Vext Science, Inc. (VEXT) Earnings Call Transcript & Summary

Good morning, everyone. Welcome to Vext Science's Third Quarter 2022 Financial Results Conference Call. As a reminder, this call is being recorded on November 17, 2022. [Operator Instructions] I would now like to turn the call over to Jonathan Ross. Please go ahead.

Thanks, operator. Good morning, everyone, and thanks for joining us today. Vext's third quarter 2022 financial results were released this morning. The press release, financial statements and MD&A are available on SEDAR as well as on the Vext website at vextscience.com. We would like to remind listeners that portions of today's discussion include forward-looking statements, and the forward-looking statements are included in today's press release. There can be no assurance that these forward-looking statements will prove to be accurate or that management's expectations or estimates of future developments, circumstances or results contained therein will materialize. Risks and uncertainties that could affect future developments, circumstances or results are detailed in the MD&A and Vext's other public filings that are made available on SEDAR, and we encourage listeners to read those risk factors in conjunction with today's call. As a result of these risks and uncertainties, the developments, circumstances or results predicted in forward-looking statements may differ materially from actual development circumstances or results. This presentation also includes non-IFRS financial information and such non-IFRS financial measures are subject to the disclosure and reconciliation included in our press release disseminated today. Forward-looking statements made during this conference call are made as of the date of this call. Vext disclaims any intention or obligation to update or revise such information, except as required by applicable law. Vext's financial statements are presented in U.S. dollars and the results discussed during this call are in U.S. dollars. I will now pass the call over to Eric Offenberger, Chief Executive Officer of Vext.

