Cronos Group Inc. (NASDAQ:CRON) Stifel Canada Future of Healthcare Conference December 7, 2022 1:00 PM ET
Company Participants
Mike Gorenstein – Chairman, President and Chief Executive Officer
Conference Call Participants
Andrew Carter – Stifel
Andrew Carter
Thank you very much, and welcome back to our conference. Good afternoon. We are honored to be joined today by Mike Gorenstein, President, CEO and Chairman of Cronos Group. I, of course, I’m Andrew Carter. I cover cannabis and outdoor living here at Stifel. And so I think with that, Mike, I think we’ll just get right into it. We know who you are, but step back, tell us a little bit about Cronos. What was different and kind of the different approach you employed here to kind of start attacking the global cannabis category, starting in the first fully federally legal market Canada.
Mike Gorenstein
Yes, thanks for having me again, Andrew. Yes, I think we certainly started off different with a different view, maybe longer term, bigger picture, and now we’re kind of very happy that we – the patient took that approach. I think it’s probably well documented. I started off in the U.S. and was sort of looking at ways to get in the industry. Saw some of the regulatory challenges in the U.S. and saw Canada as an early opportunity to really go build a platform in a federal legal market where we could focus on innovation, focus on sort of getting everything right and then moving to other markets as they open.
So our focus is much less driven on capacity and more about, what IP can we build, how do we get the right products for specific consumers and how do we make sure that something that’s transportable and borderless. And I think that’s kind of led us to where we’re today.
Andrew Carter
Got you. Of course, the business itself though does start in Canada. You’ve carved out a nice nascent position. You have – by most data, like one of the stronger brands. But start out like you did say you took a different approach, talk about what the limitations are of the market and at this stage over four years since legalization, what has surprised you in the market’s development?
Mike Gorenstein
Sure. So I think there’s a couple – there’s limitations and there’s like, there’s things that are certainly huge opportunities and I try to think of it kind of relative to the U.S. versus a Europe. But one of the limitations of a very restrictive marketing regime that’s pretty close to what the U.S. tobacco marketing regime is. So your ability to differentiate around packaging is, it’s still there, but it’s still a little bit more limited. You do have with some formats kind of real issues around what you can do for how much you can put in pack, what the concentration is. So specifically on edibles that’s been an issue. And then I think probably the biggest overall limitation is the actual market structure.
Having a pretty high excise tax and then also having provincial monopolies that take a large amount of the margin, but also sort of control how distribution works so it takes a little bit longer to ramp up. So, I think that those are certainly things that would be market limitations. And then maybe the biggest kind of surprise or thing that I wouldn’t have predicted is, we knew that everyone would rush into Canada. We got in earlier than we saw the momentum pile up because it was a very attractive opportunity to get a head start on a global growth industry that we haven’t seen in – really in generations. It’s this obvious. But I thought you would’ve seen sort of winners emerge faster in companies, it’s just taken a lot of time to happen. So, there’s a lot of overcapacity that should have had that work its way out of the system faster than it did.
Andrew Carter
How long do you think that that correction will last? Because in terms of the – we’ve seen the irrational dynamics, we’re actually starting to see some bankruptcies, but then we turn over and see someone buying the assets. So is this a just a slow burn or is there any kind of gravity here for around economic reality?
Mike Gorenstein
It’s funny that question about why people are buying them, if that worries me. I think when you’re a standalone company and you’re sort of struggling and fighting for survival, there are things that you’ll do to stay alive maybe longer than you would do if say you’re a larger going concern and you have a division or a unit or a brand or facility that is just cash burning and you can’t really figure out how it becomes a positive contributor. I think what we’ve seen is that depending on the competitor when they do buy a brand or a facility, tend to see something actually exit the system faster when that happens because it just gets rationalized quicker.
So yes, I think it’s starting to speed up. I mean, look, there’s a lot to work through, but I think that the pace has moved a lot faster than it had been in prior years. And that’s probably not just related to cannabis, it’s just the amount of money circulating. Not to get into a big interest rate, money supply discussion, but I think as that tightens that’s where you see exit much faster. You don’t have capital injections like you used to.
