With more than two-thirds of Americans supporting marijuana legalization, it feels like it's only a matter of time before pot is federally legalized in the U.S. When that happens and cannabis can freely cross state lines, significant growth opportunities for the industry and the companies operating within it will appear.
But that doesn't mean legalization will be a smooth ride for everyone, or that it will simply translate into more revenue for the already-large cannabis producers in the country. There will definitely be growth, no doubt, but Aurora Cannabis (NYSE:ACB) CEO Miguel Martin recently cautioned investors that there could be significant challenges that come with legalization.
The pot market could look a lot like Canada's
Canopy Growth (NASDAQ:CGC) CEO David Klein expects his company to be operating in the U.S. within the next 12 months. That suggests some significant marijuana reform would need to take place (likely full legalization) before then. However, Aurora's CEO doesn't appear to be as optimistic, believing that legalization could take longer than what people believe -- although he didn't make a specific prediction as to when it might happen.
And when the U.S. decides to legalize marijuana, Martin said in a recent interview that he thinks regulators will look to the Canadian model and use a similar approach, stating that, "I just think that people are a little bit naive if they don't think it's going to look a lot like Canada and a lot less like the Wild West when it comes to federal regulation of cannabis."
While borrowing ideas from the Canadian market would help U.S. regulators navigate legalization and perhaps speed up the process, it could pose challenges for the industry. In the Canadian cannabis industry, one of the major issues is that there are many warning labels on products and minimal space for a company to even feature its name or logo. That makes branding almost impossible, and it also doesn't help that advertising is virtually non-existent.
Another onerous restriction on cannabis producers in Ontario, specifically, is that they are not able to possess a retail license. The maximum ownership they can have in a company that has a retail license is 25% -- and that's after the provincial government increased the percentage from 9.9%. This prevents licensed producers from having too much power and prioritizing their own products in stores.
And for the products that get onto store shelves, companies also have to be careful with how they are named. Cannabis-infused beverages, for instance, aren't able to use 'beer' or 'wine' in their names nor can the products even be associated with an alcoholic beverage. This eliminates any advantage Canopy Growth may have enjoyed by partnering with Constellation Brands and potentially piggybacking off the popularity of its popular Corona and Modelo brands. Not only are cannabis products in Canada dull-looking, but big producers like Canopy Growth can't take advantage of some of the popular brands they're aligned with, making it difficult to differentiate from competing products.
Why a legal market could be bad news for large multistate operators
The biggest problem that a highly regulated market might bring for multistate operators is that it could make growth more difficult. Last year, the Brightfield Group released results from a poll of 3,000 Canadians and it found that more than 40% of respondents were aware of Tweed (a brand that Canopy Growth owns) and approximately one-third knew of Aurora. However, outside of those big names, there wasn't a whole lot of familiarity. For 17 brands, the level of awareness was below 20%. That includes a relatively big name in the industry like Tilray. Just 9% of consumers were aware of its brand.
This is good news for small cannabis companies looking to grab market share, since it means a strong established brand isn't guaranteed to dominate the industry. But for large multistate operators like Curaleaf (OTC:CURLF) or Trulieve Cannabis (OTC:TCNNF), legalization under that scenario could inhibit their growth. Large Canadian cannabis companies are struggling to generate much revenue growth even though it has only been a little over two years since the country legalized marijuana in October 2018. In its most recent fiscal year, Aurora's net sales of 278.9 million Canadian dollars for the period ending June 30, 2020, were just 13.6% higher than they were in the previous year. That pales in comparison with U.S. multistate operator Curaleaf, which generated $396.4 million in revenue over a shorter nine-month period ending Sept. 30, 2020, which was a year-over-year increase of 172.3%. The company operates more than 90 dispensaries across 23 states and has 22 cultivation sites and 30 processing locations. It sells consumers a variety of products, ranging from vapes and flower to mints and edibles.
However, this doesn't mean that Curaleaf's growth will suddenly dwindle down to less than 20% post-legalization. After all, the U.S. pot market is much larger than Canada's; cannabis research company BDSA projected last year that it could be worth $34.5 billion in 2025, while the Canadian market will be worth just $6.5 billion by then. But there's no doubt that a tough approach to regulation could negatively impact consumer recognition of even the biggest brands.
What does this mean for investors?
There's no reason for investors to worry right this second. There are still many question marks surrounding legalization and what it may look like when it arrives. But for an industry that can sometimes be overly bullish on the future, it wouldn't be a bad thing for investors to scale back their expectations a bit as legalization often means more rules and red tape. That's why Martin's conservative outlook for the industry appears to be much more realistic than Klein's.
Investors need to be careful in considering the price they pay for a pot stock today and avoid justifying a high premium by simply rationalizing that there will be more growth down the road. Although the industry is still in its early growth stages, that doesn't mean top brands will dominate, especially amid more stringent regulation. And for many stocks, that future growth is already priced into their current share prices.