The U.S. pot market remains illegal at the federal level, despite dozens of states passing legislation to permit it for either medical or recreational use. Full legalization could still be years away. And while there may be lots of excitement about that and removing many barriers for cannabis producers, that doesn't mean it will be a smooth ride for investors and businesses.

Canada legalized marijuana more than three years ago on Oct. 17, 2018, and companies there still struggle with profitability. Legalization has created many challenges for businesses, and one cannabis executive believes the U.S. will repeat many of the same mistakes Canada has made. That could be a big problem for cannabis investors.

A farmer holding a tablet in a hemp field.

Image source: Getty Images.

'Challenging and dysfunctional'

Those are the words Sundial Growers (NASDAQ:SNDL) CEO Zachary George used to describe the Canadian pot market at the Benzinga Cannabis Capital Conference last month. Among the reasons he describes it as such is that regulations aren't consistent from one province to another. And excise taxes can significantly chip away at a company's top line; over the first six months of this year, excise taxes of 5.4 million Canadian dollars have eroded away more than 22% of Sundial's top line.

In an industry where margins aren't strong to begin with since prices need to be competitive, that can make it even more difficult for a business to stay out of the red. Over the past two quarters, Sundial has incurred a net loss of CA$186.7 million -- deeper than the CA$104.4 million loss it incurred a year ago. Although excise taxes alone can't be blamed on the poor bottom line, Sundial and other producers are operating in a challenging industry where competition is fierce due to regulators simply allowing too many producers.

According to an analysis from MJBizDaily, the cannabis site estimates that since legalization in 2018, not even one-fifth of the cannabis produced in Canada has made it into retail stores. Given the significant competition, products are just not moving as quickly as they otherwise would. The country went from having too few producers at the start of legalization to now dealing with issues relating to oversupply. 

Heavy marketing and advertising restrictions (e.g., there isn't much of it anywhere) mean that top growers such as Aurora Cannabis and Canopy Growth can't use their market position or resources to their advantage. This makes it easier for craft growers to grab market share since brand awareness and recognition of popular brands will likely be low among casual consumers. Although Tilray's CEO Irwin Simon was dismissive of craft, referring to them as "ankle biters," they pose a serious challenge to the industry's top companies and their ability to generate revenue growth.

Canopy Growth released its latest earnings numbers earlier this month, and its net revenue of CA$131.4 million for the period ending Sept. 30 was down 3% year over year. Meanwhile, it still incurred a staggering adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) loss of CA$162.6 million.

What does this mean for U.S. cannabis companies?

Federal legalization of marijuana will solve many problems for multi-state operators. Not only will their products be able to cross state lines (in states that permit the products), but it will also be easier for companies to access banking services and raise money without having to dip into the equity markets. 

But if Sundial's CEO is correct that the U.S. will repeat the same mistakes as Canada when it legalizes marijuana, top cannabis companies such as Trulieve Cannabis and Curaleaf Holdings may find it difficult to grow their sales. With more competition and restrictions on marketing, their market share could fall and so too could prices, making margins worse and profitability more difficult to achieve.

For investors, all this serves as an important reminder to temper expectations about legalization and what it will mean for the sector. While it will create more opportunities, they won't come without challenges along the way. And that's why it's important to consider cannabis companies that are reporting strong bottom lines today, because it may be difficult to do so in the future.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.