Delta 9 Cannabis Inc.

Good morning, everyone, and welcome to the Delta 9 Cannabis Q1 2020 earnings call. At this time, all participants have been placed in listen-only mode.

Following the presentation, we will open the line for a 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 and public filings, which are available on SEDAR.

I would now like to turn the call over to Delta 9 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 Q1 2020 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 2020 financial statements, and management's discussion and analysis have now been made available on SEDAR and our company website.

And with that, let's begin. As we all know, the Canadian cannabis industry has encountered growing pains and challenges over the past several quarters in Canada's initial rollout of the legalized recreational use market.

Over the past 12 months, cannabis sector participants have experienced significant headwinds relating to missed revenue and earnings expectations, delays in retail store rollouts, bottlenecks at provincial crown distributors, and a general oversupply situation, which has worsened into the back half of 2019. More recently, the global escalation of the COVID-19 pandemic has created significant uncertainty for businesses across all sectors, and has created volatility in global capital markets.

To date, and as you'll see in the company's Q1 results, Delta 9 has been fortunate to have weathered this crisis better than most companies. We are extremely pleased today to be presenting very strong Q1 2020 financial and operating results, as we've expanded our core businesses and continued to execute on our growth plan.

These results demonstrate a significant year-over-year and quarter-over-quarter improvement for Delta 9. 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 changes which we're making to continue to drive growth and create shareholder value.

We'll begin with a discussion of operations and material milestones for the company over the reporting period. But firstly, and to address the elephant in the room, an overview of the impacts of COVID-19 on our operations.

On March 30, we announced publicly that we have implemented numerous precautionary health and safety measures across our operations to protect customers and employees while maintaining operations amid the COVID-19 pandemic. The company's management has been active in implementing measures to protect staff and stakeholders from exposure to the COVID-19 virus.

These measures include moving many head office functions to working from home, implementing flexible sick time, increasing sanitation procedures in retail stores and production facilities, encouraging proper hygiene and hand washing for staff members, providing personal protective wear for staff for both retail stores and production facilities, enforcing physical distancing practices, and many more. We continue to update these policies and procedures daily, and at the recommendation of federal and provincial health professionals.

Our company, as with many others, has encountered challenges with staffing in our retail and production operations, 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 any material disruption to our operations.

As has been reported in the media, we have generally seen an uptick in our retail business. Online and clicking collect sales have boomed, as people quarantine at home and see contactless shopping options.

Physical retail stores have been busier than ever, with increased foot traffic and increased cart sizes. Management is now actively exploring all federal and provincial support programs to determine if the company is eligible for any direct or indirect support.

We feel it is important to note that we would acknowledge that this crisis is far from over, and the company's businesses could be adversely affected by the effects of the ongoing crisis and economic fallout. However, we would reiterate that the company continues to make wholesale shipments to all of our provincial markets, our retail stores continue to operate, and we continue to provide consulting services, grow pods, and genetics to our B2B clients across the country.

Now into our operational overview. On the cannabis cultivation and processing side of the business, we will begin with an update of activities on our Delta 9 facilities in Winnipeg.

The primary purpose of these facilities is of course to cultivate, process, and manufacture high-quality cannabis products. The company's proprietary production methodology is based around our modular, scalable, and stackable production unit, which we call the grow pod.

And we believe that these growth pods provide numerous benefits versus traditional open warehouse and greenhouse cannabis production operations, namely, a high level of control over the growing environment, contributing to a higher quality cannabis product, the ability to customize the growing environment for each genetic strain of cannabis, maximizing the quality and output of these varieties. The growth plots are relatively inexpensive and provide an attractive return on invested capital.

The modular format minimizes the risk of contamination or spread of contamination from plant disease, and the modular format minimizes the risk of materially significant crop loss. On December 2, 2019, the company announced that we received approval from Health Canada for an additional 95 grow pods, bringing our total number of growth pods approved by Health Canada to 297.

