HEXO Corp.

Good morning. I'd like to welcome everyone to HEXO Corp's second quarter 2023 conference call. Joining us today is Charlie Bowman, President and Chief Executive Officer of HEXO Corp, and Julius Ivinsits, Chief Financial Officer of HEXO. As a reminder, this conference is being recorded. Please note that all financial information is provided in Canadian dollars unless otherwise stated, and that a copy of the Q2 results can be accessed on CDAR and EDGAR. To open the call, Charlie and Julius will provide their commentary on the quarter, followed by a question and answer session. To ensure that we get to as many questions as possible, we ask participants to limit themselves to one question. With that, I'll now pass the call over to Charlie Bowman, President and CEO of Hexacorp.

Thanks and good morning, everyone. I'm pleased to review our results from the quarter ending in January 31st, 2023. We'll begin by detailing some of our financial accomplishments, highlight a few of our key products and operational achievements that happened this quarter. Our goal is to take you along the journey to a leaner operation, focused on the quality and near-term profitability. Afterwards, Joyce will walk us through HEXO's financial results. First, before I start, about nine months ago, I had an opportunity to sit down with a number of the original shareholders, none of who have sold a single share of stock. Their advice to me was once we reset the balance sheet is to take off my corporate tie and to focus on the key consumer elements of why people purchase campus. High THC, price and terpenes. Grow the best strains to deliver this consumer experience at the lowest price we can. And that's what we've been doing. So let's address this legacy balance sheet, which was my first priority. Over the past six months, our aggressive cost-cutting strategy has reduced HEXO's overall debt whilst improving our balance sheet. We repaid a total outstanding principal of $40,700,000, which was matured on December the 5th, 2022, with an all-include and unpaid interest. This was the first major step of strengthening our balance sheet. Next, we focused on strengthening our margins with a higher-value product mix leveraging a series of intense cost reductions and pricing disciplines. We focused on quality. We measure it by pharmacopeia test methodology procedures. We focused on the critical items and improved our first pass success rate. All in, our team decreased our operation expenses and significantly reduced our trade receivables. Now, turning to our product and operational developments, we've streamlined our recreational cannabis portfolio focusing on delivering the best consumer experience. We expanded our health and wellness portfolio by addressing unmet consumer needs that only cannabis can address, featured on our ReadyCan medical platform. We've signed a long-term agreement with Entourage Health, securing a multiple channel distribution network into the medical cannabis market over the next three years. This partnership is key to expanding our health and wellness portfolio and accelerates our ability to grow the business and deliver premium cannabis products to more Canadians, but to especially our veterans. In the recreational market, we are focused on creating a unique sensory experience by highlighting some amazing terpenes and high THC strains from our in-house developed TNT strains. We launched three new Redican branded products and two new original Stash products, all using the new TNT strains. These strains were released after about 20 months of research and development, which reinforces our belief that properly balanced terpenes dramatically enhance the cannabis experience. In fact, consumers validated our commitment to this unique cannabis experience. Our first TNT launch, Animal Runts, sold out within 24 hours of its release. Replenishment sold out in two days, And the third order sold out in less than a week. The fourth order is in the process of packaging this week. It was, if not the, fastest selling strain in Ontario cannabis board history. The good news, Violet Fogg is next. As we move towards a leaner portfolio, our longstanding commitment to innovation remains strong. So this next generation of products from our internal genetics program highlights total cannabinoids, high THC percentage, with a wide range of terpenes. It is this continued pursuit to deliver the highest quality cannabis that allows our premium strains to wear the crown on a Redican brand. We produce some of the industry's highest THC percentage, and without a doubt, the total cannabinoid content. And with an incredible breadth of terpenes and flavonoids, it's an outstanding consumer experience. Furthermore, these new cultivars give us a high production yield with greater margins, and the industry's leading terpenes, THC percentage, and total cannabinoids. In fact, that's TNT. So lastly, our team is committed to the ongoing cost efficiency by reducing the overall footprint. We've deployed resources into our profitable segments and eliminated unprofitable business brands. For example, we saw the high growth potential in the pre-roll segment, specifically in the infused pre-roll area. We expanded our capacity in our popular straight edge pre-rolls facility in Fenwick, Ontario at the end of this quarter. This increase fourfold of Ready's straight edge capacity and expands our product offering and capabilities. It enables HEXO to deliver the preferred cannabis experience to all of our ReadyCan and original stash customers. And with that, I'll turn the conversation over to Julius to discuss our financial results.

