Valens Company Inc (VLNS) 2020 Q3 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to The Valens Company Third Quarter 2020 Financial Results Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Everett Knight, Executive Vice President of Corporate Development and Capital Markets of The Valens Company. Everett, please go ahead.

Thank you, operator. Good morning, and welcome to The Valens Company Third Quarter 2020 Financial Results Conference Call. A replay of this call will be archived on the Investor Relations section of The Valens website at thevalenscompany.com/investors.

Before we begin, please let me remind you that during the course of this conference call, Valens' management may make statements, including with respect to management's expectations or estimates of future performance. All such statements, other than statements of historical fact, constitute forward-looking information or forward-looking statements within the meaning of the applicable security laws and are based on expectations, estimates and projections as of the date hereof.

Specific forward-looking statements include, without limitation, all disclosure regarding future results of operations, economic conditions and anticipated courses of action. These forward-looking statements are subject to a number of risks and uncertainties that may cause actual results to differ materially from expectations. For more information on the company's risks and uncertainties related to forward-looking statements, please refer to our latest annual information form and our latest management's discussion and analysis, otherwise known as MD&A, each as filed with the Canadian securities regulatory authorities at www.sedar.com or on The Valens Company's website at thevalenscompany.com.

The risks described in the annual information form, which may cause the actual financial results, performance or achievements of The Valens Company to be materially different from estimated future results, performance or achievements expressed by forward-looking information or forward-looking statements are hereby incorporated by reference herein.

Although these forward-looking statements reflect management's current beliefs and reasonable assumptions based on current available information available to management as of the date hereof, we cannot be certain that the actual results will be consistent with the forward-looking statements in the future. We caution you not only to place undue reliance upon such forward-looking results. For any reconciliation of the non-GAAP measures discussed, please consult our latest MD&A as filed on SEDAR.

Joining me on the call today are Mr. Tyler Robson, Chief Executive Officer; Mr. Chris Buysen, Chief Financial Officer; and Mr. Jeff Fallows, President.

With that, I would now like to hand the call over to Tyler. Tyler, please go ahead.

Thank you, Everett, and welcome to everyone who has joined our earnings call to discuss our results for the third quarter ended August 31, 2020. Later on today's call, Jeff Fallows will provide a more comprehensive update on our market operational achievements. Everett Knight will highlight industry trends and capital markets activities, and Chris Buysen will give an overview of our financial results in the third quarter. But first, I'm going to cap this quarter's performance and talk about our accomplishments and obstacles we faced.

I'm pleased to say that despite global volatility and economic uncertainty that has defined 2020, here is The Valens Company we continue to execute and execute well. In short, the pullback and extraction in the last few quarters has been challenging, but I am proud to say that we have successfully accelerated our product manufacturing platform, which we view as the future of the company.

For the third quarter of 2020, net revenue was $18.1 million, a 2.8% increase from $17.6 million in the second quarter of 2020. Last quarter, we went into more detail regarding the reduction in extraction volumes. As a result, it is no surprise that we saw a toll processing and co-packing category decreased from $7.3 million in the second quarter to $2.6 million in the third quarter. However, through incredible efforts of our team, we greatly accelerated the growth in our product sales category by 52% in the third quarter. This means our product sales in the third quarter are up 83% of our revenue or $15.1 million compared to $9.9 million in the second quarter of 2020.

Revenue from the product sales include white label and customized product sales, both winterize, distillate and isolate sales. We expect this segment to continue to increase as we expand both our portfolio of third-party brands and product capabilities. We also expect direct provincial sales from our third-party customers to increase significantly, and we expect product sales to make up greater than 80% of our sales in the next few quarters.

As these results show, we have made significant progress building our white label and custom manufacturing business, in line with our corporate strategy. It is our goal to eventually touch 20% of all manufactured products in the 2.0 market. We are pleased that throughout the quarter, we have retained our position as a first choice partner in many leading -- with many leading license producers, Cannabis brands and CPG companies in Canada. We saw an increase in custom manufacturing agreements signed in the third quarter, generating first time revenues from these new agreements in support of 2.0 product launches in the marketplace. We are now running our operations faster than ever before with increasingly efficient production turnaround times.

I'll now turn the call over to Jeff Fallows, President of The Valens Company, to dive deeper into our operational achievements in this quarter and outlook for the rest of the year and provide more details on our progress internationally. I will be available for questions at the end of the call.

Thanks. During the third quarter, I'm proud to say that our team manufactured a record 56 SKUs, representing a 56% increase from the 36 SKUs we manufactured in the second quarter of 2020. The SKU spans 4 product categories with formats ranging from disposable vapes, vape cartridges, oils and oral sprays to beverages and concentrates and were manufactured in partnership with over 10 of Valens customers. The increase in SKUs quarter-over-quarter can be attributed to product launches from new brand partnerships and the expansion and fulfillment of existing contracts announced in previous quarters.

Some of the SKUs manufactured in the third quarter include SUMMIT and BASECAMP from A1 Cannabis, from first set of cannabis-infused beverages to enter the Ontario market versus hydrocarbon-derived crumble, the first entry of the concentrate subcategory into the Canadian market and currently ranking fifth by dollars sold above SKUs in the concentrates category since launching on the Ontario cannabis store only a few weeks ago.

TREC Brands, WINK Chalice and Onyx vape cartridges, the first vape products to enter the brand's premium product portfolio and Verse Tropic Lemon 510 vape cartridges that launched in mid-September and already a best seller on the Ontario cannabis to our website.

