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Good day, ladies and gentlemen. We would like to welcome everyone to Alcanna Inc.'s Second Quarter 2020 Earnings Results Call. [Operator Instructions] A copy of the company's earnings press release and management discussion and analysis is available on their website and includes cautionary language about forward-looking statements, risks and uncertainties, which also apply to the discussion during today's conference call. All amounts discussed on today's call are quoted in Canadian dollars. I will now turn this call over to Mr. James Burns, Alcanna's Chief Executive Officer. Please go ahead, sir.
Thanks, Paul. Welcome to those calling in. Appreciate your interest in our company. As has been a recent practice for us, I won't give an opening statement, and we'll just turn it over to questions relatively quickly. Clearly, we've been -- we're pleased with the results of Q2 in the context of the pandemic that our business has been able to stay open and to meet the needs of our customers quite well throughout the piece, and the results speak for themselves, I think. So with that, I will turn it over to questions, please, Paul.
[Operator Instructions] We have the first question from Jenny Wang from Eight Capital.
Congrats on the quarter. Could you just talk a bit about what factors contributed to the fairly strong liquor margins this quarter, 22.7%? Would you say this was impacted by the closure of on-premise locations? And then a follow up to that would be any changes to where you expect liquor margins to end, let's say, a year to 18 months out?
Jenny, sure. As we have been quite clear for some time now, our intent was to raise margins carefully and slowly throughout 2021 -- 2020. And to -- because of the situation, we've been able to -- into -- early on in Q2, we were at the margin level that we had really targeted to be at the end of this year as opposed to that early on into it. A couple of reasons for that. A little bit pricing, not very much. A lot of it was mostly -- we have changed the way we buy. We've changed the way we promote. We are taking advantage of limited-time offers much more carefully now and utilizing our warehouse to maximize our buying power and to contribute to margin. And while this is on gross margin, we're also very -- got labor in a good shape in our stores at just the right amount to balance between cost and maintaining good customer service and -- during very, very busy times. So a lot of factors contributed to it. Clearly, volume and sales and demand for -- an interesting fact, I think, most people don't seem to really understand is that overall liquor consumption is down in the population since the middle of March, not up. What's changed is on-premise was literally closed for 2 to 3 months. And then when it reopened, first to a limited and then to a much more sort of normal degree in a lot of jurisdictions, especially here in Alberta, the customer traffic just wasn't there. So the fact that the government allowed the restaurants to be open is all very well and good, but if people don't want to go, it doesn't really help them. So restaurants have been open in Alberta since May 14, so over 3 months. Yes, they have limited capacity because of social distancing, but our results since May and right through till sitting here today had not changed. So the reopening of restaurants has not affected the consumer demand for off-premise alcohol buying -- drinking at home essentially. Maybe a lot more people are ordering SkipTheDishes and ordering their food at home, but so far -- and we don't see this changing just because pricing to buy at a retail store is so far superior to buying in a restaurant. Anecdotally, we've heard that even people who do go to restaurants are not staying. They're eating fast, staying -- in and out, stay for an hour, and -- which the restaurants are encouraging to try to get some business in their limited-capacity footprints now. Not ordering the second bottle of wine. Not having the predinner drinks or the cocktails or the after dinner, and -- all of which, I think, is playing into our belief -- our strong belief that this is not just a onetime blip, it's a trend and societal and consumer behavior trend that will be in place for the foreseeable future.
And while restaurants are seeing a small comeback, bars and lounges are not. And so again, that's just a great tailwind for us, as Jamie said, for the foreseeable future. The other thing that impacted margins, Jenny, is we weren't as promotional in the beginning part of Q2. With the pandemic going on, we just didn't see the need. There was really no reason to have a lot of promotions out there. Not to say that we had no sales, we had some sales, but we just weren't as promotional. So you'll see us turn on some promotions in Q3 and Q4, which will blend the rate out again, but that'll be offset by better buying, other initiatives that we have underway. So the rate will still increase as we go through the rest of the year, just not as much as what we had expected because we've made more progress than what we expected to this point.
