TheCannalysts have gone deep on Auxly ($XLY), as we’ve been following them since the beginning.

They’ve demonstrated proficiency in dealmaking, in product and brand design, and have shown willingness to adapt to retail market conditions. Due to these (and other) reasons, I see less operational risk present here than in several peers Our last structure was relatively succinct as we see this company having a relatively ‘simple’ path forward: increase sales.

We wondered last time if their sales decline was temporary, and noted the higher expense incremental debt is bringing. Let’s find out how things are going.

To the financials!

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• Sales are up by $5MM (good)
• Interest expense has been moving around quite a bit over the past 5 quarters. Sequentially: $2.5MM; $4.1MM; $2.2MM; $3.3MM; $3.6MM. The trend is unkind.
• Inventory of cannabis oil more than doubled (looks like incoming feedstock), finished goods and WIP went up $4MM, packaging and materials down by more than $5MM. All looks like a company ramping production.
• A bought deal with Mackie was announced just prior to these financials. More below.
• $XLY did a deal with Trichome Financial to factor their receivables (Note 15). While normal course for business in several industries, this is the first formalized deal I recall seeing in cannabis. $XLY retains credit and late payment risk though, it functions purely as a secured credit facility.
• Full steam ahead at DoseCann, another $3.9MM in capital committed to extraction capacity. $1.9MM of it allocated (but non-committed) to ethanol. I’ve seen enough LP’s aspire to take extraction in-house to think that these actions aren’t a raging endorsement of a 3rd party business model. Time will tell.
• $XLY’s relationship with Sunens sounds – at best – aspirational. $XLY states they are ‘anticipating’ to transition to Sunens becoming one of its’ primary suppliers. That’s real news. Something went in sideways and pear-shaped.
• Related to that or not, Sunens applied for and received a processing licence since summer.
• Hah! ‘Terroir Driven’ used to describe outdoor weed. I absolutely love it. $XLY has also committed another $3.5MM in capital to see Robinson’s outdoor grow get to harvest.

Ok. It’s worth repeating: $XLY is very good in disclosure.

An insight into how companies adapt to market conditions is contained in their MD&A, within an update on the Kolab subsidiary. $XLY shuttered that grow back at the end of June to have them focus on pre-roll production. One might assume that Imperial Brands could be of some help around the idea of filling combustable tubes with a specific filler, but if they did help out, it doesn’t look like it did much (at least in terms of speed). Note the lead time and capital required for automating pre-rolls. From decision to go-live, it’ll have taken more than a year to see it achieve full production:

I recently saw a retail investor’s comment about a mis-labeling of product by another cannabis company. The company had inadvertently put a wrong word on the label (‘ingestion’ versus ‘inhalation’) which triggered a recall. This was on an initial product shipment (natch), and the company is in need of cash flow. The comment related to how little the cost of relabeling would be, and that returned products would be turned around in short order. Simple, right? The reality of that recall isn’t simple at all.

The State Monopoly received that initial shipment from the company, put the products up on the website and in-system, subsequently shipping to stores that had placed pre-orders. This took 7 business days. During that time, 3 ‘complaints’ were lodged with Health Canada about the labels, who notified the State Monopoly, who notified stores that had the product to return it. They were given 3 weeks to do so (those complaints could have stemmed from anti-legalization malcontents or perhaps a competitor). By the time the pallets were shipped back to origin and returned, a total of 6 weeks had passed since product launch – with no meaningful revenue to speak of. By the time the re-labelled vapes were sent back to the monopoly, they were also priced lower (by $3) to keep in position with competing product. Such is what a month and a half in retail can mean.

Regarding Imperial, what does $XLY’s ‘strategic partnership’ with them bring – aside from the prospect of being able to get at Dad’s wallet? The same thing as Constellation ($STZ) or Altria ($MO) or Couche-Tard ($ATD) would be expected to bring to their respective partners. Strategy:

We’ll see as time goes on how strategy around brands and distribution and fabrication is working. I suspect Fire & Flower has benefitted greatly from $ATD’s input, and likely $WEED ($STZ) and $CRON ($MO) have by their partners as well.

A upbeat paragraph in Note 26 (Subsequent Events) bears a look. First time I can recall having a deal snatch described as being a nifty thing to have happen:

The $12MM recently raised – for 40MM in shares and 20MM in $0.40/3 year warrants (worth about ~=$0.21 each) – is cheaper than the convertible facility they lit up earlier this year. It should provide relief from having to go back to the bank machine so often. This quarter’s reported sales numbers probably lubricated discussions preceding it. For comparison, that convertible facility mentioned sent out a total of 36MM units (36MM shares and a total of 20MM at-the-money warrants) at 7.5% interest over 2 years, and attracted a $600k fee. Underneath it, $XLY raised a total of $10.6MM.

Managing working capital during growth phases is critical. In terms of the total, the Mackie money is about half of the cost of the convertibles. It’s easy to imagine $XLY inking with Trichome & Mackie was a relief internally. :

That’s about it. Operational adjustments and leadership changes were announced and implemented, which then culminated in Chuck’s departure back in October.

For next quarter….$XLY investors should be eager to see them repeat strong growth again, along with seeing SG&A continue to trend downwards (another $2.5MM by end of the year is their target).

These financials are going in a direction that makes capital raises easier, and phone calls from major shareholders shorter. While $XLY’s a ways off, it looks like sales and their brands are gaining traction. Next quarter, we’ll be looking to see if/how run rates hold and if expansion continues. An increase in sales like this over sequential quarters for both 1.0 & 2.0 products would be a strong positive.

As counterbalance, there’s a few negative things I’ve heard about their relationship with Sunens is aspirational, the 632MM share count is BIG (Imperial striking their option would take it over a billion), and a need to balance production capacity in the near/mid term…. are challenges. While the bulk of options and warrants are largely out of the money, know that another 31MM have gone out this year at/near market.

The preceding is the opinion of the author, and is in no way intended to be a recommendation to buy or sell any security or derivative. The author holds no position in $XLY