Hexo’s Burn Rate Is Dangerously High

Investors should wait to see if HEXO will stem its losses

Hexo Corp (NYSE:HEXO) is another one of the many publicly traded Canadian cannabis stocks losing money. But it is desperately trying to create a brand name for its products in Canada and overseas and turn around its financial situation.

Hexo Stock Burn Rate Is Dangerously High
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As you might suspect, Hexo stock is very speculative. It sports a $1.1 billion USD market value but has never made a profit.

Its stated goal is to reach $400 million CAD in profit by the end of the year. Even with its recent Newstrike acquisition, which is also bleeding losses and has very little revenue, that does not seem very likely.

Could that change? Let’s look at this more closely.

Heavy Losses Being Racked Up

HEXO recently reported losses of C$24.9 million ($18.7 million USD) on net revenues of $31.9 million CAD ($23.9 million USD) for the 9 months ending April 30, 2019. That means that its losses represented 78% of revenue.

HEXO lowered net income losses to 59% of sales in the April quarter. But cash flows were still $44 million ($33 million USD) in the red for the 9 months ending April.

Hexo’s Acquisition of Loss-Making Newstrike

Hexo closed an all-stock deal to purchase of Newstrike Brands for its shares valued at $263 million CAD in May, after its third quarter ending April 30. This deal will start producing consolidated revenue for two months of its Q4 ending July. Hexo said at the time that with Newstrike it can now reach $400 million by end of July 2020.

That seems almost incredible. Newstrike produced revenue of just $8 million in 2018 and had no revenue in 2017, according to Sedar, the Canadian version of US S.E.C. Edgar database. Newstrike had losses of CAD$ 20.2 million in 2018 and CAD$14 million in 2017.

Combining Newstrike’s $8 million sales with Hexo’s estimated $45 million or so expected sales for the year ending July 2019 would only give the two a combined run rate of $53 million annually. This does not get HEXO close to its stated $400 million target for the year ending July 2020.

Burn Rates Rise Together

The deal was very expensive for Hexo shareholders for two reasons. First, the combined cash bleeding cannabis firms will produce cash flow losses totaling at least $99 million CAD, including Newstrike’s annual cash flow losses. For example, HEXO had negative cash flow of $44 million for its first 9 months and likely had another $15 million in cash flow losses in for its Q4 to July.

Newstrike had $39 million CAD in cash flow losses for all of 2018, before it raised $141 million in cash to stem those losses. So the two together will burn $99 million of their combined cash balances unless their sales and cash flow turn around.

Secondly, Newstrike shareholders ended up with 14.4% of the combined 246 million shares before outstanding options. At HEXO’s price today of $4.48, the total market value of both companies is now $1.1 billion USD ($1.467 billion CAD). That means that Hexo paid $158 million USD ($211 million CAD) (14.4% x $1.467 billion CAD) for a company with only $8 million CAD in revenue that bleeds $39 million in cash flow.

That’s 26x revenue and 5.4x negative cash flow.

How Far Can Hexo’s Cash Go?

Newstrike came with cash and securities. Newstrike had $106 million CAD in net cash and securities as of the end of December 2018. It likely has burnt through another $20 million as of July, considering its $40 million burn rate last year. (Newstrike never announced its March financials so it’s not clear how much more losses HEXO has had to absorb.) That leaves $86 million.

HEXO had $189 million CAD in cash and securities and $34 million in debt, leaving it with net liquidity of $155 million as of April. But as pointed out above, HEXO has likely burned through another $15 million in its Q4, so its net liquidity is likely about $140 million as of July. Combined the two have about $226 million as of the end of July.

We pointed out above that the annual burn rate is at least $99 million, unless their sales and cash flow turn around. That means the combined $226 million in net cash and securities could only last two years unless its sales and cash flow turn around.

HEXO has been selling new equity shares to finance its losses. In January, HEXO sold $57.7 million ($43.2 million USD) in HEXO stock at a price of $6.50 per share ($4.875 USD) to finance its losses. It also borrowed $33.7 million ($25.3 million USD). The U.S. stock price is now $4.48, down 8% from the secondary offering price.

Investors’ Appetite for Share Sales May Be Waning

This kind of cash flow drain for the two companies together is unsustainable for longer than a year or so.

In HEXO’s case, as with many of the marijuana stocks in Canada, there is not sufficient light on a path to cash flow profitability. Combining two loss making companies, despite all their synergies and prospects together, might not stem those losses quick enough.

After one more year of $100 million CAD losses, investors in new equity raises by HEXO would want to see a clear path to cash flow profitability.

A Non-Virtuous Circle

Here is how that works: If the market suspects that the company is running out of money, as it will with one more year of losses (i.e. considering the $99 million CAD cash flow drain), HEXO’s credibility will wane with investors. The equity price for the capital raise will likely be significantly below today’s level without that clear path to profitability.

That is probably why management started saying they expect to reach $400 million in sales, without a clear explanation of how it would be done in its presentation during the announcement of the Newstrike deal in March.

By running large cash flow losses, HEXO runs the risk of a falling into a non-virtuous circle where it becomes very difficult to raise capital. What will happen is that within a year or so with continuing cash losses, the market will anticipate the company’s need to raise capital.

It will want the equity raise price to be lower to be able to price future potential cash flow drains with the new capital. This then becomes a non-virtuous circle of falling price because of an expected lower price needed for a capital raise.

What Should You Do?

Hexo and Newstrike have a lot of plans together to increase sales and produce synergies. But they will have to work hard to make sure not to burn through much of their cash balances over the next year. Otherwise they will have to raise equity at lower prices than today, diluting their shareholders even further.

Defensive investors should look to see what management says in their reports for the July quarter. How much cash do they have, and debt? What is their plan to get to $400 million CAD in sales by July 2020, when right now their combined run rate of revenue is only about $50 million to $55 million?

How will they stem an estimated $100 million in cash flow burn? In fact, will the burn rate rise as Hexo uses up its cash balances to pay for capex and other investments needed to get its infrastructure to $400 million in sales?

All of this means shareholders should wait before buying HEXO stock before the July earnings and management’s predictions about the combined company. Hexo has not revealed yet when it will announce those earnings.

As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2019/08/hexos-burn-rate-is-dangerously-high/.

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