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Did This Deal Just Make Marijuana Stock HEXO a Bargain?

Todd Campbell, The Motley Fool

Canada's biggest marijuana stocks get the most attention. But the global marijuana market is worth $150 billion annually, and that suggests there's plenty of room for smaller pot stocks, including HEXO (NYSEMKT: HEXO). HEXO has been running under the radar compared to Goliaths Canopy Growth (NYSE: CGC) and Aurora Cannabis (NYSE: ACB); however, that could change following HEXO's decision to acquire Newstrike Brands for $263 million in shares. Is HEXO now a bargain worth buying?

What's the deal?

Canopy Growth and Aurora Cannabis are firmly entrenched as the top-tier leaders in this fast-growing marketplace. The two control about 50% market share in Canada's new recreational marijuana market already, and as a result, each is expected to produce hundreds of millions of dollars in sales in 2019. HEXO's acquisition of Newstrike Brands doesn't put it within striking distance of Canopy or Aurora yet, but it does give HEXO a shot at being one of the biggest second-tier marijuana companies.

A gold marijuana leaf on a table beside marijuana buds.

IMAGE SOURCE: GETTY IMAGES.

HEXO is licensed to market recreational marijuana in three provinces: Ontario, British Columbia, and Quebec, where its headquarters are located. Once this acquisition is complete, it will be able to market marijuana in eight of Canada's 10 provinces, giving it access to over 95% of Canada's population.

Thanks to the deal, HEXO will also add 470,000 square feet of indoor marijuana production space, putting it in a position to produce up to 150,000 kilos of cannabis per year.

In exchange, Newstrike Brands shareholders will receive 0.06332 of a HEXO share for each Newstrike share, giving Newstrike investors 14% ownership of the combined company. Based on HEXO's closing price on March 12, the acquisition value is $263 million.

A game-changing decision

HEXO's larger production and distribution footprint should cause its revenue to skyrocket. Canada's medical marijuana market has been up and running for years, but its recreational, adult-use market only opened for business in October. Adult-use sales were initially hamstrung by product shortages. However, industrywide investments in grow space should fill the gap between demand and supply, allowing more money to shift from the black market to the legal, regulated market. In the fourth quarter, Canada's CA$307 million in legal sales accounted for only 20% of the total spent on cannabis in the period.

As the country's recreational market matures and product availability improves, significantly more sales are likely to move out of the shadows, fueling revenue growth at HEXO and its peers. This market could also get significantly bigger if Canadian regulators approve the sale of cannabis-derived finished products, including beverages, later this year.

An OK of cannabis beverages would be particularly good news for HEXO investors. In 2018, beer giant Molson Coors (NYSE: TAP) inked a deal to collaborate with HEXO on nonalcoholic drinks containing cannabinoids, such as cannabidiol (CBD), that are extracted from marijuana. The two companies are developing these beverages through a joint venture that's 57.5% owned by Molson Coors.

An outstretched hand holding stacks of $100 bills.

IMAGE SOURCE: GETTY IMAGES.

A bargain worth buying

Marijuana stocks won't be confused with value stocks anytime soon, but some marijuana stock valuations offer investors a better bargain than others. That could be the case with HEXO following this acquisition.

HEXO's management says the newly combined company can achieve $400 million in sales in 2020. Based on that figure, its $1.2 billion market cap means shares are trading at roughly three times next year's revenue. By comparison, Canopy Growth is expected to reach a $1 billion sales run rate in 2020, which means its forward price-to-sales ratio is 16. There's no telling what happens next with HEXO's shares, but the difference in valuation makes it one of the more compelling marijuana stocks investors can consider buying right now.

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Todd Campbell has no position in any of the stocks mentioned. His clients may have positions in the companies mentioned. The Motley Fool owns shares of Molson Coors Brewing. The Motley Fool recommends HEXO. The Motley Fool has a disclosure policy.