Canopy Growth Corp

TSX:WEED

Earnings Call Transcript 2020-Q2

[Operator]

Good morning, and welcome to Canopy Growth's Second Quarter Fiscal 2020 Financial Results Conference Call. Canopy Growth issued, before financial markets today, on November 14, 2019, a news release announcing its financial results for the second quarter fiscal 2020 ended September 30, 2019. This news release is available on Canopy Growth's website and has been filed on SEDAR. On the call this morning, we have Mark Zekulin, Canopy Growth's Chief Executive Officer; Mike Lee, Canopy Growth's Executive Vice President and Chief Financial Officer; and Rade Kovacevic, Canopy Growth's President. [Operator Instructions] Certain matters discussed in today's conference call or answers that may be given to questions asked 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 measure adjusted EBITDA. These measures do not have any standardized meaning prescribed by IFRS. Adjusted EBITDA is defined in the press release issued this morning as well as in this period's management discussion and analyst document filed on SEDAR. Please note that all financial information is provided in Canadian dollars unless otherwise specified. Following prepared remarks by Mr. Zekulin and Mr. Lee, 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 Mr. Zekulin. Mr. Zekulin, please go ahead.

[Mark Anthony Nicholas Zekulin, CEO & Director]

Thank you, Sharon, and good morning, everyone. Thanks for joining us. So a little bit of, I guess, housekeeping before we start. Last quarter, we -- or I guess I took the time to have a lengthy introduction to go over our strategy, remind people what it was and confirm we're staying true to it. So I give you my word, we won't do the same lengthy summary this time. Mike and I, between us, will stick to probably under half an hour. We'll leave half an hour for questions, and then we'll let everybody get back to their day. The second thing, just to let you know, there are 4 slides that we have put up on our website, which speak to -- as a complicated quarter, we decided to put some information down on paper about adjusted EBITDA, inventory levels working up to normalized margins. So those are there. Mike will use those as he speaks a little bit later on. So with that said, I think it is fair to say it's been a challenging couple quarters in the cannabis sector. So I would like to first address that head on; second, speak to what we, as a company, have done this quarter to adjust to some of these short-term challenges; and third, reinforce our view that, over the medium term and despite the current climate, we feel exceptionally bullish on how Canopy is set up to win. So firstly, the big picture. To be clear, there is still an emerging global cannabis opportunity worth hundreds of billions of dollars across medical, pharmaceutical, CBD and recreational cannabis. However, we know the bellwether remains what is happening in the Canadian recreational market. It is the first national, federally legal, large-scale market opportunity for the sector to execute upon. And the market opportunity today is simply not living up to expectations and at the risk of oversimplifying the inability of the Ontario government to license retail stores right off the bat has resulted in half of the expected market in Canada simply not existing. Ontario represents 40% of the country's population yet has 1 retail cannabis store per 600,000 people. When 1 year into the market, the addressable market is nearly half what is expected, there is going to be meaningful short-term problems. So as a company, we're pleased to see the recent announcement that Ontario has made a commitment to move towards an open allocation of retail licenses, where the number of stores will only be limited by market demand. This is a big deal, but it cannot come soon enough. There is sufficient supply for an orderly store rollout to happen now as it did in Alberta over the past year. And until this happens, the cannabis sector cannot reach its full sales potential and cannot convert consumers from the illicit market into the legal market. Having said that, the stores will open, Cannabis 2.0 product launches will come, and the size of price will still materialize for Canopy because we have the strength, resources and build-out to weather the short-term storm. We've said it before and we'll say it again. This is and always has been a long-term game, and there is no company better positioned to win it today than Canopy. So stores aside, let's look a bit closer at the first year of Canadian recreational cannabis and Canopy performance this past quarter. Canopy continues to hold the strongest market share in the Canadian recreational market, with still over $1 in every $4 spent at the till being spent on a Canopy product in our estimation. Canopy is #1 still in Ontario, #1 in Nova Scotia, #1 in PEI and #1 in Alberta, the country's most developed market, at over a 35% market share. In Québec, we are #2, only behind HEXO. Our products are performing, customer affinity is growing, and we are consistently delivering our flower, oil and softgel products to market. And we have the inventory and breadth of SKU variety to maintain and increase that share as the market grows. Now as has been covered by many of you on this call, we have witnessed a slowdown by provincial buyers in the recreational channel as they rightsize their own inventory levels after significant inventory accumulation. Despite this headwind, solid product inventory helped drive strong shipments of dried flower and pre-rolled joints across our Canadian recreation channels in the last half of the second quarter. This helped Canopy end the quarter with dry bud shipments up 12% quarter-over-quarter. Signaling that Canadian end consumer demand for recreational cannabis is growing, gross revenue from Canopy-owned same-store retail sales grew 17% in the second quarter. Accounting for same-store sales as well as the opening of additional stores, gross revenue from recreational cannabis retail sales increased by 24% to $13.1 million. Additionally, gross revenues before accounting for returns and provisions increased sequentially by 6% to $118.3 million across the company. So considering the challenging dynamics that have existed in Canada, we are pleased overall with how the second quarter unfolded. However, detracting from these successes, after a detailed business review, we have concluded that it is appropriate to reflect returns, return provisions and inventory adjustments, which Mike will expand upon later. Management believes that these are extraordinary measures that, now taken, will not occur again and that inventory and production levels across all products are now within an appropriate range as we look ahead to future quarters. Obviously, these abnormal restructuring items had a distorting impact on our gross margin to the tune of $40.4 million. Mike will offer more specifics related to the charges against gross margin later in the call using those handy sheets we talked about. Jumping ahead to the medium term. We are also very excited for the launch of Cannabis 2.0 products, which we believe will