Canopy Growth Corp

TSX:WEED

Earnings Call Transcript 2019-Q2

[Operator]

Good morning, and welcome to Canopy Growth Second Quarter Fiscal 2019 Financial Results Conference Call. Earlier today, Canopy Growth issued a news release announcing its financial results for the second quarter ended September 30, 2018. This news release will be available on Canopy Growth's website and filed on SEDAR. On this -- on the call this morning, we have Bruce Linton, Canopy Growth's Founder, Chairman and Co-Chief Executive Officer; and Tim Saunders, Canopy Growth's Chief Financial Officer. [Operator Instructions] Certain matters discussed in today's conference call or answers that may be given to questions could constitute forward-looking statements. Actual results could differ materially from those anticipated. Risk factors that could affect results are detailed in the company's annual information form and other public filings that are made available on SEDAR. During this conference call, Canopy Growth will refer to supplemental non-GAAP measurement, adjusted EBITDA. These measures do not have any standardized meaning prescribed by IFRS. Adjusted EBITDA as defined in the press release issued earlier today as well as in this period's management discussion and analysts document that would be filed on SEDAR after the close of financial markets today. Please note that all financial information is provided in Canadian dollars unless otherwise specified. Following the prepared remarks by Mr. Linton and Mr. Saunders, the company will conduct a question-and-answer session, during which questions will be taken from analysts. [Operator Instructions] I would now like to turn the meeting over to Bruce Linton. Mr. Linton, please go ahead.

[Bruce A. Linton, Co]

