Cresco Labs Inc.
Q3 2020 Earnings Call Transcript

Published: 18 Nov 2020

[Operator:]

Good day and welcome to Cresco Labs’ Third Quarter 2020 Earnings Conference Call. All participants will be in a listen-only mode. Please note this event is being recorded. I would now like to turn the conference over to Jake Graves, Investor Relations for Cresco Labs. Please go ahead.

[Jake Graves:]

Good morning and welcome to Cresco Labs’ third quarter 2020 earnings conference call. I am joined today by our Chief Executive Officer and Co-Founder, Charlie Bachtell; our Chief Financial Officer, Dennis Olis; and our Chief Commercial Officer, Greg Butler, who will be available for Q&A. Prior to this call, we issued our third quarter 2020 earnings press release. This document has been filed with SEDAR and is available on our Investor Relations website at investors.crescolabs.com. We plan to file our financial statements and MD&A for the 3 and 9 months ended September 30, 2020 on SEDAR subsequent to this call. Before we begin our remarks, I would like to remind everyone that certain statements made on today’s call may contain forward-looking information within the meaning of applicable Canadian securities legislation as well as within the meaning of the Safe Harbor provisions of the United States Private Securities Litigation Reform Act of 1995. Such forward-looking statements may include estimates, projections, goals, forecasts or assumptions, which are based on current expectations and not representative of historical facts or information. Such forward-looking statements represent the company’s beliefs regarding future events, plans or objectives, which are inherently uncertain and are subject to a number of risks and uncertainties that may cause our actual results or performance to differ materially from such forward-looking statements, including economic conditions and changes in applicable regulations. Additional information about the material factors and assumptions forming the basis for our forward-looking statements and risk factors can be found under Risk Factors in Cresco Labs’ public filings available on www.sedar.com. Cresco Labs does not undertake any duty to publicly announce the result of any revisions to any of its forward-looking statements or to update or supplement any information provided on today’s call. In addition, during today’s conference call, Cresco Labs will refer to some non-IFRS financial measures such as adjusted EBITDA and operational gross profit, which do not have any standardized meaning prescribed by IFRS. We believe these non-IFRS financial measures assist management and investors in understanding and analyzing our business trends and performance. Please refer to our earnings release for the calculation of these measures and reconciliation to the most directly comparable measures calculated and presented in accordance with IFRS. These non-IFRS financial measures should not be considered superior to, as a substitute for or as an alternative to and should only be considered in conjunction with the IFRS financial measures presented in our financial statements. Please also note that all financial information on today’s call is presented in U.S. dollars, unless otherwise noted and all interim and financial information is unaudited.

[Charlie Bachtell:]

Good morning, everybody and thank you for joining us on the call today. We hope you and your families remain healthy and well. We had the privilege of speaking with you today about the fastest growing industry in the United States. For those who have participated in the U.S. cannabis sector for a long time as an investor, a patient, an employee or a business owner, we echo your excitement for where this industry is heading. Simply put, cannabis is well on its way to $100 billion industry and is now a permanent feature of our economy, producing the highest organic revenue growth in the sector for the second quarter in a row. Cresco Labs has instantiated itself within the very top tier of the industry. I will begin with some highlights from the third quarter and review the five specific ways Cresco Labs has been delivering growth and shareholder value in 2020. Dennis will provide a discussion of our financial results and capital position. And then we will conclude our remarks with some comments on the recent U.S. election and its impacts on our industry. After that, we look forward to answering your questions. Our thesis remains that you win this industry by building the most strategic geographic footprint establishing meaningful material positions in each of those markets and prioritizing the middle two verticals of the value chain. The acceleration of our growth this year is a reflection of the value of our differentiated strategy. We are telling the unique story of strategic breadth, depth and execution. Because of the investments we have made, the changes we have managed through, and the hard work devoted by our team over the last 12 months, Cresco Labs entered the third quarter firing on all cylinders. Revenue in Q3 was $153 million, an absolute increase of $59 million, or 63% sequentially. This is our third consecutive quarter of more than 30% sequential top line growth. With $90 million in net wholesale revenue, we are the number one operator in the industry focused on the wholesale distribution of branded products. With nearly $63 million generated from our 19 stores, our retail platform is outperforming. During Q3, we also substantially increased operating leverage and profitability with adjusted EBITDA of $36.4 million, or 30% of revenue. To top it off, we generated our first full quarter of positive free cash flow in addition to positive net income.

[Dennis Olis:]

