Lowell Farms Inc. (OTCQX:LOWLF) Q3 2022 Earnings Conference Call November 9, 2022 5:30 PM ET
Company Participants
Bill Mitoulas – Investor Relations
George Allen – Chairman
Mark Ainsworth – Co-Founder and Chief Executive Officer
Brian Shure – Chief Financial Officer
Conference Call Participants
Doug Cooper – Beacon Securities
Operator
Hello, and welcome to the Lowell Farms 2022 Fiscal Third Quarter Earnings Call. All participants will be in listen-only mode. [Operator Instructions.] Please note, this event is being recorded. I would now like to turn the conference over to Bill Mitoulas, please go ahead.
Bill Mitoulas
Thank you. Good afternoon, and welcome to today’s conference call to discuss the Royal Farms, Inc., financial results for the fiscal third quarter of 2022. Before we begin, please let me remind you that during the course of this conference call, Lowell Farms Inc., management may make forward-looking statements. These forward-looking statements are based on current expectations that are subject to risks and uncertainties that could cause actual results to differ materially from expectations. These risks are outlined in the Risk Factors section of our Form 10 filed on EDGAR and our listing statement filed on SEDAR.
Any forward-looking statements should be considered in light of these factors. Please also note that any outlook we present is as of today, and management does not undertake any obligation to revise any forward-looking statements in the future. This call includes George Allen, Chairman of the Board, Mark Ainsworth, Co-Founder and Chief Executive Officer as well as Chief Financial Officer, Brian Shure, will go into detail about the company’s financial results for the quarter later in the call.
The Q&A portion of this call is open to analysts’ questions to provide further insight into the company’s performance, operations and go-forward strategy. For those of you who may happen to leave our call before its conclusion, please be advised that this conference call will be recorded and archived on our Investor Relations website page. And now I’ll hand the call over to George. George, please go ahead.
George Allen
Good afternoon, and thanks for your time. There is much to discuss here given the disappointing results we’re presenting today, and I will be speaking for Mark tonight as he’s lost his voice with a cold. He’s on the call and we’ll be able to answer questions at the end. Conditions in California are tenuous at best, and there’s an overwhelming sense that something is going to break. Specifically, we’ve seen a continuing decay in retail demand, coupled with a general lack of health among retailers.
In May of last year, sales across state according to headset are down 16%, led by a 19% decline in flower sales, the largest sales category. What’s more surprising is that unit volume over this period is down 2%, meaning that the decline in prices has not created any demand response from the consumer. There’s two possible explanations for this, either we’re seeing a decline in cannabis consumption or there is a secular shift into an alternative purchase channel, namely the legacy or illicit market. We suspect the latter, but supporting data is indeed elusive.
Now against this backdrop, retailers are struggling to pay their bills and the round robin approach to running up tabs across vendors has kept them alive so far, but we know that they’re running out of room to maneuver as tax bills catch up with them. In response to profit pressures, we see a concerted effort from retailers to raise their markups in an attempt to make up for decline in traffic. And while we cannot be sure, we fear that this is further driving consumers into alternative channels.
In this context, we see a handful of strategies that other operators are embracing for survival. Most of our peers are focused on either massive economies of scale or a retail first vertical integration strategy as a vehicle for success. If been following our story, you know that our path is somewhat different in that we see much of our future in product innovation and indeed, this is how we arrived at the Lowell 35 launch. Only two product categories have experienced sales growth over the last 18 months, and that’s pre-rolls and beverages.
Given the relatively small revenue base in the beverage category, the only real opportunity for growth has been in pre-rolls. And thus, we’ve seen a lot of our competitors come searching for revenue growth in the pre-roll category. While we continue to enjoy the Number 1 market status in flower pre-rolls and overall Number 2 status in pre-rolls overall, we are seeing more competition. Luckily, most of our competitors are focused on the infused category, which is adjacent to but not immediately competitive with our core book of business at Lowell.
Now I’m very, very pleased with the early success of the 35 product, which I’m going to go into in detail in a minute. But unfortunately, the success of the 35 product is not the only trend in our business. California cannabis continues to be in an oversupply mode and prices per flower continue to fall. We have seen some slippage in bulk prices and CPG package flower continues to be trench warfare with fly by night brands, making momentary shelf space with unsustainable pricing only to disappear and be replaced by another contender moment later.