Great. Thank you and good morning, everyone. I know we're all going to want to talk a lot about what's going on in Canada in the first 30 days, but I want to frame what we're talking about, I think in a bit bigger and more interesting way. We've run through as a company the whole startup phase in Canada. What you saw in this last quarter really the ramp up. And I think what you're going to see is there are sort of 3 6-month segments of how this market is going to go, and the first 6-month segment is only 30 days old. But it's going to be 3 sprints, which are get out of the gate and get the stores filled. The stores continue to be built out and the products roll in. And the second part of it is going to be to keep up with a channel demand as we enter to the third phase, which is the more comprehensive products, and I'll come back to that. But we don't generally give a comment on consensus or analyst numbers because this is such a new sector. And so all I would say is that I don't think analysts were wrong on the target number, but I think they were early on the quarter, and that I don't feel particularly concerned that you're way off on the year for our fiscal year. But you need to look at the things I'll come back to later as the variables on that. So to kick off, really what we've been focused on is the future in our opinion is intellectual property and converting cannabis flower into an ingredient and building it up to more value-added products. And so we haven't historically talked a lot about the 15 clinical trials that we have planned and structured. I've talked a little bit about the fact that we've been approved and are launching of Phase IIb primary insomnia trial. In the animal treatment of anxiety, trials have been approved, no objection letters in place and those are moving forward. And really that leads to some of the stuff that we've worked on in this ramp up, which if you look at the companies that we've either got acquisition agreements with and all the internal work, the number of patents that we have filed and are defending and we think are quality patents, are about 120. And they go across hardware, product formulations, genetics, product innovations, medical treatments. This is not like a sort of one space, one item. And the reason is, I think what you're going to find is as we get into that third 6-month sprint for recreational cannabis, that the science that we're talking about here will inform the definition and delivery of those products. It will be differentiated. And they will be the ones when we talk about brands that people will actually be able to identify a better product in a specific package with the key name tied to Tweed that will actually be the one that they seek and they'll stay with. And so that's really kind of the packaging of it. We put something out on October 3 that I didn't yet get a single question on, which is that the Ontario Long Term Care Association has embarked on a study of how do we make geriatrics' life butter, which a -- up to a 500 person study over a 6-month period, and the whole point of is to displace a whole bunch of pharmaceuticals that aren't necessarily benefiting the geriatric and aging crowd to the level of satisfaction of their physicians, and they're causing a great deal side effects that are displeasing their families. That's the sort of thing that I think looks out and says how do we disrupt really deeply and carry it over. That kind of IP goes where we're trying to get to with some of our international stuff. Maybe we should put press releases out for things that aren't done, but that's not been our history and that's not what we're actually going to do. So we've had a number of times where we almost got to export to the U.S. under DEA approved exports, but the paperwork wasn't always easy to get done on this side of the border. Now we've exported to the U.S. products, which are GMP-1, focused on meeting standards so that institutions on the U.S. side can actually use cannabis that's been produced in a way that could become inputs to a decision tree that may or may not result in more comfort with medical and/or rec and state rights and things like that. But that is a big deal. The whole notion of what's happening with hemp, we have a substantial hemp operation that we've been working on in Canada. We have intellectual property that we've developed around how to manage hemp. And that we thought that was prudent because I think hemp is going to happen in the U.S. and when it does, that's not the time to start. You should have already been started up and ramped up and get ready to revenue up. We think we are. And in that whole world, when we look at what the products are, the single biggest challenge we see in the U.S. is the fact that it's, yes, illegal, but really the claims made on some of these products are without science. And so the science in order to make a valid product has to be done and we're working on that. When we swing just over the Caribbean, we put out a press release indicating that we now have a license in Jamaica. And I think Jamaica is going to do a great job of not exporting cannabis, but importing more tourists. And that Tweed Jamaica is going to be something when you're on vacation, you may become officially ill and have access to that product, and that will make your vacation more enjoyable and the government more money and everybody a little safer in the process. The credibility we have in Jamaica has caused us to have an opportunity to export to another Caribbean Island, which haven't named, but we think is sort of the dominoes tipping over through that region. And when you think about the number of tourists that will have exposure to brands, so 4.2 million to 5 million tourists in Jamaica, if we can get our brand in front of that cohort on their favorite week of the year, we think that cascades very well back into what they're going to be doing for the rest of the year, which is earning the next vacation and choosing Tweed as their recreational product. When you get down a little bit south of the U.S., our Latin America activities, everything we have down there is structured so that it's 100% ours as we go forward. It reels in, and we're not in a margin sharing model, we're in an execution of operations, exporting our intellectual property and cranking up medical outcomes to a very substantial middle and high-income class in a region with a huge population. So our activities are principally headquartered in Colombia but very active and have been for a few years in Brazil, and building up our capacity in Chile and as we go down through that area. So quite significant and in both, particularly the Jamaica circumstance where others have struggled to actually have cash and the ability to move and build, we haven't. We have been able to figure out how to structure capital into the region so that we can actually build out the facilities and be ready to have our stores open. So maybe to come back to Canada. As far as we can tell, we've been doing sort of daily analysis of data from as many sources, provinces, in-stores. Our analysis is that we're about 30% of the available SKUs. But I can tell you as an investor, you do not want us to sell only bud and bud forever. So our strategy was and will continue to be, first we launch with our core store bud brands because we think people wanted to walk in the store, buy dried cannabis and conclude that, that was interesting, but what they expect is something better and different. So now we've launched our gels, which are soft gels. They are essentially what I think is the Canadian gummy bear equivalent, and they're well-structured and will be continuously available. So if people tried another product at launch and that product sold out. What they're going to have is the second wave from Canopy, which is going to be sustained, differentiated and you as an investor will love because it's a much better defendable margin model. The next wave is pre-rolls, and maybe we, in a ramp up, did something a bit different, but we actually have an engineering department. And the reason we have an engineering department is we thought it was important to actually be able to control our intellectual property, not share margins with people into the future and not get in a circumstance where we couldn't continue to build better and bigger infrastructure for every circumstance that we needed. So our pre-rolls are created on an equipment set that meet the really tight and specific standards of weight per roll and the volume that we expect to put through, and that's our IT. And part of it is, if you're at all interested in history, when you look at how the cigarette market works, owning the intellectual property around creating cigarettes turned out to be a pretty good thing. So we think we're in a good spot with that. As we go down, there are only a handful of stores opening in Canada and every week, there's trying to be more. Where we thought it was prudent to focus was on the stores that are open with salespeople that can be trained. We've trained over 650 customers service reps for a variety of stores and provinces across the country. And where sales reps can actually differentiate our product, make sure that it's in the right position, make sure that the education is correct so that when you win, it's not a random lottery. And while we appreciate the change in Ontario and think it was prudent to dump the old plan, in the short term, there's nobody that you can educate. There isn't necessarily even a wizard on how people make purchases. So while we try to support all stores and we know that we can fulfill all our commitments, our priority is on physical stores and the inclusion of our product where we want it and the inclusion of our gels and rolls as those stores come up. And that will, in our opinion, turn into a much longer and more prosperous relationship than being in a random lottery on a website. So the inventories are there. We have the gel caps in inventory, we have the inputs and pre-rolls in inventory. We are in a mode where everything we're trying to do will feed into good science turns to good products turns to good outcomes. And so I do think you're going to see as we go through the first 6-month sprint that the revenues come up. But don't forget about the rest of the world. I saw this announcement that Malaysia is contemplating covering medical cannabis as probably one of the 3 biggest announcements in the history of our sector, and I'm not sure if they've got pick up to the level it would make sense. For the first country of that origin and region, to say that they are thinking about medical rather than thinking about it as an illegal threatening marijuana product. And it goes from what I mentioned at the beginning, when you can actually work with the long-term care and you can start to see regions in that sort of world evolving their perspective, the rate of which this market grows is going to be gigantic. And those with the best science, the best brands are going to win. And so Tim will describe some of the numbers we used for our ramp up, but I'd say, get ready for revenue up as well. Go ahead, Tim.

[Timothy Rob Saunders, Executive VP & CFO]

