Good morning, ladies and gentlemen. Welcome to Village Farms International's 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 Investor 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.
Thanks, Annetta. 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. 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 the 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 our Q&A at the end. 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 somewhere. We're proud of our numbers. Also I want to dedicate this quarter, if there's 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. Now the results. If you'll just humor me for a minute. When I received these results, the draft numbers about 10 days ago, for some of you, I was in the 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.
Towards the end, if you did something right before graduation, they used the term, "Looky, looky here." It's kind of funny, I hadn't even thought about that for many decades till I saw these numbers. We were very proud of the performance by our Pure Sunfarms team. Looky, looky here to these numbers. That's how we're going to start, and bravo zulu to all the team members at Pure Sunfarms and Village Farms in these great results. Okay. Let's start with the results around the contents of Delta-3 still being in production ramp-up during this quarter, as the two remaining quadrants were only planted out in April, as we announced Delta-3 reached full production on schedule post Q2, and I'll discuss that in a moment.
Total sales for Pure Sunfarms Q2 and all other numbers I discuss here are before Village Farms' 50% share. They increased 125% sequentially from Q1 to CAD 32.4 million. I want to note 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 than 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 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 one, 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 was CAD 0.65 per gram in Canadian currency. Again, that is all-in production cost. That's down meaningful from approximately CAD 1.35 in Q1 and works out to CAD 0.82 for the first half of the year. Steve will provide more context 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. while I believe this is still the case, given the intense focus on this metric by our competitors.
We are providing it now for additional content for the market. As the 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. Driven primarily by the lower cost of production, Pure Sunfarms' gross margin for Q2 expanded significantly to 84%, from 65% in Q1. Q2 marked the third consecutive quarter of profitability for Pure Sunfarms, and that's the 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. 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 our 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. 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 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 climatological 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 have continued to play a critical role to support Pure Sunfarms' success. Added the exceptional senior management and our CEO, Mandesh Dosanjh, and his team that he's building to drive our product and branding strategy, processing, product development in all downstream verticals. It's quite a team and very impressive. Village Farms has played, again, a critical role throughout, bringing our three 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 the 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 on the cultural side. Today, just two 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 years, some even as much as nine years, and having spent tens or even hundreds of millions of CAD 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 a success and 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-end 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. I'm 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 1,000,000 square feet. According to Health Canada data, as of March 31st 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 the license amendment, some refer to as a packaging license, that will 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. Expect to realize higher selling prices going forward.
Pure Sunfarms is also actively engaged in discussions with other provinces around sales and distribution, with plans 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 whom Pure Sunfarms has a supply agreement under which it committed to 40% of Pure Sunfarms output, has since the last part of Q2 been electing not to fully exercise its right to purchase 40%. Under the agreement, Pure Sunfarms is committed to and has been selling all output that Emerald committed to but has not purchased to other licensed 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 of the 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 to date gives us tremendous amount of confidence as Pure Sunfarms moves forward with the conversion of Delta-2, the next 1.1 million sq ft 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. Mobilization of equipment and all the technologies we need to start the process is on-site. We expect to start pulling the first half of the current crop in two 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 1st. 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, 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 hires under Mandesh's leadership, broad and deep CPG experience on board. VP of Ops, Mike Latimer, out of Labatt's Honda, PwC. Maria Guest, VP Brand Commercial, already had a year or so in cannabis and 12 years of AB InBev and Labatt's. Richard Lanthier, VP Quality, 14 years natural health products and three pharma companies. Zach Farr, Director of Production, 12 years at Pepsi and so on. Adam Patterson, Supply Chain Director, previous in cannabis, 10 years retail CBD companies, DAVIDsTEA , so on. Bill Hare, Director of Engineering, a 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 the 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, 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 near CAD 2.5 million worth of seed and went to work with a great partner in forming Village Fields Hemp, for outdoor cultivation and CBD extraction in the Southeast of the United States to start with. During Q2, we took two 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 have an outstanding partner there as well, who's 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 be 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 2019.
Village Fields Hemp is now well advanced planning and engineering work on its large-scale extraction operation in Georgia, which will be located in Suwanee and serve the Southeast U.S. operations. These are also scheduled to be operational by the end of Q1 next year. That's about 720 acres total production outdoors for this year. Second major milestone, with the legalization of hemp and CBD in Texas, we moved forward in our earnest, our greenhouse hemp cultivation program and start a 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 and extracting as soon as possible as Texas sets up regulatory framework, and we can obtain the requisite licenses.