As you will recall, we didn’t see the logic in following prices downward, and our sales in package flower had been softer than expected, most notably in our value brand, House Weed but also in lower flower. While our market share in pre-rolls has maintained relatively stable according to headset, we have seen sales attrition there as well, perhaps attributable to seasonal buying patterns given the very tight working capital conditions we find in our retail partners. We also faced challenges within our LFS business as we appear to be the victim of an uneven playing field as enforced by local regulators who have looked the other way as operators continue to flagrantly violate building codes with noncompliant drawing facilities.
Collectively, the poor operating performance continues to put pressure on our balance sheet and liquidity precisely at the moment when we perceive the most opportunity in our business. The confluence of factors is making it difficult for us to achieve our target of self-sufficiency. Cost containment is obviously a priority during this time. And given the decline in revenues, the drop in adjusted EBITDA from the second quarter to the third quarter from a loss of $1.1 million in Q2 to a loss of $1.7 million is disappointing, but also reflective of our efforts to eliminate extraneous expense at this time.
Against this backdrop, we continue our efforts to raise capital, and we are in discussion with several interested parties, but we have also decided to commission a strategic alternatives committee of the Board to initiate a strategic review in light of some acquisition interest we have had in the business. While it is premature to discuss the prospects for this committee’s work, we think it is an important step given the current market environment and our liquidity.
Next, I’m going to start with some detail around our Lowell 35 launch as we launched it at the very end of the quarter. We launched the Lowell 35 on September 29 at a price point that is below 88% of flower sales in the state, and our thesis was that we could attract consumers from flower into pre-rolls. The new 35 form factor encourages cannabis snacking for heavy users with all the flavor of flower and the convenience of a vape pen.
Another aspect behind the product launch is the deep body of knowledge and IP that we are building around the product manufacturer. This product is extremely complicated to produce and the knowledge that we have acquired through the All Good transaction as well as built up over time, gives me great confidence that we will have some running room before we see a lot of competition in this SKU.
We launched the first 3 SKUs within a select group of 16 stores. Three weeks later, we opened up the sale of the product to all stores within the state. The launch of the 35 has been the most successful in company history. In the 5.5 weeks since launch, Lowell has penetrated over 130 doors within the state. The Lowell brand is currently active within 389 stores and delivery depots across California, thus implying that we have already achieved a 33% penetration with this new SKU. I can’t emphasize enough how challenging this is to do in the current environment. Retailers are flushed with inventory and very hesitant to bring on new SKUs, which are likely to render existing inventory old or obsolete.
Now since launch, we have experienced a nearly 2x lift in pre-roll market share across our launch stores out of the gate. This means that the sales volume of our new products are rivaling that of our legacy products without substantial cannibalization. That’s great news. Additionally, the 35s have already surpassed the consumer loyalty benchmarks set by our legacy products as measured by repeat purchases within a 14-day period. This is a very important factor since we feel that our brand awareness will compel consumers to try the product at least once, but our sales ambitions require that we foster loyalty and habitual usage among consumers in order to drive real revenue growth.
Using proprietary retail analytical tools that we have built. We see that the vast majority of sales of the new 35 product came at the substitution of some product other than pre-rolls. Nearly 60% of 35 spend came through consumers shifting from flower. Only 23% of 35 spend came from consumer substituting for some other pre-roll choice. This early data substantiates our assertion that the 35 product will be a vehicle for growing the pre-roll category, an important factor for us, given our already leadership position within pre-rolls.
While it’s early, I think the sales momentum we’re experiencing within the product gives us confidence that over time, this SKU will produce us meaningful revenue growth. While forecasting demand is more arced in [signs] at this stage, we estimate retail sales for these first three SKUs of approximately between $40 million and $50 million annually at retail price points once the product is fully distributed across the state. And this is going to take time. We further believe that the acceptance of the product will grow further as consumers get accustomed to the convenience factor of the product and thus, sales potential will rise beyond that.
