Auxly Cannabis Group Inc

TSX:XLY

Good morning. My name is Joanna and I will be your conference operator today. At this time, I would like to welcome everyone to the Auxly Cannabis Group Q1 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session from the company's financial analysts. [Operator Instructions] Thank you.

Thank you Mr. Schmitt, you may begin your conference.

Thank you, Joanna, and good morning, everyone. Thank you for joining us for Auxly Cannabis Group's first quarter 2023 financial results conference call. My name is Brian Schmitt, CFO of Auxly Cannabis Group. And joining me today is Hugo Alves, CEO. A replay of this call will be archived on the Investor Relations section of Auxly's website. I encourage you to follow along with the presentation slides, which are posted on our website in the Investor section, under Presentation.

Before I turn the call over to Hugo, I would like to remind everyone that our discussion today involves forward-looking statements that are based on assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from the views expressed today. Management can give no assertion that any forward-looking statement will prove to be correct. Forward-looking statements during this call speak only to the original date of this call, and we undertake no obligation to update or revise any of these statements except as required by applicable law. Management refers you to the cautionary statement and risk factors included in Auxly's disclosures. I note that all references on this call are to Canadian dollars unless otherwise stated.

With that, I will turn it over to our CEO, Hugo Alves.

Thanks, Brian. Good morning, everyone and welcome to our first quarter 2023 earnings call. I'll start the presentation on Slide five of our investor deck. As mentioned on our last call, 2022 was a challenging year for the Canadian Cannabis industry. In order to better position Auxly within the current market realities, we evolved our strategy at the end of the third quarter of 2022 and continue to do so today by streamlining our portfolio to focus on consumer favourites and the largest product categories of dried flour, pre-rolls and vapes, enhancing our capabilities and automation at our Leamington facility to deepen and further leverage our high-quality low-cost cultivation and manufacturing advantage.

We're reducing costs throughout the organization and internalizing our sales team to focus exclusively on Auxly products, improved relationships with retailers and increased distribution for our products. With those actions in mind, our overarching goal for 2023 is to achieve sustainable profitability by increasing our annual net revenues by 15% by focusing on key product categories, building portfolio depth within those categories, and growing distribution and consumer excitement within those categories by leveraging our internal sales team.

We also aim to improve blended gross margins to 35% to 40% by leveraging Auxly Leamington's high-quality, low-cost cultivation advantage and continuing to enhance our automated manufacturing capabilities, we'll continue to vigorously take cost out of our business to keep SG&A to below 40% of net operating revenue and of course we will continue to prudently manage the company's balance sheet and streamline assets where possible.

These initiatives have started to bear fruit over the past two quarters where we already on track in several key areas such as cost of finished cannabis, inventory sold margin at 37% and positive operating cash flows of CAD3 million.

Turning to Slide six, dried flower pre-rolls and vapes account for 85% of all industry sales and represent the largest opportunities for Auxly. We are a leading category in each of these key product categories. We have established a vapor portfolio of consumer favorites, driven by consumer focused innovation and where we have three strong and differentiated vapor brands at different price points and thanks to the success of all three brands, our vapor products are broadly distributed nationally.

As I shared with you on our last call, we have started to lean into dried flower and pre-roll products and are making excellent progress in establishing our brands within those products segments. We feel that our Auxly Leamington facility with its high quality and low cost of cultivation gives us a natural competitive advantage in both formats.

We have made significant investments in pre-roll manufacturing and packaging automation to develop what we believe is a best and class product in terms of quality, consistency and price and as a result of those efforts, we have continued to increase our share of market in, including now being the fifth largest LP in the dried flower category. In addition, we anticipate that our third much larger automated pre-roll filling machine will arrive in Leamington during Q2, which when commissioned, will significantly increase our pre-roll throughput.

Moving to Slide 7, we continue to be committed to building lasting brands that resonate with consumers, and we will continue to make investments in insights, innovation and brand development so that we can ensure we are helping consumers live happier lives by consistently delivering phenomenal products at a great value under brands they can trust. We have a well-rounded brand portfolio, which addresses various consumer segment, product formats and price points.

Back Forty continues to be our largest and strongest brands. Consumers continue to love the brand's value proposition of simple high-quality cannabis at a great everyday price. Back Forty products are widely distributed, being found in over 90% of retail locations in Canada, and as a result, Back Forty has consistently been a leading brand nationally over the past 12 months.

We recently added a fifth brand to our portfolio, Parcel to compete in the fast-growing ultra-value pricing tier. We have seen the ultra-value price tier grow rapidly over the past 12 months as consumers look for increasing value for money in the face of economic uncertainties. Approximately two thirds of dried flower volumes now transact at the ultra-value price segment. And Auxly Leamington's high-quality, low-cost advantage allows us to offer consumers single-strain dried flower at ultra-value pricing while maintaining profitable margins.

And we are delighted with the early performance of Parcel products as a new and increasing source of revenue, and we look forward to increasing the breadth of Parcel's product portfolio and increasing distribution over the course of 2023.