Thank you, Charlie and good morning everyone. I will start by saying that as a company and as a management team, we could not be more proud of the results this quarter. Our team has shown an outstanding ability to execute our strategy. And after a period of investing in our infrastructure, the hard work is now being shown in the numbers. I will begin my remarks by reviewing the financial highlights from the third quarter then discuss our balance sheet and capital position. Please note that all numbers are stated in U.S. dollars. Revenue in Q3 was $153 million, an increase of $59 million or 63% sequentially. Allow me to repeat that, we grew our top line revenue by 63% in one quarter. This marks the third consecutive period of more than 40% sequential revenue growth. Revenue mix in the third quarter was comprised of 59% wholesale and 41% retail were achieving growth across our footprint as we continue leading in our top 3 states and see increased contributions from other markets. On top of the substantial top line growth in Q3, we also had record operating margins, increase profitability and positive free cash flow. Third quarter operational gross profit grew 82% sequentially to $18.6 million and margins increased by 600 basis points to 53%. As we expected, the cost associated with the expanded cultivation facilities normalized in Q3 and we saw a material increase in gross profit. We are really pleased with the margin improvement this quarter and believe there is additional upside as we strengthened our vertical operations in other states. Q3 SG&A as a percent of revenue was 31% compared to 48% in Q2. Excluding share-based compensation and one-time cost, SG&A was 26% of revenue compared to 35% in Q2. As Charlie mentioned, comparing Q1 to Q3, our revenue increased by $87 million, while our SG&A expense was flat. As we continue to make investments in our people and our platform to support future growth, we expect SG&A as a percent of revenue will continue to trend downward. Third quarter adjusted EBITDA was $46.4 million, a 182% increase from Q2. As impressive as the sequential revenue growth was, the growth of adjusted EBITDA quarter-over-quarter was even more remarkable. Net income for the third quarter was $4.9 million. We continue to believe adjusted EBITDA is the best measure of our performance as it does not include the impact of biological assets and other mark-to-market items, which can cause quarter-to-quarter volatility. Q3 operating cash flow improved significantly to $18 million compared to a negative $10 million in Q2, a swing of approximately $28 million sequentially. Operating cash flow would have been even more impressive, but for this year’s unique concentration of tax payments in Q3. Third quarter CapEx was approximately $10 million as we opened 2 new retail stores and made investments in automation at several of our production facilities. At the end of Q3, we still had approximately $50 million in tenant improvement allowances available to fund the expansions of our cultivation production facilities in Michigan, Massachusetts, and Ohio. This $15 million is in the addition to the cash on hand. The combination of these items resulted in our first quarter of positive free cash flow. Cash and cash equivalents at quarter end was $57.7 million. Along with our tenant improvement allowances, we expect to be able to fund our near-term growth projects without the need for additional capital. As we look to deepen our market positions in our existing geographical footprint and evaluate opportunities in other states, we will remain opportunistic. While our track record of execution and results give Cresco Labs ample access to capital, we will continue to be responsible stewards of capital, make decisions that align with our growth plan and act in the best interest of our shareholders. Because of the investments we have made over the last 12 months and the hard work devoted by our team, Cresco Labs entered the third quarter firing on all cylinders. Our results substantiate the value of our differentiated strategy and we will continue to execute on our plan to capture growth in the years to come. Thank you for your time today. And I will now pass the call back to Charlie for his final remarks.

[Charlie Bachtell:]

Thanks, Dennis. On November 3, 5 of 5 states passed new cannabis use laws through valid initiatives, included with states like Montana, South Dakota and Mississippi with historically conservative constituencies. We all know that cannabis makes good policy. But if this election is shown as anything, it’s that cannabis has become both good policy and good politics and that provides a very positive outlook for this industry. The U.S. cannabis market has become a permanent feature of the U.S. economy, growing at a faster rate than every other industry in the country and its doing so with one hand tied behind its back. As any responsible organization should, we have taken critical steps to prepare our business for any possible scenario related to national reforms on cannabis. However, regardless of changes at a federal level, the reality is, the U.S. cannabis sector will continue its exponential growth, and Cresco Labs will continue to execute its vision of being the most important company in the industry. Thank you for your time today. I will now ask the operator to open the line for questions.

[Operator:]

Thank you. And our first question comes from the line of Kenric Tyghe with ATB Capital Markets. Your line is now open.

[Kenric Tyghe:]

Thank you and good morning. better than congrats this morning on the size of that date, so very well done to the team. If I could just quickly on my – on a question here, Charlie, can you speak to in Illinois and in Pennsylvania, where is demand hold for your increased capacity strongest, and to the extent you can – can you provide any color on whether you saw share gains on a consequence or rather the quantum of those potential share gains in either of those two markets?

[Charlie Bachtell:]

I sure can. Thanks, Kenric. Thanks for the nice compliment too. So Illinois and PA as it relates on where I guess more demand came from for our increased supply, I would say, was observed well by both states. Both of these states are currently in – will remain for the foreseeable future supply constrained markets. So, very encouraged by what we have seen in both of those markets and our new capacity in both of those markets. And the – sorry, could you repeat the second part of the question on that?

[Kenric Tyghe:]

And then just with respect to share gains in channel and your take as to how your share exited the quarter?

[Dennis Olis:]

We did. And then I will ask Greg for if he has some additional color, but we definitely saw share gain from the additional supply that we brought to market in both of those states. And it does – it sets us up well for 2021 as well. Greg, additional?

[Greg Butler:]

Yes, no, that’s the question. I think, if you look at Illinois, Illinois had a great quarter, it was up 31%. So, this market transforms at very healthy strong market that’s continuing to show growth. We are happy that we are outperforming that growth number, so taking share. That’s a little bit more tricky during the volume lead on the market. Our estimates kind of have us that market is growing similar it’s not even a little bit ahead of Illinois. And again, our performance really strong in Pennsylvania and so in both of those particular in Illinois, where we do have state data, we are growing ahead of the market.

[Kenric Tyghe:]

That’s great. Thank you, Greg. And then just a quick follow-up with respect to California, what’s your mind has been the single biggest change you have seen either in market or in your own operations and markets that has supported the sort of performance that you have reported here this morning?

