Delta 9 Cannabis Inc.

Good morning, everyone, and welcome to Delta 9 Cannabis’ Q2 2019 Earnings Call. At this time, all participants have been placed in listen-only mode.

Following the presentation, we will open the line for question-and-answer session for financial analysts. 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.

Thank you, Alexa, and good morning, everyone. Thank you for taking the time to join us for Delta 9’s Q2 2019 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, Q2 2019 financial statements and management discussion analysis have now been made available on SEDAR and our company website.

And with that, let’s begin. In the second quarter of 2019, Delta 9’s businesses have made significant progress.

Similar to the first quarter of this year, the Canadian cannabis industry has faced headwinds, including delays in retail store roll outs, regulatory scandals and mixed financial results. For many reporting issuers, this has meant a step back in recorded results over the previous period.

We believe that in spite of these challenges, today’s results demonstrate significant financial and operating results for the company. We remain bullish on the outlook for the company and the Canadian cannabis sector as a whole over the coming quarters and years.

Management would first like to highlight the following key milestones achieved over the second quarter 2019. In the second quarter, our principal expansion activities were focused on Delta 9’s Winnipeg base production facilities.

The primary purpose of these facilities is to cultivate process and manufacture the highest-quality cannabis products. Our proprietary cannabis production methodology is based around the modular, scalable and stackable production unit, which we call the Delta 9 Grow Pods.

As we all know for 2019, our stated goal has been to complete our Phase II expansion plans for our Delta 9 facilities, increasing our overall number of Grow Pods installed within the facility and approved by Health Canada to approximately 600 from 154 as at December 31st of last year. This expansion is planned to increase our overall production capacity to 16,500 kilos from approximately 4,200 kilos as at last December.

On May 20, during the quarter, the company announced that it received approval from Health Canada for an additional 48 Grow Pods, bringing our total number of Grow Pods approved by Health Canada to 202. The company anticipates that after placing these Grow Pods into production, we will add approximately 1,150 kilos to our planned production capacity, bringing our overall current planned capacity to 5,300 kilos per year.

As at June 30, the company had 297 Grow Pods installed within the facility, and we remain on pace with our planned Phase II expansion. We will continue to provide updates to the market as expansion areas are completed and approvals are obtained from Health Canada.

Over the quarter, we continue to expand our portfolio of cannabis products from our production in wholesale division with new product development activities. Over the quarter, Delta 9 sold over 30 different varieties of dried flower products through our premium and super premium categories, as well as three milled flower cannabis products.

In early June, we saw a successful launch of our first cannabis pre-rolled product, which we call Delta 9 Bliss. The company has seen significant consumer trending towards pre-rolled cannabis products over the past two quarters and will be investing additional resources into increasing our capacity to create pre-rolled cannabis products.

To date, we have sold over 75,000 cannabis pre-rolled, and moving forward, we will begin to include cannabis pre-rolled sales into our quarterly KPIs. We continue to bring on additional cannabis genetics from our seed bank to develop our pipeline of high-quality products.

Over Q3 this year, we plan to release several high potency cannabis strains, high potency dried cannabis extract product and we anticipate receiving our sales license for our initial cannabis oil products with the issuance of our renewed Health Canada license at the end of this month. Looking forward to the upcoming extract regulations this fall, we began preparing for wholesale and retail sales of cannabis extract products.

On the wholesale side and subsequent to the end of the recording period, company announced that it had entered into a one year of white labeling agreement with Westleaf Cannabis to purchase cannabis derivative products from Westleaf’s large-scale extraction and manufacturing facility located in Calgary, Alberta. The deliveries of these cannabis products are expected to begin after October 1 and subject to the receipt of a final license approval from Health Canada for Westleaf’s facility.

This agreement will allow the company to bring Delta 9 branded extract products to market in the late 2019 and early 2020. Delta 9 supply chain and retail teams have already begun preparing for the introduction of these products into our retail distribution infrastructure.

As of the end of Q1 2019, the company had existing supply agreements with the province of Manitoba, the province of Saskatchewan and the Auxly Cannabis Group. Our distribution strategy has to be – has been to focus on specific provincial markets with a goal of achieving market share and mindshare with the consumer, as the company expands its production capacity.

