This Marijuana Top Pick Just Earned a Downgrade

There's arguably no industry that's generating more buzz right now than cannabis.

As legalizations have taken place in Canada, throughout multiple U.S. states, and around the world, we've witnessed the budding potential of this industry, with Arcview Market Research and BDS Analytics citing $12.2 billion in global sales in 2018. Considering that tens of billions of dollars are being sold annually in the global black market, the opportunity is ripe for these sales to be gradually moved to legal channels as more countries roll out the red carpet for cannabis. If this happens, opportunistic pot stock investors who stay the course could walk away with a lot of green.

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But as is often the case with any nascent industry that faces high expectations, hiccups are prevalent. In Canada, we've witnessed persistent supply shortages wreak havoc on the operating results of most marijuana stocks. And while Wall Street has mostly been forgiving of these weaker results, that's not always the case.

This cannabis industry "top pick" just had its rating and price target cut

Last week, Quebec-based HEXO (NYSEMKT: HEXO) reported its fiscal third-quarter operating results. The company wound up generating around 13 million Canadian dollars in sales (about $9.8 million), which was far and away more than it sold in cannabis at this time last year, but was actually down 3% from the second quarter. HEXO also wound up losing about CA$17.6 million on an operating basis if one-time gains from the fair-value adjustments on biological assets were taken out of the equation.

While these results were mostly disappointing, they weren't unexpected given Canada's supply-chain problems. However, that didn't stop one investment firm from downgrading HEXO.

Shortly after dishing on its third-quarter results, CIBC analyst John Zamparo downgraded HEXO to a rating of neutral from outperform, while also lowering his price target on the company by more than 10%, to CA$8.50 ($6.34) from CA$9.50. The reason? Despite HEXO forecasting CA$400 million in sales in fiscal 2020, Zamparo sees risks in the company's plan to launch a host of derivative products. That makes Zamparo and CIBC considerably more cautious on the company.

Of course, keep in mind that analyst ratings and price targets can differ greatly -- especially in a nascent industry like legal cannabis. Christopher Carey at Bank of America continues to tout HEXO as his firm's top pick in the space, with a $10 price target on the shares. Even after its weaker-than-expected third-quarter results, B of A has stood by its longer-term outlook on HEXO.

Which investment bank is right?

The surprising answer is that they both might be correct.

HEXO has top-pick qualities that can't be overlooked

On one hand, HEXO does have the hallmarks of a winning cannabis play. Following the closure of its Newstrike Brands acquisition for nearly $200 million, HEXO is now Canada's sixth-largest producer at peak capacity (150,000 kilos a year). As a top-tier production company, that makes HEXO a logical supply partner.

It also has one of the most de-risked production portfolios among growers, with an aggregate of 200,000 kilos of output heading to its home province of Quebec on a five-year supply deal. Inclusive of its Newstrike acquisition, and factoring in its ramp-up, this might work out to 30% of its total production through 2023 already being spoken for. Quebec also holds the option to extend this supply deal for a sixth year.

Quietly, HEXO has also been landing a number of important, high-margin partnership deals. It formed a joint venture with Molson Coors Brewing in early August that'll see the duo create a line of nonalcoholic cannabis-infused beverages, which will be sold under the brand name of Truss. These infused beverages, along with a host of alternative consumption options, are set to go on sale by no later than mid-October.

HEXO's two-year deal with Valens GroWorks also can't be ignored. As part of the agreement, HEXO will supply Valens with at least 30,000 kilos of hemp and cannabis biomass in the first year for extraction purposes, with the amount being supplied increasing to at least 50,000 kilos in the second year. When combined with more than 600,000 square feet of processing and manufacturing space of its own, it's very clear that HEXO has its eye on high-margin derivative product expansion.

The derivatives space will be highly competitive

On the other hand, Zamparo at CIBC brings up an overlooked, but incredibly important fact. Namely, that there will be a boatload of competition in the derivative space, especially when it comes to infused beverages. It's unclear at this point just how much of a needle-mover these derivative products will be in the early going. Yet given HEXO's aggressive call for CA$400 million in fiscal 2020 sales, the launch of these derivative products would have to be close to flawless for the company to meet its sales goal.

To build on this point, we've witnessed a dried flower supply shortage since the recreational marijuana market opened in Canada last October. There's absolutely no guarantee that compliant packaging shortages and regulatory red tape are resolved by the time derivative products are ready to hit dispensary store shelves. Demand hasn't been an issue for Canada's cananbis industry since mid-October. But persistent supply-chain problems could quickly deflate the buzz surrounding the launch of derivative products.

CIBC may also be factoring in a weaker bottom-line outlook as a result of these supply chain woes. Wall Street's full-year consensus per-share loss estimate for fiscal 2019 has more than doubled to CA$0.16 over the past three months, while analysts' fiscal 2020 profit per share estimate has dropped by almost 30%. CIBC's lowered price target may more adequately reflect that HEXO's path to profitability won't be as smooth as expected.

Ultimately, both Carey and Zamparo may be correct, with Zamparo highlighting near-term concerns that could constrain HEXO's valuation, and Carey seeing the long-term value in a mature HEXO.

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Sean Williams owns shares of BAC. The Motley Fool owns shares of TAP. The Motley Fool recommends HEXO. The Motley Fool has a disclosure policy.