Q2 2022 Hexo Corp Earnings Call

Good morning, everyone and thank you for joining us today.

Late last night, we released our Q2 2022 results for the quarter ended January 31 2022.

Before I jump into the results this quarter I wanted to provide an update on a couple of key developments that occurred over the course of the last couple of months.

When I joined <unk> in November last year, I was immediately passed with preparing a very challenged balance sheet. As a result of the <unk> acquisition and the related convertible debenture that was put in place at that time last summer.

The proposed agreements, we've announced with til rate will restructure and reduce our significant debt burden and providing ample liquidity cushion, while minimizing dilution to existing <unk> shareholders, a key pillar underpinning our path forward strategy.

This was indeed, a transformational quarter for the company.

While the convertible note with a significant inhibitor to excellent growth prospects I am pleased that we can now as a result of our recently announced proposed strategic alliance with del Rey put that behind us and continued to position ourselves to retain and grow our significant market share, but we've become a cash flow positive business within the next four quarters.

Let me begin by reviewing the proposed strategic partnership with til rate before providing an update on our path forward strategy.

Okay.

On March 2nd <unk> entered into a proposed strategic alliance.

With til Ray brands in which til.

We will acquire U S $211 million of senior secured convertible notes that were originally issued to XO.

Originally issued by XO to hydro investments.

This proposal alliance between <unk> achieved several goals, including de Leverages, the balance sheet to a more manageable level. It raises sufficient liquidity to fund the path forward, including unlocking of U S $80 million of restricted cash at.

It preserves value and minimize dilution to existing shareholders.

And it offers significant commercial benefits to XO, representing upside to the path forward.

Further the separate three year Canadian $180 million equity backstop commitment demonstrates the support and belief of our existing shareholders.

The <unk> agreement is expected to deliver up to $50 million combined cost synergies within two years of the completion of the transaction and will leverage both companies' commitment to innovation and brand building to strengthen market positioning and capitalize on opportunities for growth.

Most importantly, the terms of the agreement provides <unk> with the financial flexibility to execute on the path forward.

With runway and strong liquidity profile enhanced by the standard commitments to be used monthly as needed.

I am pleased to report that this proposed transmitted transformative strategic alliance is on track and is expected to close in May.

Okay.

Okay.

As you May recall last quarter, we introduced the path forward strategic plan that utilize a textbook current assets and our capabilities to drive accelerated organic growth build market share and become operationally cash flow positive within the next four quarters.

The path forward is made up of five priorities continue to reduce manufacturing and production costs streamline and simplify the organizational structure.

Realized cost synergies from acquisitions and recent plant closures.

Focus on revenue management, including more disciplined pricing.

And five accelerate organic growth.

Building market share capturing market share gains and cashing missed missed revenue opportunities.

This plan is underpinned by specific actions to fortify our balance sheet strengthened the leadership team and enhance our corporate governance, which have already been successfully executed.

The plan is expected to generate incremental run rate cash flow of $37 5 million in fiscal 2022, and an additional $135 million in fiscal 2023 for a total of $172 $5 million over the next two years from a combination of cost reductions and anticipated revenue growth.

I would now like to provide a brief update on each of the core pillars of the strategy.

Reducing manufacturing and production cost.

The company expects to reduce manufacturing production costs by leveraging existing capabilities across facilities. We are actively applying best practice and learning from our highest margin categories and top facilities across the entire operation to improve and optimize productivity.

To date, we've identified approximately $30 million savings from optimizing hexcel production network and leveraging the capacities of recent acquisitions.

Specifically this includes transitioning from co packing agreements towards and has production.

Leveraging <unk> scale to deliver on procurement savings and Reconfiguring the company's production network to achieve greater efficiencies for example, moving production and distillate production to the <unk> facility.

Yeah.

The company expects to streamline and simplify our organizational structure and more closely align operating costs with.

With overall revenue.

