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Edited Transcript of VFF.TO earnings conference call or presentation 13-Aug-19 3:00pm GMT

Q2 2019 Village Farms International Inc Earnings Call

Delta Aug 21, 2019 (Thomson StreetEvents) -- Edited Transcript of Village Farms International Inc earnings conference call or presentation Tuesday, August 13, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Michael A. DeGiglio

Village Farms International, Inc. - Founder, CEO, President & Director

* Stephen C. Ruffini

Village Farms International, Inc. - CFO, Executive VP, Company Secretary & Director

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Conference Call Participants

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* Aaron Thomas Grey

Alliance Global Partners, Research Division - MD & Head of Consumer Research

* Andrew Partheniou

GMP Securities L.P., Research Division - Analyst

* Doug Cooper

Beacon Securities Limited, Research Division - MD and Head of Research

* Eric Des Lauriers

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* Hugh Cooper;RBC Dominion Securities;Vice President and Director

* Scott Thomas Fortune

Roth Capital Partners, LLC, Research Division - Director & Research Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen. Welcome to Village Farms International Second Quarter 2019 Financial Results Conference Call. Yesterday, after market close, Village Farms issued a news release reporting its financial results for the second quarter ended June 30, 2019. That news release, along with the company's financial statements, are available on SEDAR and on the company's website at villagefarms.com under the Investors heading.

Please note that today's call is being broadcast live over the Internet and will be archived for replay both by telephone and via the Internet beginning approximately 1 hour following completion of the call. Details on how to access the replays are available in yesterday's news release.

Before we begin, let me remind you that forward-looking statements may be made today, during or after the formal part of this conference call. Certain material assumptions were applied in providing these statements, many of which are beyond our control. These statements are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied in forward-looking statements.

As a summary of those underlying assumptions, risks and uncertainties is contained in our various securities filings, including Village Farms' current annual information form for the year ended December 31, 2018, and MD&A for the quarter ended June 30, 2019, which are available on SEDAR.

These forward-looking statements are made as of today's date and except as required by applicable securities law, and we undertake no obligation to publicly update or revise any such statements.

I would now like to turn the call over to Michael DeGiglio, Chief Executive Officer of Village Farms International. Please go ahead, Mr. DeGiglio.

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [2]

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Thanks, Jennetta. Thanks everyone, for joining us both by telephone and Internet today. With me -- joining me for today's call is our Chief Financial Officer, Stephen Ruffini. And the agenda for the call. We'll start with a review of the excellent Q2 financial results for Pure Sunfarms, which contributed to one of the best quarters in recent memory for us here at Village Farms and provide an update on steady progress of our U.S. Hemp/CBD initiatives. Steve will review our Q2 financial results in detail, return with some closing thoughts and open it up to Q&A at the end.

So starting with Pure Sunfarms' standout Q2 results, let me just say, as always for us, we will go straight to our results without deflection, no matter what they are. We're not going to start out by some of our competitors who seem to talk about opening up a small dispensary in Timbuktu or somewhere and we're proud of our numbers. So also, I want to dedicate this quarter, if there is such a thing to our villagers, our core group of loyal shareholders who've been unwavering since we entered the space and have supported the company and believe in our ability to lead the cannabis industry in Canada long and strong to them. And now the results. And if you'll just humor me for a minute, when I received these results draft numbers about 10 days ago -- for some of you, I was in Navy for about 26 years with my active reserve time. And when we did officer candidate training with the baddest Marine Corps DIs you can ever imagine, everything you did was wrong, but towards the end, if you did something right before graduation, they use the term, looky looky here. And it's kind of funny. I hadn't thought about that for many decades until I saw these numbers, and we were very proud of the performance of our Pure Sunfarms team. So looky looky here to these numbers. That's how we're going to start and bravo, salute to all the team members at Pure Sunfarms and Village Farms on these great results.

Okay. So let's start with the results. We're in the contents of Delta 3 still being in production ramp-up during this quarter, has 2 remaining quadrants. We only planted out in April as we announced Delta 3 reach full production on schedule post Q2, and I'll discuss that in a moment.

Total sales of Pure Sunfarms in Q2 and all of the numbers I discuss here are before Village Farms' 50% share. They increased 125% sequentially from Q1 to CAD 32.4 million. I want to know here that Pure Sunfarms continues to wait on its license amendment permitting sales directly to provincial, territorial and other retailers. Q2 sales were almost entirely to other licensed producers, so we realized somewhat lower pricing and we expect to achieve selling directly to provinces in the future. For competitive reasons, I won't be providing specifics around the selling price, but I will note that spot market demand remains strong and the spot market pricing continues to be attractive, and Pure Sunfarms continue to sell everything it's producing.

With respect to cost of production from day 1, we have stated our belief that Pure Sunfarms can be the low-cost producer in Canada, and the Q2 results are now providing us with continued confidence here going forward. All in all, cost of goods sold were CAD 0.65 per gram. Again, that is all-in production costs. That's down meaningful from approximately about CAD 1.35 in Q1 and works out to CAD 0.82 for the first half of the year. Steve will provide more contents around this number when he discusses the financials.

You've heard me say that in the end, the only production cost that really matters is on the last day of the fiscal year. And that's due to variations that are seasonal. But what I believe this is still the case given the intense focus on this metric by our competitors, we're providing it now additional content for the market. As Canadian market continues to develop and mature, it's become increasingly evident, as we have said all along, that being a low-cost producer of high-quality safe cannabis will be a significant advantage.

Driving primarily by the lower-cost production, Pure Sunfarms' gross margin for Q2 expanded significantly to 84% from 65% in Q1. Q2 marked the third consecutive quarter profitability for Pure Sunfarms and that's third consecutive quarter of sales and profitability. That's every quarter since our first full quarter of sales with total net income, again, before Village Farms' 50% share increasing 226% sequentially to CAD 37.2 million.