Turning to Slide 8, as consumer preferences continue to evolve, innovation and new products continue to drive both consumer and customer purchasing behaviors. In 2023, we will continue to innovate to meet the evolving needs of our consumers, but we will focus principally on dried flower, pre-roll and vapor product formats. We will look to increase the breadth of our product portfolio in those key categories to set the stage for continued growth and further leverage the competitive advantages that we believe Auxly has in those three product categories, as outlined earlier in this call.

Over Q1, we successfully released 23 new SKUs into our key product categories and will continue to seek additional listings for exciting new flower pre-roll and vapor products throughout 2023 and leverage our new internal sales team to build retailer excitement and distribution for those products.

Turning to Slide 9, Auxly Leamington is one of the premier cannabis cultivation facilities in the world. There are very few competitors that can match our mix of high quality and low cost, and we plan to leverage this advantage to continue building to leadership in the dried flower and pre-roll segments and improve our overall gross profit margin.

Through continuous improvements in cultivation strategies and genetic selection, we have seen overall product quality and potency increase over the past 12 months and importantly, have seen those improvements translate into increased sales in market. As I already mentioned, we have increased our focus on flower innovation and have a portfolio of commercially-ready strains for launch over the course of 2023.

Turning to Slide 10. We have also continued to progress our automated manufacturing capabilities. We successfully installed and commissioned our second pre-roll filling machine at our Leamington facility, doubling our filling capacity. As mentioned, we are also getting ready to accept delivery of a new, much larger first-of-its-kind filling machine, which will again materially increase product throughput and efficiency and make us the largest manufacturer of cannabis pre-rolls in the country.

We believe that our low-cost cultivation structure, increasing throughput capacity and related automation will allow the company to make further inroads into the pre-roll category, which is part of our plan, along with dried flower sales, to steadily increase net revenues over time.

I will stop here, and I'll turn over the presentation to our CFO, Brian Schmitt, to walk you through the financial results. Brian, over to you.

Thank you, Hugo. If I can get everyone to turn to Slide 11 for a quick snapshot of our revenues and product sales mix. Starting on the left side of the page, we outlined our 5-quarter sequential revenue results. Historically, in the first quarter, we have experienced a significant dip in revenues. Revenues for this quarter declined a modest 3% from the fourth quarter of 2022, whereas during the same period in 2022, the decline was 23%. We believe this is primarily attributable to our continued efforts to increase sales of dried flower and pre-roll products and increase the breadth of our SKUs carried by retail stores where listed.

On the right side of the page, Auxly reported net revenues of CAD24 million for the first quarter of 2023, an improvement of CAD1.3 million or 6% as compared to the same period in 2022, and as previously mentioned, a modest decline from the previous quarter. The company was the number five LP for the fourth quarter with 5.5% share of market with a continuing shift in category sales to dried flower and pre-rolls. For 2023, this percentage increased to 55% from 39% a year ago. Lastly, our revenue distribution with our three primary customers, BC, Alberta and Ontario remained consistent at approximately 85%.

The next slide captures several financial metrics for the company. Beginning on the left side of the page, gross profit margin of 33% for the quarter was double that of the first quarter 2022, primarily due to improvements in the cost of finished cannabis inventory sold, lower total impairments of CAD0.7 million, partially offset by net losses of CAD0.4 million related to unrealized and realized fair value adjustments.

The graph below includes the impact of depreciation, however excludes all other noncash and fair value adjustments. And it shows further strengthened margins of 37% for the first quarter versus 23% during the same period of 2022, an improvement of over 60%.

Cost of finished cannabis inventory sold margin was also sequentially better than the 30% margin achieved in the fourth quarter of 2022. The sequential improvements were achieved as a result of the company utilizing low-cost cannabis from our Auxly Leamington facility and the streamlining of certain cannabis products and operating results.

The middle section of the page shows progress in the reduction of SG&A to CAD10.1 million during the current quarter, down from CAD12.6 million the year before with reductions in several categories, including: wages and salaries of CAD1 million, resulting from the streamlining of operations and supporting staff as we focus our product portfolio; office and administrative expenses of CAD1.3 million; and lower sales expenses of CAD0.6 million, primarily associated with the internalization of the sales team.

Adjusted EBITDA was positive for the company for the first time in its history, a sequential improvement from the fourth quarter of 2022 by approximately CAD1 million and a substantial improvement of CAD6.4 million from the first quarter of 2022. These year-over-year improvements were driven by all three key earning categories. Net revenues increased by CAD1.3 million. The cost of finished cannabis inventory sold decreased by CAD2.5 million with an equal reduction in SG&A.

Net losses for the current quarter were CAD10.2 million, improving by CAD29.6 million over the first quarter of 2022, primarily as a result of better operating results, as noted by the improved adjusted EBITDA this quarter and as a result of losses of CAD25.7 million in 2022 related to the closure of Auxly Annapolis facilities.