Against this rising demand profile, we have a product pipeline which will expand to bring more diversity to the consumer offering beyond these first three initial SKUs. Over the upcoming few months, we’ll be expanding our 35 offering in various stages, including the addition of new blends, two new infused lines and various brand co-lab launches with other popular brands in California cannabis. Since we launched the 35 at the end of the third quarter, revenues for the period were relatively minimal.
Now I’m going to turn my commentary to Q3 CPG revenue performance, which was only minimally impacted by this 35 launch. During the quarter, we changed the accounting for how we account for slotting fees paid to retailers, and we now treat those fees as deductions from revenues instead of sales and marketing expense. The change also resulted in a deduction in reported Q3 revenues for slotting fees associated with prior periods.
The net effect is that the accounting change exacerbated our sequential revenue decline in CPG sales. Normalized for this change in accounting, CPG sales fell 9% sequentially during the quarter. Much of this decline pertains to the weakness in what we call our noncore CPG categories that include our SKUs outside of flower and pre-rolls as we have become less price competitive in those categories with the advent of competition.
In general, we have fought very, very hard not to follow the market downward on price as we have found that the detrimental impact to margin is generally not recoverable with increases in volume. We have also learned that price decreases are never a two-way street. As an alternative, we’re working to address the opportunity with further brand expansions so as not to cannibalize our existing book of business with lower-priced offerings. This takes time, but we know how to do it, and ultimately, it preserves value over the long run.
Turning to bulk. The bulk market continues to show weakness heading into the final quarter as pricing pressures accelerated relative to the trends we witnessed between Q1 and Q2. During the quarter, we sold nearly 5,400 pounds of bulk flower versus 6,300 pounds in the prior quarter, a 15% decline sequentially. In addition to a decline in volume, we witnessed a 20% decline in our realized price per pound quarter-on-quarter.
Although the decline in our realized price per pound was partially due to a higher attribution of weights sold in the form of lower grade flower relative to the prior quarter. The pricing pressure in the bulk channel, coupled with the launch of the 35s prompted us to stockpile a record amount of biomass into the fourth quarter. This contributed as well to the decline in sales.
Now on to Lowell Farms Services. Much of the sequential decline in LFS revenues pertain to the fact that last quarter, we liquidated $1.6 million in flower acquired from third parties that was sold to satisfy receivable balances from those customers. The sales came at minimal margin and that phenomenon did repeat itself this quarter after we liquidated the inventory in question left over from last year’s Q4 harvest. But more troublesome is that our servicing revenues have declined over the quarter by 56%, reflecting a difficult market environment for cultivators.
We’ve been anticipating a title wave of demand driven by county level enforcement of building codes but unfortunately, the county has extended deadlines into the new year for compliance and turned a blind eye towards rampant code infractions. We do see a near-term opportunity for processing outdoor flower this quarter given the seasonal harvest schedule, but a steady stream of service revenues throughout the year will require that the county ultimately make enforcement a priority among the greenhouse community within the county. We are watching this situation very carefully.
Next, I’m going to turn out of state. We are very excited that this month, Lowell Smokes will finally go on sale in both Colorado and New Mexico with our partner [flaws]. During the quarter, we did experience a modest decline in royalty revenues offset by packaging revenues. But more encouragingly we saw early signs within the monthly data that our efforts to grow sales in Illinois and Massachusetts has begun to take hold.
Lastly, I wanted to talk about a new offering that we’re going to try this quarter in an effort to accelerate CPG sales and help our retail customers. Now we hear from many of our customers that cannot meet our order minimums for delivery service. Other customers are tight with cash and need to buy their inventory on a moment’s notice, thus they can’t wait for our delivery route.
In response, we’re going to try opening up our distribution centers in both Northern and Southern California for a cash and carry sales by appointment business. It’s basically a B2B storefront. Buyers must pass a compliance check during onboarding of their account. We believe that this will help some of our clients who are working capital constrained, and we are very optimistic about its prospects.
With that, I’m going to turn the call over to Brian. Brian?
