HEXO Corp is still a pass, says ATB Capital

The strategic partnership struck between Canadian cannabis producers HEXO Corp (HEXO Stock Quote, Charts, News, Analysts, Financials TSX:HEXO) and Tilray Inc (Tilray Stock Quote, Charts, News, Analysts, Financials TSX:TLRY) may be ultimately beneficial to HEXO but it’s darkened the picture for the Gatineau, Quebec-based company. That’s according to ATB Capital Markets analyst Frederico Gomes who delivered an update on HEXO on Tuesday where he maintained his “Sector Perform” rating while dropping his target price from $1.10 to $0.80 per share, implying a total return of 18 per cent at the time of publication.

HEXO Corp and Tilray announced their deal early in March, saying Tilray would agree to acquire up to US$211 million of HEXO’s senior secured convertible notes currently held by private company HT Investments, with a conversion price set at $0.90 per share, making for the equivalent of about 37 per cent ownership of HEXO’s basic shares upon conversion.

For that HEXO would gain access to US$80 million in cash that is currently restricted on its balance sheet, while the two companies would also be starting up a joint venture to provide procurement, distribution, transportation and insurance services to their respective operations, resulting in up to $50 million in savings over the next two years, to be split between the two companies. Further, the deal would involve HEXO issuing 7.6 million shares to investment firm KAOS Capital for an equity backstop of up to $180 million. (All figures are in Canadian dollars except where noted otherwise.)

Now, HEXO and Tilray announced on Tuesday definitive agreements regarding the deal, with some changes accounted for. Tilray is going to acquire US$193 million in principal outstanding under HEXO’s senior secured convertible notes, down from US$211, while the notes will be amended to include a conversion price of $0.85 per share (previously $0.90) and to bear interest of five per cent per annum (previously ten per cent). The new conversion price implies that Tilray would have the right to convert into about 35 per cent of HEXO’s shares as opposed to the previous 37 per cent.

“We believe that finalizing this agreement not only will significantly improve HEXO’s capital structure but also creates substantial cost and market advantages. It’s an ideal outcome and one we’re exceptionally pleased with,” said Mark Attanasio, Executive Chairman of the Board of Directors of HEXO, in a press release. “This arrangement with Tilray will place HEXO on a solid path for the future.”

The transaction will also see HEXO issue to HT Investments a number of shares equal to 12 per cent of the outstanding principal as of closing at a price of US$0.54 per share. As well, HEXO has agreed to pay Tilray a monthly fee of US$1.5 million for advisory services and HEXO said it may issue shares at a seven per cent discount (previously ten per cent) to its 20-day VWAP to raise up to $5 million per month over a period of 36 months. HEXO and Tilray also said the strategic alliance would now realize up to US$80 million in cost savings within two years.

Looking at the new details, Gomes says it seems less attractive for HEXO shareholders.

“In our view, the definitive agreements carry revised terms which are ultimately costlier for HEXO’s shareholders due to increased dilution and a material monthly advisory fee to be paid to TLRY. While we continue to view the agreements as a necessary and positive step to de-risk HEXO’s balance sheet, we are lowering our price target to $0.80 (from $1.10) to incorporate the negative impact of the amended terms,” Gomes said.

For HEXO, Gomes has now lowered his adjusted EBITDA estimates due to higher operating expenses (re: the advisory service fee), while his revenue and adjusted gross profit estimates have stayed unchanged. On the proposed US$80 million in cost savings, Gomes said there’s a lack of visibility at the moment on how they will be achieved, so they’ve not been incorporated into his model.

For now, the analyst is calling for HEXO to generate full 2022 revenue and adjusted EBITDA of $207.1 million and negative $27.9 million, respectively, and 2023 revenue and adjusted EBITDA of $247.5 million and $10.8 million, respectively. For 2024, the forecast is for revenue of $303.9 million and adjusted EBITDA of $33.9 million.

“We have also updated our fully diluted share count to factor in the terms of the definitive agreements and the number of shares we estimate have been issued for the note conversion since our last report. Our lower price target is driven by our lower profitability estimates and the dilutive impact of the definitive agreements,” Gomes wrote.

HEXO shares have fallen hard over the past year, dropping from about $8.00 as of mid-April in 2021 to now under $1.00.