The marijuana industry's momentum in 2018 picked up in a way that we've simply never seen before. Aside from the fact that a record number of Americans want to see cannabis legalized, according to the newest annual Gallup poll, we witnessed Canada legalize recreational pot, the U.S. give the green light to hemp and hemp-based cannabidiol products, and the U.S. Food and Drug Administration approve its very first cannabis-derived drug.
The point is this: The weed industry gained legitimacy like never before. Gone are the days when investing in marijuana was considered taboo. Now the legal pot industry is a valid business model that could potentially generate big gains for long-term investors. The big question being: Which pot stocks to buy?
One of the more on-the-fence marijuana stocks is Quebec-based cannabis grower HEXO (NYSEMKT:HEXO). Whereas 10 pot stocks were, at minimum, halved in 2018, HEXO bucked that trend and ended the year higher by 5%. But should you be looking to add HEXO to your portfolio in 2019? Valid arguments can be made from both sides of the aisle, so let's take a closer look.
HEXO is making all the right moves and deserves a spot in your portfolio
If there were an elephant in the room for HEXO, it would be the company's potentially transformative joint venture with Molson Coors Brewing (NYSE:TAP), announced on Aug. 1, 2018. Under the terms of the deal, Molson Coors Brewing will control 57.5% of the joint venture, with HEXO holding the remainder. The duo will be working together to research and develop a line of cannabis-infused beverages for the Canadian market.
There are a number of exciting aspects of this joint venture for both parties. Molson Coors has been steadily losing beer market share in Canada for about a decade, and this partnership foray into the high-growth cannabis business gives the company an opportunity to flip its fortunes. Meanwhile, HEXO gains access to Molson Coors' marketing expertise and helps diversify HEXO away from a reliance on dried cannabis flower. Alternative cannabis products, such as infused beverages, almost always offer higher long-term margins and fewer pricing pressures.
Another aspect of HEXO that shouldn't be overlooked is the company's April 2018-signed agreement with the SQDC -- the regulatory agency responsible for overseeing the cannabis industry in Quebec -- to supply a minimum of 200,000 kilograms of weed over a five-year period. Under the terms of the agreement, HEXO will supply 20,000 kilos in the first year, 35,000 kilos of pot in the second year, 45,000 kilos in the third year, and a presumed 49,500 kilos and 54,450 kilos in years four and five, respectively, based on the expectation of 10% industry growth. There's also an option for the SQDC to add a sixth year to the supply agreement.
Long-term supply deals are particularly important for growers because domestic competition is expected to be fierce, and locked-in volume and/or price commitments lead to predictable cash flow. This is an industry in which there's little predictability, meaning investors are bound to appreciate this consistent cash flow.
Lastly, HEXO should rank among the 10 largest growers in Canada by peak production at 108,000 kilograms per year. The company should be finished with a 1 million-square-foot expansion adjacent to its Gatineau facility anytime now, leading to the ability to generate more than 100,000 kilograms of cannabis per year (at full capacity) from roughly 1.3 million square feet of growing space.
Risks abound with cannabis growers
Of course, there are reasons you should think twice about buying into HEXO in 2019. For starters, its partnership with Molson Coors could actually fizzle out. Alternative consumption options beyond oils and sublingual sprays aren't yet legal in Canada, and they may not get the green light until this coming summer or fall. Being at the mercy of Canada's politicians will stymie any possibility of a first-mover advantage into cannabis-infused beverages.
Making matters worse, competition is beginning to really pick up in the infused-beverage space ahead of the expected legalization of new consumption options later this year. Constellation Brands took a $4 billion equity stake in Canopy Growth; The Green Organic Dutchman announced that it'll devote 20% of its production to its edible and beverage line; Heineken is dabbling with infused beverages in California; New Age Beverages introduced a new line of infused products in October; and Anheuser-Busch InBev and Tilray announced a $100 million infused-beverage joint venture last month. In other words, these new products may not move the needle much after all once competition is factored in.
It's also unclear just how much of the legal market a company like HEXO will be able to grab. A large initial supply deal with SQDC helps, but early-stage shortages in most Canadian provinces could lead consumers to purchase their products on the black market. Remember, illicit marijuana channels don't have to pay federal excise or income taxes, and they certainly don't wait for cultivation licenses and sales permits. This means the black market can undercut legal channels on price and, for the time being, possibly outdo legal weed on supply, too. Ultimately, this could cut revenue and profit forecasts for growers like HEXO.
Don't overlook the potential for share-based dilution, either. Not to single HEXO out, because there are far more prominent guilty companies, but publicly traded marijuana stocks still have limited access to basic banking services. This coerces many that need capital for capacity expansion, product development, acquisitions, or an international push to turn to bought-deal offerings. A bought-deal offering involves the sale of common stock, convertible debentures, stock options, and/or warrants to an investor or group of investors. While effective, these issuances lead to a ballooning share count that can wreak havoc on a company's share price and weigh down the earnings per share of a profitable business.
Now that you have a better understanding of the risks and rewards associated with HEXO, what's an investor to do in 2019?
On one hand, HEXO looks to be one of the cheapest marijuana stocks on the basis of forward earnings, and it has a growing percentage of its production devoted to supply deals. Not to mention, focusing on alternative products, once legalized, should yield better margins as time moves on.
On the other hand, dilution is going to be a constant problem until operating cash flow grows significantly, and competition isn't going to allow HEXO to simply walk to the front of the line.
Ultimately, I do view HEXO as a marijuana stock you can consider buying in 2019, albeit you'd have to be willing to hang on through imminent bumpy patches. As long as you have a reasonable investment horizon of three to five years, at minimum, I believe you'll be pleasantly surprised by HEXO.
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