Canopy Growth Corporation
Q1 2021 Earnings Call Transcript

Published: 10 Aug 2020

[Operator:]

Good morning. My name is Carol, and I will be your conference operator today. I would like to welcome you to Canopy Growth’s First Quarter Fiscal 2021 Financial Results Conference Call. At this time, all participants are in a listen-only mode. I will now turn the call over to Judy Hong, Vice President, Investor Relations. Judy, you may begin your conference call.

[Judy Hong:]

Great. Thank you, Carol, and good morning, everyone. Thank you all for joining us today. On our call today, we have Canopy Growth’s CEO, David Klein; and our CFO, Mike Lee. Before financial markets opened today, Canopy issued a news release announcing our financial results for our first quarter ended June 30, 2020. This news release is available on Canopy Growth’s website under the Investors tab and will be filed on our EDGAR and SEDAR profiles.

[David Eric Klein:]

Thank you, Judy, and good morning everyone. I hope that you and your families are keeping safe and well. Although we’re still navigating through a global pandemic, I’m proud of how Canopy has responded to the challenges during this period. Since the last time we spoke, we’ve seen our nation’s rally behind social justice and racial equality, which has placed the spotlight on the challenges we face as a society as these deep racial divisions are exposed. Our thoughts and prayers go out to all of those who have been impacted by racial injustice and associated acts of violence. Canopy recognizes our responsibility to do more to increase the representation of black, indigenous and people of color employees at every level in our organization, while investing in social justice initiatives such as providing access to legal services for communities disproportionately impacted by the cannabis prohibition. Our purpose at Canopy is improving lives, ending prohibition and strengthening communities. Recently, I signed the BlackNorth CEO Pledge to ensure that progress on this issue continues to be a top priority for our company. The goal of the BlackNorth CEO Pledge is to address systemic racism in the boardroom, and includes having at least 3.5% of executive in board roles in Canada held by black leaders by 2025. I see this as a vital initiative for Canopy, given the disproportionate impact cannabis prohibition has had on people of color globally.

[Mike Lee:]

