Canopy Growth Corporation
Q2 2021 Earnings Call Transcript

Published: 9 Nov 2020

[Operator:]

Good morning. My name is Sharon, and I will be your conference operator today. I would like to welcome you to Canopy Growth Second 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 the conference call.

[Judy Hong:]

Thank you, Sharon, 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 second quarter ended September 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 Klein:]

Thank you, Judy, and good morning, everyone. I hope that you and your families are keeping safe as we begin to see COVID infection rates increase in all of our core markets. I’d also like to take this opportunity to thank our veterans across Canada and the U.S. as we prepare to observe Remembrance Day in Canada and Veterans Day in the U.S. I’m pleased with the continued progress we’re making, as our renewed strategy of winning consumer mindshare, along with increased agility and execution, drove record revenue in the second quarter. Before I discuss our performance, I’d like to take a few minutes to talk about how we see the U.S. landscape evolving, post last week’s election, and provide an update on our U.S. strategy. First, we believe, the Biden win is an important step on the path to federal permissibility of cannabis in the U.S. market through decriminalization and descheduling. Second, and maybe more important, the results of the ballot initiatives clearly showcase that support for adult-use marijuana legalization extends across geographic and party lines and is supported by a majority of Americans. Legal marijuana is becoming the American norm as ballot measures passed in Arizona, Mississippi, Montana, New Jersey and South Dakota. 36 states plus Washington D.C. have now legalized cannabis for medical or recreational purposes. This will likely increase pressure on Congress to pass major federal marijuana reform in the very near future.

[Mike Lee:]

Thank you, David, and good morning everyone. During Q2, Canopy achieved record net revenue, gross margins came in line with our expectations, and we saw another quarter of improvement in our operating expense ratio. Our free cash flow was an outflow of $190 million, which represents an improvement of 57% over the prior year, and we ended the quarter with over $1.7 billion in cash and short-term investments at quarter end.

[Operator:]

First question comes from Bryan Spillane with Bank of America.

[Bryan Spillane:]

Hey. Good morning, everyone. David, I guess, I wanted to step back and just ask about the cost savings that you announced this morning or described this morning. And I guess, two questions related to that. One is, what does that contemplate in terms of, I guess, the evolution of the U.S. market? And I guess, what’s underneath my question is, is that subject to change if the market opens faster if we get like a full federal legalization? And then, second, I guess, related to it also is in terms of pacing, can you give us any sense of just how quickly you think you can achieve those goals?

[David Klein:]

Yes. So, Bryan, so in terms of the cost reductions, they’re mostly focused on the Canadian market. We continue -- one of the reasons -- one of our drivers of our loss is that we continue to invest ahead of revenue in the U.S. Although we see that swinging around as we begin to grow revenue in the U.S., as we discussed throughout our prepared remarks. So, the U.S. activity wouldn’t necessarily affect it. Now, that said, I think, we should be really clear that if we get a permissibility triggering event in the U.S., it’s probably a 60-day window to -- until we would be able to take over full control of Acreage, at which point we might want to bring our balance sheet, our knowhow and our brands to bear on the U.S. market. So, I would hold that a bit off to the side, but that will not affect this $150 million to $200 million savings initiative that we outlined. And then, in terms of speed, we’re really talking about implementation. And so, we’ve begun the implementation process already. The real timing of when it comes through our P&L will mostly be affected by the length of time in that execution, which won’t be that long and then flow-through from inventory.

[Bryan Spillane:]

All right. Thanks. And then, I guess, that was what really underneath my questions is as we’re thinking about flowing through the savings -- I just want to make sure I’m hearing it correctly. It’s possible that it would be impacted by the triggering event, right? So, if there’s a decision or an opportunity to invest, that might affect how much of the savings you decide to flow through versus invest, at least in the medium term?

[David Klein:]

Yes. So, I would -- now I understand your question, Bryan. So, maybe just around semantics. So, would we -- we’re going to continue to execute on these initiatives. However, as I said, if the U.S. were to open, I think, we would want to make sure that we took control of Acreage as soon as possible, and then we would begin to try to build out that market. But, we’re also seeing that Acreage has a pretty clean path to profitability. And so, it’s quite possible that we could -- we wouldn’t slow down our timeline to profitability, even as we invest in the U.S.

