Canopy Growth Corporation (WEED) Earnings Call Transcript & Summary

Good morning. Welcome to day 3 of the Bank of America Consumer and Retail Tech conference. I'm Bryan Spillane, consumer staples analyst here at Bank of America. It's a great pleasure for me to get a chance to sit down and chat with Mike Lee, the CFO of Canopy growth. Canopy is unique in our coverage universe because it's a leader in an industry that's both large and small at the same time because of the legal landscape. Cannabis, in our view, is a product and ingredient with a wide array of functional promise for producing very good functional products over time. And finally, Canopy is in a multiyear process, improving virtually all aspects of its business to be more effective with what they have, while at the same time, preparing to move when the U.S. legal landscape changes. So with that, Mike, welcome.

Good morning. Thanks for having me.

So maybe the first question, just as a starting point, just there's a lot of cannabis companies in Canada, but there are only a few large players. And for investors who may be new to the Canopy story, what do you think are Canopy's competitive advantages in Canada?

Yes. Thanks, Bryan. Well, first and foremost, it starts with insights and innovation. And our strategy really is to build a world-class CPG goods company, and we're going to continue to invest behind insights and innovation to create a differentiated product portfolio that we believe will command strong margins over time. And it is interesting because the cannabis industry has evolved quite a lot over the last couple of years since legalization in Canada. And we see cannabis consumers becoming more discerning about the products that they're purchasing, not just looking for increased product assortment or new product formats, but other formats as well, other attributes. As an example, there's been a lot of focus on high THC in the flower category, it gets a lot of headlines. But we believe -- we know that there are other attributes that create that quality flower experience. And hence, we're building a best-in-class consumer insights organization that is conducting research on what really matters to cannabis consumers and are building these insights into our product road map for future new product innovation. And while we're doing that, we have already in market some very differentiated cannabis-infused products like beverages, which are bringing new consumers to the category, partially because it's a familiar format for consumers, but also because it's a sessionable format like beverage alcohol. And then looking at the case of our Tweed beverages, which are 2.5 milligrams of THC, it's similar to 1 serving of beer. So it's very approachable in that regard. But going a step further, we're also doing R&D in areas like human effects and formulation, which is really geared toward creating a portfolio of products that are focused on mood management, which we talk about a lot in the press and with investors, but we think that's really going to be a game changer for the cannabis industry. This notion of mood management. And then looking beyond our insights and innovation, I would say that we are a North American company, and that provides benefits in many ways. We can develop products and launch products in Canada and use the Canadian market as a test and learn. Our recent launch of Quatreau CBD beverages is a great example. We launched that in November in Canada, and it's already the #1 selling ready-to-drink CBD beverage in Canada. So it made perfect sense for us to bring Quatreau to the U.S. market, which we announced a couple of weeks ago. But it also works in reverse. We recently launched our Twd. strawberry gummies in the Canadian market, and it's been very well received. And we did that through leveraging learnings from our Martha CBD gummies in the U.S., where we've learned about what flavors are resonating with consumers. So this notion of being a North American company is providing lots of benefits to how we approach the market. And then last but not least, when you think about our strategic partnership with Constellation Brands, it's really been powerful. And the relationship with Constellation goes far beyond just the investment that they made in our company a couple of years ago. We've leveraged their expertise in areas of manufacturing, which was helpful when we designed our beverage facility in Canada. But it goes well beyond that. From a selling and marketing perspective, Constellation's former Chief Marketing Officer and now Managing Director of the Beer Division, Jim Sabia; along with Constellation's Wine & Spirits President, Robert -- of the Wine & Space business, Robert Hanson, they both sit on our Board, and they've been incredibly helpful in helping to shape our commercial strategies. From a government relations perspective, our U.S. GR teams work closely together to pave the way for cannabis reform at both the federal and state level. And I think a great example of the collaboration is Constellation's provided access to its distribution network on BioSteel, which we think is going to give us very high distribution rates that many other brands would take years to build in the U.S. through the convenience channel, which I think there's 150,000 stores in the convenience channel. It takes brands years to build 70%, 80% ACV distribution. We think we're going to get there very fast, leveraging this distribution network. So there's a number of examples there, but they've all been hugely powerful in moving our business forward.

