HEXO Stock: Sell Into Big Rally (Rating Downgrade) (NASDAQ:HEXO)

HEXO (NASDAQ:HEXO) has been on a hot streak since the stock collapsed following a reverse split in December. The Canadian cannabis company has substantially cut costs leading to a major dip in revenues in the last few quarters. My investment thesis is Bearish on the stock with a questionable path forward following a major restructuring.

Reverse Split

Effective December 19, HEXO competed a 14-to-1 share consolidation. The company went from 601 million shares outstanding to only 43 million shares in order to barely come into compliance with Nasdaq minimum bid listing requirements of trading above $1.

The stock action wasn’t so impressive with split adjusted shares trading above $2 heading into December and HEXO falling below $1 by mid-December. The stock rally in January to $1.60+ doesn’t even have HEXO back to the early December levels.

Typically, a reverse split leaves a negative connotation on a stock, though the share split doesn’t affect the value of the underlying assets. In this case, HEXO split due to horrible ongoing operating losses by the Canadian cannabis company and a large debt position. The reverse split hasn’t changed those weak financials.

Somewhat Better Results

For the quarter ended October, HEXO reported a massive improvement in adjusted EBITDA losses. The company has cut substantial expenses and revenues have taken a large hit with HEXO apparently chasing a lot of unprofitable sales.

The company reported FQ1’23 net revenues of C$35.8 million, down 16% sequentially from C$42.5 million. The biggest concern is that revenues don’t stabilize or even rebound and HEXO ends up in a never ending spiral downward.

The problem is that quarterly results are generally still ugly and hard to analyze due to all of the one-time costs and adjustments. Even using adjusted gross margins, HEXO is still only producing 24% margins despite cutting a lot of unprofitable sales in the last year.

The Canadian cannabis company only produces a meager C$8.2 million in gross profits on an adjusted basis. Note, this adjusted quarterly gross profit excludes a combined C$9.3 million in inventory related write offs and write downs. These charges aren’t necessarily one-time charges in a Canadian cannabis market historically inundated with excessive inventory.

HEXO did end October with an inventory balance at C$48.4 million, down from $C66.4 million in July. With sales targeted at C$150.6 million for the year, the company finally has inventory levels equal to 6 months’ worth of sales at these low margins. Inventory levels remain far too high at targeted 40% to 50% gross margins.

The real complicated part of the financials are the operating expenses where HEXO has more one-time charges than operating costs. The market really needs to see these financials for the January quarter without all of the charges to see whether the company has made any real progress.

According to HEXO, the actual G&A, S,M&P and R&D operating expenses have decreased C$14.8 million relative to FQ1’22 to only C$14.9 million. The company has made great progress to where the gross profit is approaching the operating expenses.

The problem is that huge reductions in operating expenses such as sales and marketing tend to lead to lower and lower revenues. HEXO has reported large revenue declines over the last couple of quarters.

The Canadian cannabis company has a cash balance of C$80.6 million with a net debt position of $262.3 million. Shareholders face large risks, if the company is not able to start generating positive EBITDA and ultimately cash flow to repay debt. Otherwise, the convertible debt will end up being converted into a large amount of shares, especially considering only 43 million shares are outstanding after the reverse split.

Takeaway

The key investor takeaway is that HEXO has rallied this year due to overdone weakness following the reverse split. The company has reported smaller adjusted EBITDA losses in the last few quarters, but the Canadian cannabis company is still losing money and these massive restructurings where opex is cut in half in a year are usually problematic to stable sales.

Investors should sell HEXO shares on this rally knowing the financial picture has not turned the corner here despite some promising trends.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.