HEXO Corp.
Q4 2020 Earnings Call Transcript

Published: 30 Oct 2020

[Operator:]

Good morning. Thank you all for joining us for HEXO’s Fourth Quarter 2020 Earnings Call. Before we begin, we would like to remind you that certain matters discussed in today’s call, all answers that may be given to questions are called constitute forward-looking statements. These statements are based on the company’s current internal views, estimates, expectations, and assumptions. 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 and those implied by such statements.

[Sebastien St-Louis:]

Thank you, operator. Good morning, everybody. I’d like to start by wishing everyone’s safety and health as this global pandemic continues. I’m very proud of HEXO and the team for the dedication as we navigate through the ever evolving and unpredictable environment. The safety of our team is always our first priority and we’re operating within the confines and processes we put in place at the start of the pandemic. We established a COVID-19 response team, which manages the company’s information flow of COVID-19 updates, reviews, public health and safety protocols and we’ve developed action plans to mitigate risks. We transferred all functions, which we can do to work-from-home and operate purely from that stay-at-home mode, web-based and teleconferencing platforms and our functions, which require on-site activity. We increased focus on social distancing and we added personal sanitation station and provided additional PPE. We also implemented travel restrictions and quarantines while traveling and importantly, we initiated a Hero Pay program to support our cultivation and manufacturing employees who continue to work during the pandemic. Despite the many dire economic and social consequences, the pandemic has caused the cannabis industry continues to grow. And that’s a testament to the consumer demand for safe and legal product that we offer. The industry has a $2.9 billion run rate and continues to grow. We remain in a top four market share position closing in on the third spot and increasing the gap between number of ourselves and the number five and number six LPs.

[Trent MacDonald:]

Thank you, Sebastien. Good morning, all. I recently joined the company and delighted to be part of the management team. The innovation and creativity and operational expertise I see here at HEXO is truly staggering. I believe HEXO has an opportunity to become one of the largest cannabis based companies in the entire world. Our view is that companies in a new and growing industry have to first gain a top market position with high quality winning products, but they have to do so while controlling SG&A at least that they hope to achieve consistent, robust EBITDA levels. This has been problematic for the cannabis industry. At the outset, most of the larger LPs scrambled to build out robust teams, systems and infrastructure, as if they were all going to be multi-billion dollar companies. At HEXO, we have gotten ahead of the curve and right-sizing our SG&A. But we are not done. We cannot rest on our laurels. We continue to focus on this area, ensuring that we have the right processes, tools and people to scale our top line without adding costs into the organization. While our company and the entire industry is focused on positive EBITDA. We also know this is only a first step. We need to move past EBITDA and develop a clear path to positive earnings per share. That is why, it is so important to focus on our balance sheet. To ensure our EBITDA, isn’t attained off the back of a grossly high depreciable capital base. Throughout history, there have been plenty of examples with companies with positive EBITDA who have failed due to the consistent and pervasive erosion of book value through interest and depreciation. This has been and will continue to be a problem for many larger cannabis LPs as time goes on. At HEXO, we feel we are extremely well positioned in this regard. With today’s PP&E impairments, we believe we are or are near best-in-class in terms of depreciable asset base, especially when compared to our potential future EBITDA, which again is clearing a path for positive EPS. Unlike many LPs, we want it to stop piecemealing our inventory write-down, PP&E impairments, and goodwill and intangible impairments. We truly want it to go into the next fiscal year with a strong balance sheet putting the past behind us. So we can focus on the future. I believe we’ve done just that. And so my top goals are to ensure we optimize the business, not just to get to adjusted EBITDA positive, but to achieve meaningful profitability on a per share basis. And I see plenty of opportunities to do this.

[Operator:]

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

[Aaron Grey:]

Good morning, and thanks for the question. First one from me, I just want to dig a little bit into the adult use results, excluding beverages, looks like net sales are up about 10% sequentially. I know, vape was partially attributable to the sales growth, as well as the average sales price. But even without vape, it looks like sales are up sequentially with higher ASP. So wanted to get some color on some of the shifts you might’ve seen within your flower brands or whether it was Hash and just whether or not you saw any increase in your higher up price flower brand versus the Original Stash during the quarter. Thanks.

[Sebastien St-Louis:]

Thanks, Aaron. We’re really proud about the demand of the products. This really all starts with consumer demands and the thing that’s clear is that HEXO products are flying off-the-shelves. The biggest thing we need to work on to improve go forward is supply chain to ensure we’re constantly in stock on all skews. So the revenue per gram has really increased driven by vape. So you’re correct in that assessment, but also by some new higher and flower products like Original Stash reserves. We’re also driving – we’re driving a Hash and 2.0 offerings, which are being very well received. Although again, not in market all the time. So the impact wasn’t as big as we would’ve liked. So what’s interesting about the raise in the average price per gram is that we’re clearly showing the way now that this is not a race to the bottom, that there is room for margin and that we are able to deliver that solid margin, excluding beverage again at a 42% adjusted margin. We’re very pleased with what the team has been able to do, while having one of the lowest average sales price per gram in the industry.

