Can Hexo Afford The Original Stash Product Line?

Hexo Corp (TSX: HEXO) (NYSE: HEXO) has had a rough go at the cannabis sector. Once viewed as the darling of Quebec and a goal of an ultra-premium product, the equity has faced continuous headwinds as reality hit the sector and cannabis pricing was forced to fall into line with that of the long standing illicit market.

The recent financials put out by Hexo on December 16 for the first quarter of fiscal 2020 is a perfect demonstration of this struggle. Despite increased production capacity and theoretical economies of scale, the firm has failed to manage to turn a profit. Rather, Hexo has now focused heavily on cost reduction which includes idling recently acquired facilities, laying off staff, and searching high and low for cost cutting opportunities. While the firm reduced its expenses by approximately 25% on a quarter over quarter basis, this was still not enough to stem the high rate of cash outflows.

Despite this, the company has now introduced a product meant to compete with illicit market pricing, which sells for $4.49 per gram at the SQDC, which is Hexo’s largest sales avenue. Quebec’s SQDC accounted for 73.4% of Hexo’s adult use sales in terms of volume during the most recent quarter and is thus a major account of the firm. Despite an indication of high volume of sales and demand for the initial product launch, known as Original Stash, its questionable that the sale of this product is beneficial to Hexo given the low sales prices and the firms high cost of production.

Perhaps the best way to analyze things is to look at Hexo’s expenditures on a per gram basis, given this is their means of generating revenues. First, lets begin with the basics on a per gram basis.

	Total	Per Gram
Cannabis Sold	4,325 kg	–
Net Revenue	$14,499,000	$3.35
Cost of Goods Sold	$9,947,000	$2.29
Gross Margin, Before Adjustments	$4,552,000	$1.06

As can be seen, on a gross basis Hexo is generating an average gross margin of $1.06 per gram across all lines of revenue as of last quarter, which is both medical and adult-use sales. The current sales mix is 97% adult use, which saw 4,196 kilograms of cannabis sold at a net price of $3.24 per gram. Medical sales, at roughly 3% of total sales, totaled out at 129 kilograms at a net price of $6.78 per gram.

Given that Hexo’s focus is clearly that of adult-use product, we’ll focus on the net revenue per gram in this segment of $3.24 when looking at the firms new Original Stash product line.

Next, lets look at Hexo’s average sale price at the SQDC across its product offerings, and compare that to the stated average revenue generated per gram as per the recently filed financials.

Total Hexo Branded Products	17
Average Price of Aggregate Per Gram	$5.95
Gross Revenue Per Gram	$4.35
Resulting Markup Multiplier (Average price per gram / Gross revenue per gram)	1.3678

Based on the product pricing found on the SQDC’s online portal, the average price per gram of Hexo product is $5.95. Note that we did not include Original Stash product in this figure. As per Hexo’s most recently filed financial statements, the firm generates an average gross revenue per gram of $4.35 for its adult-use product. This implies a markup multiplier of approximately 1.3678, or approximately 26.89% margin on all product sold by SQDC.

Using those figures, we can reverse engineer estimated revenues per gram for Hexo on its new product, Original Stash, which sells at a retail price of $4.49 per gram. Assuming that the SQDC is generating the same gross margin on this product, it implies that Hexo is selling the product line to the provincial distributor at an estimated price of $3.28 per gram on a gross basis. The minimum excise tax of $1.00 per gram as mandated by the federal government still needs to be removed from that figure.

Retail Price of Original Stash Per Gram	$4.49
Deduct SQDC Estimated Margin (26.89%)	$1.21
Estimated Gross Revenue Per Original Stash Gram	$3.28
Deduct Federal Excise Tax	$1.00
Estimated Net Revenue Per Original Stash Gram	$2.28

Once the federal excise tax is backed out, we can see that it is estimated that Hexo is generating $2.28 per gram in net revenues per gram of Original Stash product sold. Let’s be clear here in that this is based on historical margins being generated by the SQDC, and the assumption that the provincial distributor is generating the same gross margin per gram sold. It’s also assuming consistent cost of goods sold on a go-forward basis. Working with these assumptions, we can see that Hexo will be generating a loss of $0.01 per gram sold of Original Stash product solely on a COGS basis.

This does not include the losses attributed to inventory write downs, the expense of general and administrative expenses, marketing and promotion, depreciation, or any other expense that the issuer may incur. For comparative purposes, lets look at those costs as a function of grams sold for the last quarter.

	Total Cost	Cost Per Gram Sold
General & Administrative	$15,973,000	$3.69
Marketing & Promotion	$6,220,000	$1.43
Share-based Compensation	$8,164,000	$1.88
Research & Development	$1,744,000	$0.40
Amortization	$1,666,000	$0.39
Depreciation	$1,333,000	$0.31
Total	$35,100,000	$8.11

There’s a few things to note here. First, arguably, it may be more appropriate to recognize certain costs on a trailing basis relative to the current quarter. For instance, some G&A expenses will be attributable indirectly to the current growth and cultivation of cannabis, which will be sold in a later quarter. Second, share-based compensation, amortization, and depreciation are accounting functions that are non-cash items. However, if the firm wishes to at some point post a positive net income on an unadjusted basis, these figures do in fact matter.

Hexo’s introduction of the Original Stash product line was meant to be a direct competitor to the still flourishing illicit cannabis market. The problem however, is that the firm is simply unable to compete at such low prices based on current estimates. The multiple recent financings, of $70 million and $32.6 million, plus a pending at-the-market offering conducted by the cultivator is perhaps the best indication of the financial struggle being faced by the firm. Whatever the case, the firm will be required to continue cutting expenses if it wishes to compete in the current environment.

Hexo Corp last traded at $2.00 on the TSX.

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Information for this briefing was found via Sedar and Hexo Corp. The author has no securities or affiliations related to this organization. Not a recommendation to buy or sell. Always do additional research and consult a professional before purchasing a security. The author holds no licenses.