[Charlie Bachtell:]

Sure. So, this is Charlie. So as far as the market, I think you are just continuing to see the development of the regulated market in California and as we looked at California, the state whether or not it would fit the Cresco strategic plan, California really just became a regulated market at the beginning of 2018. So, we fully expected that it would take some time to mature. And it does favor operators that understand how to work in a complex regulatory environment. And that’s Cresco. As far as the biggest changes that we have seen from our side, this is just a continued maturation of the California assets, right, keep in mind we just added those assets at the very beginning of the year. So what we are seeing is a very effective integration capability and it’s also part of our organizational restructure with our RVPs that we announced earlier this year, having local leadership onsite in state that are managing the business with 100% of their attention is a phenomenal improvement for us. So we are very, very encouraged by what we have been able to develop in that state and also the way that it sets us up for the future. Greg, do you have any additional?

[Greg Butler:]

The only thing I would add to is as we talked in previous quarters, California was always a question mark and California had a huge Q3, but becoming a $1 billion attractive market. So, I think at least for us no doubt that is a really, really important market to be in. As Charlie said, we have really focused on strengthening our position in the doors that were in that state that matter and we are seeing really strong velocity growth in those doors. And so we are encouraged and as that market continues to grow, we are really excited about our ability to continue to take share.

[Kenric Tyghe:]

Great color. Thanks so much. I will leave it there.

[Charlie Bachtell:]

Thanks, Kenric.

[Operator:]

Thank you. And our next question comes from the line of Derek Dley with Canaccord Genuity. You line is now open.

[Derek Dley:]

Yes, hi, guys and I will echo those congrats. Phenomenal quarter. Look, one thing I found really impressive here was just the SG&A leverage and I guess it looks like you have built up some of the SG&A in Q1 and Q2 in advance of the strong revenue growth. But can you just sort of give us some more color in terms of what you are looking at in SG&A and is there any sort of an appropriate run-rate going forward?

[Charlie Bachtell:]

Thanks, Derek. Dennis, you want to take this?

[Dennis Olis:]

Yes. Thanks, Derek. So we basically held SG&A flat for the first three quarters with more of volatility and between the different quarters, but it’s essentially flat from one quarter to the next. We will – as we move into Q4 and beyond, we will continue to make some investments in our people and our platforms we will make some investments in automation in our back ends and then also in our systems. So while we will see some increase in total SG&A absolute dollars, as a percentage of revenue, it will continue to decline.

[Derek Dley:]

Okay, great. That’s really helpful. And then your comment on sort of rinse and repeat what you have done in some of your core states like Illinois, Pennsylvania, I guess when we look ahead to 2021 what additional data are getting more of a focus in 2021 versus 2020?

[Charlie Bachtell:]

Sure, this is Charlie. So for us I think we are not only we have sort of built the infrastructure here in these critical markets, the Illinois, Pennsylvania, California that will continue to develop and payoff as we go into 2021. But as we have talked about and especially with a rinse and repeat, a repeatable playbook here, we did some sale leasebacks earlier in the year to get the capital needed to build out infrastructures in Massachusetts, Ohio and Michigan. Arizona is another state too where we have got opportunity to optimize the effort that we have there. So, I think those are really the four states where we see this same playbook that’s already started to be deployed that will have material impacts as we get into 2020 – really second half of 2021.

[Derek Dley:]

Great, okay. Thank you very much.

[Charlie Bachtell:]

Thanks, Derek.

[Operator:]

Thank you. And our next question comes from the line of Vivien Azer with Cowen. Your line is now open.

[Vivien Azer:]

Hi, good morning.

[Charlie Bachtell:]

Good morning, Vivien.

[Vivien Azer:]

Good morning. So, given the substantial beat relative to certainly our estimates as well as consensus, I was wondering if we could revisit your philosophy around the guidance? Thanks.

[Charlie Bachtell:]

Yes, thanks, Vivien. And fair question, for us this year, all of this is – all of this is new, right, the scale, the investments and infrastructure, the organizational restructure that we started to develop and deploy in 2019. These were all very new components as we talked about in our Q4 call at the beginning of this year we have lot of execution risk. So for us, it was a lot of matters of the first impression, mixed with a global pandemic, that we had to change the way that we operated as a business, at the corporate level, at the production level at the retail level. So, I think what 2020 has proved for us is that we are capable of creating the infrastructure that can create this type of scale, we can execute with these new investments and tools that we have and that we manage change well. And so we are optimistic about what that means for 2021-2022 and going forward. As far as guidance, we are not in a position. There is still a lot of unknowns as we enter 2021 at a macro level and outside of the industry. So, we will continue to evaluate – we will continue to communicate and we will continue to deliver.

[Vivien Azer:]

Certainly, that’s fair. And my follow-up question, I love asking about California. I have been hearing from some other operators in the state that there have been some impacts from the wildfire in terms of just market pricing more broadly, I was wondering if you could comment on that at all? Thanks.

[Charlie Bachtell:]

I will start and then I know Greg has got some great insight on this. It is – the wildfires could potentially have an impact on the market out there, but keep in mind, there is also pretty significant outdoor cultivation that happened in California too that gets harvested right around this time of the year. So, there is kind of the tale of two different events converging. So, Greg, additional insight on that?

[Greg Butler:]

Good morning, Vivien. I think just to add on that we are what they call on Croptober, which is where you do tend to see some softness on price as inventory hits the market. I think to Charlie’s point, those two factors of buyers and then the harvest period, are likely going to blend themselves out. We are not seeing anything significant that would be of meaning for us to highlight concern on.

[Vivien Azer:]

Thank you.

[Charlie Bachtell:]

Thanks, Vivien.

[Operator:]

Thank you. And our next question comes from the line of Pablo Zuanic with Cantor Fitzgerald. Your line is now open.

