HEXO (HEXO) has been getting a lot of attention lately, primarily based upon what is considered a fairly low valuation, leading market share in Quebec, and its joint venture with Molson Coors Brewing.
While I have no problem believing it could enjoy an ongoing upward trajectory with its share price in the short term, there are a couple of things I see that it needs to answer in order to make it viable long-term holding; those include its heavy exposure to Canadian recreational cannabis, and its anemic international presence, which is the future for any Canadian-based company.
Recreational cannabis exposure
There are a couple of things to consider when analyzing Hexo's focus on Canadian recreational cannabis, and that is the positive side of it, which is an immediate revenue stream that drives revenue and investor interest. Its market-leading position in Quebec and its recent acquisition of Newstrike Brands puts it in a position of decent growth over the next couple of years, and possibly longer.
With the Newstrike acquisition, it expanded its supply agreements to eight Canadian provinces, which again, will give it a nice revenue boost.
And since I'm convinced in the short term revenue will be the major catalyst for boosting its share price and attracting investor interest, this is a solid growth catalyst for the company.
Concerning Quebec, is has a large supply agreement that gives it market share of a minimum of 30 percent for several years in the province. For that reason, assuming it can meet demand, revenue growth should remain in place for some time.
The negative side to its exposure to recreational pot is its low cost per gram that lowers margins and ultimately, earnings.
I look at recreational pot as more of a transitional part of the cannabis business that over time, will become far less important for performance and growth. With its heavy exposure to recreational pot, it puts the company in the difficult position of struggling to become profitable.
This is the time for cannabis producers to use the benefit of recreational revenue to transition to more profitable medical cannabis segment. If a company can't do that, all it has is a short-term revenue stream that fails to deliver long-term growth.
And when considering its exposure is in the Canadian market, the ceiling for recreational pot sales is very limited.
Joint venture with Molson Coors Brewing
In general, the market puts high value on cannabis companies that enter into joint ventures with larger companies, as it has with Molson Coors Brewing.
The partnership between the two is to develop cannabis-infused beverages. I'm not impressed with the deal. The major benefit in my view is that HEXO has managed to associate its name with a big player. That has value in general, but on the actual value of it in association with generating revenue and earnings, I'm not convinced it's as important as some have made it out to be.
My major reasoning for that is in spite of the hype surrounding beverages infused with cannabis, I'm not even sure the market is going to be anywhere near as large as some think.
Not only that, but I also don't get excited about these joint ventures that have yet to prove they have any value. Again, I get the value of association in regard to marketing and branding for HEXO, but whether or not this'll add much to its top and bottom lines is suspect at best.
Valuation
As for valuation, I'm not that impressed either. The share price has jumped nicely in response to several catalysts, but I think they are priced in now. I don't see it being undervalued.
The one area that has been pointed out by Bank of America analyst Christopher Carey is, that the company is undervalued because of its production capacity, which has jumped to about 150,000 kilograms per year.
Where the concern lies there is what happens once HEXO meets its supply obligations in Canada? Where will it sell its excess inventory? That's the problem with it not having any meaningful international presence.
International weakness
HEXO has a presence in one market via its partnership with Greek cannabis company Qannabos. The idea is it provides a base to work from to serve the medical cannabis markets in Europe.
That's the right strategy, but it's so far behind its larger peers that I think it's going to struggle for some time to build out that market, if it's ever able to in a significant and sustainable way.
The other issue on the international scene is the quality of companies left over to make deals with. Companies like Aurora Cannabis and Canopy Growth, among others, already have joint ventures in place with many of the leading European cannabis companies. It'll be a lot harder for HEXO to find partners that will move the needle in the global medical cannabis market. That's a real problem it has to solve fairly soon.
Conclusion
To understand HEXO it has to be understood that recreational cannabis revenue should be a bridge to expanding its presence into medical cannabis markets outside of Canada. That's the future of the industry.
It has done the right thing in rapidly expanding in the Canadian adult-use market because it will provide it the revenue to maintain and grow operations while looking for ways to enter the medical marijuana market.
HEXO does have a window of time to work with, but it's narrowing, and it has to show it can expand internationally in order to convince investors it has a long-term future.
For now it wouldn't surprise me to see it enjoy a little more momentum, but as the market digests the weakness of its exposure to the Canadian recreational pot market, it's likely a lot of the momentum it has enjoyed will come to a halt.
The Canadian adult-use cannabis market isn't enough to provide sustainable growth for HEXO, and it isn't able to transition to medical cannabis in other markets, it could fade quickly.
To read more on the nitty gritty of what’s going on in the rising cannabis industry, click here.
Read more on HEXO: