Delta 9 Cannabis Inc. (DLTN) Q1 2021 Earnings Call Transcript

Delta 9 Cannabis Inc. (DLTN) Q1 2021 earnings conference call data May. 17, 2021

Corporate Participants:

Alexa Goertzen — Manager of Corporate Affairs & Business Development

John Arbuthnot — Co-Founder & Chief Executive Officer

Presentation:

Operator

Good morning, ladies and gentlemen. And welcome to the Delta 9 Q1 2021 Results Conference Call. [Operator Instructions] This call is being recorded on May 17, 2021.

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

Alexa Goertzen — Manager of Corporate Affairs & Business Development

Good morning, everyone, and welcome to the Delta 9 Cannabis Q1 2021 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 would now like to turn the call over to Delta 9’s Chief Executive Officer, John Arbuthnot.

John Arbuthnot — Co-Founder & Chief Executive Officer

Thank you, Alexa, and good morning, everyone. Thank you for taking the time to join us for Delta 9’s Q1 2021 earnings call. With me this morning is the company’s Chief Financial Officer, Jim Lawson; and our VP of Corporate Affairs, Ian Chadsey. Our earnings press release, Q1 2021 financial statements and management discussion and analysis have now been made available on SEDAR and our company website. And with that, let’s begin.

Over 2020, the Canadian cannabis industry has expanded significantly against the backdrop of the COVID-19 pandemic. Industry retail revenues exceeded CAD2.5 billion, more than doubling versus the previous year, as the industry received essential service status throughout much of the COVID-related lockdowns nationwide. While the industry continues to struggle with challenges relating to the oversupply of cannabis products, a general shortage of retail stores in key provinces such as Ontario and Quebec and continued challenges at provincial crown distributors, 2020 was the year of overall successes in the Canadian cannabis industry.

Q1 2021 brought a wave of capital markets’ exuberance for the cannabis industry, while challenges persist for Canadian cannabis operators from an operations standpoint. Second wave COVID lockdown, SKU rationalization and cyclical purchasing delays at many provincial purchasing boards as well as a seasonal decline in cannabis retail sales in January and February and a strained overall North American economic climate have led many publicly-traded operators to post sequential revenue decline versus Q4 last year.

More recently, the U.S. election cycle has renewed excitements around the potential for U.S. federal legalization of cannabis in many countries and regions such as Israel, Mexico and the European Union and more our liberalizing laws around medical and recreational cannabis products. We continue to believe that the global reform for cannabis laws represent a generational market opportunity for companies like Delta 9 to grow and unlock significant value for shareholders.

I’m pleased today to be presenting you with Delta 9’s Q1 2021 financial and operating results. These results show a continued upward trend in year-over-year revenues, while sequential revenue results, gross margins and adjusted EBITDA were impacted by overall market conditions in the period. We have many positive takeaways from today’s results, which we’ll highlight as well as analyzing our misses, the challenges we’ve encountered and the changes we’re making to continue to drive growth and create shareholder value.

We’ll begin with a discussion of operations and material milestones the company achieved over the reporting period. But firstly, an impact or — overview, excuse me, of the impact of COVID-19 on our operations.

Delta 9 has been fortunate through the various waves of COVID-19 cases in Canada that our operations have been declared essential and allows to operate through any government-mandated shutdowns. On March 30, last year, we announced publicly that we were implementing numerous precautionary health and safety measures across our operations to protect customers and employees, while maintaining operations amid the pandemic.

The company’s management have been actively implementing measures to protect staff and stakeholders from exposure to COVID 19. These measures include moving many of our head office functions to working from home or on staggered head office shifts implementing flexible sick time, increasing sanitation procedures in retail stores and production facilities, encouraging proper hygiene and hand washing for staff members, providing PPE for staff and customers in retail stores and production facilities, and enforcing physical distancing practices between our staff and our customers and more. We continue to update these policies and procedures of the recommendation of health professionals.

Our company, as with many others, has encountered challenges with staffing in our retail and production facilities and operational constraints in certain areas of our production operations, where we are limited to occupancy while maintaining physical distancing, although to date, these challenges have not caused material disruptions to our operations. We’re hopeful with the current vaccine rollout that life is beginning to return to normal. However, we will continue to highlight the possibility that the company’s businesses could be adversely affected by the events of the ongoing crisis and economic follow.

