Auxly Cannabis Group Inc. (XLY) Earnings Call Transcript & Summary

Good morning, ladies and gentlemen. My name is Michelle, and I will be your conference operator today. At this time, I would like to welcome everyone to the Auxly Cannabis Group Q4 and Full Year 2022 Earnings Results Call. [Operator Instructions] Thank you. Mr. Schmitt, you may begin your conference.

Thank you, operator, and good morning, everyone. Thank you for joining us for Auxly Cannabis Group's Fourth Quarter and Full Year 2022 Financial Results Conference Call. My name is Brian Schmitt, CFO of Auxly Cannabis Group, and joining me today is Hugo Alves, CEO. A replay of this conference will be archived in the Investor Relations section of Auxly website. I encourage you to follow along with the presentation slides, which are posted on our website in the Investor section on the presentation. Before I turn the call over to Hugo, I would like to remind everyone that our discussion today involves forward-looking statements that are based on assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from the views expressed today. Management can give no assertion that any forward-looking statement will prove to be correct. Forward-looking statements during this call speak only to the original date of this call, and we undertake no obligation to update or revise any of these statements except as required by applicable law. Management refers you to the cautionary statement and risk factors included in Auxly's disclosures. I note that all references on this call are to Canadian dollars unless otherwise stated. And with that, I'll turn it over to Hugo to commence the presentation.

Thanks, Brian, and good morning, everyone, and welcome to our fourth quarter and full year 2022 earnings call. I'll start the presentation on Slide 5. 2022 was a challenging year for the cannabis industry. Increasing competition, fragmentation and an oversupply of cannabis continue to create pressure on pricing, and this is exacerbated by global economic headwinds, punitive taxation and unreasonably restrictive regulations, which continue to help prop up a strong illicit market. Auxly was certainly not immune from the impacts of these dynamics, but despite those challenges, we are happy to report that 2022 was a strong year of growth and progress for Auxly. We were the fifth largest LP over the course of 2022 and also maintained our #1 position in the 2.0 product segment for a third year in a row. And importantly, in order to better position Auxly within the current market realities, we evolved our strategy at the end of the third quarter by streamlining our portfolio to focus on consumer favorites and the largest product categories of dried flower, pre-rolls and vapes, enhancing our capabilities and automation at our Leamington facility to deepen and further leverage our high-quality, low-cost cultivation and manufacturing advantage, reducing costs throughout the organization and internalizing our sales team to focus exclusively on Auxly products, improve relationships with retailers and increased distribution. Turning to Slide 6. Dried flower, pre-rolls and vapor products account for approximately 85% of all industry sales and represent the largest opportunities for Auxly. We are leaders in the vapor market. Auxly finished 2022 as the #1 vapor company on a full year basis, the third consecutive year that we have managed to achieve that standing. We have 3 strong and differentiated vapor brands at different price points with all 3 brands being in the top 10 vape brands nationally. And thanks to the success of all 3 brands, our products are broadly distributed nationally, and we have refocused on vapor innovation and are happy to report that our new Ice Series Vapes under Back Forty and our blunt-flavored vapes under Kolab have enjoyed broad consumer success since launch. And since acquiring sole ownership of our Leamington cultivation facility at the end of 2021, we have started to lean into dried flower and pre-rolled products and are making excellent progress in establishing our brands within those product segments. We feel that we have natural competitive advantages in both formats. We have made incredible strides in product quality and operational efficiency at Auxly Leamington and believe it is now one of the lowest cost producers of high-quality cannabis in the country. And we have made significant investments in pre-roll and manufacturing and packaging R&D and automation to develop what we believe is a best-in-class product in terms of quality, consistency and price. In 2023, we'll continue to participate selectively in other product categories, but our organizational focus and resources will be largely dedicated to our dried flower, pre-roll and vapor products. Moving to Slide 7. We continue to be committed to building lasting brands that resonate with consumers, and we will continue to make investments in insights, innovation and brand development so that we can ensure we are helping our consumers live happier lives by consistently delivering phenomenal products at a great price under brands that they can trust. We have a well-rounded brand portfolio which addresses various consumer segments, product formats and price points. Back Forty continues to be our largest and strongest brand. Consumers continue to love the brand's value proposition of simple, high-quality cannabis products at a great everyday price. Back Forty products are widely distributed, being found in over 90% of retail locations in Canada. And as a result, Back Forty has consistently been a top 5 brand nationally by revenue over the past 12 months. In the back half of 2022, we added a fifth brand to our portfolio, Parcel, to compete in the fast-growing ultra-value pricing tier. We have seen the ultra-value price tier grow rapidly in 2022 as consumers look for increased value for money in the face of economic uncertainties. Approximately 1/3 of dried flower volumes are now transacting at the ultra-value price segment. And Auxly Leamington's high-quality, low-cost advantage allows us to offer consumers high-quality single-strain flower at ultra-value pricing while maintaining profitable margins. And we are delighted with the early performance of Parcel products, and we will work hard to increase the breadth of Parcel's portfolio and distribution over the course of 2023. Turning to Slide 8. As consumer preferences continue to evolve, innovation in new products continue to drive both customer and consumer purchasing behavior. Over the back half of 2022, we successfully launched 30 exciting new SKUs to market across all product categories. In 2023, we'll continue to innovate to meet the evolving needs of our consumers, but we will focus intently on dried flower, pre-roll and vape product formats. We will look to increase the breadth of our product portfolio in those key categories to set the stage for continued growth and further leverage the competitive advantages that we believe Auxly has in those 3 product categories, as outlined earlier in the call. In Q1 of 2023, we've already increased our SKU count in those 3 product categories by 30% on a blended basis, and we'll continue to seek additional listings for exciting new flower, pre-roll and vape products throughout 2023 and leverage our new internal sales team to build retailer excitement and distribution for those products. Turning to Slide 9. Auxly Leamington is one of the premier cannabis cultivation facilities in the world. There are very few competitors that can match our mix of high-quality and low-cost, and we plan to leverage this advantage to continue building to leadership in dried flower and pre-roll segments and improve our overall gross profit margin. Through continuous improvements in cultivation strategies and genetic selection, we have seen overall product quality and potency increase over the course of 2022 and, importantly, we have seen those improvements translate into increased sales in market. As already mentioned, we've increased our focus on flower innovation and have a portfolio of commercially ready strains for launch over the course of 2023. Turning to Slide 10. We've also made significant advancements in enhancing our automated manufacturing capabilities. We successfully installed and commissioned our second pre-roll filling machine at our Leamington facility, doubling our filling capacity. We have been working with these machines for a couple of years now and have developed what we believe are best-in-class operators and know-how, and we are seeing the results of that gained experience and the increased quality and consistency of our pre-rolled products. We have also been working collaboratively with one of the world's largest tobacco equipment manufacturers to develop a much larger first-of-its-kind filling machine which will again materially increase product throughput and efficiency and make us one of the largest manufacturers of cannabis pre-rolls in the world. We have completed factory acceptance testing of this machine. It is in transit, and we look forward to taking delivery and having it commissioned in the back half of 2023. Our automated pre-roll packaging equipment is also now operational at our Leamington facility and producing units. We continue to work with the equipment manufacturer to increase speeds to specification, and we expect to see continued increases in production of pre-rolls in Q1 2023 and beyond. I'll stop here and now turn over the presentation to our CFO, Brian Schmitt, to walk you through the financial results. Brian, over to you.

