The cannabis industry continues to deliver storylines, both negative and positive, that leave investors scratching their heads about which pot stocks to buy. One recent story has shined a light on Hexo (NYSE:HEXO), which could end up hurting Hexo stock holders.
Hexo, the largest company by market share in Quebec, Canada’s second-largest province by population, is facing additional scrutiny after The Friendly Bear, a short-seller research firm released a report July 29 suggesting it was using aggressive promotion tactics on Snap Inc’s (NYSE:SNAP) Snapchat in violation of Canada’s strict advertising laws regarding minors.
The Friendly Bear went as far as suggesting Hexo could be Canntrust 2.0, a reference to Toronto-based CannTrust (NYSE:CTST), who’ve been forced to cease cannabis sales while Health Canada decides whether to suspend or revoke its license as a result of an audit that found the company was growing pot in five unlicensed rooms at its Pelham, Ontario, grow-op.
Hexo Stock and Regulations
Let’s be clear about one thing.
Any advertising violations, which Hexo vehemently denies, are not the same thing as growing illegal pot. People could go to jail over the CannTrust issue.
“We’re in uncharted territory,” said Trina Fraser, a cannabis lawyer with Brazeau Seller Law, about the Health Canada probe. “The potential for people to go to jail certainly exists. The potential for significant fines to be levied certainly exists.”
Anyone who’s invested in cigarette companies knows you don’t go to jail for advertising violations. Until proven otherwise, Hexo’s reputation is entirely intact, in my opinion.
However, the incident should make investors question Hexo’s valuation.
Hexo Stock Valuation
As I write this, the Hexo stock price is $4.70, well below $10, the share price I predicted it would hit in my May article about the company. At its current price, it has a market cap of $1.14 billion.
As InvestorPlace’s Ian Bezek recently stated, Hexo is nowhere near generating the CAD$400 million ($302 million) in revenue it’s projecting by the end of 2020; it’s currently at an annual run rate of C$70 million.
However, consider these two points before dumping on Hexo’s current valuation.
First, the Motley Fool’s Keith Speights wrote an excellent piece July 28, using a back-of-the-napkin calculation to determine Hexo’s future valuation.
Speights hypothesized that since the Canadian adult-use recreational marijuana market is projected to reach $5 billion by 2024, and Hexo has 30% market share in Quebec, a province that accounts for 21% of Canada’s population, it should have 6.3% market share for the entire country. He then upped that to 7% to account for its market share outside of Quebec.
I like the way he’s worked backward from the total market estimate. While it might turn out to be lower than $5 billion, the odds of Hexo losing market share in Quebec is unlikely.
So, that works out to revenue of $350 million by 2024, or 3.3 times sales based on its current valuation. That’s the first floor on HEXO.
The Molson Coors Floor
The second floor is the 50/50 joint venture with Molson Coors (NYSE:TAP).
As I stated in July, the Truss partnership with Hexo is ready to go when the legalization of cannabis-infused drinks happens in October, and distribution rolls out in December after the required 60-day waiting period.
“We’ll have a very large supply so we’ll be in a good position to be able to meet the demand of the marketplace and at the same time also ensure that we’re meeting the variety that the marketplace wants,” Hexo’s VP of Strategic Development, Jay McMillan said in an interview at the World Cannabis Congress in Saint John, New Brunswick, in June.
What’s that worth to Hexo stock?
I believe that cannabis-infused drinks, edibles and vape concentrates will be far more lucrative on a global basis than the dried flower. The revenues generated from Truss could be significantly higher than Hexo’s dried flower sales.
And that doesn’t take into consideration the real possibility that Molson Coors could partner with Hexo in the U.S.
So, I don’t think it’s out of line to suggest the drinks portion could be worth at least $175 million (half the $350 million estimate by 2024 for dried flower) to Hexo.
Add that to the $350 million and you get a current valuation that’s just 2.2 times sales.
Does Molson Coors act as a floor on Hexo stock?
I think it does.
At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.