Cronos Group Inc. (NASDAQ:CRON) Q4 2019 Earnings Conference Call March 30, 2020 5:30 PM ET
Anna Shlimak – Investor Relations
Mike Gorenstein – Chairman, President and Chief Executive Officer
Jerry Barbato – Chief Financial Officer
Conference Call Participants
John Zamparo – CIBC
Tamy Chen – BMO Capital Markets
Andrew Carter – Stifel
Rahul Sarugaser – Raymond James
Chris Carey – Bank of America
Vivien Azer – Cowen
Matt Bottomley – Canaccord Genuity
Michael Lavery – Piper Sandler
Good evening, my name is Ryan and I will be your conference operator today. I’d like to welcome everyone to the Cronos Group 2019 Fourth Quarter and Full Year 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.
Thank you, Ryan, and thank you for joining us today to review, Cronos Group’s 2019 fourth quarter and full year financial and business performance. Today, I’m joined by our Chairman, President and CEO Mike Gorenstein; our CFO, Jerry Barbato and Xiuming Shum, EVP, Legal and Regulatory Affairs.
Cronos Group issued a news release announcing our financial results, which are filed on EDGAR and SEDAR 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’d 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, including as a result of the factors described in the cautionary statement and risk factors included in the company’s earnings release and regulatory filings, including the company’s most recent annual report on Form 10-K by which any forward-looking statements made during this call are qualified in their entirety.
In addition, during this call, certain financial measures may be discussed that are not recognized under U.S. generally accepted accounting principles referred to by the Securities and Exchange Commission as non-GAAP measure. We believe that these non-GAAP measures as this management and planning, forecasting and evaluating business and financial performance, including allocating resources. Reconciliations of these non-GAAP measures to their closest reported GAAP measures are included in our earnings press release furnished to the SEC.
I’d also like to note that we were conducting our call today from our respective remote location. As such, there may be brief delays, crosstalk or minor technical issues during this call. We thank you in advance for your patience and understanding.
We will now make prepared remarks, and then we’ll move to a question-and-answer session.
With that, I’ll pass it over to Cronos Group’s CEO, Mike Gorenstein.
Thank you, Anna, and good afternoon, everyone. These are certainly unprecedented time and we are doing our best to adapt to our current situation and make the most of the challenges we face. I hope everyone in the line is staying safe and healthy and a little later, I will address the actions we are taking in response to COVID-19.
First, I want to address recent developments related to our financial reporting and internal control. As well as, the remediation actions we are taking in response to our review. We completed a thorough review of our financials and controls, and we are committed to making things right and implementing the best practices of financial reporting. I want to thank our finance team and advisors, who worked closely with us over the last few weeks to get this done.
As you know, the Audit Committee of the Cronos Group Board of Directors recently conducted a review of certain bulk resin purchases and sales of products through the B2B wholesale channel. Following completion of the review and upon the recommendation of the Audit Committee and advice from our independent auditor, KPMG, Cronos determined to restate our unaudited interim financial statements for the first, second and third quarters of 2019. Accordingly, the Company reduced revenue for the three months ended March 31, 2019 by C$2.5 million and the three months ended September 30, 2019 by C$5.1 million.
We take these matters seriously and I want to make a few things clear. We’re talking about three transactions related to the wholesale B2B channel. This part of the business is not expected to be a core driver of our growth, given the strategic initiatives we have underway. We became aware of the need for a review of these transactions, as a result of our internal reporting processes and the channels for individuals to raise concerns. And we are pleased with the process work as intended. When you look at the big picture and the path forward, these transactions do not affect our ability to execute against our strategy and create long-term shareholder value.
Now that our review is complete, we are taking comprehensive action to improve internal policies and procedures and strengthen internal controls, including our financial reporting. We anticipate implementation of these steps to take several quarters. Let me walk through some of these actions. First, we are taking steps to segregate duties over sales and purchase transactions. As part of this, we are updating internal policies for our sales and supply chain departments, building extensive customer and vendor databases and launching revenue recognition training and education programs for employees in these groups.
Second, we are enhancing our controls and procedures related to non-regain transactions, especially wholesale B2B transactions. To that end, we will now know and require teams to produce accounting memorandums with key transaction details, develop business cases that outline the purpose of the transaction and request approval from either Jerry or myself. We will also enhance our certification process so that employees better understand these transactions and how does it impact our financial results. And third, we are enhancing our quarterly risk assessment and controls processes to reflect changes in our business.
We are committed to making things right and implementing best practices for financial reporting. As a growing company in a rapidly evolving industry, we have taken a number of actions over the last year to enhance our internal capabilities and add resources across functions to support our strategic growth initiatives. As you know my focus and the company’s focus is on creating long-term shareholder value by developing disruptive intellectual property and building an iconic brands. I encourage long-term thinking and do not tolerate or incentivize short-termism. Our value will come from technology breakthroughs and branded sales that help build and strengthen our relationship with our consumers.
Before we discuss the results and company updates, I’d like to touch on the evolving COVID-19 situation and how Cronos Group has made necessary changes to our business during this unprecedented time. Our top priority continues to be the health and safety of our employees, our consumers and ensuring them secure our supply chain. We’ve assembled the global cross functional internal task force led by me that has been closely monitoring the situation daily. The Company also has business continuity plans in place to support its employee base, while continuing to develop and produce reliable high quality products that meet the needs of our consumers.
