Cronos Group (TSX:CRON) Q2 2020 Earnings Call

0:00 Good morning. My name is Lashana, and I will be your conference operator today. I would like to welcome everyone to Kronos Group's second quarter 2020 earnings conference call. Today's call is being recorded. At this time, I would like to turn the call over to Shane Laidlaw, Investor Relations. Please go ahead. Thank you, Lashana, and thank you for joining us today to review Kronos Group's second quarter 2020 financial and business performance. Today, I am joined by our Chairman, President, and CEO, Mike Gorenstein, our CFO, Jared Barbato, and our EVP of Legal and Regulatory Affairs, Sun Ming Shum. Corners Group issued a news release announcing our financial results this morning, which are filed on our EDGAR and CDAR profiles. This information, as well as the prepared remarks, will also be posted on our website under Investor Relations.

0:48 Before I turn the call over to Mike, I would like to remind you that our discussion during this conference call will include forward-looking statements. that are based on assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements, including as a result of the factors described in the cautionary statement and risk factors included in the company's earnings release and regulatory filings, including the company's most recent annual report on Form 10-A and quarterly report on Form 10-Q, by which any forward-looking statements made during this call are qualified in their entirety. In addition, during this call, We believe these non-GAAP measures assist management in planning, forecasting, and evaluating business and financial performance, including allocating resources.

1:41 Reconciliation of these non-GAAP measures to their closest reported GAAP measures are included in our earnings press release furnished to the SEC, which is available in the press room section of our website, thecornosgroup.com. These non-GAAP measures may not be comparable to measures used by other issuers. I'd also like to note that we are conducting our call today from our respective remote locations. As such, there may be brief delays, crosstalk, or minor technical issues during this call. We thank you in advance for your patience and understanding. We will now make prepared remarks, and then we'll move to a question and answer session. With that, I'll pass it over to Kronos Group CEO, Mike Gorenstein. Thank you, Shane, and good morning, everyone. To start the conversation, I'd like to speak about two issues affecting everyone around the world today. First, I want to address the topic of racism, and specifically, how we at Kronos are dedicated to making a difference.

2:34 As a leader in the cannabis industry, we are committed to using our voice to lead our industry forward responsibly. We cannot do that without recognizing the historical injustice specifically tied to cannabis prohibition that continues to this day. As we continue to grow, entering new and evolving markets, we are committed to supporting meaningful and progressive social justice reform and legislation in markets such as the U.S. We believe this work starts from the inside out, so we have established a committee to address how we as a company can make an impact in the communities we operate in, both through our time and financial investment to fight racial injustice and inequity within our industry. We are fortunate to have a platform, resources, and influence, and we will continue to use it to do our part to combat racial injustice and to change society for the better.

3:27 Secondly, COVID-19 has impacted markets, industries, and people globally, leading to material changes in the way we live and the way we do business. We've also seen the profound impact our products have on our consumers' everyday lives, and we continue to modify and monitor our distribution networks to bring quality products to market during this time. Kronos Group was founded on the mission to improve people's lives by unlocking the full potential of cannabis, and our company has always been at the forefront of providing safe access and high quality products to patients and consumers. As you know, my focus and the company's focus are on creating long-term shareholder value by developing disruptive intellectual property and building iconic brands.

4:12 I always encourage long-term thinking, especially in today's economy and environment. Kronos is truly building a business for the future. Our value will come from technology breakthroughs and branded sales that will help establish relationships with our consumers. Moving to our operations in Israel. In June 2020, following the successful shipment of bulk-dried flour from Canada to Israel, we commenced sales of Peace Naturals branded cannabis to the Israeli medical market. This is an important milestone for Kronos, and we look forward to expanding our distribution and the Peace Naturals brand in the Israeli market. The team at Kronos Israel is also preparing to introduce new SKUs in adjacent categories, such as oils and pre-rolls, which will further establish our leadership position.

4:58 Allow me to take a moment to dive more into the Israeli market and how we've positioned ourselves as a leader there. Israel has a population of just over 9 million people and boasts one of the world's highest cannabis usage rates. Unlike the North American cannabis markets, Israel has a much less competitive illicit market, given Israel's stringent border controls and security infrastructure. The Israeli government has taken several steps to optimize and expedite the patient access process for medical cannabis. In 2016, the Israeli Ministry of Health published a medical cannabis information booklet and guide, which includes a methodology intended for doctors to prescribe cannabis. This is meant to guide and assist in customizing treatment with medical cannabis. Many doctors in the Israeli healthcare systems have been trained and certified using this clinical methodology, which enables them to provide treatment and issue patients licenses for possession and use of medical cannabis.