Thank you, Bruce, and good morning, everyone. Yes, I think the key takeaways today are: one, we had strong double-digit medical cannabis sales in line with management expectations; two, strategic acquisitions and investments that further strengthened our IP capability is critical to our long-term success; three, we are well positioned for a strong start to recreational cannabis market in Canada; and four, as Bruce outlined, we are building a strong presence in key international markets. So I'll now proceed with a review of the second quarter. Revenue for the second quarter ended September 30 was $23.3 million, representing a 33% increase over the same quarter last year. Revenues in the second quarter were in line with management's expectations leading into the opening of the recreational cannabis market. By intention, the company made limited test shipments amounted to $700,000 in order to test supply chain systems and logistics before the launch of recreational cannabis on October 17. Volume sales into the recreational channels did commence after the quarter-end. In the 3 months ended September 30, 2018 and '17, oils, including Softgel capsules, accounted for 34% and 18% of product revenue, respectively. The total quantity of cannabis sold during the 3 months ended September 30 was 2,197 kilograms and kilogram equivalents, at an average price of $9.87 per gram, up from 2,020 kilograms and kilogram equivalents last year, which were sold at an average price of $7.99 in the same period last year. The higher average price was due primarily to a change in the product mix, including the increased sales of oils and gel caps and higher-priced strains as well as sales into Germany. The average price per gram sold in Germany during the second quarter was $13.58 per gram. We have and continue to invest significant effort, capital and resources in activities and programs to ready the company to participate in and lead the Canadian recreational cannabis market. These investments continue to cover the company's entire business operations including production, fulfillment, marketing, sales and general administration. In the second quarter of fiscal 2019, the company harvested 15,217 kilograms, with close to 2 million square feet of greenhouses in BC, Québec and Ontario licensed recently, including 1.1 million square feet licensed in early October, to bring our total license platform to 4.3 million square feet. We expect the amount of cannabis harvested to increase in the coming quarters. Now turning to gross margin. The cost of sales includes the impact of operating cost of subsidiaries not yet cultivating or selling cannabis, including our BC Tweed and Mirabel facilities that were only partially licensed in the quarter as well as higher overheads incurred while preparing operations for the legalization of recreational cannabis and the diversion of growing space in Smiths Falls to creating clones for transfer to the company's other growing facilities. Excluding the costs associated with noncultivating subsidiaries totaling $7 million, the gross margin for the fair value impacts on cost of sales and other charges would have been $13.6 million or 58% of sales. During the quarter, the reported fair value changes in biological assets and other inventory charges or other charges netted to an expense of $40.6 million and included adjustments to net realizable value of inventory targeted to the recreational market, which reflects wholesale pricing. And to a net write-off of approximately $16 million related to plants culled in the quarter due to timing issues with respect to having infrastructure ready for licensing and receiving those harvested plants. Since then the required infrastructure has been completed and the licensing since received. Next, turning for a moment to operating expenses in the second quarter. As we've highlighted previously, the company continues to make significant investments across all areas of our business to strengthen the company's leadership position in the Canadian and global medical cannabis markets as well as in preparation to lead the recreational cannabis market. Sales and marketing expenses include costs associated with the development of branding, marketing and education campaigns, the development of new permitted product SKUs, the development of recreational product packaging, the development of cannabis retail and education programs as well as costs associated with the company's medical outreach program. These expenditures represent the company's view that strong brand recognition is, over time, essential to the company's successful market share acquisition strategy, particularly in the new recreational market in Canada. These costs represent a strategic upfront investment, which management believes will have a long-term benefit in customer acquisition and retention. Further, the company is making these investments to aggressively seek new domestic and international business opportunities to build for the future. As a result, sales and marketing were up significantly relative to same periods last year for the purpose of being ready for the future state recreation market, while at the same time developing international markets. Sales and marketing expenses for the 3 months ended September 30 were $39 million or 167% of revenue, a big investment. During this period, we launched our national "Hi" media campaign, which included digital placements across Canada, brand activations in communities from coast to coast and content creation, including for the new -- for the tweed.com website, and marketing automation platforms and developing competencies in retail. In respect of government regulations, all non-age-gated properties were removed on October 16, 2018, prior to the Cannabis Act taking effect. The company has continued to invest in age-gated channels for both media and experiential marketing, across all brands and adherence to C-45 guidelines on promotion. In comparison, sales and marketing expenses for the 3 months ended September 30, 2017, were $7.6 million, which was done as a purely medical market. G&A expenses for the 3 months ended September 30 were $37.1 million. Of note, the second quarter fiscal 2019 G&A included a provision for excess office space in Montréal, which is no longer occupied, and that amounted to $4.2 million. In comparison, G&A expenses for the 3 months ended September 30 last year were $8.4 million. Acquisition-related expenses for the 3-month period ended September 30 was $3.2 million. These expenses related to acquisitions of Hiku Brands as well as the unowned shares of BC Tweed and Canopy Health. In addition costs were incurred due to the ongoing evolution of potential acquisitions, building a pipeline of M&A potential targets and reflects increased legal, accounting and strategic business consulting services required to complete or evaluate these potential or completed transactions. We are likely to acquire additional strategic assets in the future as we pursue our business strategy, and as we've communicated previously following the strategic investment by Constellation. The noncash share-based compensation expense related to options granted to employees and consultant of the company and to acquisition-related milestones combined for the 3-month period ended September 30 to $99.6 million, which $50.7 million was related to acquisition milestones. In practice, all employees of the company receive stock options as part of the compensation package. Acquisition-related milestone payments based on future performance and related criteria have been treated as stock compensation expense instead of being allocated to the purchase price. In comparison, the noncash share-based compensation expense related to options granted to employees and consultants of the company and to acquisition-related milestones combined in the same period last year was just $7 million. Now I will turn my attention to other expenses and net income. Other expenses of $115.7 million are primarily made up of fair value changes on financial assets and financial liabilities, the more -- majority of which is noncash. The amount was primarily made up of changes in the fair value of the senior comparable notes. Due to marketing -- marking-to-market, we saw the trading price of convertible notes increase from about $102 to $149 per unit at the end of the first quarter to the end of second quarter, and resulted in an expense of $223.4 million on the revaluation. This loss was partly offset by a gain amounting to $62.7 million related to the acquisition of Canopy Health Innovations and gains totaling $48.2 million, driven mostly by fair value changes on the TerrAscend warrants of $44.7 million. $115.7 million in other expenses described above accounted for $0.52 of the reported $1.52 loss per basic and diluted share in the quarter compared to a net loss of $0.01 per basic and diluted share when compared to period last year. The after-tax net loss in the quarter, inclusive of the noncash share compensation expenses, fair value impacts and other expenses, as just described, amounted to a loss of $330.6 million or $1.52 per basic and diluted share. And compared, as I said, to $1.6 million or $0.01 per basic and diluted share in the same period last year. Next, I'll touch briefly on the supplemental non-GAAP measure, adjusted EBITDA. Adjusted EBITDA is defined as earnings from operations as reported before interest and other expenses, tax and adjusted for moving stock-based compensation expense, depreciation and accounting for biological assets and inventory and further adjusted to remove the acquisition-related costs. We report adjusted EBITDA believing it is a useful financial metric that will help investors assess the operating performance of the business before the impacts of investments, acquisitions, income taxes and fair value measurements. Adjusted EBITDA in the second quarter fiscal 2019 amounted to a loss of $57.7 million compared to an adjusted EBITDA loss of $4.8 million in the same period last year. We believe our deliberate and ongoing investments in building the company's production platforms, brands, international reach, partnerships and operations which directly impacted our adjusted EBITDA during the period is necessary to strengthen the company's global leadership position. Now turning our attention to the balance sheet and cash flows. As of September 30, 2018, the company's cash and cash equivalents totaled $429.5 million, obviously, before the $5 billion was closed on November 1. This represents an increase of $106 million from March 31, 2018. The increase was principally due to the issuance of $600 million in comparable notes in the first quarter, offset by investment in the expansion of our production assets, strengthening corporate capabilities, brand-related campaigns and the establishment of physical retail stores in Newfoundland, Manitoba and Saskatchewan. The working capital deficit reflects the reclassification of the convertible notes after giving effect to a tender offer on the notes triggered by the investment by Constellation. The value of the liability reflects the fair value changes in the debt. The tender offer was made on November 2 and runs to December 5. As of today, no one has submitted their notes for conversion, but so may choose to do so before the tender expiry date. If any are submitted, the company intends to pay cash instead of issuing shares. After December 5, any unconverted notes will revert to its prior long-term debt status. Inventory at September 30 amounted to $150.4 million, up from $101.6 million at end of March 31. At September 30, 2018, biological assets amounted to $20.7 million, up from $16.3 million at the end of March 31. Together inventory and biological assets totaled $171.1 million at September 30, up from $118 million at the end of March. Inventories are continuing to be scaled to meet management's expectation of market demands, including the demand from the legalized recreational market. At September 30, inventory quantities amounted to 31,214 kilograms of dry cannabis; 21,499 liters of cannabis oils, ranging from concentrated resins to refined oil to finished oil; and 1,497 kilograms of Softgels. In comparison to March 31, 2018, we had 15,726 kilograms of dry cannabis, 6,969 liters of cannabis oils and 356 kilograms of capsules. Management continues to believe that significant demand will develop for cannabis oil and, in particular, Softgels in the recreational market. As such, the company continues to increase inventories of extract-grade dry cannabis held for conversion and increase the quantity of cannabis oil and Softgel capsules we have on hand. Of interest for primarily analysts, on the share count as of today, we had 337,362,196 shares outstanding. With the warrants, options and RSUs, the fully diluted share count is as of today 518,386,356 shares. Bruce, this concludes my review of the financials for the second quarter, and I'll turn it back to you for some closing remarks.

