Marijuana consumers spent 152 million Canadian dollars legally on pot in the fourth quarter, despite Canada's recreational adult-use marijuana market only being open for about 10 weeks. The sales strength suggests revenue at Canada's leading cannabis companies could increase significantly in 2019, especially if marijuana supply catches up to consumer demand. While there are larger marijuana stocks investors can consider owning, HEXO's (HEXO -8.12%) supply agreement with Quebec, growing interest in cannabis among consumers, and an envy-inspiring product mix could make it a top stock to buy. Here are three reasons why.
1. Clarity into future revenue
Canada's legal recreational market is only in its infancy, so it's still unclear which companies will be the biggest winners and losers, particularly among smaller growers. There's no guarantee HEXO will capture meaningful market share in Canada, but its agreement to supply a substantial amount of cannabis in Quebec reduces uncertainty and provides clarity into the company's future revenue.
In Q4, 84% of HEXO's CA$16.2 million in gross revenue, including excise taxes, was due to sales in Quebec, Canada's second-largest province by population. The company's five-year supply agreement in Quebec is for 20,000 kilos of supply in the first year, 35,000 kilos in its second year, and 45,000 kilos in its third year. The final two years' supply will be based on the previous three years. HEXO's market share in Quebec was roughly 35% in the fourth quarter.
A big concern is that the industry will overinvest in marijuana production capacity, causing headwinds to profitability. However, the company's leading position in Quebec, plus its contracted supply agreement, suggests HEXO won't have a problem selling what it grows. Last quarter, its marijuana production was a little less than 5,000 kilos, but it's targeting 150,000 in peak production annually. Its Quebec agreement plus its production forecast has it guiding for $400 million in revenue next fiscal year.
2. An expanding market
About 15% of Canadians, or 4.6 million people, report using marijuana within the past three months. However, legalization is expanding interest in marijuana to more people. According to Statistics Canada, the government's data-crunching agency, nearly 20% of Canadians think they'll use marijuana in the next three months. If so, the market will increase to about 7 million cannabis consumers.
The market could get even bigger if legalization attracts former marijuana consumers back. About 30% of Canadians over age 15 report that they've used marijuana in the past, and according to Canada's National Cannabis Survey, it's former users who are most interested in using marijuana in the coming three months.
Since only 26% of nonmedical marijuana consumers report buying marijuana legally and illegal sales still represent 80% of all marijuana spending, there's plenty of opportunity for legal cannabis companies to attract new customers.
3. Greater choice
Dried flower is most popular in the illegal marijuana market, but it's far less popular in the medical market and to people interested in trying marijuana for the first time. That's important, because it suggests that there's a big opportunity for companies to develop new marijuana products that resonate with people uninterested in combustible products, like joints.
Developing new products that use marijuana as an ingredient opens up significant opportunities for brand differentiation, too. And if products like edibles and beverages are only available through legal channels, it could help convert more black-market business to the regulated recreational market.
These products can also command higher prices and offer producers better margins than dried flower, which can experience significant price variability depending on supply.
HEXO's product mix is already tilting toward these value-added products, and a relationship with beer giant Molson Coors (TAP -4.32%) may improve its mix even more in the future. Cannabis oil accounted for 23% of its adult-use revenue last quarter, up from 19%. As a result, its revenue per gram equivalent, including excise taxes, increased to $5.83 from $5.45 quarter over quarter.
Canada's regulators haven't approved the sale of beverages containing chemical cannabinoids extracted from marijuana yet, but a decision on beverages could happen this year. If it does, then HEXO could be a winner, because it and Molson Coors launched a joint venture last year to develop cannabis beverages.
Overall, HEXO's sales forecast for the coming year gives it a lower forward price-to-sales ratio than its larger competitors, and there's room for upside to its forecast because of growing interest in marijuana and the potential approval of cannabis consumer goods. Therefore, if you're looking for a small-cap marijuana stock to add to portfolios, HEXO could be a good choice.