Growth of sales of recreational cannabis might be modest comparing Q1’19 to Q4’19.
CRON is exposed as it may not have achieved impressive sales growth in a flat market.
CGC is exposed due to the high percentage of its revenues that are derived from recreational cannabis.
As we approach Q1’19 earnings from a number of Canadian cannabis producers, it is prudent to see which of the big names are exposed to a sell off. The reality is that all of these names are exposed to a potential sell off or have the possibility to rally as well. Still, two names came up based on the factors I examined, Canopy Growth Corporation (CGC) and Cronos Group Inc. (CRON).
Why consider who might be exposed?
In late April, a report from BMO Capital Markets, details shared by Barron’s, noted that analyzing data from StatsCan it appeared sales of legal cannabis in January/February (2019) were flat relative to September/October (2018). Recall legalization of recreational cannabis didn’t actually occur until October 17, 2018.
Figure 1: Cannabis retail trade sales by month and province/territory. Data from Manitoba, Yukon and Northwest Territories were suppressed in October and November to meet confidentiality requirements of the Statistics Act. Data quality “Excellent” for all points except Saskatchewan (Dec., Jan., Feb.; very good, very good, good) and British Columbia (Jan.; good). StatsCan notes that the total for retail trade excludes North American Industry Classification System (NAICS) 454. Data for Nunavut unavailable. Note that there are 28 days in February and 31 in December. Source: Statistics Canada. Table 20-10-0008-01 Retail trade sales by province and territory (x 1,000). Chart by Biotech Beast.
The same report also notes that retail sales aren’t necessarily the best estimator of revenues for cannabis producers, instead shipments to distributors must be considered. Unfortunately, those at BMO found shipped volumes (for recreational sales) also did not look good in terms of January/February vs. late-2018 comparisons. It has been noted that a decline in shipments isn’t that surprising as September/October shipments would represent initial orders from provincial distributors, essentially the channel has to be filled. As such, I find the use of supply data to have limitations as severe as retail sales if not more so when it comes to getting an idea of revenues at the level of the corporation.
I don’t make any assumptions based on the data here that the eventual market size for recreational cannabis is not what we thought it might be. Still, if you’re trying to spin the above data as proof that we’re headed towards $4.34 billion in sales of legal recreational cannabis in Canada in 2019, good luck with that. What we can see in the data is that Alberta, which accounts for 11.6% of Canada’s population, is outperforming Ontario (38.7%) and Quebec (22.6%). It has been suggested that the regulatory framework is a factor that could stifle growth, and so those investing in cannabis stocks might hope some changes come in that regard allowing the other territories to pull their weight.
While I don’t make any assumptions in this article about where the industry is headed, the market might. I think perception matters more than reality for short-term trades around events (like earnings). While, in the long run, the industry could easily go on to justify its current valuation, in the short term, the market might have a tantrum if Q1’19 sales offer dismal growth relative to Q4’18. I think that is exactly what we are headed for, in fact.
CRON is exposed
In February, I explained, “Why It’s Time To Dump CRON.” I tabulated all the supply agreements CRON and its peers like CGC, Tilray Inc. (TLRY), Aurora Cannabis Inc. (ACB), and Aphria Inc. (OTC:APHA) had noted with the relevant provinces and territories heading into October 17, 2018. I noted CRON appeared to be the least prepared for the launch of recreational cannabis and that Q4’18 earnings would disappoint. CRON’s Q4’18 earnings did indeed disappoint with the company reporting net revenues of C$5.6M and providing no breakdown on recreational vs. medical revenues. The stock sold off and analyst downgrades followed.
Figure 2: Past six months of CRON trading. Note the log scale. Source: Stockcharts.com annotation by Biotech Beast.
So, what has changed since legalization? Has CRON issued any press releases noting new supply agreements? No, it hasn’t. The best we have is a mention in the company’s Annual Information Form indicating CRON has secured listings with retailers in Saskatchewan. That doesn’t seem to be mentioned in the Q3’18 MD&A (where only Ontario, British Columbia, Nova Scotia, and Prince Edward Island were mentioned). Check out Figure 1 above to get an idea of the value of the market in Saskatchewan. Given softening sales in Q1’19, the need for provinces and territories to seek out additional supply agreements isn’t as large as it was heading into legalization. Many of CRON’s peers noted in their supply agreements periods of at least six months or in some cases years. It really looks like CRON missed out by not being ready for legalization. There have been some examples of new agreements nonetheless, but if CRON has signed any, it hasn’t bothered to tell investors the good news.
The basic thesis is this; CRON’s Q4’18 sales of cannabis were poor, nothing has changed and so the numbers in Q1’19 are also going to be poor. It is hard to achieve increased market share and sales growth in a flat or even contracting market. CRON probably won’t even tell investors what recreational revenues were, uncertainty which will not likely please the market. On the most recent earnings call, CRON’s CEO hardly appeared to be promising a breakdown of recreational vs. medical cannabis revenues next quarter.
