Village Farms International, Inc. Q2 FY2020 Earnings Call

Good morning, ladies and gentlemen. Welcome to Village Farms International’s Second Quarter 2020 Financial Results Conference Call. Yesterday, Village Farms issued a news release reporting its financial results for the second quarter ended June 30, 2020. That news release along with the company's financial statements are available on the company's website at villagefarms.com under the Investor's heading. Please note that today's call is being broadcast live over the Internet and will be archived for replay, both by telephone and via the Internet, beginning approximately one hour following completion of the call. Details of how to access the replays are available in yesterday's news release. Before we begin, let me remind you that forward-looking statements may be made today during or after the formal part of the conference call. Certain material assumptions were applied in providing these statements, many of which are beyond our control. These statements are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied in forward-looking statements. A summary of these underlying assumptions, risks, and uncertainties is contained in a company's various securities filings with the SEC and the Canadian regulators, including its Form 10-K, MD&A for the year ended December 31st, 2019 and the 10-Q for the quarter ended June 30, 2020, which are available on Edgar. These forward-looking statements are made as of today's date and except as required by applicable securities law, we company undertake no obligation to publicly update or revise any such statements. I would now like to turn the call over to Michael DeGiglio, Chief Executive Officer of Village Farms International. Please go ahead, Mr. DeGiglio.

