• An anonymous source provided us with recordings of Hexo running aggressive product promotions on Snapchat as recently as June 2019
  • By advertising on Snapchat, Hexo is taking an extreme regulatory gamble
  • Advertising cannabis products and brands via social media in Canada is extremely restricted, almost to the point of being illegal.  Advertising directed at teenagers is definitively illegal.
  • The ads we reviewed were a) run on Snapchat, a social network synonymous with teenagers, and b) included slogans that encouraged risk taking, and associated Hexo’s brand and products with “glamour, excitement, and vitality” – all advertising factors that are strictly against Health Canada promotion regulation
  • In March 2019, Snapchat admitted in public government testimony that its age verification system does not work, meaning that Hexo cannot rely on Snapchat age verification systems
  • Heath Canada reiterated warnings against promotion in March 2019 and Hexo’s main market Quebec is particularly sensitive to both a) advertising of cannabis and b) advertising of cannabis directed at teenagers (evidenced by recent edibles ban).  Could the SQDC exercise its termination clause with Hexo similar to the way Tilray dropped Namaste as a result of SQDC attention?
  • Remarkably, these aggressive Snapchat ads came over three months after Health Canada’s clear warning letter
  • We therefore think that Hexo could be the next victim of the Summer of Cannabis Scandals and expect its stock price to follow the recent trajectory of CannTrust (i.e. 60% downside from current levels)

Author’s Note: A copy of this report will be sent to Health Canada

Introduction – Canntrust 2.0?

Observers of the cannabis market are no doubt well aware of the significant regulatory woes currently facing CannTrust.  We see significant similarities between CannTrust and Hexo and believe that Hexo has been taking extreme regulatory risks as it pertains to promotion.  We see 60%+ near-term downside in Hexo shares and leave readers to ponder a simple question – if business was so strong at Hexo, why would the company run the risk of violating easy-to-follow advertising regulations and do so on an app specifically synonymous with teenagers?

Notably, prior to revelations in early July 2019, CannTrust was widely viewed as one the most trusted names of the cannabis space (no pun intended).  The narrative around CannTrust has now fallen apart and the stock is down ~60% in the past few weeks as investigative reporters have surfaced evidence that the company was growing marijuana in unlicensed rooms.  What is truly notable about the CannTrust situation is that the company was in fact operating legally in that it is a legitimate Licensed Producer (“LP”) of cannabis.  The company slipped up and broke Health Canada rules by going beyond the terms of its license and producing black market cannabis in rooms in which it did not have proper license to do so.  The fact that Health Canada has come down so hard on CannTrust for this violation demonstrates that Health Canada is taking regulatory violations seriously and making examples of bad actors. 

CannTrust is not the only big cannabis name to face problems this summer.  In fact, the whole space is having a scandalous summer, with Bruce Linton’s shocking departure from Canopy, CannTrust’s aforementioned illegal grow, and Curaleaf’s FDA woes.

We think Hexo may be the next domino to fall in the Summer of Cannabis Scandals...

We believe that Hexo is running a risk that has gone unnoticed by the market and cannabis investors that is likely to be equivalent or worse to what CannTrust did – particularly given that Hexo is headquartered in and so dependent on Quebec, a province that has demonstrated clear hostility towards questionable business tactics from LPs.

Cannabis Advertising In Canada Is a Big No-No, So What Is Hexo Thinking?

First, some background on Health Canada regulations relating to paid advertising.  The Cannabis Act has strict rules surrounding promotions, including a stipulation that promotion of cannabis is generally prohibited. More on this below:

Source: Health Canada

Observe two videos that were sent to us via an anonymous source here and here (both recorded on June 26, 2019) that show Hexo advertising their Elixir product via Snapchat.  We were able to independently verify their authenticity and confirm that Hexo has in fact been running ads on Snapchat for some time.

Source: Snapchat ad provided to us

Advertising of cannabis is extremely restricted in Canada.  We were therefore shocked to receive an ad for a cannabis product in Canada.  First and most importantly, the very fact that Hexo is running advertising is alarming given the extremely tight restrictions on Canadian advertising of cannabis. 