In future quarters, we will be focused on increasing operating efficiencies to drive greater product volumes with existing customers in order to grow our overall market share.

To prepare for this, we are accelerating our white label and custom manufacturing footprint to not only fully capitalize on the existing market but also establish a leadership position in the next growth phase Cannabis 3.0, where we will look to create next-generation products for our customers.

At the end of July, we submitted a license amendment for our K2 facility, which we expect to be approved in the coming months, pending Health Canada review. We expect the GMP compliant facility to come online by the end of the fourth quarter, providing an additional 42,000 square feet of manufacturing capacity and advanced product development capabilities to deliver edibles, topicals and advance our existing concentrate offerings beyond crumble. The facility will hold the largest concentrate producing capacity in the country, including our proprietary hydrocarbon extraction capabilities and will allow Valens to expand its existing portfolio to include waxes, batten and live resin vape pens in addition to bringing our new partners to grow this highly anticipated product segment.

It will also expand our vape pen production and co-packing service capabilities, meaning increased capacity to deliver Valens industry-recognized vape product development services, including our blend formulation processes using our proprietary terpene database and highly customizable hardware options. Already a leader as the largest third-party manufacturer of vape pens in the Canadian cannabis space, Valens is positioned for continued success in this category.

The GMP-compliant mass manufacturing facility is the first of its kind in the cannabis space and will provide the resources to execute on a global scale and unlock margin potential. We expect to obtain EU-level certification for our K2 facility in fiscal 2021.

Our 30,000 square foot GTA facility will also focus on the execution of Valens white label and custom manufacturing services with the concentration on beverage formulation and co-packing capabilities. The time line for construction -- completion has been delayed by a few months as a result of logistical challenges due to the COVID-19 pandemic, but the GTA facility is on track to be licensed in the second quarter of 2021.

I'd now like to take the time to highlight our product strategies and research and development initiatives over the next few quarters.

First, I'd like to talk about our product ingredient capabilities. Valens is the largest provider of cannabinoid-based ingredients in the Canadian cannabis industry with the ability to produce full and broad-spectrum oils, distillate, resin and isolate. Currently, we are in the process of finalizing R&D efforts for THC-free products, a clear differentiator in the CBD space. And moving into 2021, we plan to expand our ingredient offering to further differentiate our platform.

Next to tinctures and capsules. Although we are capable of manufacturing both product formats, we have seen significant growth in our tincture manufacturing as it has become a more preferred method for consumption. We are proud to have recently hit a commercialization milestone in this product category with a 44-day turnaround from concept to market. We have also made strides to revolutionize this more mature category in Canada. Using SoRSE by Valens emulsion technology, we have created a terpene-rich oil blend with a faster onset time. We view tinctures as an entry category into global legal markets as demand remains robust, demonstrated with our growing shipments of tinctures to Australia.

In the cannabis-infused beverage category, we have launched 3 SKUs out of Western Canada, and we are currently in the process of expanding this offering to include drink [trucks] and carbonated beverages using our SoRSE by Valens technology.

We are encouraged by the growth of the cannabis-infused beverage category, which has exceeded our initial estimates, already making up 1.5% of the Cannabis market in Ontario, BC and Alberta, according to headset as of July 2020. We have seen the most growth -- excuse me, with vape products as they make up the largest Cannabis 2.0 category. The increase -- to increase our market share, we have expanded our capabilities to include distillate base, distillate with terpene reintroduce CO2 full spectrum, hydrocarbon cured and now live resin base.

Other brands sold through the Ontario cannabis store in September 2020, Valens manufacturing partners accounted for 4 of the top 15 brands by dollar value with the products from 2 of the partners establishing that spot, despite only being in the market for a few weeks after launching partway through the month of September.

Moving forward, we believe we will be a dominant manufacturer in the concentrates category with our first-mover capabilities to manufacture a wide range of products, including waxes, battens, dab tabs live resin and live resin caviar in addition to solventless concentrates such as hash, specialty hash, pressed hash and pressed rosin.

Lastly, we expect edibles and topicals to come online early in 2021. On the edible side, we anticipate having gummy and mint SKUs ready for market and expand into other innovative categories shortly thereafter. We are currently in the process of expanding our topical capabilities from moisturizers to include relief drugs, massage oils and back balms, and we continue to conduct R&D and commercialization efforts in both categories.

I encourage all investors to take a look at our B2B brochure, which will soon be available on our website to see a breakdown of our full suite of manufacturing capabilities.

As Valens continues to advance its product development capabilities, producing a bespoke portfolio across all derivative product categories, will serve as a key differentiator for our business as we work to enter new strategic partnerships globally. In the third quarter, we had a major milestone in our international activities, our first shipment to the Australian market, all the 56 product SKUs produced in the third quarter, 3 were developed as part of The Valens distribution agreement with Cannvalate. We also expect to make additional shipments of oils to Australia imminently, subject to export permit approvals. We expect to see market share growth in the Cannabis 2.0 product shipped in the fourth quarter, both in Canada and overseas as we continue to demonstrate the market potential for Valens products.

I'll now turn the call over to Everett to walk through some of our corporate highlights. Everett, please go ahead.

Thank you, Jeff. To begin, I would like to thank our shareholders for their continued support. The third quarter was an important quarter for The Valens Company as we demonstrated our capabilities as a large-scale product manufacturer. Traditionally, we've been grouped in the same category as extractors as a way of classifying cannabis businesses that do not cultivate. But we do not believe this classification is an accurate representation of our business model or our competencies. Most importantly, it drastically underestimates the ability of our platform to drive value for our shareholders.