Brian Shure
Thank you, George, and thank you for your time, everyone. Before I begin, please note that we are reporting our Q3 2022 results in US GAAP and a portion of my commentary will be on a non-GAAP basis. So, please refer to today’s earnings release for a full reconciliation of GAAP to non-GAAP results. We report all figures in U.S. dollars, unless otherwise indicated. I would also note that these results are unaudited. Our quarterly report on Form 10-Q will be filed with the SEC and CSC on November 14.
We are reporting Q3 revenue of $8.7 million, down 34% sequentially and down 31% year-over-year. DPG revenue declined 18% sequentially to $6.1 million and declined 31% year-over-year. Despite the decline in CPG revenue, Lowell brand revenues remained strong, up 2% from the prior quarter and reflecting 82% of CPG revenues in the current quarter compared to 66% last quarter and 64% in the third quarter last year.
As George mentioned, we changed the accounting for slotting fees paid to retail partners during the quarter. Previously, these fees had been booked as sales and marketing expenses and are now treated as a deduction from revenues. The change results in a $0.7 million reduction in Q3 revenues, $0.4 million of which was related to prior periods.
The bulk flower revenue decreased sequentially to $2 million and increased 2% year-over-year. The decrease from Q2 is due to both pricing declines as well as volume declines. As flower pricing continued to show weakness in the quarter, we made the decision to stockpile biomass following a highly productive quarter at farm. Lowell Farms Services revenue decreased to $0.3 million as the company scaled back service production following Monterey County’s decision to allow noncompliant drying and processing facilities through at least the year-end. Out-of-state licensing revenue increased 13% sequentially to $0.3 million as shipments of packaging to licensees increased during the quarter. Gross margin as reported was 21.9% in the third quarter compared to 11.3% sequentially and 0.5% year-over-year.
In the third quarter, the margin decline was due to inventory adjustments in prior period variances, the reclassification of slotting fees along with lower volumes in both CPG and bulk sales. Excluding the effect of out-of-period expenses incurred, gross margins would have been minus 2.9% for the quarter. Operating expenses were $3.3 million or 38% of sales for the quarter compared to $4.5 million or 34% of sales in Q2 this year and $7 million or 56% of sales in the third quarter last year, reflecting cost reductions realized year-over-year.
The operating loss in the third quarter was $5.2 million compared to an operating loss of $3 million sequentially and an operating loss of $7 million year-over-year, reflecting lower margins in the current quarter and reduced volumes. Net loss for the third quarter was $4.8 million compared sequentially to a net loss of $4.6 million, which compares to a net loss of $8.7 million in the third quarter last year.
Adjusted EBITDA in the third quarter was negative $3.5 million compared sequentially to adjusted EBITDA of negative $1.1 million and negative adjusted EBITDA of $5.2 million year-over-year. Without the impact of the out-of-period adjustments itemized above, adjusted EBITDA for the third quarter would have been negative $1.7 million.
Turning to the balance sheet. Working capital was $15.1 million at the end of the third quarter compared to $14.5 million at the end of the second quarter, and the company had $3.3 million in cash compared to $2.2 million at the end of the second quarter. Capital expenditures of $1.9 million were incurred in the third quarter and were used primarily for the purchase of equipment for the Lowell 35s. In the third quarter, we completed a convertible debt offering, providing $6.7 million in financing and an additional $2 million was provided by employee retention credits earned in 2021.
With that, I’ll turn the call over to Mark. Mark?
Mark Ainsworth
Thanks, Brian. Let’s turn it over to the operator for questions.
Question-and-Answer Session
Operator
Thank you, Mark. We will now begin the question-and-answer session. [Operator Instructions.] Our first question today comes from Doug Cooper of Beacon Securities.
Doug Cooper
Just on the — So, let’s focus on the 35s for a second. What is the — is pricing at 88% or 88% — sorry, let me look back at my notes.
George Allen
Yes. We basically said it — we launched at a price point that’s below 88% of the convertible amount of flower. So, like it’s an eight to weed and we launched it below that price point. So, that means that 88% of flower is sold in the state is sold at a higher price than the price point at which we sold the pre-rolls.
Doug Cooper
Right, and what is the gross margin on that product at that price point?
