Canopy Growth Corp (CGC) 2018 Q2 法說會逐字稿

Good morning, and welcome to Canopy Growth's Second Quarter Fiscal 2018 Financial Results Conference Call. Earlier this morning, Canopy Growth issued a news release announcing its financial results for the second quarter of fiscal 2018 ended September 30, 2017. This news release will be available on Canopy Growth's website and filed on SEDAR. On this morning's call, we have Bruce Linton, Canopy Growth's Chairman and 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 measures, weighted average cost per gram, gross margin and adjusted EBITDA. These measures do not have any standardized meaning prescribed by IFRS.

Weighted average cost per gram, gross margin and adjusted EBITDA are defined in the press release issued earlier today, as well as in this period management's discussion and analysis documents that will be filed on SEDAR. Please note that all financial information is provided in Canadian dollars unless otherwise specified. (Operator Instructions)

I would now like to turn the meeting over to Bruce Linton. Bruce, please go ahead.

Thank you. Good morning, everybody. So the way I'd like to approach this quarter is I'm going to leave, as often the case, much of the details and really all the narrative around the historic numbers to Tim because it seems that with our company and maybe this sector generally, the subsequent events are greater than the prior period's total events and are subsequent events and what we did in the quarter really arches head up where we're going. So Tim will give a fulsome disclosure on that.

What I want to focus on is what we've done and where we're going and where we are on track. And so as you look around our company now, events that I think signal that we're in the right spot and what we're doing is on the right track is getting the historic first province MOU in place for supply for 2018. And I highlight that, there are a lot of other things I could hit first, but a big part of what makes a provincial bureaucrat comfortable, or for my friends in U.S. a state leader, is certainty, and probably 2 things that they've enjoyed most in dealing with us I think is the fact that we have been able to deliver reasonably large quantities of product, have built an inventory capacity and have built and are expanding, not just creating the platform.

And so when you look at our expansion, we've kind of announced about 2.4 million square feet indoor and greenhouse growing, much of which is an expansion on either an existing location or existing practices, and so we could talk bureaucrats through the reasonable certainty that whether it's a big greenhouse in British Columbia at 1.3 million square feet, or expanding the one we have in Niagara, or putting up a new facility of 160,000 square feet inside an existing building in Edmonton or adding an expansion at our facility in Smiths Falls of 300,000 square feet, all of those are pretty certain events which I think is quite helpful when dealing with bureaucrats who are quite anxious, eager, uncertain, active, all those words you might expect for bureaucrats on a marijuana file for 2018.

And then we take that and add some of the things that we've sort of wanted to highlight which are international. You'll note that we've been the first company into Denmark and historically we're also the first company, and the way we become the first company is starting early. So Denmark, with respect to cannabis, Denmark going -- getting Alcaliber for the people who may not have encountered -- check out Alcaliber, they're one of the most substantial producer of alkaloids and they're looking at a migratory path that includes having cannabinoids as their production platform. So tying those up in Spain.

I can now say that I'm actually the chairman of a marijuana company in Jamaica which certainly should improve my perception as cool because in Jamaica we've established our partnership there which frankly has been a year-plus process of selecting the right party, making sure that we're on the right track for the licenses, but getting that to where we want to be. And so the international opportunities are now increasingly happening, but we're also linking in our division called Rivers and Rivers was able to put quite a lot of money over the quarter in Canada. We see a way that they're going to be a key part of our expanding supply chain in Canada, but increasingly part of our international play.

And further to laying down track, we quietly worked away and have filed 27 patents now through Canopy Health which is a separately focused and funded division designed to create intellectual property and outcomes around true medical research involving cannabis so that we can have an array of products which are for sale through and by Canopy proper, and the intellectual property is developed and resides inside Canopy Health. So as we focused on one indication and got those patents out, the next wave is what we're working on and over the next year we'll spend the money to put together the necessary research to be sure that those patents actually have our novelty and knowledge incorporated into them so that we think they're defensible.

And so the company I think is doing what we usually do which is really just driving ahead, looking out a year, 12-18 months, and making sure we're doing the actions today that establish us as the continued leader. And the quarter, it's kind of odd to be nonchalant about more than doubling your revenue, having growth in every category, introducing new products with higher margins, but I'll let Tim take over those historic yet interesting items.

So over to you, Tim.

