Village Farms International, Inc. Q1 FY2023 Earnings Call

Good morning, ladies and gentlemen. Welcome to Village Farms International's First Quarter 2023 Financial Results Conference Call. This morning, Village Farms issued a news release reporting its financial results for the first quarter ended March 31, 2023, that news release along with the company's financial statements are available on the company's website at villagefarms.com under the Investors 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 1 hour following completion of the call. Details of how to access the replays are available in today'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 this 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 the company's various securities filings with the SEC and Canadian regulators, including its Form 10-K, MD&A for the year ended December 31, 2022 and 10-Q for the quarter ended March 31, 2023, which will be available on EDGAR. These forward-looking statements are made as of today's date. And except as required by applicable securities law, we 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, Bella. Good morning, everyone, and thank you for joining us on today's call. With me are Village Farms' Chief Financial Officer, Steve Ruffini; Village Farms' Head of Canadian Cannabis, Mandesh Dosanjh; and Village Farms' Executive Vice President of Corporate Affairs, Ann Gillin Lefever; and Patti Smith, Vice President and Corporate Control. As per our usual format, Steve and I will review the operating highlights and financial results for the quarter, and then open up the call for questions. So let's begin. The first quarter was a solid start to 2023 with three particularly noteworthy highlights. First, our fresh produce business is tracking towards our goal of achieving sustainable positive adjusted EBITDA for this year. Fresh delivered its third consecutive quarter of significant sequential improvement, approaching breakeven adjusted EBITDA with a Q1 EBITDA loss of just under $1 million. That's a $5.2 million turnaround from Q1 last year and a $2 million improvement from Q4. While there's still much work to be done, I'm encouraged by the meaningful and steady progress over the past several quarters. Second, despite what remains a very difficult environment in which to operate, our Canadian cannabis business continues to be one of the best and most consistent performers in the country. Retail branded sales once again significantly outpaced market growth, and we expanded market share while continuing to generate positive adjusted EBITDA, which we did again this quarter. And third, we have added markets to our Canadian export channel, which is generating strong momentum in this part of our international cannabis strategy, where margins are much higher and taxation is rational. Let me address each of these, starting with Canadian cannabis first. Village Farms' Canadian cannabis business keeps putting up big points on the scoreboard, which in a normal operating environment would be recognized. There are three key areas in which the team continues to deliver: One, our number one position in dried flower category nationally, which we have held consistently for five quarters now, and which remains the largest product category and the basis for all product formats; two, our strategic acquisition of Rose LifeScience, which has been accretive to their growth in the important Quebec market, and thus a contributor to our overall growth; and three, our execution, commercialization and investment in innovation, which propelled us into the number two market share position overall last year and which we maintained during Q1 of this year. Notably, we are one of just three of the top ten producers that meaningfully grew market share over the past year, and we outpaced the second biggest gainer by more than two to one. Our low-cost production capabilities and continued incremental gains in our efficiency enabled us to generate year-over-year growth in adjusted EBITDA, our 18th consecutive quarter in positive territory. The team is focused on execution against those variables in our control. Yet despite the proven and sustainable strategic advantages built into our Canadian cannabis model, we are operating in a structure that keeps much beyond our control. It feels like we are playing the game with one hand and both feet tied behind our back. The iconic federal legalization of cannabis in Canada is approaching the six-year mark. It was a bold, courageous and progressive move designed to bring about the availability of a safe, regulated product, create a new healthy competitive industry and convert an illicit market into beneficial tax revenue. As we speak, when many other governments exploring legalization, we are asked about the Canadian model. There are many positives: The availability of a safe, regulated product; innovation and emerging research to benefit the consumer; and a partnership between operators and regulators where the rules are largely transparent or at least a means to discuss. Yet as we and other licensed producers have noted respectfully in our conversations with the regulators, the Canadian excise tax is strangling the economics of producers and as a result, not generating the sustainable tax dollars government expected. To put this in context, Q1 alone, we incurred CAD 18.6 million in excise tax, more than our entire payroll expense on branded sales of CAD 47 million or 40% of our provincial sales in the quarter. This does not include payroll tax or property tax or licensing tax or income tax. If we were an alcohol or tobacco company, that nearly CAD 19 million in excise tax would be in the neighborhood of just under CAD 5 million. Let me say that again: If we were an alcohol or tobacco company, we'd have paid roughly CAD 14 million less in tax this quarter alone. It's ludicrous. It's not surprising that then, as others have noted, the majority of licensed producers are not paying these taxes. We suspect the economics do not allow it. It has been well documented by industry experts that the government is the most profitable entity in the Canadian cannabis supply chain, and we believe the illicit trade is likely the most profitable. This has provided the illicit markets ample room to underprice the legal, safe market, a major reason why the illicit market remains strong and underground for the industry. It's questionable then if the legal industry will be able to convert to remain 40% or so of all Canadian cannabis sales, that is still illicit product under excise tax regime. This is clearly inconsistent with the industry's desired contribution in that it challenges local enforcement efforts. It challenges profitability. Just look at the lack of the corporate income tax contributions, the thousands of job losses and impacts on ancillary businesses and local communities. And it challenges future investment. Innovation cannot be filtered out of continued capital injection. I feel this is another area that illicit trade can surpass the industry. More significant changes to the tax structure, flat per gram tax takes the absurd to another level in the context of the rapid expansion of the value segment of the market, including our own Fraser Valley Weed Company. All of this is one reason we are attracted to the opportunities in international markets. The second highlight for our Q1: leveraging experience in Canada for international opportunities, with their attractive profit profile is a core part of our cannabis strategy, and we are seeing very good momentum. Year-over-year export sales were up more than tenfold and now contribute nearly 7% to our Canadian cannabis segment sales. Most of the export growth to date, including this quarter, has come from our first export market. Earlier this year, we added a second export market with the launch of Pure Sunfarms brands in Israel. And last week, we announced our launch in the German medicinal market, after successfully completing all testing protocols and testament to our team and local partner, IUVO Therapeutics. While the lead up to both market launches had its delays, I'm pleased that we have received follow-on orders for both countries, and we are thrilled to build our business with some local partners. And then finally, my third takeaway for Q1 is a significant turnaround in our fresh produce business. Fresh is an important strategic business for Village Farms. We are committed to de-risking it and returning it to profitability as part of our long-term growth strategy. Q1 was another very encouraging step in that direction. The macro environment has improved, oversupply is getting under control and we have made adjustments for inflation. We continue to work on our improvements across all aspects of our operations from greenhouse to customers receiving docks, including best-in-class operating protocols to manage plant viruses, as you know, that's been difficult the last few years. Our fresh results for the first quarter continue to support our confidence in sustainable improvement, improved financial performance for our produce business this year and reinforce our belief in the value of this business. Fresh and cannabis are synergistic. Each benefits from the other's expertise, assets and deep rooted experience. We have capitalized on these synergies in Canada and have long eyed the United States. As such, we have formally applied for a medicinal license in Texas, where the lead use of medicinal cannabis may be greatly expanded to include chronic pain. While the number of potential licenses and timing of when a state will make a decision are unknown, we are encouraged by the potential to contribute our cannabis expertise of decades of investment in the state of Texas and our deep agriculture roots to any future plans by Texas to award additional licenses. Should we receive a license, we will work with the stock exchanges towards an acceptable ownership structure that would enable us to participate in the market. With respect to our current CBD business in the United States, Balance Health Botanicals continues to hold its own in another very difficult market in which to operate. We continue to benefit from the success of Synergy+ and its line of products last year. So far this year, this business is operating more or less on plan and with the continued focus on costs supporting near breakeven adjusted EBITDA. Regulation of the CBD business would be a meaningful game changer for this business, and we eagerly await the outcome of the Farm Bill 2023 this year. The potential review of the category, in the meantime, the team is operating under the highest production standards, both from our current customers as well as the opportunity to expand when food drug mass retail are ready and open.