And finally, total Pure Sunfarms' EBITDA, which most notably excludes the benefit of the change in biological asset increased 194%, again, sequentially to CAD 25.2 million. That equates to an EBITDA margin of 78%, an increase of 1,900 basis points from the EBITDA margin of 59% in Q1 of this year. I want to be clear that this is true profitability based on cannabis production and sales of only cannabis products. There is nothing in these numbers artificially inflating the cost for this quarter.

Pure Sunfarms' Q2 financial results clearly rank among the largest most efficient, most profitable licensed producers in Canada. That was our initial goal before we continued on to other initiatives, including brand strategy and product development. In fact, Pure Sunfarms remains one of the few major licensed producers in Canada to report profitability, let alone, consistent profitability, and I wish to reiterate my comments about this on our last call. Based on my 30-plus years in the business, achieving profitability this quickly while still in production is a great achievement, but it's not luck. It's like the harder we work, the luckier we get, but on the other hand, this is based on experience and know-how and everything we've communicated recently in driving these numbers.

For us at Village Farms -- Pure Sunfarms' Q2 operational financial performance and achieving such levels in just 24 months since Village Farms first announced our intention to enter the cannabis space in Canada is all more -- all the more satisfying because we see it as a clear validation of a differentiated strategy. A strategy that was dismissed by many when we first announced our intention to enter the space.

Village Farms has built a best-in-class cannabis operation evidenced by these Q2 results. We have achieved this with a foundation of exceptional assets and the understanding of the value of converting existing high-performance greenhouse operations with decades of site-specific operating history, years of chronological data and most importantly, an established and trained labor workforce. Village Farms transferred our own exceptional growing and operational personnel to Pure Sunfarms and we've continued to play an integral role to support Pure Sunfarms' success.

And added the exceptional Senior Manager and now CEO, Mandesh Dosanjh and his team that he is building to drive our product and branding strategy, processing, product development in all downstream verticals. It's quite a team and very impressive. And Village Farms is playing, again, an integral role throughout bringing our 3 decades of experience in large-scale, low-cost precision agriculture to bear.

We were disruptors. In fact, when looking for a partner in entering the space to help us expedite licensing process, we turned down a number of large producers as partners, names you would well recognize because they didn't share our vision on the way to grow in the cultural side. Today, just 2 years later, Pure Sunfarms has not only caught up to the rest of the industry, but has propelled itself past most of its peers in terms of production capacity, sales and production costs, and consistent meaningful profitability despite most others having a significant head start many, many years, some even as much as 9 years and having spent tens or even hundreds of millions dollars more to start up their operations.

Pure Sunfarms has set a new bar for the industry going forward. We very much look forward to Pure Sunfarms building on the success in a number of value-driving milestones throughout the remainder of 2019 and 2020. As we announced at the beginning of July, subsequent to the quarter and year and on schedule, Pure Sunfarms achieved its full run rate production at 75,000 kilograms annually, which should be reflected in higher production sales volume for Q3 and Q4. We're very proud to note that Pure Sunfarms' Delta 3 facility is the first and only single site fully operational cannabis facility in the world in excess of 1 million square feet. According to Health Canada data, as of March 31 of this year, Pure Sunfarms' [1.03] million square feet represented 14% of the current cultivation capacity in Canada, tied for the largest in the country.

Earlier I mentioned license amendment, some refer to it as packaging license, that will now allow Pure Sunfarms to sell dry cannabis products directly to provincial and private retailers in Canada. The process has taken longer than expected. We filed in December of 2018, and while frustrating, we respect the tremendous workload of the folks at Health Canada these days. To our understanding, Pure Sunfarms has met all Health Canada criteria regarding the amendment and continues to prepare for sales and distribution to the Ontario Cannabis Store, which it has a supply agreement in place.

We expect to realize higher selling prices going forward. Pure Sunfarms is also actively engaged in discussions with other provinces around sales and distribution. We plan to rapidly expand branded sales well beyond Ontario. Yet another opportunity for sales and earnings growth going forward at Pure Sunfarms is evolution of its product offering. Most importantly, the addition of oils and other derivative products. Pure Sunfarms is making steady progress on a 65,000-square-foot state-of-the-art processing center located within the Delta 3 facility. The processing center, which will include on-site extraction capabilities and designed for full GMP compliance and certification and remains on schedule to be completed by the end of 2019 and operational as soon as possible thereafter subject to Health Canada licensing.

I mentioned earlier that pricing in the spot market remains quite favorable. Recently Pure Sunfarms has been benefiting to an even greater degree as Emerald Health Therapeutics [with] Pure Sunfarms has a supply agreement under which it committed to 40% of Pure Sunfarms' output. As it's the last part of Q2, they've been electing not to fully exercise its rights to purchase 40%. Under the agreement, Pure Sunfarms are committed to and has been selling all output that Emerald committed to, but has not purchased to other license producers in the spot market. This is clearly beneficial to Pure Sunfarms and it's realizing a price in the spot market in excess of the predetermined selling prices to Emerald's supply agreement.

As a reminder, the supply agreement, this particular one concludes at the end of the year and will be transitioned to a new agreement for up to 25% of Pure Sunfarms' production at prevailing market prices.

The unmitigated success of Pure Sunfarms today gives us tremendous amount of confidence as Pure Sunfarms moves forward with the conversion of Delta 2, the next 1.1-million-square-foot sister facility to Delta 3, which is expected to, at a minimum, double Pure Sunfarms' production output. Conversion of the external infrastructure at Delta 2 is now underway. All design and planning has been completed. And mobilization of equipment and all the technologies we need to start the process is on-site and we expect to start pulling the first half of the current crop in 2 weeks and start internal conversion. Delta 2 should begin contributing revenues as early as Q2 2020 next year and be operating at full run rate of production of an additional 75,000 kilograms minimum in Q4. Taking Pure Sunfarms totally to at least 150,000 kilograms next year. As we did with Delta 3 facility, personnel from the existing Village Farms growing, maintenance teams and most critical skilled labor force will be transitioned to Pure Sunfarms December 1. Those who are regulars to these calls have often heard me speak often about the necessity of a best-in-class growing operation to build an exceptional agricultural product brand. That was our goal for Pure Sunfarms, and I'm proud to say that we have achieved that goal. Pure Sunfarms is a best-in-class growing operation. It provides a requisite rock solid foundation upon which Pure Sunfarms can build a differentiated market-leading brand and so forth.

