Canopy Growth Corp. (CGC) Q1 2021 Earnings Call Transcript

Canopy Growth Corp. (CGC 15.03%)
Q1 2021 Earnings Call
Aug 10, 2020, 10:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning. My name is Carol, and I will be your conference operator today. I would like to welcome you to Canopy Growth first-quarter fiscal 2021 financial results conference call. [Operator instructions] I will now turn the call over to Judy Hong, vice president, investor relations.

Judy, you may begin your conference call.

Judy Hong -- Vice President, Investor Relations

Great. Thank you Carol, and good morning everyone. Thank you all for joining us today. On our call today, we have Canopy Growth's CEO, David Klein; and our CFO, Mike Lee.

Before financial markets open today, Canopy issued a news release announcing our financial results for our first quarter ended June 30, 2020. The this news release is available on Canopy Growth's website under the investors tab and will be filed on our EDGAR and SEDAR profile. Before we begin, I would like to remind you that our discussion will include forward-looking statements that are based on management's current views and assumptions, and that this discussion is qualified in its entirety by the cautionary note regarding forward-looking statements that's included at the end of this morning's news release. Please review today's earnings release and Canopy Growth's reports filed with the SEC and SEDAR for various factors that could cause actual results to differ materially from the projections.

In addition, reconciliations between any non-GAAP measures to their closest reported GAAP measures are included in our earnings release furnished to the SEC and Canadian securities regulators. Please note that all financial information is provided in Canadian dollars unless otherwise noted. Following prepared remarks by David and Mike, we will conduct a Q&A session, during which questions will be taken from analysts. To ensure that we get to questions from as many as possible, we ask an to limit themselves to one question.

With that, I'll turn the call over to David. David, please go ahead.

David Klein -- Chief Executive Officer

Thank you Judy, and good morning everyone. I hope that you and your families are keeping safe and well. Although still navigating through a global pandemic, I'm proud of how Canopy has responded to challenges during this period. Since the last time we spoke, we've seen our nations rally behind social justice and racial equality which has placed to spotlight on the challenges we face as a society as these deep racial divisions are exposed.

Our thoughts and prayers go out to all of those who have been impacted by racial injustice and associated acts of violence. Canopy recognizes our responsibility to do more to increase the representation of black, indigenous and people of color employees at every level in our organization, while investing in social justice initiatives, such as providing access to legal services for communities disproportionately impacted by the cannabis prohibition. Our purpose at Canopy is improving lives, ending prohibition and strengthening communities. Recently, I signed the Black North CEO pledge to ensure that progress on this issue continues to be a top priority for our company.

The goal of the Black North CEO pledge is to address systemic racism in the boardroom, and includes having at least three and a half percent of executive and board roles in Canada held by black leaders by 2025. I see this as a vital initiative for Canopy, given the disproportionate impact cannabis prohibition has had on people of color globally. In fact, as political pressure begins to build for cannabis permissibility in the U.S., I'd like to reiterate the case for an updated federal stance on cannabis. At a time when millions are marching to dismantle systemic racism, federal cannabis legalization would represent an important departure from the decades-old war on drugs which caused unfair rates of incarceration among minorities.

We're also facing a recession caused by COVID-19. And it's estimated that the legal sale of recreational cannabis in the U.S., if legalized in all 50 states today, would generate more than $175 billion by 2025 in federal sales, business and payroll taxes and add nearly 1.6 million jobs by 2026. There is no question that our industry can be a key driver of the United States economic recovery. When we gain control of the pandemic and begin to restart the economy.

Congress seems to have recognized the same potential that we see in cannabis with bills like the MORE Act, and with momentum growing across both sides of the -- it's our vision to unleash these enjoyable and remarkably safe products for adults to consume in a responsible matter. As we expand our presence in the U.S., we will continue to contribute our knowledge in partnership with the appropriate regulatory bodies in order to ensure safe and effective standards are implemented. Now, let's discuss the progress we're making at Canopy in our quest to create a cannabis-focused leading CPG company. There are four key themes that Mike and I would like to focus on this morning.

First, Canopy is improving execution and nimbleness in Canada. We've quickly completed a rollout of our value-flower strategy. We've significantly improved our customer order fill rates. Our Cannabis 2.0 portfolio continues to gain momentum, and we're adapting quickly to the changes in the marketplace and competitive dynamics.

Second, we're improving our quality. We're enhanced -- we've enhanced the moisture content of our flower products, and we've launched a number of research initiatives to further improve our flower quality. Our commercial team continues to engage with bud tenders and staff at retail stores to drive increased awareness of our quality initiatives and consumer feedback on the quality of our cannabis beverages continues to be very positive. Third, we've got a number of exciting developments happening in the U.S.

market. We launched our new e-commerce site, shopcanopy.com in the U.S. Our First & Free brand has expanded into topicals and creams, and biosteel, ready-to-drink beverages in tetra packs are now available, just to name a few. And finally, we continue to focus on financial discipline while also investing for future growth opportunities.

Let me tie these themes and provide details on the progress we're making to the key strategic priorities I laid out during our Q4 investor call and reinforced during our virtual investor meeting. We said we're building a world-class, consumer-centric and innovation-driven company. So let me give you a few examples of the progress we're making here. We've completed a nationwide repositioning of our TWD flower including changes to price pack architecture with higher and more consistent THC ranges.

We're seeing improved sales velocity and market share performance, with our dollar share increasing nearly five points in value flower in the province of Ontario during the latest four weeks ended July 19. I know some are concerned about the growth of the value segment and potential for further price compression in the industry. So let me share my perspective on this. First, I think the value segment plays an important role in converting illicit sales into legal sales which should be positive for the broader category.

