Edited Transcript of HEXO.TO earnings conference call or presentation 13-Jun-19 12:30pm GMT

Under the direction of our Chief Innovation Officer, Veronique Hamel, we're continuing to expand our R&D and innovation team with top scientists, chemists, who have extensive experience in CPG companies such as Kellogg's, Church & Dwight, Coca-Cola, Philip Morris, Cambel Soups, Smucker's. That's just to name a few.

We now have 25 PhDs on staff. They are focused on developing new and innovative products for the market, best-in-class technology for our Powered by HEXO experiences.

Building on our innovative technologies, critical in building brand, we believe that brand will be the final moat, by which CPG cannabis companies are differentiated. But in the meantime, those products and that moat will be built on distribution and technology.

Having consistent, quick-on and quick-off cannabis experiences that include sleep, sport, focus, diet, sex and fun, delivered through a full range of Powered by HEXO products is what we're striving to create. Developing these experiences and partnership with Fortune 500 partners through our hub and spoke is how we're going to achieve that goal.

We've added key people to the team with extensive leadership and CPG experience, including our new COO, Donald Courtney, notable experience at Mars, Pepsi Bottling Group and also at the Head of the MedReleaf.

As well, we recently welcomed Michael Monahan as our newly appointed Chief Financial Officer. Michael's guidance will help the company drive our global strategy moving forward based out of the U.S. and he brings his wealth of experience from privately held and public companies such as Nutrisystem where he had a very successful exit.

We recently secured about 200,000 kilograms of hemp supply for CBD and non-THC cannabinoid extraction in fiscal 2020 and a closer term, we've done a secondary supply agreement of approximately 60,000 kilograms of hemp to be supplied in the next 2 quarters as we prepare for the upcoming demand in edibles and concentrates pending legalization in October in Canada.

Our hemp supply chain is a critical element to our strategy to be in 8 U.S. states in 2020 legally through traditional non-MJ channels. We're looking forward to the following months, so that we can elaborate on that strategy.

We've signed a multiyear extraction agreement with Valens to extract a minimum of 30,000 kilograms in year 1 and 50,000 kilograms in cannabis and hemp biomass in year 2. So this helps to smooth out our operating ramp up [incurs] as we expand our production to our near-term target of 150,000 kilograms and prepare for the legalization of edibles in October.

Note that our Belleville site that I'll speak about later in the call will actually be built to support the extraction using all types of extraction technologies for about 375 tons of processing capacity annually.

We were the first cannabis company to join Food & Consumer Products of Canada, which is the largest voice of the Canadian food, beverage and consumer products industry. We welcome the addition of 374 new employees, which brings our headcount to 822 employees at the end of Q3 and today, very proud to say that the team has grown to 1,100 and everyone's working very hard. I thank them very much.

We continue to expand our CSR initiatives, focused on being good corporate citizens. Our support has helped to ensure that those who depend on the services of Moisson Outaouais and the Ottawa Food Bank will continue to receive the necessary access to fresh, sustainable food using environmentally sound technology.

Our customers remain our focus. To date, we have sold over 7.5 million grams of adult-use in medical cannabis to Canadians who depend on our safe, reputable and high quality products. Adult-use grams and grams equivalent sold increased 9% to 2,700 from last quarter as we continue to expand our distribution across Canada.

Q3 2019, we produced approximately 9.8 tons of dried gram equivalent, so 9,800 kilograms and 98% increase from the previous quarter. That was due mainly to our increased yields in our 250,000 square-foot B6 greenhouse and also our first harvest of 1 million square-foot B9 greenhouse. First harvest, I remind everyone that happened 5 quarters out from us announcing that we would build that facility, one of the fastest build-outs of a large-scale, modern cannabis facility on the planet.

We're preparing for Phase II of the Canadian adult-use market with the legalization of edibles and concentrates, which is expected in October 2019. Although there is some timing risk to that date, we may see a delay from a regulatory perspective of up to 60 days, pushing us into December. We are developing gummies, a premium vape line and a line of cannabis-infused beverages with Truss, our joint venture with Molson Coors, Canada.

We remain focused on delivering net revenue in fiscal 2020 of over $400 million and that, of course, excludes Truss beverages.

