Canopy Growth Corporation

Good morning and welcome to Canopy Growth's second quarter fiscal 2020 financial results conference call. Canopy Growth issued before financial markets today on November 14, 2019, a news release announcing its financial results for the second quarter fiscal 2020 and its September 30, 2019. This news release is available on Canopy Growth's website and has been filed on CDAR. On the call this morning, we have Mark Zekulan, Canopy Growth's Chief Financial Chief Executive Officer Mike Lee, Canopy Growth Executive Vice President and Chief Financial Officer Enrati Kovacevic, Canopy Growth President. At this time, all participants are in a listen-only mode. Certain matters discussed in today's conference call or answers that may be given to questions asked could constitute forward-looking statements. Actual results could differ materially from those anticipated. Risk factors that could affect results are detailed in the company's annual information form and other public filings that are made available on CDAR. During this conference call, Canopy Growth will refer to supplemental non-GAAP measure adjusted EBITDA. These measures do not have any standardized meaning prescribed by IFRS. Adjusted EBITDA is defined in the press release issued this morning as well as in this period's management discussion and analyst document filed on CDAR. Please note that all financial information is provided in Canadian dollars unless otherwise specified. Following prepared remarks by Mr. Zekulin and Mr. Lee, the company will conduct a question and answer session during which questions will be taken from analysts. If you'd like to ask a question, please press star 1 on your telephone keypad. I would now like to turn the meeting over to Mr. Zekulin. Mr. Zekulin, please go ahead.

Thank you, Sharon. And good morning, everyone. Thanks for joining us. So a little bit of, I guess, housekeeping before we start. You know, last Last quarter we, or I guess I took the time to have a lengthy introduction to go over our strategy, you know, remind people what it was and confirm, you know, we're staying true to it. So I give you my word we won't do the same lengthy summary this time. Mike and I between us will stick to probably under half an hour. We'll leave half an hour for questions and then we'll let everybody get back to their days. The second thing, just to let you know, there are four slides that we have put up on our website which speak to, as a complicated quarter, we decided to put some information down on paper about adjusted EBITDA, inventory levels, working up to normalized margins. So those are there. Mike will use those as he speaks a little bit later on. So with that said, I think it is fair to say it's been a challenging couple quarters in the cannabis sector. So I would like to first address that head on. Second, speak to what we as a company have done this quarter to adjust to some of these short-term challenges. And third, reinforce our view that over the medium term and despite the current climate, we feel exceptionally bullish on how Canopy is set up to win. So firstly, the big picture. To be clear, There is still an emerging global cannabis opportunity worth hundreds of billions of dollars across medical, pharmaceutical, CBD, and recreational cannabis. However, we know the bellwether remains what is happening in the Canadian recreational market. It is the first national, federally legal, large-scale market opportunity for the sector to execute upon. And the market opportunity today is simply not living up Two expectations. And at the risk of oversimplifying, the inability of the Ontario government to license retail stores right off the bat has resulted in half of the expected market in Canada simply not existing. Ontario represents 40% of the country's population yet has one retail cannabis store per 600,000 people. When one year into the market, the addressable market is nearly half what is expected There is going to be meaningful short-term problems. So as a company, we are pleased to see the recent announcement that Ontario has made a commitment to move towards an open allocation of retail licenses where the number of stores will only be limited by market demand. This is a big deal, but it cannot come soon enough. There is sufficient supply for an orderly store rollout to happen now, as it did in Alberta over the past year, and until this happens, The cannabis sector cannot reach its full sales potential and cannot convert consumers from the illicit market into the legal market. Having said that, the stores will open, cannabis 2.0 product launches will come, and the size of prize will still materialize for Canopy because we have the strength, resources, and build out to weather the short-term storm. We've said it before and we'll say it again, this is and always has been a long-term game. and there is no company better positioned to win it today than Canopy. So stores aside, let's look a bit closer at the first year of Canadian recreational cannabis and Canopy's performance this past quarter. Canopy continues to hold the strongest market share in the Canadian recreational market with still over one in every four dollars spent at the till being spent on a Canopy product in our estimation. Canopy is number one at Patil in Ontario, number one in Nova Scotia, number one in PEI, and number one in Alberta, the country's most developed market, at over a 35% market share. In Quebec, we are number two, only behind EXO. Our products are performing, customer affinity is growing, and we are consistently delivering our flour, oil, and soft-shell products to market. And we have the inventory and breadth of skew variety to maintain and increase that share as the market grows. Now, as has been covered by many of you on this call, we have witnessed a slowdown by provincial buyers in the recreational channel as they right-sized their own inventory levels after significant inventory accumulation. Despite