In the second quarter of 2020, spending on the legal pot market in Canada finally came in ahead of the black market. One of the big reasons the industry has been making progress is that companies have been introducing value brands that are more competitively priced. It helps increase sales while also encouraging people to buy from licensed producers rather than illicit dealers.
This month, HEXO (HEXO -1.66%) announced the launch of a new brand called Bake Sale, which promises to be even more aggressive in terms of price. The company says it will have "one of the lowest prices per gram in the country," potentially undercutting some competitors by as much as 20%. While the move may help facilitate more growth, could it do more harm than good if it chips away at the company's margins?
Are HEXO's margins strong enough to withstand the hit to its gross profit?
A major disadvantage of lower-priced products is that they result in a lower gross profit for the company. And without a strong gross profit, there may not be enough after cost of goods sold for a company to cover its overhead and operating expenses.
On March 18, HEXO released its second-quarter earnings for the period ending Jan. 31. While its net sales of 32.8 million Canadian dollars grew by 93.3% year over year, that resulted in just CA$6 million more in gross profit (before adjustments). The company's gross margin of 35.5% was higher than it was a year ago at 33.4%. However, with a new value brand, the company's margins will likely decline in future periods.
While investors would love to see an increase in the company's sales, which will likely happen if the new brand can help HEXO take more market share, it may come at a price: profitability. In Q2, HEXO proudly stated that it met its objective of positive adjusted EBITDA (just narrowly at CA$0.2 million). It's likely that will go back into the red if its gross margins shrink.
Does the acquisition of Zenabis help?
One issue that complicates things is the company's acquisition of cannabis producer Zenabis (ZBISF). Announced in February, the move will bolster HEXO's position in Canada and international markets. Zenabis has a facility in the EU, and HEXO says the acquisition will also make it a top-three licensed producer of adult-use pot sales in Canada. Zenabis can also help improve HEXO's top and bottom lines. In 2020, Zenabis generated CA$59.3 million in net revenue (nearly double what it did in the previous year) and its adjusted EBITDA was a positive CA$3.5 million.
In any merger or acquisition, there are often redundancies that the combined company needs to eliminate, and that can mean it will take a while before operations are running efficiently. However, HEXO projects that within one year of the transaction closing, it will realize CA$20 million in annual synergies as a result of the deal. I wouldn't hold my breath on what looks to be a very optimistic projection. Over the trailing 12 months, HEXO's operating expenses have totaled CA$82 million while Zenabis incurred costs of CA$36 million. With combined annual operating expenses of approximately CA$118 million, the anticipated savings would amount to roughly 17% of that total. That's no small improvement.
Investors shouldn't forget that this is the same company that once forecasted its annual sales were on track to hit CA$400 million only to end up withdrawing the forecast months later. And so any projection from HEXO should be taken with a grain of salt.
Should you invest in HEXO?
There are two things I steer clear of when investing in companies: businesses with low margins and management that makes aggressive forecasts. HEXO ticks both of those boxes.
I consider anything less than 40% to be a low margin because it means that even with strong sales growth, there may not be much incremental gross profit. If HEXO's gross margin falls to around 30% (which it might, depending on how well its value brand does), then even if the company's quarterly sales were to double by another CA$33 million, that would only mean CA$9.9 million in additional gross profit.
While it may be enough to land the company in the black, it's also assuming a significant rate of growth. And if the company is going to be focusing on the European market, its operating costs and overhead may only get larger in the future, making it more difficult to turn a profit. As of right now, it's a toss-up as to whether or not HEXO can stay in the black once all is said and done. There are simply too many variables to account for right now -- the impact of the acquisition, its values brand, and the pandemic.
And while being a top-three producer in Canada sounds great, investors shouldn't forget that with Aphria and Tilray merging, the field will also be smaller to begin with. HEXO is saying all the right things, but investors should be careful to take it all into context and not be too quick to trust the company's ambitious forecasts. By creating big expectations, it could set the stock up for losses later on if HEXO falls short. Considering all of the other great cannabis companies out there today, HEXO is one pot stock I would avoid.