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Re: greenwillow post# 2410

Friday, 08/31/2018 2:37:02 PM

Friday, August 31, 2018 2:37:02 PM

Post# of 2914

Citron Is Wrong About Cronos Group

Aug. 31, 2018 2:30 PM ET

By Amir Houriani - Seeking Alpha

Summary


This article is in response to Andrew Left’s report titled “Cronos: The Dark Side of The Cannabis Space."

Andrew Left has made multiple serious accusations, which I believe are unmerited.

Cronos' management needs to respond strongly and transparently to generate investor trust.

This article is in response to Andrew Left’s article titled "Cronos (NASDAQ:CRON): The Dark Side of The Cannabis Space.”

Andrew Left is a notorious short seller, made famous on his short sell of Valeant. I have followed Andrew for years and respect his opinion and success, but he is not always right. I believe Andrew’s assessment of Cronos, and subsequent short sell, is not based on a strong foundation.

His report consists of four main arguments about why Cronos is a short-sell candidate:

Cronos is worth $3.50 based on the relative valuation of its competitor, Organigram.

Cronos is not fully transparent about the size of its supply contracts with Canadian Provinces.

Cronos’ exposure to the German market is less than investors expect.
Cronos has a history of three product recalls, which creates concern about product quality.
I would like to address each of these points individually.

Cronos is worth $3.50 based on the relative valuation of its competitor, Organigram

Let’s first assume, for all intents and purposes, that Organigram is a 100% comparable company to Cronos. This would assume they are 100% equivalent in business models, management teams, product quality, etc. We’ll just assume this is the case to make the discussion simpler, even though I believe Cronos has a much stronger management team.

I believe, however, that Andrew grouped Cronos and Organigram together because their revenues are both close to ~$3.5M/quarter:

To keep things simple, let’s assume that annualized revenue for both companies is 4x the quarterly:

Organigram
Market Cap: $625M
$14.8M Rev. (Q2 x 4)
Market Cap / Revenue: 42x

Cronos
Market Cap: $1.6B
$13.6M Rev (Q2 x 4)
Market Cap / Revenue: 118x

Applying OGI’s market cap/revenue multiple to Cronos would give us a market cap of $570M, or $3.24. I’m assuming Andrew used this method, but with adjusted revenue figures to create his $3.50 price target.

There’s a big problem, however – you can only apply the revenue multiple from Organigram to another company (Cronos) if they’re growing at the exact same rate. There are other factors too (e.g. management team quality, business model, etc.), but we’ll keep it simple and focus on the biggest driver of the revenue multiple – growth rate.

The growth rates between Cronos and Organigram are vastly different.

Organigram grew revenues by 94% in Q2’2018 (from $1,917,000 to $3,726,000). These figures are in CDN.

Cronos grew revenues 428% (from $643,000 to $3,394,000). These figures are in CDN.

Although Cronos started from a smaller revenue base, they more than quintupled their revenues quarter after quarter. Organigram nearly doubled revenues, and both companies now have a very similar revenue profile.

I would expect Cronos to be a much larger company than Organigram 5 years from now. I also would apply a much higher revenue multiple to Cronos than I would to Organigram, given the massive difference in growth rates. Cronos would deserve a massive premium in relative valuation to Organigram because investors will enjoy a much more rapid revenue climb with Cronos, and enjoy the subsequently larger profits.

In short, I believe applying Organigram’s revenue multiple to Cronos is not correct, and I believe Andrew Left knows this as well. He’s a smart enough guy to know that significantly higher growth rates demand significantly higher relative valuations.

Cronos is not fully transparent about the size of its supply contracts with Canadian Provinces

Andrew makes the following argument:

“Cronos management appears to have been deceiving the investing public by purposely not disclosing the size of its distribution agreements with provinces – unlike every other major cannabis player.

Our sources have informed us that it’s because the agreements are so small they could never justify the premium investors are paying for the stock.”

Andrew basis his arguments on 1) an unverified source he has, and 2) purely based on the fact that Cronos does not disclose the size of supply agreements. This sounds less like concrete evidence, and more like forcing information to fit a narrative.

I would like Cronos to release the details behind the supply agreements, but I do not agree with Andrew’s guess that the actual amounts will be significantly lower than investors expect. Andrew has provided zero concrete evidence to support his claim. If he had copies of the supply agreements, then that would mean something, but he has just shared his thoughts and not evidence.

Andrew also, conveniently, did not mention that Cronos just announced a five-year Take-or-Pay supply agreement for 20,000 kilograms of cannabis annually from Cura Cannabis Solutions. This was announced three weeks ago on Cronos’ Quarterly Results. The excerpt is as follows:

“Cronos Group entered into a supply agreement with one of the largest cannabis companies in the world by revenues in the first quarter of 2018, Cura Cannabis Solutions ("Cura"). Cura signed a five year take-or-pay supply agreement to purchase a minimum of 20,000 kilograms of cannabis per annum from Cronos GrowCo starting from the date Cura receives its production and sales licenses from Health Canada.”

