This article was updated on Dec. 7, 2017, and originally published on Jul. 17, 2017.
When it comes to North America's fastest-growing industries, chances are you'd struggle to find any with a higher, more consistent growth rate than legal marijuana. And investors know it, which is a big reason some of the largest marijuana stocks have risen by 100%, 200%, or even more, over the trailing one-year period.
According to cannabis research firm ArcView, North American sales of legal pot, both recreational and medical, soared 34% in 2016 to $6.9 billion, and they're expected to grow by an average of 26% through 2021 to nearly $22 billion. This growth is expected to come from legalization of the substance -- Mexico legalized medical cannabis throughout the country in June 2017, and eight states have legalized recreational weed in the U.S. since November 2012 -- and organic growth from states and countries where the drug is already legal. In Canada, for instance, the number of eligible medical patients has been growing at a pace of almost 10% per month, according to Health Canada.
Pot stocks face numerous challenges
But the weed landscape isn't perfect. Marijuana stocks also face a plethora of challenges each and every day.
As an example, U.S.-based cannabis companies have little or no access to basic banking services. Financial institutions in the U.S. report to the Federal Deposit Insurance Corporation, which is a federally created entity. Since marijuana is a Schedule I, and ergo illicit, substance at the federal level, banks deny financial services (even checking accounts) to pot businesses for fear of fines or criminal penalties under a strict interpretation of federal law. That means these businesses have to rely solely on cash, which is a big security concern.
Weed-based companies also get no love come tax time. Because they sell a Schedule I substance, they're disallowed from taking normal corporate income-tax deductions. Profitable marijuana companies are left to pay tax on their gross profits instead of their net profits, leaving less money to reinvest in the business.
Throughout North America, marijuana stocks are also subject to political challenges. In the U.S., industry opponents such as Attorney General Jeff Sessions stand at the ready to trample states' rights and prosecute medical-marijuana businesses. Meanwhile, conservatives in Canada's parliament are doing what they can to halt the progress of a recreational legalization bill that Prime Minister Justin Trudeau introduced earlier this year. Conservatives in Canada argue that a home-grow option in the bill would give minors easy access to cannabis, and that a lack of DUI guidelines for marijuana use make legalizing the drug dangerous.
Bad news for Canadian marijuana stocks
Well, I have news for marijuana stock investors: There's a new threat on the horizon, at least for our neighbors to the north.
In May, Health Canada, the regulatory agency that seeks to protect the medical welfare of Canada's citizens, announced that it was making a number of changes to the country's medical marijuana program. Some of these changes included eliminating the red tape associated with gaining licensing approval for production. However, the big change it announced was that it would increase the number of licensed cannabis producers. As of May 24, there were only 44 licensed producers throughout the country, but 187 applications were at the review stage. It seems unlikely that the number of licensed producers is going to quintuple overnight since not every application will be accepted, but there's a real possibility of significant near-term licensed producer growth.
Right now, Canada's biggest medical growers include Canopy Growth Corp. (NASDAQOTH:TWMJF), Aphria (NASDAQOTH:APHQF), Aurora Cannabis (NASDAQOTH:ACBFF), and MedReleaf (NASDAQOTH:MEDFF). This news suggests that all four will soon face a significant uptick in competition, making their expansionary efforts all the more important, with Canada tinkering with the idea of legalizing recreational weed.
Canopy Growth Corp. completed the acquisition of Mettrum Health in January, boosting its medical patient reach throughout Canada, and it also purchased 472,000 square feet of land housing and surrounding its headquarters. This, along with 2.4 million square feet under development as of the end of the latest quarter, should allow it to further boost its production capacity.
Meanwhile, the other three industry juggernauts have mostly stuck to more organic methods of capacity expansion. Aphria's $100 million capital project, known as Phase IV, will boost capacity to 1 million square feet and 100,000 kilograms of dried cannabis annually when completed in Jan. 2019. Aurora Cannabis' Aurora Sky project is a mammoth 800,000-square-foot facility that could very well be the most automated and technologically advanced grow facility when finished in mid-2018. It'll also be capable of 100,000 kilograms of annual dried cannabis production. And finally, MedReleaf is using its initial public offering proceeds to expand capacity at its Bradford, Ontario facility.
A grim reality
Just how badly could this increase in competition sting the likes of Canopy Growth, Aurora Cannabis, Aphria, MedReleaf, and its peers? According to an analyst note from Neil Maruoka of Canaccord Genuity, Health Canada's willingness to grant more licenses means it's unlikely that any one company will control more than 20% of cannabis supply.
Said Maruoka: "Our projections of respective market sizes remain largely unchanged, and while we remain confident this growth can be achieved, we also believe the significant increase in granted licenses is likely to create stronger competition among LPs [licensed producers]. We continue to expect that established producers with solid balance sheets, such as Canopy, Aphria, and Aurora, are likely to emerge as dominant players; however, we no longer feel it is reasonable to assume that any one LP can capture over 20% share of a likely increasingly crowded market."
Maruoka and his firm wound up lowering their respective market share estimates for leader Canopy Growth to 15% of the recreational market (assuming approval) and 12% of the medical market, down from an initial share forecast of 21% and 17.5%, respectively. Canaccord also expects Aurora Cannabis to be second with 10% of recreational and medical market share, and Aphria third with a 9% recreational and 7.5% medical share.
Not surprisingly, Maruoka and his firm also lowered their price targets for a half-dozen marijuana stocks and reduced their rating on five of six companies. As a sign of how far Aphria had fallen from its 52-week high at the time, it was actually upgraded even though its share-price target was modestly lowered.
All bets are off
Despite its consistently strong growth rate, there simply aren't any guarantees at this point that success awaits marijuana stocks. There have been some encouraging early signs of profitability, albeit minimal, from companies such as Canopy Growth, Aphria, and MedReleaf, but at the same time, there aren't any assurances that Trudeau can get his recreational-cannabis legislation signed into law. After all, he's been pushing for legalization for years without any progress, so what's to say with any certainty that it happens now?
With competition increasing, the future uncertain, and most marijuana stocks either unprofitable or valued at nosebleed P/E ratios, your best bet for the time being is to steer clear of the industry.