HEXO Corp.
Q2 2022 Earnings Call Transcript

Published: 18 Mar 2022

[Operator:]

Good morning. My name is Rob, and I will be your conference operator today. At this time, I would like to welcome everyone to the HEXO Second Quarter 2022 Earnings Call. Before we begin, we would like to remind you that certain matters discussed in today's call or answers that may be given to questions asked could constitute forward-looking statements. These statements are based on the company's current internal views, estimates, expectations, opinions, forecasts, beliefs, assumptions and other statements that are not statements of fact regarding the future of the business, future plans, strategies, operational results and other future conditions. These statements should not be read as assurances of future performance or results. They involve known and unknown risks, uncertainties and other factors that could cause actual results, performance or achievements to differ materially from current expectations or those implied by such statements. This morning's discussion is qualified in its entirety by the cautionary note regarding forward-looking statements and the risk factors that are included in the annual information form, Management Discussion and Analysis and annual report. Please review these materials for more information about the forward-looking statements and the risk factors that could cause actual results, performance, development or events to differ materially from our current expectations and those implied by such statements. HEXO disclaims any intention or obligation, except to the extent required by law, to update or revise any forward-looking statements as a result of new information or future events for any reason. I will now turn the call over to Scott Cooper, President and CEO of HEXO.

[Scott Cooper:]

Good morning, everyone, and thank you for joining us today. Late last night, we released our Q2 2022 results for the quarter ended January 31, 2022. Before I jump into the results of this quarter, I wanted to provide an update on a couple of key developments that occurred over the course of the last couple of months. When I joined HEXO in November last year, I was immediately tasked with preparing a very challenged balance sheet as a result of the Redecan acquisition and the related convertible debenture that was put in place at that time last summer. The proposed agreements we've announced at Tilray will restructure and reduce our significant debt burden and provide ample liquidity cushion while minimizing dilution to existing HEXO shareholders. A key pillar underpinning our Path Forward strategy. This was indeed a transformational quarter for the company. While the convertible note with a significant inhibitor to HEXO's growth prospects, I am pleased that we can now, as a result of our recently announced proposed strategic alliance with Tilray, put that behind us and continue to position ourselves to retain and grow our significant market share while we become a cash flow positive business within the next 4 quarters. Let me begin by reviewing the proposed strategic partnership with Tilray before providing an update on our Path Forward strategy. On March 2nd, HEXO entered into a proposed strategic alliance with Tilray brands in which Tilray will acquire USD 211 million of senior secured convertible notes that were originally issued to HEXO -- originally issued by HEXO to High Trail Investments. This proposed alliance between HEXO and Tilray achieved several goals, including

[Curtis Solsvig:]

Thank you, Scott, and good morning, everyone. This is my first time in the CFO chair at HEXO, and I look forward to working with you. Before drilling into the details, let me recap a couple of Scott's points and give you a high-level summary of the quarter. Our biggest financial challenge has been to fix the balance sheet, to relieve the drain of the senior secured convertible note and established liquidity. With Scott's leadership, we've made enormous progress on both of those objectives in Q2. Once we close the Tilray transaction, the monthly redemptions will end, the maturity is pushed out for 3 years, and we free up USD 80 million in restricted cash. Once we close on the equity backstop, we'll have another $60 million of cash per year, if necessary, through the sale of equity. As the new management team sells in and we dive deeper into the business, we're seeing what I call a target-rich environment. We're continuing to improve our profitability through cost savings, revenue enhancement, improved capacity utilization and operational efficiency and better inventory turns. We remain confident in our ability to capture the run rate cash flow improvements previously outlined in The Path Forward of $37 million by the end of fiscal '22 and an additional $135 million by the end of fiscal '23. At a high level, this quarter operationally, on a quarter-to-quarter basis, we raised unadjusted gross margins from 25% to 36% and added $5 million to EBITDA. In this quarter, we also reexamined the valuations of our business and concluded that we had to recognize substantial impairments. We took $100 million in fixed asset impairments, $141 million in intangibles and wrote off the entire balance of goodwill of $375 million. Finally, despite improving EBITDA by $5 million quarter-on-quarter, we didn't reach EBITDA breakeven. And as a result, we've breached the covenant on the senior secured convertible note. The noteholder subsequently waived enforcement of the default through the earlier of May 17th, or closure of the Tilray deal. Nevertheless, under accounting rules, we revalued the senior secured convertible note to the default rate of 115% of face, triggering a fair value loss of $50 million. Once the Tilray transaction closes, that note will be revalued to actual face value at the time of that transaction. Now I'll discuss the results in more detail. First, with respect to revenue. Total revenues were $52.7 million and were our second consecutive quarterly high, representing a 60% increase over Q2 the prior year. International sales were a particular bright spot, growing 36% quarter-on-quarter. Zenabis international sales nearly doubled quarter-on-quarter and accounted for 54% of our total international volume. Medical revenues had a healthy quarter-on-quarter, 21% growth reflecting a reinvigorated product innovation pipeline and renewed focus on deployment of our commercial capabilities. We continue to be optimistic about HEXO's ability to capture revenue and market growth. We're overcoming the operational challenges that left as much as 70% of our orders unfilled. For example, we are aligning our cultivation with market demand through weekly meetings between the markets and operational sites of the business. We've also made great strides in debottlenecking key parts of the production process, increasing throughput and reducing unit costs at the same time. Turning to gross margin. Our adjusted gross margin improved quarter-over-quarter from 25% to 36%. This was a function of multiple factors