We announced that these cost reductions will be achieved through a combination of reduced reliance on outside consultants streamlining the organization as a new it platform is implemented.

<unk> in the organization and realizing the synergistic benefits of previous act with acquisition.

These initiatives are expected to represent a 30% reduction in the company's SG&A by.

By fiscal year end 2023.

As part of these initiatives subsequent to the quarter end the company announced the reduction of 180 positions, resulting in savings of approximately $15 million on an annualized basis.

Half of these positions are related to previously announced closure of stellarton facility.

The remaining reductions were related to reducing back office positions, where there is significant overlap as a result of the recent acquisitions simplifying excellent operating model to drive clear accountability and Delayering management.

Third the company expects to continue to deliver on synergies as a result of the recent acquisitions.

Fourth <unk>.

We will continue to focus on revenue management, including more disciplined pricing across our entire range.

Leveraging our brand continuum, we are well positioned to differentiate ourselves across features.

Balancing our approach to both volume and profit.

Excellent offer greater value great value to consumers strong margin for customers and grow our own margins.

And fifth to increase revenue the company plans on accelerating growth through organic market share gains and capturing revenue opportunities through better demand planning acting on proprietary consumer insights and building strong customer relationships.

For example in the past the company was delivering only 65% to 70% of its demand to customers. The company is now connected with demand forecast to what it intends to harvest.

We're taking learnings from the legacy ready candidate applying across applying them across the entire organization.

Okay.

Earlier this year, we executed a proprietary quantitative consumer survey with thousands of consumers that identified usage occasions and demand spaces.

The cannabis category and this will use this to drive unique innovation and brand building and a new marketing leadership.

The company will also put a focus back on medical and consolidate our medical efforts with Red again, given their strength in this category.

We are making substantial progress on our plan and only one quarter and it is yielding results.

With that I would like to now turn the call over to Kurt.

Thank you Scott and good morning, everyone.

This is my first time in the CFO chair at textile and I look forward to working with you before.

Before drilling into the details let me recap a couple of Scott's points and give you a high level summary of the quarter.

Our biggest financial challenge has been to fix the balance sheet.

To lead the drain of the senior secured convertible note and establish liquidity.

<unk> leadership, we've made enormous progress on both of those objectives in Q2.

Once we close the <unk> transaction the monthly redemptions will end.

Maturity is pushed out to three years and we free up.

$80 million U S and restricted cash.

Once we close on the equity backstop will have another $60 million of.

Cash per year, if necessary through the sale of equity.

As the new management team settles in and we dive deeper into the business, we're seeing what I call a target rich environment for continuing to improve our profitability through cost savings and revenue enhancement.

Improved capacity utilization and operational efficiency and.

And better inventory turns.

We remain confident in our ability to capture the run rate cash flow improvements previously outlined and the path forward of $37 million by the end of fiscal 'twenty, two and an additional $135 million by the end of fiscal 'twenty three.

At a high level this quarter operationally on a quarter to quarter basis, we raised unadjusted gross margins from 25% to 36%.

And added $5 million to EBITDA.

And this quarter, we also reexamined the valuations of our business and concluded that we had to recognize substantial impairments.

We took a $100 million and fixed asset impairments of $141 million and intangibles and wrote off the entire balance of goodwill of $375 million.

Finally, despite improving EBITDA by $5 million quarter on quarter.

We didn't reach EBITDA breakeven.

And as a result, we breached the covenant on the secure on the senior secured convertible note.

The note holder subsequently waived enforcement of the default.

Through the earlier of May 17, or closure of the <unk> deal.

Nevertheless.

Under accounting rules.

We revalued the senior secured convertible note to the default rate of 115% of space.

Triggering a fair value loss of $50 million.

Once the sell rate transaction closes that note will be revalued to actual face value at the time of that transaction.

Now I'll discuss the results in more detail.

First with respect to revenue total revenues were $52 7 million.

And we're our second.