further differentiate our offering and bring new customers into the market. Many years of investment in market research, product development and product marketing has prepared what we believe will be the highest-quality, most differentiated vape, beverage and edible products available on the market. On October 29, we hosted a media event, during which, media toured our chocolate and beverage production facilities, were introduced to our distilled cannabis concept and were given the opportunity to taste nonactive versions of beverages and chocolate products that we plan to bring to market. The beverages will range from spirit alternative products to ready-to-drink Tweed-branded beverages to refreshing sparkling waters and citrus-flavored beverages. Over the coming months, we will conduct various trade shows for retailers and stakeholders across the country to familiarize them with our offering, and we'll also reveal our vape product portfolio at that time. All of our extraction and value-add facilities are fully licensed and ready to go, with the exception of our beverage facility, which we hope to have licensed by Health Canada imminently. While I have focused thus far on the dynamics of the Canadian recreational cannabis market, it is important to recognize that the global medical cannabis and cannabinoid markets are core parts of our business and are all performing strongly. Our Canadian medical cannabis business grew 8% last quarter, while our international medical cannabis business grew by 72%. Combined, total organic global sales in our medical business was up an impressive 23%. And notably, oils and softgels now represent over 50% of our global medical business. We continue to focus internationally on physician education as international markets expand. An accredited physician education program is now launched in Australia, where the market continues to grow at a rapid rate. In Europe, our Danish greenhouse has received GMP certification, and we expect that facility to serve our European production needs by fiscal Q1 2021. And in Africa, we have now completed our first sales for Spectrum products in South Africa. These first sales are always the most complex, and they test logistics systems and bureaucracy new to cannabis, laying the framework for greater sales over time. We are also focused on launching CBD sales in South Africa in the coming months. In the United States, our focus on the CBD market opportunity has continued this past quarter. As you may recall, we made significant investments in U.S. hemp cultivation this past season, planting thousands of acres of hemp largely via contracts with American farmers. The harvest of our 2019 hemp crop is nearing completion, and we are pleased with the overall yields and crop quality. This harvest puts Canopy in a strong position to meet anticipated high growth of consumer demand for CBD in the U.S. and abroad. As our large-scale Canadian construction projects are coming to a close, we are aiming our focus on building out our best-in-class production facilities across the United States. Those efforts remain on track at our previously announced facility in Kirkwood, New York, and at other sites not yet publicly disclosed. We are deploying all the learnings, scale and sophistication of our Canadian production environment to the U.S. market. We continue to build a pipeline of new CBD products, including skin care and cosmetics, therapeutic creams, beverages, vape products, oils and softgels. Our team remains on track to launch a selection of these new CBD products in the U.S. before the end of this fiscal year. The first wave of new products is currently being manufactured, and our U.S. marketing efforts are scaling up in anticipation of the launch. Our acquisition of a 76% stake in BioSteel Sports Nutrition was a strategic investment into a truly authentic brand whose products are used by the likes of Wayne Gretzky, Brooke Henderson, Connor McDavid and Ezekiel Elliott, to name but a few. During the close of that deal and shortly thereafter, BioSteel has already expanded into the United States with over 6,000 points of distribution with national retailers across the country. BioSteel is in the process of formulating the world's first better-for-you CBD sports nutrition offerings set to be on shelf in the United States early in the new year with over a dozen new products. Our partnership with Acreage Holdings continues to progress, and they are well into plans to roll out our Tweed-branded cannabis in multiple U.S. states within the fiscal year. They are also refining plans to open Tweed and Tokyo Smoke-branded dispensaries in select metro locations across the U.S. And finally, they continue to build out their own set of brands and intellectual property portfolio. So stepping back, last quarter, we talked about our path to success for long-term shareholder value creation. We discussed developing intellectual property, building brands, building international reach and ensuring scaled production for current and future products. We continue to do all of those things. We continue to make a meaningful shift from builders to operators in Canada with our entire infrastructure platform now substantially built out. While there are headwinds in the Canadian market, we are well capitalized, substantially built out and continue to execute in Canada and globally to ensure we are leaders in the global market, whether that market be medical, CBD or recreational. Last quarter, provisions and returns aside, we saw increases in our retail store revenues, our Canadian medical cannabis revenues, both our organic and inorganic international cannabis revenues, the company's other revenues as well as overall gross revenues. We also saw total cannabis shipments out the door improve quarter-over-quarter. We believe these fundamentals all point in the right direction for our company. Now last call, we also discussed the goal of achieving net revenues of $250 million in the fourth quarter of fiscal 2020 with a gross margin of 40%. While Canopy is geared up with product inventories, production capability and sales efforts to deliver on the $250 million objective, we do not believe at this time that there will be sufficient points of retail sale in the near term to unlock the necessary Q4 demand. As a result, management believes that achieving our Q4 milestone of $250 million is increasingly unlikely. Finally, as you all know, on July 3, we announced a leadership change that saw Bruce Linton leave the company, myself move from my role as President and Co-CEO to sole CEO and Rade Kovacevic become President. Additionally, we announced that I also made the decision to leave Canopy after assisting during this transition period, with the expectation that this would occur within this calendar year. While the search is not yet complete, I can confirm that the company is continuing to explore a very short list of exceptional candidates and that we expect to make a further announcement within the coming weeks. This concludes my remarks, and I pass the call over to Mike to review our second quarter fiscal year 2020 financial results in greater detail. Mike, over to you.