The contract has teeth to it, and if Cura does not purchase the 20,000 kilograms of cannabis, then they will be penalized financially. This will be a massive source of revenue for Cronos:

The 20,000 kilograms amounts to 20,000,000 grams
Average selling prices are ~$6.50/gram
This amounts to ~$130,000,000 revenue/year (20,000,000 grams x $6.50/gram)

This is in addition to the supply agreements received by Canadian Provinces and other private companies. This seems like a good foundation of revenue for 2019.

Cronos’ exposure to the German market is less than investors expect

Andrew argues that in Cronos’ 2017 press release, they announced a partnership with G. Pohl-Boskamp GmbH & Co. KG. Pohl-Boskamp - an international pharmaceutical manufacturer and supplier, with access to 12,000 pharmacies. He then noted that on Cronos’ Q1’18 earnings call, management shared that Germany currently accounted for 6% of sales.

Andrew believes that Cronos is overstating how significant the German market would be to their company. I agree that 6% German exports is low, but the agreement was only in place for ~2.5 months before the first quarter started. That’s 75 days. I would give these contracts time to grow to their fullest potential, as both parties (buyers and sellers) are working in lock step (starting with small purchase orders and expanding from there).

Cronos currently has about 105 employees, which is probably more than they had in Q4’17 – Q1’18. I would make a bet that Cronos is utilizing most of their resources to prepare for the Canadian recreational market fully legalizing on October 17, 2018 (six weeks away). This would require utilizing the sales force to focus on generating local supply agreements in advance of the prohibition termination.

Cronos has had a history of 3 product recalls, which create concern about their product’s quality

Andrew pointed to three product recalls:

“In Feb 2015, Cronos (its wholly owned subsidiary Peace Naturals) had its first known recall for wrongful labeling if not worse, wrongful testing.”
“In May 2017, Cronos once again had a recall, but this time for using what appeared to be pesticides that they ought not to have.”
“Without disclosing to investors or to the SEC, their product got recalled in Germany for Microbal contamination here. Cronos raised $100m just a few days later on Mar 21, 2018, In our opinion that is securities fraud ”

I will address these individually.

The first recall, on February 2015, was due to wrongful labeling / testing. This is not evidence of a product quality issue, and is due to a mistake in labeling or lab testing. The current management at Cronos also took over in 2016, so this was a previous issue with the previous management team.

The second recall was due to use of pesticides that should not have been used. This should never have happened, and because the mistake was not repeated afterwards, it seems like Cronos fixed the issue.

The third recall is Andrew’s most ridiculous. This recall impacted a 1 Kilogram batch, which translates to ~$6,500 of revenue dollars. Below is a direct excerpt from Andrew’s source website:

The product initially passed third-party lab testing, but failed at the German testing site. The reality is that the third-party lab that conducted the initial test had failed. The batch was sent to be tested to avoid this problem in the first place.

I’m not sure how voluntarily recalling 1 kilogram ($6,500) of cannabis, and not reporting it to shareholders, would classify as “securities fraud,” as Andrew stated.

Like his other arguments, they seem to be more based on scary words vs. reality.

Closing Thoughts

When I first saw Andrew Left short thesis on Cronos, I did not know if I wanted to thank him or be upset with him. Short sellers serve a market purpose – they highlight when companies have underlying issues, and give shareholders a red flag to sell the stock early. So I approached his report openly, because, if he was right, he would have mitigated my losses to 30% compared to 100%, by giving me enough time to liquidate my shares.

Unfortunately, I believe Andrew did Cronos a massive disservice. I do not believe his short thesis stands on a strong foundation, and I believe he knows this as well. This is why he began covering his short on the same day (disclosed during the CNBC interview) – if Andrew had conviction, he would have held the short down closer to $3.50.

Andrew also did a poor job defending his position on CNBC, and circled back to the same argument over and over: That even if none of these issues applied, that Cronos was worth only $3.50 based on relative comparables, instead of arguing/providing substantive information to support his claims about Cronos and its 1) supply agreements, 2) Germany, and 3) product recalls.

Management’s response will be critical in the coming weeks. How they respond to this will impact the stock permanently. I believe the following response would eliminate permanent damage from the stock:

A direct address of every point made on Andrew’s short sell report, including information on their exposure to the German market.
An update on the current business and immediate priorities (e.g. recreational market in Canada, European growth, etc.).

A certified letter from their auditors regarding the size of the supply agreements with Canadian provinces.

From the information I have seen, Andrew’s short report is unverified and weak. I will wait for management’s response and may consider increasing my position accordingly.

Disclosure: I am/we are long CRON.

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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