Alcanna Inc.

Matthew Rudd - SVP & CFO

Kyle McPhee - Cormark Sabahat Khan - RBC Capital Markets George Doumet - Scotiabank John Zamparo - CIBC Robert Gibson - PI Financial Tal Woolley - Eight Capital

Thank you, Elliot, and good morning to those on the line. Thanks very much for joining us today.

I'm here this morning with David Gordey, he's our Chief Operating Officer and Executive Vice President for Canada. We've assumed that you've all read our news release, so we'll keep our prepared remarks fairly brief.

And after our comments, we'll be available for any questions you have. Within the news release, you would have seen that the new President and Chief Executive Officer, Ken Barbet, along with Richard Perkins will take on the role of Executive Vice President of the business transformation.

Both joined the Company effective, yesterday. Both of these gentlemen bring significant experience in the retail alcohol industry to be able to execute the new vision and strategy for the Company.

The MD&A provided a high-level overview of the broad areas of focus, and we'll be in a position to provide more detailed updates on the specifics of the implementation and the results of this strategy in due course. Now when we look back on the second quarter, the Company's sales and profit decline continued.

Our same-store sales in Canada were down 3.9% in the second quarter compared to the same time last year. Both the Alberta and BC markets had unfavorable weather in the first half of the quarter and Alberta continued to be impacted by the economic slowdown as well as pressure from competition in the province.

In the U.S., same-store sales were down 4.5% in the second quarter compared to the same quarter last year. The economy in Alaska has not improved, and competition is also continuing to intensify in Kentucky as well as New Jersey.

Those are markets where we've seen new entrants and expansion of some of the standalone liquor stores from grocery competitors continue as well, that put some pressure on our same-store sales in both of those markets. Our gross margin percentage in the quarter increased to 26.1%, that's compared with 25.1% in the second quarter of last year.

A big part of the reason for this increase was a lower mix of beer sales, which attract a lower gross margin percentage than our other categories, and that was mainly due to the poor weather we had in Canada. Our operating profit declined due to several factors in the quarter.

First, the minimum wage increase in Alberta and BC has just caused inflationary increases to our in-store labor cost, which we've attempted to manage and offset by carefully managing our hours, but it still had an impact. Secondly, we had incremental marketing cost in the quarter.

This was in an effort to drive traffic to our stores, once we saw the weather improve as the quarter came to a close. We also incurred some additional marketing support relaunch of several of our stores we renovated in the quarter.

We also had Easter shift into the second quarter from the first quarter last year, which added some marketing costs. And we also made a decision to rebrand our store in Connecticut, from LQR MKT to Wine and Beyond, is the new brand and had costs incurred to relaunch that brand.

Lastly, within the quarter, we had a large nonrecurring loss recognized on the remaining lease term of an unopened store location we have in Berlin, Massachusetts. This is a lease we signed in 2015 with a 10-year lease term and subsequent analysis we had performed, determined that this location wouldn't generate significant enough return on capital to warrant opening the location, and so the decision was made to not open the space.

Efforts to date to sublease the space have been unsuccessful, so we recognized a loss this quarter for $4.2 million, for effectively the remaining lease term and that was all taken in the second quarter. The other nonrecurring expense we had impacting our operating profits was $1.4 million of costs that was incurred to contest the dissonant proxy raised for the Annual General Meeting in June.

That dissonant proxy was ultimately successful and this is what has resulted in the new strategic plan that we've highlighted in the MD&A. So operating profit before amortization was $5.3 million in the second quarter, that's a decline of $7.1 million compared to the same quarter last year.

When we adjust for the unfavorable lease for the Berlin, Massachusetts location and the incremental cost for the contested AGM, our adjusted operating profit before amortization was $10.9 million, and that's $1.5 million lower than the same quarter last year. In the second quarter, we incurred a net loss of $1.4 million or $0.07 loss per common share.

On an adjusted basis, excluding those 2 large nonrecurring items, along with $1.2 million of noncash finance cost we had recognized on the early redemption of our old 5.85% subordinated debentures. It normalized to $3.7 million for the quarter or $0.11 per common share.

So with that summary, I'll refer you to our news release and MD&A for further details on our second quarter financial and operating performance. And now hand the call back over to Elliot to start our Q&A period.

I see in your MD&A filings here, you've made cost cuts a big priority at the corporate and store level. Can you kind of detail some of those changes, maybe quantify total targets and maybe point out the big moving parts?

At this point, anything's forward-looking. I think we're not in a position to give much guidance at this point.

What I will tell you is that effectively with the change in leadership and at the board level, it's a situation where line by line, item by item, every element of where we spend our money is going to be critically analyzed and determined if it's something we need going forward or if it's something we can look at to further improve our operating margin as well as our cost profile. Where we've attacked so far, we've looked at head office spend and really tried to go down the path of operating a bit more efficiently at the head office by automating a lot of things, streamlining some processes.