Second, we intend to use our consumer insights to create differentiated quality flower products so that we can also trade up our value consumers to our mainstream and premium products. And third, our ability to compete in all price segments will help build scale which will enhance our margins. In addition to value flower, we're seeing the process of repositioning select mainstream and premium flower brands in the market, implementing higher and more consistent THC ranges while actively engaging with bud tenders to bring awareness of our product quality. We've initiated a consumer research initiative to better understand the flower consumer including how they define overall product satisfaction and the critical elements that drive those perceptions.

This will also serve as a foundation for our design-to-value initiatives. We're implementing pricing adjustments on select vape offerings, and we'll be refining our lineup of 510 cartridges with a more focused approach. We're unleashing our innovation pipeline with our differentiated product portfolio as we now have four beverages in market and have achieved a No. 1 dollar share in beverages, accounting for 74% of all ready-to-drink cannabis beverages sold year-to-date in Canada.

In fact, we've shipped over 1.2 million units of our beverages since the end of March compared to 4.2 million units sold across all brands throughout the entire U.S. in all of 2019. We're on track to expand our market leadership in beverages with shipments of Houseplant Lemon and Quatreau CBD beverages in the coming months. In the U.S., we now have over 25 U.S.

hemp-derived CBD SKUs across our first and free, this works and biosteel brands with more to come. Storz & Bickel is seeing strong consumer pull in both Europe and expanded distribution in North America behind our differentiated Volcano Classic and hybrid vaporizers and portable vaporizers, Mighty and Crafty plus lines. In fact, Volcano Classic is celebrating its 20th -- 20-year anniversary this year, with a limited addition of gold plated volcano classics in 24 Karat Gold. And our This Works team launched a timely innovation, stress check hand sanitizers.

That was very well received in the U.K. market which we are now bringing to the U.S. market. The second area of our strategic focus is to win in our focused markets of Canada, U.S.

and Germany. Here, I'd like to take this opportunity to outline a number of exciting developments in the U.S. market, the biggest cannabis market in the world. First, we recently launched shopcanopy.com, the new e-commerce website, dedicated to a growing portfolio of U.S.

hemp-derived CBD product lines. We believe this website offers our consumers a convenient one-stop destination to explore and purchase over 25 product SKUs from brands including first and free, this works and biosteel. The site will continue to feature Canopy's new brands including the highly anticipated launch of Martha Stewart branded CBD products which will take place within the next month. Second, we're very excited about the traction biosteel is getting in the U.S.

market. biosteel's ready-to-drink non CBD hydration sports drinks have been launched in environmentally friendly tetra pack packaging and are currently available for sale online in the U.S. in addition, actively engaging with major retailers as we look to expand distribution of biosteel products across the U.S. And finally, last week, biosteel signed a multiyear partnership with Patrick Mahomes, a super bowl MVP.

Patrick joins the biosteel roster of elite athletes as a partner, and we're thrilled to have such an influential sports thought leader on the biosteel team. Turning to Acreage. We announced in June an amended plan of arrangement with Acreage that solidifies our path forward. We believe the updated arrangement which must be approved by Acreage shareholders, provides cash for Acreage to develop and grow its federally legal hemp-derived CBD business, while reducing Canopy's purchase obligation and conserving 65 million shares of Canopy Growth stock.

One will continue to target delivering profits and growth by narrowing its focus on key profitable operations. Canopy has already licensed Acreage with rights to certain Canopy IP including IP related to our beverages and vapes as well as our brands as part of the original agreement. Acreage has, in fact, launched our Tweed-branded flower in Illinois, Maine, Massachusetts in Oregon. Acreage has rights to launch Canopy's best-in-class products and brands into the U.S.

market including our cannabis-infused beverages, and we expect to hear more about this from Acreage shortly. In addition to Acreage, TerrAscend provides us with additional optionality in the U.S. THC market upon federal permissibility. TerrAscend also owns Arise Bioscience in the U.S., a leader in the production and distribution of hemp-derived health and wellness products with access to over 10,000 retail locations nationwide.

The third strategic priority for us is quality execution, and we're making progress here as we improve our execution and increase our agility throughout the organization. We've got a number of flower quality improvement programs under way based upon consumer insights. To name just a couple, we're optimizing our drying processes to raise the moisture content of our flower products. And we're also looking at maximizing aroma and terpene profiles throughout our drying and curing processes and working with sensory panels to ensure that our products align with consumer preferences.

The new organizational structure is largely complete with our product teams now organized by global product lines of flower, vapes, edibles and beverages and skin care and topicals, supported by our insights and innovation teams. The new commercial team will work closely with the product and insight teams to keep our pipeline of amazing products flowing through all of our sales and distribution channels. Our new operating model is already driving quicker decision-making and increased agility as an organization. We've made strides in our supply chain, ensuring that we can better fulfill our customer orders with the right products at the time.

Just to highlight a couple of examples. For our Canadian medical business, confidence in supply of spectrum yellow oil is at a level where we've decided to reduce the cost of this medical product by 25% for patients in need. And our beverage production has increased significantly, more than doubling from June to July and is expected to nearly double again in August to ensure we keep our beverages fully stocked at retail. Finally, we're improving our cost structure and financial discipline.

Mike will provide more details in this area, but just to highlight a few examples. Our headcount is down more than 18% since the beginning of the year. Our total opex declined by 23% compared to a year ago, and we've reduced our cash burn by more than 50% from the prior-year period. During our virtual Investor Day in June, we provided you with key metrics to gauge our progress and I'm going to update you now on how we're doing against those metrics.

