Newstrike acquisition a ‘stopgap’ in manufacturing ramp-up, says HEXO CEO

HIGHLIGHTS

1. HEXO’s acquisition of Newstrike, which closed on Friday, was done more for manufacturing space than cultivation capacity.
2. HEXO is having trouble processing and packaging the cannabis it is growing; CEO predicts little Q3 sales growth.
3. Acquisition gives HEXO six additional provincial sales agreements.

HEXO Corp. bought Newstrike Brands Ltd. more for its licensed manufacturing space than for its cultivation capacity, according HEXO CEO Sébastien St-Louis.

The extra cultivation space – nearly 200,000-square-feet of licensed canopy space between Brantford, Ont. and Grimsby, Ont. (plus another greenhouse under construction) – adds redundancy to HEXO’s growing system, Mr. St-Louis told Cannabis Professional. However, the real value of the acquisition, which closed on Friday, lies in Newstrike’s licensed space to process and package cannabis products.

“What we’re doing is we’re moving some HEXO technologies [to Newstrike facilities] as we’re ramping up to the October launch of edibles, beverages and vapes,” said Mr. St-Louis. “We believe that for a cannabis company that wants to do products in every category... it takes one square foot of manufacturing space for every square foot of cultivation.”

HEXO already owns a 25 per cent stake in a two-million-square-foot former Sears distribution centre in Belleville, Ont., which it plans to use as its main manufacturing hub. But this space hasn’t been fully renovated or licensed to handle cannabis.

Mr. St-Louis variously described the Newstrike acquisition, which was valued at approximately $263-million when the deal was announced in March, as “a great bridge [to] Belleville being fully operational" and a “stopgap in the ramp up” of the company’s manufacturing capacity.

Even before the introduction of new product categories, HEXO is having trouble processing and packaging the cannabis it is growing in its massive greenhouse complex in Gatineau, Que.

After an impressive jump in sales last quarter, Mr. St-Louis expects to report little quarter-to-quarter growth in revenue in its upcoming Q3 earnings. That’s largely due to processing bottlenecks, he said.

“The reason for Q3 being flat is that we didn't have enough infrastructure; we had underestimated the amount of manufacturing space that it takes to take these products from cultivation all the way to consumer packaged good, and I think everyone in the industry made this mistake," Mr. St-Louis said.

“Imagine automated weighing and packaging systems," he said, describing the infrastructure needs of a cannabis company. "It’s the quality assurance and control process rooms... it’s the actual labelling of the product, the excise stamp application, the shrink wrapping, the boxing, the skidding, all the logistics, all of the nuts and bolts around actually taking an agricultural product and transforming it into a consumer good.”

While manufacturing space is the focus of deal, Newstrike also gives HEXO around 160 trained staff, nearly $100-million in cash on its balance sheet and a broader set of relationships with provincial wholesalers. Before the deal, HEXO had supply agreements with three provinces: British Columbia, Ontario and, most importantly, Quebec, where 84 per cent of its product was sold last quarter.

By acquiring Newstrike’s relationships, HEXO will have agreements with every province except Newfoundland and Labrador. Newstrike’s relationship with the Ontario Cannabis Store is particularly valuable, St-Louis said.

In the short-term, HEXO intends to continue selling Newstrike’s UP brand, although this may be wound down over time as HEXO focuses on its “Powered by HEXO” brand identity. Likewise, Newstrike’s much-touted relationship with the Tragically Hip will be lower profile post-merger.

"We’re not going to brand everything around the Tragically Hip,” said Mr. St-Louis, although he does plan to have the band members contribute “as part of the creative team.”

Newstrike’s other key partnership with food company Neal Brothers Inc. will continue, with HEXO using the joint venture to develop edibles products. Eventually, Mr. St-Louis hopes to attract a larger joint venture partner for edible products – similar to its beverage joint venture with Molson Coors. But in the short term, Neal Brothers will act as a kind of pilot project.

“Using Neal Brothers to demonstrate our capabilities around putting these great cannabis experiences that are ‘Powered by HEXO’ on a chip, in a tomato sauce, etc. is a great step towards us being able to land those edibles Fortune 500 partners,” Mr. St-Louis said.