And Hexo’s earnings last week suggest very little improvement. The cannabis company announced a brand-new $25.5 million offering this week. Until it takes significant steps toward profitability, I expect more of the same from Hexo stock.
Investors are no longer giving cannabis stocks a free pass. They’ve been burned by cannabis stocks, and they are finally staying away from companies with near-term balance sheet issues. Hexo stock may ultimately be a big winner in the long-term boom in global cannabis demand. But at this point, investors need to be very careful in the cannabis space, and Hexo is not the preferred play.
Hexo’s Cash Problems
Hexo reported just 15 million CAD in net cash at the end of the April quarter. That net cash includes 94 million CAD in cash and 79 million CAD in debt. The company also raised roughly another $50 million in cash in May via an equity and warrant offering. And of course, there’s the new $25.5 million offering as well.
To Hexo’s credit, its free cash flow improved from negative $80 million in the previous two quarters to just negative $30 million in the most recent quarter. However, another way to look at it is that Hexo burned twice its net cash position last quarter.
Prior to this week’s offering, Cantor Fitzgerald analyst Pablo Zuanic estimated Hexo’s share count to be around 496 million. If investors include other derivatives, the fully diluted share count was up to around 625 million.
In the past year, Hexo’s outstanding share count is up 59%. The May offering suggests that number is still growing. Zuanic estimates Hexo’s true dilution has been about 75% since the end of January once all warrants and derivatives are factored in. Again, that doesn’t include this week’s offering, which represents about 6.5% of the company’s market capitalization.
Hexo’s sales growth in the recent quarter was impressive. Revenue was up 30% compared to the previous quarter. However, average recreational pricing was down 9% sequentially. Zuanic estimates Hexo’s average recreational cannabis price in the quarter was about half the average price among its Canadian legal producer peers.
Hexo has said it will be generating positive earnings before interest, taxes, depreciation and amortization in the first half of fiscal 2021, which begins in August. However, Zuanic says the stock’s valuation is simply too high given the near-term execution risks.
“Operating trends are improving, but we take issue with the valuation (given recent dilutive actions) and risk of further funding needs,” he says.
“HEXO trades at 6.3x current [enterprise value-to-sales], compared with 5-6x for [overweight]-rated APHA and OGI (two companies in better financial shape and with higher margins),” Zuanic says.
Cantor Fitzgerald has an “underperform” rating and 66-cent price target for HEXO stock.
How to Play HEXO Stock
At this point, with HEXO stock down so much in the past year, there may be limited additional downside in the near term. However, until the company stops bombarding shareholders over and over with more dilutive financing, HEXO stock is simply too much of a risk.
I first wrote about cash burn issues for Aurora Cannabis (NYSE:ACB) back on July 22, 2019. Since that time, ACB stock is down 79.8%. Cannabis investors have moved on from the “growth at any cost” thesis that worked back in 2018.
I’m a long-term bull on cannabis stocks. But investors have learned the hard way that they can’t simply rush in and buy any old cannabis stock that hits the market. Valuation, dilution, earnings and cash burn all matter.
Picking the ultimate cannabis winners and losers at this point is extremely difficult. The cannabis business is still in its infancy. I have been recommending all cannabis investors take advantage of the power of diversification. Buy a basket of at least five or six of the highest-quality cannabis stocks.
Consider buying Zuanic’s value recommendations of APHA stock and OGI. I would also recommend buying Canopy Growth (NYSE:CGC) and Cronos (NASDAQ:CRON), the two best “big four” Canadian legal producers. Finally, add a couple of top-tier U.S. operators, such as Cresco Labs (OTCMKTS:CRLBF) and Trulieve Cannabis (OTCMKTS:TCNNF).
Wayne Duggan has been a U.S. News & World Report Investing contributor since 2016 and is a staff writer at Benzinga, where he has written more than 7,000 articles. Mr. Duggan is the author of the book Beating Wall Street With Common Sense, which focuses on investing psychology and practical strategies to outperform the stock market. As of this writing, Wayne Duggan was long CGC.