Edited Transcript of PYX earnings conference call or presentation 8-Nov-18 1:00pm GMT

Good morning, everyone, and thank you for joining us.

We are entering the third quarter on the heels of an exciting Investor and Analyst Day, which many of you told us was successful in terms of giving clarity to our strategy and the great potential of our One Tomorrow transformation initiatives. We have embraced our new identity as Pyxus International; and are living our mission to be the trusted provider of responsibly produced, independently verified sustainable and traceable products, ingredients and services to businesses and consumers. Our track-and-trace system, branded SENTRI, along with our agronomy services, are proving to be key differentiators as we develop markets and partnerships across all aspects of our business. The new businesses within our global speciality products group are continuing to gain momentum, as we will discuss in more detail in just a bit.

Turning to the company performance for the second quarter. As many of you know, the second fiscal quarter is typically a seasonally lower quarter. And this year was additionally impacted by decreased volumes due to shipment timing, in comparison to a larger South American crop in the second quarter of fiscal 2018 and the stronger U.S. dollar in certain markets. In particular, the North American tobacco market was impacted by new and increased tariffs on U.S. tobacco, adverse weather conditions and the strong U.S. dollar. As a result of announced foreign tariffs and Hurricane Florence, we anticipate a combined negative impact to operating income for the full fiscal year of approximately $25 million related to the North American tobacco business and the new Argentina export tax when compared to the prior year. We are working to offset these impacts. And we expect a solid back half to this fiscal year, dependent on shipping and meeting shifting geographic requirements due to new tariffs.

The delay of legalization in Canada of adult-use cannabis from June to October shifted the start of sales to our first -- our fiscal third quarter. In addition, we experienced a slower rollout of our industrial hemp business due to weather and the impact that had on completing construction of the new facility in Eastern North Carolina. Despite these challenges, we are continuing to execute on our full year plan and are maintaining our previously announced guidance.

Joel will go into more detail on the financial results from the second quarter in a few minutes. In the meantime, I'd like to highlight for you some of the milestones in advancing our strategic initiatives.

In our Alliance One leaf business, you may have seen the announcement we made after the close of market yesterday. As we look at the current global trade environment, we find ourselves facing a confluence of significant events, including new and increased foreign tariffs on U.S. tobacco, declining export demand and the strength of the U.S. dollar. In order to ensure we are best positioned to meet the needs of our customers and sustain long-term growth, we made the difficult but necessary decision to repurpose our Farmville, North Carolina facility and consolidate all U.S. processing operations in our state-of-the-art facility in Wilson, North Carolina, beginning with the 2019 season. The Farmville facility will maintain capabilities for storage and special projects. However, the consolidation will unfortunately result in a workforce reduction. Given that there are a number of uncertainties with a respect to this transition, we are not yet able to estimate the restructuring charges to be incurred in connection with these actions.

We recognize the impact this decision will have on our employees, their families and the Farmville community; and are committed to helping those impacted as we consolidate our tobacco processing operations. We are focused on the success of the U.S. tobacco industry, our contracted farmers and driving strategy and long-term sustainability to the U.S. market.

Turning to our GSP businesses, we'll start with industrial hemp. Our industrial hemp joint venture Criticality continues to advance in the production of cannabidiol hemp oil or CBD and related consumer products. Criticality is receiving hemp and will be processing at its new facility in Wilson, North Carolina, starting in December. In addition to producing bulk CBD products for industrial B2B customers, Criticality will also manufacture and distribute a line of consumer products under the proprietary Korent brand. While the effects of Hurricane Florence resulted in facility construction delays, there was little impact on the Korent hemp crop. One of our competitive differentiators is the quality of our products and traceability of our sources of supply. While the storm may have affected some of the supply of late-maturing hemp varieties as well as reduced CBD concentration levels, we have been able to procure the hemp required to meet our plan.

In the e-liquids category, we're experiencing continuous growth of our West Coast e-liquids businesses. And as a result, we are moving our production space from a 16,000-square-foot facility to a new 45,000-square-foot facility. This will combine our Nicotine River, Humble Juice Company and zip fulfillment operations into one location, which we'll -- we expect will enhance its synergies across the lines, allow us to improve customer service and to realize greater operational efficiencies.