[Mike Lee, Chief Financial Officer]

All right. Thanks, Mark. Good morning, everyone. Let me first begin my remarks with a brief review of our top line performance. Total gross revenue on products shipped during the second quarter of fiscal '20 before charges of $32.7 million was $118.3 million, which is up 6% versus Q1 of the first quarter. In a few minutes, I will break down the $32.7 million in charges, which primarily relate to the restructuring of our recreational oil and softgel business. Inclusive of these charges, Canopy generated net revenue of $76.6 million on net cannabis revenue of $53 million and sales of 10,913 kilogram and kilogram equivalents. Drilling further into the cannabis net revenue of $53 million, there are 4 trends that I would like to note. First, our Canadian retail business, which is the best bellwether of consumer demand, performed extremely well during the quarter, growing to $13.1 million, which is up 24% versus Q1 and up 17% on a same-store sales basis. Second, overall Canadian recreational flower sales continued to perform well, and gross revenue on recreational flower was $59 million, which is down a modest 3% versus Q1. Third, the Canadian medical channel continues its growth trajectory with gross revenue of $14.1 million, which is up 8% versus Q1. And fourth, the international medical channel achieved record-level gross revenue of $18.1 million, benefiting from a full quarter of gross revenue from C3 but also delivering 138% organic growth in our international medical business, reaching $4.1 million in Q2. Now that we've covered our core channels of business, let me now focus on the restructuring costs related to oils and softgels. You may recall that in Q1, we evaluated what was, at that point, the most recent provincial and territorial inventory levels related to sales observed in the rec channel, and we concluded that a risk of oversupply of certain oils and softgels existed in certain markets due to underdeveloped retail markets in several provinces. Based on that assessment, we reported in our Q1 results variable consideration that may result from rights of return in the amount of $8 million of gross revenue. And in Q2, we continued to see a disconnect between inventory levels and the rate of sale for certain products in the market. Hence, we recently modified our retail pricing architecture and our package assortment to allow us to focus on a smaller portfolio of products at more competitive price points while we continue to educate recreational consumers about the benefits of these formats. And following the shift in this strategy, we reviewed all remaining inventories for both product on hand as well as product in the provinces to determine which product would be returned, which product would remain with the provinces and be subject to buy-downs and which product would be unaffected. And the result of this evaluation is $32.7 million in revenue provisions broken down into 3 categories of charges: number one, pricing actions that are required to establish this new pricing architecture; number two, returns from provinces for discontinued or slow-moving product; and number three, inventory impairments for excess or obsolete on-hand inventories. So I'd like to run you through this list, and I'll start with number one, which is pricing. Recreational oil and softgel pricing adjustments of $10.3 million are required to establish our new pricing architecture. And of this, $5.9 million has already been processed and $4.4 million will be processed soon. These charges fully account for a full reset of pricing at the provincial level. However, new retail prices will take some time to flow through the market as inventory at retail is sold and replenished with new product. Pricing has been reset at Canopy-owned retail locations, but as a reminder, regulations do not allow the LPs to buy down third-party retail inventory in most provinces. Incidentally, in conjunction with the oils and softgels pricing review, we also looked at dry flower and concluded there is $3.5 million of additional provisions warranted for potential buy-downs on certain mid-level THC, CBD strains, but none of this pricing was processed at the end of Q2 and, thus, remains as a general provision on our balance sheet. Moving on to number two, returns. To date, we have taken actual returns of $20.5 million from the provinces, and we expect another $6.4 million to be returned in coming weeks for a total of $26.9 million in product returns. And also note that these charges are netted against the $8 million provision from Q1, leaving a net charge of $18.9 million for the quarter. Moving on to number three, inventory provisions. With the new retail pricing set within our own retail stores, we used the new sales velocities that we're experiencing as well as those seen within markets where we have already implemented pricing to determine our expected days of supply once this new pricing flows through to broad retail. And we also used our latest projections on store openings to help calculate our forward-looking demand. And in doing this, we identified $15.9 million of products that have been deemed excess or obsolete, and this charge has been recorded in cost of sales. So in summary, the restructuring charges just highlighted result in a revenue impact of $32.7 million. And in determining the impact to gross margin, we incorporated the recovery of COGS for products returned to inventory, we included the recovery of excise taxes, and we factored returned product into our days on hand calculations to ensure that returns were factored into our excess and obsolete calculations. And the sum of these impacts on a gross margin basis is $40.4 million. With these charges recorded, there is now less than $10 million of oils and softgels in Canopy's inventory on hand, and there's approximately $2 million of inventory across Alberta and Ontario provinces. So we believe this issue is fully behind us. With this, let's move on to a full analysis of gross margin for the quarter. Gross margin in the second quarter of fiscal '20 before the IFRS fair value impacts was a loss of $9.7 million or negative 13% of net revenue, which is a reduction from 19% reported gross margin in Q1 and well off of our target of achieving 40% in the near term. The lower gross margin was primarily driven by the previously mentioned restructuring charges of $40.4 million, but it also includes $10.5 million of operating costs related to facilities not yet cultivating or processing cannabis or facilities with underutilized capacity. And it's worth noting that the impact of facilities not fully utilized has decreased from $24 million in Q4 of last year to $16 million in Q1 of this year to $10.5 million in Q2. And we expect this cost to continue to cycle downward as the infrastructure build-out in Canada and Denmark approaches completion and as the manufacturing facilities for Rec 2.0 products begin production. Excluding both the restructuring costs as well as the costs associated with underutilized assets results in a normalized gross margin before the fair value impacts in cost of sales, and other inventory charges is $29.2 million or 38.2% of net revenue. And as Mark highlighted, this is summarized in a Q2 2020 supplemental information presentation that's located on our Investor Relations section of our company website. Taking a step back, gross margin is an extremely important metric for our company, and as we continue to work toward the 40% margin goal highlighted