In just over four months, euphoria will strike the Canadian cannabis industry once again. After becoming the first industrialized country to legalize recreational marijuana in October 2018, Canada is prepared to launch derivative pot products by mid-December. This launch of derivatives is being referred to as "marijuana legalization 2.0."
A derivative product simply means a consumable that isn't dried cannabis flower. Vapes are forecast to be the best-selling derivative product, once sales begin, with edibles, nonalcoholic infused beverages, topicals, and concentrates all generating significant sales and juicy margins. As a reminder, traditional dried flower is generally a low-margin product, making the upcoming launch of derivatives a highly anticipated event for money-losing pot stocks.
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Furthermore, the younger generation of cannabis consumers have made it clear that they prefer derivatives, as opposed to smoking dried marijuana flower. Since this younger generation of consumers will fuel growth for years to come, the industry is taking their preferences to heart.
Everything would appear to be pointing toward a positive and profitable launch of derivative pot products in December. However, things may not go as planned. Here are three ways marijuana legalization 2.0 could wind up disappointing investors.
1. Supply issues persist well past December
Arguably the biggest concern for the upcoming launch of derivative products is that what derailed the dried cannabis flower launch won't be even close to resolved by mid-December.
Health Canada, the regulatory agency responsible for overseeing the regulated marijuana industry, had more than 800 licensing applications on its desk for review when the year began. Most of these applications took months -- or longer than a year in some cases -- to review, with producers needing separate approvals to grow, process, and sell cannabis. The turnaround to gain full approval can take a long time, and it's helped to keep a lot of cannabis off dispensary store shelves. Even though Health Canada has implemented changes, it's likely going to be many quarters before this backlog of applications has been dealt with.
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In addition to the licensing application backlog, Canadian pot stocks have also been dealing with a shortage of compliant packaging solutions.
While I would expect headway to have been made on the persistent dried flower supply issues in Canada by the time derivative products launch in mid-December, I wouldn't expect them to be anywhere near fully resolved. That would mean the strong likelihood of initial supply shortages for derivative products for at least a couple of quarters.
2. Competition for certain derivatives is fiercer than forecast
A second concern is that Wall Street and investors may be far too optimistic about the initial impact of derivatives on the bottom lines of cannabis stocks.
On one hand, there's no mistaking the benefit of focusing on higher-margin alternative consumption options. Cronos Group (CRON 1.85%), which I've chided as overvalued for months, has been smart about its long-term strategy by focusing more on cannabinoid-based production and less on dried flower. At less than 120,000 kilos of dried cannabis peak output per year, Cronos may not even be a top 10 player. But Cronos Group's focus on commercial cannabinoid production, and its recent acquisition of Redwood to gain hold of the Lord Jones CBD beauty products line, demonstrates its focus on margin quality over top-line quantity.
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But companies like Cronos pretty much all have the same idea, and there's bound to be plenty of competition in vapes, edibles, and especially infused beverages.
Pot stock HEXO (HEXO +0.00%), for example, has been bludgeoned in recent months, losing nearly half of its value. While supply issues certainly do tell the tale of why HEXO's recent performance hasn't been pretty, part of this decline could be investors coming to terms with the idea that HEXO's joint venture (known as Truss) with Molson Coors Brewing (TAP 0.07%) could face plenty of competition. Focused on creating a line of nonalcoholic cannabis-infused beverages, HEXO and Molson Coors are set to face an unknown but growing number of competitors in the beverage space.
Even if derivatives don't face the same level of commoditization as dried cannabis, competition could still be fiercer than forecast.
3. Brand-name players may see little benefit by entering the derivative market
Investors might also be disappointed by just how little the needle moves for brand-name companies that have entered the derivative market.
Using the example above, Molson Coors partnered with HEXO in a 57.5%-42.5% joint venture last August. With declining beer market share in Canada, the company is looking for anything that will reignite sales growth and improve brand loyalty. Molson Coors believes infused beverages might be the answer. But keep in mind that Molson Coors operates in more than 25 countries, and generates in the neighborhood of $10.6 billion in sales each year. Adding an infused cannabis product in one country may not move the needle much, if at all, for Molson Coors, especially if beverage competition is fierce.
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The same could be said for Constellation Brands (STZ +0.20%), which owns a mammoth 37% equity stake in Canopy Growth (CGC 3.75%), the largest marijuana stock in the world by market cap. Obviously, there's a big difference between being an active investor in a company, like Constellation is for Canopy, and simply forming a joint venture or partnership. Nevertheless, the company behind the Modelo and Corona beer lines aims to work with Canopy Growth to develop and launch a line of infused beverages, which could lead to many of the challenges described above. Not to mention, Constellation Brands' operating results have been dragged down by widening losses at Canopy Growth.
Don't get me wrong, derivatives are going to be the smart way for cannabis stocks to play this industry over the long run. But if you're expecting marijuana stocks to right the ship in short order simply because new consumption options are being launched in a little over four months, you could be sorely disappointed.
