Delta 9 Cannabis Inc

TSX:DN

Earnings Call Transcript

[Operator]

Good day, ladies and gentlemen, and welcome to the Delta 9 Q2 2022 Financial Results Conference Call. [Operator Instructions] Also note that the call is being recorded on August 16, 2022.

And I would like to turn the conference over to Alexa Goertzen. Please go ahead.

[Alexa Goertzen, executive]

Good afternoon, everyone, and welcome to the Delta 9 Cannabis Q2 2022 Earnings Call. [Operator Instructions]

Delta 9 would like to remind listeners that today's call may contain forward-looking statements that reflect the company's current views with respect to future events. Any such statements are subject to risks and uncertainties, which could cause results to differ materially from those projected in the forward-looking statements. For more information regarding risks and forward-looking statements, please refer to the Delta 9 Cannabis Inc. public filings, which are available on SEDAR.

I'd now like to turn the call over to Delta 9's Chief Executive Officer, John Arbuthnot.

[John Arbuthnot, executive]

Thank you, Alexa, and good afternoon, everyone. Thank you for taking the time to join us for Delta 9's Q2 2022 earnings call. With me this afternoon is the company's Chief Financial Officer, Jim Lawson; and our VP of Corporate Affairs, Ian Chadsey.

Our earnings press release, Q2 2022 financial statements and management discussion and analysis have now been made available on SEDAR and our company website. And with that, let's begin.

In the past year, Canadian cannabis industry sales have continued to expand, posting monthly retail cannabis sales of $376 million as of the most recent Statistics Canada, Data. Annualized retail cannabis sales now exceed $4.5 billion. And with the market plan -- we're anticipated to increase at a compound annual growth rate of approximately 10% over the next 5 years. The industry is expected to double in terms of retail cannabis revenues by the end of this decade.

The industry continues to deal with challenges relating to an oversupply of cannabis products, generally compressed wholesale gross margins, growing pains at provincial crown distributors and overall capital markets volatility. We continue to believe that the growth rate in the Canadian cannabis market and the global reform of cannabis laws represents a generational market opportunity for companies like Delta 9 to grow and unlock value for investors.

I'm pleased today to be presenting you with Delta 9's Q2 2022 financial and operating results. These results include the first full quarter of operating results from our acquisition of Uncle Sam's Cannabis and Discounted Cannabis in Q1 this year. We have many positive takeaways from today's results, which we will highlight as well as analyzing our misses, the challenges we've encountered and the changes we are making to continue to drive growth and create shareholder value.

We will begin with a discussion of operations and material milestones for the company, which were achieved over the reporting period. On the cannabis cultivation and processing side of the business, we'll begin with an update of activities at our Delta 9 facilities in Winnipeg. The primary purpose of these facilities is to cultivate, process and manufacture high-quality cannabis products. The company's proprietary cannabis production methodology is based around a modular, scalable and stackable production unit that we call our Grow Pods.

In Q2 this year, the company continues to have 297 Grow Pods licensed in the operation within our Delta 9 facilities. We are now operating these assets at or above the original design capacity for the facilities and are beginning to assess efficiencies in terms of the number of harvest rotations per year, average grams per harvest and overall potency in order to maximize the returns from these assets. We will continue to update the market on expansion progress as these facilities continue to develop and as we develop our expansion plans through the end of 2022 and beyond.

On our portfolio of cannabis products over the past 2 quarters, Delta 9 has been narrowing the scope of our cannabis cultivars under production to those that are in high demand and at the higher end of the potency range. We currently produce approximately 15 different genetic strains of cannabis, each with its own unique chemical cannabinoid content, terpene and flavonoid profiles, and continue to maintain more than 100 additional cultivars being stored in an on-site seed bank to provide for product optionality into the future.

We are continuing with our production pivot towards higher-potency cannabis strains, which are the highest demand segment with the retail cannabis consumer. Over the past 18 months, the company has increased its average THC in its harvested cannabis flower products to over 20% THC in Q2 this year. That's from less than 15% on average at the beginning of 2020. The company continues to improve processes for drying, curing and processing of dry cannabis flower material, and we'll continue to strive to produce the highest quality cannabis products at scale.