[Bruce A. Linton, Co]

No, thank you, Tim. I think -- I bet there are some questions and we might as well advance straight into those.

[Operator]

[Operator Instructions] Our first question comes from the line of Tamy Chen from BMO Capital Markets.

[Tamy Chen, Equity Research Associate]

My first question is on the U.S. market. It's looking like the Farm Bill for CBD may come first before the STATES Act for federal decriminalization. And my question is if so, could you talk a bit about what your initial strategy into the U.S. may be under the Farm Bill?

[Bruce A. Linton, Co]

Yes, sure. So I had mentioned earlier in the call, we have been hemp farmers for this past summer and busy on the processes related to drying and the potential for extraction and scaling a bunch of IP and that results from an acquisition that we announced probably a year ago for some parties that have had substantial hemp experience. We think a lot of that will carry over. What we wanted to do, though, is recognize that when hemp becomes convertible to CBD that, I suspect, will cause the effective price of CBD to go to an extremely low point. And so it's really going to be about the science of converting it into outcomes. And so things like the clinical trial we're running on how do we make dogs less anxious will have, I think implications on how do we make geriatric adults less anxious and products that will be registrable with actual claims based on science. And so really what we're looking at is what do you turn CBD into versus how do you farm it, despite the fact that we think we'll probably need and be in the farming and extraction business as well. And so I think we're well positioned with the resulting products that you'd want to begin to launch that actually use CBD in an effective fashion versus making claims that we see in the market in the U.S. right now that are unvalidated.

[Tamy Chen, Equity Research Associate]

Okay. And my follow-up is more on the EU side. So we're seeing growing momentum for further medical legalization in Europe. So could you talk a bit about Canopy's strategies for the Europe medical opportunity? And what advantages Canopy has relative to both other Canadian license producers and as well as other producers in Europe and Israel or LatAm with respect to getting into the Europe medical market over time?

[Bruce A. Linton, Co]

So I think Europe is actually the most or almost the most exciting activity going on. So we've been busy in Germany. I think we've been sending product there for, I guess, approaching 2 years. We have been educating physicians and pharmacists with our Spectrum educational package. I think we've had about 1,000 pharmacies in Germany move our product and we're now in the process of seeking approval for upgraded formats of the product. We have plants in the ground in a couple of countries in Europe already and greenhouses. We have unannounced activities tied up in some of the emerging locations because they're not material, we didn't announce them. And we think that what we've found over the years is everything we announce is a good idea and everybody tries to follow it. So our preference is now that we're executing before announcing, and it's -- it'll become evident what we're doing. But really most of the places want proven medical outcomes. They're not just looking for a medical ingredient, which is essentially what it's classified in. And so I think a lot of the work we're doing has been thoughtful, and the trial design that, that result and the methodologies would be at least on an expedited basis able to be introduced into the other geographies as evidence. So we're liking Europe a lot. We like the fact that the payee is often the government and the population seems to be somewhere in that sort of $400 million to $500 million, depends who you want to roll in, including the U.K. right now. We've been quite busy there.