Andrew Carter
Fair enough. And then I guess then kind of a second thing to build upon that is everyone bandies about favorable changes. I mean, there’s a couple things you mentioned in there. Some are Health Canada, federal driven, some are provinces driven. Could you give us kind of your view of kind of the review that I believe Health Canada is kind of undertaking now? Some of the industry demands, I think excise tax, they want that to go to ad valorem versus the fixed rate, marketing restrictions, packaging restrictions, any outlook for that changing and kind of what the government approach here will be?
Mike Gorenstein
Yes, I mean, something’s been promised and I think that there would be review. And I think, look, we are reaching or getting closer to reaching a point where the benefits of legalization. I don’t think there’s a debate that those are positive for Canada. And I also think that when you look at the contributions of GDP a lot of the ways those have showed up historically, it looks like cannabis has been doing extremely well. You think about all the construction and all the different the services that have involved in building up the industry but there do need to be structural changes for that to continue. And so I think there’s a lot of, you covering it from your position, probably more aware of the challenges than you would think depending on the group of government, how aware they are.
So there’s a lot of information government think is positive, but as far as speed of change, I am always the most pragmatic or hesitant to really predict when it will happen. And we want to make sure that we’re able to operate well and get to the position we need to be in regardless of whether it’s changed. So I think that there will be change at some point, but it’s very difficult to predict timing.
And so, that’s at the federal level, what I will say, and I think could happen maybe sooner, is at the provincial level, what you’re seeing is a lot of the retailers. Historically, it’s been mostly LPs that are speaking up or retailers are starting to get to a point where they’re very frustrated and these are not larger companies or small mom and pops that are worried about going out of business. And I think that is probably the biggest wake up call for change that we’ve seen from a regulatory perspective yet. And I think there is likely to be some response to that before maybe the federal level, but that’s a prediction that is just my gut.
Andrew Carter
Want to circle back to that. But the first thing you said around the Health Canada review, you mentioned a lot of economic reasons for the changes to drive to kind of sustain the tailwind of positive contributions. Does Health Canada look at it that way? Or is it like, for instance here, both know here in the U.S., the FDA looks at tobacco purely from a public health standpoint and some of the economic issues aren’t as considered. How does Health Canada look at and…
Mike Gorenstein
Yes, I don’t think Health Canada looks at, I think the broader government looks at that. And my point is, I think it’s a measure for success. So if you’re looking at say like the headline GDP number from cannabis and cannabis services, your view might be this has been a great success. But Health Canada, there is actually a proxy there because one of the goals that is behind legalization is moving – Canada realize you’re not going to deter consumption of cannabis. It’s going to happen regardless. But why not make sure that you can do it in a more responsible way, keep it out of the hands of children, have more transparency to the supply chain, put out a product that’s safer but if you don’t have legal sales taking share from the illicit market, you don’t accomplish those goals, right.
So all the things that were set up there is a proxy for what the sort of units that are being moved, sits at. So I think that is something they are interested in. There’s all types of competing goals that all tie into it, like packaging and environmental, right. So I think there’s different things that tie into it. Healthcare specifically though, they are concerned about health, there are other groups that concern themselves with finance, but if you see a flourishing industry, I think that idea of switching away from the illicit market, which the Health Canada does care about, I think it shows it’s succeeding.
Andrew Carter
The second point you made kind of about the – was more to the Crown corporations. Every province say, Saskatchewan you have to go through the middleman. You mentioned that there is potentially some momentum for changes there from retail. First off, are the retailers getting on the same page in order to make like it known? What would be helpful solutions and what do you think would be helpful solutions at this point that actually could be achieved?
Mike Gorenstein
Well, I think there’s a lot, again, it depends which province we’re talking about, but I do think that, it’s much easier at the local level to react than it is at the federal level. And I think that there’s much more sensitivity for how some of those small businesses are performing, put life savings into what they thought was an opportunity to basically create generational wealth and now are looking at wealth destruction.
So I think that sometimes the way things are ordering, the way the systems work and what the margin structure is, what’s available to retailers, there’s a lot that’s logistic based and a lot that’s financial based. And I think both of those can be huge catalyst to help retail and I think provinces are listening because when you’re hearing it from both sides, it’s hard to ignore.