The Canadian cannabis industry has been through some volatility, I guess, to put it mildly over the last year. You had a surge in supply in the market, then disruption from COVID. So maybe first in terms of supply dynamics, can you just walk us through what happened and how Canopy has adapted, and kind of where we sit today with that?

Look, there's no question that the initial build-out of capacity by the Canadian LPs was aggressive. But the production surplus was, in many ways, amplified by a relatively slow rollout of the retail build and the more populated provinces of Canada. But the good news is that we're seeing a lot of progress. When you look at a province like Ontario, which has 13.5 million population, the largest province in Canada, by far, last year at this time, in March of last year, there were only 50 stores in all of Ontario. By the end of last year, it was up to 270 stores. So they really started to accelerate new licenses last summer. And that's continued into this year. So earlier this year, Ontario further accelerated the licensing of stores up to 30 per week and our projections suggest that we could see over 1,000 stores in Ontario by the end of the year. And mind you, this is all during COVID, right? So it just goes to show you that in many ways, as challenging as COVID's been, this industry has continued to show a lot of progress. And when you look at where the industry is through that acceleration of retail stores last year, the industry has doubled and ended last calendar year 2020 at over $2.6 billion in sales. And now the legal market in Canada has exceeded 50% of the total market. And mind you, the founding goal of the Canadian Cannabis Act was to convert that illicit market and bring it into the legal channel, right? So we're past the 50% mark. And I think that happened last fall. But on the supply side, look, there's still a lot of LPs in Canada. At last count, I think there's over 600 license holders. And we are seeing progress with other LPs. Some of the large ones are shuttering capacity similar to what we've done. Some are delaying the expansion plans that they had. So we do believe that supply and demand will come into balance over time. Are we there yet as an industry? No. But we think it's coming. When we look at Canopy, specifically, as you know, we've been focused on rightsizing our footprint, starting from last February when -- shortly after David Klein joined the organization, we made some no-regret decisions on some of our facilities. And when you look at the work that we've done -- we probably could have talked about this more at our last earnings call. But as of Q3, our kilograms harvested were in balance with kilograms sold. That's a huge accomplishment in the first time in a long time where our supply and demand was balanced. And that being said, given that we're in a growth industry, you might ask, well, how are you going to source for growth? Well, as part of our end-to-end supply chain review that we conducted last year, we are now -- we have a sourcing strategy in place where we're going to rely on third-party offtake for a portion of our supply. So we've got a strategy in place that's going to really serve as a hybrid supply chain where we'll source internally where it makes sense, some will rely on the market where that makes sense. So we're confident that our supply chain is moving in the right direction. But it doesn't end there. We are in a 3-tier system. So folks that aren't familiar with the Canadian cannabis market, it's a 3-tier system. So the LPs sell into the provincial agencies, and the provincial agencies sell to the retailers. And one of the things that we found is it's important to partner with the provincial agencies closely when it comes to demand planning. So just in the past year, we've integrated business planning with our large provincial customers, and that is paying huge dividends on the supply chain. It's improving fill rates, it's leaning out inventories. Their inventory turns are improving. Our inventory turns are improving, and there's just been a number of benefits and synergies across the supply chain. So we're continuing to partner with the agencies to strengthen that process even further.

One of the questions we get is just the pricing tiers in the Canadian market, value, mid and premium. And so I guess, can you talk a little bit about your approach there? And I guess really the punchline is how important is value? Like do you need to be in value to win?

Look, the value segment during the past year has played a critical role and helping to convert the illicit market into the legal channel. So from that perspective, it's been a big catalyst for growth for the industry. But looking past the illicit market conversion, we see the value category as a long-term category in this industry. And you'll find that's typical in most CPG categories where there is a value category. And we've carved out a leadership position in value through our Twd. brand, and that brand alone, just the flower sales for that brand is now the #1 flower brand in Canada, and that brand is about 10% of total flower sales across the industry. So we've carved out a strong position there. But as you can imagine, we're also working on premiumizing our portfolio because it's -- value is table stakes, but over time, it's really about premiumization in this industry and giving consumers reason to trade up to mainstream and premium segments of the market. And this is really where I would go back to our insights and innovation work. And through understanding what attributes matter to consumers and what they're willing to pay, we can further segment the market and design our products around those key attributes. Twd. gummies, example, we focused on flavor and appearance of the gummies. But we've got a whole strategy in place where we're going to move up that value chain with gummies over time through additional attributes such as rapid onset gummies. Because we know that there's a segment of consumers that want that that rapid onset and others don't. So there's other features and benefits that we'll be incorporating into our gummy strategy over time to provide that compelling reason to move up that value chain.