As we’ve expanded this capacity, we begin to build on these previous distribution agreements. During the quarter on May 24, the company announced that the Alberta Gaming, Liquor and Cannabis Authority has authorized the company to supply cannabis to the AGLC for retail sales in the province of Alberta.

The company made its first shipment to the AGLC within the second quarter of 2019. We’re now expanding our distribution in Saskatchewan and Alberta with a goal of reaching as many retail stores as possible over the next three quarters.

With increases in production capacity, the company is now ready to begin to reach nationally with our distribution reach. We’re now in active discussions with several national retail chain and provincial distributors, and will continue to announce new supply agreements to the market as they are forthcoming.

A large part of the company’s strategy and our approach to the Canadian cannabis market has been to vertically integrate into retail sales. We feel that this strategy will carry numerous benefits, including capturing retail sales margin, which would otherwise be lost, controlling the direct-to-consumer sales force and product narrative, having control over in-store marketing and branding options, gathering live feedback, consumer trends and preferences through our data and analytics collection.

The company opened its first Delta 9 Cannabis store on October 17 last year. And since that time, the company has expanded its retail division to three operating stores and almost 100 full-time employees and has generated over $10 million in retail cannabis revenues.

Construction is nearing completion at our fourth location in Thompson, Manitoba, which is planned to open at the end of this quarter or early in the Q4 and plans are in the works for multiple additional locations across Western Canada over the coming quarters. Management’s intent is to build a network of dozens of Delta 9 branded cannabis storefronts over the coming years, which will allow for private retail sales.

We are actively pursuing retail expansion opportunities in all Canadian provinces, which allow for private sector retail cannabis sales and will continue to expand on this vertical integration strategy into the Retail segment. Now on to the discussion of our key operating parameters for the quarter.

Beginning last quarter, we committed to build into our quarterly management discussion documents certain key performance indicators, which can be used to better assess the performance of our operating businesses and provide investors and analysts with transparency around our reporting numbers. For the period, we would highlight the following figures.

In terms of total grams produced over the quarter, approximately 675,000. This is up from 418,000 in the previous quarter, a gain of approximately 61%.

We would note that this is still below the design capacity for our Phase I assets. The shortfall here we feel has been that as the company has increased our overall batch sizes, which has contributed to significant efficiencies in terms of production costs, our operating assets have not yet been able to operate at full capacity.

We will continue to push on – in terms of our turnaround time and operating efficiencies for these assets towards full capacity. However, we would know that the output that we are realizing from our Grow Pods on a per batch basis is in line with or exceeding our original expectations.

So we do not anticipate any overall changes to our planned production capacity numbers. We would highlight significant improvements in our direct production cost per gram, which came in at $1.05 per gram, that’s down from $1.44, or 27% from the previous quarter, and now places us in the industry-leading category with only a few producers in line with that $1 per gram metric.

Total cost per gram was $1.21, that includes packaging labeling and any other fully burdened cost per gram sold at the wholesale level. Again, we feel that is an industry-leading metric.

Total grams released for sale up significantly over the quarter to approximately 565,000 from 185,000, total grams sold upwards of 520,000, up 34% from the previous quarter. Average selling price per gram turned it down from 764 gram to 563, mostly due to the increased distribution on a bulk wholesale basis to our supply agreement with Auxly Cannabis.

From our retail unit total gram sold trended up significantly with three operating stores versus one in the previous quarter, 282,000 grams distributed, up from 190,000 in the previous quarter. Average selling price per gram remained generally in line at 1,242 per gram from 1,284 in the previous quarter.

Number of retail transactions processed increased exponentially to 84,000 from 44,000 in the previous quarter. The company is now transacting over 1,000 cannabis retail transactions per day on average.

Our average transaction size was down over the quarter to 4,146 from 5,827 on an average retail transaction, mostly due to the introduction of convenience packaging sizes and pre-rolls throughout the period. On the financial results, again, we feel significant improvements over the previous quarter.

Total net revenues for the three and six-month period were $8.88 million and $14.52 million versus $715,000, and $1.05 million for the previous year period, an increase of over 1,100% and 1,200%, respectively, versus the previous year, obviously, significant growth over the previous 12-month period. Sequential quarterly net revenues increased 58%, up from $5.63 million for the period ended March 31.