But these aren’t just any ads – these are ads on Snapchat – the preferred social app for teens…

Second, Hexo’s express decision to advertise via Snapchat is something that we (and we think the regulators) will call into question.  At the very least, we are sure that such ads deserve greater scrutiny, just like the black market illegal growing by CannTrust deserved extra eyes.  According to data, Snapchat is arguably the most popular social media platform for teenagers (see below).  In fact, 75% of US teenagers allegedly use Snapchat, with some reports suggesting teen love for Snapchat is what keeps the company afloat.  We expect that Hexo’s argument would be that it asks Snapchat to filter its ads to a select audience, but we note that Snapchat executives themselves have admitted in public hearings that their age verification process for the mobile app – which is by far its most popular service – is lacking to say the least.  Surely if Hexo had done any amount of due diligence, it would have discovered that this issue exists on Snapchat’s platform, rendering “age-targeted” ads less than helpful. 

Source: Pew Research Center

Furthermore, anyone with even a shred of familiarity with teenagers know that they lie habitually – and especially about their age.

Given Snapchat’s strong association with teenagers and tight regulations surrounding marketing to young people, Hexo investors need to ask themselves why management would be willing take the risk of advertising on Snapchat.  We see similarities between Hexo and CannTrust in this regard.  CannTrust was already one of the top LPs yet risked it all for some incremental raw product.  In the case of Hexo, why take the obvious and glaring risk of placing ads on the social media app for kids when the regulations are so clear cut?

Putting the age-related marketing messaging aside, the Hexo ads that we observed on Snapchat also appear to be clearly intended to connote a positive emotion and glamorous image which is yet another potential regulatory violation.  For example, let’s dissect the screenshot below:

Source: Snapchat ad provided to us

The ad above asks “Are You Ready” and displays prominent text suggesting that Hexo’s cannabis spray will deliver “A Fresh Spark”.  In a separate ad for a different Hexo formulation, the ad slogan for Hexo asks viewers “Are You Ready” and markets “THC On the Go”. 

Some of this marketing language is clearly subjective brand and product related promotional content that goes beyond a simple factual claim.  In fact, the language “A Fresh Spark” is language that a reasonable person could easily view as conveying glamour, excitement, and vitality – messaging that is strictly forbidden under Health Canada regulations. 

And even worse, the language Are You Ready is CLEARLY language that is encourages taking dares or risks.  The fact that the company was willing to put an ad slogan out that is this aggressive in a mass telecommunication ad via Snapchat is a HUGE red flag and, in our view, is inconsistent with the direct language of Health Canada regulations.

Source: Triple H Giphy

Again, we ask the question – why is Hexo playing fast and loose with promotion on Snapchat – including using what appears to be extremely aggressive SLOGAN – when the penalties are severe including huge potential files and jail time?

And for readers who think that Health Canada does not view advertising violations as serious – think again.

This law blog highlights that Canadian advertising restrictions on cannabis really are strict.  In fact according to the blog, in March 2019, after recognizing real problems in the space, Health Canada put a letter out to Licensed Producers with the following blurb.

Source: CannaLawBlog

In that same blog, Health Canada allegedly specifically called out that companies promoting their products need to take reasonable steps to ensure promotion cannot be accessed by young persons.

Notably, the author of the law blog acknowledges that “in the case of many social media platforms, it is unclear what steps can or should be taken by license holders to meet this goal”

This purported letter from Health Canada to LPs dated March 2019 makes Hexo’s decision to run ads on Snapchat in June 2019 truly remarkable and raises the question of why the company would take such a risk if business was in fact booming.

Hexo Takes a Gamble on Advertising Just as The Hype Around Hexo Is Rapidly Fizzling

Hexo has deep roots in Quebec.  The company was once the source of great hype due to its sweetheart deal with the SQDC in which Quebec was obligated to buy minimum volumes of cannabis from Hexo. 

Based on our research and conversations with industry participants, we also believe that the guaranteed purchase commitment is coming to an end in October 2019, which could result in significantly less purchases for Hexo going forward (especially in its main market).    We note that the language in Hexo’s press release was squishy, suggesting that only Year 1 of the contract with SQDC included a fixed purchase obligation, with the outer years relying on “expected supply” levels”:

Source: Company press release

What impact will Hexo’s decision to run aggressive Snapchat ads have on SQDC’s decision to continue buying from Hexo?

Could Namaste’s issues in Quebec Suggest that Hexo Could Lose Its Most Prized Customer (the SQDC)?

Let’s look at an instructive case study – Namaste.  Last year, Namaste threw a huge party with young women dressed in “sexy nurse” outfits at one of the biggest clubs in Montreal led by none other than Snoop Dogg.  In that case, Quebec’s Office of the Minister of Health launched an investigation into Namaste.  There was widespread speculation, highlighted in this article, that Tilray abruptly cut its ties with Namaste as a result of this scandal. 