[Operator:]

Next question comes from Michael Lavery with Piper Sandler.

[Michael Lavery:]

You’ve talked a lot about the 2.0 opportunities. And now, we’re lapping a year ago, the write-down on oils and softgels. But, it’s interesting that the product splits you give for Canadian rec, show those sales to be pretty similar. How should we think about -- and softgels and oil is actually up pretty significantly. How should we think about the opportunity for 2.0 relative to your expectations, and what’s ahead? Is it tracking where you expect it to? Should we see a step up from some things like the Quatreau launch, or how does it look against where you expected us to be at this point?

[David Klein:]

So, I’ll start out, Michael, and then I’ll let Mike fill in. But, I think, the write-down last year was really more about misestimating how quickly the market demand would arrive. But, we are seeing good demand in the market for softgels and oils. And the same kind of issue, maybe as we launch drinks, as you’re going through channel fill and trying to understand the consumer demand, you have to build -- in the drinks instance, we had to build our production to meet that demand. In the oil and softgel instance, we had a slow production down. So, I think it’s just the nuances of launching products in new products in a new industry that have maybe created some of the fits and starts, because I would say, in general, we’re happy about how we’re growing across all of the categories in 2.0.

[Mike Lee:]

Yes. And it’s a very broad question, Michael. So, just on the softgels and oils, the softgels and oils are a lion’s share of the medical channel and continue to perform well. As you know, the medical channel, patients have decreased month-on-month since the rec channel was created two years ago. But within that medical channel, patients, the retention rate has been high, the spend per patient continues to grow, and it’s been quite a stable business for us from a price and volume perspective. Looking more broadly at 2.0 in terms of what’s coming and what the learnings have been and what you can look from Canopy over the next several months, look, we’ve looked hard at our vape portfolio and recognize that price continues to compress within the vape category. We will be introducing cartridges later this year that increase the fill rate from 0.42 to 0.5 mls, which will get us more competitive in the market. We’re -- we’ve done some price resets on the chocolate category, and we’re continuing to plan for new product introductions there as well. And then, it really is about leaning into beverages in every way, shape or form. We’re excited about our results, but we’re also excited in some ways that competitors are also validating the space and bringing new offerings into the category, because we believe that’s going to further build the category, and that’s going to further open up points of distribution over time, putting pressure on the provinces to provide for on-premise consumption and things like that. So, we welcome the competition. We think our beverages will stack up against any competitor out there and more coming from Canopy over time in the beverages category as well.

[Operator:]

Next question comes from Vivien Azer with Cowen.

[Vivien Azer:]

Hi. Good morning. Just recognizing your desire to consummate the Acreage deal but also acknowledging the Republican control, the Senate is probably a pretty meaningful limiting factor there. It seems like your focus needs to continue to be market share for the adult-use market in Canada. And in that vein then, David and Mike, I’m curious to understand how you guys are thinking about navigating kind of the tension in your operating model relative to retail operators. You guys kind of uniquely have a big retail presence. Some of your retail competitors have not taken kindly to that. So, how do you think about managing your access and shelf space in terms of driving overall market share? Thanks.

[David Klein:]

Yes. So, look, Vivien, this is an issue that a lot of companies, as you well know, wrestle with. I think that there’s an opportunity for us to bring the learnings that we take from our Company-owned stores and pass them on to our retail partners in the marketplace. So, I think there’s a way that we can really make sure that we’re a value added partner. We’re not looking to build retail locations across Canada. I think, we’re fairly comfortable with the footprint that we have today. And so, yes, I understand that there’s the risk of channel conflict, but we believe that we’re going to be open and helpful to our retail partners in such a way that make it a positive experience.

[Mike Lee:]

I would just add to that that channel conflict is not new to Canopy. We’ve experienced that over the times in the medical channel, even with some of our craft grow partners, this is something that Canopy has had experience with over a number of years. And at the end of the day, we have very strong relationships with many of the key accounts across Canada, and they want our brands. Our brands are growing in terms of popularity, as demonstrated by a market share, and these retailers want our brands. So, clearly, it’s a fine line to walk, but we rest on the strength of our brands.

[Operator:]

Next question comes from Tamy Chen with BMO Capital Markets.