On 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 the highest-quality cannabis products. The company’s proprietary cannabis production methodology, as you all know, is based around the modular, scalable and stackable production unit that we call the grow pod. In Q1 2021, the company has 297 grow pods licensed by Health Canada and in operation within our Delta 9 facilities. We are now operating these assets at or above the original design capacity of the facility and are now 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 returns from these assets. We anticipate that once we have been able to maximize the efficiency of these assets, our production capacity may exceed the design capacity of approximately 8,300 kilos of dried cannabis per year.

The company’s purpose-built processing sensor, which was licensed in April 2020 and allows for fully automated bottling, packaging, capping and labeling functions for its consumer package, dry cannabis products, is now fully operational. We anticipate that once the processing center is operating at capacity, it will allow for processing of up to 25,000 kilos a year of dried cannabis flower material.

The company is in the process of expanding its Health Canada license perimeter from its current 80,000 square feet to approximately at 135,000 square feet to allow for future expansion of our cannabis-related operations on-site. We will continue to update the market on expansion progress as the company further develops its forward-looking expansion plans through 2021 and as licensing approvals are received from Health Canada.

On our portfolio of cannabis products, there’s been a significant amount of excitement in the cannabis space over the rollout of cannabis 2.0 products. However, dried flower and pre-rolls continue to demand the majority market share by category in the Canadian marketplace, with much of the consumer demand in the high-potency, high-THC segment. Delta 9 currently produces approximately 30 different genetic strains of cannabis, each with its own unique chemical cannabinoid content, terpene and flavor [Indecipherable] profiles. And we have another 100 or more strains being stored on-site in a seed bank to provide for product options into the future. We are continuing with our production pivot towards higher potency cannabis strains, which are the highest demand segment with the retail consumer.

Over the past 15 months, the company has increased its average THC in its harvested cannabis flower products to over 18% from less than 15% at the beginning of 2020. Cannabis pre-rolls became an increasingly important category in 2020 as consumers moved to smaller packaging sizes that saw convenience in a pre-rolled setting. Company’s pre-rolled products currently account for approximately 15% of our overall offering, with our Blitz and Twist pre-rolls making up two of our Top 20 selling products in Delta 9 retail stores last year. We plan to further invest in automation of our pre-rolls manufacturing in 2021, which will increase our capacity significantly to produce and distribute pre-rolled cannabis products across all of our provincial markets.

Now in oils, extracts and derivative products. Over 2020, we saw a very successful initial sell-through in the market for our cannabis 2.0 products, including ingestible oils, vape cartridges and cannabis concentrates. In the second half of this year, Delta 9 will relaunch all of our 2.0 product lines, including new products, new improved formulations and leveraging partnerships with the industry’s leading white label suppliers to drive margin improvements.

Our full 2.0 product portfolio will include four different formulations of ingestible cannabis oils, three formulations of 510 vape carts, cannabis keef, press stash [Phonetic] and rosin in the concentrate formats category. It’s our belief that these categories will continue to become an increasingly important component of the medical and recreational use cannabis markets into the future.

In our retail stores, Delta 9 is carrying the full complement of new 2.0 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 consumer and be able to pivot to capitalize on these new product opportunities. Overall, cannabis 2.0 products have become better supplied over the last number of quarters, addressing previous supply shortage concerns from many of these product categories. We are now seeing more than 15% of retail revenues coming from these new derivative product categories.

From a distribution standpoint, we 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 cannabis are expected to make up a large component of the company’s overall business. We’ve undertaken a strategy to continue to add new distribution markets incrementally as our supply capacity has increased that come online in order to reach our ultimate goal of becoming a national distributor of recreational use cannabis products.

Throughout the year 2020, Delta 9 added two additional provincial markets, Newfoundland and Ontario, and we’ve expanded our SKU selection across virtually all provincial markets that we participate in. As of today, Delta 9 is licensed in six provincial markets. On top of Newfoundland and Ontario, we are also licensed for distribution in Manitoba, Saskatchewan, Alberta and British Columbia. As the company increases its production capacity, we plan to expand our distribution into additional provincial markets through supply listings or formal supply agreements in those markets.