Thank you, David, and good morning, everyone. Against a volatile macro backdrop and a continued dynamic market, Canopy delivered resilient financial performance in Q1, driven by diversified revenue sources and stronger cost discipline. In Q1, our net revenue increased 22% versus prior year. And total OpEx declined over 23% year-on-year, and CapEx continued to moderate both on a year-on-year basis and quarter-on-quarter basis. Our free cash flow was an outflow of CAD 181 million, which is over 50% improvement versus prior year. And we also maintained a strong balance sheet, with CAD 2 billion in cash and short-term investments at year-end. Now, let me review Q1 performance in more detail, starting with net revenue. We generated CAD 110 million of revenue or 22% growth versus prior year. Our global medical revenue increased 54% over the prior-year period, and we’re continuing to see strong growth in both our international flower business, with year-on-year growth of 181%, and C3 with year-on-year growth of 75%, in part due to the recognition of a full quarter of revenue in Q1 of this year versus a partial quarter last year due to acquisition timing. Adjusting for the timing of acquisition, our international medical sales grew 43% on an organic basis versus year ago. Our Canadian medical business grew 19% year-over-year as we lapped last year’s supply challenges, but enjoyed higher average basket sizes in Q1 of this year, in part due to pantry loading as a result of COVID-19. But we are pleased with our continuing ability to attract and retain veteran patients. And over the past year, the number of veterans that have registered with Spectrum has increased by 77%. Revenues generated by our strategic businesses increased by 70%, driven primarily by Storz & Bickel, which grew 76% year-over-year, and the increase was driven by strong consumer pull as well as expanded distribution in the US. This Works and BioSteel performed in line with expectations in the restricted COVID-19 environment. For BioSteel, an increase in sales from our ecommerce channel was offset by a significant decline in traditional retail sales caused by the closure of many brick-and-mortar retailers in Canada due to COVID-19. But we expect improved performance from BioSteel, driven by the easing of COVID-19 retail restrictions in Canada as well as expanded distribution in the US in coming months. Our Canadian rec net revenue decreased 11% year-on-year, due in part to the restricted cannabis retail operating environment in response to the COVID-19 pandemic as well as increased competition. Our B2B net revenue decreased 10% over the comparison period last year, with sales of new Rec 2.0 products being more than offset by declines in flower and pre-rolls, driven by increased competition and decreased market share. However, our rec B2B business saw sequential improvement through the quarter, driven by four factors. First, adjustments to our cultivation planning and supply chain drove short-term improvements in our ability to fulfill customer POs, with supply attainment increasing from 56% in Q4 to 87% in Q1. And in recent weeks, our supply attainment performance has exceeded 90%. Second, the continued rollout of our 2.0 product portfolio drove 13% of our B2B net revenue in Q1, up from 2% in Q4. Third, and as David highlighted earlier, our nimbleness to react quickly to the growing value segment drove improved performance for our value brand, Twd., starting in June with further improvement throughout the current quarter. And lastly, we believe the continued pace of retail store licensing and openings in key provincial markets, especially Ontario, contributed to increased sell-in during the quarter. And total active store count nationwide grew by 130 stores in Q1 versus Q4, with Ontario seeing 61 additional stores to now over 100 stores operating. Looking ahead, we expect the pace of store openings in Ontario over the next number of months to continue to have a positive impact on the sector sell-in into that province. And the province is delivering on its commitment to license 20 stores per month, meaning we can expect an additional 100 stores to be licensed by the end of this calendar year. Moving on, we are no longer providing our kilogram sold and average selling prices as our business shifts to a more diversified product line from flower. So, let me offer you some color on price and mix impacts during Q1. Our flower B2B business saw sales decline 20% in Q1 compared to Q4, driven by a volume decline of 5% and an average selling price decline of 15%. The decline in the ASP is mainly driven by geographic mix, as product sales in Alberta were lower and product sales in Ontario were higher, as well as a migration toward higher-sized package offerings. In Q1, Twd. accounted for 40% of our flower sales, up from 26% in Q4. And we expect continued declines in ASP in the current quarter as we’ve completed our value flower price pack architecture and now are in the process of resetting prices in certain mainstream flower products. In addition, with the expectation of a large number of stores opening in Ontario over the coming quarters, we would expect this to be reflected in geographic mix shift toward Ontario that will put further downward pressure on ASPs. We plan to provide volume price/mix changes by key format beginning with our Q2 financial results. Our B2C sales decreased by 12% over the prior quarter, primarily as a result of the continuation of store closures in response to COVID-19 pandemic through mid-May. It is worth noting that since our 22 corporate stores reopened in the latter half of Q1, B2C sales have returned to pre-COVID levels. With this, let’s now move on to a full analysis of gross margin for the quarter. Gross margins at 7% was below target. The biggest driver was an estimated CAD 18 million impact related to under-absorption of fixed costs resulting from lower production output, stemming from reduced demand and our SKU rationalization