As of today, our manufacturing facilities remain open, as governments in the regions, where we operate have designated our business as essential. We have implemented work-from-home policies for certain employees and we strict no travel policy including between our sites. For our manufacturing facilities, we enhanced hygiene and sanitation practices, modified schedules, and maintain social distancing protocols. As circumstances vary per region and country, we’re working diligently to continue to act in accordance with all applicable guidance from local, federal and international health and governmental authorities, and we are prepared to make additional operational adjustments as necessary.
Despite our business continuity efforts, we may see an impact on certain parts of our business such as operational capacity or supply chain delays, but we will remain vigilant in our evaluation the situation as it unfolds, and we’ll continue to make decisions based on what is best for our company, our employees, and our customers. We know our consumers are relying on us during this time, and we’re responsibly rising to the challenge.
With that, let’s take a closer look at the progress we’ve made on our strategy over the last quarter to continue to build our foundation for long-term growth. First, I’ll start with the progress we made in establishing and growing our brand portfolio. Our goal is to bring high quality consistent cannabinoid products to the market, while expanding how consumers approach and shop for the category.
In the fall of 2019, we added the luxury hemp-derived CBD brand Lord Jones to our brand portfolio and welcomed the talented and creative team to the Cronos family. Under the Lord Jones brand, we now manufacture, market and distributed hemp-derived CBD-infused skincare and other personal care products in the U.S. market in e-commerce and retail outlets such as Sephora, SoulCycle and Neiman Marcus.
During the holiday season, Lord Jones experimented with its own retail by activating three holiday pop-up shops at the Westfield holiday markets. We were able to see how a larger retail concept could work and learned about consumer habits during the holiday season. We’re looking forward to bringing this brand and other skincare brands and products to more consumers in 2020.
Last quarter, we also announced the launch of PEACE+, a new hemp-derived CBD brand in the U.S. Now we are very excited to bring this brand to market. We’ve made the decision to take a measured approach to the distribution of hemp-derived CBD tinctures product line. To that end, we decided to pause the distribution of PEACE+ hemp-derived CBD tinctures through Altria sales and distribution network, while we collect more information and assess the evolving environment. Cronos remains committed to meeting the demands of adult consumers and will continue to evaluate other product formats and categories that we believe may be more suitable for the PEACE+ brand in the current and evolving climate.
As we move to new markets, trade channels, product formats and launch new brands, we remain fully committed to doing so in a responsible way. To set that standard and take a position of leadership, we sometimes will make difficult decisions in the short-term, but we believe this approach will position us as the market leader in the long-term. We continue to welcome open dialogue, collaboration and look forward to working with industry peers, regulators and governments to allow for reasonable regulation to prevail. We are committed to ensuring the advancement of consumer education, science, research and elevation of standards for cannabis consumer products in all of the markets we serve.
In the Canadian 2.0 market, our adult-use brands, Spinach and COVE launched new vaporizer products. COVE, our premium brand launched an elegant vaporizer pen, while the Spinach line was inspired by sought after strain specific terpene profiles and formed by consumer insight work both hit market in late December of last year. A lot of work went into our launch for vaporizer products, and although we use non-proprietary hardware to start within the Canadian market, we did so purposely, because we know consumers are in a trial phase, when a new market begins.
We take a consumer first approach to everything we do and that is a direct reflection of the new tailored 510 vaporizer product lines for COVE and Spinach. We worked with Cronos Device Labs to bring the best version of this product to market. Our cartridges are made with quality stainless-steel components, food grade silicone and our tamper resistant. We spent months doing our diligence with boots on the ground with our suppliers to ensure the products released in market were properly tested before launch.
Our rechargeable draw batteries have contemporary intuitive designs and include mechanisms to prevent overheating. And our formulations are made with premium cannabis extract and all-natural terpene-rich flavors. We’re proud of our uncompromising approach to quality, which is at the heart of everything we do. As we continue to glean more consumer insights into the Canadian market, we look forward to developing innovative and differentiated products that meet the needs and exceed the expectations of our consumers.
Turning to distribution, in the Canadian market, in Q4, we expanded our distribution network and began selling products to cannabis control authorities in Manitoba, New Brunswick and Quebec. Cronos currently sells dry flower, pre-rolls, cannabis oils and cannabis vapes through its adult-use brands, COVE and Spinach, to cannabis control authority in Ontario, British Columbia, Alberta, Nova Scotia, and Prince Edward Island, as well as to private-sector retailers in Saskatchewan.
We firmly believe that the best way to create value through the supply chain is by working with contract farmers and suppliers to support our capacity needs versus building out our own cultivation for those needs. We continue to structure our supply chain with efficiency and flexibility and the best interests of our business in mind with the goal to create a global network of co-manufacturing and contract farming with first-class operating partners.
To this end, and in the fourth quarter, we continue to build out and transition certain facilities at the Peace Naturals campus to pride for more R&D activities and the production and manufacturing of derivative products. We are pleased with the progress we were making with the redesign and believe this is a natural evolution for our business, as we look to evolve and drive efficiencies at our facilities.
We also continue to make progress at our international production and manufacturing facility in Israel, as we move closer to operational readiness. For this facility, we work closely with our partners at Kibbutz Gan Shmuel and are able to leverage not only their agricultural expertise but also their skilled labor pool and extensive infrastructure including warehousing, utilities and much more.
In December of 2019, Cronos Israel successfully passed full Good Agricultural Practices audits for propagation and cultivation, as well as GMP and Good Distribution Practices inspections for the manufacturing and distribution facilities. These licenses allow us to cultivate, manufacture and sell products in Israel. We’re in the process of waiting for official GMP certification for the facility, which is expected to occur in phases throughout 2020 for flower, pre-rolls and oil. We look forward to working towards our GMP certifications and getting Peace Naturals products to the Israeli medical market later this year.
