HEXO Corp (HEXO) Q2 2023 Earnings Call Transcript

HEXO Corp (NYSE: HEXO) Q2 2023 earnings call dated Mar. 17, 2023

Corporate Participants:

Charlie Bowman — President and Chief Executive Officer

Julius Ivancsits — Chief Financial Officer

Analysts:

Matt Bottomley — Canaccord Genuity — Analyst

Frederico Gomes — ATB Capital Markets — Analyst

Aaron Grey — Alliance Global Partners — Analyst

Presentation:

Operator

Good morning. I’d like to welcome everyone to HEXO Corp.’s Second Quarter 2023 Conference Call. Joining us today is Charlie Bowman, President and Chief Executive Officer of HEXO Corp.; and Julius Ivancsits, Chief Financial Officer of HEXO. As a reminder, this conference is being recorded. Please note that all financial information is provided in Canadian dollars, unless otherwise stated and a copy of the Q2 results can be accessed on SEDAR and EDGAR.

To open the call, Charlie and Julius will provide their commentary on the quarter, followed by a question-and-answer session. To ensure that we get to as many questions as possible, we ask participants to limit themselves to one question.

With that, I’ll now pass the call over to Charlie Bowman, President and CEO of HEXO Corp.

Charlie Bowman — President & Chief Executive Officer

Thanks and good morning, everyone. I’m pleased to review our results from the quarter ending in January 31, 2023. We’ll begin by detailing some of our financial accomplishments, highlight a few of our key products and operational achievements that happened this quarter. Our goal is to take you along the journey to a leaner operation focused on the quality and near-term profitability. Afterwards, Julius walk us through HEXO’s financial results.

First, before I start, about nine months ago, I had an opportunity to sit down with number of the original shareholders, none of who have sold a single share of stock. Your advise to me was once we reset the balance sheet is to take off my corporate tie and to focus on the key consumer elements of why people purchase campus, high THC, price and terpenes were the best strains to deliver this consumer experience at the lowest price we can and that’s what we’ve been doing. So let’s address this legacy balance sheet, which was my first priority.

Over the past six months, our aggressive cost cutting strategy has reduced HEXO’s overall debt whilst improving our balance sheet. We repaid a total outstanding principal of $40,700,000, which was matured on December 5, 2022 within all accrued and unpaid interest. This was the first major step of strengthening our balance sheet. Next, we focused on strengthening our margins with a higher value product mix, leveraging a series of intense cost reductions and pricing disciplines. We focused on quality. We measure it by Pharmacopoeia test methodology procedures. We focused on the critical items and improved our first past success rate. All in, our team decreased our operation expenses and significantly reduced our trade receivables.

Now turning to our product and operational developments. We’ve streamlined our recreational cannabis portfolio focusing on delivering the best consumer experience. We expanded our health and wellness portfolio by addressing unmet consumer needs that only cannabis can address featured on our Redecan medical platform. We signed a long-term agreement with Entourage Health securing a multiple channel distribution network into the medical cannabis market over the next three years. This partnership is key to expanding our health and wellness portfolio and accelerates our ability to grow the business and deliver premium cannabis products to more Canadians, but to especially our veterans.

In the recreational market, we are focused on creating an unique sensor experience by highlighting some amazing terpenes and high THC strains from our in-house developed TnT strains. We launched three new Redecan branded products and two new Original Stash products, all using the new TnT strains. These strains were released after about 20 months of research and development, which reinforces our belief that properly balanced terpenes dramatically enhance the cannabis experience. In fact, consumers validated our commitment to this unique cannabis experience. Our first TnT launch Animal Rntz sold out within 24 hours of its release, replenishment sold out in two days and the third order sold out in less than a week. The fourth order is in the process of packaging this week. It was if not the fastest selling strain in Ontario Cannabis Board history. The good news Warlock is next.

As we move towards a leaner portfolio, our longstanding commitment to innovation remains strong. So these next-generation of products from our internal genetics program highlights total cannabinoids, high THC percentage with a wide range of terpenes. It is this continued pursuit to deliver the highest quality cannabis that allows our premium strains to wear the crown on Redecan brand. We produce some of the industry’s highest THC percentage and without a doubt the total cannabinoid content and with an incredible breadth of terpenes and flavonoids, it’s an outstanding consumer experience.

