Delta 9 CEO Discusses Recent Year-End Financials, Profitability, and 2020 Outlook

Capital 10X interviewed Delta 9 (TSX: DN) CEO John Arbuthnot to discuss the company’s year-end financials, first operating income, and plans for 2020.

He also details the value of having a diversified revenue stream, Delta 9’s product strategy, and provides sum of the parts breakdown on future revenue potential.

Transcript

Evan Veryard: [00:00:08] All right, I’m here with John Arbuthnot from Delta 9. CEO. John, thanks for taking the time to chat today.

John Arbuthnot: [00:00:14] Thank you for having me.

Evan Veryard: [00:00:16] So, why don’t we just get started with a bit of an overview of the company for investors who aren’t familiar with the Delta 9 story?

John Arbuthnot: [00:00:23] Absolutely. So, I mean, Delta 9 is one of the oldest cannabis companies here in Canada. We were originally licensed in December 2013. We became the fourth licensed commercial cultivator of medical cannabis under the previous Health Canada medical cannabis regime. Really from there, the early years of the company were quite modest as a small, privately held LP. 2017 became the real growth year for us. We raised about ten million dollars throughout the year, listed our company shares publicly on the Toronto Venture Exchange, November 2017. Since that time, we’ve raised about 80 million through a mix of debt and equity to fund our expansion across our business operations. We now consider ourselves one of the few, you know, call it vertically integrated operators in the cannabis space. So we are licensed by Health Canada for cultivation, processing and extraction. We’re licensed across four provincial markets here in Canada, Manitoba, Saskatchewan, Alberta and B.C. From a distribution standpoint, we are a licensed retailer currently operating four retail stores with near term plans to add an additional three to that portfolio, and a longer term plan to build out a chain of Delta 9 branded retail stores across western Canada.

It’s really our vertically integrated approach on the market and we have what we refer to as our B2B segment. So, effectively as sales of our proprietary growing platform, providing consulting and licensing services to other license and pre-license cannabis businesses, and sale of cannabis genetics. So all in all, we’re one of the few — call it diversified players in the Canadian space, giving investors diversified exposure to not only the production, processing, extraction, wholesale, retail, and then the picks and shovels side of the industry through the B2B component. So, I think it’s certainly a unique offering. The company has grown significantly over 2019 and was actually able to uplift our shares and meet the end of the third fourth quarter last year to the main board Toronto Stock Exchange, where we now trade under the symbol DM.

Evan Veryard: [00:02:32] Excellent. So, first of all, congratulations on that milestone because I’m sure that’s a big one for you guys. And we will be getting into the financials shortly, because there is a lot to take in right there in terms of the different segments and as well as your performance, because it really is sort of a step ahead of some of the other bigger producers that investors are a bit more familiar with. But right now we’re starting all of the interviews. And you mentioned this as well, we’re just tackling the elephant in the room that is COVID 19 and the impacts that it is having on your business. So could you just talk to investors a little bit about what effects you’ve seen?

John Arbuthnot: [00:03:06] Yeah. So, we put an update out to the market this morning by way of press release. Just kind of updates around our response and the measures that our company is implementing and really the continuity factor behind our operations. So to date, there has been no disruption of any of our operations. Our wholesale shipments are continuing to go out to our respective provincial markets. Our retail stores do continue to operate and our B2B segment is continuing to see deliveries of grow pods and continuing on with our pipeline of existing projects. So, I’ll say that to date, again, there has been no material disruption to our businesses, of course. This is evolving. You know, kind of day by day as we’re seeing announcements from different governments and then the response of our respective health authorities, both provincial and federal. I think it’s important to note that through all of this, you know, obviously employee, customer health and safety is top of mind. We’ve highlighted as well the different measures that the company has implemented. You know, really as the situation has been evolving. So, at our production facility here, I mean, obviously, as a Health Canada license facility, we already have or have had in place for a number of years, personal protective equipment for our staff. So, masks and gloves, onsite laundry for scrubs. Really, the facility is kept to pharmaceutical standards in terms of cleanliness.

