Canopy Growth CGS Q3 2021 Earnings Call Transcript

Amy: (00:00)
Good morning. My name is Amy, and I will be your conference operator today. I would like to welcome you to Canopy Growth’s third-quarter fiscal 2021 financial results conference call. At this time, all participants are in a listen-only mode. I will now turn the call over to Judy Hong, Vice President Investor Relations. Judy, please begin.

Judy Hong: (00:23)
Great. Thank you, Amy, and good morning, everyone. Thank you all for joining us today on our call today, we have Canopy CEO, David Klein, and CFO Mike Lee. Before financial markets open today, Canopy issued a news release announcing our financial results for third-quarter end of December 31 2020. This news release is available on our website under the investors’ tab, and will be filed in our EDGAR and SEDAR profile. We’ve also posted our supplemental earnings presentation on our website for you to follow along during this call. Before we begin, I would like to remind you that our discussion during the call will include [inaudible 00:01:02]-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 [inaudible 00:01:11]-looking statements included at the end of this morning’s news release.

Judy Hong: (01:15)
Please review safe 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-gap measures [inaudible 00:01:34], furnished SEC, and Canadian securities regulators. Please note all financial information is provided in Canadian dollars, unless otherwise noted. Following prepared remarks by David and Mike, we will conduct a question and answer session. To ensure that we get to as many questions as possible, we ask the analysts to limit themselves to one question. And with that, I’ll turn the call over to David. David, please go ahead.

David Klein: (01:59)
Thank you, Judy, and good morning, everyone. I sincerely hope that you and your families remain safe and well, and then we can begin to get control of this pandemic. As I reflect upon my first year as CEO of Canopy, I’m extremely proud of all the accomplishments we’ve made in positioning Canopy to be the leading cannabis-focused CPG company in the world. I started my first earnings call outlining my early insights into our strategy, and also mentioned to all of you that this was going to be a transition year. Now in our fourth quarter, we’re at the end of that transition year and our team has made great progress. Throughout the transition, we had to make difficult decisions to right-size our production footprint and say goodbye to teammates. This was typically a very public process, but this fiscal year, we also hired almost 500 people in strategic roles, to support a growth agenda into FY22. And as we look forward to the prospects of promising cannabis reform in the U.S., under the new administration and Congress, I’m more excited than ever about achieving Canopy’s vision of unleashing the power of cannabis to improve people’s lives.

Now for the quarter at hand, during the third quarter, we’ve continued to execute against our new strategy, strengthening our competitive position in our core markets, improving our execution, and accelerating our path to profitability. There are four key things that Mike and I will focus on this morning. First, we’re building strong momentum in establishing a track record of winning in our core markets. Second, we’re seeing tangible improvements in both our commercial and supply-chain execution. Third, we’re further accelerating our U.S. growth strategy as we expect significant cannabis reform during this Congress. And finally, we are firmly on a path to profitability. Let’s tie these themes together and delve deeper into our performance and strategy. First, we further strengthened our competitive positioning in our Canadian recreational business. Our overall share is up 30 basis points to 15.7% in Q3 versus Q2, and we’ve regained the number one market share position in the Canadian rec market during Q3, based on our proprietary market share tracker. This is led by our share in Flower, improving 180 basis points to 19.2% in Q3, driven by continued strength in our valued Flower brand, Twd.

Our beverages achieved over 34% market share in Q3. Even as new beverage brands have entered the marketplace, we’ve retained the top three brands, and our beverages are commanding higher velocity versus competitive set on a per skew basis. Quatreau CBD beverages were launched during Q3 and the brand has already become the number one ready-to-drink CBD beverage brand. Second, our U.S. CBD business is gaining momentum on the back of highly-successful Martha Stewart CBD product launches. Martha Stewart-branded CBD products have experienced strong consumer demand to date, with Martha’s media appearances generating lots of brand awareness, despite the crowded space. In just four months since launch, Martha Stewart CBD products have already exceeded the annual sales of over 94% of all CBD brands sold in the U.S. And based upon the current run rate, Martha would rank among the top 3% of all CBD brands. Our consumer research shows that 1/3 of Martha gummy purchases were first-time CBD consumers, indicating that we are already achieving our ambition with Martha to bring new consumers into the category.

The Martha Stewart CBD Collection is now sold in over 580 vitamin shop locations across the U.S., and we’re focused on further expanding distribution into other brick and mortar locations. We recently expanded the Martha Stewart product line to include pet CBD products, which are now available on our shopcanopy.com website, as well as our e-commerce partner sites. The launch of Martha’s CBD pet products resulted in a record-breaking day of press coverage, earning over one billion media [impressions 00:06:23]. And just last week, we launched SurityPro, a new line of science-backed, CBD products for dogs, formulated to deliver the most CBD per body weight on the market. Both Martha Pet and SurityPro products are based on the industry-leading research conducted by Canopy Animal Health. However, SurityPro takes a more customized approach to support the individual needs and health of each pet, and is targeting pet specialty stores and the Veterinary Channel. SurityPro is offered in more sizes and formulations to offer precise, controlled, and convenient delivery of the recommended CBD amount, and contains additional ingredients to further support pets’ needs. And finally, our CPG brands, BioSteel, This Works, and Storz & Bickel, continue to build momentum.