activities. Our Canadian cost structure relies heavily on throughput as we have built a large-scale infrastructure. And to put this in context, we believe the current infrastructure in Canada can support growth for us to become a CAD 2.5 billion to CAD 3 billion business without much additional capital spending. We’ve already proven that we can deliver 40%-plus gross margins and are confident that we will return to that level as we work toward higher capacity utilization across our facilities. Taking beverages as an example, with the robust demand we’re seeing for our beverages, we are ramping up production and the throughput of our beverage facility has doubled in July from June, and we plan to double again in August. And based on the continuing strong consumer pull we are seeing, our beverage facility could reach capacity much sooner than expected. In addition, overall cannabis legal sales are continuing to grow as more retail stores open up and new value offerings are helping to convert the illicit market. And as we capture our fair share of this industry growth, we expect further improvement in utilization of our facilities. In the meantime, we have a number of initiatives underway, both in the short term and the medium term that we believe will further bolster our margin performance. In the short term, we’re looking at ways to reduce our variable costs, including labor. In the medium term, we are focused on further optimizing production through a full end-to-end strategy that looks at people and process, technology and infrastructure that we believe will lead to best-in-class margins over time. And we plan to share details of this project at our next earnings call. Q1 margins were also negatively impacted by an estimated CAD 11 million charge related to manufacturing variances, which included out-of-spec production that did not meet new targeted THC ranges. In the quarter, we also recognized an inventory provision of CAD 5 million based on revised forecasts relative to our inventory holding policies. Now, let me briefly cover our operating expenses. Overall, SG&A decreased by 7% over the comparison period last year. Sales and marketing expenses decreased 25% year-on-year and 44% quarter-on-quarter, driven by a couple of factors. First, marketing and promo expense declined by over CAD 10 million versus the prior year due to delayed or canceled activities as a result of COVID-19 as well as elevated spending from last year to capture retail space. Second, compensation expenses increased year-over-year due to higher US investment, but Canada compensation expenses decreased due to head count reductions. And relative to Q4, compensation expenses declined by CAD 4 million, following our corporate restructuring actions and the temporary furlough of corporate retail staff due to the closure of our corporate stores. G&A costs increased by 2% year-over-year but decreased 18% quarter-over-quarter, due in part to a decline in professional fees, lower facility expenses and lower travel costs. R&D expenses increased 61% year-over-year, mainly driven by research studies that did not begin until Q2 of last year and increased activities to support Cannabis 2.0 product development. R&D expenses decreased by 34% quarter-on-quarter as we are now reallocating our R&D efforts to focus on projects that have high commercial return potential, with less emphasis on pharmaceutical-driven clinical trials. Stock-based compensation expense in Q1 decreased 63% versus prior year to CAD 28.6 million, in part due to the forfeiture of options resulting from staff reductions that occurred during the quarter. Stock-based compensation is expected to increase to approximately CAD 45 million in Q2 as forfeitures are not expected to occur at the same level. Next, I would like to discuss free cash flow. Our free cash flow in the first quarter of fiscal 2021 was an outflow of CAD 181 million, which is over 50% improvement compared to the prior year. Our working capital declined year-over-year due to lower inventory levels. And importantly, we ended the quarter with inventory of CAD 389 million, slightly down from the prior quarter. And while we have more work to do, we believe this demonstrates our effort over the past few quarters to better align our supply and demand. CapEx declined to CAD 62 million, down both on a year-on-year basis and a quarter-on-quarter basis. As you can see in our quarterly results, we are making progress against our key financial metrics that we presented at our June Investor Meeting. On profitability, we delivered a reduction in SG&A load as a percentage of sales, while we are working to get back to our 40% gross margin target. And on cash flow, we achieved a decline in both working capital and capital expenditures. Before I close, I would like to offer a few key factors to consider on Q2. First, from a net revenue standpoint, we expect gradual improvement in our Canadian rec business as store openings in Ontario should provide continued tailwind. Our strategic businesses should continue to see solid growth from a new product launch and expanded distribution, while we expect Storz & Bickel to see more normalized growth in the second quarter. Secondly, we expect our gross margins to continue to be pressured by under absorption of fixed costs in the near term and believe Q2 margins are likely to come in below 20%. Third, while we expect a sequential pick-up in marketing expenditures and trade promotion activities as COVID-related restrictions are lifted, we expect to see additional benefit from reduced head count as we complete our organizational review in coming months. So, to summarize, we are progressing against our strategic priorities, we remain focused on strengthening our commercial and operational execution, while maintaining our financial discipline. This now concludes my review of Canopy Growth’s financials for the first quarter of fiscal 2021. Operator, David and I would be happy to take questions from analysts.