[Operator]

Your next question comes from the line of Martin Landry from GMP Securities.

[Martin Landry, MD Equity Research & Equity Research Analyst]

Bruce, you mentioned that your SKUs obtained, I think 30% of listings in physical stores nationwide.

[Bruce A. Linton, Co]

30% of the currently in-stock inventory nationwide.

[Martin Landry, MD Equity Research & Equity Research Analyst]

Sure, so meaning as of yesterday, or ...

[Bruce A. Linton, Co]

Well, as we've been sort of running up, it's sort of, however, 25% to 30%. But yes, what our expectation was is that people might take things away from the medical world, push everything into the rec world. As it sells out, they don't have things for either market. That was not our strategy. We wanted to be like a sustaining winning race rather than a flash out of the gate.

[Martin Landry, MD Equity Research & Equity Research Analyst]

Yes. My question was more, there was a limited number of stores operational even today. So I find it would be probably a little bit more helpful if you can talk maybe about your market share in Ontario, the largest market in October, how you fared?

[Bruce A. Linton, Co]

Yes. So when we looked at it, we really had to be polite about the prior plan, which was to have almost no stores, call them 35 and a population of 7 million people, where there's over, I think 800 liquor stores. So when you're in the sector, you say that's a good idea because it's improper to say it's a bad idea to the government. It was a bad idea. When they then said we're flipping and we're going to have the private sector create a lot of stores, that actually is a good idea. But in the interim, where it's a website where you can't actually affect anything other than you put it up and somebody buys it and then saw that wasn't the right stuff. Did they make a good decision, is shipping going to be reasonable? We've been pretty up the curve on Ontario. I think the first place the OCS came to learn about cannabis was the Canopy store, and our business, I should say, in Smiths Falls. And it was our view that if they were successful in selling on the web, they would be unsuccessful fulfilling because it is a very different business, B2C than it is B2B. It took us 4 years to ship 1 million packages and they will have to ship 1 million packages in 30 days, probably. So we didn't push the OCS. We supported them, but it's -- where our push has been is where the physical stores are. So it's been a very intentional, and will continue to add to what they have there, but it hasn't been our biggest priority to have the most product and push in Ontario. I think physical stores like Alberta, Québec, for sure New Brunswick, Newfoundland, those jurisdictions have been where we pushed as hard as we could.

[Martin Landry, MD Equity Research & Equity Research Analyst]

Okay. And if you would have to pick a market share that you think you've achieved so far, direct market, can you give us some sort of order of magnitude for us to work with?

[Bruce A. Linton, Co]

Well, we're not -- so we've gone 30 days of a launch where there were almost no stores, as we've discussed, there were only websites in some places. What we're looking at is how do we sustain our delivery, how do we differentiate our products, and how do we migrate people from buying bud to buying formats that actually make us all more margin. And I think when you look at that over the 90-day period of Q3 for us and over the fiscal balance of the year to the end of March, we've stated our goal is that we'd be disappointed if we had a 30 share, but we're working for that as the minimum. And I don't think we're in a spot where we have the limited resources of cannabis or the limited formats. So I think we're going to be durable and get there. And so that's the revenue up opportunity.

[Martin Landry, MD Equity Research & Equity Research Analyst]

Okay, okay. And just finally, is there any -- do you have any bottlenecks internally that could prevent you to attain these numbers at this point?

[Bruce A. Linton, Co]

Sure. Every day, there is a different bottleneck, but I would suggest that they're more less of an issue. So things like applying those damn excise stickers was a bottleneck because they didn't want to apply to certain things, and we were running short runs which meant we couldn't put as many packages through. But I would say that with our engineering and operations team we feel like we're actually getting -- moving. And maybe the mental image is watching -- we talk internally about watching the races where you've seen Bolt would always win, but he didn't start off leading because he had to get the momentum going. We feel we're in a bit more like that mode. But moving around bottlenecks, that's why we have internal resources to run all of these things and not outsource. And so it feels like we're in very good shape to deliver the product, fill all the orders, have all the formats. It's feeling like a very solid position.

[Operator]

Your next question comes from the line of Vivien Azer from Cowen.

[Vivien Nicole Azer, Managing Director and Senior Research Analyst]

So Bruce, from a high-level perspective, I'm going to my model and I'm hard pressed to find a quarter over the last 4 years, where your revenues declined sequentially. Yet the first quarter where you're ramping into adult use, which I appreciate happens in waves and whatever, lots of kind of fits and starts as the market transitions. Like I'm hard-pressed to understand like how you guys posted a 10% sequential decline in revenues. So help us understand that, please.

[Bruce A. Linton, Co]

Sure. So really, there was no product shift. Functionally, what we were doing was stress testing the system out of requests with all the provinces so they could actually make sure their barcodes match with our board, their scanners match with ours, but really there was, call it, no revenue shipped to the provinces. But with all the hubbub around it, what we saw was a bit of a distraction we think in our medical customers and a couple of hiccups in terms of getting the normal run rate to Germany in terms of permitted exports and the product approvals and things getting across. So I'd attribute half of the decline to just not normal course in Germany, and a little bit of a pause with the medical people. Now that said, once rec happens, I think we're going to see an uptick in truthful conversations at doctors' offices because before rec was available, if you said to your doc, "Don't really like the side effects of my RA medication," they might look over their glasses at you and wonder if you just wanted to party. Now you have that choice and we have a doctor discussion, I think people are going to be more transparent. So we'll see over the next couple quarters, but I think you're going to see a strengthening of the medical business. And Germany, I think we're now back on normal track. So yes, it is the first time in our history that I'm aware of, where we actually had a slowdown. But I think it was more of a distraction than a pattern.

