Cronos Group Inc

TSX:CRON

Earnings Call Transcript 2017-Q4

[Operator]

Good morning. My name is Lisa, and I will be your conference operator today. At this time, I would like to welcome everyone to the Cronos Group Inc. earnings conference call. [Operator Instructions] The company's Q4 2017 financials related MD&A and earnings news release have been filed on its SEDAR profile. This information as well as the prepared remarks will also be posted on its website at www.thecronosgroup.com under Investor Relations. During the course of this call, year-over-year comparisons that management makes will be in respect of fiscal year 2017 versus fiscal year 2016, unless stated otherwise. During this call, various remarks management makes about future financial performance, strategic goals, plans and prospects of the company constitute forward-looking statements for the purposes of applicable securities laws. These statements are based on assumptions that are subject to risks and uncertainties. Management refers you to the cautionary statement and risk factors included in the company's MD&A and annual information form filed on SEDAR for a description of these risks, uncertainties and assumptions. Although management believes that the expectations reflected in these statements are reasonable, it can give no assurance that expectations of any forward-looking statements will prove to be correct. Actual results may differ materially from expectations, plans and prospects contemplated in these forward-looking statements as a result of various factors, including those discussed in the company's annual information form and MD&A filed on SEDAR. I will now turn the call over to company's management. Thank you. Mr. Gorenstein, you may begin your conference.

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

Thank you, everyone, and welcome. To kick things off, we'll have Billy go through some of the financial highlights, I'll then give a year-end review for 2017, discuss where we are with our strategic objectives and what you can expect going forward as 2018 rolls on. Billy?

[William Hilson, Chief Financial Officer]

Thank you, Mike, and good morning, everyone. So just jumping in. Revenues in the fourth quarter ended December 31 were $1.6 million, representing a 274% increase versus the same quarter in fiscal 2016. Revenues on a full year basis of $4.1 million, representing a 636% increase over the same period in 2016. The main drivers associated with the increase in revenues were primarily due to the ramping up of production, accelerating patient onboarding, increase in business-to-business sales and a ramping of cannabis oil sales in Q4 2017. In the 12 months ended December 31, export sales to Germany accounted for 15% of the reported revenue, business-to-business sales represented 38% and domestic medical sales represented 47% of revenue. Product sales continue to track to forecast based on the introduction of new cultivars and expanding our strain-specific oil product offerings as well as continued strategic focus on building a platform by expanding international sales. Total cost of sales for the year were a recovery of $3.1 million in fiscal 2017 as compared to a recovery of $1.4 million in fiscal 2016. The improvement was largely driven by the consolidation of results in Peace Naturals for the full year in 2017 as compared to only 4 months in 2016, but also driven by the larger volume of plants in their life cycle during full year 2017. Note, this is partially offset by an increase in inventory expense to cost of sales due to the increased sales and an increase in production costs incurred to support the growth of the plants. Gain in biological assets for the quarter of $5.5 million is representative of the increase in the number of plants under cultivation at quarter and year-end, as we expand production and bring new -- bring online new product -- production facilities. During the full year period ended December 31, the total production of dry flower was 1,861 kilograms at a cost of approximately $4 million, resulting in total production cost of $2.14 per gram. Management anticipates production cost per gram to improve significantly as production output increases over the next couple of quarters. Operating expenses for the fourth quarter, including salaries and benefits of nonproduction staff, stock-based compensation, general and admin, interest and depreciation expenses, totaled $2.9 million and represent an increase approximately $0.8 million from the same period last year. Operating expenses on a full year basis of $9.3 million representing an increase of $5.2 million increase over 2016. The increase in these costs includes investments made in staffing, business and corporate development activities. As a result of the above, in the fourth quarter, Cronos recorded net income of $2.1 million compared to $1.4 million in the fourth quarter 2016. On a full year basis, net income of $2.5 million for fiscal 2017, representing a $3.7 million increase compared to a net loss of $1.2 million in fiscal 2016. Total other income of $2.1 million in the fourth quarter represented an increase of $1 million compared to the same quarter in 2016. On a full year basis, total other income was $4.9 million, representing an increase of $4.5 million compared to fiscal 2016. The increase is a result of sales of shares of noncore strategic holdings, namely AbCann, Hydropothecary and Canopy as well as a small gain pickup from our strategic 20.3% holdings of Whistler Medical. As a result of the above, in the fourth quarter, Cronos recorded net income from operations of $2.1 million and $2.5 million on a full year basis. Comprehensive income of $1.8 million on a full year basis as compared to $0.4 million in fiscal 2017 -- 2016 representing an increase of $1.4 million. The increase was a result of converting the 2016 net loss into net profit for 2017, offset partially by a small decrease due to the sale of other investments during the period as accumulated gain previously recognized as other comprehensive income was reclassified to income during the period. Turning to the balance sheet and cash flows. At December 31, the company's cash position was $9.2 million, representing an increase of $5.7 million since the end of last year. Subsequent to the year-end, the company closed 2 equity financings and has a current cash position of approximately $118 million. Inventory at December 31 amounted to $8.4 million up from $1.9 million at year-end 2016. Together with biological assets of $3.7 million, total inventory in biological assets at the end -- year-end amounted to $12.1 million versus $3.7 million at year-end 2016. Property, plant and equipment increased by $42.1 million during the year, of which the vast majority was attributable to the investment in the 315,000 square-foot expansion and extraction land project, which is on track for completion by mid-2018.And finally, turning to cash flows. The quarter ended December 31 resulted in $2.5 million in cash flows used in operations as the company is ramping up staffing and increase in expenses to bring the new greenhouse in building B4 online. Mike, this concludes my review of the financials for the year and quarter ended December 31, 2017. And I hand it back to you.

