Cronos Group Inc (CRON) Q4 2018 Earnings Conference Call Transcript

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Cronos Group Inc. (NASDAQ:CRON)Q4 2018 Earnings Conference CallMarch 26, 2019, 8:30 a.m. ET

Contents:
Prepared Remarks Questions and Answers Call Participants
Prepared Remarks:

Operator

Ladies and gentlemen, please stand by. Cronos Group’s Fourth Quarter and Full Year 2018 Earnings Conference Call, will begin momentarily. Thank you for your patience, and please, continue to stand by.

Good morning. My name is Michelle, and I will be your conference operator today. I would like to welcome everyone to Cronos Group’s Fourth Quarter and Full Year 2018 Earnings Conference Call. Today’s call is being recorded.

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

Anna Shlimak — Investor Relations and Communications

Thank you, Michelle. And thank you for joining us today to review Cronos Group’s fourth quarter and full year 2018 financial and business. I am joined by our Chairman, President and CEO, Mike Gorenstein and our CFO, William Hilson.

Earlier this morning, Cronos Group issued a new release announcing our financial results, which are all filed on our SEDAR and EDGAR profile. 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, I would like to remind you that our discussion during this conference call will include forward-looking statements that are based on assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements.

Management, can give no assurance that any forward-looking statements will prove to be correct. Forward-looking statements during this call speak only as of the original date of this call, and we undertake no obligations to update or revise any of these statements except as required by applicable law. Management refers to the cautionary statement and risk factors included in the company’s most recent MD&A and Annual Information Form by which any forward-looking statements made during this call are qualified in their entirety. We will now make prepared remarks, and then, we will move to a question-and-answer session.

With that, I’ll turn the call over to Mike.

Michael Gorenstein — Chairman, Chief Executive Officer, President

Thank you, Anna, and good morning, everyone. During my remarks today, I’d like to do a year-end review. I think it’s important to look back and reflect on all that we accomplished in just one year, as both our company and the industry move at such a fast pace.

2018, was a highly productive year for Cronos Group, with many notable company and industry milestones achieved. This past year, saw the legalization of cannabis for adult use, making Canada, the first G-7 country to legalize adult-use cannabis nationally. We are proud to be a participant in this emerging market.

As I mentioned before, the Canadian government’s leadership in implementing a federally legal framework is the reason we chose to operate in Canada. When we set out on this journey 3 years ago, we knew the value of operating in a legal environment would allow us to learn, build, and create a company that has the potential to be a global industry leader. We take pride in leading the industry forward responsibly, and are motivated to create meaningful products that excite our consumers, and bring happiness in an improved quality of life.

The growth opportunities in the cannabis industry are vast, with our differentiated brands, global footprint, growing production capacity and supply chain, commitment to cannabinoid innovation, and a strategic investment from Altria Group, Cronos Group, is well positioned to realize these opportunities.

To set the stage for our earnings call today, I want to briefly review the four aspects of our strategy. At Cronos Group, we are establishing an efficient global production footprint and supply chain, developing a diversified global sales and distribution network, we are creating and monetizing disruptive intellectual property, and growing a portfolio of iconic brands that resonate with consumers.

During this call, we’ll discuss each of these strategic pillars, and we’ll provide an update on what we are going to do to grow our business globally. I’ll start with our production expansion. In August, 2018, Peace Naturals, our center of excellence, received authorization from Health Canada, to cultivate cannabis in an additional building: Building 4. This 286,000 square foot facility is GMP-certified, and is ramping its production of cannabis. The facility produced its first harvest in December, 2018, and we still expect all flower rooms to be populated in the first half of 2019.

The Cultivations Building 4, runs under a perpetual harvest cycle, similar to a manufacturing facility. Like other large-scale agricultural facilities, we expect that with each cycle, our yields will continue to improve as we dial in controls. We are very proud of this facility, our Peace Naturals campus, as a whole, and what we were able to build in such a short period of time.