And as many of you are aware, October 17 was the effective date for legalization of adult-use recreational cannabis in Canada. Over the last few months, our indirect Canadian subsidiary FIGR has been preparing for the launch of its branded products. FIGR had the first-ever legal recreational cannabis sale on Prince Edward Island. FIGR was also the only company to have cannabis oil available in Prince Edward Island and 1 of 2 companies to have cannabis oil in Nova Scotia on opening day. FIGR East, which is licensed under the name Canada's Island Garden, received its oil production and sales license at the end of August and is currently 1 of only 29 companies to have received that license from Health Canada. As of now, FIGR products are available for legal recreational purchase by adult consumers at all PEIMC retailers across Prince Edward Island, with strong initial sell-through at retail. In addition, FIGR Norfolk, licensed as Goldleaf Pharm, received its cultivation license from Health Canada on September 28. And they have begun cultivation at its Simcoe, Ontario facility.

While it's early to tell trends, for the first 2 weeks of sales, FIGR has obtained a -- 13% of the legal adult-use recreational cannabis market in Prince Edward Island and is growing market share rapidly in Nova Scotia. With this success, FIGR is continuing its expansion and is well on its way to attaining more than 1 million square feet of production.

The core of our One Tomorrow transformation is to drive progress towards our strategic goals: firstly, achieving sustainable profitable growth by investing in opportunities in innovative, higher-margin products that further diversify our business; secondly, improving profitability and efficiency and simplifying our organizational structure; and finally, improving execution and growing market share of our leaf business. We are seeing the success of these 3 pillars of our strategy every day, and we look forward to keeping you up-to-date as we progress across all our business lines.

And I'll ask Joel to speak to our performance for our second quarter of fiscal 2019.

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Joel L. Thomas, Pyxus International, Inc. - Executive VP & CFO [4]

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Thank you, Pieter.

For the second quarter of fiscal 2019, total sales and other operating revenues decreased 11.7% to $394.9 million compared to the same period in the prior year. This is primarily due to a 10.8% decrease in volumes mainly attributable to the timing of shipments; and a larger crop last year in South America; additionally, the strength of the U.S. dollar and the impact on sales prices, including sales denominated in certain local currencies, which partially offset our changes in product mix in North America and Asia and caused average sales prices to decrease 0.9% compared to the prior year. Lower volumes and stronger U.S. dollar decreased tobacco cost of goods sold by 10.1%, but the change in product mix resulted in an increase in average tobacco cost per kilo of 0.8% compared to the prior year.

Third-party processing services decreased 15.1% primarily due to reduced volume in South America and Africa. Hurricane Florence impacted the second quarter's U.S. flue-cured tobacco crop, and foreign tariffs on U.S. tobacco has affected demand. As a result of these factors, factory processing throughput declined for the 2018 U.S. crop, increasing conversion costs. This impact of reduced U.S. volumes will also be seen in the back half of fiscal 2019 in both processing and full-service business. Decreased throughput in South America, Africa and North America increased processing costs by 22.6%.

Gross profit decreased 29% to $49.2 million, and gross profit as a percentage of sales declined to 12.5% this year compared to 15.5% last year. SG&A increased 13% to $39 million, primarily from the inclusion of new startup businesses in the current year and increased costs associated with developing and supporting these new ventures as they continue to move through the startup phase. Tobacco-related SG&A was down versus the prior year.

Operating income decreased by $26.9 million to $12.6 million as a result of lower gross profit and higher SG&A costs. Net loss was $54.6 million, and adjusted EBITDA was $25.9 million.

For the 6 months ended September 30, 2018, total sales and other operating revenues decreased 5.3% to $685.9 million compared to last year due to lower average sales prices as a result of product mix and the strength of the U.S. dollar versus certain foreign currencies. Volumes declined 1% from the prior year due to opportunistic sales in North America last year and the late shipments from Guatemala in this year. U.S. dollar strengthening impacted sales prices, including sales denominated in certain local currencies. The change in product mix and the stronger U.S. dollar decreased tobacco costs of goods sold by 5.4% and average tobacco cost per kilo by 4.4%.

Third-party processing services decreased 20%, which was primarily due to reduced volume in South America and Africa. And the impact of Hurricane Florence on the U.S. flue-cured crop diminished factory reprocessing throughput for the 2018 U.S. crop, resulting in higher conversion costs. The impact of reduced U.S. volumes will also be seen in the third and fourth quarters in both processing and full-service business. Decreased throughput in South America, Africa and North America, partially offset by the impact of a stronger U.S. dollar on costs, increased processing costs by 3.3% during the 6-month period.

