Hexo released their Q1 F2021 earnings today.

Outlook from this MDA:

• The Company expects to be Adjusted EBITDA positive for the three months ended January 31, 2021, subject to certain assumptions (outlined below) regarding store count, product output, 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 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.

I cannot believe they played a promotional video on their earnings call. And then spent a good portion of call on justifying share price relative to peers. For a company that diluted shareholders repeatedly in F2020 they sure threw some shade on those raising now…. When share price is higher than when they did.

And they did a reverse split of 4:1 on Friday.   These guys need to look in the mirror. Being #1 in Hash and beverages is not like being #1 in any of the top 3 categories of flower, vapes and prerolls.

This Q

Pluses

• Sales increase +8%
• Gross Margin 41% BUT without writeup of inventory it is 35%.  Once Adult Beverage JV is moved to Molson’s books this should improve further.
• Good cash balance

Minuses

• Sales increase did not keep pace with Quebec rec sales.  Quebec was up 40% in the first two months of this Q versus last Q.
• Sales increases in adult use are getting smaller by $ each of last two Q’s. 
• Their Adjusted EBITDA includes Other Income of $1.8 million.

Some good disclosure from Hexo in MDA on segments.

Income Statement Drivers and Breakeven Sales:

Revenue Table:

Net Sales for the Q were $30 million a +9% increase from last Q.  Adult rec was $27 million (+$1.7 million or +12%) while medical was marginally down and wholesale was -$0.3 million. International reappeared for second consecutive Q at $1.1 million (-$0.2 million) sold to Israel.

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.

Of the +$2.3 million in sales increase this Q:

• +$2.0 million in Original Stash for +7% QoQ
• +$1.8 million in OS Hash
• +$0.9 million in prerolls
• +$1.1 million +54% was increased beverage sales as their canned beverages and Verywell drops that were available for the entire Q,
• With Medical, WS and International down a combined $0.5 means…
• Vapes and other adult rec was down $3 million

The net selling price of Adult Use excluding beverages took a sharp turn downwards at -27% QoQ to $2.17/gram.  Again an oddity, the Average Net Selling Price for beverages dropped 89% to $0.79/gram.  This could be because of the tilt to canned beverages from Verywell drops mentioned below.

They sold 15,806 KGs +79% QoQ at a decreased per gram of $1.88/gram versus $3.06/gram last Q. The decrease is the hard tilt to Original Stash in the Q.  What is odd is the Adult Beverages consumed a lot more KGs QoQ at 3,872 KGs on sales of $3.1 million versus 334 KGs on sales of $2.0 million the previous Q.  I will keep an eye on this going forward.

Adult Use Cannabis Revenue – Peer Trend

Hexo is 4^th in the above peer group. 

They indicate they are the Canada leader in Hash and 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.

They indicated on CC that at present (not during Q) they are #3 in Alberta at 7% share and #6 in Ontario at 5% share.

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 1 peer group Hexo is the 5^th largest company by Revenue.  

Gross Margin: Peer and Trends

Their historic GM is riddled with cost based writedowns in most Q’s during F2020.  This Q they had a write up of inventory by $1.5 million.

GM was $12 million for Oct 2020 Q versus -$36 million last Q. at 41% GM this Q on a cannabis only basis they land at #2 in the peer group.

GM was also reportedly impacted by the new bottling facility.  Until licensed, the facility is 100% on Hexo balance sheet.  When the facility is licensed the revenue, and costs, will be consolidated to Molson Coors through the Truss JV and net incremental loss or profit will appear on Hexo. 

COGS & GM Table:

GM per gram sold decreased by $0.82 to $1.10/ gram prior to any write offs/ups and impairments.

Cost per gram did decrease significantly QoQ to $1.06/gram from $1.96/gram, but this was offset by decreases in revenue per gram.

GM, netted for impairments, improved by $2.3 million with the entirety in beverages. It will be interesting to see what happens when Truss GM and SGA move to Molson’s.

Gross Margin Larger Peer Group

Hexo vaults to #1 in this peer group.  Note: CGC, APHA, and TLRY have considerable non cannabis revenue which distorts GM%.

SGA and SBC: Trend Analysis

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

Selling and marketing decreased QoQ to $2.1 million (-$0.3 million) and are 7.1% of sales.  The dollar amount is consistent with Q3F20 pre beverage launch.

G&A decreased $0.5 million to $12 million QoQ and in line with Q3 F2020. At 40% of sales it is the lowest on record.

