Hexo released their Q3 F2021 earnings today.

I have a Q into their CFO, as I have an issue with EBITDA.

EBITDA NOTE MDA:

9-Month YTD “Depreciation, included in cost of sales” equals $6,293.

Q3 9-Month YTD Note 31:

Yet in the 9 Month YTD note it is $1,502 which is EXACTLY the Q3 3-month figure.

Q2 YTD 6-Month YTD Note 30:

… And went backwards from Q2 F21 YTD $4,791 (which equals Q1 + Q2 from EBITDA).
Something is whacky here. I will update when I hear back from CFO. And as a result,… my Adj EBITDA is different from theirs.

Last Q

Pluses
• Sales increase +12% with recreational 11%.
• Gross margin remains favorable to industry peers.
• SGA control remains good with decreases as % of sales.
• Good cash balance.

Minuses
• Gross Margin fell from 41% to 34%. Once Adult Beverage JV is moved to Molson’s books this should improve.
• Sales increases in adult use were consistent each of last two Q’s at $2.8 million and $2.9 million this Q.
• Their Adjusted EBITDA includes Other Income of $1.7 million.

This Q:

Pluses:
• Ontario sales increased 14% QoQ.
• Opex was stable, although G&A went up and SBC went down similar amounts.

Minuses:
• They give back three quarters of revenue growth in one quarter
• GM, which had been 35-40% range in Q1 and Q2, dropped to 19%
• They harvested twice as much as they sold and now have +4Q’s of inventory on hand.
• They are going to only have $69 million in cash post Redecan. They will need to raise.

Some good disclosure from Hexo in MDA on segments especially on GM.

Income Statement Drivers and Breakeven Sales:

Revenue Table:

Net Sales for the Q were $23 million a -31% or -$10 million decrease from last Q. Adult rec was $19 million (-$7.8 million or -29%) while medical was unchanged down and wholesale was -$0.2 million. International disappeared for Q, but we were told $2 million was sold to Israel post Q (24-month purchase agreement).

Last Q we noted: “Note the sales increases QoQ in absolute terms in Adult use is declining. This Q was +$2.8 million after being $3.5 million and $4.8 million the previous two Q’s.” Sales velocity not only slowed but reversed.

Adult Use net revenue (net of Adult Beverages) is lowest since Q ended January 31, 2020.

They attribute, and took ownership (rare in these days), to the decrease being two pronged:

• They introduced and flooded market with 22% hash. Then a lot of new competitors supply came in at 26-27%.
• They were rotating strains, a process started 9 months before the issue would surface, and cultivars that grew at +20% at their indoor facility could not hit that mark at greenhouse. These were popular Quebec products and that, coupled with new craft Quebec growers, eroded market share.

As a bright spot, they did increase +14% in Ontario QoQ.

Overall sales were the lowest since the similar Q in F2020, so they gave back three quarters of sales growth in one Q.

Beverages also took a downturn with -10% or -$0.3 million to $3.0 million. And beverages is still a negative GM.

The net selling price of Adult Use excluding beverages took a sharp turn downwards at -14% to $2.22/gram a similar per gram revenue to Q4F20. UP brand being a larger mix of revenue the reason.

They sold 12,189 KGs -20% QoQ, at a decreased per gram of $1.85/gram versus $2.16/gram last Q.

A little concerned about their Delta of Harvest versus Sold starting to swell just as they add more cultivation assets from Zena, NRTH and Redecan. This Q they produced double what they sold. Will discuss this a little more in the inventory turnover section below.

Adult Use Cannabis Revenue – Peer Trend

Hexo is 3rd in the above peer group passing ACB, assuming Tilray and Aphria are aggregated.

They indicate they are the Canada leader in Hash and the market leader in beverages. They indicate with Redecan they will be number 1 in adult use.

Medical Use Cannabis Revenue – Peer Trend

Canadian medical is a rounding error. Expect the next Q to include a $2 million shipment to Israel.

Income Statement Drivers and Breakeven Sales – Peers

In our Tier 1 peer group Hexo is the 4th largest company by Revenue.

Gross Margin: Peer and Trends

Last Q:

GM was $11.3 million for this Q versus $11.9 million last Q which included a $1.5 million write up. GM was 34% versus 41% last Q or 35% without write up.

