Canopy Growth Corporation (NASDAQ:CGC) Q3 2023 Earnings Call Transcript

Canopy Growth Corporation (NASDAQ:CGC) Q3 2023 Earnings Call Transcript February 9, 2023

Operator: Good morning. My name is Michele and I will be your conference operator today. I would like to welcome you to the Canopy Growth Third Quarter Fiscal 2023 Financial Results Conference Call. At this time, all participants are in a listen-only mode. I will now turn the call over to Tyler Burns, Director, Investor Relations. Tyler, you may begin your conference call.

Tyler Burns: Thank you, operator. Good morning. Thank you all for joining us. On our call today, we have Canopy’s Chief Executive Officer, David Klein; and Chief Financial Officer, Judy Hong. Before financial markets opened today, Canopy issued a news release announcing our financial results for our third quarter ended December 31st, 2022. This news release is available on our website under the Investors tab and will be filed on EDGAR and SEDAR. Before we begin, I would like to remind you that our discussion during this call will include forward-looking statements that are based on management’s current views and assumptions and that this discussion is qualified in its entirety by the cautionary note regarding forward-looking statements included at the end of this morning’s news release.

Please review today’s earnings release and Canopy’s reports filed with the SEC and SEDAR for various factors that could cause actual results to differ materially from projections. In addition, reconciliations between any non-GAAP measures to their closest reported GAAP measures are included in our earnings release. Please note that all financial information is provided in Canadian dollars, unless otherwise noted. Following remarks by David and Judy, we will conduct a question-and-answer session, we will first address questions uploaded by verified shareholders using the Say Technologies platform. Following that, we will take questions from analysts and to ensure that we get to as many questions as possible, we ask analysts to limit themselves to one question.

With that, I will turn the call over to David. David, please go ahead.

David Klein: Thank you, Tyler. And good morning everyone. During our Q2 earnings call, I clearly outlined Canopy’s top priorities in becoming a North American Cannabis leader, which included actions to drive Canadian profitability, and empowering Canopy USA to progress the US THC strategy. On today’s call, I’ll provide comprehensive updates on both priorities, which are imperative to achieving our ambition of long-term North American cannabis market leadership. Following my remarks, Judy will review our Q3 results, provide an update on our path to profitability, and outline the cost savings anticipated from the business changes announced today, as well as discuss our balance sheet. The transformative plan introduced today addresses the actions needed to drive profitability, but also to secure the future of our business.

The intent of establishing a legal cannabis industry in Canada was to combat the illicit market. At the outset, the legal sector was poised to be a source of immediate economic development, with significant job creation and tax revenue. As a global first mover, the legal Canadian cannabis industry was originally projected to grow into a CAD7 billion market over time, however, that market aspiration has not come to fruition. Today, there are two very different cannabis markets in Canada; one that’s legal, highly taxed and regulated, and one that’s thriving in illicit. The unregulated illicit market is generating billions of dollars of revenue with a 40% market share, and faces virtually no risk of enforcement. The legal sector out of necessity, is forced to be price-competitive with an illicit market that does not pay excise taxes, does not pay provincial board markups, and is not restricted in the products and pricing that they offer.

The competition with the illicit market, compounded by an overbuilt legal cannabis industry, has caused price compression across the board. We expect the sector challenges to remain for years to come and as a result, the sustainability of this legal sector is in question. Make no mistake building an industry from the ground up is not linear and the knowledge gained has been significant. We stand ready to work with regulators, politicians, and provincial boards to improve the punitive regulatory environment based on experiences from the front lines. However, despite these market realities, Canada remains a large market in which canopy is well-positioned with strong brand recognition, a diversified portfolio of products in the adult use segment, and a growing share of the medical market.

The backdrop I just outlined formed the catalyst for the actions announced today, which are intended to position our Canadian business to be profitable and self-sustaining. The Canadian Business Transformation Plan includes consolidating our production and operational footprint shifting to a brand-led asset-light model and completing an organizational restructuring that better aligns our resources with market realities. Specifically, we intend to exit our 1 Hershey Drive Smiths Falls, Ontario facility as we consolidate cultivation at existing facilities in Kincardine, Ontario, and Kelowna, British Columbia and where necessary, enhance our offering with a flexible flower sourcing strategy. Similarly, similarly, we will be outsourcing non-flower formats such as beverages, edibles, vapes, and extracts as we implement a nimble asset-light model that allows us to be dynamic and actively respond to market demands.