When we reflect on 2019, I think one of the spaces we’ve made exciting progress on is our intellectual property initiatives and our commitment to investing in cutting edge, breakthrough technologies that we think will have the potential to disrupt our industry as well as others. We are pleased with the progress we were making in our research collaboration with Ginkgo, which will allow us to produce cultured cannabinoids at commercial scale.
Ginkgo has filed certain patent applications pertaining to the fermentation of cannabinoids to protect intellectual property developed as part of the research progressing under our partnership. Under the partnership, Cronos Group is the exclusive licensee of the intellectual property covered by the patent applications for the target cannabinoids. In November, we welcome the employees of Cronos Fermentation, which include a team of engineers, scientists, production and quality assurance personnel previously employed by Apotex Fermentation.
We believe that Cronos Fermentation will allow us to accelerate our breakthrough technology initiative by optimizing the cannabinoid fermentation manufacturing process in advance of a commercial scale rollout. We have commenced work on developing scale up and downstream processes at Cronos Fermentation, while in parallel, Ginkgo develops microorganisms for producing cultured cannabinoids, as Cronos develops the processes and parameters, these learnings will be applied to the strains that will be utilized for commercial production of cultured cannabinoids. Cronos Fermentation has received the R&D license and is waiting to receive of our production licenses, which is required for the commercialization of cannabinoids at the facility.
In short, we are very pleased with our progress and look forward to bringing this disruptive technology to market when available. I’d like to close my remarks by reflecting on the incredible year we had. We often don’t think about all that we were able to achieve and the sheer speed of our growth in just a short amount of time, but it’s important to remember everything that was accomplished to bring us to where we are today.
Here are some of the key accomplishments in 2019. We closed $1.8 billion investment from Altria and began tapping into Altria’s expertise in manufacturing, product development and much more. We look forward to continuing to work with Altria as we build the cannabinoid industry together. We opened an R&D focused initiative, Cronos Device Labs, which how do they talented research and product development team with significant vaporizer experience that is leading the charge to develop next generation vaporizer products.
We hired Chief Innovation Officer, Dr. Todd Abraham, who brings over 35 years of R&D in consumer product experience to cannabinoid research and innovation. We acquired a pharmaceutical fermentation facility to advance our research with Ginkgo and eventually manufacturer of cultured cannabinoids at commercial scale for the Canadian market. And we entered the U.S. market by acquiring a premium hemp-derived CBD brand, Lord Jones and welcome their talented team to the Cronos family.
Overall, we believe that we are positioning the company for long-term success by investing in innovation, R&D and brands. Our strategy is focused on sustainable growth and we believe what we are building will generate long-term shareholder value.
With that, I’ll turn it over to Jerry to provide a discussion on this quarter’s financial results.
Thanks, Mike, and hello everyone. I will provide specific details on our results for the fourth quarter and full year 2019. All the figures that I will review today can be found in the 10-K filed with the SEC. But first I want to reiterate some of the key points Mike provided earlier regarding the restatement. This is a matter that the Board of Directors and the entire management team at Cronos Group take very seriously.
We completed a thorough review of our financials and internal controls. I’m grateful to our finance team and advisors, who work incredibly hard to complete the review in a timely manner. We are taking comprehensive action to improve internal policies and procedures and strengthen internal controls, including financial reporting and are committed to best practices.
This includes implementing the following steps. First, we are ensuring the segregation of duties over sales and purchase transactions. Second, we are enhancing our controls and procedures related to non-routine transactions, especially wholesale sales and purchases. And third, we are enhancing our quarterly risk assessment and controls processes to reflect changes in our business.
We have said consistently over the last year that one of our biggest priorities is attracting and retaining the right talent in the right areas, which will help us, prepare for our future growth initiatives and we will continue to do so to fortify our infrastructure. Our top priority is to enhance our internal controls and financial reporting practices. These efforts are already underway and I’m confident, we will be even stronger as a result of this undertaking.
Before discussing our financial performance, I’d like to make a few comments about our transition to U.S. GAAP reporting, our filing including our press release and then generally how we do the business. As I mentioned in my remarks last quarter, Cronos started filing domestic SEC report as of January 1, 2020 and our financial results are now reported in U.S. GAAP with the U.S. dollar as a reporting currency. Historical financial information is included in our 10-K filing, which is currently available on EDGAR and SEDAR.
Regarding the conversion to U.S. GAAP, the most significant change from IFRS is related to biological asset accounting, which does not exist under U.S. GAAP. Under U.S. GAAP, agricultural products are valued on the balance sheet at the lower of cost or net realizable value as opposed to IFRS which accounts for these products at fair value, less estimated selling costs. We’ve also updated our financial disclosures and reporting structure to reflect how we are managing the business. Going forward, we will discuss our business with two segments, U.S. and Rest of World. Lastly, we are now using operating income to evaluate performance and allocate resources across our business segments.
Operating income is the metric used across many industries including CPG and consumer staples. Some of you may know this metric by other names including income from operations or operating profit. I like to spend a moment explaining this measure and why we find it useful in understanding our business performance. Operating income or loss is defined as net revenue less cost of sales and operating expenses. At the segment level, operating income excludes corporate expenses, which do not directly impact the underlying performance of the segment.
