Canadian cannabis company HEXO (HEXO +0.00%) hasn't been performing well this year. Its share price is down more than 50% year to date, worse than the broad holdings of the Horizons Marijuana Life Sciences ETF (HMLSF +0.00%), which has fallen 19% over the same period.
But as poorly as HEXO stock has performed thus far, it could be on a path to decline even more this year. Here's why investors should sell the stock before things get even worse:
Its debt could soon become a big problem
If there's one thing that can cripple a company's flexibility, it's debt. HEXO released its third-quarter results on June 11, and the company's balance sheet wasn't all that strong. One of the concerns that investors should have is that as of April 30, HEXO recorded total liabilities of CA$146.1 million. That's up from CA$89.9 million back on July 31, 2019.
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A key reason for the increase is that HEXO now has CA$48.7 million in convertible debt and CA$25.1 million in lease liabilities that it didn't have last year, and both are non-current liabilities. Rising debt levels could make it more difficult for the Quebec-based cannabis company to raise funds. Raising money during the COVID-19 pandemic and recession was already going to be difficult to begin with. A less-than-ideal balance sheet isn't going to help things.
Another consequence of too much debt financing is rising interest costs. In its "other income and losses" section, HEXO noted interest and financing expenses totaling CA$3.3 million, up from just CA$148k in the prior-year period. Over the past nine months, the delta is even greater, with HEXO reporting interest and financing expenses of CA$7.3 million, compared with just CA$164k during the same period in 2019.
The company continues to burn through cash
In Q3, HEXO burned CA$8.1 million from its day-to-day operating activities. That, coupled with the company's mounting debt, could create a challenging situation for HEXO.
The company's cash and cash equivalents balance as of April 30 was CA$94.3 million, which is down from CA$113.6 million on July 31, 2019. And just days after the release of its earnings, HEXO announced more financing -- this time in the way of shares, aiming to use an at-the-market equity program to raise as much as CA$34.5 million to inject some added liquidity into the company.
This could be indicative that things are getting worse for the cannabis company, which wouldn't be surprising during a recession as consumers may need to cut back on their expenses. The company said that it would use the proceeds of the share issue for "general corporate purposes."
Focusing on value brand "Original Stash" could make things worse
HEXO had a good showing on its top line in Q3, as sales were up 30% from the prior-year period. But management noted in its earnings release that the boost came mainly due to "Original Stash," the company's value brand. It's designed to be more competitive with the black market by offering lower prices, but it could hurt the company's potential to post a profit.
In Q3, HEXO's gross margin was 40%. A year earlier, however, gross margin was at over 49% -- and the company still reported a loss from its operations. Even though HEXO's gross sales before excise taxes nearly doubled during this past quarter, rising from CA$15.9 million a year ago to CA$30.9 million, its gross margin before fair value adjustments increased by just CA$2.3 million.
Since a flat-rate duty is a component of how cannabis excise taxes are calculated, there's potential for excise taxes to make more of a dent in HEXO's sales the more it leans on lower-priced items. In Q3, excise taxes were 29% of gross revenue compared with 19% during the same period a year ago. And as HEXO sells more of its Original Stash, that percentage could go even higher.
What should investors do?
HEXO's sales growth in Q3 looked promising at first, but given that the company reported a net loss of CA$19.5 million -- well above the CA$7.8 million loss it incurred in Q3 of 2019 -- it's hard to say that the company's going in the right direction.
The pot stock's underperformed compared to its peers in the Horizons ETF, and these results don't suggest things are going to change anytime soon. With a tough road ahead for the Canadian economy, cannabis investors should be extra picky when looking at pot stocks.
HEXO could be in for a bumpier road than its peers given it's already raising cash again, and lower margins could only exacerbate its cash needs in the near future. For those reasons, HEXO's a stock investors should stay away from, at least for now.