In Q1 2020, our principal focus was on bringing these assets into full production. We anticipate that once the current licensed grow pods have begun to produce finished products on a recurring basis, that our facilities will have an annual product capacity of approximately 8,300 kilos per year.

On April 8, subsequent to the end of the reporting period, the company received approval from Health Canada for our purpose built processing center, which will allow for fully automated bottling, packaging, capping, and labeling functions for our consumer packaged dried cannabis products. We anticipate that once the processing center is operating at capacity, it will allow for processing of up to 25,000 kilos per year of dried cannabis flower material.

On April 13th this year, we announced that in light of the COVID-19 pandemic, we have paused our previously announced expansion plans and capital deployment for the remaining Phase 2 areas of our Delta 9 facilities. The expansion will continue once we have greater certainty regarding global capital markets, macroeconomic, and public health conditions.

We will of course continue to update the market on our expansion progress and licensing approvals as they are received from Health Canada. Now, 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 continues to demand over 70% market share by category in the Canadian marketplace, with much of the consumer demand in the high potency segment. Delta 9 currently produces approximately 30 different genetic strains of cannabis, each with its own unique chemical cannabinoid content, terpene, and flavonoid profiles, and with another 40 strains being stored on site in a seed bank to provide for product options into the future.

We believe that we have one of the largest in-house stocks of unique cannabis genetic strains among cannabis producers in Canada. We are continuing with our production pivot towards higher potency cannabis strains, which are the highest demand segments with the retail consumer.

Whole flower dried cannabis currently accounts for approximately 75% of the company's overall product offering by revenue. Cannabis pre-rolls became an increasingly important category in 2019, as consumers moved to smaller packaging sizes, and saw convenience in a pre-rolled setting, Delta 9 launched four cannabis pre-rolled products in June 2019.

And through the balance of the year 2019, we sold over 500,000 cannabis pre-rolls. The company's pre-rolled products currently account for approximately 15% of our overall product offering, with our Bliss and Twist pre-rolls making up two of our top selling products in Delta 9 retail stores in Q1 2020.

The company currently produces and sells a selection of blended cannabis products, which consist of several high-quality dried cannabis products blended together to produce a milled finished product. Our [Technical Difficulty] currently account for approximately 5% of our overall product offering by revenue.

In 2020, the company will begin introducing value priced blended products to compete with other low price cannabis flour in the 14 gram to 28 gram setting. On oils, extracts, and derivative products, on October 17 last year, Health Canada released updates to the cannabis regulations in the Cannabis Act, 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 market. Through our subsidiary, Delta 9 Bio-Tech, we are currently licensed by Health Canada to produce and 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 cannabis markets into the future. Our oil products currently account for approximately 10% of our overall product offer.

The company currently produces a line of dried sift cannabis products for the recreational cannabis market, which involves sifting the company's blended cannabis products and refining it, leaving more of the high potency resin glands and less low potency plant material. The final finished product is a yellow brownish powder and has a potency of up to double that of dried flower.

The company is currently deploying its Sapphire line of dried sift products for the recreational cannabis market, and we released these first products for sale in the first quarter of 2020. On the vape side of the market, the company is currently working with Westleaf through its subsidiary, Westleaf Labs, to develop a line of vaporized cannabis oil products, including a line of vaporizable oil cartridges and a line of disposable vape pens.

The products will be branded as Harmony, Cruise, and Blast, and will contain distilled cannabis oil and cannabis terpenes in varying concentrations. We plan to release our first vape products into the market in the near future.

In our retail stores, the company is currently 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 lines and formats are having a positive impact with the consumer, and we'll be able to pivot to capitalize on these product opportunities into the future.

And 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 recreational use cannabis products are expected to make up a large component of our overall revenue and business.

Our distribution strategy will be to enter a target market and to achieve market penetration, targeting market share, as consumers adopt Delta 9 branded products. The company has added new distribution markets incrementally, as our increased supply capacity has come online over the past 12 months to 18 months, in order to reach our ultimate goal of becoming a national distributor of recreational use cannabis products.