[Aaron Grey:]

All right. Thanks for that. That’s super helpful. And then just looking at sales provincially, I know Quebec has obviously a big promise for you guys. But Ontario has been another market that you guys have looked at. So you’re just looking at retail sales data from Truss Canada, Ontario has obviously been a outperformer the past couple of months in terms of growth as additional stores have come online. So curious as to your efforts to kind of pick up share in that region and how that’s gone, obviously it remains rather competitive market but a lot of opportunity there. So I’d love to hear your insights in terms of the opportunity for you within Ontario. Thanks.

[Sebastien St-Louis:]

Yes, Aaron. So the strategy at HEXO was always start in our whole market of Quebec and we remain the market leader in Quebec and the preferred supplier to the SQDC. I think the SQDC itself is continuing to grow stores at a very good pace. As far as Ontario, we’re really excited about what Thomas and his team has are doing over the OCS, big focus on store proliferation, and we’re also excited to be a big part of that journey. We’re only at the start of that journey. So this is maybe the second quarter where we’re really starting to build up in Ontario and we’ve made some really significant progress. So if you look about three quarters ago, we did not have any meaningful share. And now HEXO sits at around 5% market share in Ontario. So a meaningful start and our plan of course, is to hit a top two market share nationally, which would translate to about a 20 share in Ontario. We think with the investments in supply chain we can get there over time.

[Aaron Grey:]

Great, thanks for that color. I’ll jump back in the queue and pass along for others.

[Operator:]

Your next question comes from David Kideckel of ATB Capital Markets. Your line is open.

[David Kideckel:]

Good morning. Congrats on the quarter and thanks for taking my question. First question, just going back to the provincial split year, Sebastien, so 5% Ontario in this quarter. Should we assume that the rest of the 95% is all Quebec, or do you have some share in Alberta and any other provinces?

[Sebastien St-Louis:]

Yes, David. So it wasn’t 5% of sales for HEXO. I was saying into the overall Ontario market HEXO accounts for 5% market share.

[David Kideckel:]

Okay, understood. So then maybe on that break up – are you able to break up your provincial split then with sales nationally?

[Sebastien St-Louis:]

So I won’t give you the full breakdown in every market. I can share that in Quebec, we remain the number one player by market share, by volume that’s still north of 30% by kilograms, by price. It’ll fluctuate month-to-month and quarter-to-quarter. We are listed nationally, but not with a full product offering. So the next priority is really to make sure that the full product offering gets everywhere and that we remain in stock. And that’s really supply chain driven. So the good news is we have plenty of demand and there’s no demand problem at the moment.

[David Kideckel:]

Okay, great. Another question, I want to go down to beverages for a second here, and congrats on the launch of Truss. I just want to – first of all, just for some housekeeping, rectify something. In your earnings release, it says sales for the quarter ended July 31 accounted for about 7% of sales for beverages. But in your prepared remarks, the rollout occurred in August. So I just want to rectify if you’re speaking of 7% sales for the quarter ended, or since the commencement of the rollout, which was in August. And after that, just my question is what have you seen so far for consumer demand? Which types of beverages have been the most popular, it’s CBD, THC, high THC, low-THC, any color would be helpful? Thank you.

[Sebastien St-Louis:]

Thanks, David. Yes, so just – for the housekeeping piece, you’re looking at the quarterly numbers, but pre-August, we did have the very valve drops in markets. So those accounts for the nominal sales that you started to pick up and when we refer to the launch in August, that’s the ready-to-drink portfolio, and it’s been a phenomenal success. Again, so we were about three months later than some of our key competitors and really launching the full – or half the full portfolio nationally. But in those three months that measured at the till sales, HEXO and Truss are now the market share leader. So on a weekly basis, we are selling more beverages at the till than any single competitor in Canada. So that’s a phenomenal success and shows you the amazing work the Truss team has done on the portfolio. The portfolio is quite balanced. There’s offering for everybody. We have zero calorie CBD beverages in our Sicilian Lemon and Verywell on the wellness line. You have high-THC beer products available in model, which is a 5 milligram THC offering. And then you have quite a few other occasions when you start to look at our little victory products, which are a 2.5, 2.5, so a one-to-one blend, which are made from real wine. That’s been the alkalized, so very, very high quality product, a phenomenal taste. And on the kind of flavor forward profile then we went to House of Terpenes. So House of Terpenes has been a really interesting success. Our Limonene is probably the highest seller in that category. But we’re also starting to see an interesting uptake on our more unique flavor profiles, like our myrcene product. So House of Terpenes, myrcene is a cocktail we designed to appeal to a flavor forward cannabis kind of serves, it pairs amazingly with steak and it’s to go and replace kind of what you would typically take as a strong alcohol occasion. So what’s been really interesting is that first consumers didn’t know where to place that product and the reactions were mixed. Some people were surprised. There was a little bit of negativism, but as people have been trying the product and are learning to pair it with some heavier foods, they’re really starting to enjoy that myrcene product. So we’re starting to see sales pick up. What would I think has really been successful in the Truss strategy has been the portfolio approach. There’s really something for everybody, whether you’re looking for zero calorie, low calorie wellness better for you, a THC or CBD offering. There’s something for everyone.

