It has now been three full years since Canada legalized the recreational marijuana market on Oct. 17, 2018. In the early stages, marijuana producers in the country were generating strong growth numbers due to the new segment of the market opening up (previously, only medical marijuana had been legal). But fast forward to today, and top companies like Hexo (HEXO +0.00%) have been struggling to produce consistent quarter-over-quarter growth.
A big reason: The role of the craft cannabis producer. Smaller companies focused on quality have been able to prevent these larger producers from dominating the industry. They've become thorns in the sides of the bigger players who may not be taking the threat seriously enough.
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Multiple companies acknowledge smaller producers, but aren't worried about them -- yet
When cannabis producer Hexo reported its third-quarter earnings (for the period ending April 30) in June, its revenue of 22.7 million Canadian dollars was down 31% from the second quarter, in which sales were CA$32.9 million. CEO Sebastien St. Louis said that some new cannabis strains were lower in quality than the company expected, and that created an opportunity for smaller producers to steal market share, noting that "craft has absolutely surprised us." However, he believes that the company can produce better products on a more consistent basis than craft growers.
Hexo isn't the only company that has faced challenges due to craft. The largest cannabis company in Canada, Tilray (TLRY 1.56%), reported its latest results in October. While its sales grew 43% year over year to $168 million for the period ending Aug. 31, which is largely due to the merger with marijuana producer Aphria that closed in May with its results now included in Tilray's overall tally, it too faced challenges from smaller producers that CEO Irwin Simon referred to dismissively as "ankle biters." Tilray's goal is to reach a market share of 30% in the Canadian marijuana market, but analysts today estimate that percentage is closer to 12%.
Dismissing the threat could prove to be costly
Canadian marijuana stocks have been struggling since legalization, largely due to the underwhelming results that producers have been generating since then:
As of the three-year mark, there are 776 marijuana producers in the country, and oversupply continues to be a problem in the industry. And if companies such as Hexo and Tilray don't take the threat seriously, it could lead to more underwhelming results in the future.
What should investors do?
The role of craft producers isn't proving to be a worry for large multi-state operators in the U.S. because those companies are still in their early growth stages. In Canada, however, the market is well past that point. The market isn't brand new, and terrific sales growth is no longer a guarante; there's loads of competition and companies have to fight for market share. Craft may play a significant role in the U.S. market as well, but for now the growth opportunities there remain plentiful as more states open up for business.
One way investors can look to minimize their risks in the sector is by avoiding companies like Tilray that have ultra-aggressive growth targets (aiming to hit $4 billion in revenue by 2024) and where quality may not be the highest priority -- and given the CEO's comments calling the competition "ankle biters," that only creates more concern that craft isn't being taken seriously.
There's still considerable risk in the sector. But the safer bet for now is for cannabis investors to focus on marijuana companies that are generating profits and that are at least reporting decent margins on their products, which suggests that there is a focus on quality there (as opposed to low-quality products that would be cheaper in price).
