Canopy Growth Corporation
Q2 2020 Earnings Call Transcript

Published: 14 Nov 2019

[Operator:]

Good morning and welcome to Canopy Growth's Second Quarter Fiscal 2020 Financial Results Conference Call. Canopy Growth issued before financial markets today on November 14, 2019 a news release announcing its financial results for the second quarter fiscal 2020 ended September 30, 2019. This news release is available on Canopy Growth's website and has been filed on SEDAR. On the call this morning, we have Mark Zekulin, Canopy Growth’s Chief Executive Officer; Mike Lee, Canopy Growth’s Executive Vice President and Chief Financial Officer; and Rade Kovacevic, Canopy Growth’s President.

[Mark Zekulin:]

Thank you, Sharon, and good morning, everyone. Thanks for joining us. So a little bit of, I guess, housekeeping before we start; last quarter we -- or I guess I took the time to have a lengthy introduction to go over our strategy, remind people what it was and then confirm we're staying true to it. So I give you my word, we won't do the same lengthy summary this time. Mike and I, between us, will stick to probably under half an hour, we'll leave half an hour for questions and then we'll let everybody get back to the days. The second thing just to let you know there are four slides that we have put up on our website, which speak to as a complicated quarter, we decided to put some information down on paper about adjusted EBITDA, inventory levels, working up to normalized margins. So those are there. Mike will use those as he speaks a little bit later on. So, with that said, I think it is fair to say it's been a challenging couple of quarters in the cannabis sector. So I would like to first address that head on. Second, speak to what we, as a company, have done this quarter to adjust to some of these short-term challenges; and third, reinforce our view that over the medium-term and despite the current climate, we feel exceptionally bullish on how Canopy is set up to win. So, firstly, the big picture. To be clear, there is still an emerging global cannabis opportunity worth hundreds of billions of dollars across medical, pharmaceutical, CBD and recreational cannabis. However, we know the bellwether remains what is happening in the Canadian recreational market. It is the first national federally legal large-scale market opportunity for the sector to execute upon. And the market opportunity today is simply not living up to expectations and at the risk of oversimplifying the inability of the Ontario government to license retail stores right off the bat has resulted in half of the expected market in Canada simply not existing.

[Mike Lee:]

Thanks. All right. Thanks, Mark. Good morning, everyone. Let me first begin my remarks with a brief review of our top-line performance. Total gross revenue on products shipped during the second quarter of fiscal 2020 before charges of $32.7 million was $118.3 million, which is up 6% versus Q1 of the first quarter.

[Operator:]

First question comes from Vivien Azer with Cowen.

[Vivien Azer:]

Hi, good morning. Thank you so much for the question. Appreciate the color on the revenue target. Certainly you guys are not alone in calling out the challenges from a retail distribution standpoint limiting the revenue opportunity. But Mike, can you offer any more clarity in terms of what we should expect from a revenue perspective now that the $250 million is off the table? Thanks.

[Mike Lee:]

Yeah. So thanks Vivien. And Mark, I'll take this one. I think we’re seeing there are a lot of variables out there. We know what we can do. But if we just look short-term at what's happening we're waiting to see Cannabis 2.0 products get to market. We're waiting to see whether there are delays over Christmas or how that happens. Obviously, we're waiting to see the store rollout, and frankly we're waiting to – we think we've seen the provinces right-sized a lot of the inventory levels that they're holding, which a lot of analysts have talked about and seeing that production memorized. So we are feeling bullish, but on the other hand, I think there are just too many variables for us to try to give direct guidance on what the upcoming quarters look like.

[Vivien Azer:]

Okay. That's fair. Maybe just a follow-up then, on the U.S. CBD opportunity can you offer a little color on how we should think about shipments impacting your fiscal third quarter 2020. Seemingly, you'll be pushing some product into the market?

[Mike Lee:]

So – is that for events in Q3 or Q4?

[Vivien Azer:]

Well, I thought you were going to – you would have recognized some revenue in Q3, but if it's Q4 then yes, any commentary in the back half on revenue generation expectations for U.S. CBD please?