In Quebec, we will see sourcing of flower from the Mirabel facility. As the Mirabel facility is operated through a joint venture structure, we’re engaging with our JV partners on the long-term future of that site. We recognize our core competency is brand development with strong routes to market. The Canadian transformation is intended to closely mirror the plan structure of Canopy USA, which we believe to be a winning model. The changes announced today are in addition to the following cost savings initiatives that were completed in Q3, including the divestiture of national retail operations, closure of our Scarborough, Ontario research facility, and outsourcing of our genetics program to Quebec-based EXKA. The restructuring of our Canadian cannabis business into a standalone business unit and the reduction of our SKU count by approximately 50% as we focus on the highest performing segments within the Canadian adult use cannabis market.

The changes announced today will result in approximately 800 employees exiting the business over the coming months, with 40% of that reduction occurring immediately. We expect these further adjustments to reduce annual SG&A and COGS by an additional combined CAD140 million to CAD160 million over the next 12 months. Judy will speak to the financial aspects of our restructuring in greater detail during her prepared remarks. Now, let me spend a few minutes discussing business outside of Canadian cannabis, starting with our international markets. Where Australia is worth highlighting as our sales in this market have increased nearly 200% year-over-year and demonstrated steady growth. Storz & Bickel or S&B continues to demonstrate its capabilities and appeal with core and limited time premium vape offerings like the Peace Volcano.

In the third quarter S&B delivered its best quarterly revenue since Q4 FY 2022. This growth was driven by traditionally strong seasonal demand for premium cannabis vaporizers. Overall, S&B continues to be a key profit contributor in the Canopy brand portfolio, and is poised for innovation and growth. Turning to BioSteel, we’re very pleased with the strong momentum at retail despite quarter over quarter volatility in reported revenue due to the timing of distributor loadings. According to Nielsen data, BioSteel share of isotonic beverage sales in the Canadian National convenience and gas channel reached 10.4% in the third quarter and 13.8% in Ontario. In the US, the brand has also made impressive distribution gains over the past year with IRI data showing BioSteel’s ACV at 34% for the quarter.

This was matched by notable sales gains, with scan sales in the US region increasing 157% from the prior year. With expected distribution gains and velocity growth driven by our investment and brand activation, we expect to see revenues increased significantly over coming quarters. Finally, I’d like to speak to Canopy USA, which continues to progress the US strategy. With a lack of developments in Washington, I strongly believe that through Canopy USA, we’ve taken control of our destiny to capitalize on the once in a generation opportunity in the largest cannabis market in the world. Our primary objective for Canopy USA is to optimize the value of our entire US cannabis ecosystem, Acreage, Wana, Jetty and TerrAscend. By leveraging their brands portfolios, routes to market, and operations, we’re pleased to see the ecosystem exploring opportunities to collaborate and grow with examples including Wana and TerrAscend bringing Wana Edibles to New Jersey, and the expanded availability of Wana in the State of Maryland.

Wana launching in New Mexico and Missouri in addition to releasing a suite of new sleep product offerings. And Jetty Extracts announcing upcoming product availability in the state of New York. After closing, Canopy USA expects to reduce its annual operating expenditures, including eliminating redundancies and the public company reporting cost of Acreage, all of which are expected to be realized shortly after closing these transaction. This is a novel and groundbreaking strategy. We’re resolute in remaining dual listed as the Canopy USA strategy progresses and as we continue to finalize our proxy, we anticipate holding our shareholder vote as early as April 2023. With that, I’ll turn it over to you.

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Judy Hong: Thank you very much, David and good morning, everyone. I’ll focus my remarks on one a brief summary of our third quarter results; two, an overview of the financial details of our transformation plan for Canadian cannabis business; and three, discussion of our cash flow and balance sheet. Beginning with a review of our third quarter fiscal 2023 financial results. In Q3, we generated net revenue of CAD101 million, representing a 28% decline over the prior year period. When adjusting for the impact of divestitures of C3 and the Canadian retail business, revenues decreased 23%. Revenue highlights include Canadian medical cannabis increasing 9% versus the prior year period; Storz & Bickel increasing 50% sequentially compared to Q2; and our Australian cannabis business having its seventh quarter in a row of record revenue.

