I wrote about Hexo (NYSE:HEXO) stock last month. I emphasized that Hexo’s acquisition of the failing Canadian cannabis company Newstrike would increase its burn rate.
Nothing has happened since then to change my mind. In fact, I believe the stock could fall further. Here’s why:
This month HEXO will report its quarterly and annual results for these periods to July 31. The bottom line is this: HEXO stock could fall after the earnings are released. Here is why:
- Hexo’s acquisition of Newstrike will increase the combined companies’ cash burn rate.
- Investors want to see a coherent plan on how Hexo’s sales goals will lower that cash burn rate.
Hexo closed on the all-stock deal to buy Newstrike on May 24. I estimated last month that Hexo paid about $158 million US ($211 million CAD) for Newstrike.
I noted that Newstrike had cash flow losses of $39 million CAD in 2018. Newstrike has likely lost at least 50% more than that amount this year including about $15 to $20 million CAD in cash burn in Q4.
So if you add in HEXO estimated cash losses of $15 million to $20 million CAD in Q4, the two combined probably burnt $40 million CAD in real cash flow together.
Newstrike’s Appeal: Its Cash Balance
One of the reasons why HEXO bought Newstrike was because the latter came with a pile of cash and securities. In my previous article on Hexo stock, I estimated based on public filings that Newstrike had about $86 to $90 million CAD at the close of the acquisition on May 24.
Combined with HEXO’s own cash and securities of $189 million CAD in April, the two together probably have $230 million CAD after their Q4 cash burn losses. The combined debt balance is at least $40 million, so the net cash is probably below $200 million CAD.
I estimated that the two combined are burning cash at a rate of about $100 million a year. This means they have really no more than a year or so of cash burn. After that Hexo has to raise equity or debt to finance further losses.
Will Higher Sales Reduce the Cash Burn?
Hexo’s management has stated that the two companies will reach $400 million CAD in one year up from a combined $50 million CAD run rate as of April. Investors should look carefully at management’s presentation for its Q3 results to see if they have a clear plan to reach this goal.
But that may not be a positive for the Hexo stock. Unless HEXO can get control of the two companies’ cash burn rates, dramatically increasing sales will only exacerbate the combined cash burn.
What to Do?
Short sellers have been buzzing around Hexo stock. Shorts already account for 11% of Hexo stock outstanding, according to Yahoo! Finance.
They are looking for red meat. They will see an increased burn rate and lower cash balance, along with a higher debt ratio in Q4. This will push HEXO stock lower. Getting to $400 million CAD with a higher cash burn rate will only pour fire on Hexo’s stock.
A coherent plan should be presented by management in its Q3 results as to how HEXO will reach its $400 million CAD sales goal in one year.
That plan has to also show how there will be a lower cash burn rate as a result – or at least an estimated cash burn rate that trends lower towards profitability. For example, if its estimated gross margin stays low, working capital needs will only increase operating cash flow losses. How is management going to handle that?
If these concise plans are not presented, expect short sellers to continue to push the stock down after the earnings are released.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here. The Guide focuses on high total yield value stocks and was launched on August 30. Subscribers during September receive a 20% discount, plus a two-week free trial.
