Big things are happening with our neighbor to the north. On June 19, after Bill C-45 (officially, the Cannabis Act) bounced back and forth between both houses of Canada's Parliament, the Senate approved the Cannabis Act, sending it to royal assent. Shortly thereafter, Prime Minister Justin Trudeau, who'd championed the idea of legalizing adult-use cannabis for years, announced that Oct. 17, 2018, would represent the official waving of the green flag for recreational marijuana in Canada.
Aside from the fact that Canada is set to become the first industrialized country in the world to have legalized recreational weed, it's also on track to add in the neighborhood of $5 billion annually to this rapidly growing industry. Going from a few hundred million dollars in annual sales to billions each year is what's coerced investors to pile into pot stocks.
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Looking into the Canadian cannabis crystal ball
But, truth be told, there's a lot we still don't know about Canada's legal cannabis industry. Namely, because no industrialized country has ever legalized recreational marijuana before, there's no precedent to look back on with regard to demand, supply, or other industry intangibles. However, unknowns aren't going to stop me from making prognostications about the Canadian cannabis industry. While I can't guarantee they'll come true, here are four reasonable predictions for legalization in Canada.
1. Cannabis shortages will extend through 2019
When the calendar changes to Oct. 17, it's practically a guarantee that demand for marijuana is going to exceed supply -- and by a significant amount. Regulatory agency Health Canada predicts that demand could hit 1 million kilograms domestically each year. Meanwhile, production for every licensed grower combined may not even be at half of this level on an extrapolated annual basis by Oct. 17. That should be a recipe for relatively strong per-gram cannabis prices out of the gate.
There are two particular reasons for this pot shortage, and my expectation that it'll continue until at least the end of 2019. First, capacity expansion for cannabis growers has been staggered. Growers had to be certain that the Cannabis Act would pass before they were going to spend tens or hundreds of millions of dollars on expansion. Passage didn't appear to be a near-certainty until roughly seven months ago, when the federal government worked out a two-year tax-sharing agreement with nearly all Canadian provinces. With most expansion projects expected to be completed between mid-2018 and the end of 2020, it'll take time before the annual run rate of supply meets demand.
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The second reason for this shortage can be blamed on Health Canada, which is responsible for issuing cultivation licenses and sales permits to domestic growers. As reported by Marijuana Business Daily, Health Canada has a backlog of more than 500 cultivation applications to contend with, and those applications usually take six months to multiple years to review. Then, assuming a grower has been granted a cultivation license, it has to work its way through the line ride again while waiting for a sales permit. On average, it takes Health Canada 341 days to issue sales permits. This red tape could create an under-the-radar supply shortage over the next year and change.
2. Oversupply and dried cannabis commoditization begins in 2020
However, my expectation is that things will change once 2020 rolls around. By 2020, a vast majority of capacity expansion projects should be complete, with planting and harvesting underway. Meanwhile, Health Canada will have had ample time to work its way through the backlog of cultivation applications and sales permits. Though production figures are extremely fluid, my estimate is that Canada could approach up to 2.5 million kilograms of production annually by 2020.
Assuming domestic demand remains around or just above 1 million kilograms per year, as suggested by Health Canada, domestic oversupply should easily top 1 million kilograms, and may even near 1.4 million to 1.5 million kilograms. Where will this excess supply go, you ask? The hope is that it'll be exported to some of the more than two dozen countries where medical cannabis has been legalized. Many of these countries have nascent or nonexistent domestic grow operations, which means relying on the very few countries allowed to export medical marijuana, such as Canada.
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The question is: Can foreign markets absorb more than 1 million kilograms of oversupply? Quite a few pundits say yes, but I'm not entirely convinced. Keep in mind that while more than two dozen foreign markets have legalized medical weed, not all of them allow dried cannabis to be prescribed. The makeup of the oversupply -- i.e., how much is dried cannabis versus how much is comprised of cannabis alternative, such as oils -- will, therefore, play a pretty important role in determining whether this oversupply is adequately dealt with.
Chances are, though, that dried cannabis prices will begin to fall precipitously not long after legalization. We've seen this happen in Washington, Colorado, and Oregon, in the United States. As dried cannabis becomes commoditized and its supply explodes, it's likely that growers will see their margins on dried product shrink, even with the benefit of economies of scale.
3. Consolidation could actually ramp up
Even though we've already witnessed a ramp-up in industry consolidation, with Aurora Cannabis (ABCFF 1.44%) acquiring CanniMed Therapeutics, and currently in the process of buying MedReleaf in an all-share deal worth $2.5 billion (the largest pot deal in history), consolidation could pick up even more.
One of the more overlooked aspects of legalizing adult-use marijuana is that it now becomes fully legal for financial institutions to offer basic banking services to pot-based companies. Previously, with cannabis being illicit, banks had to worry about the potential for monetary and/or criminal penalties if they were caught providing financial services to the marijuana industry. With the Cannabis Act now passed, banks are free to extend lines of credit and offer loans to weed-based businesses. In fact, Aurora Cannabis was among the first to take advantage of this, with a $200 million credit facility (a mixture of term loans and a line of credit) recently set up with the Bank of Montreal.
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Prior to legalization, the only real means of raising capital to expand capacity and make acquisitions was through bought-deal offerings. A bought-deal offering involves the sale of common stock, convertible debentures, stock options, and/or warrants in exchange for capital. Though bought-deal offerings seemingly always did the trick in raising capital, they're also incredibly dilutive to existing shareholders since they can dramatically increase the outstanding share count.
My prediction is that having access to basic banking services should reduce the need to turn to bought-deal offerings and spur industry consolidation.
4. Substantive profits will remain elusive for many marijuana stocks
While it's probably not what marijuana stock investors want to hear, my belief is that profitability for most pot stocks will come in below expectations in the years to come.
As noted, there's a pretty good chance that an oversupply will hit the domestic Canadian market by 2020, weighing on the price of dried cannabis. Some growers, such as CannTrust Holding, Aphria, and Canopy Growth Corporation, have done a good job of diversifying their production away from dried cannabis and toward oils and capsules, which should be able to avoid pricing pressures. Gross margins for these growers should be higher than many of their peers as a result, while some of their peers could see their margins tumble.
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Perhaps the bigger issue is the aforementioned growth in the outstanding share counts of most pot growers. As a result of bought-deal offerings, significantly higher share counts will make it much tougher for marijuana stocks to report substantive per-share profits. Furthermore, with stock options, warrants, and/or convertible debentures still to be accounted for, most pot stocks could see their share counts increase over the next couple of years, worsening the impact on earnings per share.
In other words, it remains to be seen if rapid growth will actually translate into green for pot stocks.