Got it. And just to recap on your -- on the last earnings call, you mentioned kind of your 1 year to 18 months' target of 23.5% to 24.5% liquor margins. Is that still intact? Or should we kind of expect a little bit higher? Or any change there?
I think that's a reasonable range. It's kind of wide, but I think we'll be in that range.
Yes.
Depends on how things evolve, how the competitive environment evolves, how the economy evolves.
Yes. The economy evolves. I understand we're to hear today what the federal government is planning to do with EI program to replace the CERB in terms of cash in the system for people and how that impacts discretionary spending -- money people have to spend and so on. So we have to watch all of that and be careful. You can't just go raising prices for the sake of it. I mean we're in a very extremely competitive industry, as we've pointed out many times over the past couple of years, and you have to price within the context of the competition. Our company has shifted, quite dramatically, its focus, and we're essentially, for the most part, a discount liquor company now. With -- our Ace banner has 102 stores, whatever it is, and Liquor Depot is 79 now. So -- and Wine and Beyond, which is our large-format store, which does have luxury products but it's not a luxury store, its margins are more or less the same as Ace. So it's a place to get great prices, and customers are not comfortable with that. We attracted a huge number of new customers to Wine and Beyond during -- especially during lockdown, but then they've stayed ever since, who were never necessarily been into Wine and Beyond, maybe were confused as to what it was, maybe thought it was a high-end place or something when they come in. And I think they came and are still coming in, in incredible numbers because of the large footprint and there's a lot of space, people feel safe in there, you can move around. The average customer was staying there for over an hour during the lockdown, I think it was somewhere to go, to be honest. But -- and filling their baskets and realizing that the pricing in there for most items was exceptionally good compared to anywhere else. So we feel we've got the company positioned relatively well to fit to climate of the times.
Okay. And maybe on the cannabis side, in terms of cannabis margins, over 34% this quarter. Is that where we should expect margins to sit going forward? Or are there any exceptional items that happened in the quarter?
That's pretty much standard for the industry, as I understand, reading some other people. And we just -- we obviously go comparison shop our other retailers. Most people are -- started getting around 34%, 35% margin right now. I don't see that continuing, Jenny. In Alberta, there's 511 stores or some insane same number right now. Our stores have been extremely stable on a sales-per-week basis because we're in good locations. But ones who are in terrible locations, which is the vast majority of them, are just having more and more stores sharing tinier and tinier pieces of their part of the pie. And the only competitive response people in that situation can do over time, if you look at any retail 101, is drop prices. You can't do more marketing because you can't market. So we don't anticipate margins staying in the competitive environment at this level for too much longer in Alberta. Ontario, yes, because it's -- the rollout of new licenses is taking excruciatingly slow. So they're still vastly underserved by retail outlets in Ontario, and until it gets to sort of the Alberta level of saturation or oversaturation, Ontario will -- margins will stay good.
One opportunity that still exists for margins in the cannabis space is 2.0 products. We really haven't seen a lot at this point. What there is, there's a lot of stuff that people just don't really want, that's what they're producing. And the stuff that people do want, there's not a lot of supply. So there's still opportunity for positive margin growth from those items as the margins come down on the products that have been out for a while.
Yes. On flower it will come down, yes. Countering that is the wholesale price of flower is coming down extremely fast because there's so much oversupply from the LP. So that will help us as retailers be able to have the lower prices but still maintain some margins for -- very strong. But is 35% -- 35% is just not sustainable for a long time in any retail. It just isn't. There's too much -- you do very well at 35% in a retail environment. So as long as you're controlling your labor and your rent is fine and so on, the -- there's too much room for people to undercut you over time. But as David says, the 2.0 products are in -- the Health Canada numbers are just essentially meeting us. What really matters is what actually people want, not what they produce. There's mountains of chocolate that customers are not interested in chocolate. Gummies and some of the beverages, things that people want, there's very, very limited supply. So we get tiny amounts, and we sell it out really quickly every week. And because of that limited supply, obviously, you can keep your margins healthy.