Valens is not an extractor. From a fundamental revenue standpoint, especially demonstrated through our product sales in the third quarter, we are the largest third-party manufacturing company in the Canadian cannabis industry.

To further drive this message forward, we officially completed our name change in the third quarter to The Valens Company, a rebrand that positions the business globally as a leader in the end-to-end development and manufacturing of cannabinoid-based products.

In recent months, the Canadian cannabis market has shown tremendous growth. As of July 2020, Cannabis sales in Canada jumped 15% month-over-month to $2.73 billion in annualized sales and when you include -- when including medical sales, it is estimated to be a $3.3 billion plus annualized marketplace. We are finally seeing positive signs of growth, despite early challenges with retail rollout with over 1,100 stores in Canada, including over 150 in Ontario today.

In July, derivative products made up 27% of all sales in Alberta, British Columbia and Ontario, which we view as no small milestone, considering that Cannabis 2.0 products first hit the shelves at the start of 2020. At Valens, we believe that the derivative product category will not only surpass the U.S. states that are closer to 50% in overall markets -- or on overall sales, but eventually make up 75% of the overall sales as consumers seek new health-conscious and social friendly forms of consumption beyond dried flower. We continue to believe that we are the best position in Canada for the growth of this derivative marketplace, not only to launch higher-quality me-too products seen today, but also next-generation products curated through advanced research and development.

We believe large CPG companies will look to enter this space through proven third-party operators who have scale and efficiencies to bring their products to the mainstream market profitably. As one of the lowest-cost producers of 2.0 products in Canada -- products in the Canadian cannabis industry, there is no doubt in my mind that Valens will attract these partners with the nimblest platform to adapt to future trends in the industry as we move closer to Cannabis 3.0.

To extend our leadership position and advance our reputation as a cutting-edge provider at the forefront of this industry, the company is participating in a medical cannabis real-world evidence study led by Dr. Hance Clarke of the University Health Network, otherwise known as UHN in Toronto Canada. The study will explore the therapeutic effects of medical cannabis in adults with chronic pain, sleep or anxiety issues and will leverage the blockchain secure technology of the medical cannabis by shoppers online product portal of both tested and verified cannabis products. Being able to participate in this real-world study and having the opportunity to understand how our products could be used as a treatment is an exciting development for us. With insights and data from the study, we look forward to further advancing our commitment to developing and testing the highest quality and most reliable products for our patients using cannabis for both medical and recreational purposes.

Also in the third quarter, The Valens Company was granted a cannabis research license under Health Canada's Cannabis Act and cannabis regulations through its wholly owned subsidiary, Valens Agritech. This license permits us to conduct controlled human trials for the sensory evaluation of our cannabis extracts, concentrates and oils, including vapes and beverage and edible products at our extraction, manufacturing and testing facilities in Kelowna, BC. This exciting and strategic milestone gives us the competitive advantage to further innovate and differentiate our leading derivative product offerings. With this research license, we are now able to perform sensory assessments at the product development stage to determine quality and marketability of our products to maximize potential launch successes. Findings from future proprietary research initiatives will advance our understanding of cannabis preferences, allowing us to continue developing premium next-generation products that meet evolving customer and consumer needs.

This license has come at an opportune time as we get ready to launch a range of new product formats, including edibles and topicals in the coming quarters. To conclude, we will continue to make every strategic decision with our shareholders at the forefront. Our track record of this can be illustrated by our last 12 months return on capital at 4.1% compared to the industry average at 95% -- negative 95.9% according to Capital IQ as of the middle of October, October 15.

As always, communicating effectively and transparently with our shareholders and stakeholders and maximizing return on invested capital remains core to our operating philosophy.

I'll now turn the call over to Chris Buysen, CFO, to run through the financial results for the quarter. Chris, please go ahead.

Thank you, Everett. In the third quarter, consolidated revenue increased $0.9 million or 5% to $18.5 million compared to $17.6 million in the previous quarter ended May 31, 2020, and $16.5 million in the third quarter of 2019.

Net revenue, which excludes excise taxes, for the third quarter of 2020 was $18.1 million. This increase in revenue was driven by a $0.5 million increase in revenue from the cannabis operations, which generated revenue of $17.7 million compared to $17.2 million in the previous quarter as a result of the continued scale-up of white label Cannabis 2.0 product sales, which generated increased frequency and size of purchase orders from the provinces and the sale of bulk winterized and distillate oil.

As mentioned earlier, product sales in the third quarter made up $15.1 million of net revenue, a 52% increase from $9.9 million in the second quarter of 2020. Product sales consist of bulk winterize, distillate and isolate and white label and custom product sales. This growth was offset by reduced shipments of biomass from extraction partners as our partners adjusted their workforce and operations to manage through the uncertainty created by the COVID-19 pandemic. In the third quarter, we extracted 8,054 kilograms of biomass, using both input from our LTE partners for toll processing and Valens own inventory for 2.0 products.

In addition, the company generated $0.7 million in revenue from analytical testing to the company's lab compared to $0.7 million in the previous quarter ended May 31, 2020, including $0.3 million in intercompany testing revenue as the volume of third-party tests completed by the lab increased slightly in the third quarter.

Trade accounts receivable increased slightly by $3 million or 10% to $32.6 million at August 31, 2020, compared to $29.6 million at the end of the prior quarter ended May 31, 2020. The expected loss rate for overdue balances is estimated to be $0.3 million based on subsequent collections, discussions with associated customers and analysis of the credit worthiness of each customer. We expect net trade accounts receivable to decrease into the fourth quarter as provincial sales ramp up to form a greater overall percentage of the company's revenue.