New hired under Mandesh's leadership brought in deep CPG experience on board. VP of Ops, Mike Lattimer, out of Labatt, Honda, PwC; Maria Guest, VP, Brand Commercial, already had a year or so in cannabis and 12 years of AB Inbev and Labatt; Richard Lenz, VP, Quality, 14 years natural health products in 3 pharma companies; Zach Barr, Director, Production, 12 years at Pepsi and so on; Adam Patterson, Spot Supply Chain Director, previous in cannabis, 10 years retail CBD companies, DAVIDsTEA, so on. And Bill Hayter, Director of Engineering, great mechanical engineer, ran his own firm. These are just a few of the key executives that are on board Pure Sunfarms recently and now will take the company to an even greater level of profitability, I'm sure.

Turning to United States and hemp/CBD business. To our U.S. Hemp program where, as a reminder, our goal is to build a vertically integrated consumer packaged goods company, growing, extracting and producing our own CBD products for big-box retail market. On our last call, I talked about our aggressive pursuit of this huge opportunity. We announced it right after legislation was passed in December, purchased $2.5 million worth of seed and went to work with a great, great partner and forming Village Fields Hemp for outdoor cultivation and CBD extraction in the southeast of the United States to start with.

During Q2, we took 2 additional major steps forward. First we expanded our outdoor hemp cultivation program to Colorado through a joint venture with Arkansas Valley Green and Gold Hemp. That's the name of the company for the excellent growing area that's located adjacent to the Arkansas river in southern Colorado. We've an outstanding partner there as well who is the founder of one of Colorado's largest licensed outdoor cannabis growing operations. Arkansas Valley has already planted out 120 acres to start this year and we expect to begin harvesting in October. It will have its own extraction, on-site extraction operations expected to be operational and processing crude CBD oil by early 2020 and looking at smokable CBD flower as well. Our other JV, Village Fields Hemp has approximately 600 acres in production in Virginia, North Carolina, South Carolina, which will begin harvesting in the coming weeks, with initial sales of hemp biomass to commence in the fourth quarter of '19. Village Fields Hemp is now well in advance planning and engineering work on its large-scale extraction operation in Georgia, which will be located on Soperton and serve the southeast U.S. operations.

These are also scheduled to be operational by the end of Q1 next year. So that's about 720 acres total production outdoors for this year.

Second major milestone with legalization of hemp and CBD in Texas. We move forward in our earnest -- in earnest our greenhouse hemp cultivation program and started conversion and advancement of half of our 1.3-million-square-foot, ultra-high-tech Permian Basin greenhouse cultivation extraction facility. We plan to start growing, extracting as soon as possible as Texas sets up regulatory framework and we can obtain the requisite licenses. So we're waiting on Texas and with Texas waiting on the USDA, as all the other states that were not approved under 2014 Farm Bill are.

We're off to a great start with our hemp and CBD programs. We're building a rock solid foundation of exceptional growing operations as we did in Canada with Pure Sunfarms that will enable Village Farms to build an exceptional brand in CBD market. Hemp biomass sales will start this year. CBD crude sales will start early next year and then we'll move to production of branded and white label CBD products formulation to our existing model to national big-box pharmaceutical companies, grocery companies as well as other retailers throughout the country.

So with Pure Sunfarms, numerous milestones throughout this year and next to drive growth in revenue and profitability in the U.S.A. There is a considerable opportunity and we are doing a lot of work in the background to support our strategy. We're very active in moving forward quickly in R&D in a number of areas, including genetic seed development, advanced growing techniques for plant -- for greater plant health and working with a number of universities in that endeavor. Plant health is key and I would say that's probably at the top echelon of why we're successful. Cannabis is a very nascent industry as we all know and the tools available for our growing operations are not there, it may be years before the regulatory process allows that. So integral is keeping your plant health up. And I firmly believe that with solid plant health, you can avoid all diseases, including mold, which many don't believe.

So enough of that for now. To conclude, Pure Sunfarms is indicative of the value of our strategy to pivot towards new outsized growth opportunities and transform the earnings potential of Village Farms. We are only able to capitalize on these significant high growth opportunities in cannabis and hemp and CBD because of the organizational strength and know-how we have amassed as one of the largest and longest operating greenhouse-grown produce businesses in North America.

As I've discussed on prior calls, produce business has been challenged in recent years, primarily due to imports from Mexico, which has significant labor cost advantages. We are pivoting with this business too, moving production in Mexico as we transition our North American greenhouse and assets of cannabis and hemp toward significantly better economic returns. There will be some short-term pain, but for the long -- but there will be long-term gain in our produce business, we work through this transition.

We've already increased some of our sales 18% this quarter out of Mexico as we start to replace that capacity like Delta 3 and soon to be Delta 2 and the Permian Basin facility. And you can see that in our results, but our produce business will emerge significantly stronger down the road, more competitive and more valuable. And clearly, the financial returns and the shareholder value both short and long-term that are being generated by our transition to cannabis and hemp are worth it.

Now I would like to turn the call over to Steve who will walk you through our financial results. Steve?

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Stephen C. Ruffini, Village Farms International, Inc. - CFO, Executive VP, Company Secretary & Director [3]

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Thanks, Mike. I'll just touch on each one of our business lines, produce, hemp and cannabis relatively quickly. First, produce. Obviously we are disappointed with our produce results. A gross loss in the quarter of $3 million is obviously disappointing, it is not the first time. Last time we had a gross loss in the quarter was the second quarter of 2012 as a result of a hailstorm, which ended the Texas crop rather quickly. In this particular instance, we've had -- as we've said, we've transitioned one of our green -- started transitioning one of our greenhouses, so that crop has been pulled. Obviously maintaining our labor force, et cetera, is extremely important, so those costs just hit our cost of sold directly.

