At the end of July, a short seller went after Hexo Corp. (NYSE:HEXO) — and the market yawned. In fact, the HEXO stock price bottomed the Friday before, gained 9% the day of the report, and even with a pullback is up over 11% since the session before its release.
The market’s lack of response isn’t terribly surprising. Short sellers have had a few high-profile misses of late. In late 2017, Citron Research infamously compared Shopify (NYSE:SHOP) to Herbalife (NYSE:HLF); SHOP stock has tripled since then.
Closer to home, in December Quintessential Capital Management alleged self-dealing at fellow cannabis producer Aphria (NYSE:APHA). Quintessential made some good points: Aphria took a C$50 million impairment on acquired assets barely four months later. APHA stock lost half its value after the release, then promptly rose 150% before fading along with other cannabis plays.
So there are some reasons why investors might see this bear raid, too, as much ado about nothing. And in terms of the most widely-covered allegation, it may be. But the report does highlight some potential risks to HEXO stock — risks that investors would be wise to at least keep in mind going forward.
The Snapchat Risk to Hexo Stock
The primary allegation from short seller The Friendly Bear is that Hexo’s advertising on Snap (NYSE:SNAP) platform Snapchat could violate Health Canada regulations. The Friendly Bear compared Hexo to CannTrust Holdings (NYSE:CTST), whose stock plunged after illegal grow rooms put its production license at risk.
The argument is intriguing, if a little thin. Health Canada regulations prohibit advertising of any kind to minors (those under 18, the federal minimum age for cannabis purchase in the country, though most provinces set the age at 19). Snapchat, of course, sees heavy usage among teenagers.
But, as The Friendly Bear points out, the regulator also forbids advertising that associates the brand with “glamour, recreation, excitement, vitality, risk or daring.” An ad captioned “A Fresh Spark” may well fit that bill. Both issues are amplified by the fact that Health Canada, in March, emphasized both the promotional nature of some online advertising and pointed to concerns about social media ads being seen by customers who were not of age.
In a statement to Bloomberg, Hexo refuted the report. It noted that it doesn’t run campaigns in its home province of Quebec, where regulations are more stringent. And it said its agreement with Snapchat ensures ads reach only adults.
That response seems to have satisfied investors. And perhaps with good reason. The regulations are stringent, and perhaps somewhat vague. Even if Health Canada determined that the ads were in violation, one imagines Hexo would be able to pull or revise its advertising. Comparing Hexo to CannTrust, in particular, seems like a potential bridge too far.
Two More Risks to the HEXO Stock Price
That said, the report also contained two other intriguing facts that didn’t seem to gain as much attention. First, the author highlighted a potential risk to Hexo’s relative dominance in Quebec. The company owns about 30% share in that key market, thanks to a first mover advantage and its physical presence in the province.
An agreement with the province ensures guaranteed purchases of 20,000 kilograms in year one, per a Hexo press release from last year. But it’s not clear that the guaranteed extends beyond year one, with Hexo itself writing at the time that the agreement was “expected to supply” increased amounts going forward. With competition increasing, the expected growth in demand may not materialize.
The second source of potential pressure comes from a recent regulatory measure. Quebec already has banned the sale of candies, in an effort to protect minors. Federal regulations on edibles appear to be much the same, ahead of the expected launch of those products near the end of this year.
That’s a potential issue for Hexo in Quebec and beyond. After all, Hexo itself is focused on becoming, as it terms it, “the premier branded ‘ingredients for food’ cannabis company.” If regulations compress the edible market, Hexo, more than other cannabis plays, would suffer.
Patience May Be Wise With HEXO Stock
None of this is to say that investors should have sent the HEXO stock price tumbling — or that Hexo stock is a short. I wrote last month that HEXO would be an intriguing buy at some point. The stock has returned to similar levels, but I’m still somewhat loath to rush in.
The focus on edibles is wise for a smaller producer — but that catalyst remains likely six months away. Cannabis stocks continue to struggle, with even Aphria’s blowout earnings report not enough to spark a sector-wide rally.
And Hexo Corp. doesn’t have a lot of room for error. It remains reliant on Quebec. It will remain reliant on edibles going forward. If either of those two markets is smaller than hoped, Hexo’s growth slows. And a market cap still over $1 billion (including the effect of warrants) may well come down. The HEXO stock price may be cheaper, but that’s not the same as it being cheap.
As of this writing, Vince Martin has no positions in any securities mentioned.
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