Okay. That's helpful. And maybe just one last one on SG&A. It was flat this quarter. Is this the level that we should expect going forward?
Yes. With the exception that we had some one-off costs this quarter related to the secondary offering that we did and COVID expenses, which I think we gave some guidance on in the MD&A. So between those 2 items, I think we had about $2 million, $2.5 million of extra costs that I don't see going forward.
Right. That were all over within Q2. Our hero pay ended in the middle of June in -- at the end of Q2. So -- and obviously, the onetime transaction costs are onetime transaction costs. There's always room to improve SG&A and we continually look at it, that's business. But...
Our operations team has done a great job of getting labor in the stores to where we wanted to be at the end of the year. Again, they've done a great job of accelerating their programs there. So we're in our range going forward.
The next question is from Kyle McPhee, Cormark Securities.
Just on your working capital, your inventory, it looks like you put a lot of cash into inventory in Q2. I suspect some of that's just the new stores opening up. But is there anything else in there in Q2 that maybe made it an abnormal use of cash for inventory? Maybe something like stocking up on the limited-time offers from suppliers?
Yes. So 2 things there, Kyle. One, at the end of March, when we didn't really know which way the pandemic was going to impact our business, we really lowered inventory levels, just to turn it into cash because, again, we just didn't know how this business would do or how the governments might react and close us or keep us moving. So we've had a stock-up from that point. The other place that we've increased inventories is just we have some stores that are just doing gangbuster numbers, and we needed to put more inventory in there to support those increased sales. And then the third place, as you pointed out, is there's been some great deals on some LTOs from the vendors, and so we've stocked up to keep our margins healthy and remain competitive in the marketplace.
Got it. And on those limited-time offerings, was this kind of just normal-course sized buying for you, or was it bigger than typical this year, so given you have the capital, your balance sheet is in such a good shape and maybe helping gross margins more than otherwise?
We made a deliberate -- we sat down with our operating team, and they asked, and they had a well-thought-out plan for -- wanted as much as -- at the high point, as much as $10 million to $12 million extra dollars to invest in inventory because of the LTOs they saw coming and the conversations they've been having with vendors as to what might be possible. So it was a very deliberate thing we did. And you'll see the benefits of that on the income statement over the next quarters because it's purchased now, but the pricing is -- it will have the impact on -- positive impact on margins going forward. So yes, it was strategic. It was carefully done. And as David said, some of the stores, especially the Wine and Beyonds, we just literally couldn't keep -- the shelves are running out every single weekend. Those stores are doing Christmas-like numbers week after week after week, and we just couldn't literally keep it on the shelf. So we really had to put in greatly enhanced inventory in-store just to keep them running and meet the customer demand.
Got it. Okay. And then based on all the color you just gave, it sounds like in the back half of the year, your working capital flow should normalize. So it's usually a cash inflow, is that still the case this year?
Absolutely, yes.
Yes. No, we don't plan on increasing inventory dramatically. We'll have a little bit of a spike going into the holiday...
Into Q4.
When we get that back through Christmas.
Yes. That's right, Kyle.
Okay. And then moving on to your leases. And in an environment like this, I think there's potential for renewal at lower rates. Is that in the cards for you? Do you even have a significant portion of leases up for renewal this or next year?
Well, when you have as many leases as we do, you always have normal flow, like 10%, give or take, whatever, of leases every year come due. So yes, no, absolutely. I think we can say with almost certainty there's not going to be any rent increases, for sure. And it's situational, case by case. If you've got some of our great Liquor Depots in -- which have restrictive covenants in a grocery-anchored mall, which do very well, and we wouldn't have the same leverage you might think we'd have with the landlord because we -- if you say no, they get somebody else. So other situations, we do have tremendous leverage. Obviously, one of the very few retailers right now who is not only able to pay the rents but very comfortably able to pay the rents. So we're a very desired tenant. Always have been, but even more so now. I think where we see the opportunity on rents, Kyle, is new builds, like new Wine and Beyond sites. As big-box retailers continue to struggle and either go under or try to get out of leases, we see a tremendous opportunity, if we're patient, to get some extremely attractive real estate for very extremely attractive rents to build Wine and Beyonds, especially, in places where so far we've had trouble, namely Calgary and British Columbia. But the deals are already starting to come. Right now, we think the landlords are still living in the past and haven't accepted what their future is going to look like, but that will come with time.
