Things were all smiles back in March when HEXO (HEXO +0.00%) released its fiscal second-quarter results. For the period, which ended Jan. 31, the cannabis grower and distributor achieved its goal of reaching positive adjusted EBITDA.
However, when it posted its fiscal Q3 results on June 14, management didn't focus as much on the bottom line -- no doubt because it was a loss, and broke HEXO's streak of seven straight periods of quarter-over-quarter improvement.
For the period that ended April 30, sales were down 31% year over year, and there's no shortage of reasons why. Here are three of the most concerning items I saw in HEXO's latest report that should have investors thinking twice about putting this pot stock into their portfolios.
Image source: Getty Images.
1. There were multiple supply related issues
CEO Sebastien St. Louis didn't try to sugarcoat the problems the company ran into during the quarter. One of them related to product quality. HEXO planned to replace some of its strains with ones that it believed were "incredibly promising," but when it came time to cultivate, the quality was subpar. As a result, the new strains were not of the same quality as the ones the company was no longer retaining in its inventory.
Although it was admirable for the CEO not to evade the issue, it still presents a real concern. HEXO's sales decline took place while retail sales of cannabis in Canada were rising -- up 6.7% from January to March, when they hit 298 million Canadian dollars. If product quality issues were to blame for a significant share of HEXO's steep sales drop-off, it suggests there is a lot of risk in the company's operations.
2. Craft competition chipped away at its market share
The CEO also admitted that HEXO "underestimated the speed with which the cannabis industry moves," saying that its supply of high-potency products came up short of demand.
In part because of that shortage, smaller producers were able to fill the void and take sales away from HEXO. Although St. Louis was dismissive of the impact, referring to it as "mostly a one-time thing," there's a concern here, too; if products from craft producers (e.g., small cannabis companies) are adequate substitutes for HEXO's own, that could suggest challenges ahead if there is an increase in competition. Ironically, one of the reasons St. Louis has given for not being concerned about craft products is that they are of lower quality -- but he said this toward the end of the quarter, when those rival businesses were also running short on high-potency cannabis products, not unlike the quality issues HEXO ran into during the period.
St. Louis may claim he's not worried about these developments, but they serve as a reminder that growing competition could make it more difficult for HEXO to even keep its sales consistent, let alone grow its business. Along with the steep drop in revenue this past quarter, it reported an adjusted EBITDA loss of CA$10.8 million.
3. There were no international sales
HEXO first launched international products last year when it announced a 24-month agreement with Breath of Life International, an Israeli-based medical marijuana company. International sales have never accounted for much of the company's top line. In fiscal Q2, they totaled just CA$2 million, or 6% of all sales. But in fiscal Q3, international sales were zero. In the earnings release, HEXO said that was as a result of "revised prerequisite testing and an additional certification by the Israeli government."
While HEXO says it is now in compliance and will resume international sales, this was another example of a situation where management wasn't able to react quickly enough. If international cannabis revenue were a bigger chunk of HEXO's business, the drop in revenue would have been even more significant.
This is a stock I would stay far, far away from
HEXO has been aggressive in trying to bolster its business with recent deals, including the acquisitions of Zenabis and other smaller cannabis companies. But it has plenty of problems of its own that it needs to address. I would have a hard time trusting the company to not only prevent these supply and quality-related issues from recurring, or o efficiently integrate its new acquisitions into its operations.
Simply put, too many things caught HEXO and its management off guard last quarter for me to see this as a stock worth taking a chance on. The company's recent acquisitions only add to the risk of even greater losses ahead as it takes on multiple challenges simultaneously.