[Operator:]

Your first question comes from the line of Aaron Grey from Alliance Global Partners.

[Aaron Grey:]

Congrats on the products you get made on The Path Forward. So talking about the bright spot, you said in international, you said Zenabis build Q-over-Q. Just any incremental color you could provide there, maybe in terms of the markets you're selling to? And also going forward, whether or not there was kind of some onetime calendar expect that level of sales to continue going forward?

[Scott Cooper:]

Aaron, thanks for the question. Val, could I ask you to take that one?

[Val Malone:]

Yes, for sure. Yes. So markets that we continue to sell into as we work with Zenabis are, of course, Israel, Malta and into Europe. We have strong relationships within the international domain and expect to see continued growth.

[Scott Cooper:]

And, Aaron, we're also looking at South Africa and Australia as markets as well.

[Aaron Grey:]

Okay. Great. Glad to hear that continue to see growth there. And the second question for me, Scott, you talked about some survey work you guys are doing right now on the consumer front, just keep understanding, obviously, aligning better with demand and cultivation and it seems like teams are communicating more now. Talk about maybe some of the insights that you're continuing to see unfold. Obviously, a lot of moving parts in the marketplace in terms of consumer demand, whether it be price or TAC levels. So maybe some high level views in terms of how you view the marketplace today from your studies and what you believe consumers are going to look for demand going forward?

[Scott Cooper:]

Yes. Great question. Thanks, Aaron. Again, Valerie, I'll turn that one over to you.

[Val Malone:]

No problem. Yes. So we were, again, extremely fortunate to conduct a national study of over 3,000 Canadian consumers. And within that, we were able to identify over 6 unique demand spaces, which really coined the understanding of usage occasions and consumption habits. And we're uniquely tailoring our overall offering to consumers to align with that. I will suggest some key findings that we have found is the importance of sleep to the Canadian consumers and how cannabis plays an important role within that. I would also suggest that your question around potency is important to Canadian consumers overall in this top of mind as we are outlining and building our product road map moving forward.

[Operator:]

Your next question comes from the line of Pablo Zuanic from Cantor Fitzgerald.

[Pablo Zuanic:]

Can you just give us an update, if it's possible, in terms of your regional coverage within Canada. I mean, the company started very strong in Quebec, right? Then it seemed to lose share there and gaining in Ontario and Alberta. But just an update in terms of where you are, especially with Redecan and the assets you acquired in terms of regional scope, if you can break it? And then an update in terms of how much share you've lost in Quebec. And I'll have a follow-up.

[Scott Cooper:]

Right. So we are -- Marketing President Valerie, I can turn it over to you again just around the market positions in each of the provinces and the Redecan rollout as well.

[Val Malone:]

No problem. We continue to maintain the #1 share position in in Canada, a rolling 3-month share of 10.3% overall. We continue within large markets to continue to leverage our partners as it relates to Quebec, Ontario, Alberta and British Columbia. I'm really excited to announce that we have seen the expansion of Redecan on the national level. We've introduced Redecan into Manitoba, Saskatchewan, Newfoundland, New Brunswick and Nova Scotia and PEI. In addition, in February, we saw the introduction of Redecan into the Quebec market. So continued efforts as we build out our product pipeline and continue to grow our market share with our key board partners.