Cannabis pre-rolls have become an increasingly important category in the Canadian cannabis market over the past 2 years as consumers moved to smaller packaging sizes and see convenience in a pre-rolled setting. The company's pre-rolled products currently account for approximately 15% of our overall product offering with our Bliss and Twist pre-rolls making up 2 of our top 20 selling products in Delta 9 stores. This year, we will also expand this product offering to include strain-specific cannabis pre-rolled products in our 0.5 gram setting.

In Q1 this year, we released our new 0.25 gram pre-roll offering, unique -- offering a unique platform for Canadian consumers and a convenient personal use setting in the pre-roll category. In Q2 this year, Delta 9 launched its new infused pre-roll incorporating the highest potency cannabis distillate into our pre-rolled lineup.

Now on oils, extracts and derivative products. Over 2021, Delta 9 saw successful initial sell-in to the market for our Cannabis 2.0 products, including adjustable cannabis oils, vape cartridges and cannabis concentrates. In 2022, we will relaunch all of our 2.0 product lines, including new products, new and improved formulations and leveraging partnerships with the industry's leading white label suppliers to drive margin improvements.

Our full 2.0 product portfolio by end of this year will include 3 formulations of ingestible cannabis oils, 3 formulations of vape -- 510 vape carts, cannabis kief and pressed hash in the concentrates formats category. It is our belief that these categories will continue to become an increasingly important component of the recreational use market into the future.

In our retail stores, we continue to carry the full complement of these derivative cannabis products from the industry's leading manufacturers. We believe that through our retail unit, we will be able to extract valuable intel on which of these new product formats are having a positive impact with the end customer.

From a distribution standpoint, we continue to believe that the domestic market for recreational use cannabis presents a major growth opportunity for the company over the next several years. Wholesale revenues from the sale of recreational use cannabis products are expected to make up a large component of the company's overall business. We've undertaken a strategy to add new distribution markets incrementally as our increased supply capacity has come online and ramped up over the past 3 years in order to reach our ultimate goal of becoming a national distributor of recreational use cannabis products in Canada.

At the end of Q2, Delta 9 was licensed for distribution in Manitoba, Saskatchewan, Alberta, British Columbia, Ontario and Newfoundland and Labrador. The company is currently undertaking license applications in additional Canadian markets, and we highlight the Quebec market as our next key planned market entry in the second half of 2022. As well, we continue to explore international distribution opportunities in markets like Australia, Israel and the EU.

On vertical integration and cannabis retail sales, over the past 18 months, Delta 9 has made significant progress in expanding its retail footprint. Delta 9 started the year 2020 with only 4 operating retail stores in Manitoba. We fast forward to Q1 of this year and Delta 9 opened our 17th cannabis store on Portage Avenue in Winnipeg. In late Q1, the company announced a transformative retail acquisition to acquire all of the assets of Uncle Sam's Cannabis Ltd in connection with their 17 operating retail stores based in the province of Alberta and operating under the Uncle Sam's Cannabis and Discounted Cannabis brands.

The combination of the Uncle Sam's Cannabis stores and Delta 9's existing store network has made Delta 9 a leading multi-banner retailer of cannabis products in Canada. Yesterday, and in conjunction with the release of our Q2 statements, Delta 9 announced our next planned retail acquisition of 3 operating garden variety branded cannabis stores in Manitoba. The $3.25 million all-stock transaction is anticipated to add between $7 million and $8 million in annualized retail revenues, and we anticipate the deal will be immediately accretive to EBITDA and with the planned closing date of August 29.

By the end of August, Delta 9 plans to be operating 38 cannabis retail stores across Canada with several additional stores within our development pipeline, positioning as one of the country's largest vertically integrated cannabis retailers. The company has an aggressive growth strategy to actively acquire cannabis stores that will provide meaningful revenue growth and positive adjusted EBITDA.

Investors can look forward to numerous store openings in the back part of 2022 and into 2023. We continue to actively pursue retail expansion opportunities in all Canadian provinces, which allow for privatized retail cannabis sales and we'll continue to expand on our vertical integration strategy in the retail segment.

