Citron Comes for Cronos

Citron Research, a well-known US short seller finally decided to enter the cannabis ring with a blindside on Cronos Group (Ticker: CRON) sending the stock down almost 30% on Thursday.

Source: Google

Citron points to four main factors justifying their view that Cronos is worth $3.50 a share when the stock is currently going for over $9.00.

  • Cronos had three product recalls in the last three years with the most recent happening to product recently exported to Germany.
  • Cronos signed much smaller supply deals with the provinces than peers
  • Cronos is way behind peers in R&D spending
  • Valuation should be closer to Organigram than Canopy Growth

In our view Andrew Left from Citron knows how to make a flashy entrance into the market, but though he is always yelling about smoke he never actually finds a fire (Shopify is a case in point).

He will take his gains and move on quickly to the next stock with a premium valuation while investors with the conviction to stick with Cronos will be left alone to ride the stock back up to new highs.

Our Counter

Product Recalls

Pesticide recalls in 2017 were concerning, but Cronos was not the only company to fail a test during the early days of the medical cannabis program.

Cronos has a completely clean slate since then and the recall Citron highlights is benign in comparison.

Dried flower grown by Peace Naturals, a Cronos subsidiary, passed a microbial test done by SGS, a third-party commercial lab in Canada, before it was shipped off to Germany.

Cronos’ partner in Germany had the same batch retested and found conflicting levels of microbes compared to the Canadian lab results.

At worst the blame lies with SGS for problems with their testing equipment or protocols, not with Cronos.

Citron claims this was a recall that was not disclosed to investors and could be considered securities fraud, but in reality this was a voluntary withdrawal and was in no way a government-mandated recall.

One could even argue the publication of this information along with a statement by the CEO on March 14, a week before the bought deal was announced, is perfectly adequate public disclosure.

Securities fraud this is not.

 

Supply Deals

Even though producers like to tout new supply deals with the provinces, in reality these deals in no way imply financial success.

Provincial supply agreements are initial allocations not binding purchase agreements.

The provinces will only renew purchase orders for the strains buyers want, so a supply agreement signed before the rec market even opens is not a volume commitment in any way.

Current capacity gets you a provincial supply agreement but future capacity and profitability is what will really matter for investors and Cronos is no worse off than any other licensed producer.

 

R&D Spending

Only 3 of 11 large producers are spending more than $1 million a year on R&D and 1/3 are spending nothing.

Citron points out that Cronos spent only $1 million on R&D this year, implying they are behind in clinical trials, however they fail to mention a lack of R&D spending from the rest of the industry as well.

Looking at the latest annualized run rate for R&D spending of the 11 other large producers we can see only three are spending more than $1 million a year on R&D and 1/3 are spending nothing.

Even Tilray, a company who looks to be an R&D leader, is only spending 10% of the budget on actual clinical trials with the rest going to product development.

Cronos is definitely not falling behind peers when it comes to medical research.

R&D Spending and as a % of Revenue

SEDAR, Grizzle Estimates

Valuation

We do not disagree with Citron that Cronos is sporting a premium valuation at more than 30x estimated 2020 EBITDA (now 23x after the selloff), but the valuation is no different than any other highly regarded licensed producer in the space.

The market is pricing cannabis stocks based on their potential 3-4 years into the future making it meaningless to use historical financial data to compare one company against another.

Organigram may be cheap but that doesn’t mean Cronos is expensive.

2020 EV/EBITDA Multiple

SEDAR, Grizzle Estimates

Buy and Hold

Cronos was unlucky to be the one pot name on Citron’s hit list, but unfortunately for short sellers the story is no different than any other richly valued producer.

Every producer has their unique strengths and weaknesses, but the growth potential of the legal cannabis market cannot be ignored.

All Citron did is give cannabis investors a cheaper entry point leading up to legalization day.