Gross margin declined year-over-year, with the decline due to a shift in the business mix from the divestiture of C3, the impact of last year’s COVID-19 Relief Program, and a decline in BioSteel’s gross margins. Adjusted EBITDA loss increased by CAD21 million to CAD88 million compared to a year ago. Approximately CAD8 million of the adjusted EBITDA loss during Q3 resulted from a few discrete items including costs associated with returns in our US CBD business following our strategic change; the write-down of aging inventory of BioSteel; and accredit to a distributor which is related to the previous sales made to Israel. Free cash flow improved 13% year-over-year due in part to lower capital expenditures. Now, let’s take a look at the results from each area of our business.

Canada cannabis revenue declined 23% compared to the prior year period, and declined 11% sequentially compared to Q2, with the decrease due to lower adult use B2B revenues, partially offset by a 9% growth in our medical cannabis revenue. The impact of the retail divestiture during Q3 was approximately CAD1 million. Canada cannabis adjusted gross margin was negative 8%, but cash gross margins improve to 29% when normalizing for the impact of depreciation and certain non-cash inventory charges. The year-over-year improvement in cash gross margin is driven by mix improvement and the cost reduction actions announced in April of 2022. And today’s announcement is expected to further improve cash gross margins and address the gross profit dollar headwinds that have stemmed from lower revenue.

In the rest of the world cannabis segment, revenues excluding C3 experienced the 54% decline year-over-year due to a decline in the US CBD business and the impact of shipments to Israel. The current quarter did not have any shipments to Israel, which negatively impacted by sales by CAD4.7 million compared to the prior year period. This was offset by strong performance in Australia, nearly tripling revenue compared to Q3 of last year. Year-to-date, our international cannabis sales, excluding US CBD business are up 43%, despite the decline in sales to Israel. Adjusted gross margins for this segment with negative 33% in the current period compared to positive 32% a year ago, which reflects the discrete factors that impacted sales that I discussed earlier in the call.

We expect gross margins in this business to revert back to the historical level going forward. BioSteel revenues were relatively flat to the prior year period and lower than Q2 mostly due to the impact of timing of distribution loadings. The timing boosted Q2 sales, while Q3 revenues were also impacted by shipment timing shift into Q4. Year-to-date, BioSteel revenues have more than doubled, and we expect to see strong growth resuming in Q4. Adjusted gross margins for BioSteel were negative 37% in the period, which was impacted by inventory write-downs and higher third-party shipping, distribution, and warehousing costs across North America. The inventory write-downs relate to an aging inventory of ready-to-drink product, which is primarily due to the previous inventory build ahead of distribution gains that progress slower than anticipated in the U.S. The acquisition of a manufacturing facility in Verona, Virginia during Q3 is expected to improve BioSteel’s gross margins by reducing contract manufacturing costs and the BioSteel team has several initiatives in place to further reduce its cost of goods sold in the coming quarters.

We expect BioSteel’s gross margins to approach industry standards as sales scale over time. Storz & Bickel revenues decreased 20% as compared to the prior year period, yet increased 50% sequentially compared to Q2. While cautious consumer spending in an uncertain inflationary environment is impacting demand and higher priced items, we did begin to see resumption of sales to key distributors in the US market. Note that this also represents Storz & Bickel best revenue quarters since Q4 of FY 2022. Gross margin for Storz & Bickel remained healthy at 45% in the current period. This first revenue decreased 22% of the current period compared to the prior year due to challenging UK retail dynamics. Gross margins declined slightly to 49% from 51% in the prior period.