Consecutive quarterly high.

Representing a 60% increase over Q2 of the prior year.

International sales were a particular bright spot growing 36% quarter on quarter.

<unk> international sales nearly doubled quarter on quarter and accounted for 54% of our total international volume.

Medical revenues had a healthy quarter on quarter, 21% growth.

Reflecting a reinvigorated product innovation pipeline and renewed focus on deployment of our commercial capabilities.

We continue to be optimistic about <unk> ability to capture revenue and market growth.

We're overcoming the operational challenges that left as much as 70% of our orders unfilled.

For example, we are aligning our cultivation with market demand through weekly meetings between the market and operational sides of the business.

We've also made great strides in Debottlenecking key parts of the production process, increasing throughput and reducing unit costs at the same time.

Turning to gross margin.

Our adjusted gross margin improved quarter over quarter from 25% to 36%.

This was a function of multiple factors strong performance in general at Red again.

Favorable product mix within adult use.

Successful introduction of several new products.

And growth in medical as we noted above.

Also hexose total non beverage gross margin before adjustments.

Increased by 15% from the previous quarter.

While this is a striking the improvement it is not out of line with our larger industry peers.

Turning to SG&A those expenses remained flat from prior quarter and have decreased on a prorated basis.

<unk> expenses realized after the acquisition date of <unk> and 48, north in the first quarter.

Impairments to PP&E intangible assets and goodwill were taken after the cannabis the Canadian cannabis market experienced adverse changes as I noted.

These impairments have been reflected in significant adjustments to management's forecast.

Future net cash inflows and earnings from previous budgets and forecasts.

As noted our adjusted EBITDA increased by $5 6 million from a negative $11 two to a negative $5 6 million.

Okay.

Increase was driven by increased gross margins and flat SG&A expenses.

In addition to the previously mentioned restructuring of secured note Hexcel is also in negotiations with SaaS capital on partners to finalize a standby equity purchase agreement.

It is expected that the standby agreement will permit XO to demand the chaos and its partners subscribe.

In aggregate of Canadian 5 million common shares per month over a period of 36 months.

With a maximum standby commitment to be $180 million over the term of the agreement.

A 5% standby commitment fee payable in common shares will be due upon.

Some of this agreement.

The proceeds from a standby commitment are expected to be used to fund interest payments under the notes and general corporate purposes.

The standby agreement remains subject to negotiation and completion and among other things receipt of necessary regulatory and <unk> approvals.

Looking forward.

As we've made real progress in our capital structure and balance sheet, we continue to focus on the path forward.

And I'll, just remind you of those five priorities.

Continue to reduce manufacturing and production costs.

Streamline and simplify the organization.

Realized cost synergies from acquisitions and recent plant closures.

Focus on revenue management, including more disciplined pricing.

Accelerate growth for organic market share gains and capture missed revenue opportunities.

We've already been successful in building a strong foundation for this plan by fortifying the balance sheet.

Strengthening the leadership team and enhancing corporate governance.

On a final note I would also like to thank everyone at <unk> for their commitment and effort over the last year.

We recognize the resilience and positive outlook for the whole team in a challenging period.

We've now turned the corner and I look forward to leveraging this team's expertise to build a robust future perhaps up.

Thank you for your continued support.

Operator, we would now be happy to take questions from the participants.

At this time I would like to remind everyone in order to ask a question Press Star then the number one on your telephone keypad.

Your first question comes from the line of Aaron Grey from Alliance Global Partners. Your line is open.

Hi, good morning, and thanks for the questions here and.

Congrats on the progress you have made on the path forward.

So talking about the bright spot you you said in international.

He says Zenovich doubled Q over Q, just any incremental color you can provide there maybe in terms of the markets you are selling to and also going forward, whether or not those kind of some onetime founder you expect that level of sales to continue going forward. Thank you.

Yeah.

Good morning, and thanks for the question.

Could I ask you to take that one.