5:55 The Israeli Medical Cannabis Agency currently grants personal medical cannabis permits and prescriptions to patients to treat a variety of medical conditions. and unlike the Canadian medical cannabis program, patients fill prescriptions directly through pharmacies. The medical patient count in Israel is expected to grow rapidly, representing an excellent opportunity for our business to grow in this market. The rapid growth in the Israeli medical market reminds us of the early days in Canada's medical market, with demand outpacing supply and the stigma associated with the product quickly fading away. Beyond the medical market in Israel, We are encouraged by the progress being made on further legalization of the potential adult use market, which provide more legal access to cannabis in Israel. There are currently two bills being reviewed by the government, and they are progressing through Parliament quicker than many had anticipated.

6:46 As a reminder, Kronos Group consolidates the results and captures 90% of the economics through our equity interests across the Kronos Israel entities. With our manufacturing footprint, established local team, strong brand and product portfolio, we are very well positioned to succeed in the market. Kibbutz Khan Shmuel is one of the largest and most sophisticated kibbutzim in Israel, producing and exporting a variety of products to 35 countries throughout Europe and Asia. For our Kronos Israel facility, we work closely with our partners at Kibbutz Khan Shmuel and are able to leverage not only their agricultural expertise, but also their skilled labor pool. with about 80 employees currently working on site and extensive infrastructure including warehousing, utilities, and much more.

7:31 I'm pleased to share that we are in full production and have had successful harvests. Outside of Kronos Israel's direct operations, we have further committed to the region and have a strong presence from an R&D and analytical sciences perspective. We have two partnerships with top cannabis researcher, Dr. Didi Miri, through the skin care repair research we are doing at Technion and through the analytical testing lab on Kronos Israel's campus called Canasol. Under our agreement, Canasol is developing a commercial cannabis analytical testing business on-site at Kronos Israel. In addition, we have created our own research hub, Kronos Device Labs, which employs about 30 people and is focused on everything from understanding the effects of different cannabinoids to creating next-generation devices for cannabis products.

8:19 Turning to the Canadian market, in the second quarter, we continue to supply the adult use market, working with provinces and private retailers to meet demand during this time. As COVID-19 continues to impact global markets and global supply chains, we have seen an uptick in sales driven by consumer demand and the growth in retail outlets in key provinces. Despite the strength we have seen and the continued store openings in some provinces, We remain cautious, knowing that the shock of the economy could potentially have negative impacts on our industry. In Canada, we're now seeing most retailers open with limited capacity and social distancing guidelines. Several provincial purchasers continue to implement health and safety measures and reduce staff at on-site operations, including limited delivery time slots, which have posed logistical challenges and created a reduction in purchase order fulfillment.

9:13 The slowdown and disruption faced by retailers are in addition to quarantine measures and travel restrictions, which would impact the ability of consumers to readily access our products outside of online channels. These restrictions will continue to change and evolve, which creates uncertainty in forecasting consumer demand and sales velocity. Despite the changing landscape, throughout the second quarter, the Alcohol and Gaming Commission of Ontario continued to grant retail store authorizations. with the objective of making the legal supply of cannabis more broadly available. With over 100 stores authorized to open as of July, Ontario seems to be committing to their plan of growing store count each month throughout 2020 and they have a long runway for growth given the demand for new retail licenses.

10:01 In the Canadian 2.0 market, our adult use brands, Spinach and Cove, and our direct-to-consumer medicinal cannabis brand, Peace Naturals, continue to expand distribution throughout the country in their respective channels. We are proud of our uncompromising approach to quality, which is at the heart of everything we do. As we continue to glean more consumer insights into the Canadian market, we look forward to producing new and differentiated products over time. We know the adult use consumers and medical patients in Canada are looking for value during this time, and some of our peers have committed to a deep discount strategy as a way to provide this perceived value to the consumers and to compete with the illicit market. At Kronos, we believe that the real essence of value revolves around the trade-off between the benefits the consumer receives from a product and the price he or she pays for it.

10:51 We pride ourselves on the quality of the product we bring to market. For instance, our vaporizer devices aim to deliver a premium extract for consumers with precise cannabinoid concentration levels and terpene profiles for consistent experience. The premium cannabis extracts are made using CO2 extraction processes and each product has a unique and aromatic blend which uses all natural terpene rich flavors. All of our batteries and cartridges were rigorously tested before sale and we continue to receive positive feedback on these innovative new products. We believe our consumer benefit and pricing profile provide a great value to consumers currently. We will continue to look at ways to provide more value to the consumer, whether through benefit or price, on a regular basis as the industry evolves.