The company has now recorded over $21 million and trailing 12 months revenues up from approximately $1.7 million in the previous 12-month period. When we compare our revenue segmentation versus the previous quarter, we see that wholesale cannabis revenues came in relatively flat at $2.91 million versus $2.93 million in the previous period.

Retail cannabis revenues were up fairly significantly over the period coming in at $3.51 million, up 44% from $2.4 million in the previous quarter. Business-to-business activities outperformed our expectations significantly posting revenues of $2.2 million, up from 45,000 in the previous quarter with significant number of Grow Pods deliveries booked within the quarter.

Cost of sales for the three-month and six-month period were $5.9 million and $9.7 million, or approximately 67% of overall revenue. Management would highlight the proportionate increase in cost of sales versus our previous year due to increased volume from our cannabis retail and business-to-business segments, which typically provide lower gross margins than our cannabis wholesale business.

We would also highlight that given the significant increases in revenue and its lower-margin businesses from the sequential quarter. The company has observed wider margins in its cannabis wholesale business due to low – lower overall cost per gram.

We anticipate that as production capacity increases in 2019, the cost of production and cost of sales will continue to trend down as a percentage of overall revenues due to incremental efficiencies in labor and increased purchasing power for key inputs, this should assist in driving gains in overall gross profitability over the year. From a gross profit perspective, before accounting for fair value adjustments and biological assets for the three and six-month period were approximately $2.95 million and $4.76 million, a 33% of overall revenue, up significantly over the previous year’s results.

Sequential gross profit before accounting for fair value adjustments and biological assets increased approximately 62% versus the previous three-month period ended March 31. Overall, we would highlight the company’s progress and demonstrating that our business model is capable of scaling revenues and doing so in a way that is sustainable and profitable.

Operating expenses for the three and six-month period were $4.6 million and $9.8 million versus $2.8 million and $4.9 million for the previous year. We would highlight that the proportionate increases in overall operating costs have been offset by larger increases in revenue and gross profitability, indicating the company’s business models are beginning to trend towards net profitability.

Sequential operating expenses decreased $523,000 from the period ending March 31, demonstrating that cost control implemented by management continue to contribute to improvements in overall expenses. The company’s loss from operations for the three and six-month period were approximately $1.1 million and $2.05 million versus $2.1 million and $4.1 million for the previous year.

We attribute the improvements in the loss from operations from increased wholesale, retail and business-to-business revenues and gross profits over the past two quarters. For the second quarter, the company has began to incorporate adjusted EBITDA into our management discussion and analysis.

Our adjusted EBITDA is a non-IFRS measure used by management that does not have any standardized meaning prescribed by IFRS and may not be comparable or similar to measures presented by other companies. We define this adjusted EBITDA as the income or loss from operations as reported before interest in tax, adjusted for removing share-based compensation, depreciation and amortization, the fair value effects of accounting for biological assets and inventories.

We believe that adjusted EBITDA and the attribution such in the manner described above provides a meaningful and useful financial metric, as these measures demonstrate the performance of our operating businesses. The company’s adjusted EBITDA loss for the three and six-month period was $663,000 and $2.6 million versus $1.8 million and $3.2 million for the previous year.

We would highlight the improvements in adjusted EBITDA loss over the past two quarters as a generally positive indication of the performance of our company’s operating businesses and narrowing our quarterly loss. On our working capital position as of June 30, the company maintained a strong working capital position of $15.4 million versus $20.6 million for the year-end December 31.

To ensure the company remains adequately capitalized for its continued expansion and ongoing operations, management has undertaken a few notable activities subsequent to the end of the reporting period. Firstly, on July 17, the company announced that it had completed its previously announced public offering of debenture units for aggregate both gross proceeds of approximately $11.8 million.