I’d like to now provide an update on our actions to achieve profitability. Our previously announced cost reduction initiatives are already driving improvement in cash gross margins in the Canadian cannabis segment. However, our adjusted EBITDA losses have not improved meaningfully due to the decline in our Canadian cannabis revenue, as well as investments behind BioSteel. As David mentioned, this morning, we announced a plan to transform our Canadian business to an asset-light brand-driven model, significantly reducing our operational footprint as well as headcount across our organization. As a result of these actions, we expect to reduce our overall costs by an additional CAD140 million to CAD160 million comprised of a CAD90 million to CAD100 million reduction in cost of goods sold, and CAD50 million to CAD60 million reductions in SG&A expenses.

The reduction is incremental to the CAD100 million to CAD150 million of cost reduction plan that we announced in April of 2022. The additional cost reductions are expected to come from several areas. One, reduction of our Canadian cannabis operational footprint. Our plan to exit cannabis flower cultivation in our Smiths Falls, Ontario facility and seizing the sourcing of cannabis flower from the Mirabel, Quebec facility is expected to result in a much smaller cultivation footprint. In addition, we plan to close the 1 Hershey Drive facility in Smiths Falls and move manufacturing for smaller footprint, while moving production of all Cannabis 2.0 formats to third-party partners. And we’ve already closed the Scarborough, Ontario research facility.

These operational footprint adjustments are estimated to deliver CAD35 million to CAD40 million in annualized cost savings and reduce their distribution costs as well as other supply chain related costs by an additional CAD100 million — CAD10 million in annualized cost of goods sold. We anticipate these operational changes will be completed in Q2 of FY 2024. Two, reduction in headcount across our operations. Headcount reductions across cultivation, manufacturing, and other areas of operations are expected to generate CAD45 million to CAD50 million in annualized cost of goods sold savings. Three, reorganization of our sales and marketing organizations. We have streamlined the sales and marketing functions under the creation of a standalone Canadian business unit with focus on key accounts, high margin customers, and our medical sales.

This is expected to result in a leaner selling organization and reduction in certain marketing expenses, with an estimated cost reduction of CAD10 million to CAD15 million in annualized sales and marketing costs. And four, reduction in R&D and G&A spending. We’ve eliminated our central R&D resources, outsource our genetics program, and embedded innovation functions within the Canadian business unit. This is expected to deliver CAD10 million to CAD15 million in annualized cost savings. And right-sizing of our essential support teams from both a headcount and operational spend perspective to the size of the current business and market realities, is expected to generate an additional CAD30 million in annualized G&A expense savings. Overall, we expect to reduce our total costs by CAD240 million to CAD310 million upon completion of the April 2022 cost reduction initiatives, as well as the actions that we’ve outlined this morning.

We expect the combined cost savings program will position Canopy to be profitable in our Canadian operation, even with no improvement in revenue from the current run rate. And as such, we reaffirm our previous expectation of achieving positive adjusted EBITDA in FY 2024 with the exception of investments in BioSteel. Let me now spend a few minutes on our cash flow and balance sheet. Our cash balance declined by CAD354 million during Q3 compared to Q2, which is higher than the recent quarterly cash outflow. So, let me walk through the various drivers. First, we paid off CAD117.5 million of our term loan, which was the first of the two payments as part of our agreement to tender $187.5 million of the outstanding term loan. Second, cash used for acquisitions and investments during Q3 included CAD24 million in acquisition of a manufacturing facility for BioSteel, which should provide an attractive return on investment, and a CAD38 million related to an option premium payment to purchase Acreage’s debt.

Third, our free cash flow in Q3 with an outflow of CAD146 million. This included cash interest payments of CAD28 million in Q3. Cash outlays also included approximately CAD20 million that are not part of our adjusted EBITDA, which includes acquisition-related costs, primarily related to the reorganization of Canopy USA and divestiture of our retail business, as well as certain cash restructuring costs. Q3 CapEx came in at CAD2 million, significantly lower compared to the prior year period and for the full year 2023, we continue to estimate CapEx to be in the range of CAD10 million to CAD20 million. Our cash and cash equivalents remained strong at CAD789 million and our overall debt position has been reduced to CAD1.2 billion as of Q3 quarter end, down from CAD1.5 billion at the end of Q4 of fiscal 2022.