Subsequent to the end of the quarter, the company had collected its trade accounts payable outstanding with the same partners or has recorded an impairment loss provision, representing 44% of trade accounts receivable balance, which supports the cash position of the company and speaks to the strength of our relationship with industry partners. The team remains focused on managing credit exposure with all of our customers.

Gross profit increased to $7.3 million or 39.5% of revenue for the 3 months ended August 31, 2020, compared to $6.3 million or 35.8% of revenue in the previous quarter ended May 31, 2020.

Gross profit decreased $5.5 million or 42.9% for the 3 months ended August 31, 2020, compared to $12.8 million or 77.8% of revenue in the same period of fiscal 2019. The reduction in gross profit can be attributed to the continued pullback in toll extraction volumes as the company shifts its focus towards driving greater white label and custom manufacturing, product volumes and sales. The gross profit from cannabis operations for the third quarter was $6.8 million or 38.4% compared to $6 million or 34.7% in the previous quarter ended May 31, 2020. The increase in gross margin was largely driven by the inventory write-down of $1.5 million in the second quarter compared to $0.5 million in the third quarter and the continued reduction in toll processing extraction volumes realized in the third quarter of 2020. The analytical testing operations saw an increase in gross profit dollars for the third quarter to $0.6 million or 86.8% compared to $0.5 million or 69.7% in the previous quarter ended May 31, 2020, and $0.1 million or 66.8% in the same period in fiscal 2019.

Operating expenses for the quarter were approximately $10.7 million compared to $10 million during the prior quarter ended May 31, 2020. Adjusted EBITDA was $1.4 million or 7.8% of revenue for the third quarter of 2020 compared to $2.7 million or 15.3% of revenue in the quarter ended May 31, 2020. We are very proud to have achieved positive adjusted EBITDA for a sixth consecutive quarter, especially for the past 2 quarters, despite challenging conditions in the market due to the COVID-19 pandemic. We are one of very few companies in the cannabis space that have been able to achieve this level of financial performance for our shareholders.

For the third quarter of 2020, the company posted a net loss of $3.1 million or $0.02 per share compared with a net loss of $3.5 million or $0.03 per share in the prior quarter ended May 31, 2020.

On May 29, 2020, the company entered into a syndicated credit facility with CIBC and ATB Financial. Under the terms of the credit facility, CIBC and ATB will provide the company up to $40 million of secured debt financing at interest rates ranging from prime plus 2% to prime plus 2.5% per annum, depending on certain financial covenants. The credit facility consists of a $20 million secured term loan, which was fully drawn at August 31, 2020, and $19.5 million remains outstanding after the first principal repayment of $0.5 million on August 31, 2020, and up to a $20 million secured revolving loan, which has not been drawn at August 31, 2020.

In addition, the credit facility contains an accordion feature that could allow the company to increase the aggregate commitments by up to an additional $10 million. The credit facility has a 3-year term maturing May 29, 2023, and is secured by a first ranking charge over substantially all of the company's assets. The company had $30.3 million in cash and short-term investments as of August 31, 2020, compared with $58.7 million at November 30, 2019.

With that, I will now turn the call over to the operator to open the lines for the Q&A.

(Operator Instructions) Our first question comes from the line of David Kideckel of ATB Capital Markets.

Congratulations on the quarter. Congratulations as well, I mean, for the fact that last quarter, you announced that your extraction of (inaudible) business was going to be coming down, really no fault of your own, and being able to pivot to white label and custom manufacturing part of the business. So the question is, given that this revenue was flat essentially quarter-over-quarter, even taking into account this (inaudible) from tolling, can you maybe provide any guidance for what we should be thinking about for overall revenue for the next quarter?

And just for those on the phone, I will be quarterbacking sort of the -- and directing the questions on this side just to ensure that there's coordination on our side. But from looking at the next quarter, obviously, Dave, we don't give guidance from quarter-to-quarter on financial metrics. But I think we should -- you can see directionally, you can see our product sales continuing to evolve and grow as part of a percentage of our revenue and also in terms of aggregate dollar values. As we look out into the next few quarters, we're very encouraged by what we're seeing in terms of our product development pipeline and also our commercialization efforts to bring products to market.

Okay. Dave. Let me maybe expand on that, too. We've kind of illustrated that through SKU numbers right now. But as we do more provincial sales, look forward to us showing up as a percentage of market share as well from a provincial sales standpoint. So if you're tracking this, I think you can track the success of our product portfolio through our brands, through that market share development and as well as driving unit volume through those SKUs. I think that's something to keep an eye up on.

Agreed. Okay. And moving along as well, I'll lump these 2 questions kind of together, but by our math, and I think, Chris, you mentioned, you just -- you did just north of about 8,000 kilograms of -- or you have that with respect to biomass processing. So by our back of the map and math, it brings it to around 3% capacity utilization. So my question is really twofold. Number one, is that correct? And also, if so, I think, Jeff, Tyler and Everett, you mentioned moving into the next phase of cannabis products, the 3.0 type products, can you kind of maybe comment a little bit more about what you think those products will look like? And if we're at -- we're sitting at 3% capacity utilization right now, what percent do you think that's going to bring you overall within your existing facilities?

I'll address the capacity utilization, and then I'll let Tyler to speak of some of the Cannabis 3.0 opportunity. From a capacity standpoint, it's -- certainly, at the 8,000 kilograms. We're operating at the lower end of our capacity utilization. But it obviously depends on product mix as well and -- so the product that's going through. So from a percentage perspective, it's your mass numbers that makes sense. But with -- it obviously depends on the product that's going through. As we look forward, obviously, we expect that utilization to increase as we're launching more and more products in the market. And again, as capacity comes online, in particular, the product coming off the field over the next several months, obviously, we're well positioned to be able to deal with that. Tyler, maybe you want to have a conversation on the Cannabis 3.0 products?