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

Thanks, Billy. So as I mentioned, 2017 for us, especially fourth quarter, is really setting the table for 2018, and that includes really all 4 areas of our strategic priorities. Beginning with capacity. Construction of building 4 remains on track to begin operating this summer. We've flower rooms that are substantially complete now, and we have all the fertigation in place, lights already hung, so we're very excited about that. The pilot greenhouse at Peace Naturals is fully licensed and operational today. We're expecting our first harvest coming up this quarter. The reason that greenhouse is strategically important for us is that we've actually separated out the different bays of the greenhouse to be able to collect data. So that when we build large scale greenhouses at other places in the world, we'll be understand whether or not we're getting more efficient yields and production out of different types of poly and high-tech glass. We've been able to establish international production, receiving licenses in Israel as well as the cultivation research license in Australia through our joint venture, Cronos Australia. We completed the rebrand of Peace Naturals, which is really important doing the packaging flip over to make sure that everything was uniform. Being able to launch our strain-specific oils, which have been extremely favorably received, now being the highest-rated cannabis oils on Lift. And finally, transitioning over to Pohl-Boskamp GmbH as our distributors and having products shipped towards the end of Q4. And we've now seen that become a more well-oiled and consistent distribution channel. Putting different infrastructure from a internal controlled and financial perspective, building out more of our core team and lifting on that, that was an important goal that we accomplished. A lot of that started in Q4, continued into Q1. Being able to focus on distribution and bringing in recreational brand, starting with MedMen. We think that's very important because it gives us access to we believe is the most important point-of-sale data that we're able to collect from recreational with multiple locations across California and now Nevada. And finally, making sure that we have sort of that detailed POS data when recreational goes live in some of the western provinces, where we expect private retail to be allowed. So with that we'll open it up to questions. And I'll leave to the operator to start bringing them in.

[Operator]

[Operator Instructions] Our first question comes from the line of Martin Landry from GMP Securities.

[Martin Landry, MD Equity Research & Equity Research Analyst]

My first question is on your production costs. It looked -- it looks like they've spiked considerably in Q4, and that may be just as a function, as you've said Billy, in terms of processing more plants. But wondering if you could give us a little bit more details on your production cost of $3 million for the quarter? And also, if you can break that down on a per gram basis, when we exclude the gain on biological assets? I'd be interested to get your production costs per gram this quarter and where it's trending for Q1?

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

Sure. So I think what you're seeing is a combination in the way that's calculated in the financials with biological assets. When it's actually sliced out, we've seen the cost trend down. So for the year, if you're using the financial statements to get to roughly $2.14 per gram or around $2.09 per gram in Q4, the way we've calculated that's including depreciation and including horticultural and lab staff, it also includes all of our R&D. One of the unique situations that we have is, any of the R&D we're doing, the product is still actually sold. So we're building that into the COGS. When R&D is successful, it's sold directly to patients under our brand. If we aren't happy with the results of an R&D trial, the product is generally wholesaled to other producers, so that we are able to maintain our brand equity as a premium producer.

[Martin Landry, MD Equity Research & Equity Research Analyst]

Okay. And that -- the production costs, does it include your fulfillment and packaging costs?

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

On a per gram basis, the packaging cost is not built in.

[Martin Landry, MD Equity Research & Equity Research Analyst]

Okay. And what would that amount to?

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

Well, the packaging cost is -- it varies depending, again, on which actual product we have, and then, you have fixed cost absorption issues. So when you're modeling this out for rec, I think it's certainly going to vary. But if you look through Note 7, I think you'd be able to back in some of the differences. Again, if you're dealing with say 10- or 15-gram package versus a 5-gram or when we start looking at rec, 1- and 3.5-gram, I think it'll different, but you should find the detail on Note 7.