Like a lot of categories and a lot of things that we consume, right, COVID has been a big test period, right, in terms of -- especially how consumers access products. So can you talk a little bit about that? What impact COVID has had on consumers and how they buy product? And do you think some of this sticks longer term?

Yes, it's been an interesting year. The -- at the very beginning of the pandemic, we saw a ramp-up in bulk buying. And I think this is not a surprise. This happened in grocery and many other CPG categories. There's a bit of a hoarding dynamic going on. And we saw consumers stocking up to reduce their frequency of store visits and all of our metrics dramatically change. When you look at units per transaction, average unit retail, dollars per transaction, all of those metrics that you look at as a retailer just went off the charts. But that quickly passed 10, 12 weeks into the pandemic. And we did see that despite the pandemic challenges, there was an ongoing interest in new formats. Consumers were really interested in trying new formats in the market. And not just consumers, but even retailers were really excited to get new formats into the market. So the industry has continued to prosper in that regard. And we expect this trend to continue, pass the pandemic. There's a bit of discovery happening in this category as existing consumers convert over to the legal channel from the illicit, but then as new consumers come in, there's a lot of learning going on. And hence, these new product offerings provide education experiences, learning experience for consumers. But one trend we do see that we think we're very well positioned for is this notion of having more sessionable cannabis products, right? Products that have a clear, distinct session associated, and our beverages are a great example of how people just want to -- they may not know how much to consume. So these prepackaged formats with a clear portion make it very easy and very approachable. But look, when you sort of pull all this together, what have we learned through the pandemic, it's underscored that cannabis is a massive growth opportunity. And that includes not just THC, but also CBD. And we see a lot of growth coming, not just in Canada but the U.S. as well. And when you think about some of the trends like CBD -- it's a stressful time. It's a stressful time for all of us. It doesn't matter what demographic you are, where you live. And CBD has proven out to be a great way to manage stress and anxiety. So if nothing more, we've learned that cannabis is just a powerful category that's got a lot of runway ahead.

So maybe that kind of ties into -- on the last earnings call, you put out some 3-year goals, which a lot of companies are having trouble giving the next quarter. So just what are you seeing in the business that right now -- and the industry that gives you confidence in your 40% to 50% sales CAGR and 20% adjusted EBITDA goals? And maybe how we should just think about the cadence of that over the next couple of years?

