Cronos : 2022 – Q3 Transcript

Event Type: Q3 2022 Earnings Call (Corrected version)

Date: 2022-11-07

Company: Cronos Group, Inc.

Ticker: CRON-CA

COMPANY PARTICIPANTS

Shayne Laidlaw - Cronos Group, Inc., Head-Investor Relations

Michael Ryan Gorenstein - Cronos Group, Inc., Chairman, President & Chief Executive Officer

Robert L. Madore - Cronos Group, Inc., Chief Financial Officer

OTHER PARTICIPANTS

W. Andrew Carter - Analyst

Michael Freeman - Analyst

Vivien Azer - Analyst

John Zamparo - Analyst

Nadine Sarwat - Analyst

Andrew Bond - Analyst

Matt Bottomley - Analyst

MANAGEMENT DISCUSSION SECTION

Operator

Good morning. My name is Chris, and I will be your conference operator today. I would like to welcome everyone to Cronos Group's 2022 Third Quarter Earnings Conference Call. Today's call is being recorded.

At this time, I would like to turn the call over to Shayne Laidlaw, Investor Relations. Please go ahead.

Shayne Laidlaw

Thank you, Chris; and thank you for joining us today to review Cronos Group's 2022 third quarter financial and business performance. Today, I am joined by our Chairman, President and CEO, Mike Gorenstein; and our CFO, Bob Madore. Cronos Group issued a news release announcing our financial results this morning, which is filed on our EDGAR and SEDAR profiles. This information, as well as the prepared remarks, will also be posted on our website under Investor Relations.

Before I turn the call over to Mike, let me remind you that we may make forward-looking statements and refer to non-GAAP financial measures during this call. These forward-looking statements are based on management's current expectations and assumptions that are subject to risk and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Factors that could cause actual results to differ materially from expectations are detailed in our earnings materials and our SEC filings that are available on our website, by which any forward-looking statements made during this call are qualified in their entirety.

Information about non-GAAP financial measures, including reconciliations to US GAAP, can also be found in the earnings materials that are available on our website. We will now make prepared remarks, and then, we will move into a question-and-answer session.

With that, I'll pass it over to Cronos Group's Chairman, President and CEO, Mike Gorenstein.

Michael Ryan Gorenstein

Thanks, Shayne; and good morning, everyone. I'd like to start our call today by discussing the strategic realignment we have been working on this year. We've taken steps to cut costs, as you've seen within our operating expense structure and continue refining our budgeting and capital allocation processes to improve further. Our slimmer cost structure and more targeted approach to growth across segments helps ensure that we're allocating funds to the right products and initiatives.

All new investments share a common goal: Profitably grow Cronos with a focus on borderless products and brands that can adapt to new markets as they open. Thanks to continuous efforts and reinforcing our start-up mentality, we remain on track to hit our cost-savings target of $20 million to $25 million in operating expenses in 2022. As we complete the budgeting process for 2023, we remain keenly focused on cutting additional costs throughout our

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business to provide a firm footing for Cronos to build its borderless product portfolio and enable long-term sustainable growth.

A key area of focus for us has been adapting our supply chain. The build-out of downstream processing capability at GrowCo is progressing with flower packaging up and running, and we continue to be pleased with the cultivation performance at GrowCo and our other CMO providers. In third quarter, GrowCo reported to us preliminary unaudited revenue of approximately $5.8 million to non-Cronos customers. And as a reminder, GrowCo has been repaying its senior secured loan, which is now approximately $73 million. These loan receivables, combined with our balance sheet of approximately $890 million in cash and short-term investments, and strategic investments in Cronos Australia and PharmaCann, set us up well to enter new markets as they open.

Balance sheet management through economic uncertainty is paramount. And our desire to maintain a significant industry-leading cash balance ahead of potential global strategic growth opportunities has guided many of our decisions year-to-date. To maximize the benefits of our balance sheet, we have repositioned a significant portion of our cash into short-term investments to take advantage of the higher interest rate environment.

