Description

Thesis Summary: When it comes to shorting, I focus on irretreviably bad businesses burning tons of cash that have a high chance of ending at zero, even if the stock is already down a lot and/or is a tough borrow (see my prior writeups on Nio, Japan Display, Sharp, etc). Hexo Corp (TSE: HEXO), a Canadian cannabis licensed producer (LP) based in Quebec, fits the bill perfectly. While this was of course a better short 3-6 months ago, HEXO is quite likely to see a further material decline in its stock, perhaps all the way to zero, in the next 3-4 quarters because it competes in a commodity market with the worst supply/demand imbalance I have ever seen (Canadian cannabis); it is burning oodles of cash; and it is quite likely to trip covenants on its debt in Jan 2020. Even if it survives as a going concern thru the end of next year, it is highly likely to be continually rerated lower by the market from its still lofty valuation levels (6x FY20E EV/sales, and >2x book value) as the market realizes the company will imminently enter distress, is structurally unprofitable, and will need to trade closer to recoverable asset value (hint: a lot lower than book value). Apparently the new CFO (since May) thought similarly, because he jumped ship less 4mos into his tenure – just before the co pulled 2020 guidance and then announced they were going to dump product on the market at a 50% DISCOUNT to prevailing retail rates. More on that later.

HEXO is dual listed on the TSE and the NYSE; borrow is available, but very expensive, at 40-50% rates. Clearly this is a ‘shoot him in the back’ kind of short, and that is not for everyone. Still, I think this has a long way to fall and it won’t take a year if the view is correct, so I view it as a highly alpha-generating idea even net of the high borrow cost. The fully-diluted market cap today is around $1.1bn CAD and it trades $10-15mm CAD a day, so this is actionable for most all funds.

This will not be a long writeup; I am happy to answer questions in the comments. There are three main points to the thesis:

1.     Canadian cannabis is the worst commodity market you will likely ever see and the price war is about to get epic

2.     HEXO’s idiosyncratic issues

3.     Scale of cash burn, likely covenant breach and consequences for the stock

Problem 1: Canadian Cannabis – the hunger games are coming

Canada is drowning, absolutely drowning, in cannabis. Others have written coherently about this (see Kuppy’s great synopsis here https://adventuresincapitalism.com/2019/07/15/shareholders-must-stoned/, and there was a good write-up on Canopy Growth here on VIC), so I don’t need to repeat what has been said. Suffice to say that marijuana in Canada has simply followed the pattern of endless other commodity bubbles from yesteryear: too much capital, irrational exhuberance, a massive over-estimation of demand that led to insane over-build of capacity and inventories and now – late in the game – the inevitable crash. It is becoming eminently clear that the vast majority of cannabis consumers were already serviced by the black market (at 50% cheaper rates than the legal stuff) and that all the new capacity that every LP has rushed to add is simply malinvestment waiting to be written off. Here is the latest data (thru July) from Health Canada, showing the disparity between demand (actual sales) and supply (finished and unfinished inventories):

Putting the above graph into simple terms, in July, 11.5t of cannabis was sold (legally) in Canada but finished inventories are 5x as much and WIP across the market 25x higher (!), and this imbalance is getting worse every month. In fact the inventory build in unfinished product each month the last 4-5 months is 2-3x the total monthly consumption across the whole market. You think there are a lot of unsold Teslas stuffed in parking lots across the US? Every second warehouse from Saskatoon to St John is filled to the brim with weed that nobody wants to buy. Remember pot has been legal (in flower/bud/oil forms, not vapes/edibles/beverages, etc) for basically a year now, and there has been a steady increase in consumption, as the chart shows. But usage would have to jump at least another 15x to make a dent in the inventories still inexorably being created by all those idiot LPs…

OK, you may ask, why haven’t prices cratered yet? Well, the LPs have simply sold a lot less than they have been producing (in an effort to support prices) – partially because they hoped/prayed demand would improve; and partly to maintain the game a little longer. Each successive quarter, though, the imbalance between product sold and product produced has, quite clearly, gotten more ridiculous.

