Since May 2019, stocks in the cannabis industry have been on a meltdown. The irrational exuberance prior to the downside ensured that the correction is steep. Hexo Corporation (NYSE:HEXO) has been no exception, and Hexo stock has slumped by 72% since May.
The downside momentum certainly seems to have decelerated and Hexo stock has been in a consolidation zone. From a fundamental perspective, there is unlikely to be a major positive trigger in 2020.
On the other hand, industry-level concerns sustain. This is likely to ensure that Hexo stock price remains sideways to lower in the coming year.
First Quarter Concerns
Hexo reported first-quarter results for 2020 on Dec. 16, and the results highlighted several concerns.
The first point to note is that Hexo reported cash and equivalents of $CAD140 million for 4Q19. The company’s cash position for 1Q20 was $CAD55 million. Further, for 1Q19, cash used in operations was $CAD21 million and it worsened to $CAD34 million for 1Q20. Clearly, Hexo remains in a period of cash burn, which has accelerated on a year-on-year basis.
In the first week of December, Hexo did raise $CAD 70 million private placement of unsecured convertible debentures. This will boost the liquidity position for the near-term. However, it is unlikely that cash burn will be plugged in 2020. I therefore expect more fundraising and equity dilution can keep the stock subdued.
On look at the financials, a second challenge is as follows: The average selling price of dried cannabis for the quarter ended January 2019 was $CAD5.83. For the most recent quarter, the average selling price has declined to $CAD4.35. The inventory for dried cannabis has declined for the first time in September 2019. However, with ample inventory of dried cannabis and cannabis oil, it is unlikely that prices will trend higher. This will impact margins through 2020.
Hexo Stock and Value-Added Products
Hexo, similar to other cannabis companies, is focused on the launch of value-added products. This includes recreational cannabis as well as medicinal cannabis products. The company estimates that the global market size of cannabis is $250 billion.
However, I believe that the inflection point is still few years away. In other words, recreational and medicinal cannabis will make gradual inroads in the big addressable market.
In November 2019, the U.S. Food and Drug Administration warned 15 companies for illegally selling products containing cannabidiol in ways that violate the Federal Food, Drug, and Cosmetic Act. The FDA also mentioned that “Consumers may also put off getting important medical care, such as proper diagnosis, treatment and supportive care due to unsubstantiated claims associated with CBD products.”
As a matter of fact, the FDA has just approved one prescription human drug product to treat rare, severe forms of epilepsy. Therefore, most of the medicinal cannabis products in the market are based on claims or beliefs. This needs to transform into evidence-backed research. The market is unlikely to grow until then.
Similarly, vaping products containing THC has resulted in more than 1,000 reports of lung injuries. This makes the regulators as well as the consumers cautious. The bottom line is that it might be just too early to believe that robust growth is likely for value-added products.
On the other hand, Hexo will need to invest in clinical research as well as aggressive marketing. This would imply sustained cash burn for the company even beyond 2020.
My Final Thoughts on Hexo Stock
Hexo is still at an early stage of growth and there are plenty of challenges ahead. There is no doubt that Hexo is creating a healthy portfolio of value added products. However, these products are unlikely to translate into cash flows anytime soon.
Hexo is targeting positive EBITDA in 2020. But I remain skeptical considering the industry headwind related to regulations.
Overall, Hexo stock might remain sideways to lower in the coming year and I would avoid exposure. However, there will be near-term trading opportunities from overbought or oversold levels.
As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.
