Interview with OrganiGram CFO Paolo De Luca, 9/7/2018

Run time – 19:30 (Transcript below)
Published 9/7/2018



David Kretzmann:            David Kretzmann here at the Benzinga Cannabis Capital Conference here in Toronto, and I’m joined by a special guest right now, the CFO of OrganiGram, Paolo De Luca. Paolo, thanks so much for taking some time to talk to The Fool. We had a chance to speak to your CEO, Greg Engel, a couple months ago, but before we dive into the latest with OrganiGram, you joined the company in December. I’m just curious if you could walk us through what drew you to OrganiGram?

Paolo De Luca:                   Great. Thanks for having me. I joined the company in December of 2017. One of the things that really appealed to me about the company and the industry was obviously that Canada is on the leading edge of the recreational movement around the world. We’ll be the second company to be legal from a recreational perspective after Uruguay, and cannabis is also becoming, by way of its sophisticated capital markets and also the fact that the medical program has been around for a few years and we’re launching recreational in October, it’s becoming the center of capital formation, so you’re seeing a lot of even U.S. cannabis companies listing on our Canadian Securities Exchange [inaudible 00:01:15] so we have three exchanges, the TSX, the TSX Venture, and now the Canadian Securities Exchange that list cannabis stock, so there’s a lot of expertise that’s developing here.

A lot of the investment banks and brokers are comfortable dealing in the space and I think we’re a leader in the world on cannabis, and that’s one of the reasons I want to join, because my background has always been in capital markets and I like to be where the activity’s at. I’m very happy to be here and it’s been a fun ride since I’ve been with the company.

David Kretzmann:            Awesome. Doing our best to deal with the background noise here, and I know especially with October 17th, that legalization date approaching for a producer like OrganiGram, building relationships with retailers is really important, so maybe you can just give us some highlights of how that’s going, what you’re doing to get a foot in the door and just what that process looks like to build relationships with retailers and what that landscape looks like over the next six to 12 months.

Paolo De Luca:                   Sure. Actually, a lot of the relationships have developed and are being built over the last couple years, to be honest with you, so if you haven’t really been working on the relationships up until now, you’re not in a position really to sell into those markets. One example I’ll use is our head of marketing, Ray Gracewood, he worked at Sleeman, not Sleeman … Moosehead Breweries for nine years, so he already has relationships with a lot of these private and public retailers across Canada, so we’ve been working with them well in advance of the launch of recreational market, and in fact we have a partnership with a group in Colorado called The Green Solution who own … I believe they own something like 16 out of the 250 stores, or 400, I can’t remember the exact number of stores in Colorado, but that group has been very successful in garnering a 9% market share in Colorado, and what we’ve actually done is brought a lot of the public and private retailers down to Colorado and showed them the way that retailing is done in Colorado and obviously that’s helped us develop and foster relationship with the private and public retailers here in Canada.

The leg work has been being laid down for at least a couple of years now and the other thing in terms of the way we’ve built our team, it’s a … it’s really compromising our management team of people that have a deep pharmaceutical, biotech, consumer, packaged goods, food manufacturing and beverages and really what we’ve got there is a skill set that can address the market, not only now which is medical and becoming recreational, but also the regulations that will allow us to sell edibles going forward. So with an edible product, you really want to have kind of that food manufacturing mentality and for example, our VP of operations has a deep experience working for … making food as a plant manager and also as the VP of operations at [inaudible 00:04:17] which is a chocolate company that for example supplies chocolates to Laura Secord here in Canada.

David Kretzmann:            Got it. Obviously right now it’s a moving target, particularly when it comes to branding and packaging with recreational cannabis and what that looks like in Canada, but maybe you can speak to the challenges and what you’re aiming to do to build a brand in this emerging category, both on the medical side, which you’ve been established in for quite some time now, but also on the recreational side as that comes online.

Paolo De Luca:                   Yeah. There’s two initiatives that I can point to right off the bat is we piloted one of our brands that we’re gonna be using for the adult rec market, the Edison and Edison Reserve. Edison would be our mainstream brand and Edison Reserve would be our premium brand, just think of it like Johnnie Walker Blue. We piloted those … the Edison concept in the medical market and we tested it with our clients and customers in the medical market, so we know how people respond to it in terms of pricing, differences between mainstream and premium, and so Edison is actually the cornerstone of some of our brands, so that’s one initiative I can point to, and the other thing I would mention is there are a lot of restrictions on packaging and labeling and so forth so one of the things, again, going back to your question on developing relationships, we’re gonna be looking to work with and train staff with public and private retailers so that when people are in the stores and they’ve passed the age-gated control, there will be a lot of point of sale material and digital media available to the sales people and customer service people in the stores to help promote our brands within the store concept.

David Kretzmann:            Got it. What would you describe as OrganiGram’s biggest differentiator? What is it that distinguishes OrganiGram from other licensed producers out there? Or maybe another way to ask is what do you see as the company’s competitive advantage going forward?