previously, it's important to note that every Canopy employee that participates in our bonus program has this goal included in their annual incentive, so we can assure you that this is a priority for the entire organization. Now speaking briefly about operating expenses. Our sales and marketing expenses were $60.5 million in the quarter, representing an increase in staffing as we build out our network of Tweed and Tokyo store retail locations. But we're also making investments ahead of revenue to prepare for the second phase of recreational cannabis as well as CBD products in the U.S., all of which are expected to launch later this year. Our G&A expenses grew to $87.9 million primarily due to onetime nonrecurring costs of $19.6 million. Of the $19.6 million, $10.8 million pertains to a legal dispute with a third-party hemp farmer in the United States, for which we are seeking remedy for breach of contract. The remaining $8.8 million pertains to estimated exit costs for retail locations that were leased ahead of Rec 1.0 before the full set of regulatory and permitting rules were known. Share-based compensation expense was $92.9 million and is up $5.6 million from Q1 of fiscal '20. The increase is primarily attributable to accelerated vesting due to the executive transition announced in July. Separately, management has restructured its share-based compensation program that will lead to reduced expenses and share-based compensation in the upcoming fiscal year. Moving beyond operating results. I'd like to spend a few minutes on other income and expense. Total other expenses are $109.3 million during the quarter, primarily driven by fair value adjustments. First, we recognized a noncash unrealized gain of $164 million driven by fair value changes related to senior convertible notes, which is due to the decrease in Canopy's gross stock price from June 30 of this year through September 30 of this year. Second, we recognized a noncash expense of $235 million related to the fair value change in the Acreage call option. Now as a reminder, the Acreage arrangement provides Canopy with the option to acquire 100% of the shares of Acreage, with a requirement to do so once U.S. cannabis production and sale is federally legal in the U.S. And in exchange for this option, Canopy made an upfront payment to Acreage shareholders of USD 300 million, which is now recognized as a financial asset on Canopy's balance sheet, with the subsequent changes in the fair value of this option recognized on our consolidated statement of operations. And the fair value of this instrument is driven by many factors, including the relative value of the 2 companies. And because the stock price of Acreage is influenced by the fixed exchange rate of 0.5818 shares, we cannot rely solely on Acreage's stock price to determine the relative value of the 2 companies. Hence, we must also evaluate the entire sector of MSOs in the U.S. to help derive the value of Acreage. And because the multi-state operator sector valuations decreased in Q2, the relative value of Acreage is implied to have decreased more than Canopy and therefore a loss was recognized. Now let's briefly cover adjusted EBITDA, our supplemental non-IFRS measure, for Q2 of fiscal '20. Adjusted EBITDA in Q2 amounted to a loss of $155.7 million as compared to a loss of $92 million in Q1. The adjusted EBITDA loss includes the full impact of the restructuring charge of $40.4 million as well as the $19.6 million of onetime nonrecurring costs included in G&A for the third-party disputes as well as the provision for onerous leases. The remaining decline was $3.6 million and was driven by increased operating expenses. Our net loss on a reported basis, which includes all fair value adjustments for biological asset accounting, was $374.6 million or $1.08 per basic and fully diluted share. Turning to the balance sheet. As of September 30, we had cash and cash equivalents available as well as marketable securities on hand totaling $2.7 billion, representing a decrease of approximately $400 million since June 30, 2019. And the primary uses of cash during the quarter was $228.3 million for infrastructure, with the balance related to ongoing debt servicing and funding for operational losses. Our biological and inventory on hand ended the quarter at $572 million, which is up from $496 million in Q1. And this includes $219 million of fair value adjustments, along with the $353 million of inventory at cost. And of the $353 million of inventory at cost, $65 million pertains to markets outside of Canada, which leaves us with $288 million of inventory at cost related to our Canada operations. So let me now address our dry flower inventory, which comprises a portion of the $288 million. Looking at our current demand projections, which includes estimates for new store openings, we estimate our supply and demand for dry flower will reach equilibrium in the summer or fall of next year. And these demand projections assume 40 new stores opening per month in Ontario starting in January, which is informed by the pace of new store openings that were experienced in Alberta. Hence, we believe we are well positioned on our flower inventory levels, and we will continue to monitor the situation closely. And we have illustrated the supply and balance of dry flower in the supplementary information package referenced earlier. It's also worth noting that the balance of our inventory, which includes extracts and oils and isolates as well as other raw material inputs, is in line with demand and, in many cases, has an extended shelf life that provides us with lots of flexibility. Next, I would like to provide a brief update on our foreign private issuer test that was completed at the end of Q2. As part of our U.S. financial reporting requirements, we have confirmed that as of September 30, 2019, Canopy Growth no longer meets the criteria for qualification as a foreign private issuer. Hence, as of April 1, 2020, Canopy Growth will be considered a United States domestic issuer and a large accelerated filer, and with this, we will transition to U.S. GAAP. And our new reporting will impact certain elements of our financial reporting, and we will provide an overview of the financial reporting changes at our upcoming Q3 financial results conference call. Finally, I would like to provide a brief update on the priorities that I covered during our last call. We are making tremendous progress in reengineering our financial close and reporting processes, and we expect to achieve the accelerated close time lines at year-end. We continue to make tremendous progress in improving our control environment and are working to remediate our material weaknesses with end-user computing by the end of this fiscal year. And we recently launched a project to implement SAP across the enterprise, starting with the U.S. market. And having a Tier 1 ERP solution in place will give us the platform needed to scale our business in coming years and provide us with the capabilities to truly make us a digital company. So suffice it to say, it's a very exciting time for Canopy. The investments we're making in people and process and technology will position us for global leadership. And despite some of the short-term headwinds that we're facing, we're confident that we will continue to be the steady hand of this industry going forward. This concludes my review of the Canopy Growth financials for Q2 2020. And operator, we would be happy to field any questions at this time.