Thank you, Charlie, and good morning, everyone. I'd like to remind you that all numbers I share today are Canadian dollars, unless otherwise stated. Before diving into the financial results, I'd like to comment on one of our biggest financial challenges, cleaning up the balance sheet. Our strategic redeployment over the last two quarters has included a thorough review of our underperforming assets, and taking a strong action to repair the balance sheet. The early financial results of our fiscal year demonstrate a prudent path towards long-term profitability. As Charlie noted, the debt repayment has helped de-lever our balance sheet, positioning HEXO for long-term financial success. I would also like to note that despite difficult market conditions and intensifying competition, which has put significant pressure on pricing, we have made the decision to maintain our fair pricing as part of taking a sustainable approach and our commitment to quality. Now I will discuss Q2 results. This quarter, the company has hit two important milestones. First, positive net income, and the second, positive cash flow from operations. This is attributable to an 11% reduction in SG&A spending from the prior quarter, along with a 20% reduction in trade accounts receivables. Revenue did, however, slow in the quarter with a 26% decline to $24.2 million when compared to Q1-23 of $35.8 million. The decline can be attributed to a number of different factors. Price reductions by our competitors in our biggest markets, Ontario, Alberta, Quebec, and British Columbia, leading to HEXO market share declines. Also, the revenue was impacted by returns of seasonal products due to low velocity, unavailable supply for certain demanded products, and specific products being placed on hold due to pricing reductions in key Ontario markets. Lastly, we ceased recognition of cannabis-infused revenue as the result of the Trust operationalizing their cannabis selling license. At the same time, our net sales declined 54% relative to Q2-22 due to increased competition and diminished performance of Hexo brand in key markets of Ontario, Alberta, and Quebec, along with the removal of product portfolios from the divested 48 North Business and Zenebus brands. Looking at our adjusted EBITDA in the quarter, we saw a loss of $2.4 million which is an increase of $1.8 million from the prior quarter, Q1-23. On the positive note, the Redican branded sales did increase 9% from Q2-22 as a result of an increased effectiveness on the Alberta market. Furthermore, our increasing gross margins confirmed that we're on track to profitability. On a final note, I would like to thank everyone at HEXO. for their ongoing commitment and positive outlook. We look forward to leveraging this team's experience to become the standard of the excellence in the industry. Thank you for continued support. Now I turn the conversation back to Charlie.

Thanks, Julius. Before we open the floor to questions, I'd like to echo that the successes we achieved in the second quarter resulted from our strategic alignment, which included tackling the legacy balance sheet, stripping all non-productive processes, capitalizing on our strengths. These adjustments will continue to create a more profitable entity for the balance of the year. Finally, I'd like to thank all my fellow Fenwick, Cayuga, Masson, GrowSites, and all of our employees and partners for their commitment to our business and customers. This transition has not been simple or easy, but I can't thank my team much more for their intense efforts in making HEXO a success. With that, we'll continue our remarks and open the floor to questions.

Thank you. If you would like to ask a question, please press star then one on your telephone keypad. The first question is from Matt Bottomley with Canaccord Genuity. Your line is open.

Good morning, everyone. Thanks for the question. I just wanted to get a little bit more color on what you believe the, you know, the sustainability is in the, you know, let's call it medium terms for the strategy of, you know, maybe forgiving some revenues to protect profitability. You know, when you kind of look around some of the dispensaries and just the restrictive nature of the regulations, it just seems, you know, increasingly difficult for any LP to kind of get differentiation on math with respect to, you know, branded products or things that are more, you know, the characteristics of the products themselves as opposed to pricing. So, I'm just curious, not trying to tease guidance out or anything like that, but just where you sort of think the top line erosion could go proportionately from where you are today, given the dynamics in the sector.

Thank you, Matt. That's an outstanding question. We took a hard look when the price war began last quarter, a little before the last quarter, and measured out what would be the impact to us if we actually participated in maintain that volume revenue number, volume and revenue, and what that would impact into our net income as it would come down. And it was significant. You know, you're talking anywhere from five to eight million loss. And it just wasn't something that we wanted to entertain. At the same time, we were in the process of getting ready to launch our TNT series. And with that, to your point, right now, cannabis is cannabis. And so the key point of differentiation is that consumer experience. The consumer experience comes from THC, it becomes from total cannabinoids, and it comes from terpenes. And so our points of differentiation was to launch these high THC, high terpene strains, and place them in across the different parts of Canada. So in some parts, we have Animal Runts and Violet Fog. In other parts of the market, we have Ghost Gelato, Sex Panther. Across the board, we have the CBD Kush, which is more of a medical brand and fitness and well-being. And so the goal here was to get the strains out and allow those strains to start to differentiate. In addition to our straight edge, we recognize the growth of the infused pre-roll, and we have launched our Atomic Sour Haze, into this area, and we've got a series of other products coming on. So for us, it was to reset the balance sheet, to reset the operations so that we could not provide me-too products into the market, but to have truly differentiated cannabis products with standing experience from the consumer side. And that's what we focused in. That's a great question.

I appreciate that. And then just one more quick one for me, just on the cash flow generation profile. So Plenty of you guys inflected into positive territory from operations. It looks like, though, when you look at the dynamics, there's pretty big swings still in working capital that are causing for some of the volatility. So I'm just wondering how you see that smoothing out over the next little while and if you think the inflection into positive territory is sustainable within the next couple of quarters.