Subsequent to the end of Q3 2019, we completed the acquisition of Newstrike, providing us with the near-term increase in production to 150,000 kilograms annually, expanding our cultivation to 3 campuses, giving us resiliency and redundancy and giving us access as well to 9 provincial agreements, so now reaching over 95% of the Canadian population and increasing the HEXO family by approximately 250 employees.

I mentioned Belleville earlier on the call, very proud to say we are on track. We -- Phase I was online in May as planned, and we plan on having the building fully operational by the fall. That will include not only HEXO core operations in about 580,000 square feet, but also the Truss-Molson Coors joint venture, which we're expecting to have a full line of bottling and canning made available to be ready for October legalization as should regulations allow.

A 1.5 million square-foot facility will also allow future Fortune 500 partners a licensed, centrally located facility optimized for their specific manufacturing requirements. Looking forward to sharing the future on our future partners.

it was very exciting announcement this morning. We announced that HEXO was now officially international licensed in multiple jurisdictions with our Greece update. So we announced that HEXOMed has received its medical cannabis installation license in Europe and that's another step towards our plan of providing regulatory access to Fortune 500 companies, so that we can use their existing distribution networks in countries such as the U.K., France and all supplied from European domicile.

Financial results. Our total gross revenue was $15.9 million for the third quarter, an increase of 11.8x over the same quarter in the prior year. As I guided last quarter, gross adult-use revenue remained flat at $14.6 million. In comparison to the same period in 2018, it increased by almost 1,000%, which included only medical sales last year.

We expect revenues to double this quarter with realized sales from the first harvest from B9 and our 1 million square-foot facility and also as we start to shift flower outside of Québec, which we're very excited to do.

Sales volume increased 9% to 2,700 kilograms from 2,500 kilograms in Q2. While we're in dry products, accounted for about 84% of gram and gram equivalent sold during the quarter. Oils accounting for the remaining 16%.

We achieved adult-use revenues per gram of $5.29, a 0.54 decrease over last quarter due to a shift in product mix. And 91% of our sales were done in Québec, with 9% coming from Ontario and BC, reminding everyone that we had not begun starting -- selling flower in Ontario and BC.

Cost of sales remains consistent with the prior quarter, about $6.6 million including the cost of dry flower and the transformation costs related to oil and value-added products. The fair value adjustment on the sale of inventory was $4.7 million, which has increased from $572,000 in Q3 '18 due to an increase in sales, which was offset by lower fair value per gram on the adult-use market.

The fair value adjustment on biological assets was $20 million compared with $2.5 million in Q3 2018. This is due to an increase in the number of plants on hand, the result of bringing B6 and B9 fully online. So B9 is full of plants today. You can see that in a video that was publicized on Tuesday. I'd invite everyone on the call to go Google for that HEXO reel, you can see our staff hard at work and B9 full of plants.

We also drove higher yields this quarter on a per plant and per square foot basis, and we expect that to continue meaningfully as we ramp through our 150-ton a year production capacity.

Our gross margin before fair value adjustment on biological assets was $6.4 million, yielding a 49% gross margin on net revenue. So holding towards the 50%, we do expect over the next 24 months as there is significant pricing compression that the flower might drag those gross margins towards the 40%. We do expect that as we introduce more and more advanced products, we'll be able to pull that gross margin back towards the 50%, but do expect some turbulence on gross margin in the short term.

Operating expenses. Our G&A increased to $10.5 million in Q3 from $2 million in Q3 2018. This reflected the growth in operations as we continue to strengthen our general, finance, administrative staff, an increase of $3 million. Rental expense increased by $790,000 related to rent on the Belleville facility. Professional, listing and legal expenses increased by $9,000 as a result of corporate development initiatives and increased financial reporting and regulatory requirements from the TSX and the New York Stock Exchange American. And insurance increased $1.8 million due to an increase in property, plant and equipment being covered and D&O premium increase as a result of listing on the New York Stock Exchange. G&A is expecting to trend with revenues over the remaining quarter in 2019.

