Following an abysmal fourth quarter, pot stocks are once again on fire to begin 2019. In January, 15 of about four dozen marijuana stocks shot higher by at least 50%, and the most widely followed cannabis exchange-traded fund, the Horizons Marijuana Life Sciences ETF, was up again (albeit by a lesser amount than January) in February.
It's not hard to understand why investors are so enamored with the cannabis industry. Late last year, Canada became the first industrialized country worldwide to legalize recreational weed, a handful of U.S. states gave the green light to pot during midterms in the U.S., and President Trump signed the Farm Bill into law. Even though the U.S. would easily be the largest marijuana market in the world if it were federally legal, it's Canada that continues to captivate investors.
But what you might find surprising is just how much legal marijuana Canadians purchased in 2018 following the Oct. 17, 2018 adult-use legalization date.
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The surprising amount of legal cannabis Canadians bought in 2018
Last week, Statistics Canada, a compendium of statistics on Canada's economy, society, and environment, released sales data from the month of December for a number of categories, including a somewhat brand-new category: "Cannabis stores." Since the weed industry is highly regulated, the sale data released by Statistics Canada is considered "excellent," meaning it's viewed as highly accurate. Here's how the sales data shook out for the months of October (beginning on Oct. 17) through December in 2018:
- October: 43.1 million Canadian dollars ($32.7 million)
- November: CA$53.2 million ($40.4 million)
- December: CA$55.2 million ($41.9 million)
Despite recreational marijuana sales shooting out of the gate in a two-week span in October, retail sales appear to have cooled off dramatically with December's sales total increasing by less than 4% on a sequential monthly basis. In aggregate, the Canadian pot industry logged CA$151.5 million ($115 million U.S.) in recreational weed sales in 2018 and, based on December's sales, are running at an extrapolated annual rate of CA$662.4 million ($502.9 million), which is well off the multibillion-dollar sales estimates that analysts have tossed around.
How is it that an industry with an incredible amount of public and investment support has flopped so badly in its first 2 1/2 months of sales? Let's take a closer look.
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Here's why Canadian pot sales have disappointed in the early going
The big problem for Canada thus far is that it's contending with a supply issue. For starters, it's going to take up to two or three more years for growers to get their capacity up to full production. Aurora Cannabis (ACB 0.58%), the nation's leading producer, noted during its recently released second-quarter operating results that it was producing at an annual run rate of 120,000 kilograms a year, as of February. This was more than double its previous production rate on an annual basis that was reported in September.
Then again, Aurora Cannabis is still nowhere near what I believe to be its peak potential of 700,000 kilos a year. It's still in the process of building out its huge Aurora Sun facility, and has taken over previously announced greenhouse expansions for MedReleaf and ICC Labs, which were acquired last year. It might take until 2021 or 2022 until Aurora Cannabis' true output potential is realized. With most growers experiencing the same ramp-up timeline, there's simply not enough supply on the market to meet demand.
But it's not just a grower-based supply issue -- Health Canada has created problems of its own. Regulatory agency Health Canada, which is responsible for overseeing the issuance of cultivation, processing, and distribution licenses, as well as sales permits for the pot industry, has a monstrous application backlog.
Back in May 2018, Marijuana Business Daily noted that more than 500 cultivation sales applications were waiting for approval or rejection, with most of these applications taking months or potentially years to receive an answer from Health Canada. Likewise, sales-permit applications were taking an average of 341 days to gain approval in May 2018. Even the most prominent growers are waiting a year or longer to complete the cultivation, sales, and permitting process from start to finish. It's unclear when this regulatory red tape will clear out.
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To build on this point, packaging and processing has also been an issue. Reports suggest that unprocessed cannabis flower supply is sufficient at the moment, but a lack of processing licenses, coupled with insufficient compliant packaging, has limited the amount of legal product making its way to licensed Canadian dispensaries.
And lastly, it's a provincial issue. In Ontario, for example, Canadians only have the option of purchasing legal weed through the province's online cannabis store. Even though brick-and-mortar retail dispensaries are in the works -- 25 retail licenses are expected to be issued by April -- physical locations aren't yet an option. Sales could be constrained until local dispensaries pop up in highly populated areas of Ontario.
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It's time to rein in those expectations
As much as investors want to view Canada as a cannabis success story, they also have to realize that building a legal pot industry from the ground up will come with hiccups. Between regulatory red tape and the natural progression of capacity expansion for growers, it might be time to rein in your sales expectations for much of the industry.
For example, long before Canopy Growth (CGC 1.77%) reported its fiscal third-quarter operating results in recent weeks, what few analysts had been covering the company were busy reducing their sales estimates in the near and intermediate term. Whereas some analysts had previously been calling for as much as CA$140 million in Q3 2019 sales, Canopy Growth wound up reporting closer to CA$83 million in net sales, inclusive of excise taxes. If even the most well-known name in the industry, Canopy Growth, and its highly popular Tweed brand are struggling to hit lofty sales expectations in the early going, it's very likely going to be a problem for the entire Canadian cannabis industry.
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Don't think for a moment that investing in U.S. pot stocks is a cure-all. The state of California, which is the fifth-largest economy in the world by gross domestic product, has also badly missed the mark on cannabis sales. Initially projected for around $643 million in full-year tax revenue, California brought in closer to half this amount in its first year of recreational weed sales. Regulatory issues and rampant dried flower oversupply have plagued the industry in the early going.
To be clear, the legal weed industry does have the tools to thrive in North America over the long run. But expecting marijuana sales to go parabolic without any early-stage problems isn't going to happen.