With respect to the other Texas greenhouses, they have had various pressures throughout this growing season and the crop did not end well. As we've talked about in the past, most of our costs are fixed. We're trying to spread our costs over the full year, full crop year. With respect to the crop, when the crop doesn't end well, essentially you accelerate those costs down to 0 on June 30.

So new crop in Texas going forward, we are looking to get back to a gross profit for the rest of the year with respect to our produce. With respect to SG&A, those are corporate SG&A costs. Historically, we've put those into the produce column because we've had those historical costs. Year-on-year our SG&A increased 6%, excluding stock comp. Obviously, a year ago, we weren't on NASDAQ. A year ago, we were a foreign private issuer, we're no longer a foreign private issuer. So we are spending dollars now getting ready to be fully SEC compliant on January 1, which includes (inaudible). Obviously, when we went on NASDAQ, needless to say, our D&O insurance and other costs like that went up on a year-on-year basis. None of those have anything to do with produce, actually our direct produce SG&A has come down on a year-on-year basis.

So the incremental increases folks are seeing in our SG&A are directly related to our new business lines and that's all I'll say about that.

With respect to hemp, not much has happened in this quarter. It's relatively some SG&A costs, that's it. There won't be much in the third quarter either. The initial harvest is expected later in August and September. Obviously, those crops need to be dried. So the market should not expect any significant revenues, what have you, or any significant changes in the hemp results in Q3. And when the Q3 results come out, we'll talk about the Q4 expectations in November.

With respect to Pure Sunfarms, obviously, a very, very strong quarter as the market can see. With respect to the strong cost of sales, I tried to indicate and lead the market to that conclusion on the May conference call. I stated on the May conference call that 30% of the Q1 cost of sales were seasonal for Pure Sunfarms and that is in the form of power, in the form of electricity. Obviously, in the summer months, we don't need that.

The greenhouse growing, whether it's us or for anyone else, particularly in Canada will be seasonal. So you will see lower cost per gram of production in Q2 and Q3 than you will in Q4 and Q1. So there will be some variability in the gross margin of Pure Sunfarms due to the seasonality of those costs. Part of the improvement wasn't just the seasonal cost, it's the benefit of the ramp-up. As I stated with produce, a lot of your agricultural costs are fixed. So as you're ramping up and you're getting more revenue and more volume from the greenhouse, obviously, your cost per gram come down.

So the market should expect the Q3 cost of goods sold will benefit obviously from the continued summer production. And the market should expect that those strong cost per gram will continue with starting to see an increase in Q4. Q4 will have some winter production in its sales and will -- but we'll still also benefit from some of the summer production due to the lag time between harvest and sales. And with respect to Q1, Q1 will historically probably be Pure Sunfarms' highest cost per gram in a given quarter.

With respect to the expectations for Q3, as we discussed on the May call for Q1, the leading indicator is the bio asset. As we've done in the past, the full set of Pure Sunfarms' financials are contained in Note 7 of the Village Farms' financial statements. If one were to refer to those right now, you would see the bio asset for Pure Sunfarms on June 30 was CAD 36.4 million. The bio asset at March 31 was CAD 18.2 million. So that's a leading indicator of the third quarter being significantly stronger than the second quarter results that we've just reported.

And with that, I will turn it back over to Mike.

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [4]

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Thanks, Steve. Okay. Just to review and conclude, our Q2 results are clear evidence of fundamental transformation of the earnings potential of Village Farms. Pure Sunfarms is already making meaningful contribution to our financial results and that business is really just getting started. We expect Pure Sunfarms to deliver consistent quarter-on-quarter growth throughout this year and next driven by Delta 3 at full production capacity, anticipated start of sales to the Ontario Cannabis Store and [other] provincial, territorial and private retailers, expansion of product sales into pre-rolled and oils and other [derivative] products. Delta 2 facility coming online next year doubling the capacity there. We continue to be optimistic about the potential for Pure Sunfarms to exercise the option on the Village Farms' 2.6 million massive square foot Delta 1 facility in return and further expand production to as much as 300 kilograms -- 300,000 kilograms or more. Similarly, our hemp and CBD business well positioned to contribute near-term growth, revenue and earnings going into next year. First sales of hemp biomass later this year, sale of crude, as I said, earlier followed by our own CBD products next year. Expand outdoor cultivation next year, begin cultivation in our Permian Basin greenhouse as a start in Texas as soon as we're licensed to do so. And positioned very well for early move for this massive opportunity in U.S.A.

So with that, we'll open up the session to Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Doug Cooper with Beacon Securities.

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Doug Cooper, Beacon Securities Limited, Research Division - MD and Head of Research [2]

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Congratulations on a great quarter. And Mike gave us a great update. I just want to focus in on the cost per gram CAD 0.65 in the quarter. How low do you think that can go as you get more economies of scale through the ramp-up? And I see that a number of Canadian LPs are moving to or bringing on outdoor grow. Can you just talk about maybe how that can compare and what your thoughts are on that?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [3]

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Well, it's kind of funny, Doug. I mean every time I see a large LP announcing they're doing an outdoor grow, I shake my head because they just don't get it. It makes me think that they're just having a difficult time executing on the technology side because to me, in Canada it just doesn't make sense. Regarding the cost, I think, one -- I think we can drive our costs down. We're not saying -- we've always stuck to under CAD 1 a gram and we're sticking to that, but clearly I think our cost can be driven down and this is on flower more and more. And of course, that cost will be significantly lower as we move into oil. But we've seen some really unbelievable things based on our years of growing multiple crops. I've seen it and the team has seen it, that it's pretty unbelievable where we think we can go with the right technology. Nothing we talk about now, but I think the possibility is really great in the future to drive cost to phenomenal low going forward. And it's all centered around plant health and processes in growing. So I actually believe we can compete worldwide even if importation has opened up. But that's not tomorrow, but -- I can't give you specific numbers, but I think we can still hammer it though.