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

SBC is at $2.9 million a decrease from $4.3 million QoQ as share price has been decreasing.

R&D was $1.0 million up from $0.7 million last Q.

Depreciation and Amortization was $1.4 million versus $1.4 million last Q.

Total Opex was $19 million down from $21 million last Q.  Opex has decreased five consecutive Q’s and decreases QoQ are getting smaller.

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 62% to evidence +NOP.

NOP for the Q net of IFRS was negative $7.4 million versus negative $57 million last Q. The swing in impairments to inventory are the largest reason for the improvement.

Other Income and Expenses aggregated negative $3 million versus negative $46 million last Q. Of note:

• Last Q Expense $54 million inducement of Convertible Debenture holders to convert to equity. None this Q.
• Last Q Expense $46 million impairment of PPE as management idled equipment and redundant property versus expense of $0.8 million this Q.
• Interest Expense of $2.3 million a decrease from $2.7 million last Q as debentures were reduced for entire Q. 
• Last Q Expense of $1.8 million accruing to onerous contract with MediPharm Labs, which totaled $4.8 million for the year. Nil this Q.
• Other Income of $1.6 million versus $2.3 million last Q.  They do not back this out of Adj EBITDA. Nor do they provide a note on it. It appears it could be the sublease of Truss facility to Truss JV.

Net Income net of IFRS on Bio Assets and Inventory rang in at negative $4.2 million a versus negative $170 million last Q. The inventory impairments, conversion of debentures to equity and impairments of PPE were the large items last Q.

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

At current GM% and cash Opex$, Hexo requires 19% increase in incremental revenue to reach +EBITDA.

EBITDA Trend and Peer:

My figure of -$2.2 million differs from theirs of -$0.4 million as they do not back out Other income and they back out SBC embedded in CoGS of $0.6 million.  Problem is their SBC on their cash flow statement balances to what is in Opex, so I only deducted what was in the cashflow statement. And Other Income… I cannot find a reason to not back it out as it does not seem operational in nature.

This is an improvement from last Q of -$5.6 million or an improvement of +$3.4 million.  The increase in GM net of impairments plus the improved cash Opex of $0.5 million are the reason.

Balance Sheet Items of Note:

Cash:

Cash and restricted cash decreased by $11 million QoQ to $181 million.  Cash is in good condition, but it has come at huge dilution and before the recent run up in cannabis stock prices. 

The Restricted cash of $31 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 increased to 15,806 KGs (+6,970 KGs) and increased their harvest to 17,462 KGs (+922 KGs) for a net add to inventory of 1,656 KG.  As per above, cannabis beverages consumed a good deal of cannabis.  If they keep this alignment in Harvest to Sales, it bodes well for them.  On the CC they indicated they even used all their trim.

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

Harvesting only below Aurora and 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.  And keep in mind they wrote down cost-based inventory by $68 million for F2020.  

Biological Assets increased to $11 million from $8 million and are at their highest since April 2019.

Inventory to Sales: Peer and Trend

Total inventory increased $10 million to $75 million or 2.54X sales.  Inventory impairments at bay for now.  Only Aurora is lower in Inventory to Sales.

Sold vs Harvest KGs and Sales vs Inventory $’s

They increased inventory by $10 million as they added KGs to inventory this Q and had a $1.5 million write up.

The $30 million in convertible debentures mature December 2022.  The $29 million term loan matures February 2022. It will flip into current liabilities in two Q’s.

What I said last 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.

This Q:

A small sales increase and it looks like they are losing market share in Quebec.  The declining QoQ $ sales increase is something to keep an eye on.  Hexo will need to focus on growing Ontario revenue as store counts increase.

They were able to maintain gross margin in their overall portfolio with the improvement in Beverage GM in the Q. Without the improvement in beverage GM, they would have slid backwards in $’s.

This was a progress quarter but less than the previous one.  EBITDA remains negative and they have $2.3 million in interest expense quarterly plus a further $7.9 million in Current Portion of debt and leases.

Cash position finally looks to be in a place where dilution will not be an issue for a few Q’s.  Couple that with inventory looking to be in control and their new CFO seems to have addressed some of the concerns within his control. 

I would suggest investors keep an eye on Quebec retail sales in relation to Hexo sales growth.  This is still their main driver of growth.  No other LP would benefit as much from the Quebec government acting like Alberta and Ontario and opening up retail stores than Hexo.

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.