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Hexo under 'increased pressure' as unlicensed pot recalls CannTrust scandal

An employee collects cuttings from cannabis plants at Hexo Corp's facilities in Gatineau, Quebec, Canada, September 26, 2018. REUTERS/Chris Wattie
An employee collects cuttings from cannabis plants at Hexo Corp's facilities in Gatineau, Quebec, Canada, September 26, 2018. REUTERS/Chris Wattie

Shares of Canadian pot producer HEXO (HEXO.TO)(HEXO) fell to a two-year low after the company revealed late Friday that it grew cannabis in a space “not adequately licenced” by Health Canada at a Niagara, Ont. facility. Now, analysts are asking why it took months for the company to tell investors after management discovered the lapse.

The public admission by Gatineau, Que.-based HEXO came more than two-and-a-half months after the company said it discovered its “Block B” room inside a building formerly-owned by Newstrike Brands was not fully licenced on July 30. Hexo acquired Newstrike Brands on March 28 for $263 million.

News of unlicensed cultivation at HEXO came on the heels of a dismal week of financial results from the sector’s largest producers, and months after the revelation of illegal growing at Vaughan, Ont.-based CannTrust (TRST.TO)(CTST), a scandal that led to the firing of CEO Peter Aceto and saw thousands of kilograms of cannabis seized by Health Canada.

CannTrust shares have fallen more than 80 per cent since the company disclosed Health Canada's finding that it was growing pot in a Southern Ontario greenhouse before getting the appropriate licences. HEXO shares are down about 53 per cent year-to-date following a series of financial stumbles, layoffs and operational changes.

According to HEXO, Health Canada requested additional information from Newstrike Brands about the building where Block B is located in October 2018, a month before it granted a licence for the facility. HEXO said, “the team was under the impression that Block B was included in the licence.” Adding to the confusion, HEXO said Health Canada inspected the facility where Block B is housed in February 2019.

“No observations were made about cultivation in this space,” HEXO stated in a news release. “This further reinforced the assumption that it was indeed a licenced growing space.”

CEO Sebastien St-Louis said Health Canada was instantly notified when management discovered the licensing lapse, adding the regulator is satisfied with management’s corrective actions. HEXO has since shuttered its Niagara operations, moving production for its UP cannabis brand to its Gatineau facility.

Why this was publicly disclosed on Friday

HEXO said it is “choosing to proactively address this occurrence now as it recently became aware [sic] false information that was being circulated to damage the reputation of the company.”

BMO Capital Markets analysts Tamy Chen and Peter Sklar said while HEXO has said no consumers were impacted, and the unlicensed grow was not intentional, investors may not appreciate being kept in the dark.

“We believe investors may feel that HEXO should have disclosed this immediately upon discovering the unlicensed growing given the sensitivity around the industry following CannTrust,” the pair wrote in a note to clients on Sunday.

“In addition, we believe investors may feel that HEXO should have identified this issue during the acquisition [of Newstrike Brands] due diligence process.”

Chen and Sklar maintain their “market perform” rating on HEXO shares with a price target of $3.00.

Canaccord Genuity analyst Matt Bottomley cut his price target to $2.75 from $3.00 on Monday, while maintaining a “hold” rating. He said it’s discouraging that HEXO made no mention of the licensing situation in its fiscal fourth-quarter earnings release on Oct. 29.

“We expect HEXO to see increased pressure on its valuation as investors weigh the potential impact of this new information,” he wrote.

Toronto-listed HEXO shares fell 8.51 per cent to $2.15 at 12:26 p.m. ET on Monday. New York-listed shares dropped 8.56 per cent to $1.63.

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