Got it. Okay. And all those Wine and Beyonds, I don't think I saw CapEx spend for Wine and Beyonds in your updated guidance. Is the new locations within the cards for early next year, and we might see some of that CapEx this year?
Yes. We have one for sure in the books that there might be a little bit of spend this year, but most likely mostly in Q1. And we're trying to open in Kelowna before Easter next year, somewhere in that time range, so our first foray into British Columbia. And we're actively looking for more sites. We have some things in mind that we want to do. But again, as Jamie said, we'll play out how the landlord see rents going forward.
Yes. I mean we can sign 5 leases today on yesterday's news rents, but we're not going to do that. Why would we do that? We'll wait a few months until these people see the reality here, get the rose colored vision that their assets are now liabilities, so they better come to the table.
Got it. Okay. And last thing on leases here. I think you have a number of leases in place for cannabis stores not yet opened but coming. I'm wondering if you were actually paying the rent on those in Q2. Or does those rent payments start later, so there was no kind of unabsorbed rent in your Q2 OpEx?
Almost none in Q2. It's -- but it does start in [ Q3 ].
I can think of, I think, 2. Yes, but it's relatively small, exactly. Most of them, in Q3, we're paying the rents. It all depends on -- you usually get a 3-month fixturing period. And depending when we got the lease and how long that took, so we'll...
It does start here in Q3.
Yes, yes. I think we're paying rent on all of them now, yes.
[Operator Instructions] Next question, John Zamparo, CIBC.
I want to get back to liquor margins and the completion -- or I guess, substantial completion of your SAP install. What does that allow you to do that can result in further margin expansion over the next year or so?
It's actually not SAP, it's Microsoft Dynamics 365, so -- John. But our ERP, yes, yes. No. You go ahead, David.
Yes. The improvement in margins that we're going to get likely are kind of next year and beyond. This year has just really been a focus of get all the stores on, make sure it's stabilized, that it's performing well for a customer interaction. But what we've been doing in the background is really finding the right mix of centralized procurement versus the stores. We've talked in the past about how 80% plus of our replenishment is done by our stores versus the office with some sort of technology behind that, supporting that to make better buying decisions. And so as we go into 2021 and the system is stable, which we're -- knock wood, we're in pretty good shape on that already, you'll start to see some margins come as we get a little bit more strategic in how we buy.
Okay. Understood. And I want to get a sense of how you're thinking about the fourth quarter at this point. It's, of course, seasonally very strong. Presumably, there'll be less socializing in Q4, but balance that against the fact that more consumption will be at home, so I just would like to get your thoughts of how you're thinking Q4 would play out this year in the current environment?
Yes. John, as I said a little bit earlier, we're -- we see for the foreseeable future, and what does that mean? 12 months? 18 months? I don't know. Till there's a vaccine that the trends that have developed over the 4 to 5 months of, first, total lockdown, and then partial lockdown. It was never really total in Alberta but substantial lockdown are going to continue. And we see absolutely no signs that they're not and quite kind of the reverse. They're even getting stronger again as entertaining is now something you do at home. You want to watch the hockey games, you do it in your rec room. You don't go to a bar or a restaurant. And that's just going to continue for foreseeable future. Not only are people -- certainly generation of my own kids in their 30s, they weren't big -- they didn't cook much before this. And now they're used to it, and their Visa bill at the end of the month is a lot lower than it used to be when they stay out at the bars and restaurants, and they kind of like it. So they're still ordering in some food, but they're buying their alcohol at home and they're entertaining at home instead out of home, which was their culture and lifestyle. And here in Alberta, we see that trend very strong and getting stronger. So yes, there won't be office parties and people going out to restaurants and so on. But all of that, there will still be seasonal buying. People still are going to have dinners. Thanksgiving, Christmas we still see is going to be extremely strong. It's hard to see we can get any stronger than we've already been week after week because it's -- but I think it'll happen. I mean we're extremely -- we're in this now situation for the foreseeable future, 12 to 18 months. Until there's a vaccine and this is actually over with, if in fact it ever is, then nothing is going to change, in our opinion.