[Pablo Zuanic:]

Thank you, Charlie and congratulations on a great quarter. Look at obviously, we know the market data so we have a good sense of what’s happening at the state level in terms of growth in California, in Pennsylvania, right. So, it sounds like we all even though it was 124, it was 250 million short. So obviously, we miscalculated the share gains that you are having. So, it’s a two-part question. Number one, is there anything that we should consider in the fourth quarter that will imply share loss either you are seeing other operators having a lot of cultivation capacities in Illinois and Pennsylvania or even some phenomenon in California we should consider, but also related to that walk us through the math into the fourth quarter if you are not giving guidance and just how much more capacity or yields or productivity are you getting over the assets in Illinois and Pennsylvania in terms of output for the fourth quarter? And same question for California, right, revenue per account up 25%, the market is up 20%, total wholesale up 56%. So, you are gaining new accounts, how much room do you have to add more accounts in California or it’s going to be more an issue of revenue per account, just help us model that out in terms of how to think about the fourth quarter next year? We have the market data so we have that number right, but congrats again? Thank you.

[Charlie Bachtell:]

Thank you, Pablo. So as it relates to share loss in PA and Illinois, I don’t think we are anticipating share loss in Q4 as much as both of these markets and any more doors open, right. So in Illinois and in the Q3 data, I think there were 72ish contributing dispensaries, I think there might be 75 or 76 that are open today. I think that’s only like an incremental 21 doors that have opened in the state this year and were 4 of them. So, we need some more additional doors to open as we mentioned that have been unlocked in the prepared remarks that there is more second stories from the incumbents, there is the 75 additional licenses that hopefully will come online here after the new year. So, we need some more doors to open. As far as the way that we are looking at revenue for Q4, it’s real with how we have been able to execute the expansion this year. Our results prove that the strategy of focusing on wholesale is the most valuable approach. But now that we have harvested from all rooms in the fourth quarter, now is a stage where we are investing in automation, optimization, downstream ops to increase fulfillment and believe that will manifest in more growth in the first half of 2021 And then we will also have additional capacity projects openings that will be happening on the fun part of next year as well. As far as California, California is a little bit different, again, because of the access to the flexibility, I guess that’s associated with that market structure out there. So, it’s not only your own internal capacity, but you have the ability to source. It’s more of the business model out there. So there is more flexibility there, Greg, additional color on California and share going forward.

[Greg Butler:]

Palbo, I think the only thing to add what you – similar to what you said in Illinois, as we think of California, it’s really the volume through the doors as we go to grow. And so we expect that market will continue to show healthy growth going into Q4 and then we will increase our losses across the doors that we have exiting Q3. But on Illinois, to reference Charles’ point while we think the doors need to open in this state to really continue to drive some significant growth mistakes, we have no anticipation to give up any interest share, as we go into Q4 into 2021.

[Pablo Zuanic:]

That’s great and a just a quick follow-up. So the other day I was looking at your total number of operating stores like 19, that looks very small compared to peers, but obviously is not having an effect on your numbers, I mean in sales up 60% in retail. Just remind us of the plans to have more stores whether in the fourth quarter of 2021 or that’s just definitely not a priority it is all about wholesale capacity?

[Charlie Bachtell:]

And I am – it’s a great question. And it is Charlie we have one more store in Illinois right? That’ll be our 10 store in Illinois which would make us the first operator to get to all 10 stores open. We anticipate that that comes online before the end of the year, it’s possible that slide into the very beginning of next year. And then we have a couple more that will be coming on in the first half of 2021. And yes, so we have a couple more that we think first half 2021 towards the end of it. But retail, it’s not that it is, as you mentioned, it’s not that, it’s de prioritized from our perspective, it’s a valuable asset. But we do believe that investing continue investment on the production side and the ability to produce the branded products and get those on to all of the other shelves that open provides the longest term value for the organization.

[Pablo Zuanic:]

Got it. Thank you.

[Charlie Bachtell:]

Thanks, Pablo.

[Operator:]

Thank you. And our next question comes from the line of Michael Lavery with Piper Sandler. Your line is now open.

[Michael Lavery:]

Thank you. Good morning. How do you think that interstate commerce could evolve in the event of federal legalization? And how that impact how you make them think about cultivation investments?

[Charlie Bachtell:]

Good morning, Michael. So and this is Charlie. The prospect of interstate commerce, look – we I would tell you, when I thought about getting into the industry, the idea of interstate commerce was front and center, right? And so from the early stages of developing the strategic approach to the industry, that was always a component of building a long-term viable, successful sustainable business model. And so it’s not a coincidence that we focus on the middle two verticals of the value chain at some point if interstate commerce the interstate commerce is available, the focusing on brand in distribution of brand will help us mitigate the risk that some that are not is focused on the creation of branded products and the distribution of branded products into other people’s stores. It mitigates risk to a greater extent than potentially some other strategic models now, looking into the crystal ball, do I think that interstate commerce is a near-term possibility? I would say it’s less likely than likely. But we are prepared for however, this develops at a federal level. And we pride ourselves on the level of engagement that we are bringing to government affairs. So it’s – we are present put it away.

[Michael Lavery:]

That’s helpful. And then, just a follow-up on vapes, can you just give a little color on the Live, Resin Vape launch and what you are seeing there and how that’s progressing?

[Charlie Bachtell:]

Sure, Greg, if you add some color on that one?

