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The Biggest Challenge Facing the Canadian Marijuana Industry

A lit cannabis joint in front of a red Canadian maple leaf.

In just five days, Canada's Senate could alter the face of the legal cannabis industry throughout the world with its vote on bill C-45, which is best known as the Cannabis Act. If approved by the Senate, it would pave the way for Canada to become the first developed country in the world to legalize adult-use cannabis.

What does legal weed mean for Canada and its supply chain of growers, processors, distributors, and retailers? How about $5 billion, or more, in added annual sales? Mind you, this comes on top of what the industry is already generating from the export of medical marijuana to foreign countries where medical weed is legal, as well as domestic medical cannabis sales. It's this expected surge in sales that's pushed growers to expand their capacity as quickly as their balance sheets will allow. It's also the reason pot stock valuations have soared in recent years.

A lit cannabis joint in front of a red Canadian maple leaf.

Image source: Getty Images.

The Canadian cannabis industry has faced numerous challenges

Of course, this isn't to say that the Canadian weed industry hasn't or won't face a number of challenges in the months and years that lie ahead. For example, the projected launch of recreational marijuana was delayed until August or September, from the beginning of July, in order to allow growers enough time to get their product to retailers.

Financing had been another major concern for most Canadian pot stocks. Since marijuana is still illegal at the federal level, banks usually want nothing to do with cannabis-based companies. This has meant the need for publicly traded marijuana stocks to turn to dilutive bought-deal offerings in order to raise capital. While the industry is now overflowing with cash, it's investors who could pay the price in the years to come as a result of weaker earnings per share.

But looking ahead, the biggest issue facing the Canadian pot industry appears to be whether or not it can rid itself of the black market.

A young man wearing a hoodie and carrying a potted cannabis plant.

Image source: Getty Images.

The Canadian weed market's biggest challenge

Prime Minister Justin Trudeau, who's been the key figure championing the legalization of recreational marijuana in Canada, has long opined that the best way to remove the black market from the equation is to tax adult-use cannabis at a low rate and make legal weed comparable in price to illicit pot. This is why Canada's tax proposal calls for a $0.77-per-gram (1 Canadian dollar) tax on cannabis up to $7.70 (CA$10), and then a flat 10% tax on more expensive strains.

By comparison, some folks in California could be paying up to 45% in sales tax to purchase recreational marijuana. Additionally, excise tax rates on beer, wine, and liquor in Canada tend to hover around 50%, 65% to 70%, and 80%, respectively. That's how relatively low Canada's tax on cannabis is compared to U.S. legal states and to its own domestic alcohol industry.

However, simply charging a low tax rate and de-emphasizing tax revenue isn't a guarantee to succeed. What some folks might be overlooking is the fact that the black market has virtually no overhead costs. There are no cultivation licenses or sales permits to buy or wait for, no rent to pay, and no tax to hand over to the federal government. Even with an ideal tax situation, it's not out of the question that the black market retains a significant portion of the Canadian domestic and export pot business -- at least initially.

A cannabis processor holding a trimmed bud in their hand.

Image source: Getty Images.

Things may change, but it'll take a few years to play out

Where things could get really interesting is roughly three-to-five years from now, when the supply of legal cannabis increases considerably and dried cannabis begins to be commoditized.

For example, most growers are still a year or two away from being at full production capacity. But by 2020, my personal estimation is that we could see a run rate of 2.4 million kilograms per year from Canadian growers. At least domestically, this works out to a well over 1 million-kilogram oversupply. Assuming exports are unable to gobble up the entirety of this oversupply, it's not out of the question that dried cannabis prices might drop precipitously over the course of a few years. Should this happen, the price difference between the black market and legal markets would narrow. Or, to put this another way: only when dried cannabis margins shrink significantly, and legally operating businesses are able to use economies of scale to their advantage, will legal cannabis stand a real shot at kicking illegal marijuana out of the market for good.

Why is it important if the black market remains? While I'm certain there will be plenty of sales growth to go around for growers and retailers, the presence of the black market would cause peak sales estimates to have been overstated. It could also make it a struggle in the early going for legal retailers charging a significantly higher price point than black-market weed. And, may I remind you, many of the largest growers are unlikely to be significantly profitable anytime soon.

As much as I've harped on shareholder dilution and oversupply being an issue for Canadian pot stocks, they may take a back seat, at least initially, to the dangers of competing against black-market marijuana.

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