Yes. And look, just to be clear, we provided medium-term guidance, and we're still not providing quarter-to-quarter guidance, just given that, yes, things are a little bit choppy with the COVID pandemic. But look, over the last year, we've done a lot of work sizing up our core markets of Canada, U.S. and Germany. As we shared last year, we have a new strategy in place, and we've been cascading and operationalizing that strategy across the organization. We've been going through a number of org changes really since last April and May, and even recently, there -- we've had some announcements around kind of our final wave of org changes. And then we also launched this end-to-end supply chain review last spring, and we've been doing a lot of work on implementing those findings as well. So we've done a lot of work on our business, Bryan, just a massive amount of work. And when we think about the growth opportunity, we guided that we see 40% to 50% revenue growth over the next several years. And when you unpack that and look at each of the key segments of our business, you look at our Canadian rec business, for example, I just laid a foundation for you on the illicit market converting, store count increasing. So when you look at expectations, our expectations of this market, we think the market is going to grow 40% in our fiscal '22, which starts April 1. And then over the FY '22 through FY '24 period, around 25% to 30% growth, but really strong growth for several years as this market matures. And that's really driven by store count. And we're estimating that in Canada, stores will reach 2,400 by the end of our FY '22. So about a year from now, 2,400 stores, up from around 1,500 today. So call it, 50% growth in store count. And that's really just going to open up the legal market and give more and more consumers reasons to come into the legal channel. We also have a big medical business in Canada. And although the medical channel itself is kind of flattish, we've had very good performance and growing market share as we're continuing to offer new items through that channel. So we see growth coming from medical. Our international medical business will really be driven by our German medical market and growing with the market, so less about market share gains, but more about just the market itself is continuing to expand. You look at our U.S. CBD business, and it's still early days in the U.S. for us on CBD, but we're very happy with the growth we're seeing from Martha. We recently announced our Quatreau beverage launch, which we're really excited about. And we've got other products that we've not yet announced, but the U.S. CBD market is a viable, high-growth market that we think is going to give us a lot of tailwind over the next couple of years. And then you look at our CPG businesses, which perhaps we should spend more time talking about, but we're very excited about BioSteel and This Works and Storz & Bickel. And we're already posting strong growth in those businesses, and there is tremendous runway in terms of distribution expansion and new product launches. So we have several years of strong growth ahead on those businesses. And that's before they fully expand into like the THC category or fully into the CBD category, this is just looking at those businesses on their own. So lots of runway. When we think about the EBITDA guidance that we provided, we are looking to be profitable in the second half of FY '22. And we set out a goal of getting to a 20% adjusted EBITDA margin by FY '24. But again, it comes back to growth and the economies of scale that come with that. And that's the ultimate foundation of our path to profitability, but we're also working on expanding our gross margins and SG&A efficiencies, and this comes back to the work that we've been doing over the past year. And just through that work between COGS and SG&A, we've identified $150 million to $200 million of savings over the next 12 to 18 months, with the majority of that coming in FY '22. And these work streams are happening now. Again, read the press releases, right? We've rationalized facilities. We're restructuring our teams. We're building sustainable operating models across the business that are going to scale. So we've done the work, and we're very confident that we know what work needs to get done and how it's going to get done, and we're moving fast. So last and not least, I'd just remind everybody that the guidance we provided does not include the U.S. THC market. So when you start to layer that on, it becomes an even more compelling growth story.

Just one piece within the -- your assumptions or your targets is an expectation that prices will contract over the next 12 to 18 months in Canada. So -- but it looks like flower pricing stabilized a little bit. So can we just -- like, I guess the idea is it actually playing out better than you thought? Is there potential upside to that outlook? Just how we should think about that?

Yes. Look, the value category didn't exist 14 months ago, right? Because the industry was still supply-constrained and getting the right product to the right market and all of that. So when you look at pricing over last year, with the establishment of value category, average prices have come down, but a lot of that's due to the value category coming into play. We do see price compression continuing into FY '22. Our estimates are high single-digit price compression. And we have seen the market start to stabilize, but we're not there yet. And as long as there's still 600 LPs in the market with elevated inventory levels, there's going to be some price volatility. So the good news is we're building that into our algorithm, and that's incorporated into our targets. And we think that even with that price compression, we can achieve our profitability goals by the second half of this fiscal. So it's something that we're watching closely. And we've got a whole new rev management capability that we built in-house. So we've got really good insights on what the competitors are doing as part of our proprietary market share and retail tracking tools. So we're watching it closely.

Mike, you've referenced a lot, just the internal changes that you've made at the company over the last year or 2. And I guess you just did it an end-and-end review of the business. So maybe just -- maybe what are some of the biggest learnings there? And then maybe some of the things that made behind the scene that will fuel the business that maybe we don't fully appreciate?