[Vivien Nicole Azer, Managing Director and Senior Research Analyst]

Okay. Then a follow-up to that, please. Given your commentary on consensus and just by the fact that we were materially broken since those 2 came in below both our estimates and The Street, so I think it would be prudent for you guys to comment on the cadence of revenues for the back half of the year, please.

[Bruce A. Linton, Co]

Yes. I think most were expecting that the provinces would be taking product in a material way. And as we look across the entire sector, the provinces were not ready to take product and then it became urgent and it remains urgent on the product shipping. So when we look at it, I think the way I opened it is I said you were early on the anticipated volume, but I don't think you're materially wrong on -- and I can't comment on every individual, but as we look across the general group, on what the year looks like for our fiscal. And so we really -- I think we're starting to slide into the model as you're thinking about it. I just -- we tried to signal on September 27 that we were not shipping to provinces other than stress testing, I think was the exact phrase we used. So now it's praying time, and it's feeling like the provinces are starting to get their momentum as well.

[Operator]

Your next question comes from the line of Oliver Ree (sic) [ Rowe ] from Scotiabank.

[Oliver S. Rowe, Associate]

So you touched on it previously, but with the Constellation deal closed now, could you just elaborate on your capital allocation plans? How you plan on putting that $5 billion to work and how you measure return on that capital?

[Bruce A. Linton, Co]

Sure. So we've been going through with our new board and with Constellation. We have a roster of elements we might wish to acquire, none of which are producers in Canada, but there are a number of technologies that we think make sense that are out there on a global basis. So that, depending on the mix of cash and shares would probably enable up close to $1 billion of things that we look at. And I'm not saying we're pulling the trigger on all of them. We're also building out a capacity to have a bottling line, which is now finalized and designed and site preparations have commenced. So that we think beverages will be a format of product that makes sense. With the regulations of Canada, there is no certainty, but we think that could be a -- be ready for Q4 calendar 2019. So that adds up a little chunk. And then what we're trying to do is be ready, as one of the callers talked about, the crank in Europe is significantly, but hemp in the U.S. could be sooner than you think. And so we're going to have some dry powder ready to go rather than reacting and looking for capital and structuring that, we will be instantly in. And so that buildout won't use it all, but the first $1 billion, we certainly have a plan on. And I don't know if Tim wants to comment more. We certainly looked at our IRR models, and we've become a lot more disciplined in NPV and the way we structure our acquisitions. And from a money management perspective, it's been quite remarkable, the cash that wish to new money managers, and I don't if you want to speak to that, Tim, or further comment?

[Timothy Rob Saunders, Executive VP & CFO]

Yes. Certainly the kind of transactions we're looking at in the future, these are cash-generating businesses or fit strategic niches or needs that we have in the company. So that they lend themselves through more traditional ways to value these things as opposed to some of the M&A activity in the first couple years of this industry where there was an unknown future, unknown predictable cash flow. So there's a lot more rigor around our ability to evaluate these investments. And they run through the traditional valuation models to get -- make sure that we're covering cost of capital and generating good returns. But most importantly, adding to the strategic need that we need to build at this business.

[Oliver S. Rowe, Associate]

That's good color. So we start to see companies lock in retail leases in Ontario, despite ongoing policy uncertainty. Have you made any headway on figuring out your strategy that could get you into the Ontario retail market? How do you sort of see that playing out?

[Timothy Rob Saunders, Executive VP & CFO]

Yes, so the rules haven't been printed yet, really it's going to come down to certain definitions. We would be quite fine with the locations which we have under, I'll call it control, that they become franchises, that maybe they are operated by others but they carry our brand because really for us, retail does give you a little bit of torque, but you have to sell into the warehouse for the province and then out to retail. But data is critical, what's moving, what's not moving, what are the points of education that are causing an upsale. So we do want -- we want to be able to have access to data as our primary driver and we think we have a lot of trade in that process. We do expect to have somewhere between 1 and 4 licenses granted to us. If it's based on licensed production sites, we have 4 in the province.

[Operator]

Our next question comes from the line of Mike Hickey from Benchmark Company.

[Michael Joseph Hickey, Research Analyst]

I guess it sounds like you're prepared to sort of map some pretty big resources to the U.S. here probably sooner than most people expect, with hopefully the passing of Farm Bill. I guess how big do you see the CBD market in the U.S.? Because it seems to be exploding here, mostly anecdotal, but I'm just sort of curious the math behind your intent to probably take a big move to the U.S. And I'm also wondering as you think about building brands and products around CBD in the U.S., if that's -- there's a natural extension to recreational cannabis or medical cannabis down the road once we have the appropriate federal guidelines in the U.S.?