[Greg Butler:]

Good morning. And I think, your question is we have had Cresco liquid Labs across our markets for some times we have obviously launched that in some of our newer markets so far. Liquid Live as a segment of vape continues to show some very nice growth, since we had that 10 right now is a great segment to be in. We do have a dominant share in our core markets and a very strong position in our core markets with our vape products. And we are seeing that growth in our new emerging markets.

[Michael Lavery:]

And yes, I was thinking more like Illinois, California. On the California side, how much was that a driver of your gains there or was it some of it, but really, the upside was just execution on distribution and things like that?

[Greg Butler:]

Yes, thanks for the support. Now, I think the – if you look at California, as we talked about in previous earnings calls, our plan for that state was to get to a healthier core set of both accounts and core set of brands. And so the growth you are seeing in Q3 is getting that right set of customers that driving velocity growth across those customers. And right now, we would contribute more of that velocity growth of incredible flower that we are seeing in our facilities in our market and also strength in driving partner brand growth in California across the doors.

[Michael Lavery:]

That’s great color. Thank you so much.

[Charlie Bachtell:]

Thanks, Michael.

[Operator:]

Thank you. And our next question comes from the line of Andrew Partheniou with Stifel GMP. Your line is now open.

[Andrew Partheniou:]

I will echo pretty much everybody’s comments on the absolute incredible results here guys. Well done. Maybe just continuing on California, we have heard a lot of operators struggling to have a successful business model there. But it seems like you guys are generating good traction. Could you give a little bit more color on kind of the pitfalls that maybe other operators have done that you guys are successfully avoiding? And is it really just getting the right customers and driving revenue through those doors and how much – how many more doors throughout the state do you think that you guys can still have more runway to go?

[Charlie Bachtell:]

Thanks for the question, this is – and the compliment. Thank you. This is Charlie. I will start and then Greg has more context, but I think California, I don’t think anybody argues against the fact that California is the largest cannabis market in the world. But also true is it’s very competitive. And it’s also sort of very – I would tell you protected, there is a cultural component to operating the California and, and you got to figure out how to solve the riddle. And you would have to execute, you have to execute operational at a different level. And that is why I think if you are looking at the, the pure set and reluctance to go into the state, look, it’s complex it is not easy to figure out how to solve the California weather. And I am far from saying that we have figured it out. I think we are just bringing our model to California we are bringing a level of engagement and focus. And we are putting the resources there that we traditionally doing every one of our other market and that is proving to be successful for us. More detailed in that specific Greg you want to touch on?

[Greg Butler:]

Sure and good morning, Andrew. As Charlie said California obviously very large market, which makes it on top of mind for everyone, but one of the most competitive markets probably also in the world. So, you are absolutely correct, it is a difficult market to fight in. If I were to say what’s driving our growth today, one is we got an incredible team in California across the board, we have just amazing cultivation coming down with some great genetics, which is helping us really win in the flower segment of the market with some of the most flower consumers out there. We also have a really, really strong team that required to what it has on the continuing platform. We are out there ensuring that we are in the right doors and driving growth in those doors. And so that’s something we are very pleased about. I know we have talked about what we are doing with that asset in the last few calls. It was a bit of me explaining that we are doing you are going to have to trust us and now you are seeing the results of that come to life in Q3, which we are very encouraged with as we look forward. Now, obviously what we do want to stay within the doors that matter in the state and that changes quite a lot. We want to ensure that we are bringing those – our manufactured goods now to the market as well in addition to really strong flower growth, which we believe we have upside there. And as we have right sized, the cost structure of the continuum platform, we are in a really nice position now to start looking at other partner brands that we can serve as a platform, which would help us grow up. So there is a couple of ways in that we can get growth in the future of California. But if you are asking what was the secret sauce, I really think we have had a really, really great team in the market that’s putting out some incredible products and building some relationships with customers.

[Andrew Partheniou:]

Great, thanks for that additional color. And just switching gears on capital allocation. You guys mentioned, the first quarter that you are generating free cash flow, like we are not the last. But you also have, apparently CapEx, funded through sale lease tax in other states. So, with that in mind what would we say is – what would you say as the prioritization of your free cash flow? Could we see potentially a return to the M&A market to enter new states or maybe something else?

[Charlie Bachtell:]

This is Charlie. I will start and then Dennis has some perspective on that as well. Look, we are observing what’s going on in the industry, again, 2020 was big for us to prove execution and confirm the playbook, so, rates on the peak becomes a reality. And I don’t think we were looking at, of course, continuing to invest in the portfolio that we built, we strongly believe that we build the most strategic geographic within the states. But there is opportunities, if there’s especially if they make sense from a balance sheet standpoint, from an income statement standpoint, we are evaluating opportunities, and we will continue to be very strategic in the way that we move forward with those – Dennis?

[Dennis Olis:]

Yes. Thanks for the question. So we are very pleased with the cash flow performance that we had in Q3. We talked a little bit about this coming in Q2, and we saw June had a positive operating and free cash flow. So that continued, we actually had a $10 million income tax payment in Q3, which normally would have been paid in Q2. So that numbers that were reported for both operating cash flow – free cash flow on Q3 would have been a little bit better. And having said that, we have certainly have access to capital markets will continue to invest in back in automation, in branding, and marketing. But you noted, we do have over $50 million of funds available to us through the TI funds that we acquired in Q2. So that does give us the opportunity to make investments in Michigan, Massachusetts and Ohio to build up additional capacity in those spaces. As far as M&A goes, we are constantly looking at options we have, I think, proving ourselves to be very diligent and good stewards of capital, making sure that we get a proper return on any investment that we make. But I think the flexibility that we have from a generating free cash flow, and the performance that we had this quarter, gives us a lot more optionality going forward.

