After a huge rally to start the year, Hexo (NYSE: HEXO) has come crashing back down to earth. The stock is now down 48% in the past three months. Cannabis investors may be puzzled as to what has changed the market’s mind about HEXO stock so definitively.
Several factors have been weighing on Hexo shares in recent months. But at the end of the day, this type of extreme volatility is exactly what cannabis investors should expect in the near-term. Here are four reasons investors have been dumping HEXO stock.
1. The Market Is Getting Real About Cannabis Valuations
Long-term growth stocks are always the most difficult to value because of their combination of high expectations and unpredictability. Hexo and other cannabis stocks offer long-term investors one of the highest potential growth opportunities in the market. But the shares are already priced with high expectations in mind.
Hexo, for example, trades at a 33.8 price-to-sales ratio. That PS ratio is down from above 90 three months ago. Long-term investors must continue to balance realistic valuation based on fundamentals and long-term opportunities for growth in the cannabis market.
2. Hexo Cannabis Pricing Is Under Pressure
Hexo’s fiscal third-quarter earnings report was relatively solid in terms of numbers. However, Hexo already has much lower cannabis prices than most of its peers. The company’s CEO warned investors that pricing would be under further pressure in the months ahead.
Bank of America analyst Christopher Carey said the pricing pressure Hexo is facing isn’t a case of market competition. Instead, he says the pressures are coming from the Canadian province of Quebec, where Hexo holds about a 30% market share.
3. Hexo Stock Is Battling New Quebec Restrictions
As if pricing pressures weren’t enough, Quebec is also imposing new cannabis restrictions. On July 24, Quebec unveiled a new draft of legislation that bans certain cannabis edibles, including chocolates, candies and desserts. The reasoning for the move is to protect children from cannabis abuse.
Quebec also has proposed measures to ban cannabis additives intended to modify the smell, taste or color of products. Finally, Quebec is proposing a ban on any cannabis products intended for topical use.
4. Guidance May Be Too High
Following its earnings report, Hexo issued fiscal 2019 revenue guidance of C$400 million. Consensus analyst estimates are calling for C$324 million. Carey is one of the guidance skeptics.
“While certainly HEXO has capacity to hit this figure, we are unsure the market can withstand this much product, with the total Canadian cannabis retail market currently at a sub $1bn annualized run rate (though more stores should expand the market),” Carey says.
He is projecting revenue of C$310 million, well below both company guidance and Wall Street consensus. Long-term investors should keep in mind that even Carey’s conservative projection represents a staggering 436% year-over-year growth.
The Bottom Line on Hexo Stock
Every time I write about cannabis stocks, I give the same advice. Cannabis stocks like Hexo are high-risk/high-reward speculative investments. No matter what, cannabis investors should be anticipating major volatility to continue.
Unfortunately, it’s way too early to determine with any degree of certainty which handful of cannabis stocks will ultimately dominate the space. Hexo is certainly off to a good start.
“We think Hexo is a good operator, with a model positioned for future growth (int’l) and challenges (price pressure),” Carey says.
Rather than gambling on one or two cannabis companies, long-term investors should consider reducing risk by betting on the cannabis group as a whole. Investing in five or six of the top cannabis stocks, including HEXO stock, Canopy Growth Corp (NYSE: CGC), Aurora Cannabis (NYSE: ACB), Cronos (NYSE: CRON) and others, helps leverage the power of diversification. Ten years down the line, chances are the two or three dominant players in the cannabis space will come from somewhere within that group.
As of this writing, Wayne Duggan did not hold a position in any of the aforementioned securities.