Furthermore, these new cultivars give us a high production yield with greater margins and the industry’s leading terpenes, THC percentage and total cannabinoid. In fact that’s TnT. So lastly, our team is committed to the ongoing cost efficiency by reducing the overall footprint. We’ve deployed resources into our profitable segments and eliminated unprofitable business brands. For example, we saw the high growth potential in the pre-rolls segment, specifically in the infused pre-roll area. We expanded our capacity in our popular straight edge pre-rolls facility in Fenwick, Ontario at the end of this quarter. This increase fourfold of ready straight edge capacity and expands our product offerings and capabilities. It enables HEXO to deliver the preferred cannabis experience to all of our Redecan and Original Stash customers.

And with that, I will turn the conversation over to Julius to discuss our financial results.

Julius Ivancsits — Chief Financial Officer

So thank you, Charlie, and good morning, everyone. I’d like to remind you that all numbers I share today are Canadian dollars, unless otherwise stated. Before diving into the financial results, I’d like to comment on one of our biggest financial challenges, cleaning up the balance sheet. Our strategic redeployment over the last two quarters has included a thorough review of our underperforming assets and taking a strong action to repair the balance sheet. The early financial results of our fiscal year demonstrate a prudent path towards long-term profitability. As Charlie noted, the debt repayment has helped delever our balance sheet positioning HEXO for long-term financial success. I would also like to note that despite difficult market conditions and intensifying competition, which has put significant pressure on pricing, we have made the decision to maintain our fair pricing as part of taking a sustainable approach and our commitment to quality.

Now I will discuss Q2 results. This quarter, the company has hit two important milestones: first, positive net income; and the second, positive cash flow from operations. This is attributable to an 11% reduction in SG&A spending from the prior quarter, along with a 20% reduction in trade accounts receivable. Revenue did however slow in the quarter with a 26% decline to CAD24.2 million when compared to-Q1 23 of CAD35.8 million. The decline can be attributed to a number of different factors. Price reductions by our competitors in our biggest markets, Ontario, Alberta, Quebec and British Columbia lead into HEXO market share declines.

Also, the revenue was impacted by returns of seasonal products due to low velocity, unavailable supply for certain demanded products and specific products being placed on hold due to pricing reductions in key Ontario markets. Lastly, we ceased recognition of cannabis infused revenue as the result of the trust operationalizing their cannabis selling license. At the same time, our net sales declined 54% relative to Q2 ’22 due to increased competition and diminished performance of HEXO brand in key markets of Ontario, Alberta and Quebec, along with the removal of product portfolios from the divested 48North business and Zenabis brands.

Looking at our adjusted EBITDA, in the quarter, we saw a loss of CAD2.4 million, which is an increase of CAD1.8 million from the prior quarter Q1 ’23. On the positive note, the Redecan branded sales did increase 9% from Q2 ’22 as a result of the increased [Indecipherable] on the Alberta market. Furthermore, our increase in gross margins confirms that we’re on track to profitability.

On a final note, I would like to thank everyone at HEXO for their ongoing commitment and positive outlook. We look forward to leveraging this team’s experience to becoming the standard of excellence in the industry. Thank you for continued support.

Now I turn the conversation back to Charlie.

Charlie Bowman — President & Chief Executive Officer

Thanks, Julius. Before we open the floor to questions, I’d like to echo that the successes we achieved in the second quarter resulted from our strategic alignment, which include tackling the legacy balance sheet, stripping on non-productive processes, capitalizing on our strengths. These adjustments will continue to create a more profitable entity for the balance of the year. Finally, I’d like to thank all my fellow Fenwick, Cayuga, Masson growth sites and all of our employees and partners for their continued commitment to our business and customers. This transition has not been simple or easy, but I can’t thank my teammates more for their commitment and efforts in making HEXO a success.

With that, continue our remarks and open the floor to questions.