We also have many liquidity options available to us and are laser-focused on improving our cash position and further reducing our debt over the next few months. First, of the remaining senior notes due in July 2023, Constellation has already indicated its intention to purchase for cancellation up to CAD100 million principal amount. Second, we have a very constructive relationship with all our debt holders and we continue to consider ways to reduce debt in a accretive manner, balancing our focus on remaining — maintaining our financial flexibility and cost of capital. Third, we are in active discussions around monetizing numerous non-core assets that we have, which includes facilities that we’ve already closed. Fourth, $2 billion base shelf remains fully available to us.

And importantly, we expect the cost reduction initiatives to reduce our operating cash outflow by more than half with significant quarter-over-quarter improvement starting in Q1 of our fiscal 2024. Let me now provide some perspective on the balance of fiscal 2023 revenue outlook. First, we expect strong growth from BioSteel in Q4 with increased marketing investments, driving gains and sales velocity as well as new distribution. Our Canadian cannabis business is expected to show stabilization in net revenue as we undergo our Business Transformation Plan. Note that with the disposition of our Canada retail being completed at the end of Q3, the Canadian adult use business to consumer revenues will now be eliminated from our go-forward results, which will negatively impact both year-over-year and quarter-over-quarter comparison.

Our Europe and west of the world’s business is expected to show year-over-year decline in Q4 as we no longer expect to see sales to Israel going forward. For Storz & Bickel, we’re encouraged by improved us distribution in the third quarter. But note that Q3 results benefited from Black Friday and the holiday season, so we expect seasonality to contribute to a modest decline in Q4 versus Q3. In conclusion, achieving profitability is critical for us and with the decisive actions we announced today, we’re focused on executing this transformation in Canada and significantly reducing our cash burn over the coming quarters. This concludes my prepared comments. We will now move into the question-and-answer session. To begin with our Q&A session, we’ll first address an investor question that was uploaded through the question-and-answer platform developed by Say Technologies.

Tyler, can you please state the first question.

A – Tyler Burns: What do you feel the effects of legalization in the United States will have on the company and the industry as a whole?

David Klein: So, — thanks, Tyler. Look with the lack of developments in Washington on federal legalization, we’ve decided not to wait for regulatory reform to happen in order to reap some benefits through our ecosystem in Canada, USA. And you know that just to reiterate what that is that’s really putting together our Wana brand, our Jetty brand, Acreage, together so that they can operate in a collaborative fashion, grow their business faster than they might do if they were to continue to operate as separate companies, and realize cost synergies. And so we continue to work on our Canopy USA strategy, which we commented on, both in the earnings release as well as in our prepared remarks. So, yes, I think that we’re all hopeful that at some point, we have full federal legalization in the US, but we see that happening — continuing to happen very slowly. So, we’ve taken matters into our own hands. With that, operator, Judy, and I will now take questions from our analysts.

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Q&A Session

Operator: Thank you, sir. Your first question will come from Tamy Chen at BMO Capital Markets. Please go ahead.

Tamy Chen: Thank you. Good morning. Judy, I just wanted to ask in terms of the EBITDA, could you comment a bit on what the EBITDA loss looks like between the particularly the Canadian cannabis segment and then your consumer segment? I’m just looking at based on your total cost analysis to-date and you’re reaffirming EBITDA guidance, that it seems the majority if not possibly all of the currently reported consolidated EBITDA loss is due to the Canadian cannabis segment and that possibly the consumer segment EBITDA, maybe already in the positive. Are able to comment on that? And can you just give a little bit more detail on the cadence of all these cost savings as we progress through the quarters and fiscal 2024? Thank you.

Judy Hong: Sure Tamy. So, I would say when you look at our total adjusted EBITDA losses, the way I would think about it is sort of break into a few different segments, right? So, number one, to your point, right now, the two main drags in terms of our adjusted EBITDA losses are One Canada, and second, the investments that we’re making in BioSteel. So, with all the actions that we’ve announced in terms of our Canadian Business Transformation Plan, our expectation is that once we’re complete with the plan, that all of our operations across our businesses will be profitable, with the exception of the investments that we’re making in BioSteel. So that’s the outline of my comment around FY2024. So when you look at the businesses that we have stores and big goal is a profitable business, you can see that in the gross margins.