Thanks, Jon. Good morning, everybody, and thank you for joining our quarter 3, 2022 financial results conference call. I am joined on the call today by Stephen Bankosz, CFO of Vext. I will provide a brief overview of our results before turning it over to Stephen for an update on our financial performance. During the third quarter, our team continued to execute against the backdrop of a very challenging environment for most consumer-facing companies. Revenue was down compared to the same quarter last year and compared quarter 2 of 2022. Quarter 3 is historically our slowest quarter due to weather, vacation timing and kids getting back to school. However, the drop in sales on a sequential basis goes beyond seasonal weakness and points to a shift in consumer behavior as record high inflation continues to impact consumer spending across industries. Within this context, our team drove 60% adjusted gross margin in the quarter by maintaining an emphasis on value-focused products, rapid innovation and targeted promotions to generate traffic, which enabled us to mix back and build basket in the context of the market. In Arizona, there was sustained economic pressure on the consumer, with Phoenix continuing to record the highest rate of inflation in the country, averaging 13% through September 2022. Additionally, the state reported that recreational sales had plateaued since reaching a record high of $81.2 million in April, while the medical market continues to shrink. Arizona isn't the only state facing challenges in the environment. You have to remember that consumers can't buy cannabis on credit. Consumer borrowing has reached record heights and increased by 7.4% in the third quarter alone. This is a double-edge sword for cannabis operators, where they can't accept credit and consumers are faced with mounting debt service costs. The sector faced very well through COVID, but a steep drop in discretionary cash has been putting the industry to the test. The wholesale side of our business was down as well as other retailers adjust for our consumer spending in the short term and look to stock more of their own product as the market gets more competitive with an increased focus on margins. As experienced operators, we continue to look for efficiencies. Adjusted EBITDA came in flat with last year and lower than quarter 2. We produced margins of 43%, down 12.6 percentage points versus quarter 2 of this year. Given the macro backdrop, we see this as acceptable short-term performance. Vext's proven track record of execution and culture of operational excellence, position the company well in the context of the tough market. Companies that can promote effectively and offer consistent selection, quality and value to the customer will foster enduring loyalty. This is exactly how Vext' s portfolio is positioned in the market. From a sales perspective, despite quarter 3 being our historically slowest quarter, we consistently brought traffic into our stores given their strategic locations and targeted promotional activities. We recognize that selection and pricing tiers are extremely important in today's economy. Vext has a proven ability to innovate and bring products to market that customers want at solid price points. During quarter 3, we released an all-new range of Halloween edibles and dessert-style THC infused toppings that were received well by consumers. We continue to focus on product development and our marketing through innovative in-store promotions as well as emphasizing impulse purchase items to build the basket size. From a cultivation perspective, we are also well positioned. The expansion of our Prescott facility has been totally absorbed by our current vertical operations. We are currently awaiting the certificate of occupancy to go live with Phase 1 of the Eloy. Once this additional cultivation capacity comes into play, we won't have to rely on the market for any material flower purchases at our current retail base. We expect to receive a certificate of occupancy before the end of the year. In the meantime, we have been able to do some creative deals leveraging our processing capacity to do some contract manufacturing. The expansion plans of our retail and manufacturing footprints remain on track. Our discussions are ongoing with the city of Phoenix to expand our central Phoenix dispensary to 5,000 square feet, and they add another 6,000 square feet of manufacturing to our current operations in the city. We are currently awaiting the use permit and want to complete both these builds will support the growth of our wholly owned Vapen products as well as our third-party partner brands. The timing of these initiatives is based upon permitting as well as improvements in the economy. Turning to Ohio. As I've noted on our past couple of calls, we have emphasized the potential of the state and see it as our next big leg of growth. Ohio has exhibited better supply/demand dynamics than many other markets, including Arizona, given its structure and stage of development. During 2022, Ohio's medical cannabis sales surpassed the $1 billion mark since going into effect in 2019, exceeding projections. The states saw a 44% increase in the number of patients with active recommendations and active registrations over the past 12 months according to state data. This growth in addition to the state's highly regulated vertical structure, and potential for future transition to adult use makes it a very attractive market. Earlier this month, we announced that in association with our joint metro partner, we have received all necessary approvals and are fully funded to build out an initial cultivation area about 25,000 square feet with the potential to expand up to 50,000 square feet. The first harvest of this facility is expected to be achieved by the first quarter of 2023. As a reminder, we are also granted ownership of an operating manufacturing facility in Jackson, Ohio through JV, which continues to support the stocking of Vapen brands on over 95% of the dispensary shelves in the state. We are also progressing with our plans to establish a retail foothold in Ohio. As noted, previously, we are in the process for applying to the State Board of Pharmacy for a license transfer of a cannabis dispensary in Columbus, Ohio to a JV that will be set up immediately after approval. We anticipate receiving it by the end of the first quarter of 2023. We continue to be on the lookout for other attractive opportunities to expand our retail footprint and subsequently our market share in Ohio. In closing, I will reiterate that while the overall market environment will remain challenging for many operators, Vext track record of constantly innovating and offering a broad range of value-priced products has made safe in one of the Arizona's top brands. We also continue to be Ohio as a key growth opportunity and look forward to expanding our offerings in that state. With an unwavering focus on delivering profitability and cash flow, Vext has the foundation to grow in this environment with an eye to driving returns and shareholder value. With that, I will now pass the call to Stephen for a quick review of the financials. Stephen?

Thanks, Eric. As a reminder, the shift to a for-profit model as of quarter 1, 2022 makes direct comparisons to prior year periods more challenging until we lap that event in quarter 1, 2023. Revenue during the quarter was $7.7 million, a 12.5% decrease compared to Q2 of 2022 and lower compared to $9.4 million in quarter 3 of 2021. Gross profit before the impact of biological assets was $4.6 million in quarter 3. This compares to a gross profit of $4.1 million in the prior year period and adjusted gross profit of $6.5 million in quarter 2. Adjusted gross margin was 60% in quarter 3 compared to 75% in quarter 2. Adjusted EBITDA margins for the quarter were 43% in quarter 3 as compared to 55% in quarter 2 of 2022 and 37.5% in quarter 3 of 2021. Operating expenses were up in the quarter versus last year and versus quarter 2, however, I'd like to note that stripping out noncash items and interest costs, core cash operating expenses were down compared to quarter 2, which means we are still being effective in driving efficiencies in the business even in this environment. Cash flow from operations came in at negative $0.9 million during quarter 3. Biological asset recording and a reduction in sales for the reasons Eric outlined are the primary drivers here. Vext ended the quarter with $12 million in cash at September 30, 2022, adequate to execute our business plans. Earlier this month, we announced a refinancing of the company's existing $4.4 million principal amount of 10% secured nonconvertible debentures that were coming due at the end of December 2022 with 11.25% subordinated nonconvertible debenture maturing in December 2027. This refinancing gave us additional room on the maturity front as we continue to execute our growth plans at an attractive cost of capital. Thanks, everyone, for joining us for our quarter 3 financial results conference call. I'll now turn it over to the operator for your questions.