[Martin Landry, MD Equity Research & Equity Research Analyst]

Yes. Okay. I see that, $0.97. And then, just wondering if you could talk a little bit about your yields per square foot? What you've seen in Q4 and how that's been trending into Q1?

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

Sure. Well, I'll leave out the greenhouse for now. It's still a little tough to break that out. As far as our weeding cultivars, speaking for B2 and B3, roughly, 70 grams at harvest per square foot. Again, I'm excluding Building 1, because that's 2 tier cultivation, so it would upwardly skew the numbers. And that's still between 5 to 6 turns per year depending on cultivar, but edging closer to 6 around 5.7.

[Martin Landry, MD Equity Research & Equity Research Analyst]

Okay. And did you say that's for certain cultivars or for all of your plants?

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

There is a variance among cultivars for, let's say, the cultivar we are growing the most of it's 70. But given the limited additions range and variances, it ranges quarter-to-quarter and a lot of that is driven by genetics. So it can move upward or downward depending on the actual genetic we're growing. And then based off of feedback, we sort of just skew rationalization to understand which genetic we put in. But it's very tough to give a standardized measure without breaking out cultivars.

[Martin Landry, MD Equity Research & Equity Research Analyst]

Okay. And the last question for me, just trying to understand a little bit how you are preparing for the Canadian recreational market? Wondering are you starting to build up a little bit of inventory ahead of the opening of the rec market because -- also wondering in terms of timing for your Building 4, are you going to have -- is Building 4, will it be ready to service the rec market on day 1? Just trying to understand a little bit how are you getting ready for that?

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

Sure. And I think the first question all of us would love to have a definitive answer to is when day 1 is. For us, we expect day 1 to mean really few months before the stated date. But if you look at our notes, you'll see Q4, we've built roughly 1,100 kilos, if you break out and do the calculation of inventory, and given that Q1 is about 2 weeks away, we'll be able to sort of see how we're progressing. Because of the uncertain timing and because of the need to serve international channels and medical patients, we are trying to maintain some level of safety stock, but making sure that we're still having very good churn through that inventory first in first out. We want to make sure the product's always fresh, again, maintaining a premium brand equity. The timing for Building 4, we are still on track to have plants in there for July. So in the event that rec is starting on the earlier time of the stated framework, we'd be able to sort of push out the inventory we build and more aggressively build some of that safety stock, and then we would be able to follow with the product coming out of Building 4 and the other production facilities. We're not repackaging inventory when it comes to actually saving because of the lack of clarity on packaging regs. We expect that very soon. We have 2 different iterations of what we expect the packaging to be, that will be ready to be printed. And also waiting for final clarity on what orders would be province by province because tax stamps and different supply chain logistical issues.

[Operator]

Our next question comes from the line of Matt Bottomley from Canaccord Genuity.

[Matt Bottomley, Analyst]

Maybe just following on some margins questions there. Is there any consideration of how you're going to divvy up the inventory when it does come up to rec? Looking at Q4 here just based on Billy's comments, it looks like about 85% was sold domestically. So do you see that same proportion continuing when recreational comes online? Obviously, it's better pricing in Germany, but imagine building a recreational presence is also important off the bat as well?

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

Yes, that was actually for the year. So the Q4 -- 85% domestic is for the year. Q4 is a unique quarter because of the flip over between distributors. And also because of the way that we account in Germany. So for -- when you're thinking of revenue, and this will -- this is something we'll be able to give more illustrative example of Q1, we're receiving a transfer price and then a royalty with a roughly 40-day lag when the product is sold, it's recognized. So Germany, it's tricky to break out. As far as what will -- what that allocation would be, it won't necessarily, I think, be as large domestically because of production internationally. And as international production scales, we'll certainly use that for international distribution well, let's say, Canadian production is fungible because of the ability to sell in the recreational channels and to export. International production, we don't expect to be able to import for recreational. So that will contribute to the break down. Also, we think the first year, while there will be certain -- certainly a fair amount of demand, we believe that the bulk of the demand and the better margin profile will commence once we're able to start selling derivative products.

[Matt Bottomley, Analyst]

Okay, great. And then just on that, then, how are you seeing that tracking into your quarter? I know it's only a couple -- your current quarter. I know it's couple of weeks away. But if I think I saw in the MD&A, 21% of your sales were oil in the quarter. Are you seeing that move up to the 30s and 40s? I know there is some other LPs out there reporting numbers in those ranges.