Yes, I'm happy to. So when we really look at 3.0, I think we need to break it down a little bit more fundamentally sound than just a 3.0 category. David, when you really look at adult rec use in Canada, then you look at medical, then you add health and wellness. You will see 3.0 products against each different vertical and different form factors. And one thing we're seeing in Valens is the lack of innovation coming out of the Canadian space right now. So we're actually super excited to launch new form factors with different delivery systems for different users. So the one thing we'll talk about, first of all, is just health and wellness when we're going to start seeing back balms and different products like that, whether it's a lip balm or CBD-infused honey. The balance will start dabbling in verticals we're not currently generating revenue in. So I think that's a larger question, and we'll not be able to tack on this call because there's a very diverse product offering coming and part of it, too, is both providing shareholder value, but also creating new revenue opportunities. So we believe that market is untapped today and we're excited to kind of launch new products in those verticals.

Our next questions come from the line of Doug Miehm of RBC Capital Markets.

Yes. First question just has to do with the EU approval. What are the hurdles that you need to pass over the next little while to see that approval in 2021?

I think you (inaudible)

Sure. Yes. So basically, what we're doing with our facility, Doug, from a strategic standpoint, is we've segregated only a part of our facility for EU GMP. So the rest of it can remain nimble like our current Canadian platform, where we're generating revenue here short term. The process really is to get vendor validation from a place in the EU to come in and validate your processes. So when this facility was being built, we did have 2 consultants to actually build it to EU GMP spec and now what we're doing is just trying to line up that vendor verification as we ramp up on the actual equipment to GMP specifications.

Okay. And you can provide any better timing on when that may occur?

So we should have information here shortly. I know we said fiscal 2021. We're obviously working forward. And with K2 looking to get licensed here shortly, that will really be the first indicator here, Doug. So I think why don't we keep in contact over the next few months, and we'll keep you updated on the exact time frame once we have that actual vendor verification lined up.

Okay. And then the second question just has to do with your capital and the types of companies you're working with. Obviously, in the past, given the EBITDA that you produced, and I'd say that the capital that you've invested in the business. Most people would argue that you're very good stewards of capital on relative basis versus your competitors. I guess what my question is really has to do with you have receivable strength, but could you comment on the quality of the balance sheets of the companies that you're working with these days? So LPs, whether they be large or small? And how that's having an impact on your ability to work with companies?

Chris Buysen, do you want to take this one?

Sure. Yes. So I guess from a customer standpoint, as we kind of chatted about earlier in the call, we're continuing to see kind of that shift from our historical kind of toll processing, co-packing relationships with LPs to more of a product offering where we're going direct to province. So definitely on that side of the business, we're seeing no risk from a credit standpoint. As far as the existing relationships with our LPs, we are watching and monitoring that extremely closely. I think our track record historically with the kind of minimal amount of write-offs or exposure that we've had, I think, proves to kind of our process and our diligence in making sure that we're not extending credit past what we're comfortable with to any of our partners.

Yes. Doug, one thing I'll just add very quickly is everybody is worried about the extraction volumes tightening up a little bit. The extraction is still there, but at some point in time, we need a level of comfort that people can pay their bills. So I'm not willing to stick my neck out further than I have to for some of the partnerships we have and tell they become a little bit more fundamentally sound. So it's a unique dance right now we're doing with some of our partnerships. And again, it's about the risk profile we're comfortable with taking. And until some of these guys get their balance sheets in order, I think we're going to limit what we're willing to put out there.

And Doug, maybe to expand on it from a guidance standpoint, I think you can expect this to come down as a percentage of revenue. We're already seeing that happen right now kind of subsequent to quarter end. So I think that from -- especially as provincial sales ramp up, too, and we're getting paid by the government, and that has a greater percentage of. This is something we have to worry less in the quarters, but I think our controls are really proving out in the meantime.

Our next questions come from the line of Andrew Partheniou of Stifel GMP.

I guess to follow-on on Doug's question. We're full into October. There's potentially the outdoor crop season coming. Just wondering what you guys are hearing in terms of pulling demand or potentially lack thereof for October?

Maybe I'll start with this one. So obviously, that's a key area for us, and those conversations have been ongoing for quite some time from our side in terms of reaching out to either outdoor growers or to our LP customers and ensuring that we're top of mind as they are considering this. So I'd say we're watching that very closely and the conversations we're having -- have had recently are encouraging with the opportunity that provides us. Again, when and actually that opportunity does come to us, we're not giving guidance on that, but we are encouraged by the conversations that we're having.

The next question, maybe you can just remind us, with the imminent onboarding of your K2 facility, how is that going to affect your manufacturing footprint? It's kind of interesting that you guys are going to be expanding while LP peers are contracting their footprint. So how do you reconcile that? And how does that position Valens to capture future opportunities in Cannabis 2.0?