Questions and Answers:

Operator

[Operator Instructions] The first question is from Matt Bottomley with Canaccord Genuity. Your line is open.

Matt Bottomley — Canaccord Genuity — Analyst

Hey. Good morning, everyone. Thanks for the question. I just wanted to get a little bit more color on what you believe the sustainability is in the, let’s call it, medium-term for the strategy of maybe forgiving some revenues to protect profitability. When you kind of look around some of the dispensaries and just the restrictive nature of the regulations, it just seems increasingly difficult for any LP to kind of get differentiation on math with respect to branded products or things that are more the characteristics of the products themselves as opposed to pricing. So I’m just curious, not trying to tease guidance out or anything like that, but just where you sort of think the top line erosion could go proportionately from where you are today given the dynamics in this sector?

Charlie Bowman — President & Chief Executive Officer

Thank you, Matt. That’s an outstanding question. We took a [Technical Issues] when the price war began last quarter — a little before the last quarter and measured out what would be the impact to us if we actually participated, maintained that volume — revenue number, volume and revenue and what that would impact into our net income as it would come down and it was significant. You’re talking anywhere from CAD5 million to CAD8 million loss. And it just wasn’t something that we wanted to entertain.

At the same time, we were in the process of getting ready to launch our TnT series. And with that, to your point, right now, cannabis is cannabis. And so the key point of differentiation is that consumer experience. The consumer experience comes from THC. It becomes from total cannabinoids and it becomes from terpenes. And so our point of differentiation was to launch these high THC, high terpenes strains and place them in across the different parts of Canada. So in some parts, we have Animal Rntz and Violet Fog. In other parts of the market, we have Ghost Gelato, Sex Panther. Across the Board, we have the CBD Kush, which is more of a medical brand and fitness and well being. And so the goal here was to get the strains out and allow those strains to start to differentiate.

In addition to our straight edge, we recognized the growth of the infused pre-roll and we launched our Atomik Sour Haze into this area and we’ve got a series of other products coming on. So for us, it was to reset the balance sheet to reset the operations so that we could not provide made to [Phonetic] products into the market, but to have truly differentiated cannabis products with standing experience from the consumer side. And that’s what we’ve focused in. That’s a great question.

Matt Bottomley — Canaccord Genuity — Analyst

I appreciate that. And then just one more quick one from me, just on the cash flow generation profile. So head that you guys inflected into positive territory from operations. And it looks like though when you look at the dynamics, there’s pretty big swing still in working capital that are causing for some of the volatility. So I’m just wondering how you see that smoothing out over the next little while and if you think the inflection into positive territory is sustainable within the next couple of quarters?

Julius Ivancsits — Chief Financial Officer

Yeah. I can take that one. A large chunk of it is if you just look at trade AR from quarter-to-quarter, you see a significant drop, while it was flat from Q4 to-Q1. And so we very aggressively improved our cash collection efforts and then changed our invoicing procedures a bit to basically move up those payment cycles. That coupled along with if you look at our SG&A footprint and just overall footprint, those expenses are down quite significantly. So we’re happy on how that is trending in the business. Hopefully that answers your question.

Matt Bottomley — Canaccord Genuity — Analyst

Got it. Thanks a lot guys.

Operator

[Operator Instructions] The next question is from Frederico Gomes with ATB Capital Markets. Your line is open.

Frederico Gomes — ATB Capital Markets — Analyst

Hi. Good morning, Charlie and Julius. Thank you for taking my question. In terms of your balance sheet and your capital needs, you mentioned your ATM. Is there any specific reason why you have decided not to start using that yet just given that you seem pretty close to breaching our covenant there? And the second part here is just if you decide to use that ATM going forward or just some sort of other equity raise, how would that impact the conversion price of the senior notes held by Tilray? Thank you.