As the year 2019 progressed and supply capacity ramped up, the company added several additional supply agreements. We are currently licensed for distribution in Manitoba, Saskatchewan, Alberta, and British Columbia, and we are in active negotiations with other provinces to continue to expand our distribution capacity.

As the company increases its production capacity, we plan to add new distribution markets through either formal supply listings or formal supply agreements in those markets. On vertical integration and retail sales, we believe that there are a 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 in a marketing restricted environment, capturing additional revenues and gross margins from retail sales, and direct feedback from consumers regarding product trends and marketing strategies.

We intend to build out a network of dozens of Delta 9 cannabis store branded storefronts over the coming years in markets which allow for private retail sales. Over the past 12 months, Delta 9 has made significant progress in expanding our retail footprint.

We now operate four cannabis retail stores, which have produce significant retail revenues and growth over the past year. On September 19 last year, we announced that through our wholly owned subsidiary, Delta 9 Cannabis Store, we would enter into a binding agreement with Modern Leaf Group in Alberta to acquire the group's assets located in Alberta relating to two proposed cannabis retail stores.

We plan to close this transaction in the near future. Our plans from here are to open an additional 12 cannabis retail outlets in jurisdictions which allow for privatized retail sale over the next 24 months.

We are actively pursuing retail expansion opportunities in all Canadian provinces which allow for privatized cannabis sales. And we'll continue to expand on our vertical integration strategy into the retail segment.

On business to business opportunities, we derive a portion of our overall revenues from sales of cannabis genetics, sales of grow pods, and licensing and consulting activities provided to other licensed and pre-licensed cannabis companies. We believe that these opportunities provide us with a number of benefits, including a complimentary business vertical, which produces diversified and high-margin revenue, third Party validation of our proprietary growing platform, valuable partnerships with other pre-licensed and licensed companies, and the opportunity for international expansion and non-cannabis revenue streams.

We will continue to pursue and expand on these B2B revenue opportunities over the balance of 2020. Now, considering the financial results and turning to the balance sheet and financing activities during the quarter, the company ended the quarter with approximately $6.3 million in cash, an increase from $5.8 million as at the end of last year, and approximately $23.9 million in working capital, an increase from $22.8 million as at the end of last year.

Total assets at the end of the quarter totaled $72 million, up from $66 million as at the end of last year, resulting from an increase in current assets and right to use assets. Liabilities totaled $35 million, up from $31 million as at the end of last year, resulting in an increase from current borrowings and the offsetting right to use assets.

We believe that the company is currently positioned with a strong balance sheet and is well capitalized for continued growth. We would emphasize that, given the company has reached a position of operating profit, positive adjusted EBITDA, and positive cash flow from operations, the capital projects have reached substantial completion.

We believe that we are well capitalized with sufficient cash on hand for our ongoing operations. On key performance indicators, management provides quarterly updates on our progress on key performance factors for our businesses.

In the first quarter, the company produced approximately 1.2 million grams of dried cannabis, down slightly from approximately 1.3 million grams in the fourth quarter last year. We expect these production numbers will increase over the coming quarters, as the 95 grow pods from our December expansion approval are operationalized.

Production cost per gram and total cost per gram increased slightly to $0.98 and $1.10 respectively, versus $0.91 and $1.04 for the fourth quarter last year. We would highlight, however, that these production cost figures are quite competitive in the context of the current cannabis flower market.

Total grams sold in wholesale and medical markets rebounded significantly in the first quarter to 591,000 grams, versus 416,000 grams in the fourth quarter last year. This marks the company's strongest quarter for grams sold in the past five quarters, as well, the company's average selling price rebounded to $4.50 per gram versus $3.59 in the fourth quarter last year.

