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HEXO: Can the Company Break the Illegal Cannabis Market?

After HEXO (HEXO) released horrible preliminary FQ4 revenue numbers, the company came out with an innovative product to crack the low prices of the illegal cannabis market. The company had built the investors up on FY20 revenue targets of C$400 million that have now been withdrawn. The stock still can’t be touched at lows below $2, but the ability to innovate in the face of an adjusting market is encouraging for the long term.

Value Brand

The biggest issue facing the Canadian recreational cannabis market is the still vibrant illegal market. The lack of retail stores in Canada is contributing to a market unable to undercut legal cannabis on supply that combines low prices with easier access to customers to still cover nearly 50% of the market.

To address this market reality, HEXO quickly developed the Original Stash brand to combat the illegal market with a low-price option. The value brand sells 28 grams (1 oz) at black market prices. The retail price in Quebec was listed at C$125.70 including sales taxes, equivalent to C$4.49 a gram.

A survey from Abacus Data found that:

  • 15% of Canadians say they have purchased dried flower since legalization and 4% purchased capsules.
  • 55% purchased in a physical retail store, 28% in a legal online store.
  • But 1 in 5 say they purchased on "another online store or website" and 31% purchased from "another source" such as black market.

Stats Canada lists the Q# difference between legal and illegal cannabis as nearly double the price. The illegal prices are now C$5.59 per gram. On the FQ4 earnings call, the CEO claimed the value product was 10% below the black market price and actually profitable.

Whether the initial rollout has been extremely successful or not is unknown at this point. What is known it that HEXO found a solution to lead the market for the time being.

Upside Potential

The stock has taken a beating as the company pulled FY20 estimates for revenues of $300 million to analyst estimates now below $90 million. The numbers start to appear far too low with Cannabis 2.0 and the value brand hitting the market at the end of calendar 2019.

HEXO cut 200 employees and closed some cultivation facilities to cut costs. The company forecasts reaching EBITDA positive in 2020, but the inability to hit previous FY20 financial targets has the market very skeptical, especially with a new CFO.

The biggest problem is that any failure to reach EBITDA positive on target will require massive stock dilution to fund losses. The company has just enough cash to finish their existing Belleville facility for Cannabis 2.0 products and cover cash flow losses over the next year or so. HEXO already needs to raise additional capital via at-the-market stock offerings to provide a capital cushion.

Consensus Verdict

As far as the cannabis producer's verdict on the Street, it is a toss-up among analysts, as TipRanks analytics exhibit HEXO as a Hold. Out of 13 analysts polled in the last 3 months, 2 are bullish on Hexo stock, 8 remain sidelined, and 3 are bearish. (See HEXO price targets and analyst ratings on TipRanks)

Takeaway

The key investor takeaway is that HEXO has made some crucial steps to turn around their business. The analyst estimates appear too conservative now, but the Canadian cannabis company needs to prove out the new value brand concept and start the Molson Coors beverage JV on a solid footing before the stock will turn appealing to new investors.

For now, investors should safely watch from the sidelines.

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