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Is HEXO Stock a Buy on the Dip?

Cory Renauer, The Motley Fool

Canadian cannabis producer HEXO (NYSEMKT: HEXO) recently unveiled results from the three months ended April 30, 2019. There were some impressive top-line numbers, but they were largely ignored and the stock finished the week of its announcement 32% lower than a peak it reached near the end of April.

Is this dip a chance to pick up a leading cannabis producer at a discount, or could this be the beginning of a longer slide? Here's what you need to know about HEXO's chances to turn this ship around.

A cannabis leaf on top of a pile of one hundred dollar bills.

Image source: Getty Images.

Reasons to buy

There aren't many industries growing faster than licensed cannabis right now. Using 2018 as a baseline, global sales are expected to double by 2022.

In 2019, worldwide sales of legal marijuana are expected to come in 38% higher than a year earlier, and HEXO's top line bears this out. During the company's fiscal third quarter, net revenue grew 950% year to year to CA$13 million.

HEXO didn't just report a lot more top-line revenue -- the company's gross profit during the fiscal third quarter rose 746% to CA$6.4 million before adjusting for changing values of growing plants.

HEXO sold 2,759 kilograms during the three months ended April, and according to management, this figure would have risen much further if the company had more product to sell. The fourth quarter should be much better thanks to a new 1-million-square-foot greenhouse that completed its first harvest in April, which was too late to make an impact on third-quarter sales. A contract to supply Quebec with at least 200,000 kilograms over the next five years, beginning later this year, will provide a fairly reliable revenue stream.

In October, Health Canada will probably begin allowing the sale of cannabis-infused edibles and beverages. Through a joint venture with Molson Coors Brewing, HEXO's ready to jump into the market for nonalcoholic beverages infused with cannabis.

Starting a new beverage business with Molson Coors isn't the only forward-looking deal that the company's completed over the past year. It's also splashed out on an acquisition of Newstrike Brands, which will boost production capacity, and an extraction deal to provide the raw material for derivative cannabis products.

A person with gloved hands holding cannabis buds.

Image source: Getty Images.

Reasons to be nervous

The global market for licensed cannabis is being fueled by U.S. states that keep initiating medical and recreational programs. As long as the federal government considers cannabis illegal, HEXO can't sell any cannabis products containing tetrahydrocannabinol (THC) in the U.S. without risking its stock market listing.

Net revenue soared compared to the previous-year period, but compared to the previous quarter, it fell 3% to CA$13 million. This could be due to a lack of product to sell on HEXO's part, but investors should know that Health Canada has reported growing inventories and stagnating sales of licensed cannabis for the country as a whole.

Canada's highly regulated legal market hardly made a dent in its thriving illicit market, which still accounts for around four-fifths of total cannabis sales in the country. Unless the government steps aside and allows the legal-weed industry to compete without both hands tied behind its back, the illicit market isn't going away.

Selling licensed cannabis across the pond isn't going to be any easier. Most local law enforcement organizations in the EU don't consider chasing small-time cannabis dealers an acceptable use of time or money. Few are as casual about cannabis as the Netherlands, but I'd be surprised if any of the member states don't have at least a few unlicensed storefronts operating in their largest cities.

A man with a pencil in his mouth looking at a receipt.

Image source: Getty Images.

In the numbers

Rapid expansion has saddled HEXO with unsustainable operating expenses. For example, sales, general, and administration costs reached 121% of net revenue in the third quarter, and these expenses are hard to trim without calling attention to the problem. If the company can't find a buyer for tons of cannabis left over after meeting obligations to Quebec, its CA$188 million cash cushion will dwindle faster than expected.

Cannabis-derived products are increasingly popular in markets where they're available, but that doesn't necessarily mean we're going to see everyone drinking one bottle after another of popular new nonalcoholic beverages infused with cannabis. Health Canada will allow just 10 milligrams of THC per container or package, which makes them practically useless to frequent cannabis users.

Trying to sell beverages and edibles that aren't any use to a demographic that's responsible for a majority of overall cannabis sales is going to be a tough slog uphill. March was the best month yet for cannabis sales in Canada since adult-use sales began last October. Unfortunately, dry flower sales during March were only 27 kilograms higher than a peak reached in December, and oil sales were just 4 liters above a peak reached in January.

By the end of summer, HEXO thinks its greenhouses will be pushing out cannabis at a rate of 150,000 kilograms annually, and the company needs to sell all of it to support its recent $1.4 billion market cap. If legal sales don't improve much, HEXO will need to gain at least one-quarter of Canada's available market to move that amount and justify its sky-high valuation.

The analysts who pick stocks for our premium services aren't nearly as pessimistic about the future of licensed cannabis as I am. Although HEXO is performing much better than most of its peers, it's still operating in an industry with much slimmer margins and a smaller available market than its market value suggests. I'll keep this stock on a watch list, but I'd need to see it dip further before it seems worth the risk.

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Cory Renauer has no position in any of the stocks mentioned. The Motley Fool owns shares of Molson Coors Brewing. The Motley Fool recommends HEXO. The Motley Fool has a disclosure policy.