Description

Cronos is the best way to play Cannabis Re-Scheduling

On the last day of August, the Department of Health and Human Services (HHS) recommended that cannabis be re-classified from a schedule 1 controlled substance to a schedule 3 controlled substance.The DEA is now expected to agree to such changes and make its recommendation to the Attorney General and the President of the United States, who would confirm such changes.

Let’s be clear about a few things –

1. This was a political move.

The timing of this comes on the heels of the Supreme Court student debt decision and the resumption of student debt payments and is designed to gin up support among the younger generation before the 2024 election. Biden’s DEA has every intention of accepting this re-classification (our research indicates that they have already done the work to accept it). They might sit on their final decision to accept it in order to make sure that it goes to Biden’s desk closer to 2024 elections. Again, given this is all a political calculus at this point designed for an upcoming election - we can expect that the administration will go full steam ahead on this at the most optimal timing for themselves politically. 

2. This changes everything for the cannabis space.

This change in classification means that marijuana would no longer be considered as something akin to heroin or LSD but instead as something similar to anabolic steroids – e.g. having a deemed benefit or potential therapeutic uses.

While states can have their own legislation regarding marijuana allowing individual entities within states to operate, this schedule 1 classification restricts cannabis companies from having access to banking, liquid capital markets, IP/patent protections, insurance and virtually any federally controlled program. Additionally, it prevents companies from having access to business deductions (e.g. SGA can’t be deducted from gross margins) and the conduct of business can’t occur across state lines. This creates a lot of distortions in the business operations and have made cannabis companies hard to invest in.

This classification change would mean that the Section 280e of the internal revenue code would no longer apply to cannabis – which would allow for cannabis companies to have access to business deductions, conduct research, and be able to conduct business across statelines. The latter will completely disrupt the current market structure of MSO’s and how they operate today and begin a shift to a more traditional adult CPG market structure e.g. like alcohol and cigarretes. 

The next question is how do you invest in this?

The reflexive response might be to buy a multi-state operator e.g., Cresco Labs, Cura Leaf. These are the folks who are vertically integrated – they cultivate cannabis and distribute and then sell it in their stores within the states they operate in. While these names will no doubt see a big up lift in shares as these events unfold – there is a better risk-reward in the NASDAQ listed Cronos (CRON) – which has better downside protection in the form of cash and hidden assets and is positioned to take advantage of what the marijuana space will ultimately look like as it has the best IP and the best potential distribution network.

As mentioned, the cannabis space today is distorted because of the byzantine regulatory frameworks and the lack of legalization. What this has all meant is that cannabis companies have to essentially do everything in state. 

You grow, manufacture, create brands and distribute and sell in one state.

That model doesn’t make any sense in a legalized future. The guy who makes your yoghurt, doesn’t own the cows that produce the milk nor does his own the stores where you buy the yoghurt. He’s focused on creating a great yoghurt that he then brands well and that you choose over other yoghurts.

Today an MSO may have an advantage in a state like Massachusetts because they have the most efficient cultivation facility there making them the low cost producer in the state.  But interstate commerce changes that because the most efficient facility in Massachusetts is at best half as efficient as an average facility in Oregon or Washington, etc.

In consumer-packaged products – you win by focusing on IP and branding.

When marijuana transitions towards a more traditional CPG model akin to what tobacco or alcohol are like today, owning the fields or the retail stores will not matter, but having the best IP and branding will. 

This is where Cronos comes in.

While MSOs have spent very little on R&D given the punitive cost of doing so given 280e, Cronos has focused entirely on developing IP and brands for both flower and edibles and they have a locked in distribution network through their global exclusivity deal with Altria. It’s reasonable to expect given comments on focus on preroll development, the Altria partnership and R&D spend that they will have a disruptive preroll product.

As some context, Altria gave them ~$1.8 billion in cash for 45% of the outstanding shares of CRON in 2019. Altria distributes Marlboro cigarettes across tens of thousands of retail channels in the United States and Cronos would be their partner, able to take advantage of this massive distribution network once cannabis is legal.

Today, Cronos trades as if there is little going concern value. The company has a market cap of $850mm and close to $850mm in net cash (with no debt). In other words, it trades for almost 0 enterprise value. Given the rise in interest rates, that cash on the balance sheet is a valuable asset that should spit off $50mm in net interest payments to themselves which will more than cover their current cash burn.

In addition to this cash, they have a number of hidden assets that could easily be monetized.

• Canadian business doing $70M in revenue
  • #1 edible brand in Canada sitting at 20% market share, which outperforms all leading US brands in market
  • Spinach is the #3 overall brand in Canada with each participating category holding a top 10 spot (#1 in edibles, #2 in flower, #7 in vapes, #8 in pre-rolls)
• Israel business doing $25M in revenue. One of the top 3 brands in the Israel market with approximately 15% market share.
• 6.3% ownership stake in PharmaCann one of the largest private US MSO’s. The stake is currently on the books for $49M
• 10% stake in Vitura, leading publicly traded Australian medical cannabis provider. This stake is worth approximately $19M
• Owns 50% of the equity in Cronos GrowCo a profitable growing operation. Generates quarterly interest and principal payments on $84M loan which Cronos Group lent to GrowCo
• And there is more cash coming in the door. The company announced they would sell their Stayner facility listed on the market for $19M and announced they would sell their Winnipeg fermentation facility (a former FDA pharmaceutical bio-fermentation facility) currently on the books for $24M

That more than protects your downside given the current EV. 

On the upside here, if full legalization proceeds ahead, then you have the company that has the best branded products, especially in edibles where they have roughly 20% of the market share versus their nearest competitor at 6%.

As this becomes more like a traditional consumer packaged goods market, their market position and their distribution nodes will matter in a way that it hadn’t before. 

Hard to fully quantify this upside, the stock would be up significantly from here. The reality is that CRON is built for what cannibas would look like as a normal CPG market while the MSOs are built for the current bizzare system we have. As the regulations move towards the former and away from the latter - CRON has the most to gain.  

Catalyst

- DEA accepting the scheduling change

- SAFE Banking

- Wyden/Schumer Bill