Hexo released their Q4 F2021 earnings today, and hooo boyo, it’s an interesting one.

It’s a Q4 so the auditors have to offer an opinion.  And Hexo gets banged with a “going concern” note that is not like the usual “going concern” notes, and it is centered around the Senior SECURED Convertible Debenture they raised to fund the cash portion of the Redecan purchase.  First, let’s look at a comment I made last Q:

“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. “

Well, the debenture went into default prior to the first Q it was on the books, which triggers cash interest.

Auditors Note:

Hexo did negotiate the reduction from $5.00 share price to $1.50, noted above, to delay triggering cash payments.  The problem is the that the holder of the note does not want to hold more than 9.99% of Hexo shares, as they would have to report share purchases/sales and disclose who they are.  Any settlement above this amount has to be paid in cash or the lender must relent on their 9.99% provision.

Here is the Optional Redemption note:

Problem is… investors do not know where that line is drawn.  How much cash will have to exit Hexo to satisfy the lenders? How much in shares will be paid?

Good questions.  And if you listen to the conference call, they indicate they are “actively working to address the issue”. The lender has given some amendments that favor Hexo (the drop of the VWAP above), but these really have not affected the amount that lenders are owed and when they are owed said money.

Due to the default, the Sr Secure Debenture resides in Current Liabilities at $367 million.  There is USD 80 million in Restricted Cash held by the collateral agent, but this is to cover shortfalls in payments owed and will not likely be used unless a payment default occurs. 

I cannot imagine how the lenders feel with a loan in default by the first reporting Q.  But I do know that the lenders are in the driver’s seat.  Settling the debt of CAD 367 million at yesterday’s share price of $2.00 would add 184 million to the 127 million present float.  An I-banker on the CC thumbnailed the amount to get the facility out of default would be 40 million shares or $20 million.

I would like to tell you the interest rate, but I cannot find one in the notes.  The debt principal was $434 million at issue.  Hexo only received 91%, as the note was sold at a discount. (eg the 9% owed back was some baked in interest). The note matures May 1, 2023. The repayment on redemption would have been $478 million.  So, Hexo received $395 million and had to repay $478 million in two years. That would be $83 million in “interest” or a 21% interest expense over two years.  So, 10.5% annually on a thumbnail at $43 million annually. 

The note holder can require monthly redemptions of the principal of US$ 15 million or US$ 20 million from October 2021-September 2022.  These can be settled in cash or equity.  But the catch is the holder cannot exceed 9.99% in total Hexo equity.

This debt instrument is extremely complex.  It is a lit fuse that needs to be extinguished. It is in Note 19 for those interested.

I think Hexo waited until the last possible day of reporting period to file these year ends hoping that they had reached an amendment with the lenders.

Last 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.

This Q:

Pluses:

• Sales rebound to $39 million +71% or +$16 million QoQ.  International and Wholesale are $8.7 million of the increase, Beverages (which they only own 50% but report on consolidated basis) was $2 million, and Zenabis was $6.8 million.

Minuses:

• Adult Use sales, net of Zenabis Adult Use Contribution of $4.0 million, was $1.4 million after last Qs decrease of $8 million.
• GM decreases to 4%. Backing out inventory impairments and it is 20%.  There are some inventory step ups from Zenabis that would add another 1-2%.
• SGA increases $5.6 million as Zenabis was loaded for two months.
• They have $67 million in unrestricted cash. Depending on how the debt renegotiation goes, that might be too little.

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 $39 million a +71% or +$16 million increase from last Q.

Adult rec was $24.6 million (+$5.4 million or +28% QoQ) of which Zenabis accounted for $4.0 million. Their revenue per gram dropped 10% to $1.98 as they sold more lower priced value brands (Bake Sale).

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 in Q3F2021.” This Q they have an organic increase of $1.4 million, but they remain well below two Q’s ago.

They have been bumped to #2 in Quebec at -19% decrease or -$1.9 million. They did increase in Alberta +76% +$1.7 million and Ontario +31% +$1.5 million.

Wholesale returned at $1.9 million. But it was sold at negative GM at a price per gram of $0.84.  Better than nothing.

International returned in the Q at $2.6 million (part of a 24-month purchase agreement).

Cdn Medical was down and is irrelevant.