[Tamy Chen:]

I just wanted to ask a little bit more on the cost savings initiative that you’ve announced. I guess, just two quick parts. First is, can you help us understand in your Canadian business, what you envision sort of the final footprint or asset base to look like coming out of this? And then, just secondly on this, you’ve described this as accelerating the profitability in Canada. I think, if we kind of take a step back in some of your previous comments, it sounded as though you were looking to take a bit more of a gradual tackling to cost because you didn’t want to affect your ability to grow. So, I’m just wondering, just with the language of accelerating, has something changed in your outlook of growth in Canada that’s prompted the sort of acceleration? Thanks.

[David Klein:]

No. Not at all, Tammy. I think what’s actually changed is we -- it was important to me that we didn’t come in -- and when I came into the Company anyway and just start cutting things, that would be detrimental to building brands, connecting with our consumers and growing our top line. I feel that we now have -- we’ve gone through many, many months of reorganization on the commercial side of our business. And so, we now feel we have the right commercial organization, the right product and marketing organization. We’re beginning to build that insights muscle and we’ve really focused the innovation muscle in the business. And so, now that those things are in place and they’re beginning -- it’s very early, but they’re beginning to produce some results. Now, we can really look at the areas of our business that are -- we just haven’t been running efficiently because we grew so quickly. And so, we worked through an outside-in process where we looked at the entirety of our cost infrastructure. And now, we have a very clear view as to where we need to go. And Mike can provide more details on what that might look like.

[Mike Lee:]

Yes. It’s a great question, Tamy. When you go back to the March announcement, when we announced the closure of our facilities in Vancouver, in many ways, that was a no regrets move that was easy to make based on how the facilities were performing and call it the near to medium-term requirements from a supply and demand perspective. We just weren’t remotely balanced at that time. And a lot of this -- again, just to remind everybody, this comes back to how quickly this industry has evolved. Everyone can agree, it’s evolved slower than what everyone expected. And hence, a lot of LPs have had a bit of an overhang. That being said, for the last several months, we’ve been in deep, deep analytics on our entire operations and supply chain, and have now built a fact-based, data-driven approach on all the elements that we need to go after in order to achieve what’s really -- we talk about 40%, but our aspiration is to have a real CPG P&L with margins even in the excess of that. So, we’re pushing ourselves really hard on this. And what we’ve learned is across our operations and supply chain in Canada, there’s really four broad themes of opportunity. Number one, we bid off too much complexity across the business. We have too many finished goods SKUs in the market, which is a natural outcome of a brand-new market where Canopy, like many other licensed producers, were aggressively introducing as many products to the market as possible, without having real consumer insights or history on what consumer needs were. And now that we’re two years in, we’ve got a very honed view on what SKUs matter and which ones don’t. So, SKU rationalization is going to be key. Cultivar rationalization is also going to be key. When you think of the economics of a greenhouse, cultivars drive complexity, and complexity is a drag on productivity. So, we are going to rationalize cultivars. And again, based on consumer insights and based on design-to-value to make sure that we are just as competitive, if not more competitive, on the other side of this program, to make sure that we’re not burning furniture, if you will. So, that’s one, managing complexity. Number two, optimizing our network. So, we’ve continued to challenge ourselves on our site infrastructure. We’ve continued to hone the purpose and strategy behind each facility. Some facilities are really great at quality, some are really great at volume, but there hasn’t been a good marriage between what that facility is doing today and what it should be doing. So, we’re restructuring each of our facilities so that they really are purpose-driven with the KPIs that are tied back to that strategy. We’re also going to optimize our extraction capacity. Extraction today looks very different than it did two or three years ago when most of the LPs thought that was going to be a bottleneck capability. Well, today, we’ve got plenty of capacity and we have an opportunity to drive savings through rationalizing our extraction capacity. We think that in that same vein, we have tens of millions of dollars of procurement savings, both direct procurement savings tied to procurement for items that go into our production process as well as procurement savings on indirect items, meaning items that aren’t involved in production but are more around the OpEx side of things. So, that’s number two. Number three, improving processes and improving our operating model. We’ve made a lot of progress on fill rates, getting to 90%. But, the inverse of that is we’re missing 10%. And we believe that we can get to 98% or 99% over the next year to two years by optimizing our S&OP processes, honing our demand forecasting and really making sure that we’re producing the right product at the right time with the minimal amount of inventory. Increasing productivity is the fourth area of opportunity, and this is around org structure and making sure that we’re right-sized for the current state of the organization but also making sure that our supply chain is productive on things like use of backhaul routes that we’re paying for or migrating to more competitive common carrier rates or even looking at packaging opportunities, using design-to-value, where many on this call have talked to me about some of our packaging being over-engineered in the past. So, we’re going after that. So, those are really the four pillars of this program, and they’re all phased out over the next two years. And I can tell you, without getting into the phasing of how this lands in each quarter over the next two years, that we are going to pursue as much of this as quickly as possible with a forward-leaning approach on infrastructure. And hopefully, that gives the street confidence that we’ve done the homework here, and we’re very confident that we can deliver this over the next two years. Dave, anything else you want to add?

