Hexo Corp (NYSE:HEXO) has been trending lower since the end of April 2019, but it’s not just Hexo stock, the entire pack of cannabis industry stocks have witnessed sharp correction. in the last few months.
When I last wrote on Hexo stock, it was trading at $3.99 and I opined that the stock can bounce back from deeply oversold levels. The stock moved higher by 23.8% to $4.94. However, the rally was followed by a swift correction and the stock is back to $4.0.
As I initiate coverage again on HEXO, I am of the opinion that the stock will continue to provide trading opportunities. Long-term investors should, however, stay away from the stock.
This coverage will elaborate on the factors that serve as negative triggers for long-term investors.
Competitors are Relatively More Attractive
If I had to choose stocks from the cannabis industry for long-term exposure, I would prefer investing in Canopy Growth (NYSE:CGC) or Aurora Cannabis (NYSE:ACB). Of course, these two names have also witnessed a sharp decline in stock price.
However, in an industry that is already shaping up to be significantly competitive, Canopy and Aurora are better bets.
To elaborate on the reason, selling dry cannabis or cannabis oil is unlikely to be a long-term revenue and free cash flow driver for companies.
It is product innovation and wide market reach that will deliver revenue growth traction and free cash flows. To be specific, product innovation would imply deep inroads in medicinal cannabis and value-added recreational cannabis. Just as an example, cannabis drinks that serve as an alternative to alcohol.
When it comes to product innovation and regional expansion, Canopy Growth and Aurora Cannabis have an advantage over Hexo Corp.
As an example, Aurora Cannabis has 15 production facilities globally with a presence in 25 countries. In addition, the company has been more aggressive in terms of inorganic growth and investment in R&D. The company’s medical distribution network is also robust as compared to Hexo.
Similarly, Canopy Growth has 90 patents with over 240 patents filed. The company also has operations in 12 countries and the patents indicate the level of R&D investment.
The key point is that all these companies are focused on valued-added cannabis products and medicinal cannabis for growth and margin expansion. If long-term exposure has to be considered, Aurora and Canopy are ahead in the race with higher financial muscles.
Cash Burn and Equity Dilution
In January 2019, Hexo had issued common shares worth C$57.5 million. With negative operating cash flows, I believe that further dilution of equity is a concern.
The first reason is the high investment costs of R&D research. If investments are not robust, Hexo stock can fall behind peers in terms of product launch.
The second reason is relatively high level of investment in marketing. There needs to be increasing awareness and visibility of medicinal products and that will require investment.
In addition, it is worth noting that companies like Aurora and Canopy have pursued inorganic growth to expand into new regions. The potential acquisition would need financing and that increases the prospects of equity dilution.
From the industry perspective, an oversupply of dry cannabis is a concern for Hexo and other players. The oversupply has been swelling and the implication is lower realized price of cannabis and margin compression. This would additionally depress cash flows.
Concluding Words on Hexo Stock
The Hexo stock price has been on a downward trend with intermediate rallies. The factors of competition, cash burn, an oversupply of cannabis and equity dilution have contributed to the weakness.
These factors will continue to impact stock sentiment in the foreseeable future. With relatively strong players in the industry, Hexo Corp is unlikely to be the first preference for a long-term investor. For traders, the stock continues to be attractive.
Hexo Corp has a pipeline of products that includes vapes, edibles and beverages. It remains to be seen if sales scale up to a level that translates into a robust EBITDA margin. Until then, markets are likely to remain skeptical.
As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.