[Operator:]

Thank you. Your first question comes from Vivien Azer from Cowen. Please go ahead.

[Viv Azer:]

Hi. Thank you. Good morning. I wanted to focus on your outlook for pricing. David, you noted some price realignments on vapes and then layered on top of that, obviously, the value launch. So, as we think about kind of the evolution of pricing, we’ve got a couple of negative mix drivers. Just trying to think about kind of order of magnitude, where you think you’re going to see the most pressure on the top line from the price deflation (00

[David Klein:]

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[Viv Azer:]

Thanks. And if you could just comment on the vape price adjustments that you mentioned?

[David Klein:]

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[Viv Azer:]

That’s helpful. Thank you.

[Operator:]

Your next question comes from Tamy Chen from BMO Capital Markets. Please go ahead.

[Tamy Chen:]

Yeah. Thanks. Good morning. Thanks for the question. I wanted to touch on the new high THC hurdles that you set on your product quality for flowers. So, when I think about your current grow (00

[David Klein:]

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I asked them to increase quality so that we can improve consumer pull over time and that includes the THC component, and the team has responded well. But it takes a while for that to pull-through at retail. So, you’re not even necessarily seeing the results of the work that we’ve done on shelf at retail yet. And then I asked them to give us a strategy to get us to best-in-class margins. That work is still underway. And as Mike mentioned, we hope to have some things to talk about on our next earnings call.

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[Mike Lee:]

Yeah. I think really looking at the 7% gross margin reported in that quarter, I think it’s easy to bifurcate out between volume impacts on lower production volume versus extraordinary activities that come back to execution. And the 7% is really a reflection of around CAD 18 million of fixed cost absorption tied to lower volume than originally planned for the year. And when you adjust for that and look purely at what should have happened for the quarter just based on those impacts, that brought us to around 17% or 18% margin for the quarter. And we think that’s a good proxy of what to expect over the next quarter or so. As volume starts to ramp back up, we see a clear path to getting back to the high 30s that we demonstrated for Canada back in Q4. The other thing that dragged our margin down is really just executional items. So, getting our pack dates right, so that we can ship product with enough shelf life before it goes to the province. There were some production challenges in terms of getting the phasing of production lined up in such a way that allowed us to provide for adequate shelf life. So, it gets back to what David’s talked about countless times, which is we’ve got to have the right quality and quality is the function of just not THC level and terpenes, but it’s also going about to have the right shelf life remaining. And that’s where the complexity of our operation comes into play, and this is where the SKU rationalization is really providing us with a much simpler framework to run our supply chain off of. So, my view is when you look at the supply chain in Smiths Falls, we clearly have a large scale facility and as this business matures, as the industry matures, the fixed cost leverage that we’re expected to see here, provides us not just runway to 40%, but we see going north of that over time.

[Tamy Chen:]

Thank you. Very helpful.

[Operator:]

Your next question comes from Andrew Carter from Stifel. Please go ahead.

[Andrew Carter:]

Good morning. I just wanted to ask and kind of pursuing the amendment with Acreage, I appreciate the potential reduction in dilution for Canopy and the downside protection here. But the disclosed business plan from Acreage suggests just 1% of the US market below your kind of 10% to 15%. I guess given the interest by Canopy in pursuing other options along not much work done to-date by Acreage, could you help us understand the incremental commitment here of at least CAD 87.5 million versus kind of letting this agreement run its course and potentially having full flexibility to pursue other options? Thanks.

[David Klein:]

Look, we think that Acreage, by their own admission, isn’t where they want to be. They have a really strong plan to correct those shortcomings, and we feel pretty good about that plan. I’d also say, Andrew, that the original transaction left very little wiggle room in terms of outs. And so, it wasn’t as simple as letting it play out and walking away.

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[Andrew Carter:]

Thanks. I’ll pass it on.

[Operator:]

Your next question comes from Bryan Spillane from Bank of America. Please go ahead.

[Bryan Spillane:]

Hey, good morning, everyone.

[David Klein:]

Hey, Bryan.

[Bryan Spillane:]

I wanted to follow-up on Vivien’s question earlier just about value and pricing. And I guess what I was thinking about was just you think about the value offering getting into the market, how do we think about just how much of that will lift in market share, right? So, taking share from the illicit market. And then how much of that might be offset from a trade down from the more value-added product into the value segment? So, I’m just trying to get an understanding of just what that trade-off might be between gaining share but also potentially it cannibalizing your existing business?

[David Klein:]

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I also think that we’re in our infancy as an industry, Bryan, in terms of trading consumers up and talking to them about the differences in experiences and quality that happens at different price points, and then demonstrating that with the products that we have in the marketplace.

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[Bryan Spillane:]

All right. Thanks, David. I’ll pass it on.

[Operator:]

Your next question comes from Pablo Zuanic from Cantor Fitzgerald. Please go ahead.

[Pablo Zuanic:]

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[David Klein:]

Yeah, Pablo, good question because there are something like 2,700 brands of CBD in the US, right? So, there are a lot of products out there. I think what we have the ability to do by using brands like Martha Stewart, by using brands like even BioSteel as it begins to gain traction and This Works as it gains traction in the US and First & Free, we have the ability to make sure that we get in front of the consumer to talk about our brands.