We believe operating income provides us the clearest view of the segments’ core business performance as compared with other metrics, because it does not exclude depreciation or amortization of revenue generating assets. These revenue generating assets have a real economic cost and measuring the business performance through EBITDA, which excludes these items which represents results that are not reflective of our underlying business performance.
Our asset-light strategy demands that our segment managers to be ever vigilant and financially disciplined regarding their capital expenditures. By measuring and discussing our performance in terms of operating income, we believe that we are holding our segment managers accountable for their investments and accurately reflecting the merits of our asset-light strategy. We review these results on an adjusted basis, which excludes certain income and expense special items, which may be highly variable, unusual, or in frequent and can distort underlying business trends and results.
We’ve included a section in a press release that provides information and details on the special items for this quarter and year-end comparison periods for 2018. Also, we’ve included reconciliation tables in our press release and 10-K that bridged the reported GAAP operating loss to the adjusted operating loss for each of our segments.
Turning to Q4 results, I will focus most of my comments on the fourth quarter’s performance versus that of the fourth quarter of 2018, which is a slight change from the sequential discussion in prior quarters. The company reported net revenue of $7.3 million in the fourth quarter, a 71% increase from prior year. Revenue growth for the quarter was driven primarily by distribution of vaporizer products in Canada and the inclusion of financial results for the Redwood acquisition.
In the Rest of World segment, reported net revenue for the fourth quarter of 2019 was $4.6 million, an increase of 8% from the fourth quarter of 2018. This is primarily driven by the continued expansion of growth in the adult-use business in Canada and the introduction of vaporizer products in the fourth quarter of 2019.
Gross margins for the Rest of World segment were negative in the fourth quarter, a decrease from the fourth quarter of 2018, primarily driven by inventory write-downs in 2019. We incurred an inventory write-down of approximately $24 million in the fourth quarter, made up of a one-time charge of $1.9 million related to the repurposing of certain facilities at the Peace Naturals Campus and a $22.1 million write-down on cannabis oil and flower.
If we were to adjust for the effects of the inventory write-downs, gross profit for Q4 would have been $2.2 million, representing gross margins of 48%. We do however anticipate inventory write-downs in the short term due to pricing pressures in the marketplace and while the company executes its operational repurposing of the Peace Naturals Campus.
Operating expenses in the Rest of World segment totaled $37.3 million in the fourth quarter of 2019, representing an increase of 247% from the fourth quarter of 2018. This increase is primarily driven by higher sales and marketing costs associated with agency and market research fees connected to the adult-use markets.
G&A growth was driven by an increase in headcount as well as various professional and consulting fees. The repurposing costs at the Peace Naturals Campus accounts for $5.3 million of the growth and R&D expenses increased mainly due to the cost associated with Ginkgo. The Rest of World segment reported an adjusted operating loss of $51.8 million in the fourth quarter of 2019. The loss increased significantly from the fourth quarter of 2018, primarily due to inventory write-down and higher operating costs partially offset by an increase in net revenue.
In the fourth quarter, the U.S. segment reported net revenue of $2.7 million, as Redwood continues to expand the distribution of Lord Jones products in retail and through e-commerce channels. Gross margin for the segment was strong at 53% driven by Lord Jones position in the super premium luxury CBD category.
The segment reported at adjusted operating loss of $1.8 million in the fourth quarter of 2019. This loss was primarily driven by higher marketing costs associated with the continued expansion of Lord Jones products and that’s upcoming new products and brand launches. Overall, Cronos reported an increase in net income from the prior year, primarily due to the change in fair value of the financial derivative liability associated with Altria’s investment, which is described in more detail in the 10-K.
In the fourth quarter, the company recorded a non-cash gain of $118.8 million related to the change in fair value of these financial derivative liabilities. Cronos continues to expect there may be significant reported earnings volatility, primarily driven by the fair value of quarterly adjustments related to the movement of Cronos Group’s stock price.
Turning to the balance sheet, the company ended the quarter with approximately $1.5 billion in cash and short-term investments, essentially unchanged from the third quarter. Capital expenditures for the full year were $39 million. This spending includes investments in our Peace Naturals Campus, Cronos Fermentation, our Israeli facility and device technology innovation at Cronos Device Labs. We remain focused on deploying capital in a disciplined manner and only in ways that align with our strategic priorities.
I’d also like to provide an update on the redesign at our Peace Naturals Campus that we announced last quarter. We optimize our Peace Naturals Campus for alternative uses such as R&D facilities and derivative product manufacturing. Since our last earnings call, we have removed rooms from cultivation in a number of the buildings at the Peace Naturals Campus and began the transition of space for R&D and derivative manufacturing.
During the fourth quarter, we recorded a total pre-tax one-time charge of $7.2 million related to the repurposing efforts at the Peace Naturals Campus, with $1.9 million associated with an inventory write-down and $5.3 million of operating expenses, primarily related to impairment costs.
Overall, we are pleased with this strategic progress the business made in 2019. It was a year of transition and significant investment toward achieving our long-term goals. We expect to continue to invest behind our strategic initiatives in both the U.S. and Rest of World segments. We know that it won’t be easy, but I’m optimistic about our plans for 2020 and beyond to achieve long-term leadership in the cannabis space.
With that, I’ll turn it over to Mike for closing remarks before Q&A.