George Allen
So, it’s like — it’s heavily dependent right now on the efficacy of running the manufacturing machine and running the machine to make it. But we’re currently posting it somewhere in the sort of mid-40s right now.
Doug Cooper
Okay. Just the numbers came out from Canada in August, and pre-rolls are now 30% of the total market, almost equivalent to flower. I think it was 38%. The market in Canada is flower versus 30% pre-rolls, up from 15% in January for pre-rolls. What is — where is California right now in terms of pre-roll market share?
George Allen
In California right now, Doug, it’s like — I want to say it’s like 15% or 16%. So, Canada is about twice where we are in California, but California — California’s been growing, percentage of share has been growing as well, and I think we’re going to — I don’t think that there’s any reason why we can’t get to the numbers that Canada has in terms of percentage of sales.
Doug Cooper
And how are the machines operating in terms of their utilization, what you expected? Is there any — was there any issues on racking them up?
George Allen
It’s a really complicated piece of equipment. And frankly, what we found is that the OEM is supportive of the equipment, but the OEM really doesn’t know run the equipment with THC. And so, there was a little bit of a leap of faith there that would have been very hard for us to take without the All Good — without acquiring the All Good team because they haven’t really spent a lot of time crafting the SOPs to build it. I would generally say like — it is frustrating because there are moments in time where the product, the machine, can be unpredictable.
We are producing a very healthy amount of inventory, and we’ve got a very technical team that is building up a wealth of knowledge as to how to run the inventory. But it’s an incredibly precise piece of equipment that is very sensitive to both changes in biomass and the environmental conditions in which you’re making the equipment. So, what I think that means from my standpoint is it’s not nearly a walk up to turn it on and watch equipment spinout — watch pre-rolls spit out the other end. It’s far more complicated than that. And I think that creates both a moat and intrinsic value in the business as we sort of build-up knowledge to produce the product.
Doug Cooper
So, you have one line running, or where are you at —
George Allen
Yes, right now we have one train — right now we have one train going, yes.
Doug Cooper
Okay. So, when you talk about California’s got to break at some point, I mean this has been now a few years. So, it’s been like this. What — besides people — the regulatory enforcing, what else needs to be done?
George Allen
I don’t know — it’s a hard question. That’s a really hard question. I think what eventually happens, I think we really have two fundamental questions. I think you have first on the supply side. I think the supply side is it’s pretty darn obvious that there’s too many suppliers on product, over-capacity. The cultivation on its very basic level, it’s oversubscribed in the state. And what you think we’ve always seen in cannabis is a very slow response cycle. I mean good oil well, people turn off the oil well, if it’s below the marginal cost of production, cannabis is different because there’s a lot of people who make up the cannabis industry who aren’t necessarily well positioned to reenter the job market elsewhere, so — or well inclined.
So, I think there’s a delay factor there that happens. And so, I think the only possible answer is we’re going to have to see supply fall away. I do think there’s some demand drivers that I think most of the demand increases we’ll see come from the fact that product is more — moving more and more across the country with relative fluidity in California continuously.
I can’t substantiate at all, but I’m quite certain that some of the sales softness we’ve seen across the country in cannabis operations is due to the fact that there’s just — there’s just a massive amount of inexpensive cannabis coming out of California that’s running us out of market. So, I think on that side, it’s pretty obvious we need a supply some sort of supply correction.
On the retail side, I also think you’ve got some challenges there. And to be honest with you, the biggest problem we have in last mile fulfillment is around 280 because 280E forces all the operators to mark the product up so excessively high, that it leaves a huge amount of opportunity for retailers, or for the illicit market, to come in underneath. And that — So, I think you’ve seen that sort of dueling set of priorities, but when the product has fallen as severely as it has, it has turned into just a complete pandemonium in terms of retailers. And we were watching retailers raise margins by five points a quarter in an effort to try to recover lost profits from declining traffic.
Doug Cooper
Well, listen, I think in Canada, obviously, we’ve seen a similar situation. It seems the early stages of trying to rectify itself. I’ve seen just from my eyeball looking around the city here, there’s a whole bunch of retailers going on the business. Supply seems to be curtailed as cultivation guys go to business as well. So, maybe that will come to California. Do you hold out any help for the lame duck for [passing it safe] and what the implications are making for you guys?