[Andrew Partheniou:]

Okay. Thanks for taking my questions and congrats again.

[Charlie Bachtell:]

Thank you, Drew.

[Operator:]

Thank you. Our next question comes from a line of Neal Gilmer with Haywood Securities. Your line is now open.

[Neal Gilmer:]

Yes, good morning and yes, obviously a great quarter. Many of my questions have been answered. But maybe one of your responses to the earlier question with respect to Pennsylvania and Illinois, your commented that there supply constrained states and you expect it to stay that way for some time may be sort of philosophy I know you just continued expansion in each of their respective states. What’s your philosophy going forward? Are you using that to do further capacity expansion to address that market?

[Charlie Bachtell:]

Thanks, it’s a great question. And this is Charlie again we will continue to evaluate where to spend the next dollar. And I can tell you, the team, we built out a phenomenal team in-house here that really helps us think through all the options that are on the table, and we do the analysis and confirm, where the next dollar should be spent. So Illinois and PA are definitely not off the table, there’s an argument for especially the expansion that we did in PA was not as large as the one that we did in Illinois but we will just continue to evaluate all options and make sure that we are making the most strategic decision with the deployment of capital that’s interested shareholders. And now we will continue to do that in 2021.

[Neal Gilmer:]

Okay, thanks for that. And then maybe just the tenant improvement of $50 million, you guys have in the tenant improvement allowances across those 3 states. Do you have any timeline for what you are communicating to the market as far as when you expect to use that backlog?

[Charlie Bachtell:]

Yes, I think it’s same playbook and we have already started with projects, in all three of those states. So we are happy to have them under way. And if you look at sort of the way that Illinois and PA unfolded for us, that’s why we think second half 2021 is when you really start to see the benefits from the consistent approach and how we build out capacity and in that capacity comes to market.

[Neal Gilmer:]

Thank you. Thanks very much. Appreciate it.

[Charlie Bachtell:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Matt McGinley with Needham. Your line is now open.

[Matt McGinley:]

Thank you. On the gross margin side you previously expressed, if that would be in the 50s, in terms of rate in 2020, and up as a gap during this quarter. How much of a margin differential do you have between states where we operate at scale like Pennsylvania and Illinois, versus states where you have small operations, and this gross margin improvement from here come from these smallest states that are ramping or more from efficiency in your ?

[Charlie Bachtell:]

Thanks Matt. I will let Dennis answer that.

[Dennis Olis:]

Yes, thanks for the question, Matt. So, we are extremely pleased with the gross profit performance that we had in Q3, we talked about the expectation that we would see a step up improvement from Q2 to Q3. And we saw that so we could not be more pleased with the results. As far as the gross profits by state, certainly with the larger states that we have they do get a larger margin. Part of that is scale that these other states come up to scale they will continue to see improvements. But we don’t report on gross profit that is state by state level, but clearly and in Illinois and Pennsylvania, those margins exceed the other states.

[Matt McGinley:]

Okay. And then for Charlie probably asking the same question probably for the third time, in this call but on the investment in the strategic markets, as you think you have that capital deployment. Does it make more sense from a risk and return profile to expand existing facilities, which presumably have less risk, but maybe lower return or does it make more sense to expand the footprint since in new states where you could have a longer runway for growth, but presumably, that would have more risk. I guess even more important to have a footprint at this point, there is one point out there to extend in your existing markets.

[Charlie Bachtell:]

I mean, excellent question, because this is the million dollar question. What we have done over the last 2 years, right is, it’s given us the opportunity to even have the thought of if the current, platform is successful enough and offers enough long-term viability and value to just continue to invest in it. And the answer is, of course, yes. the 9 states that we have you are talking about, 7 of those markets are in the top 10 from a population standpoint, at a state or at a city level. It’s possible that we the majority of those have adult use within the next 12 to 18 months. So there is just a ton of opportunity that’s in the platform currently. But yes, you have to balance that with. We are not building a company to win Q4 2020, right. We are building the company to have success in 2022, 2023. So we definitely are looking down the path. There are some opportunities out there that we think would even add to the strategic footprint that we build. But they have got to be the right, the right opportunities at the right time. So all of that’s part of the evaluation process. There’s no perfect answer to it. It’s an ongoing process.

[Matt McGinley:]

Thank you.

[Operator:]

Thank you. And our next question comes from the line of Graeme Kreindler with Eight Capital. Your line is now open.

[Graeme Kreindler:]

Hi, good morning and thank you for taking my questions. I just wanted to ask you a question following up on the comments made earlier with respect to gross margin by state. And I understand that’s not something that’s segmented out just with respect to California, seeing the really strong sequential growth on revenue and really are trying to continuing since Q1, I was wondering if you could provide any color in terms of how that gross margin has trended relative to the rest of the portfolio? Are we seeing a significant increase in those gross margins? Are you being able to leverage costs just over a higher revenue base and would appreciate any thoughts regarding that? Thank you very much.

[Charlie Bachtell:]

Thanks, Graeme. Dennis, will take that one.

[Dennis Olis:]

Yes, thanks for the question, Graeme. So we continue to see sequential improvement in our gross profits in California. So it’s been more of a gradual improvement over the last several quarters, we expect to see that continue going forward. It as we have talked about in the past, it still lags a little bit of from some of the other larger states like Illinois and Pennsylvania. But we continue to make the appropriate investments. And we are starting to see the returns from those investments. And we would expect those to continue, like I said, it will be a gradual increase rather than a step function improvement from quarter to quarter.

