), 15%; CBC(A), 10%; CBG(A), 10%; THCV(A), 15%; CBGV(A), 10%; CBDV(A), 10%; CBCV(A), 10%.”
Press release, September 4, 2018

Signing this deal appears to resolve Citron’s concerns about Cronos’ R&D spending totaling only ~$1 million.

In addition to discussing the Ginkgo deal, Gorenstein also noted that Ontario prohibits producers from revealing the size of their supply deals, and that size isn’t important anyhow: Orders will depend on consumer preference and which products generate sales, which remains to be determined. Cronos also noted the 20,000 kg/year supply deal with Cura, announced last month.

Based on that deal, supply agreements in four provinces (BC, ON, NS, PEI), as well as international agreements (which Citron lamented were small, perhaps $177,000), Gorenstein asserted that demand will not be a problem for Cronos, and it will be more about decisions on where to allocate its products. Cronos’ CEO also said that Cronos was in a healthy cash position and would not need to raise capital.

Analysis

First and foremost, Cronos’ deal with Gingko resolves Left’s concerns about a lack of R&D spending. If Ginkgo can achieve its objectives – producing large quantities of the pure cannabinoids listed for <$1,000/kg, that could be immense for Cronos. That price would be quite a feat: “inexpensive” cannabis costs start at ~$1,000/kg (or $1/gram), so being able to produce pure, specific cannabinoids at that price would be quite a feat.

Being able to produce pure cannabinoids for this price – rather than just cannabis which might include ~20% cannabinoids in a mixture with one another – would enable Cronos to be a low-cost leader in all sorts of value-added products.

And those value-added products will be the future of the industry, in my view. Constellation’s investment in Canopy Growth and Molson-Coors’ (TAP) joint venture with HEXO (OTCPK:HYYDF) are both aimed at producing products other than just dry cannabis flowers/buds. While some cannabis producers are focused on high-quality flowers – Supreme Cannabis (OTCQX:SPRWF) most notably – cannabis sales have shifted more and more towards non-flower products in legal markets.

In Colorado in 2014, 74.5% of medical cannabis and 66.1% of adult-use cannabis was focused on dry flower (or “buds”). By 2017, that figure had dropped every single year across both markets – down to 61.2% of medical users and 54.1% of recreational users.

There is little reason to expect that Canada – or any other future legal jurisdiction – will be any different. Refined products can provide a better user experience, especially for users who do not like the taste of cannabis smoke, prefer the high of edibles, may be more health-conscious about the potential risks of smoking, or who don’t like the discomfort, coughing, and obvious smells produced by smoking cannabis.

Refined products offer far more possibilities for product differentiation. Refined products can vary significantly – an edible product might look like a can of Red Bull, a bottle of beer, a breath-freshening spray, or a Jolly Rancher candy. Within each of those categories, differences can be substantial, such as taste, marketing, texture, potency, and cannabinoid mixtures (THC vs CBD, indica vs sativa, etc).

Further, users are much more likely to grow attached to a refined product than raw product – for example, I have much stronger preferences in what brand of sub sandwich I might want than what brand of lettuce I prefer.

This can allow for increased customer loyalty and much stronger pricing power. Evidence in Colorado shows that flower and concentrate prices have declined since legalization, while edible prices – both adult use (“AUMJ”) and medical (“MMJ”) have remained very consistent.

By focusing on these products – especially when able to obtain the key ingredients for cheaper than peers – Cronos could be able to grow a large, loyal customer base on high-margin value-added products.

Risks

There are risks to investing in Cronos. Cronos has signed a deal with Ginkgo to try to develop access to cannabinoids at low prices, but that is hardly a guarantee of success. That research could fail to find cost-effective means of producing the desired cannabinoids, for example.

Any investment in any cannabis stock is very risky. Market valuations are frothy and could decline. The industry is in a nascent stage, with recreational cannabis not even legal in Canada yet, much less in future international markets. It is probable that there will be more losers than winners in this market as it develops.

For that reason, I suggest to new investors to invest in a basket of cannabis stocks – perhaps in an index fund like the ETFMG Alternative Harvest ETF (MJ) or the Horizons Marijuana Life Sciences Index ETF (OTC:HMLSF). I would also suggest using dollar-cost averaging, to protect from spikes. The market is frothy right now, and the declines could by just as painful as the rise has been joyous. Don’t let “fear of missing out” dictate a quick investment strategy: Invest slowly and thoughtfully. I would further suggest allocating only a portion of your portfolio the cannabis stocks. Personally, I have 15% of my portfolio – maximum – allocated to cannabis stocks. If the price increases of the past few weeks continue, I will need to trim holdings to maintain the sector diversity of my portfolio.

Invest in this sector carefully: It is an emerging market, and it is likely to have wild fluctuations in both directions.

Comparison to Peers

Based on Cronos’ Q2/18 FS, Cronos had 176.9 million shares outstanding and 40.1 million outstanding warrants and options. Based on a Black-Scholes model (using 144.8% volatility and a 2.23% risk-free rate, since options are $CAD for TSE:CRON), the value of the outstanding options and warrants is ~C$230 million. Given net cash (including investments) of ~C$286 million and a share price of C$14.65, this implies an enterprise value of ~C$2.7 billion.

Based on this enterprise value, Cronos has an EV/gram of 2019 production (excluding GrowCo, as discussed in the MD&A) of C$ 58/gram. Meanwhile, Cronos has an EV/supplied gram of C$ 137. This figure is based on Cronos’ supply agreement with Cura, but excludes the provincial supply agreementswith British Columbia, Ontario, Nova Scotia, and Prince Edward Island (covering 55% of Canadians).

Overall, Cronos looks a little expensive compared to its peers. Cronos’ enterprise value-to-production ratio is much higher than all of its peers, although that figure excludes Cronos’ 50% stake in a future 850,000 sq ft greenhouse in Ontario which was announced in July. However, post-2019 expansions are also similarly excluded from peers.

Per supplied gram, Cronos’ price is cheaper than Canopy Growth – whose price is high in the wake of the Constellation investment – and more costly than HEXO, but in line with Aphria and Aurora (OTCQX:ACBFF). Cronos looks to be priced in line with peers on this metric, aside from HEXO looking particularly cheap.

Takeaways

Cronos’ CEO’s response to Citron was very effective, resulting in strong gains after hours on September 4. Gorenstein focused on Cronos’ potentially-promising agreement with Gingko Bioworks. If that research is successful, Cronos could take a strong position in the value-added segment, which has been an increasingly important segment in legal markets like Colorado. That segment offers the ability to attract and retain customers more effectively with product differentiation, represents an increasing part of legal markets, has been much more resistant to pricing declines, and potentially offers higher margins – especially if Cronos can produce specific cannabinoids for under $1,000/kg.

Cronos offers an attractive option to investors who believe in what Cronos’ management is doing and their focus on value-added products. However, it does appear a little pricy when compared to its peers, especially given relatively low production for its enterprise value.

However, I believe new investors should be cautious in investing into the industry, considering the level of price increases we have seen since August 14. Those dramatic rises make a price correction likely in the future, and investors should consider using techniques like dollar-cost-averaging to limit the potential for buying at a peak in the market.

I do not own Cronos at this time, but I would consider purchasing shares on a pullback. Until such a pullback, I am neutral on the company.

Article courtesy of Jonathan Cooper / Seeking Alpha

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