One of the biggest barriers to the growth of legalized cannabis is the persistence of illegal cannabis.

Illegal cannabis is not taxed, it is not inspected, and it could come from anywhere. That includes a local grower who works for a murderous cartel based outside the country.

But there’s a reason people still shop through the black market.

It is cheaper, and in places with well-developed illicit markets like California and Canada, the cannabis is normally of high quality. Most analysts believe that more than half of cannabis sales in both Canada and in California continue to be from illegal sellers of illegal cannabis.

Hexo Corporation (NYSE: HEXO) is trying to change that.

The company announced a new budget brand: Original Strain.

The brand is designed to sell for C$4.49 per gram, which is about what the company estimates that buyers on the black market pay for quality cannabis. The only catch is that customers must buy it an ounce at a time – that’s 28 grams, for a ticket price of $125.70.

This is an interesting experiment, and I’m glad that someone is doing it.

But I’m not sure Hexo is the right company to try it first…

Hexo’s Well-Intentioned Plan

Hexo’s costs are still higher than many other Canadian growers, so the potential hit to profits through selling cannabis cheaper could be very large.

It’s also a departure from the company’s original business plan, which was to charge a premium price.

On the other hand, Hexo recently reduced its sales estimates in part because it wasn’t growing the most in-demand strains.

So this may be a way to dump some unwanted cannabis on the market at a discount!

But this plan could cause a “race to the bottom” in the Canadian cannabis market.

Despite early shortages, there is a real possibility of an oversupply of low-quality cannabis in Canada in the next several months.

I don’t think prices will go down to the insane levels we see in places like Oregon (as of April 2019, Oregon was the cheapest place to buy legal cannabis in the United States), but even at $4.49 per gram, higher-cost producers like Hexo could see profit margins erode significantly.

However, the risk may be worth the reward.

Why Hexo’s Plan Could Work

If Hexo can really make a dent in the illicit market, it will help not just Hexo but all Canadian companies.

And as it sells more of that low-cost cannabis, it can bring its costs down. Some of the larger producers are making cannabis at around C$1 per gram or less.

Assuming that half of that $4.49 per gram goes to the distributors and retailers, a $1 cost would give Hexo a gross margin in excess of 50%.

We’ve always known that there would eventually be pressure on lower-quality cannabis prices, so in some senses, all Hexo is doing is getting ahead of the market.

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If it can gain a meaningful share of the low-cost market and even take some market share from illicit providers, it has the basis of a very nice business. After all, McDonald’s makes more money than probably every high-end steakhouse in the world combined, and it does that through low prices.

The Canadian market is set to double or more with the introduction of Canada 2.0, and it could double again if Hexo makes a dent in the illicit market.

But an unanswered question is just how seriously Hexo intends to take this low-cost strategy.

My Main Concern

For right now, the big discount is for a single product – a specific strain of cannabis flower – and customers must buy 28 ounces at a time to qualify.

That’s $172, which is above the average transaction in Canada.

Will the low-price strategy continue as the company transitions into vapes at the end of this year?

We can expect that its beverage products launched with Molson Coors Brewing Company (NYSE: TAP) will at least start at a high price.

I suspect that Hexo itself does not know the answer to that question.

It seems like the company is trying to find its place in the Canadian cannabis market, and it’s trying a variety of strategies to see what works.

For the sake of the industry, I hope as Hexo throws different things at the wall, something does stick.

Greg Miller

Executive Director, National Institute for Cannabis Investors

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Comments

8 responses to “Hexo’s Big Plan to Battle the Black Market”

  1. Greg, how can you seriously consider Hexo’s play on cheap pot, being a partner of Molson Coors newsworthy, when other NICI portfolio plays are looking for your guidance?

  2. Hexo has a great idea offering cannabis at a price that allows those who have $125.00 to buy an ounce of cannabis, but what about the consumers who would love to purchase a good grade of cannabis without going to illegal sellers? If the consumer could buy 1/2 ounce you would have a lot more people buying your product & they would not go to the dealer on the street.
    Belinda

  3. Greg,
    If you are illegal you make money. If you are legal you pay for permits, fees, license’s , taxes. etc… The Black market had a big head start.

  4. Hi Greg,
    Thank you for considering our questions. I hope you can clarify this one.
    I am reading that many of the companies we are investing in are trashing huge quantities of the excess pot they have grown. The idea has be suggested that this means most of the pot companies will either go out of business or that their pot will be so cheap that they can’t make money. This sounds negative for our stocks. What do you think?

    M. Potter

  5. I’m so disappointed with Hexo’s results. I believed in it, invested heavily for my means, and lost more than 50% of my money. Can i hope to recuperate any of my losses, and when ?
    And why all the expansion in the Gatineau area ?
    Why the investments in Greece, where Cannabis is and has been sold everywhere, even in vending machines in garages ….? Greeks have a headstart in that business. What does Hexo hope to accomplish there ?
    And why did one of the top executives of the company resign recently ? This is always a very bad sign… thanks for answering my questions.

  6. I am hearing a lot of figures, facts, etc about different companies past performances but when it comes to the current companies to consider, I am being advised to purchase yet another report for $599, membership for $4795, etc so That leaves me wondering where to go from here as I am looking to make some money not keep dishing it out. Yes, I realize that there is RISK BUT I can’t help but wonder if this is another dead end.

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