HEXO Corp.

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 first quarter 2022 earnings call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question, again press star one. 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 plan, 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. HECSL 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.

Good morning, everyone, and thank you for joining us today. Late last night, we released our Q2 2022 results for the quarter ended January 31st, 2022. Before I jump into the results 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 retican acquisition and the related convertible debenture that was put in place at that time last summer. The proposed agreements we've announced with Tilray will restructure and reduce our significant debt burden and provide an 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 was a significant inhibitor to Hexel'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 four 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 U.S. $211 million of senior, secure convertible notes that were originally issued by HEXO to Hytrail Investments. This proposed alliance between HEXO and Tilray achieved several goals, including It deleverages the balance sheet to a more manageable level. It raises sufficient liquidity to fund the path forward, including unlocking of US $80 million of restricted cash. It preserves value and minimizes dilution to existing shareholders. And it offers significant commercial benefits to HEXO, representing upside to the path forward. Further, the separate three-year Canadian $180 million equity backstop commitment demonstrates the support and belief of our existing shareholders. The Tilray Agreement is expected to deliver up to $50 million combined cost synergies within two years of the completion of the transaction and will leverage both companies' commitments to innovation and brand building to strengthen market positioning and capitalize on opportunities for growth. Most importantly, the terms of the agreement provide HEXA with the financial flexibility to execute on the path forward with runway and strong liquidity profile enhanced by the standing commitment to be used monthly as needed. I am pleased to report that this proposed transformative strategic alliance is on track and is expected to close in May. As you may recall, last quarter we introduced the Path Forward, a strategic plan that utilizes HEXO's current assets and our capabilities to drive accelerated organic growth build market share, and become operationally cash flow positive within the next four quarters. The path forward is made up of five priorities. Continue to reduce manufacturing and production costs, streamline and simplify the organizational structure, realize cost synergies from acquisitions and recent plant closures, focus on revenue management, including more disciplined pricing, and five, accelerate organic growth like building market share, capturing market share gains, and capturing missed revenue opportunities. This plan is underpinned by specific actions to fortify our balance sheet, strengthen the leadership team, and enhance our corporate governance, which have already been successfully executed. The plan is expected to generate incremental run rate cash flow of $37.5 million in fiscal 2022 and an additional $135 million in fiscal 2023 for a total of $172.5 million over the next two years. from a combination of cost reductions and anticipated revenue growth. I would now like to provide a brief update on each of the core pillars of the strategy. Reducing manufacturing and production costs. The company expects to reduce manufacturing production costs by leveraging existing capabilities across facilities. We are actively applying best practice and learning from our highest margin categories and top facilities across the entire operation to improve and optimize productivity. To date, we've identified approximately $30 million in savings from optimizing HEXO's production network and leveraging the capacities of recent acquisitions. Specifically, this includes transition from co-packing agreements towards in-house production, leveraging HEXO's scale to deliver on procurement savings, and reconfiguring the company's production network to achieve greater efficiencies, for example, moving vape production and distillate production to the Redican facility. Two, the company expects to streamline and simplify its organizational structure and more closely align operating costs with overall revenue. We announced that these cost reductions will be achieved through a combination of reduced reliance on outside consultants, streamlining the organization as a new IT platform is implemented, right-sizing the organization, and realizing the synergistic benefits of previous acquisitions. These initiatives are expected to represent a 30% reduction in the company's SG&A, by fiscal year end 2023. As part of these initiatives, subsequent to the quarter end, the company announced the reduction of 180 positions resulting in savings of approximately $15 million on an annualized basis. Half of these positions were related to previously announced closure of Stellarton facility and the remaining reductions were related to reducing back office positions where there is significant overlap as a result of the recent acquisition, simplifying EXO's operating model to drive clear accountability and de-layering management. Third, the company expects to continue to deliver on synergies as a result of the recent acquisitions. Fourth, HEXA will continue to focus on revenue management, including more disciplined pricing across our entire range. By leveraging our brand continuum, we are well-positioned to differentiate ourselves across features and price balancing our approach to both volume and profit. HEXA will offer great value to consumers, strong margin for customers, and grow our own margins. And fifth, to increase revenue, the company plans on accelerating growth through organic marketeer gains and capturing revenue opportunities through better demand planning, acting on proprietary consumer insights, and building strong customer relationships. For example, in the past, the company was delivering only 65% to 70% of its demand to customers. The company has now connected its demand forecast to what it intends to harvest. We're taking learnings from the legacy of Redican and applying them across the entire organization. Earlier this year, we executed a proprietary quantitative consumer survey with thousands of consumers that identified usage occasions and demand spaces in the cannabis category, and we'll use this to drive unique innovation and brand building in our new marketing leadership. The company will also put a focus back on medical and consolidate our medical efforts with Redican given their strength in this category. We are making substantial progress on our plan in only one quarter, and it is yielding results. With that, I would like to now turn the call over to Kurt.

Thank you, Scott, and good morning, everyone. This is my first time in the CFO chair at HECSEL, 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 establish liquidity. With Scott's leadership, we've made enormous progress on both of those objectives in Q2. Once we close the till rate transaction, the monthly redemptions will end, maturity is pushed out for three years, and we free up $80 million U.S. 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 settles 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 terms. 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 breach EBITDA breakeven. And as a result, we breached the covenant on the senior secured convertible note. The note holder subsequently waived enforcement of the default through the earlier of May 17th foreclosure of the till rate 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 till rate 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 of the prior year. International sales were a particular bright spot, growing 36% quarter on quarter. Zenebus 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 market and operational sides of the business. We've also made great strides in de-bottlenecking 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, strong performance in general at Retican, favorable product mix within adult use, successful introduction of several new products, and growth in medicals we noted above. Also, HEXO's total non-beverage gross margin before adjustments increased by 15%