Thank you, Bruce, and good morning, everybody. To begin my remarks, I'll briefly touch on the re-filing of our annual statements for the year ended March 31, 2017, on SEDAR yesterday and which is also disclosed by way of press release after the close of financial markets. The restatement accounted for firstly the understated value of the 11% interest that we have in AusCann Holdings, as well as the options that we also hold in AusCann. The adjusted fair value increased the investment by $18.3 million and the options by $5.7 million at March 31, and the value was previously carried at its cost-base of nil, which was a consideration that we paid for that minority investment.

The AusCann investment is considered under IFRS as a category called available for sale which is a financial asset in an IFRS term. In addition, the options are considered a derivative financial instrument that is measured and re-measured to its fair value at the end of each reporting period. So background to that is prior to February 3, 2017, the AusCann shares didn't have a quoted market value, and the fair value of its equity interests and options in AusCann couldn’t be reliably measured. So the equity interest, any options were carried at the cost amount of nil. In the quarter ended March 31, AusCann completed a capital reorganization and became listed on the Australian stock exchange, and following the IPO, Canopy Growth's shares and options in AusCann were escrowed until February 3, 2019.

So we've gone back to accounted for as a asset held for sale under IFRS which is measuring and re-measuring its fair value at each period end. In addition, a matter of housekeeping, we also adjusted for the material non-cash change related to the valuation of biological assets at March 31, as we previously disclosed in the first quarter. So as a result of these restatements, the company's reported net loss was reduced or improved from $16.7 million to a net loss of $7.6 million for the year ended March 31, 2017.

So now I'm going to proceed with the review of the financial results in the second quarter. Revenues in the second quarter ended September 30th were $17.6 million, representing a sequential quarter-over-quarter increase of 11% that is compared to Q1, and 107% increase over the quarter ended September 30th last year. In the 3 months ended September 30th, oils including soft gel capsules accounted for 18% of the reported revenue. Revenue in the 6 months ended September 30th totaled $33.4 million, representing a 115% increase over the same period last year when revenues were $15.5 million.

It's worthwhile highlighting that revenues in the 6 months ended September 30th already equal 84% of the revenue generated in all of last year. The total grams sold during the second quarter was 2,020 kilograms in kilogram equivalents at an average price of $7.99, up from 1,169 kilograms in kilogram equivalents at an average price of $7.01 per gram in the comparison quarter last year. In 3 months ended September 30th, oils including soft gel caps, as I said, accounted for 18% of the reported revenue for each period, and the higher average price -- average prices due primarily to the improved mix of oil products, including the soft gel capsules that we introduced late in the first quarter of fiscal 2018 this year. Year-to-date, the company has sold approximately 3,850 kilograms at an average price of $7.98 per gram, as compared to 2,153 kilograms at an average price of $7.05 in same period last year.

Next I'd like to speak to the weighted average cost per gram cultivated and sold. The weighted average cost per gram is a supplemental non-GAAP measure, and is described as to its basis on Page 4 of the press release and in the MD&A. Canopy Growth's weighted average cost per gram is comprised of first the cost of harvest which include all of the cash operating costs including principally growing labor, utilities such as hydro and water, grow nutrients, rent and allocated overheads.

Second, the post-harvest cost consists of cash operating costs related to the production of value-added products including cannabis oils and soft gel capsules. Post-harvest costs also include cash operating costs associated with trimming, milling, drying, lab services and testing and allocated overheads. And lastly our shipping and fulfillment cost consist of cash costs related to expedited carrier delivery to patients where applicable and royalties paid under license agreements to product and brand partners including Leafs By Snoop and DNA Genetics. Shipping fulfillment also includes cash operating costs associated with labor, for prepackaging and dispensing and order fulfillment and shipping, along with packaged materials such as bottles, boxes, labels and also allocated overheads.

So getting to the numbers, in the second quarter of fiscal 2018 the weighted average cost per gram to the point of harvest was $0.72 as compared to $0.99 in the same period last year representing a decrease of 27%. The decrease in cost at the point of harvest is due in part to operating efficiencies from adding 12 additional grow rooms representing a 100% increase in the flowering space at Smiths Falls now operational and overall plant yields are up. The second quarter of fiscal 2018 is the 5th consecutive quarter when the cost at point of harvest was less than $1 per gram and fell relative to the previous quarter. These costs are competitive within the industry and especially competitive for a product mix including high-quality indoor production as well as greenhouse production, and we may see further optimization as increasing percentages of each facility are brought in line and efficiencies are fully realized.