Tamy Chen – BMO Capital Markets
Thanks. Good morning, everyone. I just had a housekeeping question first. Are you able to disclose the breakdown of your volumes sold between rec, Canada medical and any international export?
Mike Gorenstein – Chairman, President and CEO of CRON
Thanks. When we look at how we plan on disclosing, I think there is a few things to keep in mind. I’d say, first, we’re still in a situation where we’re trying to manage how we allocate between medical patients, provinces, private retail partners and international partners, in a pretty big shortage situation. But, we do look in the future as we think it becomes more material to break out in channels, but I think we’re going to keep it as disclosed for now. – Q4’18 earnings call, March 26, 2019.
I believe it is still time to dump CRON. I’m not expecting an encouraging increase in sales of cannabis from the company. What we learned from the previous post-earnings sell-off was that it can take several sessions for the sell-off to really kick in. Analyst downgrades and the passing of options expires likely allowed the stock to move down further. The strategy recommended in my previous article of a bear call spread allows one to join the market makers in any case and might be a good idea again heading into CRON’s earnings.
Some of the risks associated with any short-biased trade would include CRON reporting earnings which impress the market. Notably, CRON’s investmentfrom Altria Group (MO) did close in Q1’19 and sold out of its position in Whistler Medical Marijuana Corporation, both of those activities will bring in plenty of funds (~C$2.4B and 2.5M ACB shares, subsequently sold for proceeds of C$25.6M). The market might forgive poor revenue growth from CRON given these deals. Further, CRON might issue press releases around its earnings date of new developments which if perceived in a positive light by the market might offset losses from any poorly received earnings announcement. CRON is set to report earnings 8:30 AM EDT on Thursday, May 9.
CGC is exposed
CGC seems to a darling of the Canadian cannabis producers and that is part of what sets it up for such a fall if it doesn’t perform. CGC is quick to note its status as a market leader. When we consider the ratio of net revenues from recreational cannabis to net revenues from medical cannabis of $59M:$16.5M, it seems like CGC would be particularly susceptible to a downturn or flat sales in the recreational market.
Figure 3: CGC notes its status as a market leader and provides a breakdown of net revenues and shipments. Source: February presentation from CGC.
By comparison, ACB noted with earnings for Q4’18 that net revenues of $54.2M included $21.6M from recreational cannabis and $26.0M from the Canadian and international medical markets. As such, ACB essentially represents the opposite of CGC, deriving more of its revenues from medical cannabis than recreational cannabis. I’m not saying ACB is a good long heading into earnings, however, that isn’t what the article is about. The point is that some names are more exposed to the apparently flat or even declining sales of legal recreational cannabis in Canada. Given the proportion of its revenues that come from recreational cannabis, CGC is one of the more exposed names, in my opinion.
The good news is that CGC continues to expand, reducing its dependence on the Canadian recreational market. For example, on May 2, 2019, CGC reported it had acquired C3 Cannabinoid Compound Company, a Germany company marketing dronabinol, among other products, in select European territories. Since C3 had sales of C$41.5M in 2018, we might expect it to bring in an additional C$10M per quarter (at least) heading forward for CGC. The problem is that it’s too late for Q1’19. It seems possible that this acquisition might represent CGC’s strategy to get some more revenues on the balance from outside of the Canadian recreational market, perhaps in response to tepid growth in that market. The same can be said about CGC’s recent, not yet finalized, Acreage Holdings (OTCQX:ACRGF) deal. On the other hand, CGC has been heavily cashed up for a while now since the Constellation Brands (STZ) investment, and so, increased exposure to the European (medical) and US markets seem like obvious moves, instead of just sitting on its cash.
Figure 4: Past six months of CRON trading. Note the log scale. Source: Stockcharts.com annotation by Biotech Beast.
CGC’s website suggests an earnings date of June 20, 2019. I believe CGC could trade down on that date. I note that there was very little reaction, actually, there is a rally in response to initial and subsequent reports that February sales data did not look impressive. I believe the market simply needs to see some modest Q1’19 numbers for the reality to set in. Again, a bear call spread is my preferred trade to get exposure to events like this, but a short is a possibility heading into earnings. The possibility exists that CGC sells off beforehand as peers report their results and the market realizes that the situation is pretty bleak (recreational revenues are indeed flat). ACB is planning to report earnings on May 15 and TLRY on May 14, as mentioned above CRON reports on May 9. As such, a smarter play might involve a short-biased trade in CGC somewhere during the period of May 8 to May 15.
The risks of any short-biased trade in CGC around earnings (June 20) include, but are not limited to, the potential for earnings to impress the market, causing the stock to trade up. Some cannabis producers have been able to net impressive revenues from shipments of medical cannabis which can be irregular and harder to predict. Further, CGC might have material announcements around or on that date which offset any potential negative impact from earnings. The risks of a short-biased trade during the period of May 8 to May 15 include, but are not limited to, positive results from competitors showing that the recreational market is doing just fine causing CGC itself to rally. Negative results from competitors could cause CGC to rally too! Also, CGC could announce positive developments during that period causing the stock to trade up.
Orignal article from Seeking Alpha
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