11:37 Moving to the U.S., I want to start off the discussion by welcoming Summer Freen into her new role as General Manager of our U.S. segment. Last month, Summer was named General Manager of our U.S. hemp-derived CBD business with oversight of sales, marketing, and operations. Summer officially joined Kronos in January of this year, but she has been part of the team since 2018 in her role at Altria. While at Altria, Summer led the strategy and business development team's due diligence in the cannabis space, which culminated in the strategic investment from Altria. She has been responsible for leading our U.S. sales efforts, including managing brand and retail partnerships for Lord Jones. Summer is a proven and results-oriented leader with 14 years of regulated consumer packaged goods experience.

12:24 We're confident in our U.S. brands and our strategic direction under Summer's leadership. There are many opportunities we see on the horizon, from introducing new product formats under Lord Jones to launching new brands and targeting different retail channels and consumers. Last quarter, in response to market feedback and part of our evolving effort to provide true value to our consumers, our Lord Jones brand launched a new size format for our hero product, the Lord Jones CBD Body Lotion. Now available in a larger 100ml bottle, our popular body lotion is twice the size but available at the same price as our original 50ml size. In conjunction with this introduction, we lowered the price of our original 50ml size by 30%. We think the new pricing structure provides for a great entry point to attract trial consumers into the brand and convert them to refeed customers.

13:16 The support from our consumers during this quarter has been felt, and we're excited to be bringing these new format sizes and products to our loyal Lord Jones consumers. We would be remiss not to mention the work we are doing with Ginkgo and our joint venture, Naturera. Following the successful fermentation of CBG at R&D scale at Gronos Fermentation, we have continued to optimize the process for downstream processing and scale-up procedures, and are very pleased with our results to date. With the progress we have made, we remain on schedule to produce fermented cannabinoids at commercial scale in September of 2021. And in Colombia, our joint venture, Natuera, successfully completed three additional test exports of hemp-derived CBD extract to the U.S.

14:01 between May and July of this year for business development and R&D purposes. Although this does not signify the start of revenue for this business, they provide good learnings that set us up well for the future. During these unprecedented times, it is very encouraging to see that we are making progress against our strategy across our global footprint. The current environment doesn't make things easy for any industry, let alone one that is in a nascent stage of development, but I am very proud of our employees and all that we have accomplished during this time. From our production and manufacturing facilities to our continued R&D efforts, we are creating and launching new products and brands in different markets across the globe, and we are committed to bringing high-quality brands and products to our consumers.

14:46 There are a few silver linings from this environment. First, given our strong balance sheet and decreased access to capital for industry competitors, we continue to feel that we are extremely well positioned to be opportunistic in how we create value for shareholders. Second, we believe that as attention turns to economic recovery, accelerating cannabis legalization is a great solution to help create much-needed jobs and tax revenue. We can't always tell what the future holds, but we remain optimistic and ready to seize opportunities as they come our way. With that, I will turn it over to Jerry to provide a discussion on this quarter's financial results and our remediation efforts. Thanks, Mike, and good morning, everyone.

15:31 Turning to our financial results, the company reported consolidated net revenue in the second quarter of 2020 of $9.9 million. A 29% increase from the prior year period. Revenue growth year-over-year was driven primarily by the continued growth in cannabis products in the adult-use Canadian market and the inclusion of Redwoods Financial Results, our U.S. hemp-derived CBD business that was acquired in September of last year. Revenue was partially offset by non-recurring wholesale revenue in the Canadian market in the second quarter of 2019. Consolidated gross profit for the second quarter of 2020 was negative $3 million, a $7 million decline from the second quarter of 2019.

16:22 The decrease versus prior year was primarily driven by a $3.1 million inventory write-down on dried cannabis and cannabis extracts within the rest of world segment caused by cannabis price compression in the Canadian market, as well as an increase in cost of sales driven by a higher volume of adult use sales and the lack of wholesale revenue. If we were to exclude the inventory write-down of $3.1 million, gross profit in the second quarter of 2020 would have been $0.1 million, representing a gross margin of 1%. We anticipate inventory write-downs to continue in the short term due to pricing pressures in the marketplace. Reported operating loss for the second quarter of 2020 was $34.8 million, representing an $18 million decline from the second quarter of 2019.

17:14 The loss was due to a combination of factors, including a decline in gross profit, general and administrative expenses as a result of increased headcount, sales and marketing costs related to the development of new and existing brands and product lines, and R&D expenses, mainly due to increased spending on research at the Kronos Device Labs Research and Development Center and upscaling activities at Kronos Fermentation. Additionally, within G&A, we had $3.5 million worth of expenses driven by review costs and costs related to the company's responses to requests for information from various regulatory authorities related to our previously disclosed restatement of our 2019 interim financial statements.