Yes. Happy to touch on that one, and I think we can really blow the doors open of what we're doing. One of the biggest things people don't realize is just the physical space constraint we have in our current facility. When you send 100,000 bulk battens to one of our partners, it takes about 5 pallets. But if you're putting those into master cartons and then you're putting those into master case files, then you're shipping to 4 different provinces with different orders, different SKUs. It's a sheer volume thing we're challenging right now. So one of the bottlenecks is physical space. So as soon as we bring on K2 in the very short next little while here, we blow that open, but a lot of things people aren't paying attention to, again, is the innovation that we've done, the legwork we've done, where we just don't have physical space. And that's why I touched on it earlier. The innovation in Canada right now, I think it's lacking. So with more physical space, we've done the R&D. We've done the shelf stability. We've done the consistencies. So as soon as we get physical space, we're going to be playing in new verticals to create new river opportunities and drive more shareholder value and continue to grab market share.

So it's not a lack of thought process of why we expanded when we did, it was more of a proof of concept. And I think everybody else in the space got out over their skis, and they're correcting now where we're being a little bit more strategically aggressive, I'll put it, moving forward.

Is there any particular vertical that this facility helps fortify in your portfolio?

I would say that there's a few for sure. So I think the edible space is going to be one where we'll see us enter fairly quickly. And then health and wellness, we're not going to touch too much more on that, but I hinted before at back balms, soaps, lip balms, just a few different verticals, again, we think are being underserved. And if you look at some of the growth verticals in the U.S., there is some unique opportunities to position ourselves ahead of time. So you'll see that in the next few quarters coming out.

Our next question has come from the line of Neal Gilmer of Haywood Securities.

Maybe just to follow-on your previous comments there, Tyler. As we look at Q4 and then 2021, I sort of get the impression, you saw significant SKU growth in Q3. We probably don't see too much more in Q4, just as you guys focus on market share capture and penetration. And then as K2 gets approved and comes online, then we'll start to see that SKU count continue to increase in fiscal '21. Is that a correct takeaway from those comments?

Yes. Neil, you're 100% correct. One thing to -- when we're working with some of the provinces directly as we continue to expand that portfolio, some of the purchase orders were smaller, whether they were 1,000 cases moving to 3,000, moving to 8,000. We're seeing continued growth. So I don't think you're going to see too much of an expansion in SKUs, but just sheer volume as we get our name out there and again, expand on some of the existing relationships. And part of it, too, is just grabbing market share right now and being a little bit more strategic when and how we launch products. There's a ton of me-too products where there's 58 distillate pens. There's is 58 winterized pen. So again, setting ourselves apart, bringing a little bit more of a technology or IP play and really setting ourselves apart for our product offering. And I think we're excited at the opportunity to really showcase our talents of what we've been working on for so long.

Great. My second question is somewhat of a follow-up as well. With this croptober and lots of expected supply coming on to the market, I'm going to look at it from a different perspective, maybe on your gross margin profile and what you can -- sort of insight you can provide there. So can you use some of that supply that's going to be out there for your own feedstock? And could that potentially lower your overall cost structure and provide a little bit of increase in gross margins going forward?

Definitely, I can speak to that. So we definitely are constantly watching what's available in market, making sure that we're sourcing products is going to drive strong margins kind of going into the future, knowing where we see kind of power prices going over the next couple of quarters. We definitely are preparing ourselves to capitalize on that, which we'll see flow through the gross margin profile of our products that we're taking to market.

Our next questions come from the line of Patrick Sullivan with Eight Capital.

I just got a couple of quick ones here. I guess when you talk about the Cannabis 3.0 products and specifically the live resin pens and the rosin and hash and things of that nature, what percentage do you think that makes up over the overall cannabis market longer term? Was it a 5%, 10%, 3%? Any color there would be great.

Sure. I can jump in on this one. So if you look at the concentrate market that is, it's 1.9% of Canada today as of July, if you look at the U.S. data that we have on some of the 5 kind of mature states, it's 9.5% of the market. So it's the fastest-growing category from what we can see, even if you see our crumble, even from just launching kind of mid- to end of September there, it's already fifth in SKU, and we're seeing great kind of sales velocity on it. I think that as we broaden that live resin, waxes, different rosins, I think that will grow specifically. When you look at the U.S., it's really live resin and waxes that dominate the markets. But as Tyler mentioned, there's innovative products that are making high growth and sales velocities and some California, Colorado that we have really key capabilities being one of the largest mass manufacturers of it. So I see in the next few quarters what happens is it goes from 1.9% today and starts to go to where the U.S. is a road map of that 9.5% and 10%. So call it next year, maybe at 6% or 7% and then grows from there. But I think it's going to be a 10% steady state of the market and growing.

Great. That's awesome. And then do you think that there's any regulatory impediments in the Canadian marketplace right now that would make it more difficult for you to achieve that -- or for these products to achieve that 9% long term? Is there anything different that you may not be able to do in Canada that they are able to do in those markets to Colorado with these products?

So I would say that, that's a loaded question because are there some bottlenecks or challenges in Canada? The answer is yes, there are. But not for Valens. So when you really look at our product portfolio and what we've done, we did a lot of the legwork that no one else has, whether it's shelf stability, consistency, oxidization rates. When you look at the U.S. and how they're launching products, they have no standardization. They have no consistency. They have no trust in their product. So when you look at degradation over time, there's no consistency or -- again, no trust. So we've been a little bit more methodical, a little bit more meticulous. But when we're bringing those, what we'll call 3.0 hydrocarbon products to market or even 2.0, you can be assured that we are extremely comfortable with the products we're launching and how we're launching them. So we won't be impeded, but I think a few other Canadian companies will be.

Okay. Great. And one final one here. So with the expansions coming online, K2 and GTA, how much people addition, how much scale-up on the like G&A are you expecting to see? Or is a lot of things -- are a lot of things automated? Will it be high-level automation? I guess I'm kind of trying to figure out how the EBITDA margin may look in the near term. Will it be hurt in the short term before those things? Is it like you hire before things come online or just a little bit more around that would be great.