On business-to-business opportunities, the company continues to derive a portion of our overall revenues from the sales of cannabis Grow Pods from licensing and consulting activities provided to other licensed and pre-licensed cannabis companies. We believe that these B2B opportunities provide the company with a number of benefits, including a complementary business vertical, which produces diversified and high-margin revenue, a third-party validation of the company's proprietary Grow Pods platform creates valuable partnerships other pre-licensed and licensed cannabis companies and provides the opportunity for international expansion through noncannabis revenue streams.

To date, Delta 9 has licensed more than 13 third-party facilities just in the Canadian market as well as 2 internationally, representing over 130 Grow Pods for our micro cultivation partners. We will continue to pursue and expand on this B2B revenue opportunity over the coming year. And the company is also continuing to pivot and expand its sales and marketing efforts for its B2B segment in the United States and other international markets.

Now on to financial results. We'll begin with an assessment of the balance sheet. The company ended the quarter with approximately $15 million in cash, inclusive of the company's draw on its operating line of credit and showed approximately $18.3 million in working capital.

During the first half of 2022, the company has undertaken multiple financing and refinancing transactions to strengthen our balance sheet and continue to fund growth. The first was the company's closing of a $32 million credit facility from Connect First Credit Union at the end of Q1. These credit facilities include a $23 million commercial mortgage facility, a $5 million acquisition facility used for the Uncle Sam's transaction and a $4 million authorized overdraft facility. This facility matures after 5 years and amortizes over a 12-year term. The fixed interest rate for the first 5 years of the term are 4.55%.

As noted in our press release dated February 1 this year, these facilities provide an attractive and industry-leading interest rate, annualized interest and principal repayment savings and expansion in operating capital through the acquisition and working capital facility.

The second was the company's closing of a $10 million strategic financing from Sundial Growers in the form of a 3-year $10 million secured convertible debenture, which again, closed at the end of Q1. In Q2, the company announced a $5 million nondilutive shareholder loan as well as a $2 million overnight marketed offering of equity units. The result of these transactions is a balance sheet, which provides a significantly improved working capital position to that at the end of last year where we showed a working capital deficiency and positioning Delta 9 with 2 new strategic partners in Connect First and Sundial Growers to help facilitate the next stage of the company's growth.

Total assets at the end of Q2 totaled $106.8 million, up from $74 million as of the end of last year. We believe the company is currently well capitalized to continue to execute on its expansion plans and can act opportunistically where assets become available, which can expedite expansion, provide strategic value and improve the financial and operating performance of the company.

On key performance indicators for Q2 this year. In the second quarter, the company produced approximately 2.6 million grams of dried cannabis, up modestly from Q1 this year. As the company continues to improve its production efficiencies, we expect that these production numbers will continue to increase over the coming quarters. Production cost per gram decreased to $0.55 versus $0.57 in the first quarter this year. We would highlight that these production cost figures are quite competitive even comparing to our largest competitors in the context of the current Canadian cannabis flower market.

As the company continues to refine its production techniques, we anticipate that our economical cost base will be essential to improving gross profitability in upcoming quarters.

Total grams sold increased to 1.4 million grams in our wholesale segment. That's up from 900,000 grams last quarter. We note that overall grams sold in the past 4 quarters represent a significant improvement over the previous 4 quarters. The company's average selling price increased to $3.65 per gram. That's up from $3.14 per gram in Q1. We have now seen average wholesale selling prices stabilize in the $3 to $3.50 per gram range over the last number of quarters and feel that Delta 9 can reach sustainable profitability from our wholesale cannabis sales at current levels.

Continuing to address the company's wholesale business and improving overall grams sold and average selling price will continue to be a focus for us moving forward. The company saw a record 348,000 retail transactions in our retail store network in Q2 with a strong contribution from our newly acquired Uncle Sam's and Discounted Cannabis stores. Average transaction size did trend downward to approximately $37 per transaction as a result of the increased Alberta market activity, which generally sees lower average transaction size.

On revenue and revenue segmentation, total net revenues for the 3-month period ending June 30 were a record $17.5 million, an increase of 4% year-over-year and up 40% sequentially versus the first quarter of 2022.