[Mike Lee:]

Yeah. I think our target remains Q4 of this fiscal, while it is potential some of that creep into Q3 I don't think there'll be anything material in Q3 to be quite honest. And we're – I'd say our hemp operations are now completing. We have the contract manufacturers in place. We have actual manufacturing underway. The team is ramping up. We have probably around 100 people in the U.S. now and a lot of head office resources going towards that. But like all things cannabis nothing is easy. The conversations with retailers aren't easy. The basics of setting up an online store are more challenging than selling a widget. So we work through all those things and are confident to see product in Q4.

[Vivien Azer:]

Okay. That's helpful. Thank you.

[Operator:]

Next question comes from Tamy Chen with BMO Capital Markets.

[Tamy Chen:]

Yeah. Thanks. First question is, I was just wondering, so on your assumption that you're making about Ontario 40 stores a month starting in January. So you're looking at Alberta as a precedent, but I'm just wondering, have you got a sense from the current Ontario provincial government? Are they ready to do something like this starting in January?

[Mike Lee:]

Yeah, it’s a great question. So I'd say two things. What we put out in that slide deck is as an illustrative case. So you can assume that going into that are tons of assumptions, about our market share, the sales per store, new products, all of that sort of stuff. But the big variable is how many stores are rolled out and mostly that Ontario. So I think the first point I would make is, we've modeled less stores, more stores and it shifts from -- maybe shifts from equilibrium in June to August and maybe it shifts inventory in hand from 4.5 months to six months or the other way around. But in virtually all of those models where we see any sort of Ontario rollout, we still feel good about where we are. To answer the question directly, I think the entire sector is putting a lot of pressure on the Ontario government. You've seen that we've done together, and they're certainly saying that they're going to do all those things, but we haven't seen the action. I think it's important to note that they have announced essentially roughly another 70 to 75 stores that will come regardless through the lottery system. So in some ways that speaks to some of those early months already stores in the process even if they don't do anything else, but we are confident we'll see in the next couple of months that they will make a move to sort of ensure that that number continues into the out months.

[Tamy Chen:]

Okay, thanks. And second question is. Mike, so I just wanted to confirm when you talked about the new pricing architecture was that specifically or only to the oil fuse in the rec market? Or does that pertain to flower too? Because what I'm getting at here is I noticed by my math your average net selling price net for rec on flower still is higher than some of the other peers that we've seen. And I'm just wondering, could there be potential downside there because we are seeing a number of LPs becoming more aggressive on flower pricing in the rec market?

[Mike Lee:]

Yeah, good question. So the ASP that you look at for dry flower quarter-to-quarter was down and product mix was the driver as we get our TWD brand in market in earnest. We are filling the supply chain. If you recall early in the year that was one of the brands that we were holding back as we were filling our flower channel. So now that that's out there. We expect that TWD will play a role but the mix in Q2 of our dry bud shipments was weighted more toward that as we fill that pipeline. The pricing architecture changes that we talk about for softgels and oils does pertain to softgels and oils across Canada. And I would think about it as a 5% to 7% price reduction on average depending on the provinces, there's some variation across the provinces. But I think 5% to 7% would be a good proxy of the architecture changes that we're making.

[Tamy Chen:]

Okay. Thank you.

[Operator:]

Next question comes from Chris Carey with Bank of America.

[Chris Carey:]

Hi, good morning.

[Mike Lee:]

Hi, Chris.

[Chris Carey:]

Hi. So I guess, I'm trying to get a sense here for, if things have really bottomed here right? Or if there is potential, I suppose cliffs ahead right because -- and certainly what the stock is doing pre-market, I think would indicate that the investment community is really looking for what actually is fundamental trough. And I think the decision to take the provision on oils makes sense, right? But then, I'm kind of scratching my head about this assumption for 40 stores per month in Ontario and Ontario's revenue per store is just so much higher than the rest of Canada which -- so it's a pretty significant driver of inventory depletion. And I guess I'm just trying to frame in my head, what happens if that doesn't occur, right? Because production was 40,000 kilos again this month or this quarter and I'm just trying to frame in my head, what happens if you don't get these 40 stores right because do you have to - do you have to like slow down your production? Do you have to shut down some facilities? What are the implications for gross margins? And obviously you have more mix coming to the equation. And so really all that together but the sort of philosophical dynamic that I'm trying to get at here is when we can get comfortable that things have sort of bottomed and maybe I'm just trying to kind of walk through that analysis and maybe I'm not quite there yet. So anything you can do to help me would be appreciated.