Growth via innovation continue to be a theme for us. In Canada, our Spinach brand is winning in the edible and vape categories. And we expanded on our offerings in these two categories with Spinach FEELZ, CBN gummy, and vape products. We're excited that this portfolio of rare cannabinoids continues to grow. And with a best-in-class product development team, we believe we can continue to provide consumers with superior and differentiated products, utilizing rare cannabinoids.

Further leveraging rare cannabinoids to expand our portfolio will continue to be pivotal for our ongoing new product launches. Having, most recently, announced the achievement of the equity milestone for THCV, we are pleased with the product development progress across categories and look forward to sharing more details on new product launches in the future.

This quarter, we also received the results of an important third-party verified study, which evaluated the sustainability and impact of traditional method of cannabis extraction and their own proprietary fermentation methods. The results were clear. The environmental footprint of growing plant indoors is high, and using innovative fermentation processes dramatically lower the environmental impact of cannabinoid production. These results show a striking advantage for the fermentation method, as the average percentage carbon footprint saving of the fermentation method is 99.8%.

While our industry is young, it's never too early to lead and invest in technology that helps contribute to a greener future. While fermentation enabled us to make a smaller environmental impact, it also allows us to leverage rare cannabinoids, making way for unique and new experiences through proprietary blend of cannabinoids. The fact that we're able to create great new products while being environmentally friendly is a win-win for Cronos.

Despite a challenging macro environment in Canada, driven by disruptions at our provincial customers in Ontario and British Columbia, our team continued to push new innovations and drive profitable growth. To make up for these disruptions, we strive to maintain supply continuity with customers. Although those efforts resulted in higher labor and shipping costs, we expect that the focus we put on making sure our products were on the shelf will pay dividends over the long-run.

The following market share commentary will all be referencing Hifyre data. In the flower category, 28-gram bags have come to dominate the market, making up 7 of the top 10 SKUs. Spinach once again the number one ranked dried flower SKU in September, with our 28-gram Wedding Cake offering, achieving a nationwide flower market share in Q3 of 6.4%, up 50 basis points from last quarter, making us the number three brand nationally in flower.

28-gram flower typically carries a lower-margin profile. Despite this impact to our financials, it is important that when selling into the provinces and building relationships with retailers, that we have a full product portfolio that they are looking for. Our 28-gram products are winning on quality, not just being the cheapest. We are confident that over the long run, in partnership with GrowCo and other contract manufacturers, we can improve on the margin profile of the category.

Moving to edibles, Spinach continues to expand market share, up 100 basis points from last quarter to 15.3% and 19.8% market share when looking at just the gummies category. Five spinach gummy SKUs are in the top 15, including the number one and number two market share positions on a per SKU basis. We continue to be more efficient and targeted with our SKU launches in edibles, driving market share gains with limited cannibalization, which is exemplified by our Spinach FEELZ rare cannabinoid focused gummy additions, which are quickly climbing market share ranks.

In vapes, we expanded market share by 70 basis points versus last quarter to 4.1%, driven by the wave of new products we brought to market this year, including the Blackberry Kush CBN vape, the Tropical Diesel CBG vape, and Atomic Sour Grapefruit vape.

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In pre-rolls, despite not being where we want to be yet, we had several innovations and SKU assortment changes that we expect to change the trajectory of this category for us. This overhaul will include new packaging; market- aligned pricing; and innovative, new infused pre-roll offerings that just shipped last week.

These new Spinach pre-rolls include a THC-boosted product called Atomic GMO, which is a crossbreed of two of our best-selling flower offerings, Atomic Sour Grapefruit and GMO Cookies; as well as the CBG-infusedpre-roll under the new Spinach FEELZ sub-brand. We are very excited to get our new pre-roll product assortment into the retail channel, so our sales team can do what they do best.