[David Kideckel:]

That’s great color. Thank you, Sebastien. I’ll hop back in the queue.

[Operator:]

Your next question comes from Rupesh Parikh of Oppenheimer. Your line is open.

[Rupesh Parikh:]

Good morning. Thanks for taking my question. So I want to start out with a question just on liquidity. Is it clearly, you had a strong cash position at the end of June? Is there any color you can provide in terms of what you expect to spend for CapEx and just how you’re thinking about cash generation this year?

[Trent MacDonald:]

Hi, Rupesh, Trent here now. Yes, well, we have a pretty robust investment plan on capital over the next fiscal year. We continue to invest in our Belleville facility to ready ourselves for things that are coming for both Truss and the potentially other CPG partners. We want to continue to have operational efficiency on meeting product supply with that forecasted demand. So we’re still putting money into that facility and believe there’s a really high IRR that comes with that spend. So we’re not scaling back at all on our path forward to capital investment.

[Rupesh Parikh:]

Okay, great. And then given that, I think your Q1 – I believe your Q1 just ended. Is there anything you can comment just in terms of this Q1, how to think about it from a top line and from a gross margin perspective?

[Trent MacDonald:]

Well, we’re not really giving guidance. I think as an industry guidance has gotten a lot of people into trouble. And so we’re trying to step back from that. Although we can – we have said and Sebastien repeated early, we are moving towards EBITDA positive and continue to move down that path. Our sales are healthy. We have been taking the time to invest in that forecasted demand and understanding it and making sure that we can match supply. To Sebastien’s point earlier, we have launched lots of great products. 28 gram or less Original Stash was a great example of it, where we went into market. Hadn’t really anticipated the forecasted demand to be as high as it was and ran out of supply. And then of course, all of our competitors duplicate our efforts and jump in and take some share. We don’t want that to happen. We’re too innovative in terms of our product development and product launches. A lot of money and time and resource wind to that process. And so we don’t want to be setting ourselves up where customers are disappointed because they don’t have product to buy, if they’re trying it for the first time or coming in for a repeat purchase. So we’re taking some real time in Q1 to get that right, to set ourselves up for longer term success.

[Rupesh Parikh:]

Okay, great. And my final question, maybe for Sebastien. Just on cannabis 2.0, so clearly good progress this quarter. I just want to get a sense of how you’re thinking about the mix as we go forward for balance of the year. Not looking for guidance, but just anything, just qualitatively you can share in terms of how you think about the cannabis 2.0 contribution.

[Sebastien St-Louis:]

Yes, Rupesh. Thanks for that. And absolutely, I can tell you where our focus is. We’ve been – we’ve really narrowed the focus over the last few quarters at HEXO in order to really go deep in the areas and win the categories, in which we play. You saw us redefine the market on flower completely, right. You almost have half of the market now that came behind us after we launched Original Stash, 28 gram a last year. And you’re seeing us do it again on Hash and extract. So overall, I think categories will be about 40% to 50% flower go forward. I think that’s a solid number on dried flower. Pre-rolls probably 15% to 20%, vape probably 15%, then we think Hash can be very significant part of what remains in the market. And those are really the four areas of core focus that we do on our own. Beyond that we’re really looking to partners to add new products into market. And this is why we’re thrilled to be with Molson on the beverage side. And that’s working phenomenally with taking the number one spot of all LPs in Canada. But overall, I think if you focus on those four top categories, you cover 80% of the market.

[Rupesh Parikh:]

Okay, great. Thank you.

[Operator:]

Your next question comes from Matt Bottomley of Canaccord Genuity. Your line is open.

[Matt Bottomley:]

Yes. Good morning. Thanks for taking the question here. Just wanted to get a bit more color on the inventory write-off in the period, last quarter, there was none. And then the quarter before you had book to spell. But just in that kind of period from fiscal Q2 to fiscal Q4, does this legacy dry. But that was written off, whether new or sort of days sales, like us increases into the inventory in interim period that we then written down. Just think of its timing of what exactly this is written off and it was your days sales, your 2Q or does just days sales back as driving by there’s something that’s been on the floor for long period of time.