[Mark Zekulin:]

Yes, totally. And great question. I would say, if we park the question for a second and we look at everything else going on in the business, right? Our recreational market share is sitting north of 25% across the country in our view. Gross revenues prior to adjustments up 6% to $118 million. Canadian medical sales up, global Medical sales up, retail sales up, fifth largest retail network overall cannabis shipments up. So we feel provision aside, we feel very strong about the quarter actually. As you speak to the stores, again we put one illustrative case in there of the store openings. And today we are at a bit of that perfect store where provinces are working down inventories. Cannabis 2.0 is still yet to come and we have 60% of the population with only 10% of stores in Canada. I think if we look positively on that last one, it is such a big deal and it's actually such an easy solution, right? The government has recognized the need to have more stores. They've recognized that they want to explore their distribution models. They recognize that they want to move to an open market system. So I think for sure, you hit on the point. There is still a $6 billion Canadian market, when you convert the illicit market. That is all there. We're waiting for stores. We cannot -- to your point, if Ontario doesn't open stores for another year we all have a problem. I don't think we can -- why try to -- that. But there's no reason to expect that will happen. They've indicated they're going to open stores everybody is pressuring to open stores. Hopefully, they're listening to calls like this and considering the impact it's having on our sector. And I think we'll see that happen.

[Chris Carey:]

Okay. Okay, okay. Then maybe the other element which I just wanted to dig into a little bit is I fully appreciate the pre-revenue investments and I think we all understand what's in play here and it's a very large market with Huge TAM. And you guys are one of the few companies that actually has capital to make investments. And so it makes a lot of sense to do that. But I guess on the other end there's this dynamic of markets are coming together maybe a little bit slower from a legal standpoint and we all get that they're there and that revenue is there to be had. But with the quarter-over-quarter deterioration in free cash flow, I mean, is there an element here where you kind of say, okay, we get the importance of pre-revenue investments, but we also get this other dynamic that the market is coming together at a certain pace and maybe we need to be more dialed about the money that we're putting to work. And maybe, if you could comment on how you see free cash flow trends going forward. So is there anything there, would also be very helpful.

[Mark Zekulin:]

Yes. No. Thanks. And I'll let Mike speak to the free cash flow going forward. I think it's fair to say, we have built this company for the long term, as you say, though the long-term markets are all there. There are short-term challenges in Canada and even other places, as we look for more certainty in the U.S. And while we build for the long term, our focus on the long term, we're not naïve to the short-term either. So, over the last several quarters, we have actually been making tough decisions to limit certain research expenditures, limit certain hires to keep within the reality of what's happening. And I think, the other key thing to focus on is infrastructure and M&A. Right? I mean, we are in the fortunate position of having over $2.5 billion in the bank with our Canadian infrastructure essentially fully built out, with our European infrastructure essentially fully built out, with our global M&A program largely completed. There will always be opportunistic focuses, but we've filled all the holes we have. So, the big things that draw off our capital are minimized right now. We are being very prudent to make sure we look at current events, but we're also not taking drastic steps that will undermine our success in the long term, because speaking of cash flow we don't need to do that.

[Mike Lee:]

I would just add that, when you think about OpEx taking that part of the question first, Chris. From an OpEx perspective, there has been investment in back office capabilities over the last six to nine months and we are on the tail end of that back office investment. The G&A increases that you saw in the quarter are largely driven by one-time events, non-recurring events that will normalize in the next quarter. But our back office is largely in place. With respect to other operating expenses, we continue to balance investments in long-term strategy versus short-term results and we recognize that the Canadian market is six to 12 months behind where we thought it would be, given the store openings and we are continuing to challenge ourselves to make sure that we're scaling our organization appropriately keeping that in mind, but we are not sacrificing any of the longer-term investments that are multi-year investments, but any interruption to that would be highly disruptive to our strategy. So set that aside and when you look more broadly across our international markets, the U.S. continues to be our number one investment for operating expenses. And we've built a team of just north of 100 people on the ground and there will be continued investment over the next 12 to 18 months as the CBD scales up. More broadly, looking at free cash flow, we've put objectives in the public domain around expectations on Canada and how it's going to perform over the next year in terms of adjusted EBITDA, when do we expect to get the entire enterprise to adjusted EBITDA positive and all of that. But with that, thinking about free cash flow and the capital spending investments that were made, we're coming off of a major phase of investment from Canada and we are literally in the final stages of that and paying bills on the last part of it. And then our next wave of investment will be in the U.S., but it's a much smaller wave initially. So, our capital spending will be muted over the next 12 to 18 months relative to the last 12 to 18 months that you've seen. So, we would expect that our free cash flow will continue to improve over the next year to year and a half.

