Hexo $HEXO reported increased revenues. And while the data was a miss by expectations there are a few factors I wanted to line up so an investor could see what the potential of this company would be over the coming year. I do see the possibility of upside in the stock. But, Hexo has some work to do to get there. In the meantime, Hexo is in the middle of acquiring Zenabis $ZBISF and this will nearly double revenue for Hexo while opening up avenues into the rapidly expanding European medical cannabis market. This appears to be a good fit. What I like most about Zenabis is the potential upside for the stock; I believe the terms were in favor of HEXO.
Here is the chart on HEXO along with a comparison of Zenabis:
While HEXO has moved higher over the course of the past year, ZBISF has remained muted relatively.
What could Zenabis potentially be worth? This is the opportunity that I am looking at and from that, bringing in the revenues and potential earnings from Zenabis into Hexo presents an interesting opportunity. I am going to focus on this first and then get into Hexo’s potential valuation.
Zenabis has some interesting aspects to it. First, I believe there is a lot of upside potential for the company and it will add significantly to Hexo.
Revenues for Zenabis are steadily increasing:
As you can see, there is a gradual increase in quarterly revenues. We are still waiting for the latest earnings report and there is no telling where it might come in. My best guess is that there is a continued push upwards and the number comes in above $20M. Should that be the case, I could see the next four quarters printing about $115M.
A $115M annual print is in line with the industry; I do not see that as a stretch. Zenabis is starting to see a lot of positive growth coming in from Europe. This is one of the synergies that is going to help Hexo.
Zenabis Gross Margins
As it turns out, Zenabis is almost there with consistent gross margins:
The latest report had one-off write-downs that affected gross margins. Otherwise, 50% are about the average for Zenabis. This is slightly below average for a producer/grower of cannabis and a move upwards of just 5% gets Zenabis into a range that is within the norm for growers.
Zenabis Operating Costs
Total operating costs for Zenabis are close to industry norms and this is a positive:
For a grower, the industry norm of the next performers is between 30% – 35%. Outside of outlying factors, Zenabis is very capable of achieving this metric on a regular basis.
This natural inclination of management to push costs lower while continually working to increase revenues and increase maintain high gross margin levels. On a few levels, Zenabis will actively achieve these metrics. It is a process and natural progression.
Valuing Zenabis: what could ZBSIF be worth?
If Zenabis management were to continue on its path forward and grow the company, while at the same time achieve more consistent margins and cost metrics, I believe there is a strong opportunity here: HEXO might have picked this company up for a song.
Keep in mind, management’s job of achieving certain metrics: Higher gross margins and simultaneously lower cost margins. I am going to use this concept in valuing Zenabis.
First, there are ~857M shares outstanding and the stock is trading at about $0.11 per share.
If revenue continued upwards, I could see $115M printed in the next four quarters. Keep in mind, we should be seeing a new earnings release very soon. I believe the $115M is very modest; $125M – $140M may be very possible. I think $115M is on the low end. But, it is a basis for us to find where this stock could be in the next year’s time.
If gross margins were to get to a more consistent level while also achieve an industry norm, 55%, Zenabis could earn $63M in gross profits; 55% of $115M.
Total operating costs would likely come in ~35% of revenues, this would be ~$40M in total operating costs.
This leaves $23M for total operating profits.
Earnings from Continuing operations are likely to come back into line. There was a previous loss of ~$12M owed to unusual items. I can see this line item coming in at about $5M – $7M deduction leaving some ~$15M in net profits.
Off of 857M shares outstanding, that is ~$0.0175 EPS. On the low end, ZBSIF could be trading at $0.875 per share. On the higher end, it could be trading at $1.75 per share.
Hexo might be picking up Zenabis for a song. But, there is work to do to get to this future multiple, albeit, Zenabis is not too far off from these metrics I am projecting.
Now we turn to Hexo, which is enjoying increasing quarterly revenues:
Hexo has impressively pushed its revenues higher and higher over the past several quarters. And, with the Zenabis acquisition, this positions Hexo to double revenues. Then, with the added access to Europe, Hexo could increase its market share potential. This synergy will push revenues upward for Hexo. I am projecting some $150M in revenues in the next four quarters. This will help with other metrics that Hexo has not quite gotten a handle on.
Hexo Gross Margins
At 56.4%, for a producer/grower of cannabis, Hexo is right there. This is important. As revenues continue to increase, marginal output, the output of continuous additional products, will add additional gross profits on an upward sloping basis. The rate declines once Hexo achieves a certain level of production. But, Hexo’s capabilities are nearly doubling with the Zenabis acquisition.
With economies-of-scale, I am projecting that Hexo achieves a consistent 60% over the course of the next year. This, on top of the increased revenue of $150M.
Hexo Operating Efficiencies
Unfortunately, although Hexo has achieved some solid numbers with margins, they have yet to become efficient on a cost basis:
So, what does this mean? First, this is an operating cost metric based upon revenues. With gross margins, you have the cost of goods as a percentage of revenue. Cost of goods is the cost of what it takes to make perhaps a preroll of a vape product. Usually, the manual labor cost is in this.
With Operating Costs, this metric includes things such as the facility rent, SG&A, and other back-office costs associated with running the business, versus the cost of making a product.
Two things: First, this is a mathematical formula. Total Operating Cost over Total Revenue. There are fixed costs associated with the business, such as the rent I just mentioned. This is a fixed cost and no matter what Hexo has to pay the rent. But, as mentioned, I am anticipating an increase in revenue over the next year of ~50% to ~$150M.
While the rent for the facility is exactly the same, the amount of revenue generated in the same building and by the same amount of individuals increases. This would mean Hexo will become more efficient on a cost basis in this metric.
Hexo needs to achieve the 35% level. The increase in revenue over the next year may do that for the company alone. But, Hexo does need to maintain vigilance with costs as revenues increase. Some costs go up along with revenue. But, the rent on the building stays the same.
I am projecting a 45% cost efficiency for Hexo with operating costs. This is slim. But, this is over the course of 1 year’s time and it may be that the Hexo surprises to the upside with this metric.
So, what could Hexo be worth if they continued to increase revenue as I am projecting? This is simple math and we can break that down just as we broke down Zenabis.
- Total revenue would be $150M;
- Gross profits would be $90M (60% of $150M);
- Operating Costs would be $60M (40% of $150M);
- Continuing Ops Profits will come in ~$20M (~.12.5% of revenues)
- $20M total net earnings for the year
- 122M shares outstanding = $0.1639 EPS
- Future earnings multiple of 100x EPS brings the stock price to $16.39
- Factor in the value of Zenabis, $17.50
There is room for improvement from Hexo. What if operating cost metrics achieve 35%, which is the industry norm? That really pushes the stock significantly. Also, what if margins can achieve a 65% level, where the very best cannabis companies are hitting? That adds an additional $15M to operating profits from those two metrics.
That is the potential for the company to achieve. Should they bring cost metrics in line with the industry, maintain o increase gross margins, then there is a lot of upside potential for Hexo. Perhaps as much as pushing the stock upwards to $17.50 per share.
If Hexo can achieve these goals, HEXO hits $17.50 per share this year.
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