In the second quarter fiscal 2018, the weighted average cost per gram during post-harvest including cash costs related to the production of cannabis oils and soft gel capsules was $0.53 as compared to $0.71 in the second quarter of last year representing a decrease of 25%. The decrease in post-harvest cost is due in part to gains in the efficiency of oil extraction resulting from the use of the custom-built industrial scale CO2 Super Critical extraction machine that was commissioned at the end of the first quarter in fiscal 2018, as well as efficiencies gained through other post-production activities such as trimming and drying.

In the second quarter fiscal 2018, the weighted average cost per gram for shipping fulfillment cost was $1.48 as compared to $1.01 in the same quarter last year. The increase in shipping fulfillment cost during the second quarter was due to higher investments in packaging, delivery and overall experience excellence since last year. Investments that we see is key differentiators to the customer experience and affinity for the brands.

Next I'll briefly discuss the gross margin. The second quarter gross margin before the fair value effects of the IFRS accounting for biological assets and inventory was $10.1 million or 57% of sales as compared to $5.1 million or 60% of sales in the second quarter last year. The lower gross margin percentage was due primarily to the impact of a $700,000 write-down in hemp-based inventory due to the discontinuation of product lines and a $400,000 charge due to idle grow operations at the Creemore location while being reset under Canopy direction.

Excluding these effects and the costs associated with non-cultivating subsidiaries totaling $1.8 million, the gross margin before the fair value impacts and cost of sales would have been $11.9 million or 68% of revenue. In the 6-month period ended September 30th, gross margin before the effects of the IFRS fair value counting through biological assets and inventory was $19.1 million and 57% of revenue as compared to $9.3 million last year and 60% of revenue for the same period. Adjusting for similar exclusions that was previously described totaling $33.2 million year-to-date, the gross margin would have been $22.3 million or 67% of revenue.

Now turning for a moment to operating expenses for the second quarter, sales and marketing expenses for the second quarter were $7.6 million or 43% of revenue. These costs include investments made in staffing and resourcing the marketing and sales functions needed in coming regulated recreational and international markets, costs associated with the company's medical outreach program and the growing customer care center which interfaces directly with the company's growing base for customers. Since September of last year, the number of customers has grown from over 24,000 to over 63,000 at September 30, 2017.

Year-to-date, the sales and marketing expenses were $14 million or 42% of revenue compared to sales and marketing expenses were $5.1 million or 33% of revenue in the 6 months last year. G&A expenses in the second quarter were $8.4 million or 48% of revenue. These costs include investments in governance and supporting corporate infrastructure as we build the company, and more specifically include higher accounting, legal and professional services fees of $2.2 million related to supporting those governance programs as well business development activities. In comparison, G&A expenses were $4 million or 47% of revenue in the 3 months ended September 30, 2016. Year-to-date G&A was $15.9 million or 48% of revenue compared to $6.9 million or 40% of revenue in the same period last year.

Stock-based comp, depreciation and amortization, all non-cash expenses were approximately $11.2 million and $4 million respectively in the quarter ended September 30th.

As a result of all of the above, in the second quarter of fiscal 2018 we recorded a loss from operations of $1.1 million and after income tax expense the company reported a net loss of $1.6 million or 1% -- $0.01 per basic and diluted share. This compares to net income of $5.4 million or $0.05 per basic and diluted share in the same period last year. Year-to-date, we recorded a loss from operations of $5.4 million and after income tax expense and other fair value changes in the financial assets related to the -- primarily to the options on AusCann, the company reported a net loss of $10.8 million or $0.07 per basic and diluted share. This compares to net income of $1.5 million or $0.01 per basic and diluted share in the same 6-month period last year.

Now I'll talk to the non-GAAP measure adjusted EBITDA. Adjusted EBITDA, as the operator mentioned, is defined in the press release and MD&A. Essentially it's the income from operations reported before the interest and tax, and also adjusted for moving other non-cash items identified in the P&L and the cash flows, as well as removing the effects of the acquisition-related costs. Adjusted EBITDA in the second quarter of fiscal 2018 amounted to a loss of $6.2 million as compared to an adjusted EBITDA loss of $1.9 million in the same quarter last year. For the 6 months ended, the company's adjusted EBITDA was a loss of $11.3 million compared to an adjusted EBITDA loss of $3.2 million in the same 6-month period last year.