But at the same time, increased hand sanitizer stations, increased hand-washing stations, emphasizing those good hygiene practices, limiting the number of people operating in any areas to ensure the physical distancing components are kept with. There are things that we can do in our production operations to increase safety. Likewise, in our retail operations, increased hand sanitizer stations in store for customers, limiting the number of customers in store, you know, to call it 10 to 12 at any given time. Keeping to the physical distancing in our checkout line ups, we’ve actually closed our sensory bar so people can no longer smell or interact with the product limiting the customer or staff interactions. Really, everything that we can do and even into last week installing plexiglass shields at our checkouts. Really, again, make sure that customers and staff are at safe distances. And we’ve gone beyond that as well. We’ve implemented as of last week a grateful pay initiative for our frontline staff, adding an additional $2 an hour to both of our front line retail and wholesale staff. So similar to what we’re seeing from a lot of large grocery chains. Obviously, we want our employees to appreciate that this is a difficult time. We all appreciate that. We’re trying to do the best that we can for our customers, for our staff, for the communities in which we operate as well.

Evan Veryard: [00:05:51] Excellent. I appreciate the color. That’s fantastic on, you know, really recognizing what the employees behind Delta 9, you know, the risk they’re taking with the ability to just sort of pay that forward, I think is very…I commend you for that. Now, I want to move next to the financial results released. 2019 year end results, just shy of two weeks ago now. So, do you want to just — maybe just give your color on what you think investors should really focus on as it relates to those results?

John Arbuthnot: [00:06:20] Absolutely. So, maybe I’ll touch on the balance sheet items. Kind of out of the gates here. I know a lot of investor questions that we get are around, you know, where the balance sheet is, there’s obviously a volatile capital markets environment we’re operating in right now where cash and access to cash is key. So, I’ll highlight the balance sheet components and then run through the year end and Q4 operations. So, a lot of I think positive takeaways as well. We can add a little bit on the misses and what the company is doing to address that moving forward. But on the balance sheet side, and if we walk back to say end of Q2, 2019 end of June. The company only had about 3 million in cash, about 15 million in working capital. Obviously, we have then looked forward — a number of CapEx projects to be completed by end of year to really ramp up the business to a sufficient point where we can reach critical mass for profitability.

So, the company undertook a few financing activities through the back half of the year. We raised eleven point eight million through a convertible debenture which closed in July. We then went to our bank, Canadian Western Bank here in Canada, increased our pre-existing credit facilities from twelve (12) million to eighteen point one (18.1) million to give us significantly additional access to capital through that existing credit facility. And really, we highlight for investors that we’re one of the few reporting issuers, even in the Canadian space that has access to conventional lending facilities through Canadian chartered banks. So I think, you know, shines a light on the maturity of the company that we are debt ready through the through our commercial banking. The net effect of these financing activities, the operations surrounded here. The company finished the year with about five point eight million in cash, and over twenty two million in working capital, so significant improvements over what we had been seeing a few quarters prior to that, a significant amount of working capital and still retained access to about nine point five million untapped under that credit facility.

So, I’d say adequate cash, significant access to cash and would highlight as well for investors, that the vast majority of our ongoing capital projects were completed or substantially completed by the end of the fourth quarter, if not early into the first quarter, 2020 here. So, it positions the company well in terms of the balance sheet. We have a healthy debt to equity balance, which we continue to monitor and in compliance with all of our debt covenants under our credit facility. So, I think what highlights, certainly the strength in the balance sheet as a very positive takeaway from the year end results.

Evan Veryard: [00:09:01] For sure. I think too, one thing that’s worth highlighting — I don’t think you mentioned was just, you know, when the convertible debentures are due, which isn’t until 2022. So, I mean, you look at a lot of companies that are sort of up against the wall in terms of when they took on data a while ago and it ended up being, you know capital — the stock price fell. And now those are looking pretty scary for investors. But for you guys, you just took them on this past year. You have a couple of years of runway before you’ll have to pay those down or ideally they convert as well. But, you know, looking at the operations, sort of nice sideways, you know, you guys are near — you were operating profit in Q4 and nearly positive adjusted the offer for 2019, which I don’t think a lot of LPs can say these days. So, do you just want to give a bit of a highlight on the income side of things?

John Arbuthnot: [00:09:50] Yeah, absolutely. So, you know, to speak to the full year results. The company produced about thirty one point eight (31.8) million in top line revenue for 2019. That was up about three hundred and fifteen percent from 7.6 million for 2018. So, obviously significant improvement results. The first full operating year in this legalized recreational use market and I think shows investors that the investments that we’ve been making, the capital investments, the store rollouts, et cetera, are really paying dividends in terms of creating growth from a revenue standpoint. Gross profit and gross profitability obviously significantly improved over the previous year. We improved our gross margin to 32 percent from twenty seven (27) percent the previous year and throughout the year, generally improving quarter over quarter in terms of our operating expenses. We were one of the first companies to really take a hard look at our operating expenses, acknowledged that we would need to push through to profitability from operations in 2019 to really demonstrate that maturity for the company’s business model. And then Q4, I mean to see that pivot really occurring in the fourth quarter and we’d highlight fourth quarter operating revenues about ten point six million, the strongest quarter in the company’s history, up significantly from the sequential quarter of 6.6 million. So very positive improvement even quarter over quarter versus the third quarter of 2019T. Gross profit for that quarter before any accounting adjustments, about 3.2 million.