[Chris Carey:]

Okay. Thanks for those and I'll pass it on.

[Operator:]

Next question comes from Andrew Carter with Stifel.

[Andrew Carter:]

Hi thanks. Good morning. I think part of the issue in the first wave which kind of manifested this quarter's results has been really a lack of stability into the market just new and evolving. So, I kind of wanted to first start give a sense of where you think your capabilities are now versus throughout kind of the first way into kind of making adjustments and understanding that? And then also kind of how much is left your customers both provincials and retail stores. And then regarding kind of your visibility I think what is does your ability to make changes in the second wave increased significantly now so that you can kind of respond to customer demands more quickly?

[Rade Kovacevic:]

Yes. So, Rade here. So, I think several points on it. I think firstly, last year at the rollout of legalization, we had little to no data. We are looking at what U.S. markets had done but we had nothing within the Canadian regulatory context for recreational legalization while making production decisions. And so we looked at things such as soft gels and oil forecasted them to be 15% of the market and kind of be around 5%. I think the big change that we've had over the last 12 months is we now have data, right? It took about four to eight months for us to start gaining provincial asset till data. So, rather than simply the B2B sales, we're seeing what it's selling through the customers so that we could change our product portfolio and our mix and SKU rationalize to make sure we had the right SKUs in place that we're having pull-through and be able to have that continuous supply to build customer fairly. I think the other thing we've done well is working with the provinces in terms of routine meetings to make sure we are producing products that meet their demand. So, going back to average selling price and rack one of the good examples where we've been very successful is high TC products 20% plus, TCM flower, where we've been able to do very well take advantage of a gap in the sector on supply and that end and execute prudently. I think as we move into cannabis 2.0, what we've been able to do is take the demand we've seen and leverage that into our supply and demand planning for new products such as bakes, beverages, and chocolates. And I think our ability to scale advanced manufacturing products. And to your point on an agile basis or similar to how we deal with excise stamping, the automation of this manufacturing procedures allows us to allocate products, later in the process leading to shorter lead-times and ensuring that we can change our portfolio mix quite quickly to meet market demand. So, overall, I think we're confident we're taking a prudent approach noting, of course, that these are new products and with any innovation, there'll always be risk, but we feel pretty strongly about our ability to execute going forward.

[Andrew Carter:]

Okay. And you mentioned the second wave on the products. There's been quite a bit of investment there both internal M&A, the partnership with Constellation. In your initial kind of discussion with your customers' provincial and private operators, do you get a sense like on the pricing side, are they starting at where kind of the supplier pool for dry flower prices? Or are you getting kind of credit or kind of -- for the capabilities you bring to bear getting a higher kind of I guess share of the value chain with your second wave products?

[Rade Kovacevic:]

Yeah. So I think it's fair to say, it's not based off flower pricing. We're introducing over 30 plus products at the outs of Cannabis 2.0 with another 20 plus products coming over six months to 12 months thereafter. We've had great meetings with the provinces. Most of them at this point are pretty close to having finalized their listing process and we've had great reception. I think a good example would be on the beverage front. Our strategy as everyone knows from day one has been to disrupt beverage alcohol. And so pricing our beverage products at a slight premium to beverage alcohol is important, if it's going to be a direct trade-off. And the province have been very receptive to that approach and we're very happy with the outcomes on that front. On the vaporizer side, I think it's more looking at a number of occasion uses and so forth in terms of pricing. But I think the work that we've done to make sure that our products are serialized, that they’re tamper evidence, that they're RoHS, meaning no heavy metals in the equipment and UL certifications and so forth. All that work we did over the past two to three years to our tech R&D team is really coming out to pay dividends at this point to ensure that we have leading products that make customers in both provinces and retailers feel comfortable carrying our products. And so on the whole I think we're really happy with where our Cannabis 2.0 products have landed. We're happy with the price points in gross margin that we'll be able to bring forward with these. And thirdly, we're also happy with the ability to scale in reaction to market demand as more stores come online and these products start to gain market share.