This Q:

GM dropped from 35% to 22% all in, and -$6.7 million to $4.9 million. Adult Beverages still are a drag and producing negative GM at -$0. 6 million or -1% of sales. Adult Use dropped from 37% to 28%. Price concessions were made to move product.

I want Cronos investors to take note of the negative GM in the beverage segment. To cover automation and fixed costs in production the hurdle rate to positive GM% requires quite a base load of sales to achieve. Expect this to happen when they flip their fermenter on, assuming they disclose.

COGS & GM Table:

GM per gram sold decreased by -$0.36 to $0.41/ gram prior to any write offs/ups and impairments. This is their lowest on record.

Cost per gram increased QoQ to $1.45/gram from $1.40/gram.

GM slid by $7.7 million with adult rec $4.6 million and International entire margin from the previous Q disappeared this Q.

It will be interesting to see what happens when Truss GM and SGA move to Molson’s.

Gross Margin Larger Peer Group

Hexo slides from #2 in this peer group last Q to #5 this Q. Note: CGC, APHA, and TLRY have considerable non cannabis revenue which distorts GM%.

SGA and SBC: Trend Analysis

NOTE: I have moved restructuring, impairments and acquisition costs to Other Income/Expenses to maintain peer comparability.

Selling and marketing increased marginally QoQ to $2.4 million ($0.3 million) and are 11% of sales. This is the highest dollar amount, albeit modestly higher, in four Q’s.

G&A increased $2.5 million to $14.8 million and is highest since Jan. 31, 2020 Q. They segment G&A but they changed format between quarters, making comparisons difficult. Salaries and Benefits and G&A were up $0.9 million. Determining the balance of delta is not possible.

They indicate they want SGA to be 25% of sales as a target to reach for. They will need sales to rebound and some SGA to move to Molson’s and sales to increase to get there, as they are at 76%.

SBC is at $2.7 million a decrease from $5.3 million QoQ as share price has been retreating.

R&D was $0.7 million versus $1.1 million last Q.

Depreciation and Amortization was $2.0 million versus $2.0 million last Q.

Total Opex was $23 million flat QoQ but given decrease in sales it grew to 100% of sales.

SGA and SBC: Peer Analysis

Hexo is 3rd best in Peer Group.

Implied Breakeven Sales to +Net Operating Profit divided by Current Q Sales:

Using current GM% and Opex$’s Hexo requires incremental sales of 193% to evidence +NOP.

NOP for the Q net of IFRS was negative $18.3 million versus negative $11.6 million last Q. Drop in Sales, GM% and Opex holding steady were the contributors.

Other Income and Expenses aggregated negative $6.8 million versus negative $16.6 million last Q. Of note:
• Acquisition costs were $0.4 million last Q and increased to $1.9 million this Q. This will stay up as they get through Zena, NRTH and Redecan.
• Revaluation of financial instruments was $9.9 million last Q versus $0.4 million this Q
• Share loss in JV swung $2.2 million from $2.6 million.
• Interest expenses grew to $3.3 million from $2.7 million
• Other Income from truss and other items was $1.2 million versus last Q $1.7 million.
• Loss on disposal of long-lived assets last Q was $1.3 million nil this Q.

Net Income net of IFRS on Bio Assets and Inventory rang in at negative $25 million a versus negative $28 million last Q. Most of the swing is in other expenses as these decreased by $10 million QoQ.

Implied Breakeven Sales to +EBITDA divided by Current Q Sales:

At current GM% and cash Opex$, Hexo requires 66% increase in incremental revenue to reach +EBITDA.

EBITDA Trend and Peer:

My figure is different then theirs. I have it at -$13.4 million and they are at -$10.9 million for a difference of $2.7 million. Part of that is they have SBC in CoGS below what I have tracked QoQ from their cash flow statement. The other part is they do not back out Other income from Truss of $1.2 million.

This is hard slide from last Q of -$12 million. The drop of $7 million in GM accompanied by increase in cash based opex is the reason.

Balance Sheet Items of Note:

Cash:

Cash and restricted cash decreased by $54 million QoQ to $113 million. They presently have $469 million in cash as result of ATM and Secured Convertible Debenture raise for Redecan, but net of Redecan payment that will be $69 million.