We're waiting on Texas, and with Texas waiting on the USDA, as all the other states that were not approved under the 2014 Farm Bill are. We are 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 the CBD market. Hemp biomass sales will start this year. CBD crude sales will start early next year. we'll move to production of branded and white label CBD products formulation through our existing model to national big box pharmaceutical companies, grocery companies, as well as other retailers throughout the country. with Pure Sunfarms, numerous milestones throughout this year and next to drive growth and revenue and profitability in the USA.
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 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. Integral is keeping your plant health up. I firmly believe that with solid plant health, you can avoid all diseases, including mold, which many don't believe. 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 have 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 to Mexico as we transition our North American greenhouse and assets to cannabis and hemp for significantly better economic returns. There'll be some short-term pain, but there will be long-term gain in our produce business as 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. You can see that in our results. Our produce business will emerge significantly stronger down the road, more competitive and more valuable. 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'd like to turn the call over to Steve, who'll walk you through our financial results. Steve?
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 on the quarter of CAD 3 million is obviously disappointing. It is not the first time. Last time we had a gross loss in a quarter was the second quarter of 2012 as a result of a hailstorm which ended the Texas crop rather quickly. In this particular instance, as we've said, we've started transitioning one of our greenhouses, so that crop has been pulled. Obviously, maintaining our labor force, et cetera, is extremely important. Those costs just hit our cost of goods 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 cost over the full crop year with respect to the crop. When the crop doesn't end well, essentially you accelerate those costs down to zero on June 30th. 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-over-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. We are spending dollars now getting ready to be fully SEC compliant on January 1st, which includes Sarbox.
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. the incremental increases folks are seeing in our SG&A are directly related to our new business lines. that's all I'll say about that. With respect to hemp, not much has happened in this quarter. 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 in September. Obviously, those crops need to be dried, so the market should not expect any significant revenues or what have you, or any significant changes in hemp results in Q3. when the Q3 results come out, we'll talk about the Q4 expectations in November.
With respect to Pure Sunfarms, obviously, a very strong quarter as the market can see. With respect to the strong cost of sales, I try 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. You will see lower cost per gram of production in Q2 and Q3 than you will in Q4 and Q1. 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. as you're ramping up and you're getting more revenue and more volume from the greenhouse, obviously your cost per gram come down. the market should expect the Q3 cost of goods sold will benefit obviously from the continued summer production. 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 we'll still also benefit from some of the summer production due to the lag time between harvest and sales. with respect to 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 seven 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 30th was CAD 36.4 million, that's Canadian. The bio-asset at March 31st was CAD 18.2 million. That's a leading indicator of the third quarter being significantly stronger than the second quarter results that we've just reported. With that, I will turn it back over to Mike.
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 Sun Farms already making meaningful contribution to our financial results, and that business is really just getting started. We expect Pure Sun Farms 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-roll 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 Sun Farms to exercise the option on the Village Farms' 2.6 million massive square foot Delta-1 facility and return and further expand production to as much as 300,000 kilograms or more.
Similarly, our hemp and CBD business is well-positioned to contribute near-term growth revenue and earnings going into next year. First sales of hemp biomass later this year, sales of crude, as I said earlier, followed by our own CBD products next year. Expand outdoor cultivation next year. Begin cultivation of permanent basin greenhouses that start in Texas as soon as we're licensed to do so, and positioned very well to really move for this massive opportunity in the USA. With that, we'll open up the session to Q&A. Operator.
At this time, if you would like to ask a question, please press star, then the number one on your telephone keypad. Again, that is star one to ask a question. We'll pause for just a moment to compile the Q&A roster. Your first question comes from the line of Douglas Cooper with Beacon Securities.
Hi, good morning, guys, and congratulations on a great quarter. Mike, that was a great update. I just want to focus in on the cost per gram and 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? 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 around that?
Well, it's kind of funny, Doug. 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 you're 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, 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. Clearly, I think our costs will be driven down, and this is on flower more and more. Of course, that cost will be significantly lower as we move into oil. 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 costs to phenomenal low going forward. It's all centered around plant health and processes in growing. I actually believe we can compete worldwide, even if importation is opened up. That's not tomorrow. I can't give you specific numbers, but I think we can still hammer it down. </edited_transcript
Right. 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. 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 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 is the plan to bring that in, and how quickly can that be done?
If other companies start to have financial concerns, obviously we have one out there right now, would there be assets out there that, if you could buy them at pennies on the dollar, would that be of interest to you?