Charlie Bowman — President & Chief Executive Officer

Yeah. This is Charlie. Thank you, Frederico. For the ATM, one of the reasons that we’ve taken a look right now of not tapping into the ATM was during this price war that was going on for lack of better words, we needed to establish what the new baseline was going to be as we look through to what the — our cash consumption would be and also how low we can take our cash burn from a standpoint of our cost takeout and our savings. In addition, with the velocity of the new strains coming on, it really does reset what the balance in the business was looking like. We’ve been really fortunate with both our primary debt holder, which is Tilray, but then all of our partners that we work with about supporting us as we go through from a standpoint of what we would need from cash, what we would need from a standpoint of working together t ensure that we have enough cash to run the operations.

And then I think most importantly is when you look at like Tilray, they’re not only an investor in us. They’re also a primary customer for us too. And so there’s lots of ways that we can work together to address this capital needs. The ATM is clearly one of them. We’ve had a number of banks that we’ve had discussions about for investment. So the good news is we have a number of options. The goal here was is to live within our means right now. And as I said a number of quarters ago, the goal for our operations has always been to be self-sustained. And so that’s kind of still the mindset that we have right now. Julius, any color you want to add?

Julius Ivancsits — Chief Financial Officer

No. We’re continuously working with our Board and internal management to evaluate all strategic financing opportunities. So whether that be ATM, whether that’s e-lock or other means that’s always on the table and under evaluation.

Frederico Gomes — ATB Capital Markets — Analyst

Thank you. I’ll hop back. Thank you.

Operator

The next question is from Aaron Grey with Alliance Global Partners. Your line is open.

Aaron Grey — Alliance Global Partners — Analyst

Hi. Good morning and thanks for the questions. So first one from me, just wanted to get some confidence that we think the impact might be of some of the changes that OCS is making and whether or not that impact might be more so for the retailers, so some of it might flow through and they look to reduce the margin that they’re taking. And then whether or not any of that give back might just flow right down to continued pricing pressure assuming that might end up flowing through to your guys profitability as well? Thanks.

Charlie Bowman — President & Chief Executive Officer

That’s a great question, Aaron. From a standpoint of — all the boards have been really active about reaching out to us. I don’t think anybody was surprised with the price war and the magnitude that went on in the last five months. I think the damage that could occur to the industry is significant because no one wins in a price war. And so I think one of the areas with the OCS taking a lower margin and resetting is clearly to help quite a bit of the retailers because a lot of the — especially smaller independent retailers are bleeding from a standpoint of just the plethora of retailers that are on the market right now and undercutting one another.

I think from a standpoint of how this takes on, what we look at it is I can’t say on the industry and the others, but we look at the discipline of the business. The business should be profitable. The business should have a point of differentiation in every product line that it brings to the market and you should charge a fair value. That doesn’t mean I charge the premium the highest. It also means I’m not the lowest in the industry, but it should be fair. Our products are all priced in a good spot where we’re in a fair area, fair price point. As far as our margins go, we’ve done an incredible job within the operations of getting cost out to where I feel very comfortable with the statement that if we’re not the, we’re one of the lowest cost operators in the industry.

As such, it allows you to take that volatility when people do silliness like to get into a price war and it should be more disciplined than that. The back side of that is if there is additional margin that comes out by the Board, by the government, what it should allow is to take away from the illicit market because the illicit market had a fantastic grow this past year. And as a result, they have ploughed it in throughout the country and it has taken away some quite a bit of the growth. So that’s one of the key things that we work with and hopefully, the government continues to take on is to curve this illicit market. It’s a good question. Thank you.

Aaron Grey — Alliance Global Partners — Analyst

Okay. Great. No, thanks very much for that detailed answer. That’s helpful. I’ll jump back in the queue.

Charlie Bowman — President & Chief Executive Officer

Thank you.

Operator

[Operator Instructions] And it looks like we have no further questions at this time. I’ll turn it back over to Charlie Bowman for any closing remarks.

Charlie Bowman — President & Chief Executive Officer

Just wanted to say thank you to everybody and the time. It was a dynamic nine months that we’ve gone through and from a standpoint of walking us the opportunity to go through what our quarter two results are, I just wanted to say thank you and I know from time-to-time we have analyst calls that are scheduled up. Any additional questions they have, we’ll be more than willing to take on. Thank you very much and I hope everybody has a fantastic Friday.

Operator

[Operator Closing Remarks]