[Graeme Kreindler:]

Okay, thank you. I appreciate that. And then maybe to take that a step further, you mentioned California reaching the $1 billion mark, quarterly sales mark, we are seeing that market continue to come into its own and mature, we are going down this shared real estate market, when you think of the long-term potential of that state, particularly on a gross margin standpoint, where do you think those that could ultimately level out or trend to – I think the general conception or thought is that – that will be a state that will continue to have less attractive margin characteristics, but based on what you are building and how we are seeing the growth there? Do you think there is room for surprise, related to where our expectations might be on a go forward basis? Thanks.

[Charlie Bachtell:]

Yes, thanks. And like I said, we continue to see sequential improvement. And as we continue to build out our capabilities in the state, we do expect to see a margin improvement over the next couple of quarters, in terms of the absolute percentages and growth that is not something that we typically do provide that we will expect to see. I would say a couple hundred basis points improvement over that couple of quarters.

[Greg Butler:]

And I think, I add to that.

[Charlie Bachtell:]

Sure.

[Greg Butler:]

Good morning, Graeme. Just a reminder yes, I’m wondering, California is a structurally different market for us, and that we are both wholesale provider and a distributor. And so as you look at market just reminder is that distributor margin that we make our partner brands will always be a little bit different than what we make off with brands that we manufacture ourselves. And so comparing California to the rest of the portfolio is not a perfect comparison point because of differences on how we operate in that state.

[Graeme Kreindler:]

Understood. Thank you very much for that.

[Charlie Bachtell:]

Thanks, Graeme.

[Operator:]

Thank you. And our next question comes from the line of Scott Fortune with ROTH Capital Partners. Your line is now open.

[Scott Fortune:]

Good morning. Congrats on an impressive quarter. Just to equate Charlie kind of timing, I know its crystal ball, the timing of the new states, Arizona, New Jersey coming on board and the state surrounding them if you are looking at kind of capital allocation in the key states in 2021, and any thoughts around that timing side of things?

[Charlie Bachtell:]

Yes. so with the results in Arizona and New Jersey, we are thrilled I think it’s – yes, every additional state that passes and adult-use law means two more senators in DC that have constituents that wanted adult-use cannabis in their state, so it’s encouraging at a macro level for the industry in – I think that doesn’t get enough attention when we focus just on states, love Arizona, glad it happened. We will continue to build out and optimize our operation there in look at opportunities to increase our market share. New Jersey we are not in New Jersey, but we love the impact, the halo effect of that New Jersey passing because we do kind of have New Jersey surrounded and I think that will encourage the efficient move forward by New York and Pennsylvania, to move in that direction as well. So I just think it’s setting these states up very, very well for long-term success, and also for it to be good contributing components to our platform for a long time to come.

[Scott Fortune:]

Great. I appreciate the color and then real quick, looking out with the step function of growth in the second quarter and in third quarter. Now, how should we look at the growth sequentially in fourth quarter, and looking out into 2021 as you add cultivation are within a key as a step function quarters, or is that going to be more linear as we look at the 2021? Just can you help us understand the growth sequential in 4Q in last few years, Illinois and Pennsylvania have come on board here now?

[Charlie Bachtell:]

There we go. So you certainly know I think it’s fair to say that as far as Q4, as I mentioned earlier in the call, the growth that we saw out of the investments that we made in two strategic states, where we got a full quarter of production out of those the new square footage, we are going to continue with the plans and in the execution of the optimization, the automation, downstream ops improvements, to increase – increase fulfillment, that will be seen now come after the New Year. And there will be some other components that come online, you we expect some additional, as I mentioned that the retail stores that we are going to be opening in the first half of the year that includes hopefully some early in the year of additional retail in Ohio, through the Verdant acquisition. But I think it’s fair to say that in Q4, we have got some additional investment optimization that will pay off in 2021 and then the additional cultivation development in 2021, in those new states that we mentioned coming in later in the year.

[Scott Fortune:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Andrew Semple with Echelon Capital. Your line is now open.

[Andrew Semple:]

Hi and good morning and congrats on the impressive results. I just wanted to touch on California again. Did you introduce any new third-party brands onto your distribution platform that have recently outperformed? Or has the strong performance been mostly driven by a consistent offering relative to the prior quarter? And if you could also touch on how Cresco branded products continue to performance as part of that mix?

[Charlie Bachtell:]

I am sure that Greg, take that one.

[Greg Butler:]

Hey, good morning, Andrew. So your preferred question, did we add any new partner brands, quarter-over-quarter, we have not most of that growth has come from a strength of the relationships that we had, as part of our kind of focus in our core partners in that market. The second part of your question, is outperformance – we are really, really pleased with our performance in California and two parts one is, as I just mentioned before, we were able to drive partner growth in state. But then also, with our own brand portfolio we are driving a significant growth Floracal flower brand, which is our largest owned brand, in California continues to show nice growth. And so we are really pleased that both partner brands and our new brands and portfolio are growing in the state.

[Andrew Semple:]

That’s great color, I appreciate that. I also want to spend a little bit more time on the retail operations, 60% quarter-over-quarter growth there. What was the principle driver behind that was just having better availability of supply on the shelves in some of your key markets, or just getting the right type of products? Or were some of your new store opening Superstore contributors or are you just seeing impressive, same store sales growth more broadly across the network? If you had any color there, that would be appreciated.

