Cresco Labs - Q1 2020

Transcript

Operator (participant)

Good day, and welcome to Cresco Labs' first quarter 2020 earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, then one on your touch-tone phone. To withdraw your question, press the pound key. Please note that this event is being recorded. I would now like to turn the conference over to Aaron Miles, Vice President of Investor Relations for Cresco Labs. Please go ahead.

Aaron Miles (VP of Investor Relations)

Good afternoon, and welcome to Cresco Labs' first quarter 2020 earnings conference call. We look forward to speaking with you today and discussing the great progress we have made as a company. I am joined on the call today by our Chief Executive Officer and Co-founder, Charlie Bachtell, our Chief Financial Officer, Ken Amann, and our Chief Commercial Officer, Greg Butler, who will be available for Q&A. Prior to this call, we issued our first quarter 2020 earnings press release. This document has been filed with SEDAR and is available on our investor relations website at investors.crescolabs.com. We plan to file our financial statements and MD&A for the three months ended March 31st, 2020 on SEDAR by May 29th.

Before we begin our remarks, I would like to remind everyone that certain statements made on today's call may contain forward-looking information within the meaning of applicable Canadian securities legislation, as well as within the meaning of the Safe Harbor Provisions of the United States Private Securities Litigation Reform Act of 1995. Such forward-looking statements may include estimates, projections, goals, forecasts, or assumptions, which are based on current expectations and are not representative of historical facts or information. Such forward-looking statements represent the company's beliefs regarding future events, plans, or objectives, which are inherently uncertain and are subject to a number of risks and uncertainties that may cause our actual results or performance to differ materially from such forward-looking statements, including economic conditions and changes in applicable regulation.

Additional information about the material factors and assumptions forming the basis of our forward-looking statements and risk factors can be found under Risk Factors in Cresco Labs' public filings available at www.sedar.com. Cresco does not undertake any duty to publicly announce the result of any revisions to any of its forward-looking statements or to update or supplement any information provided on today's call. In addition, during today's conference call, Cresco will refer to some pro forma and non-IFRS financial measures, such as pro forma revenue, Adjusted EBITDA, and an Operational Gross Profit, which do not have any standardized meaning prescribed by IFRS. We believe these non-IFRS financial measures assist management and investors in understanding and analyzing our business trends and performance. Please refer to our earnings press release for the calculation of these measures and a reconciliation to the most directly comparable measures calculated and presented in accordance with IFRS.

These pro forma and non-IFRS financial measures should not be considered superior to, as a substitute for, or as an alternative to, and should only be considered in conjunction with the IFRS financial measures presented in our financial statement. Please also note that all financial information on today's call is presented in U.S. dollars, unless otherwise noted, and all interim financial information, including disclosures for any pending acquisition, is unaudited. With that, I will now turn the call over to our CEO, Charlie Bachtell. Charlie, please go ahead.

Charles Bachtell (CEO and Co-founder)

Good afternoon, everybody, and thank you all for joining us today. Since we held our Q4 earnings call a little over a month ago, we're going to keep our prepared remarks on today's call on the shorter side and leave more time for your questions. I'm going to start off with some of the highlights from the first quarter, then take a deeper look at the most substantial opportunities for Cresco this year and discuss how we're executing on those opportunities so far. After that, Ken will provide highlights from our financial results and discuss our capital position in more detail. In the current environment, it is more important than ever to have strong fundamentals, a successful business model, and a responsible capital agenda. As an organization, we know that you win this industry by building the most strategic geographic footprint and by gaining meaningful material positions in those markets.

And vertical integration is key in the short term, but the greatest opportunity for creating long-term shareholder value is achieved by prioritizing the middle two verticals of the value chain. Q1 was a great quarter. Despite all of the challenges associated with scaling our business, integrating M&A, and operating in a global pandemic, we hit our internal budget, and the first quarter of 2020 was the most productive quarter in Cresco's history. In Q1, we generated 18% sequential revenue growth on the exact same asset base as pro forma Q4, and we delivered our fourth straight quarter of positive Adjusted EBITDA. Q1 top line growth is actually 26% when you account for the revenue that would have been classified as intercompany between Cresco Labs and Origin House in Q4.

We achieved these results while making substantial investments in the business that have set us up to deliver consecutive quarters of growth throughout the remainder of 2020. While I am very proud of our performance in Q1, this quarter was about building, staffing, integrating, and refining our operations in the largest and most important cannabis markets in the U.S., and we are very well positioned to see the fruits of that labor in the coming quarters. While recognizing the benefits of our expanding retail operations, we continue to prioritize the middle two verticals of the value chain, branded products and wholesale distribution of those branded products. Building capabilities in these two verticals takes more time and can be a slightly longer path to realizing revenue growth compared to a retail-first strategy.

However, the evidence from well-established global CPG industries has continually demonstrated that branded products and wholesale distribution capture the majority of margins and offer the most long-term value. Cannabis will be no different, and Cresco remains the foremost operator in these two verticals. Using our strategy of operating in strategic states and creating meaningful material market positions in each, there are five specific ways we're delivering growth and return on invested capital in 2020. First is by dedicating our resources to markets with appropriate regulation and strong consumer demand. In Illinois, even with a full month of stay-at-home orders and social distancing, April cannabis sales were the highest they've ever been.

Based on the current trend, the Illinois market will be between three and a half and four times larger in 2020 than in 2019, resulting in a nearly $1 billion-dollar industry in its first year and an estimated $3 billion-$4 billion market at maturity. In Pennsylvania, it's a similar story. The ceiling of consumer demand is yet to be seen and is limited only by supply, which continues to support our thesis for investing in wholesale capacity. While regulatory holdups have stagnated growth in Massachusetts and Nevada, we're able to adjust our focus and continue driving growth. This is why having a diversified and strategic geographic footprint is crucial. Earlier this week, we announced our transaction with Verdant Creations in Ohio. This is another perfect example of our strategy at work, going deep in regulated, populated markets.

Ohio's average weekly cannabis sales grew 33% from February to April. The addition of Verdant would increase our vertical integration and market share in the seventh most populated state in the country. It's important to note that of our nine operational states, six of them are in the top 10 most populated states in the U.S. Second, we're materially scaling our wholesale capacity to gain disproportionate market share in these states. I mentioned that in Q1, revenue grew sequentially on an identical asset base, but now we're shifting into a higher gear. To meet the outside demand in Illinois, we recently completed cultivation expansions across our three facilities, bringing our combined capacity to 215,000 sq ft of cultivation space, the largest capacity of any operator in the state.