[Pablo Zuanic:]

Just a follow-up, Scott. Maybe focusing on -- it's a 2-part question, one, an update in terms of the JV with Molson Coors and the relationship there? How much progress are you making in Canada and in the U.S. with the JV? And the second part of the question is more about your U.S. plans. I understand you were hamstrung with a convertible debt. Now you have the agreement with Tilray. In the past, prior CEO had talked about buying land and cultivation in California. I just want to see an update in as to how you're thinking about the U.S. opportunity, or you have too much to fix right now that you're going to be buying assets in the U.S.

[Scott Cooper:]

Yes. Thank you for the question. So first, on the joint venture with Molson and Truss Beverages, I continue to be very pleased with the progress that Truss Beverages is making. It was recently announced as a result of the efforts of Truss Beverages in a number of companies in collaboration with the government that one of the kind of restrictions around the beverage category was you can only purchase 5 beverages within your limit, and that's been increased to 48. So we anticipate continued progress. The innovation funnel that Truss has for 2022 is second to none, and they continue to be very consumer-focused and have very strong customer partnerships. So very pleased with that. In the U.S., we continue to roll out CBD beverages and continue to have a strong commitments to that business as well and in a number of new states, both in direct-to-consumer and with distributors. And on your second question around the U.S. expansion plans, we continue to absolutely look at the U.S. market with interest around operating within kind of the legal framework. In the short-term, we continue to progress the action plan around extracts of hemp drive CBD and other minor cannabinoids as an ingredient. And as we get through the balance sheet transformation, free up cash within that framework, we will absolutely be looking to the U.S. in the right kind of sequencing and time frame for growth and expansion.

[Operator:]

Our next question comes from the line of John Zamparo from CIBC.

[John Zamparo:]

I wanted to start on the cost cutting. It's a lot of moving parts. So I just want to better understand it. I think it's $50 million in synergies from M&A last year. There's another $30 million in savings from the production network that you've identified subsequent to that. There was around $35 million savings on SG&A, if you referenced the 30% cut and now $25 million savings for your portion of the Tilray deal. So roll all that together, you get to around $140 million. I'm trying to get a sense of ultimately how much of that falls into COGS versus SG&A?

[Scott Cooper:]

Yes, thanks for the question, John. Curt, can I turn that one over to you?

[Curtis Solsvig:]

Yes. John, you're right. It is a complicated set of numbers. And we have been trying to isolate those numbers ourselves. Just in the last few weeks, we've set up a special team in a value creation office to be tracking all of those initiatives separately. And I anticipate that as we get better at tracking those things, we'll be able to offer specific details. You touched on the $35 million from SG&A. That's pretty well isolated in SG&A. But the balance of it is going to be a combination of both COGS and SG&A, and we'll be sharpening that up and sharing it with you in the future.

[John Zamparo:]

Okay. Understood. And just a clarifying question on that. Was there any progress made on the $37.5 million in targeted F '22 savings in F Q2? Or is that all targeted for F Q3 and Q4?

[Curtis Solsvig:]

Yes. So we did do a significant headcount reduction in February, which will certainly show up in Q3. There were some ongoing cost reductions in Q2, but I think the bulk of the $37.5 million we're going to capture in fiscal '22 is going to be in the second half of the year.

[John Zamparo:]

Okay. Got it. And then on the revenue side, you did endure some significant organic declines, and you referenced some meaningful missed opportunities. But can you add more color on some of the other initiatives you have to retake share? It does seem like some of your competitors have caught up to some of the products that HEXO does well in. So I'm curious what you're working on innovation or what other initiatives you have to take back share?

[Scott Cooper:]

Yes. Great question. Thanks for the question, John. Val, I'm going to turn that one over to you.