While yield in cost-per-gram has been the standard unit cost metric for the cannabis industry to-date, we think this is starting to evolve. We still think that COGS will be an important measuring stick, but by that, I mean cost of goods sold, not cost of grams sold. Efficiency, in downstream processing and packaging in categories such as pre-rolls, will be a differentiator in an area we will increasingly focus on. And as value added products come online, the relevant cannabis cost will shift from grams of cannabis flower to milligrams of cannabinoid. And we’ve already seen the shift begin in the proposed tax regulations in Canada from weight of dried flower, to active ingredient.

With this shift in mind, we will continue working to optimize our supply chain toward final products. As supply catches up to demand, we believe that having experienced large-scale agricultural expertise and labor management practices will be extremely important. This is why our approach to further scaling at capacity involves taking our genetics, growing methodologies, and best practices that we developed at Peace Naturals, our center of excellence, and in creating co-manufacturing relationships with sophisticated agricultural operators around the world. We are confident and committed to our cultivation partnerships.

In Canada, we launched a joint venture, Cronos GrowCo, with a group of investors led by Bert Mucci, a leading Canadian large-scale greenhouse operator. As discussed during our previous earnings call, Cronos GrowCo is constructing an 850,000 square foot purpose-built greenhouse, which is expected to produce up to 70,000 kilos of cannabis, annually. Construction of the greenhouse has begun, and we expect to complete the superstructure of the greenhouse in the second half of 2019. And similar to how we’re bringing Building 4 online, we expect this greenhouse to become operational in phases, in 2020.

We are also making progress on our international production footprint. First, turning to our joint venture of Cronos Israel, with the Israeli agricultural collective, Kibbutz Gan Shmuel. Cronos Israel, is focused on the production, manufacture and distribution of medical cannabis, and is in full construction. We anticipate the construction of the 45,000 square-foot greenhouse will be complete in the first half of 2019, and construction of the manufacturing facility will be complete in the second half of 2019.

Cronos, holds an effective 90% economic equity ownership across the entities in Cronos Israel. In January, 2019, the Israeli government approved the export of medical cannabis from Israel, which will allow license holders to export to countries that have explicitly approved the import of medical cannabis. We intend to pursue the licensing for, and export of medical cannabis products from Cronos Israel, to our European and global distribution partners, once production operations are up and running.

In 2018, we also brought our production model to Latin America. Cronos, announced a JV with a leading Columbian agricultural services provider, with over 30 years of research and expertise, managing industrial scale horticultural operations. This partnership, establishes the newly formed entity, NatuEra in Columbia, that will: develop, cultivate, manufacture, and export cannabis-based medical and consumer products for the Latin-American and global markets. NatuEra, was granted a license to cultivate non-psychoactive cannabis plants to produce seeds for planting and the manufacture of derivative products.

We understand that many investors are modeling cannabis companies off of capacity. However, our business model is not to be the former. We think that there will be value created across many verticals in the cannabis industry’s value chain, including cultivation, and wholesale supply, research and development, branded product manufacturing, marketing, and retail. We see tremendous opportunity across the whole industry, but recognize that we can’t be all things to all people. Rather, we will focus on areas where we see long-term sustainable value like, developing and marketing innovative-branded products, and then, work with experts in the other verticals.

This focus has proven successful in analogous industries such as consumer packaged goods, and pharmaceuticals. And we think it will prove successful in the cannabis industry, as well. In other words, you can expect our focus to be on making the cheese rather than raising and milking the cows.

Moving on, to distribution. Canada, became the first G-7 country to legalize cannabis sales for adult use. Cronos, participated in the launch of this new market through our 2 adult-use brands: COVE, and Spinach. Currently, these brands are distributed in Ontario, British Columbia, Nova Scotia, Prince Edward Island, and Saskatchewan.

As our production capacity grows, we intend to expand distribution into additional Canadian provinces and territories. In 2018, we also announced to join venture with MedMen Enterprises to create MedMen Canada. The private retail landscape is evolving and changing, so we continue to review and analyze the situation as it develops in each province. We think this is a valuable relationship with a large recognizable brand.

Additionally, this year, we announced that Cronos GrowCo entered a supply agreement with Cura Cannabis. Cura, signed a 5-year take-or-pay supply agreement to purchase a minimum of 20,000 kilos of cannabis annually, from the date they received those licenses. We believe, partnering with companies like Cura and MedMen set Cronos Group up for strong relationships as new and large markets opened and regulations evolve.

