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Down 74% in 7 Months, Is HEXO Now a Buy?

By Sean Williams – Dec 4, 2019 at 6:51AM

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Valued at just three times fiscal 2021 sales, is cannabis stock HEXO a screaming buy or a value trap?

What a difference half a year makes.

Earlier this year, it was as if marijuana stocks could do no wrong, and Quebec-based HEXO (HEXO 2.73%) was among those leading the pack. Having transferred from the over-the-counter exchange to the New York Stock Exchange earlier in the year, HEXO's stock hit what would be its pinnacle in late April at $8.28 per share and a market cap of well over $1 billion.

However, the past seven months have been nothing short of tragic for shareholders of the very popular pot stock. Shares of HEXO have shed 74% over this time frame, and Wall Street has piled on with downgrades and price target cuts of its own.

The question is, with HEXO losing roughly three-quarters of its value in about a half a year, is now the time to buy? Let's take a brief look at the pros and cons before officially weighing in.

A gloved processor using scissors to trim a cannabis flower.

Image source: Getty Images.

The buy thesis

Arguably, the most attractive aspect of HEXO is the company's mammoth supply agreement signed with its home province of Quebec. Signed in 2018, HEXO will be responsible for providing at least 200,000 kilos of dried cannabis over the next five years to Quebec's recreational industry, with Quebec having the option to extend to deal to a sixth year. HEXO already boasts around a third of all market share in Quebec, and it's possible that this single supply deal could amount to around a third of all production from the company over this five-year period. This deal helps to add some level of (hopeful) certainty that just doesn't exist with most Canadian pot growers.

Another aspect shareholders have to like about HEXO is its dealmaking. The company bolstered its peak production potential with the Newstrike Brands purchase, and signed a two-year extraction-services agreement with Valens GroWorks in April that'll help the company diversify its portfolio to produce higher-margin derivative products. Perhaps no deal is more important than the joint venture created between HEXO and Molson Coors Brewing, known as Truss. This joint venture should be among the leaders in cannabis-infused beverage sales.

Investors are also bound to appreciate the responsiveness of management to recent industry weakness. Rather than simply allow Canadian supply issues (I'll discuss these in the next section) to wreak havoc on margins, HEXO has decided to cut 200 jobs, idle its Niagara grow farm, and temporarily reduce production space at its flagship Gatineau facility by 200,000 square feet.

Lastly, there's the company's perceived valuation. After trading at very aggressive sales multiples throughout 2018 and early 2019, HEXO is now valued at about three times Wall Street's projected sales for fiscal 2021. Considering that Wall Street is still counting on triple-digit percentage sales growth in fiscal 2020 and 2021, this might be more than enough to entice cannabis stock investors to take a position.

A man in a suit putting his hands up, as if to say no thanks.

Image source: Getty Images.

The avoid thesis

Of course, there are two sides to every coin, and there are obviously plenty of bears betting against HEXO, as evidenced by its abysmal seven-month performance.

It's pretty evident that the biggest problem for HEXO, and entire Canadian industry, is supply related. As I promised to touch on a bit earlier, Health Canada has done a relatively poor job of tackling its enormous backlog of cultivation, processing, and sales license applications. We've also seen Ontario, the most populous province in Canada, struggle to approve retail licenses. For a province of 14.5 million people, just two dozen marijuana dispensaries were open for business a full year after adult-use sales kicked off. These issues are making it difficult for any Canadian growers to succeed. And while fixable, these issues will take numerous quarters to resolve.

A second issue is that HEXO's push into the derivatives market may not be as impressive as once envisioned. Competition among cannabis-infused beverage makers should be heated, and all of the supply problems that have affected dried cannabis flower since October 2018 are likely to continue well into the launch of derivative products, which are set to hit dispensary shelves in the next couple of weeks. In other words, the high-margin boost that HEXO was counting on is probably going to disappoint.

A third concern for HEXO would be the company's potentially less-than-enticing cash position. It's no secret that financing has always been a bit of a concern for marijuana stocks, but HEXO's roughly $139 million Canadian in cash and short-term investments at the end of its most recent quarter aren't really a lot considering the upgrades it still had planned at Gatineau, Niagara, and on the processing side of its operations. With sales and profit forecasts being scaled back considerably, much of HEXO's remaining cash could begin going up in smoke over time.

And, lastly, we've witnessed sales and profit projections fall off a cliff for HEXO. Yes, the company is now valued at only three times fiscal 2021's sales, but it's also expected to lose CA$0.11 per share in 2021 when a profit of CA$0.28 per share was expected as recently as three months ago. Things are deteriorating rapidly for HEXO on the income front, and its share price confirms it.

A person holding up a large puzzle piece with a question mark drawn on it.

Image source: Getty Images.

The verdict

Now that we've had a look at both sides of the aisle, let's revert back to the original question at hand. Namely, with HEXO having lost 74% of its value in a seven-month span, is it now worth buying?

My blunt answer? No.

However, I should preface that I'm far less negative on HEXO than I am on most other Canadian growers. For instance, I am appreciative of management's no-nonsense approach to cost-cutting and being frank with investors about what needs to happen for the company to thrive. I also believe that setting aside around 600,000 square feet of facility space or processing and manufacturing, in addition to striking an extraction deal with Valens, will be smart and help lift operating margins over the longer term. There are assets and deals here that make sense as a buy under the right circumstances.

What's impossible to overlook, though, are the persistent supply issues the Canadian industry will continue to deal with, HEXO's unimpressive cash pile (at least in the context that it'll probably keep dwindling as it loses money), and recent management commentary. In particular, my colleague Keith Speights notes that HEXO's management sees the need to achieve 20% market share throughout Canada to be profitable, yet lacks the game plan to do so.

With better values apparent in the U.S., and even among its Canadian peers, HEXO is a pot stock best left on the shelf.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of Molson Coors Brewing. The Motley Fool recommends HEXO. and Valens GroWorks. The Motley Fool has a disclosure policy.

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