[Operator Instructions] Your first question will come from Russell Stanley of Beacon Securities.

Maybe first on Arizona. I just wanted to -- maybe a little more color on the manufacturing -- contract manufacturing business. To the extent you saw contribution you made in the quarter and relative to the Q2 levels and just a better understanding as to how much visibility you have on this revenue source going forward?

Thanks. As far as like how much it contributed and stuff like that, we don't really quantify it. We know kind of what the sales dollars were on it, and it's not a material amount. The issue really isn't the topline [indiscernible] what it does to the bottom line. So since it's basically a labor component, it has a great margin and a great return for us, but it also helps cover some of the fixed expenses and has allowed us to drive more efficiency into the operation. So we think it's still beneficial, and we think it's going to continue. The other aspect I would say on it is a lot of people have what they consider to be their brand or their special thought. And as you enter into the market into cannabis with the licensing requirement in that, we think a lot of people still want to come into the marketplace. So from our perspective, if we're just manufacturing and don't have the commercial responsibility that why not take advantage of it. So we think it's going to continue to grow. We have some longer-term supply commitments with people that are going to last for the next 12 to 18 months, and the team does a really good job performing. So we see it as an enhancement to the business, not necessarily a segment that becomes a major driver but it definitely helps with the margin.

Got it. And maybe moving to Ohio, I'm not sure what you can say on this, but can you comment, I guess, as to how the dispensary in Columbus is performing and you noted the supply-demand dynamics there being stronger, given Ohio is still medical only, how would you characterize the customer and the basket size at that store, I guess, against what you see at the 2 stores in Arizona.

Yes. I don't have any insight, obviously, to the exact basket size or the customer makeup in that store at this point in time. But what I do know is on the topline, it continues to grow every month, month over month. It's so -- it's performing well. It generates its own cash. We don't have to put any cash infusion towards it or anything along those lines. So those are all positives. It will throw off cash. So we're really excited that. What I see in Ohio, and we're really extremely excited that we have plants in the ground and the cultivation. So we actually have rooms planted out there or we plan to be in full capacity by early second quarter next year. As we've talked about in the call so far that we're going to have our first harvest sometime in the first quarter. We're anticipating sometime in February. We continue to see a strong demand in Ohio. We continue to see strong pricing that is better than you're seeing in Arizona or any of the more mature markets. And I think that's the case that everybody -- all the calls so far this earnings cycle indicated the same thing that there's margin pressures in most of the developed markets. So very excited about it. Very happy about the store. Seasonality, I think December will be a little bit of a tougher month as everybody tries to move into the year-end inventories. But we've seen a rebound in average basket size in Arizona in the fourth quarter like we do every year coming out of the summer heat. So we anticipate that to continue to be the case.

Maybe if I could sneak in one more and get back in the queue, but in Ohio, you mentioned looking for more retail and just wondering the extent you can say whether your preference is for existing stores or undeveloped retail licenses or a mix of both? And any color you can provide on how you're thinking about that.