First, are we winning with the consumer is measured by market share in our core markets in net sales growth year over year. In Q1, we've maintained No. 2 market share in Canada medical and No. 1 market share in German flower market.

In Canada, recreational -- we remain top three in most provinces. However, we're not satisfied with our current positioning. To that end, you will see continued improvement in flower quality and performance, continued optimization of our SKU offerings and product portfolio, improved sales and operational execution to ensure that we're continuously on shelf at retail and consumer promotional activity which builds on the strength of our Tweed, Tokyo Smoke and Houseplant brand names. Second, are we improving our execution is measured by increases in our customer order fill rates and reducing out of stocks at retail.

We made progress during Q1 with our supply attainment rates averaging 87% in Q1 versus 56% in Q4. In recent weeks, our supply attainment rates have risen above 90%. And our internal checks suggest we've reduced out of stock issues at retail, and we're looking for further improvement in this area to help us gain share, as I just outlined. Mike will address the key financial metrics in his remarks.

We know there's more work ahead of us, and we continue to expect FY '21 to be a transition year for us. But I'm confident that our renewed focus in new operating model, along with a talented team and a strong balance sheet will power our transformation into a world-class consumer-centric organization and deliver on our commitment for strong top-line growth while improving profitability. And now Mike will review our Q1 financial results.

Mike Lee -- Chief Financial Officer

Thank you David, and good morning everyone. Against a volatile macro backdrop and a continued dynamic market, Canopy delivered resilient financial performance in Q1 driven by diversified revenue sources and stronger cost discipline. In Q1, our net revenue increased 22% versus prior year. And total opex declined over 23% year on year, and capex continued to moderate both on a year-on-year basis and quarter-on-quarter basis.

Our free cash flow was an outflow of $181 million which is over 50% improvement versus prior year. And we also maintained a strong balance sheet with $2 billion in cash and short-term investments at year-end. Now let me review Q1 performance in more detail, starting with net revenue. We generated $110 million of revenue or 22% growth versus prior year.

Our global medical revenue increased 54% over the prior-year period, and we're continuing to see strong growth in both our international flower business with year-on-year growth of 181%, and and C3 with year-on-year growth of 75%, in part due to the recognition of a full quarter of revenue in Q1 of this year versus a partial quarter last year due to acquisition timing. Adjusting for the timing of acquisition, our international medical sales grew 43% on an organic basis versus a year ago. Our Canadian medical business grew 19% year over year. As we lapped last year's supply challenges, but enjoyed higher average basket sizes in Q1 of this year, in part due to pantry loading as a result of COVID-19.

But we are pleased with our continuing ability to attract and retain veteran patients. And over the past year, the number of veterans that have registered with Spectrum has increased by 77%. Revenues generated by our strategic businesses increased by 70% driven primarily by Storz & Bickel which grew 76% year over year. And the increase was driven by strong consumer pull as well as expanded distribution in the U.S.

This works and biosteel performed in line with expectations in the restricted COVID-19 environment. For biosteel, an increase in sales from our e-commerce channel was offset by a significant decline in traditional retail sales caused by the closure of many brick-and-mortar retailers in Canada due to COVID 19. But we expect improved performance from biosteel driven by the easing of COVID-19 retail restrictions in Canada as well as expanded distribution in the U.S. in coming months.

Our Canadian net revenue decreased 11% year on year, due in part to the restricted cannabis retail operating environment in response to the COVID-19 pandemic as well as increased competition. Our B2B net revenue decreased 10% over the comparison period last year with sales of new Rec 2.0 products being more than offset by declines in flower and pre-rolls driven by increased competition and decreased market share. However, our Rec B2B business saw sequential improvement through the quarter driven by four factors. First, adjustments to our cultivation planning and supply chain drove short-term; improvements in our ability to fulfill customer POs with supply attainment increasing from 56% in Q4 to 87% in Q1.

And in recent weeks, our supply attainment performance has exceeded 90%. Second, the continued rollout of our 2.0 product portfolio drove 13% of our B2B net revenue in Q1, up from 2% in Q4. Third, and as David highlighted earlier, our nimbleness to react quickly to the growing value segment drove improved performance for our value brand, TWD, starting in June with further improvement throughout the current quarter. And lastly, we believe the continued pace of retail store licensing and openings in key provincial markets, especially Ontario, contributed to increased sell in during the quarter.

And total active store count nationwide grew by 130 stores in Q1 versus Q4 with Ontario seeing 61 additional stores to now over 100 stores operating. Looking ahead, we expect the pace of store openings in Ontario over the next number of months to continue to have a positive impact on the sector sell in into that province. And the province is delivering on its commitment to license 20 stores per month, meaning we can expect an additional 100 stores to be licensed by the end of this calendar year. Moving on.

We are no longer providing our kilogram sold and average selling prices as our business shifts to a more diversified product line from flower. So let me offer you some color on price and mix impacts during Q1. Our flower B2B business saw sales decline 20% in Q1 compared to Q4 driven by a volume decline of 5% and an average selling price decline of 15%. The decline in the ASP is mainly driven by geographic mix, as product sales in Alberta were lower and product sales in Ontario were higher, as well as a migration toward higher sized package offerings.

In Q1, TWD accounted for 40% of our flower sales, up from 26% in Q4, and we expect continued declines in ASP in current quarter as we've completed our value flower price pack architecture and now are in the process of resetting prices in certain mainstream flower products. In addition, with the expectation of a large number of stores opening in Ontario over the coming quarters, we would expect it to be reflected in geographic mix shift toward Ontario that will put further downward pressure on ASPs. We plan to provide volume price/mix changes by key format beginning with our Q2 financial results. Our B2C sales decreased by 12% over the prior quarter primarily as a result of the continuation of store closures in response to COVID-19 pandemic through mid-May.