HEXO is a case in point. In the Oct’18 quarter (the first legalization period last yr), they produced 3550kg but sold only 950kg (dried product, adult-use only); in the Jan’19 quarter they produced 4938kg and sold 2537kg (so not a huge difference); but in the Apr’19 quarter the differential exploded, with 9804kg produced but only 2759kg sold. Of course now is the right time to mention that HEXO alone has built a greenhouse in Gatineau capable of churning out 108,000kg of product a year (meaning even last Q they were at 30-40% of capacity) AND they just bought another LP with 42,000kg of capacity (called Newstrike), taking company-wide capacity to 150,000 kg – or just a cool 5x more capacity than their current annual run-rate sales (around 35,000kg/yr). These numbers are not unique, but are emblematic of behavior across the industry. As I said, Canada is drowning in cannabis…

So prices haven’t dropped yet (thru April), but it is inevitable they will start dropping like a stone, and soon. HEXO gave the first warning of this in a recent PR where they withdrew 2020 sales guidance and suggested 4Q (through July’19) sales would be just $15mm (or almost inline with 3Q sales despite previous guidance that they would double). The commentary around the guidance cut was scary, as well – ‘lower than expected sell through’, ‘early signs of pricing pressure’ were specific call outs – and no doubt we will hear more on the upcoming call (this Thurs, Oct 24). More on that shortly.

Problem 2: HEXO’s idiosyncratic issues

HEXO is based in Quebec, and a very large majority (~80%) of their near-term revenues come from their status as a licensed supplier to this particular province. There are some real benefits to being Quebec based – lower electricity costs (hydro-derived); generally lower labour costs – but these seem to have been outweighed by much stricter regulation. Thus, for example, HEXO has specifically called out the local regulators as being slow to allow derivative cannabis products (sprays, oils, gels, etc) that have higher margins and have been allowed in other provinces much faster; HEXO has apparently also been hampered by the slower pace of retail openings in the province (again a function of regulatory oversight). This will become a further problem when/if cannabis beverages are legalized and allowed in the province (something that was meant to become law by October 2019 but the HEXO CEO is already walking back, as discussed in this video https://www.bnnbloomberg.ca/hexo-s-new-discount-bulk-pot-offering-not-a-loss-leader-ceo-1.1333089) since, with the Molson Coors, JV, HEXO is really counting on cannabis beverages to make it a real player from next year.

Otherwise, the major idiosyncratic issue with HEXO is that they have bitten the bullet on massive price cuts and so they are likely to see their margins slashed – and their carried asset values obliterated – sooner than anyone else. Just last week, HEXO has fired the first shot in the price wars by announcing a new bulk purchase brand, ‘Original Stash’, where they will be selling dried product for the all-in price of $4.5/gram to the consumer. Since the average retail price across the country is $10/g, and the average illegal price is $5.5/g, HEXO is essentially under-cutting the legal market by 50% and the illegal market by 20%, impact on their margins be damned.

What will the impact be on HEXO margins? Well, in Q1-3 this year, they managed gross margins in the mid-40s % and net ASPs (ie, removing 18% excise tax) of $4.3-4.8/gram. In other words HEXO was making gross profits per gram of around $2 (actually $1.9 last quarter, and $2.25 in Q2) – and will likely report lower GMs again in the upcoming Q4 given the abysmal pre-announcement on revenues – but the important takeaway is that if they are willing to sell in bulk at $4.5/g all in, given the excise tax (call it 18%) and the wholesale discount (guided historically at 35%), HEXO’s net ASP on bulk sales may be as low as $2.4-2.5/gram. So gross margins may literally fall from 45% to 20%, overnight – and this is before the competition shoots back. Of course, the company is hoping to make some of the margin back on volume…but this is a race to the bottom scenario, and most all major competitors – including those like Canopy and Aurora with significantly more scale in production – will just be forced to cut alongside, or to even lower levels (after all, they have much bigger greenhouses than HEXO they need to fill). How will the market react when HEXO is first to report collapsing gross margins and large impairments both to existing inventories and biological asset valuations (which today are marked using assumed ASPs of $4.95/gram, or basically double the likely ASP of Original Stash)?

