The cannabis industry was supposed to be unstoppable in 2019, with Canada launching derivatives and a number of U.S. states delivering strong organic growth. But reality hadn't come close to matching the perception by the time the curtain finally closed.
Following a red-hot first quarter that saw more than a dozen pot stocks gain at least 70%, cannabis companies finished the remainder of the year in a steep nine-month downtrend. Persistent supply issues in Canada, exorbitant tax rates on cannabis in select U.S. states, and a huge black market presence have all made life difficult for North American pot stocks.
This decline also has some investors believing that marijuana stocks may now be intriguing values. This is especially true of Quebec-based HEXO (NYSE:HEXO), which shed 54% of its value in 2019 and lost more than 80% from its closing high in late April.
But is a more than halving of HEXO's share price a reason for investors to buy into this growth story in 2020? Don't bet on it.
To date, HEXO has been a master dealmaker
On paper, HEXO would appear to offer a lot of value for investors. For one, it's a major producer, with at least 150,000 kilos of peak production capacity at its disposal when fully operational. Having so much output should lead to per-gram production costs that are below the industry average, as well as make it a popular company with which to forge supply deals.
Speaking of which, HEXO is the grower behind the largest provincial supply deal to date: a 200,000-kilo, five-year agreement with its home province of Quebec. This deal, presumably, accounts for a third or more of HEXO's production over the next five years and provides some level of cash flow certainty that most other pot growers don't have.
HEXO has also been a stud in the dealmaking department. The company wound up acquiring Newstrike Brands to bolster its production and has worked out a two-year agreement with The Valens Company to have an aggregate of 80,000 kilos of hemp and cannabis biomass processed for resins and distillates that'll be used in derivatives. As a reminder, HEXO has more than 600,000 square feet set aside solely for processing and manufacturing.
It also formed a joint venture (known as Truss) with Molson Coors Brewing in 2018 that recently launched a line of cannabis-infused nonalcoholic beverages. HEXO has gone all-in on high-margin derivatives, and has eagerly awaited the December 2019 launch of these alternative consumption products.
Sounds like a high-growth, feel-good story in the cannabis space, right? Well, not so fast.
But there's more to success in the pot industry than dealmaking
One pretty notable problem for HEXO, and the entire pot industry for that matter, is the persistent supply issues throughout Canada. While these problems are fixable, they're not going to be resolved overnight. Regulatory agency Health Canada will take numerous quarters to work through its cultivation and sales licensing backlog. And Ontario is only now transitioning away from its ineffective lottery system for dispensary licenses, meaning the ramp-up in legal sales channels in the country's most populous province will remain slow.
For HEXO, this slow ramp-up in sales means ongoing losses. Having previously touted fiscal 2020 sales of 400 million Canadian dollars ($308 million), HEXO completely pulled the plug on this prognostication and announced production and job cuts instead during the fourth quarter.
In an effort to better align output and expenses with current market conditions, HEXO is planning to idle its Niagara grow farm, acquired via the Newstrike deal, as well as halt cultivation on 200,000 square feet at its flagship Gatineau facility. By my estimation, these moves reduce the company's peak annual output by about a third, or 50,000 kilos. Though this should shrink the company's operating losses, it also means it won't be anywhere near operating efficiency.
It's also worth pointing out that HEXO has invested a lot of money and time into high-margin derivatives. But its "return" for these investments has so far been a delayed launch of alternative pot products and the expectation of tough competition, especially in the Canadian beverage space.
Perhaps most concerning is that HEXO ended its most recent quarter with less than CA$55 million in cash and cash equivalents, not including CA$18.8 million in restricted cash. HEXO did raise $25 million (that's in U.S. dollars) in December by selling its common stock at a substantial discount to its previous day's closing price, but its cash position remains worrisome with the industry facing as many near-term challenges as it currently is.
HEXO needs a lot to go right in 2020
Although this is not a cannabis stock that investors should consider chasing in 2020, it's not out of the question that its situation improves. HEXO could prove me wrong if a couple of things go its way this year.
For instance, all eyes are going to be on Ontario following its move to a more traditional dispensary licensing system. The province believes it can increase its number of open dispensaries to 250 by year's end, up from just 24 in October 2019. If Ontario regulators can outpace their own projections and find a way to get legal-channel product in front of consumers, then HEXO's sales (and those of its peers) should surpass substantially reduced expectations.
With HEXO also making hard cutbacks now, including 200 job cuts across numerous divisions, it's possible that the company's operating cash flow could prove better than expected in 2020. Again, with cash on hand being a clear concern among investors, an improvement in operating cash flow (not necessarily bottom-line losses) would probably be enough to inspire more confidence in management.
Nevertheless, I'm expecting HEXO's obstacles to outnumber its opportunities in 2020, making it a stock that investors would be best off watching from the safety of the sidelines.