Hexo to launch low-cost cannabis product to undercut illicit market shops

That’s cheaper than the average cost of a gram of cannabis at $7.37 per gram during the third quarter, with the price of legal and illegal weed at $10.23 and $5.59 per gram, respectively, according to the latest Statistics Canada analysis of crowdsourced data.

Hexo is targeting the roughly half of Canadians who — one year after the legalization of recreational pot — are still buying weed from the illicit market, its chief executive Sebastien St-Louis said.

“That 51 per cent of Canadians that buys illegally, when they walk into their dealer, they don’t pay tax… Hexo is absorbing that cost for them. We’ve listened, we’re removing their reason for not shopping legal,” he said in an interview.

He said Hexo is able to offer a one ounce, or 28 gram, product at this relatively low price point for various reasons, such as less packaging needed for the bulk size rather than individual packaging for each gram or 3.5 gram product. St. Louis added that the licensed producer increased its production scale and lower hydroelectric costs in Quebec also allow the company to reduce its price.

Hexo worked with Quebec’s provincial cannabis corporation on this pricing strategy and it will be on sale exclusively at its shops starting Thursday. The company is currently working with entities in other provinces, such as Ontario and Alberta, to do a similar low-cost product.

Canada legalized recreational cannabis on Oct. 17 last year, making it the first G7 country and the second country in the world to take that landmark step.

Canadians still buying pot illegally

Once the initial product shortages and supply chain bottlenecks eased, legal cannabis sales in Canada have grown but a large proportion of buyers continue to turn to illegal sources for pot.

In the second quarter, household expenditures on cannabis at licensed retailers was $443 million, up from $172 million in fourth quarter of 2018, according to Statistics Canada. But pot expenditures at unlicensed retailers amounted to $918 million, down from $1.17 billion in the fourth quarter of last year.

When deciding where to buy cannabis, 76 per cent of Canadians who consumed pot in the first half of the year cited quality and safety as an important consideration while 42 per cent mainly considered price, according to Statistics Canada survey results released in August.

Given its discount to legal offerings, Hexo’s value brand will likely be on consumer radars, said Douglas Miehm, an analyst with RBC Capital Markets.

“Pricing must also be complemented with a certain level of quality to achieve sell-through,” he said in a note to clients. “The latter is unclear at this stage, and thus, we would need more evidence of this before viewing the strategy in a more positive light.”

St. Louis said that the cannabis used in its Original Stash products are only low price.

“This is high-quality cannabis flower,” he said, noting that it has between 12 and 18 per cent tetrahydrocannabinol, the compound that produces a high.

He added that it is not a loss leader, but would not talk about specific margins until Hexo reports its earnings on Oct. 24.

Potential price war

Miehm said Hexo’s low-cost product launch “supports our view that the industry is likely to face pricing pressure as a result of significant oversupply towards the end of the year.”

When asked about a potential price war among other large-scale producers, St. Louis said he was not concerned.

“It’s not much of a war, if the other side has no chance,” he said. “Most of the other licensed producers don’t have the cost structure that Hexo does.”

The product launch comes after Hexo lowered its net revenues forecast for its upcoming fourth-quarter ended July 31 and it withdrew its $400 million net revenue guidance for its 2020 financial year.

Hexo’s aggressive strategy with this value brand was “likely driven by poor sell-through” of its products, said Owen Bennett, an analyst with Jefferies.

He said in a note to clients that the pot producer has had a tough time getting product traction outside of Quebec, and this “looks to be an aggressive move to address limited demand for Hexo and increase market share.”

St. Louis said more details on its guidance would be provided during its upcoming earnings, but said the decision to pull back stemmed from the uncertainty facing the cannabis industry.

“We didn’t want to be in a situation to commit to specifics in this unsure industry,” he said.

He added that Hexo is “very bullish” on Original Stash, and that it will be a key part of its strategy to reach 20-plus per cent market share in the coming years and ramp up its revenues.

Bennett expressed skepticism that Hexo’s value brand could drive market share, noting that price-conscious consumers who are buying from the illicit market are less likely to pay more than $125, regardless of price per gram.

“We question how successful it will be given current legal demand is for higher quality and the $125 price is not consistent with illicit purchasing habits,” he said in a note. “We do not see this as a precursor to industry-wide price compression, which we see more isolated to low quality and oil.”