Delta 9 Cannabis Inc.

Good morning, everyone. And welcome to Delta 9 Cannabis’ Q3 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 Q3 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, Q3 2019 financial statements and management discussion analysis, have now been made available on SEDAR and through our company Web site.

And with that, let’s begin. As we all know the Canadian channel this industry has encountered growing pains and challenges over the past several quarters, and Canada’s initial roll out of the legalized recreational use of market, including delays in retail stores rollout, bottlenecks at ground distributors, regularity scandals and permitting reporting issuers, mix financial results.

Through our last three quarters of this year, Delta 9 has reported strong revenue growth and overall financial results, as we’ve expanded on our core businesses and continued to execute on our business plan. Today’s third quarter results show that we are not immune to the challenges faced by our industry.

We have many positive takeaways from today’s results, which we will highlight, as well as analyzing our misses, the challenges we’ve encountered and changes we’re making to continue to drive growth and create shareholder value. First on facility expansion activities.

In the third quarter of 2019, the company’s principal expansion activities were focused on Delta 9's Winnipeg based facilities. The primary purpose of these facilities is to cultivate process and manufacture the highest quality Cannabis products.

The company’s proprietary production methodology is based around the modular, scalable and stackable production unit, which we call the Grow Pods. We believe that these Grow Pods provide numerous benefits versus traditional open warehouse or greenhouse now outdoor Cannabis production operations, most mainly a higher level of control over the growing environment, contributing to higher quality Cannabis products, the ability to customize the growing environment for each genetic strain of Cannabis that we grow, maximizing the quality and output of these variety, relatively in-expenses and provide an attractive return on invested capital.

The modular format reduces risk of contamination or spread of contamination from disease or pest and the modular format minimizes the risk of material crop loss. And now for 2019, our goal is to continue to expand our Phase II areas at Delta 9 facility by increasing our overall number of Grow Pods approved by Health Canada to 608 from 154 as of the end of the December last year.

On May 20th this year, the company announced it received approval from Health Canada for an additional 48 Grow Pods, bringing us total number of Grow Pods approved by Health Canada to 202. The company has placed the additional 48 Grow Pods into production, and we anticipate of adding an additional 1,150 kilos per year of dry cannabis flower production, bringing our overall anticipated annualized capacity to 5,350 kilos per year.

As of today's date, the company has installed 297 Grow Pods within the current Health Canada License facility, 95 of which are currently pending Health Canada approval to be placed into production and as numerous other pods in varying stages of construction, and installation and approval. The company is continuing with its planned Phase II expansion of the Delta 9 facilities, which is anticipated to increase our overall production capacity to 16,500 kilos of dry cannabis flower per year from 5,300 kilos as of today.

We will continue to update the market on expansion progress and licensing approvals as they are received from Health Canada. On our portfolio of cannabis products, company currently produces approximately 30 different genetic strains of cannabis, each with its own unique chemical cannabinoid content to serpin and flavinoid profiles, and with another 40 strains being stored on-site in a seed bank to provide for product options into future.

Management believes the company has one of the largest in-house stocks of unique genetic cannabis strains amongst cannabis producers in Canada. We are continuing with our production pivot towards higher potency cannabis products strains, which are the highest demand segment with the retail consumer.

Whole flower dry cannabis sales currently account for approximately 75% of the company's overall product offering by revenue. The company released its first pre-rolled cannabis products to market in June 2019.

These products consist of blended cannabis flower rolled into a joint format for sell in the recreational cannabis market. The company's seen significant consumer response to cannabis pre-rolled given the convenience of purchasing a ready to consume product.

To-date, we produced and sold hundreds of thousands of the cannabis pre-rolled units. The pre-rolls clearly account for approximately 15% of our overall product offering by revenue.

Company currently produces and sells the selection of blended cannabis products as well, which consists those high-quality cannabis strains blended together to produce a milled finished product. The company's house blended products currently account for approximately 5% of our overall product offering.

On oils, extracts and derivative products, the company was licensed during the quarter to sell cannabis oils, extracts and derivative products. It's our belief that these products will become an increasingly important component of the medical and recreational use market into the future.