Thanks, Mike. Consolidated sales for all of Village Farms for the first quarter were $64.7 million, a decrease of 8% from Q1 of last year, with the decrease due to lower sales from fresh produce and U.S. cannabis, which were partially offset by Canadian cannabis sales. On a constant currency basis, sales declined 5%, with a stronger year-over-year U.S. dollar reducing our reported number by 2.6%. On a constant currency basis, our cannabis business sales were 48% of our consolidated U.S. dollar sales. Consolidated net loss for the quarter was $6.6 million or $0.06 per share compared to a net loss of $6.5 million or $0.07 per share for the same period last year. The slight increase in net loss was mainly due to our improved operating loss of improvement of $2.2 million, being offset by a higher year-on-year in our income tax expense of $2.3 million as we are booking a valuation allowance for our U.S. tax losses, which we started in Q4 of 2022. Operating loss before tax for Q1 improved 27% from Q1 last year. Improvement was mainly the result of the improved operating performance from VF Fresh. Consolidated adjusted EBITDA for Q1 was $519,000. This is a significant year-over-year improvement from negative $6.1 million for Q1 last year, which is mainly the result of a $5.2 million fresh produce EBITDA turnaround Mike discussed earlier, as well as higher EBITDA from our Canadian businesses and a 13% year-over-year decrease in corporate costs to $2.2 million, excluding stock compensation. Turning to our Canadian cannabis results, which I will discuss in Canadian dollars to provide a more accurate gauge of period-to-period performance without exchange fluctuations. Net sales for Q1 grew 23% year-over-year to CAD 34 million, with retail branded sales growing 40%, once again outpacing overall Canadian market growth by a wide margin. Beginning this quarter, we are breaking out our international export sales in our Canadian cannabis business as they are becoming a larger part of our sales mix. And as Mike discussed, with more favorable margins, it is an increased focus for us. International sales were $1.7 million, which was a 750% increase over Q1 of last year. Non-branded or wholesale sales for Q1 were $2.3 million compared with $4.9 million in Q1 last year. As already low spot prices in an oversupplied market were further eroded by large inventory liquidations. As we have discussed many times, the wholesale market is opportunistic for us, and we have been selective around our participation in the current market environment, with the expectation of improved pricing when supply is more aligned with the market demand. Gross margin for Canadian cannabis in Q1 was 33%, essentially in line with our 34% adjusted gross margin we reported in Q1 of 2022, which excluded the purchase price inventory adjustment in that period. The slight decrease in margin was primarily related to a sales mix with a higher portion of lower-margin Fraser Valley sales as that brand continues to have success in the value segment of the market, and it was not launched until the back half of 2022, being for the most part offset by the higher margins on our higher international sales. Selling, general and administrative expenses for Canadian cannabis for Q1 were CAD 9.3 million or 27% of net sales, unchanged from CAD 9.3 million in Q1 last year, but down as a percentage of sales from 34% in Q1 2022.