BioSteel ready-to-drink sports beverages are beginning to hit the retail shelves in the U.S. and the team has secured agreements with several large, national chain accounts. This Works had a strong quarter driven by Amazon UK and U.S. Expansion, with our e-commerce business doubling in Q3. We launched This Works Stress Check Collection with handcare products in the U.S. late in Q3, and we’re now focused on launching a broader range of our stress check products in the U.S. and the UK. Storz & Bickel growth continues to be driven by strong consumer pull in the U.S. We’re seeing sales to our distributors, as well as our direct-to-consumer e-commerce channel, continuing to grow. In December, Storz & Bickel celebrated the 20th anniversary of the VOLCANO, launching an ultra-exclusive 100-unit release of the 24-karat gold signature edition VOLCANO, and releasing a documentary in Rolling Stone magazine. Let’s now turn to improvements we’re seeing in our quality and execution. First, I’d like to highlight progress on our Flower Quality Improvement Program. Over the past several months, we undertook our largest ever cannabis consumer study, to dig into what drives satisfaction, quality, and willingness to pay for flower consumers.

This was done through first conducting a number of qualitative, in-depth interviews with focus groups, which would follow it up with a quantitative survey of 2,500 consumers across Canada. To highlight a few key learnings, when asked about their ideal experience with flower, consumers claim that THC content affects price in flower quality, as the most important contributors to their satisfaction with their flower. What’s interesting however, is that when we dig deeper, there’s a whole list of attributes that, knowingly or unknowingly, drive overall satisfaction, like great aroma and taste, whether the flower is hand-trimmed, effects that starts when expected, or last as long as expected. In other words, it’s not just about THC level or price, it’s the overall consumer experience, starting with a positive and easy shopping experience, then going into the consumption experience, from opening the product, seeing fresh, aromatic bud, then ensuring great tastes and smells while smoking, and delivering the effects they were promised. By delighting from beginning to end, our intent is that our brands deliver satisfaction every time.

We’ve taken all of these insights to create a roadmap of our future product renovation and innovation pipeline, and our design to value approach ensures that we’re being purposeful in adding features and benefits that consumers are willing to pay up for, that will drive premiumization of our flower portfolio over time. Elements of this work are already being incorporated in our product offerings. For example, we shifted to using genetic strain names on Tweed products with four new skews in Quebec, where we saw initial success in December. And we will have a number of new products across our premium mainstream in value flower segments entering the market over the coming months. At the same time, our commercial and operational execution continues to improve. Our fill rates have improved materially over the past year, reaching 98% in Q3 of fiscal ’21. We’ve accomplished this through a combination of better demand forecasting and supply management. And I would like to thank our commercial and operations teams for all of their hard work over the past year.

Our commercial team has done an amazing job standing up joint integrated business planning processes with our provincial customers. Through joint demand planning, routines that align forecasts, leveraging data and category management insights, our demand forecasting has proved significantly. On the supply side, our Canadian operations teams have made tremendous progress in fulfilling our customer orders in a timely manner. One of the key enablers has been implementing a flexible workforce model that, together with cross-functional training, provides for more agile and efficient operations, as well as reduced costs. As another testament to our progress, the new operating models helped Canopy achieve 99% fill rates with our largest customer, the Ontario Cannabis Store, or OCS, during December 2020. We believe our ability to consistently deliver quality supply, will be a key competitive advantage for Canopy going forward. Next, I’d like to spend a few minutes on how we see the U.S. landscape progressing, and how we’re accelerating our U.S. growth strategy. With the Democrats now controlling the White House and both Chambers of Congress, we expect significant cannabis reform to take place during this Congress.

Democratic control of the White House, Senate, and House, creates a unique window of opportunity for advancing cannabis reform through Executive Action and Legislation. Just last week, we saw the announcement from Senators Schumer, Wyden, and Booker, that the Senate is committed to introducing and passing powerful cannabis reform legislation. We anticipate that this legislation will include comprehensive reform, to ensure restorative justice, protect public health, and implement responsible taxation, while ending cannabis prohibition. We believe that this legislative package. Or a combination of reform measures, could allow Canopy to enter the U.S. THC market during calendar 2021. Our Government Relations Team is working very closely with key members of Congress, to pave the way for cannabis reform that addresses both the much-needed social justice reform and provides a boost to the post-pandemic economy, by creating jobs and generating tax revenues. In addition, it was announced yesterday that Canopy is a founding member of the newly-formed United States Cannabis Council or USCC.

