Altria’s Second Biggest Mistake: Cronos Continues To Wither

Source: Cronos

Summary

Altria (MO) made two big, flashy investments in December 2018: investing $1.8 billion into Cronos (CRON) and $12.8 billion into Juul. Neither investment has paid dividends: as of March 31, Altria is down $8.6 billion on Juul (67%) and $536 million on Cronos (31%).

Cronos has spent one-quarter of the money it received from Altria. About half of this money went towards the $300 million purchase of Lord Jones CBD. That business saw its revenue decline 19% sequentially to $2.2 million in the first quarter. Until business improves, Cronos paid 34x run-rate sales for a business with 50% gross margins in a competitive sector with few barriers to entry.

The company’s cannabis business, meanwhile, has reported mixed results. Revenues have increased over the past five quarters, improving Cronos to the 7th-largest Canadian cannabis company from its prior position as 9th-largest. However, the company has also impaired inventory for three consecutive quarters and significantly overstated revenue twice last year, prompting an SEC inquiry.

Despite these issues, Cronos trades for a premium over all its significant peers. In my view, the company does not warrant this premium, and I plan to continue avoiding any investment in Cronos.

Cronos Dreams Big: Small Cannabis Maker Sells Global Vision

The Cronos/Altria partnership was set to create a leading global cannabis platform

The Cronos/Altria partnership was set to create a leading global cannabis platform. Source: Cronos.

Huge investment; questionable recipient: Seventeen months ago, Altria invested $1.8 billion into Cronos. This investment was part of a pattern of Altria’s investments in “sin” sectors outside of its core cigarette market, along with a much larger investment in Juul two weeks later. Altria’s investment was, and is, the second-largest investment in the cannabis sector.

In exchange for its $1.8 billion, Altria received a 45% equity stake in Cronos at a price of C$16.25 per share. It also received warrants to take this stake up to 55% ownership. Those warrants cost C$19 per share to exercise and expire on March 8, 2023. Altria’s investment is down ~54% from this purchase price.

The company had also considered an investment in Aphria (OTC:APHA), but ultimately chose Cronos as its cannabis partner. The pair aimed to create a leading global cannabis platform.

Altria’s investment was terrific for Cronos but very questionable for Altria itself. When the deal was announced, I publicly questioned whether the company had made the correct choice:

“This is a risky deal for Altria shareholders. Altria is paying a high price for a medium-sized Canadian cannabis producer, and I believe it will be difficult for them to get full value from this deal.” -Dec 8, 2018

This story is not over yet – Cronos remains a growing cannabis business in an emerging market – but thus far, Altria’s investment does not appear to be a wise one. Rather than shrewdly purchasing a strong cannabis company at a low price, it appears that Altria bought into hype near the peak of cannabis euphoria.

Withering Away: Cronos Spends Altria’s Money

At the time of Altria’s investment, Cronos was a small, cash-poor, money-burning cannabis company. In the fourth quarter of 2018, it had $24 million of cash in the bank, revenue of $4.3 million, and an annual cash burn of $240 million. Given that cash burn, the company were quite short on cash, and Altria’s billions were like manna from heaven.

Fast forward fifteen months to the first quarter of 2020.

Cronos has spent one quarter of the funds from Altria on a CBD company and losses from operations and expansion.

Cronos has spent one-quarter of the funds from Altria on a CBD company and losses from operations and expansion. Source: Author, based on company filings.

Big spending; modest growth: Today, Cronos has spent one-quarter of Altria’s $1.8 billion investment. Half of that money went to the $300 million purchase of a small, partly insider-owned CBD company, Lord Jones. The remainder of this capital has been spent on operating losses and capital expenditures. Curiously, capital expenditures decreased after Altria’s investment – Cronos spent $88 million in 2018 before receiving Altria’s money but only $39 million in 2019.

Thanks in part to Altria’s investment, Cronos has been able to modestly improve its standing among global cannabis companies.