It is worth noting that since our 22 corporate stores reopened in the latter half of Q1, B2C sales have returned to pre-COVID levels. With this, let's now move on to a full analysis of gross margin for the quarter. Gross margins at 7% was below target. The biggest driver was an estimated $18 million impact related to under-absorption of fixed costs resulting from lower production output, stemming from reduced demand and our SKU rationalization activities.

Our Canadian cost structure relies heavily on throughput as we have built a large-scale infrastructure and to put this in context. We believe the current infrastructure in Canada can support growth for us to become a $2.50 billion to $3 billion business without much additional capital spending. We've already proven that we can deliver 40% plus gross margins and are confident that we will return to that level as we work toward higher capacity utilization across our facilities. Taking beverages as an example, with the robust demand we're seeing for our beverages, we are ramping up production and the throughput of our beverage facility has doubled in July from June, and we plan to double again in August.

And based on the continuing strong consumer pool we are seeing, our beverage facility could reach capacity much sooner than expected. In addition, overall cannabis legal sales are continuing to grow as more retail stores open up and new value offerings are helping to convert the illicit market. And as we capture our fair share of this industry growth, we expect further improvement in utilization of our facilities. In the meantime, we have a number of initiatives under way, both in the short-term and the medium-term that we believe will further bolster our margin performance.

In the short term, we're looking at ways to reduce our variable costs including labor. In the medium term, we are focused on further optimizing production through a full end-to-end strategy that looks at people and process, technology and infrastructure that we believe will lead to best-in-class margins over time. And we plan to share details of this project at our next earnings call. Q1 margins were also negatively impacted by an estimated $11 million charge related to manufacturing variances which included out-of-spec production that did not meet new targeted THC ranges.

In the quarter, we also recognized an inventory provision of $5 million based on revised forecasts relative to our inventory holding policies. Now, let me briefly cover our operating expenses. Overall, SG&A decreased by 7% over the comparison period last year. Sales and marketing expenses decreased 25% year on year and 44% quarter on quarter driven by a couple of factors.

First, marketing and promo expense declined by over $10 million versus the prior year due to delayed or canceled activities as a result of COVID-19 and as well as elevated spending from last year to capture retail space. Second, compensation expenses increased year over year due to higher U.S. investment, but Canada compensation expenses decreased due to headcount reductions. And relative to Q4, compensation expenses declined by $4 million following our corporate restructuring actions and the temporary furlough of corporate retail staff due to the closure of our corporate stores.

G&A costs increased by 2% year over year but decreased 18% quarter over quarter due in part to a decline in professional fees, lower facility expenses and lower travel costs. R&D expenses increased 61% year over year, mainly driven by research studies that did not begin until Q2 of last year and increased activities to support Cannabis 2.0 product development. R&D expenses decreased by 34% quarter on quarter as we are now reallocating our R&D efforts to focus on projects that have high commercial return potential with less emphasis on pharmaceutical-driven clinical trials. Stock-based compensation expense in Q1 decreased 63% versus prior year to $28.6 million, in part due to the forfeiture of options resulting from staff reductions that occurred during the quarter.

Stock-based compensation is expected to increase to approximately $45 million in Q2 as forfeitures are not expected to occur at the same level. Next, I would like to discuss free cash flow. Our free cash flow in the first quarter of fiscal '21 was an outflow of $181 million which is over 50% improvement compared to the prior year. Our working capital declined year over year due to lower inventory levels.

And importantly, we ended the quarter with inventory of $389 million, slightly down from the prior quarter. And while we have more work to do, we believe this demonstrates our effort over the past few quarters to better align our supply and demand. Capex declined to $62 million, down both on a year-on-year basis and a quarter-on-quarter basis. As you can see in our quarterly results, we are making progress against our key financial metrics that we presented at our June investor meeting.

On profitability, we delivered a reduction in SG&A load as a percentage of sales, while we are working to get back to our 40% gross margin target. And on cash flow, we achieved a decline in both working capital and capital expenditures. Before I close, I would like to offer a few key factors to consider on Q2. First, from a net revenue standpoint, we expect gradual improvement in our Canadian Rec business as store openings in Ontario should provide continued tailwind.

Our strategic businesses should continue to see solid growth from a new product launch and expanded distribution, while we expect Storz & Bickel to see more normalized growth in the second quarter. Secondly, we expect our gross margins to continue to be pressured by under absorption of fixed costs in the near-term and believe Q2 margins are likely to come in below 20%. Third, while we expect a sequential pickup in marketing expenditures and trade promotion activities as COVID-related restrictions are lifted, we expect to see additional benefit from reduced headcount as we complete our organizational review in coming months. So to summarize, we are progressing against our strategic priorities, we remain focused on strengthening our commercial and operational execution, while maintaining our financial discipline.

This now concludes my review of Canopy Growth's financials for the first quarter of fiscal '21. Operator, David and I would be happy to take questions from analysts.

Questions & Answers:

Operator

[Operator instructions] Your first question comes from Vivien Azer from Cowen. Please go ahead.

Vivien Azer -- Cowen and Company -- Analyst

Hi. Thank you. Good morning. I wanted to focus on your outlook for pricing.