This is an important milestone for the industry, as the overwhelming feedback we heard in our conversations with elected officials and regulatory bodies, is how disjointed and fragmented the industry currently is in its advocacy efforts. The USCC will provide one united voice, creating alignment across the nation’s top cannabis operators, as well as cannabis organizations, and will address important issues such as regulations, access for veterans, diversity and inclusion, decriminalization and expungement of nonviolent cannabis records, sustainability, and many other key topics important to Canopy and others in our industry. As we anticipate cannabis reform to gain momentum in the coming months, we’re also accelerating our efforts to lay the foundation to win in the U.S. THC market, once it’s permissible. Canopy already has an efficient pathway to the U.S. through our Acreage arrangement. I’m pleased with the new leadership now in place at Acreage, with CEO Peter Caldini bringing a strong background of success in CPG and healthcare industries. Acreage’s renewed strategic focus, combined with an attractive footprint, position…

… focus combined with an attractive footprint positioned the company well to deliver strong top and bottom-line performance in the coming quarters. It’s Canopy’s intent to utilize our arrangement with Acreage to assume a controlling position immediately upon federal permissibility. In addition, pending closing of the announced plan of arrangement with Canopy Rivers, our conditional stake in TerrAscend will increase to approximately 20%, which provides additional optionality to strengthen our U.S. businesses. We’ve also been investing in our U.S. infrastructure to set up the U.S. organization, including our manufacturing footprint.

Let’s now turn to our medium-term targets, including our expectations to achieve positive adjusted EBITDA during the second half of upcoming fiscal year of ’22. Mike will walk you through the details, but I want to highlight a few points. First, the cannabis industry is a growth industry, and I firmly believe that we will deliver superior top-line growth over the next few years.

Second, our cost-saving program is well underway, and I’m confident we can achieve savings of 150 to $200 million over the next 12 to 18 months. Third, we’ll continue to invest in consumer insights and R&D, which we believe will be key to creating a differentiated product portfolio that delights our consumers and command superior margins over time. Lastly, our medium term targets do not assume our entry into the U.S. THC market, which could provide further upside. At this point, I’ll turn it over to Mike to review our Q3 financial results and provide details around our financial targets.

Mike: (16:44)
Great, thank you, David, and good morning, everyone. I’m pleased with our Q3 performance, which, again, demonstrated that we are building a track record of solid revenue growth, profit improvement, and reduced cash burn. To further highlight our results, we generated a record quarter of revenue at 153 million gross margin improved versus last quarter. Our adjusted EBITDA loss narrowed to 68 million and free cashflow narrowed to an outflow of 135 million.

Mike: (17:17)
Now, let’s first cover Q3 results in detail, and then I’ll discuss our financial targets starting with net revenue. We generated 153 million of net revenue or 23% growth year over year and an increase of 13% over the previous quarter. Total Canadian recreational net revenue increased 9% versus the prior year. Recreational B2B net sales were flat versus year ago but increased by 2% relative to Q2 driven by several factors such as store openings, particularly in Ontario, market share gains led by our flower products, and 2.0 products, which delivered 9% of gross revenue in Q3.

Mike: (18:04)
These growth drivers were partially offset by a negative mixed shift towards the large pack size offerings in our flower business, which was relatively undeveloped last year. To better illustrate what’s happening within flower, it’s best for us to examine Q3 relative to Q2 to further understand the price, volume, and mix impacts within our flower portfolio.

Mike: (18:27)
Starting with volume, we grew B2B rec flower gross revenue by 15% during the quarter with volume increases in nearly all of our package sizes with the exception of 5-gram and 15-gram, which decreased slightly. Across these packages, average price decreased approximately 1%, some of which was driven by geo mix as more of our revenue came from Ontario, which has a lower average price than their average province. Conversely, size mix improved by 1% as the growth in our 3.5-gram and 7-gram packages grew faster than our 28-gram package, further highlighting mixed management is a critical lever in our business. In summary, our flower price mix analysis suggests that the market is showing signs of stabilization.

Mike: (19:22)
Let me now provide additional market share matrix based on our internal share tracker. Our recreational market share increased a 15.7% during Q3, up 30 basis points versus Q2. This includes market share improvements of 60 basis points in Alberta and 120 basis points in British Columbia. Market share in Ontario decreased 80 basis points in the quarter, but we’ve seen a rebound in January where our share increased by 150 basis points, and we now have the number two market share position for the month of January, which we’re very proud of. Our share of the Canadian flower market increased the 19.1%, up 180 basis points versus last quarter. Finally, our share of the Canadian beverage market was 34% in Q3. Notably, the total beverage category sales grew by over 25% during the quarter and now accounts for nearly 2% of total cannabis sales based on our market data.

Mike: (20:25)
Rec B2C sales increased 33% with same-store sales growing 26% versus Q3 of last year. We note that B2C sales are a better reflection of demand trend as the B2B sales that we report can be impacted by the provincial board’s ordering patterns, inventory levels, and timing of new product launches.

Mike: (20:49)
Turning to medical. Our global medical net revenue increased 10% over the prior year period as increases in Canadian medical and C3 were partially offset by a decline in German flower compared to last year. Summarizing our global cannabis business, Canopy generated net revenue of $99 million or 9% growth over the prior year.

