To say that marijuana stock investors have had a rough ride in recent months would be a brutal understatement. Following a first quarter that saw most pot stocks run significantly higher, cannabis stocks have spent much of the past 10 months (since the end of March 2019) in a precipitous downtrend.
To our north, Canadian pot stocks have been hurt by supply issues. Health Canada has not been quick to approve cultivation and sales license applications, and it ultimately delayed the launch of high-margin derivatives. Meanwhile, Ontario, the country's most populous province, had been relying on a lottery system to award retail locations, which, frankly, didn't work. At the one-year anniversary of adult-use sales commencing, just 24 dispensaries were open in Ontario.
In the United States, it's been more of a tax issue than a supply problem. High tax rates in recreationally legal markets have made it impossible for legal producers and retailers to compete against black-market growers. The result, as you've seen, is considerably lower marijuana stock valuations.
Unfortunately, the purge doesn't look to be over just yet.
Wall Street pulls the rug out from under HEXO
Last Tuesday, Jan. 28, prior to the opening bell, institutional equity research firm MKM Partners announced a downgrade and significant price target cut to Quebec-based grower HEXO (NYSE:HEXO). Having previously rated HEXO as an outperform with a price target of 5 Canadian dollars ($3.79 U.S.), MKM Partners and its covering analyst Bill Kirk cut the company's rating to neutral and slashed its price target by 70% to CA$1.50. Despite the neutral rating, the new price target implies downside of 14% in HEXO's stock from where it closed the day prior to MKM Partners updating its rating.
Why the downgrade? In the research note released, Kirk provided a laundry list of problems for the company, but suggested a recently filed lawsuit by extraction-service provider MediPharm Labs (OTC:MEDIF) against HEXO for nonpayment of CA$9.8 million in cannabis resins was "the straw that has broken our back." For those unaware, extraction providers like MediPharm process hemp and cannabis biomass for growers and provide the distillates, resins, concentrates, and/or targeted cannabinoids they use to create higher-margin derivatives. These high-margin products began hitting Canadian dispensaries shelves in mid-December.
But as the note provided points out, HEXO has had all sorts of issues since October, including the departure of its chief financial officer, the complete retraction of the company's previous guidance, production cutbacks, and layoffs.
Although HEXO has vowed to vigorously defend itself against MediPharm's claim of nonpayment, Kirk also notes that HEXO has a poor track record when it comes to making statements that come true. "With a weak track record on accurately making positive predictions, it is difficult to handicap this latest issue," said Kirk in the note.
HEXO's problems come to the forefront
While the MediPharm lawsuit might be the straw that broke MKM Partners' conviction in HEXO, the writing has been on the wall for months that HEXO was in some pretty deep trouble. This became especially evident after the company announced the idling of its Niagara facility in October, which was acquired when it purchased Newstrike Brands in May 2019, and laid off 200 workers from a variety of departments.
Maybe the most immediate concern for HEXO is its funding. Through a combination of at-the-market offerings and a CA$70 million convertible debenture offering in December 2019 that'll come due in December 2022, HEXO looks to have raised about CA$100 million since October. But even so, its cannabis operations continue to lose money, and the company is expected to contend with a host of lawsuits, of which MediPharm has simply become the latest. With HEXO clearly reeling, it's unlikely to find any financial institutions willing to extend it an olive branch.
Another concern is that the company could lose its listing on the New York Stock Exchange (NYSE). In spite of HEXO's still-reasonable $363 million market cap, its share price is dangerously close to the $1 minimum price needed to maintain continued listing on the NYSE. Historically, when a public company's stock is booted from a major exchange to the over-the-counter exchange, it does not bode well for its share price.
HEXO's management team has also incited concern with commentary that it would need to gobble up 20% of Canadian market share to become profitable. Said CEO Sebastien St-Louis during the company's fiscal fourth-quarter conference call, "[F]irst of all, the nonnegotiable is we have to be profitable in Canada and we have to be a top 2 brand in Canada. That means 20% market share nationally, and I believe that we have the assets, the people, [and] the cost structure to do that." HEXO is in no position to be a market share leader in Canada, with the exception of its home province of Quebec.
The baby steps HEXO needs to take in 2020
At this point, MKM Partners' downgrade and price target cut of HEXO certainly seems fair given the numerous problems the company is contending with. But this isn't to say things can't improve for the company in 2020. The key is going to be taking baby steps in the right direction and not getting overly aggressive, which is what got most Canadian pot stocks into the current messes they're in.
First, we're seeing a concerted effort by HEXO to reduce its expenditures. Even if the company winds up sacrificing its rapid growth rate in order to rein in costs, I view this as a long-term positive for the company. HEXO needs to demonstrate to Wall Street that it can minimize losses and its cash burn before it's going to be given any chance of long-term success.
HEXO is also going to need to show that its hefty investments into high-margin derivatives are paying off. Admittedly, a lawsuit from MediPharm just 1.5 months after derivative sales began is not a step in the right direction. But if HEXO can find a way to make each dollar count more by selling higher-margin products, it'll go a long way to pushing the company toward positive operating cash flow.
There's no doubt that the cannabis space remains fluid, but for the time being, HEXO does not belong in investors' portfolios.