Thank you, Jack, and thank you to everyone for joining us today. With me for today's call is Village Farms' Chief Financial Officer, Stephen Ruffini. Today's call will start with a review of the highlights of the quarter, particularly the sixth consecutive quarter of profitability for Pure Sunfarms and positive EBITDA in our Produce business. Steve will discuss our financial results, and I'll briefly address our confidence in the future of our company before we open it up for Q&A. Regarding COVID-19, I'm pleased to report that all Village Farms and Pure Sunfarms facilities in Canada and the U.S. have operated without interruption since the pandemic began. We have experienced very few COVID-19 cases, limited to two of our four produce facilities in Texas, and we have followed appropriate protocols with no material disruption to operations. Our ability to manage the pandemic's challenges reflects our commitment to health authority recommendations, which exceed the already high hygiene and safety standards in place as a highly regulated fresh food producer. Aside from the slowdown in provincial retail cannabis infrastructure impacting industry sales, COVID-19 has not negatively affected our operations, and we do not anticipate any lasting effects. Before I begin my scripted remarks, I want to emphasize how crucial this recent quarter was for us and express my satisfaction with the results. We have demonstrated that Pure Sunfarms can lead the Canadian cannabis market with high-quality products at competitive prices while achieving profitability. This clearly indicates the long-term viability of our business. Now, let's discuss the highlights for the quarter. As a reminder, we own just under 59% of Pure Sunfarms as of the beginning of the second quarter. The second quarter further showcased Pure Sunfarms' earnings potential, primarily due to our transition to cannabis production from our existing low-cost, large-scale, technologically advanced growing operations. With over thirty years of experience in intensive agriculture, along with the best management team in the industry, we maintain a frugal approach to SG&A, a strategic brand and product positioning, and a focus on cash flow generation, all while understanding the requirements for competition in the Canadian market. In Q2, we achieved our sixth consecutive quarter of positive net income and our seventh consecutive quarter of positive EBITDA since we began shipping cannabis at scale back in Q4 2018. We accomplished this while shifting from wholesale to predominantly branded retail sales. The all-in cost of production per gram for Q2 was CA$0.84, which includes depreciation and packaging logistics. This brings Pure Sunfarms' average all-in cost per gram for the past four quarters to CA$0.80. Although we are pleased to lead all Canadian public greenhouse and indoor producers in this metric, we also believe we can reduce this further as we enhance our operations, bring our extraction operations online, develop new strains, and refine our growing techniques. Our ability to produce high-quality cannabis at industry-leading costs gives Pure Sunfarms a significant competitive advantage and strong pricing power while still generating profits. I want to note that we are currently assessing whether to continue providing our cost of goods sold on a per gram basis. It has not benefitted us competitively to disclose this number, which we also do not provide for our produce business. With our established low-cost leadership and proven track record, we believe that gross margin, net income, and EBITDA metrics will be sufficient for evaluating our operational performance moving forward. On the sales front, retail branded sales for Q2 increased slightly from Q1, but sales volume saw an 89% jump as we introduced large format value products. It’s worth highlighting that we achieved a 33% gross margin in Q2, even with our aggressive pricing strategy and the shift in our sales mix toward larger products. This quarter illustrates our ability to impact the market in response to illicit trade competition, and we are experiencing solid momentum as we start Q3. July was a record month for sales of Pure Sunfarms products in Ontario, Alberta, and British Columbia. Wholesale sales, as expected, dropped from Q1 due to some large non-monetary sales to extract, where we exchanged flower for distillate. We are noticing increased sales activity from other licensed producers, likely due to challenges they face growing quality cannabis at scale and at feasible production costs. We have set a corporate goal of capturing a 20% market share of the Canadian market while supplying 35% of the cannabis demand. Additionally, comparing Pure Sunfarms' Q2 results with last year's figures, it's important to note that Q2 2019 consisted solely of wholesale sales prior to our retail licensing. Despite ongoing challenges from COVID-19, we anticipate several growth factors driving Pure Sunfarms in the second half of the year. First, the legal cannabis market is growing at a rate above expectations, having more than tripled from the previous year. We expect consumer conversion from the illicit market as price, quality, safety, product variety, and access to retail stores in the legal market improve. The OCS reported that in Q4 of 2019, over 80% of cannabis consumed in Ontario was still sourced from the illicit market, indicating a significant opportunity for those who lead in the legal market. We have prioritized converting traditional users into the legal market since launching retail. Many traditional users favor purchasing legally given the right access to quality products at competitive prices. Furthermore, we are seeing momentum in bricks-and-mortar retail stores across Canada, particularly in Ontario, which will benefit all suppliers, but Pure Sunfarms is likely to gain the most due to our significant market share. Thirdly, we continue to launch new products in the dried flower segment, which remains the largest market and will likely continue to be for the foreseeable future. We are adding new SKUs in terms of package sizes and introducing exciting new strains, including high THC options. Our entry into the market with competitive pricing has led to our large format products consistently being among the best sellers at the Ontario Cannabis Store since their launch at the end of Q1. We are also expanding into new provinces, having started shipments to Saskatchewan at the end of Q2 and to Manitoba last month, adding access to an additional 10% of the Canadian market. Currently, Pure Sunfarms products are available in five of the six largest provinces, representing 70% of Canada's population, with Quebec being our next focus. Lastly, and most importantly, Pure Sunfarms will soon commence shipments of its first bottled oil and other 2.0 products to retail, starting with our three largest markets. We will maintain our aggressive pricing while continuing to elevate quality and offer products that cater to consumer demands. This strategy is essential to capture share from the illicit market and compels us to compete effectively in the Canadian marketplace. Importantly, Pure Sunfarms enters these new categories with a strong position in the dried flower market. I am happy to report that for Q2, Pure Sunfarms was again the top-selling brand by volume at the Ontario Cannabis Store, nearing a 14% market share for three consecutive quarters since entering the retail market in late September last year. It's a remarkable achievement for Pure Sunfarms, and since October 1 of last year through the end of July, we have consistently ranked number one in sales. I want to highlight that Ontarians have purchased more Pure Sunfarms dried flower products than any other brand in this time frame. Congratulations to the Pure Sunfarms team for this significant accomplishment. In a rapidly changing market with numerous product launches, Pure Sunfarms has consistently had products in the top ranks for dried flower sales, often occupying multiple spots among the five best-selling products. It's notable that we achieved this success without major promotional spending, celebrity endorsements, or media hype—just great brand positioning executed by our exceptional management team, contributing to our low SG&A. Our strategy focuses on delivering high-quality products that consumers want at attractive prices. Additionally, a recent survey revealed that more Canadians believe the best cannabis is produced in British Columbia compared to anywhere else in Canada, which holds true. We understand the importance of geographical location for cultivating cannabis, as it significantly affects product quality. We have seen solid brand performance in Alberta and BC, where we have recently begun shipping. Currently, the biggest challenge for Pure Sunfarms, as with all suppliers, is that there are simply too many producers in the market for the size of the legal market, numbering more than 50 in some provinces. There seems to be a short-term tendency among provincial boards to diversify their budgets. However, the market is steadily growing, and the supplier landscape will stabilize. There are numerous producers without a sustainable business model, unable to grow quality products or manage costs effectively, and many have been depleting their finances over time. In the meantime, we have scaled back production at Delta 3 to better align our output with sales. With 16 grow rooms at Delta 3, we can quickly adjust production volumes and the types of products we grow. Our focus remains on cash flow generation, emphasizing how much we can sell rather than just how much we can grow. Pure Sunfarms aims for at least 20% market share in the dried flower segment across Canada over the long term, a target we reached in Ontario back in April. We remain optimistic that as the industry matures from its startup phase into a more efficient market, this goal is well within reach. Our leading greenhouse cultivation costs will support our market share growth against illicit trade, highlighting the critical need to capture a substantial share from the illicit market. Competing with the illicit market is our key strategy for driving sales, and the tactics we have in place are effective and yielding results, positioning us well for upcoming launches of our bottled oil and 2.0 products. Now, regarding our Produce business, Village Farms had a strong second quarter, delivering nearly a $6 million year-over-year turnaround in adjusted EBITDA, resulting in positive $1.2 million EBITDA. This increase stems from several factors: progress in transitioning our own growing capacity, effective cost management, and boosted pricing due to heightened consumer demand as more people eat at home. Most of our Produce business is through grocery stores rather than food service, and pricing has remained robust in Q3. It's encouraging to note that the infrastructure supporting our Produce business drives our next phase of opportunities as we position Village Farms for the advancement of cannabis and CBD both domestically and internationally. Since entering the cannabis sector in June 2017, Village Farms has not added any personnel to pursue these opportunities, instead utilizing our existing team's resources within the Produce business while covering overhead costs for these pursuits. This highlights our core identity as a vertically integrated company that generates high returns from agricultural products. Moving on to the U.S. CBD and cannabis landscape, we are closely monitoring regulatory developments surrounding CBD and are optimistic about the FDA's recent comments toward establishing a more coherent regulatory framework for CBD in products, as well as potential for federally legalized high THC cannabis in the U.S. With one of the largest greenhouse footprints in North America, we can rapidly enter either market and already have begun converting our Permian basin facility. We aim to become a significant player in the U.S. market. We recognize the FDA currently has other priorities, but we believe the agency appreciates the importance of providing a clear path forward to allow companies to make informed risk assessments for industry growth. To clarify, we are in a holding pattern but remain committed to the CBD market. We have witnessed numerous companies struggling due to vague regulations in an industry hampered by risk, leading us to be prudent about our position. We don't need to rush into the market and will not jeopardize our shareholders. On the international front, Pure Sunfarms is executing its plan in Canada effectively and is well-positioned for sustainable growth as one of the few large suppliers set to dominate the market. This success has allowed us to extend our focus internationally, always prioritizing responsible capital allocation toward well-researched opportunities with potential returns. In July, we took our first step by acquiring just under 16% of DutchCanGrow, a Netherlands-based consortium of partners pooling expertise to obtain a license to supply cannabis to approximately 80 licensed shops in 10 cities participating in a government pilot program. This initiative aims to enhance the safety of cannabis products in the Netherlands and reduce criminal activity associated with the current illegal market. While the competition for licenses is fierce, we are hopeful given our partnership's strengths and the cannabis experience we bring from Canada. While this program could potentially expand to a national level involving more than 500 coffee shops, we view this as a valuable opportunity and possible springboard for further legal cannabis ventures in European markets. We understand these are long-term decisions that may take years to materialize, but we believe in establishing a foothold now. Additionally, we recently acquired 6.6% of Altum International, a leading young CBD platform in the Asia-Pacific region poised for high THC opportunities. Altum aims to penetrate the Asia-Pacific market through proprietary brands, commercial CBD ingredients, and educational retail stores. They are already making strides in Hong Kong, which has a favorable regulatory environment for CBD, and are expanding into other key markets. We are actively investigating additional international opportunities that leverage our successes in Canada. I want to remind you that our Village Farms International Farm 2.6 million square foot Delta 1 facility adjacent to the Pure Sunfarms greenhouse facilities remains available for CBD or high THC cannabis production for export, should Pure Sunfarms not exercise its option on that facility before its expiration in September 2021. Now, I will turn the call over to Steve, who will walk us through our financial results and summary. Thank you.

