Hexo released their Q4 F2020 earnings today.

Last CC, Hexo CEO Sebastian St. Louis mentioned that he was “excited” over a dozen times about the upcoming Q.  I do think he was very overly excited last CC based on the results we are seeing this Q. 

Hexo’s operations in F2020 in one page:

That is a lot of cash-based impairments on inventory for the year, $68 million plus +$5 million in write offs. They wrote down $32 million in Trim for the year.

They now claim to have a “clean balance sheet” and have “industry leading” inventory management, which at 2.4X sales it has been reset to a lower figure.  Yeah, OK let see you go a few Q’s without a cost-based impairment. 

Outlook from last MDA:

• The Company expects to be Adjusted EBITDA positive in the first half of fiscal 2021, subject to certain assumptions (outlined below) regarding store count, operational improvements, cost saving initiatives and the economic impact of COVID-19.
• Assumptions built into the forecasted Adjusted EBITDA are partially based on the following: forecasted store rollouts based on conversations with provincial cannabis agencies; THC improvement from cultivation which are expected to lead to improved sales of favourably priced products; new product rollouts of Vapes, Extracts, Edibles and Pre-rolls between March and May of 2020; Growth in sales to provinces outside Quebec; Changes to captive D&O Insurance resulting in cost savings; Trim utilization initiatives and operating expense driven by restructuring, reduced travel and consultants.
• These assumptions are exclusive of the effects of COVID-19, which could be material.

Outlook has now been “conditioned”. Some of the conditions are within their control (in bold), which is very odd.

Outlook from this MDA:

• The Company expects to be Adjusted EBITDA positive in the first half of fiscal 2021, subject to certain assumptions (outlined below) regarding store count, operational improvements, cost saving initiatives and the potential economic impact of COVID-19.
• Assumptions built into the forecasted Adjusted EBITDA are partially based on the following: forecasted store rollouts based on conversations with provincial cannabis agencies; THC improvement from cultivation which are expected to lead to improved sales of favourably priced products; new product rollouts of Vapes, Extracts, Edibles/Beverages and Pre-rolls between March and October of 2020 as well as the successful capture of market share of these products; Growth in sales to provinces outside Quebec; Changes to captive D&O Insurance resulting in cost savings; Trim utilization initiatives and operating expense driven by restructuring, reduced travel and consultants.
• These assumptions are exclusive of the effects of COVID-19, which could be material.

I still cannot get a handle on them conditioning Outlook on items within their control.

Some good disclosure from Hexo in MDA on segments.

Income Statement Drivers and Breakeven Sales:

Revenue Table:

Net Sales for the Q were $27 million a +23% increase from last Q.  Adult rec was $25 million (+$3.5 million or +14%) while medical was marginally down and wholesale was +$0.3 million. International entered the equation this Q with $1.3 million sold to Israel.

The increase in sales decreased QoQ from last Q $4.8 million to this Q $3.5 million.

Of the +$3.5 million in sales increase this Q:

• $1.3 million was 2.0 products exclusive of beverages, largely vapes
• $1.6 million was increased beverage sales as their canned beverages joined Verywell drops that were launched in the previous Q.
• That leaves $0.6 million in flower and 1.0 oil offerings for the balance.

They sold 8,836 KGs -8% QoQ at an increased per gram of $3.06/gram versus $2.30/gram last Q. Improvements were across the board in Adult use and beverages, medical, and wholesale.

Interesting to note on CC they indicated they are the present leader in market share in beverages and are “fast approaching” the #3 market share spot across Canada.  That would be ACB that they are closing in on overall market share.

Adult Use Cannabis Revenue – Peer Trend

Hexo is 4^th in the above peer group. 

They indicate they are the Canada leader in Hash, which is a small offering. And presently (not for the Q) the market leader in beverages.  But I do not see that on Headset data.  But the Headset data does not include Quebec where they have a +30% share of overall market.

Medical Use Cannabis Revenue – Peer Trend

Canadian medical is a rounding error.  They did evidence a shipment to Israel, the start of a 24-month purchase agreement.

