Executive Summary: HEXO's (HEXO) stock price skyrocketed 47.83% last Monday seemingly without a catalyst. A deep-dive into the firm's capabilities heavily suggests that the move was due to HEXO's receipt of the cannabis 2.0 license, whose economic value the firm is uniquely positioned to fully extract. My analysis and valuation imply a fair value of CAD 2.24, a 64% upside to the current share price.

The Driver of Stock Price Surge

The firm recently received approval from Health Canada to produce and sell cannabis 2.0 products from its Belleville facility and its Truss JV facility. Cannabis 2.0 products are cannabis cased edibles and beverages. Whilst cannabis 1.0 products refer to dried flower and cannabis extract products. HEXO's stock price soared an eye-watering 47.83% on June 8th, a week after the company announced an amendment of the receival license (the stock price see-sawed for the rest of the week but these price moves were relatively trivial given Monday's stock surge). Consequently, there are two possible explanations for the price surge:

  • The stock price move was random.
  • Stock markets are only semi-efficient and some stocks are inefficient at pricing in new information.

Given the magnitude of the price, we can safely eliminate the first hypothesis; the price move is simply too many standard deviations to be considered random. Consequently, we are left with the second hypothesis, which given HEXO's market cap of just $406.98 million is unsurprising. The price surge raises a serious question for long-term holders of the stock, is now a good time to exit their position? In a word, no.

Despite the astronomical one-day price surge, the stock remains undervalued from a fundamental perspective given HEXO's unrivaled ability to develop, market, and sell differentiate cannabis 2.0 products thanks to its JV with Molson Coors (TAP). The stock also remains underpriced from a historical perspective and this is potentially dangerous when it comes to valuing the stock since it traded at a high of ~$7.80 compared to ~$1 currently. Therefore, one can justify an upside potential of 5x and still appear to be conservative. To understand why HEXO cannot return to its historical trading highs, we must unpack why it was driven to these levels first.

Why HEXO's stock price will not reclaim its historical highs

Pot stocks were driven to unsustainable valuations based on three false narratives. The first is the belief that cannabis 2.0 products as gateway consumption mode that will attract 6.2 million potential adopters into the adult-use market. The second was that eradication of the black market was considered a fait accompli of legalization. The second is a logical implication of the second-high participation rates in the legal adult-use market. I will tackle them in order.

Most industry pundits continue to propagate the narrative that cannabis 2.0 products are a gateway consumption mode. It is tempting to believe that new forms of cannabis consumption will lead to a larger consumer base. Yet, the argument is the logical equivalent of asserting that Jell-O shots will attract new consumers to the alcohol market. Cannabis's low addiction rates are widely accepted finding in academic circles. The cumulative risk of habit formation for cannabis peaks at 10% according to the National Comorbidity Survey (NCS) of 1990-92 while the same risk for alcohol is 19.8% well above that of cannabis, yet remains a hair below cocaine's 21.37%. Moreover, NBC News reported that even though edibles compromise 0.32% of cannabis consumption, edibles consumption accounted for 10% of cannabis-related ER room visits. Consequently, edibles are in no way a gateway mode of consumption. Therefore (this is not a trivial distinction), the adult-use cannabis market is not a growth industry. What we are witnessing is simply a supply transition from the illegal to the legal market.

This leaves us with assumptions two and three, which appear to have some basis in reality given current price dynamics as of December 2019 when prices in the legal market stood at $10.30 according to Statistics Canada while black market cannabis retailed for $5.73. If these price levels are sustainable, the cross-market price elasticity of demand for legal cannabis is essentially inelastic.

Unfortunately, for Licensed Producers (LPS) cannabis consumers cross-market price elasticity of demand for cannabis categorically not inelastic. The price disparity between the licit and illicit market is not idiosyncratic to Canada. Similar patterns were observed in the formative years of the recreational markets in Oregon, Colorado, and the other US states that legalized adult-use cannabis. Subsequently, their legal markets faced severe pricing pressure as supply-side constraints eased, the novelty effect wore off, and, most importantly, the markets reached a steady-state equilibrium.

The Canadian market cannot escape economic law; according to a study conducted by Parliamentary Budget Officer on the dynamics between the black and legal markets, at current price levels, only 34% of cannabis users would enter the legal market. LPs are posting impressive top-line growth due to a low base effect, but they face a low ceiling and are headed for a hard landing if their prices remain uncompetitive with the black market.

Consequently, I expect the next few years to be characterized by fierce price competition as LPs engage in a zero-sum game with black market suppliers as they compete over essentially limited consumer base. Note that even though LPs invest (waste) sizeable dollar amounts into building brands for their cannabis 1.0 products, they are essentially pushing a string and are unlikely to gain any semblance of pricing power. Like all commodities, cannabis is a homogenous product. Canadian consumers are just as likely to pay a premium for brand name cannabis as you are for brand name potatoes. Thus, not only will the black market remain active well past the inception of the legal market but also consumers will need to be coaxed into the legal market.

HEXO Is Best Placed to Extract Value from Cannabis 2.0 Products

Having dispelled the false narratives, we can now take a deep-dive into the market's reaction to HEXO's receipt of cannabis 2.0 license and the importance of its JV with TAP.

The demand side dynamics of the cannabis market are striking like the alcohol market, a minority of consumers account for the vast majority of end demand. In the cannabis industry, daily consumers typically consume 1.90 grams a day compared to occasional users (less than once a month) who consume 0.6 grams per day. Furthermore, daily users (see chart below) consume more cannabis than any other consumer cohort and, therefore, are HEXO's coveted clientele.