In addition to the improvements in operation, cash used in operating activities also improved significantly, transitioning from a CAD7 million use of cash in the first quarter of 2022 to a source of CAD3.2 million this current quarter. The CAD10.2 million change was primarily a result of improvements in operating activities of CAD5.9 million and working capital management of CAD4.3 million.

With that, I'll turn it back over to Hugo for closing remarks.

Thank you, Brian. We are excited by our early 2023 results, and we are optimistic for the remainder of the year. We believe that we have a great plan that is built upon proven demand for our products, outstanding employees, top-tier assets and an underlying desire to continue to put our consumers first by delivering safe, effective, high-quality products that help them live happier lives. As always, I want to thank you for your time and your interest in Auxly, and I'll now turn it over to the operator to open the floor for Q&A from our analysts. Thank you.

[Operator Instructions] First question comes from Frederico Gomes at ATB Capital Markets.

Congratulations on reaching adjusted EBITDA positive this quarter. My first question is just -- so on your margins per segment, just looking across, you mentioned that you were focused in flower, pre-rolls and vapes for this year. What category are you seeing the best margin profile in, just given that flower, we see that a lot of competition in value and pre-rolls, we also see a lot of players going into that segment? And then vapes, obviously, you have talked about the pricing environment previously. So how do you see the margin for each segment evolving this year?

Fred, thanks for your question. We've seen significant -- we indicated last year that we were expecting a margin improvement, and there was some delay but we ended up the fourth quarter at 30%, as I indicated in my remarks. We've seen an improvement simply in the dried flower and pre-roll sections because of the low-cost structure of Auxly Leamington. A substantial percentage of those cost -- of the cost structure of those products is associated with the cannabis input materials.

So because we believe we have one of the lowest cost structures in the country, that is starting to translate to higher margins in those two categories. And we've also shifted our sales mix as indicated in the slide. Over half the sales now are 1.0 products versus, as you know, the company started with 2.0.

We've also made operational changes to allow increased margins in our vapor segment. Last year, we took pricing reductions later than many other LPs. So the operational changes helped in the vapor section. And in addition to that, we've negotiated some favorable forward pricing for hardware from our main supplier, which began with new orders in calendar 2023. So we're starting to see some of that impact as well.

Okay. And then just looking at seasonality, you mentioned that Q1 is your weakest quarter in the year. Last year, you saw a very large increase from Q1 to Q2. So for this year, what sort of revenue ramp should we expect to happen? And then associated with that as well, just looking through the remainder of the year, again, last year, we saw a dip in sales in Q3. So would you say that your revenue will sort of follow the same pattern throughout this year or is it going to be more stable?

Yes, Fred. Good questions. I think last year was a bit of an anomaly because we were transitioning from a higher percentage in the vapor market as we held off pricing reductions. I would say going forward, the pattern, in our view, would be more representative of calendar 2021, where we would see a small increase each quarter with, I'll say, peak sales anticipated for the fourth quarter of this year. We did have some timing of innovation and load-ins from Q2 to Q3 of last year, compounded asset as our vapor share changed during 2022.

Okay. And then on pre-rolls, I think you mentioned that you had new machinery coming in and the goal to become the largest manufacturer of pre-rolls in the country. So can you talk a little bit about that? And how's -- what's the sort of step-up change you expect in your pre-roll manufacturing with this new equipment? When will that exactly come online? And how fast do you believe you can gain share in that segment?

Yes, Frederico. So we expect with the commissioning of the new package -- sorry, the new filler, there will about 5x increase existing throughput. But of course, it will take us a bit of time to get there, right? Like these machines, I think as anyone who's operated them know that you have to get used to operating. We've now got two of them under our belt. We've been working with the manufacturer on this machine for in excess of a year. We think it will be commissioned throughout late Q2, early Q3. So it will give us a significant bump in throughput.

And in terms of continuing to win share, it's a focus area for us. Our strategy is to really lean into pre-rolls, I think expanding strains and distribution in B40 in the market now. So you're starting to see Back Forty in the ascendancy in this pre-roll category. But it will take us -- our plan is a full year plan. It will take us a year to ramp up properly.

And then just one last question about your SG&A. How do you view that -- the SG&A trending over the remainder of the year, given that you have internalized your sales force? And is there any low-hanging fruit here that could drive additional cost savings over the near term? Or is it more about keeping your costs flat and growing at a rate that is below your expected revenue growth?

Yes. I think in terms of dollar SG&A, we expect that the dollars to be similar to the current quarter. In terms of percentage, yes, that will largely be assisted with increasing revenue over time. We were at 42% for the quarter, so pretty close to our target. But I think for your modeling purposes, SG&A similar to the first quarter would be appropriate.

There are no further questions at this time. You may proceed.

Thank you, everyone, for listening to the first quarter conference call for Auxly Cannabis Group. We look forward to our next call mid-August with our second quarter results. Thank you very much.

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating, and we ask that you please disconnect your lines.