HEXO Stock Has a Cash Problem

Stocks to sell

Back in July, I wrote that Aurora Cannabis (NYSE: ACB) had a cash burn problem. In the past week, it has become painfully clear HEXO (NYSE: HEXO) stock has one too.

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The HEXO stock price has tanked another 22.8% in the past two weeks. Unfortunately, analysts are not recommending investors buy the dip just yet.

The honeymoon period for cannabis stocks is over. HEXO stock clearly has near-term issues with its balance sheet and will remain a risky bet until something changes. While HEXO may ultimately play a big role in the cannabis boom, investors need to be very careful with HEXO stock at this point.

HEXO’s Cash Issues

On Oct. 23, HEXO announced a C$70 million ($53.4 million) private placement in the company. The unsecured convertible debentures pay an 8% interest rate payable quarterly. If fully converted, the private placement could add about 22.1 million new shares of HEXO stock, a roughly 7% dilution.

The following day, Hexo announced it is laying off 200 employees. Those employees represent about 24% of the company’s 822 total employees reported earlier this year. In a statement, the company said the layoffs are a necessary adjustment based on its updated 2020 outlook for revenue growth.

In addition, HEXO announced it is suspending production at its Niagara facility and at 200,000 square feet of its main Gatineau location. The company said the suspension is due to “current market conditions in Canada.”

Finally, this week Hexo reported its delayed fiscal fourth-quarter earnings report. The numbers weren’t pretty. HEXO reported negative free cash flow of C$119 million, down from -C$43 million in the third quarter. To make matters worse, HEXO reported just C$136 million in cash at the end of the quarter.

To look at the situation another way, HEXO had a little more than one quarter’s worth of cash remaining at the end of the fourth quarter, assuming its cash burn stops accelerating. The company subsequently potentially diluted current shareholders by 7% to get another C$70 million in cash. That’s less than a single quarter’s worth of cash burn at the current rate.

Analyst’s Take on HEXO Stock

Like other Canadian cannabis producers, HEXO clearly seems to be having a cash crunch. Bank of America analyst Christopher Carey says fourth-quarter earnings confirmed that the company has major near-term challenges.

Carey says HEXO stock investors have to face the reality that the company is not operating optimally at this point. In a weaker-than-expected market, that inefficiency is getting exposed.

Carey says the layoffs, private placement and production cuts are potential near-term solutions. But they fail to change the underlying causes of the problems. In addition, the pricing of the offering suggests raising capital may prove difficult in coming quarters.

“The key data point, in our view, is that the offering was priced at a discount to the trading price of Hexo’s CAD shares (e.g. C$3.16/share conversion vs. a trading price at press release of C$3.31/share), e.g. converts are already in the money, effectively making the convertible debenture more like an equity offering that pays an 8% coupon,” Carey says.

HEXO stock is already down 73.4% in the past six months. Carey says there will likely be additional downside for the stock given HEXO is unlikely to get anywhere near consensus Wall Street revenue growth expectations in the near-term.

“With visibility on go-forward revenue already low (BofAML FY20e revenue of C$122mn is -28% vs consensus), it is difficult to become constructive on shares,” he says.

How To Play HEXO Stock

Since I wrote about Aurora’s cash burn problems back on July 22, ACB stock is down another 46.3%. Unfortunately, HEXO stock now appears to be in a similar situation.

I’m a long-term bull on cannabis stocks. But the early 2018 rally in many of the cannabis plays was irrational and expanded their valuations way beyond where they had any business being.

The cannabis business is still in its infancy. Picking long-term winners and losers at this point in the game is little more than betting on roulette numbers at the casino.

Instead, I recommend investors pick a basket of at least three or four of the top cannabis brands to make a play on the business as a whole. HEXO could ultimately survive this cash crunch and emerge as one of the long-term global cannabis winners. At the same time, things could also easily go from bad to worse if HEXO has difficulty raising additional cash.

Even if you plan to ultimately add HEXO stock to your cannabis basket, I would recommend not doing so at the current time.

Instead, consider building your cannabis portfolio around Canopy Growth (NYSE: CGC) and Cronos (NASDAQ: CRON), two stocks with relatively stable cash positions and deep-pocketed partners.

As of this writing, Wayne Duggan did not hold a position in any of the aforementioned securities.

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