[Trent MacDonald:]

Yes. Again, Trent here. Well, if you look at what our Q3 balance sheet looked like, and we had been piecemealing this inventory right down as a lot of the LPs have been doing over the course of the past four to five quarters. When I came into the organization, it was the very first thing, even before I came to the organization that was the very first thing that I was looking at. And Sebastien and I had a great conversation. The number of days sales in inventory that were sitting there Q3 comparative to our peers was – I thought was relatively high. It weld way too high in fact. And I think that’s still a problem across the entire industry. And look, we want to be able to move forward with a clean balance sheet. And so it was imperative for us to get that inventory down to a manageable level from days inventory and supply match that to our production plan for the coming year, and where we think forecasted demand is going to be and we’re in it, just a very, very, very healthy place. So across different categories within inventory to answer questions, we looked at those that were, it had been slower moving or getting a little bit aged in terms of freshness, because that is a strategy of ours and appropriate write-downs where applicable. Again, the bigger broader strategy here is to have a strong balance sheet. And don’t set ourselves up for future impairments and future write-downs. We want to come into the year with a clean, strong balance sheet and just move forward. And I think we’ve done that more than anyone else in the industry quite frankly.

[Matt Bottomley:]

Understood. And then maybe, do you have any color on, because unfortunate with the accounting standard development, fair value adjustments that increased over time. Do you have an estimate of how much of that is cash versus non-cash? Just sort of the reversal of previously increased equity or increased inventory on the fair value from…

[Trent MacDonald:]

Well, most of fair value adjustments are non-cash as you know. It’s an accounting standard versus us investing. We invest in cost biological assets and cost inventory, and then we have to adjust the fair value based on the market trends and what we, as management are getting from industry news and industry data and we adjust the inventory carrying balances accordingly. So all fair value adjustments for the most part are non-cash.

[Sebastien St-Louis:]

What’s interesting, I think, Matt, is that the work we’ve done that Trent has led on the balance sheet is starting now to match the work happening in operations. There’s an overarching strategy at HEXO and my marching orders to the team are to make sure we deliver high quality product. And that includes being able to deliver at the right cost, at the right potency, but also with the right freshness. So making sure that consumers are continuously getting a fresh stream of product, this quarter, what’s incredibly significant starting in Q1, not only are we starting from a clean balance sheet, but we’re not adding to the problems over the next 12 months, what’s coming out of the greenhouse and what’s being transformed is being done and as needed basis to the demand. So we are really getting close to being able to supply in on a one-to-one demand and not repeat these mistakes of the past that all licensed producers have made, where started accumulate a massive inventory stockpile that you have to write down. So I think on a go forward, this is what really positions HEXO to win is that we are matching supply to demand.

[Matt Bottomley:]

And just one more for me, on the buying patterns of the cannabis, are you seeing any sort of linear relationship or any other probably you can surprise, particularly with Ontario as the state of retail stores . How does that roll through inter – actual buying patterns, obviously, I know it’s going to be different skews and new product launches that you guys have done. But just maybe overall on average, is that something that is flowing through now, where when you see these very attractive stash cannabis numbers, where every month the Canadian industry is at a new high month-over-month, is that something that’s flowing through now and in those provinces where retail stores are facilitating higher participation in the legal market?

[Sebastien St-Louis:]

Yes, Matt, I apologize if I don’t precisely answer your question. You’re breaking up a little bit at the front end. But I understand that you’re asking like the additional total Canadian market demand and is that flowing through to two LPs? And I think definitely one of the changes in the industry narrative that’s important to note now. Sales at the licensed producer level are no longer limited by store growth. I think our provincial partners have done a phenomenal job opening stores. I think they now have the most aggressive plan I’ve seen since the beginning of legalization to open more. So don’t misconstrue that. There is additional upside to opening more stores, but the current goal of LPs there we can grow within the current store environment. So there is – the logistics are now in place for us to do our job, which is phenomenal. In terms of seeing that flow through, I think what’s really exciting is you’re seeing HEXO being one of the very few licensed producers that are taking share. So again, if you look at the market share listing, I mean, HEXO quarter-over-quarter, we grew our net sales 17% that’s best-in-class. We’re right up there with the absolute best competitors and the market that follows pretty closely with the market has done over the last couple of months. What’s interesting is we’re starting to see most of our competitors’ falter where HEXO has closed the gap with the number three competitor by market share. We’ve increased the gap between ourselves and the number five and the number six, there’s still as well – and I’ve talked about this last quarter. I think we’re still going to see most smaller producers have a lot of difficulty over the next 12 to 24 months. And at the moment, those smaller producers account for about 30% of the total national share. So that’s where you’re seeing the national number grow faster than the top LPs like HEXO, is the smaller producers that are still hanging around and getting less things. But it’s very challenging for these small producers to remain competitive. They do not have the scale. They do not have the operating expertise and they do not have the portfolio approach. So I think 12 to 18 months that rectifies, that frees up that balance 30% of the market to be absorbed by the top performing LPs. And we are hot on the tails of that top three spot to ensure we’re here for a long time.