The expansion represents a 6x increase in cultivation capacity from what we sold into the market in Q1. This additional canopy can not only increase our quantity of supply, but also gives us the flexibility to use different product forms to adapt to market conditions and consumer preferences as this market matures. With a limited amount of incremental capacity reaching the market in Q2, the majority of this additional supply will be harvested and sold on a rolling basis through Q3. Despite not having any of this additional supply online in Q1, we still sold more units of flower than any other operator in the state. In Pennsylvania, we recently completed the expansion of our cultivation and manufacturing facility in Brookville, bringing cultivation space to 88,000 sq ft, which marks a 4x increase.

Like Illinois, a limited amount of the incremental production will hit the market in Q2, with the remaining new supply to be harvested and sold on a rolling basis through Q3. As we roll off these major CapEx investments, the expansions in Illinois and Pennsylvania will display our operating leverage by significantly growing our revenue, our market share, and profitability with a limited need for additional SG&A. Third, we're generating growth on the retail side of the business, with increasing same-store sales and also with new store openings. Our total retail revenue grew 87% quarter-over-quarter, bringing our retail share of our total revenue to 43% in Q1. While COVID has upended most traditional retail industries, our customer throughput has never been higher, even compared to the first week of the year when adult use was legalized in Illinois.

We believe the true test of a company's COVID response will be seen in the Q2 results, not in Q1's. In Illinois, our order fulfillment is up by nearly 40% since the pandemic started. We quickly learned how to adapt to the new normal of a modified retail environment and build better tools to support omni-channel ordering. In April, again, with the same operational footprint, we realized our highest ever share of the Illinois retail market because we developed our Sunnyside platform to fulfill COVID requirements and consumer needs. With an expected doubling of our retail footprint in Illinois by year-end, we're poised to gain even more retail market share in a state where we also have the largest wholesale advantage. As we recently announced, we just opened our sixth and seventh Sunnyside retail stores in Illinois.

Sunnyside River North is the first adult-use only dispensary in the city of Chicago, and Sunnyside Danville is the first adult-use only dispensary in Eastern Illinois. In Pennsylvania, our revenue growth rates have returned to pre-COVID trends, and our category mix is improving with increasing flower availability. We witnessed basket sizes jump by nearly 25% when the pandemic set in, but we've also been able to sustain those purchase levels all the way through Memorial Day. We're licensed for three more retail locations in the state and expect our next store to open in Philadelphia during Q3. For the nine stores across our footprint that were open in Q1 of 2019, same-store sales increased 144% in Q1 of 2020, and based on these strong results, we're pleased that our newly improved owned retail model is offering strong returns and outperforming historical averages.

Fourth, we're executing in California. Q1 was the first quarter that we consolidated our new California assets into our results. While this boosted revenue, it also temporarily impacted margins as we worked to tailor the assets to function in line with Cresco's California growth strategy. As mentioned on our last call, our team has worked to further optimize the distribution platform, capturing synergies, lowering costs, and growing operating leverage within the state. In addition, we've also optimized fleet logistics, implemented business intelligence tools to better understand cultivation costs, and enhanced accounts receivable measures. As a result of our team's efforts, we expect to not only grow revenue on the Continuum platform, but to also generate an increasing contribution to Adjusted EBITDA throughout the year. As we've pruned the lower-performing, partner brands from the platform, the result has been a significant increase to the overall sales growth.

Excluding bulk and exited partner brands, Continuum was up 36% sequentially in Q1. The growth was driven by owned brands, up 38%, with Cresco brands leading the charge, up 40% quarter-over-quarter. As an organization, we know that to build a truly national cannabis brand, winning in California is a prerequisite. We've said all along that the acquisition of Origin House gives us the best cannabis distribution platform in the largest cannabis market in the world, and this has remained true. Our California team has done an incredible job on the integration, and we look forward to seeing these efforts reflected in our financial performance in the quarters ahead. Fifth, we're focused on operating more efficiently across all of our markets as we scale.

As demonstrated by our results in Q1, we've driven organic growth in our wholesale business by our ability to flex cultivation and manufacturing assets and drive more revenue from the same base. Simply put, we've become a better operating company since the beginning of the year. Continuous improvement is key, especially as you scale a business. Getting more juice from the same squeeze is the sign of operational execution. To highlight a few examples of recent successes, in Pennsylvania, with the same amount of FTEs and resources, we've been able to increase plant cloning by 195%. We've increased packaging throughput of flower by 140%, and we've increased packaging of capsules and lotions by more than 50%. In Joliet, we've ramped up edibles production, increasing throughput by 50%, while simultaneously reducing the number of shifts.

In California, we've increased our delivery success rate to 96%, and with much credit to the cultivation team members who have joined us from FloraCal, all of our cultivation facilities across the country are beginning to produce a greater volume, quality, and consistency with each successive harvest. In summary, it's been an extraordinarily productive few months at Cresco. I couldn't be more proud of our Cresco family for what we've been able to accomplish in Q1, how we've come together, how we've taken care of each other, and the mountains we've moved year to date.

The steps we've taken so far this year have put us on the path to grow revenue and achieve true cash flow profitability in the second half of the year. We're focused on the most strategic markets with the strongest consumer demand. We're capitalizing on opportunities in those markets by increasing our wholesale capacity. We're executing in California. We're operating more efficiently across the business. We're generating growth from new and existing retail stores, and we're establishing meaningful material positions in our markets. I'll now pass the call to Ken, our CFO, to provide highlights from our financial results and to discuss our capital agenda.

Kenneth Amann (CFO)

Thank you, Charlie, and good afternoon, everyone. I'll begin by reviewing the financial highlights from the first quarter, then discuss our balance sheet and capital agenda. Please note that all numbers are stated in U.S. dollars. As Charlie mentioned, Q1 was the most productive quarter in Cresco history. We achieved record revenue and Adjusted EBITDA, and we did so while making substantial investments to secure our financial success. With these investments behind us, no material M&A transactions pending, increased capacity coming online in Illinois and Pennsylvania, and additional dispensaries opening, we expect to deliver significant revenue, profitability, and growth in 2020. Revenue in the first quarter was $66.4 million, up 215% compared to the same period of the prior year, an 18% increase quarter-over-quarter on an identical asset base as pro forma Q4.