Second, on August 14, the company announced that it come to terms on an amendment to the company’s existing credit facility with Canadian Western Bank, the principal turns of which provide for the following: the limit for our existing demand operating loans for the purpose of day-to-day operations was increased to $4 million from $2 million; to date, the company has never drawn on this facility; now the $500,000 has been added for the purpose of enabling the delivery of letters of credit required in connection with the company’s retail business operations; a non-revolving credit facility in the amount of $4 million has been added for the purpose of lease of equipment required for the company’s wholesale operation; and the principal amounts of demand non-revolving equipment credit facilities under our existing credit facility has been reduced to reflect principal repayment over the previous period. The net effect of these changes is increasing our previous $12 million facility to allow the company to up to $18.1 million in funds from the bank.

As of June 30, the company had used approximately $4.6 million of this facility, leaving approximately $13.4 million available to the company. We believe that the company is currently positioned with a strong balance sheet and as well capitalized for our planned expansion.

We will continue to use the mix of existing cash on hand, operating cash flows, and if necessary debt and equity financings to continue our expansion over the following year. Now as we look forward to the balance of the year 2019, we feel that the company is very well positioned to execute on its vertical integration and growth strategies.

We see 2019 is a critical year for the company, which will lay the foundation for Delta 9 to become a top 10 contender as a vertically integrated player in the Canadian cannabis market and ultimately beyond. And with that, we’ll close off the management commentary and turn the call back over to the operator for questions.

Hi, guys, thanks for the call. Can you hear me, okay?

Yes. Good morning, Kim.

Just wanted to elaborate on your comments regarding batch sizes and how that’s impacting your overall operating capacity. And then maybe I’ll follow-up with a little bit more on retail after that.

Yes, absolutely. So, as we’ve scaled our production facility, we’ve gone from dozens of these Grow Pods in production to hundreds.

As a part of that and in order to increase our overall batch size, we are effectively chaining Pods together. So where previously we would be producing a batch in, say, one Grow Pods, which would be in the area of six to seven kilos of output, we would now have eight to 10 Pods producing 50 to 60 kilos per batch.

As we have done that, it’s meant that as certain Pods are harvested, they may not be turned over back into production immediately, but rather waiting period of days or weeks until the balance of the Pods within the same block of containers are ready to place back into productions. So when we talk efficiencies, it really has been the turnaround time or the number of crop turns per year that has fallen short of management’s expectations.

As we have increased that batch size, we’ve certainly seen measurable increases – or sorry, measurable decreases in our cost per gram, leading us to believe that these efficiencies from a batch size perspective are certainly much needed. We are now turning our attention back to the turnaround times from these areas.

We expect that into Q3 and Q4, we will begin to operate very close to that design capacity for the facility.

Okay. So basically, does that mean some of the Pods are sitting idle between when you harvest and when you start the next crop?

That is what we observed over the second quarter, Kim. Again, much of those efficiency gains, I think, have now been realized into Q3.

We would expect to see a general increase in that production capacity versus design capacity into Q3, with the full balance of those results coming into Q4.

Okay, great. That’s really helpful.

Thank you. And then maybe…

One follow-up….

Go ahead.

…sorry, Kim, one further thought on that. As we’ve invested in automation as a facility, most notably automation of our watering systems.

Again, this has been driving that decrease in cost per gram for us, although we would notice well that the full implementation of a number of these automation procedures was only implemented mid in the second quarter. So we should continue to realize efficiency gains, again, as we increase that overall output capacity and begin to realize the full benefits of those automation features.

Gotcha. And are there any other initiatives kind of that you’re looking forward to that would increase your capacity?

I think now is really the time for us to scale. Again, we point to an increase in the overall number of license containers or Grow Pods in the second quarter.

We anticipate this continuing into the back-half of the year. I think really we’ve proved the model that these Grow Pods are scalable.

From a business perspective, they’re certainly competitive on an overall output perspective, at a cost program perspective. So now it’s time for us to ramp up that production.

Gotcha. And on that one, you’re still – my understanding is you’re still waiting on the subdivision approvals with the city of Winnipeg, you’re hopeful that they’ll be approved by the end of the quarter.

If all goes as expected on those timelines, what would you look – be looking in terms of timeframes to get those next 300 or so Pods?

Well, again, we point to as of the end of quarter 297 Pods installed within the facilities, with only 202 approved. So there is still a significant capacity.