And you can see that that's allowed us to realize some savings as the year has progressed, but I think it's safe to say that our new leadership team is looking for more.

Okay. And then on the -- can you maybe expand on the inventory initiatives, beyond rollout of the ERP, which sounds like it's more of a 2018 heavy-type stuff.

What's going to change? Are you still looking at ending the use of the warehouse on the bridge-buying and kind of fully moving to just in time?

Or is there anything you can offer on that?

Little too early to comment on that. It's -- it'll act on my previous comments on the operating expenses and this is something that would be carefully and critically analyzed.

A lot of time would be spent in the stores looking at -- even down to the layout and stat of the stores. Is there a different way we can configure our store layout to give us some inventory reductions, all the way through to the procurement process.

I mean, these are things that would be carefully studied and looked at for ways to further decrease our inventory in a more meaningful way. Where we've really attacked so far is just arming our stores with better data to make better buying decisions, and that's caused us to move the needle a little bit.

But, like with operating costs, a lot more work to do in inventory reduction.

So just on the U.S. side, you called out the competition in Kentucky, and can you maybe comment on are there still more counties that are going wet from dry, whereabout do you think that is in the cycle?

Like, are you beginning to lap some of those tougher comps? And is there any strategies that you are putting into place to maybe try to combat this competition from some larger players?

Yes. On the wet and dry issue, we're not comping a lot of those until we get into fourth quarter.

We haven't become aware of any additional counties so far this year that have moved from dry to wet. There's been a big movement over the last several years and several counties have moved.

That said, there still are some that remain dry, but really no indication at this point in terms of which ones are leaning even directionally. So that one is a bit of a wait and see, but I think more broadly, knowing that that's an issue that remains as well as competition in that market, I mean that's an issue that will remain and continue to be prevalent, and won't necessarily go away.

I think the focus of -- with the new leadership team onboard, is to develop more effective strategies dealing with this competition, really carefully analyzing that situation and really taking a fairly comprehensive look at our strategy in the U.S. So I think, stay tuned for further updates there.

And then just maybe an update on the private and exclusive label program, where it is as a percentage of sales? Even if you can share for the wines category.

And how much that may have contributed to the gross margin improvement?

Yes, go ahead, David.

So Sabahat, good to hear from you again. The program is continuing to increase our penetration in each one of the categories.

And at least, as we've talked about in the past, we've started to really introduce private labels into the spirits category now. And so we've seen good increases across wine and spirits.

But where we are with the program is where we are at with inventory and cost reduction, which is we're going to take a pause here and take a real hard look at the program and figure out how can we make more money out of it. We've made good progress to this point in time and now the question is how to get more juice out of that lemon.

And then just one last one for me. On the minimum wage, is there -- do you guys have an estimate on maybe how much of a drag it could be for the rest of the year as it kind of rolls out?

Or is that something you're just keeping an eye on and trying to offset in other areas?

Well, it certainly won't help our cost profile, but it's tough to quantify because we're giving a hard look at just how our stores operate and you're going to have the headwinds of your cost of labor going up, but are there strategies we can put in place to further streamline and operate a bit more efficiently at store level. So without having the answer on how much more efficient we can be with usage of our hours, difficult to quantify.

Our goal is to offset and mitigate that increase by finding efficiencies, but I think a little bit too early to guide on that one.

When you look at from October to the end of October this year to five years ago, minimum wage in developments at Alberta has increased by 30%, Sabahat. That's a significant increase, and we haven't been able to see the inflation in retail prices to the same extent.

And over the last couple of years we've done a lot of work to mitigate that, and we'll continue to do that.

I have to focus a little bit on the same-store sales growth in Canada. It looks like on a normalized basis were relatively flat sequentially.

I think some of the commentary in the MD&A suggests that the resource market is somewhat recovering. So just wondering if we're seeing any deterioration in Edmonton or Calgary?

And how do you guys anticipate the recovery in general, when it comes to the urban centers?

Well, George, you're right. I mean, in not all of resource markets did we see a recovery.

Grande Prairie, certainly was performing better as we've highlighted in our MD&A. But you have markets like Fort McMurray that have been kind of sluggish, although that's a lot of noise in that comp year-over-year because they were closed for a month during the forest fires, and now have a big influx once that market reopened and got back opened for business, that it's going to be a bit noisy and tough to tell exactly where we stand in a market like Fort McMurray, which is a big market for us as well.

Within Edmonton, I'll turn it over to David as well, he can offer his insight. But I can't point to anything I saw significantly moving the needle upwards into the quarter.

But again, we had a lot of noise within the quarter, with some poor weather we were dealing with. So again, very difficult to assess exactly where we are.

And on forward-looking matters, I mean, I'll leave that to the economists. I mean, we're probably reading the same economic reports.