While we're pleased with this top line growth, as Charlie mentioned, the 18% sequential increase is actually higher when factoring in the $3.4 million of revenue that would have been considered intercompany between Cresco and Origin House in Q4. In other words, if Origin House was consolidated in Q4, the combined business grew sequentially by 26%. While we do not intend to break out intercompany revenue going forward, it is important to highlight the growth of our position in California in Q1. Overall, this growth was achieved without having any meaningful production capacity come online or any new dispensaries open. It was driven by our ability to squeeze growth from our existing assets. We generated 86% of our revenue in our three core states of Illinois, Pennsylvania, and California in the first quarter.

While we believe these markets continue to represent the greatest near-term opportunities for Cresco, we're encouraged by the progress we're making in Ohio, Arizona, and Massachusetts now that the adult-use sales have been reactivated earlier this week. We have now completed ambitious construction projects in both Illinois and Pennsylvania that have increased our cultivation capacity by 6x and 4x, respectively. We will realize the effects of these expansions starting in Q2 and ramping up as we harvest new rooms on a rolling basis through Q3, which will provide for substantial revenue growth and increase Cresco's market share in both states. Operational Gross Profit in Q1 was $32 million, or 48% of revenue, compared to 51% of revenue in Q4.

As we detailed on our last call, we did see an anticipated reduction in gross profit margin this quarter as a result of consolidating Origin House, but this was largely offset by improved margins in our two largest states, Illinois and Pennsylvania. We expect to return to 50%+ gross profit margins over the course of the year, especially as we leverage our infrastructure and continue to optimize operations in California. First quarter SG&A expense was $46.7 million. During the quarter, we incurred $11.8 million of one-time costs, primarily associated with closing our outstanding acquisitions, as well as $1.4 million of non-cash costs related to share-based compensation. Removing these one-time and non-cash costs, our operating SG&A was $33.4 million, or 50% of revenue.

SG&A was flat compared to Q4 as a % of revenue, but as revenue ramps in our key states and we continue to make operational improvements across the business, we expect that SG&A as a percent of revenue to decline materially in future quarters. I'm proud to say that we delivered our fourth consecutive quarter of positive Adjusted EBITDA, $3.2 million in Q1. During the quarter, we invested in both CapEx and OpEx to continue building our lasting positions in the middle two verticals of the value chain. Looking ahead, we anticipate increased profitability in the remaining quarters of the year as we bring additional supply to market and continue to rationalize and grow the California business. Net loss in the quarter was $13.4 million.

As net income includes the impact of biological assets, depreciation and amortization, taxes, interest, and one-time charges, we continue to believe that Adjusted EBITDA is the best measure of our performance. For further detail, we've provided a reconciliation of Adjusted EBITDA in our earnings press release. Turning to the balance sheet, we ended the quarter with $68.6 million in cash and cash equivalents. As anticipated, cash utilization was elevated in the quarter as we completed significant investments that will drive Cresco's future growth. Q1 CapEx was $41.7 million, driven by the expansion projects in Lincoln, Kankakee, and Brookville, as well as several other simultaneous construction projects across our platform. We also had $46 million in outflows in Q1 associated with the cash consideration to close the acquisitions of Valley Ag and Hope Heal Health.

That said, we now have no material M&A transactions pending and forecast significantly less cash outflows from investing activities in the remainder of the year. Any incremental CapEx for cultivation expansions will be funded through sale-leaseback transactions, similar to the one we recently completed in Michigan, which added $16 million in non-dilutive capital, or from positive cash flow from operations expected in the back half of 2020. It's important to note that there was also a timing difference on the reimbursement of a tenant improvement allowance for one of our cultivation expansion projects, which resulted in us receiving $10 million in payments subsequent to the end of the quarter.

Cash flow used in operations was $40.1 million in Q1, which includes approximately $11.8 million of one-time costs, mainly associated with the closing of three acquisitions and our credit facility, and $8.2 million of investments in working capital, substantially related to increased packaging and hardware inventory. When COVID-19 began, as a precaution, we took steps to shore up our supply chain and ensure that we had sufficient resources to weather a potentially prolonged disruption. Thankfully, we haven't seen any meaningful disruptions to our supply chain to date, and we started drawing down on this inventory. Our efforts during the first quarter have set the stage for strong continued growth for the remainder of 2020 and beyond.

In light of the COVID-19 pandemic, now more than ever, is the time for financial prudence and laser focus on the markets offering the highest returns on invested capital. We have an enviable footprint with ample organic growth opportunities, and we're focused on gaining meaningful, material positions within these markets. The greatest opportunity for creating shareholder value is achieved through vertical integration and a prioritization on the middle two verticals of the value chain. And looking ahead, we expect to drive substantial revenue and profitability growth as we execute on our strategy. Thank you for your time today. I'll now hand the call back to Charlie for final remarks.

Charles Bachtell (CEO and Co-founder)

Thanks, Ken. Despite the challenges presented to the industry as a result of COVID-19, we remain confident in Cresco's growth trajectory this year. Our work over the last six months has culminated in the completion of some of the largest indoor cultivation expansions ever seen in the sector, and we are so thankful to have these projects behind us. Consumer demand is strong, and we're serving more retail customers today than we were in the pantry loading phase leading into the stay-at-home orders.

From a regulatory perspective, the industry has experienced positive outcomes at the state level, with governors reaffirming the status of cannabis as an essential business, and at the federal level, with the SAFE Act being included in the House's latest CARES 2.0 bill. Thank you again to the Cresco family for managing through what has been an incredibly unique and challenging set of circumstances. 2020 is going to be an exciting year for Cresco, and I very much look forward to speaking with you again on our Q2 call. As always, we appreciate your support, and we hope you and your families are safe. Thank you for your time today. I'll now ask the operator to open the line for questions.

Operator (participant)

As a reminder, ladies and gentlemen, to ask a question, you will need to press star one on your telephone. To withdraw your question, press the pound key. In the interest of time, we ask that you please limit yourself to one question and one follow-up. If you have any additional questions, you may rejoin the queue. Please stand by while we compile the Q&A roster. And our first question comes from Derek Dley with Canaccord. Your line is now open.