Well, you have to always look at an asset if it's distressed. 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 said a year ago that at some point we may start the commoditization process, because if we feel so confident in our costs. 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. That's going to set the bar on price. Of course, they have to make their profit. Of course, taxes come out.
at the end of the day, the growers are all going to have to compete at this price to take out the illicit trade, and that's the bar. if our cost of production continues down, then we could start to come down and push the commoditization. the first guys I think out are CAD 3 plus a gram, and then on the cost of production and the tubes, and take that additional market share. I would do Delta one tomorrow if I could, because I know what the cost of that facility now, we have the confidence could be, and I think it'd be hard to anybody compete with that, especially as we move into more oils going forward, because that production cost of flower is much higher than oil. I'm very confident where we can go in the future.
I guess maybe just on my last question being, because it's a wholesale business right now, you're not supporting brands at retail or on the SG&A cost 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?
Well, I would say, this sets the bar for the EBITDA margin, so ± a couple of %, because SG&A, marketing in Canada is not going to be like marketing in U.S. It's going to be a whole different venue. It's very controlled. Companies that are spending all this money, the Hollywood crowd, so to speak, I just don't get it in Canada. You're very restricted in what you can do. 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. I don't think that cost is going to really move our SG&A line up, because as we double production, 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. I think the EBITDA margin is sustainable, and even as it commoditizes out, those cost efficiencies that I can see are very real going forward, and I think we could sustain these kind of numbers for the foreseeable future.
Great. 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?
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. To the best of 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, can't trust. These guys should be in jail as far as I'm concerned. When that kind of stuff happens, I would think if I was working for Health Canada, it would affect my trust in other companies, and I'm going to kick up my processes across the board. 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. I think there's a lot of different forces at work, but it's going to come. We have everything set up to go. Whether it's a month or three months, I don't think it's going to affect our ability to execute very well this year. I'm not that worried about it. I can't say when. I'll leave that up to the government to decide.
Okay. Right.
Thanks, guys.
Okay. That's it for me. Thanks, guys.
Your next question comes from the line of Andrew Partheniou with GMP Securities.
Hi, and thanks for taking my call, and congrats on the outstanding quarter. I wanted to ask, for the Pure Sunf arms utilization capacity in Q2, can you give us a little bit of color on where that was? given that in Q3 it's going to be at full production, could be interesting to see what kind of increase in results that could mean.
Well, let's just say it was about half utilization. I know what the number is. I'd have to look it up. Based on the licensing, we picked up a lot of our licenses in a very short amount of time between December and February. Then, of course, you have to propagate the plants before you get into the growing room. I think we were about 50%. I would probably say that's a decent number to look at between the first half of the year and the second half of this year.
Okay. That's great. Thank you. 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?
This is Steve. It's roughly in line with their 25% for next year. It does vary. You got to remember, Pearson Farms is producing fresh batches every single week. That's what it's designed to do. depending on the batch, depending on Emerald's product line, some instances they're taking the full amount. In some instances, they're taking a lesser amount. net, it's roughly in line with what their new supply agreement will be starting January 1st.
Fantastic. Thanks for that.
Again, it's all being sold. Anything they pass on is all being sold at a higher price to other licensed producers, so.
Right.
Okay.
you guys are still planning on unveiling the brand at the same time as receiving the packaging license?
Yes.
Yes.
That's the plan.
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. Given that the Texas greenhouse is probably better positioned for that than potentially outdoor cultivation like many people are doing, maybe you can give a little bit of color on how that fits into your strategy.
Well, we're certainly looking at that. It's a trend that's coming up. As we said, in early stages of talking about differentiating the market, just say it's a 90/10, 90 CBD grown from hemp in the field versus 10 or 15% from a controlled environment, that validation for those percentages will come. 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 four to five crops per year per section, the control to keep a quality flower as far as a controlled environment versus outdoors. Yeah, we had touched on that before, and I think that's an area that we're definitely going to look at going forward.
I find it very interesting given, I'm not sure how accurate the prices that we're seeing are, but it seems like it's 10 times or above smokable flower versus biomass. 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?
I don't think we're prepared to say that at this point in time. 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 and what part of that space. I think it's just too early on, Andrew, to comment.
Okay, no worries. Just the last one for 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?
Yeah. Well, I'm really happy about the FDA and their possibility. If they take long, 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 a CPG pivot here, at least in the U.S. with our assets and what we're doing in the field, the branding side is very important. Our concept is you got to get the foundation right on the cultural side. 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. At some point, it's okay to be purely a CPG company.