Paolo De Luca:                   That’s an excellent question, and it ties in also from someone who’s considering to invest in the company. We are an indoor producer and generally speaking, indoor producers produce a better quality product. There’s a couple of ways I can … a couple of examples I can give to you that would demonstrate this.

One, of the Cannabis Awards last year in Canada, of the six product categories, all six of them were won by LPs that we’re producing in an indoor environment. Of those six categories, we won two out of the six awards. So, A, it’s a testament to indoor growing, and, B, a testament to our growing, and the two awards that we won were top sativa, which is our Wabanaki strain and Blueberry Cheesecake, which is our blend. So we won the top sativa and the top blend.

The theory, historically, has been that indoor production though is more expensive to cultivate, and we’ve seen a shift in Canada where a lot of people have gravitated to building expansion in greenhouse, thinking that in the long run it’s gonna be a price competitive business and that your cost of productions have to be ultra low. In fact, right now I can confidently state based on the review that we’ve done in the market, we have the lowest cost of production. Our last quarter, we … our cost of cultivation, including depreciation, which is a non-cash item, was 80 cents a gram, excluding it was 66 cents a gram.

Now, there is not … there’s no cost for packaging, which is a bit of a moving target right now because we’re still finalizing the packaging for some of the rec markets that we’re about to enter and the [inaudible 00:08:09] sizes really drive the packaging cost to a large degree, but if you think about it for a second, we have an indoor award-winning production and the lowest production costs in the industry. You can imagine that we’ll be able to gain a market premium on the selling price and then obviously from a margin perspective, because our costs are so low, we should have some of the best margins in the business.

David Kretzmann:            Awesome. Something I’ve always thought about and I know I’m not the first one to bring this up, but Canada is a colder climate. What happens down the road if it becomes easier to cultivate cannabis in maybe warmer climates where you can still grow indoor, but at a lower cost so you’re not spending as much on energy to keep it warm or whatever might go into that. How do you sustain that kind of advantage if there are other regions that are able to cultivate at maybe a lower price without expending as much money on energy or expenses like that?

Paolo De Luca:                   Sure. One of the things that you still can’t replicate though in an outdoor environment, it certainly in theory is gonna be cheaper because you’re not paying for the electricity, but the one thing you can do in an indoor environment that you can’t do in an outdoor environment is control the conditions 100%. You control exactly when the lights turn on, how much light, how much water, how much fertilizer you’re giving it, and because of that, you’re able to drive an outcome in terms of the product. That gives you a consistency that I think, in terms of wanting to build a brand long term, you think about going to McDonald’s here or going to McDonald’s in Moscow, theoretically speaking, your Big Mac should be the same in both locations.

Well, with an indoor environment, we’re able to produce the same type of output because we control the conditions perfectly. In an outdoor environment, you can’t do that so I think outdoor is probably in the long run better suited for creating active pharmaceutical ingredients or APIs, cannabinoids that are then used in other products, but in terms of dried flower production, you’re still gonna get a better … you’re always gonna get a better product indoors and there’s always gonna be a premium paid for it, which will outweigh, presumably, the increased cost of production. But again, our cost of production indoor are so low, we’ve driven them to such a low point at this point that we’re … I heard someone talking about it in a presentation earlier that at Columbia they can grow for 10 to 20 cents, well, we’re not that far off and if we can drive even more efficiencies, we might get to that same cost. Because one of the drivers of cost of production are also the output you get. As you drive more yield per square foot, your cost per grams will go down.

David Kretzmann:            Sure. What’s your approach to capital allocation? I know this summer you made a biotech acquisition, a [inaudible 00:11:06] acquisition, balance sheet right now looks pretty healthy. I know you’re still, I think in phase four, building out a facility. So maybe you can just walk us through what the capital situation looks like and what’s your strategy and priorities when it comes to allocating that capital going forward?

Paolo De Luca:                   Excellent question. We manage our balance sheet very prudently. We have … we had 159 million of cash on our balance sheet at the end of May, which is our Q3 2018 quarter end. That’s more than enough to help us complete our phase four build out. Even considering some of the smaller investments that we’ve announced, so our view is that, A, we’re gonna be cash flow positive as soon as rec starts. We’re not gonna … we’re gonna turn from a company that’s bleeding a little bit of cash compared to other LPs, we’re actually doing quite well, to a company that’s gonna be immediately cash flow positive. That’s number one.

Two, there’s a lot of other avenues that are opening up in terms of raising capital through traditional bank debt financing and we also have a good relationship with Farm Credit Canada and Opportunities New Brunswick, so we have funds that are available that we can draw from them.

But in terms of capital allocation, we tend to be very prudent. We do not tend to do these larger deals that some of the companies do in the space. Certainly we’ve had opportunities, for example, to enter Australia and write big checks to go to Australia, but we’ve seen that the valuations look unreasonable at this point in time so we’re not prepared to do that. We’re focusing on Canada first. We’re focused on having the best indoor facility in the country and making sure that we deliver properly in the adult rec market, and we’ll for example enter other markets around the world prudently and working with local partners in a way that makes sense where we can see the pay back in a reasonable period of time.