Thank you, Jerry. Cannabis is a young industry with a lot of potential opportunities in front of it. For the last few years, capital has been cheap, assets have been expensive and the available product formats as well as distribution was limited. 2019 was really the first year of widespread industry adversity. In 2020 that trend has continued adding macroeconomic headwinds around the world that require adjustments to the way people interact with one another and do business. Now in our industry today, capital is more expensive and assets are cheaper, even though distribution is beginning to open up and new product formats are becoming available for sale.
Our long-term thesis on cannabis has not changed. And we believe with our strong balance sheet, investments in disruptive intellectual property and the flexibility provided by our asset-light model, we are well positioned to be opportunistic and aggressively seize on opportunities in the near, medium and long term.
With that, let’s now open the line up for questions.
And we do have our first question coming in from the line of John Zamparo from CIBC.
Thank you. Good afternoon. I wanted to touch on business disruption at Lord Jones, presumably SoulCycle and four locations across the U.S. are closed, but seems like there maybe some restrictions on the Lord Jones website. So just wondering, will that be in place as long as the shelter-in-place rules are in effect in California? And just can you talk broadly about how large the DTC businesses as far Lord Jones versus brick-and-mortar stores?
Sure. Thanks. It’s a great question. Recently, our business has been declared as essential. So those from a supply chain perspective, we’re still able to keep things open. Of course, it’s something that we need to monitor, how potentially things rollout and how they develop. But as of right now, we’re able to continue getting product made and shipped. As far as, DTC versus retail, these really are unprecedented times and there – it’s pretty early to be able to actually conclude anything from the data we’re seeing, obviously with retail on a lot of categories being closed off. We’re seeing what we think is some shift from retail to DTC as people are self-quarantined. but also it’s probably too early to be able to determine whether any sales trends or pantry loading versus sustained changes in the way that consumers are making purchases. So, I think it’s something that we’ll continue to monitor, but we do expect as long as the nationwide trends that we’ve seen continued that there’s more likely to be a shift to online purchasing versus brick-and-mortar.
Okay, thanks. And then my follow-up is on PEACE+. Can you talk about the regulatory environment for CBD right now? We’ve seen any encouraging signs on that front? It seems like the FDA was pretty cautious in its statement in December, but have you had any conversations with the FDA that’s led you to any conclusions on what the final outcome might be here, whether it’s maximum potency or preference to allow certain products or just any commentary there would be great. Thank you.
Sure. I think U.S. CBD and FDA stance is something we continue to monitor and as with any regulatory environment, we welcome open dialogue, collaboration and look forward to working with our industry peers, regulators and governments to make sure that, we’re providing for reasonable regulation and prevail. I think that a lot of some of the trends that we were focused on as far as which way regulations have been going, recent events with COVID has certainly changed. I think where the focus from a lot of government organizations are, so many developments there can be changed depending on how close it’s dealt with and where regulators seal the need to shift their attention.
At this time, we do have another question on the line. This is from the line of Tamy Chen from BMO Capital Markets.
Yes, thanks. First question is just wanted to understand with respect to revenues, just how do you think about it? When will it begin to grow meaningfully? It seems like things in the U.S. may still be some time away given the regulation. So, specifically in Canada, I’m just trying to understand what the challenges may be, it doesn’t seem like there’s a supply issue anymore, so just wanted to get a better sense of when we should think about revenues will really start to pick up there. Thanks.
Yes. With new form factors in Canada and sales from U.S. have direct CBD products in the U.S. We believe that this will result in a sales mix, weighted more towards adult-use sales and less towards opportunistic sales that we had in Canada. And as we launched 2.0 products and our vape launch in late 2019, we believe will help accelerate growth in Canada.
Yes. I think when we’re looking specifically at Canada, obviously, store growth in 2.0 are big impacts. But also I think what impact COVID may or may not have is going to be important. In Ontario, we’ve seen new cannabis dispensaries continue to open even during the called the COVID Era. But while cannabis dispensaries have been deemed an essential business in Ontario, we don’t really have visibility in how the pace of future store growth might be affected by other potential delays like from trades or macroeconomic headwinds. But also, I think that’s counterbalanced by increase in recent online sales.
I think that you’ve seen Ontario discuss again, though I think we still need more time and data to be able to evaluate just how much is due to pantry loading versus sustained changes in purchasing habits and how consumers will be shopping as they self-quarantine. Overall though, when we think about the position that we’re in and the macroeconomic environment, the way that we look at it as there’s distribution points continuing to open up, we expect competition, we’ll consolidate and we think that provides more opportunities for us to be aggressive in growing the business.
Got it. Okay. And my follow up is with respect to Ginkgo. So, Mike, I just wanted to confirm one of the comments you made earlier. So, at this point, has Ginkgo largely done the formulation work? Are you just waiting for the facility to receive its production license and then you can move into the commercialization part or is the R&D formulation, there’s still more work to be done there? Thanks.
Sure. So, the formulation work is work that we do at Cronos with the work that ginkgo is doing is giving us strains that are able to ferment cannabinoids. the work of how we combine those cannabinoids, what type of consumer products we put them into, it’s something that’s specific to what we’re doing in-house at Cronos and of course, a difference would be just rare cannabinoids being able to get those in any type of commercial quantity from cultivation extraction is difficult, but the THC and CBD, for example, it’s the same cannabinoid we formulate with that we would be getting from supply today. Essentially, the separation between what’s done at Cronos Fermentation versus Ginkgo, you could think of that is comparable to setting up a cultivation facility and then putting in the processes of how you grow the product, how you harvest, how you – and how you ultimately cure. at Cronos fermentation, we’re going through those prophecies while the genetics, which is – we think about cultivation. The genetics are being developed same way you would breed a new plant strain. Ginkgo was essentially breeding and designing those strains that we will cultivate or ferment at Cronos fermentation. Is that helpful?