[Charlie Bachtell:]

Yes, great question. And I will start it and then hand it over to Greg for more detail. But I think it goes back to again the beginning of the year changes that we made in the retail component of our business are just fundamentally different. And I think we entered the year as a company with retail and I said this before. I think we have grown into I think now we can call ourselves a retailer which is different so just it couldn’t be more proud of but that teams many have to put together throughout the year so far. Greg?

[Greg Butler:]

The only thing that I’d add to that, maybe a little more context color is to Charlie’s point we are seeing same store sales growth of about a 179% versus the same stores that were opened a year ago, which to Charlie’s point is really encouraging as we continue to grow our retail, but then also in this quarter in particular, we were able to open some really, really solid stores that were able to drive new growth for us quarter-over-quarter through those new store growth.

[Andrew Semple:]

Congrats again and thanks for taking my questions.

[Charlie Bachtell:]

Thank you.

[Operator:]

Thank you. And our next question comes from a line of Glenn Mattson with Ladenburg Thalmann. Your line is now.

[Glenn Mattson:]

Yes, thanks for taking the question and congrats also on the quarter. So just building on, Charlie, on another question on the halo effect after the New Jersey passage and obviously we have all heard comments from the governor of New York about rapidly reverting to adult rec as well, but you have said this now for a few years in a row, so I’d curious what your thoughts are and if you have had any discussions about how effective it will be this time around number one and then number two, like how do you plan for that? And how do you ramp in the event that does happen and potential around that? That’s it for me. Thanks.

[Charlie Bachtell:]

That is valid question. And I can get a simple answer would be it’s a different set of circumstances this year. The not only the state level and country level, we are in a different position, currently in from an economic standpoint, than we were at the beginning of the year or last April, when the last discussion happened about adult-use in New York. So I think different set of circumstances will more likely than not lead to a different result. And what we do to get ready for it is, again, it’s the playbook. It’s investing in capacity. It’s the thing that we have done in the other states, Illinois, Pennsylvania, etcetera, of making sure that we are ramping up to be able to meet that demand that will come from the flipping of the switch like that. So we will be ready for that.

[Operator:]

Thank you. Our next question comes from a line of Russell Stanley with Beacon Securities. Your line is now open.

[Russell Stanley:]

Hi, good morning and thanks for taking my question. First of all, on receptive Illinois and this has probably been asked in a couple of different ways, but maybe I can try it this way. When you think about your current capacity across whatever sort of optimization plans you can implement, how do you think about the number of dispensaries you can support given the number of second sites still to come and the additional 75 that you predicted there should be this year or next year?

[Charlie Bachtell:]

Good morning, Russ. It’s a good question. At a high level, we can support more. And we will have the ability to continue to support more, especially as those with downstream optimizations continue to develop this quarter and into 2021. But we do – we need them to open and so there is a really good read on a calendar of the next three months what that looks like. And there’s definitely stores opening but we need more in we need those 75 new licenses to actually get issued, we need those stores to get open we need those doors to open. That’s the main unlock. Greg any additional color on that?

[Greg Butler:]

Sure and good morning, Russell. The only thing I would add to Charlie’s point is, we feel we have got capacity that’s going to support door growth. Just be interesting effects we look at lets say like Michigan currently has 271 dispensaries open and right now Illinois is 73, but so and Michigan is showing some really tremendous growth. So as those doors open up in Illinois, it makes it a lot easier for consumers to access the products. And so that would be a pretty nice growth thrust behind the owning market and from a supply perspective, we feel like we are in a good position but as those doors open up, and we can settle. So maybe echoing Charlie’s point, getting those doors open in Illinois would really help.

[Russell Stanley:]

Great. Thanks on that. If I could just as a follow-up with respect to Pennsylvania, and I understand retailers is secondary to your wholesale distribution. But I think on our prior call Charlie you mentioned having appetite potentially for additional retail in Pennsylvania, given kind of 3 license for 6 and a cap of 15. So just wondering, are you still evaluating opportunities there or the evaluation expectations kind fall into vote a New Jersey? Thank you.

[Charlie Bachtell:]

You had third question and yes, again, we are evaluating additional opportunities in Pennsylvania just the same way that we are evaluating additional opportunities across the country, in other states in the platform already. So it’s an ongoing analysis, if we find the right opportunity, we will move forward with it. If we don’t, then if there is other opportunities that are more accretive, we’ll pursue those.

[Operator:]

Thank you. And our last question comes from a line of Jesse Pytlak with Cormark Securities. Your line is now open.

[Jesse Pytlak:]

Hey, good morning. Just a quick question for me just, as we hear news of the resurgence of pandemic and states that have been . Just wondering if you have seen any change in consumer trends or behavior just in the past few weeks or even today that some of these restrictions take hold and just maybe some major concerns that you are looking for?

[Charlie Bachtell:]

Good morning, Jesse. Very, very valid question. Look, I think it’s something that all businesses are constantly evaluating in identifying risks, and making sure that you are putting processes in place to mitigate to the greatest extent possible. And I think the benefit that we have is we have been doing this now for actually over 8 months. And we have got great processes in place. We have got a great team in place. So we are better prepared to handle the challenges of COVID now than we were first time around and we have become a better operator because of it. So it’s something that we will continue to manage and we are encouraged by the latest news that’s come out with regard to potential promising looking vaccines. So, hopefully this is something that won’t be an ongoing event, but it is something that we – its front of mind and we are constantly managing.

[Operator:]

Thank you. And this does conclude today’s question-and-answer session as well as today’s conference call. Thank you all for participating. You may now disconnect. Everyone have a great day.