And for the first time in a while, we're starting to see a bit more optimism in this forecasts, but I think we need to treat them as what they are, forecasts.

And George, I think if and when we see a recovery, where we will feel like ease in the resource markets first. The activity in the field and the oil patch will pick up out there, which will translate into better sales for us out there.

And then hopefully, it cascades down the province from north to south, it's kind of how it goes. Calgary is generally the last place that the oil companies will start investing, they won't invest in head office until things are really rocking out there.

So generally, the history has been north to south improvement over time.

Great. That's helpful.

And maybe just a bit of a follow-up question here. I think the expectations in the past was to try to pass through some of those increases in minimum wage.

It looks like it has been tough to date. What are you guys looking at and when should we start to see a clear path towards doing a little bit more of that?

So it was noted on, back in Sabahat's question, is we would absolutely love to pass on a number of the increases in minimum wage we're seeing through our retail pricing. However, there has been a big ceiling put on retail pricing by our competition as the discounters in the province of Alberta have become more prevalent in the market.

They're keeping retail pricing down and so for us all being competitive, we're having to stay in line. We've tried a few times over the last 12 months to take a leadership position in the industry and move pricing up, but no one seems to follow yet.

And I think the reason why is those discounters are just operating on a different cost model than us. We're very much an entry-level wage type organization, and they're much more of a owner-managed operation where minimum wage really doesn't impact them as much.

So those are some of the challenges we're dealing with, and we'll continue to fight through for the next few months.

And just shifting gears towards the other gross margin. You guys alluded to earlier on, obviously, there's some gains in private label, but there is also a favorable mix shift, I think on the beer side of things.

Do we expect that to reverse in the coming quarters? Just trying to get a sense of how much of that significant move in gross margins year-over-year is expected to remain as we cycle through the rest of the year?

Yes. It's difficult to say, not knowing exactly what the specifics of our go-forward strategy are going to be, but that certainly will be mindful of maintaining profitability and that includes gross margin.

I think we're pretty careful in our MD&A to make it clear that the 100 basis point improvement we saw in the second quarter, we couldn't, as a management team, take all the credit for that. We were helped, if you want to use that word, by a shift in the mix away from beer which helped pop the gross margin rate.

And if you look back to first quarter, we were kind of in that 20 basis point range as an increase and that largely falling out of private label penetration increasing as well as some things we were doing to limit the depth of our discount in a store level. I think those are things you can anticipate, continuing, and we'll guide if it's going to be something different.

But in terms of the 100 basis point increase, we wanted to make that pretty clear that, that was somewhat driven by external factors as opposed to things we were doing as a management team, so I wouldn't necessarily forecast that to continue. Although, maximizing gross margin has been a strategy of ours.

And just one last one, if I may, on more of a housekeeping side of things, but can you maybe quantify dollar value for the higher selling and distribution expenses, I guess, more strictly related to the higher marketing spend for the Easter shift this quarter?

Yes. So within the document, we haven't given those specifics, and nor are we overly excited about sharing detailed marketing tactics and strategies.

But what I can tell you, is that we did see an increase and it was a decently sized increase, enough for us to talk about within the MD&A. But yes, not overly comfortable giving specifics on the dollars we spend on marketing for Easter.

I want to get to the change in the Edmonton market regulation. I thought that occurred in Q1, I could be wrong.

But if that was the case, what -- kind of what changed during the quarter that made you figure where it's worth calling out?

Yes, this is an impact we actually haven't yet directly seen an impact yet. I mean, the regulation's changed and it didn't create a situation in Edmonton, where we've gone to the wild west where you can put a liquor store wherever you want.

It's a fairly limited area of Edmonton where the rule hasn't gone away, it's just simply giving you the window to apply for exemptions and put Liquor Stores within 500 meters of one another, but as long as it's in a separate site, a separate retail development. So our initial look at it is, we thought there were opportunities for us to both win and loose and some of the exposure we had we looked at and felt there were ways to button that up, that's still how we're feeling.

But I think it's a case of just seeing competition from the discounters, rather than their foot being taken off the gas, as we've maybe started to see some modest economic improvements in Alberta. We've actually seen quite the opposite, where they're as aggressive as ever.

And so I think it's a combination of just seeing discounters become more aggressive, certainly signaling that they're not going to stop opening new stores. We can't fight the battle and button up every single site out there, so it'll have an impact.

It's something that we believe we have strategies in place to mitigate, and it's a focus of the new board and leadership team, obviously, to see are there more impactful strategies we can put in place and help us deal with the proliferation, frankly, of discount operators here in Alberta. So really a combination of all those things, John.

Okay. That's helpful.

Sticking with competition maybe in the U.S. Same-store sales decline seem to have peaked in Q4 last year, but would you say that we've seen the worst of this?

Or would you characterize the level of competition to be accelerating at this point?