18:04 Our consolidated adjusted operating loss for the second quarter of 2020, which excludes the one-time review cost, was $31.3 million. Turning to our reporting segment, in the Rest of Worlds segment, we reported net revenue in the second quarter of 2020 of $7.7 million, a 1% increase from the prior year period. Revenue growth year-over-year was driven primarily by increased distribution of cannabis products in the Canadian market, including the launch of cannabis vaporizers in both the adult use and direct-to-consumer categories, partially offset by non-recurring wholesale revenue in the Canadian market in the second quarter of 2019.

18:51 Gross profit for the rest of the world segment was negative $3.5 million, a $7.6 million decline from the second quarter of 2019. The decrease year-over-year was primarily driven by by a $3.1 million inventory write-down on dried cannabis and cannabis extracts, primarily caused by price compression in the Canadian market and the higher volume of adult-use sales and lack of wholesale revenue. If we were to exclude the $3.1 million inventory write-down, gross profit in the second quarter would have been $-.5 million, representing a negative 6% gross margin. As we work to create an efficient global supply chain for 2020 and beyond, we anticipate that gross margins will continue to fluctuate.

19:40 This is due to the current underutilization of certain manufacturing facilities that are being repurposed and the work that is underway to streamline our third-party biomass supply chain. We anticipate that these operational pressures will ease as our manufacturing and purchasing teams continue to make progress in these areas. Turning to our Canadian cannabis vaporizers, as we have spoken about before, we made the strategic decision with our launch to utilize contract manufacturers to increase speed to market at the onset of cannabis 2.0 legalization. Further, we believe that contract manufacturing allows us to be more flexible and responsive to trends in the marketplace, while also aligning with our asset-light model.

20:26 We continue to work with contract manufacturers to reduce costs while continuing to provide quality products to our consumers. Reported operating loss in the rest of the world segment for the second quarter of 2020 was $22.1 million, representing a $5.4 million decline from the second quarter of 2019. The loss was primarily driven by a decline in gross profit and higher R&D costs related to our spending on research at Kronos Device Labs R&D Center and upscaling activities at Kronos Fermentation. Before getting into the U.S. business operating results, allow me to talk about the impairments we took this quarter in the segment. The company reported $35 million of impairment charges on its reporting unit and $5 million of impairment charges on the Lord Jones brand.

21:22 Due to the ongoing developments of the COVID-19 pandemic, closures of the retail stores have been longer than expected and revenue growth has been slower than anticipated. With slower growth, the company's operating results in the U.S. segment have been negatively affected by the global pandemic, and the timeline of society getting back to normal is uncertain. Based on the valuations, the carrying value exceeded the fair value, resulting in an impairment on both the reporting unit and the Lord Jones Grant. Turning to the U.S. segment, Reported net revenue in the second quarter of 2020 was $2.2 million. Gross profit for the U.S. segment was $0.6 million, representing a gross margin of 27%.

22:08 We believe the decline in gross margins within the U.S. segment this quarter were transitory in nature, driven by premiums paid for our essential employees during the COVID-19 pandemic, as well as increased discounts and promotions in the direct-to-consumer channel to drive online sales growth in an effort to offset the negative impact of retail channel customer closures due to COVID-19. Reported operating loss in the U.S. segment for the second quarter of 2020 was $5.6 million. The loss was primarily driven by a decrease in gross profit. Sales and marketing costs incurred in relation to the development and launch of new U.S. hemp-derived CBD products under the Lord Jones brand, new brand development, and increase in headcount to support growth initiatives across a variety of functions.

22:59 Overall, Kronos Group reported a decrease in net income from the prior year, primarily due to the non-cash impairment charges and the change in fair value of the financial derivative liability associated with Altria's investment, which is described in more detail in the 10Q. In the second quarter, the company recorded a non-cash loss of $35.9 million, which related to the change in fair value of these financial derivative liabilities. Kronos continues to expect there may be significant reported earnings volatility, primarily driven by the fair value quarterly adjustments related to the movement of Kronos Group's stock price. Turning to the balance sheet, the company ended the quarter with approximately $1.3 billion in cash and short-term investments, which held relatively slack from the first quarter of 2020.

23:53 Capital expenditures for the quarter were $8.6 million. This spending includes investments related to Kronos Fermentation, the Peace Naturals Campus, our Israeli facility, and our new ERP system, which I will talk more about shortly. We remain committed to deploying capital in a disciplined manner and only in ways that align with our strategic priorities. Now, I would like to provide an update on our remediation efforts in relation to the material weaknesses that we disclosed in our fourth quarter of 2019 filings. We, as a company, are committed to instituting best practices for financial reporting. Our management, with oversight from the audit committee, continues to work diligently to phase in our plan, and we have made substantial progress in the implementation process to date. We have implemented all the controls we laid out last quarter to address our material weaknesses and have begun rigorous testing internally.