[Matt Bottomley:]

Thanks, Sebastien. Very helpful.

[Operator:]

Your next question comes from John Zamparo of CIBC. Your line is open.

[John Zamparo:]

Thanks. Good morning. I wanted to follow-up on the question with sales performance in FQ1. Your comments about wanting to get supply chain rate. And making sure you’re always in stock. Should we interpret that as you might not see as much of as a sequential increase in Q1 versus what you saw in Q4?

[Sebastien St-Louis:]

Yes, John, thanks. We’re working on it. So with – we’re not providing guidance either way, but for sure as part of an overarching strategy, we want to make sure that the year 2021 is a blowout and that we move up that market share ranking. So I’m much more interested in making the top three position from a market share position that the specific number on the quarter.

[John Zamparo:]

Okay, understood. Maybe more of a housekeeping question, but can you help us understand how the accounting practice on Trust will play out over the next few quarters? And when these results transition to the equity pickup line rather than in your P&L?

[Trent MacDonald:]

Sure. Let me answer that. We’re still working through the license process and it can’t move over until that process has gone through its entirety. So once it does get its license, it will become a separate legal entity – well, separate legal entity now, but it’ll move to separate legal entity accounting. And therefore, to your point, it will come off of our results and come to equity reporting. I don’t have an actual timeline on that, but it is in process.

[John Zamparo:]

Okay. Got it. And then last one for me, maybe you don’t want to disclose an actual number and that’s fine. But can you talk about how your large format value products with the Original Stash performed in the quarter versus prior quarter? And it does seem like, like you said Sebastien, other competitors have really crowded the category. So I’m trying to get a sense of how that performed quarter-over-quarter? And how much of a priority for you is it to win that category? It sounds like, it’s maybe not so much and that you’re focused more on higher profit or more profitable items, but just would like to get your commentary there. Thanks.

[Sebastien St-Louis:]

Hey, John. I think when we made the move last year and we reset the whole market, right? Like there was no such thing as a $2 gram until HEXO created the category with that 28 gram offering. And when we did it, the first comments were okay, race to the bottom, never going to make any money. The next step in that evolution of our strategy, we proved we could make money. We proved that that product could hold a 40% portfolio margin and was part of that portfolio margin strategy. We proved it again this quarter with the portfolio margin actually increasing, that’s Phase 3. So what’s been interesting is all our competitors have kind of just brainlessly copied without understanding the strategy. What we did is, we came back in over top with a better feature set. So we introduced Original Stash reserve, we’re leveraging that now with the relaunch of our Up brand. So we’re super excited about that coming to market with a very clearly defined feature set. So Up flower is actually going to market with a guaranteed 20% plus THC. That’s a first in the whole industry. So it’s never been done where flower has had a defined feature sets under a brand. And we think that’s going to be a phenomenal success and another opportunity to increase our price per gram. So the strategy as a whole you asked me, am I trying to win value? No, am I trying to win low cost high quality product under Original Stash? Yes. And am I trying to gradually increase my price per gram by bringing back new feature sets, continuing to innovate in market. Absolutely. And that’s tracking very well. As we dial in our supply to our demand, I don’t really see the necessity to go invest in additional capital to build capacity for that race to the bottom. The capacity that we have coming out of our flagship grow in Masson-Angers and Gatineau is phenomenal product. And so that allows us to compete in that 28 gram format. Quite frankly, a higher price point than most value brands of some of our competitors. A lot of my competitors have come in on that 28 grand format, and this is on the – against the base original Stash product. They’ve come in at $99 and we’re still performing very well at $125. So I think you see consumers saying, oh, well, the best value in that mid-market is really Original Stash and then we have an opportunity, of course, the price even higher with the Original Stash reserve.

[John Zamparo:]

That’s very helpful. That’s all for me. Thank you very much.

[Operator:]

Your next question comes from Andrew Carter of Stifel. Your line is open.

[Andrew Carter:]

Hey, thanks. Good morning. I wanted to understand the inventory dynamics a little bit, because you did outline pretty specifically where the write downs were in the quarter by purchase or harvest. And if you add back the charges, you do have kind of capitalized inventory growing $2 million. But I was kind of confused because a lot of it was also a big draw down on purchase inventory. So I wanted to get an understanding of kind of where you were from supply demand in the balance on kind of your supply chain internally as it stands today.

