The Surprising Culprits Behind the Potential Downfall of Marijuana Stocks

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The Canadian cannabis industry has been operating under the assumption that, if its major growers can crank up the volume of production, the country’s demand for recreational marijuana will follow. This is, of course, an inherently risky move, and the biggest threat that could stand in the way of the industry getting its happy ending may be surprising to investors.

For those interested in investing in cannabis, the surprising threat to the success of Canada’s highly-anticipated recreational market may be marijuana itself. 

The black market is one of the major threats to the success of Canadian growers. Investors need only look at California’s example to gauge the serious nature of this threat. The legal recreational marijuana market opened on January 1 in California, with high expectations for weed sales; the reality, however, has been underwhelming thus far.

And the issue is far from trivial, with California projecting $185 million in revenue in the first six months of the year, owing to taxes on legal weed. January through March this year, however, California has only brought in $33.6 million from taxes collected from legal weed sales.

Weed availability on the black market is the culprit. Marijuana businesses that have gone through the state to obtain licenses for their recreational sales are pointing their fingers at the amount of weed available on the illegal market in California. Sellers on the black market bypass taxes altogether, allowing them to offer lower prices to consumers, to the detriment of legally licensed businesses and the state.

Canadian marijuana stocks are concerned that, with the country’s existing black market for cannabis already substantial, they will experience the same problem as California. 

Statistics for last year’s marijuana sales in Canada highlight the legitimate concern. Of the total number of Canadian dollars spent last year on marijuana, $4.6 billion went toward marijuana that was not for medical use. In other words, these dollars were spent on the black market, since medical marijuana is the only legal market currently in Canada.

And the black market won’t just disappear once recreational marijuana is legal in Canada. The country’s largest growers, at the very least, can expect competition on some level from black market sellers of cannabis. And like California, customers will probably have similar access to lower prices from these illegal competitors.

The availability of marijuana on the black market, however, is not the only threat to Canadian cannabis stocks; the threat of oversupply remains a serious possibility, without even factoring in illegal supplies of marijuana.  

The combined production capacity of the country’s three major growers, alone, Canopy Growth (NYSE:CGC), Aurora Cannabis (NASDAQOTH:ACBFF), and Aphria (NASDAQOTH:APHQF), is somewhere around 1.3 million kilograms per year. Adding the capacity from Aurora’s recent acquisition of MedReleaf (NASDAQOTH:MEDFF), and this figure is significantly higher. 

The problem arises when one looks at estimations for Canada’s recreational demand, which may fall between 600,000 and 900,000 annual kilograms. Clearly, even at the highest end of projected demand, the supply provided by even these three big growers will far surpass demand.

It doesn’t take an expert in economics to see the problem: any time supply exceeds demand, prices drop. A drop in prices means falling revenue for cannabis growers. And the compounded effect of oversupply and availability of cheaper marijuana from illegal sellers may inflict a harder blow on marijuana stocks.

While marijuana may be the biggest threat Canadian cannabis stocks encounter, it’s equally important for those investing in cannabis to maintain a larger perspective.

One of Canada’s plans involves imposing an excise tax that would cover a minimum of 10% of the price of recreational marijuana products. Provinces also plan on adding 5-15% sales taxes to recreational product prices. As a result, consumers may be paying a total of 25% in taxes for the purchase price.

California, on the other hand, imposes an excise tax of 15% on sales of recreational cannabis, with sales taxes in some of the state’s counties up to 9.2%. On top of this, many Californian cities impose their own rates of sales tax, which altogether, means in some areas up to 45% of the product’s cost is taxes. This is higher than what Canada has planned for marijuana product taxation.

Investors need to keep in mind the other legal recreational market that serves as a case study: Colorado. Here, recreational marijuana has been legal since 2014. Even with its own black market, Colorado has seen a steady increase in marijuana sales in the past few years; just last year, sales reached $1.5 billion. This is hopeful news for Canadian marijuana growers and investors, for if Canada’s recreational market follows a similar trend as Colorado’s, the threat should be minimal to the major growers.

As for the threat of oversupply in Canada, one Motley Fool analyst believes the likelihood leans more toward supply shortage, at least in the initial stages following legalization. The capacity statistics that are tossed around by many of the leading growers are projections of future capacities, as in, a year or more from now. The reality of production capacity figures at the start of the recreational market may be significantly lower.

It’s also important for investors in marijuana stocks to remember that the largest Canadian growers have focused on expanding among international markets, not only domestic.

Canopy Growth, Aurora Cannabis, and Aphria have all looked toward global opportunities for growth, wanting to capitalize on the increasing international demand for medical cannabis, particularly in Germany’s rapidly expanding market. With global demand growing and more countries opening legal MMJ markets of some kind, the total demand may very well exceed current projections for supply offered by Canada’s leading growers.

The story may get its happy ending after all, with Canadian cannabis growers seeing customer demand proportionate to the increased capacity.

(For more information on cannabis oversupply, read Marijuana Stocks and Supply: Is it Time to Freak Out?)

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