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Doug Cooper, Beacon Securities Limited, Research Division - MD and Head of Research [4]

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Right. And I guess, maybe just on the strategy side, presumably the realized prices if you were able to sell directly right now would be a couple of dollars higher per gram at least. But from a strategic perspective, once you get the ability to do so, the cost per gram that other companies have reported thus far are certainly significantly, significantly higher. You mentioned the word disruptor, how much market share would your assets enable you to have and what would be the strategy to do so to that end? You mentioned D1 there briefly. What are the plans to bring that in and how quickly can that be done? And if other companies start to have financial concerns, obviously, we have one out there right now, would there be assets out there that you would -- if you could buy them at pennies on the dollar, would that be of interest to you?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [5]

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Well, yes, we always look at an asset if it's distressed. I mean I think there's going to be a lot of assets that get repriced a couple of times over the next couple of years. I mean I said a year ago that at some point we may start the commoditization process because we feel so confident in our cost. Look, at the end of the day in Canada, the Canadian government wants to displace the illicit trade and they're not going to do that by arresting anybody who's breaking the law. They're going to do it by pricing the product to be competitive or more competitive than the black market. So that's going to set the bar on pricing. And, of course, they have to make their profit. And of course, taxes come out. So at the end of the day, the growers are all going to have to compete at this price to take out the illicit trade, that's the bar. But if our cost of production continues down, then we could start to come down and push the commoditization. And the first guy is I think at $3 plus a gram and then on the cost of production and the (inaudible). And take that additional market share. I would do Delta 1 tomorrow if I could because I know what the cost in that facility now, we have the [confidence] to be. But I think it would be hard for anybody to compete with that, especially as we move into more oils going forward because the production cost of flower is much higher than oil. So I'm very confident where we can go [in the future].

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Doug Cooper, Beacon Securities Limited, Research Division - MD and Head of Research [6]

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And I guess, maybe just my last question being you don't have -- because it's a wholesale business right now, you're not supporting brands at retail or on the SG&A costs and so forth. Once you get into your own brands, and presumably spending has to go up a little bit to do that, what do you think the long-term EBITDA -- assuming where your costs are and pricing is today, but certainly the 78% EBITDA margin is eye-popping, what should the market be thinking about in terms of long-term sustainable EBITDA margins in your view?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [7]

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Well, I would say this sets the bar for the EBITDA margin, so plus or minus a couple of percent because SG&A. Marketing in Canada is not going to be like marketing in U.S.A. It's going to be a whole different venue. It's very controlled. I mean the companies are spending all this money -- the Hollywood crowd, so to speak. You just don't get it in Canada. You're very restricted in what you can do. And Pure Sunfarms is going to roll out a great branding strategy that's based on the Pure Sunfarms brand and it's going to be really based on the quality of the product we put in the marketplace. But I don't think that cost is going to be -- is going to really move our SG&A line up because as we double production, the cost -- our overall cost for SG&A is just going to be driven down even with that initial marketing cost. We have a team in place. There's a great team fully in place today. So I think the EBITDA margin is sustainable and even as it commoditizes out, those efficiencies -- cost efficiencies, that I can see are very real going forward. And I think we could sustain these kind of numbers for foreseeable future.

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Doug Cooper, Beacon Securities Limited, Research Division - MD and Head of Research [8]

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Great. And just my last one, on the packaging license, you mentioned it in your speech at the beginning, I know it's Health Canada and you have no, I guess, ability to push them, but what is your thoughts now on when this might be delivered?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [9]

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I'm not going to say because I had talked to when we thought we would receive it and that was predicated on knowing that we're compliant and we are. As best as my knowledge, we've met all the criteria. And it was also based on the time it was taking for other competitors. I can't say what the reason is. It's out of our control. I don't know if it has to do with some of the bad actors out there. I mean CannTrust, I mean these guys should be in jail as far as I'm concerned. And when that kind of stuff happens, I would think if I was working for Health Canada, I'd be -- it would affect my trust in other companies and I'm going to kick up my processes across the board. So that could be part of what's driving it recently.

There's a lot of companies out there that have odor issues because they're located in the middle of a residential area. That's not the case with us, but that's getting traction. So I think there's a lot of different forces at work, but it's going to come. And we have everything set up to go. So, whether it's a month or 3 months, I don't think it's going to affect our ability to execute very well this year. So I'm not that worried about it. So -- but I can't say when. I'll leave that up to the government to decide.

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Operator [10]

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Your next question comes from the line of Andrew Partheniou with JMP Securities.

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Andrew Partheniou, GMP Securities L.P., Research Division - Analyst [11]

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Congrats on the outstanding quarter. I wanted to ask for the Pure Sunfarms' utilization capacity in Q2, can you give us a little bit of color on where that was? And given that in Q3, it's going to be at full production, it could be interesting to see what kind of increase in results that could mean?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [12]

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Well, I mean let's just say it was about half utilization, I can't -- I mean I know what the number is and have to look it up, but based on the licensing, we picked up a lot of our licenses in a very short amount of time between sort of December and February and then, of course, you have to propagate the plants before you get into the growing room. So I think we're about 50%. So I'd probably say that's a decent number to look at between the first half of the year and the second half of this year.

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Andrew Partheniou, GMP Securities L.P., Research Division - Analyst [13]

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Okay. That's great. And you mentioned that Emerald is not taking advantage of its 40% on its contract. Do you know -- or rather can you give a little bit of color on what kind of quantity they are buying if that's above or below what it's going to turn into at the beginning of next year?