Internationally, Cronos Group made strides in 2018 to expand its global reach, with a distribution agreement, supplies in medical market in Poland. In June, 2018, we entered into a 5-year exclusive distribution partnership with Delfarma, a pharmaceutical wholesaler, with a distribution network of over 5,000 pharmacies, and more than 200 hospitals to supply Peace Naturals brand cannabis products. We also have a 5-year exclusive distribution agreement with Pohl-Boskamp, an international European pharmaceutical manufacture and distributor for the German market, which was signed in 2017.

We see Europe and Asia Pacific to be extremely important markets for the future, but in the near-term, it is our belief that the development of pharmaceutical foreign factors and delivery systems for medical cannabis will play a crucial role in growing the prescription and patient base in these markets. We are in the process of pursuing regulatory pathways for additional non-combustible products with our partners, at Pohl-Boskamp, who have expertise in the registration of new drugs in Germany.

We take a calculated approach in committing our current supply, as we want to ensure we support our direct-to-patient clients, our provincial and private retail partners, our international partners, and the end-consumers in all of these markets. As new distribution channels open, we must balance supporting our existing global footprint, and meeting the demands of the newly created channel. At this stage of our business, we are very cognizant of this delicate balance, while our supply ramps to meet the growing demands of our global distribution.

On our last earnings call, we spent a lot of time discussing the intellectual property pillar of our strategy. As our business and company evolve, this pillar will continue to be incredibly important in creating and driving value for our business.

I want to reiterate the strategy. We are dedicated to creating, monetizing, and building a moat around disruptive intellectual property. At Cronos Group, we seek to build the world’s most innovative cannabinoid company, where we develop and research efficient processes to effectively produce and formulate the full spectrum of cannabinoids, not just THC and CBD. We are using the plant as a blueprint in order to learn and then, create differentiated active ingredients by reconstituting cannabinoids and terpenes in combinations that have specific psychoactive effects and/or therapeutic benefits.

We’ll then formulate those active ingredients to optimize bioavailability and customize them for the appropriate delivery systems, depending on the product, its effect, use case, and its commercialization pathway. One of the ways that we will accomplish this goal is through our strategic partnership with Ginkgo Bioworks, which we announced in early September. We believe this landmark R&D partnership has the potential to disrupt the industry. For the benefit of new followers to the Cronos story, I’d like to briefly explain the significance of this announcement, and the power of partnering with an unparallel company like Ginkgo.

Our objective with Ginkgo is to produce cultured cannabinoid at commercial scale. This not only includes THC and CBD, but also a rare cannabinoid that are economically impractical or near-impossible to produce at high purity and scale through traditional cultivation and extraction. And going back to our strategy, we, at Cronos, believe that rare cannabinoids are key to product differentiation, but today, are nearly impossible to produce commercially. By using fermentation, Cronos and Ginkgo could materially reduce the cost of cannabinoid production at commercial scale, and enable the production of rare cannabinoids.

Using this production methodology, we could leverage existing fermentation infrastructure, rather than incurring heavy capex to build and manage new cultivation and extraction facilities. Additionally, we believe this technology will make it easier for us to deliver product consistency.

The partnership is currently focused on 8 cannabinoids. Ginkgo, will design microorganisms which can produce these cannabinoids at scale using fermentation. The partnership is aligned to incentivize each party. Cronos common shares will be issued to Ginkgo, when each of the 8 cannabinoids can be produced for less than $1,000 per kilo of pure cannabinoid at a scale of greater than 200 liters. In total, 14.7 million shares will be issued in tranches based on each cannabinoid. In addition, Cronos will fund R&D and foundry expenses, which are expected to be approximately $22 million over the term of the partnership.

In November, 2018, Ginkgo, received the relevant licenses to conduct cannabinoid research, from the DEA, and also, from the Massachusetts Department of Public Health. We think, it will take up to September 2020, and 2021; 3 years from the time the deal was announced, in September, 2018, to reach the equity milestones for the target cannabinoids.

Upon reaching these milestones, Cronos, will have the exclusive right to use and commercialize the key patented intellectual property related to the production of the target cannabinoids, perpetually and globally. We know that flower and pre-rolls will continue to be desirable and significant consumer products. We believe the production of derivative products will be achieved using cultured cannabinoids.

