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.
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.
Executive Director, National Institute for Cannabis Investors
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8 responses to “Hexo’s Big Plan to Battle the Black Market”
October 21 2019