Income Statement Drivers and Breakeven Sales – Peers

In our Tier 2 peer group Hexo is the largest company. We might have to graduate them to the Tier 1 group.

Gross Margin: Peer and Trends

With the exception of the previous Q 54% CoGS to sales, Hexo has been in the 64-68% range.  Without impairments, GM has been 30% for three Q’s and 40% in the Q previous to this one.

Their GM is riddled with cost based writedowns in most Q’s during F2020.  This Q the GM was -133%, on the backs of $44 million in writedowns, after +39% last Q when writedowns were minimal. 

Hexo has a new CFO (again) and they indicated they were previously taking a piecemeal approach to write offs.  They decided this Q to take chainsaw to inventory.  I think I will wait until they “show me” they are managing their inventory better, as they still produced twice of what they sold this Q.

GM was negative $46 million for F2020 versus +$21 million for F2019.

GM was also reportedly impacted by the new bottling facility.  Until licensed, the facility is 100% on Hexo balance sheet.  When licensed the revenue, and costs, will be split with Molson Coors through the Truss JV.

From MDA:

• During the three months ended July 31, 2020 the Company’s cumulative gross margin excluding adult-use beverages was approximately 42%, compared to approximately 44% in the previous period. The major contributing factor to this, was the Company’s non-beverage adult-use gross margin decreasing 4% to 39% in the period. This was due to the Company’s sales mix in the period, as the Company looks towards gaining market share with cannabis vapes and hash products which contribute lower gross profits when compared to dried cannabis sales. New in the period, were the international sales to Israel, which contributed a 50% gross margin to the Company. The wholesale gross margin may vary from period to period as they are dependent upon the specific wholesale agreements with other licensed producers. Medical sales gross margin remained consistent, period over period.

COGS & GM Table:

Despite a drop in KGs sold of 762 KGs for the Q, GM per gram sold improved by $0.05 to $1.10/ gram prior to any write offs and impairments.

Cost per gram did increase significantly QoQ to $1.96/gram from $1.25/gram, but this was offset by increases in revenue per gram.

Gross Margin Larger Peer Group

Hexo is second from last due to impairments.

SGA and SBC: Trend Analysis

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

Selling and marketing increased from the drastic cuts in Q2 to $2.4 million (+$0.3 million) and are 8.7% of sales.

G&A increased $1.2 million to $12.4 million QoQ, reversing the three Q trend of decreases but still well below the $16 million evidenced in the first Q in F2020.   

SBC is at $4.3 million a decrease from $6.2 million QoQ as share price has been decreasing.

R&D was $0.7 million down from $1.0 million last Q as products under development have been launched.

Depreciation and Amortization was $0.7 million versus $1.0 million last Q, likely owing to previous impairments of PPE and Goodwill and intangibles.

Total Opex was $21 million down from $22 million last Q.  Opex has decreased four consecutive Q’s and decreases QoQ are getting smaller.

SGA and SBC: Peer Analysis

Hexo is 2^nd best in Peer Group. 

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

As Hexo evidenced a negative GM% we cannot determine this breakeven.

NOP for the Q net of IFRS was negative $57 million versus negative $14 million last Q. The impairments to inventory are the largest reason for the decay.

Other Income and Expenses aggregated negative $114 million versus negative $3 million last Q. Of note:

• Expense $54 million inducement of Convertible Debenture holders to convert to equity
• Expense $46 million impairment of PPE as management idled equipment and redundant property
• Interest Expense of $2.7 million a decrease from $3.3 million last Q as debentures were reduced. 
• Expense of $1.8 million accruing to onerous contract with MediPharm Labs, which totaled $4.8 million for the year.

Net Income net of IFRS on Bio Assets and Inventory rang in at negative $171 million a versus negative $17 million last Q. The inventory impairments, conversion of debentures to equity and impairments of PPE were the large items.

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

As Hexo generated a negative GM% we cannot complete this breakeven calculation.