Mike: (21:14)
Our strategic businesses also continue to perform well, delivering 61% growth versus prior year. STORZ & BICKEL grew 52% year over year, benefiting from more effective distribution than U.S. and strong consumer pool. This Works sales increased 32% compared to last year due to continued growth in e-commerce, and sales of the Stress Check hand sanitizer launched in the U.K. and the U.S. BioSteel saw strong sales growth over the prior year due to expanded distribution in the U.S., and we note that over half of BioSteel sales during the quarter came from the U.S.

Mike: (21:55)
With this, let’s move on to gross margin for the quarter. Reported gross margin, including restructuring and other related charges, was 16%. Adjusted gross margin, which excludes restructuring and other charges, was 26% in Q3, representing an improvement of 700 basis points from 19% in Q2. Relative to Q2, our gross margin improvements driven by improved revenues resulting in better asset utilization while cost savings initiatives had limited impact in Q3 as most of our initiatives started in December. Next, I would like to briefly cover operating expenses. Overall SG&A decreased 15% versus the prior year driven by 15% reduction in sales and marketing, a 23% reduction in G&A, and a 33% reduction in R&D. These decreases are a direct result of the improved cost discipline we’ve instituted across the business as well as our new strategy and new org design coming to life. With these cost reductions, our head count decreased by 29% over the last 12 months even as we hired new employees to strengthen our capabilities in key areas of the business.

Mike: (23:12)
Next, I would like to cover free cashflow. Our free cashflow in the third quarter was an outflow of 135 million, which represents an improvement of over 62% versus the prior year. Our working capital decreased year over year due to reduced inventory levels, and capex declined to 48 million, which is down 72% from Q3 of last year and over 47% from the prior quarter.

Mike: (23:40)
I would now like to provide some details around a reported net loss of 829 million. First, included in our net loss is the previously announced restructuring charge related to our end-to-end supply chain review, and as a reminder, over 85% of the charge was non-cash. Second, our net loss includes expenses reflected in the other income and expense section of our income statement, and several of these charges are tied to non-cash fair value adjustments related to our various financial instruments, most of which are the result of the rise in Canopy’s share price during Q3. The main drivers include fair value adjustments for our convertible debt, the Acreage instruments, and the Constellation B warrants. Partially offsetting these losses is a sizable gain on the TerrAscend investments, which have appreciated in value since Q2.

Mike: (24:42)
Now, I would like to speak to our path to profitability and the medium term financial targets that we communicated today. The key targets that we intend to deliver include the following: delivering 40 to 50% compounded annual revenue growth during the next three fiscal years ending fiscal ’24, achieving positive adjusted EBITDA during the second half of fiscal ’22, achieving a 20% adjusted EBITDA margin in FY ’24, generating positive operating cashflow in FY ’23, and finally, generating positive free cashflow in FY ’24.

Mike: (25:25)
Before we delve into these specific targets, I would like to provide some context for the drivers of Canopy’s current EBITDA loss in FY ’21. Year to date, our adjusted EBITDA is a loss of 246 million, and the key drivers of this loss are as follows. First, we are investing in R&D, which is core to our strategy of building a differentiated portfolio that will position us ahead of our competitors, and our R&D expenses of $55 million is greater than the combined R&D spend of the top five Canadian LPs.

Mike: (26:05)
Second, we’re investing in building our U.S. infrastructure, which continues to be one of our top core markets and a key strategic priority. Third, our Canadian operations were built to support significantly higher revenue, which we believe will be realized as Ontario and other jurisdictions complete their retail build-out, but in the short term, this has obviously served as a suboptimal cost structure with high fixed costs. With this as in the backdrop, we intend to achieve these financial objectives through consistent top-line growth, margin expansion, and SG&A efficiencies while continuing to invest in product innovation, research, and consumer insights.

Mike: (26:52)
First, on top-line growth, we expect 40 to 50% compounded annual sales growth between fiscal ’22 and fiscal ’24 driven by the following: approximately 40% growth in the overall Canadian rec market in FY ’22 from a continued increase in retail store openings. We also estimate 25 to 35% compounded annual growth from the Canadian rec market between FY ’22 and FY ’24. Our Canadian rec sales growth is expected to be driven by the growth of the overall market and market share gains. We expect to grow our Canadian medical sales through market share gains in a stable to declining Canadian medical market.

Mike: (27:43)
Growth of our international medical business is expected to be driven mostly by the growth of the German medical market. We expect to see growing sales contribution from our U.S. CBD-focused brands driven by distribution expansion and new products. Growth from our strategic business units, BioSteel, STORZ & BICKEL, and This Works, will be driven by distribution expansion and product innovation.