24:54 The testing by our independent auditor is in process on certain controls and will progress on to testing the rest of the controls throughout the course of 2020. Lastly, to improve our efficiency as an organization, we successfully implemented an ERP system across our Canadian businesses, which went live in July. We have also commenced work to broaden the reach of our ERP system to our US business which is expected to be launched in the first half of 2021. The new ERP system will be a meaningful component of the internal control over financial reporting and enable us to reduce our reliance on manual controls and realize efficiencies throughout our supply chain and operations.

25:39 I continue to be encouraged by the work our teams are doing globally, both in our wholly owned business and with our JV partners. With that, I'll turn it over to Mike for closing remarks before Q&A. Thank you, Jerry. Despite unprecedented shifts in the global economy and the way we live, Kronos has remained focused on delivering on our priorities, and we are well positioned to weather the storm. We are constantly assessing our consumers' shifting needs. Whether our consumers are seeking positivity, self-care, or wellness, we remain committed to providing quality products with the level of consistency and quality that consumers have come to expect from our brands.

26:26 Our strategy, which is built on multiple growth engines, is as vital as ever. Our growing diversified portfolio of brands, which participate across geographies, channels, and categories, provide us with many ways to fuel our global business. And our asset-light model will continue to play a crucial role as we continue to scale our business. Kronos has always been a company of people that thrive in new markets, embrace change, and welcome hard problems, and by staying flexible, We are positioned to opportunistically create value as the landscape continues to shift. With that, let's now open the line for questions. Ladies and gentlemen, at this time, if you would like to ask a question, please press star followed by the number one on your telephone keypad.

27:13 If you would like to withdraw your question, press pound key. Please be advised that you are only allowed to ask one question and one follow-up question. Your first question comes from the line of Tammy Chin with BMO Capital Markets. Hi. Thanks. Morning, everyone. First question is, Mike, I think you said previously that with respect to your, you know, broader strategy, one part of it is you're sort of letting or waiting the industry kind of sort out both in Canada and even the U.S. before you embark on larger moves. So just wanted to get a sense, where are you on that? I mean, has the industry sort of started to develop or mature a bit more where you are looking at possibly making some larger moves in the business?

28:05 Sure. So, you know, when we look at, say, Canada, for example, and I'll answer the Canada and the U.S. separately, I think what we're really looking for is where our brands or unique products with Thank you for joining us. What's really important for us from a ROIC perspective is knowing that we're able to get something that hits a consumer need that we can take across borders and really be able to scale and build a moat with consumers.

28:56 I think it's still early in the product and brand launches that it's hard for us to find something that it would be better for us, at least at this point in time, to make an acquisition versus continue to just build out ourselves. The U.S., I would say, it's really more of a regulatory question at this point. I think you do see a little bit more uptick in consumer relationships with brands, but watching and being proactive about how the regulatory environment develops, and I think with a lot of the different developments around COVID likely accelerating our view of when We see legalization.

29:45 I think that brings us closer to when we would be making one or more moves in the U.S., but still, given the restrictions, it's not something that will happen immediately. My follow-up is on the Israeli market. So following your comments there, I noticed that a number of your competitors in Canada are now also moving to import into the Israeli medical market. It's actually become what seems to be more of a net importer rather than I think previously expectations were that they would be a net exporter. So I'm just wondering, does that affect your Israeli strategy given your production hub that's there and and when you talk or think about the opportunity in Israel and the size of the market, and obviously the population is smaller than Canada, so I don't know if you're able to kind of quantify how many patients are right now, what the possible size of the opportunity could be down the road.

30:45 Thanks. Sure. So, I think, you know, Israel is an exciting market and while we did originally think of it as something that would be used as an export hub, we have been Thank you for joining us. From a competitiveness on cost and price, it's difficult to see Canadian exports in the long term as being something that will continue to supply the Israeli market. For us, it's using our Canadian production to really supplement what we have there domestically right now.

31:47 I think just the conditions and the environment in Israel make it just more advantageous to produce. So I expect we'll continue to see rapid growth. I think it's too early to be able to provide any specific numbers, but I do use the analogy to Canada a few years ago, where if you go back, we were seeing a lot of growth in the medical market and there was a shortage. But now that we've been through the first readings in the Israeli parliament over a more full legalization bill, I think We look at our domestic footprint as something that will be essential and give us a big advantage when we see legalization. And again, a smaller population and while still early from a structural perspective, being able to go direct from a producer to a store without any wholesalers should make it easier to scale and from a margin perspective we would expect to be more attractive.