Thank you, Hugo. If I can get everyone to turn to Slide 11 for a quick snapshot of our revenues and product sales mix. Starting on the left side of the page, revenue was $24.7 million in the fourth quarter of '22, approximately $4.6 million lower than the same period of '21, however, $4.9 million higher than the third quarter of 2022, which helped the company achieve a milestone by becoming the top licensed producer in the sale of Cannabis 2.0 products for the third consecutive year. In addition, Auxly broadened its distribution of dried flower and pre-roll products, commenced limited B2B sales while transitioning to a tighter product portfolio focusing on dried flower, pre-rolls and vapes. On the right side of the page, Auxly reported net revenues of $94.5 million as compared to $83.8 million during the same period in 2021, an increase of 13% which was slightly below industry increases of 18% primarily as a result of declining vape sales throughout the first 3 quarters of the year. During the year, Auxly's share of market declined to seventh position during the third quarter, in part due to lower sales and industry consolidation, but has since improved to #6 during the fourth quarter with further strength in Q1 of 2023 to #5 per headset data. Our strategy to shift category sales to be in line with the overall industry by leveraging Auxly Leamington's advantages is starting to pay off. During the course of the year, the percentage of flower and pre-roll sales increased from 30% to 42%, an improvement of approximately 40%. Lastly, our revenue distribution with our 3 primary customers, British Columbia, Alberta and Ontario, remain consistent at approximately 85%. The next slide captures several key financial metrics for the company. Beginning on the left side of the page, gross profit margin of 3% for the quarter was lower than the fourth quarter of 2021 due to impairments of inventory, which were slightly lower than 2021 and by the noncash unrealized fair value gains on biological assets and realized fair value losses on inventory, which amounted to a net loss of $4.6 million in 2022 versus a $0.5 million gain in 2021. For the year, gross margin was 17%, which was a result of changes in biological and inventory impairments, which were impacted by the first quarter charges related to the closure of Auxly Annapolis facilities. The graph below includes the impact of depreciation, however, excludes all other noncash and fair value adjustments. And it shows much stronger margins of 30% during the fourth quarter of 2022 versus 20% in the prior year. Costs of finished cannabis inventory sold margin also improved during the year at 23% in the first quarter and ending at 30%, resulting in a full year blended margin of 26% versus 25% in 2021. These improvements were achieved as a result of the company utilizing low-cost cannabis from our Auxly Leamington facility and streamlining of Cannabis 2.0 SKUs in operating costs. The middle section of the slide shows progress in the reduction of SG&A to $9.5 million during the fourth quarter, down from $12.7 million the year before with reductions in several categories, including wages and salaries of $1.8 million resulting from the streamlining of operations and supporting staff as we focused our product portfolio. For the year, SG&A increased by $2.3 million to $46.6 million. The inclusion of Auxly Leamington for an additional 11 months in 2022 as compared to 2021 was partially offset by reductions from the closure of the Auxly Annapolis facilities and cost savings implemented in the fourth quarter of this year. Adjusted EBITDA losses were below $1 million in the fourth quarter of 2022. This represented the company's best performance to date and was approximately $5.3 million better than Q4 of 2021 and $5 million better than the previous quarter. These improvements were driven by stronger margins on cost of finished cannabis inventory sold and lower SG&A. The full year impact of $4.8 million -- the full year improvement, sorry, of $4.8 million to negative $16.9 million was primarily a result of the fourth quarter improvements. Net losses for the fourth quarter were $16.1 million, improving by $2.3 million, primarily as a result of lower gross profit, income tax recoveries and lower total expenses. As adjusted EBITDA improved to within $1 million of breakeven, substantially all of the fourth quarter net losses were noncash, inclusive of interest expense where approximately 2/3 of the total expense is due to accretion on the company's convertible debentures. For the year, net losses were $130.3 million, an increase of $96.6 million, which stems from gains of $20.3 million in 2021 and losses of $45 million in the third quarter of 2022 related to the impairment of goodwill and other assets and $25.7 million in losses related to the closure of the Auxly Annapolis facilities. Despite the increase in net losses, cash used in operating activities improved significantly. During the fourth quarter of last year, cash used in operations was $13.3 million as compared to cash provided by operations of $5.8 million this most recent quarter, a net improvement of $19.1 million. For the year, cash used in operations declined to just $2.5 million as compared to $49.8 million used in 2021. And this was primarily accomplished through working capital management and improving operating results. Lastly, the fourth quarter was a very positive quarter for the company, and we are seeing further sales momentum in the first quarter as indicated by headset data. We recognize that we operate in a dynamic industry with unique challenges. However, we are focused financially on what we believe to be a balanced approach to revenues, margins and SG&A and look forward to building upon the success of Q4 into 2023. With that, I'll turn it over to Hugo for concluding remarks.