Turning to Israel, our PEACE NATURALS products continue to win in the market. Our team in Israel grew reported net revenue 88% year-over-year to $7 million. And on a constant currency basis, net revenue in Israel increased 98% year-over-year to $7.4 million. We've had incredibly positive patient reactions to our newest strain launches, Cocoa Bomba, Wedding Cake and GMO Cookies, in addition to our packaging redesign, which allows for additional information on the terpene profiles of our products.

Israel's patient count continues to grow as well, adding approximately 1,500 new medical cannabis patients in September, nearing a total of 120,000 patients. This is the third consecutive month we have seen patient growth of approximately 1,500 or greater. The reacceleration and year-over-year growth for patient permits provides a good foundation for growth in the Israeli market for us to capitalize on.

Earlier this year, our brand PEACE NATURALS launched an ad campaign in partnership with the Warriors 4 Life in Israel. The campaign called on mayors to restrict or stop traditional firework shows that cause distress and anxiety to medical patients and those with PTSD as a result of conflict and war, a serious problems faced by many veterans in the country. We are proud to have been awarded a prestigious Clio Award for this campaign in the Social Good category. Congratulations to our deserving PEACE NATURALS team in Israel and the amazing Warriors 4 Life do for our veterans.

I want to take a moment to shed light on our US business performance. As you have heard over the past couple of quarters, we have completely shifted away from our beauty category focused portfolio. All inventory that is beauty- focused is being worked through in the wholesale and DTC channels as we shift the focus of these brands to adult- use product formats. We continued improving our cost structure in the US and believe it is important to focus our investments only in areas that will give us an advantage in adult-use product formats. We are focused on creating borderless products and brands that can easily be adapted to emerging cannabis markets as they become commercially viable opportunities. The pivot in our US business further drives us towards our singular focus of creating adult-use cannabinoid products.

Looking to the adult-use cannabis market opportunity, we are pleased to see progress by the Biden Administration last month to issue pardons for minor cannabis-related offenses at the federal level and urging governors to do the same. These actions represent a small, but important step towards healing the harms done by cannabis prohibition in the United States. We believe cannabis should be legal and that a comprehensive and reasonable regulatory framework should be put in place for the industry. As legalization efforts continue across the US, we are committed to using our voice to lead the industry forward responsibly, and we will continue to be an integral part of the conversation. We're proud to support responsible legalization efforts and meaningful social justice reform.

Moving to Australia, where we have an approximate 10% stake in Cronos Australia, the team is executing at a high level in early stages of the market development. During our third quarter, Cronos Australia announced a $0.01 per share cash dividend, which yielded Cronos approximately $390,000 in October. Having a long-term,low-capital investment such as Cronos Australia start to pay capital back is a big positive.

Cronos Australia also recently reported strong financial results, with revenue in September hitting a record AUD 9.9 million, which is a run rate of nearly AUD 120 million annually. To continue to drive long-term growth, they recently brought a new state-of-the-art distribution center online. With a growing infrastructure, expanding medical market and strong team, we look forward to Cronos Australia's continued growth and market penetration.

And last, but certainly not least, I would like to congratulate Jeff Jacobson on his expanded role and promotion to Chief Growth Officer. Jeff has been with Cronos since 2016 and most recently served as SVP, Head of Growth, North America. In addition to Jeff's oversight of the marketing and sales functions, in his new role, he will oversee North American operations. Given the speed at which this industry moves, we believe having one leader guide the process from the point of idea creation to getting the product on the shelf will lead to better results for us going forward. Congrats to Jeff on this new role.

With that, I would like to pass it to Bob to take you through our financials.

Robert L. Madore

Thanks, Mike; and good morning, everyone. Company reported consolidated net revenue in the third quarter of 2022 of $20.9 million, a 3% increase from the third quarter of 2021. Constant currency consolidated net revenue

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increased 7% to $21.8 million. Revenue growth year-over-year was primarily driven by an increase in net revenue in the Rest of the World segment driven by cannabis flower sales in Israel and cannabis extract sales in Canada, partially offset by reduced sales in the US and lower cannabis flower sales in Canada driven by adverse price/mix. Consolidated gross profit for the third quarter of 2022 was $1.2 million, representing a $1.9 million improvement from the third quarter of 2021.