Andrew Carter
Right. Next thing I would say is, we spoke a little bit about the rational dynamics that’s really born out on the price compression that’s expect in every markets, but it continues, you’ve largely stayed above the fray, but you’re also not immune to it. Like, this year you made the decision to go more forcefully in the 28 grand bags. So first off, I’d ask, what drove that decision? And kind of also secondly, it’s – you’ve noted that this is a more differentiated product, rather relative to what else is in the – I don’t even know if you can call it deep discount segment, but maybe this is the right discount segment or maybe it’s the right segment to attract consumers.
Mike Gorenstein
Yes. I think that the flower market, we’ve always thought that the way to win in flowers is really genetics. And that’s one, and then we’ll probably get into it a little bit later, but pre-rolls, right? And when you think about it what we want to see is that we have genetics that are performing well. This is actually the second year in a row that another SKU we’ve had the number one flower SKU. So, I think it’s important to do that, but also in order to be able to compete, this category does become more and more commoditized when you look at just flower.
It is, the closer you are to the plant, the harder it’s to differentiate. Genetics are not. And so, we do still want to maintain that difference. The idea of being able to be borderless, knowing we’ll be able to take what we’re doing here and win when we go to Israel, when we move in other markets, that’s still really important to us. But there is a reality that if you want to be able to compete and that’s where consumers are moving.
The heavy user that’s rolling at home, that isn’t worried about portability that is a segment that you have to look at what a consumer wants. And I think that’s sort of where flower has been trending for a large part of it. What I will say though is part of what’s difficult from our structure to sort of understand how things flow to us is that GrowCo, we don’t consolidate GrowCo, so you don’t necessarily see some of the results we have. But the fact that we own 50% of that and we’re purchasing the flower from GrowCo the margin, it’s a – that overall does contribute to the bottom line is probably better it looks.
Andrew Carter
Got it. Yes. So that’s actually an interesting segue to kind of jump into GrowCo. So first off to that, it’s been kind of a multi-year initiative you have. Step back and first off, talk to us about that, but also I’d like to hear kind of the confidence you had to make that kind of your sole supplier and close kind of the Stainer indoor facility and making this kind of your primary source of biomass.
Mike Gorenstein
Yes. So look, the reason that we were in Stainer is when we had the first license in Canada, with the PEACE NATURALS a lot of the locations that you see and a lot of the LPs that are out there, it’s really, it was very difficult to get a license. You started off with the eight licenses, the first kind of like era of Canada, and then it eventually evolved. Everyone has a license now, but getting a municipality was favorable. Being able to find labor force that was able and was willing to move into cannabis was important.
And it was really difficult to get a license. So the locations that were picked weren’t necessarily ideal for agriculture, right? It wasn’t necessarily great for logistics and transportation. And when we looked across and we thought about skillsets, who eventually is going to win? I thought that we had the best IP or the best in genetics, and our growth process were really strong. We did a ton of R&D. But the idea again, is a portable platform was always to find where’s the best place to do things, what’s going to be the most efficient?
And I thought it was only a matter of time before the people that would dominate in ag would dominate in the flower category in cannabis, right? So we kind of did a tour, we looked at who was successful in Canada, and we found the Mucci Group. They are one of the – I think the largest strawberry farmers in North America, one of the largest in cucumbers, lettuce, tomato. And they just had infrastructure that was there.
And ultimately we looked at them and said, hey, we have the cannabis know-how, we’ve got all this data, we have genetics, but the infrastructure they have and the ability to focus on managing the labor and the nuances of a ag operation, that takes a lot of resources and a lot from, where we want to put our focus, which is really on the products and on innovating and branding and distributing them.
So we set up pilots. We had them working at Stainer for a while to kind of learn the process. We moved into GrowCo based off a lot of learnings that we had. We purpose built it. And once we got it up and running we kind of saw pretty early like, hey, this is looking really good. We could purchase product from them for cheaper than we were producing it on our own. And that’s excluding the 50% ownership.
So quality is great, consistency is there and I think the results have kind of proven out. But I think that’s a model you’ll see in other countries as well. I think that if you can dominate in multiple plants, there’s something that unique about cannabis that you can’t learn how to do. And we’ve always believed that you picked your spot within the value chain and then you find experts to participate in others.