Now on vertical integration and cannabis retail sales, we continue to believe that there are a number of benefits to pursuing this vertical integration strategy into retail. This gives us a direct control over the direct-to-consumer sales force through our in-store bud tenders and allowing us to control product distribution. In a very limited marketing and advertising environment that we operate in here at Canada, this gives us control over the direct-to-consumer branding and marketing initiatives. It allows us to capture additional retail revenues and gross margin from the sale of retail products here in Canada. And it gives us direct feedback and data and analytics regarding product trends, marketing strategies, etc.

Over the past 12 months, Delta 9 has made significant progress in expanding our retail footprint. We started last year with only four operating stores in Manitoba. On May 29 last year, we closed our previously announced transaction with a Modern Leaf Group to acquire two cannabis stores in Alberta. And following the completion of that transaction, we opened those stores in June last year. In September last year, we opened our fifth cannabis retail store here in Manitoba located in the Kenaston Common.

On November 9, we closed our previously announced acquisition of the Auxly Co-Lab store in Lloydminster, Saskatchewan. We reopened the rebranded store the same day. And on December 21, last year, we opened our six cannabis retail store at Manitoba, our ninth overall. So opened the year with four operating stores, we closed out 2020 with nine operating retail stores. As of today’s date, we operate 12 retail stores, having opened our first Express store in the Port of Avenue West area, Winnipeg in Q1 this year and another superstore in the Bunn’s Creek shopping center in Northeast Winnipeg in Q1. Subsequent to the end of the quarter, we opened our 12th operating retail store in the Northgate Shopping Center here at Winnipeg.

We plan to open and operate up to an additional eight retail outlets and jurisdictions, which allow for privatized retail cannabis over the next nine months. We are actively pursuing retail expansion opportunities in all Canadian provinces, which allow for privatized retail sales.

On B2B opportunities, the company continues to derive a portion of our overall revenues from the sale of cannabis genetics, sales of grow pods and from licensing and consulting activities provided to other licensed and pre-licensed cannabis companies. We continue to feel that this business vertical gives us a complementary vertical, which produces diversified and high-margin revenue streams. It provides us with third-party validations of the company’s proprietary growing platform. It’s creating valuable partnerships with other licensed and pre-licensed companies, and it’s given us the opportunity for international expansion through our non-cannabis revenue streams.

To date, we’ve licensed over 12 third-party facilities here in Canada, representing over 150 grow pods for our micro cultivation partners. We continue to pursue and expand on these B2B revenue opportunities over this year. The company is also continuing our pivot to expand our sales and marketing efforts for our B2B unit into the United States. We anticipate to see larger growth from our U.S. B2B sales in H2 2021 as this pivot begins to take effect.

Now turning to the financial results, I want to begin by reminding investors of major changes in accounting policy at the year-end 2020. As a part of our year-end 2020 audit, the company has changed its accounting policy pursuant to International Accounting Standard 41 to determine the measure of fair value of biological assets and it’s changed the classification between biological assets and work-in-process inventory. We’ve done this to provide a more accurate, reliable and relevant information regarding our financial position, financial performance and cash flows. These changes, again, include changing the classification of a biological asset versus work-in-process inventory to occur at the point of harvest, rather at the point of transfer to finished goods inventory. This is reflected in moving assets from biological assets to inventory.

Changing fair value estimates to be determined on a strain-by-strain basis rather than an average basis, changing expected harvest yield, expected from flowering plants to be determined on a strain-by-strain basis rather, again, than an average basis, and incorporating the concept of cost to finish included in cost to sell, including all costs necessary to complete the production of a product subsequent to the point of harvest. This would include drying, curing, labor, packaging and labeling, product treatment, quality control, etc. Again, we feel these changes provide a much more robust valuation model and are in line with similar models used by our industry peers. We would encourage investors to review the notes in the financial statements and MD&A, and please feel free to follow up the management with any questions.

Now on to the financial results. We’ll begin with an overview of the balance sheet. The company ended Q1 with approximately CAD4.6 million in cash. This was a decrease from CAD8.1 million as of the end of last year, and we ended the quarter with approximately CAD20.7 million in working capital. This was down slightly from CAD22.9 million as of the end of the year.