Derek Dley (Equity Analyst)

Yeah. Hi, guys, congrats on a strong quarter. Can you just talk about what you saw in Illinois within the adult-use market in terms of, you know, the physical restrictions that were put in place during COVID? Wondering if you could kind of break down what you saw in terms of basket size, traffic size, and even if you can give us some color just in terms of the penetration of your customers that were walk-ins, that were curbside, that were, you know, using your online platform, et cetera?

Operator (participant)

Speakers, you're now live.

Charles Bachtell (CEO and Co-founder)

Sorry, we had a technical difficulty there, guys. Derek, we did hear your question, though. Thanks for the question. As it relates to you know the impact of COVID at a retail level and sort of the physical components of it, you know, without a doubt, there were a lot of process modifications and physical components to the process modifications too, that needed to be put in place to appropriately manage the environment and the safety of you know the team members and the customers. That, of course, you know, social distancing is probably the overarching component of it.

So, you know, matters were put in place to ensure social distancing, but across the board, as you could expect, it modified the way that we engaged with the consumer. And it required that we minimize to the greatest extent possible sort of the face-to-face interaction and shifted to this omni-channel sort of approach, a virtual approach. Luckily for us, we'd built the technology over the last year or so for really a live or a real-time online ordering platform that was tied to inventory. So you didn't have scenarios where people would order online, and then they'd show up, and it was gone. It was ordered online, it was removed from inventory, it was set aside, and then they were notified when it was ready to be picked up.

So I think what you'll see, and Greg's gonna add some additional detail to this, but what you saw from us was a pretty marked improvement in figuring out how to do that as we got more and more comfortable, and we had real-life data to be able to analyze. So we identified a few different levers that we could pull on to really increase throughput, and increase the success rate also of the online ordering platform. Walk-ups were minimized to the greatest extent. On the medical side, we still allowed for walk-up orders and in-person ordering, but we switched 100% of adult-use ordering to online. Greg, you wanna add any additional color?

Gregory Butler (Chief Commercial Officer)

Sure. And, thanks, Derek. Good to talk to you. I think I'll just hit quickly on your specific questions around, did we see anything on, you know, major ticket transaction changes and usage? To Charlie's point, what we saw in our medical markets is the medical market actually stayed relatively constant since we restarted the year, both on average transactions per week and average basket sizes. Clearly, we saw a little bit of growth mid-March as I think people were worried about what was gonna happen with stores. Were they gonna close? And so they started buying inventory, and then that kind of washed out in the following week, and then we're back to a stable perspective on medical. And on adult use, to Charlie's point, absolutely correct.

We did see, you know, in the first couple of weeks, some pullback on people going to the stores. But I will tell you, we are now starting to see some of our best days ever, as now customers are coming back. We are fulfilling both through online ordering, pickup at our stores, and drop-in for medical patients, and so we are getting pretty close back to where we were coming into the COVID crisis, and so I think it emphasizes two points. One is, demand for cannabis in Illinois remains incredibly strong, and the more that we can safely allow patients and consumers to access product at our stores, we will be able to continue to drive incremental growth.

Derek Dley (Equity Analyst)

That's great. Thank you very much.

Charles Bachtell (CEO and Co-founder)

Thanks, Derek.

Operator (participant)

Thank you. Our next question comes from Vivian Azer with Cowen. Your line is now open.

Vivian Azer (Managing Director)

Hi, thanks so much. Hope everyone continues to be safe and healthy. I just wanted to touch on, California, Charlie. Nice growth, considering there wasn't distribution expansion. So the question and the follow-up, or a two-part question, if you will. You know, number one, as you kind of worked through the disruption in California, can you offer any incremental color around just the operating landscape there? We've heard, you know, that's been a challenging market, broadly, with COVID. And then the follow-up is: Can you just remind us where you are from a distribution perspective? You know, ACV is a measure that we would, you know, traditionally use, in traditional consumer packaged goods. And so, you know, what percentage of targeted dispensaries are you in now, and, and how do you see that evolving? Thanks so much.

Charles Bachtell (CEO and Co-founder)

Thanks, Vivian. I'm gonna hand that question to Greg. He's got the most line of sight on it.

Gregory Butler (Chief Commercial Officer)

Hi, Vivian. Thanks for the question. So let me take it each part of your question by parts. I think your first one was just color on the California market. As you know, California still remains probably the largest cannabis market in the world and probably one of the most competitive cannabis markets in the world. I think one thing that's often overlooked when we talk about the complexities of California is that the illegal market is still healthy and growing. And if you look at Q1 of this year, and this is coming from BDS's most recent data, not only is California the market quarter-over-quarter growth in Q1, but you're also seeing sustained month-over-month growth in the market, even during COVID.

So, similar to the conversation we just had in Illinois, like, demand in that market is still there. Retail is figuring out how to service that demand, and overall, we're seeing really good quarter-over-quarter, month over month growth in the market. And also, if you look at kind of pre-COVID, I guess you might say COVID start and then COVID now, you are seeing average daily sales increasing across counties across the state, with SoCal experiencing the highest growth. And so overall, we are somewhat on a upward trend in the California market that we think is gonna sustain as we look in the future quarters. From, I think, your second part of your question was ACV percentage. Absolutely, we track that.

So two things that we do with our portfolio is, brand velocity and distribution, percent ACV. Velocities on our brands continue to grow. So we're really encouraged by that because I think as we talked last time, Q1 was our launch our brands, but now as we're seeing brands get in the doors, velocities increase, and customer orders repeat, those are all really encouraging signs for new brands. And from an ACV perspective, right now, the Continuum platform reaches about 80% of customers in the state. And already in Q1, we're getting to at least 50% of that portfolio on Continuum with our brands.

Vivian Azer (Managing Director)

Terrific. Thanks for the color.

Gregory Butler (Chief Commercial Officer)

Yep. Thank you.

Charles Bachtell (CEO and Co-founder)

Thanks, Vivian.

Operator (participant)

Thank you. Our next question comes from Michael Lavery with Piper Sandler. Your line is now open.

Michael Lavery (Senior Equity Research Analyst and Managing Director)

Thank you. Good evening. You mentioned your strategic priorities, and one of them is turning California into a center of profitable growth. Can you just give us some sense of how far it might be from profitability, and what are the key things you need to get there?