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So, we think there’s an opportunity for the leaders in the space that have high-quality products and have the ability to kind of penetrate the consumer consciousness with names like Martha Stewart, we believe that there’s a way to build a bit of a moat around ourselves and to create differentiation against the 2,700 brands that are in the space. And the other point that I would add to that is as we look to engage with major retailers, as the FDA works its way through its process and opens the door so that the major retailers come into the space, we’re getting a lot of mindshare from them because of who Canopy is and our connection with Constellation Brands. And then we bring in things like the Martha Stewart brand name and the This Works brand name, we believe that we’ll be able to get a leg up on the competition that at this point is just throwing those 2,700 brands kind of against the digital wall, if you will.

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So, we think there’s an opportunity for the leaders in the space that have high-quality products and have the ability to kind of penetrate the consumer consciousness with names like Martha Stewart, we believe that there’s a way to build a bit of a moat around ourselves and to create differentiation against the 2,700 brands that are in the space. And the other point that I would add to that is as we look to engage with major retailers, as the FDA works its way through its process and opens the door so that the major retailers come into the space, we’re getting a lot of mindshare from them because of who Canopy is and our connection with Constellation Brands. And then we bring in things like the Martha Stewart brand name and the This Works brand name, we believe that we’ll be able to get a leg up on the competition that at this point is just throwing those 2,700 brands kind of against the digital wall, if you will.

[Pablo Zuanic:]

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[David Klein:]

Yeah. We’re encouraged by what we’re seeing in Q2. The consumers are coming back to the stores. The number of trips are going up when we look at our own corporate retail. Dollars per transaction is up, partially due to continued stock-up activity, but as consumers are trying Cannabis 2.0 products, they’re actually spending more at retail. So, a lot of the fundamentals are strengthening across all of our corporate stores. And then more broadly, we think a lot of those trends are extending to the broader market. Just more trips and consumers are continuing to spend more per transaction. When we look at our own performance, a lot of it comes back to our fill rates that we talked about earlier. We are approaching our 95% fill rate, and that was a lost opportunity for us that we spoke about at our last call. And this is just a testament to the work that we’ve done operationally to really build in that muscle tissue to allow us to react to purchase orders as they come through on a much faster cycle time. So, look, there’s still lots to be done in terms of getting our fill rates up, getting in-stock rates up, a lot more stores need to be added to really mature this market, but we think Q2 is off to a good start.

[Operator:]

Your next question comes from Matt Bottomley from Canaccord Genuity. Please go ahead.

[Matt Bottomley:]

Good morning. Thanks for taking the questions. Just curious if you could comment a little more on where you see the beverage market going, particularly in the Canadian market for THC-infused. Given what we’ve seen in the US, it’s a very small percentage of the market share for these sort of 2.0 type products, but it’s not really formulated product down there. So, I guess, two parts to the question. One, where is the market right now with respect to the percentage of the overall retail dollars that we’re seeing? I imagine, it’s still pretty nascent, but just curious if you have a range of what percentage beverages are. And where do you see that going relative in the US, given that you’ve started on a pretty good foot year-on-year rollout?

[David Klein:]

Yeah, so, Matt, I’ll take part of it and Mike can fill in maybe where I miss because as a recovering beer guy, I love the trends that we’re seeing in the drinks market in Canada. We’re still sourcing a majority of our consumers from existing cannabis users, which makes a lot of sense, right? Because you have to make a decision to go into a dispensary and buy the product and take it home. We’re getting all kinds of anecdotal evidence of people bringing it home and finding that that typically ends up being the mother-in-law, but like the mother-in-law is trying the product hasn’t been a cannabis user, decides that it makes them feel great and maybe they’re sleeping better than they ever have in the last 10 years, right? And so, they’re starting to order from some of the web delivery platforms like an OCS. We’re hearing all kinds of stories like that.

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[Mike Lee:]

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[David Klein:]

And by the way, we’re not done, right? So, we have more drinks coming to market, and our innovation team is working like around the clock to understand what is the next version, what is the next iteration of our drinks product so that we continue to stay ahead?