EBITDA Trend and Peer:

My figure of -$5.6 million differs from theirs of -$3.3 million as they do not back out finance income (but they do interest expense, cute), their finance expenses is $700 below the income statement line item,  and they have $0.2 million in amortization buried in Opex. I did not track down the remaining differences.

This a deterioration from my calculation last Q of -$4.8 million.  The decrease in GM net of impairments outweighed the improvement in cash Opex.

Balance Sheet Items of Note:

Cash:

Cash increased QoQ by $90 million to $184 million as they converted debt to equity, utilized their ATM of $35 million and issued new shares of $57 million in May 2020.  They really squeezed shareholders this past Q via dilution.  And this morning they announced an 8:1 reverse stock split in order to maintain their US listing.

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

Their KG sold dropped to 8,836 KGs (-762 KGs) and decreased their harvest to 16,540 KGs (-2,590 KGs) for a net add to inventory of 7,704 KGs, almost equal to sales for the Q.

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

Harvesting only below Canopy, Aurora and Aphria.

“Gas in the Tank”: Trend Analysis

Hexo does not break out WIP and Finished Goods, so we only have an inventory delta.  And keep in mind they wrote down cost-based inventory by $44 million this Q and $68 million for the year.  

Total inventory decreased $19 million to $65 million or 2.4X sales.  They might be able to make it a quarter or two before having to address inventory, which would be a nice change.

Sold vs Harvest KGs and Sales vs Inventory $’s

They decreased inventory by $19 million largely due to $45 million writedown as they added KGs to inventory this Q.

Term Debt Notes:

• Noted last Q: the re-instatement of the $15,000 Term Loan capacity that previously expired un-used on December 31, 2019. In order for the Company to draw on this additional capacity, the Company must be (i) in compliance with its debt covenants; and (ii) achieve net revenue of $28,400 for the quarter ended July 31, 2020. The additional capacity is available to be drawn upon until November 30, 2020.
• They did not make the $28.4 million revenue target and their bank removed the $15 million in available term debt.  Speaks to the mind of their lenders.
• The full $ amount of the term loan was placed in Current Liabilities due to breach of non-financial covenant which was remedied post Q end. 

What I said last Q:

A good increase in sales, yet Ontario and Alberta went backwards, the latter for provisions and returns.  More competition is arriving to compete with Original Stash.

Gross Margin improved to 40% via cost improvements outpacing revenue per gram reductions.

Their SGA aggregates $13 million against GM of $8.8 million. After they pay for SGA they still have interest expense of $3 million to contend with.

Cash looks reasonable at $94 million against commitments of $23 million for 2020 and 2021. Inventory is 3.8:1 sales.

This was a “progress” quarter. They will need a couple more “progress” Quarters where they can continue to generate GM$ increases in order to get over the hump and show they have stabilized operations.  It will be interesting to see of Original Stash can keep powering Hexo on sales front AND maintain GM in the 40% range.  Getting some 2.0 products out there will help, especially if they get the take up in Quebec that they do on 1.0 products.

This Q:

Hexo is in a large group pf LPs that need to conjure sales.  Progress was made on adult use sales but the sales increase slowed QoQ. Cannabis 1.0 products produced only a $0.6 million QoQ increase.  SGA decreases have also slowed.

If they hit a 40% GM they need a $25 million increase in sales, just shy of doubling, to get to +NOP and a $12.5 million increase (+46%) to get to +EBITDA.   They indicate they hope to be EBITDA positive in first half of F2021.  I would bet against them hitting that EBITDA flag plant by first half of F2021.

They should have enough cash for their requirements, but they were elusive on the CC on the dollar amount of capex spend for F2021.

Hexo will have to show they can make it a few quarters without impairing inventory and demonstrate a GM in the low 40% range while increasing sales to change the trajectory of this story.

Sebastian, I was not as “super excited” as you were on the last CC on this Q.  This is a “meh” Q despite the sales increase as the parade of F2020 impairments continued.

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.