Both of these metrics highlight the company's progress in tackling the relative weakness in our wholesale figures over the last two quarters. This will continue to be a focus for us moving forward.

In our retail business, the number of grams sold and number of transactions increased significantly over the previous quarter, as we saw increased foot traffic and sales activity across our locations, as well as online. Average cart size increase as a result of larger average I'll call it COVID-19 related purchases, larger number of online purchases, which generally have larger cart sizes, and more consumers adding cannabis 2.0 products to their overall purchases.

Average selling price per gram trended down as new quote value products are introduced with selling prices between $6 and $8 a gram. Although, we should note that this figure includes gram equivalents for extracts and 2.0 products, which may obfuscate these figures versus previous reporting periods.

On revenue and revenue segmentation, total net revenues for the three-month period ending March 31, 2020 were $11.75 million, versus $5.63 million for the three-month period the year earlier, an increase of 109%. Sequential quarterly net revenue increased 11% from $10.59 million for the fourth quarter last year.

From a segmentation standpoint, revenue from wholesale cannabis sales was $2.99 million versus $1.45 million in the fourth quarter. Retail cannabis revenues were $5.85 million versus $5.05 million for the fourth quarter.

B2B revenues were $2.98 million versus $3.79 million in the fourth quarter last year. We would point to significant year-over-year increases in net revenue as a positive indication that the company's diversified revenue and growth strategy has been able to contribute significant growth.

We attribute the increase in sequential quarterly revenue to strong performance in our retail and B2B segments, and a general rebound in wholesale business volumes and wholesale average selling prices. We believe that, given the relative novelty and uncertainty of the global cannabis industry, the company's diversified revenue strategy and vertical integration strategy approaches will allow us to better react to market challenges than our competitors.

Gross profit before accounting for changes in the fair value of biological assets for the three-month period was $4.89 million, or 42% of revenues, versus $1.82 million or 32% of revenues for the same period a year earlier, an increase of 170%. Sequential gross profit before accounting changes increased 51% from $3.23 million for the same period ending December 31, 2019.

Gross profitability, again, before accounting adjustments, improved by 10% versus the same period the previous year, as we realized improvements in our wholesale and B2B profit margins. Gross profitability for our business segments was 64% for our wholesale cannabis business, 25% for our retail cannabis business, and 56% for our B2B business segment.

Our total weighted average gross profitability was 42%. Gross profit after accounting for changes in the fair value biological assets was $7.66 million versus $4.22 million for the same period a year earlier, an increase of 81%.

Sequential gross profit, again after accounting for accounting adjustments, increased 47% from $5.22 million for the same period ended December. Operating expenses for the three-month period ending March 31, 2020 were $4.76 million, or 40% of net revenue, versus $5.17 million, or 92% of net revenue for the same period the year earlier.

Operating expenses were generally in line with expenses for the sequential three-month period ending December 31 at $4.74 million, or 45% of net revenue. We would highlight the cost controls implemented in early 2019 have been largely successful in reining in costs, and have allowed the company to trend towards profitability, as revenues have grown and expenses have represented a much smaller percentage of overall net revenue.

The company's net income from operations for the three-month period ending March 31 was $2.9 million versus a loss from operations of $946,000 for the same period the year earlier. This also compares with net income from operations of $481,000 for the sequential period ending December 31.

We attribute the increase in net income from operations to a successful implementation of our diversified business plan and increased wholesale and retail cannabis revenues versus the sequential period. The company's adjusted EBITDA for the three-month period ending March 31 was $1.65 million versus an adjusted EBITDA loss of $1.98 million for the same period the year earlier.

This also compares with an EBITDA loss of $91,000 for the period ending December 31 last year. We would highlight the significant improvement in adjusted EBITDA versus the previous year in the sequential quarter as a very positive indication of performance of the company's operating businesses.

And we would highlight that this marks the first quarter of positive adjusted EBITDA in the company's history. The company's positive cash flow from operations for the three-month period ending March 31 was $1.54 million versus negative cash flow from operations of $7.23 million for the previous year.