32:53 So I think The medical market is one aspect, and preparing for full legalization is also something that we're very focused on. Thank you. Your next question comes from the line of Raul Saragusa with Raymond James. Morning, Mike and Jerry. Thanks so much for taking my question. As you know, you know, we focus a lot on your synthetic biology program. So, Jerry, you referred to some, you know, increasing costs at Kronos Fermentation. It would be great to get an update on, you know, where those costs are being attributed, how is the scale-up going, Mike, you know, is the timeline associated with September of next year still hold?

33:40 Sure. Thanks, and good morning. So, I think the scale-up costs, and, you know, there's certainly some capex and different infrastructure requirements Making sure that we have commercial fermentation infrastructure ready, having the different security packages. These are all planned CapEx, but there is some work that was needed to do to take the facility from when it was used and still for pharmaceuticals under Apotex to converting it to be something that fits under C45 is where some of the costs are. And we've been doing a number of will continue to increase production.

34:25 So there are costs with that. But I think it's been going well, and the increase in cost is positive because it just shows we're continuing to ramp up and figure out downstream processing. So there will be costs as we build out the downstream processing trains to be able to Thank you for joining us. Great, great, and thanks, and one very quick follow-up question.

35:12 Clearly there's an expansion of your activities in the U.S., and as the regulatory environment starts to get clarified, particularly around CBD, how do you see potentially expanding or extrapolating that program into the U.S.? Yeah, it's certainly a focus of ours, and I think it's not specifically CBD. You know, there are other cannabinoids that We're again focused on, and I think that similar to Canada, we do plan to expand things. And when you look at how we're set up in the Canadian market, a lot of what we're doing is, of course, focusing on the Canadian consumer, but also trying to get learnings on how we can then seamlessly bring those products and those processes into the U.S. So the products we believe that will win in the Canadian market, I think it's just Thank you for joining us.

36:34 Being able to work with universities, being able to have the type of infrastructure that we do and do that research is very, very important. Of course, the largest consumer market being in the U.S. We are still doing our consumer research in the U.S. and focusing on developing products that ultimately will be something to meet consumer needs in the U.S. market. Great. That's very helpful. I'll throw it out there. Your next question comes from the line of Andrew Carter with Stiefel. Hey, thanks. Good morning. We're going to ask about the rest of the world business and specifically Canadian adult abuse business. Two quarters in a row where we've seen kind of the gross margin really deteriorate. And I know you mentioned lower pricing, so I guess a couple questions. Number one, when will we see kind of stability for the gross margins on this business?

37:21 And then you do employ a third party for a flower cost. Are you upside down on cost? Are you seeing flower cost ease at all? Thanks. I'll stop there on the first one. Great. Good morning, Andrew. So we're not going to provide guidance going forward on margins, but as we said in our prepared remarks, margins in the rest of the world segment will continue to fluctuate over the next year to both market dynamics and our strategy, which we believe is setting us up for long-term success. You know, I think we're confident on our asset-light model, but with that asset-light model, we're experiencing some margin pressure today. You know, with the price of third-party flour, comes down over time. Our margins will improve.

38:08 And then, you know, just in the market in general, we're seeing continued pricing pressure across the Canadian market where producers are lowering their prices and offering larger format size offerings. And then, you know, as Mike talked about in his remarks, we are ramping up Kronos Israel's business and have just begun sales in that medical market, which will have some impacts on our margins. I got it. and then kind of stepping back into kind of thinking about the Lord Jones business. It's been hit pretty hard by specialty. You've taken kind of an impairment, which means you've kind of reviewed the business. What are kind of your expectations of that business if you could provide any kind of long-term targets for that business? And, you know, does it grow in the second half or is 2020 just going to be a difficult year with all the challenges from COVID-19?

38:57 Yeah, thanks again, Andrew. You know, I think we're... And I can tell you that at the onset of 2020, we were very excited about the prospects for meaningful growth in the U.S. business. But COVID-19 pandemic has had a significant impact on many of our customers who have experienced temporary store closures, and some of them have been permanently closed, which has negatively impacted sales and demand, quite frankly, in the segment. So, you know, right now it's very difficult for us to predict what the rest of 2020 holds, because as you see stores open, in some states and localities they're having to reclose, and what you really can't figure out is what's the impact on the consumer in the short run.

39:56 Just because a store may open back up, you're not going to get the same foot traffic through the store and the interactions and the number of people allowed in stores. All right. Thanks. I'll pass it on. Your next question comes from the line of Seth Rubin with CIBC. Hi, this is Seth on for John Zanfaro. Thanks for taking my question. So I guess taking to Lord Jones, there's some signs you can offset the loss in brick and mortar through online channels, either through direct-to-consumer or online retailers. And then I have any update on Lord Jones and the CBD strategy overall would be appreciated. Yeah, thanks for the question, Seth. So, you know, while on the surface it may seem a bit disappointing that our U.S. business was flat quarter over quarter, COVID obviously had a significant impact on our brick-and-mortar sales, but I would say we did fairly well in the second quarter, having very little sales to our retail partners and focusing on our direct-to-consumer.