[Operator]

[Operator Instructions] First question comes from Vivien Azer with Cowen.

[Vivien Nicole Azer, MD & Senior Research Analyst]

Appreciate the color on the revenue targets. Certainly, you guys are not alone in calling out the challenges from a retail distribution standpoint limiting the revenue opportunity. But Mike, can you offer any more clarity in terms of what we should expect from a revenue perspective now that the $250 million is off the table?

[Mike Lee, Chief Financial Officer]

Yes. So thanks, Vivien, And Mark, I'll take this one. I think we have seen there are a lot of variables out there. We know what we can do. But if we just look short term at what's happening, we're waiting to see Cannabis 2.0 products get to market. We're waiting to see whether there are delays over Christmas or how that happens. Obviously, we're waiting to see the store rollout, and frankly, we're waiting to -- we think we've seen the provinces rightsize a lot of the inventory levels that they're holding, which a lot of analysts have talked about and seeing that start to normalize. So we are feeling bullish, but on the other hand, I think there are just too many variables for us to try to give direct guidance on what the upcoming quarters look like.

[Vivien Nicole Azer, MD & Senior Research Analyst]

Okay. That's fair. Maybe just a follow-up then. On the U.S. CBD opportunity, can you offer a little color on how we should think about shipments impacting your fiscal third quarter '20? Seemingly, you'll be pushing some product into the market.

[Mark Anthony Nicholas Zekulin, CEO & Director]

Sorry, Vivien, is that for U.S. in Q3 or Q4?

[Vivien Nicole Azer, MD & Senior Research Analyst]

Well, I thought you were going to -- you would have recognized some revenue in 3Q, but if it's 4Q, then yes, any commentary in the back half on revenue generation expectations for U.S. CBD, please.

[Mark Anthony Nicholas Zekulin, CEO & Director]

Yes. I think our target remains Q4 of this fiscal. While it is potential some of that might creep into Q3. I don't think there'll be anything material in Q3, to be quite honest. And we're -- I'd say our hemp operations are now completing. We have the contract manufacturers in place. We have actual manufacturing underway. The team is ramping up. We have probably around 100 people in the U.S. now and a lot of head office resources going towards that. But like all things cannabis, nothing is easy. The conversations with retailers aren't easy. The basics of setting up an online store are more challenging than selling a widget. So we worked through all those things and are confident to see product in Q4.

[Operator]

Next question comes from Tamy Chen with BMO Capital Markets.

[Tamy Chen, Analyst]

First question is -- I was just wondering, so on your assumption that you're making about Ontario, 40 stores a month starting in January, so you're looking at Alberta as a precedent, but I'm just wondering, have you gotten a sense from the current Ontario provincial government? Are they ready to do something like this starting in January?