Our last caller seems to have fallen off time, but we do have another question on the line from the line of Andrew Carter from Stifel.
Hey, thanks. Good afternoon. Just wanted to ask and you mentioned that kind of growth starting to accelerate meaningfully in Canada, obviously you mentioned that kind of the challenges were unveiled in 2019 and now, we have kind of an accelerated shakeout will – if you will. How kind of are you thinking about Canada now versus how you’ve thought about it historically in your portfolio? Is there an opportunity to invest more in this market now? Is there an –is it acquisitions? Just any help and how you’re looking at the landscape right now?
So, I think certainly trends as far as the way that things are setting up with having less access to capital across the space and having at least in the last few months in near-term, limited opportunities for distribution albeit increasing, we do expect, certainly consolidation will hit. I think M&A; we haven’t really changed our view that what we’re looking for is ultimately something on the brand side or something on the intellectual property side that’s ultimately scalable. How consumers end up building relationship with different brands would ultimately dictate in Canada specifically whether or not we – we’re looking for growth organically or through acquisition. But we do expect that the competitiveness for organic growth is something that will become easier as a lot of the capital reserves going to be depleted with competitors, with marketing.
So, ultimately, opportunities that may have looked at in the past that we were to revisit them today would certainly look more accretive, but it really comes down to does it help us with our relationship with the consumer to make an acquisition and would it be more accretive to look at it through organic growth versus acquisition.
Okay. And then second question, just kind of on your vaporizer business that you’ve launched, you’ve obviously jumped out to a pretty nice start given your supply chain, maybe wanted to ask – you obviously mentioned COVID-19 disruption and a lot of questions on kind of the Chinese supplies issues. So, first question and there, and can you kind of give us an idea on these device sales, how accretive they are to your gross margin overall and the profitability of your business? Thanks.
Yes, I think there’s, we could separate that into two categories. I think the actual – the device meaning the battery and then the cartridge, which has the actual cannabis oil in it. So, I think we look at the batteries really is more of a marketing opportunity, not something that’s supposed to drive gross margin. But we do think that the cartridges, especially given pressure in the flower side over the long-term, we expect that that’s going to be accretive especially, if we continue with the progress of ginkgo and being able to take that that technology and put it into vaporizer products. We think would change the way that we look at our business.
Yes. While we have healthy margins on our base today, we decided to outsource the manufacturing to CMOs really to make sure that we get the product format, the product type right before bringing it in-house, so we can dial it in and improve margins over time as well as the market continues to fluctuate in terms of pricing. And so we’ll see how that plays out over the course of 2020.
And there are more questions on the line. This next question is from the line of Rahul Sarugaser from Raymond James.
Good evening, Mike and Jerry. thanks so much for taking my questions. So, my first question really is with respect to the PEACE+ brand is the launching of the first thousand stores get started at all and now that the product line is on hold when do you expect to re-launch it?
Sure. It did not. I mean there are certainly steps in the process that we took, but ultimately, we decided to pause and reassess the landscape. I think when a different product might be launched is something that will depend on how we do the landscape and ultimately, what gives us the opportunity to meet consumer needs. But when we think of things right now, retail – launching a new brand in retail, given the environment of COVID is something that we’re going to have to think through as far as timing and when we start seeing a return to normalcy is one we would start thinking about taking a product and putting it into a new retail location, but I think supporting a new brand on shelf in the kind of social distancing world we’re in is something that would be pretty difficult.
Great. That’s really helpful. Thanks. And then my second question is when do you expect the tech transfer of the first couple of strains developed by Ginkgo to happen over to the Winnipeg facility? And do you have any visibility on when you anticipate commercial production of those first couple cannabinoids to happen?
Sure. I think it’s something that we’ll be able to give more color on as time goes on. What I can – what I can say is that we’re still very confident in the timeline that we gave when we announced the deal being September of next year.
And there are more questions online. This next question comes from Chris Carey from Bank of America.
Thanks, guys. good evening.
So maybe, a big picture, we’re a little over a year from the close of the Altria transaction. And I guess I’m struggling a little bit just to understand where Cronos is going in the near to medium-term. Lord Jones was a big price tag, but it’s obviously, small contribution now maybe, that improves over time, but certainly not yet. The U.S. CBD launch is getting delayed potentially indefinitely. It sounds like there’s a repivot back to Canada adult-use, not that there never was a focus there, but certainly, it seems like more of an emphasis given that’s going to be the market for you in the near-term. And so I guess I’m trying to understand where all those works that we’ve been talking about, it starts to get commercialized or 2020 is another year where kind of swatches the cash balance while many others don’t focuses on the long term and it comes this very long-term type story or if there’s some of this work that maybe comes through fruition sooner. So maybe, if we could just talk about kind of where things are going in the near to medium-term, it would be helpful for me. Thank you.
Sure. So, I’ll take the first part of that and in relation to our Redwood acquisition. So, we’re very excited about the future potential for Redwood and we anticipate significant growth across our new U.S. platform and we believe that the U.S. provides significant opportunity for redwood to deliver value to Cronos. We selected redwood as our U.S. platform, not only to the strength of Lord Jones, but more importantly, the talented team that Rob and Cindy, the cofounders have assembled. While I won’t share our plans for competitive reasons, we believe that through the combination of the Redwood team and front offices, existing resources that the acquisition of redwood will deliver significant returns to shareholders over the medium to long-term.