Of course the third idiosyncratic issue facing HEXO in particular is executive turnover. I alluded to it in the introduction, but a relatively high-profile CFO (ex Nutrisystem) was hired to much fanfare in May; he abruptly left earlier this month, and we just had the guidance cut. I am particularly troubled by this departure because HEXO has not even reported the July’19 quarter yet (the company’s Q4), but the CFO clearly had a very good look at the Oct’19 quarter as well (his departure was announced Oct 4), so I am quite confident whatever bad news we hear on Thurs re the July quarter is not the end of it. In fact I think the CFO leaving now is a failsafe to make sure he is at least a couple of quarters removed from real financial/cashflow trouble, which appears to be around the corner for the company…

Problem 3: Cash Burn and imminent liquidity troubles

Like many Canadian LPs, HEXO has been burning a lot of cash, through a combination of lack of operational scale; unfavorable working capital movement (the aforementioned increases in inventories); and high capex (building out greenhouses and processing, etc). Unlike some other names, HEXO does not look particularly levered, with last reported unrestricted cash of $173mm against term loan debt of just $35mm. The company also garnered perhaps $70mm in cash when it acquired Newstrike, as well as another $40mm from exercised warrants in the soon-to-be-reported Q4. All good, right?

Not so fast. The company burnt $55mm/qtr average the last 3Qs, and I think they will burn closer to $70mm in the upcoming Q4 (a combination of lower ASPs, higher cash out to W/C thru inventory build; and more capex associated with finishing the Gatineau capacity and the Newstrike property retrofits). Thus, all told – and accounting for the warrant cash and acquired Newstrike cash – I think the company will enter next fiscal (recall this means from August this year) with maybe $210mm cash or so, ie, barely 1yrs cash at current burn rates.

Things gets complicated by the fact that the term loan has fixed charge coverage (>1.25:1) and total leverage (<3:1) covenants that kick in from Jan’20 that are basically impossible to be met (the company is still negative EBITDA and the CFO just quit, remember?). Thus, unless renegotiated, that loan will likely need to be repaid, perhaps as soon as the end of this year/early next year – reducing available cash well below $200mm, perhaps to the $170-180mm range. If my cash burn estimates for the upcoming 4Q are even ballpark, the company will at this point (call it by calendar year end) have <3 quarters worth of cash remaining…and all this before gross margins invariable cliff-dive from the mid-40s to the 20s (or lower).

All this may not be enough to get a ‘going concern’ mentioned in the upcoming Q4 report, but I certainly think there could be some alarm bells ringing by the time next quarter rolls around to be reported (the October quarter, likely reported in mid-December). At this point and even assuming some diminution in capex (as facility construction should be mostly completed) I can’t see how cash burn doesn’t fall to lower than say $40mm meaning the available cash as at end Oct may well be sub $150mm, pro-forma for losing access to the Term Loan, and given the near-term cash burn history at the company and obvious disarray in the underlying market, the stockmarket should begin to price this as a distressed asset. The company would be sensible to dilute shareholders (again) thereafter, likely in early January, to provide a cash cushion heading into the term loan – no matter the price – adding a further fillip to the short, if the stock somehow manages to hold up north of 2x book value.

What’s it actually worth in a distressed scenario? Well, net assets pro-forma for Newstrike are probably somewhere around $550mm, but of this most of the tangible value is in cash (which is being burnt away) and then PP&E ($175mm today, likely $220mm post Q4) but which is simply excess greenhouse and buildings (almost none of it is land). What is that worth in a market like this? No one would miss it if it disappears…Otherwise the Molson JV is marked at $48mm but that is only because HEXO gave Molson $41mm in warrants (struck at $6/share or something) which they impute as the value of the JV – realistically they only put $7mm cash into the venture and they have no products on the market yet so who knows if a) Molson is committed and b) what the real value to an acquirer is. Inventories and biological assets are the other big category ($50mm as of last balance sheet, likely much higher, maybe $70mm(?) as of July’19) and as you have probably guessed this isn’t worth the paper(s) its rolled in given all of the above.

So adding it all up I wouldn’t be surprised to see the market extract a significant discount to book value for at least the PP&E, the inventory, the biological assets, and the Molson JV, if or when the cash balance gets low enough (and the TL gets pulled) to get the market worrying about going concern risk. That could be as soon as this upcoming report (though unlikely) but in my view much more likely in mid-Dec or thereafter with the Jan’20 report (due early March). Thus I could easily see this trading well below book value – implying a 60%+ return on the short side in 4-5months. Ultimately this probably heads much lower but that is a decent starting point for the short.

Catalyst

Q4 earnings (this Thurs)

Q1 earnings (mid-Dec)

Potential TL covenant breach and/or repayment to avoid covenant breach (early Jan/maybe Feb)

ongoing price wars in Canadian cannabis