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Hexo Has Difficult Days Ahead, Analyst Says

support@smarteranalyst.com (Ben Mahaney)

Jefferies analyst Owen Bennett is not a fan of Hexo (HEXO), and for the time being at least, his antipathy is proving well-founded.

On Wednesday after close of trading, Canadian marijuana stock Hexo reported its fiscal Q3 earnings results. "Earnings" per se weren't horrible. The stock reported a $0.04 per share loss, which while not great, was at least better than the $0.05 per share that most analysts had expected it would report. Rather than earnings, Bennett's problem with Hexo is the company's sales -- and the negative trend those sales are starting to exhibit.

Hexo, you see, has publicly declared its intention of growing sales from about $4 million last year, to about C$400 million next year. Problem is, while sales did in fact grow strongly in Q3 2019 relative to Q3 2018 numbers, they didn't grow as strongly as Wall Street had hoped they would -- and in fact, sales declined sequentially from Q2 to Q3.

"Hexo's Q3 net revenue came in below estimates at C$13.0m," noted Bennett, versus the consensus number of C$14.7 million. Arguably worse, Q3 sales came in $400,000 below the C$13.4 million Hexo booked in Q2 -- the opposite of what Hexo had predicted going into earnings. This was despite Hexo growing both the volume of marijuana it produced, and sold, in Q3 relative to Q2.

Why? According to Hexo's report, the price of both marijuana grown for recreational consumption, and also medical marijuana prices (expressed in C$ per gram) declined quarter-over-quarter -- by 9% and just under 1%, respectively. The company's "average gross selling price" also declined by 9%, to C$5.48 per gram.

Nor does this appear to be a one-time letdown. To the contrary, Bennett quoted management warning of "significant pricing compression" over the next 24 months. This will have a negative effect not just on sales, but on the profit margins Hexo earns on those sales as well. Instead of the 53% gross profit margin that analysts had expected Hexo to earn in Q3, the company grossed just 50%. And now, Hexo management says its "gross margins for flower" could fall to as little as 40% over the next two years.

Additional risks highlighted by Bennett include: potential delays by Health Canada in giving guidance on the marketing of "derivative" (i.e. non dried flower) cannabis products, potential delays in Hexo's construction of its Belleville processing site (designed to process 375,000 tons of marijuana per year), the possibility that "muted" sales will result in an oversupply of marijuana in Quebec, and the likelihood that such an oversupply will further depress prices -- perhaps hurting margins even worse than management is already warning about.

None of this, it bears mentioning, bodes particularly well for Hexo's stated intention of growing its marijuana sales to C$400 million by 2020. And that, in a nutshell, is why Bennett is maintaining his "underperform" rating on Hexo stock, and his price target of C$7.70.

To read more on the nitty gritty of what’s going on in the rising cannabis industry, click here.

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