[Mark Anthony Nicholas Zekulin, CEO & Director]

Yes, it's a great question. So I'd say 2 things. What we put out in that slide deck is an illustrative case. So you can assume that going into that are tons of assumptions about our market share, the sales per store, new products, all of that sort of stuff. But the big variable is how many stores are rolled out and mostly that's about Ontario. So I think the first point I would make is we've modeled less stores, more stores, and it shifts from -- maybe shifts from equilibrium in June to August, and maybe it shifts inventory on hand from 4.5 months to 6 months or the other way around. But in virtually all of those models where we see any sort of -- with respect to Ontario rollout, we still feel good about where we are. To answer the question directly, I think the entire sector is putting a lot of pressure on the Ontario government. You've seen op-eds that we've done together to pressure them. They're certainly saying that they're going to do all those things, but we haven't seen the action. I think it's important to note that they have announced essentially roughly another 70 to 75 stores that will come regardless through the lottery system. So in some ways, that speaks to some of those early months of the -- are already stores in the process, even if they don't do anything else. But we are confident we'll see it in the next couple months that they will make a move to sort of ensure that, that number continues into the out months.

[Tamy Chen, Analyst]

Okay. And second question is -- Mike, so I just wanted to confirm, when you talked about the new pricing architecture, was that specifically or only to the oils used in the rec market? Or does that pertain to flower, too? Because what I'm getting at here is, I noticed, by my math, your average selling price, net, for rec on flower still is higher than some of the other peers that we've seen. And I'm just wondering, could there be potential downside there because we are seeing a number of LPs becoming more aggressive on flower pricing in the rec market?

[Mike Lee, Chief Financial Officer]

Yes, good question. So the ASP that you look at for dry flower quarter-to-quarter was down, and product mix was the driver as we get our TWD brand in market in earnest. We are filling the supply chain. If you recall, early in the year, that was one of the brands that we were holding back as we were filling our flower channel. So now that that's out there, we expect that TWD will play a role, but the mix in Q2 of our dry bud shipments was weighted more toward that as we filled that pipeline. The pricing architecture changes that we talked about for softgels and oils does pertain to softgels and oils across Canada. And I would think about it as a 5% to 7% price reduction on average depending on the provinces. There's some variation across the provinces. But I think 5% to 7% would be a good proxy of the architecture changes that we're making.

[Operator]

Next question comes from Chris Carey with Bank of America.

[Christopher Michael Carey, Research Analyst]

So I guess I'm trying to get a sense here for if things have really bottomed here, right, or if there's potential, I suppose, cliffs ahead, right, because -- and certainly, what the stock is doing premarket, I think, would indicate that the investment community is really looking for what actually is fundamental trough. And I think the decision to take the provision on oils makes sense, right? But then I'm kind of scratching my head about this assumption for 40 stores per month in Ontario, and Ontario's revenue per store is just so much higher than the rest of Canada, which -- so it's a pretty significant driver of inventory depletion. And I guess I'm just trying to frame in my head what happens if that doesn't occur, right, because production was 40,000 kilos again this month -- or this quarter. And I'm just trying to frame in my head what happens if you don't get these 40 stores, right, because -- do you have to like slow down your production? Do you have to shut down some facilities? What are the implications for gross margins? And obviously, you have more mix coming into the equation. And so really all that together, but the sort of philosophical dynamic that I'm trying to get at here is when we can get comfortable that things have sort of bottomed. And maybe I'm just trying to kind of walk through that analysis, and maybe I'm just not quite there yet. So anything you can do to help me would be appreciated.

[Mark Anthony Nicholas Zekulin, CEO & Director]

Yes, totally. And great question. I would say if we park the question for a second and we look at everything else going on in the business, right, our recreational market share is sitting north of 25% across the country, in our view. Gross revenues prior to adjustments, up 6% to $118 million. Canadian medical sales, up; global medical sales, up; retail sales, up, fifth largest retail network; overall cannabis shipments, up. So we feel -- provisions aside, we feel very strong about the quarter, actually. As you speak to the stores, again, we put one illustrative case in there of the store openings. And today, we are at a bit of that perfect storm, where provinces are working down inventories. Cannabis 2.0 is still yet to come, and we have 60% of the population with only 10% of the stores in Canada. I think if we look positively on that last one, it is such a big deal, and it's actually such an easy solution, right? The government has recognized the need to have more stores. They've recognized that they want to explore their distribution models. They've recognized that they want to move to an open market system. So I think, for sure, you hit on the point. There is still a $6 billion Canadian market when you convert the illicit market. That is all there. We're waiting for stores. We cannot -- to your point, if Ontario doesn't open stores for another year, we all have a problem. I don't think we can -- why try to overlook that? But there's no reason to expect that will happen. They've indicated they're going to open stores. Everybody is pressuring them to open stores. Hopefully, they're listening to calls like this and considering the impact it's having on our sector. And I think we'll see that happen.

[Christopher Michael Carey, Research Analyst]

Okay. Okay. Then maybe the other element which I just wanted to dig into a little bit is I fully appreciate the pre-revenue investments, and I think we all understand what's in play here. And it's a very large market with huge TAM. And you guys are one of the few companies that actually has capital to make investments, and so it makes a lot of sense to do that. But I guess on the other end, there's this dynamic of markets are coming together maybe a little bit slower from a legal standpoint. And we all get that they're there and that revenue is there to be had. But with the quarter-over-quarter deterioration in free cash flow, I mean, is there an element here where you kind of say, okay, we get the importance of pre-revenue investments, but we also get this other dynamic that the market is coming together at a certain pace, and maybe we need to be more dialed about the money that we're putting to work? And maybe if you could comment on how you see free cash flow trends going forward. So anything there would also be very helpful.

