This Megamerger Might Be Required Before Canadian Cannabis Stocks Can Rebound

Global cannabis sales are projected to reach $176 billion by 2030. What's more, U.S. legal marijuana sales are expected to make up more than half of this total at nearly $100 billion per year by the end of the decade, according to the marijuana research firm Research and Markets. And if this upbeat forecast turns out to be correct, the legal marijuana industry will post a compound annual growth rate of roughly 24% from 2021 to 2030. Legal marijuana is thus on track to be the fastest-growing industry this decade.

Despite this blistering growth rate, publicly traded marijuana stocks have been a huge disappointment for shareholders over the past four years. Bureaucratic red tape, legal roadblocks in key markets including the U.S. and European Union, overly aggressive expansion plans by the industry's biggest names, never-ending capital raises at shareholders' expense, white-hot levels of competition from both legal and black-market growers alike, and an ongoing shift in consumer dynamics have all acted in concert to crush valuations across the space. 

Image source: Getty Images.

Legal marijuana's growing pains sparked widespread consolidation across the industry in 2021. Last year, Canadian cannabis titans Aphria and Tilray Brands (TLRY +6.68%) tied the knot, Canopy Growth (CGC +2.63%) struck multiple high-dollar deals to shore up its position in its domestic market of Canada and prepare for an eventual dive into the U.S. market upon federal permissibility, and scores of U.S. based multistate operators agreed to join forces in 2021.

Most industry insiders, however, agree that a lot more deals -- especially in the hotly contested Canadian market -- will be required to improve free cash flows, gross margins, and the overall investability of legal marijuana as a whole. Here is one hypothetical mega-deal that would go a long way toward improving market conditions in the Canadian cannabis market. 

The Canadian megamerger that ought to happen 

Even as Canadian licensed producers (LPs) have struck dozens of merger agreements over the past couple of years, the country's biggest names in terms of the scale of their commercial operations -- Aurora Cannabis (ACB +2.69%), Canopy, and Tilray -- have all failed to achieve profitability on a consistent basis, and most analysts expect these three companies to be cash flow negative on a full-year basis over the next fiscal period.

Keeping with this theme, Wall Street recently slashed the 12-month sales targets for Aurora, Canopy, and Tilray because of growing competition from top-notch craft producers such as OrganiGram, falling prices across every product category, and less-than-perfect internal controls. As a direct result, these Canadian cannabis behemoths have all seen their share prices crater of late:

ACB data by YCharts

What's key to understand is that these top Canadian LPs have long been banking on U.S. federal legalization to change their fortunes. However, the Biden administration hasn't shown any interest in this idea. While President Biden has signaled a willingness to consider increasing access to the plant for research purposes and enacting reforms on the criminal-penalty aspects of cannabis, full-scale legalization doesn't appear to be in the cards on his watch. In fact, the U.S. may not legalize marijuana at the federal level until the tail end of the decade, even as lawmakers on both sides of the aisle push for major cannabis reforms.

These top-tier Canadian LPs, in turn, would be wise to double down on their domestic and ex-U.S. international commercialization efforts through a megamerger. Such a move would bring upwards of $2 billion in U.S. sales under one roof by the next fiscal year, significantly lower white-market competition in Canada, and give the newly formed entity far greater pricing power in its domestic market.

The rationale for such a merger is further supported by the fact that Aurora, Canopy, and Tilray don't have the type of rock-solid fundamentals to mount a comeback in this moody market as standalone entities. The Canadian cannabis market simply isn't big enough to support all three of these companies in a comfortable manner, especially with a handful of craft competitors nipping at their heels and price compression across every product category becoming a serious headwind in the country. 

All that said, the probability of a megamerger appears to be on the low side. Tilray is attempting to rebrand itself as a global consumer-goods company in the eyes of investors, and Canopy seems committed to its U.S. expansion plans -- despite the lack of support for federal reform at the highest levels of government.