In just over eight weeks, Canada will make cannabis history by becoming the first industrialized country in the world, and only the second overall behind Uruguay, to legalize recreational marijuana. Though passing the Cannabis Act took a bit longer than marijuana enthusiasts would probably have liked, it's nonetheless a step forward that's expected to result in up to $5 billion in added annual sales for the industry.
Face the facts: Pot stocks won't live up to the hype
But you'd probably never know that Canada was on the verge of such a big event by taking a gander at marijuana stocks as a whole. Since peaking in January, the North American Marijuana Index, which includes some of the top growers and cannabinoid-based drugmakers throughout North America, has lost about a third of its value. And were it not for a rally last week on word that Corona beer maker Constellation Brands was taking an additional $3.8 billion equity stake in Canopy Growth Corp. (CGC 3.67%), this decline would have been closer to 40%.
Image source: Getty Images.
While some pundits would suggest that this is nothing more than a healthy pullback in an otherwise gangbusters growth industry, I've begun to lean decisively toward the opinion that marijuana stocks simply won't live up to the hype -- and I've got a handful of reasons to support my thesis.
1. Sales potential will initially be constrained by supply issues and Health Canada
When the proverbial green flag waves on Oct. 17, 2018, one factor that looks to be working in favor of growers is the per-gram price for dried cannabis. Even though Canadian regulators have sworn up and down that there won't be a cannabis shortage, growers are nowhere near the capacity they need to be to meet estimated domestic and export demand. That's because growers had to wait until it appeared certain the Cannabis Act would pass before spending hundreds of millions of dollars on capacity expansion.
On one hand, this should lead to higher gross margin. But from another perspective, it also means that growers won't be able to fully take advantage of strong prices out of the gate. A few growers, such as Canopy Growth, which had 19,721 kilograms of dried cannabis in its inventory for the October launch as of the end of its fiscal first quarter, could see some bright spots. However, when looked at as a whole, the industry is unlikely to see significant benefits due to supply constraints.
As the icing on the cake, regulatory agency Health Canada is having to work through a massive backlog of cultivation licenses and sales permits. These often take time to approve, which could keep cannabis growers stuck on the sidelines.
Image source: Getty Images.
2. History says oversupply will decimate the per-gram price for dried cannabis
Though we've never seen an industrialized country give the green light to recreational weed before, we have seen a handful of U.S. states do so -- and the result has been the same in pretty much every instance thus far.
In Colorado, Washington, and Oregon, the three states to have launched adult-use weed sales prior to any of the other legal U.S. states, oversupply has run rampant. In Colorado, big businesses gobbled up as many growing licenses as they could and have flooded the market with marijuana. Similar oversupply has been observed in Washington state, too. As for Oregon, with no limit on the number of permits that can be issued, oversupply seemed all but a certainty. In all three instances, the per-gram price for dried flower has plunged.
Now, if there's a silver lining here for Canadian growers, it's that economies of scale should allow them to remain profitable if the per-gram dried flower price plunges. But make no mistake about it; if the price for cannabis drops significantly, there are going to be negative consequences to the gross margin of growers. This looks to be the fate of the Canadian pot industry beginning in 2020 and beyond.
Image source: Getty Images.
3. The black market won't just disappear
Another consideration investors have to take into account is the existence of the black market. Throughout North America, more than 85% of all cannabis sales in 2016 were controlled by the black market. The legalization of recreational pot in Canada, along with the expansion of legal weed in a number of U.S. states, is bound to shrink this figure in the years that lie ahead. But to think that sales will simply move over to legal channels without any trouble would be a utopian assessment.
In Canada, the federal government set what's roughly a 10% excise tax on the sales price of recreational cannabis products. That's considerably lower than the tax folks have to pay on beer, wine, and spirits, which can range from 50% to 80% in our neighbor to the north. But even then, this 10% excise tax could be enough to keep a lot of sales within black market channels.
Remember, the black market doesn't have an excise tax to pay, it doesn't have to follow strict packaging and marketing guidelines, and there's no licensing fee, sales permit, or rent to cover. The black market could still notably undercut legal channels on price, which could reduce the revenue potential of the legal weed industry to our north.
Image source: Getty Images.
4. Export demand volume is a complete unknown
Marijuana stock investors are also lying to themselves if they think they have any bead on what foreign market demand will look like in a few months or a few years.
When recreational weed launches in October, initial demand from the more than two dozen foreign countries to have legalized medical marijuana in some capacity should be strong. That's because many of these countries have nascent or nonexistent grow facilities to meet their domestic demand.
However, with my own prognostication of the Canadian marijuana industry pacing 3 million kilograms of production per year by as soon as 2020, up to 2 million kilograms of this production may need to find a home overseas. If this were 2018, there's a possibility of that happening. But by 2020 and beyond, we're liable to see these foreign countries introducing their own domestic grow farms, which could cut into demand from Canada.
To add, not all of the foreign countries to have legalized medical marijuana have approved the use of dried cannabis. This suggests that growers focusing on cannabis oils will be in much better shape when exporting to overseas markets. Canopy Growth Corp. ended its latest quarter with 14,895 liters of cannabis oil, as well as 1,055 kilograms of its softgel capsules for medical patients. It's in decent shape when it comes to meeting overseas demand, but its peers that have a greater focus on dried flower may not be as lucky.
Image source: Getty Images.
5. Dilution is a long-term issue
To wrap things up, dilution also looks to be a long-term issue for pot stocks.
Prior to the passage of the Cannabis Act, Canadian marijuana stocks had virtually no access to basic banking services. Since the federal government deemed weed as illegal, banks found to be offering loans, lines of credit, or even a checking account, to marijuana-based businesses could have faced fines or criminal penalties. This left Canadian pot stocks with one choice to raise capital: bought-deal offerings.
A bought-deal offering is where a publicly traded company sells common stock, convertible debentures, stock options, and/or warrants to an investor or group of investors in exchange for cash. Though marijuana stocks have had absolutely no issue raising cash via bought-deal offerings, they immediately, and over time, increase a company's outstanding share count. In doing so, it dilutes the existing share price, while making it tougher for pot stocks to deliver a meaningful per-share profit.
Probably the most blatant example of share-based dilution is Aurora Cannabis (ACBFF 1.44%). In order to finance the $2.5 billion acquisition of MedReleaf, the $852 million buyout of CanniMed, its Aurora Nordic partnership with Alfred Pedersen & Son, and its organic Aurora Sun and Aurora Sky builds, Aurora Cannabis turned to one bought-deal offering after another. Since the end of fiscal 2014, Aurora's share count has ballooned from a little over 16 million to around 950 million. Worse yet, this figure could still head higher with the impact of options, warrants, and share-based compensation still to come.
To put things bluntly, marijuana stocks are going to have a hard time living up to the hype.