On marketing and promotion, we had an increase to $5.1 million in Q3 from $2.1 million in Q3 2018 and this reflects the implementation of our adult-use marketing and promotion events to build brand recognition and establish HEXO in the adult-use market. We expect this to trend with revenues in the final quarter of 2019. Our long-term goal on our marketing spend is to be roughly around 5% of revenue, and we believe we're on target looking at forward revenue of $400 million or $20 million for the year, excluding sales and operations, of course, so just on pure marketing spend.

Our stock-based compensation increased to $8.1 million in Q3 2019 from $783,000 in Q3 '18. This relates to an increase in the number of options outstanding and represents our increase in headcount as a result of a significant increase in the underlying market prices of those options granted during the period.

Net loss from operations for -- of $2.2 million in Q3 2019 compared with a $2.7 million loss in Q3 2018 and this was offset by higher revenues and increased biological fair value adjustments as our production increases.

Net loss from operations decreased 61% over last quarter due to an increase in fair market value adjustment on biological assets based on increased scale of operations and the additional plants in our B9 greenhouse.

Other income and expense of $0.5 million loss in Q3 2019 compared with $682,000 in Q3 2018 was due to revaluation of financial instruments of about $1.1 million and a fair value loss on a convertible note receivable of $4.1 million.

Happy to turn it over to analysts on the call, looking forward to taking your questions. Thanks for being here.

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) Your first question comes from Rupesh Parikh of Oppenheimer.

--------------------------------------------------------------------------------

Erica A Eiler, Oppenheimer & Co. Inc., Research Division - Equity Research Associate [2]

--------------------------------------------------------------------------------

This is actually Erica Eiler on for Rupesh. So first, I wanted to touch on the $400 million revenue target. We were just curious, the sensitivity and ability to hit this target if we do see the regulatory delays in advanced products and also maybe you could talk about some of the risks you see to potentially achieving this target.

--------------------------------------------------------------------------------

Sebastien G. St-Louis, HEXO Corp. - Co-Founder, President, CEO & Director [3]

--------------------------------------------------------------------------------

Erika, yes, there are 2 key risks to the $400 million. So the first one is, of course, as you pointed out, the regulatory risk. So if we don't get the advanced products, that would put -- and I believe the risk of not getting it is negligible. I think the risk is really in delays. As I mentioned on the call, I think a delay to December -- it would be prudent to expect the delay potentially into December, but if it's further delayed, that could put upwards of $100 million of that $400 million at risk as that -- we're planning advanced products to be about 25% of that number.

The second risk is an execution risk, so much more in our control, relating to our Belleville facility. So to achieve that $400 million target, we do need Belleville to be operational in the fall. And we are on track for that. But if something should happen outside of expectation, that would put that number at risk. We are confident we will deliver an operational facility in time.

--------------------------------------------------------------------------------

Erica A Eiler, Oppenheimer & Co. Inc., Research Division - Equity Research Associate [4]

--------------------------------------------------------------------------------

Okay. Great. That's very helpful. And then, I just also wanted to quickly touch on market share. Is there any update on your sense of what your market share is currently?

--------------------------------------------------------------------------------

Sebastien G. St-Louis, HEXO Corp. - Co-Founder, President, CEO & Director [5]

--------------------------------------------------------------------------------

We believe that we're holding pretty strong as one of the top Canadian LPs. We're not sure exactly where. Put us somewhere between top 3 and top 5 is probably a good guess, but we have some more work to do on those numbers.

--------------------------------------------------------------------------------

Operator [6]

--------------------------------------------------------------------------------

Your next question comes from Oliver Rowe of Scotiabank.

--------------------------------------------------------------------------------

Oliver S. Rowe, Scotiabank Global Banking and Markets, Research Division - Associate [7]

--------------------------------------------------------------------------------

When I think about Québec, which is obviously an important market for you, you're expecting 20,000 kilograms in sales to Québec in the first year of [rec]. I think we're over halfway through that year now and sales have been about 5,500 kilograms to that province. So it seems to me like it could be a bit challenging for the SQDC sales to triple over the remaining 5 months. Do you see a risk that the SQDC doesn't need that much product, but takes it anyway and that leads to significant inventory builds and maybe even impacts demand on your year 2 contract?