Mike: (28:13)
The second driver to our path to profitability is margin expansion and SG&A efficiencies driven by our cost savings program that is under way. We expect to achieve cost savings of 150 to $200 million over the next 12 to 18 months with the majority coming through in FY ’22. On cost of goods sold, we are targeting savings of 100 to 120 million from four main areas: network optimization, including Canadian facility closures that we announced in December, will result an annual savings of 50 to $60 million; SKU and cultivar rationalization, which will unlock efficiencies across our operations and deliver savings of approximately $15 million; organizational changes, which will further optimize our operating model to be more focused on end-to-end productivity, will generate savings of $15 million; and finally, we expect 20 to $30 million from logistics optimization and other supply chain initiatives.

Mike: (29:25)
We also expect to generate SG&A savings of around 50 to $80 million. This includes organizational design efficiencies and other related savings of 20 to $30 million, in direct procurement savings of 10 to $20 million, office space and facility optimization of 10 to $20 million, and savings of $10 million from our planned divestiture of Canopy Rivers. I’d like to emphasize that implementation of a number of these work streams is already well underway, and from a-

Mike: (30:03)
… these work streams is already well underway. And from a gross margin cadence perspective, we expect Q4 gross margins to be in the high 20s. Further, we expect gross margins to gradually improve during the course of FY22, with the full year FY22 gross margin of approximately 40%. So with the combination of strong top-line growth, lower cost of goods sold and operating expense reductions, we expect Canopy to achieve positive adjusted EBITDA during the second half of FY22, and 20% adjusted EBITDA margin by FY24. Finally, we expect further moderation of our negative free cash flow through a disciplined capital allocation. We expect CapEx to be below $200 million in FY21 and FY22. And beginning in FY23, our CapEx becomes mostly maintenance capital, and for modeling purposes, we’re assuming 5%-6% of net sales.

Mike: (31:03)
A key priority for Canopy is maintaining balance sheet flexibility, and with $1.6 billion of cash and short-term investments at the end of Q3, we believe we have a strong foundation. We’re also continuing to assess various financing options to further enhance our financial flexibility, to take advantage of potential opportunities in our core markets. Before I close, I would like to offer a few key factors to consider as it relates to our Q4 outlook. First, from a net revenue perspective, we expect our Canadian rec business to continue to benefit from additional store openings in Ontario and our improved order attainment. We expect modest headwinds from renewed COVID restrictions, particularly in our own retail businesses, as well as provincial boards and retailers looking to carry fewer weeks of inventory.

Mike: (31:59)
Second, our strategic businesses should continue to benefit from expanded distribution and strong consumer demand in the US. Third, we are continuing to monitor the global COVID-19 pandemic, and the extension of lockdown measures in Germany is likely to provide a continued headwind in our international medical business. And lastly, as I highlighted earlier, we expect gross margin to continue to improve in coming quarters with Q4 gross margins likely approaching the high 20s. In conclusion, we are executing against our cost savings program with several initiatives already underway to capture savings quickly, and we believe the foundation is in place to accelerate our top and bottom line growth, and achieve profitability during the second half of next fiscal with further improvement anticipated in the out years. This concludes my prepared comments. Operator David and I would be happy to take from the analysts.

Speaker 1: (33:21)
To ask a question, please press star one on your telephone keypad. The first question is from John Sparro of CIBC. Please go ahead, your line is open.

John Sparro: (33:32)
Thanks, good morning. I just wanted to get a bit more clarity on what you view as necessary to be able to operate without restrictions in the US THC. And presumably, cannabis has to be removed from the controlled substances act, but David, you’d referenced in an interview recently that maybe revised Cole Memo, combined with safe banking and executive actions would put you in a position to operate in US THC in ’21, and it seems like you’re reiterating that today. It does seem like that’s a bit more optimistic of you than some of your peers. So just, I’d like to get a bit more color here and ultimately, is it up to Canopy to interpret what is and isn’t considered federal permissibility, or is there input from Constellation and then the exchanges? Just anything else on incremental there would helpful. Thank you.

David: (34:17)
Yeah. John, good question. We’re working literally daily with Constellation, with our government relations team, with our partners at the exchanges in banks, to work our way through this. Because I think the important thing will be, if it’s not in the form of some variant of legislation, such as the Booker Wyden Schumer work, and it comes and we were to hit the place where we had some executive action, in terms of a regulatory change, it would really be dependent upon the wording in a lot of the regulatory documents. So we’re working very closely with our lawyers and with our partners to make sure that we are very careful in how we proceed here, but we remain pretty bullish on our ability to be able to step in into the US at the right time.

David: (35:26)
I also want to point out two things, really. One is we’re not just sitting around waiting for US permissibility. You’re seeing a lot of good progress being made at Acreage, a lot of good activity going on at TerrAscend, and we’re continuing to build our route to market and production capabilities around our CBD business, which will be helpful, post permissibility. So I think there’s good action going on today. I think we’re going to watch very carefully what happens from an executive and regulatory action fronts, and make sure that if we actually meet the hurdles that make our teams comfortable, that we then proceed. And clearly, we’ll be quite supportive of the work that the Senate and the House are doing to push legislation forward. I’d also like to point out that, in our arrangement with Acreage, that a triggering event is defined as straight up legalization in the US, or at the discretion of Canopy. So we have a little bit of flexibility there, we’re going to be very careful that we don’t violate any laws as we move forward.