There's also 2 other things at play, which might be a little small, but they add up to be something that's helpful to us, which is people are -- have a lot more disposable income, even though maybe the economy is a lot softer. They're not maybe putting their kids into hockey and spending big money on that. They're not doing trips. They're not making other purchases in their lifestyle. And so there's a little bit more room in the budget for alcohol right now. The other one is Alberta has a lot of Snowbirds. And I don't think they're going to be going to the U.S. So we're going to have a little bit larger population base in Q4 and Q1. Again, small, but every little bit helps. So there's a lot of things that are contributing to this tailwind going forward.
Okay. That's helpful. I want to get some clarity on a comment you made in the press release. You said in the -- it was the second half of Q2 and into Q3 that you've seen transaction count normalize versus last year, but basket remained elevated versus last year. Is basket size kind of the same second half of Q2 and in the beginning of Q3 versus the first half? Or is it just compared to last year that it's still up?
Just compared to last year. So no, we're not seeing the big 20% increases in basket size, but it's still very healthy. And again, I think it's more just because people are consuming more alcohol at home.
Right, exactly. No one is stocking up. No one is afraid that we're going to close. And during -- especially in the early months of COVID for like late March level stock-up. But April and May, while things were really locked down, people just didn't want to go out. So once they did go to the -- our stores, they would buy a lot. And they were not just for themselves, but for their family and friends, and so -- to minimize who in your family grouping had to go to a store to be out in public. So that stopped. But as David said, it is the overall at home on-prem. Off-prem is depending who you -- on-prem, I should say, depending what numbers you want to believe and it's all over the map, but it's probably something around 20% of the market, or it used to be. Some people say 25%, some -- it depends. But whatever it is, it's a huge, huge number. And it's just essentially gone. So they -- but the liquor sales -- even though overall consumption is a little bit down, not a lot, but a little bit. If you read the -- all the earnings reports and the announcements by the various distillers and wineries and breweries, there's sort of a joke people are having around that everyone is drinking themselves to get through the pandemic. It isn't actually true, consumption is about -- it's more or less the same. It's just all off-premise.
Got it. Okay. And then lastly for me on Ontario cannabis. You referenced it earlier, and we've all seen the delays on the licensing process. Do you feel confident you can get to the 6 to 7 open before year-end? And just broadly, how are you thinking about this market now versus, say, 3 to 4 months ago now that we are seeing some more stores open? You've obviously got the one store in Queen Street, which now has some competitors in the region. So just would like to get your sense of your thinking on Ontario cannabis more broadly.
Yes. To answer your first question, are we confident we'll have them open in the year? No, not at all. I can't -- I don't know what the government is going to do. I haven't a clue. They're extremely slow. I mean you compare the Ontario performance to the regulator out here, it's just night and day. These guys know what they're doing. So we have no idea how long it's going to take. We will build out, I think, 7 more stores now and have them ready. If we get them licensed, we'll go do some more. If we're just sitting on them and not getting licenses, we're not going to go invest to paying leases on stores that aren't open and have CapEx invested in a store that's just sitting waiting for a license. So we're -- it's kind of -- we're going to wait and see, John. And if the government -- the regulator gets the licensing process ramped up, obviously, there's going to be lots of competition eventually, it's just how fast it's going to be there. So it's -- we run our cannabis division the way we run the rest of our company, like a real business, somewhat unique in the industry, I might add. So we're going to do it as we can make money and get a profitable return on our investment as opposed to a hype job trying to sell shares. So we're going to be careful, and we'll do it when it's financially sensible to do it. And eventually, we'll be at the top of the pack, just like we are in Alberta, making money.