--------------------------------------------------------------------------------

Sebastien G. St-Louis, HEXO Corp. - Co-Founder, President, CEO & Director [8]

--------------------------------------------------------------------------------

Yes. So definitely, a risk. I think the demand is there in Québec. I think the SQDC has been doing a fantastic job. But since there were inventory supply shortages on the early days from most LPs, so HEXO was delivering on its purchase orders, but the SQDC [weren't] getting fully supplied. They slowed their store ramps. So the original plan called for about 25 stores in Québec by this day. And last quarter, we were at about 13.

Now the good news is SQDC has now gone back to 7 days of full-time selling. So that adds significant demand. They've added more stores now, so we have a brand-new store in Gatineau right next to an Ottawa population center. I do think there could be some timing risk around a few of those tons -- of those 20 tons. And of course, as you pointed out, it is a take or pay contract, but we value our relationship with SQDC more than the few million dollars in revenue we can get this quarter. So we're working very closely with them. [We've asked our] SKU mix to create more interesting products. We plan on launching a whole bunch of new products over the following couple of quarters, which we think will help that, but expect some timing risk whether it's in October, November, December time line to hit the full 20, I think, would be a reasonable assumption. We're confident we can completely offset that and more, of course, in other provinces.

--------------------------------------------------------------------------------

Oliver S. Rowe, Scotiabank Global Banking and Markets, Research Division - Associate [9]

--------------------------------------------------------------------------------

That's helpful. And just a follow-up on Québec. I know the province recently added 6 more suppliers to the prior 6 and I believe that you're targeting 30% share in Québec. So is that at risk as they increase supply or do you think 30% is a pretty sustainable number for you, no matter how many suppliers they have?

--------------------------------------------------------------------------------

Sebastien G. St-Louis, HEXO Corp. - Co-Founder, President, CEO & Director [10]

--------------------------------------------------------------------------------

It's always going to be at risk. I mean people are going to be gunning for the top spots in Québec. I mean it's the second largest market in Canada and now people are finally realizing that. Thankfully, HEXO has a preferred supplier status. We have a great reputation in Québec. Our products are loved. So I think it's very feasible to defend our 30% market share but of course, we'll have to be very vigilant. We'll have to keep listening to our customers and responding to their needs.

--------------------------------------------------------------------------------

Operator [11]

--------------------------------------------------------------------------------

Your next question comes from Chris Carey of Bank of America. We have a question from Chris Carey.

--------------------------------------------------------------------------------

Christopher Michael Carey, BofA Merrill Lynch, Research Division - Research Analyst [12]

--------------------------------------------------------------------------------

Hi, can you hear me?

--------------------------------------------------------------------------------

Sebastien G. St-Louis, HEXO Corp. - Co-Founder, President, CEO & Director [13]

--------------------------------------------------------------------------------

Yes. Thank you, Chris.

--------------------------------------------------------------------------------

Christopher Michael Carey, BofA Merrill Lynch, Research Division - Research Analyst [14]

--------------------------------------------------------------------------------

So just on your expectation for the 40% gross margin in the near term. I mean how much of that is investment without getting kind of the requisite sales leverage and mix, mix being flower and oils? And really, what I'm trying to get at is, [what] you secure your capacity for longer-term margin is because clearly, expectations are for your gross margins to be a little bit higher over even the medium-term horizon. So I'm wondering if you could just talk to the near- and longer-term dynamics around the gross margin line.

--------------------------------------------------------------------------------

Sebastien G. St-Louis, HEXO Corp. - Co-Founder, President, CEO & Director [15]

--------------------------------------------------------------------------------

Yes. Absolutely. I think -- so longer term, I think 50% is definitely doable, but that will be contingent on us building a brand moat long term. I think the 50% will be reserved to the top 3 or 4 global cannabis companies that are able to create brand pull. Otherwise, cannabis companies as a whole, not just HEXO, will be pushed towards the 30%, right, in the long term.

I think in the short term, the pressure is completely different. The pressure is because as we've mentioned in Québec, new producers constantly coming online, coming to the provinces and we're talking right now about, for example, in Québec, 6 new producers online, but remember that there's 150 companies in Canada that have licensing, that want to start to sell flower. So what can happen in the next 18 months is that those companies are coming to the provinces, saying I want to get my flower listed.