So again, record quarter for us in terms of gross profitability. As you pointed to, adjusted operating profit. Profit from operations was about 400,000, the first positive quarter in the company’s history. Adjusted EBITDA loss was about eighty thousand dollars, down from about eight hundred thousand dollars in the previous quarter. So, you know, we’ve been generally guiding investors. So, when the company can achieve 10 to 11 million and top line revenue becomes that break-even point for us from an operating income. In an adjusted EBITDA standpoint, I think it really is a pivotal quarter for the company in terms of showing that pivot towards being a positive operating cash flow entity, which as you mentioned, is quite scarce in the cannabis space today.

Evan Veryard: [00:12:08] Excellent. And I appreciate the color. And you’re absolutely right. It is certainly a milestone to be achieving that. So congratulations. Would you be able to just provide a bit more color for investors? I know we talked earlier. You kind of have those three revenue sources, retail, wholesale and business to business. Could you talk about the contributions they made in 2019, and those contributions you see them making moving forward?

John Arbuthnot: [00:12:29] Yes. So I’ll just speak briefly — in kind of the current state and highlight each of those segments and how they performed in 2019, how we feel they can perform on a forward looking basis. So, we refer to our production and wholesale businesses as really based off of our Health Canada license facility here. It’s an eighty thousand square foot facility where we grow in these proprietary grow pods and they’re effectively retrofitted shipping containers. We take standard 40 foot high cube containers, install customized wall panels. Electrical lighting, HVAC Systems, and we’re now left with units that are modular, scalable and stackable. A lot of our focus here is high quality flour, really emphasizing that indoor high quality, hydroponic, high potency type product mix to really put us in the high quality category. Throughout the year, we received several expansion approvals from Health Canada. As of the end of year, we’re operating two hundred and ninety seven (297) of these grow pods, so gives us an annualized capacity of around eighty five hundred kilos per year.

And you look at that versus our Q4 output numbers about thirteen hundred (1300) kilos. There’s obviously significant growth that we can still see in our production output, but we would point as well to the economic argument to be made for this growing platform. A number of investments in automation throughout the year have really been driving down our production costs throughout the year. As of Q4 the company hit ninety one (91) cents in cash cost of production, which puts us, I believe about fourth or fifth in terms of the overall Canadian cannabis industry in production efficiency.

So, not only are we focused on high quality products, it’s also coming at a low cost. And further to that, we’d emphasize just that this production model has a built-in, call it risk mitigation function and you compare this versus the big open greenhouse. So, the outdoor crops, which at the end of the day this is an agricultural product. It’s acceptable to disease, to infection, to active pests. In those applications, those issues can often become systemic and cause total crop losses very quickly. Having these smaller, compartmentalized areas means that we were de-risking our overall operations by putting that into these small, compartmentalized areas. So, we do feel there’s a number of benefits to this type of production platform versus what you may see in a conventional greenhouse or outdoor grow. As we look then forward to 2020, what we really expect from this business unit — we are pending a Health Canada approval, as we noted in our year end management discussion analysis for the next part of our Phase 2 expansion. It’s a purpose built and fully automated production line which takes our finished flower or blended cannabis or pre-rolls, puts it into the finished package, labels, induction, sales tax, stamps, all of that fully automated. The line will have an annualized capacity of up to twenty five thousand (25,000) kilos.

So, very significant capacity that we’re building in here just from a processing standpoint, really allow us to continue to expand our cultivation operations and be very efficient in terms of moving those products through to market and wholesale. When we look at our annualized capacity, and while we don’t necessarily provide formal guidance for any of our business units, we would point to investors that at our average selling price, and with eighty five hundred kilos annualized capacity, the company has a potential revenue from our wholesale business up between 25 and 35 million a year.

