A strong start to Canada's recreational marijuana marketplace last year took a breather in the first quarter, causing sales at HEXO (HEXO) to miss expectations. Nevertheless, HEXO's making progress on plans to ramp up its marijuana production and it's sticking with sales guidance that reflects blistering growth. Here's what you you need to know about HEXO's fiscal third-quarter results and its future potential. 

1. Disappointing sales? Maybe not

HEXO's fiscal third-quarter gross revenue was 15.9 million Canadian dollars, down from CA16.2 million in fiscal Q2. The slowdown is particularly disappointing because fiscal Q2 revenue was 144% higher quarter over quarter. Nevertheless, investors might not want to overreact to its quarterly revenue decline. Despite gross revenue slipping, sales still grew 1,185% year over year. Furthermore, its CA$38.7 million in gross revenue through the first nine months of this fiscal year is up 1,006% year over year.

A marijuana leaf on a green background.


2. A "guaranteed" source of sales

HEXO has cannabis government supply agreements with the four largest Canadian provinces and it has distribution arrangements with retailers that give it access to an additional five provinces, but Quebec is its most important market.

The company's five-year preferred supplier agreement in Quebec allows it to sell 20,000 kilos of adult-use marijuana in the first year, 35,000 kilograms in year two, and 45,000 kilos of marijuana in year three. The final two years' volume is to be determined, but management thinks it can supply 203,950 kilos to Quebec through this contract. 

HEXO estimates its adult-use market share at 30% in Quebec based on publicly announced supply agreements, and over the five-year period of its supply agreement, management thinks it could pocket about CA$1 billion in revenue.

3. Increasing marijuana capacity

HEXO expects it will need more marijuana production to meet future demand, so it's expanding its existing facilities so that they can grow more. Once that expansion is finished, HEXO estimates its annual marijuana production will be about 108,000 kilograms per year. Following its recent acquisition of Newstrike Brands, it believes its total production capacity will be 150,000 kilos per year. For perspective, HEXO's marijuana production was 9,804 kilos in fiscal Q3, up 98% from fiscal Q2, which was 39% higher than fiscal Q1.

4. It's mostly dried flower

Adult-use market sales are tilted more toward dried flower than oils. As a result, dried flower accounted for the lion's share -- 84% -- of HEXO's revenue last quarter. The large proportion of dried flower in its product mix is a headwind to pricing and profit because extracts, including oils, are pricier and offer better profit margins. Unfortunately, its product mix worsened in Q3. Oils only accounted for 16% of revenue, down from 23% in fiscal Q2, which caused revenue per gram equivalent, including excise taxes, to slip to $5.29 from $5.83 in the previous quarter.

5. Swelling losses

HEXO's investments in production and distribution mean its expenses are climbing and, combined with slipping prices per gram, that's causing losses to mount.

Its operating expenses totaled CA$24.1 million last quarter, up from CA$18.5 million in fiscal Q2. Its operating loss was CA$2.2 million and its net loss was CA$7.8 million in the fiscal third quarter.

Marijuana buds in front of a U.S. flag.


6. Plans to enter the U.S.

The passage of language in the U.S. Farm Bill federally legalizing hemp last December has opened the door for Canadian marijuana companies to enter the much larger U.S. marijuana market.

In the past, HEXO's avoided the U.S. so it wouldn't run afoul of stock exchange listing requirements, but now that hemp's off the U.S. controlled substances list, it plans to legally enter eight U.S. states in 2020 via "a variety of distribution channels to offer a variety of products under our non-THC experiences." 

It seems the foray into the U.S. market will be made primarily with cannabidiol (CBD) products derived from hemp. In HEXO's quarterly filing, it said: 

We have taken significant steps in ensuring that we are adequately poised to meet the future demand of the CBD derivative product markets within Canada and globally. This includes having secured a large and steady supply of quality hemp for product transformation at our in-progress Belleville facility. We are in the process of obtaining technology to clean outdoor field hemp of harmful pesticides, which we believe gives us an edge in bringing quality extracts to the US. We have 8 high CBD hemp strains in tissue culture in partnership with the University of Guelph as we are preparing the groundwork to evolve to a field sourced, forward contract.

7. A phenomenal forecast?

Slowing Canadian adult-use sales relative to the fourth quarter last year may prove temporary. Canadian regulators are considering allowing the sale of more products, such as vapes, edibles, and beverages, in the adult-use market. HEXO's expectation is for these products, including beverages it's developing with Molson Coors through their joint venture, Truss, to be available by December. 

Coming into its fiscal third quarter, HEXO implied fiscal fourth-quarter net revenue could be around CA$25 million and it said fiscal 2020 revenue could reach CA$400 million, excluding excise taxes. 

If the company can deliver on that sales guidance, then buying shares following HEXO's post-earnings sell-off could end up paying off handsomely.