Cannabis ingestible oils currently make up approximately 5% of our overall product offering by revenue. On October 17th of this year, Health Canada released updates to the cannabis regulations, which allow for the production and sale of an expanded portfolio of cannabis derivative products.

The company is undertaking multiple strategies to bring these cannabis 2.0 products to the market. Firstly, the company is developing the line of dried sift cannabis products for the recreational of market, which involves shifting our high quality blended products and refining them, leaving more of the high-potency and less of the low potency plant material.

The final product is the yellowish/brownish powder that has a potency that is up to double that of whole flower. The company plans to release dried sift products to the recreational market in the fourth quarter of this year.

On July 24th during the quarter, company announced that it entered into a one year white-labeling agreement with Westleaf Cannabis to purchase cannabis derivative products from Westleaf’s large scale extraction and manufacturing facility located in Calgary. Under the terms of the white labeling agreement, Delta 9 will purchase up to $4 million of various white label cannabis derivative products with an option to increase this amount to $16 million over the next calendar year.

The company anticipates first deliveries of cannabis derivative products from Westleaf will commence in the first quarter of 2020. Our first look into cannabis 2.0 products will focus on the vaporizable pens, and we'll expand from there as we begin to see insights as to consumer trends into these segments.

In its retail stores, the company will carry a full complement of new 2.0 cannabis products from 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 product opportunities.

From a distribution standpoint, management believes 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 recreational use cannabis products are expected to make up the major components of the company's overall business.

Our distribution strategy will be to enter a target market and achieve market penetration, targeting significant market share as consumers adopt Delta 9 branded products. The company has undertaken a strategy to add new distribution markets incrementally as our increased supply capacities come online in order to reach our ultimate goal of becoming a national distributor of recreational use of cannabis products.

The strategy began last summer with the addition of our 2,300 kilo per year supply agreement with the Province of Manitoba. Beyond our home province, the company secured additional supply agreements with the Auxly Cannabis Group to supply cannabis flower and trim from 1,100 kilos this calendar year, scaling to 5,500 kilos in the next calendar year.

As the 2019 year has progressed, as supply capacities ramped up quarter-over-quarter, the company has added several additional supply agreements. Delta 9 is now licensed for distribution in Saskatchewan, Alberta and British Columbia, and is in active negotiations with other provinces to continue to expand our distribution capacity, as the company increases its cannabis production capacity plans to expand its distribution into additional markets through supply listings or formal supply agreements in those markets.

Now on vertical integration and retail cannabis sales. We believe that there are number of benefits to pursuing a vertical integration strategy into retail, including control over the direct to consumer sales force and product distribution, control over the direct to consumer branding and marketing initiatives, capturing additional revenues and gross margin from retail sales and direct feedback from consumers regarding product trends, marketing strategies, et cetera.

Management intends to build a network of dozens of Delta 9 cannabis store branded storefronts over the coming years in markets which allow for privatized retail sale. Over the past 12 months, Delta 9 has made significant progress in expanding its retail footprint.

On September 27th, during the quarter, company opened its fourth retail cannabis store located in the City Center Mall in Thompson, Manitoba. As at September 30, the company operated four retail stores that sell recreational cannabis under the trade name Delta 9 Cannabis Store, the two Winnipeg, one in Brandon and one in Thompson, Manitoba.

These retail stores have become some of the largest volume cannabis retail stores across Canada. On September 19th, during the quarter, the company announced that it entered into a binding letter of intent to acquire from Modern Leaf Group all of the assets located probably in Alberta relating to two purposed Cannabis retail stores.

The purchase price for the proposed transaction is $1.3 million with $1 million being through the issuance of stock and $300,000 in cash. This marks the company’s first push west of Manitoba in the retail vertical.

Our plan continues to be to operate up to an additional 14 retail outlets and jurisdictions, which allow for privatized Cannabis retail over the next 24 months. We're actively pursuing retail expansion opportunities in all Canadian provinces, which allow for privatized retail sales, and we’ll continue to expand on our vertical integration into the retail segment.

