Cronos Group Inc. — Q2 2020 Form 10-Q
Reporting period: Three and six months ended June 30, 2020; unaudited. Amounts are in U.S. dollars unless noted. Cronos is a global cannabinoid company reporting U.S. hemp-derived products and cannabis operations in its United States and Rest of World segments.
Financial performance
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Net revenue, after excise taxes | $9.9 million | $7.7 million | $18.3 million | $10.7 million |
| Gross profit (loss) | $(3.0) million | $4.1 million | $(9.4) million | $5.6 million |
| Gross margin | (30)% | 53% | (51)% | 53% |
| Operating loss | $(34.8) million | $(16.8) million | $(79.8) million | $(26.9) million |
| Net income (loss) | $(107.7) million | $185.9 million | $(32.0) million | $499.9 million |
| Cash used in operating activities | — | $(77.2) million | $(56.8) million |
Q2 revenue increased 29%, mainly from the Redwood acquisition and growth in Canadian adult-use sales and vaporizer products. Six-month revenue increased 72%, reflecting Redwood and Rest of World growth. In Q2, U.S. segment revenue was $2.2 million and Rest of World revenue was $7.7 million; U.S. revenue was flat versus Q1, according to management.
Margins deteriorated sharply. Cronos recorded inventory write-downs of $3.1 million in Q2 and $11.0 million for the first half, citing Canadian price compression, oversupply, fixed-price supply contracts, and operational changes at Peace Naturals. Excluding the write-down, Q2 gross profit would have been approximately $0.1 million, with a 1% margin; the first-half gross profit would have been $1.6 million, with a 9% margin. Cost of sales also rose with adult-use volumes and lower wholesale sales.
The Q2 net loss included $40 million of impairment charges—$35 million against Redwood-related U.S. goodwill and $5 million against the Lord Jones brand—and a $35.9 million loss from revaluation of derivative liabilities. For the first half, a $77.5 million derivative revaluation gain partly offset operating losses and impairment charges. Derivative revaluations are non-cash and sensitive to Cronos’s share price and other valuation assumptions.
Operating expenses rose substantially year over year. General and administrative costs included $3.5 million of Q2 and $7.9 million of first-half costs related to review of the 2019 interim restatements and regulatory information requests. Adjusted operating loss, a non-GAAP measure, was $31.3 million in Q2 and $71.9 million for the first half.
Liquidity, assets and obligations
- At June 30, 2020, cash and cash equivalents were $1.110 billion and short-term investments were $213.6 million, together about $1.323 billion, down from about $1.506 billion at year-end 2019.
- Total assets were $1.910 billion; current assets were $1.402 billion and current liabilities $235.2 million. Total liabilities were $247.2 million, including $10.2 million of lease obligations and $205.7 million of derivative liabilities. The filing reports no conventional borrowings on the balance sheet; Cronos also had significant loans receivable, including the GrowCo facility.
- Investing activities provided $39.8 million in the first half, principally reflecting net disposals of short-term investments; capital expenditures were $13.3 million and advances on loans receivable were $24.0 million. Financing activities used $1.2 million. Cash declined by $90.0 million, including a $51.4 million adverse currency translation effect.
- Management said existing cash and short-term investments should fund operations and capital expenditures for at least the next 12 months. Net interest income was $11.5 million for the first half, approximately unchanged year over year.
Material developments, outlook and risks
- COVID-19: Management said U.S. retail closures and weaker demand materially constrained U.S. revenue growth and compressed U.S. gross margin through higher labor costs, discounts and promotions. It expected U.S. results and demand to remain negatively affected and did not consider the impairment-related decline temporary. Global production facilities remained operational, but supply, shipping, customer access and production disruptions remained possible. Rest of World revenue was not materially affected during the period.
- Outlook: No numerical revenue or earnings guidance was provided. Management anticipated further inventory write-downs in the near term from market pricing pressure and expected increased marginal production costs at Peace Naturals. It stated that the duration and ultimate financial impact of the pandemic could not be reasonably estimated.
- Reporting controls and restatement matters: Management concluded disclosure controls were ineffective at June 30 because of material weaknesses involving risk assessment, segregation of purchase and sales responsibilities, and non-routine transactions affecting revenue recognition. Remediation controls had been implemented; testing of remaining controls was expected in Q3, but full remediation was not expected until year-end 2020. The company was responding to regulatory requests relating to its 2019 interim restatements.
- Litigation: Shareholder class actions in the U.S. and Canada relate to prior revenue and internal-control disclosures. A separate Alberta proposed consumer class action seeks C$500 million plus C$5 million in punitive damages against each defendant, including Cronos, over advertised cannabinoid content. The company said outcomes were uncertain and expected litigation and regulatory proceedings relating to product marketing, distribution and sales to increase.
- Concentration and dilution: Four Rest of World customers represented 73% of Q2 total revenue before excise taxes. The Altria warrant and other rights were carried as Level 3 derivative liabilities; as many as approximately 162 million securities were excluded from diluted share calculations as anti-dilutive or contingent at period-end. Outstanding shares were 349.9 million at June 30.
- Subsequent events: On July 24, Cronos amended the Natuera loan, increasing its aggregate principal commitment to $15.5 million and extending maturity to March 1, 2021. On July 20, separation agreements accelerated vesting of 732,972 Redwood-related RSUs; Cronos expected to recognize $6.2 million of compensation cost in Q3.
Key facts for investors to verify
- Whether revenue growth converts into sustainable positive gross margins, given inventory write-downs, price pressure and higher production costs.
- Whether U.S. demand, retail access and margins recover, and whether further impairment of Redwood goodwill or the Lord Jones brand is required.
- Progress and independent evidence of effective remediation of revenue-recognition control weaknesses, and any outcome from restatement-related regulatory reviews or shareholder claims.
- Credit quality and recoverability of loans and advances to joint ventures, especially GrowCo and Natuera, alongside planned cash use and capital spending.
- Potential earnings and dilution effects from Altria-related derivative rights, other contingent securities, and the substantial customer concentration.