Gross profit decreased 7.5% to $90.6 million, and gross profit as a percentage of sales declined to 13.2% this year compared to 13.5% last year. SG&A increased 13.4%, primarily from the inclusion of new startup businesses in the current year and increased costs associated with developing and supporting these new ventures as they continue to move through the startup phase. Tobacco-related SG&A was down versus the prior year. Resulting costs from restructuring costs are primarily related to employee severance costs in connection with the closure of a redundant foreign processing facility during the first fiscal quarter.

Operating income decreased $21.6 million to $17.3 million as a result of lower gross profit and increased SG&A.

Interest expense increased by $700,000 from the prior year to $68.2 million primarily due to higher average interest rates on our seasonal lines of credit. Net loss was $55.4 million, and adjusted EBITDA was $45.3 million.

Additionally, during the first 6 months of fiscal 2019, we purchased $17.9 million of our existing senior secured second lien notes at a discount, resulting in debt retirement income of $500,000 and a remaining face amount of $645.1 million.

Looking ahead, we are committed to managing our working capital as we continue to drive efficiency improvements, as you can see in our focus on minimizing uncommitted tobacco inventory levels. Our current ending balance is down 16% from the prior year period, the lowest second quarter balance in 8 years. As Pieter mentioned, there are challenges this year. However, we are continuing to execute on our full year plan and maintain our prior announced guidance.

Now I'd like to turn the call back to Pieter for some closing remarks.

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J. Pieter Sikkel, Pyxus International, Inc. - Chairman, President & CEO [5]

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Thank you, Joel.

Our performance in fiscal 2019 remains promising as momentum builds in each of the disruptive GSP categories across e-liquids, industrial hemp and legal cannabis. And as a result, we anticipate a stronger second half of our fiscal year. We never lose sight of our responsibility to our employees, our contracted farmers and their families and all aspects of our supply chain around the globe as we strive to attain our corporate sustainability targets across our business lines. Through it all, we remain committed to maximizing opportunities to drive enhanced shareholder value and to transforming people's lives so that together we can grow a better world.

On that note, operator, please open the line for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We will now take our first question from Bryan Hunt of Wells Fargo.

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Bryan Cecil Hunt, Wells Fargo Securities, LLC, Research Division - MD & Senior Analyst [2]

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My first question is, when you look at the 12% sales decline year-over-year, how would you parse that out between the decline in shipments on a smaller crop, timing of shipments and a stronger U.S. dollar? I'm just trying to understand the magnitude of what may be more permanent or versus a timing issue.

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J. Pieter Sikkel, Pyxus International, Inc. - Chairman, President & CEO [3]

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I think the majority of the -- a decline in shipments really relates to South American shipments, more than anything else. The crop and the shipping schedule of the customers that we have for this year are later than we -- than last year. And we're really expecting those products to ship out in the third and fourth quarters. That's what we've got on the shipping schedules, and that's obviously is what we're working very hard to achieve. At the end of the day, we still feel we've had a good season in South America. We've had good orders. We have low inventory and low uncommitted inventory, and now it's a matter of then we finish processing. It's now it's just a matter of shipping the product out. For the rest of the globe, I think we're seeing a stronger year in Africa and Europe and pretty much flat across Asia and with some opportunities. And of course, North America, particularly on full service, is where we'll see significant reductions year-on-year due to Hurricane Florence.

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Bryan Cecil Hunt, Wells Fargo Securities, LLC, Research Division - MD & Senior Analyst [4]

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My second question is, and you laid right into it, tariffs and Hurricane Florence have a potential negative impact on EBIT of $25 million, and yet you all have maintained your previous guidance of $170 million to $190 million. And you didn't call out $170 million to $190 million explicitly in the press release, but you said you're maintaining your previous guidance. Can you talk about, one, what maybe is going better than expected to offset this $25 million hit to earnings?

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J. Pieter Sikkel, Pyxus International, Inc. - Chairman, President & CEO [5]