Andrew Carter
Got it. And then kind of – so you mentioned the early success, I believe you said it is paying down the debt loan it has with you. I guess, there’s two prongs to their business. A, they supply you, you’ve got primary kind of exclusive rights to that without the inventory risk. But the second thing is, has it surprised you how strong that their third-party sales have been just given how much capacity’s out there in general in Canada?
Mike Gorenstein
It hasn’t because it’s high quality and their cost structure is, lets them – still, again, same reason that we would buy from them, right? Others can look at it and say, wait I can get a better quality product for cheaper than I can produce it myself. When you start getting in this stage, we’re now where survival matters and getting the profitability matters. We don’t have the same ego and empire ability that the industry was plagued by in Canada before. It’s just what makes economic sense. So yes, I think it works.
One of the reasons we also didn’t want to fully own the supply chain was really probably two. One would be we wanted to make sure that the direct operators were as focused and motivated as I would be with Cronos. But also I think it’s a lot easier for someone to buy from a company where someone else – it’s not fully controlled by a competitor, we have a vested interest in it, but there’s someone else day to day managing the P&L. So I think that does give confidence to third-parties and not surprising all, we always thought the model would work.
Andrew Carter
Got it. And I guess, how far could they go? I mean, there are, like you said, there are a lot of – there’s a lot of capacity out there, but they’re underwater relative to this. Could this – could there be a step change in this business as sales to others that you’d participate in maybe support capital? Or just kind of how do you think about that potentially playing its own kind of game of being a stronger supplier from an agricultural standpoint?
Mike Gorenstein
Yes. Look, I certainly think there can be but also, look, we are generally going to be conservative in the way that we approach anything there. I think that we like that they’re cash flow and paying down debt. I think that’s important. I do think as you see other suppliers go out of business that does make the opportunity bigger. I don’t know that there’s going to be any acquisition opportunities. And part of the reason that’s so successful is because of the infrastructure that they have purpose built. So, it certainly could expand at some point in the future, but it’s not immediate priority for us.
Andrew Carter
Got it. Let’s talk about more what the core priorities are, which is the product development. I guess, the first thing to talk about here is, we’ll get into the edibles, but kind of what gets underpinned here is Ginkgo and what that’s done. Could you explain kind of from the start, the Ginkgo and actually also you made an announcement this morning as well, you might – this might be a good time to bring it up?
Mike Gorenstein
Yes. So, again, going to innovation and differentiation, I think flower certainly one thing that we talked about, but flower, again, it’s genetics. Another way genetically to differentiate is using fermentation. So when someone prefers one screen to another, sometimes it’s the taste, sometimes it’s the look. But I think the biggest driver is what the effect is. It’s not like alcohol or tobacco. We have pretty consistent effect brand to brand or product to product.
Cannabis sometimes uplifting, sometimes it makes you go to sleep, sometimes it makes you laugh for a couple hours, makes you super hungry. And I think that’s really based off of what the actual ingredient, what the cannabinoids are. And being able to control for that with flower is difficult, but being able to make those individual cannabinoids, the rare cannabinoids is really key.
So when I look at what happens when you have a sub product that stands out on shelf, how do you do that? If you want something that makes you sleep, CBN is sort of emerged as a cannabinoid that that helps with that. We like CBC for a lot of reasons, I think it’s more of an energizing effect the way we formulated it. But to Ginkgo is a platform that lets us just across every value-add product, launch something differentiated and be able to start targeting effects.
And I think that when you look five, 10 years from now people will realize indica sativa is a really misused framework that’s based off of the organs of genetics, not effects. People will be able to shop and say, I want this product because it delivers X effect to me. Like, hey, I’m having trouble sleeping. Hey, I want something that wakes me up. I want something that’s good for a movie versus a hype. And Gingko is a huge part of letting us deliver that experience. And I think the CBC gummies are released today. I expect that to perform extremely well.
Andrew Carter
Question like, in terms of, I guess, one of the potential challenges here is communicating to the consumer. Obviously, the molecules a molecule, it’s the same thing coming out of the plant. But what’s – is there a lot of consumer education or feedback of fermented cannabinoids versus the kind of the plant-based?