So through this year so far, it's been relatively stable, but by stable, I mean, it's significant levels of competition. We just haven't seen an increase so far this year, but to me, when I look at that market at least, I don't necessarily see the subsiding anytime soon.

I think competition will continue coming, and for us to presume otherwise I think would be unwise. So again, I think I made the comment earlier that the U.S.

is an area of focus for our new leadership and board. To presume that competition at this level of intensity will continue, and if it does, what do we do as a company to mitigate and manage that, that will be a focus.

Okay. Moving back to the gross margin rates, you called those lower beer sales, but is any of that improvement attributable to the Always on Sale program?

We would have seen improvement there consistent with the first quarter, that's a strategy we've kept up with in the second quarter. And it has given David and his team one more tools in their toolkit to help better protect gross margin, better manage gross margin, and I think they continued to make hay with that program in the second quarter.

And last one for me, any update you can give us on the province's view on recreational cannabis? Any reason to be less or more optimistic on that front versus the last time we spoke?

Haven't heard anything from them publicly. I believe they just -- the province of Alberta just concluded a survey and study that kind of concluded at the end of the month, and we'd expect, in the short term here, the results where they effectively surveyed the province and getting the province's view on their constituents and how they would prefer to see this rollout in Alberta.

So we have not heard on that and so at this point, really nothing new to share on that front, John. We're going to wait and see just like everyone else.

And see if this will present an opportunity for us as a company, that makes sense.

You said you're looking at the Saskatchewan facility and return on invested capital. If you decide not to go ahead, is that something that could be sold or what could you do with that option?

It's not a situation where we can likely sell the license, if we decide not to go, effectively, the license will just simply not be issued to us. It's a license that we do not have, it's conditional upon us, successfully building and opening a site.

And at that point the province would award us the license, so effectively it just becomes a license we don't receive.

Okay, great. And going back to the gross margin, you saw a pickup in wine versus beer.

Do you think that's a trend that's happening in the province? Or maybe some color would be appreciated?

Yes, I think it's the trends that we've been seeing over the last 1 to 2 years are where we're headed. I don't want to read too much into what happened in Q2.

It was really a big weather shift there. So I won't read too much into the Q2 results.

Okay, good. And lastly, you said you might use increased credit availability for some of the strategic initiatives.

Can you just remind me of what sort of capacity you have there?

Well, I would say that most of the strategic initiatives we're looking at, when it relates to recurring capital expenses, our intent would be to fund those through inventory reduction. I think when we look at our leverage today, it's likely as high as we want to have it.

But again, I don't want to speak for our new board at this point, but to me when I look at it as the CFO, it's a situation where I wouldn't be much more comfortable taking on anymore leverage than we have half today. So I think our goal broadly is to find a way to execute this new strategy and plan and throughout it, not see our levels of leverage increase.

Just wanted to talk about an area where both the incoming management team and the existing management team agreed and that was inventory reductions. You were down, I think, about 10% year-over-year.

How -- I think you were targeting close -- something like 20 to 25 yourselves. Like, how far along are you in this process?

I know you've been running some authorizations to get that going. So how far along are you on your own -- on your existing plan?

Well, still early stages. I mean, it was -- so we've had some success so far and the exciting thing is I think we're just scratching the surface here.

I mean, it was a case of putting in just some very basic tools and processes to get us some easy wins and some quick wins right off the bat. But even through those very basic process changes and tools, we've been able to realize some savings, which is really encouraging when you think about things like a new ERP and new business processes coming into really kick that into the next level.

But even in advance of the ERP coming in, we're still targeting significant inventory reductions. I think it's still too early -- early days here to really put financial parameters around that at this point.

But it's something that us as a company will continue to attack aggressively here. And I think, even with the change in leadership and change in board, this is something that we'll attack with an even higher level of urgency and really sink our teeth into it and start to make some movement there rapidly.

Okay. And then just lastly, I just want to make sure definitionally I'm understanding who you're talking about exactly, but when you refer to the discounters in the market.

Are you talking specifically about independents and those who like -- or are you referring to like anyone who will sort of play like a high-low game? Because like, you can see that in the grocers, you can see that elsewhere.

And so I'm just trying to understand exactly who you were referring to when you say that?

Yes, and so when we talk discounters, that's not necessarily just your small independent one or two store chains, where we've seen them take their pricing down too. What you're starting to see are chains that run effectively and every day discount price, in addition to running promotional pricing at or around cost as well.

So they're competitors where you really don't get much of a reprieve, even when they're on their every day price. They're always running that discount profile, and we would suspect a materially lower gross margin percentage than us.

Okay. Applying a point on it.

The grocers have not really changed their pricing model significantly, it's the others in the province that have.

Okay. Well, thanks, everyone, for joining us today.

I appreciate everyone attending, and we look forward to speaking again at the end of the third quarter.