HEXO Corp. (HEXO) Q3 2019 Earnings Call Transcript

We have recently secured about 200,000 kilograms of hemp supply for CBD and non-THC cannabinoid extraction in fiscal 2020, and closer term, we've done a secondary supply agreement of approximately 60,000 kilograms of hemp to be supplied in the next two 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 eight US 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 multi-year extraction agreement with Valens to extract a minimum of 30,000 kilograms in year one and 50,000 kilograms in cannabis and hemp biomass in year two. So this helps to smooth out our operating ramp up and curves 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're the first cannabis company to join Food and 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, I'm very proud to say that the team has grown to 1,100 and everyone is 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 and 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, a 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 five 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 two 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 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 CAD400 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 a 150,000 kilograms annually, expanding our cultivation to three campuses, giving us resiliency and redundancy and giving us access as well to nine provincial agreements, so now reaching over 95% of the Canadian population and increasing the HEXO family by approximately 250 employees.

I mentioned Bellville earlier on the call, very proud to say we are on track. Phase one was online in May as planned and we plan on having the building fully operational by default. That will include not only HEXO core operations in about 580,000 square feet but also the Truss, Molson Coors joint venture which we are expecting to have a full line of bottling and canning made available to be ready for October legalization 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 HEXO MED has received its medical cannabis installation license in Europe and that's another step toward our plan of providing regulatory access to Fortune 500 companies, so that we can use their existing distribution networks in countries such as the UK, France and all supplied from a European domicile.

Financial results. Our total gross revenue was CAD15.9 million for the third quarter, an increase of 11.8 times over the same quarter in the prior year. As I guided, last quarter gross adult-use revenue remained flat at CAD14.6 million in comparison to the same period in 2018, it increased by almost a 1,000% which included only medical sales last year. We expect revenues to double this quarter with real life sales from the first harvest from B9 in our 1 million square foot facility, and also as we start to shift flower outside of Quebec which we're very excited to do.

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

We achieved adult-use revenues per gram of CAD5.29, a CAD0.54 decrease over last quarter due to a shift in product mix and 91% of our sales were done in Quebec 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 quite consistent with the prior quarter about CAD6.6 million, including the cost of dried flower and the transformation costs related to oil and value-added products. The fair value adjustment on the sale of inventory was CAD4.7 million, which has increased from CAD572,000 in Q3 '18 due to an increase in sales, which was offset by lower fair value program on the adult-use market. The fair value adjustment on biological assets was CAD20 million compared with CAD2.5 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 real, 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 to a 150 ton a year production capacity. Our gross margin before fair value adjustment on biological assets was CAD6.4 million, yielding a 49% gross margin on net revenue. So holding toward the 50%, we do expect over the next 24 months as there is significant pricing compression that the flower might drag those gross margins toward the 40%. We do expect that as we introduce more and more advanced products, we'll be able to pull back gross margin back toward the 50%, but do expect some turbulence on gross margin in the short term.

Operating expenses, our G&A increased to CAD10.5 million in Q3 from CAD2 million in Q3 2018. This reflected the growth in operations as we continue to strengthen our general finance, administrative staff, an increase of CAD3 million. Rental expense increased by CAD790,000 related to rent on the Belleville facility. Professional listing and legal expenses increased by CAD900,000 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 CAD1.8 million due to an increase in property plant and equipment being covered and D&O premium increased 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 CAD5.1 million in Q3 from CAD2.1 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 CAD400 million or CAD20 million for the year, excluding sales and operations of course, so just on pure marketing spend.