this headwind, solid product inventory helped drive strong shipments of dried flower and pre-wool joints across our Canadian recreation channels in the last half of the second quarter. This helped Canopy end the quarter with dry bud shipments of 12% quarter over quarter. Signaling that Canadian end-consumer demand for recreational cannabis is growing, gross revenue from canopy-owned same-store retail sales grew 17% in the second quarter. Accounting for same-store sales as well as the opening of additional stores, gross revenue from recreational cannabis retail sales increased by 24% to $13.1 million. Additionally, gross revenues before accounting for returns and provisions increased sequentially by 6% to $118.3 million across the company. So considering the challenging dynamics that have existed in Canada, we are pleased overall with how the second quarter unfolded. However, detracting from these successes, after a detailed business review, we have concluded that it is appropriate to reflect returns, return provisions, and inventory adjustments, which Mike will expand upon later. Manager believes that these are extraordinary measures that now taken will not occur again and that inventory and production levels across all products are now within an appropriate range as we look ahead to future quarters. Obviously, these abnormal restructuring items had a distorting impact on our growth margin to the tune of $40.4 million. Mike will offer more specifics related to the charges against growth margin later in the call using those handy sheets we talked about. Jumping ahead to the medium term. We are also very excited for the launch of Cannabis 2.0 products, which we believe will further differentiate our offering and bring new customers into the market. Many years of investment in market research, product development, and product marketing has prepared what we believe will be the highest quality, most differentiated, vape, beverage, and edible products available on the market. On October 29th, we hosted a media event, during which media toured our chocolate and beverage production facilities We're introduced to our distilled canvas concept and we're given the opportunity to taste non-active versions of beverages and chocolate products that we plan to bring to market. The beverages will range from spirit alternative products to ready-to-drink tweed branded beverages to refreshing sparking waters and citrus flavored beverages. Over the coming months, we will conduct various trade shows for retailers and stakeholders across the country to familiarize them with our offering and we'll also reveal our vape product portfolio at that time. All of our extraction and value add facilities are fully licensed and ready to go with the exception of our beverage facility which we hope to have licensed by Health Canada imminently. While I have focused thus far on the dynamics of the Canadian recreational cannabis market, it is important to recognize that the global medical cannabis and cannabinoid markets are core parts of our business and are all performing strongly. Our Canadian medical cannabis business grew 8% last quarter while our international medical cannabis business grew by 72%. Combined, total organic global sales in our medical business was up an impressive 23%. And notably, oils and soft gels now represent over 50% of our global medical business. We continue to focus internationally on physician education as international markets expand. An accredited physician education program is now launched in Australia where the market continues to grow at a rapid rate. In Europe, our Danish greenhouse has received GMP certification and we expect that facility to serve our European production needs by fiscal Q1 2021. And in Africa, we have now completed our first sales of Spectrum products in South Africa. These first sales are always the most complex and they test logistic systems and bureaucracies new to Canvas laying the framework for greater sales over time. We are also focused on launching CBD sales in South Africa in the coming months. In the United States, our focus on the CBD market opportunity has continued this past quarter. As you may recall, we made significant investments in U.S. hemp cultivation this past season, collecting thousands of acres of hemp, largely via contracts with American farmers. The harvest of our 2019 hemp crop is nearing completion, and we are pleased with the overall yields and crop quality. This harvest puts Canopy in a strong position to meet anticipated high growth of consumer demand for CBD in the US and abroad. As our large-scale Canadian construction projects are coming to a close, we are aiming our focus on building out our best-in-class production facilities across the United States. Those efforts remain on track at our previously announced facility in Kirkwood, New York and at other sites not yet publicly disclosed. We are deploying all the learnings, scale, and sophistication of our Canadian production environment to the U.S. market. We continue to build a pipeline of new CBD products including skincare and cosmetics, therapeutic creams, beverages, vape products, oils, and soft gels. Our team remains on track to launch a selection of these new CBD products in the U.S. before the end of this fiscal year. The first wave of new products is currently being manufactured and our U.S. marketing efforts are scaling up in anticipation of the launch. Our acquisition of a 76% stake in BioSteel Sports Nutrition was a strategic investment into a truly authentic brand whose products are used by the likes of Wayne Gretzky, Brooke Henderson, Conor McDavid, and Ezekiel Elliott, to name but a few. During the close of that deal and shortly thereafter, BioSteel has already expanded into the United States with over 6,000 points of distribution with national retailers across the country. while it feels in the process of formulating the world's first better-for-you CBD sports nutrition