Thank you, Brian. Turning to Slide 13. As I mentioned at the start of this presentation, we operate in a highly dynamic and challenging market. In order to best position Auxly within that reality, we are entering 2023 with improved earnings performance, increased focus on key product formats, lower cost and increased efficiency which we expect will yield positive results. And with those actions in mind, our overall overarching goal for 2023 is to achieve sustainable profitability by increasing our net revenue by 15% through our focus on key product categories, building portfolio depth within those categories and growing distribution and excitement by leveraging our internal sales team, improving blended gross margins to 35% to 40% by leveraging Auxly Leamington's high-quality, low-cost cultivation advantage and continuing to enhance our automated manufacturing capabilities. We're going to continue to vigorously take cost out of our business and build on the savings realized in Q4 of 2022 to keep SG&A to below 40% of net operating revenue; and of course, we'll continue to prudently manage the company's balance sheet and streamline assets where possible. We are excited and optimistic for 2023. We believe that we have a great plan that is built upon proven demand for our products, outstanding employees, top-tier assets and an underlying desire to continue to put our consumers first by delivering safe, effective, high-quality products that help them live happier lives. As always, I want to thank you for your time and your interest in Auxly, and now I'll turn it over to the operator to open the floor for Q&A from our analysts.

[Operator Instructions] Your first question comes from Frederico Gomes of ATB Capital Markets.

My first question is on your margins. So this quarter, the gross margin came in at around 30%, which, if I remember correctly, is in line with the guidance that you had previously provided. Now for 2023, you are guiding for margins in only the 35% to 40% range. So can you talk about what is making you more optimistic on your margin side? Is it maybe driven by Leamington on performing better than you initially expected?