[Mark Anthony Nicholas Zekulin, CEO & Director]

Yes. No. Thanks. And I'll let Mike speak to the free cash flow going forward. I think it's fair to say we have built this company for the long term. As you said, the long-term markets are all there. There are short-term challenges in Canada and even other places as we look for more certainty in the U.S. And while we build for the long term, are focused on the long term, we're not naive to the short term either. So over the last several quarters, we have actually been making tough decisions to limit certain research expenditures, limit certain hires to keep within the reality of what's happening. And I think the other key thing to focus on is infrastructure and M&A, right? I mean we are in the fortunate position of having over $2.5 billion in the bank, with our Canadian infrastructure essentially fully built out, with our European infrastructure essentially fully built out, with our global M&A program largely completed. There will always be opportunistic focuses, but we've filled all the holes we have. So the big things that draw off our capital are minimized right now. We are being very prudent to make sure we look at current events, but we're also not taking drastic steps that will undermine our success for the long term because, speaking of cash flow, we don't need to do that.

[Mike Lee, Chief Financial Officer]

I would just add that when you think about OpEx, taking that part of the question first, Chris, from an OpEx perspective, there has been investment in back office capabilities over the last 6 to 9 months, and we are on the tail end of that back office investment. The G&A increases that you saw in the quarter are largely driven by onetime events, nonrecurring events, and that will normalize in the next quarter. But our back office is largely in place. With respect to other operating expenses, we continue to balance investments in long-term strategy versus short-term results, and we recognize that the Canadian market is 6 to 12 months behind where we thought it would be given the store openings. And we are continuing to challenge ourselves to make sure that we're scaling our organization appropriately, keeping that in mind, but we are not sacrificing any of the longer-term investments that are multiyear investments that any interruption to that would be highly disruptive to our strategy. So set that aside, and when you look more broadly across our international markets, the U.S. continues to be our #1 investment for operating expenses. And we've built a team of just north of 100 people on the ground, and there will be continued investment over the next 12 to 18 months as the CBD scales up. More broadly, looking at free cash flow, we've put objectives in the public domain around expectations on Canada and how it's going to perform over the next year in terms of adjusted EBITDA, when do we expect to get the entire enterprise to adjusted EBITDA positive and all of that. But with that, thinking about free cash flow and the capital spending investments that were made, we're coming off of a major phase of investment from Canada, and we are literally in the final stages of that and paying bills on the last part of it. And then our next wave of investment will be in the U.S., but it's a much smaller wave initially. So our capital spending will be muted over the next 12 to 18 months relative to the last 12 to 18 months that you've seen. So we would expect that our free cash flow will continue to improve over the next year to 1.5 years.

[Operator]

Next question comes from Andrew Carter with Stifel.

[William Andrew Carter, Associate Vice President]

I think part of the issue in the first wave, which is kind of manifested in this quarter's results, has been really a lack of visibility into the market, just new and evolving. So I kind of wanted to first start, give a sense of where you think your capabilities are now versus throughout kind of the first wave into kind of making adjustments and understanding that and then also kind of how much is left to your customers, both provincials and retail stores. And then regarding kind of your visibility, I think what is -- does your ability to make changes in the second wave increase significantly now so you can kind of respond to customer demands more quickly?

[Rade Kovacevic, Acting President]

Yes. So Rade here. So I think several points on it. I think firstly, last year, at the rollout of legalization, we had little to no data. We were looking at what U.S. markets had done, but we had nothing within the Canadian regulatory context for recreational legalization when making production decisions. And so we looked at things such as softgels and oils, forecasted them to be about 15% of the market and pens at around 5%. I think the big change that we've had over the last 12 months is we now have data, right? It took about 4 to 8 months for us to start getting provincial at-the-till data. So rather than simply the B2B sales, we're seeing what is selling through the customers so that we could change our product portfolio and our mix and SKU rationalize to make sure we had the right SKUs in place, that we're having pull-through and being able to have that continuous supply to build customer affinity. I think the other thing we've done well is working with the provinces in terms of routine meetings to make sure we are producing products that meet their demand. So going back to average selling price in Rec 1, the good examples where we've been very successful is high-THC products, 20%-plus TCM in flower, where we've been able to do very well, take advantage of a gap in the sector on supply in that end and execute prudently. I think as we move into Cannabis 2.0, what we've been able to do is take the demand we've seen and leverage that into our supply and demand planning for new products such as vapes, beverages and chocolates. And I think our ability to scale advanced manufacturing products, and to your point, on an agile basis or similar to how we deal with excise stamping, the automation of these manufacturing procedures allows us to allocate products later in the process, leading to shorter lead times and ensuring that we can change our portfolio mix quite quickly to meet market demand. So overall, I think we're confident we're taking a prudent approach, noting, of course, that these are new products. And with any innovation products, there'll always be risk, but we feel pretty strongly about our ability to execute going forward.

[William Andrew Carter, Associate Vice President]

Okay. And you mentioned the second wave on the products. There's been quite a bit of investment there, both internal, M&A, the partnership with Constellation. In your initial kind of discussions with your customers, provincial and private operators, do you get a sense, like, on the pricing side, are they starting at where kind of the supplier pool for dry flower price is? Or are you getting kind of a -- kind of credit or kind of -- for the capabilities you bring to bear, getting a higher kind of, I guess, share of the value chain with your second wave products?