At the time of Altria’s investment, Cronos was the 9th-largest Canadian cannabis company by revenue, trailing behind each of Canopy Growth (CGC), Aurora (ACB), Aphria, Tilray (TLRY), CannTrust (CTST), HEXO Corp. (HEXO), Organigram (OGI) and Supreme Cannabis (SPRWF) (in descending order of revenue). Today, it is the 7th-largest Canadian cannabis company by revenue. Its CBD revenue has put the company ahead of Supreme Cannabis (pending first-quarter results on May 15), while CannTrust failed due to scandal, as I’ve previously discussed.

Cronos spends four times as much on operating costs as they sell in cannabis.

Cronos spends four times as much on operating costs as it sells in cannabis. Source: Author, based on company filings.

Cronos released its first-quarter results on May 8th. Shares fell modestly on these results. The highlights of these results include:

  • Revenue grew 15% to $8.4 million. Cannabis revenue grew 36% sequentially, while CBD revenue fell 19%.
  • Gross margins were marred by inventory impairment for the third consecutive quarter. This led to reported gross margins of -77%. Absent impairment, CBD gross margins were a healthy 50%, while cannabis gross margins were a dismal 6%.
  • Operating costs of $39 million, or more than 4.5x higher than revenue, although they fell 11% sequentially due to one-time costs last quarter.
  • Free cash flow improved to a $45 million cash burn, a modest improvement from $54 million last quarter. In both quarters, most of this burn is due to operating losses.
  • Cronos ended the quarter with $1.3 billion in cash, down $171 million from last quarter.

Perhaps the best aspect of these results was the strong growth in cannabis revenue. However, that news was offset by very poor cannabis gross margins of only 6%, compared to 48% last quarter.

CBD sales falling is a poor sign for Cronos’ $300 million Lord Jones investment, which I have previously questioned. Falling CBD sales were announced on the same day that CV Sciences (OTCQB:CVSI), a small independent CBD company, announced its third consecutive quarter of double-digit CBD revenue declines. Perhaps, as I suggested for Charlotte’s Web previously, the bloom is off the CBD rose across the sector and consumers are tired of paying top dollar for below-medical doses of non-intoxicating CBD.

Cronos reports a non-operating gain due to its falling stock price.

Cronos reports a non-operating gain due to its falling stock price. Source: Cronos filings.

Account quirk creates positive EPS: Seeking Alpha’s coverage of Cronos earnings also highlighted positive EPS, but this EPS is an accounting quirk.

Due to the nature of Altria’s warrants and top-up rights (anti-dilution provisions), Cronos reports a large non-cash, non-operating profit whenever its share price falls. Since Cronos shares fell 20% during the first quarter, the company “gained” $113 million – the same amount that Altria’s warrants declined.

Absent this revaluation, Cronos lost $0.10 per share, up from a $0.15 per share last quarter (also absent the revaluation).

Outlook

Cronos is very costly based on forward sales while forward EBITDA is negative.

Cronos is very costly based on forward sales, while forward EBITDA is negative. Source: The Growth Operation Canadian LP Comparison.

Cronos is most costly than its Canadian peers based on forward sales. This premium is likely based on the company’s very strong balance sheet and its relatively high forward growth prospects.

In my view, Cronos does not warrant this premium.

I have been unimpressed with the company’s use of capital: the related party purchase of Lord Jones for $300 million was a costly investment in a tiny company operating in a very competitive market with few barriers to entry and no durable competitive advantages. I have similarly been unimpressed with its accounting efforts, including overstating revenue in two quarters last year and recording inventory impairment in three consecutive quarters.

I see Cronos as a poorly run mid-sized cannabis company which has been a poor steward of Altria’s capital. While Cronos’s spending has been somewhat modest compared to the free-spending ways of Canopy Growth, the money it has spent has shown very few dividends. It will take a long time to make back Cronos’s $300 million investment in Lord Jones when the business is generating $2.2 million of revenue at 50% gross margins.

In short, I see Cronos as Altria’s second-largest mistake behind its investment in Juul. Neither deal has paid dividends yet. I do not plan to initiate a position in Cronos.

Happy investing!

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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