Several problems were immediately apparent when HEXO (HEXO) reported its fiscal 2020 first-quarter results on Monday morning. For one thing, the company's revenue slipped 11.4% from the previous quarter to $20.2 million Canadian. HEXO also reported a net loss of CA$62.4 million, significantly worse than its prior-quarter net loss of CA$81.6 million.
But some of the challenges the Canadian cannabis producer encountered in its latest quarter were not as obvious. Here are three problems you might not have noticed in HEXO's Q1 results.
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1. Lower selling prices
Even though HEXO's revenue slid from the previous quarter, the company actually sold more cannabis in the Canadian adult-use recreational market. Granted, it was only a small amount more -- 4,196 total grams and gram equivalents sold in fiscal 2020 Q1 compared to 4,009 total grams and gram equivalents sold in fiscal 2019 Q4. But you wouldn't have thought that HEXO sold more cannabis by just looking at the company's significant revenue decline.
The problem is that HEXO's average selling prices per gram are much lower than in the past. HEXO reported adult-use shipped revenue per gram and gram equivalent sold in Q1 of CA$4.82, down from CA$5.69 in the previous quarter. After adjusting for price concessions and provisions for sales returns, the company's adult-use gross revenue per gram and gram equivalent sold fell to CA$4.35 in Q1 from CA$4.74 in the previous quarter.
HEXO said its lower selling prices reflect "the new economic demands of the Canadian cannabis market." And with the company prioritizing its new Original Stash value recreational cannabis brand, lower selling prices could become the new normal.
2. Spending a huge amount on rewarding employees
Canopy Growth's stock rewards for employees ranks as one of the company's biggest expenses and one of the top reasons the company won't become profitable anytime soon. But Canopy isn't the only Canadian cannabis producer spending huge amounts on share-based compensation. HEXO belongs in that club, too.
HEXO reported share-based compensation totaling nearly CA$8.2 million in fiscal 2020 Q1. That's enough to make the line item the second-highest operating expense for the company trailing behind only general and administrative expenses. It's even higher than the amounts that HEXO spends on marketing and promotion and research and development combined.
There was some good news, though. HEXO's share-based compensation in Q1 declined from CA$10.2 million reported in its fiscal 2019 fourth quarter.
3. Multiple material weaknesses identified
Financial misstatements can cause a stock to plunge. HEXO didn't report any such misstatements in the first quarter, but it did announce the discovery of several material weaknesses in internal control over financial reporting. Problems with these internal controls increase the possibility of financial misstatements. HEXO stated that an internal risk assessment found the company had five material weaknesses in internal control over financial reporting:
- The company "did not implement and maintain effective controls surrounding complex spreadsheets."
- It "did not have effective information technology (IT) general controls over all operating systems, databases, and IT applications supporting financial reports."
- It "did not have effective controls around its year-end inventory count procedures."
- The company didn't "maintain effective controls over the purchasing of capital goods and services, including the authorization of purchases, processing and payment of vendor invoices, the classification of various expenses and capitalization of assets."
- It didn't "maintain effective process level and management review controls over manual financial reporting processes and the application of IFRS [International Financial Reporting Standards] and accounting measurements related to certain significant accounts and non-routine transactions."
This disclosure raises the question as to whether or not there were any areas where HEXO actually did maintain effective internal controls. The best news here, though, is that the company discovered the issues, acknowledged them, and is working to resolve them.
On a path to profitability?
HEXO's new CFO, Steve Burwash, said three months ago that the company thinks that it will achieve positive adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) in calendar year 2020. The company reaffirmed this goal of becoming EBITDA positive next year, adding as it has in the past that doing so was "subject to certain assumptions regarding store count, operational improvements, and cost saving initiatives."
There's a long way to go: HEXO reported an adjusted EBITDA loss of CA$24.6 million in the first quarter. And even if and when the company achieves positive adjusted EBITDA, it still won't be truly profitable.
However, despite its obvious and not-so-obvious problems, HEXO should benefit from several factors that are likely to help most Canadian marijuana stocks. The retail environment in Canada should improve next year, especially as Ontario opens more retail cannabis stores. The cannabis derivatives products market should pick up momentum. In addition, the companies that have encountered problems with product returns (including HEXO) continue to learn more about which products consumers want and don't want.
It's too soon to know if HEXO will have a great year in 2020. But the company should have a better year than it had in 2019.