Yes. Yes, it's a good question. Well, first, I would say, this wasn't just a consulting exercise, right? This was a project that involved tremendous collaboration across all of our functional stakeholders. And through that work, we identified a number of opportunities. Some are quick wins, which we've executed against, and some are more structural moves that take time. But all of this work culminated in a road map with a very clear sequencing of activities that are going to enable us to deliver on these milestones. And we've put a pretty robust project management office in place to keep us on track. So a lot of rigor has gone into this. It's not just a desktop consulting exercise. We validated these things. When you get into some of the key learnings, some of it may be surprising, some may be unsurprising. But we found that complexity management is a key unlock. Complexity can kill you in this industry. And whether it's through optimizing the number of strains or optimizing the number of finished goods that we offer, we have a clear pathway in place that's commercially aligned to drive down complexity across our business that will not affect market share, but will unlock productivity and reduce cost, just through a more efficient operation. This notion of end-to-end optimization has been a key unlock for us as well. And we've redesigned our operations and our supply chain to have demand signals linked all the way back to cultivation, which didn't exist in the past. And we now have, through our design work, this notion of mission control across our entire supply chain so that we've got real visibility into what's happening at every step along the way and making sure that we're being agile and adjusting as the consumers adjust. And we believe doing this is going to increase productivity, improve our agility and reduce cost. And then finally, smart spending is a big key unlock. And that's a program that many other companies have implemented over time. And it's a philosophy on how you manage categories of spend. And we believe through our design-to-value program that we've implemented, where consumer preference comes into setting product specifications, we think that program, coupled with the bargaining power that we have as we scale, is going to enable us to drive down procurement costs across the organization. So those are the major ones. But I would say that -- and all of this work, it's not just about driving down costs. It's about agility and increasing agility along the way. And one example of that is what we recently implemented with our operations team in Canada is this notion of a flexible workforce model, which now allows our manufacturing teams to move around to various product lines and departments based on fluctuations in demand. So this is allowing us to redeploy resources more efficiently. And that's proven out to work because we're now getting to fill rates with the provinces that are as high as 99% fill rates that we've achieved in some cases. So it's really working, but it's a lot of work, and our teams are moving as fast as we can.

You're aiming to be cash flow positive by fiscal '24. What prevents you from getting there sooner? Just what are the obstacles, I guess, to being cash flow positive before then?

Yes. Well, so just to clarify, Bryan, we're targeting to get to adjusted EBITDA positive in the second half of our upcoming fiscal. But even with that, there will be CapEx invested back in the business. And as the business grows, there will be working capital needs as we continue to scale. And we'll see our CapEx start to taper off in FY '23 as those economies of scale are delivered. And as we start to drive up those utilizations and get the infrastructure work behind us. So we are projecting operating cash flow positive in FY '23 with positive free cash flow in FY '24.

Okay. And then maybe just to shift a little bit to the short term. Some of your peers have been a bit more cautious about some of the recent industry trends in Canada. So maybe give us -- if you can, give us a little bit of a snapshot of what's going in the market currently? And maybe some comments on market share also would be helpful.

Okay. Yes. Well, look, during our Q3 earnings call, I provided a few factors to consider as it relates to Q4. So let me elaborate on that. So first of all, I want to be clear, we are very bullish on the Canadian market and with strong year-over-year growth expected to continue. We're very happy with the growth that we're seeing across the market, and we expect to continue to grow market share along that journey. That being said, when we look at Q4 relative to Q3, we're seeing some headwinds. And it's somewhat due in part to seasonality because our Q3, which is OND, October through December, there is some seasonality that comes into play. But there's also been a COVID resurgence that has led to some disruptions in Canada over recent months. And I'll just give you a few examples of what we're seeing. So for one, while we're quite happy with the number of license issuances that have occurred, there have been some delayed openings due to COVID. Many, many stores that -- both our stores, but talking to some of the other retailers, we're seeing reduced foot traffic with many retailers operating at reduced capacity like shorter store hours or reverting to curbside pickup only. And then just to be clear, we have both a B2B business, which is what we sell into the provinces. And then we also have a B2C business, which is our retail store operations in Canada. And when you look at our B2C business, our corporate-owned retail stores, we've seen impacts. Our own stores are saying, weekly sales, down about 10% relative to the weekly sales that we saw in Q3. So that gives you a sense of the scale of the challenge. And then when you look holistically at B2B, we're seeing a different dynamic, which is many of the provinces have been reducing their inventory levels which affects our sell-in to the market. So for example, I think Alberta is the best example. Alberta, as a province, has seen some pressure from its lost gaming revenue. And as a result, they've been managing down inventories to free up working capital over the past several months. So when you look at our inventory that sits within Alberta since last August, our inventory level with Alberta has come down around 40%. And then into this year, into our Q4, we've seen about a 30% decline, additional declines since February. So it's really the provinces tightening up their inventories at a B2B level, coupled with reduced traffic at the retail store. So that's what we're seeing now. But again, this is all temporary headwinds due to some of the COVID measures. When you look at other parts of our business like Germany, the lockdown measures there are serving as a headwind because our salespeople are unable to visit the pharmacies. So they just don't have the ability to make the sales calls. And then because we're in the pharma business, the fact that people are deferring elective procedures is also affecting demand as well. When you look at the U.S., I think the biggest challenge in the U.S. right now is as a new CBD business, selling in new product to retailers and getting product on to the shelf set, the retailers are either slowing down resets or pushing back resets because of the same COVID measures. So it's just not as easy to get on the shelf as it has been previously. So that's just a dynamic that, quite honestly, has occurred over the last several months, if not 6 months or so. But again, the punchline here, Bryan, is these are all temporary COVID headwinds, and I think we're all encouraged with the progress that we're seeing on the vaccines. And as that loosens up, we think people are going to come back to the stores, and retailers are going to do shelf resets and all of that. So it doesn't take us away from our optimism around the business nor does it create concern around our FY '22 metrics and goals that we've put out.

