Interview with The Hydropothecary Corp’s CEO, Sebastien St. Louis

Run time – 15:00 (Transcript below)

Published 8/13/2018

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Transcript:

David Kretzmann: I’m David Kretmann, advisor of Marijuana Mavericks, and joining me on the line today we have a special guest, the co-founder and CEO of The Hydropothecary Corporation, Sébastien St. Louis. Sébastien, thanks so much for taking the time, and I thought we could just jump right into it. For those who aren’t familiar with the story of Hydropothecary can you give us a background on what led to the founding of the company?

Sébastien: Thanks very much for having me David, and for Hydropothecary, now, HEXO corporation it was founded five years ago, and it came from an idea sitting around a campfire. When I was sitting with one of my good friends who works for Health Canada who mentioned that there was legalization, this was back in July 2013, a long time ago, that mentioned there was legalization of the medical cannabis, and I thought it was a tremendous opportunity. I’m an ex-manufacturer by trade and I’ve been a financier in the banks before that, and so this really brought together an ability to go back to my entrepreneurial roots, and get into the manufacturing sector in a strong cash flow business, so that’s why I got into it.

David Kretzmann: What distinguishes the strategy for HEXO today from other licensed producers in Canada?

Sébastien: I think HEXO’s really been driven by four strategic pillars. We’ve set out on a deep-then-wide strategy. I think, that’s really how you look at it where it’s different whereas a lot of the licensed producers have gone out and said, “Well, we’ll do everything and everything,” HEXO was really always focused on core product innovation, and then deep distribution relationships. We’ve started with Québec, and we’ve locked up 35% market share for the next five years in Québec with an over a billion dollar contract with government of Québec.

Right now, we’re in the process of finalizing throughout Canada including Ontario, and we plan to have that wrapped up in the next few months, so we’re really now talking about solidifying those relationships, making sure that we have deep distribution throughout Canada at which point we’ll launch our international platform which starts in Europe and Latin America. Our process has always been to go deep in the markets, make sure that we have a very strong, defensible position backed up by high-quality products, innovative products, and on that side in which we’ve been able to bring all sorts of new products to market. Hydropothecary, or HEXO is still the only company with a sublingual spray on the market, and we plan on being among the first to launch a full range of cannabis beverages in Canada.

David Kretzmann: Can you give us a better idea of the nuances of the Québec market compared to other provinces as far as with that supply agreement are you providing white label product, or is HEXO’s brand able to be on that product? Can you just walk us through what that looks like?

Sébastien: HEXO’s goal, it’s long-term goal is to be a fast moving consumer products company. It’s consumer packaged goods, our expertise and then product development, and so with that what’s very important is to have a brand associated with that, to be able to tie in our innovation, to be able to tie in our customer understanding. This will definitely be HEXO branded products although in the future we look at HEXO as a house of brands, so an ability to be able to create new brands depending on what needs we need to communicate to the customer, or what requirements the customers want.

What’s interesting about Québec is that it’s a complete vertically controlled government distributed system, and so it’ll be government run stores to start, and all controlled through the SQDC, so through the Québec crown corporation. HEXO has the largest contract with the Québec crown corporation over the next over the next five years totaling over a billion dollars. We will be shipping our products into a distribution center in Québec, which just like every other LP we’ll be shipping into that distribution center, and then those products will be redirected across retail locations in Québec run by the government.

David Kretzmann: Earlier, you mentioned the recent exciting announcement of the joint venture you all have with Molson Coors Canada, can you just walk us through how that relationship came about, and what investors should be watching over the next 1 to 3 years with that partnership?

Sébastien: It’s really a milestone achievement, and probably the biggest, and most important deal we’ve ever done, which is saying a lot considering we just signed a billion dollar sales contract. This is the second major strategic company, and I’m talking Fortune 300 companies here that have taken a look at marijuana. The first one was the Constellation-Canopy deal, and now we have the Molson Coors-HEXO deal. With it, what we’ve done is we’ve managed to create a structure, which is non-diluted to HEXO shareholders, we’ve created a JV, which is exclusive between Molson Coors, and HEXO to launch a full line of cannabis beverages, and this goes beyond beer, across Canada.