Total assets at the end of Q1 totaled CAD75 million, again down slightly from CAD76.4 million as of the end of last year. As the company’s asset base has expanded over 2020, we’ve maintained a healthy debt-to-equity and debt-to-asset ratio. We’re currently well capitalized to continue to execute on our expansion plans, and we 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 in the quarter, we provide quarterly updates on our progress on KPIs to assess the successes of our business units. In Q1 this year, the company produced approximately 2.2 million grams. This was up slightly from 2.1 million in Q4 last year. The company’s total quarterly grams produced have increased over 80% versus the same quarterly period last year, demonstrating significant improvements in ramping the company’s production assets over 2020 and through the first quarter of 2021. We expect these production numbers will continue to increase over the coming quarters as the company continues to tweak our production efficiencies. Production cost per gram and total cost per gram decreased to CAD0.60 and CAD0.75, respectively, versus CAD0.67 and CAD0.80 for the fourth quarter last year. We would highlight that these production cost figures are quite competitive, even comparing to our largest competitors in the context of the current cannabis flower market.

We anticipate the decrease in production cost per gram will ultimately increase to improve gross profitability over upcoming quarters. Total grams sold in our wholesale and medical markets was approximately 1.1 million grams. This was down slightly from 1.25 million grams in Q4 last year, but up by a factor of almost double from less than 600,000 grams in the same period the previous year.

We’ve made significant progress, not only in the rebound in cannabis wholesale sales and grams sold over the past two quarters, but we’ve also seen improvements in customer feedback and overall sell-through from provincial wholesalers to retailers over the back half of 2020 and into Q1 2021. This leads us to believe there is continued positive momentum in Delta 9’s cannabis wholesale business.

The company’s average selling price decreased to CAD3.16 per gram in Q1 from CAD3.57 in the fourth quarter, but still up from an all-time low of CAD3.08 a gram in Q3 2020. We’ve now seen average wholesale selling prices stabilized over the past two quarters, and we feel that Delta 9 can reach sustainable profitability from wholesale cannabis sales at current levels. Continuing to address the company’s wholesale business and improving overall grams sold, an average selling price will continue to be a focus for us moving forward.

In our retail business, number of grams sold continues to trend upward, offset by a decrease in average selling price per gram, although we would note that the increased relevance of cannabis 2.0 products, which are measured in grams equivalent, is obscuring these KPIs versus previous periods prior to the introduction of these products.

Overall cart size was stable at CAD47.79 per transaction in Q1. This was down modestly from the Q4 shopping boom around the holiday season, where we peaked at CAD50.13 per transaction, but still up from less than CAD45 per transaction a year ago. Including our investor web page, retail store and medical clinic, Delta 9 now sees well over 1 million unique web page visitors to our websites each year.

On revenue and revenue segmentation, total net revenues for the three-month period ending March 31 were CAD13.2 million versus CAD11.8 million for the same period in 2020. This is an increase of 12% year-over-year. Sequential quarterly net revenue decreased 6% from CAD14.15 million in the fourth quarter last year. From a revenue segmentation standpoint for Q1, retail revenue increased 59% year-over-year to CAD9.3 million; wholesale revenue increased 44% year-over-year to CAD4.3 million; and B2B revenues were CAD186,000. This was down from CAD3 million the year earlier.

We would point to the year-over-year increases in net revenue as a positive indication that our diversified and growth strategies have been able to contribute to overall revenue growth. We attribute the decrease in sequential quarterly revenue to weak performance in our B2B segment. This is due to a slowdown in project developments and grow pod deliveries due to the economic impacts of COVID-19 and a general slowdown in capital spending in the Canadian cannabis market.

In the upcoming quarters, we will continue to focus on our three main initiatives to drive revenue growth: firstly, a continued expansion of the company’s retail store chain, while continuing to market the company’s price leading strategy to leverage customer acquisition at new and existing company stores. We’ll continue to build momentum in the cannabis wholesale segment with a focus on expanding product distribution across our six provincial markets; and we’ll look to renew B2B revenues through a focus on creating relationships in the Canadian micro cultivation industry and expanding into emerging markets in the United States and beyond. We continue to believe that given the relative novelty and uncertainty of the global cannabis industry that our diversified revenue and vertical integration approach 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 period ending March 31 was CAD3.7 million. It’s approximately 28% of net revenue versus CAD4.9 million or 42% of net revenue for the same period last year, a decrease of 24%. This also compares with CAD4.4 million or 31% of revenue for Q4 last year.