[Bruce A. Linton, Co]

Yes. So it's a bit of a touchy one to answer because we're still -- with our weekly updates and what's going on with GR, it's hot, it's cold, it's hot, it's cold, but right now the indications are Farm Bill's hot, get it done. CBD, I think as an ingredient, can be very disruptive across everything from antiinflammatory scenario, so whether it's sports drinks to other scenarios of that nature to, we'll call it anxiety modification or management. And it's going to come down to who gets the data to get the branded product that actually works. And I think we're doing a very good job on that and I believe we have a leadership position on that. How big is the market? Is it going to be fragmented? Will they allow interstate commerce with CBD? What's going to happen with all the adjacent THC, right? So the definition of hemp is it has 0.3% or less THC. Well, if you think about how many hundreds of thousands of kilograms of CBD are going to be extracted from hemp, multiply that by 0.3 and you end up with a lot of THC. Well, we have the right to use that THC in scientific endeavors. So there's a whole bunch of adjacent elements to that whole hemp discussion, and we haven't actually factored in any of the utilization related to disrupting cotton and things like that. To us that's somebody else's business. Maybe it's a saleable product, but the segment could be huge. The form factor, what you feed into an extractor as hemp is just really just not a whole lot different than marijuana for THC. So I think you'll see a value of moving early and getting really good at extraction as a preparatory step. So you may see overspend to be extremely well-positioned, but I don't think that'll be unrewarded.

[Michael Joseph Hickey, Research Analyst]

Okay, that's helpful. The second question from me is sort of how you think about sort of second half calendar year '19 and the legalization of edibles and crop insurance if you expect sort of a smoother launch, your share expectation, et cetera? And then onto that, just sort of any updates, I guess on your work with cannabis-infused beverages in terms of onset, duration, if you've had some success there, and I guess how you think about the market opportunity for infused beverages beyond the dispensary. Because at least in the States, Colorado, Washington, you have brands, products but it remains a rather niche market. And you wonder if it's just sort of trapped in the dispensary where it's really just hard to justify, I think for a lot of retailers to keep shelf. But your thought, I guess on that small basket of questions would be appreciated.

[Bruce A. Linton, Co]

So I think the 2 parts were what about indigestibles, because I don't think it's going to be just edibles in the second of 2019. I believe no matter which government's in power, their objective will remain consistent, which is they're not going to hold back this program because it's going to be about diminishing criminal returns. And the returns on vapes and ingestibles are very good. So I'm reasonably confident that they will for sure stay the course on that launch. And then it'll be questions as to what evidence do you have of efficacy, safety, et cetera. Our governors in every province or state are the liquor authorities. And I think if you come to Canada, you'll find that they principally sell beverages which are shelf stable and nothing else. So their comfort with that form factor I think is going to be very high. The second part though is, yes, we have been working on bioavailability, flavorings, we have worked with Constellation on branding analytics of who wants what when. There's been a lot of work on beverages and the fact that they have any share in most of the U.S. markets surprises me because most of what we focused on was what's wrong with the products that exist, which is takes too long to onset, has too much in it for duration. And generally, isn't a particularly appealing beverage in terms of coloration or flavor because there's a lot of masking agents. And I think our researchers have done a good job. And I think Greenstar, which was a Constellation division, spent money well to look at where we need to hit. And when I left our facility on Monday, we were clearing and preparing the site where the bottling line will be. And it has a schedule for construction that I hope will just stay on and see it sort of complete sometime in May as far as the actual structural building. So I think we are lining up the governance model, the product and the production. Stuff could go wrong, but I don't think anyone else is on the same space, thought process or position at all as we are.

[Operator]

[Operator Instructions] Your next question comes from the line of Graeme Kreindler from Eight Capital.

[Graeme Kreindler, Research Analyst]

I was just wondering, can you please elaborate on the strategy in terms of meeting and keeping up with growing demand in medical markets domestically and internationally? On top of how you characterize it as sprints in the recreational market, how the company looks to stay ahead of the curve on all 3 of those?

[Bruce A. Linton, Co]

Yes, so we're running, Tim, correct me if I'm wrong I think, we are at about 4.3 million square feet of approved production assets, which do include the capacity to extract and things of that nature. And we have about another 1.7 million-ish square feet that we think is ready for and generally should be approved almost, some of the buildings still small portions in say New Brunswick or Newfoundland aren't at that, where we're talking 100,000 or 200,000, 300,000 square feet of that. And so we have in our ops curve and our commitment to medical patients was that if you're a patient on July 1, when it was announced, we'll always have the product for you. So what we map out is what does the market look like for medical, what's the form factor for medical, which is shifting as you can see in our price point to increasingly gels. And then our production up in Denmark and some of the products that we have being harvested down in Spain, we're focusing on how do they meet GMP or GAP practices so that they could actually begin supplementing our domestic production in Canada for product markets in Europe. And so that combination sort of looks like it works quite well to get through the target revenues that we have. So it does need to work, but it's not all new to us, and the practices we put in, in places like Spain and Denmark bore quite a lot from what we've learned over 4, 5 years of running greenhouses as the first operator in Canada. So it feels like it's going to work, it's going to come down to form factor. But the shift to oil seems to be quite steady.

[Operator]

Your next question comes from the line of Vivien Azer from Cowen.

[Vivien Nicole Azer, Managing Director and Senior Research Analyst]

So first I appreciate your strategy on focusing on brick-and-mortar stores versus e-commerce. But I'm having a hard time reconciling that commentary with the continued inventory build when a province like Québec is so tight on supply that they're closing their doors 3 days a week. So help me square that circle.

[Bruce A. Linton, Co]

Yes. So I think if you look at Québec and who's showing up with product, we're increasing our position and what we were fulfilling. So I wouldn't necessarily attribute their absence of product to us and increasingly not. So the first province in which we put our gel caps was Québec. We think that if they open and they keep scarcity happening and our product's there, it's going to do quite well. It's not all perfect, right, where -- things are not balanced yet. It's a 6-month window. But that's the sort of shift where we're doing it. And I think they'll have a time where they start opening their doors and that the products they have represent more and more of us. And Québec is exhibit A why we actually chose to put our gel there first.