Charles Bachtell (CEO and Co-founder)

Thanks, Michael. Appreciate the question. We're gonna give that to Ken.

Kenneth Amann (CFO)

Sure. Since the closing of the Origin House transaction, we've been focused on capturing cost synergies and optimizing our operations across California. The teams have come together, and they're executing on our plan for cost reductions. Since the close of Origin House in January, we've identified over $8 million of annualized cost savings, which will be realized beginning in Q2, and we'll really see the full impact of those exercises in Q3.

Charles Bachtell (CEO and Co-founder)

Greg, you wanna add some color to that?

Gregory Butler (Chief Commercial Officer)

Yeah, happy to add more color. I think, if I just conclude that, as you look to where we are, from the last call, we said that our goal was that we wanted to achieve $7 million on run rate savings. We've executed against that to date, and so we are... That $7 million will continue. As we now move into the next area, we think there's incremental dollars for us to go get. Focus on two areas: one is some incremental labor opportunities we have around territory and back office synergies, but also we are now entering into the phase where we'll be doing some facility efficiencies, and so that also will help drive incremental cost savings to that $7 million that we have executed.

Michael Lavery (Senior Equity Research Analyst and Managing Director)

Okay, great. Thank you. And just on the sales split, you added Origin House, but then still had your share of sales from the dispensaries actually increase. I assume that's driven by Illinois, but can you give us a sense of how you expect that split to look going forward? Is the first quarter pretty indicative of how the full year may look, or is that gonna continue to shift?

Charles Bachtell (CEO and Co-founder)

Thanks, Michael. And this is Charlie to start, you know, some of that definitely has to do with the fact that we launched adult use here in Illinois without the benefit of any of our own incremental additional capacity coming online. So while others have completed some smaller expansion projects when it comes to the supply side that brought more product into the marketplace, but it wasn't ours, but that also gave us more products on our shelves to be able to sell.

So I would also be remiss if I didn't say that the new sort of leadership team and approach on the retail side has outperformed. It is - it's phenomenal. New ways of working, new processes in place. It's really refining our footing on the retail side, more so than we ever have before, so very encouraged by what we've seen there. Maybe Ken has some additional details.

Kenneth Amann (CFO)

Yeah. Hi, Michael. This is Ken. So the revenue split in Q1 was 57% wholesale, 43% retail. That was the highest percentage of retail that we've seen to date, and that was largely based on the transition to adult use in Illinois. That did have a material impact on the overall quarter, but we do expect to return to, roughly around 65%, 35% wholesale versus retail, with additional cultivation coming online in the back of the year.

Michael Lavery (Senior Equity Research Analyst and Managing Director)

Okay, great. Thanks a lot.

Charles Bachtell (CEO and Co-founder)

Thanks, Michael.

Operator (participant)

Thank you. Our next question comes from Jesse Pytlak with Cormark Securities. Your line is now open.

Jesse Pytlak (Equity Research Analyst)

Hey, good afternoon. Just, just on the operational gross margin, appreciate the color you provided in terms of the step back with Origin House integration. But in terms of kind of the, you know, the second quarter and as we go forward, like, is it safe to think that the first quarter might represent a trough level, or can it still remain quite depressed in Q2 as well?

Charles Bachtell (CEO and Co-founder)

Thanks, Jesse. We'll, Ken will answer that one.

Kenneth Amann (CFO)

Hi, Jesse, it's Ken. So we did see a slight dip in the Operational Gross Profit margin quarter-over-quarter. As we said earlier, that was very much anticipated with the consolidation of Origin House. However, you know, as we work to integrate Origin House, we do expect margins to return to the 50+% range as we optimize those operations in California, and we bring on additional scale in Illinois and Pennsylvania, and then I think longer term, we expect our margins to be consistent with the CPG category of roughly 55%.

Jesse Pytlak (Equity Research Analyst)

Okay. And then just as a follow-up, I know you called out the kind of the $11 million of add backs in the Adjusted EBITDA reconciliation. But, you know, if you take out kind of the non-cash component, is the balance almost entirely acquisition-related costs, or are there some other chunks in there as well?

Kenneth Amann (CFO)

Yeah, that was primarily related to the three acquisitions that we closed in the quarter, plus, the credit facility. So you had an increase, you know, a spike in legal costs, professional fees, and advisory fees, all hitting Q1 associated with those transactions, which are now largely behind us.

Jesse Pytlak (Equity Research Analyst)

Thank you. I'll pass the line.

Gregory Butler (Chief Commercial Officer)

Thank you, Jesse.

Operator (participant)

Thank you. Our next question comes from Robert Fagan with Stifel GMP. Your line is now open.

Robert Fagan (Analyst)

Thanks, guys, for taking the questions and a solid quarter. Charlie, I think you mentioned some interesting statistics about Continuum platform growth during the quarter, and I think I might have missed it, but if you could just maybe give us some comments around how... I think you mentioned something like 36% sequential growth, but excluding bulk sales, just to get a read on Origin House's performance, as you know, overall organic growth may suggest somewhat of a flat type of performance there. If you could just add color, it'd be great.

Charles Bachtell (CEO and Co-founder)

Yeah, Robert, thanks for the question. I'm gonna hand that to Greg, Greg, best to answer.

Gregory Butler (Chief Commercial Officer)

Yeah. So let me give some context on how our different brands are performing in California quarter-over-quarter. You know, overall, the platform from Q, I think you saw this in the numbers before, from Q3 to Q4, we saw a dip as we were rationalizing our brands to really get to a profitable platform, which has been our focus for that business. As we now look from Q4 to Q1, the platform is growing on a quarter-over-quarter basis. Cresco Labs brand is driving that growth up about 40% on that Q4 to Q1. But also, one of the jewels of the deal that we got was also the incredible FloraCal brand, which also now we've been able to really generate some life into that as well.

We saw a growth of 30% on a quarter-over-quarter basis. So some really strong growth out of our quote-unquote "own brands," but also of the partner brands that have stayed on the platform also showed really healthy growth on a quarter-over-quarter basis, driving double-digit growth. So as we look to where we are, yes, we've rationalized down to what we now think is our healthy SKU mix and brand mix, going forward, which clearly you're starting to see in this quarter's results. But as we look to the future, we expect to continue that growth on those brands, and then also, as we get to a healthy platform, continue to look for other additional partner brands that can offer a scale.