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Stephen C. Ruffini, Village Farms International, Inc. - CFO, Executive VP, Company Secretary & Director [14]

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This is Steve. It's roughly in line with their 25% for next year. It does vary. You've got to remember Pure Sunfarms is producing fresh batches every single week. That's what it's designed to do. So depending on the batch, depending on the Emerald's product line, some instances, they're taking the full amount. And some instances, they're taking a lesser amount. But net-net, it's roughly in line with what their supply -- new supply agreement will be starting January 1. Again, it's all being -- it's all being sold, anything they pass on is all being sold at a higher price to other licensed producers.

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Andrew Partheniou, GMP Securities L.P., Research Division - Analyst [15]

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Right, right. And you guys are still planning on unveiling the brand at the same time as receiving the packaging license?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [16]

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Yes.

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Stephen C. Ruffini, Village Farms International, Inc. - CFO, Executive VP, Company Secretary & Director [17]

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Yes, that's the plan.

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Andrew Partheniou, GMP Securities L.P., Research Division - Analyst [18]

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Okay. Great. Transitioning a little bit to the U.S. market, you spoke previously about market segmentation. Maybe you can discuss a little bit on the smokable hemp flower trend that we're seeing now and given that the Texas greenhouse is probably better positioned for that and potentially outdoor cultivation like many people are doing, maybe you can give a little bit of color on how that fits into your strategy?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [19]

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Well, we're certainly looking at that. I mean it's a trend that's coming up so -- and as we said early -- in early stages of talking about differentiating the market, just say it's a 90%-10%, 90% CBD growing from hemp in the field versus 10% or 15% from a controlled environment. That -- those -- that validation for those percentages will come and this is an example of a product line that's getting traction that would work very well in a controlled environment just because we're producing 4 to 5 crops per year per section for control to keep the quality flower as far as a controlled environment versus outdoors. So yes, we had touched on that before, and I think that's an area that we're definitely going to look at going forward.

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Andrew Partheniou, GMP Securities L.P., Research Division - Analyst [20]

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I find it very interesting given I'm not sure how accurate the prices that we are seeing are, but it seems like it's 10x or above smokable flower versus biomass. So it seems like an interesting opportunity. Given that and also the progress that you guys are making in the U.S. overall, can you give a little bit of color on maybe interest of potential buyers or the prices or volumes that you might be seeing on a preliminary basis for U.S. CBD products?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [21]

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I don't think we're prepared to say that at this point in time. So I think that's a big part of our strategic focus starting here in September through the rest of the year on exactly where we want to initiate and play in what part of that space, so I think it's just too early on, Andrew, to comment.

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Andrew Partheniou, GMP Securities L.P., Research Division - Analyst [22]

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Okay. No worries. And just the last one from me, if I can put it in there, is the USDA should be coming out with regulations sometime soon. Do you have any little bit of color that you can provide on that as well in terms of timeline?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [23]

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Yes. Well, I'm really happy about the FDA and their possibility. I mean if they take longer, it's fine with me because that's allowed Village Farms -- again, we want brand rules at the end of the day, there's no doubt about it. As we look at CPG pivot here, at least in the U.S. with our assets and what we're doing in the field, that branding side is very, very important, but our concept is you've got to get the foundation right on the cultural side. And it's great to be a CPG company that has no tie to manufacturing or growing in this instance, but we don't see it that way, mainly because the genetics have not been developed yet and that will come. And at some point, it's okay to be purely a CPG company. So that said, even when it comes to regulatory processes, that gives us -- if the FDA takes another 6 to 8 months, a year, to get it right, that's helping us build this foundation over existing players in the space that are sort of coming out of the grave -- existing players in the space that have been producing before it was decriminalized in December. So we're happy about that. And I think the FDA plays an integral role in regulating the industry. So we're glad to see that happening. And if they take their time, it just gives us more time to get our ducks in order.

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Stephen C. Ruffini, Village Farms International, Inc. - CFO, Executive VP, Company Secretary & Director [24]

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Thank you, Andrew. We've got to move on to the next question.

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Operator [25]

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Your next question comes from the line of Scott Fortune with Roth Capital Partners.

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Scott Thomas Fortune, Roth Capital Partners, LLC, Research Division - Director & Research Analyst [26]

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Congrats guys on a good quarter. Real quick follow-up on Pure Sunfarms. I know you're expecting the licensing. Can you step us through on the timing as far as the rollout of the brand? And then kind of how far along are you in discussions with the different provinces outside of Ontario to begin selling at those provinces? How should we look at that?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [27]

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Yes. We're way along with the other provinces just that most of them are waiting until we have the license to commit to a contract, but that dialogue is taking place. And I think it'll happen very quickly after the license. We talk about Ontario because we do in fact have a contract with Ontario, while they are waiting to see us get our license. So that's well underway. As far as the brand strategy is in place and ready to go, Pure Sunfarms has been working all out on that for about 9 months. It's -- they're ready to go, but I think that will coincide more or less with the license coming on board. And as I said earlier, I just don't know when that's going to happen. So like everyone else, it's out of our control and every Friday, we wonder if it's this Friday, so...

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Scott Thomas Fortune, Roth Capital Partners, LLC, Research Division - Director & Research Analyst [28]

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Okay. And expanding upon that and the contraction strategy side of things, is there a percentage that you're targeting towards the cannabis 2.0? Can you step us through near-term extraction until that facility gets built out? What's the strategy from that standpoint?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [29]

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Well, we're going to stay internal because we like to control the vertical all the way through. And I think we can do it at a fairly good cost, where we're going to shoot for GMP certification on our extraction side so that, that market opens up. Even for exports, Europe at some point, we'll be ready to go there. We have everything in place to be able to start extracting by year-end, this December, depending on licensing. So I think next year we'll be rolling forward. And as the market moves and we bring on Delta 2, I wouldn't be surprised that next year we could be looking at -- it's more -- this is somewhere in the 30 -- 30% range. I think, in the future, it could be 50%, but I think 30% is probably a number I'm throwing out there. I mean the Pure Sunfarms team would probably know better, but in some of the conversations we had, that seems to be a number going forward, so...