The higher adjusted loss relative to last year was due to the investments being made as described earlier in our corporate infrastructure, operations, marketing, sales and functions and to build -- building for the kind of company we're going to be heading into calendar 2018, as well as the other costs that were identified earlier, that is cost associated with the Creemore facility being idle for much of the quarter and the hemp write-off of $700,000. We believe our deliberate and ongoing investment in building the company's production platform, brands, international reach, partnerships and operations which directly impacted our net earnings and adjusted EBITDA during the period is necessary to strengthen the company's global leadership position heading into next year.

Now turning your attention to the balance sheet and cash flows, at September 30th the company's cash comprised of cash equivalents was $108.2 million representing an increase of $6.4 million since last yearend. The increase is attributable to the combined net proceeds from the $25 million private placement common share issuance that was completed in July, as well as Canopy Rivers' first quarter private placement of approximately $36 million and the exercise of options and warrants, mostly offset by cash used to fund operations, investments in facility enhancements totaling $25.5 million and investments made in and through affiliates totaling $13.4 million.

Investments in facility enhancements were primarily improvements at our Smiths Fall facility including the expansion into the rest of the building for future capacity and capability, also the previous announced expansion of Niagara-on-the-Lake, and construction at Bowmanville, Ontario, as well as initial outlays for the Fredericton and New Brunswick and Edmonton, Alberta locations, as well as deepening enhancements in our information technology capability.

Inventory September 30th amounted to $73.3 million, up from $46 million at March 31 and the biological assets were $23.5 million, up from $14.7 million at the end of last fiscal year. Together inventory and biological assets totaled $97 million, up from $60.7 million at the end of yearend, and the inventories, as Bruce talked about, everything scaled to ensure sufficient supply for the expected market demand especially coming from the provinces.

At September 30th, the company held 12,064 kilograms of dry cannabis and 2,683 liters of cannabis oils ranging from concentrated resins or refined oil to finished oil. Included in the dry cannabis quantities were 1,679 kilos available for sale in the company's online stores, 3,355 kilograms in process of finishing or waiting approval for sale and 7,030 kilos of extract-grade cannabis held for conversion to saleable oils and capsules.

So, Bruce, this concludes my review of the financials for this quarter and I'll hand it back to you.

Great. Thanks, Tim. I'd ask to open up it up for questions.

(Operator Instructions) And your first question comes from the line of Jason Zandberg with PI Financial.

I just wanted to -- lot to go over here, just -- and I don't want to hog the floor too long, but just -- I wanted to first of all just talk about the upcoming rec market and provincial supply agreement. So we've seen you were successful in New Brunswick with getting a supply agreement there. Just wondering if in that situation, the province looked upon those that were investing and supplying product from within the province and just wondering if that tends to be the same viewpoint from other provinces that you've spoken with in terms of having that local supply, given that Canopy, you guys are spread out throughout the country and are well-positioned for that, I was wondering if that is a key negotiating part to dealing with the provinces on rec?

So I would say it varies by province. Probably New Brunswick has been the fastest to establish that. I would say similar to many European geographies, this is not actually about marijuana production, it's both economic outcomes, it's about job generation. And so in that province was a factor. I would say uniform across all the provincial discussions we're engaged in is making sure you have the product, that there is certainty that the product will be available because they're signing up to a commitment of you will get me this much and you'll have some flexibility in format, but it has to be here. And so job creation and embarrassment wouldn't work, but it is a factor and I would say it's more of a factor in the smaller provinces. So I think it will be a helpful checkbox, but it isn't the first thing to look at.

As well, do you have an estimate in terms of your capacity at the launch of rec, it's -- like let's assume it is July 2018, do you have any idea what your capacity would be at that point in time?

We haven't put it out there, but assume inside the place that for -- since day 1 we've run construction review meetings, run these with -- think of Gantt charts and budgets and delivery dates and that we've amped up that capability year-on-year so that now for every site we look at, a schedule delivery obligations who's contracted for them and when the first day we expect to have product in for each site that we're building out. And so because we've done enough builds, we're pretty comfortable that we know how to deliver it on time and the effect of that is that, we can -- we think we can make a very big hit in each of the provinces that are going to commit, and I know that's not a specific thing, but look at the number of sites we built, bringing the first greenhouse on. We acquired a greenhouse in Niagara, I believe it was the 18th or 19th of June and we had plans going in on the 11th of August. The site had no fencing, no security and no approvals other than it had been proposed as a site. And so I think we have a pretty strong history on both construction and meeting the criteria, and so I would expect with all those numbers of expanded square feet, we have a plan that they're going to be contributing for the 2018 window.