David, you noted some price realignments on vapes and then layered on top of that obviously the value launch. So as we think about kind of the evolution of pricing, you got a couple of negative mix drivers. Just trying to think about kind of order of magnitude, where you think you're going to see the most pressure on the top line from the price deflation that you discussed? Thanks.

David Klein -- Chief Executive Officer

Yeah. From a top-line standpoint, Viv, I think that we'll continue to see the value flower category grow. And again, I think that is good news to the extent that we're taking share away from the illicit market, I think what we have to do at Canopy is a better job of articulating some of the differentiating characteristics of our products that sit above value, right? So I think you can see -- we will see value continue to grow. But again, I believe that's just a healthy evolution in the market.

I also just want to comment on that as well. Like the -- as we continue to work through challenges, as it relates to gross margins, our objective is to deliver that above 40% gross margin, even with a growing value segment which means we just have to evolve our production assets so that we can deliver profitably where the consumer wants to spend. And that's where -- Mike talked about the strategic review we were doing a long -- within our production footprint, that's really what we're trying to get at is the right mix adjusted production footprint so that we can deliver top-line growth by taking share from the illicit market, while at the same time, deliver the margins that we set -- that we would get to.

Vivien Azer -- Cowen and Company -- Analyst

Thanks. And if you could just comment on the vape price adjustments that you mentioned?

David Klein -- Chief Executive Officer

Yeah. I think, Viv, we still have -- the market is so young, it's -- it feels different to me than more established markets where you see a trend begin and then people have to follow. I just think that when we start looking at price-per-consumer experience, we're probably not where we need to be from a vape standpoint. And we don't think that puts a lot of pressure on our top line because we're just not all that large in vape, and we believe we have the margins to be a little bit more aggressive which is why we're going to be a bit more aggressive on 510s.

Vivien Azer -- Cowen and Company -- Analyst

That's helpful. Thank you.

Operator

Our Next question comes from Tamy Chen from BMO Capital Markets. Please go ahead.

Tamy Chen -- BMO Capital Markets -- Analyst

Yes, thanks. Good morning. Thanks for the question. I wanted to touch on the new high THC hurdles that you set on your product quality for flowers.

So when I think about your current grow assets, many are quite large and some are quite labor-intensive. And I think the focus for the company previously had been using cannabis as an ingredient for 2.0. So my question is, I mean how can these facilities I guess meet the new high THC hurdles that you've set for flower consistently at scale, and do it at better margins than you're doing now, particularly if pricing pressure continues to intensify?

David Klein -- Chief Executive Officer

Yeah, Tamy. So I think -- you might correct me if I'm wrong here, but I think like 88% of our output in the quarter was high-THC flower. So the facilities are clearly capable of producing at that level. We're also doing a lot of work around optimizing that footprint.

We'll look for some products for -- to rely maybe a bit on outdoor grow as we go forward. So I think it's less about what we're capable of producing and maybe even less about the margins in each facility. But as Mike mentioned in his comments, it's throughput. And so for us, we have to get the throughput up in our facilities through growing the top line and/or completing that strategic review of our facilities so that we have that right set of assets going forward.

But it's not really a function of being able to produce high-THC flower, now it's really dialing in the COGS. And it probably warrants a bit of a discussion about COGS that I'll tag team a little bit with Mike. We -- when I was brought in, I was asked by the board to ensure that Canopy is a multiyear growth story with a path to profitability, right? So for me, job one was to make sure that we had the appropriate output coming out of our production assets and not have so many empty shells or SKU stocking out at retail in Canada. And I think the team has responded well in Q1.

I asked them to increase quality so that we can improve consumer pull over time, and that includes the THC component, and the team has responded well, but it takes a while for that to pull-through at retail. So you're not even necessarily seeing the results of the work that we've done on shelf, at a retail yet. And then I asked them to give us a strategy to get us to best-in-class margins. That work is still under way.

And as Mike mentioned, we hope to have some things to talk about on our next earnings call. And so -- and then lastly, I also asked them to not build inventory so that we could have more attractive gross margins if we put more throughput through our plants, but we would just be building inventory. So I think that we've executed on the near-term components of the plan. I think from here is where -- we have some work to do.

And Mike, I'd like you to maybe walk through a build in your mind from where we ended in the quarter from a GP standpoint up to up to our margin target.

Mike Lee -- Chief Financial Officer

Yeah, I think really looking at the 7% gross margin reported in the quarter, I think it's easy to bifurcate out between volume impacts on lower production volume versus extraordinary activities that come back to execution. And the 7% is really a reflection of around $18 million of fixed cost absorption tied to lower volume than originally planned for the year. And when you adjust for that and look purely at what should have happened for the quarter just based on those impacts, that brought us to around 17% or 18% margin for the quarter. And we think that's a good proxy of what to expect over the next quarter or so.

As volume starts to ramp back up, we see a clear path to getting back to the high 30s that we demonstrated for Canada back in Q4. The other thing that dragged our margin down is really just executional items. So getting our pack dates right, so that we can ship product with enough shelf life before it goes to the province. There were some production challenges in terms of getting the phasing of production lined up in such a way that allowed us to provide for adequate shelf life.

So it gets back to what David's talked about, countless times which is we've got to have the right quality, and quality is a function of just not THC level and terpenes, but it's also about to have the right shelf life remaining. And that's where the complexity of our operation comes into play, and this is where the SKU rationalization is really providing us with a much simpler framework to run our supply chain off of. So my view is when you look at the supply chain in Smiths Falls, we clearly have a large-scale facility. And as this business matures, as the industry matures, the fixed cost leverage that we're expected to see here provides us not just runway to 40%, but we see going north of that over time.

