The high-flying cannabis sector has hit some turbulence in the past six months and investors are wondering whether the pullback has simply gone too far.
Volatility in marijuana stocks is not new and investors should expect that trend to continue as the sector works through the growing pains associated with the emergence of a new industry.
Analysts and investors agree that the potential growth is enormous, as governments worldwide adjust their cannabis regulations. Medical marijuana sales alone should make the global market attractive, and the recreational opportunities, especially in the related product markets such as edibles, drinks, and pharmaceuticals could eventually rival existing mainstream brands in those sectors.
That said, valuations must be realistic.
Losses are acceptable in the ramp-up stages, when companies are building scale and gaining a foothold in key emerging markets. Investors, however, eventually need to see a path to profitability.
Let’s take a look at HEXO (TSX:HEXO)(NYS:HEXO) to see if it deserves to be on your buy list.
Tough times
Until recently, HEXO had managed to avoid much of the negative sentiment that hit the Canadian pot producers in the past year. Scandals on non-compliance at other companies ranging from claims of self-dealing to unlicensed production tainted the sector in the first half of the year.
HEXO, however, has since run afoul of investors due to its significant reduction in revenue estimates.
What happened?
When HEXO bought Newstrike Brands in May, the company indicated that fiscal 2020 revenue would potentially hit $400 million. HEXO repeated the guidance in June and even anticipated revenue for fiscal Q4 2019, which ended July 31, would be roughly $26 million.
In early October, ahead of the scheduled Q4 earnings release, the company stunned the markets with a a warning that its Q4 revenue would actually be $15.5-$16.5 million.
The company also abandoned its outlook for 2020 and announced plans to cut 200 positions.
At the end of October, the company said net revenue for Q4 was actually $15.4 million and net revenue for the 12 months ended July 31 was $47.3 million.
The company reported a net loss of $56.7 million in the quarter and a total net loss of $81.5 million for all of fiscal 2019.
Guidance for Q1 2020 is net revenue of $14-18 million.
Risks
HEXO recently announced that it had to turn to insiders for a cash infusion of $70 million, indicating that banks and other potential lenders are now backing away.
The company is still facing revenue challenges due to the slow rollout of retail stores in Quebec and across the country. HEXO is Quebec’s leading cannabis company, but is having trouble competing in the seven other provinces in which it has supply agreements.
In the event that the situation doesn’t improve in the coming months, the company could face a cash crunch.
Should you buy HEXO?
The stock trades at $2.80 per share at writing, giving the company a valuation of $720 million. HEXO still sees itself as being one of the names that will eventually dominate the global cannabis market, but the reality is more likely to be a takeover of the company by a competitor, or a consumer brands company, such as its drinks partner, Molson Coors Canada.
News of large unsold pot stockpiles across the industry is putting added pressure on HEXO and its peers, and more downside could be on the way before the pullback runs its course.
As such, I would keep any contrarian bet small right now, or even wait until the dust settles a bit before buying the stock.
While a takeover bid could emerge, it might come at a lower price.