Mike Gorenstein
There really isn’t. A lot of that has to do with the way the regulations are set up. We would love to communicate some of the ESG benefits. You’ve got – we released the study, it’s probably 99% reduction in energy that carbon footprint that goes into making the product. But it’s – there’s a lot of things that you’re communicating to consumer when you get to the point of sale. And I think really the effect is what they’re most interested in right now. And so we haven’t seen a lot of questions around that. I think that when the consumer likes the value they’re getting for the price they’re paying and they like the differentiated effect, that’s where their focus is. So it’s something that we try to be open about and try to communicate. But I think the actual product itself is where the focus has been for consumers today, which we thought we would be communicating more about it and there’d be more questions that they’re just having.
Andrew Carter
Got it. And then you’ve had a pretty successful edible launch so far. I guess, can you talk about like a, kind of the points of differentiation your product, it’s obviously something that you can prove out Canada, it’s something you could take to the U.S. kind of what’s unique about this. I mean, the Ginkgo obviously helps that. And then just kind of help us understand and how you’re building the architecture of sours and fields?
Mike Gorenstein
Sure. So if you think about like the ground floor of the gummy platform that we have, right? That’s really sours and texture certainly matters. We spend a lot of time thinking about texture. I think the biggest differentiator for us right now is taste. I think the color certainly helps. So we have dual colors and we have really three tastes, three flavors that are in the actual gummy. On each side, the different color, depending on which skew you have multiple flavors. And when you put them together and eat it all at once, it actually gives you a third flavor. So we actually were pretty deliberate about the way we would do that. So you have a flavor curve when you eat it all at once, or you can pick each side.
That’s kind of like the ground floor kind where we are today. And then, the next one that we launched, we now have three different skews in the market and that’s fields. So sour is sort of like your ground floor, your base. The next level up is fields, and that’s where we start introducing other rare cannabinoids in. So it’s not just THC or CBD. But we now CBG, CBN, CBC on the market. And having that platform where you can see there’s different colors, there’s different formulations that can go in. Let’s start getting okay, maybe you have picked the flower or sorry, the flavor you like, what about the effect? How different of an effect can you get? And so I think it’s the beginning of us opening up some of the Ginkgo platform and the innovation pipeline we have. And there’s more floors to come, but today that’s where we are and it’s being received extremely well.
Andrew Carter
Behind edibles, kind of what’s your hierarchy? I mean, you have to think about Canada a little bit differently than the U.S. so kind of walk us through that. I believe it’s pre-rolls first and then try to do something in – and then actually doing something vapor.
Mike Gorenstein
Yeah, pre-rolls is certainly first for us, it’s like edibles. It’s something that we put a lot of resources in, spend a lot of time on and what we do have pre-rolls that have been out. Certainly that’s not the offering that we are satisfied with. We look at the ways to innovate. And there’s a lot to come on pre-rolls. I think pre-rolls would be the largest of the platforms we’re talking about here. I think it’s going to just keep taking share from flower over time. And I think it’s not hard to imagine why we’re focused on it, why we think we have a right to win. Ginkgo’s thought of as a cannabinoid partnership, but just from knowledge of how to take a highly regulated plant and put it into an adult consumer product. I feel like the insights we’ve been able to get from Altria have been extremely helpful.
But yeah, I think eventually you can as a convenient product, you’re going to be able to deliver cannabinoids cheaper in a pre-roll than in flavor because you don’t have to worry about how well manicured it is. You’re able to make it consistent by infusing it with cannabinoids and it’s portable. So I think pre-rolls is really the future. I think that’s where a lot of the value will move to. And it’s much easier to differentiate in the pre-roll than is in flower.
Andrew Carter
And then in terms of vapor, I mean, where does that kind of – where does that rank as a priority?
Mike Gorenstein
It’s important to us. I think it’s another way of being able to differentiate with flavor and with cannabinoids. I would say that’s as far as big innovations to come, we put that after pre-rolls and we still have innovations to come in edibles. Actually we came back, we adjusted the portfolio. So, turned, I think we’re doing very well on vapor, certainly still opportunity. But the dynamics of vapor, there’s kind of two things to think about as far as innovation. One is the – what’s your formulation, what’s the kind of branded cartridge. And the other is what’s the hardware? And given the way that the structure is in Canada, it’s pretty difficult to introduce and iterate with hardware. Hardware, I think there’s a lot of room for improvement in hardware. Tech is certainly out there to do it, but it’s – the incentives are a little bit different because of the way the model is controlled in Canada at the provincial level than in say, the U.S. or eventually Europe.
