The legalization of cannabis in Canada, various U.S. states, and other countries around the world is no doubt exciting. After all, it's been a long time since an entirely new legal industry has come to the fore. Investment bank Cowen Group (NASDAQ:COWN) even thinks the global legal cannabis market could equal $75 billion by the year 2030, up from just $17 billion in 2019.
And as Canada was the first North American country to fully legalize cannabis on a recreational basis in late 2018, it's home to the early leaders in the industry. In addition, some of the large Canadian pot producers have attracted some big-time investors and executives from the consumer packaged goods and spirits industries.
These include tobacco company Altria's (NYSE:MO) strategic investment in Cronos Group (NASDAQ:CRON) and spirits company Constellation Group's (NYSE:STZ) investment in Canopy Growth (NYSE:CGC). Additionally, big-time activist CPG investor Nelson Peltz has joined production leader Aurora Cannabis (NYSE:ACB)as its strategic adviser, and former Hain Celestial CEO David Simon is now CEO of Aphria (NYSE:APHA).
In addition to this vote of confidence from the legacy consumer packaged goods industry, Canada just unveiled "Cannabis 2.0," legalizing cannabis derivatives such as edibles and vapes last week, which could lead to more growth for the industry ahead.
However, before you hit that "buy" button on any of these Canadian pot companies, one chart from Health Canada, the Canadian government agency that covers the cannabis industry, should stop you dead in your tracks.
Inventory is exploding
As you can see below, Canadian producers have continued to crank out cannabis and cannabis-derived oils, only to see anticipated sales growth lag well behind this production surge. In addition, the backlog of cultivation and retail dispensary licenses at Health Canada has impeded the retail build-out for dispensaries, limiting access to legal cannabis in the country. The slow dispensary rollout, as well as high excise taxes, has likely spurred many to return to the black market, which is still present and often sells cheaper product.
This combination of a production surge and the delays in the cannabis infrastructure build-out has led to a huge surge in cannabis inventories:
From October 2018 through July 2019, inventory for dried cannabis have more than tripled, while monthly sales (the purple line) have only increased about 80%. As of July, the industry was sitting on about 30 months of inventory based on July sales figures.
The picture is also dire for cannabis oil, though not quite as drastic, with about 16 months of inventory:
This isn't good for several reasons. Oversupplying the market in the near term has led to plummeting prices for cannabis sales per gram, squeezing industry margins. In addition, accounting rule IAS 41 means that cannabis companies can record the value of their inventories as current gross income. This incentive to produce could have played a part in the current awful inventory situation.
For instance, due to Canopy Growth's huge surge in its inventory (some of which is recorded to profits), its gross margin is actually greater than its net revenue! However, that still didn't stop the company from racking up more than 123 million Canadian dollars in operating losses last quarter, even when factoring in these inventory-related profit gains.
However, if the price of cannabis falls further, it's possible that all of these companies may have to write down these past profits in the future, since that inventory could be sold at lower future prices.
In addition, these cannabis companies are already dealing with a lack of profitability, and some have suspect balance sheets. In particular, Aurora Cannabis, while being a best-in-class operator, still has to deal with a CA$230 million convertible bond due in March of 2020. As such, any potential logjam could depress sales and profits at the most inopportune time.
Finally, according to High Times magazine, dried cannabis plant can retain its potency for a while but then loses its luster at about six months to one year after production. Given that the industry is sitting on two and a half years' worth of inventory, it's possible some of the previously recorded profits could actually be written off to zero, exacerbating all of the above concerns.
The time isn't now
Though cannabis stocks have by and large plummeted over the summer, reflecting these concerns, it's probably best to steer clear of these names until the dust settles regarding Canada's infrastructure build-out and the inventory situation improves.
The cannabis bubble of the past year is in the process of bursting, but given the giant industry inventories and skyrocketing costs, it's way too soon to call a bottom. Cannabis 2.0 will need to bring a giant surge of demand for the industry to just get back to even.
Editor's note: This story has been corrected. Nelson Peltz is not on Aurora Cannabis' board.