[Sebastien St-Louis:]

Thanks, Andrew. Yes, really overall we’re in phenomenal shape, probably best-in-class from a supply demand mix on a go forward basis after these changes to the balance sheet.

[Andrew Carter:]

Okay. Sounds good. I wanted also ask because you completed the ATM during the quarter of $34 million, but prior to the ATM, they get a net-net cash position of more than $130 million. You’re clearly on track with the business in terms of your expectations. And you have much larger goals in mind then kind of the straits giving you credit for. So I’m not sure I understand why exhaust ATM issuance late in the quarter essentially $1 a share. So could you help us understand kind of the capital allocation here?

[Trent MacDonald:]

Yes. Look, we unlike a lot of our competitors want to – going back to the balance sheet and ensure that we have a very, very, very strong balance sheet. And so that means liquidity. That means great working capital ratios and the cash was there, we could go to market at the time and there was some demand for the ATM and we took it, took that opportunity. We wanted to have the say, that we’ve set ourselves up for the long-term and we have. And so, we’re not – never say never, but we’re at a great place. And so, our debt is not high, we have very low secured debt at $30 million. We’ve taken care of the convertible debentures on our balance sheet. We’ve increased our cash reserves. We have strong working capital. We’ve written down our inventory, we’ve taken our impairments. We don’t have any goodwill on our balance sheet at all. I mean, I would stay on that balance sheet up to any other of the larger LPs in the market and then some. That’s what I think people just have to do their homework here when you’re thinking about HEXO to your point clearly we’re in a position of strength. And so the ATM took place and it was the right thing to do at the time. And now we’re sitting in a tremendous position of strength.

[Andrew Carter:]

Thanks. I’ll pass it on.

[Operator:]

Your next question comes from Douglas Miehm of RBC Capital. Your line is open.

[Douglas Miehm:]

Yes. Good morning, Sebastien, Trent. Just as it relates to production capacity in Belleville, looks like you have some significant plans here and with your building to get to number one on the beverage side, just want to make sure that you’re going to be able to supply the market over the next few years. Can you maybe give us a few details on how things are going there and the capacity utilization?

[Sebastien St-Louis:]

Yes. So thanks very much, Doug and good morning. So, one of the advantages of having partnered with Molson Coors on Trust is that they’ve come in with experience that did not exist and barely exists today in the cannabis industry as a whole. What they’ve done with that Trust facility is staggering. So capacity is not an issue for Trust. There’s really no – we won’t bump up against any capacity constraints on our bottling and canning lines for a long time, which was part of the strategy, ensuring that we could build a robust portfolio, not just for this year, but really for five years out, because we think beverages could be between 15% and 20% of the total category. Now there’s some meaningful things that need to change from a regulatory standpoint for that to happen. We’re convinced they will happen, but it’s a matter of time. And these are for example, the five beverage limit to purchasing. This is the broader distribution of CBD beverages outside of strictly cannabis stores. So there’s a couple of dominoes that need to fall. But when that happens, what’s interesting, we’ve proven out we have the best portfolio now. We’ve proven out that we can produce at scale. And so the question – and we’ve proven out, we can get the distribution. So with that regulatory, when those are regulatory hurdles come we are really well positioned to make sure we’re first and perhaps even more excitingly, all those learnings can translate to the U.S. So whenever changes we see following this election, we’ll be able to take advantage there as well.

[Douglas Miehm:]

Okay, perfect. My second question just has to do with – I guess, what I’m interested in is how you’ve been able to move to a number one market share within – and we know that there’s not a lot of company, so operating in the space on the beverage side. But maybe you could delineate why you believe that you’ve been able to take that number one share away from the large company in the space.

[Sebastien St-Louis:]

Doug, I think it really comes down, because of better products. I think the product portfolio is broader. So it’s more appealing to a wider range audience. I think we’ve done phenomenal work from a quality. So if you look at the actual capabilities of our facility, we have a better ability to control oxygen into the product, which means a better stability, better taste. I think we put a lot more work into the taste of the product. So for my personal taste, they taste better. So we don’t have any lingering cannabis taste, our emulsion technology is better. I think that we made a better formulation from a calorie perspective. So if you look at most of our competitors products, you’re talking to 100 to 150 calories a can. We don’t want that. The millennials and younger generations, nobody wants to ingest 150 calories as sugar. So this is what super exciting about taking a product like Mollo, either our 5 milligram THC offering or the light version of 2.5, each of those beers, which tastes great by the way, it’s a light beer, but a bit more complex than your typical say light. So a little bit of complexity to it, but that’s a 30 calorie product. So it’s absolutely phenomenal, right? Like when I was on my cottage the other day, I have some friends having the chance to try it and they were blown away that between Molson and HEXO and Trust we were able to create a product that was better tasting than a lot of the flagship beer products out there, a fifth of the calories that also delivered a phenomenal head high. So I think it’s just been the – it’s a confluence of a lot of things. And we have a lot of work to stay number one. I think it the number one leadership margin right now is still very tight. It’s not a large margin. And so we’ll have to work to continue to stay there, to continue to innovate and that’s a big part of what we’re doing with our powered by HEXO investments and the R&D investments that HEXO does behind the scene and the value that we contribute to the partnership.