On business-to-business opportunities, the company derives a portion of our overall revenue from sales of Cannabis genetics, sales of Grow Pods and from licensing and consulting services provided to other licensed and pre-licensed cannabis companies. We believe that these opportunities provide us with a number of benefits, including a complementary business vertical, which produces diversified and high margin revenue, third party validation of our company's propriety Grow Pods platform, valuable partnerships with other pre-licensed and licensed cannabis companies and the opportunity for international expansion and non-cannabis revenue streams.

We will continue to pursue and expand on these business-to-business revenue opportunities over the coming year. Other notable catalysts for the company during the reporting period included, changing of the company’s trading symbol on July 24th from D or 2DN from NINE to facilitate the listing of our warrants and debentures in connection with the financing completed during the period, which we’ll speak more on in a moment.

On September 3rd, during the quarter, the company shares another security fees trading on the Toronto Venture Exchange, and we’re listed on the main board of Toronto Stock Exchange. We marked this event as significant as the company has, in less than two years as a public company, achieved all the requisite milestones in order to qualify for listing on Canada’s most senior experience.

The goals of the uplifting are to improve liquidity and visibility of Delta 9 Stock, as well as making the company more attractive to institutional investors participating in the Cannabis industry. Now turning to the balance sheet and the financing activities for the quarter.

The company ended the second quarter this year with approximately $3 million in cash and approximately $15 million in working capital. From there to ensure that the company remained adequately capitalized for our continued expansion and ongoing operations, we’ve undertaken few notable activities during the third quarter this year.

First, on July 17th, the company announced that it had completed its previously announced public offering of debenture unit for aggregate gross proceeds of $11.8 million and net proceeds of approximately $10.5 million. The convertible debentures bear interest at a rate of 8.5% per year from the date of issue payable semi-annually, and will mature three years from the issued date on July 17, 2022.

The principal amount of each convertible debenture is convertible at a price equal to $1.21 subject to certain conditions. Second, on August 14th during the quarter, the company announced that it had come to terms on an amendment for the company’s existing credit facility with the Canadian Western Bank.

The net effect of these changes is increasing our previous $12 million facility to allow the company to access up to $18.1 million in funds from the bank. As of September 30, the company had used approximately $7.7 million of this facility, leaving approximately $10.4 million available to the company.

As of the end of this quarter, the company showed a healthy cash position of $10.2 million in cash on hand, up by approximately $7.2 million from previous quarter and over $23.5 million in working capital, up by $0.5 million over the previous quarter. Total assets at of the end of quarter totaled $67.3 million, up from $45 million as of the end of last year.

Liabilities totaled $32.2 million. At the end of the reporting period, the company reported a healthy debt and tangible net worth ratio of 0.47 at a current ratio of more than 7.3.

Winnipeg compliance was all of our provision under our current credit facility. Management believes that the company is currently well-positioned with a strong balance sheet and is well capitalized for a planned expansion.

We will continue to use the mix of existing cash on hand, operating cash flows and as necessary, debt and equity financings to continue to expand over the coming years. Now, in terms of key performance indicators for the company during the quarter.

We seek to provide the market with key performance indicators to give the market a sense of how we are performing quarter-over-quarter for our respective business units. From our production and wholesale unit, total grams produced during the quarter were 871,000, up from 675,000, an increase of 29% quarter-over-quarter.

Direct production cost per gram was in line with the previous quarter at $1.80 that was up $0.03 from the previous quarter. Total cost per gram of production was $1.21, in line with the previous quarter.

Total grams sold in the medical and recreational markets were 548,000, up 4% from the previous quarter. Average selling price per gram was $4.19, down approximately 25% from the previous quarter.

In our retail unit, total grams sold were approximately 349,000, up 24% from the previous quarter. Average selling price per gram remained in line at approximately $12.47 per gram.

Number of transactions processed was 108,000, up 28% and average transaction size remained in line at $41.67 in retail. From a revenue standpoint, total net revenues for the three month and nine month period were $6.6 million and $21.1 million respectively versus $1.2 million and $2.3 million for the three month and nine month period in the previous year, an of 432% and 821% respectively.