Thank you, Steve. So in closing, I want to reiterate some points. One, we are pursuing return-enhancing growth opportunities that line up with our expertise and core capabilities. This focus matters. We are still in the very early stages of cannabis markets in North America and around the world, and there are many wrinkles in these markets still to be ironed out. Two, we are holding ourselves accountable for what is in our control. Finally, I appreciate listening to our reflections on the challenges in the Canadian cannabis sector. I also appreciate the partnership of many in this industry. Governments are making bold decisions to revise decade-long entrenched stigmas about cannabis, and we applaud their strategic rationale to provide a safe, regulated product. This is core to our DNA also. Village Farms will continue to work with all regulators to get the balance right to achieve these goals for the benefit of the industry, for the benefit of consumers and for the benefit of Village Farms and all its stakeholders. We'll turn over for calls at this point. Operator, Bella, we're ready.

Our first question comes from Frederico Gomes with ATB Capital Markets.

First question is on the produce side. Can you maybe provide some more color on what exactly drove the margin improvements in produce? How much of it you think is under your control to maybe continue driving those improvements over the remainder of the year? And how do you see that segment performing for the next two quarters?

We are very focused on what we can control, particularly regarding margins. Price compression continues to be a factor, but innovation is helping to offset it. Currently, about 30% of our processes involve new product offerings. On the produce side, we are making significant investments in artificial intelligence and autonomous growing systems. We introduced one of these systems about 1.5 years ago, and the results have been excellent. We plan to expand this initiative to all our Texas and Canadian facilities starting in 2024. The early results indicate increased yield, better efficiency, and lower costs. We are also investing around $3 million in new automated equipment that will be operational this fall for our Texas crops, which will enhance labor efficiency. We are managing our operations at the facility level and, as mentioned, we are continuously evaluating our retail customers to optimize our business for maximum profitability, even if it affects revenue variably. These strategies are aimed at achieving positive EBITDA and eventually positive cash flow. All these factors, among others, are expected to contribute to higher margins. However, it's important to remember that we are in a commoditized market, competing with Mexico, which places limits on the potential for higher gross margins primarily driven by pricing.

Okay. Thanks, Mike, for that color. Just maybe moving on about your application for a medical cannabis license in Texas. Can you talk maybe a little bit more about the potential opportunity you see, and then what sort of timeline can we expect there in terms of not only a decision on the license, but also actually potential start of sales?