Thanks, Mike. I will discuss some key figures from our Q2 results by business line. First, regarding Produce, while it may not be the most popular topic, it remains our core business as we transition into a new agricultural-based consumer packaged goods line. Our Q2 produce sales rose by 15% year-over-year in U.S. dollars to $47.6 million from $1.3 million. Our cost of goods sold remained relatively stable year-over-year, leading to an improvement in our gross margin of $6.5 million compared to 2019, resulting in a gross margin percentage of 7.4% in Q2 2020, a recovery from a negative gross margin of 7.2% in Q2 2019. Typically, Q2 has been challenging for our produce business due to the North American tomato supply dynamics, as all U.S., Canadian, and Mexican greenhouse producers harvest during this three-month window. The principle of basic economics applies here; increased supply amidst flat year-round demand results in historically tough pricing in the spring and early summer months. However, contrary to past trends, 2020 has seen a positive shift for us with increased demand from our retail customers. As Mike noted, our big box grocery stores and national grocery chains are experiencing a surge in customers staying home and eating at home, while global tomato supplies are facing issues that are reducing overall supply. Consequently, basic economic principles are in play, leading to increased pricing. In Q2 2020, our average tomato price rose by 39% compared to the previous year. The pricing increase was most significant for our large commodity tomatoes, as we've witnessed greater consumption of larger tomatoes since the start of the coronavirus pandemic, which has reversed the consumer trend towards smaller, high-priced, flavorful tomatoes in recent years. We expect this strong year-over-year pricing trend to continue, resulting in positive EBITDA and cash flow from our produce business, which will cover all public company expenses for Village Farms for the remainder of 2020. Now, turning to our cannabis business. For new investors, our cannabis operations are entirely through our joint venture, Pure Sunfarms. Although Village Farms owns 58.7% of Pure Sunfarms, we cannot consolidate it due to lack of control. Therefore, Pure Sunfarms' financial results appear in our statutory results as a single line item in our income statement and balance sheet. We do provide the complete Pure Sunfarms balance sheet and income statement for the quarter and the six months ended June 30 in U.S. dollars in our financial footnotes, available in our 10-Q filed last night. Pure Sunfarms experienced a significant decline in sales, margin, and EBITDA in Q2 2020 compared to Q2 2019. The Canadian market conditions, including demand and supply dynamics, have changed considerably over the past year, and this has nothing to do with coronavirus, as some have suggested. Therefore, comparing our Q2 2019 and Q2 2020 results doesn’t accurately reflect the progress Pure Sunfarms has made. In Q2 2019, the market was completely wholesale, with everything Pure Sunfarms produced being bought by other licensed producers in anticipation of cannabis 2.0, along with expectations of a rapid rollout of provincial retail outlets, which did not materialize. Fast forward a year, and the market dynamics are quite different. We are now facing oversupply, and, as Mike pointed out, there are too many suppliers. Consequently, the average retail channel price in Q2 2020 is less than half the Q2 2019 wholesale price we received, resulting in a substantial year-over-year change in our results. A better comparison is Pure Sunfarms' sales from Q2 2020 to Q1 2020, which did see significant changes due to reduced demand stemming from store closures and stay-at-home orders in Canada, primarily influenced by the demand for larger format products compared to smaller format products, which traditionally fueled our business. As Mike mentioned, provincial retail sales volume increased by 89% quarter-on-quarter, driven by large format, lower-priced SKUs, which made up 80% of our Q2 sales. This remains a highly profitable segment for us, reflected in our gross margin. Regarding our cost per gram metric, which is not standard in the industry, we did provide it for this quarter but may refrain from doing so in the future as it doesn't offer a relevant comparison between Q2 2019 and 2018. The cost of goods sold per gram in 2020 was CA$0.84, compared to $0.65 per gram last year, which was purely wholesale and did not include packaging or logistics expenses. In 2020, with most volumes going to retail, our cost of goods sold will encompass those packaging, logistics, and the additional post-harvest labor required as we enter cannabis 2.0 in Q3. Additionally, I'd like to note our balance sheet and cash flow, which are often overlooked when discussing the cannabis business. For the six months ended June 30, 2020, Village Farms had positive cash flow from operations of $2 million, recovering from a $9 million cash outflow during the same period in 2019, making for an impressive turnaround of $11 million. Village Farms is sustaining itself through its produce business, and we’re not diluting our shareholders or raising cash unnecessarily. We’ve managed to fund two acquisitions and two investments in Holland and Asia from our produce cash flow. We anticipate a strong conclusion to the year, and with that, I'll hand it back to Mike.