Andrew Carter
Got it. I do want to move, so yeah, I’d be remiss we didn’t move on to the U.S. and kind of the perspective on the potential regulatory changes. We have some news, obviously safe didn’t make the NDA. You – I think we’ve spoke about this before, you actually think the scheduling review is a much bigger deal than safe. So let’s chat about that because kind of the news is out on safe and we’ll see if anything happens with it.
Mike Gorenstein
Yeah. So I do you want me to talk about safe or…
Andrew Carter
Yeah, no that perspective really on you were more excited probably about the scheduling our that was announced in October than the incremental benefits from something like a safe.
Mike Gorenstein
Yeah, I think what safe feels like, it’s just something people have been focused on so long that now there’s a lot of investor sentiment that’s tied to safe passing. But if you really dig into what’s the biggest benefit of safe, to me it feels like it is sentiment. It’s not really something that is going to drive fundamentals, right? The iterations we’ve seen is safe, are not changing capital markets access. It’s not for NASDAQ or NYSE. You’re not affecting 2AE, maybe it’ll change things around payments certainly remains to be seen what the language says. And I think as far as credit, you’ve got pretty debt laden companies that are not cash flow. And I don’t know that you’re going to see a wave of credit come if safe passes. What you really need is, again, getting rid of 2AE, you need to have, I think borders start to fall down.
So you have a competitive supply chain in the illicit market. You want to be able to bring in innovations. And I think that comes with rescheduling. And while I think the criticisms of rescheduling and maybe why it was a little bit dismissed by the investor community is rescheduling is not a perfect framework. It’s not comprehensive, but to me what it is, it’s an ultimatum. It’s sort of a countdown clock, which says, okay, Congress said you cannot come up with a comprehensive framework that you want to put in and you can’t compromise. This isn’t going to stay illegal. It’s going to move to what might not be optimal for accomplishing the regulatory goals. But it will open the industry up and it will become legal because keeping it illegal has failed. And I think that becomes clear.
You have close to 40 states now in some form or another of legalized cannabis. It’s essentially legal, but the federal regs have to catch up to it. So to me that is actually something that we now have almost like an outside date, something that you have to race against. And rescheduling is what opens things up. So I think, well, people might fear interstate commerce, certainly for us in the way we’re structured, it’s very exciting for us and being able to go in and directly participate is what we’ve been waiting for. So rescheduling very exciting or descheduling.
Andrew Carter
Got you. And then I guess we’ll kind of finish on that note, kind of talk about Altria, just to clear all confusion. The warrant expires in March, I believe that’s – that expires that does not affect the agreement, but just confirm that here today and just talk about the agreement, what they bring to the table, and kind of the long-term plans for utilizing that to attack the U.S.?
Mike Gorenstein
Yeah, so exclusivity is completely intact. Board seats everything’s intact. The warrant really is it’s just an option to be able to take control. And that depending on if there’s significant changes, they would really be would they exercise? Assuming that they do not, we would be operating day-to-day the same way we have been. And there’s really no change whatsoever as far as you know, where that relationship is it’s fully exclusive partnership. They have amazing infrastructure in the U.S. and unmatched distribution capabilities. And then, convenience stores a network of farmers that understand how to take genetics, how to pass them through systems. We can process it in the combustibles and to vapes and other oral products. And I don’t think it’s a secret that while it’s certainly cannabis is adjacent to nicotine, there is certainly unit declines.
So while, it’s still extremely profitable, while there is EPS growth. Unit declines is something that the entire tobacco industry faces from their legacy products, and finding ways to be able to absorb cost by adding more units that are adjacent makes sense. So, we like the idea of being able to use all three distribution, use manufacturing expertise, use that network of farmers that great expertise in regulatory. So we think it’s a pretty perfect fit and couldn’t think of a better partner in the U.S.
Andrew Carter
That’s great. With that, thank you very much for taking the time today, Mike. Thank you all.
Question-and-Answer Session
Q –
Be the first to comment