[David Klein:]

That’s good.

[Operator:]

Next question comes from Aaron Grey with Alliance Global Partners.

[Aaron Grey:]

So, I want to dive back in terms of the incremental flower sales we saw in the quarter. It was good to see, obviously, a lot of that was driven by Twd and your large-format value segments. Just wanted to get to any color you could provide on the sell-through, especially in terms of retail and some initial consumer adoption? Because, obviously, still a pretty competitive category. It seems like you still saw some market share growth in October from your commentary in the prepared remarks, but just any incremental color you can provide there as there’s still a lot of your competitors out there who are also competing in that low price value segment? Thanks.

[David Klein:]

Yes. We’re very happy with the progress that we’ve made on all of our flower products, including Twd and Simple Stash. Simple Stash has been a good opportunity for us to help balance our inventory, and Twd has just been a good value proposition. We’re offering that in packages up to 28 grams, and there’s been strong demand. We’ve continued to build out distribution across Canada. I’d say, we’re just about there in terms of the distribution build-out. So, look, it’s a valid category. Our market share entail tells us that it’s going to be it’s around 30% to 33% of overall flower consumption today. And when you take a step back, this category likely would have existed last year at this time, had not every LP been short on supply. Every CPG category that I’m familiar with has a value hierarchy, and we think that the value category is here to stay. Big question will be what’s going to happen with value category pricing over time? I’m of the opinion that it will continue to move around, but over time, it’s going to start to tighten up. But, time will tell on that. The key is making sure that we’ve got the right production strategy behind each tier of product, which ties into my earlier remarks, which is making sure that every one of our facilities is purpose-driven to make sure that we’re growing the right product for the right category out of the right facility and hitting the right cost. So, we believe, even at the price points that you see in the market, we can hit our margin targets with Twd being a third of our business over time.

[Mike Lee:]

And the thing I’d like to add to that, Aaron, is that we have a couple of objectives. One is to grow our market share, which means we need to sell the consumers what they want at the price point that they’re willing to pay, which is why the insights work that we’re doing is pretty exciting because we think it’ll position us to drive a little bit of a trade-up on attributes that are relevant to the consumer. And we’re also looking to balance our inventory. We’re not interested in showing good gross margins this quarter only to have to have big write-offs in the future. And so, we’re working toward that balanced inventory. And I would say, we, for the most part, achieved that this quarter. And then, irrespective of the price points, we’re committed to achieving that at least 40% gross margin number that we put out. So, we think that the value category is actually helpful on all of those three points that I just made. And we’re actually really pleased with where we’re able to get to in the quarter with it.

[Operator:]

Next question comes from Andrew Carter with Stifel.

[Andrew Carter:]

I had to double-click on the beverages for a second because in the Headset data we have, it showed the sales did plateau early and it kind of declined. And some numbers you’ve given on shipments that would suggest you’re kind of quarter-to-date, I think it’s 300,000 units. I think you did 150,000 units last week of June. That’s what you said in the Investor Day. It doesn’t seem like shipments are picking up. So, could you help us understand kind of what you’re seeing with the traction by the consumer of that platform? Thanks.

[David Klein:]

Yes. So, I think what we’re seeing is, we continue to get strong consumer response. I would say that as competitors come into the space, we do know that we’re getting trial across the competitive entrants, but the repurchase rate on our product remains pretty high. And as Mike said, I think, bringing as the point here is we have to grow the whole category. And so, I would say, the biggest barrier to growing the category is really going to be related to equivalency standards changing over time in Canada, so that people can buy more than a couple of units at a time. And then, we think the entire category gets to grow. And right now, I believe the latest data I saw, we have five of the top seven SKUs in the marketplace. And we feel pretty good with our positioning. But yes, we are looking forward to being able to grow the entire category, which means we’re going to need to see a bit of a move from a regulatory standpoint.