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Scott Thomas Fortune, Roth Capital Partners, LLC, Research Division - Director & Research Analyst [30]

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Okay. And shift real quick on the U.S. hemp side, obviously, kind of the biomech is seeds and genetics are for planting next year, have you guys gone out and forward purchased seeds? And in a sense, what type of size from a harvest are you guys kind of potentially planning for the following year?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [31]

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Yes. We're not putting too many of those numbers out. I mean I could tell you we purchased when there was no seed available back -- at the end of the last year, we purchased well over $2 million. So clearly it's always on our radar screen to be ahead of the curve and we do have a number of initiatives that we haven't talked about tied to seed and genetics. Probably don't want to go there here because of competitive reasons. And I mean a lot of folks are clearly working on the genetics, but till such time that the large multibillion dollar seed companies get in the space and I don't think that's going to be too long. I think a lot of the companies have to take that burden on, we are too. We're working with some great folks, with some great universities pushing that forward. And the genetics even on the field side have to be tied to critical day length. And if you look at Texas alone as a state, I mean it's like a country, there are so many different latitudes and climates. So you have to gear those genetics to that and the same in the greenhouse and looking at percentages of CBD, and so on. So it's an exciting place to be, and of course, it creates IP if you're fortunate enough to hit on something that's the Holy Grail and that's a big focus for us. But we are looking at next year, and I think we'll be in pretty good shape.

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Operator [32]

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Your next question comes from the line of Eric Des Lauriers with Craig-Hallum Capital.

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Eric Des Lauriers, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [33]

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Congratulations on a really impressive Q2. I was wondering if I could just start with margins, obviously a great strong point for Pure Sunfarms, a little bit weaker as it relates to produce. So if I could dig in there a little bit. So on the produce side, margins impacted by decrease in production, which with a fixed cost, obviously increases the cost per pound there. So the conversion of the half of greenhouse in Texas obviously having an impact, Delta 2 as well. Could you give us a sense of how much this sort of interim period, especially as it relates to Texas -- we've no produce sales and no hemp sales, can you kind of give us a sense of how much that impacted your produce gross margins this quarter?

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Stephen C. Ruffini, Village Farms International, Inc. - CFO, Executive VP, Company Secretary & Director [34]

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This is Steve. It's not insignificant, but it's not that significant. When we're talking in hundreds of thousands of dollars, it's not that significant. The bigger issue is the end of the Texas crop. This year, we had higher expectations and essentially, you have to accelerate your -- we undercharged ourself on a per pound basis. So we have to end the crop in June 30, the crops all gone, so you have to bring all those crops off your -- off out of inventory and run them through your income statement. So it's really kind of a catch-up for costs incurred in prior periods because the crop is gone. So on a go-forward basis, as Mike side, the Delta 2 grow team will transition December 1, they're continuing to grow tomatoes, as we talked about in the MD&A. Part of it -- half of that facility will begin conversion at the end of September. So there will be some incremental, call it, overhead cost of goods incurred in the fourth quarter relating to Delta 2 that hit our books that have no revenue to generate against them, as again, we're planning on transitioning the growing team on December 1 as Mike said earlier.

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [35]

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But we can't underestimate the cost, I mean the whole company is pivoting. So a huge part of our cost is going into a different direction. And the cost of doing that over the last 2 years has all been -- it's being picked up because we report (inaudible) as a produce company. But these costs are well within a normal SG&A percentage, but at the same time, we would not incur these costs if we weren't investing in a whole new area. We haven't taken a penny of profit or cash flow that's paying for the whole Village Farms team. And a lot of us are supporting that effort within the Village Farms team, across every discipline from accounting and finance to R&D to asset development and the whole IT team, and so on, and that's supporting our joint venture partners. So it's really -- that's a significant part of that cost. And to answer your question with Monahans, as soon as we get the license, we're ready to roll, but if that happens -- we can't control the USDA. The USDA has communicated they're going to get the regulatory process right.

And if it takes 3, 4 months longer, it is, and Texas can't move to that. So -- but in the long term, it's a great move for us. So I think in Monahans, that is one of the most high-tech facilities anywhere in the world and we're going to take it to another bar. This is the time to make some technological advancements that we think will hugely pay off on the cannabis side and I'm not at liberty to talk about them, but we'll take that time to do it. So unlike other our competitors that have 110% SG&A costs and have burn rates and are losing CAD 300 million a quarter, in a way, that sort of partly outburn costs, but we're doing it with an underlying business that's supporting it. So we feel good about that, even though we're showing some negative loss to the business.

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Eric Des Lauriers, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [36]

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Got it. That makes sense. And then just one on the retail side of things. I guess so as we look at 2020, kind of assuming you have the packaging license and amended sales agreement by then, so as we look at 2020 and maybe into '21, how should we think about your target breakdown between wholesale and retail in terms of sales?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [37]

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Well, I think we kind of touched on that on the previous call, but I mean I think probably prudently, it would be around 20% differential on the pricing because I think we want to remain -- we're climbing on sort of a sweet spot where we want to be on the pricing, where we would like to see our products sold. And I think even when you hear about some -- you hear some stories that there is an oversupply, well, I don't believe that. I mean if you're trying to sell your product at CAD 14, CAD 15 a gram, there's probably an oversupply, but if it's priced right, it's that sort of every day. And as the team -- the Pure Sunfarms team will launch their concept of the brand and I'm totally on board with it, but I think that positioning is where it's at. So I don't think it'd be prudent to say we're going to see a huge 30%, 40% differential. I think it's probably more in than 20% range.

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Operator [38]

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Your next question comes from the line of Aaron Grey with Alliance Global Partners.