41:00 Now, with that, we had a lot of price promotions and discounts to drive those sales, but quarter over quarter, in spite of having such little revenue to those retail partners, and then as we look forward, I mean, We feel confident in the plans the business has to correct the trajectory of that business and are very excited to see what summer will do to lead the business forward. Great, thanks. And just a quick follow-up, if I can, just on your capital allocation strategy looking forward, do you maybe expect any significant CapEx projects in the pipeline? Yeah. We're always evaluating opportunities, but I think from the brand portfolio that we have right now, we're pretty comfortable with where we are from an infrastructure perspective.

41:51 I think outside of any acquisitions or further launches where we might want to backfill margin with CapEx, we're pretty comfortable with where we are today, so not much to be expected there. Thanks. Your next question comes from the line of Vivian Ezer with Cowan. Hi, good morning. I wanted to follow up, please, on Lord Jones as well. You know, certainly some moving pieces in the quarter in particular as we try to triangulate to a normalized gross margin. So, you know, on the one hand, you have the price reduction on your core offering, but then as well as increased promotion. But I would think With the deflation that you're seeing in the commodity market, there should be some kind of offset.

42:46 Is there any color you can offer if we try to normalize for all those puts and takes, distribution, price adjustments, and commodity deflation, what the gross profit profile would have looked like? Thanks. Thank you, Vivian. The margins in the U.S. were impacted by both components, both the revenue and the cost of goods sold in the quarter. both due to COVID and our response to that pandemic. You know, if you start with the net revenue impact, we increased discounts and promotions to our consumers in that online channel. You know, we pulsed in a lot of those 30% discounts. And then on the cost side, we paid our essential employees premium pay, which drove up our COGS. So both of those components negatively impacted margins in the quarter.

43:35 I think it's hard to predict when our margins will get back to some sort of normalcy based on the COVID pandemic and the opening of retail stores. But you're absolutely right. I mean, some of our costs will be going down. The question is, is that offset by the premium pay? And from the revenue side, what happens with the retail environment? Understood. Maybe just to follow up on that a little bit more specifically, can you contextualize What you're seeing in terms of price deflation on the input for the War Jones product? Thanks. Yeah, I think certainly we've seen prices rapidly come down, but that does take some time to actually flow through to what you're seeing on margins. You know, if you think of when, from an accounting perspective, new input would actually match the product that we're selling. We do see it coming down.

44:34 We think it could even come down further, but it takes time for us to flush through the current CBD supply we have on hand. Understood. Thank you very much. Your next question comes from the line of Michael Lavery with Piper Sandler. Good morning. Thank you. You have your Peace Plus looking like it's set to launch now in Arizona, California, Illinois, and Pennsylvania. Can you give a little sense of maybe how soon that's coming, how broad of a launch it may be, and why those states in particular? Sure. Thanks, and good morning.

45:23 Peace Plus is still something that we're monitoring the macro environment, whether regulatory or just what's happening with retail before aggressively expanding. And I think when you look at our focus for the back half of the year, we're really looking to a different brand, so Laura Jones and then a more mainstream skincare brand that would be where our attention is. Again, though, having everything ready for Peace Plus, we will be opportunistic time-wise to make sure that When we see the right timing and the right opportunity, we'll move forward with it. So is there not a set schedule just yet? There's not a set schedule.

46:10 I think it's more of a case in timing. We want to make sure that we bring our other brand to market first, and then having Peace Plus ready, we'll start rolling it out after that. Okay, and just to follow up, I know we've covered Lord Downs pretty well already, but I just want to understand the thinking behind the write-down in the sense that, you know, I think typically in a situation like that, if it's considered transitory pressure, then you wouldn't have to take the write-down. Is there something beyond the COVID-19 pressure that you're pointing to? Has your thinking on the market changed, or is it more just a It was a deep analysis that we looked at, and yeah, there are some temporary pressures, and we haven't met expectations from the original model.

47:08 And what we don't know and it's difficult to predict for us is, hey, how long does COVID last? And then how long does that impact on consumer behavior last? So yeah, I would say, yeah, we took a conservative approach. I just think Your next question comes from the line of Bill Park with MKM Partners. Your next question comes from the line of Bill Kirk with MKM Partners.