Robert Fagan (Analyst)

Okay, great. And, you know, given the reopening of the recreational stores in Massachusetts very recently, I understand, but can you guys give us your insights into, you know, what kind of pent-up demand you're seeing? Is there a huge rush for customers to come back to the stores? Any insight there would be great.

Charles Bachtell (CEO and Co-founder)

Yep. Thanks, Robert. This is Charlie. So at a high level, very excited to see Massachusetts come back online with adult use. That said, it's a modified adult use, right? It's curbside pickup only. That is different. That is a barrier to throughput. That again, you know, you've gotta create ways to optimize. We're lucky there. We've got a fairly good setup with our building and parking situation there, where we can get pretty good throughput. But we're looking forward to the day that, you know, in-store transactions can resume. And, you know, we're bullish on that market, though. I think that market coming into the summer now, reopening to the extent that it has, the momentum is there. It's moving in the right direction from a pent-up demand standpoint. Greg, you've got great line of sight on that.

Gregory Butler (Chief Commercial Officer)

Yep. Thanks, Robert, for question. So just kind of building what Charlie is saying, a couple of things we're seeing. So obviously, we're only a couple of days since we got back into allowing adult use, and so there is considerable noise in the data. But I can tell you from our own retail stores, the minute that passed, we've seen rates pick right back up on interest of orders. And so clearly, there is consumers looking to consume and now coming back to the market. To Charlie's point, we're incredibly bullish on Massachusetts. We think there's great potential for us in retail and in wholesale. As we come back from COVID restrictions, coming into COVID, our wholesale business, we just started to launch, and we saw great traction across doors.

Now that we're able to get back into those doors, we think we have a really competitive position in Massachusetts because of our portfolio, where we are offering a portfolio of brands and forms, which our competitors don't have today. And the prime example of that is our Liquid Live Resin forms, where we think that brand has a great position to be a leader in that market and really define next-gen vape products to Massachusetts. So, to Charlie's point, demand is there. It's gonna come back as more of the stores open up, and we're really excited about our retail position and our retail growth that we have ahead of us, and then also our wholesale position with our portfolio of brands to take some meaningful share of the market.

Robert Fagan (Analyst)

Great. Thanks for that color, guys.

Charles Bachtell (CEO and Co-founder)

Thanks, Robert.

Operator (participant)

Thank you. Our next question comes from Russell Stanley with Beacon Securities. Your line is now open.

Russell Stanley (Managing Director of Equity Research)

Hello, everybody. Thanks for taking my questions.

Charles Bachtell (CEO and Co-founder)

Hi, Russ.

Russell Stanley (Managing Director of Equity Research)

First of all... How are you doing? First on the retail end, and I apologize if I missed it, but can you provide, I guess, the latest timelines on Illinois sites eight through 10, and the same with Pennsylvania? I think you mentioned filling in Q3, but what about sites five and six there?

Charles Bachtell (CEO and Co-founder)

Yeah, sure, and this is Charlie, I'll take that one. So, you know, we're pleased to get number six and seven open here in the state. We announced over the past couple of days that Danville location did really well yesterday. It was nice. It was a good opening. You know, you always like to see just the execution and the ability of the team to handle an opening. So that was good. Today's opening in River North, you know, I swung by there this morning, you know, very excited to get that store open. You know, if I just to sidetrack a bit, you know, the opening of that River North store is really the sum of the culmination of our mission, right?

We started this company five years ago or so with the mission of normalizing and professionalizing cannabis, and you know, to be able to open up what will be a flagship type location, you know, at the corner of State and Clark in downtown Chicago and River North, with literally sharing a wall with the Starbucks. You know, that, I think I said five, six years ago, you know, one day we'll be opening up dispensaries right next to Starbucks, and to be able to do that today, it was quite an achievement, and again, you know, the way that it worked, it was, you know, in conjunction with the social equity-focused adult-use law here in Illinois, you know, a ton of community engagement, involvement, and participation to get that open.

It was a monumental occasion for us, and the team just continues to perform well here in Illinois. You know, Friday was, I think, one of, if not, the best day that we had year to date. So it was a great, great momentum that we have on the retail side. As far as locations, eight, nine, and ten, we are looking to be able to open eight and nine here shortly, I think, if not in June. In June or right at the beginning of Q3?

Gregory Butler (Chief Commercial Officer)

Q3.

Charles Bachtell (CEO and Co-founder)

Q3. Right at the beginning of Q3. And then, the tenth location is still TBD. That's our second location in downtown Chicago. Not 100% sure there. That one was definitely impacted by the COVID delay in local approvals. We, you know, for example, on that, even the River North location, that location was ready to open mid-March, right when COVID hit. So the fact that we're opening it today, you can see even something that was teed up, ready to go, ready to open, already inspected, there was about a 2-2.5-month delay that was put on top of that. So the second Chicago location was nearly as far along, so that one's still TBD. In Pennsylvania, again, Philadelphia location, beginning of Q3, locations four and five, I'm sorry, five and six, still earmarking for this year, likely Q4.

Russell Stanley (Managing Director of Equity Research)

Awesome. That's great color. And just a bigger picture question around purchasing patterns and what you're seeing so far, given the macro environment. Are you seeing any sort of notable product shifts, either in your own brands or in third-party brands that you carry in store? Are you seeing any shifts out of higher priced products into more mainstream priced products at this point?

Charles Bachtell (CEO and Co-founder)

I'm gonna give that to Greg.

Gregory Butler (Chief Commercial Officer)

Thanks. Thanks for the question, Russ. So I'll try to give you some highlights on what we're seeing from consumer demand. I think we moved into COVID, a lot of the hypothesis in this industry was that we were gonna see a shift out of inhalables as more consumers were concerned about the respiratory impacts of COVID, and perhaps that's shifting to other forms like edibles. As we've now gotten more weeks under our belt and looking at what's happening on consumer behavior, we're not seeing that. Inhalables continue to grow and continue to represent a meaningful share in the market.

Edibles continue to grow in other forms, but they're not growing share, per se. So if you look at the consumer behavior from the major segments, you're not seeing significant share shifts between those as we go through COVID. Now, we're clearly seeing growth because cannabis, across our markets in particular, continues to grow, but not a significant shift. From a price perspective, we always look at pricing, and particularly, we look at more established markets, like Colorado, Oregon, and California, to understand if there's any significant price declines. And clearly, in our stores as well, demand by price tier has stayed relatively stable as we continue to go through each week.