[Vivien Nicole Azer, Managing Director and Senior Research Analyst]

Okay, that seems reasonable. Then just as a follow-up pivoting to Ontario, you've got an e-commerce model only for the next like 5 or 6 months. So help me think through why that province, in particular given how large is it, doesn't deserve a different strategy?

[Bruce A. Linton, Co]

Well, I think as you get to that -- as you get further out, you will see more and more of our product there because I think you're going to find that there's less and less of others and that we support them more and more. But we're going to have more and more stores open, right. I don't think the objective of Alberta's 17 stores is a lot more. So it's going to be constantly a bottleneck balancing act. The initial order from Ontario was quite small and our subsequent order was quite large and there were bottlenecks for them in that a truck can arrive, but maybe it doesn't get up to the store for 7 or 8 or 10 days. So those things are all being worked through. You will see more of our product there, but we're talking about the 30 -- first 30 days out of the gate, in our view was that people will buy whatever's there, there will be no limit, there'll be no opportunity to inform them. It's going to sell out from most others and then when we sustain ourselves, it's going to actually reward us with the top line growth that we want over the 3 months and 6 months, not the first 30 days. So I'd -- just keep an eye on that site. As hard as it is search stuff, like if you've been on that website as much as we have, there are probably 100 things you'd like to fix on that website. But I bet they fix them and I bet we show up more.

[Operator]

Your next question comes from the line of Martin Landry from GMP Securities.

[Martin Landry, MD Equity Research & Equity Research Analyst]

Yes, 1 -- 2 follow-ups for me. Your gross margin I think came in around 28% and it was much lower than what we were looking for. I was wondering when can we expect things to improve on the production cost side? You're getting bigger scale, you're growing greenhouse, which should be lower cost. How -- at some point -- at what point do you -- does your gross margin move up towards the 60% and 70% where it was at some point?

[Bruce A. Linton, Co]

Sure. Go ahead, Tim.

[Timothy Rob Saunders, Executive VP & CFO]

Yes. No, like I think what you're seeing that during that quarter we went from a 2.3 million to 4.3 million square feet of licensed space. And so during that time, there was still a lot of underutilized capacity. So once -- now that we -- I guess we're now up to 4.3 million square feet after the most recent license upgrade in October. So you're going to see more utilization. You've got approximately 3 points -- 4 points -- almost 4 million square feet of greenhouse space between Niagara, Mirabel and BC Tweed. Once those are fully producing, you're going to see higher utilization of that space and you're going to see drop in the cost of production. So what we're seeing is a period of transition, getting these facilities ready to produce and so those costs are pushing through right now on the P&L, but those will be behind us.

[Bruce A. Linton, Co]

Yes. And Martin, remember when you think about all the additional licenses granted, that was exciting and good news. What it meant though is much of Smiths Falls had to be turned into a clone factory. Now the clones are everywhere, they're propagating out at those locations and we can revert back into the primary purpose for the Smith Falls facility. But you also get the yield off the other one. And so in this past quarter, you saw quite a lot of that going on.

[Martin Landry, MD Equity Research & Equity Research Analyst]

So if I hear you well, Q3 should -- we should see a nice improvement on your gross margin line?

[Bruce A. Linton, Co]

Yes, it starts improving. And then you start having -- at the initial point of rec in Canada, provinces are screaming, "Get me product," which means that you don't necessarily optimize cost. You try to make sure you get them product, so sometimes you might have to put it on a plane. Sometimes you're running a lot of overtime, but we're finding that craziness for the first 30 days is now starting to become a predictable, more reasonable model. And we can actually start and really look at how we run the business versus how we satisfy the end of prohibition. And I think you'll find that as we go through the quarter, we're really sort of locking down on that.

[Martin Landry, MD Equity Research & Equity Research Analyst]

Okay. And I -- my last question is you had a marketing campaign, a national campaign with your high logo. Wondering do you have any data point you could share in terms of brand awareness or clicks that would help us understand a little bit how much traction your brand is getting?

[Bruce A. Linton, Co]

Yes, I don't have that right at my fingertips, but we're talking about it because in major markets, up until the night of the 16th, we ran really effective pop-ups, meaning engagement in community, billboards and systems that put Tweed front of mind further. And then we had to take them down, and we did not receive a letter from Health Canada to say that we were not in compliance, because we are actually took things down around them properly. Now if you go to a social event where it's perhaps in a bar which is 19 and over, you will see a stage backed by Tweed and you'll see bathroom posters where it's in those little steel frames. And so we're staying in compliance and we're actually seeing quite good traffic and engagement, particularly on social media where people are posting up. But I don't have the exact click-through data on me. I'll make sure for the next call I do.

[Operator]

And that concludes the Q&A portion of today's call. I'd like to turn the call back over to Mr. Bruce Linton for some closing remarks.

[Bruce A. Linton, Co]

I think we've covered everything off, and I will get now to explaining it to -- on CNBC and CNN and other locations in New York. So thank you for your time, everybody.

[Operator]

This concludes Canopy Growth First Quarter Fiscal 2019 Financial Results Conference Call. A replay of this conference call will be available until February 12, 2019, and can be accessed following the instructions provided in the company's press release issued earlier today. Thank you for attending today's call, and enjoy the rest of your day. Goodbye.