offerings set to be on shelf in the United States early in the new year with over a dozen new products. Our partnership with Acreage Holdings continues to progress and they are well into plans to roll out our Tweed-branded cannabis in multiple U.S. states within the fiscal year. They are also refining plans to open Tweed and Tokyo Smoke-branded dispensaries in select metro locations across the U.S., and finally they continue to build out their own set of brands and intellectual property portfolio. So stepping back, last quarter we talked about our path to success for long-term shareholder value creation. We discussed developing intellectual property, building brands, building international reach and ensuring scaled production for current and future products. We continue to do all of those things. We continue to make a meaningful shift from builders to operators in Canada, with our entire infrastructure platform now substantially built out. While there are headwinds in the Canadian market, we are well capitalized, substantially built out, and continue to execute in Canada and globally to ensure we are leaders in the global market, whether that market be medical, CBD, or recreational. Last quarter, provisions and returns aside, we saw increases in our retail store revenues, are Canadian medical cannabis revenues. Both are organic and inorganic international cannabis revenues, the company's other revenues as well as overall gross revenues. We also saw total cannabis shipments out the door improve quarter over quarter. We believe these fundamentals all point in the right direction for our company. Now, last call, we also discussed the goal of achieving net revenues of $250 million in the fourth quarter of Fiscal 2020 with a growth margin of 40%. While Canopy is geared up with product inventories, production capability, and sales efforts to deliver on the $250 million objective, we do not believe at this time that there will be sufficient points of retail sale in the near term to unlock the necessary Q4 demand. As a result, management believes that achieving our Q4 milestone of $250 million is increasingly unlikely. Finally, As you all know, on July 3rd, we announced the leadership change that saw Bruce Linton leave the company, myself move from my role as president and co-CEO to sole CEO, and Rade Kovacevic become president. Additionally, we announced that I also made the decision to leave Canopy after assisting during this transition period with the expectation that this would occur within this calendar year. While the search is not yet complete, I can confirm that the company is continuing to explore a very short list of exceptional candidates and that we expect to make a further announcement within the coming weeks. This concludes my remarks and I will pass the call over to Mike to review our second quarter fiscal year 2020 financial results in greater detail. Mike, it's over to you.

All right. Thanks, Mark. Good morning, everyone. Let me first begin my remarks with a brief review of our top line performance. Total gross revenue on product shift during the second quarter of fiscal 20, the four charges of $32.7 million, was 118.3 million, which is up 6% versus Q1 of the first quarter. In a few minutes, I will break down the 32.7 million in charges, which primarily relate to the restructuring of our recreational oil and soft gel business. Inclusive of these charges, Canopy generated net revenue of 76.6 million on net cannabis revenue of 53 million, and sales of 10,913 kilogram and kilogram equivalents. Drilling further into the cannabis net revenue of 53 million, there are four trends that I would like to note. First, our Canadian retail business, which is the best bellwether of consumer demand, performed extremely well during the quarter, growing to 13.1 million, which is up 24% versus Q1 and up 17% on a same store sales basis. Second, overall Canadian recreational flower sales continue to perform well, and gross revenue on recreational flower was $59 million, which is down a modest 3% versus Q1. Third, the Canadian medical channel continues its growth trajectory with gross revenue of $14.1 million, which is up 8% versus Q1. and fourth, the International Medical Channel achieved record level gross revenue of $18.1 million, benefiting from a full quarter of gross revenue from C3, but also delivering 138% organic growth in our international medical business, reaching $4.1 million in Q2. Now that we've covered our core channels of business, let me now focus on the restructuring costs related to oils and soft gels. You may recall that in Q1 we evaluated what was at that point the most recent provincial and territorial inventory levels related to sales observed in the REC channel. And we concluded that a risk of oversupply of certain oils and soft gels existed in certain markets due to underdeveloped retail markets in several provinces. Based on that assessment, we reported in our Q1 results variable consideration that may result from rights of return and the amount of $8 million of gross revenue. And in Q2, we continued to see a disconnect between inventory levels and the rate of sale for certain products in the market. Hence, we recently modified our retail pricing architecture and our package assortment to allow us to focus on a smaller portfolio of products at more competitive price points while we continue to educate recreational consumers about the benefits of these formats. And following the shift in this strategy, we reviewed all remaining inventories for both product on hand as well as product in the provinces to determine which product would be returned, which product would remain with the provinces and be subject to buy-downs, and which product would be unaffected. And the result of this evaluation is $32.7 million in revenue provisions broken down into three categories of charges. Number one, pricing actions that are required to establish this new pricing architecture. Number two, returns from