Health Canada Just Failed the Marijuana Industry... Again


In terms of growth prospects, no industry is blazing a trail quite like legal marijuana. The newly released "State of the Legal Cannabis Markets" report from Arcview Market Research and BDS Analytics calls for more than $40 billion in global licensed-store revenue by 2024, up from just under $11 billion in 2018 (a compound annual growth rate of 24%). If these figures prove accurate, quite a few pot stocks should be rolling in the green, so to speak.

Even though the United States is viewed as the crown jewel of the cannabis movement, it's Canada that's led the way on the legalization front. In October, our neighbor to the north became the first industrialized country in the world, and only the second country worldwide behind Uruguay, to legalize recreational cannabis. Arcview and BDS foresee around $4.8 billion in yearly pot sales in Canada by 2024.

Image source: Getty Images.

Canada's pot industry has faltered badly, thanks to Health Canada

While this might seem like the perfect recipe for success, the launch of legal weed hasn't exactly been a budding success in Canada. In January and February, licensed cannabis store sales in Canada actually declined, with February sales coming in about 13% lower than where they were in December. That's a head-scratcher given the popularity surrounding marijuana and the favorability the public has toward legalization.

This sales weakness can be boiled down to a combination of three problems.

First, growers were unwilling to spend $100 million-plus on capacity expansion projects until they knew for certain that the Cannabis Act would become law. That didn't happen until late 2017/early 2018, which was less than a year before the official launch of adult-use marijuana. Nearly all growers are still in the process of building out their capacity, which has left supply far below actual domestic demand.

Second, most growers have also complained of compliant packaging shortages. Regulatory agency Health Canada laid out a series of guidelines that growers, processors, distributors, and retailers would need to follow if they wanted pot products to wind up on cannabis-store shelves. That's led to a shortage of compliant packaging in the early going, which in turn has kept unfinished cannabis sitting on the sidelines.

But the biggest problem of all has arguably been the regulatory red tape associated with Health Canada. As the agency tasked with reviewing and approving or denying cultivation, processing, distribution, and sales license applications, Health Canada was working with a backlog of more than 800 applications in January.

Image source: Getty Images.

As you can imagine, having such a large backlog has meant long wait times for applicants. Aphria, for example, has been waiting more than a year for an answer to its cultivation license application on Aphria Diamond, its joint venture with Double Diamond Farms that'll ultimately produce the bulk of its annual output (140,000 kilos of Aphria's projected 255,000 kilos at peak production).

Recently, Health Canada implemented what it believes will be a "fix" for this mess. Rather than having growers submit cultivation applications well in advance of actually beginning construction on their farms, Health Canada will now require that grow facilities be complete prior to submitting applications. This should, in theory, remove a number of underfunded applicants, as well as prioritize those larger players that have completed their buildouts. Nevertheless, this workaround will take many quarters to play out, which could man extended wait times for cultivation and sales license approval for most Canadian pot stocks.

Health Canada fails the marijuana industry, once again

But this isn't the only time that Health Canada has failed the marijuana industry. Roughly two weeks ago, we learned that the most anticipated event in 2019 -- the launch of derivative cannabis products (e.g., edibles, vapes, concentrates, topicals, and nonalcoholic infused beverages) -- would be delayed.

According to a press release from Health Canada that finalized the regulations for the production and sale of cannabis extracts and topicals, amended regulations will go into effect by no later than the one-year anniversary of the launch of adult-use marijuana (Oct. 17, 2019). However, "it will take time, after that date, before new cannabis products become available for purchase," according to the release.

Image source: Getty Images.

Cannabis-store license holders are going to be required to give Health Canada notice 60 days prior to selling these new derivative products, with the regulatory agency not expecting alternative consumption options to go on sale until mid-December 2019, at the earliest. Additionally, as we saw with recreational dried flower, the uptick of supply in licensed dispensaries could be slow if supply chain issues persist.

In short, whereas pretty much all marijuana stocks and investors were looking toward October 17, at the latest, as the point where high-margin weed sales would kick in, there'll be a roughly two- to three-month gap now before high-margin derivative sales really take off. For investors, that means waiting until possibly April to June before we see a derivative-focused uptick in pot stock sales for the calendar year first quarter in 2020 (Jan. 1, 2020-March 31, 2020).

The impact on Canadian pot stocks could be mixed

Even though all marijuana stocks are planning on incorporating derivatives into their portfolios, this Health Canada decision hurts more pot growers than it helps.

Aurora Cannabis (NYSE: ACB) is one such company that's not going to be pleased with this decision. Aurora's management team has been clear that the medical marijuana market is its focus. Medical cannabis patients tend to use pot products more frequently, buy more often, and are far more attracted to derivative products than dried flower. Although oils, sprays, and capsules are legal now, Aurora is counting a broader assortment of derivative production to drive its bottom line into the green. It looks like a tapered launch of derivatives may now push profitability for the company into 2021.

Image source: Getty Images.

The story is the same for Cronos Group (NASDAQ: CRON), which is angling to be more of a cannabinoid company than dried flower producer. Following a $1.8 billion equity investment from Altria, it's expected that Cronos will work with its new partner to develop vape products in Canada. The launch of these vape products, and Cronos Group's ability to take advantage of its up to $100 million partnership with Ginkgo Bioworks to develop targeted cannabinoids, is now on hold for a few more months.

Quebec-based HEXO (NYSEMKT: HEXO) shouldn't be a fan of this news, either. HEXO has more than 600,000 square feet set aside for manufacturing and processing cannabis, which is a fancy way of saying that it's set aside a lot of space to develop derivative products. Further, HEXO recently signed a two-year agreement with Valens GroWorks that'll see Valens provide extraction services for at least 80,000 kilos (in aggregate) of hemp and cannabis biomass. HEXO's potential to turn a profit may also have been pushed back a quarter or two.

Maybe the only pot stock that could benefit from this delay is Ontario's CannTrust Holdings (NYSE: CTST). In late March, CannTrust announced its intention to acquire up to 200 acres of land that'll be put to work for outdoor cannabis growing. Much of CannTrust's outdoor grow will be used for extraction purposes and the creation of derivative products. However, it's unlikely that we'd see this outdoor production hitting processors for extraction prior to first quarter of 2020, at the earliest. In other words, CannTrust's late play for added outdoor capacity means it won't fall too far behind the curve, if at all.

In sum, it's probably time to trim your near-term expectations for Canadian marijuana stocks.

Sean Williams owns shares of CannTrust Holdings Inc. The Motley Fool recommends CannTrust Holdings Inc and HEXO. The Motley Fool has a disclosure policy.


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