Tamy Chen -- BMO Capital Markets -- Analyst

Thank you. Very helpful.

Operator

Your next question comes from Andrew Carter from Stifel. Please go ahead.

Andrew Carter -- Stifel Financial Corp. -- Analyst

Good morning. I just wanted to ask in kind of pursuing the amendment with Acreage. I appreciate the potential reduction in dilution for Canopy and the downside protection here. But the disclosed business plan from Acreage suggests just 1% of the U.S.

market, below your kind of 10% to 15%. I guess given the interest by Canopy in pursuing other options along not much work done to date by Acreage, could you help us understand the incremental commitment here of at least $87.5 million versus kind of letting this agreement run its course and potentially having full flexibility to pursue other options? Thanks.

David Klein -- Chief Executive Officer

Look, we think that Acreage, by their own admission, isn't where they want to be. They have a really strong plan to correct those shortcomings, and we feel pretty good about that plan. I'd also say, Andrew, that the original transaction left very little wiggle room in terms of outs. And so it wasn't as simple as letting it play out and walking away.

It was really the challenge for us and for the Acreage team was to really recraft a deal that would give them the maximum -- the highest probability of success because the other scenario where they they kind of limped along wasn't palatable to Acreage and their shareholders or Canopy and our shareholders. So I think it was really actually a good approach to keep Canopy with the ability to get a fast start in the U.S. upon permissibility which by the way I think, is coming faster than clearly, people thought it would maybe a year ago. And we're already seeing the benefit of having our brands in the U.S.

market, and I can't wait to get our 2.0 products in the market. So I think it was I think it was the way to create a real victory out of the original arrangement that we had with Acreage.

Andrew Carter -- Stifel Financial Corp. -- Analyst

Thanks. I'll pass it on.

Operator

Your next question comes from Bryan Spillane from Bank of America. Please go ahead.

Bryan Spillane -- Bank of America Merrill Lynch -- Analyst

Hey. Good morning everyone.

David Klein -- Chief Executive Officer

Hey Bryan.

Bryan Spillane -- Bank of America Merrill Lynch -- Analyst

I wanted to follow-up on Vivien's question earlier just about value and pricing. And I guess what I was thinking about was just, we think about the value offering, getting into the market, how do we think about just how much of that will -- the lift in market share, right. So taking share from the illicit market? And then how much of that might be offset from a trade down from the more value-added product into the value segment? So I'm just try to get an understanding of just what that trade-off might be between gaining share but also potentially it cannibalizing your existing business?

David Klein -- Chief Executive Officer

Yeah, so like it's a strange industry when you think about that. We talk about market share, but it doesn't really include the illicit market, right? So I would say what we're doing is you almost have to look at those markets side-by-side and say, if a majority of the illicit market is it is kind of price-sensitive and is already playing in value. I think we're just saying we're taking share of the value market that already exists. I also think that we're in our infancy as an industry, Bryan, in terms of trading consumers up and talking to them about the differences in -- this isn't -- there's been a lot of discussion on the cannabis space about does it end up being a commodity business? Well, this isn't -- we're not buying car parts here.

We've got consumers that are ingesting products into their bodies to create an effect, and we think that there is most definitely the ability to differentiate on quality and experience. And so I think that, yes, we're going to see the value share of the legal market approach 50%. However, I think that the real endgame here is to grow the legal market pie as big as we can, and then look to trade those consumers up which is again a little bit different than the way you might think about a normal CPG category because we -- most CPG categories don't have this big leakage into an illicit space. For me, the most important -- the most important question however is as we grow that pie, can we deliver on our margin expectations? And we believe that we can, because we'll be helped by the throughput through the facilities that we have, and we believe there's tremendous opportunity to continue to optimize through the design-to-value initiatives, the products that we offer in that value segment, and then create differentiation for mainstream and premium.

And that's -- but look, that's not going to be an overnight game which is why we're saying it's a bit of a transition year. I would argue, we've said it's a transition year for Canopy, I would argue it's a transition year for the industry while we recruit share from the illicit space.

Bryan Spillane -- Bank of America Merrill Lynch -- Analyst

All right. Thanks David. I'll pass it on.

Operator

Your next question comes from Pablo Zuanic from Cantor Fitzgerald. Please go ahead.

Pablo Zuanic -- Cantor Fitzgerald -- Analyst

Thank you. Good morning. Just on the U.S. CBD strategy, can you just try to frame it in terms of the potential impact on profitability? Obviously, it's an industry with very little barriers to entry.

You have to develop these brands out of -- besides Martha Stewart, the other brands are not so well known. So how much should that be a concern in terms of how that impacts your plans to get into a positive profitability?

David Klein -- Chief Executive Officer

Yeah. Pablo, good question because there are something like 2,700 brands of CBD in the U.S., right? So there are a lot of products out there. I think what we have the ability to do, by using brands like Martha Stewart, by using brands like even biosteel as it begins to gain traction, and This Works as it gains traction in the U.S. and First & Free.

We have the ability to make sure that we get in front of the consumer to talk about our brands. And I think you're right, low barriers to entry, but I also think that there's a lot of bad product out there. And we believe that as consumers try products like the Martha Stewart products that will be in the market over the next couple of months, they will notice a difference. It's -- there is a visible or visible an effect that you feel when you consume the Martha Stewart gummies, then you don't experience when you use many of the products in the space.