Hexo’s CEO Sebastien also admitted on an Apr 11, 2018 conference call:

“I don’t think there would be any reason for the SAQ to not renew our contract. However, in the case of any material breach of contract, fraud, complete nonperformance, it would certainly be at their option to terminate the contract. But I do not expect any of those things to materialize”

Do Hexo’s aggressive ads on Snapchat impact the SQDC calculus that Sebastien laid out above?

The number of LPs has also exploded in the past few months.  Hexo was once the first-mover beneficiary in Quebec because its LP dates back all the way to 2014.  However, today there are 14 LPs in Quebec, eight which popped up since Hexo signed its deal with SQDC (that is just in Quebec – in overall Canada the number of LPs has doubled in a short period of time).

Source: Health Canada database

Assuming our read of the take-or-pay roll-off of Hexo’s agreement with SQDC is accurate, this means the company is likely to face stiff competition for future volumes after October 2019.

Adding insult to injury, in Hexo’s primary market Quebec, the government just recently decided to severely restrict the sale of cannabis edibles in an effort to protect children (note to reader: if Quebec is doing this to protect children, what do you think they might do when they find out about Hexo’s use of Snapchat?). 

This is a massive lost market opportunity for Hexo which still enjoys dominant market share in Quebec.  Clearly the addressable market that Hexo can go after has seen a significant downsizing as a result of Quebec’s edible regulations, all while at the same time the competition is heating up. 

So here we have Hexo – which was once the darling of Quebec – staring down a) an October 2019 expiration of a take-or-pay agreement that will switch to a demand-driven agreement, thereby potentially significantly slashing Hexo’s go-forward revenues, and b) a significant reduction in Hexo’s addressable market due to recent harsh edible regulations in Quebec.  This does not even factor in the risk that SQDC terminates its relationship with Hexo due to Hexo’s aggressive advertising strategy.

Conclusion

In October 2018, cannabis was legalized in Canada.  Since then, Health Canada has increasingly stepped up its enforcement of cannabis companies in the country.  The recent tribulations of former industry darling CannTrust highlight that Health Canada takes regulatory matters very seriously and demonstrates that regulatory scrutiny can render a cannabis business in Canada uninvestible. 

Health Canada has been carefully monitoring advertising activities of the cannabis industry and felt the need to send a letter reminding Licensed Producers of their legal obligations in March 2019.  The letter specifically reminded companies about staying clear of young users in promotions and also about the potential fines and jail time that LPs can be hit with should they violate regulations. 

Despite presumably receiving this letter, Hexo marched forward and ran ads that we believe appear to glamourize cannabis usage on the social media network most synonymous with teenagers – Snapchat.  Snapchat has publicly admitted it cannot verify the age of users that sign up on its mobile app in a forum that was readily accessible to any potential Snapchat advertiser.  In light of this fact pattern, we believe a) that there is significant underappreciated regulatory risk at Hexo that could unravel its business in a similar fashion to CannTrust, and b) that the company must really feel the need to spur demand if it is willing to gamble on promotions via Snapchat. 

We think the Hexo’s fortunes are clearly turning as a result of what we believe to be a take-or-pay clause in the SQDC contract that comes to an end in October 2019 as well as the recent ban on edibles in Quebec.  In the midst of a deteriorating market dynamic and addressable market, we find it remarkable that Hexo would take the huge risk of advertising on Snapchat. 

To summarize the basics:

  • Hexo may be inappropriately promoting its brand and products in Canada
    • Could Health Canada or other regulators decide to scrutinize Hexo in a similar fashion to CannTrust?
  • Hexo may be inappropriately targeting youth because of its Snapchat advertising
    • Could the SQDC or others review contracts and exercise termination provisions?
  • If Namaste is an example, the Quebec regulators will likely at least open an investigation into Hexo for its advertising practices
  • If CannTrust is an example, Hexo may face action by Canadian regulators
    • Health Canada has been clear about its opinion on promotion in March 2019 yet Hexo still decided to run Snapchat ads in June 2019
  • This is just one example of extremely questionable business judgment that we found – are there other skeletons hiding in the closet relating to either advertising or other business practices?

We therefore believe the worst is yet to come for Hexo.  In light of this, we see 60%+ downside in Hexo shares because we believe the company could face a similar fate to CannTrust in the coming weeks.