If This Metric Is Correct, Canadian Pot Stocks Are in For an Unpleasant Surprise

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The marijuana industry is budding before our eyes, and investors simply haven't been able to get enough of pot stocks in recent years. Even including the correction many have undergone over the trailing three months, quite a few of the largest cannabis stocks are up more than 1,000% over the trailing-two-year period. Not too shabby!

Three reasons pot stocks have been unstoppable

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Leading this charge higher in marijuana stocks are three catalysts. First, rapid sales growth has investors excited. According to cannabis research firm ArcView, in partnership with BDS Analytics, the North American legal cannabis market is expected to grow by 28% a year through 2021. We're talking about an industry that could catapult from less than $7 billion in sales in 2016 in North America to $25 billion in sales by 2021. That's growth pot stock investors simply can't ignore.

Secondly, there's a lot of public support for cannabis. Within the U.S., no fewer than five national polls over the past year have found overwhelming support for legalization. Gallup, which has perhaps the most-followed of these annual polls, found that 64% of respondents favored the idea of legalizing weed in October 2017. By comparison, support stood at just 25% back in 1995. That's how quickly the public's perception of pot has morphed in just over two decades.

Lastly, and perhaps most importantly, Canada stands on the verge of legalizing recreational marijuana by this summer. Canada is on track to become only the second country overall (the other being Uruguay), and the first developed country, to OK the sale of marijuana to adults aged 18 and up. In doing so, it would be opening the door to an industry that could generate $5 billion or more in annual sales, on top of what medical cannabis and exports are already generating.

On paper, this looks like a can't-lose proposition for investors -- and thus far, that's been the case. However, that may soon change.

Is a marijuana glut inevitable?

In anticipation of an expected legalization in June, with adult-use sales commencing in either August or September, Canadian cultivators have been expanding their capacity as quickly as their wallets will allow. Doing so does make sense, as growers that can meet the initial surge in demand are the likeliest to sign multiyear supply agreements, as well as create brand and product attachments with domestic consumers.

But there's a problem that a lot of investors continue to overlook: the growing possibility of a marijuana glut caused by overproduction.

To date, Health Canada has approved more than 90 cultivation and/or sales licenses to pot companies, and the list is only expected to get longer. Here's a rough look, which combines a few of my own estimates with that of those provided by the companies themselves, of what peak annual production might look like for some of the bigger players:

  • Canopy Growth Corp.: more than 300,000 kilograms
  • Aurora Cannabis: 283,000 kilograms
  • Aphria (NASDAQOTH: APHQF): 230,000 kilograms
  • MedReleaf: 140,000 kilograms
  • OrganiGram Holdings: 113,000 kilograms
  • Hydropothecary Corporation: 108,000 kilograms
  • Emerald Health Therapeutics: more than 100,000 kilograms

Again, this is just a snippet, but it equals close to 1.3 million kilograms of annual production, likely by 2020. When the dozens of other growers not mentioned are included, it becomes feasible that 1.8 million to 2 million kilograms of annual production could be reached by 2020 or 2021. By comparison, a mixture of analysts and government reports have suggested that domestic production is expected to hover around 800,000 kilograms.

What the heck is Canada supposed to do with 1 million extra kilograms of dried cannabis per year? Some of it could be exported to foreign markets that have legalized medical marijuana, but it's unclear if those markets could support such a massive amount of oversupply, assuming domestic demand forecasts prove accurate.

However, should this oversupply become a reality, at least one metric suggests that marijuana stocks, and thusly investors, could be in deep trouble.

This metric suggests Canadian pot stocks are in trouble

According to price data from Cannabis Benchmarks, as noted in MarketWatch, legal weed prices in the U.S. dropped 20% in 2016 and a further 16% in 2017. The bulk of this drop in price is likely a result of oversupply.

For instance, in Colorado, we've witnessed larger growers gobble up licenses and crank out production en masse in order to (presumably) drive smaller players out of the market. Between October 2015 and August 2016, Colorado's wholesale cannabis price per pound plunged from $2,400-$2,600 to a range of just $1,400-$1,600. A similar pattern could play out for our neighbor to the north.

Assuming an average current selling price of 8.50 Canadian dollars per gram ($6.64) in Canada, a similar drop in price as reported by Cannabis Benchmarks would yield a per-gram retail of just CA$5.71 by 2020 ($4.46). Even though Canadian growers are using economies of scale to their advantage in lowering costs, we're talking about moving from a $6 per-gram gross margin to perhaps a less than $4 per-gram gross margin. That may not sound like a big deal, but when taking into account recent shareholder dilution from bought-deal offerings, along with the added costs of marketing, packaging, financing, consulting, electricity, growing, share-based compensation, and so on, the profitability of Canadian pot stocks may very well disappoint investors.

The wild card remains the individual distribution channels for these aforementioned growers. Aphria, which recently acquired Nuuvera, boosted its access to a dozen countries, including Canada. Having channels to offload its projected 230,000 kilograms in annual production could prove crucial to preserving Aphria's margins. Nonetheless, there are no guarantees that these export channels will be able to absorb the magnitude of oversupply that may present itself.

Only time will tell what happens, but marijuana stock investors should be prepared for a bumpy ride.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.