Marijuana became legal for recreational use in Canada in October 2018. That has allowed cannabis companies to offer more products to customers and significantly expand their operations. But investing in the sector post-legalization has left many investors with staggering losses. So what's wrong with the industry?
Below, in four charts, I'll provide an overview of where the Canadian pot market is today. And I'll also assess whether it's a good idea to invest in a top cannabis producer in the country.
Image source: Getty Images.
The industry has been growing rapidly, but so has the number of producers
From less than 150 licensed cultivators, processors, and sellers in the country as of the end of 2018 to more than 800 by the close of last year, there's been a huge influx of businesses getting into this hot growth sector. And it's easy to see why, as marijuana sales of CA$155 million in 2018 jumped to CA$1.2 billion the following year. And although the final numbers aren't yet in for 2021, it looks like they'll be in the neighborhood of CA$3.9 billion. The growth may continue to climb -- cannabis research company BDSA projects that by 2025, the Canadian pot market will be worth more than CA$6 billion.
Data sources: Statistics Canada, Health Canada. Table by author.
Businesses continue to struggle with profitability
Profitability in the sector can be difficult to achieve given that the industry is still in its early growth stages. It's difficult for companies to balance the pursuit of growth opportunities with keeping costs low. Tilray (TLRY) is among the best in this regard and in its most recent quarter, for the period ending Nov. 30, 2021, reported an adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) profit of $13.8 million on net revenue of $155 million, or 8.9% of revenue. Although that isn't terribly high, it's better than its peers reported in their most recent earnings results:
Data source: Company filings. Table by author.
A big part of the problem is that companies like Canopy Growth (CGC 0.89%), which had a negative gross margin, continue to incur write-downs and inventory adjustments that weigh down their numbers. And even after backing those numbers out in the adjusted EBITDA, that still isn't enough to post a profit. As shown in the first chart, there is growing competition in the sector and price compression is inevitable in the fight for market share, which, in turn, can devastate a company's hopes for staying out of the red.
Growing revenue is a challenge
After legalization, it was common for many of these cannabis producers to report triple-digit growth rates on a year-over-year basis. The reason is that in the prior-year results, the market wasn't fully open and that made it easy for marijuana producers to generate impressive numbers out of the gate.
Today, it's not nearly as simple. Although Tilray grew at nearly 20% in its most recent results, investors need to remember that it merged with Aphria last year and that acquisition has given its sales a boost. Canopy Growth and Aurora Cannabis have both struggled to keep their sales from falling.
Data source: Company filings. Table by author. YOY = year over year.
Cannabis producer OrganiGram (OGI 0.77%) is the exception on this chart, rising by more than 50% to CA$30.4 million for the period ending Nov. 30, 2021. However, that can be misleading as a year earlier, the company's sales declined on a year-over-year basis by 23%, from CA$25.2 million down to CA$19.3 million.
This volatility represents risk, so it's not surprising investors are taking a second look at the sector.
Investors have been adjusting what they are willing to pay for pot stocks
Since October 2018, pot stocks in the Horizons Marijuana Life Sciences ETF have crashed by close to 80%. During the same period, the S&P 500 rose by more than 50%. Given the lackluster results displayed above with troubling growth rates and low or unprofitable margins, it's understandable many investors to want to distance themselves from what's proving to be a very risky sector to invest in.
And one way they are adjusting their risk tolerance is by paying less of a premium in terms of revenue. Price-to-sales ratios in the sector have come down in recent years and even one-time industry figurehead Canopy Growth is no longer commanding a double-digit multiple:
TLRY PS Ratio data by YCharts
Should you consider investing in Canadian pot stocks today?
Although there are still growth opportunities ahead for cannabis producers in Canada, the top companies in the industry will have to continue to battle it out for market share with smaller businesses. And with marketing and advertising virtually non-existent (i.e., prohibited) in Canada's marijuana market, top companies like Tilray and Canopy Growth can't take advantage of their positions in the sector and simply ramp up advertisements.
That's why I wouldn't be surprised to see more struggles ahead for companies in this industry. And unless you're willing to buy and hold for several years, investing in the Canadian pot market may not be the best move you can make. There are better growth stocks to buy today that don't involve nearly as much risk. Even investing in U.S.-based pot stocks may be a better route to take.