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Aaron Thomas Grey, Alliance Global Partners, Research Division - MD & Head of Consumer Research [39]

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Congrats on the quarter. The first question is just going to be on, you mentioned the spot market remains strong. Just wanted to get some color on where you see that going forward? And then what are you seeing in terms of the overall market supply and demand and when that might reach equilibrium?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [40]

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Well, I think it'll happen. I mean I think, looking at the competitive landscape, as we've always said, this -- at the end of the day, is farming, be it high-tech farming. And farming is not for sissies or the weary, so to speak. It's hard business and you need to be on your game 24 hours a day 365, on the edge pushing it and you need to keep that plan in balance. And I look the competitors, and I think sometimes they've taken it, it's not like any other business. I mean every business is tough, but farming is real tough. So I think that's where experience makes the difference in the know-how and being able to steer that crop and keep it healthy and performing well. It's like a finely tuned athlete, you need to be in your game healthy every single day. And when you lose that, it affects you. So I can't answer when these -- the other folks will start ramping up. I mean they've been doing it a while so I would expect soon they're going to get the numbers going. And so I really can't say, but our concept is based on everything commoditized in farming and this will too. So we're focused on our costs and being able to get a chair at the table when the music stops here.

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Aaron Thomas Grey, Alliance Global Partners, Research Division - MD & Head of Consumer Research [41]

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All right. Great. And then just touching, again, on gross margin kind of more on a long-term basis. As we kind of look at the puts and takes there in terms of long-term pricing pressure, which seems to be inevitable as you mentioned, commoditization earlier, but also upside and novel form factors, and also direct to province sales mix for you guys, how best to look at the long-term gross margin opportunity for the company, at least for Pure Sunfarms?

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Stephen C. Ruffini, Village Farms International, Inc. - CFO, Executive VP, Company Secretary & Director [42]

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Yes, again, we're excited about getting the packaging license. We expect to be able to maintain the -- improve our gross margin dollars. Our gross margin percentage because of the CAD 1 tax will decrease a little bit, but the gross margin dollars will improve. And as we get into oils and extraction, again, will be -- that facility will be up and ready operational by the end of this year. Obviously, we've got to get it licensed from Health Canada. So we should see improved margin from extraction and oils beginning hopefully early 2020. And we'll see how the other various cannabis 2.0 develops in the marketplace. Ultimately, as we're vertically integrated, we're in control and actually extraction -- extracting grade is actually cheaper to harvest because we're not dealing with all the post-harvest cost of the bud. So I think we'll certainly be able to maintain a [significant] market-leading gross margin in all aspects of all products in Canada.

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Operator [43]

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And your final question comes from the line of Hugh Cooper with RBC Financial.

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Hugh Cooper;RBC Dominion Securities;Vice President and Director, [44]

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Congratulations on a great quarter. I think most of my -- I had a few questions, which have been answered. Just wanted to say that you guys have been the one firm in the industry to underpromise and overdeliver. So it's been very, very impressive. On Delta 3, you've got -- I managed a tour there and I noticed that you have a fair amount of office space and vault and so on. Delta 2 is only going to have that small extraction processing center. So you're saying 75,000 kilograms out of each greenhouse. Some of the other LPs have said they're going to get a lot more out of their greenhouses. Is that a number that is flexible or is that a base number or are you guys just -- I don't want to cramp your style, but is that just a base number or can you increase that?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [45]

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That's the number and we're sticking to it, Hugh. Look, I think you just got to look at the bio asset, which by the way we won't be reporting when we switch to U.S. here in another quarter, but it's a great indication. And the possibilities are there. We've seen what can happen and it's pretty mind-blowing where we think we'd take it. But prudently based on our experience at some point, things happen, they always happen. It's not a question of if, it's a question of when. And we wanted to take a prudent approach with the new conversion to this crop and get 4 seasons under our belt, and it's gone very well. So Delta 2 is going to have a larger production footprint than Delta 3 as you pointed out. So right there, there's a pickup gain. So I think, yes, the answer is sure, we can get there. And I mean when others say they can get it, they haven't gotten it. So everybody is saying what they can produce, but who's doing it so far. We're meeting our criteria because we had realistic goals to set. And I think at some point, we'll update that. So I hope that answers your question.

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Hugh Cooper;RBC Dominion Securities;Vice President and Director, [46]

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It does. And just lastly, you've got -- I know you guys have a lot in your plate, but are you contemplating or looking at or you have been in any talks, discussions like joint venturing anything outside of Canada or the U.S.?

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Michael A. DeGiglio, Village Farms International, Inc. - Founder, CEO, President & Director [47]

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We can't comment on that. But Pure Sunfarms, we structured the company with the total ability to do whatever it wants anywhere in the world. So I think Pure Sunfarms with Delta 2 well on its way. It's all planned out. Construction is going to start. I think the leadership at Pure Sunfarms is clearly looking at opportunities of expansion in the space in a number of areas. They should be doing it and they are within Canada. And I think it's a very focused group. I mean they're focused on expanding operations in Canada, not only just production operations, but product innovation, many different ways. And I think if they get that going and right and they could probably look at international opportunities. Separate from Village Farms, and we're totally looking at that as well. So I think there's more to come there for sure. And as we've always said, let's get the fundamentals right. We wanted to prove that we can make profit -- consistent profit, build a sustainable durable company, profit first and then go from there. I mean honestly, I see companies every day launching IPOs and all based on the CPG pedigree within the company. And these guys are very impressive, but there are a lot of great talented executives in the CPG industry out there. And any company could bring those into this space because this space is new and growing, but it's not the same to get the fundamentals down on the farming side and the production side. You got to have right products to have a good CPG company. So we see it that way and proving profitability is where we wanted to start. Now I think it opens up a lot of opportunities for us, both for Village Farms and Pure Sunfarms.

All right. Thank you, everybody. That concludes, no more questions. And we look forward to reporting in November, and thank you so much for your interest in Village Farms. Talk to you soon. Bye. Thank you, operator.

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Operator [48]

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This concludes today's conference. You're welcome.