Sequential quarterly net revenues decreased 25% from $8.8 million for the three-month period ending June. In regards to revenue segmentation by segment, wholesale cannabis revenues were $2.2 million, down 23% from the previous quarter, while retail cannabis revenues offset that at by $4.3 million, up from $3.5 million in the previous quarter, an increase of 24%.

Business-to-business revenue was down significantly at $222,000 from $2.1 million in the previous quarter. We would point to significant year-over-year increases in net revenues as a positive indication that the company's initial quarters of sales into the recreational use cannabis market have enabled us to contribute significant revenue growth.

We attribute the decrease in quarterly revenue to decreases in revenue in our wholesale and business-to-business segments. In the wholesale segment, we have seen lower sell through rates in our provincial markets due to a slower than anticipated retail store roll out combined with a more competitive wholesale environment than in previous quarters.

In response to the challenging wholesale environment, we've taken a hard look at our value proposition for our products and undertaken several initiatives to ensure that our products are attracted to retail and end consumers, including pricing a analysis to ensure that our products are properly benchmarked versus our competition, decreasing our case back sizing to ensure our products are attractive to smaller retailers, working directly with retailers to provide in-store marketing support and signing additional provincial contracts to ensure that single market issues are not impacting our company's overall results. In our business-to-business segment, timing issues around revenue recognition lead to a decrease in revenue this quarter.

Although, we generally feel that this segment continues to grow for us, or as this segment continues to grow for us, we will see less quarter-over-quarter volatility from a revenue recognition standpoint. In this segment, we currently have over a dozen projects in various stages of delivery, construction, licensing and completion, and feel this will be a very complimentary business unit for us over the long term.

Retail cannabis sales continue their strong expansion with same store sales growth in excess of 20% for the quarter. We continue to see retail as a strong vertical for us in driving revenue and earnings growth into the future.

Cost of sales for the three month and nine month period were $4.6 million and $14.3 million versus $938,000 and $1.5 million for the previous year. We continue to anticipate that as production capacity increases over the balance of the year and into 2020, 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 costs and increased purchasing power for key inputs.

This should assist in driving gains in overall gross profitability over the balance of the year 2019 and into 2020. Gross profit before accounting for fair value adjustments for the three month and nine month period was $2 million and $6.8 million.

This is versus $312,000 and $756,000 for the previous year, an increase of 550% and 800% respectively. Sequential gross profit before accounting for fair value adjustments decreased 31% versus the previous period ended June.

Gross profit after accounting for fair value changes for the three month and nine month period was $3.4 million or 51% of overall revenue, and $11.1 million or 53% of overall revenue. Operating expenses for the three months and nine months period were $4 million and $13.8 million.

This is versus $3.7 million and $8.7 million for the previous year, a modest increase for the period respectively. Management would highlight the proportionate increases in overall operating expenses year-over-year have been offset by much larger increases in revenue and gross profitability, indicating that the company's business models are beginning to trend towards profitability.

Sequential operating expenses decreased by almost $600,000 from the previous period. This is the third consecutive quarter that management has been able to decrease sequential operating expenses, demonstrating the cost controls implemented by management continue to contribute to improvements in overall expenses.

The company's net loss from operations for the three months and nine months period were $625,000 and $2.6 million. This is versus $2 million and $6.3 million for the previous year.

We attribute the overall improvements to our loss from operations to increased wholesale and retail revenues and gross profits, combined with decreases in overall operating expenses over the past three quarters. The company's adjusted EBITDA loss for the three month and nine month period was $850,000 to $3.4 million.

This compares with $2.5 million and $5.7 million for the same period in the previous year. We highlight the generally improving adjusted EBITDA losses over the past three quarters as a very positive indication of the company’s performance and the performance of our operating businesses in the wake of legalization of recreational use of cannabis last year.

Having covered off the operational components and as we look forward to the balance of the year 2019 and into 2020, we continue to feel that the company is well positioned to continue to execute on our vertical integration and growth strategies. We see 2019 and 2020 as critical years for the company, which will lay the foundation for us to become a top 10 competitor in the Canadian Cannabis market and beyond.

And with that, we’ll close off the management commentary and turn the call back over to the operator for questions.