Yes, that makes sense. And maybe just if we can shift a little bit to legalization in the U.S. You guys have been pretty vocal about it and pretty optimistic. I think the markets agree with you. So maybe can you talk a little bit about how you think -- we get this question a lot. Like how does legalization pay out -- play out? Do any of the existing -- is there any preference in terms of some of the existing proposals that are out there? I guess we're really talking about federal. And then specific to Canopy in a kind of legalized framework, just if you can remind us your deals with Acreage and TerrAscend and how that fits into kind of a footprint.

So the reason we talk about it is, because that's usually our number one question, Bryan. But -- and it changes so rapidly, right? Just every week, there's new news. And I guess, let me just start off with acknowledging the obvious, which is with the Democrats controlling the White House and both chambers of Congress, we do believe that significant cannabis reform is coming in this Congress. And that could be done through legislative actions such as Congress passing the much anticipated Booker, Wyden, Schumer Bill or it can be through a combination of other exciting reform measures such as the SAFE Banking Act, which would allow banks to engage in state-regulated cannabis markets. And possibly, in the SAFE Banking Act, there could be an expansion of the language to include safe harbor for the capital markets and the financial services sector more broadly, which is even more exciting when you think about the possibilities. It could come through executive direction as well to the Department of Justice to reissue or perhaps even expand the Cole Memorandum, which would provide safe harbor language for businesses that are operating in legal states by creating, call it, a passive enforcement environment where enforcement risk is nil. So I guess there's a number of ways the market could develop, and we're doing just a massive amount of work to prepare for these various scenarios and are accelerating our efforts to lay a foundation to win in the U.S. THC market once it's permissible. And as you know, we already have this pathway to the U.S. through our Acreage arrangement. And Acreage is showing improved performance under their new leadership and it's more focused strategy. And it's Canopy's intent to activate our arrangement with Acreage and to assume a controlling position immediately upon federal permissibility. In fact, Acreage demonstrated strong -- they just had their Q4 release, I believe, earlier this week. And with their adjusted EBITDA showing 49% improvement versus their third quarter, it's a -- they're headed toward profitability, and we're quite encouraged with the progress that they're showing. And then you think about our 20% conditional ownership with TerrAscend, which is a top-performing MSO. And TerrAscend is expected to report their 2020 revenue of, I think, nearly $200 million. And they, too, will benefit from -- the recent legalization of the New Jersey adult-use market. So they've got a lot of momentum behind them as well. So we're very excited, and we think it's going to be a year of change. And hence, we're looking beyond things like Acreage and TerrAscend because we have a lot of opportunity to build our business in the U.S. even through our CBD business and our CPG business. So more and more of our focus is shifting to the U.S. every single day.

All right. Mike, with that, we are at time. But I think that's the best teaser to leave, right? U.S. is going to be a huge opportunity, and stay tuned, right? All right. Mike, thanks again for spending time with us today. Look forward to catching up with you again soon. And thanks, everybody in the audience, for listening in, and have a good day.

Cheers. Thanks, everybody.