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

Yes. So we'd held off when we had the first oil license. We had been using more traditional extraction method. We had some delay, but we finally were approved for the strain-specific oil methodology we use, where we're separating out terpenes and reinserting them. So really that oil metric is starting from producing and selling oil in November. So you'll see that, I think, increase Q1, Q2. We also have substantial incremental capacity for extraction that's on the way. But Q1 and Q2, we expect that to be the fastest-growing segment.

[Matt Bottomley, Analyst]

Okay, great. And just lastly on my end. Just with respect to some of your strategic investments. First, just maybe a bit of color on with the MedMen relationship. Is the process currently live right now in terms of putting applications for Alberta and BC? Just wondering what you think of those 2 markets? I know they can be slightly different. So maybe just some timing on maybe when there might be some announcements there? And then any other commentary you have just with respect to Israel. I heard over the last couple months, it might be a little turbulent with respect to them rolling out there export program. So just wondering if there is any color on that as well?

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

Sure. So the first one, yes, that's -- it's been a process that we started before the announcement, the deal in terms of looking at real estate opportunities. We're focusing on Alberta and BC. Announcements will likely come closer to the date where licenses are being should, not based off of applications, but we're very optimistic in that regard. Lot of people have actually asked about what our focus would be, similar to how MedMen has approached this in the U.S. We look at fewer, bigger, better. So rather than going for 40 or 50 locations, we'll focus on a few locations that we think drive the most traffic, create brand leverage and executing on those being best-in-class retail rather than trying to have a crazy breakneck speed of opening stores up. So I think, you'll see that as we get closer, but again, a lot of this depends on regulatory clarity. We have had different real estate teams for months out there, securing different locations in the larger markets that we like. BC, Alberta, how it'll break out. Alberta, we think, there's been early adoption of the ACMPR, certainly more than we've seen in British Columbia. BC, you've got a much more established great market in retail stores. But the consumer purchasing habits are very, very strong. I think in both markets, it's important to provide a really good consumer experience or the consumers are just going to go back to the channels that they've been using for years. We're encouraged that BC is giving opportunities to incumbent retailers. For us, that does play to the strategy whether we are starting from scratch or whether we're folding in existing retail. But -- I think because of that, there should be substantial adoption. As far as Israel, from our perspective, a lot of the news surrounding issues with export has been some of a red herring. We do not believe that Trump actually called Netanyahu. We -- our communication with the regulators has suggested everything is on track. Whether exports begin in April or not, it would not affect our time line. We also think that there will be a strong domestic market, while it's not the size of Canada. You've got a pretty high usage, and you do have [ comp strained ] cities like Tel Aviv, where we think that there will be extremely strong demand. So if they were delays, that wouldn't present an issue for Phase I of 5,000 kilos. It would just factor into whether or not we're expanding into Phase II immediately.

[Operator]

[Operator Instructions] Our next question comes from the line of Vahan Ajamian from Beacon Securities.

[Vahan Ajamian, Research Analyst of Special Situations]

Just got a question on B4. So it seems like you'll have plants in and restarting some of the flower rooms around Q3 time frame. So I imagine we can start to see revenue from B4 kind of hit the income statement in Q4. How many quarters do you think it will take to have until the point where the entire facility is sort of running full tilt in terms of recognition of revenue on the income statement? Well, how steep it will ramp up? Do you think there'll be...

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

Sure. So for -- I guess, for this, I would just say that without knowing exactly how we will recognize revenue and what the payment mechanisms will be domestically for recreational, I'll sort of [ dissolve ] myself from there. But we're -- we'll be following the same perpetual harvest methodology we have in buildings 2 and 3. So it's relatively aggressive ramp up, where we have rooms for propagation that are feeding the rest of the facility. So every few days, we'll populate another flower room. Of the 20 flower rooms, you'll see a very fast ramp-up of the first half. And I think in the first 4 months, when you get through a harvest cycle, you'll start seeing us at run rate. We'll certainly monitor and see whether we're going to pull back and populating the other half over that 4 months based off of where we are with training and how we're handling harvests and overall maintenance given the amount of automation, the benching system. We think that a lot of those issues will be mitigated. We begun training staff in the greenhouse and sort of a training ground. So we think it'll be a relatively quickly ramp up. And I'd say, Q1 we should be fully operational and you should start seeing revenue recognized.

[Operator]

I'll now turn the call back over to the presenters for closing remarks.

[Michael Gorenstein, Chairman, CEO, President & Corporate Secretary]

Okay. Thank you, everyone, and we'll look forward to seeing you, again, in about 2 weeks for Q1.

[Operator]

This concludes today's conference call. You may now disconnect.