From a revenue segmentation standpoint for Q2 this year, the company recorded retail revenues of $13 million versus $10.1 million for the first quarter of this year. Wholesale cannabis revenues were $3.8 million versus $2.8 million in Q1 this year. B2B revenue was $1.2 million versus $121,000 in Q1 this year.

The company saw relative strength across its material revenue segments in Q2. And in the upcoming quarters, management will focus on 3 main initiatives to drive revenue growth. First is the continued expansion of the company's retail store chain, including further acquisitions as the company continues to execute on its retail roll-up strategy, building momentum in our cannabis wholesale segment with a focus on expanding our product distribution across our 6 existing provincial markets, adding new provincial markets through new listings as well as through bulk wholesale agreements with other licensed cannabis companies. And finally, expanding our B2B revenues through a focus on creating relationships in the Canadian micro cultivation industry and expansion into emerging markets such as the United States.

We continue to believe that given the relative novelty and uncertainty of the global cannabis industry, the company's diversified revenue and vertical integration strategies will allow us to better react to market challenges than our competitors with single business strategies.

Gross profit before accounting for changes in the fair value of biological assets for the 3-month period was $4.6 million or 27% of net revenue versus $3 million or 24% of net revenue in Q1 this year and an increase of 57% sequentially. We would attribute the increase in sequential gross profit and gross profitability to the overall increases in revenue contributions from our material revenue segments as well as improved margins in the company's cannabis wholesale business.

In the company's cannabis wholesale segment, we would note that the company has continued to see downward trending in program production costs as a result of incremental efficiencies and labor costs and overall economies of scale as the company has scaled our output over the last 2 years.

Gross profit in the cannabis wholesale segment improved in the 3-month period versus Q1 this year as a result of increased overall shipment volumes, lower average variable costs and higher gross margins due to the sale of in-house products purchased product from other third-party licensed producers.

We expect that as production cost per gram continues to trend down, and with the company's introduction of higher -- sales of higher-margin cannabis derivative products later this year that the company will experience a general improvement in gross profitability from our wholesale cannabis segment.

The company has seen relative stability in its retail cannabis business segment over the past number of quarters, and we'll continue to address KPIs such as average transaction size and average units sold per transaction and opportunities for higher-margin product sales to continue to improve retail margins. We would also highlight that once the company's B2B segment begins to produce more meaningful revenue contribution to the company's overall consolidated gross margin is expected to continue to improve.

Operating expenses for the 3-month period ending June 30 this year were $7.5 million versus $6.5 million in the first quarter this year. The most notable increases were amortization, personnel expenditures and other operating expenses. The increase in overall operating expenses is largely due to the increase in the total number of operating retail stores versus the previous period.

The company's loss from operations for the 3-month period was $3.4 million versus a loss from operations of $2.9 million for the first quarter of this year. Management is in the process of implementing cost controls across all of its major business segments, and we are confident that our renewed focus on revenue growth and improved gross profitability will return the company to profitability in the coming quarters.

Adjusted EBITDA loss for the 3-month period was a loss of $391,000 versus an adjusted EBITDA loss of $1.7 million in Q1 this year. We do attribute the EBITDA loss in the period to lower-than-anticipated gross margins. As well, we would highlight the improvement in adjusted EBITDA loss versus the sequential period as a positive indication that the company's expanded revenue performance and improved margins versus the sequential period have been successful in driving improved adjusted EBITDA profitability. We are confident that the company's recent acquisitions and renewed focus on revenue growth and profitability will again lead to strengthened adjusted EBITDA in the coming quarters.

Now as we look forward to the balance of the 2022 operating year, management feels the company is well positioned to continue to execute on its vertical integration and growth strategies. In our production and wholesale segment, the company will continue to push forward to maximize the utility and efficiency of our existing assets, increasing production output and increasing our ability to supply volumes of cannabis across all of our provincial markets.

In our retail segment, we will add to our retail and distribution capacity by adding new stores to our existing chain. We will continue to position as a retailer of choice for both retail customers and suppliers, seeking the best locations and positioning as the most competitive LP-owned retailer in the Canadian cannabis space.

