The green rush is officially on! This past Wednesday, following nine decades of prohibition, Canada lifted the curtain on recreational marijuana. Depending on the province, adults age 18 or 19 and older are free to purchase cannabis in licensed stores or perhaps even online throughout our neighbor to the north.
As you might imagine, legalization is expected to be a game-changer for the legal weed industry. Already generating hundreds of millions of dollars from the sale of medical cannabis and via exports to foreign countries where medical pot is legal, the influx of demand for adult-use marijuana should yield billions in added annual sales. This surge in sales is what's expected to lead to big profits for cannabis stocks.
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Unfortunately, with marijuana stocks having already shot into the stratosphere, there's a very real possibility that investors could see their investments shrink from here on out. Even with such an idea probably seeming preposterous given the size of the global cannabis industry, there are three blunt marijuana facts that investors have to hear, even if they don't want to.
1. Pot stocks aren't profitable on an operating basis
The first thing investors need to know is that marijuana stocks aren't anywhere near profitable on a recurring basis, even if a handful of companies have been able to report quarterly or full-year profits.
Publicly listed Canadian companies are required to report their operating results using International Financial Reporting Standards, or IFRS. One of the odd quirks of IFRS accounting is how agricultural-based companies recognize the value of their biological assets, which in this case would be cannabis plants. According to IFRS accounting, growers are required to estimate the fair value of their plants, as well as guess their selling costs, well before their pot has been fully grown or sold. This means the "value" of these biological assets changes all the time.
What's even stranger -- but again, 100% legal according to IFRS accounting -- is where this fair-value adjustment is recognized on a public company's income statement. Canadian pot stocks have chosen to recognize this adjustment above the line, meaning an upward revision in fair value actually reduces cost of goods sold. In some cases, rather than subtracting cost of goods sold from revenue, we're witnessing instances where cost of goods sold is a positive number that's added to revenue!
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Take Aphria (NASDAQOTH: APHQF) as a perfect example. The company reported its first-quarter operating results late last week, with sales more than doubling to 13.3 million Canadian dollars. Overall, Aphria logged net income of CA$21.2 million. However, most of this profit was the result of an unrealized gain on convertible notes receivable and a fair-value adjustment on its cannabis plants. If we look strictly at the company's sales and operating expenses and exclude one-time items and fair-value adjustments, Aphria generated a nearly CA$16 million operating loss.
You may not want to hear this, but the reality is marijuana stocks aren't anywhere near being profitable on an operating basis.
2. High-margin products are still a ways away from making an impact
To build on the first point of marijuana stocks not being profitable, there's the fact that high-interest, high-margin cannabis alternatives are, in many instances, nowhere near hitting dispensary shelves in Canada.
When Parliament passed the Cannabis Act on June 19, 2018, it did so by creating the simplest path to legalization as possible. This meant giving the green light to dried cannabis flower and cannabis oil as a means of consumption... but that's it. Other forms of consumption, including edibles, vapes, concentrates, and cannabis-infused beverages, aren't legal at the moment, even if there's been a lot of buzz around these alternatives. The expectation is that Parliament will take up discussion on expanding consumable options, and approve those options, next year, but there's not exactly a concrete timeline on when this'll happen.
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The reason this is such a big deal is that these alternative products have the potential to offer considerably higher margins than traditional dried cannabis. Even though recreational legalization has minimal precedence, the per-gram price for cannabis has tumbled following a short period of consumer euphoria in Colorado, Washington, and Oregon, suggesting that commoditization of dried flower in Canada is also (probably) just a few quarters away. Under such a scenario, even with the advantages of economies of scale, pot stocks are liable to see their margins constrict.
For example, HEXO Corp. (HEXO) investors are stoked about the company's joint venture with Molson Coors Brewing Co. (TAP -0.75%) in Canada, announced on Aug. 1. The 57.5%-to-42.5% joint venture (Molson Coors has the majority stake) will see the duo collaborate on cannabis-infused beverages. Molson Coors aims to reverse sluggish alcohol sales in Canada, and will use its deep pockets and marketing prowess to push pot products into new markets. Meanwhile, HEXO will be leaned on for its pot industry knowledge.
Of course, HEXO and Molson Coors are nowhere near moving the needle on these higher-margin products. Though they can collaborate and get production lines ready, cannabis alternatives won't get the green light until, supposedly, sometime next year. Even then, competition in beverages could be fierce, and it may take time before these alternative products are really a factor.
3. The black market isn't going anywhere
Lastly, even if you don't want to hear it, you should know that the black market isn't going anywhere anytime soon.
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As recently as 2016, the black market made up in excess of 85% of all North American weed sales. Although this figure will decline following Canada's recreational legalization and ongoing approvals in select U.S. states, the black market is unlikely to cede a notable percentage of its market share in North America for one big reason: price.
Don't get me wrong -- convenience and legality are important to many consumers. However, the black market can consistently undercut legal channels on price. In Canada, excise taxes on recreational pot sales come in at about 10%, which is significantly lower than the 50% to 80% excise tax applied to alcohol sales. But illicit channels don't have to pay excise taxes, federal income tax, or license fees. There are also, presumably, lower overhead costs associated with operating a black-market grow operation. In other words, it's going to be extremely difficult to chase the black market out of Canada, and that could have adverse effects on marijuana stocks.
In other words, even though most investors are high on pot stocks, the blunt truth is they could vastly underperform in the near to intermediate term.