David Kretzmann:            Speaking of big deals, earlier this week, probably … not probably, definitely, the biggest deal that we’ve seen in the cannabis industry so far, Constellation Brands investing another five billion Canadian dollars into Canopy Growth. What was your reaction to that and what impact does that deal have on a company that, at least in terms of market cap, is probably about mid level compared to Canopy, how does that impact OrganiGram’s strategy going forward?

Paolo De Luca:                   First of all, I think congratulations to Canopy for the deal. I think it’s tremendous for them and I think it’s great for the sector as a whole. It really validates the global movement to acceptance of cannabis as a legal product, both medically and recreationally. I think it’s great for Canopy and I think it’s great for the rest of the industry and a lot of the LPs here in Canada.

I think that the move was made by Constellation to show that they want to be part of the global cannabis business and I think it’s clearly a sign by them that they see potentially the U.S. opening up and I think their competitors are now gonna be forced to respond, or not respond, but they certainly have their attention. I think the deal they did last year with Canopy was significant, but certainly modest in comparison to what they announced earlier this week, so I expect that we will have overtures at some point to have people want to partner up with us and we’ll certainly entertain that if it makes sense for us, but we’re not in a rush to do anything right now, unless, again, it’s a great deal for us.

Right now, we’re focusing on [inaudible 00:14:49], making sure that we’re ready for the adult rec launch and show that we can turn a profit in the next quarter and really wrap up our production from the current 36,000 kg per annum that we’re producing to a year from now to be maybe 113,000 kg.

David Kretzmann:            Just a couple more questions. Thanks again for taking the time. At the Motley Fool, we’re a community of investors helping fellow investors and when we buy or recommend a company like OrganiGram, we have a minimum holding period of three years, and ideally much longer. So for business folks, investors like us with a long term time horizon, looking out over the next five years, what metrics should investors be paying closest attention to to best gauge the underlying health or progress of OrganiGram?

Paolo De Luca:                   Yeah, I think one of the things that you would want to look at for our company and any other company in the space is are our brands getting accepted in the market, in the recreational marketplace? That would be one. Are we getting shelf space? Are we turning a profit when we should be? For example, if companies are even with the launch of the adult rec market when there’s “a shortage” right now, if they’re having trouble turning a profit, why? Now, it could be that they’re just aggressively expanding and spending a lot of money to establish their brands, but we tend to take a more conservative view. We’re not … we don’t have the big budget spends to do the sales and promotion. We’re doing it, but we’re doing it on a much more prudent way.

I would really as an investor always look to the statements that management makes, the promises they make and their ability to deliver, so we take pride in the fact that we launched our phase two expansion when we said we would. We launched our phase three expansion when we said we would. We’re getting the production volumes that we said we’re going to. That we’ve managed, despite being … starting off as a regional player, we’ve got representation across Canada in terms of getting entry into Alberta, Manitoba, Ontario, Nova Scotia, New Brunswick, PEI, so we’re in the majority of the provinces across the country and we expect to be in all of them at some point.

One other thing I would mention too, if an investor is looking to participate in OrganiGram, we do have a convertible debenture that trades, which is unique in this space. A lot of the convertible debentures that exist are not freely tradable, which allows an investor to participate in a bit more conservative manner. For example, the debentures will mature in January 2020, they pay a 6% coupon, the convertible at $5.42. If our stock is trading let’s say at $5 now, you have downside production if you buy the debentures and if they’re trading at par, and you have the upside if it goes beyond 5.42. There’s an option there for investors if they don’t want to necessarily play the stock in the company, there’s another instrument they can play.

David Kretzmann:            Hmm. Interesting. Final question. Obviously a lot of moving pieces at OrganiGram and just within the cannabis space as a whole, but what personally gets you most excited looking at over the next five years?

Paolo De Luca:                   In terms of OrganiGram?

David Kretzmann:            OrganiGram or the industry? Yeah. What drives you over the next five years?

Paolo De Luca:                   Well, I’ll be really interested to see how the rec launch goes and it’s accepted across Canada and I think there will be some … a lot of media attention, obviously, and I think the whole world will be watching as well, so I’m interested to see how the experience … the experiment, the “experiment” works in Canada and how the rest of the world reacts to that. I think Canada obviously is a big player on the international stage and I think a lot of the European countries in particular that are maybe a little bit closer to us culturally, for example like the UK, will be paying close attention and if the rec roll out works well on a national scale as opposed to the state level that’s happening on the U.S., I think there will probably be an acceleration of medical programs for countries that don’t already have them, and I think recreation will be something that will be considered probably sooner rather than later if it’s successful here in Canada. We in OrganiGram hope to be a responsible partner in making it successful here in Canada.

David Kretzmann:            I think we’ll end it there. Paolo De Luca, CFO of OrganiGram. Thanks so much for taking time to talk to The Motley Fool and we look forward to following the progress in the quarters and years ahead.

Paolo De Luca:                   Thanks for having me.