This metric is perhaps the most positive highlight in today's statement. The company is reporting for the period earnings per share of $0.02 for the quarter.

And in closing, as we look forward to the rest of 2020, we feel that the company is well positioned to continue to execute on our vertical integration and growth strategy. We will continue to push forward to maximize the utility and efficiency of our existing assets, increase production output, and increase our ability to supply volumes of cannabis across all of our markets.

As our capacity increases, we will continue to add new markets to bring our high-quality products to consumers. We will add to our retail store and distribution capacity by adding new stores to our existing chain.

And we will continue to cultivate long-term and value-added relationships in our B2B segment as we deliver on grow pod projects across the country. There is little doubt that we will face challenges as a result of COVID-19 and the associated economic fallout.

However, we believe that through these types of tough environments, there is significant opportunity for strong operators like Delta 9 to emerge as a winner. We see 2020 as a critical year for the company, which will lay the foundation for Delta 9 to become a major competitor in the Canadian cannabis market.

Thank you everyone for taking the time to join our call this morning. And with that, I will turn the call back over to the operator for questions.

Thanks, guys and nice quarter. Just had some questions around the pricing and volumes on the wholesale side.

You mentioned that this is an area you're tackling but could you just provide a few more specifics on what's happening to drive those prices up and the volumes in the quarter?

Yes. So in terms of pricing, Kim, I think much of the rebound is really due to our product mix in terms of consumer-packaged versus bulk wholesale.

We saw a significant amount more of our revenue coming from consumer-packaged wholesale into our respective provincial markets than previously where more of our overall wholesale mix was coming in the bulk wholesale market. We are still encountering as I think much of the sector -- a very competitive market environment in the wholesale market.

There is still a -- call it a glut of cannabis flour in the market. However, and as we've discussed on previous calls, you know, the company has been taking a hard look at our value proposition ensuring that our products are priced competitively ensuring that we're seeing adequate sell-through of our products in these provincial markets.

And I think overall, we are starting to see that uptick that we've generally indicated would be coming in our overall wholesale volumes from a grams distributed basis as well as average selling price. So I think -- again, would point to the relative strength versus previous quarters in our wholesale businesses as overall positive.

Got you. And you -- are you able to share any, I guess, color on how the second quarter is looking; I guess in terms of pricing and volume relative to Q1?

I would say that pricing is relatively similar and as well volumes gets across our provincial markets, we've not necessarily seen a slowdown. Certain markets have indicated to us that certain numbers of retail stores have closed as a result of COVID-19, although at the same time indications on wholesale volumes moving through these provincial distributors has been relatively flat to the previous quarters.

So, we're not necessarily seeing a significant decrease in distribution across these provincial markets.

Got it. That's helpful.

Maybe just moving on to the capital in the quarter; can you provide a bit more detail on what that was related to? And I guess, how that looks throughout the year with the expansion plans put on hold?

Yes. So, the capital expenditures in the quarter I believe were about $2.4 million, really relating to the completion of the phase two facilities that were operationalized relating to our e-building, our Health Canada license facility.

Those expenses have been -- those capital projects have been largely completed to date. So, there may be some residual costs or some minor residual CapEx costs into Q2; however, these will be relatively minor.

And again, as we'd indicated, we have now paused on our capital expansion plan for the balance of our phase two facilities in light of the global uncertainty around COVID-19.

Got it. And if you don't mind, a couple of more questions?

Oh, please.

Or I can hop back in. Okay.

So, you've guided to some date products coming out in Q2 which would be great to see. Is that based on the assumption that Westleaf would receive it's sales amendment?

Yes. We are continuing to work with Westleaf, it's not necessarily a requirement that the company have it's sales amendments to initiate business-to-business transactions under the cannabis regulations.

Okay.