Russell Stanley (Managing Director of Equity Research)

That's great color. Thank you.

Operator (participant)

Thank you. Our next question comes from Scott Fortune with Roth Capital Partners. Your line is now open.

Scott Fortune (Analyst)

Good afternoon. Thanks for taking the questions. Real quick, kind of on the M&A side of things, can you provide a little more color on the Ohio acquisition for retail stores there, bringing max total to five, and your cultivation footprint to serve the Ohio market? Kind of at what level are these stores at? And then, this is kind of the strategy for M&A going forward as you continue to look at Arizona and some of the other states, to go deeper in those states.

Charles Bachtell (CEO and Co-founder)

Thanks, Scott. This is Charlie. Yes, I'll answer the last part of that first. You know, I think this is a really good example of the current M&A strategy. It just fits perfectly in line with our overall strategy, right? Which is that strategic geographic footprint and material meaningful positions in each of them. You know, we like having the highest market share in Illinois, highest market share in Pennsylvania. You know, that's our story, and so we're gonna keep executing on those lines. The additional four dispensaries that we'll be bringing on in Ohio, you know, the structure of those, it had to be structured in this way. Ohio has restrictions on the transferability of ownership within a year of a license becoming operational. So we worked with the regulators there.

You know, I think some of some other transactions had been announced last year in the Ohio market, and I think there were some ruffled feathers over the way that those were done. So this was done in conjunction with the regulator to make sure that everything was correct, and they were comfortable with it. So those are operating dispensaries. We have, you know, from the beginning, sort of assisted to a certain extent in helping them get off the ground and been there to make sure that they've been successful. So we'll be closing, you know, when we're permitted to close, we'll be closing on fully functional, you know, operating dispensaries there. And as you mentioned, that'll bring us up to the max five in Ohio.

I think it's important to note, you know, in Illinois, we've got 10 dispensaries. We have, you know, that will be opening, the max here is 10. In Ohio, we'll have five. In New York, we've got the max four. In Massachusetts, we've got one of the max three open, but we will be opening three, and then in Pennsylvania, you know, we've got three open, fourth to be open soon, licenses for six, but you could have up to 15 there. So we look forward to exploring opportunities to further our footprint and depth in the Pennsylvania market as well.

Scott Fortune (Analyst)

Thank you. And then real quick, is your cultivation footprint, I think you're about, what, 60% penetrating dispensaries in Ohio as you look to add there or continue to penetrate more dispensaries in Ohio?

Charles Bachtell (CEO and Co-founder)

Yeah, absolutely. You know, I think that's a case of us optimizing our operations there. We'd mentioned in the report that we were doing some upgrades to that facility. The upgrades to that facility are going to allow us to increase production materially, and with increased production, you'll see that penetration rate increase. It'll be in line with what you've seen from us in other states.

Scott Fortune (Analyst)

Okay, thanks for the color.

Charles Bachtell (CEO and Co-founder)

Thank you.

Operator (participant)

Thank you. Our next question comes from Pablo Zuanic with Cantor Fitzgerald. Your line is now open.

Pablo Zuanic (Analyst)

Thank you. One for Charlie and one for Ken. Charlie, maybe this is a concern for more medium, long term, but looking at the April data for Michigan, that market now is almost as big as Illinois, and I understand it'll be a while before, you know, the western states of Illinois or even south will be rec, but 25% of sales to the Illinois rec market are going to out-of-state residents, right, and I suppose people in Indiana or Ohio can go to Michigan now, and they have, I think there's almost 95 stores there, so two-part question for you: Is that something we should think about in terms of projecting the demand growth of Illinois? You know, you could... The market could lose part of that 25% that's going to out-of-state residents, especially with Michigan becoming so big.

And the second part, I didn't hear much about your plans in Michigan. I mean, I know it's in your portfolio, but what comes next? As I say, it's a market that's as big as Illinois. And then very quickly for Ken. Ken, I don't know if the question came up, but any color in terms of cadence for the second quarter? You know, it's a flat quarter, sequentially good, given the context with COVID. And for the back half, I know you've talked about six times, four times capacity expansion in Illinois and Pennsylvania, but in terms of a run rate, assuming double capacity in terms of what you can get in terms of throughput or cultivation in Illinois and Pennsylvania, two times versus Q1, would that be conservative, or is that the right way to think about it? Thank you. Sorry.

Charles Bachtell (CEO and Co-founder)

No, thanks, Pablo. So, Michigan, I'm thinking back just I want to confirm that I've got these in order. So as it relates to Michigan, you're right, the Michigan market has almost caught up to the Illinois market. But I would also say, if you think about it, Michigan market has been adult use for longer than Illinois. Illinois is really supply constrained. The growth potential here in this state is significant. And Michigan has historically had one of the more, I would say, flexible medical programs. Their legacy program there has been one of the more flexible. So Michigan has always served as an option for residents in the Midwest.

So I'm really encouraged by what you're seeing from Illinois's perspective of you know being a viable program. And you know Michigan has always been that the I would say the more accessible option for anybody who lived in the Midwest. So I'm encouraged by Illinois's strength coming out of the gates. I don't think Michigan will really serve as competition to it. I think Michigan has always been competition to it, so I wouldn't expect that to be increased.

As far as the Michigan market, you're right, that definitely is part of our portfolio, and we did announce a sale-leaseback earlier, which is allowing us to move forward with the build-out of the cultivation facility there. We absolutely are excited about our ability to deepen our footprint and make Michigan more of a material component of our platform. Like I said earlier, you know, six of our nine states are in the top 10 from a population standpoint. Michigan is the tenth most populated state in the U.S. It's gonna be a really nice market. With that, I'll pass it over to Ken.

Gregory Butler (Chief Commercial Officer)

Hi, Pablo, it's Ken. In terms of the Q2 guidance, you know that historically we haven't provided guidance, and the current situation with COVID makes that process even more challenging, but I'll provide some thoughts based on the results that we saw in Q1. Obviously, the 26% sequential growth that we experienced quarter-over-quarter is a large number that was driven primarily by the transition to adult use in Illinois, and we won't get that same level of increase again.