So we think there's an opportunity for the leaders in the space that have high-quality products and have the ability to kind of penetrate the consumer consciousness with names like Martha Stewart. We believe that there's a way to build a bit of a moat around ourselves and to create differentiation against the 2,700 brands that are in the space. And the other point that I would add to that is as we look to engage with major retailers, as the FDA works its way through its process and opens the door so that the major retailers come into the space, we're getting a lot of mindshare from them because of who Canopy is and our connection with constellation brands. And then we bring in things like the Martha Stewart brand name and This Works brand name, we believe that we'll be able to get a leg up on the competition that at this point is just throwing those 2,700 brands kind of against the digital wall, if you will.

Pablo Zuanic -- Cantor Fitzgerald -- Analyst

Thank you. Can I just a quick follow-up for Mike. Maybe on the Rec sales trends, very impressive in terms of you deliver I think about 5% growth in B2B sequentially compared to the guidance you've given on minus 15% through end of May. So I'm just to understand what drove that improvement.

I mean, it seems that you were able to adjust flower value flower very quickly, right? You get to 40% of your portfolio, but other things are still lagging. So just trying to get an understanding of July, August, B2B, how much has improved sequentially and where there were other factors at play, distribution, the fact that you own retail stores that are maybe better competition for your customers. Just trying to understand that because it seems that you were able to fix value very quickly but other parts need -- still need addressing?

Mike Lee -- Chief Financial Officer

Yeah. We're encouraged by what we're seeing in Q2. The consumers are coming back to the stores, the number of trips are going up. When we look at our own corporate retail, dollars per transaction is up partially due to continued stock up activity, but as consumers are trying Cannabis 2.0 products, they're actually spending more at retail.

So a lot of the fundamentals are strengthening across all of our corporate stores. And then more broadly, we think a lot of those trends are extending to the broader market. Just more trips and consumers are continuing to spend more per transaction. When we look at our own performance, a lot of it comes back to our fill rates that we talked about earlier.

We are approaching our 95% fill rate, and that was a lost opportunity for us that we spoke about at our last call. And this is just a testament to the work that we've done operationally to really build in that muscle tissue to allow us to react to purchase orders as they come through in a much faster cycle time. So look, there's still -- still lots to be done in terms of getting our fill rates up, getting in-stock rates up. A lot more stores need to be added to really mature this market, but we think Q2 is off to a good start.

Operator

Your next question comes from Matt Bottomley from Canaccord Genuity. Please go ahead.

Matt Bottomley -- Canaccord Genuity -- Analyst

Hi. Good morning. Thanks for taking the questions. Just curious if you could comment a little more on where you see the beverage market going? particularly, in the Canadian market for THS-infused? Given what we've seen in the U.S., it's a very small percentage of the market share for these sort of 2.0 type products, but it's not really formulated product down there.

So two parts to the question. One, where is the market right now with respect to the percentage of the overall retail dollars that we're seeing? I imagine it's still pretty nascent, but just curious if you have a range of what percentage beverages are? And where do you see that going relative in the U.S., given that you've started on a pretty good foot year-on-year rollout?

David Klein -- Chief Executive Officer

Yea. So Matt, I'll take part of it and Mike can fill in maybe where I missed because as a recovering beer guy, I love the trends that we're seeing in the drinks market in Canada. We're still sourcing a majority of our consumers from existing cannabis users which makes a lot of sense, right? Because you have to make a decision to go into a dispensary and buy the product and take it home. We're getting all kinds of anecdotal evidence of people bringing it home and finding that, it typically ends up being the mother in law.

But the mother in law is trying the product, hasn't been a cannabis user, decides that it makes them feel great and maybe they're sleeping better than they ever have in the last 10 years, right? And so they're starting to order from some of the web delivery platforms like and an OCS. We're hearing all kinds of stories like that. And -- so then I say, like a lot of the data that we have on the percentage of the market that ends up in a 2.0 product like drinks is maybe skewed a little bit because it's only considering the current cannabis user. So as we look to expand that market and you say, OK, in Canada, and I'll be off a little bit with these numbers, they're like 240 million cases of beer sold, that's about -- that's more than 5 billion units.

And remember, when we talk about our drinks, we're not talking about cases. We're talking about units. And so we said we've shipped 1.2 million units. There's an awful lot of units to be had by sourcing a small share from the beer market, as an example.

So I think trend is upside. It will be a slow build though right? Because we'll -- I think we'll bring in those cannabis -- the current cannabis users sooner than later, but that might be the lower percentage that people see when they look at the estimates for how big of a percentage drinks can be. Because again, you're going to have experienced users that are going to want to use different delivery methods. But growing that noncurrent cannabis user into the cannabis drinks space just looks like it's a just a tremendous opportunity.

Quite frankly, larger than the opportunity that I expected when I was part of Constellation, and we made the investment in Canopy. So again, I think the opportunity is bigger than we thought.

Mike Lee -- Chief Financial Officer

And just to build on it, David, we're around an 80% share today with four SKUs in the market. It's around 3% to 4% of industry share. And we're having out of stocks today. So we don't really know what the potential is yet.

What we do know is that we're scaling up production really quickly. For folks that came to Analyst Day last December, I think we quoted 19.5 million cases of capacity off of a -- our cans of capacity off of a single shift. So we know that we can double, maybe triple that based on demand without jeopardizing quality. So we're pushing it as much as we can.

We've got very attractive price points out in the market. And now it's just a distribution and fulfillment game.

David Klein -- Chief Executive Officer

And by the way, we're not done, right? So we have more drinks coming to market, and our innovation team is working like around the clock to understand what is the next version, what is the next-generation of our drinks product so that we continue to stay ahead?

Matt Bottomley -- Canaccord Genuity -- Analyst

That's all very helpful. Thank you. And has the government come back at all with potentially changing the equivalence grams that are in these beverages? Because I would guess that you can't really start selling two or fours of these things until that gets amended.