Thank you, Steve. So, we are now at a place where we really see the future of Village Farms coming into focus. We are realizing our vision to become a highly profitable plant-based consumer packaged goods company, leveraging our decades of experience in large-scale, low-cost intensive agriculture and our vast organizational capabilities as a vertically integrated supplier to the North American major groceries and big box retailers for emerging for new and high value opportunities. At Pure Sunfarms, our plan does not change from day one: lead the industry as a low-cost producer of quality products, establish and grow a leading market share in dried cannabis, leverage that brand performance for other large product categories, and do it with consistent profitability. We look forward to watching Pure Sunfarms build on its success with the imminent launch of its cannabis 2.0 products and the Canadian industry continue to grow. We are at the leading edge of the global cannabis frontier, and this is a massive opportunity. We are proud to already be one of the most successful companies in the world in this new industry, and we are also excited about our many future opportunities at home and abroad in CBD and in cannabis. And that will drive shareholder value in the near term, mid-term, and longer term. I just want to reiterate my opening comments about how pleased I am with the Q2 results. They clearly show the earnings power of Pure Sunfarms and how this part of our business will continue to deliver value for our shareholders. We pushed the envelope on pricing in the second quarter to demonstrate that we can compete with the illicit trade day-in and day-out and be profitable. That is a huge demonstration. And with that, we will take any questions that you may have.

Certainly. Aaron Grey with Alliance Global Partners, your line is open.

Hi, good morning, and thank you for the questions. First, congratulations on another profitable quarter for Pure Sunfarms. Regarding the retail side, you mentioned that you're performing well in Ontario with a 14% market share. It's still early in Alberta and BC, but with the increased competition in those provinces, could you provide some insights into how this has affected repurchase rates? Do you anticipate that it will require some market adjustments before these provinces contribute more significantly, or any guidance on what to expect for their growth? Thank you.

Well, you can't forget that the second quarter was an interesting quarter because of the pandemic. What happened towards the end of the first quarter of February and clearly March was a huge purchase at the provincial levels. A lot of pantry hoarding was going on, and that's had an impact sort of at the beginning of the second quarter, especially in April. So, when we look at Q2, there were a lot of things that were impacted due to the coronavirus, and it started to smooth out halfway through the second quarter. But remember that we didn't really launch in March in BC without large format. We actually launched in the OCS on 4/20 in April, so tied to that date, and then Alberta followed. So, a lot of this, a lot of the impact really started as far as sales increases towards the middle to the end of the second quarter. And now going forward, this will be the first full quarter that Alberta and Saskatchewan are on large format is in all those provinces. I think we'll demonstrate that traction in the third quarter going forward.