[Andrew Carter:]

Thanks. I’ll pass it on.

[Operator:]

Next question comes from Doug Miehm with RBC Capital Markets.

[Doug Miehm:]

Thanks. I just want to go back to -- I know there's a lot of questions around those stores and inventory and that sort of thing. But maybe I can ask the question. If you get the go-ahead from the province in Ontario, how many of those 40 stores per month could carry your banner? And then I guess the other question really has to do with inventory, 4.5 months for dried flower is a long time. Do you think you're going to have to start to write-off inventory anyway?

[Rade Kovacevic:]

Yeah. So first I'll take the discussion of new store openings. So we've talked about having trademark licensing agreements in place, which is how we've had stores under our banners in Ontario. And I think there's a few important parts that come with that, but namely is the brand recognition, the ability of a consumer to go into a store, have a brand experience and leave that store saying, I really enjoy shopping at Tokyo Smoke, it leaves a lasting brand of that's a strong value-add on top of the products we distribute. And so the trademark licensing agreements we have in place have been very successful. You'll notice we're one of the top brands you'll see in Ontario today and I don't see any reason that would change going forward. In terms of the inventory, I think the important thing to remember is that under Health Canada's regulations, there's a lengthy quality assurance process, which of course is super important and we have over 300 quality checkpoints in our release process for product to make to market. So from the time you start harvesting a crop to actually is released and available for sale is about 45 days to 60 days so 1.5 months to two months. At that point, we then have to offer it to the provinces, they place POs, so that excise stamping goes out the door. So in a perfect world, it takes two to two-and-a-half months to have finished goods ready to go out the door to retailers. Of course, our provincial partners are looking for inventory consistency. And so, often they're looking for us to have four to eight weeks of supply in finished goods in our warehouse, so they can feel confident that when the product is doing well that they'll be able to have consistent access. So we see four to five months inventory as the ideal length of period for dry flower, to make sure we have continuity of availability. And so, from that perspective, what we're trying to highlight in the supplemental is, given that flower has approximately a six to eight month lead time to market. That we feel very happy with our inventory levels today and that they're setting us up for success both in terms of, if there's a slower store rollout that we have the right inventory levels, but that, if Ontario does hit that 40-month per mark, that we're able to scale quick enough and respond and really continue to dominate market share through that dry flower.

[Doug Miehm:]

Okay, great. And the other question to follow up, I just have to -- it has to do with the new CEO. Typically when new CEOs come in, they cleared the decks and make a bunch of changes and those sorts of things. Now, thankfully you've gone out and you've taken charges and made provisions and that sort of thing. But are there any places in your business where a new CEO, you think, could come in and make significant changes. And I'll leave it there. Thanks.

[Mark Zekulin:]

Yes. So, I think, what has set Canopy apart over these six years that has allowed us to grow into the leader in the sector, is the team we have. Right? So, a new CEO will come in, they'll have to assess everything and they'll run things in a different way and all those sort of things. But at the end of the day, we have built an incredible team, an incredible company and have full confidence that we have all the right people in place from the people on this call to people running IT, to sales, to marketing, to our international team. So I think what we're trying to do is, make sure, in fact, that the new CEO comes in and has time to understand a very complicated sector, knowing that he or she has the support of an incredible team. And I'm getting the hook here from Tyler, suggesting we've got on 30 minutes so I think -- good. So thank you everybody. Thank you for the questions. And I know we have probably a number of calls with people on this call going through the rest of the day. So thank you very much and we'll talk to you soon.

[Operator:]

This concludes Canopy Growth's second quarter fiscal year 2020 financial results conference call. A replay of this conference call will be available until February 14, 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. Goodbye.