Yeah, I can take that one. A large chunk of it is if you just look at trade AR from quarter to quarter, you see a significant drop while it was flat from Q4 to Q1. And so we very aggressively improved our cash collection efforts and then changed our invoicing procedures a bit to basically move up those payment cycles significantly. That coupled along with, if you look at our SG&A footprint and just overall footprint, those expenses are down quite significantly. So we're happy on how that is trending in the business. Hopefully that answers your question. Got it. All right. Thanks a lot, guys.

Again, that's star one. If you'd like to ask a question, the next question is from Frederico Gomez with ATB Capital Markets. Your line is open.

Hi, good morning, Charlie and Judith. Thank you for taking my question. In terms of your balance sheet and your capital needs, you mentioned your ATM. Is there any specific reason why you have decided not to start using that yet, just given that you seem pretty close to breaching your covenant data? And the second part here is just if you decide to use that ATM going forward or do some sort of other equity raise, How would that impact the conversion price of the senior notes held by QRED? Thank you.

Yeah, this is Charlie. Thank you, Frederico. For the ATM, one of the reasons that we've taken a look right now of not tapping into the ATM was during this price war that was going on, for lack of better words, we needed to establish what the new baseline was going to be as we looked through to what our cash consumption would be and also how low we could take our cash burn from a standpoint of our cost takeout and our savings. In addition, with the velocity of the new strains coming on, it really does reset what the balance in the business was looking like. We've been really fortunate with both our primary debt holder, which is Tilray, But then all of our partners that we work with about supporting us as we go through from a standpoint of what we would need from cash, what we would need from a standpoint of working together to ensure that we have enough cash to run the operations. And then I think most importantly is when you look at like Tilray, they're not only an investor in us, they're also a primary customer for us too. And so there's lots of ways that we can work together to address this capital needs. The ATM is clearly one of them. We've had a number of banks that we've had discussions about for investment. So the good news is we have a number of options. The goal here was is to live within our means right now. And as I said a number of quarters ago, the goal for our operations has always been to be self-sustained. And so that's kind of still the mindset that we have right now. Joyce, any color you want to add?

We're continuously working with our board and internal management to evaluate all strategic financing opportunities. So whether that's the ATM, whether that's ELAC or other means, that's always on the table and under evaluation.

Thank you. I'll have that. Thank you.

The next question is from Aaron Gray with Alliance Global Partners. Your line is open.

Hi, good morning, and thank you for the questions. So first one for me, I just wanted to, you know, get some call in terms of what you think, you know, the impact might be of some of the changes that OCS is making and whether or not that impact might be more so for the retailers or some of it might, you know, flow through to you as they look to reduce the margin that they're taking. And then, you know, whether or not any of that give back might just flow right down to continued pricing pressure or if you think that might end up flowing due to your guys' profitability as well. Thanks.

That's a great question, Aaron. From a standpoint of all the boards have been really active about reaching out to us. I don't think anybody was surprised with the price war and the magnitude that went on in the last five months. I think the damage that could occur to the industry is significant because no one wins in a price war. And so I think one of the areas with the OCS taking a lower margin and resetting is clearly to help quite a bit of the retailers. Whereas a lot of the especially smaller independent retailers are bleeding from a standpoint of just the plethora of retailers that are on the market right now and undercutting one another. I think from a standpoint of how this tanks on, what we look at it is, I can't say on the industry and the others, but we look at the discipline of the business as the business should be profitable. The business should have a point of differentiation in every product line that it brings to the market. And you should charge a fair value. That doesn't mean I charge the premium the highest. It also means I'm not the lowest in the industry, but it should be fair. Our products are all priced in a good spot where we're in a fair area, a fair price point. As far as our margins go, you know, we've done an incredible job within the operations of getting cost out to where I feel very comfortable with with a statement that if we're not the, we're one of the lowest cost operators in the industry. As such, it allows you to take that volatility of when people do silliness, like get into a price war, and they should be more disciplined than that. The backside of that is if there's additional margin that comes out by the board, by the government, what it should allow is to take away from the illicit markets. Because the illicit market had a fantastic grow this past year, and as a result, they have plowed it in throughout the country, and it has taken away quite a bit of the growth. So that's one of the key things that we work with, and hopefully the government continues to take on, is to curb this illicit market. It's a good question. Thank you.

Okay, great. No, thanks very much for that detailed answer. That was helpful. I'll jump back in the queue.

Thank you.

Again, as a reminder, that's star one, if you'd like to ask a question. And it looks like we have no further questions at this time. I'll turn it back over to Charlie Bowman for any closing remarks.

Just wanted to say thank you to everybody and the time. It was a dynamic nine months that we've gone through. And from a standpoint of walking us the opportunity to go through what our quarter two results are, I just wanted to say thank you. And I know from time to time we have analyst calls that are scheduled up. Any additional questions they have, we'll be more than willing to take on. Thank you very much, and I hope everybody has a fantastic Friday.

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