And in our B2B segment, we will continue to cultivate long-term and value-add relationships with our B2B customers as we deliver on Grow Pod projects across the country, while deploying resources into international markets to position our non-plant touching businesses to realize growth on the ever-changing cannabis opportunities globally.

I want to thank everyone for taking the time to join our call this afternoon. And with that, I will turn the call back over to the operator for any questions we may have.

[Operator]

[Operator Instructions] And your first question will be from Venkata V at Research Capital.

[Venkata Velagapudi, analyst]

John, congrats on the quarter. I have a couple of questions. First one is on your gross margin dynamics. So this time, we can see that because of high margin from B2B segment, adjusted gross margin improved relative to last quarter. So how do you think gross margin will stack up in the next couple of quarters?

[John Arbuthnot, executive]

Yes. Good question. So if we're to look at the breakdown of gross profitability for the second quarter versus the sequential period in the first quarter. We saw wholesale cannabis segment profitability of 11% in the first quarter, improved quite materially to 25% in this quarter. Our retail business segment gross profitability has been very consistent in the 26% to 28% range for the last number of quarters, and we would anticipate, I would say, continued stability within that segment to within a few percentage points.

B2B on the back of much stronger revenue improved to a 39% gross margin from 23% in the first quarter. So we see that the more revenue is being driven by that B2B segment, the more we can anticipate overall consolidated gross margins to be improving. Although the challenge for us historically has been the volatility in the revenue recognition around our B2B segment.

So it is a real focus for us to ensure that we are seeing as much contribution margin from that segment as possible and capitalizing on opportunities, again, both in Canada and internationally, where we are seeing growth opportunities in those international markets, again, generally trending with the reform of cannabis laws. So, yes, continue to feel it's an excellent opportunity for us internationally over the medium to long term.

[Venkata Velagapudi, analyst]

That's great. And my next question is regarding the acquisition of 3 stores in Manitoba. So how much of this amount is cash payment? Or is it entirely share payment, stocks payment?

[John Arbuthnot, executive]

It's an entirely share-based transaction.

[Venkata Velagapudi, analyst]

Okay. And you mentioned that the purchase price implies a EV-to-revenue multiple of 0.41x. Is it trailing multiple or 1 year forward multiple?

[John Arbuthnot, executive]

Good question, Ven. That is on trailing revenues. So just based off of the historicals, and we have seen a very, I'll say, steady revenue profile from those assets, they've been operating for a number of years. So quite confident that this will be value add for our #1 market share position here in Manitoba and really helping us entrench that strategic moat that we've been able to create here in our core market in Manitoba.

[Venkata Velagapudi, analyst]

Okay. Perfect. So do you have any guidance for retail stores at the end of this fiscal year?

[John Arbuthnot, executive]

We would anticipate, Ven, just on organic growth, same-store count in the 40 to 42 store range by the end of this year. But that would not include acquisitions, which, again, obviously, we are looking to expand on our deal flow into later this fall and into the winter season.

[Venkata Velagapudi, analyst]

Okay. And so -- and when you say you have -- you are growing in the next retail store count. And how much of that growth can we expect to come from Manitoba and how much of that will come from outside Manitoba?

[John Arbuthnot, executive]

In terms of the organic growth, that is all Manitoba market based. In terms of acquisitions, I would say much of our focus will be into the Saskatchewan and Alberta market, so that we are seeing across all of these markets, which have reached a relative saturation in the overall number of retail stores. The significant opportunities are arising for consolidation within those markets, both I'll say, quality assets as we announced the purchase of yesterday as well as distressed asset situations. So we are seeing the cycle play out in Canadian cannabis retail, and I think that provides us with opportunity as one of the retailers that has been able to reach scale, see ourselves play a key role in consolidation over the next number of quarters.

[Operator]

[Operator Instructions] And at this time, it appears we have no further questions. Please proceed.

[John Arbuthnot, executive]

If there are no further questions, I want to thank everyone again for joining us this afternoon, and I will turn the call back over to the operator to wrap up.

[Operator]

Thank you, sir. Ladies and gentlemen, this does indeed conclude your conference call for today. Once again, thank you for attending. And at this time, we do ask that you please disconnect your lines.