John Sparro: (36:45)
Okay, that’s great. Appreciate the color, thank you.

Speaker 1: (36:50)
Your next question comes from Vivian Azare of Cowan. Please go ahead, your line is open.

Vivian Azare: (36:56)
Thank you, good morning. My question is on guidance. Good morning. And David, I think in particular for you, you and I go a ways back in alcohol and your work at Constellation, I’ve always known you to be appropriately conservative in offering external guidance. However, proceeding your entry into the Canadian cannabis industry, the space doesn’t have a great track record on that front. So I was just hoping that you could offer some color on how you thought about embedding conservatism into these financial targets, and where you think you’ve kind of expressed that most appropriately, either from a geographic or segment perspective? Thanks.

David: (37:33)
Yeah, good question. One of the things that I talked to the leadership team at Canopy about is, we need to develop a little bit of credibility because it’s somewhat lacking in this space. At least it was a year ago. And so we’ve tried this year to ensure that we deliver as expected, as we’ve gone through the year. And we’ve done an okay job of that. There’s a lot more volatility in cannabis than there is in a large alcohol company. But I think we’ve done a nice job of staying on track as it relates to this FY21 being a transition year and so forth. And so as we’ve looked forward, we very carefully vetted where we see the Canadian market going, and we know that there’s significant growth just from the channel shift in the Canadian market.

David: (38:28)
And so our first assumption was that we would hold share as that market grew, but then gain share as we continue to execute well. And I’m happy to say that those things are happening. We’re seeing the legal market grow at an increasing pace in Canada, and we’re seeing our execution from a sales execution and our operational execution standpoint, deliver up to the expectations of our provincial and retail partners. So I think Canada is, while the targets aren’t easy to achieve, we see a very clear path to achieving the Canadian targets. The next area really is the United States, and in the US, we brought the Martha Stewart CBD brand to the market in early September. And we wanted to demonstrate that we could actually bring consumer preferred CPG-like brands to market and breakthrough. And really proud of the performance of the Martha Stewart branded products.

David: (39:35)
And as we’ve said, we believe Martha is one of the top selling brands in the CBD space, in an edible space in particular in the US. I will say that while we’re getting better and better each week, literally, on data collection in Canada, data collection in the US is still a little sparse. But we think that we have a good path to growing a very solid CBD business in the US and we’re kind of extrapolating our current trends into future product offerings, and ultimately our sales targets. The other area in the US that we’re seeing really strong growth is through Storz & Bickel, as distribution has grown for Storz & Bickel. And I personally believe it’s the best vape device on the planet and we get that response from consumers all the time.

David: (40:30)
It also happens to be not super well-known, so we’re working on that in a typical CBG fashion to expose people to this really well constructed, high performing brand. And then the last area in the US that we’re looking for, for growth, is in our bio steel business. With access to Constellation brand’s gold network, which is their beer distribution network, we see tremendous upside to bio steel beginning in FY22, quite honestly. In fact, products are beginning to be available at retail, literally as we speak, in terms of the ready to drink hydration products. So I think we were reasonably conservative, and literally, we built out our forecasts almost on an ACV basis, taking into account velocity, so points of distribution and velocity. And then we’re assuming we continue to grow along with the German medical market. A lot of moving parts, Vivian, but we feel that we’ve got our arms around enough of the detail to have a high degree of comfort in being able to put these numbers out.

David: (41:48)
We’ve been working on this for a while, but we held off a little bit putting these numbers out because we wanted to see how long we would be affected by COVID and what those impacts would be. And so it maybe it took a little longer than everyone would like for us to come out with this kind of future estimates of where we’ll be, but we feel real confident in it. Mike, I’d ask you to dive in, as well.

Mike: (42:11)
Yeah, just to build on that. When you go beyond the top line and look at the guidance around cost structure, this too has been a longstanding body of work for most of calendar ’20, starting with the end to end supply chain review that we announced last spring, but even delving into each function across the organization to really make sure that every function was aligned to our overall strategy, and making sure that we were achieving best in class benchmarks, in terms of cost structure. Making sure that we had good spans and layers in place, making sure that we’ve got the right bands in place across the organization.

Mike: (42:52)
So we’ve been retooling the organization behind the scenes for a better part of seven to eight months. We haven’t talked a lot about it publicly, other than announcing some of our restructuring, but the work has been done. And that gives us the confidence on the cost structure side of things. Now, all of that being said, there are some risks out there, and this is why we were pretty broad on our direction around the top line in providing a three-year Kager, because some years are going to be stronger than others. We do have a high fixed cost structure, so our margins are somewhat sensitive to changes in volume, but we do believe that we’ve built this with a bottoms up approach that is a balanced point of view that gives us the confidence that we can deliver on these.