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Well, I mean I think, when you're looking at the situation, clearly, it's a big hit. And by far, the biggest hit of that $25 million is sitting in United States -- or out of the United States. And then a smaller piece is coming out of the Argentina export tax, and that export tax really increased to 12% and the export rebate reduced from 2.75% to 0.75%. So that really is affecting the costs of orders already completed but not shipped, so that's the struggle there. On the positive side, as I already said, we're seeing a strong year in South America, other than the Argentina export tax, compared to plan. And we're seeing a strong year in Africa with increased crop sizes out of Zimbabwe, Malawi and Uganda. And we're seeing a stronger year in Europe as well. So from the tobacco side, we're seeing some of those offsets coming from the other regions as we go out. Obviously, that leaves us with a significant amount of shipping to do from areas that are not always the easiest to ship out of, so we need to and we need the vessels to [cope] and load up those 100, 200 containers that we have on them at a time, but that's what we're pushing hard for to do. At the same time, when we're looking in Canada at the FIGR business, we certainly see the opportunity, with the yields being produced, with the pricing that's being achieved in the market, that we potentially can do a little bit better than we had predicted for the year based on both the production and the initial look at the sales numbers. And then we've also got to see how well -- the e-liquids business, certain parts of it, are actually looking pretty strong. We're seeing improvements there, particularly, I would say, from Purilum and Nicotine River. And we'll see how the rest does for the remainder of the year. And Criticality, although we got a delay in the opening of the facility, the initial products will be launched in very short order. And we'll see how well the sell-through of those goes, but there are offsets. It is by no means easy. You don't take a $25 million hit that you didn't expect and suddenly leave your year as an easy target to achieve. There's a lot of things that we have to get the whole team to work on very hard, but we see those opportunities. That's what we're seeing. That's what we've talked with the whole team about. And really those are a quick versus a long summary, I guess, of the different opportunities that are out there.

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Bryan Cecil Hunt, Wells Fargo Securities, LLC, Research Division - MD & Senior Analyst [6]

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Got you. And when you look at your share that you called out for the first 2 weeks in the cannabis market and in the areas which you play, PEI and -- where did you get this measurement from? And what does that imply in terms of sales?

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J. Pieter Sikkel, Pyxus International, Inc. - Chairman, President & CEO [7]

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We got that from -- data from the individual selling organizations in the individual jurisdictions. And that allows us to see where we are both in terms of unit price per gram, share, SKU share and all of that. And obviously, that also allows FIGR Canada to make adjustments in terms of package size, pricing and everything else. And the good news here is that what we're seeing is we're a little bit above the average selling price per gram for cannabis in the market. And we're a little bit below in terms of package size, so that give us opportunities to increase package size, to increase revenue. But FIGR did not have its premium line on the market yet due to late arrival of packaging from the supplier, so that will -- when -- that's being packaged up and delivered to stores, so that allows the potential for increasing average pricing of product as you're putting more premium into marketplace. And for us, it's a good start. Our ambition obviously is to grow our capacity, grow the volume. We should have the next stage of the expansion ready to grow in April of next year. And that, we've been pushing very hard despite heavy rain up there to get the expansion in PEI inflows before the full winter hits in so that the interior can be completed. And that will obviously allow expansion into more provinces. But we're seeing good shelf space, good reports back on the product, good reports back on the product quality. And the SENTRI system that we talked about is working extremely well and giving consumers unique transparency into the product that other products are not giving. So you can -- if you purchase a FIGR product with a code on the back, you can go onto the app on your phone. And you can see the mother plant, everything from the mother of the plant -- of the product that you're consuming, to the pesticide test, to when it was harvested and produced and everything else. And we believe that's a unique differentiator in the marketplace as well.

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Bryan Cecil Hunt, Wells Fargo Securities, LLC, Research Division - MD & Senior Analyst [8]

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My last question then I'll hand it off and get back in the queue. I know you can't quantify the restructuring charges, or at least you call out you can't, for Farmville, but from a magnitude perspective, is there any way this puts at risk the company's potential for free cash flow generation for the fiscal year?

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Joel L. Thomas, Pyxus International, Inc. - Executive VP & CFO [9]

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Yes -- no, Bryan. And we are still finishing the work around quantifying the costs associated with the repurposing of the Farmville facility, but it should be relatively de minimis. And certainly, we'll be providing that with our next set of -- next quarter disclosures, but again it should be relatively de minimis.

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Operator [10]

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The next question will come from Mary Gilbert of Imperial Capital.

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Mary Ross Gilbert, Imperial Capital, LLC, Research Division - MD of Institutional Research Group [11]

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I just wanted to follow up on Bryan's question regarding the $25 million and how you're going to make up for it. Could you give us some idea of the different components how it makes up the $25 million? And what are the risks to those components? So for example, with the other markets it sounds like those are strong, but you could have some shipping issues in getting the product shipped to customers. So what is the risk associated with that? And then yes, if you can just go through each component, including the opportunities with FIGR. We're just trying to get an idea of how easily -- well, I shouldn't say easily but how you're able to sort of deliver on the guidance given the $25 million hit.

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Joel L. Thomas, Pyxus International, Inc. - Executive VP & CFO [12]

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Yes, Mary, just to kind of follow on with what Pieter had outlined a minute ago, and that was pretty good detail there.