This was a cute Quote in their presser:
• The Company elected to repay its outstanding credit facility of $28,875 early, mitigating future interest and administrative costs.
Ehhh… they needed to repay that credit facility in order to provide the security to the Convertible Debenture lenders. I do not recall any other Convertible Debenture being secured in the large cap cannabis space in Canada. The debenture does not pay interest unless they go into default.

They will need to raise cash.

The Restricted cash of $33 million is Hexo self-insuring on Directors Insurance which save a $10 million a year as per their CC…. but ONLY if there is no claim. Not like there have been many class action lawsuits in the industry. /s

“Waterfall- Trend”: Projected Yield Bio Assets, Harvest, Sold, Delta in KGs

Their KG sold decreased to 12,189 KGs (-3,012 KGs) and increased their harvest to 25,833 (+225 KGs) for a net add to inventory of 13,644 KG. The harvest was a new record. The delta that went to inventory was the highest since January 31, 2020 Q.

“Waterfall- Peer”: Projected Yield Bio Assets, Harvest, Sold, Delta in KGs

Harvesting only below Aphria. Canopy stopped disclosing.

“Gas in the Tank”: Trend Analysis

Hexo does not break out WIP and Finished Goods, so we only have an inventory delta

Biological Assets decreased by $1.8 million to $9.2 million. They have been within a range of $9.2 and $10.7 million this fiscal.

Inventories increase $13 million to $95 million. Dried cannabis increased $12.6 million, Oils increased $1.7 million, Purchased extracts and cannabis decreased $4.6 million, and packaging supplies increase $2.3 million.

Inventory to Sales: Peer and Trend

This has me worried.

Hexo has been good this fiscal at keeping inventory impairments down. The spike to 4.21:1 inventory to sales is concerning as it is above the 4 Q ratio where we have seen other impairments. Next Q is year-end audit they will likely have some latitude as they are onboarding sales from Zena and NRTH with Redecan on the horizon in the next Fiscal period. But they are also onboarding inventory.

Sold vs Harvest KGs and Sales vs Inventory $’s

They increased inventory by $13 million as they added KGs to inventory this Q. sales and inventory lines are going in opposite directions, and not in a good way.

Trade receivables of $19 million is almost 100% of Q sales. Sales could have been backloaded in Q but it is still high.

They have a $20 million Convertible Debenture receivable making an appearance. This is Zenabis related and will likely just get washed in acquisition.

On liability side only the $25 million decrease in term debt is of note. This was needed to clear security for new secured convertible debenture.

What I said last Q:

Hexo has been hanging multiple progress quarters together. They are not huge PROGRESS, but they are gaining ground. Rec sales have been on an upward trajectory that many LP’s would love to have. The increase has been in $2.8 million range each of last two Q’s.

Gross Margin has settled in to a 35% range. They are not getting any GM from beverages and would need the sales to swing considerably higher to generate a mediocre GM. International GM, which is bulk shipped, has been strong.

SGA finally moved upwards after five Q’s of decrease.

EBITDA is moving in the right direction.

Cash balance is reasonable.

Continue headway in adult recreational is the lever Hexo needs to lean on. With the addition of Zenabis they are buying sales. Will they shutter any of Zena’s grows. The memory of purchasing HIP and writing it off five months later is still fresh.

Still only one spoke in the “Powered by Hexo” wheel, but they continue to mention dialogues with CPG. I’ll caveat that CPG is likely talking to numerous players.

This Q:

Major step back in sales, erasing three quarters of increases. GM dropped considerably and inventory is now at over 4 quarters of sales. GM of the first two Q’s is only accurate if inventory is not impaired in future. EBITDA vaulted backwards.

The bright spot was increase in Ontario sales, but they will need to recapture what they lost in Quebec for that to have value.

Any question that they needed to buy sales with Zena and NRTH? Redecan I see as more strategic and I look forward to seeing what was once private become public.

They are going to be cash strapped and they have pledged security to the Convertible Debenture holders which limits options and flexibility going forward.

I have to say, the last round of quarterly reports from Canadian LP’s have shown very little progress, if any. And I think we are two Q’s from an improvement in the industry results.

The preceding is the opinion of the author and is in no way intended to be a recommendation to buy or sell any security or derivative. The author has no position in HEXO and does not plan on entering in the next five days.