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The 3 Biggest Risks for Canadian Pot Stocks

By Sean Williams - Updated Feb 9, 2018 at 2:20PM

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Even on the verge of legalizing recreational cannabis, Canadian marijuana stocks harbor some scary risks for investors.

The legal marijuana industry is absolutely budding before our eyes, and perhaps no country is on track to take advantage of that growth more than Canada. Though ArcView is projecting North American legal weed sales growth of 26% through 2021, Canada is where legal pot sales are expected to grow the fastest.

Canada is running circles around the U.S.

Truth be told, the United States could easily be the world's most lucrative market for marijuana. Unfortunately, Congress has dug in its heels and isn't adjusting its classification of pot as a Schedule 1 substance. This means it's entirely illegal, is prone to abuse, and has no recognized medical benefits. It also puts cannabis businesses at a major disadvantage, with most unable to access basic financial services, and nearly all unable to take normal corporate income tax deductions thanks to U.S. tax code 280E.

A lit cannabis joint in front of a red Canadian maple leaf.

Image source: Getty Images.

By comparison, Canada legalized medical weed back in 2001 and has been expanding the program for medical patients in recent years under the oversight of Health Canada. In fact, a handful of medical pot growers have been profitable solely on the basis of medical weed sales.

More importantly, Canada appears to be on track to legalize recreational marijuana by July 2018. Legislation introduced by Prime Minister Justin Trudeau in April 2017 has overcome numerous obstacles along the way. This includes the federal government recently reaching a tax-sharing agreement with all of the Canadian provinces. With progressive lawmakers outnumbering conservative in parliament, legalization is looking increasingly likely. 

Should Canada green-light adult-use cannabis, it would become the first developed country in the world to do so, and it would potentially be adding $5 billion in annual sales, once fully ramped up. This, along with being a highly consolidated industry, is a big reason why Canadian pot stocks have soared.

Don't overlook these risks with Canadian pot stocks

However, Canadian pot stocks aren't perfect. Even though they've been a blueprint for success in recent years, they carry risks that could mean shareholders losing money. If you're already a Canadian pot stock investor, or are considering dipping your toes in the water, here are the three biggest risks to be aware of.

Jars filled with dried cannabis stacked on each other.

Image source: Getty Images.

1. An oversupply of pot

It's no secret that if Canada legalizes recreational marijuana, demand in the country is going to soar. Consumers within Canada, medical patients who don't want to go through the normal channels of obtaining cannabis, and tourists, could all effectively push recreational demand through the roof.

Health Canada has been tasked with regulating the pot industry by OK'ing licensing and facility approvals. Thus far, with only medical patient demand, and a handful of licensed Canadian growers able to export, supply hasn't been an issue. But that's about to change if Canada meets its July 2018 timeline for approval.

Canadian pot growers have been expanding at a truly breakneck pace. Canopy Growth Corp. (CGC 4.72%) acquired Mettrum Health and dramatically boosted its production capacity at the beginning of 2017, and now has 2.4 million square feet of capacity under construction or in development in British Columbia. What's more, it has the option of leasing another 1.7 million square feet in B.C.

Between Canopy Growth, Aurora Cannabis (ACB 7.75%), Aphria, MedReleaf, and Cannabis Wheaton Income Corp., these five companies could be delivering around 900,000 kilograms of combined annual production by 2019, by my best estimate. I'm not even certain the entire Canadian market will demand that much cannabis, even with the euphoria of a recreational weed bill possibly becoming law.

Furthermore, don't double-count demand switching from the medical side of the equation to the recreational side. As noted, medical patients may no longer choose to take that extra step of seeing a doctor and getting a prescription before purchasing cannabis. This could have growers overthinking just how much demand there will really be come July.

If Canadian pot stocks considerably overshoot on supply, margins and profitability are likely to suffer.

A street sign that says risk ahead.

Image source: Getty Images.

2. Provincial delays

Another concern that Canadian pot stock investors shouldn't discount is the possibility of problems with Canada's provinces. Even though the federal government and the provinces worked out a two-year tax-sharing agreement that gives the provinces at least 75% of the tax revenue collected, this isn't a guarantee that they're going to be ready to handle being at the front line of regulating recreational pot's launch.

Provincial mayors have frequently expressed concern since this past summer about have police and regulators in place prior to a July 2018 launch. While tax sharing was a valid issue, and mayors did chime in that a larger portion of the revenue pie was needed given their direct regulatory needs, this could simply come down to a matter of manpower. In other words, some of the provinces may not have regulators or police trained in time for a July launch.

So, what happens if the launch of recreational pot in Canada is delayed? Chances are, we'd see pot stock valuations modestly deflate. Investors have been pricing in the expected legalization of adult-use weed by July, so any delay beyond July would be viewed with skepticism or outright pessimism.

Personally, I do foresee recreational pot being legalized in Canada, but I'm not quite sold on the federal government hitting Wall Street's July timeline.

A hundred dollar bill on fire.

Image source: Getty Images.

3. Bought-deal offering-based dilution

Last but not least, I wouldn't be as concerned about near-term profitability so much as I would caution investors to be wary of intermediate-term dilution brought about by bought-deal financing. Bought-deal financing is a common method in Canada of raising capital, and it often involves the sale of stock or debentures to an investor or institution prior to the release of a prospectus.

Within the U.S., for example, getting access to loans is incredibly difficult for marijuana companies. Canadian pot stocks, though, have had no trouble finding willing investors. Prior to announcing its acquisition of CanniMed Therapeutics, Aurora Cannabis has piled up more than $400 million in cash and cash equivalents on its balance sheet, almost entirely from bought-deal financing. This capital has been critical to expanding growing capacity in Canada's ever-more-consolidated industry. 

But here's the issue: Each bought-deal offering is slated to increase the number of shares outstanding, be it immediately or within a few years. Common stock offerings increase a company's outstanding share count immediately, while warrants, options, and convertible debentures tend to do so within a year to three years. As the share count increase, the exclusivity of existing shares declines, diluting the value of existing shareholders.

For some pot stocks, this dilution has been absolutely incredible. Cash-rich Aurora Cannabis has seen its outstanding share count rise by more than 2,200% to over 375 million shares since mid-2014. Mind you, this doesn't include more than $250 million worth of bought-deal financing since the end of its fiscal first quarter. Aurora's outstanding share count is set to balloon in the years to come, meaning it'll have to earn a whole lot more in profits just to move the needle. 

Caveat emptor, Canadian pot stock buyers.

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