And obviously the highest price points that that brand Garner’s it is a profitable business. The International Cannabis, there’s some noise in that business, just given some of the actions that we’ve taken with US CBD business. And, the opportunistic sales that we had previously benefited from Israel, but all in all International Cannabis is achieving gross margin profitability and if you look at, if you get this worse than others, we think we’re pretty close to profitability and all those segments. So it’s really about making sure that all the cost savings are driving Canada to be self-sustaining and profitable. And for BioSteel, we do think the investments will eventually pay off for Canopy shareholders one way or the other in terms of really the sales growth that we’re benefiting from that business.

And I think that that does create value for Canopy Growth shareholders. In terms of the cadence of the savings that are expected to flow through, I would say, we obviously did announced the changes this morning and there is a big portion of the savings that will begin to flow through starting in Q1. But as we complete those actions in Q2, we think the bigger chunk of those savings and the progression from a quarter-over-quarter basis we really begin to start to see in Q1 and Q2 of fiscal 2024.

Operator: Your next question comes from Vivien Azer of Cowen & Company. Please go ahead.

Victor Ma: Hi, good morning. This is actually Victor Ma on for Vivien Azer. And thank you for taking the question. So broad based inflation headwinds are persisting in North America, Wildflower downgrading has been evident Canada, have you seen that accelerate at all, as consumers absorb higher energy prices this winter?

David Klein: I think we’ve seen across Canada, and I would argue in the US, we’ve just seen growth in the value segment, which we don’t play heavily in. But that’s really that’s, I think what we’re seeing, I think it’s less about overall price compression and more about this growth of the of the low end of the market.

Judy Hong: And just in terms of our business in Canada, we are looking at now the impacts from some of that price compression moderating in our business, if you look at our product mix, as we’re pre minimizing our portfolio, the decline in terms of our average pricing is beginning to moderate. So you see that in terms of the product mix shift.

Operator: Your next question comes from Chris Carey of Wells Fargo. Please go ahead.

Chris Carey: Hi, good morning.

Judy Hong: Good morning.

Chris Carey: David, you think you noted that the shareholder vote on Canopy USA was still planned for April of 2023? Or is planned for April 2023? Please correct me, if I heard that wrong, you know that there’s a lot of details in the press release this morning about, potential remedies that would make the NASDAQ and I presume the SEC more comfortable with this transaction. I’m still struggling a little bit just to understand the practical considerations here. You talk about, a smaller percentage ownership, among other things. So, just in plain terms, what would need to change to get this deal through? And then, perhaps comment on how this changes the — I suppose the reporting relationship with constellation, my read here is, you know, probably under the change instead, they’d still be reporting Canopy and equity income but I’m not sure.

So, anyway, so you could tell just trying to maybe, just dumb this down a bit and understand kind of sense of what’s actually being contemplated here. Thanks so much.

David Klein: Yeah, Chris. So — like, it’s a taken, yeah, we’re still we’re still targeting in April 2023, shareholder meeting, I don’t think it changes, any changes that we might make in the structure of our Canopy USA, business won’t affect how constellation ultimately treats their investment in canopy. And so to simplify, where we are really, again, the value of Canopy USA is in putting these businesses together, letting them generate revenue synergies, because they can effectively open markets, maybe faster, generate cost synergies by working together to drive routes to market and route to market activation within individual marketplaces, and then look at other more G&A sorts of synergies across their businesses. So we think putting the businesses together is the value unlock.

How we go about doing it is the complicated set of activities that we’re working through with SEC, as well as our — the exchanges that we trade on. And so, simplistically put, we would have to ensure that our economic ownership is in more than 90% which was a likely or potential outcome anyway, as we as we put this business together. We need to make sure that we would only have three members on the board so we would have one fewer seat on the board and that seat would come from a canopy nomination to the board we don’t think that affects the performance of the business whatsoever, and then we’d have to — in our earnings release, eliminate certain negative covenants such as that’s just adjusting some things that Canopy would have ordinarily or originally hadn’t had say over.

So what we’re really doing is we’re just positioning the company to function like every other company would gather synergies across their portfolio, drive their business in the marketplace. And these kinds of technical things are just required for us to have an appropriate level of distance from specific control of that enterprise as we go forward.

Operator: Your next question will come from John Zamparo of CIBC. Please go ahead.