Okay. Great. Thanks. That's super helpful. And then, if I could just ask one more on the gross margin side, certainly makes sense how we saw some pressure sequentially as you rolled out your value formats. A couple of things here: as we think about more value offerings coming online and them also potentially 2.0 products. It seems like you have some opportunity on the cost per gram side. How should we kind of think about the puts and takes in terms of the gross margin evolution over the next couple of quarters? Thanks.

I believe this will be the lowest point. In the second quarter, we really pushed the limits. Ultimately, it's about taking market share from the illicit trade, which is how we view this market. Whether it's dried flowers or the vapes we will be launching soon, we must navigate the challenges we face in Canada, which is quite different from any other market. Each international market has its own unique characteristics. Canada, for example, differs significantly from the U.S. The challenges we face include substantial tax burdens. Our license fees, which are based on revenue, will approach $0.5 million per month over the next six months. We also incur a $1 gram excise tax that needs to leave a strong margin for provincial boards, while we have to ensure our margins for profitability. The second quarter showed that if we want to capture market share from the illicit trade, which constitutes about 80% to 90% of the current market, we need to actively compete against it. In the U.S., the illicit trade is becoming less of a concern, but it remains a significant factor in Canada. Regardless of the gross margin results, we were pleased to see it exceed 30%, which I anticipate will be the lower end moving forward. We proved that we can thrive, achieve profitability, generate positive cash flow, and gain market share. Even if the market shifted by 5% to 10% from the first to the second quarter, we increased our sales by 90%, demonstrating the effectiveness of our competitive pricing strategy. It could be argued that aggressive is not the right term; it's essential to compete with the illicit market. As we introduce more single-strain products with high THC that command higher prices and our 2.0 products with better gross margins, those figures should rise. This quarter really showcased our ability to remain viable and profitable at these price points, and I believe we will continue to demonstrate this moving forward.

Thanks for that color. That's helpful. And I'll jump back in the queue.

Andrew Partheniou with Stifel, your line is open.

Thank you for taking my questions. I wanted to discuss the dynamics of the provincial boards, their purchasing habits, and the stock levels. You are clearly performing exceptionally well with sell-through, particularly with PSF being the top brand in Ontario. However, I have observed that at times your product is out of stock. Could you provide some insights into that and share more details regarding inventory levels? I'm curious if the provinces might be increasing their repurchases of our product, given its popularity, which could have led to significantly higher sales this quarter.

Thanks for the question, Andrew. It's an ongoing issue. Pure Sunfarms has observed that provincial buyers operate differently than those in the produce business, where managers are focused on profit and loss. In Ontario, for example, there are over 50 suppliers for flower, which is a remarkable number. We've been informed that provincial buyers have specific budgets for purchases and, when something goes out of stock, they often cannot reorder because their funds have already been spent. From our perspective, an out-of-stock situation results in a lost sale. As Mike mentioned, the Canadian regulatory system presents challenges for all licensed producers. We are dealing with provincial buyers rather than commercial buyers, who typically evaluate based on dollars per square foot, which is not the case here. However, we have seen a shift in behavior, with more frequent purchases now compared to early 2020 and late 2019, where large orders were common and reorders would take a month. Currently, we are seeing weekly orders in places like Ontario, which benefits Pure Sunfarms and helps us restock moving SKUs while minimizing over-shipping of less popular items. Ultimately, this is a consumer-branded goods business, and the introduction of new SKUs, especially larger formats, can negatively affect the sales of smaller formats, which has happened.

Yeah. And if I could add to that. I mean, we have to understand and be patient that this is a whole new massive industry, and they're feeling their way too. I think they're doing a great job in just early days here. So, when you see SKUs that are selling well, that are out of stock, it's just part of building a new base business for them as well.

Thanks for the additional color. If I could ask one more, just on the expansion of your geographic distribution and adding new provinces. You touched a little bit around that in your prepared remarks. But maybe if you could just give a little bit more color on what exactly are you working on to penetrate additional markets. What are the obstacles that you guys face as you turn on that new contract and win that shelf space?

I believe the feedback we're getting from the provincial markets indicates that we are ranked one, two, and three in sales volume, which we are very pleased about. As I noted earlier, Quebec is the last major market we aim to enter, representing 70% to 80% or more of the Canadian population. Once we establish ourselves there, we will be in a strong position. Pure Sunfarms has been careful to ensure they can meet the delivery needs of each province and understand their requirements before expanding further. It's crucial to maintain reliable delivery. They have moved quickly but cautiously, and Quebec is definitely on our radar. I hope we can make significant progress there soon, allowing us to reach our goals. Additionally, we are having discussions regarding the Maritimes, but Quebec is our next significant opportunity.

Thanks for taking my questions.

Adam Buckham with Scotiabank. Your line is open.