[Trent MacDonald:]

And I’m going to follow-up on Sebastien, because, what happens is that once people actually try the product to coming back for repeat purchase, because of all of the things that Sebastien just said. But let’s not discount the fact that, getting into market across the country really comes down to our partnership with Molson Coors as well. With the retail background, such as myself, I know that, retail is about shelf space, it’s about getting listings into market. And if you don’t have a wonderful partner like we do at Molson Coors that’s going to be difficult. And so you’re seeing that with a lot of these other smaller LPs that are coming out with beverage, they’re not getting the listings, they’re not getting the shelf space that Molson Coors is going to demand. And so that’s what’s been extremely helpful for us in terms of landing ourselves in the number one market share and then you see all the things that Sebastien said, that are holding us there and are going to help to build it, because we’re getting great repeat purchase and great uptake because of the flavor profiles and the mix of product.

[Douglas Miehm:]

Great. Okay. Thanks very much.

[Operator:]

Your next question comes from John Chu with Desjardins Capital Markets. Your line is open.

[John Chu:]

Hi. Good morning. I just wanted to continue to touch on this managing the supply and demand. So it sounds like we’re still not quite very at – I guess, at the end October. But it also sounds like you were readjusting the strains that you’re growing in terms of understanding what the consumers want. So to then there’s a process of waiting for that growth cycle to complete. Is the cultivation part of that meeting supply demand in place? And that the bottleneck of that supply side is just kind of little bit further along the process. Is that the best way to understand that’s meeting supply and demand process?

[Sebastien St-Louis:]

Yes. John, thanks. I think the supply and demand process is something we’re going to be working on forever. It’s not and let me qualify that. So overall to more directly answer your question, we are better now than we’ve ever been, and we keep improving on a day-by-day basis. However, the demand that the steam level in-store fluctuates all the time, consumers look for something new, they want to induce trial, some products they love more than anticipated right in this month on the lot with HEXO where we have a certain demand profile that we come up with our provincial partners. People go in and they try it, and then it blows the lights out and all of a sudden they want four times more than what we thought they would. And so that creates a problem. So our response to that strategically is to focus on having this freshness strategy, where we first started the genetics to your point and that’s part of our brand per genetic lab, where we’re continuously innovating and breeding new best in class strings. That by the way, is what came behind the new launch and our ability to promise a 20% THC and on. That then feeds into our Molson greenhouse, which we’ve made tremendous progress in improving the – so the cultivation team’s done a phenomenal job there in improving consistency of yields, quality of yields, and also the constant availability of fresh flowers. So if you look at what’s available in market for HEXO, you’re always getting things that are packaged on fairly recently. And then the last part of that, which there’s still a lot of progress to make there in the following few quarters will be our Belleville manufacturing, which is primary pack and secondary packaging. And our strategy is to overbuild in those areas. So we can move to a near just in time packaging strategy. And so once we get all those elements together, then – when I talk about supply and demand being an ongoing issue forever, it’s really about having best-in-class planning ability and relationships with our provincial partners in which we’ve invested heavily. So HEXO has invested quite a bit in bringing top CPG demand planners, top CPG supply liners into our organization. And we believe over the long-term that will form a moat along with the top level of relationships that performing with our partners. And one of the reasons it’s critical to make it in the top three market share spot over the long-term.

[John Chu:]

Okay. That’s very helpful. And then just a second question. So it looks like the vape pen and Hash margins were a drag, so that it looks like it’s slower than flower. And maybe just give me a sense, because I know it’s early stages for both of those products. Will margins get to a point where both will be higher in flowers and sales volumes for both of those products ramp up, or maybe just give me an idea of how they might rank in order of margin generation?

[Sebastien St-Louis:]

Yes, for sure. So, John, I think the thing with margin is right now, any new product launch, and this is the thing that cannabis companies, I worked continuously launching new products. So the margins are understated on the front end, right? Because we’re building for scale and so just by the sheer lack of volume – margin with very few product category. So the margin looks like very low. Both products over time and I’m talking six, 12, 24 months will be some of the products that can really drive margin to be superior. And so we’re quite pleased actually with how that’s tracking once it gets to scale.