Well, I don't think there's a lot of existing stores out there that haven't already been accumulated into a group. So if you look at the existing, there's not a lot of them out there. So you're probably looking at one of the new licenses that are coming online. And there's a lot of them being shopped. People end up getting the license and then they realize they don't know how to do the cannabis or what they have to do in the way Ohio structure that is not a vertical license. You now have to worry about your supply, and then there's a capping system within Ohio. So some people are already at the maximum cap so that will provide opportunities. So I think you have to look at those and see which ones make the most sense. From our perspective, what we do is really quite simple is we just focus on getting done what we have in front of us and continuing to build the structure so the company supported on the philosophies really go a good company that has ran well and stuff like that and the opportunities will present itself, you'll be able to get the funding you need to grow or to whatever the strategy becomes within that market that it presented. That said, in Arizona, you're seeing a lot of the social equity licenses trying to be sold now. I see a list all the time, people wanting to sell them. And you're seeing that price decline. I don't think it's at the bottom yet. And then yesterday, I think it was yesterday that the state came out and maybe have a new round, some medical licenses that they're going to do medical only, which continues to make the 2 existing licenses we have, I think, more valuable because they're the dual license and they're the originals, and there's not going to be any more of those type of licenses at this point in time. So that cap continues to make it good. You're continuing to see municipalities more difficult on permitting saying they've got enough permitting in Arizona's population continues to go. So I think that's great. And I [indiscernible] with Ohio. If you really look at it, Ross, Intel's also announced that they're going to do build the largest semiconductor plant in the world in Columbus. So if you look at that build, you look at the build in Arizona, I think that those 2 markets for us right now have good economic drivers into the future that's going to continue to put capital and population in those states as things relocate and people move from the East Coast and the West Coast, they're moving to those types of spaces. So I think that bodes well for us.

Your next question comes from Andrew Semple of Echelon Capital Markets.

Good morning. Thanks for taking my question here. First one for me, I just want to ask in so far in Q4, are you seeing any relief on consumer spending with the modest easing and inflationary pressures or do you think we need to see a larger decline in inflation before that happens? I guess what I'm trying to get at is your perspective on how sensitive the consumer is to inflationary pressures whether that's sensitive to minute moves or we need to see something larger?

Boy, that's the million dollar question, Andrew, if I get in and I talked a lot about this. I follow retail quite a bit, and I view the cannabis stores as nothing more than specialty retail stores and -- specialty retail operations. So I really watch like what's that Bath and Beyond doing [ coals ] is out today. So I really watch that. So I think the consumer still has some tight spending patterns and are going to be tougher. The thing I've been focusing on a lot more and we kind of covered it a little bit in our opening comments is the consumer debt, that's starting to make me a little bit cautious for 2023, that consumers have not really taken the impact yet of inflation and they've been using revolving credit. And you can see it in the numbers reporting with the interest rates moving up, I think the Fed is up 3 basis points so far this year and continuing to move that they are not paying off that credit card. So that's a revolving and that's going to continue to put tremendous more pressure on their demand. So that said, I think that it's going to be challenging for the consumer. So what's that, that means you're going to have to continue to drive down prices. And I think we talked about this on a couple of calls before, that you're going to see some rising input costs that have been there and a more pressure on the price point. That's why when we talk about what retail is doing and how you're buying in the wholesale market and stuff, I think the wholesale is going to still be a really challenging environment. I think that's going to be the biggest challenge you're going to see in the stores, you're seeing the same basic consumer impact. I think consumer count was down 2% in the stores in the third quarter, which isn't bad, but the average basket size was down 15%. So you've got that dichotomy going on. So I think there's still going to be pressure. They're still going to come in. You better be creative than how you do your price points. And it's basic business. It's all about inventory management, don't fall in love with the stuff get it sold, get it moved. That's pretty easy.

That's helpful. Appreciate that, Eric. And maybe just on your kind of last comments about being creative and to get product moving. I guess have you felt that Vext needs to do anything to update its brand portfolio with the changing market conditions. There's been a number of, I guess, the peers out there in the markets that have been moving their brand portfolios more towards a kind of good, better or best model? Do you think there's room for Vext to maybe increase the differentiation between its brand portfolios launch a more value-focused brand and increase its offering across more formats and try to really differentiate the better and best kind of brand tiers within your product portfolio?