In the fourth quarter, we also entered into a sponsored research agreement with Technion Research and Development Foundation, to explore the use of cannabinoids, and their role in regulating skin health and skin disorders. The pre-clinical studies, will be conducted by Technion over a 3-year period, and will focus on 3 skin conditions: acne, psoriasis, and wound-healing. The research, will be led by Technion faculty members, Dr. Dedi Meiri, and Dr. Yaron Fuchs, two of the world’s leading researchers in cannabis and skin stem cell research.

Dr. Meiri, heads the laboratory of cannabis and cancer research, with vast experience in cannabis and endocannabinoid research. Dr. Fuchs, heads the Laboratory of Stem Cell Biology and Regenerative Medicine, with years of experience in the biology of the skin and its pathologies. Whether the research and development leads to products that consumers will need a prescription to buy, an adult ID purchase, or can be bought anywhere, being able to educate consumers on the advantages of our differentiated products will be very important. And that’s where our brands come in. To that end, I’d like to talk about our adult-use brands.

We are focusing on providing consumers with premium, high-quality products, whether it’s flower or oil, which are available in the market today, or in the future, through our derivative product offerings. We launched 2 consumer brands in the Canadian adult-use market in October, 2018. Our brand, COVE, is focused on the premium consumer. And Spinach, a light-hearted, playful brand, is geared toward the mainstream market. Our brands are tailored to offer authentic experiences, for the respective consumer targets.

As the product offering in Canada begins to advance with the pending regulatory changes, we believe there will be greater ability to differentiate brands through derivative products, which will create a more uniquely tailored experience for consumers.

Our focus, in 2018, on establishing an efficient global production footprint, developing our global sales and distribution network, creating disruptive intellectual property, and growing our family of brands, has ultimately led to securing a major strategic partner, and investor in Altria Group.

To cap off the year, we announce that we entered into a subscription agreement with Altria. Our deal with Altria closed on March 8th. Altria’s $2.4 billion equity investment in the Cronos Group, is a major milestone for our company, and a relationship we are incredibly proud to be embarking on. Altria’s investment represents an approximate 45% ownership interest in Cronos Group. And they have also, a warrant to acquire an additional 10% ownership, which will provide Cronos Group with approximately 1.4 billion Canadian, of additional proceeds.

The warrant, is exercisable over the next 4 years. We expect this investment to lead a significant growth and value-creation for our company. The investment, not only provides additional access to financial resources, but also, the ability to accelerate and scale product development, and commercialization capabilities globally. With equivaling of the investment, our board of directors expanded from 5 to 7 members.

The board, now includes 3 existing directors: Jim Rudyk, CFO of Roots, who will serve as a lead director, and Jason Adler, co-founder and managing partner of Gotham Green Partners, and myself, as chairman. Additionally, we welcome 4 new directors: K.C. Crosthwaite Jr., Chief Strategy and Growth Officer of Altria, Bronwen Evans, an Independent Consultant, Murray Garnick, General Counsel of Altria, and Bruce Gates, former SVP of External Affairs, at Altria.

Earlier this month, we also announced an expansion of our management team. Jerry Barbato, most recently, Senior Director of Corporate Strategy at Altria, will join Cronos Group on April 15th. Jerry, will assume the CFO role from Billy Hilson. In addition to benefiting from Jerry’s 20 years of experience in strategic planning, financial analysis, and brand management, we expect his firsthand knowledge of Altria to help ensure that we fully capitalize on our partnership with him. And Billy, will move to a new role, as Cronos Group’s chief commercial officer, and will be responsible for further enhancing the commercial strategy, as well as research initiatives at the company.

Many of you may not know this, but Billy is first and foremost, a scientist. He has a bachelor of science in molecular genetics, and a master of science in biochemistry. And over 15 years of experience of multi-national pharmaceutical companies. As our company and business develop from cultivation to formulation, we expect Billy’s scientific and pharmaceutical knowledge and relationships in those fields to further enhance the commercial strategy and R&D initiatives for the company. These appointments demonstrate our commitment to a premier leadership team with the skills and experience necessary to support our next phase of growth and development.

As we work to transform what was once