Hexo: The Newstrike Mistake – HEXO Corp. (NYSE:HEXO)

Source: Author based on company filings.

Field of Dreams

In March 2019, Hexo (NYSE:HEXO) announced a $263 million all-stock acquisition of Newstrike Brands. The primary benefits of the deal were three fold:

  • Hexo would gain Newstrike’s state-of-the-art cultivation infrastructure and their premium indoor facility, increasing Hexo’s total planned capacity to 150,000 kilograms/year of cultivation.
  • Hexo would gain Newstrike’s distribution agreements with the provinces of Alberta, Saskatchewan, Manitoba, Nova Scotia, and Prince Edward Island. Prior to this agreement, Hexo only had distribution agreements in Quebec, Ontario, and British Columbia.
  • Hexo would benefit from accretive synergies, which may have the company $10 million/year.

Hexo was advised on the deal by Norton Rose Fulbright, a large London-based global law firm. After the deal, Hexo CEO Sebastien St. Louis assured investors that the deal would put Hexo on a strong path:

“With Newstrike, we’re adding talented employees and infrastructure to take HEXO to the next level on our journey to become one of the largest cannabis companies in the world. We’re extremely proud of our record of execution, and today are committing to achieving over $400 million in net revenue in 2020.”

Sebastien St. Louis, CEO of Hexo, March 2019

Hexo closed on the acquisition in May 2019, issuing 44.6 million shares, options, and warrants to acquire Newstrike. Those shares were worth $263 million when the deal was announced, $302 million when the deal closed, and are worth $58 million today.

At the time, I was bullish on the acquisition and bullish on Hexo. I was wrong. I sold my Hexo shares on Oct. 10 after Hexo slashed guidance, blaming the government rather than taking responsibility for their own over-optimistic estimates:

We expect revenues to double this quarter (Q4/FY19) with realized sales from the first harvest from B9 and our one million square-foot facility and also as we start to shift flower outside of Quebec, which we’re very excited to do.”

Sebastien St. Louis, CEO of Hexo, Q3 earnings call (this call was on June 13, halfway through the fourth quarter).

Hexo net revenues did not double in Q4. They rose 18%, and then fell 6% the subsequent quarter. Source: Author based on company filings.

Reality Bites

Hexo purchased Newstrike on promises of expanding their cultivation capacity, adding new provinces for cannabis sales, and claims of accretive synergies. The deal would aid Hexo’s journey to “become one of the largest cannabis companies in the world,” according to Sebastien St. Louis.

Spring has ended. Optimism has faded. Reality has set in.

Source: Newstrike Brands investor presentation, January 2019.

Closing shop: When Hexo acquired Newstrike, the latter had two cultivation facilities in Brantford and Niagara, ON. These “state-of-the-art” facilities included “premium indoor” cultivation space that would boost Hexo’s cultivation capacity and provide them with diversified growing techniques for global sales, we were told.

Five months after acquiring Newstrike Brands, Hexo shut down Newstrike’s Niagara cultivation facility. This facility had made up nearly 90% of Newstrike’s cultivation capacity. Hexo described this closure as “rightsizing” its operations by “winding down” operations. Hexo also slashed 200 jobs in the move, blaming market conditions. The same month, Hexo’s Chief Financial Officer left the beleaguered cannabis grower and Hexo slashed its guidance.

Apparently Hexo didn’t need that added cultivation capacity after all.

Poor due diligence: When Hexo acquired Newstrike, the latter was growing and selling cannabis from its two cultivation facilities. As with any acquisition, Hexo’s lawyers and investment bankers did due diligence on the deal to ensure than Hexo was getting what it bargained for and that Newstrike’s facilities were fully licensed, operating, and as successful as promised.

Their due diligence failed.

In November, Hexo admitted that Newstrike Brands had been growing cannabis without proper licensing. Hexo did not discover this until after they purchased Newstrike. It turned out that Newstrike had been growing cannabis in a region of their Niagara facility called Block B. But Block B had never been certified by Health Canada – the facility was not properly covered under Newstrike’s licenses.