Thank you, Fred. It's really a couple of things. You're absolutely correct. We are starting to see the benefit of Auxly Leamington and what we believe to be one of the lowest cost producer facilities in the country. And as we've shifted -- started to see a shift in our flower and pre-roll sales, as we indicated 2021 was about 30% and this year it was 42%, we're starting to get that benefit come through in our margins. In addition, we also, at the start of Q4, really started to focus our 2.0 product category and streamline some of those products in innovations and really looked at the cost structure in that facility and made some changes that started to pay off in Q4, as you can see by our results. And that's really giving us the comfort that we can achieve the 35% to 40% range for 2023.

Okay. My second question here is on vapes. So as you mentioned, Hugo, you led the vape category in 2022. But I think that the market share has eroded over the past year from what we see in the industry data. So I'm curious on whether you think that share has stabilized now? Or would you expect to go down further? And what would be the strategy in 2023 to maybe start regaining some of that share?

Fred, thanks for the question. So you're right. We did see, as we talked about on previous calls, our vapor share declined a little bit. We think that it's stabilized now. We've seen the results of that stability over the course of the last few months. Look, in terms of winning share back, I think I indicated during the call, we refocused our innovation on vapes. We started to put out new products that have been really well received in the market with our ICE series and our blunt-flavored series. Look, we're going to really focus on the targets that we put to you. We certainly could take a different approach, but we're going to look to grow share prudently, being mindful of volume versus margin trade-offs that have not always been historically positive without automation and further expense reduction initiatives. So we are seeing our vape share stabilize. We are still the second largest portfolio of branded -- of owned vapor products. And we're going to continue to refine and expand our portfolio over 2023. But certainly, the focus is on our plan as opposed to just trying to win share for ranking.

Okay. And then on the flower side, you have been gaining share in flower at quite a rapid pace over the past 6 months. In terms of the consumer segment in which you're gaining that share, would you say that most of that is coming from the ultra-value side with Parcel? And could you comment on the margins you're seeing in that segment relative to the other segments that you have in your portfolio given that Parcel deals dried flower, milled flower. So can you talk a little bit about that?

Yes, sure. So the increased market share is not coming as a result of Parcel. Even though -- it is a new brand, we've just recently launched it, we're still working to refine, testing our products in market, making sure that we've got the value proposition right. The increase is just coming from increased product quality and consistency out of our Leamington facility. We're continuing to launch some new strains. We've deepened our product portfolio, as I indicated, especially it's 30% on a blended basis. It's about 55% in flower and about 40% in pre-roll formats, driving some of that growth. So we -- it isn't coming from Parcel yet. We do have strong expectations for that portfolio. It's coming from increased efficiency and throughput, increased product quality and the increase of the breadth in our product portfolio in those product categories. And I'll pass it over to Brian to comment on the Parcel margin.

Yes. Hugo indicated just quickly in Parcel, of course, it's what we would call ultra-value. So the margins will be tighter. We will manage our brand and portfolio mix as best we can to ensure that we have an appropriate trade-off of not only top line but gross profit, which is the critical element in our view.

My last -- just one last question here. On your sales growth guidance, you mentioned 15% growth rate this year. This would be pretty much in line with the overall market, at least according to what we are expecting. So it would imply that you're not get any market share or losing but rather remaining flat. So how should we look at that guidance given that you have been gaining significant share on the flower side, which is the largest market -- the largest segment in that market? So the guidance could be potentially overly conservative. So could you talk a little bit about the guidance and what's behind that -- the driver there in terms of sales growth that you're expecting?

Yes, for sure. Yes I would say that our estimate is perhaps conservative in light of some of the other broader industry estimates. But again, we created a plan that we articulated in the outlook that allows us to be adjusted EBITDA positive and cash flow positive near the end of the year. But we took a conservative approach because we want to have sustainable growth. We're not just chasing share. It is about gross profit margin and controlling SG&A. And then we have transitioned our portfolio, right? So we're still working through the transition. As Hugo indicated, we have several new SKUs, and our innovation for 2023 will be focused on the 3 primary categories. So of course, we want to overachieve the 15% goal. However, there are a bunch of new initiatives essentially where we have new products and formats that have not yet been actualized with a long history of results. So we are confident in the plan. We think it's achievable. Yes, it essentially implies flat overall share. But as you know, there are elements to the product mix that differ. Certainly, in the pre-roll category, we are looking to do much better than we have historically. But for the terms of the guidance for now, we're going to stay with the 15%. And hopefully, we wildly exceed that target.

[Operator Instructions] There are no further questions at this time. Ladies and gentlemen, this does conclude your conference call for today. We thank you for your participation and ask that you please disconnect your lines.