HEXO now has the legal right to supply daily consumers with products that cater to their unique consumption habits. The Marijuana Policy Group placed the frequency of cannabis consumption among daily consumers at 3.29 events. The effects of inhaled cannabis can last up to 4 hours. Therefore, the total implied maximum duration of their high is 13.16 hours, provided that the consumption event took place after the maximum observed duration of a cannabis high. The oral administration of Δ9-THC leads to ~3x the level of 11-hydroxy THC than inhalation, resulting in psychoactive effects with durations in the 12-hour range. Additionally, THC concentrations in cannabis flower ranges from 12-25% whilst concentrations in edibles can reach up to 90%. Thus, cannabis 2.0 appeal to daily consumers is a one-two punch a longer high and a higher high. All other consumer cohorts use frequency implied high durations of less than 7 hours, suggesting that edibles will be too intense of an experience for them.

Most if not all LPs will eventually receive cannabis 2.0 licenses but successfully supplying a sin industry with a highly skewed demand profile requires capabilities that all LPs quite frankly lack (I'm aware of Constellation Brands (STZ) investment in Canopy Growth (CGC) and I'll cover why I'm pessimistic on CGC's prospects in a future article). However, HEXO's JV with Molson Coors provides it access to a firm whose expertise in the alcohol beverage market is an excellent analogue to the capabilities required to corner the adult-use market. Specifically, supplying a highly skewed demand side for a sin industry takes incredible capabilities in optics management, harvesting demand sustainably, regulatory navigation, excise tax management, marketing, and supply chain management. These are simply not capabilities that firms can learn by doing. Yet, this is precisely what the entire industry is attempting to do.

Most if not all LPs started their operations as medical marijuana suppliers and, subsequently, entered the adult-use market, which only seems reasonable to us because of the novelty of legal cannabis. Take a moment to guesstimate what percentage of publicly-traded firms in developed economies operate in both the pharmaceutical and recreational sector. In the context of the stock market as a whole, LPs move into the adult-use market seems far less like the natural evolution, they all claim it to be.

Deriving the Key Equity Factor Risks

HEXO's shares do not have sufficient trading history on a liquid exchange to derive a realistic and robust regression beta. Therefore, I initially used the harmonic average of the unlevered betas of its peers and re-levered the asset beta based on HEXO's steady-state capital structure. Whilst industry betas tend to be stable, mechanical decoupling notwithstanding, the peer betas reflect extreme volatility of the underlying share prices. For example, HEXO has annualized standard deviation of 80%. Far too high for a pharmaceutical or alcohol beverage firm if CAPM holds.

Once I disaggregated the total risk (variance), its underlying factors tilt. I realized that the sector's risk exposure is strikingly similar to the factor loads in emerging markets; they include but are not limited to:

  • Expropriation risk
  • Labor and technology scarcity
  • Skewed return profiles
  • New product failure risk
  • Regulatory uncertainty
  • Competition from black and grey markets

Consequently, I repurposed Cam Harvey's stellar country risk derivation to incorporate the risks associated with investing in cannabis.


This brings us to the endgame-valuation. When valuing the firm, I had two choices; firstly, stick to the industry standard and use a discounted cash flow model or use a more complex and less familiar accrual-based valuation model. The advantage of the former is its ease of use, but it has a serious drawback it is highly sensitive to capital expenditure assumptions and unless one is a genius, it is extremely difficult to accurately forecast capex expenditure without a minimum seven years (one business cycle) of financial data to base the forecast on. The drawbacks of the latter are its difficulty of use and its limited acceptance in investment circles; however, these disadvantages are offset by its reduced sensitivity to capex assumptions. Consequently, I opted to use accrual-based valuation models for this analysis, namely an abnormal earnings model and economic value-added model.

The firm's current financial statements will seem alien to its composition in a steady state. The primary change on the balance sheet will be the capital structure of the firm. According to Miles-Ezzel's theory that firms will strive to reach or maintain a target capital structure.

Consequently, I used an iterative WACC calculation to determine the appropriate discount rate for my model. Whilst a fair number of analysts tend to use a static WACC derivation. Given how significantly the balance sheet warps on its path to an optimal capital structure, the implied share price can differ materially versus a static WACC derivation. Furthermore, ignoring the impact on the capital structure is a material violation of the steady-state assumptions that underpin most valuation methodologies. Consequently, there is no way to circumvent using an iterative WACC.

The P&L also evolves dramatically over the forecast period and its evolution is not determined by the increase in leverage alone. Whilst, the market is rife with valuation models that reach a steady state in 3-5 years, the accelerated maturity of emerging firms is an egregious violation of financial theory and completed decoupled from ground reality. The panacea for this ailment is a mechanical appendix. The forecast period over which the firm's fundamentals smoothly reach the terminal growth rate, in my estimate that would occur in 2035. Since the terminal value is simply the sum of all future earnings, the extended forecast period cannot inflate the valuation of the firm.

By adhering to the tenants of financial economics, I formulated models that are internally harmonious; I reach the same target price using the economic value-added model and abnormal earnings. The former yields a price of CAD 2.24 and the latter a CAD 2.23, a difference of 1 cent. The primary difference between the two models is the capital structure assumptions. Therefore, if there is a material difference between the models, then my capital structure assumptions are incorrect. Once again, the closeness of the target prices suggests I did not violate the steady-state assumptions. Thus, despite the strong run the stock has experienced thus far, I believe that there is significant upside of 63.6% to the current share price of CAD 1.36. Investors who take long positions in HEXO stand to make sizable gains.

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