Good morning, Mike and Steve. Thanks for taking my question.

Good morning, Adam.

I wanted to dig a little deeper on pricing to start. So, it sounds like from your comments that you expect to see overall pricing stabilize somewhat moving forward at PSF. So, I guess, my question is, with where PSF is now and the product portfolio, do you believe that there is any need in the near term for price adjustments to maintain our gross share? Or do you see the current setup as hard to match by the market?

I think we don't focus much on the competition; instead, we're pushing our business model forward. Our main concern is competing with the illegal trade and understanding that it's a significant part of the market we need to address. If others can manage that, that's their problem, not ours, but that's our direction. This demonstrates our ability to compete consistently against the illicit trade. We face challenges like excise taxes and lack access to some tools that illegal operators might use, which makes it feel like we're operating with significant limitations. However, that's the reality of the Canadian market, and we must adapt and learn to compete effectively. I believe they are handling it well. Regarding pricing, they have really challenged the market, and this is encouraging because achieving a 30% margin—typical for a mature consumer packaged goods business—shows we're in a good position, even if it's on the lower end. I don't think we need to lower our prices further to compete. The 90% increase in sales volume indicates we are already at a favorable point. With the launch of single strains, 2.0 products, and other offerings, we expect higher margins, which will improve our average margin. This is likely the low end of our range, reaffirming our competitive position and boosting our confidence in the sustainability and resilience of our business model.

So, it was a great comment. Thanks. So, secondly, I guess, at a high level, can you provide some color on just how the cost profile is different between your wholesale sales, the large format, and your other SKUs?

Probably not too much. I want to keep some information from the competition, but our large format is high quality and an excellent product. We have found a way to make it work. While I’m not claiming we were the first to introduce it, we have certainly been the most successful in doing so, and it is resonating very well with consumers. This is part of our intellectual property. We are looking at production in our new processing center, hand drying, and creating products that others might consider more of a craft focus. We aim to offer a full range to satisfy all consumer needs moving forward. However, I believe the majority of the market still consists of flower products, and value-added packs will continue to lead the market.

Okay. That's great. I'll just squeeze one last one. More on the produce side. I think Steve might have mentioned the supply-demand dynamics in the tomato market and how it was a tailwind for pricing. Can you maybe provide some detail on what you're seeing in the market currently? And then when you might expect supply to catch up to where demand is?

I've always mentioned that the challenges in produce stem from the changes in the master agreement, which altered the market dynamics. It's akin to if the Canadian government started allowing cannabis imports from South America; it would shift the landscape. This is what's occurring in the produce sector, where we find ourselves competing with Mexico. Our approach has evolved to a point where we recognize that in this labor-intensive industry, we can no longer solely compete; we need to adapt. We're paying around $20 an hour, including benefits, whether for Canadian or U.S. assets, while labor costs in Mexico are roughly $6 per day in agriculture. The pandemic has indeed shifted consumer behavior; with people dining out less, we've seen over 90% of our sales directed at retail food chains, leaving food service greatly impacted. However, on a positive note, more people cooking at home has pushed fresh food sales upward, a trend we believe is likely to persist. The ongoing changes in consumer habits reflect a newfound comfort with home dining, which encourages us going forward. We are focused on strengthening our relationships with partners, recovering lost volume, and transitioning from our greenhouses. I believe that outlines our current situation effectively.

Eric Des Lauriers with Craig-Hallum. Your line is open.

Thank you for addressing my questions. I want to focus on the wholesale market. It’s reassuring to hear that you believe this price level represents the bottom for the retail side. You mentioned a revival in the wholesale market, and I would appreciate your insights on that. Do you think this trend is sustainable, or should we view these as occasional sales opportunities?

It's a challenging question to answer in terms of long-term predictions. Looking back a year, we saw a significant drop in wholesale pricing, around a third of what it was at that time. That level of decline was hard to foresee a year ago. Currently, we have strong relationships with extractors, which we hope will remain positive. We're also collaborating with other licensed producers, and it's worth noting that in our produce business, we have collaborated with competitors for many years. We've maintained good relationships with them and have supplied them as well. While I don't expect exponential growth, I do believe we will see some recovery from the very low levels we experienced in the fourth quarter. That period was essentially devoid of activity.

Okay, that's good information. Regarding the 2.0 products, we've observed mixed results in the market. They appear to be performing better than oils or soft gels, for instance. I'm curious about your insights on this and your perspective on competitors. Additionally, what do you consider a reasonable product mix moving forward? Should we expect it to be around 75% flower and 25% 2.0 products, or is that not accurate? Any insights would be appreciated.

I think flower remains the dominant product in major markets like California and Colorado. Our management team, led by Mandesh, understands the importance of observing what works for others before we proceed. We're being careful about the products we introduce in the 2.0 category, with vapes being one example. We want to evaluate how that segment performs. Once we enter a market, our goal is to optimize our approach, set the right price, ensure profitability, and aim for a strong market position. While we have plans for the future, our current focus is on ensuring we can deliver value and excel before expanding further. Other markets, such as confectionery and beverage, are still emerging, and we need to see consumer preferences develop before diving in. Our priority remains on flowers, and we are committed to increasing our market share in that area.

