Edited Transcript of HEXO.TO earnings conference call or presentation 14-Mar-19 12:30pm GMT

Thank you, Jennifer. Welcome, everybody. Really exciting times and glad to have everyone on the call today, including our first call that we're opening up to the public. So it'd be analyst questions, but we have our shareholders, investors and the public online as well. So very excited to be leading in. I mean, Q2 was a busy quarter. We continue to execute on our strategy towards becoming one of the leading cannabis producers and product innovators not only in Canada, but in the world. Our vision has remained consistent to create a branded, consistent on and off cannabis experience across a variety of verticals in a variety of experiences ranging from sleep, to sport, to sex, to diet, to fun. Through this vision, we intend to become the premier branded ingredients for food company in -- not only top 2 in Canada, but also top 3 globally. We continue to focus on operational scalability, product innovation and brand leadership on the path to achieving this goal.

In Q2, we executed on our promise to list in the U.S., gaining our New York Stock Exchange listing on the American on January 23, 2019. We closed a public offering of $57.5 million. I think very significant who were the leaders in that public offering, 2 Tier 1 chartered Canadian banking institutions, so CIBC and Bank of Montreal. We hit our construction and licensing milestones as well. We had announced a year ago that we would put up 1 million square-foot state-of-the-art purpose-built greenhouse. And not only did we get that done on time, on budget, we actually got it licensed within the construction time line. So we got everything done and ready in 12 months, which is positioning us very well for the next year.

Q2 2019, we produced approximately 4.9 tons of dried cannabis, which was a 39% increase from Q1 in 2019. As a result of the growing scale of operations, our headcount rose by 32% to 374 employees now at the end of Q2 from 283 at the end of Q1. And I want to take a moment to thank Dominique Jones, our Chief People person, who's been ramping up all our people operations, and I'm looking forward to next quarter as our people ramp is accelerating meaningfully. We also added Veronique Hamel as our Chief Innovation Officer. Veronique is amazing. She brings 25 years of innovation expertise through her leadership roles. She's built strong innovative teams at Church & Dwight, Bausch & Lomb, Bausch Health Companies. And as our CIO, will develop and oversee our research and innovation pipeline. This is really the spend that's coming from this $57 million raise we did. Over the next 2 years, we're standing up an innovation, design and engineering team that will span over 100 employees in food, vape, beverage, emulsions, extractions, and that's in addition to the current 25 or so R&D employees that are working, developing our various emulsions for our hub and spoke partners today.

So as well as working hard towards yesterday's announcement regarding our intention to acquire Newstrike Brands, we also announced something pretty exciting in the -- we took the opportunity to reach out to all of you, to all our analysts and all our partners to update what we're going to do next year. And I think it's quite significant because I think for the last while, HEXO has been expected to perform in the mid-cap range. Analyst consensus for our numbers were in the $260 million revenue range. And management, following this acquisition, is now confident enough to come out with our number for 2020 ending July. And we're very pleased to be able to share that number, which is going to be $400 million in net revenue.

For this quarter, our gross revenue was $16.2 million and that was a $13.7 million increase over the same quarter in the previous year. Our gross revenue in Q2 exceeds total fiscal by 200%. Our gross adult-use revenue was $14.8 million up from $5.2 million in Q1. I think very significant, if you remove the 1 outlier or the 1 competitor that's -- that has arguably the largest market share right now, which would be Canopy. If you put the -- look at the second grouping of every single competitor in the space, this amount of adult-use revenue puts HEXO firmly in place in that second-tier grouping right behind Canopy. So we're very excited about moving that forward meaningfully, and of course, next year when we're $400 million, we expect the majority of that to be in adult-use in Canada, and we expect to be a top 2 Canadian company.

Sales volume increased 166%, so that was about 2.5 tons from Q1 as we continue to scale up B9 and execute on our SQDC and other supply agreements. I want to take a note to mention that the SQDC 20-ton commitment is fully on track. Our relationship remains in amazing standing, and we're really excited about all the stores they're opening, the education programs they're setting up and the additional products we'll be introducing in October.

Our Belleville -- our B9 facility has -- is being stood up quite nicely. It's scaling up. It is on schedule. On that note though, there is some scale up, and I do want to adjust everyone's expectations for Q3 on that note. As harvest will be starting meaningfully during this quarter, as we shared in our MD&A, our Q3 will be relatively flat to Q2. So just want to prepare everybody that to not expect us to blow up the quarter -- this quarter. Our meaningful ramp towards that $400 million starts in Q4.

We achieved adult-use revenues per gram of $5.83. So that was actually an increase of $0.38 over last quarter. So you can start to see that demand that our customers have for our products, but also willing to pay for premium high-quality products. And 84% of our adult-use sales were realized through our agreement with the SQDC, so that was 16% in Ontario and BC. I'll remind everybody that currently HEXO is not selling any dry flower in Ontario and BC. So we're achieving these market shares and this performance without even our full toolbox. So of course, in the -- towards the end of Q3, ramping into Q4, we are unlocking that toolbox, and that's what is leading us to that $400 million in net revenue next year. Of course, the additional capacity from Newstrike is going to help as well.

Our cost of sales increased to $6.5 million as a result of increased sales, increases in transformation process of our value-added products as we're preparing as well for the legislation coming down in October. The net fair value adjustment was $4.7 million loss and the fair value adjustment on the sale of inventory was $3.7 million, which has increased from $1 million in Q2 2018 due to an increase in sales, which was offset by lower fair value per gram on the adult-use market.

Biological assets' fair value was negative $8.4 million compared with negative $1.1 million in Q2 2018, and this was due to an increase in the number of plants on hand and increased yields in the quarter. Since Q2 2018, B6, which is our 250,000 square-foot greenhouse, has become fully operational, increasing our supply to meet the demands of the adult-use market.

What's -- what I think is important -- and historically, we've talked a lot about cost per gram. And you've noticed, last quarter, HEXO dropped that metric because we thought it was confusing. We weren't getting much credit in the market for actually using a real number, although I think we were, but now we really can start talking about gross margin. And as we start to operate, that's really what's going to matter as you start to look at these product mixes. And we're very pleased to show that we had a 52% gross margin on net revenue. Gross margin after fair value adjustment on biological assets was $11.6 million.

In terms of operating expenses, our G&A increased to $8.2 million in Q2 from $1.8 million in Q2 2018, and this reflected the growth in operations as we strengthen our general, finance and administrative staff. We've added an entire strategic finance division, which is getting very robust and certainly getting their legs under them after this recent acquisition. We've added rental space in Belleville. Our total general admin payroll of $1.9 million and professional fees, listing and legal expense of about $1 million and not related to our up-listed TSX and also to the New York Stock Exchange American. Insurance also increased about $1.3 million for D&O related to the NYSE -- the move to NYSE.

In marketing and promotion, we increased to $4.8 million in Q2 from $1.4 million for the previous year. But I think, more significant is if you look at how we've dialed in our marketing expenses following our Never Jaded tour in the previous quarter. So in the previous quarter, we have had quite a big splash. We went out with a bunch of concerts. We had Wu Tang Clan, and we had celebrity chefs, and we're trying a lot of special activations. That came at a cost, and the previous quarter was about an $11 million spend. Now we're dialing it in. So at that $4 million spend level, we're more in the range of where we plan to be, which we think kind of long-term marketing expenses should be in that 5% to 8% range of revenue where we're -- and we're trying to keep it as tight as possible, while trying to lever really digital media to get more bang for our buck.