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The Fourth-Most-Popular Pot Stock Was Downgraded Twice in June

By Sean Williams - Jul 1, 2019 at 9:21AM

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Is Wall Street's shortsightedness on display with this top-tier marijuana stock?

Despite a rough second quarter, marijuana remains the buzziest investment on Wall Street. And it's not hard to see why, either, if you look at the industry's long-term growth potential.

Depending on your favorite Wall Street projection, annual sales for the worldwide weed industry will grow fourfold to sixfold over the next decade and hit as high as $75 billion. That should, presumably, lead to plenty of winners in the space and allow investors to make a handsome profit if they pick the right basket of companies to invest in.

The big question is, which pot stocks to buy?

A gloved processor using scissors to trim a cannabis flower.

Image source: Getty Images.

HEXO shareholders learn that investing isn't a popularity contest

According to investment app Robinhood, a favorite of millennial investors, four marijuana stocks are among its 14 most-held companies. This includes top producer Aurora Cannabis, Cronos Group, Canopy Growth, and HEXO ( HEXO -10.53% ), in that order. However, investing isn't a popularity contest, and in June, the fourth-most-popular pot stock, HEXO, faced two Wall Street downgrades.

Shortly after reporting disappointing fiscal third-quarter operating results in mid-June, analyst John Zamparo at CIBC lowered his rating on the company to neutral from outperform and reduced his firm's price target by more than 10% to 8.50 Canadian dollars (about $6.48) from CA$9.50. The reason behind the downgrade and target price reduction was the expectation that HEXO's derivative launch wouldn't go as smoothly as expected. Derivatives are alternative consumption options, such as oils, edibles, infused beverages, tinctures, topicals, vapes, and so on.

Then this past week, investment firm Oppenheimer threw its hat in the ring with a downgrade of its own. Oppenheimer analyst Rupesh Parikh downgraded the company to perform from outperform and had this to say in a note to clients:

With our updated forecasts and incorporating Newstrike, we now view shares as more fairly valued. ... Although we are stepping to the sidelines, we still see many positives to the HEXO story longer term and believe the name should remain on the radar for investors.

But is this pessimism warranted? Let's take a closer look.

A Canadian flag with a cannabis leaf in place of the red maple leaf and the words "Sold Out" stamped across the flag.

Image source: Getty Images.

There are reasons for near-term skepticism with HEXO

On one hand, Zamparo and Parikh have valid reasons for exercising caution.

To begin with, supply-side issues in Canada are unlikely to disappear overnight, which means the ramp-up in sales and push to profitability for cannabis stocks will take longer than initially expected. Even with licensing application changes being implemented at Health Canada, it'll take a few quarters to work through a long backlog of cultivation and sales applications. These supply-side issues could keep both dried flower and higher-margin derivative products from hitting dispensary store shelves.

To build on this point, the rollout of high-margin derivative products is going to come later than most investors had expected. Wall Street had been expecting sales of alternative consumption options to begin by mid-October at the latest. But a recent update from Health Canada points to mid-December as the earliest date at which these products will appear in licensed cannabis stores. That means the impact of these high-margin products won't even be felt until possibly April or May of next year, which is when pot stocks will report their operating results from the calendar-year first quarter of 2020.

Competition in the derivatives space is also going to be a lot fiercer than folks probably realize. HEXO is far from the only marijuana stock involved in creating nonalcoholic cannabis-infused beverages, cannabidiol (CBD) products, and other forms of derivatives.

In short, recurring profitability could be further off than Wall Street's current estimates account for.

A cannabis leaf floating on top of the carbonation in a glass, with cannabis leaves set to the right of the glass.

Image source: Getty Images.

Ignoring its long-term potential is probably a mistake

But there's a big difference between dampening HEXO's 6- to 12-month outlook and raining on its long-term parade. Whereas the company could face a host of supply-side challenges and growing pains in the interim, its dealmaking ability and focus on high-margin derivatives should pay off for the company and investors.

As I noted recently, HEXO has been a marvel on the dealmaking front. It added at least 42,000 kilos of annual capacity with its $197 million acquisition of Newstrike Brands, and a recently struck deal with Valens GroWorks will see an aggregate of 80,000 kilos of cannabis and hemp biomass converted into distillates and high-quality resins for use in those aforementioned high-margin derivative products.

I'd be remiss if I didn't mention that, in addition to working out one of the largest extraction deals signed to date, HEXO also has more than 600,000 square feet of space devoted to processing and manufacturing. This is a fancy way of saying that HEXO understands the importance of diversifying beyond simple dried flower and into a variety of higher-margin alternative consumption options.

Speaking of dried cannabis flower, HEXO also has the most de-risked cannabis portfolio of all major growers. By signing a five-year, 200,000-kilo-in-aggregate supply agreement with its home province of Quebec in April 2018, HEXO, inclusive of its recent Newstrike acquisition, and factoring in its ongoing ramp-up, probably has 30% of its production already spoken for by the wholesale market through 2023. That's predictable cash flow that's hard to come by in the still-nascent legal cannabis space.

So yes, HEXO has plenty of near-term concerns, but it could also make these neutral and perform ratings look pretty silly three or five years from now.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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