provinces for discontinued or slow moving product and number three, Inventory impairments for excess or obsolete on-hand inventory. So I'd like to run you through this list and I'll start with number one, which is pricing. Recreational oil and soft gel pricing adjustments of $10.3 million are required to establish our new pricing architecture. And of this, $5.9 million has already been processed and $4.4 million will be processed soon. These charges fully account for for a full reset of pricing at the provincial level. However, new retail prices will take some time to flow through the market as inventory at retail is sold and replenished with new product. Pricing has been reset at canopy owned retail locations, but as a reminder, regulations do not allow the LPs to buy down third party retail inventory in most provinces. Incidentally, In conjunction with the oils and soft sales pricing review, we also looked at dry flour and concluded there is $3.5 million of additional provisions warranted for potential buy downs on certain mid-level THC CBD strains, but none of this pricing was processed at the end of Q2 and thus remains as a general provision on our balance sheet. Moving on to number two, returns. To date, we have taken actual returns of $20.5 million from the provinces, and we expect another $6.4 million to be returned in coming weeks for a total of $26.9 million in product returns. And also note that these charges are netted against the $8 million provision from Q1, leaving a net charge of $18.9 million for the quarter. Moving on to number three, inventory provisions. With the new retail pricing set within our own retail stores, we use the new sales velocities that we're experiencing as well as those seen within markets where we have already implemented pricing to determine our expected days of supply once this new pricing flows through to broad retail. And we also use our latest projections on store openings to help calculate our forward-looking demand. and in doing this, we identified $15.9 million of products that have been deemed excess or obsolete and this charge has been recorded in cost of sales. So in summary, the restructuring charges just highlighted results in a revenue impact of $32.7 million and in determining the impact to gross margin, we incorporated the recovery of costs for products returned to inventory, We included the recovery of excise taxes. And we factored return product into our days on hand calculations to ensure that returns were factored into our excess and obsolete calculations. And the sum of these impacts on a gross margin basis is $40.4 million. With these charges recorded, there is now less than $10 million of oils and soft gels in Canopy's inventory on hand. and there's approximately $2 million of inventory across Alberta and Ontario provinces. So we believe this issue is fully behind us. With this, let's move on to a full analysis of gross margin for the quarter. Gross margin in the second quarter of fiscal 20 for the IFRS fair value impacts was a loss of $9.7 million or negative 13% of net revenue. which is a reduction from 19% reported gross margin in Q1 and well off of our target of achieving 40% in the near term. The lower gross margin was primarily driven by the previously mentioned restructuring charges of $40.4 million, but it also includes $10.5 million of operating costs related to facilities not yet cultivating or processing cannabis or facilities with underutilized capacity. And it's worth noting that the impact of facilities not fully utilized has decreased from $24 million in Q4 of last year to $16 million in Q1 of this year to $10.5 million in Q2. And we expect this cost to continue to cycle downward as the infrastructure build-out in Canada and Denmark approaches completion and as the manufacturing facilities for REC 2.0 products begin production. Excluding both the restructuring costs as well as the costs associated with underutilized assets results in a normalized gross margin before the fair value impacts in cost of sales and other inventory charges. is $29.2 million or 38.2% of net revenue. And as Mark highlighted, this is summarized in a Q2 2020 supplemental information presentation that's located on our investor relations section of our company website. Taking a step back, gross margin is an extremely important metric for our company. And as we continue to work toward the 40% margin Goal highlighted previously, it's important to note that every Canopy employee that participates in our bonus program has this goal included in their annual incentive. So we can assure you that this is a priority for the entire organization. Now, speaking briefly about operating expenses, our sales and marketing expenses were $60.5 million in the quarter. representing an increase in staffing as we build out our network of Tweed and Tokyo store retail locations. But we're also making investments ahead of revenue to prepare for the second phase of recreational cannabis as well as CBD products in the U.S., all of which are expected to launch later this year. Our G&A expenses grew to $87.9 million, primarily due to one-time non-recurring costs of $19.6 million. Of the 19.6 million, 10.8 million pertains to a legal dispute with a third-party hemp farmer in the United States for which we are seeking remedy for breach of contract. The remaining 8.8 million pertains to estimated exit costs for retail locations that were leased ahead of REC 1.0 before the full set of regulatory and permitting rules were known. Share-based compensation expense was $92.9 million and is up $5.6 million from Q1 of fiscal 20. The increase is primarily attributable to accelerated vesting due to the executive transition announced in July. Separately, management has restructured its share-based compensation program that will lead to reduced expenses and share-based compensation in the upcoming fiscal year. Moving beyond operating results, I'd like to spend a few minutes on other income