Rahul Sarugaser with Raymond James. Your line is open.

Good morning, Mike and Steve. Thank you for addressing my questions, and congratulations again on your impressive EBITDA performance. My first question is more macro in nature. We're observing overall market growth in dollar terms; however, incumbents, including your company, appear to be experiencing relatively stable revenue on a quarter-to-quarter basis. Can you provide insight into this situation? What factors do you believe are contributing to it, and do you think it will change as the market evolves?

I definitely think it will. I mean, the second quarter was a crazy quarter. It's almost like we're forgetting the impact of the pandemic on consumer minds. In March and April, that was just 60 days ago, 90 days ago. If you remember when we reported and the other LPs reported, it was a very unstable time, and it was hard to predict. We weren't sure if the infrastructure rollouts by the provinces like Ontario would slow; people were staying at home. So, it was really hard to look at what's happening there. I think we're already into the third quarter, and I can tell you in the third quarter, we're seeing much more stabilization, and we're seeing growth. I don't think the second quarter is probably indicative of where the market is going. That's why I'm really pleased with it, because we went through that, and we got through it in a very strong way. I think we've actually said we see growth in the third and fourth quarters continuing, not just because of the launch of our new products and new strains, but increasing market share and further penetrating and cannibalizing the illicit trade.

Yeah. Great.

On a macro level, I think I feel very optimistic.

Thanks. That's really helpful. And then just one follow-up question. You got to fight Quebec as the next vanguard province to penetrate. We recognize that Hexo has a 'preferred supplier' position in the market, whether artificial or not. How do you plan on dealing with that particular dynamic in Quebec as you penetrate?

Well, that's classified. I mean, let's just see what the results are going forward, Rahul.

Okay. Great. And then just very quickly, I'll just squeeze in a quick question about international. So, obviously, there's Dust and Grow and then the deal in Asia. How do you see your broader international strategy rolling out and committing capital to this sort of outside long-term opportunity?

The key focus is on the long-term perspective. While we could analyze specific segments, there were expectations for significant growth in the CBD market following decriminalization on December 18. However, the FDA has taken a cautious stance, and our commitment remains strong as we view this market as highly promising. We aim to be a major player, whether that involves building, acquiring, or partnering in this space, but we prefer to remain somewhat on the sidelines until we have clarity from the FDA, as it seems prudent to do so at this stage. Regarding the legalization of high THC cannabis in the U.S., it's a topic of much discussion. With upcoming elections, potential tax benefits are generating interest. The opportunities are vast, especially when compared to Canada, where we are ready to act. I generally don't focus much on the Canadian market, as Pure Sunfarms is effectively managing its operations, but I often ponder how long it will be before others miss out on U.S. market opportunities that are currently available. Additionally, having a significant presence in one of the top growing regions, Texas, is akin to British Columbia in Canada regarding cultivation conditions. We are prepared to pivot quickly, whether independently or in collaboration with partners in the future. Meanwhile, we are not complacent and are exploring international opportunities. The DutchCanGrow project is particularly exciting as it reflects a shift in a European country that has historically been resistant to cannabis legalization, showing signs of progress. This is encouraging for us as there are more European nations moving in this direction. However, we understand that these opportunities will unfold over the long term; we aren't expecting immediate positive cash flow. Our current decisions aim to balance potential short-term, medium-term, and long-term benefits, as we recognize the significant opportunities that lie ahead in the coming decade. We are committed to pursuing these possibilities.

Hi. Good morning, guys. Mike, just on the value pack you said it was 80%. I think Steve, you said it was 80% of revenue in the quarter. How big do you think the category can be in total percentage of the market?

Large format?

Yeah.

I think that, similar to what we observed in the tomato business, there has been a shift toward lower-priced products. Therefore, I believe that for the foreseeable future, large formats for dried flower will dominate the marketplace.

Yeah. If we even look at our numbers like March when we just started to launch it, the small format was greater than 50%. We were at about 40% on large; that jumped to 60% April, 76% in May, 86% in June. In the second quarter, it really went from almost non-existent in the first quarter to 78% as compared, and small being 20%. I think that can give you an indication now when we launched new SKUs, it may change. But I think a 70%, 30%, 60%, 40%, 80%, 20% is clearly possible.

The large value pack is priced at around 350 per gram for retail, which appears to be an attractive price for the consumer. Are you considering applying that same price point to a smaller package as part of the new SKUs that are coming in?

Not necessarily. I think we have to be attractive there as well, but maybe not to the same extent as the large format.

Your packaging cost now as handling cost, and then smaller formats, it's substantially higher than it is on a large format. So, you can't do that in the same value that you can in a large format. That's the beauty of the large format to the consumer, right?