[Val Malone:]

You bet. So once again, I just want to reiterate that we remain the #1 LP in the adult recreational market with 10.3% market share on a rolling 3-month basis. We are, again, working hard to launch plans to allow us to grow organically and there's tremendous opportunities with our breadth of assets that we have in the fastest-growing categories overall. Over the course of the last quarter, we very much focused on mix and driving sustainable growth for our shareholders in a day-in and day-out basis. And we're building -- we've been building our product pipeline, an innovation pipeline as it relates to Canadian consumers referencing once again the national UNA study that we conducted, which allowed us to identify unique use cases and consumption habits of Canadian consumers. You will start to see the effects of this work hit the market in early spring of this year when you start to see some of those products hitting the market. And one that I'm most excited about that I want to make sure that I highlight is the launch of our Redees Plus, which is an infused pre-roll Redecan style, so the straight edge style that will launch into the marketplace with higher THC. Again, capitalizing on the overall market moment and the key indicators from consumers in terms of their needs for potency. We leverage this information. And again, the really, really strong Redecan brand to deliver this to Canadian consumers, and you can look forward to seeing that hitting shelves like I said, in early spring. More to come on this front as we're rolling out our innovation pipeline over the next 12 to 24 months. But this is what you can expect from HEXO on a go-forward basis, insightful innovation that are meeting the needs of Canadian consumers.

[Scott Cooper:]

Yes. Val had add, the Redees Plus, we're very excited about that as well. And it took a lot of technical know-how to bring that to market. It's launched the premium price. And as you say, that's what can be expected as we continue to leverage those consumer insights and our capability to bring unique and compelling products to market.

[Operator:]

Your next question comes from the line of Frederico Gomes from ATB Capital Markets.

[Frederico Gomes:]

Maybe could you give more color on the issues you're seeing with Redecan? I know you mentioned competition in the pre-roll market, specifically in Ontario. So just curious on what you're seeing in other provinces as well as other product categories in terms of competition and potentially pricing pressure?

[Scott Cooper:]

Thanks, Frederico. Valerie, over to you.

[Val Malone:]

Yes. Sure. I would suggest that we have a unique opportunity as it relates to our breadth of brands, including Redecan and are in a unique position to leverage our value continuum allows us to address price points and specific needs of consumers across the spectrum of cannabis needs and allows us to balance both our overall volume and our profitability for our business overall. For sure, there's a lot of competition as it relates to the pre-roll category. But again, we are in a good position from our productive capabilities, our strong brand positions as it relates to Redecan and the deep innovation pipeline that we're building. So we're feeling very, very confident in our position as it relates to the market across all categories and all markets. Scott, is there anything else you'd like to add there?

[Scott Cooper:]

No. Great answer, thanks, Val.

[Frederico Gomes:]

Okay. And then just on your capital position right now, you still have some months into the deal with Tilray closes. So I know that you have some assets for sale on the balance sheet. How are you seeing that really need to raise any more capital? Or are you going to rely on those asset sales? How comfortable are you with your cash position right now?

[Scott Cooper:]

Curt, do you want to speak to that?

[Curtis Solsvig:]

Yes, sure, Frederico. The cash position is something that we track very, very closely. And we do a rolling received some disbursements forecast going out 13 weeks, conclusion of the Tilray deal in the middle of May.

[Operator:]

Your next question comes from the line of from RBC Capital Markets.

[Unidentified Analyst:]

I just wanted to get back on the Redecan revenues. So you noted in the MD&A that there was a 29% quarter-on-quarter decline on a prorated basis, and it was due to logistical issues and competition. Could you please split the proportion from both of these? And finally, I wanted to confirm that the logistical issues are now resolved?

[Scott Cooper:]

Thanks for the question. Valerie?

[Val Malone:]

Yes. As it relates to Redecan in the last quarter, there were a number of administrative and logistics issues, but were unique events that we entered in within the quarter, and it was around amalgamation and relisting with provinces. In addition to that, we shifted our overall 0 product as the Redees from 0.35 grams to 0.4, which enables us to actually sell through all of the inventory before restocking in the marketplace, overall. So there were some integration challenges that we had to overcome over the time period of the second quarter. However, demand remains strong, and we're seeing that rebound now.

[Operator:]

And there are no further questions at this time. Mr. Scott Cooper, I turn the call back over to you for some closing comments.

[Scott Cooper:]

Thank you, everyone, once again, for joining us this morning. I am pleased that we can now as a result of our recently announced proposed strategic partnership with Tilray continue to position ourselves to retain and grow our significant market share and will become a cash flow positive business for the next 4 quarters. I have full confidence in The Path Forward. And again, I appreciate everyone joining us this morning. Thank you.

[Operator:]

This concludes today's conference call. Thank you for your participation. You may now disconnect.