At this time last year, marijuana stocks were practically unstoppable -- and for good reason. Just two weeks prior, on Oct. 17, 2018, Canada had officially become the first industrialized country to wave the green flag on recreational marijuana sales. Revenue and profit projections were lofty coming out of the gate, and with billions of dollars in annual sales being conducted in the black market, it only seemed logical that the legal market would scoop up this revenue with relative ease.
But absolutely nothing since Oct. 17, 2018 can be aptly described as "easy" for the Canadian cannabis industry.
Supply issues have been a nightmare for Canadian pot stocks
Over the past seven months, pot stocks have been absolutely blasted. Many of the largest names in the industry, but especially Canadian marijuana stocks, have lost at least half of their value, if not more. That's because Canada's supply issues have no immediate remedy.
To begin with, Health Canada, the regulatory agency tasked with overseeing the industry and reviewing/approving cultivation, processing, and sales licenses, has been unable to contend with a backlog of applications that surpassed 800 at the beginning of the year. While the agency's thoroughness can be commended, it's also ensuring that cultivators are waiting many months, if not longer than a year, for the approval to grow or sell cannabis. Even with changes implemented midyear to curb the number of cultivation applications the agency receives, Health Canada is unlikely to make a significant dent in its licensing application backlog anytime soon.
Another problem in Canada is that a number of provinces have been exceptionally slow to approve or review licenses for physical dispensaries. Though I've used the example often, Ontario is the most front-and-center case. Despite being a province of more than 14 million people, it has a meager 24 marijuana retail storefronts. If consumers don't have ample avenues to purchase cannabis, they're going to turn to the black market.
Even taxation has arguably played a role. Canada's 10% excise tax does seem reasonable relative to the tax rate being applied in select U.S. states on marijuana, but it still makes life difficult for legal producers to compete with the black market on price.
This latter point leads to what can arguably be described as the scariest statistic any marijuana investors will ever see.
The scariest marijuana statistic you'll ever come across
Just a few weeks ago, Statistics Canada released a compendium of third-quarter data from the cannabis industry. Contained within this data, which is reported in Canadian dollars (CA$), was the average per-gram price for pot. The average price for legal cannabis came in at CA$10.23 per gram ($7.82) in Q3, whereas black market marijuana was reported at CA$5.59 ($4.27).
This particular data point is terrifying for two reasons. First, there's a massive 45.4% pricing gap between legal and illicit marijuana, based on the reported per-gram statistics. This confirms what an insurmountable disadvantage legal channels are contending with in trying to drive out the black market. Though there has always been some hope of costs declining as economies of scale kick in, thereby allowing growers to become more cost-competitive with illicit producers, overcoming the widest per-gram pricing gap on measurement (to date) between legal weed and black market marijuana is going to be extremely difficult. Perhaps it's no surprise then, that earlier this year Scotiabank forecast 71% of all marijuana sales in Canada in 2019 would derive from the black market.
The other component that's worrisome here is the sequential quarterly decline in the per-gram price of legal pot, from CA$10.65 in the second quarter to CA$10.23 in Q3. This is the first drop in legal marijuana pricing since sales began in Oct. 2018.
While it's fully expected that legal weed pricing in Canada would decline over time, much in the way oversupply and commoditization have pushed prices lower in states like Oregon in the U.S., a drop in prices with supply heavily constrained by regulatory and procedural issues is a complete head-scratcher.
However, Quebec-based grower HEXO (NYSE:HEXO) did allude to weaker national pricing in its preliminary fourth-quarter update. Aside from blaming the slow rollout of physical dispensaries and delays to the launch of cannabis derivatives, HEXO blamed weaker per-gram pricing for a substantial shortfall in fourth-quarter sales, relative to its prior projections.
How will Canadian marijuana stocks bridge this gap between legal and black market weed?
The big question, of course, is: How do pot stocks contend with such a large gap in pricing between legal and illicit marijuana?
One possibility, which is the route HEXO has chosen to go, is to fight fire with fire. On Oct. 16, HEXO announced that it would launch a new line of value cannabis under the Original Stash brand name in its home province of Quebec. According to the company, it can sell one ounce of Original Stash for CA$125.70, or CA$4.49 a gram, which would actually undercut much of the black market. Though this value line could certainly drive volume and interest, there's the very real possibility that HEXO's margins will be whacked as a result of this move. In order for Original Stash to be effective, HEXO will need to transition these value buyers into its higher-margin derivatives, which is no guarantee.
Another means of combating this sales weakness is for pot growers to bide their time. Both The Green Organic Dutchman (OTC:TGODF) and HEXO have announced that capacity expansion and/or cultivation in existing facilities would be idled to meet current demand levels. The Green Organic Dutchman, the first pot stock to make this announcement, has the potential to be top-tier grower in Canada. But rather than race to its peak estimated annual output of 219,000 kilos, The Green Organic Dutchman has forecast only 20,000 kilos to 22,000 kilos of output in 2020, with a mere four grow rooms being operational at the company's flagship Valleyfield campus.
It also raises the question of what the country's two biggest producers -- Canopy Growth (NYSE:CGC) and Aurora Cannabis (NYSE:ACB) -- are going to do. Both Aurora and Canopy have peak production potential of more than 500,000 kilos a year, and despite their huge international presence, aren't able to export much of their product overseas until domestic demand is being met. And this won't happen until many of the regulatory and procedural supply problems are pushed by the wayside in Canada.
Right now, Canopy Growth has more than 5 million square feet of planned cultivation space licensed by Health Canada. What's not known is how much of this space is already producing. Meanwhile, Aurora Cannabis should see its Exeter greenhouse and flagship Aurora Sun projects completed and licensed in 2020. These grow farms will add 105,000 kilos and 230,000 kilos of respective annual run-rate.
But will any of these facilities even be needed over the next two years? As of now, my expectation is no, but we'll soon have that answer.