With the Molson Coors strength and distribution, customer understanding, and product branding paired with HEXO’s innovation, and quality products we plan on taking a huge market share on day one when the beverages are expected to become legal in October 2019.

In the next three years, you asked, we believe that this partnership will allow us to expand this product line, so you can imagine those would include [de-alcholized 00:05:31] beers, they could include juices, they could include sparkling waters, and more product formats that we’re all concurrently working with Molson Coors to launch right now. We expect this to be hugely accretive when we look at the full market size of cannabis beverages, and all those different categories in the next three years our present value calculations to this JV, and just for HEXO’s partnership in the JV is over $300 million today.

David Kretzmann: Wow. Going forward, what is your approach to capital allocation? Obviously, the joint venture is a new development, but last I checked the company is debt-free, you have nearly $250 million in cash, so what are your plans going forward to invest that capital, and does the joint venture impact that in some shape or form?

Sébastien: HEXO’s been very diligent with our capital, as you mentioned we do hold a debt-free balance sheet, we’re very well capitalized. That money is going to three strategic pillars affectively. The first one being scale, so there’s about 100 million of that 260 million in cash which is slated to complete our million-square-foot expansion to bring our total production capacity to 108 tons of product by December of this year.

Then, beyond that, that leaves us with over with about $160 million, which is broadly allocated to two buckets, one being distribution, and the other being product development. Working with the JV between Molson Coors and ourselves, so the JV is funded by both parents pro rata to our ownership. HEXO owns 42% of the joint venture, so we’ll be funding 42% of it. Molson Coors is deploying 57% of the capital required by the JV, and the specific numbers around which the JV will be operating will be communicated by that JV’s management team when they’re ready.

What I can assure our shareholders for the moment is that HEXO has all the capital it needs to pursue that JV, and we still have a lot of capital left over to continue developing our own products in the edibles market, which the JV did not touch, by the way. The JV is strictly a cannabis beverage play. All edibles are still within HEXO.

David Kretzmann: Got it. Here are at The Motley Fool we’re business folks, investors, and we’re a community of investors helping fellow investors. For people here at The Fool when we recommend a company like HEXO our minimum holding period is at least three years. What metric should business folks, investors like us Fools over here what should we be watching to best gauge the health of the underlying business, and the progress of the business over the next 3 to 5 years?

Sébastien: Long-term, what you’re really looking for is the dividends play that comes out of a strong cash flow that well-run cannabis companies like HEXO will be able to generate.

In the meantime, until we are starting to drive strong positive cash flow, and the reason that’s not happening now is the industry is starting, we’re investing heavily in growing the company, but you can expect over those next three years that that strong earnings-per-share starts coming out. I think that’s going to be a key metric.

In the meantime, we’re looking to proxies. How do investors properly value or gauge which management companies will deliver the best EPS? I think you have to look at track record, and you have to look at a couple key metrics like revenue per gram. On revenue per gram HEXO is currently the highest average revenue per gram marijuana company in Canada, generating about $9.26 of revenue per gram on average. That’s thanks to our advanced products, that’s thanks to Elixir our sublingual spray, our edible powder Decarb, but also thanks to our award-winning flower from our Time of Day line, and that’s a flower that goes out at $15 a gram, so that’s the first part.

The second part that you need to look at is, can this company operate sustainably at a good competitive cost? HEXO over the last five years has always been among the leaders in cost per gram production. Currently, we’re second ranked amongst all the licensed producers at 88¢ cash cost per gram, and so I think when you start to look at 924 top line revenue and ability to drive value there with an 88¢ cost that gives a lot of room for margin even when you start factoring in retail margin and government tax.

