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This Pot Stock Is a Surprising Top Pick From Bank of America

Sean Williams, The Motley Fool

The secret is out: Cannabis is a big-dollar industry. Now that the legal pot industry has grown at a rapid pace for much of the decade, Wall Street investment firms are projecting massive annual sales figures for the end of the next decade. Cowen Group, arguably the industry's biggest cheerleader, believes yearly sales could hit $75 billion worldwide by 2030, with Jefferies calling for a more modest $50 billion by 2029. For added context, around $12.2 billion was sold worldwide in 2018.

With sales figures this robust, it's only logical to expect Wall Street and investors to flock to this "next big thing" investment opportunity. But as should surprise no one, Wall Street has been very indecisive regarding which pot stocks are the best to own to take advantage of this growth.

An up-close view of a flowering cannabis plant in a hybrid greenhouse.

Image source: Getty Images.

Bank of America initiates coverage on marijuana stocks

Last week, Bank of America (NYSE: BAC) threw its hat into the ring and initiated coverage on four marijuana stocks, three of which received "buy" ratings. Two of these ratings went to the most popular pot stocks on the planet: Canopy Growth (NYSE: CGC) and Aurora Cannabis (NYSE: ACB).

B of A notes that Canopy Growth is well positioned with Constellation Brands as a partner and equity investor and is poised to be a leading producer. Canopy noted that more than 4.3 million square feet of its roughly 5.6 million square feet of cultivation capacity was fully licensed as of the end of its fiscal third quarter. Assuming Canopy Growth produces at industry-average yields, it should have no trouble delivering 500,000 kilos to 550,000 kilos per year.

Meanwhile, Bank of America gave kudos to Aurora Cannabis for its push into overseas markets. Aurora has a distribution and/or production presence in 24 countries worldwide, and it's one of the few large pot stocks to not have landed a brand-name partner yet. That leaves the potential for an upside catalyst in the view of B of A analysts. And, don't forget, Aurora Cannabis did sell about 20% of all marijuana throughout Canada during the fourth quarter of 2018.

An investor writing and circling the word buy under a dip in a stock chart.

Image source: Getty Images.

B of A's surprising top pick is...

However, it's the third buy rating that's raising eyebrows. That's because Bank of America made Quebec-based HEXO (NYSEMKT: HEXO) its top pick in the industry, with a price target of $14 Canadian ($10.48 U.S.). This represents an additional 59% upside from where HEXO closed on Wednesday, April 17.

Why HEXO? According to B of A, it's the company's compelling market position. Per Bank of America analyst Christopher Carey in his note:

HEXO is our Top Pick in cannabis, screening compelling in our valuation framework vs. peers (EV/sales and DCF), and with fundamentals grounded by the most de-risked cannabis supply in Canada (off-take with Quebec), an innovation-forward organization and potential for additional value-add partnerships (beyond that already developed with Molson Canada).

Prior to its recent Newstrike Brands acquisition announcement, HEXO was on track for 108,000 kilos of peak output a year, 40% of which, in aggregate, was to go to Quebec over the next five years. The addition of Newstrike boosts its peak capacity to 150,000 kilos a year, but it still has at least 200,000 kilos of off-take from Quebec through 2023. Further, management has forecast CA$400 million in full-year sales for fiscal 2020, which would place HEXO at one of the lowest price-to-sales ratios in the industry.

As Carey alludes to, the company also has plenty of opportunity to expand into derivatives. Its joint venture with Molson Coors Brewing, known as Truss, will have nonalcoholic cannabis-infused beverages hitting dispensary shelves by this coming fall. HEXO could certainly branch out further into CBD products, extracts, topicals, vapes, or edibles in the months that lie ahead. 

A tipped over white bottle filled with dried cannabis that's next to a messy pile of cash bills.

Image source: Getty Images.

Here's why this pick is surprising

So you're probably wondering why HEXO is such a surprise as B of A's top choice. The answer is twofold.

To begin with, it's the first time we've really seen a stock where Wall Street investment banks have such widely differing views. On one hand, Bank of America has a $10.48 price target and has called HEXO its top choice. Meanwhile, Jefferies initiated coverage on nine pot stocks in February, giving two of them "sell" ratings. One of those two companies was HEXO, with a $4.25 price target. Mind you, this rating was bestowed on HEXO before its $197 million Newstrike Brands buyout announcement, but it's nonetheless a vast difference from Bank of America's take.

And second, it's a company that's mostly been relegated to the shadows of the cannabis industry. Don't get me wrong: HEXO's 150,000 kilos of peak annual output currently ranks as sixth largest at full operating capacity. But it's just not a leading pot stock or newsmaker among its peers. This is the first time we've really seen Wall Street go off the beaten path and select a company that doesn't have a lot of built-in premium or a significant overseas presence as its favorite.

But is B of A right? While I wouldn't go so far as to proclaim HEXO my top pick, I do have modest bullish leanings toward the company for many of the same reasons Carey described. It has a good percentage of its dried flower already accounted for and should generate substantial sales with the addition of Newstrike. The key is going to be whether or not HEXO is able to further differentiate its product line to include higher-margin derivatives. If it can, and gross margin improves significantly, Bank of America's price target could easily become reality.

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Sean Williams owns shares of Bank of America. The Motley Fool owns shares of Molson Coors Brewing. The Motley Fool recommends Constellation Brands and HEXO. The Motley Fool has a disclosure policy.