So I think for investors to expect over the next few quarters is some improvements in our wholesale business as we pivot towards higher potency, higher quality products which are demanding a higher price point in wholesale. The retail side, significant out-performer for us this year. Retail revenues were fifteen point four (15.4) million in 2019. That was up three hundred and ninety percent over the previous year. Three additional store openings throughout the year. I mentioned there are three more store openings that are planned in the near future. You know, we throw out the caveat around the near term health crisis. You know, we need to consider how appropriate it is for us to be opening stores in that context. But, you know, obviously, we continue to kind of assess these types of operational issues on a day by day. I consider what may be appropriate from a long term strategy standpoint.

But retail, you know, again, I think we would point to the positives. You know, really, we designed these stores to be in high traffic areas to target liquor, grocery, pharmacy partners, to really take cannabis retail in Canada and throw it into the high traffic, high flow traffic, and high car traffic areas. Kind of show people that cannabis is here, put it into a well-lit shopping environment, a thoughtful interior store design around the traffic flow within the store. Emphasis on ancillary products, knowledgeable customer service staff. And we actually do position our products or our pricing for sale in store to be the price leader. So we’re again, as a part of this vertically integrated model, the goal is to capture as much of the value chain, as much margin as possible up and down the value chain. So it allows us to get into retail and compete as the price leader in the market and be positioning our products very competitively, not only versus our competition in the legal market, but also versus the black market. So we feel that’s a very important competitive advantage for our retail chain.

Again, we look forward into this year, even at the end of Q4 last year, our retail chain was doing an annualized revenue run rate of over 20 million. So still some significant growth over last year’s numbers to be seen. Additional store openings will obviously drive the demand curve further. And we would generally point to that the new stories we’ve heard recently of an uptick in Cannabis retail sales as a result of some of the, you know, call it panic buying or an uptick in demand around the COVID 19 crisis.

We’ve certainly seen that increase foot traffic and average cart size has certainly been well a published story over the last few weeks in Canada. On the B2B side, revenues last year about 6.2 million, up almost 600 percent from about 900,000 in previous years. So, you know, significant growth in our B2B segment. This was our first real year to focus on that segment, building it out as a standalone business unit for us. I think we’re continuing to see a large pipeline of projects. I think investors would find it interesting that, you know, in spite of the capital markets volatility for the cannabis sector over 2019, we are still seeing significant number of businesses investing in the cannabis space, wanting to get in and build out facilities.

And you know, this unit really, it gives us upfront construction revenue or revenue from grow pods and equipment. It gives us revenue from the consulting services as we work with these groups through the licensing process. It gives us revenue from genetic sales as we establish these facilities, get them up and running with genetics. And then very often we’re signing longer term off-take agreements to be purchasing the product from these craft producers. And where we feel that to be very strategic as it allows the opportunity for smaller craft quality, really focused cannabis producers to be working with a larger integrated operator that can facilitate distribution.

We can brand, we can bottle, we can label, and we can distribute products for these groups. So we see it as a long term relationship as much as there is upfront revenue and earnings potential for us. So you put the sum of these parts together. We feel that on a forward looking basis and again, in absence of formal guidance, there’s significant growth for the company to see across these three segments into 2020. And really, would point to as well that this vertical integration is diversified revenue strategy. It continues to prove that it makes our company more nimble in terms of assessing any real stumbling blocks for our industry as the industry continues to evolve and we’ve seen the struggles for the non-vertically integrated operators. You know, call it the pure play producers in our space. We know there’s an oversupply environment. We’ve seen the strains in the overall wholesale market for cannabis products in Canada. Well, in absence of seeing growth over certain quarters this year in our wholesale business, we’ve seen very significant growth in our B2B and our retail segment to kind of take up the slack. So I think we continue to point to that this diversified revenue strategy, it allows us to address those concerns, to continue to see growth and really give investors that exposure to all of these different elements versus any of the pure play operators of the space.

Evan Veryard: [00:21:31] For sure. And I hope after the last year that cannabis investors have learned about the importance of diversification. But I think it’s also really, really helpful for you to do that. Some of the parts break down because I think with so many different pieces, especially with the B2B being more prominent than others for Delta 9, it’s very helpful for investors to understand the full on potential. Obviously, it’s very prudent not to provide guidance on these things right now, especially with the environment. So thank you for that color. Last question and then we’ll wrap it up there and maybe leave for future conversations, is just understanding your product portfolio. Near the end of 2019, you had Cannabis 2.0 start, but it takes a lot of time to develop new products, to obtain the licenses and the approvals from Health Canada. So across 2020, you know, barring, you know, significant delays from COVID 19 –. Are you guys looking to roll out any new products?

