It hasn't taken too long for the legal marijuana industry to transform itself into a big-money business. There's no doubt that tens of billions of dollars' worth of illicit pot sales are ongoing behind the scenes globally, but the legalization of recreational cannabis in Canada last year, along with 33 U.S. states, to some varied degree, led to $10.9 billion in legal weed sales worldwide in 2018. By the end of the upcoming decade, we could be talking about $50 billion, $100 billion, or even $200 billion in annual worldwide legal sales.
Although Canada isn't expected to be anywhere near the largest cannabis market in the world, it is the only industrialized country to have legalized adult-use marijuana so far. Therefore, it's sort of the blueprint/guinea pig by which other countries will likely learn from and/or emulate. And next week, on Thursday, Oct. 17, Canada will be setting an example for the world to see, once more.
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October 17 is the big day for the cannabis industry
One week from today, regulations concerning the production, processing, distribution, and sale of derivative cannabis products will officially go into effect. Derivatives are nondried-flower pot products, such as edibles, vapes, nonalcoholic infused beverages, concentrates, and topicals.
When the Cannabis Act was signed into law, only certain marijuana products were given the green light when recreational pot sales began on Oct. 17, 2018. This included dried cannabis flower, cannabis oil, and sublingual sprays. The reason these other derivatives weren't given immediate clearance likely had to do with some combination of giving the industry and regulators time to work out the kinks in a legal industry with no precedent. No doubt it also made the Cannabis Act easier to pass in Parliament if only a limited number of products were immediately available come October 2018.
However, this all changes on Oct. 17. With the exception of alcoholic beverages containing cannabis, which remain illegal, the spectrum of products available for sale will be huge in our neighbor to the north.
More importantly, margins for marijuana stocks should see a healthy boost. That's because dried cannabis flower has shown a penchant in select recreationally legal U.S. states to be oversupplied and commoditized. Meanwhile, derivatives are unlikely to face any sort of oversupply or pricing pressures, making for considerably juicier margins across the board.
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The biggest day of the year for marijuana could still be spoiled
The table would appear to be set for Canadian pot stocks to succeed in a big way. But things aren't as cut-and-dried as it might seem.
To begin with, the official legalization of derivatives doesn't mean that these products are going to be appearing in dispensaries on the same day. In fact, regulatory agency Health Canada has cautioned that it's going to take two months, until mid-December, before edibles, vapes, beverages, and so on, begin showing up in dispensaries for purchase. Similar to the launch of recreational weed products a year ago, it takes time to build up inventory in physical retail locations and online.
But that's not the biggest concern. The greater worry for the cannabis industry should be the persistent supply issues throughout the country. Since day one of legalization nearly a year ago, the supply of dried cannabis flower and oils has been constrained. A considerable cultivation and sales license backlog at Health Canada, coupled with the slow approval process for dispensary licenses in select provinces, has been responsible for a good chunk of these supply problems. While fixes have been implemented, it's going to take time to make a dent in Canada's supply issues. By the time derivatives are supposed to be making their way to dispensaries, these supply constraints will still exist. Translation: Wall Street and investors are probably too optimistic regarding early-stage derivative sales in Canada.
It's also worth noting that vape-related health concerns from the U.S. could spill over into the Canadian market and push vape sales lower. The Centers for Disease Control and Prevention had identified 1,080 confirmed or probable instances of vape-related lung illnesses as of Oct. 1, which have led to 18 deaths. With no certainty as to what's causing these mystery illnesses and deaths, it's quite possible vape sales could struggle out of the gate.
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The one industry seeing green, regardless of early-stage derivative concerns
There's no question that derivative cannabis products are the future of the marijuana industry. These are products that speak to a younger generation of users and, as noted, will generate considerably better margins than dried cannabis flower. But there's also an increasing likelihood that initial sales could disappoint given the myriad of challenges described above.
However, one industry is set to thrive even if supply issues and vape-related health concerns persist.
Extraction-service providers, such as Neptune Wellness Solutions (NEPT -37.97%), Valens GroWorks (VLNS), and MediPharm Labs (MEDIF 3.44%), are predominantly insulated from these concerns given that their revenue doesn't come from individual product sales, but rather fee-based services provided by intermediate-term contracts. That means Neptune Wellness, Valens GroWorks, and MediPharm Labs can count on predictable cash flow each and every quarter.
For instance, even though Neptune Wellness is focusing its extraction efforts on the U.S. via its recent acquisition of SugarLeaf, its subsidiary offers 200,000 kilos of extraction capacity annually in Canada. In June Neptune signed the largest aggregate extraction deal to date with The Green Organic Dutchman totaling 230,000 kilos over a three-year period.
Likewise, we've witnessed Valens GroWorks and MediPharm Labs nab big-time deals. In June, Valens upped its extraction agreement size with Tilray to 60,000 kilos annually, while also snagging an 80,000 kilo-in-aggregate two-year extraction deal with HEXO in April. Meanwhile, MediPharm has an 18-month extraction-services deal in place with Cronos Group worth $30 million that could be doubled to $60 million over 24 months.
Cannabis may be a volatile industry, but extraction-service providers are looking to be one of the safest ways to play this rapid growth and the eventual rise of derivatives.