Just wanted to touch based on the difference between your production volumes and the volumes released for sale. Was this a factor of prudential demand or did you hold back on packaging anything?

I guess, that would be my first question and then I’ve got a couple of follow ups.

So on product release for sale, Kim, it's -- our Health Canada definition of products that have received approval from our assurance department to ship. In the case of end consumer packaged products, these are effectively processed, bottled, labeled and released for sale as quickly as possible.

In the case of any bulk shipments to other licensed producers, they may not be released for sale until the time of actual shipping. So in this case, we’re generally seeing less product release for sale than our overall production output.

Now with certain cases this would be simply that the products are working their way through both the 30 day process from harvest to the point where the products could be possibly released for sale. And in other cases, again, these are simply fitting in inventory pending delivery from a bulk sales, so a few different factors that go in there.

What we generally feel is positive in the numbers here that we are seeing generally high sell through rates from our grams sold as compared to our overall production on our grams released for sale. So as much as we did see a modest increase in inventories over the period, it's significantly lower than what we’re seeing from many of our competitors where sell through rates are generally lower.

So you would characterize this as a bit of a mix between timing and demand?

That’s correct.

I guess maybe just looking out to the fourth quarter. Can you provide any color on that relative to the third quarter, and how you’re seeing demand?

It sounds like that you’re making some changes and stimulate the demand. If there was any color that you could provide that would certainly be helpful.

We don’t provide specific guidance in terms of forward-looking revenue figures for our business segments. Apart from to say that generally those initiatives that we have implemented across our wholesale units in terms of decreasing, case back sizing, initiating direct outreach to retailers, et cetera, is being received positively.

We overall feel that this will improve our sell through rates into the provinces, as well as sell through to the end consumer in those provincial markets that we've entered. And to a certain extent over the last two quarters, we've been working through I'll call it the growing pains of expanding our network across Western Canada.

But generally we do see our wholesale component improving. Again, we can point to the miss in business-to-business revenue as being related to timing around revenue recognition.

Obviously, as these products or as these projects drive through the completion on any given project, there can be significant revenue recognition. So we generally feel that, again, as that business unit for us continues to expand, we will see less quarter-over-quarter volatility in that revenue.

And overall, retail continues to be strong for us and obviously, seeing significant same-store sales growth in the last quarter, as well as adding a fourth operating store towards the end of last quarter. And as we move through the holiday season here, we would expect strong revenues from that quarter as well.

But again beyond that, I don't know that we have anything in the way of formal guidance.

For the retail operations, you are seeing like seasonality being the key driver there? It was great results on the retail side.

Yes, I mean, generally, we did see an uptick across all of our stores for the third quarter. Again, we would anticipate that would continue to trend in for the here as we enter the holiday shopping season.

Although, you know what's -- unfortunately only one year under our belt here, we don't quite have enough data points to really point to the seasonality. I think as we get a little further down the road here in retail, we will be able to trend a little bit more appropriately as to seeing whether this fits with conventional retail or conventional liquor sales trending.

But overall, we were quite encouraged with the same-store sales grow and as well continue to see, I would say, strong sentiment from the end use consumer in wanting to come into the stores, purchase legal products that are produced through the legal framework, sold through the legal framework. As well generally, we are seeing a huge uptick in inbound inquiries from customers wanting to see access to the new legalization 2.0 products.

So I think encouraging to see that even in advance of those products hitting the stores late into this quarter and into early next quarter, there is strong demand that is beginning to be formed from the consumer.

And then may be one last question. Just on the excise tax, I noticed a substantial jump in that deduction off of revenues this quarter.

Do you have any color on that?

I'll just pass that question over to Jim, Kim.

Kim, we were offsetting the recoveries against the actual tax in prior period, and the audited loss to add that to revenue. So the net revenue still stays the same, but the increase has gone to sales and of course the offsetting increase to the sales tax, excise tax cost.

So this was something more audited driven versus like a change in anything business related?

Yes, that's correct.

If there are no further questions from those on the call, we thank you again for taking the time to join us this morning. And I look forward to providing another update in the following quarter.

Thank you very much.