One year ago, there weren't many investments hotter than cannabis. Our neighbor to the north, Canada, had just launched recreationally legal weed sales two weeks prior (Oct. 17, 2018), and Wall Street's sales estimates for North American cannabis were steadily rising.
But oh, how times have changed.
Despite regulations for Cannabis 2.0 that went into effect two weeks ago, on Oct. 17, Canadian pot stocks have been pummeled for seven consecutive months. However, the bigger issue is that supply constraints in Canada are beginning to be felt at the individual company level.
Supply and pricing issues take precedence in Canada's cannabis market
With Canadian cannabis sales creeping higher at a time when they should be soaring, pretty much all major marijuana stocks have been citing a combination of regulatory and procedural issues for their poor performance.
For example, Health Canada, the agency tasked with overseeing the Canadian pot industry, including the approval of cultivation and sales licenses, has been buried under licensing applications since the beginning of the year. Even with the agency implementing a new process that requires growers to complete their cultivation facilities prior to applying for a growing license, it's going to take numerous quarters, if not well over a year, for Health Canada to work through a backlog of license applications that topped 800 at the beginning of the year. This is one factor that's keeping supply off the market.
Another Canadian-specific problem is that select provinces have been slow to approve and/or review physical dispensary licenses. In Ontario, for instance, a province with a population of 14.5 million people, there are a mere 24 open retail locations to buy cannabis. That's roughly one store for every 604,200 people, which compares to Oregon, a recreationally legal state that currently has one open dispensary for every approximately 5,600 people in the state. Without legal sales channels to purchase product, consumers have been coerced to turn to black market suppliers.
Even though Canada offers a reasonably low excise tax on its legal pot products, this can also be an impediment to legal-channel sales. You see, the black market doesn't have to wait for licensing approval to grow or sell marijuana, and they can easily undercut legally grown weed. In fact, Statistics Canada recently reported that the average per-gram price for legal and illicit marijuana widened to $10.23 Canadian and CA$5.59, respectively, during the third quarter. Legal growers simply can't compete on price, and supply issues are only compounding this problem.
It's official: Production is being idled in Canada
The big question among investors has been whether these supply issues would persist long enough to alter the expansion strategies of cannabis stocks. Based on the responses of a handful of pot stocks over the past two weeks, we now have our answer -- a definitive yes.
On Oct. 18, The Green Organic Dutchman (OTC:TGODF) became what might be the first marijuana stock to bite the bullet and update its production plans to meet market demand. In an effort to reach positive operating cash flow by the second quarter of 2020, Green Organic Dutchman has halted aggressive capacity expansion plans at its flagship Valleyfield property for the time being. Rather, the company will focus on achieving 12,000 kilos of annual output from its Ancaster cultivation farm, as well as up to 10,000 kilos of output from four grow rooms at Valleyfield. In other words, Green Organic Dutchman, a potential top-five producer with 219,000 kilos of peak annual output, appears on track to produce only 20,000 kilos to 22,000 kilos of cannabis in 2020. Said CEO Brian Athaide:
"These actions are logical next steps in TGOD's road to profitability. While we are committed to – and our strategy continues to leverage – our unparalleled scale as an organic producer as well as our international assets, we have identified areas where our scale would not provide for meaningful returns in the near term given the slower pace of legal market conversion. We will optimize our operating efficiency by deferring excess capacity and expenses, whether they center on production facilities, international expansion projects or technology."
Until this week, TGOD was by itself in making this output-reduction move. But that's no longer the case. On Tuesday, Oct. 29, Quebec-based HEXO (NYSE:HEXO) delivered its much-anticipated fourth-quarter operating results. As a reminder, HEXO had already thrown itself on the sword earlier this month by admitting that its forecast 100% sequential sales growth in the fourth quarter would be more like 19%, at the midpoint.
In HEXO's fourth-quarter report, it confirms that it's cutting 200 jobs across all department and positions throughout the company to align with a weaker demand environment, and would also be suspending cultivation activity at the Niagara facility and in 200,000 square feet of its flagship Gatineau grow farm. With the acquisition of Newstrike Brands, HEXO was to be producing as much as 150,000 kilos on an annual basis. HEXO's new run rate is approximately 80,000 kilos a year, according to its press release.
It's also worth noting that embattled grower CannTrust Holdings (NYSE:CTST) isn't propagating any additional plants at the moment, albeit this wasn't the company's decision. Back in July, CannTrust announced that it had been growing marijuana illegally in five unlicensed rooms for a period of six months. Health Canada wound up officially suspending CannTrust's cultivation and sales licenses in September, which could remove anywhere from 100,000 kilos to 300,000 kilos of peak annual output from the market (at least until the company regains its licenses, which isn't expected until the first quarter of 2020, at the earliest).
To summarize, that's anywhere from 469,000 to 669,000 kilos of annual peak production that's been whittled down to around 100,000 kilos of output, for the time being. This is the state, and the seriousness, of the supply issues in Canada, and it demonstrates that things aren't going to be fixed anytime soon. While pot stocks do have the tools to thrive over the long run, it could be a bumpy ride getting to that point.