[Matt Bottomley:]

That’s all very helpful. Thank you. And has the government come back at all with that are in these beverages? Because I would guess that you can’t really start selling things until that gets amended?

[David Klein:]

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[Mike Lee:]

We’re working on it. Yeah.

[Matt Bottomley:]

Thanks.

[Operator:]

Your next question comes from John Chu from Desjardins Capital Markets. Please go ahead.

[John Chu:]

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[Mike Lee:]

Yeah, John. So, look, what we’ve been pleasantly surprised by is stores continuing to open even during a pandemic. And our latest estimate is that by the end of calendar year, we could be in excess of 1,200 stores across Canada. So, we’re continuing to ramp up for that. As we dial in our supply chain and continue to perform in terms of PO fulfillment, as we continue to perform in terms of Cannabis 2.0 execution, more beverages, more chocolates, more vape out in the market, as we continue to round out our value offerings and as we continue to improve quality across the board, we see a lot of tailwind heading into the next six to nine months. What we don’t know is what the outcome of the pandemic is going to be. And we know that there’s potentially some solutions coming over the next six to nine months but in the meantime, this has been a pretty good defensive play. Consumers are still spending on cannabis. And with more stores coming, we think that’s going to continue to open up the market. And I know that there’s lots of questions around the future of pricing and value and all of that, but we believe that it’s growing the market, and we believe that we’ve got the production capability that’s going to demonstrate real strong potential as we build toward that market. So, all signs are good for Q2. And balance of the year is really just going to be a function of those stores continuing to open.

[Operator:]

Your next question comes from Doug Miehm from RBC Capital Markets. Please go ahead.

[Doug Miehm:]

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And then related to that, what I’m curious about is, is it more important for the company to fill its cultivation sites in terms of absorption, that CAD 18 million? Or is it more important to fill the drinks distribution and manufacturing site?

[Mike Lee:]

Yeah. Look, I’ll take a stab at this, and David, you can jump in. So, two things, on market share, we are seeing improvements in market share. Quite generally, I would say, we hit a trough in the April, May timeframe. And as we look at recent trends on share across the provinces that we can actually calculate market share for, we do see an uptick across Canada in terms of Ontario, Quebec, Alberta, BC. And we’re confident that that uptick is going to continue for all the reasons I cited at the last question. In terms of utilization of facilities, it’s an interesting situation in Canada today because so many LPs have such a surplus across their system. We’ve taken the steps of getting our supply chain in balance. And we know that in the short run, that might impair our gross margin performance as we experience lower utilization levels. And we also know some of our competitors are taking a different path, which is still continuing to operate at high utilization levels, but producing perhaps three or four times their sales each quarter in their harvest, which puts all that on their balance sheet, and that’s going to come back at some point in terms of surpluses. So, we feel good and that we’re balanced from a supply and demand perspective, we know that we’ve got continued opportunity to continue to improve our margins, and we think the priority right now is to maintain a balanced supply chain versus just filling up facilities to keep our economies of scale going. So, that’s the path that we’re taking. And again, we continue to believe that the next six to nine months for this industry are going to be very positive in terms of store counts. Cannabis 2.0 continues to build interest in this space, and we think that we are well positioned to take advantage of that over the next six to nine months.

[Operator:]

This concludes the question-and-answer portion of the call. And I would now like to turn it back to Mr. Klein for final remarks.

[David Eric Klein:]

Yeah. Thank you again for joining us. We look forward to sharing further progress in the coming months. In the meantime, I hope all of you will try our amazing products, visit our Tokyo Smoke and Tweed stores, explore our shopcanopy.com website. From there, you can go to our BioSteel and This Works website. There are just some truly amazing products out there, and we hope that they will help you understand the future of Canopy and the future of cannabis. So, I encourage you to do that. Our Investor Relations team will be available to answer any additional questions. Have a great day, everyone.

[Operator:]

This concludes Canopy Growth’s first quarter fiscal 2021 financial results conference call. A replay of this conference call will be available until November 8, 2020, and can be accessed following the instructions provided in the company’s press release issued earlier today. Thank you for attending today’s call, and enjoy the rest of your day. Good-bye.