When you consider our current situation, the percentage of large format versus small format in June was 86%, which significantly impacted our margins. However, we still exceeded 30%, which is quite remarkable. As we launch more products and our sales volume increases, we are confident that our gross margins will rise, even if large format continues to represent a significant portion of our sales at lower prices. Regarding retail in British Columbia, the Pure Sunfarms management team aimed to align with the black market price of $99 per ounce.

You mentioned that gross margin could potentially increase as the year progresses and into next year. Steve, could you elaborate on the accounting for 2.0 products? I remember you previously referred to trim as essentially waste from an accounting standpoint. How does the accounting work for that product line?

For us, cost per gram is not a standard metric in the industry. I know you and others are trying to monitor that figure. I have questioned whether it includes trim in the production calculation. Pure Sunfarms does not account for trim because our focus is on growing and utilizing the flower. However, trim is utilized in cannabis 2.0 products like vape pens. The cannabinoid content of trim is equivalent to that of high-quality flower. Therefore, I cannot speak for others, but for Pure Sunfarms, our cannabis 2.0 products will positively impact our gross margin since we value trim as zero in our accounting records.

Okay.

So, that will enhance the margin for cannabis 2.0. The percentage of trim used in the cannabis 2.0 product is at no cost.

Yeah. And also, Doug, I want to add to something. I have some numbers. Just looking at where we're headed in sort of July, we had a large format with 80% of the volume in Q2; it has sort of dropped to 60% in July and even down to 45%, 50% initially in August. So, it's going to be interesting to see if a big driver of that was also tied to the pandemic as well. We’ll get some more color on that over the next quarter or two to see how it averages out. So, I think it's still too early to say specifically what that split will be.

Okay. And then just two more quick ones for me. The $12.9 million of net sales in the quarter. How much of that was Ontario?

I don't have that information, and even if I did, I wouldn't share it.

Okay. And CapEx requirements for the second half, given you're pulling back, I guess, some D3? Just give an update where you are in D2, obviously.

Yeah. I mean ...

... what's the CapEx?

No. There's no real CapEx requirements for the rest of this year. Delta 2 has had most of the investment in there. It may only need a few million dollars to kick it off. We're starting to look at longer-term projections of capacity requirements into the third quarter next year, where we feel we may start turning Delta 2 on as well. But we're going to produce what we can sell and maintain our inventory levels at the level we want. You've seen a lot of companies, I think, just producing, producing, producing, can't sell for whatever reason taking write-downs, and we're just going to manage that process. But as far as CapEx goes, we're in good shape.

Sorry, I just wanted to ask about the inventory write-downs we've seen at other LPs. Pure Sunfarms' inventory was US$36 million at the end of the quarter. Can you provide any comments or reassurance regarding that inventory level?

We're comfortable there in the level. Obviously, we've kept it for recoverability. So, we've gone through that exercise, so very, very confident with the inventory that we have. This is a consumer goods industry at the end of the day. As new SKUs launch, it could impact in the future, down the road, our inventory valuation. That said, the beauty of cannabis is you can extract. If you have a strain that hasn't been as successful or is negatively impacted by a new strain that we've launched and the strong performance of other SKUs, if you can take it back and extract it and use the cannabinoid content in cannabis 2.0. So, getting to Mike's point, managing your production and manage for what you can sell and use and utilize in the near term is the way to avoid inventory write-off down the road.

Yeah. We feel comfortable going forward with an inventory level of about 15 to 20 tons. Because as we rollout new products, we have that. So, just on Steve's point, we're comfortable where we're at for sure.

Okay. Great. Thank you.

That's why we mentioned in the call, by the way, we did curtail some of our production at the beginning of the summer just to be able to catch up, and that's just managing the process. That has nothing to do with COVID or the pandemic; that's just managing expectations.

Perfect. Thanks, guys.

Our final question comes from the line of Scott Fortune with ROTH Capital Partners. Your line is open.

Hey, guys. This is Nick stepping in for Scott. Most of my questions have already been answered. But I just wanted some color on the CBD branding side of things, the longer term. Are you guys thinking about building your CBD brand globally in the U.S. ahead of any sort of FDA movement? You mentioned being on hold here, but any color in terms of brand strategy would be helpful. Thanks.

We want to avoid any risks at this time. However, we have a program in place where we are evaluating products that are not undergoing FDA scrutiny to determine whether we should move forward with their development. We still have access to high-quality biomass and are exploring opportunities with other companies. At this moment, I cannot confirm our next steps as we want to fully understand the FDA guidelines. We have gained a bit more confidence in recent weeks, and we hope that after the election, we can focus on this more. We are aiming for 2021 to get back on track. Thank you to everyone for joining us today. I hope we provided clarity. I am very excited about our current position and what we have demonstrated. Our foundation and business model are solid, and we can build upon that as we explore new opportunities both domestically and internationally. We look forward to reporting next quarter and appreciate everyone's participation today.

This concludes Village Farms International's second quarter 2020 financial results call. Thank you for your participation. You may now disconnect.