Yes for sure good morning, Yeah, so markets that we continue to sell into.

As we work with them the best of course, Israel, Malta and into Europe , we have strong relationships within the international domain and expect to see continued growth.

Thanks, and I'd also add we're also well and <unk>. We're also looking at South Africa, and Australia those markets as well.

Okay.

Okay, great glad to hear that.

Continue to see growth there and the second question from me.

Scott you talked about some survey work you guys are doing right now on the consumer front skewed understanding obviously aligning better with demand in cultivation and it seems like the teams are communicating more now Jeremy maybe some of the insights that you're continuing to see unfold, obviously a lot of moving parts in the marketplace in terms of consumer demands, whether it be price or THC levels.

So maybe some high level views in terms of how you view the marketplace today from your studies and what you believe consumers are going to look for demand going forward. Thank you.

Yeah, Great question. Thanks, Darren again, Valerie I'll turn that one over to you.

No problem yeah. So we were again extremely fortunate to conduct a national study.

<unk> 3000, Canadian consumers and within that we are able to identify over six unique.

Demand spaces, which will really claimed the.

The understanding of usage occasions, and consumption habits, and we're uniquely tailoring, our overall offering to consumers to align with that.

I will suggest some key findings that we have found that the importance of sleep.

The Canadian consumers and how candidates plays an important role within that.

I would also suggest that.

Your question around potency as.

It is important to Canadian consumers over around the top of mind as we are outlining and building on our product roadmap moving forward.

Okay, all right great. Thanks, so much and I will go on for so long.

Okay.

Your next question comes from the line of Tableau Atlantic from Cantor Fitzgerald. Your line is open.

Good morning.

Just give us an update if it's possible industrial of regional coverage within kind of.

The company started very strong in Quebec, right, then it seem to lose share there and gain in Ontario, Alberta, but just just an update in terms of where you are.

Especially with Rick on the assets you acquired industrial regional scope. If you can break it and then an update in terms of how much share you bluster in Quebec.

A follow up thank you.

Yeah.

Right. So we are naturally present, Valerie I'm going to turn over to you again just around the.

The market positions in each of the.

Provinces.

And nobody can rollout as well.

No problem, we continue to maintain the number one share position in adult rack and Canada Rolling three months share of $10. Three overall, we continue within large market to continue to leverage our partners as it relates to Quebec.

Ontario.

Alberta, and British Columbia, I'm really excited to announce that we have seen the expansion nabretta can on a national level, we've introduced <unk> can and Manitoba, Saskatchewan, Newfoundland, New Brunswick, and Nova Scotia.

In addition in February we saw the introduction.

We can into the Quebec market. So continued afterwards as we built out our product pipeline and continue to grow our market share with our keyboard partners.

Okay. Thank you I have just a follow up Scott.

Maybe focusing on it's a two part question one on update in terms of the JV with emotional worsen the relationship there how much progress you're making in Canada and in the U S.

Yes.

We thought JV.

The second part of your question is.

More about your U S plans I understand I'm sorry.

And we are convertible debt agreement with two way.

In the budget, probably Youll see you talked about buying land and conservation in California.

I just wanted to see an updated us how youre thinking about the U S opportunity or do you have too much to fix right now Doug.

So whenever you're buying assets in the U S. Thanks.

Yes. Thank you for the question.

So first on the joint venture with Molson and truss beverages.

I continue to be very pleased with the progress that the truss beverages is making.

Was recently announced as a result of the efforts of trust beverages and a number of.

Companies in collaboration with the government debt.

One of the kind of restrictions around the beverage category with you only purchased five beverages within your your.

You are limited and that's been increased to 48.

So we anticipate continued progress the innovation funnel.

That trust has for 2022.

Second to none.

And they continue to be very consumer focused and have very strong customer partnerships. So.

Very pleased with that.

In the U S continue to rollout CBD beverages.