They sold 23,256 KGs +91% or +11,607 kgs QoQ, at a decreased revenue per gram of $1.66/gram versus $1.85/gram last Q.  

They have removed Harvested Kilograms this Q from reporting, despite still having in their MDA a defined term for “Harvested Kilograms” which is only repeated again in its own definition.

Adult Use Cannabis Revenue – Peer Trend

Hexo is 3rd in the above peer group. Redecan gets added next Q.  They gave no guidance on Redecan contribution.

Medical Use Cannabis Revenue – Peer Trend

Canadian medical is a rounding error.  The increase is due to resuming shipments to Israel.

Income Statement Drivers and Breakeven Sales – Peers

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

Gross Margin: Peer and Trends

GM dropped from 20% to 4% all in, and from $4.4 million to $1.5 million.  Write offs and impairments aggregated $6.5 million.  If write offs were backed out GM improves to 20%, the lowest of the fiscal period.  Adult Beverages finally got a boost with GM at 33% of sales or $1.8 million from a negative last Q.  Adult Use dropped from 37% to 28% to 12% (pre impairment) over the past three Q’s.   

COGS & GM Table:

GM per gram sold decreased by -$0.07 to $0.34/ gram prior to any write offs/ups and impairments. This is their lowest on record for F2021.

Cost per gram decreased QoQ to $1.32/gram from $1.45/gram. Revenue per gram is falling faster than cost per gram can keep up.

GM slid by $3.6 million with adult rec dropping by -$2.4 million to $2.9 million.   International had a strong 65% GM.  While wholesale was sold at a 65% loss. All before impairments.

Gross Margin Larger Peer Group

Hexo slides from #5 in this peer group last Q to #6 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 QoQ to $3.7 million + $1.2 million and are 10% of sales a reduction from 11% last Q as sales rebounded.  This is the highest dollar amount in five Q’s.

G&A increased $4.3 million to $19.2 million and is highest since Jan. 31, 2020 Q. Adding Zenabis for two Q’s is the reason.   Salaries and Benefits and G&A were up $1.3 million.  Determining the balance of delta is not possible, as I had to run Q4 true ups and the format has changed during the year.

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 to get there, as they are at 59%.

SBC is at $0.8 million a decrease from $2.7 million QoQ, as share price has been retreating.

R&D was $0.9 million versus $0.7 million last Q.

Depreciation and Amortization was $2.7 million versus $2.0 million last Q.  Adding Zenabis assets likely the reason.

Total Opex was $27 million versus $23 million QoQ.  Reflect on the fact that GM was $1.5 million and you see the hill they need to climb.

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 1,772% to evidence +NOP. The 4% GM is magnifying the breakeven.  But even at the unimpaired GM of 20% they would need an additional $130 million in sales to get to +NOP.

NOP for the Q net of IFRS was negative $26 million versus negative $18 million last Q. GM declining and increase in SGA the reasons.

Other Income and Expenses aggregated negative $45 million versus negative $7 million last Q. Of note:

• Acquisition costs were $2.0 million prior Q and increased to $15 million this Q.  This will stay up as they get through NRTH and Redecan.
• Impairment of PPE of $19 million which they attribute to Zenabis cultivation assets.  Odd… you think this would have been identified in the acquisition costing unless the impairment decision was made post acquisition.
• Revaluation of financial instruments was +$7.3 million versus -$0.4 million last Q
• Fair Value loss on Sr Secured debenture was $7 million
• FX was a gain of $13 million, the USD Debenture was the driver as CAD softened against USD
• Finance expenses grew to $24 million from $3.3 million and includes interest and fees from the financings in the Q.

Net Income net of IFRS on Bio Assets and Inventory rang in at negative $71 million a versus negative $25 million last Q.  Most of the swing is in other expenses as these increased by $39 million QoQ.

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

At current GM% and cash Opex$, Hexo requires 898% increase in incremental revenue to reach +EBITDA.

EBITDA Trend and Peer:

My figure is pretty close to theirs.  I have it at -$13.5 million and they are at -$13.0 million for a difference of $0.5 million. 

EBITDA was consistent Q over Q as the increase in sales produced a larger unimpaired GM (+$3.6 million QoQ) which was offset by cash OPEX.