That said, even when it comes to regulatory processes, if the FDA takes another six, eight 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 gate, existing players in the space that have been producing before it was decriminalized in December. We're happy about that, and I think the FDA plays an integral role in regulating the industry. We're glad to see that happening and if they take their time, just gives us more time to get our ducks in order.
Thanks, Andrew. We got to move on to the next question.
Your next question.
Thanks for the time.
All right. Thanks, Andrew.
Your next question comes from the line of Scott Fortune with Roth Capital Partners.
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 it at those provinces? How should we look at that?
Yeah. We're way along with the other provinces, just that most of them are waiting till we have the license to commit to a contract. that dialogue has taken 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're waiting to see us get our license. that's well underway. As far as the brand, the brand strategy's in place and ready to go. Pure Sunfarms has been working all out on that for about nine months. They're ready to go, but I think that'll coincide more or less with the license coming on board. as I said earlier, I just don't know when that's going to happen. like everyone else-
Right
it's out of our control, and every Friday we wonder if it's this Friday, so.
Okay. expanding upon that and the extraction strategy kind of side of things, is there a percentage that you're targeting towards the Cannabis 2.0? Kind of step us through near term extraction until that facility gets built out. What's the strategy from that standpoint?
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. We're going to shoot for GMP certification on our extraction side so that market opens up. Even for export to 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. I think next year we'll be rolling forward. As the market moves, and we bring on Delta 2, I wouldn't be surprised that, next year, we could be looking at this is somewhere in the 30% range. I think in the future it could be 50%, but I think 30% is probably a number I'm throwing out there.
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.
Okay. Shift real quick. On the U.S. hemp side, obviously kind of the bottleneck is seeds and genetics for planting next year. Have you guys gone out and forward purchased seeds and since what type of size, from a harvest are you guys kind of potentially planning for the following year?
Yeah, we're not putting too many of those numbers out. I could tell you, we purchased, when there was no seed available back at the end of last year, we purchased well over CAD 2 million. Clearly it's always on our radar screen to be ahead of the curve. 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. A lot of folks are clearly working on the genetics, but till such times that the large, multi-billion 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 and some great universities pushing that forward.
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, it's like a country. There are so many different latitudes and climates. you have to gear those genetics to that, and the same in the greenhouse and looking at percentages of CBD and so on. 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. we are looking at next year, and I think we'll be in pretty good shape.
Your next question comes from the line of Eric Des Lauriers with Craig-Hallum Capital.
All right, great. Thanks for taking my questions, guys, and congratulations on a really impressive Q2.
Thank you.
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. If I could dig in there a little bit. On the produce side, margins impacted by decrease in production, which, with the fixed costs, obviously increases the cost per pound there. The conversion of the half the 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 have 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?
This is Steve. It's not insignificant, but it's not that significant. We're talking 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. Essentially, we undercharge ourselves on a per-pound basis. At the end of the crop, end of June 30th, that crop's all gone, so you have to bring all those costs out of inventory and run them through your income statement. It's really kind of a catch-up for costs incurred in prior periods because the crop is gone. On a go-forward basis, as Mike said, the Delta Two grow team will transition December 1st. They're continuing to grow tomatoes, as we talked about in the MD&A part of it. Half that facility will begin conversion at the end of September.
there will be some incremental, call it overhead cost of goods, incurred in the fourth quarter relating to Delta Two that hit our books that have no revenue to generate against them. As again, we're planning on transitioning the growing team on December 1st, as Mike said earlier.
We can't underestimate the cost. The whole company is pivoting, so a huge part of our cost is going into a different direction. The cost of doing that over the last two years, it's being picked up because we report still as a produce company. These costs are well within a normal SG&A percentage. 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. 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. Supporting our joint venture partners. That's a significant part of that cost.
To answer your question with Monahans, as soon as we get the license, we're ready to roll. We can't control the USDA. The USDA has communicated, hey, they're going to get the regulatory process right. If it takes three, four months longer, it is, and Texas can't move till that. In the long term, it's a great move for us. I think, and on 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. I'm not at liberty to talk about them, but we'll take that time to do it.
unlike other competitors that have 110% SG&A costs and have burn rates and are losing CAD 300 million a quarter, in a way, that's sort of partly our burn cost, but we're doing it with an underlying business that's supporting it. Feel good about that, even though we took some negative loss with pivot.