48:08 There's no response from that line. Your next question comes from the line of Matt Bottomley with Canaccord Genuity. Good morning, everyone. Thanks for taking the question. I was wondering if I could get some additional commentary on your views on brand building, specifically what's happening in the Canadian market here where retail sales are obviously continuing to grow pretty healthily, whereas there is some dynamics with what's in inventory throughout the sector and how some of your peers are pricing. So given the fact that a lot of your comparable peers out there with similar market paths, some of the larger games, have a higher penetration, what's your mix or trade-off between Having, I guess, more of a measured OpEx burn versus some of those peers versus brand building and just even selling products today at a break even just to get product out there.

49:02 You know, given that you can't really advertise and there's not much differentiation when you walk into these stores, maybe it's not much of an issue, but just curious on how you think that'll play out in the long term as Kronos was to build their own brand semantically. Sure. Thanks and good morning. So, that's a great question and You know, I think first I'll say when we think of brand building, we're thinking on a global scale. And I think that while you can't do broad advertising and you have to be very restricted, there still are ways that you can advertise. But building a brand isn't really specific just to what your packaging looks like and being able to put up billboards. And, you know, our approach to value creation, I'll use an analogy of look at, say, the tobacco industry over 100 years ago.

49:51 And if you go back and think about the early market, you can see something that's probably pretty similar to where we are today with the Canadian flower market and industry participants competing to figure out how to sell loose leaf tobacco. But the biggest value creation ultimately didn't come from who could outsell someone else in tobacco leaf. It came from researching consumer needs and being able to develop a breakthrough consumer product like cigarette. We believe the path to value creation for Kronos is similar. It's continuing to focus on what that breakthrough product is, being able to bring it to market, and not only being able to bring that product to market in Canada, but being able to then take that product and also launch it in Israel and the U.S.

50:37 and other markets as full legalization comes online. I think it's important that we do have product in market, that we have the sales manufacturing infrastructure to be able to continue having relationships so that we're ready when we have differentiated products that come out. And I think we've got the right pieces in place with the work that we've been doing since Todd joined us as Chief Innovation Officer and how we incorporate differentiation from rare cannabinoids and different form factors in the products. But I believe that building a brand off of essentially And then just on the flip side of that, Just looking at your balance sheet, which is one of the strongest in the sector, are you sort of comfortable at the current operating burn that you're at in order to fund those interim losses as you look for sort of longer-term brand building at more differentiated opportunities? Or is there a four- to six-month quarter pack where you'd like to get that to break even or above zero?

52:11 We're, you know, given, I think, the way that we're set up and what we look at as end markets versus, you know, where we are today, the focus really is on what is the longer-term return on invested capital versus, you know, when can we be cash flow positive. And I think that we are set up with a balance sheet where we can't absorb that, but, you Thank you for joining us. were going to continue to make.

53:08 Great. Thanks, everyone. Your final question comes online of Graham Cridner with 8 Capital. Yeah. Hi. Good morning. Thank you for taking my questions here. I just wanted to get a bit more color regarding the change in the different segments on the rest of world revenue quarter over quarter I saw. Thank you. Thank you. I think what you're seeing, at least Q2 of 2020 versus Q2 of 2019, is while our revenue is relatively flat, we sold all of our products in the second quarter in the Canadian marketplace, either in the rec or medical channel, whereas in Q2 of 2019, we had a large wholesale shipment. And I think you can't really look at...

54:21 The difference between extracts and flour, whether that's pre-rolls or even tincture oil and bakes on a quarter-over-quarter basis, I think there's always going to be fluctuations in the mix. Nathan, and just to add to that, I just want to point out a difference that if you're comparing us to peers, because we have our own distribution and Israeli entity, When we export from Canada to Israel, that's not something that shows up in revenue upon the export. It's once the branded product is actually sold through in Israel, that's when you would be seeing the revenue realized.

55:06 So there's a bit of a delay, but I would think of less of us exporting to Israel and more of just Israel as an operating company where you'll see revenue come from the same way you would see the Canadian revenue. and whether it's imported or produced in Canada is really just a supply chain issue. Okay, understood. I appreciate that, Keller. And then just one quick follow-up. I appreciate the commentary prior with regards to the USA segment and its fluctuations in gross margin there. When looking at the adjusted operating loss over a quarter-over-quarter basis, that actually improved by about 15%. I was hoping to get a bit more detail with respect to the flat revenues as you climb the gross margin, but the profit figure is actually increasing.

55:52 Just wondering what's driving that. Thank you. Yeah, I think a majority of that is just related to the timing issues of when we're spending our money. So, you know, we had a heavy Q1 and a lighter Q2. So I would really chalk it up to that. I think it's difficult to look at quarter over quarter in that business. Okay, thank you very much. This concludes our question and answer session for today. Thank you for your participation. You may now disconnect.