And last question, I just wanted to ask you about the gel caps, it seems to be a strong category within the oils component. I know when I was visiting Smiths Falls back in September it seemed like you could -- you couldn't ship it out fast enough. I just wanted to get some color in terms of what you've seen since launching gel caps and what do you expect going forward?

Yes, so gel caps is a category, I think we're the ones who've launched what I would call is a soft gel cap created in a GMP 1 environment, so you can get it to a different category dosage and structure and delivery, and definitely strong demand part of our capital plan is we expect to see quite a lot more of that, so we're lined up on how to produce those where we see them taking up. I think there's a question of which clients do you migrate or patients do you migrate versus those detailed today by our physician reps who the first time they buy cannabis it is a gel cap. And so you'll probably find there's a higher adoption rate as new clients come in to a portfolio and probably similar formats for the adult access, then when you have already a base of people accustomed to buying a certain style of product, but the demand and the margin, and it's like everything. Where we're going is to take the plant as an ingredient and turn it into a finished good because you move from a cost-plus to multiples on margin and that's our path for every category.

Your next question comes from the line of Daniel Pearlstein with Eight Capital.

Let's start off again a little bit more on the provinces. Can you talk about some of the logistics needed to be prepared for next summer, in working in coordination with them, with the liquor boards across multiple different provinces, can you give us a bit of a flavor over what needs to happen between now and being ready?

Yes, and it's interesting, Daniel, because I'm going to give you the best answer I can without fully informing others in the sector what they're not doing, but what you'll find is these provincial authorities tend to have very specific and structured IT system that are not the same, but well-structured need to the provinces from their liquor experience. And so whether or not they're going to warehouse, have us drop ship to specific locations, they can have a combination of fulfillment options which you need to make sure your IT system can plug into and that your inventory control system can actually reflect to the provincial buyers what's in the vault and what they can buy. And so there is no uniform method in the country other than I would say you need to have an advanced platform capability and you need to be able to make sure that if you've made allocations within your inventory control system, you actually have the ability to partition or effectively schedule your incoming grow finished products. To replace products you could move to different provinces so you maintain your obligation of fulfillment, and so it's a bit more like running a very advanced airport where the initial business we're in is much more about the production-only side and getting it to finished goods and making sure it ship to the right person. I would say the offtake process is going to be way more complicated than our current system and you have to have thought about that.

Secondly, can you comment on some of the branding and marketing rules as well as the suggestions suggested by a group of LPs I believe it was last week, can you talk about what was new or what some highlights were or some takeaways and how that may solve some misconceptions in the market about how the LPs will be able to brand and advertise?

Yes, so I don't believe we were overly a loud voice in any of the LP groups you're describing. Where we are is in interacting with the regulators over the last 1.5 years, 2 years since change of government, is the expectation is that the point of sale there will be a ability to have the name brand on the product, details about the product and contact information on the product. Now that the point of sales depending on the province you'll also have things that are advertising tear sheets so that the customer can make an informed decision and recognize a brand that they want to select and return to if they got what they wanted. And the reason they need to do that is if we all throw it into a Ziploc bag, put it behind a counter or maybe in somebody's puffy coat, we're not too different than the black market. And so I think you're going to find slight regional variances. Some of the provinces we've interacted with are way out there in what they like to enable. And I think that this is a first day first position, but it's going to give the customer the ability as an adult to be informed before they go in the store, bought a name they like, see that brand, buy that brand, but it's not going to have 25 color hippy-dippy packaging. It's not going to be super-appealing to kids, it's going to be informative to an adult, and that I think you'll find that that's a pretty good starting point and it will work quite well for the brands we've built out and that it'll get more open over time as more different products come in.

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

My first question is again on capacity. It would be very helpful if you can help us understand with precise numbers where you are in terms of capacity. I know that you've harvested around 4,000 kilos this quarter and if you could walk us through a little bit how that capacity is going to evolve to the opening of the rec market that would be super helpful because there's a lot of moving parts here that makes us -- makes it hard for us to just really pin down a number.