And continue to have a strong commitment to that business as well and in.

A number of new states.

Both in direct to consumer.

With distributors.

And on your second question around the U S expansion plans.

We continue to absolutely look at the U S market with interest around operating with them to kind of.

The legal framework.

In the short term, we continue to progress the.

Action plan around extracts of.

Hemp drives fee.

<unk>.

CBD and other minor cannabinoid.

In ingredients and as we get through the balance sheet transformation free up cash gain.

Gain within that framework, we will absolutely be looking.

To the U S.

And the right kind of sequencing and timeframe for growth and expansion.

Thank you.

Our next question comes from the line of John <unk> from CIBC. Your line is open.

Thanks. Good morning, Good morning, I wanted to start good morning, I wanted to start on the cost cutting.

A lot of moving parts. So I just want to better understand it I think it's $50 million in synergies from M&A last year, there's another $30 million in savings from our production network that you have.

Identified subsequent to that it was around $35 million savings on SG&A. If you referenced the 30% cut in about 25 million savings for your portion of the til rate deal. So roll all that together you get to around $140 million I'm trying to get a sense of ultimately how much of that falls into Cogs versus SG&A.

Okay.

Yes. Thanks for the question John can I turn that one over to you.

Yes.

Yes, Hi, John .

You are right it is complicated.

Set of numbers and.

We have.

I've been trying to isolate those those numbers ourselves.

Just in the last few weeks, we've set up a special team and a value creation office too.

To be tracking all of those initiatives separately.

And.

I anticipate that.

As we as we get better at tracking those things will be able to offer specific details.

You touched on the $35 million from SG&A, that's pretty well isolated.

SG&A.

But the balance of it is going to be a combination of both.

Cogs and SG&A, and we'll be sharpening that up and sharing with you.

And in the future.

Okay understood and just a clarifying question on that.

Was there any progress made on the $37 5 million in targeted at 2002 savings in FQ, two or is that all targeted for F Q3 and four.

Yeah. So.

Yeah.

We did do a significant head count reduction in February .

Which which will certainly show up in Q3.

There were some ongoing cost reductions in Q2, but I think the bulk of the.

$37 5 million, we're going to capture.

In fiscal 'twenty, two is going to be in the second half of the year.

Okay got it and then on the revenue side.

You did endure some significant organic declines and you referenced.

Meaning from missed opportunities, but can you add more color on some of the other initiatives you have to retake share. It does seem like some of your competitors have caught up to.

Some of the products that <unk> does well and so I'm curious what what youre working on innovation or what other initiatives you have to take back share.

Yeah, Great question. Thanks for the question John .

Turn that one over to you.

You bet.

So once again I just wanted to reiterate that we remain the number one LP in the adult recreational market with 10, 3% market share on a rolling three month basis.

We are again working hard to launch plans to allow us to grow organic organically and there is tremendous opportunities with our breadth of assets that we have.

The fastest growing categories overall.

Over the course of the last quarter, we very much focused on next and driving sustainable growth for our shareholders in a day and in databases and rebuilding we've been building our product pipeline.

And innovation pipeline as it relates to Canadian consumers referencing once again, the national UNH study that we conducted with it a lot which allowed us to identify unique use cases and consumption habits of Canadian consumers you will start to see the effects of this work hit the market.

In early spring of this year when you start to see some of those products hitting the market and one that I'm. Most excited about that I want to make sure that I highlight is the launch of <unk>, plus which is an infused pre roll.

<unk> style to the straight edge style that we will launch into the marketplace with higher THC.

Again, capitalizing on the overall market moment Andy.

Key indicators from consumers in terms of their needs for potency, we leverage this information and again, the really really strong.

<unk> brand to deliver this the Canadian consumers and you can look forward to seeing that hitting shelves like I said in early spring more to come on this front as we're rolling out our innovation pipeline over the next 12 to 24 months, but this is what you can expect from <unk> on a go forward basis insightful innovation. They are meeting the needs of Canadian consumers.