Yes. We've actually been starting to do that. The way we're doing it, Andrew, and again, because it takes us a little bit more time to do certain things because we want to think through it and be thoughtful about how we do it. But we've kind of always identified the Vapen brand to me. I've always looked at Vapen is like the target brand, if you would, where it's create good quality, excellent price points for the consumer who are consistent. Vapen distillate was the first distillate brand in the market in Arizona back in 2014. So we've been doing this for quite a while and have high standards of our quality and testing and stuff. And we've always identified that as the everyday consumer brand that you can go to, it's trusted that it's a good price point. It's good quality. It's like going into the grocery store and buying the -- consumers label are the brand label, store label. So we've always viewed it that way. then we've recently been introducing what we're calling Vapen Black category or the Vapen Black and the way we're positioning that is that's more of the connoisseur brand or the connoisseur quality for a moderate price. So I don't really see us moving into a high price tier. I just don't believe that, that market is that strong or it's going to differentiate enough where it really -- that you really gain that much from it. And what we're doing on the Vapen Black is that's where we're doing the live [indiscernible] products. We're doing cannabis dry terpenes and stuff like that. So we are making that differential. The one big change we need to make in the brand that we are working on right now actively is to rebrand the edible brand and take it away from like the Vapen brand to make the edibles a little bit different. We've been doing some different development within the -- in the edibles. So with that, it's -- you need to remember that the science part of Vapen -- Vext Science and just some tagline we've used for marketing, we actually have organic chemists on staff and people with that type of a background on staff and have recently filed a patent again with ASU in conjunction with ASU. So they're working on emulsion technologies and different ways to make the -- they experience for somebody on the edibles. So I think in the first or second quarter, you're really going to see a different emphasis on some of the product, and we have a new marketing approach, we think, to try to expand the base because I think if you look at population, x amount of population uses cannabis and they're going to continue to use cannabis. It's more of how do you expand that base, not keep trying to slice up the same 5 people into different things, but how do I get to 7. And that's what we're trying to look at right now. And that's really come to us through Ohio because that's really new. It's how do you get people energized?

[Operator Instructions] Your next question will come from [ Colin George ] of Haywood Securities.

Eric has gone kind of answer a bunch of the questions already as I dive into a bit of the Arizona seasonality a bit more and what you're seeing so far into the start of Q4 as some of the snowbirds come down and the population kind of ticks up in Arizona. Is it purely just transaction-based that increases or the basket sizes increasing as some of these people travel to their winter home, I guess, may be less impacted by inflation?

I think that's -- I think it's all of the above. It's -- the basket sizes are increasing because the population is increasing for that winter traveler. It's not the impact that it used to be 20 years ago in the Valley, but it still has an impact, and you can see it. I also think the other thing is, as we talked about in the call, is really a focused and a reemphasis of how do you sell and how do you market? So one of the things we've recently done as I made a comment earlier, we approach it as a specialty retail. So I went out and with the team, we hired somebody from Bed Bath and Beyond to run one of the retail operations. So to start thinking about the merchandising within the store and how you're doing it [indiscernible] and how you do the merchandising and how you do in-store manager specials and how you approach that type of thing for what's going on in that particular demographics, I think that's helping and just being awareness of upselling. So again, you guys have seen this for years because you've been following it. People had the idea and the mindset, oh, it's cannabis. People are going to want the product. I really don't have to have good business practices or good retail practices or anything like that and the economy changes and everybody is scrambling. So we're faced with that. You see billboards all over with somebody lowering the price here or lowering the price there. It's probably not driving a lot of customers, but it drives a lot of conversation that you have to be aware of when you're pricing your product in your stores.

Okay. That's helpful. And maybe just one more for me. It might be a bit of a crystal ball question. But just maybe some of your thoughts or anything you guys are hearing in terms of the Ohio market, I think there was about 5 municipalities that pass the legalization at the midterm here, the rumor of hope maybe being attached to the safe, which is Joyce [indiscernible] Republican from Ohio, do you think there is a possibility that the legislature in that state would consider legalization in a way that Illinois did? Or is it likely going to be a 2024 initiative that's going to have to come from the citizens getting it on the ballot?