Tim, do you want to tackle a bit where we had the harvest from and then I'll explain where we are with the various projects in the different geographies in terms of the platform we have that's expanding.

Well, I mean, yes, principally the harvest in the quarter, when the 12 additional grows, the 24 rooms now fully operating at Smiths Falls, that was a big part of it. The Tweed Farms harvest of course what happened after September 30th, hadn't started quite yet, so that was happening in the third quarter which we're currently in. But also the Bowmanville also back up and running, remember if you are -- it was in idle mode during a good part of the first quarter, part of the fourth quarter. So between Bowmanville back and running and 24 grows being harvested, that's where the -- where it all came from.

Great. And what we have, Martin, is we began to harvest now as the quarter ended for the first harvest out of our Saskatchewan facility. We have during the quarter made the acquisition of the adjacent property in Niagara-on-the-Lake which has a short fuse towards turning a portion of that building over to production expansion and we have a substantially moving-through-completion 220,000 greenhouse expansion at that site at the back of our current greenhouse. So those we would expect to see begin to be ready for approval and then product going in, in call it calendar Q1. And as we look east, we're in demolition and evolution of the site in Fredericton. We have our Québec site awaiting approval, so it's essentially done and inspectors have been through. We kind of open the mail every day wondering if the approval is in there, so that's one at that stage. As we go west beyond Saskatchewan, we've gone through the process of designing and electrical upgrades in the works for the Edmonton site, and we have a pretty aggressive plan on the British Columbia one so that it can have -- assuming we execute properly, plants in early 2018 would be our target for that one. So really what you're seeing is current platform in Smiths Falls cranking out substantially the one in the former Mettrum site up and sort of running fully now and expanded and then a whole bunch of stuff that we think falls into Q -- calendar Q4 for the farm, Q1 starts to see stuff at the other sites.

Any chance you can give us some sort of a range of production that you hope to have once the rec opens up?

Well, I think the last number that Health Canada which was quite some time ago had rated as that was above 31,000 kilograms-32,000 kilograms and I can't even say how historic that number might be, but many, many months. So we're starting with that base and the intent had been, and it's been said before that we would expect to be -- sort of triple that as we get to the start of the second half next year as sort of a baseline minimum, and as you would observe, we've historically not been big on making grandiose commitments, but just delivering.

Well, that's a number to start with, so thank you for that. Second question is on the patients at quarter-end. We saw a big jump in your patient number in Q4 from Q3, but in Q1 and Q2, it looks like the growth has slowed down a little bit. Is this what you're seeing in the market? Are medical patients growth -- is the number slowing down a little bit from what we've seen historically?

I think it's slowing a little bit, but I also find that through our Mettrum acquisition, we ended up with some range of clinics and we had services revenues from those clinics because we found there were -- there are parties out there who would pay more to get a patient in this window than we think is reasonable in terms of referral fee. So I think we are finding is there are a number of parties out there, including ones that really had a heavy load from vets and some others that are absolutely doing all they can to put something up on the board today. And they're engaging in a process that in my opinion, well, frankly just don't understand. Why would you be so aggressive to put a number up unless you just need a financing or something of that nature? So we could have stomped on the gas and probably pushed another $2 million or $3 million on to the revenue line, but under a model that strikes me as irresponsible versus having an increasing inventory and a reasonable approach to business. And so it's a bit slower, a bit tighter, and there's a bit of irrational effort to get clients out there in my opinion.

I'm sorry, I may have missed it, but you have exports during the quarter?

Yes, we had -- in Germany we had some sales. Frankly, the rate at which the German demand has grown has been pretty aggressive, so we've sort of reallocated and aligned some product that was for Q3 into these markets and we would expect to push more through. There's been an ongoing extension of activities in some geographies to try and get our fees done, and so that just means that the domestic supply is further out than was anticipated. So we're just kind of, okay, let's move a bit more over to there and I think you'll see that in the coming quarters.

And last question for me, in terms of your sales mix, oil extracts and gel caps were 18% of your sales. It was stable or maybe just a little down sequentially. Any reason or should we expect that proportion to move up over time? I mean is that what you anticipate?