David Klein -- Chief Executive Officer

Yeah. Look, I think there is some support of it, especially in the provincial organizations that sell the product. I just think it's going to, like anything, when you're dealing with the regulatory environment, it's going to take some time to change.

Mike Lee -- Chief Financial Officer

We're working on it. Yeah.

Matt Bottomley -- Canaccord Genuity -- Analyst

Thanks.

Operator

Your next question comes from John Chu from Desjardins Capital Markets. Please go ahead.

John Chu -- Desjardins Capital Markets -- Analyst

Hi. Good morning. I just wanted to follow-up on the comment made earlier about net revenue gradually improving in the Canadian Rec market with more store openings. So when I reflect, you've got your 22 corporate stores that are now fully open for the upcoming quarter.

Your beverage production capacity doubled in July and again in -- expected to do that in August. So that seems to be going well. You've got a national rollout out of the value brand, better fulfillment and then the 2.0 in general. So I'm just kind of curious on just the gradual improvement.

And also obviously you got more stores in Ontario and in DC as well. So kind of thought it would have been maybe a bit more accelerated growth in the coming quarters and just more gradual. Can you comment on just how you might see all those factors coming into place in the next couple of quarters?

Mike Lee -- Chief Financial Officer

Yeah, John. So look, what we've been pleasantly surprised by is stores continuing to open even during a pandemic and our latest estimate is that by the end of calendar year, we could be in excess of 1,200 stores across Canada. So we're continuing to ramp up for that. As we dial in our supply chain and continue to perform in terms of PO fulfillment, as we continue to perform in terms of Cannabis 2.0 execution, more beverages, more chocolates, more vape out in the market.

As we continue to round off our value offerings and as we continue to improve quality across the board, we see a lot of tailwind heading into the next six to nine months. What we don't know is what the outcome of the pandemic is going to be. And we know that there's potentially some solutions coming over the next six to nine months. But in the meantime, this has been a pretty good defensive play.

Consumers are still spending on cannabis. And with more stores coming, we think that's going to continue to open up the market. And I know that there's lots of questions around the future of pricing and value and all of that, but we believe that it's growing the market, and we believe that we've got the production capability that's going to demonstrate real strong potential as we build toward that market. So all signs are good for Q2.

And balance of the year is really just going to be a function of those stores continuing to open.

Operator

Your next question comes from Doug Miehm from RBC Capital Markets. Please go ahead.

Doug Miehm -- RBC Capital Markets -- Analyst

Thanks very much, and good morning. My question just has to do with, what is your market share right now in the value market? What is it change from, like if we talked about that -- those 5 percentage points? And then related to that, what I'm curious about is, is it more important for the company to fill its cultivation sites in terms of absorption that $18 million or is it more important to fill the drinks distribution and manufacturing site?

Mike Lee -- Chief Financial Officer

Yeah. Look, I'll take a stab at this. And David, you can jump in. So two things.

On market share, we are seeing improvements in market share. Quite generally I would say we hit a trough in the April, May time frame. And as we look at recent trends on share across the provinces that we can actually calculate market share for, we do see an uptick across Canada in terms of Ontario, Quebec, Alberta, DC, and we're confident that that uptick is going to continue for all the reasons I cited at the last question. In terms of utilization of facilities, it's an interesting situation in Canada today because so many LPs have such a surplus across their system.

We've taken the steps of getting our supply chain in balance. And we know that in the short run, that might impair our gross margin performance as we experience lower utilization levels. And we also know some of our competitors are taking a different path which is still continuing to operate at high utilization levels, but producing perhaps three or four times their sales each quarter in their harvest which puts all that on their balance sheet, and that's going to come back at some point In terms of surpluses. So we feel good in that we're balanced from a supply and demand perspective.

We know that we've got continued opportunity to continue to improve our margins. And we think the priority right now is to maintain a balanced supply chain versus just filling up facilities to keep our economies of scale going. So that's the path that we're taking. And again, we continue to believe that the next six to nine months for this industry are going to be very positive in terms of store counts.

Cannabis 2.0 continues to build interest in this space, and we think that we are well positioned to take advantage of that over the next six to nine months.

Operator

This concludes the question-and-answer portion of the call. And I would now like to turn it back to Mr. Klein for final remarks.

David Klein -- Chief Executive Officer

Yeah. Thank you again for joining us. We look forward to sharing further progress in the coming months. In the meantime, I hope all of you will try our amazing products, visit our Tokyo Smoke and Tweed stores, explore our shopcanopy.com website.

From there, you can go to our biosteel and This Works website. There are just some truly amazing products out there, and we hope that that they will help you understand the future of Canopy and the future of cannabis. So I encourage you to do that. Our investor relations team will be available to answer any additional questions.

Have a great day, everyone.

Operator

[Operator signoff]

Duration: 65 minutes

Call participants:

Judy Hong -- Vice President, Investor Relations

David Klein -- Chief Executive Officer

Mike Lee -- Chief Financial Officer

Vivien Azer -- Cowen and Company -- Analyst

Tamy Chen -- BMO Capital Markets -- Analyst

Andrew Carter -- Stifel Financial Corp. -- Analyst

Bryan Spillane -- Bank of America Merrill Lynch -- Analyst

Pablo Zuanic -- Cantor Fitzgerald -- Analyst

Matt Bottomley -- Canaccord Genuity -- Analyst

John Chu -- Desjardins Capital Markets -- Analyst

Doug Miehm -- RBC Capital Markets -- Analyst

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