The next question is from Jenny Wang, Eight Capital.
Just one more follow-up on a comment that you made earlier, Jamie. Could you talk a bit about kind of in recent months, what you're seeing in regards to liquor consumption habits? I know a lot of restaurants in Alberta did reopen but are still kind of operating under current restrictive social business rules. Any comment you can provide there in terms of just consumption habits?
Sure. Yes. No, I think if you just look at our own observations, our sales, talking to people in restaurants here, there -- restaurants have been open for 3 -- over 3 months here. It's been a long time. They were really only closed for 6 weeks on government decree. So -- but the people aren't going back. They're -- and when they do go, they're eating and running. And there, we do just see overall alcohol consumption is essentially flat, maybe a little down. It has been -- the on-premise has been almost totally replaced by off-premise.
The dining has gone from entertainment -- you went out to eat, but it was more for the entertainment of it. So you'd have a drink at the beginning of the meal, a couple at the end, you'd linger, you'd have a lot of fun. And people, as Jamie said, are just kind of getting in and going out. Maybe it's different from what you see out there, but that's our observations here out west.
Yes. I've gone twice since it all reopened and it's weird. The tables are spread out. There's no noise. There's no vibe in the room. You kind of just -- servers have masks on. It's just not the same.
The next question, Kyle McPhee, Cormark Securities.
One last one for me, just on your capital allocation. Your balance sheet is increasingly in great shape. It looks like your convertible refi is going to be a nonissue based on the cash you should have by then, and you haven't even drawn on your revolver as of now as well. So what do you do with your capital? Could a dividend be in the cards at some point? Or do you want to hold on to the cash for potential growth opportunities? Just any color would be appreciated on how you're thinking about that.
Well, as usual, that's an excellent observation, Kyle. We just had a Board meeting yesterday, and obviously, that was a topic of some discussion. And at this stage, we have a number of options in front of us, which we're considering for growth. There's always the Ontario liquor opportunity still there. Hopefully, that comes, in which case, we got lots of places to use our cash in Ontario building Wine and Beyond, the Ontario cannabis, BC. Wine and Beyond will be a little more expensive in BC because you're probably going to have to go buy -- because there's radius restrictions there of a kilometer, so you're going to probably have to buy a current license holder out, a current store to be able to get into a trade area. So it could be $5 million or $6 million a store by the time you invest your working capital in your inventory in BC. So we have many places we can invest capital that we still feel will provide a decent return to -- on those investments. But as I said, we're going to also be very careful. Where rents are going to come down, there's no sense jumping just for the sake of it when we can get a much more cost-effective rent structure if we bide our time and be patient. Same with Ontario, we're going to bide our time and be patient. Not so much rents there, but it's more licensing and making sure we can be open in good locations where it doesn't really matter if there's competition or not, which is what's happened in Alberta, we just really haven't dropped when people -- the competition has showed up because they showed up in places that no one wants to go. So it's a work in progress, and it's something that's sort of -- as you said, it's a very high-class problem to have. It's not even a problem, but high-class issues here. But we foresee our company doing -- continuing on the kind of operations and performance that it's had so far throughout 2020, including Q1. Pre-COVID, we just had really turned the corner and doing very well even without those last 2 weeks of March. So in terms of how we position going forward, it's something that we're -- that occupies -- that's what David and I do all day.
No further questions registered. I will return the call back to Mr. Burns.
Okay. Thanks, Paul. Thanks, everybody else. Appreciate the questions and the analysts who follow us. We do appreciate your efforts on our behalf and the time you take to understand our company. We're sort of a unique business, and no one really understands us if you don't do the work. So we do appreciate it as well as to everyone who has called in. And thanks very much, and we'll talk to everyone again in November.
Thank you.
The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.