Mike: (43:35)
So more to come, but we feel like we’re definitely headed in the right direction. And I would also emphasize that we’re going to grow into this, that in Q1, Q2 of next year, we’re likely to continue to see EBITDA losses as we scale up the business. And when you think about break even points, that $250 million revenue per quarter starts to be that magical number where we start to get across the break even point from an EBITDA perspective. So what that, scale is going to continue to be really important.

Speaker 1: (44:11)
Your next question is from Brian Spillane of Bank of America. Please go ahead, your line is open.

Brian Spillane: (44:16)
Hey, good morning, everyone. Maybe just a question about the medium term goals, and maybe just two things I was interested in. One is just the product mix that you’re assuming. Beverages, how do you see the mix evolving with beverages and [inaudible 00:44:37] products, versus [inaudible 00:44:39] And maybe, David, if you could just give us some perspective on where we stand now in beverages, in terms of market penetration, trial repeat? Like you mentioned with Martha, is it bringing new consumers in? Just an update there as well would be helpful.

David: (44:59)
Yeah. When we think about how the product mix is going to evolve over the next-

Speaker 2: (45:03)
When we think about how the product mix is going to evolve over the next 12 to 18 months, still going to be a very dominated flower pre-roll business. We’re modeling it around 79%, 80% in terms of overall flower pre-roll mix. Vape, we have modeled in at high single digits. Again, this is our product mix projections. Beverages and edibles, again, continuing to grow, but on beverages, a little bit muted in that until consumption lounges and consumption occasions open up, we’re largely governed by the points of distribution that exist through the dispensaries. And look, the flower and pre-roll business is still going to be a big part of the business for the next year to 18 months, and hence we’re really focused on driving share, driving quality, making sure we’re cost competitive, but also making sure that we’re competitive in the market in terms of retail prices because it’s going to continue to be important and it’s just foundational to our overall Canadian business.

David: (46:05)
Yes. And on drinks, Bryan, in terms of performance in Canada, there are a couple of things that are holding us back. One is the equivalency rules, which limit the quantity that someone can take away from a retail store. But even with that, we think that because we’re limited in the amount that an individual can take away that we’re not getting into new-new consumers the way we would like. We think that over the next several months, we’ll see movement in that regard in terms of equivalency, where people will be able to purchase maybe up to 24 cans of beverage, and we think that will help us when we start talking about bringing in new consumers into the space. That said, our brands are still sitting even with a lot of competition coming into the space. We have the top three brands in the marketplace, and our drinks are commanding higher velocity per SKU than the competitive set. And we feel good about what we’re offering, but we think that the near-term unlock will be a change in the equivalency rules in Canada.

Speaker 3: (47:18)
Your next question comes from the line of Tamy Chen with BMO Capital Markets. Please proceed with your question.

Tamy Chen: (47:32)
Morning. Thanks for the question. I wanted to ask on the medium-term targets. How did you or did you factor in price compression, particularly in the flower segment in Canada within that, 40% growth you expect the market to have in fiscal ’22 and then the figures you provided onwards? And then subsequent to that, I’m just wondering if you can help us understand when you did this projections and arrive at these targets, what level of market share in Canada and what level of expansion in that market share do you expect that for you to achieve in order to hit these targets?

Speaker 2: (48:16)
Thanks, Tamy. I’ll take this one. The price/mix is something we’re looking at almost on a monthly basis as we get our data, and it’s been quite interesting over the last three to four months because the flower pricing has started to stabilize. As I mentioned in my remarks, we’ve seen 1-2% price compression across most of our price categories looking at Q3 versus Q2. Mix continues to be an opportunity for us with some of the smaller-sized packages like the three and a half gram and the medium-sized seven gram. But 28-gram overall, pricing hasn’t moved a lot in the last several months. Our math says, it’s around 1%.

Speaker 2: (49:03)
So when we looked at our algorithm for next year, we wanted to be conservative so that we built an algorithm that gave us confidence in being able to achieve not just the top line but also the margin. Because as you guys know, excise taxes and things like that can be somewhat regressive in the category. So we’ve built in high single-digit price compression across the market, and we think that’s a safe assumption. Some of that might be in vape because vape continues to reset a little bit as many are tracking, but from a flower perspective, Tamy, it’s stabilized. I don’t think we’re out of the woods yet, but it has stabilized. In terms of market share, we haven’t made any aggressive assumptions on share. It’s assuming flat share with some improvements tactically across certain categories like on vape, where we’re under-indexed relative to where we’d like to be, but we’re not making aggressive market share assumptions across the board.

David: (50:03)
Yeah. And maybe one thing that I would add, and maybe this is circling back a little bit to Bryan’s question. One of the things that we’re continuing to do in our projections is to build in continued investment around innovation and R&D activities because we think that it’s a big unlock for us. We have what we believe is the best-in-industry science capabilities and some of the NPD, the Cannabis 2.0 products and maybe arguably the Cannabis 3.0 products that we have in the pipeline are pretty exciting. And while we didn’t build in upside as a result of the output of this work, we fully expect that it will provide maybe a little bit of buffer for the projections that we’ve put out there.

