The cannabis industry in Canada is hurting, and the danger is that things could get even worse. Investors have been bearish on the industry as companies have been shedding jobs, making leadership changes, and, of course, posting disappointing financial results. And there's little hope that things will improve anytime soon.
There are three reasons why investors shouldn't be too optimistic about the Canadian cannabis industry in 2020.
1. The black market will keep dominating
There's a lot of growth still left in the Canadian market as a slow retail rollout and supply issues plagued the country's first year of legal pot. The problem is that the red tape in the industry is still making black-market products more attractive, and the gap in prices is getting wider. With many restrictions surrounding advertising and how big edible packages can be, it's probably easier for consumers to find the products they want from illicit sources. And given the price discrepancy, there's even less of an incentive to buy from legal sources.
Statistics Canada released an update in January on the average price of marijuana; the findings showed that the gap was widening between legal and illegal pot. From under 10 Canadian dollars per gram last year, the average price for legal pot is now well over that mark at CA$10.30 per gram. Meanwhile, the average black-market price for pot has been falling during that time, from CA$6.44 to just CA$5.73. It's unlikely that cannabis customers are going to pay nearly double for pot in the legal market. Until prices start coming down, the industry is going to remain at a big disadvantage.
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The disappointing outlook for the Canadian industry is nothing new, and last year, research company BDS Analytics downgraded its forecast for the market. Originally expecting it to be worth $5.9 billion by 2022, BDS' revised forecast now calls for the market to reach $5.2 billion by 2024. However, if prices come down and competition ramps up, that could change things in a hurry. But at this point, given the challenges many cannabis companies are facing, they aren't going to be in a rush to lower their prices.
2. Lower prices could do more harm than good
A lack of profitability is perhaps the biggest problem in the industry today; if the average price for legal pot were to come down in Canada, that wouldn't be good news for Canadian producers as that would shrink their margins. Aurora Cannabis (ACB -6.81%) released its second-quarter results on Feb. 13, and even before the massive writedowns that it incurred during the quarter, the company's operating loss was still CA$119.6 million, just under a 50% increase from the prior-year quarter.
The company's margins before fair value adjustments of 41% are decent, but a decline in price will bring those numbers down and make it even more difficult for Aurora to improve and get closer to breakeven. It's a similar situation for other Canadian pot stocks -- lower prices may only compound their problems rather than improve their situations.
3. Stocks remain very expensive compared to their U.S. counterparts
Although marijuana stocks are falling heavily, the ones operating in Canada are still fairly expensive. Aurora, for instance, trades at more than seven times its sales over the past 12 months, while investors are paying more than eight times sales for HEXO. In contrast, Trulieve Cannabis is trading at a much more modest 5.4 times its sales. Curaleaf Holdings, when factoring in its proforma revenue numbers, could reach more than $500 million in annual sales, putting its valuation at a price-to-sales multiple about the same as Trulieve's. Both stocks look to be cheaper buys, and that's even with Aurora and HEXO incurring much more significant losses over the past year:
What should investors do?
Given the headwinds that are still facing the industry in Canada, now may not be the best time to invest in Canadian pot stocks, even with their relatively low prices. While there's still risk involving U.S. pot stocks, they look like much more stable buys today. As legalization progresses in the U.S., they could become even more attractive investments over the long term.