This is a failure of Hexo’s due diligence processes – in a heavily-regulated industry like cannabis, it’s vital that companies be able to adequately comply with those regulations. In Hexo’s defense, this unlicensed growing was harder to spot and less malevolent than that of CannTrust (CTST), which intentionally flouted Health Canada regulations. Here, it appears that Newstrike had simply made a mistake and even Health Canada did not notice that Block B was not properly licensed during an inspection of the facility including Block B.

Duplicate contracts add costs: Among other benefits of the Newstrike acquisition, Hexo touted that synergies would save the company $10 million/year. Instead, duplicate contracts may cost the company nearly C$10 million.

MediPharm Labs (OTCQX:MEDIF) filed suit against Hexo for C$9.8 million on Friday, according to reports. MediPharm is a cannabis extraction company. In February 2019, Newstrike Brands signed a C$35 million private label production deal with MediPharm. Under the deal, Newstrike would purchase C$35 million worth of cannabis oil from MediPharm. Hexo inherited this contract by purchasing Newstrike. The crux of the problem is that Hexo doesn’t want or need this deal.

Hexo already has a cannabis extraction agreement with The Valens Company (OTCQB:VLNCF). Hexo has plenty of cultivation capacity (they shut down Newstrike’s Niagara facility due to overcapacity) and could send extra cannabis to Valens for extraction – they don’t need to purchase MediPharm’s cannabis oil because they can make their own.

Source: Hexo Q1/FY20 management discussion & analysis.

Further, Hexo already has too much cannabis oil after over estimating demand. Over the past two quarters, Hexo has subtracted nearly C$9 million from their gross revenue due to product returns and provisions for future product returns. These are products which Hexo sent to distributors which went unsold and are being returned. The company has been relatively quiet about which products are included, but has recorded an impairment on oil-based products which may be suggestive that returns also are from cannabis oil products.

Hexo had been trying to negotiate with MediPharm Labs to break this contract amicably. Given MediPharm’s lawsuit, negotiations appear to have broken down.

Thoughts

Purchasing Newstrike was a mistake.

Hexo touted the added cultivation capacity but quickly shut down Newstrike’s primary cultivation facility. Hexo failed to find out about licensing problems until after their purchase, demonstrating poor diligence in this deal. Hexo touted synergies of the deal, but is instead being sued for C$9.8 million based on a duplicative contract that Hexo never would have signed.

Through the Newstrike acquisition, Hexo gained supply deals in Alberta, Saskatchewan, Manitoba, Nova Scotia, and Prince Edward Island, but has been unable to capitalize on those deals. Instead of profiting from new markets, Hexo can barely even service their existing markets. Until August, Hexo didn’t even ship dry flower to Ontario and only recently began selling flower in British Columbia. Hexo has seen very little growth compared to peers since the addition of Newstrike (during Q2/CY19):

Source: Author based on company filings. In Canadian dollars and with quarters rounded to the nearest calendar quarter.

While peers like Tilray (TLRY), Cronos (CRON), and Aphria (APHA) saw strong revenue growth in the third calendar quarter, Hexo’s revenue fell during its first full quarter of Newstrike results. Rather than providing growth, the addition of Newstrike may just be obscuring issues in Hexo’s core business.

At the same time, Newstrike is not Hexo’s only mistake. In October, the company abandoned guidance it had set halfway through the quarter, laid off 200 employees, had their CFO resign after only four months on the job, and raised C$70 million of convertible debt. Since then, Hexo has diluted shareholders twice more, in December and in January.

ChartData by YCharts

Hexo shares are down more than 80% since they purchased Newstrike in May. This is significantly worse performance than the broader Canadian cannabis market (TSX:HMMJ) (HMLSF), which is down 52% in the same period.

These losses were justified.

Perhaps Hexo can be salvaged and perhaps the turnaround will reward patient investors. If it does, I will be where I have been since October: Firmly on the sidelines.

Happy investing!

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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