[Rade Kovacevic, Acting President]

Yes. So I think it's fair to say it's not based off flower pricing. We're introducing over 30-plus products at the outset of Cannabis 2.0, with another 20-plus products coming over 6 to 12 months thereafter. We've had great meetings with the provinces. Most of them at this point are pretty close to having finalized their listing process, and we've had great reception. I think a good example would be, on the beverage front, our strategy, as everyone knows, from day 1 has been to disrupt beverage alcohol. And so pricing our beverage products at a slight premium to beverage alcohol is important if it's going to be a direct trade-off. And the provinces have been very receptive to that approach, and we're very happy with the outcomes on that front. On the vaporizer side, I think it's more looking at number of occasion uses and so forth in terms of pricing. But I think the work that we've done to make sure that our products are serialized, that they're tamper-evident, that they're RoHS, meaning no heavy metals in the equipment, and UL certifications and so forth, all that work we did over the past 2 to 3 years through our tech R&D team is really coming out to pay dividends at this point to ensure that we have leading products that make customers in both provinces and retailers feel comfortable carrying our products. And so on the whole, I think we're really happy with where our Cannabis 2.0 products have landed. We're happy with the price points and gross margin that we'll be able to bring forward with these. And thirdly, we're also happy with the ability to scale in reaction to market demand as more stores come online and these products start to gain market share.

[Operator]

Next question comes from Doug Miehm with RBC Capital Markets.

[Douglas Miehm, Analyst]

I just want to go back to -- I know there's a lot of questions around those stores and inventory and that sort of thing. But maybe I could ask the question, if you get the go-ahead from the province in Ontario, how many of those 40 stores per month could carry your banner? And then I guess the other question really has to do with inventory. 4.5 months for dried flower is a long time. Do you think you're going to have to start to write-off inventory anyway?

[Rade Kovacevic, Acting President]

Yes. So first, I'll take the discussion of new store openings. So we've talked about having trademark licensing agreements in place, which is how we've had stores under our banners in Ontario. And I think there's a few important parts that come with that, but mainly, it's the brand recognition, the ability of a consumer to go into a store, have a brand experience and leave that store saying, I really enjoy shopping at Tokyo Smoke. It leaves a lasting brand affinity that's a strong value-add on top of the products we distribute. And so the trademark licensing agreements we have in place have been very successful. You'll note we're one of the top brands you'll see in Ontario today, and I don't see any reason that would change going forward. In terms of the inventory, I think the important thing to remember is that under Health Canada's regulations, there's a lengthy quality assurance process, which, of course, is super important. And we have over 300 quality checkpoints in our release process for product to make it to market. So from the time you start harvesting a crop to it actually is released and available for sale is about 45 to 60 days, so 1.5 to 2 months. At that point, we then have to offer it to the provinces. They place POs. It gets excise stamped and goes out the door. So in a perfect world, it takes 2 to 2.5 months to have finished goods ready to go out the door to retailers. Of course, our provincial partners are looking for inventory consistency. And so often, they're looking for us to have 4 to 8 weeks of supply in finished goods in our warehouse so that they can feel confident that when the product is doing well, that they'll be able to have consistent access. So we see 4 to 5 months inventory as the ideal length of period for dried flower to make sure we have continuity of availability. And so from that perspective, what we're trying to highlight in the supplemental is, given that flower has approximately a 6- to 8-month lead time to market, that we feel very happy with our inventory levels today and that they're setting us up for success both in terms of, if there is a slower store rollout, that we have the right inventory levels, but that if Ontario does hit that 40-per-month mark, that we're able to scale quick enough and respond and really continue to dominate market share through that availability of product.

[Douglas Miehm, Analyst]

Okay, great. And the other question to follow up just have to -- has to do with the new CEO. Typically, when new CEOs come in, they clear the decks and make a bunch of changes and those sorts of things. Now thankfully, you've gone out, and you've taken charges and made provisions and that sort of thing. But are there any places in your business where a new CEO, you think, could come in and make significant changes? And I'll leave it there.

[Mark Anthony Nicholas Zekulin, CEO & Director]

Yes. So I think what has set Canopy apart over the 6 years that has allowed us to grow into the leader in the sector is the team we have, right? So a new CEO will come in. They'll have to assess everything, and they'll run things in a different way and all those sort of things. But at the end of the day, we have built an incredible team, an incredible company and have full confidence that we have all the right people in place from the people on this call to the people running IT to sales and marketing to our international team. So I think what we're trying to do is make sure, in fact, that the new CEO comes in and has time to understand a very complicated sector knowing that he or she has the support of an incredible team. And I'm getting the hook here from Tyler suggesting we're -- we've done our 30 minutes, I think. Good. So thank you, everybody. Thank you for the questions. And I know we have probably a number of calls with people on this call going for the rest of the day. So thank you very much, and we'll talk to you soon.

[Operator]

This concludes Canopy Growth's Second Quarter Fiscal Year 2020 Financial Results Conference Call. A replay of this conference call will be available until February 14, 2020, 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.