Replies to post #4919 on HEXO Corp (HEXO)

[JohnCM]

HEXO: Time To Quit The Addiction Called Dilution

Jan. 3, 2021
Seeking Alpha
Cornerstone Investments

HEXO is a top 5 LP in Canada by sales volume and has a leading market position in Quebec (33% market share).

The stock is down 45% in 2020 despite improvements in the Canadian market; we think dilutive equity issuances were the main culprit.

Despite improving operating performances, HEXO needs to do a better job of stemming cash burn and avoiding further dilution.

HEXO (HEXO) shares have lost ~45% in 2020 while the Canadian cannabis market continued to expand following its slow start since October 2018. Recreational cannabis sales almost doubled to $3.2B (annualized) in October 2020 and HEXO has benefited as its Q1 F2021 sales more than doubled from last year and it also broke even on EBITDA. However, the company still has a long way to restore investor confidence after frequently raise equity at depressed share prices. The near-term outlook for HEXO remains cautiously positive as the improving market backdrop is overshadowed by its poor capital markets track record and large overhang from dilutive securities.

How Did We Get Here?

HEXO's downfall is reflective of the past two years of legalization evolution in the Canadian cannabis market. We have seen early signs of oversupply developing well ahead financial impact were felt by the LPs. Since legalization began in October 2018 in Canada, HEXO's net average revenue (as a proxy for average prices) has declined ~50% from $4.44 per gram to $2.17 per gram. The writing was clearly on the wall and we have painstakingly illustrated for our readers in this analysis in August 2018.

The market became extremely oversupplied as LPs build massive facilities only to announce costly shutdowns that cost shareholders hundreds of millions. HEXO suffered from the industry-wide malaise but it also faced liquidity issues due to its reliance on capital markets to fund its expansion and money-losing operations. It completed a number of equity raises over the years at increasingly distressed share prices, causing additional dilution and a downward spiral that resulted in a forced 4-for-1 share consolidation in December 2020 in order to avoid delisting.

The result of the pricing compressing in Canada resulted in pressures on gross margin for HEXO. Gross margin declined from 50% to 30-35% while revenue increased due to higher sales volume. HEXO began generating revenue from its international and Canadian cannabis beverages but recreational sales still accounted for 80% of its total sales. The company has not been EBITDA positive but reported an EBITDA loss of $0.4M in Q1 F2021, which means that recent cost controls and improvement in the Canadian market have eventually resulted in higher operating profits and brought it closer to break-even.

Outlook

The outlook for the Canadian cannabis market has been improving since the COVID pandemic began. As more people stayed home, consumption of cannabis skyrocketed in both the U.S. and Canada. The industry also benefited from more retailer stores opened in Ontario as Canada's large market issued more than 300 retail licenses by the end of 2020. Lastly, lower retail prices also helped lure black market buyers as companies like HEXO launched low-cost brands that cost ~$4 per gram.

As a result, Canadian legal cannabis sales almost doubled to $270M in October for an annualized sales of $3.2B. HEXO generated $24M in recreational sales last quarter, which implies ~9% market share for the company. HEXO reported that it has ~33% market share in Quebec, the largest among all LPs. We think the ongoing improvement in Ontario retail rollout will drive cannabis sales higher and HEXO should benefit proportionately as a top 5 LP.

Valuation

HEXO has a fully-diluted market cap of ~$1.0B and trades at 7.4x EV/Sales. The valuation is in-line with top-tier LPs such as Aphria (APHA) at 8.1x cannabis sales and Village Farms (VFF) at 13.5x cannabis sales. We think HEXO's valuation is pretty rich given its past performance and its capital structure issues - HEXO issued equity too often which significantly weakened investor confidence and management credibility. Let's take a look at the several dilutive equity issuances that HEXO completed in 2020 alone:

Jan 2020: raised US$25M at US$1.67/share or ~C$2.2/share
Jan 2020: raised another US$20M at the same price as above
Apr 2020: raised C$46M at C$0.77/share
May 2020: raised C$58M at C$0.90/share
Aug 2020: raised C$35M through ATM program at average C$1.0/share
Dec 2020: offered discounted conversion price of C$0.80 to convertible debentures; $30M was converted into 37 million shares

With such frequent equity raises, equity investors could lose confidence and interest in the stock. Furthermore, HEXO's past financings resulted in a large number of warrants and options outstanding. Post the 4-for-1 split, HEXO has a basic share count of 122 million but it has another 41 million warrants and options outstanding with exercise prices between $0.5 and $0.9 per share. The remaining $40M outstanding convertible debentures are convertible at $0.79 per share for another 51 million shares.

Therefore, HEXO's fully diluted share count is actually ~200 million shares. These dilutive securities are also a massive overhang and create downward pressures due to their low exercise prices. This will continue to be an issue for HEXO going forward. (Massive overhang?? ... JohnCM)

Conclusion

HEXO is one of the top 5 LP in Canada and has a leading market share in Quebec, the second-largest market. However, the company failed to secure large funding sources and instead relied on frequent equity and warrant issuances that hurt investor interest and saddled the company with dilutive securities. Why did HEXO burn through so much cash? Because it spent ~$250M on its facilities and equipment during the last two years, part of an industry-wide overbuilding. It built a massive facility in Ontario which is less than 50% utilized now. (Old news ... JohnCM)

The Canadian market for cannabis and infused beverages are way smaller than HEXO had built for and it has to issue equity to fund its capital spending. The shares have fallen ~90% from its peak reached in Spring 2019 and we think the outlook remains cautious due to its capital structure issues. The recent improvement in Canadian legal markets helped HEXO double sales YoY and approach break-even EBITDA but more is needed for a turnaround. A logical first step would be to quit the habit of equity issuance for at least one year.