Thanks Jerry. And yes, as far as medium and long-term, I’ll take that part. I don’t think our view has changed that similar to other consumer categories. ultimately, differentiation in a product is what’s going to lead to long-term value and there are ways that we look at doing the research. Ultimately, things that we find from consumer insights research inform what we do in product development. And that certainly takes time, but we don’t want to rush products to market unless we feel that we have winning, winning product. But we do see that a technology breakthrough is ultimately what’s going to lead to us being able to generate a long-term value. So, there are a number of initiatives we have that once we think the product is ready and we think that we can meet consumer expectations and I think that’s the first step. And certainly, financial results will follow that.
Okay. And Mike, I’ve asked you this before, how you would envision the breakdown of revenue between the U.S. and I guess it’s rest of world, but more or less Canada in 2020 and I think previously the U.S. was seen as likely bigger, but it seems to me now that perhaps, it’s switched again, where the Canadian business is going to be bigger and I wonder if you can confirm it, that’s the case in your projections and maybe, offer some insight on how things develop from here. it’s just the type of thing, where the vape rollout gets commercialized quicker, where wholesale pricing has obviously collapsed and now you can really deploy this strategy of bickering, a subordinated raw material to sell under your own branded products on the flower side. So, maybe, help understand how the geographic split looks like and also what the cadence is going to look like over the course of 2020. Thanks for that.
Sure. Yes. So, I think, my previous expectations of the U.S. outpacing the rest of the world. the key to that is going to be being able to access brick-and-mortar stores and while I think in October, we’ve seen some shifts from brick-and-mortar sales to online, I think it will be difficult as long as we’re in the current environment to still outpace what we’re seeing rest of world. But ultimately, the opportunity, we still think given the size of the market, over time can be better, but cadence is really going to depend on the overall environment of being able to take different types of CBD products and put them on shelf.
As far as Canada, I think a few things have changed. A lot of it is based off of where the competitive set would be, what products we’re able to bring forward and we think that there’s likely going to be some challenges not just across our sector, but across the – all sectors given what’s happening with COVID. But given the way we structure ourselves, we think that we should emerge from the COVID crisis, whenever that timing is in a position of strength to be able to be a little bit more aggressive and continue to invest behind growth opportunities. But I think specific timing is it’s really difficult to predict, because of the way that COVID could impact when those opportunities for new growth and bringing existing projects into the market would be.
and there are have more questions on the line. This is next question comes from the line of Vivien Azer from Cowen.
Hi. Thank you. Good evening. So, I just wanted to dig in a little bit more on the inventory write-down. This is obviously, a phenomenon that we’ve seen in place in the broader landscape for many months now. And so I was just hoping to get a clear understanding of how you guys are thinking about the price compression in the marketplace, because it seems to me that at least from a retail standpoint, like that’s really only starting to hit the market, certainly kind of calendar 1Q giving the timing of the announcements of value priced introductions in the marketplace. So, when you took the inventory write-down, is the price deflation a backwards look, a forward look and any kind of color you can offer on like what underpins the rate of price deflation that informs the inventory write-down would be helpful. Thank you.
Sure. So, we’re comfortable that our balance sheet reflects the most accurate valuation of the inventory as of the end of the year and the write-down was driven by downward pressure on market prices and these prices have fallen below the cost of producing that inventory. Most notably on dry cannabis, the value of future write-downs is a bit uncertain. Therefore, we’re not disclosing a number of currently and in line with U.S. GAAP standards, we review our inventory balances quarterly to ensure that it reflects the lower of cost or net realizable value. And I think what we’re seeing in the marketplace is as you pointed out a trend lower both in the dry flower as well as the oil and resins.
Okay. That’s helpful. So, just to summarize then, if that was your kind of view of the marketplace as of December 31, it would be fair to assume that if there has been more price deflation in the marketplace in calendar 1Q, which wraps tomorrow then that could potentially result in further inventory write-down?
Okay. Thank you. And then a quick follow-up from me, it just seems like; it was months ago that I was at CAGNY with the Altria team. In fact, that was only four plus weeks ago that one of the questions that I posed to Howard Willard during the breakout was Altria’s appetite to further to distribution. the PEACE+ CBD offering in the U.S., I recognize, Mike, of course, it sounds very sound that you wouldn’t want to do a large scale rollout now, given what we know today about COVID-19, the unfortunate reality is that that wasn’t really a big consideration, four to five weeks ago. So, I am curious if you could offer whether there had been any discussions with Altria about expanding the distribution. That’s my follow-up. Thank you.
Sure. Yes. We remain an active discussion and we’re both very committed to the partnership. I think ultimately, a lot of the discussions and the thinking comes from making sure that we can find the right product formats for the current environment and given all the changes, just making sure that we’re taking a responsible and long-term view as to what the product format is and ultimately, how that proceeds by all of our stakeholders before launching and expanding distribution.
And our next question comes from the line of Matt Bottomley from Canaccord Genuity.
Yes. Good evening. Thanks for taking the questions. Just wanted to follow up from a couple of questions ago on sort of taking a step back on more of a macro level strategy for Cronos, obviously, you guys are one of two companies in the Canadian sector that has a defensible balance sheet in these troubling times with increased uncertainty. But again, sort of 7 million of revenue in the quarter, certainly, lagging a lot of your peers, certainly in the Canadian sector. And Mike, I appreciate the viewpoint of having a longer-term view versus a shorter-term view. But maybe, if we could just dig a little bit deeper with respect to where your capital allocation is going to go and how investors should judge Cronos sort of in the next four quarters or so. Given the fact that with all the things you have going on between Ginkgo and Israel, the Hampton, the U.S. obviously everything that’s happening in the Canadian market, the top line still is very modest. So, should we be expecting this to be a continued trend as you allocate capital towards the longer-term initiatives, although there’s more unknowns and risks there, or is there anything we can look at in the next couple of quarters that that can be definitive things to assess performance for Cronos in the more near-term than long?