All right. Chris Buysen...

Yes. Again, I...

Yes. I can speak to that, for sure. So I think in the short term, we'll see some scale-up in our cost profile. But I think the other thing really to focus on as we kind of transition to next door. And as Tyler mentioned, getting that additional space, we're really going to be able to achieve significant efficiencies through our processes. So as much as kind of where we're expanding our footprint, I think our overall cost structure is going to become more efficient once we're up and running. So short term, there'll be some scale-up likely, but as we kind of dial in the process and are able to take advantage of the efficiencies that we'll be able to gain with the additional space, I think that will definitely show through strength in our EBITDA margins mid- to longer term.

And sorry, just to add to that. I think that it's probably underrepresented out in the market as to the logistical challenges that our team faces every day at our initial facility. What never ceases to amaze me, the work that they can do to move things around and to get the volumes out of that facility that they do. So we're very excited about the opportunities coming online when K2 comes online. As Chris was saying, simply from an efficiency perspective, there's lots of opportunity for us there.

Our next questions come from the line of Paul Piotrowski of M Partners.

Congrats on the improvements this quarter. Can you talk about the ordering trends you're seeing with the provinces? And has there been any recent upticks you can talk about?

Sure. Maybe I'll start and then -- and Tyler, you can add on after. So as Tyler was saying initially, the initial volumes are generally quite low as they sort of test the market with the products. But as those products move quickly, the provinces are very fast to up the orders, subsequent orders. And as the -- as you also become more of a trusted partner and the products you bring through the provinces sell well week-over-week, then those order sizes at the beginning start to get larger and larger. So it's all about establishing relationships. It's all about establishing the quality of your product and the salability of your product in the market, which, as you can see from our results, is really starting to take shape on our side. Tyler?

Yes. No, I think you hit the nail on the head. I think it will certainly be an uptick in all of our verticals we're currently playing in and then we're adding new ones. Part of it is just not even proof-of-concept but consistency. And again, the level of comfort. I don't think a lot of people understand the back work the provinces have to do to get a SKU registered. So they're very hesitant to bring on new partners. So it's essentially launched 1 SKU, prove yourself launch 2, then 4, then 8. And now that our relationships are growing exponentially, we're extremely comfortable in seeing an uptick, not only in the provinces we are selling in today, but the ones we're bringing online relatively shortly.

Okay. That's great. So in terms of your current kind of product portfolio, where do you feel you guys have the largest moat or a competitive advantage?

Everett, do you want to dress this one?

Sure. I would say the number one thing to keep an eye on is concentrates, right? We have the largest mass concentrate platform in Canada. It took us 2 years to get up and running. It -- and I would say that from an expertise standpoint, we don't just launch a product to the market as fast as we can. It has to meet Valens quality specs, as Tyler has mentioned.

And I think when you look at quantitatively the terpene profiles and the actual quality of the product, we view that concentrate category as the canister, right? It's the -- they really care. They're the highest repeat customer. It's one of the highest revenue line items in the cannabis market and they care about quality.

And I think what we can do for our customers is really differentiate that, and especially with our platform, we have high hopes of getting a dominant market per share position in the concentrate category as well as vapes. I think with our cost structure, I think people underestimate that, but as well as our terpene customization, I think those 2 right off the bat, as well as then following on, and we'll talk about edibles and topicals, as Tyler mentioned, kind of following on the year, but those are first 2 concentrations and then scaling it to other verticals from there.

Okay. Just one more. So with the GTA facility, what's left in terms of CapEx?

Chris Buysen, do you want to address?

Yes. So I guess with respect to the build-out of Pommies, we're probably in the neighborhood to have it built out and fully kind of equipped in the kind of, call it, $5 million to $6 million range today.

Our next questions come from the line of David Kideckel of ATB Capital Markets.

Another couple of questions from me, guys, here. So I just want to go back to croptober and 2 questions on that. The first is, what is your -- can you give any guidance or comments on what you think this will do to your input pricing from your end? And also, just your perspectives, given where you guys sit relative to Canadian LPs, is this another major negative catalyst you see coming down the entire Canadian cannabis industry with even more excess supply, not from your end but more from the LP side?

So maybe I'll start with this, David, and then maybe I'll pass it over to Chris to finish up. Obviously, with the pricing -- input prices coming down on the back of, as you call it, croptober coming online. Certainly, that's going to help provide a tailwind for us in terms of our input pricing and the products that we have in the market. Obviously, I think as we're looking to the overall pricing in the Canadian market, pricing is expected to come down over time, pretty much across all product categories. So obviously lower input pricing in the short term to drive -- help us drive margin on our products and the long term sort of to normalize. That's also why we haven't really talked too much about that on this call. We spend a lot of time internally here at Valens to focus on our cost structure, focus on our operations and driving additional efficiencies there in anticipation of this in the pricing trends and the market changing over time. Chris, I'm not sure if you have anything outside there?

No, I think that's exactly where we see it. And yes, I think that's a good summary.

And David, overall in the market, obviously, when you have a large amount of potentially lower-priced products coming online, that's going to create challenges for some players in the market. Obviously, that's one of the advantages we think we provide our customers, which is our low-cost structure and our ability to be flexible and to help them to navigate and get products into the market that differentiate themselves. So on the one side, potentially faced with some challenges on the supply side or pricing side, but on the other hand, helping them get more and more products to market that are helping them drive margin and work through the system.

Our next question has come from the line of John Chu of Desjardins Capital Markets.