Either look in the mirror, look at the screen for John's bald head or mind to see which one is going to give me the reflection. But my two strengths are pretty straightforward. I think you just saw Ohio of us through a vote. So it's going to still stay relatively conservative in its approach. So my guess is, is that there's some pending legislation in Ohio that is to look at trying to move -- right now, you have commerce and you have pharmacy that regulates it, nothing sets over the top. I think there's legislation to try to make it 1 unit, which would then give it some -- give you the ability to do a little bit more advertising or marketing in that market, and it would make it easier for people to have the medical program expand. I think they'll go that way first, and then potentially in '23 there might be a vote to do a little bit more. But in '24, I think they'll go towards a recreational vote. I think it has legs to pass as long as the industry continues to operate well in that market, and it seems like it's doing it. So yes, I think that's going to happen. That said, I think that it's going to probably go a little bit like Illinois, but I don't think it's going to go to that at a whole sense. They really have done a good job of keeping cultivation. And the best way I can describe it, Colin, is I grew up in the Midwest in farm communities and farmland. And every year, I remember, it was either soybeans were high, corns were high, and you plant the crops and then everybody have an overabundance of the stuff. And you'd have to get a federal subsidy or it would sit in the silo and the grain bins are full and all that kind of stuff. And that was the rural setting of agriculture and that I grew up and when I work for Land O'Lakes, this a similar type of thing. Now when I watch cannabis, I'll be [indiscernible] and it's the same thing. Everybody -- they're going to grow the best of this crop, and this crop is right and they're going to grow a bunch of it. And now you do have abundance of all this stuff and what you do with it. Well, if you're not a vertical, it's really a challenge because where does it go? And if you overproduce what you can run through your store and that vertical model really fits well. A lot of states like Arizona have allowed these cultivations to become so abundant and so high, that's why it drives that wholesale price down and everything. So I don't think Ohio is going to make that mistake. I think Illinois has done a pretty good job in that regard so far, too. And I will continue to keep that state's tax base up. So I think it's really in the benefit of the state for them to control that input or that raw material piece on the cultivation side so that they don't end up in the silver abundance, which actually drops their transactional pricing and their tax revenue because remember, it's always based upon the sales price in most of these states. So they're seeing an impact on their taxes that they're taking in. And it's -- yes, it's a bad model when you're in a state that doesn't do that. So I'm comfortable that Ohio is not going to make that mistake.

Okay. I guess that makes sense that they've moved a little bit maybe not slower, but more in incremental steps as they're kind of looking to roll out the next wave of dispensaries and just the way the cultivation license is set up with an initial 25,000 before you can double it down the road. But I guess you have that -- that would be....

And we didn't talk about this Colin on the call, and we probably should give you some color on this. That's one of the advantages of our Tier 1 with our partnership out in Ohio is that, that facility is large enough that it could support up to probably a 100,000 without really having to do a bunch of double stacking or anything along those lines, you know it going up, which I'm not a big fan of ever getting people off the ground. They don't like the safety aspects of it and stuff. But without having to do that, that facility will do that. We think that's an advantage to us to be able to continue to grow because the license is tied to a physical address. So it's not like, okay, outgrow the 25,000 and I try to find another building and rebuild everything. I'm in the facility that will support that type of a growth pattern and it supports by manufacturing. It's done on 113 acres. It was originally a mushroom plant years and years ago for Campbell's and stuff. So it's really geared for agriculture, indoor and control of agriculture. So it's perfect. And we couldn't have been happier about that building in that facility. That was really a big thing to us 4 years ago when we went into this JV.

Okay. That's helpful. And I think that answers all my questions pretty straightforward quarter from you guys. It's nice to see the margins holding pretty strongly despite the seasonality in the [indiscernible] market.

Ladies and gentlemen, there are no further questions from the phone lines, and this will conclude your conference for this morning. We would like to thank everybody for participating, and you may now disconnect your lines.