The gross margin was positive 6%, up from a negative 4% last year. The improvement versus prior year was primarily driven by increased revenue in the ROW segment, mainly driven by cannabis flower in Israel; a favorable mix of cannabis extract products that carry a higher margin profile than other product categories; and lower cannabis biomass costs, which were partially offset by lower fixed cost absorption due to the timing of the wind down activities at the Peace Naturals Campus and lower revenue in the US segment.

Consolidated adjusted EBITDA for the third quarter of 2022 was negative $21.7 million, representing a $25.1 million improvement from the third quarter of 2021. The improvement versus prior year was primarily driven by decreases in general and administrative, sales and marketing and research and development expenses as a result of the company's strategic realignment initiative and an improvement in gross profit.

Now, turning to our segments. In the Rest of the World segment, we reported net revenue in the third quarter of 2022 of $20.4 million, an 11% increase from the third quarter of 2021. Constant currency net revenue in Israel increased 98% to $7.4 million, while constant currency net revenue in Canada was down 2% to $13.9 million. Revenue growth year-over-year was primarily driven by increased flower sales in Israel and increased cannabis extract sales in Canada.

These gains were partially offset by lower cannabis flower sales in Canada, driven by an adverse price mix shift. Gross profit in the Rest of the World segment for the third quarter of 2022 was $3.1 million representing a $2.6 million improvement from the third quarter of 2021. The gross margin was positive 15% up from positive 3% last year. The improvement versus prior year was primarily driven by increased cannabis flower revenue in Israel, higher cannabis extract sales in Canada that carry a higher gross margin than other product categories; and lower cannabis biomass costs partially offset by lower fixed cost absorption due to the timing of wind down activities at the Peace Naturals Campus.

Adjusted EBITDA in the Rest of the World segment for third quarter of 2022 was negative $11.4 million, representing an $18.3 million improvement from the third quarter of 2021. The improvement versus prior year was primarily driven by a decrease in general and administrative expenses and an increase in gross profit.

Turning to US segment. We reported net revenue in the third quarter of 2022 of $500,000 a 76% decrease from the third quarter of 2021. The decrease year-over-year was primarily driven by a reduction in sales as result of a decrease in professional spend and SKU rationalization efforts as the company implements its realignment of the US business. Gross profit for the US segment for the third quarter of 2022 was negative $2 million, representing a $700,000 decline from the third quarter of 2021. The decline year-over-year was primarily due to lower sales volumes and increased inventory reserves driven by the realignment activities.

Adjusted EBITDA in the US segment in the third quarter of 2022 was negative $4.9 million, representing a $7.3 million improvement from the third quarter 2021. The improvement versus prior year was primarily driven by decreases in sales and marketing, general and administrative, and research and development expenses driven by the reduction in beauty category focused R&D.

Now, turning to our balance sheet. The company ended the quarter with approximately $890 million in cash and short-term investments. As foreign exchange rate volatility has impacted our P&L, it's also had a large impact on our balance sheet. If you apply the FX rates for the period ended December 31, 2021, on the current period balance sheet, we would have approximately $940 million in cash and short-term investments. It's approximately $50 million difference.

We made significant strides to reduce spending and improve our cash burn rate. Our free cash flows improved by over 50% versus same period last year, driven by operating expense savings and a 35% reduction in CapEx, which was down to $1.6 million in the third quarter.

With that, I'll turn it back to Mike.

Michael Ryan Gorenstein

Thanks, Bob. We started in Canada to learn and build a borderless product portfolio. The lineup of products we've created to-date continue to win, driving market share gains for Cronos across categories, giving us confidence that they can win in any market. Despite certain challenges in Canada that drag on profitability, proving out our capabilities and building an elite team remain top priorities.

