There's arguably no industry creating more metaphorical and literal buzz than marijuana. What had once been a taboo industry is no longer, with worldwide sales expected to grow four to six times the $12.2 billion generated (legally) in 2018 by the end of the next decade.

But following the legalization of recreational weed in Canada, and with two-thirds of the U.S. having legalized cannabis in some capacity (the U.S. is considered the crown jewel of cannabis sales), investors have learned over the past couple of months that earnings actually matter now. This necessitates that pot stock investors pay close attention to the operating results of the most popular pot stocks.

HEXO lifts the hood on its third-quarter performance

Last week, on Wednesday, June 12, Quebec-based HEXO (NYSEMKT:HEXO) announced its much-anticipated third-quarter results. With the exception of Canopy Growth, which reports after the closing bell this coming Thursday, June 20, we've had a look under the hood of every major Canadian grower, in terms of their first-quarter calendar-year operating results (HEXO's third-quarter ended on April 30 and encompassed the February-April period).

As has been the case with pretty much every cannabis stock to come before it, HEXO delivered tempered sequential quarterly results, with supply chain issues in Canada bogging down progress. Total net sales inched just above 13 million Canadian dollars (about $9.8 million), which represented substantial growth from the CA$1.24 million in net sales in the year-ago quarter, but a 3% sequential decline from what the company recorded in second-quarter net sales.

With operating expenses nearly quintupling year over year to CA$24.1 million, it should come as no surprise that, even accounting for fair-value adjustments on biological assets, the company posted a CA$2.22 million loss from operations. If fair-value adjustments are removed for a purer look at its underlying performance, HEXO would have lost closer to CA$17.6 million on an operating basis.

A number of interesting tidbits were contained in HEXO's report

There were a number of other interesting data points in HEXO's report. For instance, 91% of the company's cannabis sales during the third quarter were tied to the adult-use market. About the only other major grower with such strong leanings toward the adult-use market is New Brunswick-based OrganiGram Holdings, which has also hovered right around the 91% mark in terms of adult-use revenue as a percentage of total weed sales.

To build on this point, 91% of this adult-use revenue was tied to the company's long-term supply deal with its home province of Quebec. In April 2018, HEXO signed a five-year deal to supply Quebec with an aggregate of 200,000 kilos of marijuana through 2023, with the annual amount being supplied increasing each year, and Quebec having the option to extend the agreement to a sixth year.

Also noteworthy was the 9.3% sequential quarterly decline in adult-use gross revenue per gram (CA$5.29 in Q3 2019 vs. CA$5.83 in Q2 2019). Although HEXO notes that excise taxes are providing an approximate CA$1.00 hit to adult-use per-gram pricing, these excise taxes were also factored into the company's fiscal second-quarter results. This suggests that cannabis stocks like HEXO are, indeed, already seeing pricing pressure on dried marijuana flower.

The single most important line in HEXO's quarterly report

But headline numbers and intriguing tidbits aside, there was a far more important statement contained within HEXO's operating results. This statement was found in the company's discussion of its medical marijuana revenue during the quarter, which is a section that some investors likely skimmed over given that it only generated CA$1.32 million for the company. In the paragraph discussing the average net selling price for medical marijuana products, HEXO's report said the following (keep in mind all dollar figures are in Canadian):

Gross revenue per gram and gram equivalent decreased to $9.11 as compared to $9.24 the same prior year period and $9.15 from the prior quarter. This is a direct result of the increase in our oil-based products sales as the product mix purchased by customers continues to shift toward smoke-free alternatives.

The expectation on Wall Street has long been that derivative products, such as oils, edibles, infused beverages, concentrates, capsules, and topicals, to name a few, would supersede dried flower in terms of use and importance. Even though HEXO is describing this "shift" in the medical marijuana section of its report -- it's far more common for medical patients to buy derivative pot products than recreational users -- it signals how rapidly this transition is occurring. Health Canada expects to legalize all alternative consumption options, save for alcoholic infused beverages, by no later than mid-October.

HEXO makes its play for high-margin derivatives

This statement holds a lot of bearing given that derivative products generate significantly juicier margins than traditional dried flower. Pot stocks that have any hope of avoiding margin deterioration are going to have to diversify their product portfolio and really target a derivative-preferring younger generation of users.

HEXO's big play, as described in its quarterly release, will be via the hemp market. Having recently announced the creation of HEXO USA, the company divulged in its report its expected entrance into eight states in 2020. Hemp is a low-cost crop that's often rich in cannabidiol (CBD), the cannabinoid best known for its perceived medical benefits. Hemp extracting should lead to CBD that can be used to create a spectrum of high-margin derivative products.

In addition to having more than 600,000 square feet in manufacturing and processing space in Canada, some of which will be devoted to extraction, HEXO also recently signed a two-year agreement with Valens GroWorks (NASDAQOTH:VGWCF) that'll see Valens supplying resins and distillates for a combined 30,000 kilos of cannabis/hemp biomass in 2019, and at least 50,000 kilos in 2020. Valens has become quite the winner of this derivative push, and is now the largest third-party extraction company.

Long story short, HEXO's quarterly report is less about its ho-hum here-and-now performance and all about an expected surge in derivative sales that should begin later this year.