Black Market Still Controls 85% of Canadian Cannabis Market

Canadian marijuana stocks languish in a trough. Much of this selling has been overdone, and there is a growing clamor that these stocks are “oversold”.

However, when it comes to what has prompted this selloff, the bottom line is clear. Canada’s legal cannabis industry has been unable to claim nearly as much market share from the black as projected.

At the beginning of 2019, Scotiabank analysts predicted that the cannabis black market would control 72% of cannabis revenues this year. Put in opposite terms, the legal industry would net only 28% of total revenues. Yet at the end of Year 1 of legalization, Canada’s cannabis industry has fallen far short of that (modest) target.

According to Cannabis Benchmarks, the legal cannabis industry has generated CAD$1.1 billion in revenues over Year 1 (beginning on October 17, 2018). This compares to Deloitte’s estimate of the overall size of Canada’s cannabis market for 2019: CAD$7.17 billion.

At current levels, only about 15% of cannabis revenues are going to the legal market. This is little more than half of what was projected at the beginning of the year.

Surging legal cannabis sales in recent months should improve that ratio slightly by year’s end. Even so, market penetration by the legal industry is the biggest reason for the slump in stock valuations.

Why has the legal industry underperformed in claiming market share? That answer can be spelled in seven letters: O-n-t-a-r-i-o. Canada’s largest province, with a population of over 14 million people, has opened a meager 25 cannabis stores to date.

That’s less than 1 store per 500,000 people.

In contrast, Canada’s cannabis leader – Alberta – now has more than 270 retail locations. This is for a population base of just over 4 million people.

That’s more than 1 store per 15,000 people.

Per capita, Ontario has less than 3% as many cannabis stores as Alberta.

Even with its much greater store concentration, Alberta’s cannabis stores are very profitable. National Access Cannabis (CAN:META), Alberta’s largest cannabis retailer, reported gross margins of 32% in its most recent quarter.

How much better would the legal cannabis industry have done if Ontario had matched Alberta – and opened 30 times as many stores?

When Ontario (finally) opened “a handful of stores” in April (nearly 6 months after full legalization), provincial cannabis revenues immediately more than doubled that month.

With Ontario representing nearly 40% of Canada’s population, had it matched Alberta and opened an additional 700+ stores, this would have more than doubled total retail capacity in Canada. If revenues increased at a commensurate rate, the legal cannabis industry would have easily exceeded the 28% estimate made at the beginning of 2019.

Instead, thanks to Ontario’s abysmal failure (with contributions from several other provinces) the legal industry is only about half the size that it should have already achieved.

This is a two-edged message for investors. On the one hand, it (partially) explains the extremely compressed valuations for Canadian cannabis companies.

On the other hand, it is yet another indication of the untapped potential as Canada’s legal industry moves into Phase 2 of legalization – and a full array of cannabis consumer products.

Thanks to the provinces (and mostly Ontario), Year 1 of legalization has been more or less a write-off for the legal cannabis industry. But with a critical mass of cannabis stores now open, Year 2 promises to be a much stronger year for the industry.