Yes. I think as a percentage it was about the same 17%, 18%, but on a much bigger number. And I think you're going to keep seeing formats evolve up and the percentage of sales, and I'd be completely shocked if we're on a call about a year from now where we're not talking about the whole sector having a much higher ratio of that sort of finished product than just dry cannabis. And at the end of the day, it's -- if you want to have someone purchase a gel cap, often it helps the physician who they see has been detailed about the product and that there are packaging and branding opportunities around it and so there's an initial onset of, oh my God, there's something new, I'm going to try, I'm going to buy it, but the sustained growth really relates to a program and we get that, we've been running the program now for about 2 quarters of education on these products.

Your next question comes from the line of Vahan Ajamian with Beacon Securities.

Couple of questions. First off in terms of inventory management, how do you allocate your inventory between satisfying your patients today which I imagine is your top priority, but then making sure you have blocks of inventory available come July 2018? Will you have to take your foot off the gas a little bit on acquiring new patients for the next 6, 7 months to make sure you have those blocks available for the rec market?

So in Q -- think October, very substantial and very satisfied with the grow plan at the farm, so we have -- I think that's the fourth year we've done a fall grow and harvest, and each year you get probably twice as good as you were before as far as how you use labor, the quality of plant. So I think you're going to see a substantial expected inventory coming out of that. I don't believe we're going to have to do anything other than kind of what we're doing which is acquire patients in a normal business model which keeps going ahead and the more detailing we do on doctors, the more I think they'll come our way because gel caps are not oil equivalent. We've told the market, every medical patient who is our customer on July 1st will have access to the products that they seek and need. So it's a priority market, it's the right thing to do, but it's also a good business thing to do, and so we're doing that. So we don't feel any pressure to take our foot off that detailing program. For what we need for the provinces, I kind of mentioned a couple of times, we have the platform and it's pretty predictable construction platform. We're using a lot of the same constructors or methods that we've used over the last 4 years, so we know the schedule. I expect that we're going to be able to deliver really strongly for what the provinces want and seems that they have pretty good expectations of us.

And question on the hemp-based inventory write-down, discontinuing product lines. Can you just give an update on the hemp business overall, where the outlook is for that?

So we have focused -- we bought a couple of different hemp businesses and put them together. We put them together under a really I think capable individual and what we focused on is what do we think could happen to legislation, how many hectors of land do we currently control? What products and formats do we have and where are the margin points? And so what we've moved our focus to is where the margin is or will be, which means you're not making as many little crunch bars that in my opinion taste delicious, but in the market's opinion yield to margin is impractical. And so we're moving to our -- or have moved to our certain inventories and certain products that have a complicated sales channel which are filled with other people who like to make simple food products to much more sophisticated and high-margin targets, and because what we're doing is private in a separate division, we don't give out all the details, but assume that we have had a pretty thoughtful strategy on hemp for over a year, or we wouldn't have been putting those pieces together. And now it seems to be fully realigned with what we want to do.

And on another kind of unusual item at Creemore, is that up and running now or is it still idle in the process of being rebooted?

It's up and cleaned up and running. It is a small site, so it doesn't currently show a material value as far as inventory, but we think it has strategic fit. It's sort of when you look at some of the things that we do with some of the other midterm assets, how you work with them is more important than just running them as a straight line. And so we continue to look at the small sites as areas which we could probably create some better value than just running 4 growers or 8 growers, but we are that now. So you can go up to Creemore and take the 15 minutes and have the whole tour.

And looks like some people are reporting that there should be some news coming out from Québec possibly as early as tomorrow, I mean, any intel you can provide on what the province might do and where it sits currently?

So I mentioned we're satisfied that we've done everything at the site in order to be eligible for a license, so now we wait for it. As far as predicting provinces, not good politics for us if we're interacting with provinces and pushing our agenda. We of course think that's what they should do. They don't always do exactly what we want, so I wouldn't want to misstep on that. I should clarify for others online that in order to get what you want, you usually have to start about 1.5 years early. So when we entered Germany as a big surprise that we were the first to export there, we've been working on that 1.5 years, and so part of the reason we have a couple of people and government relations and have had for some time is you need to have a point of interaction. It's the same reason as we announced having a chief marketing officer coming over instead of staying and maybe doing the same at Molson and building his team here. These things with provinces, brands, they all need soak time and I wish it could be faster, but I find that it's at least 12 months and often 18 months to get kind of where you want to go.

And you gave some good color on where your production might be come the start of rec sales in July, but we're seeing even sort of longer term given that JV has announced in British Columbia about a month or so ago, based on only the projects that have been announced, once they're complete, is there a sense of what your ultimate capacity would be I guess in Canada?