Got it. That makes sense. then just one on the retail side of things. I guess as we look at 2020, kind of assuming you have the packaging license and amended sales agreement by then. as we look at 2020 and maybe into 2021, how should we think about your target breakdown between wholesale and retail in terms of sales?
Well, I think we kind of touched on that on the previous call. I think probably prudently would be around 20% differential on the pricing. Because I think we want to remain. We're carving out sort of a sweet spot where we want to be on the pricing, where we would like to see our product sold. I think even when you hear some stories that there's an oversupply, well, I don't believe that. If you're trying to sell your product at CAD 14, CAD 15 a gram, there's probably an oversupply. If it's priced right, it's that sort of every day. As the team, the Pure Sunfarms team will launch their concepts and brand, and I'm totally on board with it. I think that positioning is where it's at.
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 be more in that 20% range.
Your next question comes from the line of Aaron Grey with Alliance Global Partners.
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 call 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?
Well, I think it'll happen. I think, looking at the competitive landscape, as we always said, this, at the end of the day, is farming, being 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. I look at the competitors and, I think sometimes they've taken it. It's not like any other business. Every business is tough, but farming's real tough. I think that's where experience makes a difference and the knowhow, 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. When you lose that, it affects you.
I can't answer when the other folks will start ramping up. They've been doing it a while, so I would expect soon they're going to get the numbers going. I really can't say, but our concept is based on everything commoditized in farming, and this will too. We're focused on our costs and being able to get a chair at the table when the music stops here, so.
All right. Great. Thanks. 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 in 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.
Again, we're excited about getting the packaging license. We expect to be able to 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. As we get into oils and extraction, again, 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. We should see improved margin from extraction and oils beginning, hopefully early 2020. 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 grade is actually cheaper to harvest, because we're not dealing with all the post-harvest cost of the bud.
I think we'll certainly be able to maintain a significant market-leading gross margin in all aspects of all products in Canada.
Your final question comes from the line of Hugh Cooper with RBC Financial.
Hey, guys. Congratulations on a great quarter. I had a few questions which have been answered. Just want to say, you guys have been the one firm in the industry to underpromise and overdeliver, so it's been very, very impressive. On Delta 3, I managed a tour there, and I noticed that you had a fair amount of office space and a vault and so on. Delta-2 is only going to have that small extraction processing center. 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? I don't want to cramp your style, but is that just a base number or can you increase that?
That's the number we're sticking to you. No.
Okay.
I think you just got to look at the bioasset, which by the way, we won't be reporting when we switch to U.S. here another quarter, but it's great indication. The possibilities are there. We've seen what can happen, and it's pretty mind-blowing where we think we'd take it. 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. We wanted to take the prudent approach with the new conversion to this crop and get four seasons under our belt, and it's going very well. Delta-2 is going to have a larger production footprint than Delta-3, as you pointed out. Right there's a pickup gain. I think, yeah, the answer is sure, we can get there. When others say they can get it, they haven't gotten it.
everybody's saying what they can produce, but who's doing it so far? We're meeting our criteria because we had realistic goals to set. I think at some point we'll update that. I hope that answers your question.
It does. Just lastly, I know you guys have a lot on your plate, but are you contemplating or looking at, or have you been in any talks, discussions about joint venturing, anything outside of Canada or the U.S.?
We can't comment on that. Pure Sunfarms, we structured the company with the total ability to do whatever it wants anywhere in the world. I think Pure Sunfarms, with Delta Two well on its way, it's all planned out. The construction's 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. I think it's a very focused group. They're focused on expanding operations in Canada, not only just production operations, but product innovation, many different ways. I think if they get that going and right, then they could probably look at international opportunities separate from Village Farms, and we're totally looking at that as well. I think there's more to come there for sure.
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. Honestly, I see companies every day launching IPOs and all based on the CPG pedigree within the company. these guys are very impressive. there are a lot of great talented executives in the CPG industry out there. any company can bring those into the space because the space is new and growing. it's not the same to get the fundamentals down on the farming side and the production side. You got to have the right product to have a good CPG company. we see it that way, and proving profitability is where we want to start.
Now, I think it opens up a lot of opportunity for us, both for Village Farms and Pure Sunfarms.
Okay. Thanks very much, guys.
Thank you. All right. Thank you everybody. That concludes it. No more questions, and look forward to reporting in November. Thank you so much for your interest in Village Farms. Talk to you soon. Bye.
This concludes today's teleconference.
Thanks, operator.
You're welcome.