They’re sitting idle pending Health Canada approvals, those approvals have been submitted for. At this point, I believe we have an additional several dozen containers that have been produced and are simply waiting to be installed within facilities for subsequent expansion approvals from Health Canada.

Again, in terms of the overall number of Pods produced, we remain on track to exceed that 600 for this calendar year.

And is all the warehouse infrastructure in place then?

Beyond our Phase IIa, we do have additional warehouse capacity installed for at least another 75 units. Beyond that, we are then out into the Greenfield builds, which all the design, engineering, et cetera, permits have been applied for and the construction is anticipated to begin this fall.

Okay, great. Okay, I’ve had enough questions.

I’ll pass it off and get in the queue at this time.

Thank you, Kim.

Yes, thanks for taking my question. Just trying to connect the dots here and get a total corporate-wide cost per gram.

How many grams did you sell B2B?

Oh, You know that, I mean, we consider all of our wholesale cannabis sales to be B2B to an extent. I mean, we’re just selling to the Auxly Cannabis Group.

We’re selling to provincial distributors, or we’re selling to private retailers in the province of Saskatchewan. But in terms of an overall breakdown, I would think about 40% of our sales came through our supply contract with Auxly over the quarter, with the balance going out into the Manitoba, Saskatchewan and Alberta market.

Okay. Well, how many grams in total did you sell in the quarter, per gram equivalents?

Yes. Total grams sold in the quarter was 517,000.

517,000. And the cost of sales was $5.936 million.

That’s across all of our business cadence. That’s correct.

So that’s almost – well, that’s over $10 a gram. The cost of production here was $1.44, 418,000 grams, it’s $600,000.

So where’s the other $5.3 million in cost?

Yes, keep in mind, the – Chris, when we look at our top line revenue, cost of sales, we’re looking at all of our business units. So we’re looking at approximately $3 million in revenue from our cannabis production and wholesale division.

We’re looking at another $3.5 million in revenue from our retail division and we’re looking at $2.16 million from our B2B division, as well as several other ancillary categories for revenue. All of that’s broken out in our revenue segmentation and our management discussion analysis.

But when we’re looking at the overall income statement, you would see a blending of that revenue, the sales across those three business segments.

Okay. I’m really talking about cost here.

So the cost of reading the retail stores, obviously, we assume that $5.9 million of cost of sales? What about the harvested costs, so we don’t – we extract just the harvest cost per gram?

You have $1.60 here, total cost per gram. Is that to harvest and extract or just harvest?

We have $1.05 in terms of our direct production cost per gram over the quarter. So…

$1.05?

Yes. And then our total cost per gram in terms of package labeled tax stamp, the processed material ready to sell was $1.21 per gram.

I must be looking at March there. Yes, I got it.

Right. So the $1.21 per gram on 517,000 grams, product costs are not due to harvest, it’s due to the store infrastructure?

That’s correct. And again, we point to as a part of this overall segmentation, that really the highest margin business that we have is our cannabis production in wholesale division, which is the focus of the bulk of our expansion activities.

Otherwise, our B2B and retail units are both profitable in their own rate from a gross profit standpoint, but run a much thinner margin.

Right.

Again, the company’s overall vertical integration strategy that as we attack growth in these three major segments, we effectively diversify our growth opportunity, but also capture much more of the overall value chain than an otherwise business that was operating in only one of those segments.

Great. Just the last one.

The 40% that sold to Auxly, that’s 40% of the wholesale or the B2B?

They’re effectively the same for us, Chris, and again, we’re talking cannabis wholesale. Our B2B activities, we consider our Grow Pods sales or genetic sales in our consulting division.

Well, you have three different Pods here. You’ve got the private stores that you have in Manitoba, obviously, and then you have the provincial supply agreements, and then you have your B2B sales, right?

That’s correct. Yes.

So they Auxly would be in the B2B area?

No, no. The Auxly would be in the wholesale cannabis revenues.

Okay. Include – so it’s included in the provincial supply agreements now?

That’s correct.

Okay, great. Thanks so much, and very nice price, average selling price.

Thank you, Chris.

If that is the balance of the questions, we will turn the call back over to the operator to wrap things up. Thank you again everyone for taking the time this morning.