George Allen
Yes. I think, first of all, I think State does have a fair amount of positive benefits for us. It allows us to — it takes a lot of friction out of our business from how we interface with our customers just you take a lot of the cash transactions out of the business. But in addition to that, I think it obviously lowers our cost of capital. We’ve got a mortgage that’s got a double interest expense on it. So, I think that there is opportunity there for reducing our overall cost of capital in the industry.
And then everyone is talking about this — everyone is talking about this SAFE Plus clause, which SAFE Plus is this idea that not only will they allow cannabis — you know, banks to service cannibal clients, but banks can also, through the addition of a couple of key words, can also go on to exchanges. I think it’s unlikely that in our current state of affairs, we’re going to be jumping towards a NASDAQ listing anytime soon. But what I will say is that that I think when you see the liquidity improvements from the larger operators in the space jumping into that kind of paradigm and getting the response of volume and price, then I think we see a lot more M&A activity in the market.
So, I think it will create a bit of a rising tide. By no means are we banking on it. I think there is something to be said. I don’t know how much comments I’d put behind sort of an ad hoc comment that Chuck Schumer made during a debate, but I think there is something percolating in D.C.
Doug Cooper
And just maybe I’ll just leave it with this question, and then I’ll jump back in the queue. But (inaudible), who is the owner of Circle K, obviously, did this deal of GTI in Florida, Fire & Flower, they just support a whole bunch of mount of money in there in Canada, and they’re talking about co-locations in some spots in Ontario. Do you think ultimately, this will be available in convenience stores and will not be better or worse for your [vendors?]
George Allen
Well, no. I mean, first of all, endpoint proliferation is great for our business, right? I mean we’re sort of endpoint agnostic in our space. Truth be told, I think one of the complicating factors of the California retailers, and I don’t pretend to know their business all that well, but I do think one of the things they struggle with is the expectation from consumers that there’s 1,000 SKUs on the shelf. And it’s what happened.
California cannabis almost inevitably, any given retailer’s got about 1,000 SKUs on their shelves. And that sort of aging inventory and the inventory management becomes an obstacle. And I think that one of the challenge for one of the nice things about this like Circle K kind of concepts, is you can really start to bifurcate the sort of fat end of the tail from the long end of the tail and serve customers with a shorter set of inventory. And I think that works to everybody’s benefit.
And it certainly would work to our benefit because we’re in the — we are in the fat part of the curve and we are on the brands that our customers tell us our brands that they descale want to keep on the shelves. So, we’ll see how it evolves but I think — retailers — Sorry, go ahead.
Doug Cooper
I was going to say, for lack of a better word, the [securitization] of the cannabis industry to get to a few brands if pre-rolls go to 50% of the market, just for example, then there’s only a few brands that have the capability of doing this in the cigarette style. If that’s the form factor you think is going to win, then if it’s available where you buy cigarettes, that would make things much easier in life.
George Allen
Look, I don’t think you’re ever going to convince the cannabis consumer to give away choice, right? They’re always going to want a breadth of choice, but there’s a very — it’s different between — it’s different between sort of like your habitual product versus your gifted product or sort of your long-tail product around your mom who’s got back pain or sleeping issues. So, I think there is a chance that you can coexist, but probably in a different retail form factor.
Doug Cooper
And sorry, Brian, in final, what is the cash position today of the company?
George Allen
So, Brian, I don’t know if we’re going to — we’re talking cash position right now, but we gave cash position at the end of the quarter. Brian, do you want to go through the liquidity?
Brian Shure
Yes, I mentioned that we are at $3.3 million at September 30.
Doug Cooper
So, that’s with the $6 million that you — $6.7 million that you got in, in the quarter, right?
Brian Shure
That’s all right. That’s right.
George Allen
We spent a fair amount of money getting the 35 launch up and running.
Operator
This concludes our question-and-answer session. I would like to turn the conference back over to Mark Ainsworth for any closing remarks.
Mark Ainsworth
Thank you again for joining the call and taking the time to get an update on our business. We look forward to talking with you on our next earnings call.
Operator
The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.
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