Sure. As you know, we've reported that while we're expanding internationally and looking at exporting and operations in other countries, entering the U.S. market has always been a priority for us. We are committed to finding ways to enter this market, and Texas is one of those avenues. Four years ago, Texas issued three medicinal cannabis licenses, but they had very strict limitations, only allowing doctors to prescribe for one type of epilepsy out of 13 possible forms. This has resulted in two of the three license holders being inactive. Two years ago, during the last legislative session, there were no new licenses or changes to the existing restrictions. However, this time, the Texas Department of Public Safety is set to issue more licenses, although the exact number is still unclear since there were around 200 applicants, and the cutoff was at the end of April. The governor will also have a say in how many licenses are granted. Another positive development is that a bill has already passed in the House, and the legislative session will end in May, with only about 15 working days left. If the Senate approves this revised bill, it will allow for the inclusion of chronic pain and mental health issues such as PTSD, which are necessary for making Texas a more mainstream medicinal state. This will enable doctors to write prescriptions for a variety of therapies and conditions, which makes us very optimistic if the bill passes. That’s why we’ve focused so much on Texas and its potential. We anticipate having clarity on the bill by the end of this month, and we expect to know by early fall whether we will receive a license. We are prepared to act on this.

Okay. I have one last question regarding your Canadian cannabis business. From what we've observed, the market is highly competitive and fragmented, facing pricing pressures with much of the value going to the government through taxes. What catalysts or events should investors look out for this year concerning Village or the broader industry that could improve these conditions?

The power of cannabis as a product is remarkable. A recent New York Times article highlighted the idea that if cannabis were invented today, it would be considered a miracle plant. However, we are still dealing with long-standing stigmas around it, which pose challenges. I believe investors in cannabis should take a long-term approach, as this will eventually evolve into a large global industry. I would suggest setting aside a portion of your portfolio for long-term investment, as the payoff will come, even if it benefits future generations. We are currently focused on managing our costs and enhancing our market share through innovation. We want to be in a strong position for when changes occur in the market. I am confident that if regulations are eased—not just in terms of taxes, but other areas as well—there will be substantial opportunities. We need to be patient, but I truly believe that few consumer products hold the potential that cannabis does over the next five years.

Your next question comes from Aaron Grey with Alliance Global Partners.

First one for me, just in terms of pricing in the Canadian marketplace. It seems there might be some early signs of stability from some of the third-party data, particularly in the flower category. So I appreciate any color you might be able to provide in terms of what you're seeing in the marketplace on that stability. Particularly given I know you took some price increases on certain SKUs. So what are you seeing in terms of flower pricing and how the price increases on those SKUs have been receptive in terms of the marketplace?

Thanks, Mike. Thanks for the question, Aaron. So on pricing in the market, yes, your data and intel is pretty accurate. We're starting to see that flattening out and that stabilization, specifically around flower, and it kind of leveling out and not seeing a lot of major price activities. So you're spot on there, and we're seeing the same thing. Second point on our general price increase that we started to take across the country, it started in late Q1, as I mentioned in the last earnings call in March. And so very positive reception. And what I mean by that is that retailers understood it, the Boards were very supportive of it. And I think we started to even get some really good commentary from our competitive licensed producer set that we were doing that. And I think it shows something needed and warranted in the industry. And we're seeing good momentum behind it, and we're not seeing any backlash from any of our customers. So all in all, right move, positive for us, positive for the industry, and it's being viewed as such.

Okay, okay. That's great to hear. Second question for me. You talked about artificial intelligence and how that's going to help the produce business. Sir, anything you can leverage from that potentially for cannabis as well, talk about helping drive increased yields, higher efficiency, lower costs, all things that are helping produce I would also imagine would help cannabis as well. So anything that you might be able to leverage in terms of the artificial intelligence on produce and bring it into the cannabis side?

Yes, we wanted to begin with produce in Texas, and our Delta 1 facility, which is one of the largest produce operations in the country, will continue into the new year. We're learning from this experience and plan to apply those insights to our cannabis operations. This is an autonomous growing system that operates continuously. We believe this will create significant synergies in our cannabis business, particularly in the U.S. We have been exploring this technology for years and are eager to implement it. Cultivation is a key area of focus for us, and along with brand building and innovation, our priority remains low-cost, high-quality production. This is part of our ongoing effort to improve, and we look forward to taking this next step.

And your next question comes from the line of Eric Des Lauriers with Craig-Hallum Capital Group.