Beyond that, I think it’s important to look at capability to control market share, and that’s driven by two things. It’s driven by distribution and the ability to have large contracts. Then, look to HEXO’s ability to have the largest single contract in marijuana history with the government Québec, but then also the fact that we are live in every single province except for the territories and the Maritimes. We have contracts and distribution in play essentially throughout Canada already, so that channel is enabled, and I think investors need to look very carefully because of the over 100 licensed producers right now there are only 14 that have provincial distribution contracts, so HEXO being in line to be top three at the moment amongst the major LPs.

The second thing is can HEXO actually produce, or can an LP actually produce all the products that customers are going to want? When we look at broad product categories does the licensed producer have product categories in flower, in which HEXO is an award-winner, and is able to drive $15 a gram? Do they have edibles? Which the case HEXO is unique and with an edible activated cannabis powder, our Decarb product. Do they have the ability to innovate, and to go into new categories? Now, I’m thinking sublingual sprays, which HEXO has uniquely achieved, but also now do we have a strong beverage partner? In which case there’s two choices right now, it’s HEXO and Canopy.

I think you have to look at all those different factors, and then investors of course need to take a bet on management, look at the execution track record, and look at what promises have been made by management, and what has been achieved. On that final point, I think that’s a key point of pride for me here at HEXO is that when we’ve set out to do something we’ve done it.

Last October I put out a press release that I would have a 250,000 square foot greenhouse built and operated by July of this year, and I just announced my first harvest. That was actually executed, that building, that 250,000 square foot expansion was complete on time, and we just pulled our first harvest from it last week.

David Kretzmann: That’s awesome. Just a quick follow-up there for listeners who aren’t familiar, can you just walk through briefly what is a sublingual spray?

Sébastien: A sublingual spray, and I’m glad you asked the question David because it’s a unique product, we invented it, it did not exist in the market for HEXO came out with it. It was an answer to a customer need. We looked at what do customers enjoy, and specifically new market customers enjoy about marijuana? They really enjoy the fact that it works quickly, that’s why a lot of people, we see about 75% of the consumers wanting to combust their marijuana. The reason they want to do that is because it works fast whether you smoke or vape.

Now, smoking or vaping is never the best idea. Putting a combustible into your lungs is not the healthiest way to consume, so we were looking at an alternative, well how do we reduce onset time, while enabling customers to still get that rapidity of effect? We knew that edibles, because they have to go through the liver, can take a few hours to kick in, and so there’s the segment of the market that enjoys that, but they’re not fast. How we solved that was with a sublingual spray, so we came out with Elixir. It’s a great testing peppermint spray, it’s like a Binaca, fits in your pocket. You can self-titrate, so each spray, and this is a spray that goes under the tongue, it applies about, if on our THC product, 2.5 milligrams of THC, and with the CBD product about 4 milligrams of CBD.

What happens when you spray it under your tongue, it’s actually absorbed by the body without going through the liver, so it actually works in about 20 minutes without having any of the harmful effects of smoking.

David Kretzmann: Got it. That’s very helpful. I know we’re just about out of time, so I’ll wrap up with a final question. Obviously, we’ve talked about a lot of different initiatives going on at HEXO, and you’re operating in the fast paced cannabis industries, but what personally gets you most excited when you look out over the next five years?

Sébastien: What I think is the gift that we’ve been given here in Canada and specifically as one of the major licensed producers in Canada if we have an opportunity over five years to not only partner with Fortune 300 companies, but to become amongst the top companies by revenue in the world. When you look at the worldwide marijuana market, I look at it and I see a $350 billion market. If HEXO Achieves only 2% market share worldwide over the next 5 to 10 years that would make us a Fortune 500 company as a first step with 7 billion revenue. That’s what really gets me excited. We’ve already achieved 12% market share in Canada next year, if you look at all the recreational contracts that have been allocated, and I’m looking forward to being able to go worldwide with our brands.