Also, the adult use sales in Massachusetts were closed for much of the quarter, and then recall that much of our cultivation capacity doesn't come online until the end of Q2, and then rolling through the end of Q3. But I think from what you've heard from us today, we have momentum building some of the largest markets in the country, and we have significant supply coming online over the coming quarters to deliver material growth in the back half of this year.

Pablo Zuanic (Analyst)

All right, thanks.

Gregory Butler (Chief Commercial Officer)

Thanks, Pablo.

Operator (participant)

Thank you. Our next question comes from Glenn Mattson with Ladenburg Thalmann. Your line is now open.

Glenn Mattson (VP)

Hi, thanks for taking the call. So, most of my questions have been answered at this point, but, you know, given the opportunity, Charlie, perhaps you could just give your thoughts on what you're hearing as far as the latest or what your thoughts are as far as regulatory reform in some of your key states, and just what, you know, if you have any thoughts on the national picture as well. Thanks.

Charles Bachtell (CEO and Co-founder)

Yeah, thanks, Glenn. You know, as I'm sure you would expect, I think there's a lot of momentum at the various state levels, right? You've got states that are looking at holes in their budget that weren't expecting to have holes in their budget. And there's states that already have medical programs that have been, you know, either successful from an overall size and scale standpoint, or at least from the perspective of the sky didn't fall, it's a nice, regulated program, there's professional operators in it, which gives sort of the ability of legislators to have that discussion about maybe a next phase, a modification to an adult use type program. You know, we're encouraged by still in New York.

I think New York, Pennsylvania, are definitely viable, you know, states when it comes to migration towards adult use. I think you'll see, Ohio, also start to take a look at it. You know, Arizona looks good, for November. So it's all encouraging signs, and it should be. I mean, it's so logical, it's so rational that, you know, more access to cannabis, and especially the tax revenue that can be generated from it, the job creations are, you know, potential partial solutions to some biggie, pretty big problems that these states are gonna have.

I think you could have the exact same, you know, discussion on a federal level. You know, my newly appointed role as chairman of NCR, which is an honor, and I'm happy to be involved at that level. You know, I can tell you that the conversations are happening, and again, like I said, as they should. It's not out of left field anymore. This is a logical, rational conversation that should be happening. This is an industry that can create a lot of jobs and a lot of tax revenue.

Glenn Mattson (VP)

Oh, great. Thanks for the color.

Charles Bachtell (CEO and Co-founder)

Thanks, Glenn.

Operator (participant)

Thank you. Our next question comes from Graeme Kreindler with Eight Capital. Your line is now open.

Graeme Kreindler (Analyst)

Hi, thanks for taking my question. One thing I wanted to follow up on, in the prepared remarks, you mentioned that you're seeing higher basket sizes continue, and you saw that go through to Memorial Day. So I was just wondering if you could elaborate a little bit, on the drivers of that. Is the adoption of, delivery, curbside pickup, or online ordering helped to keep that, basket size higher, or is this more just a change in consumer behavior that you've seen? Some more details on that would be helpful. Thank you.

Charles Bachtell (CEO and Co-founder)

Thanks, Graeme. Greg's gonna take that one.

Gregory Butler (Chief Commercial Officer)

Hi, Graeme, thanks for the question. To give some context on that, through our markets, we are seeing baskets grow. I think your point on curbside pickup and whatnot is certainly helping with tickets. So if you think of, like, tickets times baskets equals our retail revenues, so that helps with tickets. But the basket driver really is as supply comes online in the market, and we have access to more supply to market, not only total volume, but also across categories. What we know is, consumers will buy across categories in the basket. So, that's really what's driving the big chunk of basket growth in the market.

Graeme Kreindler (Analyst)

Okay, thank you.

Operator (participant)

Thank you. And our next question comes from Andrew Semple with Echelon Wealth Partners. Your line is now open.

Andrew Semple (Analyst)

Hi, guys, and congrats on the quarter.

Charles Bachtell (CEO and Co-founder)

Thanks, Andrew.

Andrew Semple (Analyst)

Just wanna get your thoughts on SG&A for the remainder of the year, and your comments in the prepared remarks that you expect this to decline materially as a percentage of revenue. So I guess I have a two-part question here. The first one being: Is it fair to say that you expect SG&A costs to still grow, but at a slower pace than revenue? And the second part of that question being, if I could just pull out Q2 and focus on that, where you have cultivation operations ramping up, but you're not getting the offsetting revenue. You've got a full quarter of the acquisitions you've completed, and perhaps some COVID-19 related costs. Is that a comment that's more applicable to the latter half of the year, or, or would you expect SG&A as a percentage of revenue to kind of trend down linearly?

Charles Bachtell (CEO and Co-founder)

Thanks, Andrew. Ken's gonna take that.

Kenneth Amann (CFO)

Hey, Andrew, this is Ken. Thanks for the question. The increase in SG&A that we saw in Q4 was mainly driven by some of the investments that we made ahead of the adult use in Illinois. On an absolute basis, there will be some step costs related to the opening of additional dispensaries, but overall, we expect OpEx to fall as a percentage of revenue over the course of 2020, and certainly accelerate in as we get to the back half of the year, as we complete that integration with Origin House, and then we generate significant economies of scale in Illinois and Pennsylvania.

I think, I guess what I would add to that as well is just, you know, in terms of free cash flow, what that means, from a top-line perspective, we detailed the increased capacity leading to significant revenue growth in future quarters, and we expect to gain leverage on the gross profit line with increased scale and optimization efforts. Again, most of our infrastructure is already in place. There'll be some step costs related to those dispensaries, but SG&A will decline in the back half of the year, and this leads to a situation where a higher percentage of each incremental dollar of sales should drop to the bottom line and drive free cash flow.

Andrew Semple (Analyst)

Great. Thanks for the color there.

Charles Bachtell (CEO and Co-founder)

Thanks, Andrew.

Operator (participant)

Thank you. I'm not showing any further questions at this time. I would now like to turn the call back over to Charlie Bachtell for any closing remarks.

Charles Bachtell (CEO and Co-founder)

Yeah, you know, in closing, again, I just want to reiterate how proud I am of the team for what they've been able to put together here year to date. You know, we all can understand this has been an incredible start to a year for all of the reasons that we mentioned on the call. Again, appreciate the support. Thanks for attending the call today. Hope everybody stays safe, and we are looking forward to talking to you with Q2. Thank you.

Operator (participant)

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.