Speaker 2: (50:53)
And Tamy, just to clarify that high single-digit price compression is reflected in our margin goals as well, do we’ve already factored that in as part of our cost agenda.

Speaker 3: (51:05)
Your next question comes from the line of Pablo Zuanic with Cantor Fitzgerald. Please proceed with your question.

Pablo Zuanic: (51:12)
Thank you. David, just going back to the U.S. I appreciate your conviction that you will be able to sell cannabis in the U.S. before year-end. I mean, if that’s the case, and looking at the context of the Canadian stocks in January, February have actually outperformed the U.S. stocks, why not lock other deals right now with other MSOs, right? Because, sure, we could say wait to take control of Acreage, year-end and then use that as an acquisition vehicle. But by then, valuations will even be higher for the U.S. stocks, of course, right? So just that’s the question. On the other hand with that also maybe a reminder why Acreage and TerrAscend are the right assets for you in the U.S.? In the case of TerrAscend, it’s only a 20% stake, you have Jason Wild doing business with Bruce Linton at Gage Cannabis. Acreage, it’s a bit of a retrenchment mode. So just some color there, it would help? Thank you.

David: (52:08)
Yes. So some good points there, Pablo. So I think as it relates to the U.S., we think that Acreage has put itself on a really strong path, especially with its concentration on the Northeast, if we think that we have permissibility or legalization actually in New York state. A massive market, likely, in our view, will be only second to California over time, and so we like that positioning there. And as I said in my prepared remarks, we like Peter Caldini. We think he’s a really strong operator, and so we don’t rule out Acreage actually looking at other potential acquisitions in the U.S. to expand our footprint. And as it relates to TerrAscend, we think that’s just a really well-run business, and we’re highly respectful of what Jason Wild and Jason Ackerman have been able to do in that business. We think that those businesses in and of themselves can create a lot of value for us at some point down the road.

David: (53:20)
In the interim, we’re somewhat limited in what we can do in the U.S., but that doesn’t mean we’re not doing things like building out our routes-to-market, building our production infrastructure and keeping our eye very closely on the market, developing products specifically for North American consumers that we’ll test out in Canada and be able to bring to the U.S. So we feel like we have a lot of good things going on that will unlock value for our shareholders, even if we can’t be in the plant touching business during this calendar year. But if we can, we think then that’s a super exciting position to be in.

Speaker 3: (54:03)
Your next question comes from the line of Doug Miehm with RBC Capital Markets. Please proceed with your question.

Doug Miehm: (54:11)
Thank you. Good morning. First question, again, has to do with the U.S. and in the event you have the ability to launch on the THC front, can you maybe walk us through your capabilities in terms of getting product to the market? I expect that the demand would be significant, and we saw the issues in Canada what they already launch. I know it’s different because of the MSOs, but perhaps you could go into a bit of detail there?

David: (54:45)
Yeah. So again, I think our ability to quickly enter the U.S. comes as a result of the arrangement we have with Acreage. And so immediately upon permissibility, we would trigger our rights to purchase 70% of Acreage. We would then be able to deploy our balance sheet and our know-how to help them rapidly take advantage of the U.S. market. And look, I think there’s a nuance here when we start looking at the ability to compete in the U.S. Early on in Canada, we learned that just being on the shelf was enough, right? And that kind of carried a lot of LPs for the first year, and I see a little bit of that happening in the U.S.

David: (55:29)
Ultimately, in my view, the game is going to be won by whoever produces the best experiences for the end consumer. And that’s going to be using all of the kind of CPG bag of tricks, if you will, like having a really robust supply chain. That includes interstate commerce, by the way, that has strong routes to market, that has experience innovating and understanding the consumer and building brands. And we think that Canopy, with our capabilities, combined with our partners in the U.S., combined with the capabilities that a beverage alcohol behemoth like Constellation has, we think that creates a powerful competitor in that U.S. marketplace upon permissibility.

Speaker 3: (56:21)
And this concludes our question-and-answer session for today. I turn the call back to the presenters for any closing remarks.

David: (56:36)
Yeah. Thanks, again, for joining us today. Despite the challenges faced over the past year, our business transformation is on track. Our new strategy is in place, our organizational change is complete, and our operational cost savings program is now under way. Our products are winning consumer mind share, and I hope all of you get to experience our amazing products. For those in the U.S., send a Martha Stewart CBD Gummy Sampler to your loved ones, and/or give your pets our Martha and/or SurityPro CBD pet products. For those in Canada, pick up our newly released CBD TWD strawberry gummies, and everyone should check out our BioSteel ready-to-drink drinks when you see them in your local store. Thanks again for your interest in Canopy. Our investor relations team will be available to answer any additional questions. Have a great day.

Speaker 3: (57:27)
And this concludes Canopy Growth’s third quarter fiscal 2021 financial results conference call. A replay of this conference call will be available until May 10th, 2021 and can be accessed following the instructions provided in the company’s press release earlier today. Thank you for attending today’s call, and enjoy the rest of your day.

Canopy Growth CGS Q3 2021 Earnings Call Transcript

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