[John Chu:]

Okay, great. Thank you very much.

[Operator:]

Your next question comes from Jesse Pytlak of Cormark Securities. Your line is open.

[Jesse Pytlak:]

Hey, good morning. I just kind want to circle back to some of that commentary on kind of strengthening that internal supply chain and the stock own issue that you were kind of experiencing in the quarter. Just wondering if you could maybe just quantify a bit more, what kind of an impact those stocks had and then just kind of the amount of time thinking about peak to kind of strengthen those supply chain capabilities to reduce this?

[Sebastien St-Louis:]

The quantification, I’m not sure how relevant it is, Jesse, because the number is staggering, right? So the unconstrained demand for HEXO products, if we had an unlimited on-demand supply that was instant now that’s impossible, right? Like, no company in the world in any business can do that. But assuming you had unlimited supply instantly of anything, you’re getting to a multiple of a multiple. Your sale then go – it would not be unrealistic to say we could do 10x, and this is what in the past has gotten us in trouble, because we did not understand our supply chain well enough to avoid those pitfalls of giving, for example, unrealistic guidance, because it was not constrained in the right way. So this is why we’re taking our time now specifically through to Q1. And I think over the next six to nine months, you’ll have another significant improvement in HEXO’s ability to deliver a product to market, which will really unlock that demand. Now that’s also in the context of a competitive environment where there are very few companies, I think that are focused on matching that supply and demand. And so should really provide a solid foundation for us to continue to grow sales.

[Jesse Pytlak:]

Thank you. That’s helpful. And then just kind of turning to the gross margin on beverage just kind of wondering how we should maybe think about this on a steady state basis, and then just kind of cadence to achieving that.

[Sebastien St-Louis:]

The beverages are part of an eventual portfolio strategy at a 40% margin, right? So you have to understand that this facility that we built with Trust. So the first step is being absorbed on the HEXO financial as Trent discussed earlier, when Trust obtained its Health Canada license and a standalone those financials will consolidate up to Molson Coors. And so we’ll come off of the HEXO top lines. So we will, hopefully at that time, see net income out of that business come back onto our financial statements. But the margin, I mean, obviously you’re coming in, you’re starting, you’re dividing all that startup cost on a relatively low amount of beverages pull through the market. So I think for one, it will improve greatly and contribute positively over time to net income. And two, it will not impact the gross margin in HEXO as soon as Trust gets their license, because that’ll come off our financials.

[Jesse Pytlak:]

Okay. Understood. Thank you.

[Operator:]

Your next question comes from Adam Buckham of Scotiabank. Your line is open

[Adam Buckham:]

Good morning. Thanks for taking my question. So just one quick question for me. If we look at the quarter, it’s hard to tell from your MD&A, but was the consolidation of Trust a negative to adjusted EBITDA, or was it backed out of the calculation? And if it wasn’t negative, can you quantify the amount?

[Trent MacDonald:]

Yes. No, there was no negative. The way we account for Trust is that Trust actually owes us back the net cost and burden on our P&L. So there’s an in and out, so the net it’s a zero sum balance. It does obviously impact our margins as everyone has noticed. And again, to Sebastien’s point, that’s because we’re at low volume and we’re in a CPG environment, so you’re burdening costs of goods with overheads. And so when you have those fixed costs being applied to inventory, and that flows through the P&L with COGS on low volume, clearly you’re going to have negative margin. But that’s just a scaling issue. As we continue to go forward and scale and continue to put product into production and into market that takes care of itself. We anticipate fully that it’s going to get to a healthy positive margin over time, and when it comes off of our P&L and out of our books, and we can sell it at an equity basis, that it will be – it will eventually give us a really great return on that investment. And that’s why we’re in it.

[Adam Buckham:]

Great. Thanks.

[Operator:]

There are no further questions at this time. I’ll turn the call back to management for closing remarks.

[Sebastien St-Louis:]

Thank you everybody for joining the call. So a great takeaway from our part, a big thanks to the whole HEXO team for their continued effort. I’m super pleased with our number one position in beverage, our number one position in Hash. So that’s been phenomenal. And again, we are tracking against our strategic objectives. So when I measure this quarter against the top three things we’ve said we wanted to do, which was be a top innovator, operate with a very healthy portfolio margin, and become a top two market share company. We’ve made progress against all three of those pillars. So, again, closing the gap on that top three, delivering adjusted margins without the beverage of 42% at a gross margin level. And on the innovation side, being first in a number of categories, it’s really been a phenomenal quarter for HEXO. So looking forward to delivering more and being able to really align on that over the following quarters, as we start to talk about positive EPS and really show what this team can do. Thanks for your time. And we’ll look forward to talking to you next quarter,

[Operator:]

Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.