Balance Sheet Items of Note:

Cash:

Cash (net of restricted cash) decreased by $14 million QoQ to $67 million.  They have Restricted Cash of $132 million but part of that is the debt service reserve for the Sr Secured debenture of $100 million and $30 million is their insurance reserve for their captive insurance subsidiary. The cash held in escrow of $286 million was used to pay for Redecan and was reserved from the Sr Secured Debenture proceeds.

Hexo does have a $150 million ATM with $47 million utilized.  This will likely be tapped for the Sr Secured Debenture cash interest and any redemptions to principal.

They will likely need to raise cash. 

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

Their KG sold increased to 23,256 KGs (+11,067 KGs) as they sold more product through Adult Use (+3,740 KGs) at a lower price and +4,860 KGs increases in wholesale and international.  Beverages consumed +2,473 kgs more QoQ.

They have stopped providing harvested KGs.

“Gas in the Tank”: Trend Analysis

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

Biological Assets increased by $5.1 million to $14.3 million with the addition of Zenabis.

Inventories increase $40 million to $135 million Zenabis related. Dried cannabis increased $31 million, Oils increased $5.5 million, Purchased extracts and cannabis increased $2.6 million, and packaging supplies increase $2.1 million.

Inventory to Sales: Peer and Trend

Last Q:  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.

This Q: They took a $6.5 million impairment and sales rebounded to help push the figure down to 3.5:1 inventory to sales.  They are still in a dangerous territory, and it will be interesting to see this after next Q with Redecan and 48 North included.

Trade receivables of $37 million is almost 100% of Q sales.  Sales look to be backloaded in the Q with $23 million under 30 days, $12 million between 30-60 days, and 42 million past 60 days.  Their wholesale and international sales were $8.7 million so that $12 million might be partially tied to those. Not sure what the difference would be.

PPE increases $113 million with the Zenabis assets to $394 million.

Goodwill and Intangibles increase an aggregate $122 million with Zenabis to $148 million.

I don’t think the narrative of “asset light balance sheet”, that they have been using for the past year, will be repeated with the addition of Zenabis and Redecan additions of PPE and G/I.

Accounts payable and Accrued liabilities increase $21 million to $64 million. 

They have a $50 million loan that came over from Zenabis, that was held by Sundial, in Current Liabilities.  Zenabis needed lender permission for a change of ownership.  Sundial did not give it. Sundial is asking for the Zenabis royalties that were due and are seeking $72 million.  Hexo believes the amount owed is $53 million. Note 31 indicates “Under the senior secured convertible note agreement (Note 19), the Company has restricted funds to satisfy this liability (Note 6).”

Note 6:

I see the restricted cash for Sr Secured and the captive insurance. I do not see a $19 million reserve for this loan.

The $367 million current portion of Sr Secured debenture is new.  It will be in current until an agreement is reached with lender to amend the facility to remove the current default.

Leased Liabilities increased $20 million to $42 million; $17 million came in with Zenabis.

Share capital expends by $236 million via Zenabis acquisition and ATM.

What I said last 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.

This Q:

Oooh, that comment last Q about “limit options and flexibility going forward” is getting tested VERY early on.

This Q showed progress in international sales and the addition of Zenabis sales.  Selling wholesale for a negative GM still generates cash but it is not a long-term solution to anything.

Gross Margin is my biggest concern.  They admit to leading the market in reducing pricing with some products in the Q. But their unimpaired adult use GM was only $2.9 million, the lowest of the year by far. Adult use GM of $2.9 million when SGA is $24 million is a really BIG concern.

But the BIGGER concern is how the lenders of the Sr Secured Debenture allow Hexo to remedy the cash versus non-cash interest AND the lender option redemptions.  The interest expense I have thumbnailed at $43 million a year (21 million shares at yesterday’s price). The lender has the option to require US$ 20 million a month in principal redemptions (10 million shares a month at yesterday’s price), in redemptions paid by cash or shares but shares can only be used IF the lender is below 9.99% of Hexo’s shares. Hexo only has $67 million unrestricted cash and adjusted EBITDA is running at -$13 million each of the last two Q’s.

As of this writing Hexo share price is down 10% to $1.83 and the share price has been under pressure since August 19, 2021, when it was $4.10. So, it has lost 55% in 2.5 months.

It is the lender’s move. How they react will be interesting.

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.