The legal pot industry in Canada hasn't done as well as many were expecting it to. Statistics Canada recently released the sales data for how the country's cannabis market performed in its first year, which showed revenue totaling 907.8 million Canadian dollars. That's a far cry from some estimates, which were projecting sales to be well over CA$1 billion.
There are three important reasons the numbers fell short of expectations.
1. Estimating the size of the market was always going to be difficult
In June 2018, consulting company Deloitte expected legal pot sales to reach CA$4.3 billion during 2019, and unless the Canadian cannabis legal market has exploded this past quarter, it's likely to fall well short of those expectations by year's end.
Estimating the size of an illicit market always involves a lot of assumptions, and projecting how much of that black market will turn to legal sources is another leap for analysts to make. They must rely on data collected from surveys and self-reports from cannabis users because illicit dealers don't pay taxes and the government doesn't have sales data on black market transactions. Without an objective and accurate source of data, making estimates requires extrapolations and assumptions that might not be reliable.
One research company, Brightfield Group, offered a more modest forecast for the Canadian market, with an expectation it would generate $1.2 billion in sales. But that estimate was over a period of 14 months and in U.S. dollars. The significant gap between Brightfield's estimatesand Deloitte's demonstrates how much variation there is in projecting the size of the Canadian cannabis market.
2. Retail rollout hasn't been ideal
A key reason the cannabis industry hasn't performed up to expectations in year one is that the retail market has been poor. The largest province in Canada, Ontario, didn't have retail pot shops in place until April of this year, well after legalization had occurred in October 2018. Even then, the province only allowed 25 pot shops to be set up, with applicants chosen through a lottery process. There was another lottery in August where regulators issued 50 more licenses. However, with more than 14.5 million people in the province, even if all 75 pot shops were up and running, that would only be one retail location for every 194,000 people.
Although Ontario led the way in legal cannabis sales for the year with CA$216.8 million, it wasn't far ahead of Alberta, which generated CA$195.7 million and has hundreds of pot shops open. But since Ontario is home to more than three times as many people, the gap should have been a lot bigger. The good news is that Ontario is ending the lottery system and, beginning in April, it will issue 20 new licenses every month.
Cannabis producer Aurora Cannabis (NASDAQ:ACB), for example, has been critical of the retail model and has blamed the poor retail rollout for its disappointing results. In September, the company released its year-end earnings, which showed a total net loss for the year of CA$298 million -- nowhere near profitability. Aurora previously expected to be profitable on an EBITDA basis by Q4 of fiscal 2019 but now believes it will achieve that goal in fiscal 2020.
When asked about the delay, Aurora Chairman Michael Singer was critical of one thing in particular: "We assumed there would be a more aggressive roll-out of retail outlets and if that was the case, we would have no problem reaching that milestone."
With a stronger retail model potentially ahead in 2020, Aurora and its peers could see much stronger results next year. Falling short of expectations is a key reason the marijuana stock has struggled so much this year, declining 57% year to date. That's far worse than the performance of the Horizons Marijuana Life Sciences ETF, which is down 39% over the same period.
3. The black market is still very competitive
Another key reason the cannabis industry has fared so poorly in year one is the strength of demand for black market products. The data from Statistics Canada suggests that as much as 80% of cannabis sales are coming from the black market. That's in stark contrast to what Deloitte expected, projecting that the majority of sales would be in the legal market.
However, that shouldn't come as a surprise given the lack of retail shops and the advantage of black market dealers not collecting taxes. Data from Q3 shows that legal pot costs on average CA$10.23 per gram, whereas marijuana purchased from nonlegal sources is nearly half that, with an average price of CA$5.59.
Key takeaways for investors
The growing pains for the Canadian cannabis industry are still present. But with more retail stores soon to open and more types of cannabis products ready to hit store shelves any day now, there's no reason the industry shouldn't perform better in 2020. As companies sell more products and benefit from greater economies of scale, many cannabis stocks could be closer to breaking even next year, which will send their stocks back up. Cannabis investors have good reason to be optimistic about what the new year will bring.