Yes. We don’t give forward-looking guidance on our revenue projections and as far as the capital allocation; I would say we continue to monitor our capital allocation to determine the appropriate level for reinvestment in our business as well as external growth opportunities. And we believe we’ve been very active in deploying that capital in a relatively short period of time considering that the Altria investment closed last March. We’ve acquired Redwood Holdings, we acquired Cronos fermentation. We’ve launched derivative products including vaporizers, and we have a credit facility out for our GrowCo joint venture. So, we remain focused on scaling the business for the future success and we’ll continue to evaluate external growth opportunities to deploy that capital.
And thanks Jerry. I think, one of the things that we certainly balance between external growth opportunities is also evaluating organic growth opportunities. And vaporizers is a category we really believe in leaning into as we continue to get more information and data on how some other formats in Canada have been received and we can sort of learn from what products have been put out in the market. We’re leveraging some of our IP that we got from Redwood and we’ll look at other things we have in development that I don’t think we’re talking about years before. I will start getting other product formats out and lean into them. But we do see that even over the next few months, the opportunity that we have to really grow revenue or I think, better than they were in the past, but ultimately, we’re still making sure that we take a long-term view and we’re doing things that are accretive.
So, we feel that the cost of revenue entering any specific opportunity isn’t something that generates long-term value. It’s something that will pass on. But again, given where the cost of capital for most industry participants has shifted to and looking at the pricing of different assets, we think that picture started to change and because that’s opportunity for us to move over the near to medium-term.
Got it. Thanks. And just a quick follow up, very anecdotal, but I’ve noticed in cannabis 2.0 has launched on a number of the provincial websites, the Cronos whether it’s COVE or Spinach or others. I’ve noticed those products have been a lot more relevant on those websites and it’s obviously, no one really knows by reviewing websites how much depth of supply goes behind each and every skew. But is there anything for us to read into for your next quarter that there’s been an uptick in overall penetration into this cannabis 2.0, obviously everyone’s starting from a base of zero in the prior quarter, but it’s just something I’ve noticed on a number of the provincial websites since cannabis 1.0 is that the Cronos branded products do seem more prevalent compared to what we saw just the dry bud before at lunch.
Sure. I think what you’re seeing there is just that our focus has really been a lot on the derivative products and I think that even looking at distribution in which provinces, that we we’ve entered. We want to make sure that we can support our products in the different provinces. And so we’ve expanded distribution and making sure that we have the amount of supply necessary and the right product mix is something we prioritize for vaporizers and one of the reasons that we picked having just one 2.0 product format in market is to make sure that we’re able to service a properly. So I think, again, looking at opportunities for us, we are placing a priority on making sure that there’s more organic growth this year, now that we think the – all these markets opening up with more retail stores and with more product formats.
We do have one last question on the line. This last question comes from the line of Michael Lavery from Piper Sandler.
Thank you. Good evening.
You touched on some positives in the quarter, including obviously the bigger – much bigger sales from Lord Jones and the launch in three new provinces. Obviously, Alberta being a very developed one and then it sounds like some – early on initial vaporizer sales as well. But maybe, can you just help us with a postmortem on what then still really drove even after the adjustment in 3Q, a pretty significant decline and then maybe, with that, help us understand what has or hasn’t changed as we look and try to model ahead.
Yes. So, after the restatement and we had some growth in Q4 versus Q3 and as I said before, we’re not giving forward-looking guidance in terms of revenue. I think there’s a lot of things at play, especially with COVID-19 and people going to brick-and-mortar. And I think we’ll be able to get a better sense as the environment changes and to see how many stores actually open up, especially in Ontario, while they’ve done, I guess you could say a fair job at beginning to open more stores. These are questions still remains, will they be able to get to their intended number and satisfy the market.
And maybe, just then – just make sure I’m not confusing the numbers with the restatement in U.S. dollars, what was your 3Q revenue number?
Well, we took a $3.8 million write-down or a change in U.S. dollars in Q3. So, the total change in the net revenue would be or was $5.7 million.
Because – okay. So, I guess I still just want to understand maybe, where most of the pressure is from. Is share or pricing pressure? Is it a combination of both?
I think there’s a few things in Q4 as far as like sort of how things landed versus our expectations. I think that we certainly had a focus on the 2.0 launch and given the leaning in the vaporizers. I’ll just give you an example of Alberta being a very developed province. Something that has certainly changed, but we expected that to be a big growth driver for us. And then temporarily vaporizers were not a product format that was accepted that certainly changed, but a lot of it was the timing of 2.0 launch, how different things or different provinces were accepting different product formats. Certainly, the – there’s probably a peak level of congestion that we’ve been experiencing for a certain types of flower, but we do expect that something that will begin to clear up, although it’s – the exact timing is difficult to pinpoint just from trends we’ve been seeing and where we naturally would follow those. Do we expect we expect congestion to clear up with more store openings and less competition?
And at this time, there’s no one else in queue.
If there are no more questions, hope everyone stays healthy and safe, and talk soon.