Maybe just a quick question on the margin. I know in prior quarters, you had talked about small batches being a drag on margin, but it sounds like with some of the early successes you're having with some of the SKUs that presumably -- and the big orders that you're seeing from the provinces that presumably we're going to start seeing bigger size factors, which should help improve the margin profile. Can you comment on that?

For sure. And this is -- Chris is probably best equipped to handle this, but I know that, that was an area that I spent focused on a lot in the last call, John, and part of it also goes from that small volumes. Obviously, when you do smaller volumes, there's inefficiencies. But particularly in our space-constrained environment in Kelowna, when you have more smaller lot sizes and you have to touch the product more and you have to move it around, obviously, that's a significant amount of inefficiency for us. But certainly, as our order volumes with the provinces and our order volumes, quite frankly, with the LPs, et cetera, as well continue to increase as their products begin to get traction in the market as well our volumes to go up. Chris, anything else on that on your side?

Yes. No, I think that's it. I think we'll see efficiencies on that front for sure and then it will be just a continued evolution of mix of kind of revenue that the business is generating. So I think the 39% roughly gross margin that we realized in Q3, I think for the next couple of quarters, I think we'll see it kind of around that, call it, 35% range as we work through and continue to scale the product side of the business.

Okay. Great. And then just on the 56 SKUs that you have, I'm just curious, how many of those SKUs are overlapping. So for example, is there quite a few that are in the value branded vapes where they might be competing with each other? I'm just kind of curious how that 56 SKU breaks down in terms of just competing and the risk of cannibalization?

Well, actually, glad you asked that, John, because we spend a lot of time internally focused on our product portfolio, and we talked a little bit about this last time as well, is we don't view the Valens platform or the market that has just come to us and tell us what products you want to do and we're going to launch it into the market. There's a lot of care on our side that goes, what consumer are you addressing? What other products do we have in the category? How can we help you drive volumes with that? And if we don't believe there's a market opportunity or we don't book or we have too many other products that are overlapping, as you say, helping with that sort of market intel working with our customers to produce a product that can be positioned differently so that overall the Valens portfolio represents the whole market as a whole, and as you say, not one market segment where everybody is competing with each other.

And John, maybe to expand on that, too, like with our cost profile in the 2.0 product side, as Dave questioned, like we're the lowest-cost producer of oil-based products in Canada. When we can get dried cannabis pricing for lower than people can grow at, what that makes us is a really cost-competitive platform. And as people look at our efficiencies, not only with our infrastructure, manufacturing, I think what LPs and other players getting involved in the industry are currently involved in the industry, what they should see is that it's probably cheaper to go with us rather than to do it internally. And I think that's really the platform capability that we've built and have the vision and with K2 now coming online, that's a reality.

That is all the time we have for questions today.

I will now hand the call back over to Tyler Robson for any closing remarks.

Thank you, operator, and thank you, everybody, for the time. A few things I just want to at hammer on to make sure we are all aligned, sorry. A few things that really resonate with me is everyone seems to keep calling us an extractor and I'm not really sure I understand why anymore. That's like calling myself a fingernail because I have a fingernail. We have extraction, but we also have innovation, different technologies, different IP distribution, and we've launched a significant amount of SKUs. So I think we need to shift the focus away from extraction to product distribution and product manufacturing, and you'll see in the upcoming quarters on how we continue to grab market share and execute exactly as we planned.

One other thing to -- everyone seems to talk about the toll processing going down. I don't see that as a negative. When I started the company back in the early 2012, 2013 era, the plan long term wasn't to be an extractor third-party. It was to get into product manufacturing. There was just a ton of low-hanging fruit that we saw was fundamentally sound to grab. It drove revenue, it put us in a well-positioned opportunity to execute and that's exactly what we did.

Another thing we really need to focus on are the different verticals. Everyone seems to think adult rec, it is the holy grail, that is 1 of the 3, what we're really seeing in balance. So not only are we seeing adult rec in Canada, we're seeing the health and wellness space start to unfold. And then we're seeing the medical at the international level. And again, because we're a little bit more focused than some of our industry peers, we're not really chasing medical today because the opportunity isn't there. There's a ton of low-hanging fruit and revenue to be made in Canada today. But we're not taking our focus off moving more international and medical in time. But again, I want to remain focused and I want to remain confident in the Canadian use market. As more retail stores are opening week after week, month after month, again, the opportunity is endless in Canada right now, and you'll continue to see us grab market share and bring new products and new verticals.

Another one, I think we really need to hammer home is the trust and the consistency of our products. Because we have that Thermo Fisher partnership, a lot of people aren't giving enough credit. We've never had a refill nor have we even got close to doing anything like that because we have more information, more data and a more level of comfort. And when we're talking to all the CPG relationships we have, that's one thing I really think people need to pay attention to is this trust takes years to build and seconds to lose. And I think some of our industry peers have lost trust very, very quickly and that's something Valens will never do.

And again, it's opening a wide variety of conversations that I never thought would be here. So it is an exciting time at balance. And to downplay some of the challenges we've seen in COVID wouldn't be doing a justice. We have faced some headwinds, but again, I believe we've turned the corner, moved away from extraction and really moved into manufacturing. So at the end of the day, I'm super excited for where we're going. I'm super excited for the team and how far we've come in such a short order. And I'm really excited to get new products into the market and I think everybody will be extremely happy in the future.

So I appreciate everybody's time. And with that, I'll ask the operator to close the call.

Thank you. This does conclude today's call. Thank you for your participation. You may disconnect your lines at this time and have a great day.