and expense. Total other expenses are $109.3 million during the quarter, primarily driven by fair value adjustments. First, we recognize the non-cash, unrealized gain of $164 million driven by fair value changes related to senior convertible notes, which is due to the decrease in Canopy's growth stock price from June 30th of this year through September 30th of this year. Second, we recognized a non-cash expense of $235 million related to the fair value change in the acreage call options. Now as a reminder, the acreage arrangement provides Canopy with the option to acquire 100% of the shares of acreage with the requirement to do so once U.S. cannabis production and sale is federally legal in the U.S. And in exchange for this option, Canopy made an upfront payment to acreage shareholders of $300 million in USD, which is now recognized as a financial asset on Canopy's balance sheet with the subsequent changes in the fair value of this option recognized on our consolidated statement of operations. And the fair value of this instrument is driven by many factors, including the relative value of the two companies. And because the stock price of acreage is influenced by the fixed exchange rate of 0.5818 shares, We cannot rely solely on acreage's stock price to determine the relative value of the two companies. Hence, we must also evaluate the entire sector of MSOs in the U.S. to help derive the value of acreage, and because the multi-state operator sector valuations decreased in Q2, the relative value of acreage is implied to have decreased more than canopy, and therefore a loss was recognized. Now let's briefly cover adjusted EBITDA, our supplemental non-IFRS measure for Q2 of fiscal 20. Adjusted EBITDA on Q2 amounted to a loss of $155.7 million as compared to a loss of $92 million in Q1. The adjusted EBITDA loss includes the full impact of the restructuring charge of $40.4 million as well as the $19.6 million of one-time non-recurring costs included in GMA for the third-party disputes as well as the provision for onerous leases. The remaining decline was $3.6 million and was driven by increased operating expenses. Our net loss on a reported basis, which includes all fair value adjustments for biological asset accounting, was $374.6 million or $1.08 per basic and fully diluted share. Turning to the balance sheet. As of September 30th, we had cash and cash equivalents available, as well as marketable securities on hand totaling $2.7 billion, representing a decrease of approximately $400 million since June 30th of 2019. And the primary uses of cash during the quarter was $228.3 million for infrastructure, with the balance related to ongoing debt servicing and funding for operational losses. Our biological and inventory on hand ended the quarter at $572 million, which is up from $496 million in Q1. And this includes $219 million of fair value adjustments, along with the $353 million of inventory at cost. and of the $353 million of inventory at cost, $65 million pertains to markets outside of Canada, which leaves us with $288 million of inventory at cost related to our Canada operations. So let me now address our dry flower inventory, which comprises a portion of the $288 million. Looking at our current demand projections, which includes estimates for new store openings, we estimate our supply and demand for dry flour will reach equilibrium in the summer or fall of next year. And these demand projections assume 40 new stores opening per month in Ontario starting in January, which is informed by the pace of new store openings that were experienced in Alberta. Hintz, we believe we are well positioned on our flour inventory levels and we will continue to monitor the situation closely. And we have illustrated the supply and balance of dry flour in the supplementary information package referenced earlier. It's also worth noting that the balance of our inventory, which includes extracts and oils and isolates as well as other raw material inputs, is in line with demand. and in many cases has an extended shelf life that provides us with lots of flexibility. Next, I would like to provide a brief update on our foreign private issuer test that was completed at the end of Q2. As part of our U.S. financial reporting requirements, we have confirmed that as of September 30th, 2019, Canopy Growth no longer meets the criteria for qualification as a foreign private issuer. Hence, as of April 1st, 2020, Canopy Growth will be considered a United States domestic issuer and a large accelerated filer. And with this, we will transition to U.S. GAAP. And our new reporting will impact certain elements of our financial reporting, and we will provide an overview of the financial reporting changes at our upcoming Q3 Financial Results Conference call. Finally, I would like to provide a brief update on the priorities that I covered during our last call. We are making tremendous progress in reengineering our financial close and reporting processes, and we expect to achieve the accelerated close timelines at year end. We continue to make tremendous progress in improving our control environment and are working to remediate our material weaknesses with end user computing by the end of this fiscal year. And we recently launched a project to implement SAP across the enterprise, starting with the U.S. market. and having a Tier 1 ERP solution in place will give us the platform needed to scale our business in coming years and provide us with the capabilities to truly make us a digital company. So suffice it to say, it's a very exciting time for Canopy. The investments we're making in people and process and technology will position us for global leadership and despite some of the short-term headwinds that we're facing, we're confident that we will continue to be the steady hand of this industry going forward. This concludes my review of the Canopy Gross Financials for Q2 2020 and operating. We would be happy to field any questions at this time.