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In Israel, our team continues to fight for and win market share, which is a testament to our branding and product quality. Having a team on the ground is a big differentiator for us, and you will see us continue to leverage that strength in Israel as the market continues to grow and evolve. As we continue to execute on our strategic realignment, I'm encouraged that we have maintained our innovation progress with a leaner cost structure.

I want to thank our dedicated employees, who continue to stay focused on the long-term plan. We remain singularly focused on winning in the adult-use cannabis market globally. And our industry-leading balance sheet affords us the opportunity to selectively invest and build our platform in new markets as they open.

With that, I'll open the line for questions.

QUESTION AND ANSWER SECTION

Operator

Thank you. We ask that you please limit yourself to one question and one follow-up. Stand by as we compile the Q&A roster. One moment, please, for our first question. Our first question will come from Andrew Carter of Stifel. Your line is open.

Analyst:W. Andrew Carter

Question - W. Andrew Carter: Hey. Thanks. Good morning. I wanted to drill down on the Spinach bags, which has been kind of the vast majority of your growth in kind of in the headset trends. Obviously, it shows some diminishing returns. First, is that profitable on a gross margin basis? And is the theory there like an attachment rate that allows you to get the other Spinach products, whether it be pre-rolls, vapes, on the shelf, and this is just the cost of doing business? Thanks.

Answer - Michael Ryan Gorenstein: Sure. Thanks, Andrew. Yeah - no, it is positive gross margin, and I think there's a few things. One, we do look at it, and it is important from a utilization perspective to be able to have sort of the outflow for the supply chain. But also, when you think about utilization for us, it does drive a lot of value in the GrowCo equity that we have to make sure that we're utilizing the facility.

But also, I think it's important for the strength of the brand and for some of the other products we're launching. Getting familiarity with some of the new strain will certainly fuel some of the work that we do in pre-roll and vapes. So I think when you look at it overall for the portfolio and value driver, certainly there. And I take your point on 28 grams versus 3.5 grams, but I think we have to look at what consumers want and respond to it.

Question - W. Andrew Carter: Thanks. Second question I wanted to ask about the cost savings, the $20 million to $25 million achieved this year. Can you give us a sense of how much of those $20 million to $25 million hit the P&L this year? Therefore, how much is incremental next year? And you did allude to further optimization savings. I wanted to make sure I understood that you could have more.

And I know that you said kind of the US is important for your future business, but that's $8 million of cost, if I got that right, a quarter. Is that just the cost that's going to be embedded with you until something changes, until you hit some kind of disruptive; or is even those $8 million - or therefore, $30 million annualized savings in scope as well? Thanks.

Answer - Michael Ryan Gorenstein: Sure. So when we think about the US, there's still - we see opportunity there. I wouldn't say that we are real happy with the cost structure versus what the contribution is today, but we do see opportunity in the US. So, it's still a business that we're working on and making sure that we're making it as lean as possible, and basically transforming something that's a positive contributor.

I'll let Bob speak to where we are overall in the $25 million. But part of that, when I talk about further opportunities, is just because we had the plan in the beginning of the year, doesn't mean we're not constantly looking for any incremental savings, evaluating everything we do to find places that we can improve our bottom line.

Answer - Robert L. Madore: Yeah. Thanks, Mike. I'll just add a little more color on that. Listen, we're very confident in our ability to hit the $20 million to $25 million in cost savings. Those are actual realized cost savings in this fiscal year versus the prior year. We're in the middle of and working through our 2023 budget process. And as Mike pointed out in his prepared comments, we're very focused on continuing to become more efficient and effective. Our realignment strategy and restructuring activities are really going to be a big contributor to improve not just gross margin, but also operating efficiencies, too. So, we're anticipating additional savings beyond the $20 million and $25 million we realized this year, going into 2023 also.

Question - W. Andrew Carter: Thanks. I'll pass it on.

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