First one from me, just wondering now that you're breaking out international and you reported financials. If you could just comment on the expected pace of sales or perhaps timing of sales that you're expecting this year for international?

Yes, we feel very confident. Australia has performed well for us and has been very consistent. It takes time to navigate the testing procedures and protocols, which has been challenging, both domestically and in Canada, as well as in other countries. The good news is that for Israel, where we shipped in January, and Germany, we've already received our secondary orders, which is exciting. However, we want to be a bit conservative looking ahead. We're aiming for a 10% increase this year, which we believe can rise to 15% in the following years. We are exploring opportunities in other countries, but I won't disclose details until we have made a sale and it has been accepted. I hope that answers your question.

No, that's helpful. I appreciate that. And then next question for me, I apologize if you touched on this already. But just looking for an update to the Texas greenhouse that you guys have listed for sale, just if there's any progress to comment on there.

Well, it is officially for sale, and that's all we know at this point. We have a long list of 260 possible folks receiving the package on it, and we want to move very quick. It is in production apparently, so it is a little bit of a cost drag on us because we're not in full production. But hopefully, by the time we report in August, we'll have some good news on it.

Your next question comes from the line of Michael Freeman with Raymond James.

Congratulations on a terrific turnaround in the VF Fresh segment. That effort is quite fantastic. Wanted to talk about VF Fresh and about some market cost of sales reductions year-over-year. You've seen significant reduction in greenhouse costs, which I think I understand. But I wonder if you could touch on supply partner costs. It looked like they reduced $4.8 million this quarter. I wonder if you could share some color on that.

This is Steve. The decrease in supply partner costs is directly tied to the lower volume. With less volume, there are naturally reduced payments to third parties. We usually take possession of the produce they grow under our various Village Farms labels, sell it to our retail accounts, take a percentage off the top, and pay our supply partner the remaining amount. Therefore, with reduced volume, we see decreased payments.

Got you. That makes a ton of sense. Now the next question, year-over-year for Pure Sunfarms, there's been a big EBITDA margin expansion. Wondering if you could describe the, I guess, the improvements that have been made and what factors have been driving this massive year-over-year expansion?

Yes, I can start off and if there's anything, Mike or Steve, that you want to add, you can chime in. Michael, thanks for calling that out and pointing it out. Mike alluded to some things earlier about it's always about looking at your costs, making sure you can compete and set yourself up for long-term success. So we're always going to be looking at things around our cost structure, how we improve yield, how we look at our operating costs. And you've seen our SG&A fall as a percentage of sales. We know that when we talked about it last year, it's going to continue to be a competitive environment. And so we're continually looking at where we can drive better margin on our SKUs, rationalizing our assortment, getting better performance out of our products. And then looking across all of our cost yield efficiency line items to continue to maintain our ability to drive through EBITDA performance and overall margin performance. The pricing component that I touched on earlier didn't have a large impact in Q1 because it is at the tail end of that. So I did just want to call that out. So again, looking at assortments, looking at costs, understanding how we can continually improve our overall operating structure and make sure we're setting ourselves up for that success and knowing that it's going to continue to be a tough time in 2023. I'm not sure if there's anything else you want to add, Mike, Steve.

And your next question comes from the line of Ben Klimber with Stifel GMP.

I'm shifting to operating cash flow. You reported an operating cash burn of $3.7 million this quarter. Given that the second quarter typically has lower margins, could you provide some insight into your expected operating cash flow for the upcoming quarters and for the full year?

This is Steve. The first quarter is typically challenging for our cash flow. As Mike mentioned, the Delta 1 facility in Canada is one of the largest greenhouses in North America, and it does not generate any cash for us in the first quarter, which means there's a significant cash outflow related to farming. Although that facility won't produce round produce this year, it is expected to generate positive cash flow for the next three quarters. Regarding our cannabis business, we typically see increased sales, especially with our branded products, and we anticipate higher sales internationally. Therefore, I believe our operating cash flow will improve as the year progresses.

We have a follow-up question from Ben Klimber from Stifel, but it seems he has withdrawn it. We don't have any further questions in the queue. I will now turn the call back over to Mr. DeGiglio.

All right. Thank you, Bella, and thank you to everyone for joining us today, and we certainly look forward to speaking to you at the time of our Q2 announcement and conference call in August. Have a great day. Thank you. Thanks, operator.

This concludes today's conference call. Thank you for your participation. You may now disconnect.