Yes valid readies, plus very excited about that as well and it took a lot of technical know how to bring that to market. It.

It's largely the premium pricing as you say that's.

That's what that's what can be expected as we continue to leverage those those consumer insights.

And our capability to bring unique and compelling products to market.

Yeah.

Okay I appreciate the color. Thank you very much.

Again, if you would like to ask a question Press Star then the number one on your telephone keypad.

Next question comes from the line of Frederico Goldman from HEB capital market. Your line is open.

Hi, good morning, Thanks for taking my question.

Maybe could.

Could you give more color on the issues, you're seeing with Red again.

You mentioned competition, if we roll market, specifically in Ontario, So so just curious on what Youre seeing other provinces.

As well as other other product categories in terms of competition and potentially pricing pressure. Thank you.

Thanks for Veeco.

Valerie over to you.

Yes sure.

I would suggest that we have a unique opportunity as it relates to our breadth of brands, including <unk> and our unique position to leverage our value continuum allows us to address price points and specific needs of consumers across the spectrum of cannabis needs.

And allows us to balance both our overall volume.

And our profitability for our business overall for sure. If there is a lot of competition as it relates to the pre owned category.

But again, we are in a good position from a productive capabilities are strong brand positions as it relates to <unk> and the deep innovation pipeline that we're building.

So we're feeling very very confident and are confident in our position as it relates to the market across all categories in all markets.

Scott is there anything else you'd like to add there.

No.

Great answer thanks Bill.

Yeah.

Okay. Thank you and then just on your capital position right now.

Still have.

Some months until the deal with <unk>. So I know that you have some assets for sale on the balance sheet.

How are you seeing that you need.

Need to raise any more capital or did you rely on those asset sales.

Comfortable are you with your cash position right now.

Curt John speak to that yes sure.

Frederico Hi.

Our cash position is something that we track very very closely.

And.

We do a rolling.

Receipts and disbursements forecast.

Going out.

13 weeks, and then out to 'twenty six weeks as well.

And so we manage that cash position pretty carefully.

We do have asset sales coming up.

And.

That cash, we anticipate will be going into the restricted cash.

Nevertheless.

We believe that we've got adequate liquidity to get through to the.

Conclusion of the <unk> deal.

In the middle of May.

Thank you that's helpful I'll hop back in the queue. Thank you.

Yeah.

Your next question.

Comes from the line of Sheila <unk> from RBC capital markets. Your line is open.

Hi, good morning.

Good morning.

I just wanted to get back on data driven.

Revenues. So as you noted in the MD&A that there was <unk>.

99% quarter on quarter decline on accumulative basis, and it was due to logistical issues.

And competition could you please split.

The proportion from both of these.

Finally, I wanted to confirm that these logistical issues are now resolved.

Thanks for the question.

Sorry.

Yeah as it relates to already kicking.

In the last quarter, there were a number of administrative and logistics issues that were unique event.

<unk> entered in within the quarter and it was around amalgamation and re listing with provinces. In addition to that we shifted our overall hero product that the ready from a <unk> $35, four which enabled us to actually sell through all of the inventory before restocking in the marketplace.

Overall, so there were some integration.

Challenges that we had to overcome over the over the time period of the second quarter. However, demand remains strong and we're seeing that rebound now.

Okay. Thank you.

That's it.

And there are no further questions at this time, Mr. Scott Cooper I turn the call back over to you for some closing comments.

Thank you everyone.

Thank you everyone.

Once again for joining us this morning, I am pleased that we can now as a result of our recently announced proposed strategic partnership with til rate continue to position ourselves to retain and grow our significant market share.

Become cash are cash flow positive business for the next four quarters I have full confidence in the path forward and again I appreciate everyone. Joining us this morning. Thank you.

This concludes today's conference call. Thank you for your participation you may now disconnect.

[music].

Yeah.