[Mike Lee:]

And just some of our consumer insights on beverages are quite compelling. Our data tells us we have a 70% to 80% satisfaction rate that we have greater than 75% satisfaction with taste across Tweed and Houseplant brands. 60% of customers are recommending our product to other consumers. And at the end of the day, it’s a bit of the remarks that I made earlier, which is building this category is a positive thing because the biggest gating item is points of distribution. So, we’re optimistic that that will start to open up over time. And then, from a production perspective, we’re ready to grow. We’ve done a lot of work within our beverage facility, and we can grow this business significantly with no additional CapEx. So, we’re excited about it and look forward to continued growth.

[Operator:]

Next question comes from John Zamparo with CIBC.

[John Zamparo:]

I wanted to ask about the other revenue line. I know, you don’t disclose exact numbers, but can you give some sense of order of magnitude on the three largest business units in that category? It does seem like it’s growing quite materially. So, it would just be helpful to get a better understanding of those three. Thanks.

[Mike Lee:]

Yes. Sorry, we don’t disclose that. Maybe at some point we will start to disclose it, but for the time being, we’re not.

[Operator:]

Next question comes from Glenn Mattson with Ladenburg.

[Glenn Mattson:]

On the medical side, can we just talk about that for a little bit? First, on Canadian, you said I think that it was up 7% sequentially, I believe, in Canada due to higher order sizes. So, curious what drove that, like maybe people are stocking up because of pandemic levers or maybe it’s transitory? So, anything on that? And then, the international side, I realized, like might be a little bit hard to forecast in the next -- in a very short period because of various countries going to shut down and things. But, maybe you can give us some detail or some color on how you think your stack up competitively as the markets have matured a little bit. Thanks.

[Mike Lee:]

Yes. I guess, taking the Canada medical business. I mean, it’s another strong quarter in Q2, matching performance in Q1. And it’s up 7%, 8% over prior year. And look, I get it, Health Canada continues to report declines in the medical market and the count of registrations continues to go down. I think, there was an extension, an auto extension of prescriptions up through, I think, certain patients that have subscriptions -- prescriptions could extend up through December. But, look, we see growth across all the products that we’re seeing in the medical channel in Canada. Vapes are starting to materialize in the category. Softgels and oils continue to grow. Flower continues to grow. It’s been a healthy business for us. That being said, over the next five, seven years, the business is probably going to moderate as more and more patients convert to the rec channel. But, for now, it’s been a very healthy and profitable business with strong gross margins. Internationally -- did you want to add something, Dave? Internationally, look, we have seen some more competition on the C3 business. I think, the first new entrant into the dronabinol business came in Q2. And we know that with the prescription model in Germany that providers are required to provide the lowest cost alternative, which is something that we’ve modeled out over time. But, with the gross margins that we have on C3, we’ve got plenty of opportunity to compete, and we’re committed to keeping our number one position. And then, in Q2, we did have a bit of a production disruption really tied to a one-off that has already been remediated. So, we would expect C3 to return to growth. And then, for the flower business in Germany, again, there has been a little bit more disruption from COVID-19. We haven’t had our sales guys on the street as much over the last few months as there’s been a bit of a lockdown, and we did have a small supply interruption there as well. But again, we’ve been very encouraged with the German flower business and the C3 business over the last year. And it was really the beginning of an inflection point about six months ago when our German flower business really started to grow. So, we still think, it’s a big growth opportunity for us going forward, and we think it will be a profitable growth opportunity going forward.

[Operator:]

And at this time, I will turn the call over to Mr. Klein.

[David Klein:]

Thank you, again, everyone, for joining us today. As we approach the holiday season, I hope that all of you get to experience our amazing products, including Martha Stewart CBD gummies in the U.S. and our newly released Quatreau drinks in Canada. And our Investor Relations team will be available to answer any additional questions throughout the day. Have a great day, everyone.

[Operator:]

This concludes Canopy Growth’s second quarter fiscal 2021 financial results conference call. A replay of this conference call will be available until February 7, 2021, 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. Goodbye.