John Arbuthnot: [00:22:24] Yeah, absolutely. So, I mean just speaking more generally to consumer trends, I think you know, we’ve all seen in the sector over 2019. We saw the introduction of pre-rolled products into say the second quarter. Those became a much more material revenue segment for us, about 15 percent of revenue coming from pre-rolled cannabis products. We’ve sold over a half a million cannabis pre-rolls between our launch, middle of last year and to date. So becoming a very significant segment for us. We have four main products in the pre-rolled segment in Dried Flower. We really saw a pivot very early on last year of consumers looking to prefer high THC products.

I think more so than even expected. We generally had a sense that consumers may be wanting, you know, low potency, mid potency, high potency, some CBD inclusive strains, some high terpene or unique terpene profile strains. But a lot of the focus has become on the high potency products. So early last year, Delta 9, we tapped into our seed bank. We brought on some new strains, really looking to isolate those phenotypes that would fall into the high potency category, not only be commercially interesting, but be commercially viable.  Q4 and into Q1 is where we start to see that pivot for Delta 9 and launching these new products. And any investors who are interested, I would invite them to poke online. Look at our investor materials. Look at our online store for our products being marketed in Manitoba.

You’ll see a lot of that production focus shift towards these high potency products, which obviously demand higher price points, which helps us combat margin compression in our wholesale business. Beyond that, Cannabis 2.0, it’s going to — It was the new exciting thing. We introduced these new products mid-December last year, which, of course, was in the middle of the holiday shopping season where you generally see an uptick in retail sales as well. I mean, what better thing to launch around December 15th than to have all these new products, SKUs hitting the store? It has become, you know, I’ll say material revenue segment. These 2.0 products, including vapes, edibles, drinkables, I think to date is comprising about 10 to 12 percent of our revenue through our retail segment.

What we would note, though, is that we are seeing similar supply issues to what we had seen in the dried flower market over the same period last year. So edibles, you know, we still have not seen a normalized supply environment. We almost can’t keep them on the shelves. Drinkables, likewise, we get them in and they sell out in one to two days. So until we start to see a more normalized supply environment, I don’t know that we will have a really good sense of what are the winning categories. Vapes are starting to become better supplied from a number of different manufacturers. I think that has been kind of the first indication that the supply situation is starting to get better. But overall, you know, I would highlight for investors that we really look to use our retail segments as a guiding hand for what we are doing on our production manufacturing business.

You know, I think that has become very important over the last year — is to make sure that the investments that we’re making are prudent, that we’re not simply guessing at what the market might be, that we’re making educated decisions around allocations of capital. So, you know, we’ll continue to assess what are the impacts of these product categories. Delta 9 to date has launched 1 new 2.0 product. We call it our dried sift cannabis. It’s a dried product extract that runs the THC concentration in both 33% percent and sells it about 21,000 a kilo in retail. So very premium pricing around that product. I think very interesting, giving consumers are kind of chasing THC a little bit. So being able to have that, you know, as I concentrate as a part of our offering, I think becomes that much more interesting. From here, the company plans to launch a line of vaporizer products over the next quarter or so. We’re working with Wesley Labs out of Calgary on a line of vaporizers and disposable vapes. All look for those to launch again in the next quarter or so. And then from there, additional announcements on how the company may be looking to either partner or enter the 2.0 market will be forthcoming into the latter part of the year.

Evan Veryard: [00:26:48] Excellent. Well, obviously, lots of exciting things on the run. And hopefully, you know, the application for entering Ontario moves through quickly so we can — us Ontarians can try the product as well. John, I appreciate you taking the time to chat today. And I think investors will be happy to hear all of the colors. So, thank you very much.

John Arbuthnot: [00:27:07] Happy to take the time. Thank you.

Disclosure: Capital10X was paid by Delta 9 for the costs inccurred to capture and edit the above content.

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The opinions provided in this article are those of the author and do not constitute investment advice. Readers should assume that the author and/or employees of Capital 10X hold positions in the company or companies mentioned in the article. For more information, please see our Content Disclaimer.

Evan Veryard
Evan Veryard has a Bachelor's of Chemical Engineering from McGill University and a MaSc. of Chemical Engineering from RMC. He has over 6 years of research experience focusing on industrial materials. Address: 682 Indian Road, Toronto, Ontario, M6P 2C9. Phone: 416-721-8257.
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