Is It Time To Sound The Alarm On Canadian Marijuana Stocks

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This could turn out to be a record-breaking year for the marijuana industry, and it has nothing to do with overall sales. Instead, I’m talking about the very strong likelihood that Canada will pass, and sign into law, bill C-45, which is more commonly known as the Cannabis Act.

The Cannabis Act seeks to legalize recreational marijuana throughout Canada, making it legal for adults over the age of 18 to purchase pot and pay an excise tax, just as adults do in Canada when buying liquor. If passed, Canada would become only the second country in the world to have legalized adult-use marijuana, and would be the first developed country to have done so.

Again, the chance of passage appears very high. Conservatives who have an unfavorable view of cannabis are handily outnumbered in parliament, and the Canadian federal government has worked out a two-year tax-sharing agreement with all but one province (Manitoba). In fact, the excise tax rate on recreational marijuana will be significantly lower than that of alcohol, making it relatively price-competitive with the black market. If the industry is to be successful, it’ll need to drive consumers out of the black market and into legal sales channels.

Legalization is also expected to have marijuana stock investors seeing big green dollar signs. Though estimates are absolutely all over the place, green-lighting the sale of recreational marijuana should open the door to $5 billion or more in added annual sales over what the industry is currently generating via medical cannabis sales and exporting to medically legal countries. These are figures that investors and Canadian growers can definitely get behind.

Canadian marijuana growers ramp up production

Given that there is no precedent to a developed country legalizing adult-use marijuana, Canadian growers are using every bit of capital on their balance sheets to expand their growing capacity. The thinking here is that the growers with the most production to offer when the proverbial green flag waves should be able to lock in long-term supply agreements, as well as build brand engagement with consumers. Thus, the rush to expand.

Though production estimates have been exceptionally fluid as a result of partnerships, acquisitions, and organic growth announcements, there are six publicly traded growers expected to (eventually) yield in excess of 100,000 kilograms of dried cannabis a year. These growers are:

Canopy Growth Corp.: 300,000 kilograms (my estimate)

Aurora Cannabis: 283,000 kilograms

Aphria: 230,000 kilograms

MedReleaf: 140,000 kilograms

OrganiGram Holdings: 113,000 kilograms

Hydropothecary Corporation: 108,000 kilograms

By perhaps 2021, these six growers could be completely ramped up and producing more than 1.17 million kilograms annually.

But there’s another side to this story: demand.

Is it time to be genuinely worried about Canadian pot stocks?

Even though demand for legalized cannabis should be incredibly high, and Canadian growers will have the opportunity to export marijuana to foreign countries that’ve legalized medicinal marijuana, there are no guarantees that supply and demand will be in harmony. That’s worrisome, and it’s an alarm that yet another analyst sounded recently.

Jason Zandberg of PI Financial expects there to be an oversupply of marijuana in Canada within three to five years. In a Feb. 15 note, according to Reuters, Zandberg suggested that Canadian demand could reach 900,000 kilograms a year by 2023. Comparatively, he estimated that supply would be around 1.5 million kilograms in 2023, representing roughly 600,000 kilograms of oversupply.

There are additional concerns that margins for publicly traded marijuana stocks may not be as robust as expected. Aside from oversupply concerns, regulations from Health Canada and select provinces could weigh on the ability of pot stocks to be profitable. Health Canada announced strict packaging and labeling requirements that’ll de-emphasize brand names and logos on packaging, making it tougher for growers to create an attachment with consumers. Furthermore, Quebec and Ontario have planned to allow only a limited number of government-controlled dispensaries that’ll sell just cannabis flowers and cannabis oil.

These oversupply and top-line sale concerns may be what’s behind Wall Street’s falling full-year EPS estimates for marijuana stocks in 2019.

The sideline is looking mighty attractive these days for investors

Making matters worse, quite a few growers are so busy reinvesting every bit of operating cash flow back into capacity expansion that it could be quite some time before they’re profitable.

Canopy Growth, the largest marijuana stock by market cap, and likely the largest annual producer of cannabis in Canada, may not be profitable on a recurring basis as a result of high expansion costs until 2020. Now, investors let a company like Amazon.com get away with an exceptionally high price-to-earnings ratio because it’s building success in so many industries these days, including those that offer potentially higher margins than its e-commerce site. Canopy Growth really doesn’t offer diverse channels of revenue (at least not yet). This makes Canopy, and practically all of its peers, frothy from a fundamental perspective.

Given the staggered nature of expansion projects, it may also take a good two or three years before investors get any sort of bead on whether or not supply and demand will be in balance. While Aurora Cannabis could have most of its projects complete by the end of this year, a company like OrganiGram Holdings isn’t expected to finish the expansion of its Moncton, New Brunswick, facility until April 2020. We’re only going to get bits and pieces of the puzzle each year, rather than the whole picture all at once.

Despite the excitement surrounding legal cannabis in Canada, the sideline is looking like an ever-more-attractive place for investors to be.

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