Yes, I think it's better for you -- I don't want to take the tension off the trade by giving guidance, whether that's exact numbers of revenue or platform, but we've given you a square feet and you'll start to see what comes out of the greenhouse as a harvest once. Some of the things we're doing in the other greenhouses include mixing some portions with curtains and lights and some portions without. So you'll be able to make an estimate, which is obviously intended to be much greater than the amount I put out there. Don't overlook the fact that Rivers, our investment vehicle, has really been active investing and that that turns into typically 1/3 of the assets that they go into if they're producing asset, that stream comes through our store and that the craft grow is going to be bigger and bigger because I think you're going to find that there's 2 or 3 companies in the sector that aren't for sale and that there's a whole bunch in the mid pack that have to be for sale and that the small guys will be able to operate efficiently as long as they're (inaudible) in the building and they probably won't want to have a point of sale that allows them to upload a lot of the obligations of dealing with the complicated IT et cetera that I described. And so I think the growth platform has multiple threads for us and we like those bets placed early.

(Operator Instructions) And your next question comes from the line of Jesse Pytlak with Cormark Securities.

Just kind of coming back to the province or frameworks and retail distribution, can you maybe share your thoughts a bit on how you think like supply contracts might look in some of different provinces and just kind of how shelf space might be allocated?

Yes, I think you're going to find it varies quite a lot province to province, but imagine you have the job of being the, I'll call it bureaucratic position of making it happen. You kind of make choices and they're all about risk and downside protection. So I think that they're going to need to have core shelf space covered by 1 or 2 parties who can actually supply it and then they'll cobble together probably at differential rates, not preferential rates, small suppliers into the portions that are available. And the reason they're going to do that at least for the first 2 years and we're not all that interested in working with somebody on a 1-year basis because I think what's going to happen is in the first 2 years if you structure the deals right, you can probably have a pretty nice structure for selling very simple products, and then you have to recognize that over the next 2 years if you're thinking about running a business for 2 years which is kind of we'd like to be here for many years, over the next 2 years what's going to happen after adult access happens is the sophistication of the products is going to increase for sure, and I don't care if you call it edibles, ingestibles or drinkables, those are going to be available (technical difficulty) -- and expect the medical market to double it again and again because there is medical outcomes that we achieve. And so on the combination of those items, what I think you're going to find is that you can make deals with provinces that cover you off for 2 years, give them shelf space certainty and that you implement new products over the time that have much higher margins and that as the provinces want in the third year a better take, the products actually has better sharing capabilities. And so part of the reason I was quite excited to work with Constellation was that I thought were regulated everywhere in this country by the people who regulate alcohol, not by the people who regulate grocery sales and I think that those parties are going to be quite more comfortable with a liquid-structured product than they are with necessarily a gummy bear. And so all that to say I think you have to look at it as layers and waves and probabilities of the evolution of the product and margin, and if you're big enough to help secure the first coverage, you probably have a nice play going forward.

And then just a quick question for Tim. Just in terms of the weighted average cost per gram metric, can you kind of may be talk a bit about the shipping and fulfillment expense and kind of what are the major components of that number? And what could maybe drive quarterly fluctuations and your ability to lower it longer term?

I think probably the biggest part of it is I think with the packaging materials that we put in, they're -- if you've seen our boxes like the Leafs By Snoop and DNA Genetics and well, pretty much all of the brands there, a lot of thought has gone into them in terms of the presentation. If you keep in mind relative to last year Leafs By Snoop was only introduced in October of 2016, so you didn't see that kind of presentation. So that was one of the biggest things. We've also made improvements as well on the shipping fulfillment activities themselves, but at the same time it's packaging that's probably driving most of that increase. So in a way it's -- you could consider it like a marketing expense, but is otherwise going to cost of sales.

Even if the packaging gets kind of more simple in the second half of '18, having on people's shelves and on social media if they wish to share the really awesome packaging of today I think is going to have some very nice residual value.

Brand affinity and such, yes.

I would now like to turn the call back over to Mr. Bruce Linton for closing remarks.

Well, thank you, everyone, and I anticipated incorrectly a bunch of questions about a partner we've -- a relationship we've established. So I guess you all got enough news on that, so we will let everyone get to work and thank you for your time.

This concludes Canopy Growth's second quarter fiscal 2018 financial results conference call. A replay of this conference call will be available until February 13, 2018, 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.