However, of course, we would want to be careful that we've conducted proper due diligence; so we are working through that right now with the Westleaf team. I know they are working or looking to the first production runs of these fake products over the relatively near future.

From there, you know, of course, there is a lot of work to be done in terms of commercializing those first products. But again, we would anticipate for -- would continue to guide that all of those projects are moving forward with the Westleaf Group.

Okay, great. And then maybe on the B2B side, in terms of the outlook, I think the results this quarter were good and passed our expectations.

But in terms of trending over, the next couple of quarters; do you have visibility on just kind of how that segment looks relative to Q1?

Yes. We had pointed to at the end of last year that we had a significant pipeline of these projects scheduled out over 2020.

We are -- as we said, continuing to make deliveries of grow pods across the country. Many of these projects were financed prior to COVID-19, so not necessarily seeing any major disruption in these projects moving ahead.

And at least across most provincial markets, construction projects have been deemed essential; so again, experiencing no restraints in terms of governments deeming these projects or closing down these projects, at least temporarily. I would though point to that -- of course, this is more of the infrastructure, the business investment-related side of our business; in any economic downturn, we would expect business investments to otherwise see a reflected decrease.

So, while we do have visibility on a good number of projects, deliveries, completions, etcetera over Q2 and some into Q3, beyond that, and pending the economic fallout of COVID-19, I think it could certainly have an impact on sales into the back half of the year.

Okay, that's super helpful. Last question.

Just on the retail ramp-up, you're still targeting -- I think it's 12 stores in 24 months. The Modern Leaf, I think you've guided towards this quarter closing.

How does that ramp-up look like?

Yes. So, the Modern Leaf transaction will take us to six operating stores.

We do have an additional store here in Winnipeg, Manitoba, which has been completed. There is pending licensing for a store opening.

Beyond that, our focus will be on organic store growth in Manitoba, and likely grow through acquisition into Alberta, Saskatchewan, as markets that allow for purely vertically-integrated growth. We are considering partnerships across Ontario and BC [ph], although those are markets which are necessarily restrictive around pure vertical integration.

So much of our focus will be on organic store growth here in the province of Manitoba; and then again, growth through acquisition across other markets which allow for it.

Okay, that's helpful. But that was all the questions I had.

I appreciate all your answers, guys.

Perfect. Thanks very much again.

Perfect. There being no further questions, I just want to thank everyone for joining us again for our earnings call this morning.

Oh, do we have one further question in the queue?

I'm just going to [indiscernible] my question. I just wanted to ask about liquidity and where you see it going forward.

You have some convertible bonds due in a couple years and some bank borrowings, what if you could talk about liquidity? And if you see any opportunity to buyback some convertible since their trading associate just got the part [ph]?

Thanks.

Yes, no, good questions. So, I mean, as we pointed to company increase it's overall cash position, good amount of working capital on the balance sheet as of the end of the quarter.

We'd reiterate that we feel that the company's liquidity position is quite strong, particularly relative to the company's positive earnings and positive cash flow from operations and having reached that inflection point. In terms of the forward outlook, our convertible debentures, which are sitting at $11.8 million face value, I believe are matured at June…

July 2022.

Thank you. So, still a good amount of runway before we see the maturity on those debentures.

From our standpoint, I think those debentures are trading at $0.60 on a dollar; currently, if there were an opportunity to utilize excess cash to be refinancing that at a discount, I think would be an attractive proposition for the company. Although of course, you would see an announcement on that formally before the company is looking to engage in those types of activities and would likely necessitate additional bank borrowings.

As a result, I think really our focus right now is ensuring that there is adequate cash-on-hand, access to cash through our existing credit facilities to fund operations in light of the uncertain environment. But the company is certainly willing to act opportunistically where we're seeing discount to market valuations of our convertible debentures in the market.

Great. Thank you.

And if that is the final question, I will again, thank everyone for joining us this morning for the call. If there are any further questions or otherwise, we look forward to investors and analysts reaching out to us directly.

Thank you.