As of the end of last year, the company changed its accounting policies to include post-harvest costs, as I’ve discussed previously, along with cost to sell for biological assets. As a part of this change, post-harvest costs have been included in cost of sales and transferred from operating costs. The net effect of this accounting policy change for this three-month period Q1 is an increase in cost of sales of approximately CAD1.2 million.

For comparative purposes, if we were to exclude the additional transferred costs, the cost of sales would have been approximately CAD8.3 million and gross profit conversely would have been approximately CAD4.9 million or 37% of net revenue without this accounting policy change. We would attribute the decline in gross profit and gross profitability before fair value changes of biological assets to these changes in accounting policy as well as declining profitability in the company’s wholesale cannabis business segment in the quarter as well as a shift in our overall revenue mix in the quarter towards being weighted heavily in our retail segment, where we typically see lower gross margins.

In the company’s wholesale cannabis business, we would note that the company has continued to see downward trending in program production costs as a result of incremental efficiencies in labor and overall economies of scale as we’ve scaled our operations. We do expect that as production cost per gram continues to trend down and with the introduction of higher-margin cannabis derivative products that we will experience a general improvement in gross profitability from our wholesale segment throughout 2021.

In the company’s retail segment, we do anticipate that the addition of higher-margin cannabis extract products. And as those products continue to make up a larger portion of overall revenue, this will assist in overall gross profitability in our retail segment as well. We would also highlight that once the company’s B2B segment begins to produce more meaningful revenue contributions, the company’s overall consolidated gross margin is expected to improve.

On operating expenses in the quarter, we saw quarterly opex of approximately CAD6.2 million. This is versus CAD4.8 million for the same period last year, an increase of approximately CAD1.4 million. The most notable increases in operating expenses versus the previous year were amortization expense, personnel expenses and utilities. We would note that, overall, the company has been able to generally achieve proportionately higher revenues and gross profits versus increases in our operating expenses historically over the past six quarterly periods.

However, we would note as well that this three-month period has presented operating cost challenges with increased staffing, utilities and amortization costs. We will continue to monitor these operating cost levels and implement prudent cost controls to improve profitability over the coming quarters.

The company’s net loss from operations for the three-month period was approximately CAD3.2 million versus a net income from operations of CAD2.9 million last year. This also compares to a loss from operations of CAD2.4 million for Q4 last year. We attribute the loss from operations to negative adjustments in the carrying value of biological assets on the balance sheet as well as overall weakness in gross profitability in the period. We are confident that our renewed focus on revenue growth, gross profitability and cost controls will return the company to profitability over the coming quarters.

The company’s adjusted EBITDA for the three-month period Q1 this year was CAD6,000 versus adjusted EBITDA of CAD1.6 million for the three-month period last year. This also compares with adjusted EBITDA of CAD1.9 million for Q4 last year. Again, we attribute the overall decline in adjusted EBITDA to changes in accounting policy as noted as well as declining profitability in the company’s wholesale cannabis business in the quarter as well as that shift of our overall revenue mix towards the retail segment.

As we look forward to the balance of the year 2021, we feel that the company is well positioned to continue to execute on our vertical integration and growth strategy. In our production and wholesale segment, the company will continue to push forward to maximize the utility and efficiency of our existing assets, increase production output and increase the ability to supply volumes of cannabis across all of our markets. We are nearing a point where we can sell every gram of cannabis that we can produce and start contrast to our competitors who have shuttered capacity and sold off assets over the last year. From here, there is opportunity to grow either through further capital spending and expansion or through acquisition of assets, brands and complementary products.

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

And in our B2B segment, we will continue to cultivate long-term value-added 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 business to realize growth on the ever-growing cannabis opportunity globally. I want to thank everyone for taking the time to join the call this morning.

And with that, I will turn the call back over to the operator for questions.

Questions and Answers:

Operator

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. [Operator Instructions] Okay. It appears there are no questions at this time. I will turn it back to you.

John Arbuthnot — Co-Founder & Chief Executive Officer

If there are no questions, I’d like to once again thank everyone for joining us this morning. And if there are any further questions, please don’t hesitate to reach out to management directly.

Operator

[Operator Closing Remarks]