Legalization of Recreational Cannabis in Canada: A Blueprint or Bomb?
How well has the Canadian government handled the legalization of recreational cannabis in Canada and how has it contributed to the current state of the industry? The discussion groups are seething with venom and toxicity. Bottom-feeder law firms are trying to start class action lawsuits, Aurora Cannabis is the first of their victims, Canopy Growth is “under investigation”. The acronym WTF appears in discussion group posts more often than the call sign of the company. The cannabis sector at this time is more like the opening scene of “Saving Private Ryan” than the picture of an upcoming industry (my apologies to those who haven’t seen this excellent film and don’t get the analogy). These are not happy times and there is plenty of finger pointing going on, predominantly at the Canadian and Provincial Governments and at Health Canada and how they have handled the legalization of recreational cannabis in Canada.
Oddly enough, no one is pointing a finger at the “fat cat” investment bankers, stock promoters, hedge fund managers and law firms that have helped raise close to $8-billion from public investors since 2017. These organizations took hundreds of millions of dollars in fees in the process and then vanished leaving retail investors clutching the shares of companies that may not even survive this battle.
But this article isn’t about how Bay Street took us for a ride on their magic carpet and then pulled it out from under us. There is already an excellent article in the Globe and Mail that can be found here that explains this situation with exceptional detail and clarity.
This article is a reality check of sorts. The cannabis sector has apparently gone into a kamikaze dive since May of 2019 and investors are more than just a little nervous. But will it pull out of the dive at the last minute? I for one maintain my belief that it will. I doubt every LP will survive, but I believe many will and over the next few years we will see mergers and acquisitions as this industry comes of age.
The legalization of cannabis is becoming a global trend. This is an undeniable fact and Canada is paving the way as the first G7 country to legalize cannabis. But this article isn’t about how Canada is going to lead the world in the legalization of cannabis either. This article is about how the legalization of recreational cannabis in Canada has been handled and how it compares with how it was done in Colorado, Washington State, and California.
We Need More Retail Outlets!
Many investors and journalists criticize how the legalization of recreational cannabis in Canada has been handled. But has the Canadian government’s approach really been such a colossal failure, or is it a blueprint that other nations will look to when they decide to legalize on a national level?
The legalization of recreational cannabis in Canada definitely has its down side. Probably the most heavily criticized being the slow licensing of retail outlets. In fact, many LP executives have stated this is one of the major reasons they have fallen short of revenue projections in 2019. It is also believed to be the reason the black market still dominates recreational sales in the Canadian market.
How did our comparison States fare with the roll out of retail outlets when they first legalized recreational cannabis?
Retail Outlets in Colorado
Some point to US states like Colorado as an example and say, “That’s how it should be done!” and while it may be true that today Colorado is a great example of a thriving legal cannabis industry it’s also important to remember that recreational cannabis use has been legal in Colorado for 6 years. In reality Colorado as well as the other US states we will look at have had their own share of problems with government regulation in the early stages of cannabis legalization.
After its first year of recreational cannabis sales, Colorado had issued 147 retail dispensary licenses and had 313 medical dispensary licenses. By 2018 there were 509 retail dispensaries and 505 medical dispensaries. (Note: many of the retail licenses were shared by existing medical dispensaries) The point here is that it has taken 5 years for Colorado to reach this number of retail and medical outlets. Despite the modest growth in outlets 2018 has been a banner year with record sales of nearly $1.55 billion USD.
Retail Outlets in Washington State
Washington, which legalized cannabis for recreational use 6 months after Colorado, had its own problems with government regulations, primarily with the restrictions placed on opening retail locations. A study titled “Early Impacts of Marijuana Legalization: An Evaluation of Prices in Colorado and Washington” written by Priscillia Hunt and Rosalie Liccardo Pacula in 2017 noted that, “… the roll out of retail stores was particularly slow in Washington, in part because of the cap on the total number of retail stores that would be allowed (334 by state law at the time), requiring a lottery in some locations and delaying applicant background checks and requirements.”
Imagine that! Washington State, which has the 3rd highest retail sales of all states that have legalized recreational cannabis used a lottery to award licenses for retail locations.
Washington still has a cap on the number of retail stores that can operate, increasing it from 334 to 556. There are currently 504 stores with 50 being unable to open due to another regulation that allows cities and counties to ban cannabis sales. Nevertheless, Washington posted an impressive $1 billion + in cannabis sales for 2018.
Retail Outlets in California
California is a market that more closely resembles Canada in terms of population. Although California was the first state in the USA to legalize medical cannabis, it wasn’t until January 2018 that it made recreational use legal.
California is the largest legal recreational market in the world, with 39.56 million people (Canada has 37.59 million people). However, the state has done a dismal job of issuing licenses for retail outlets. The application process is complicated because an applicant must first get approval from the local government where it wants to open its store before it can apply to the state for a license. As a result of this restrictive process, the total number of licensed retail outlets after a year and a half is just 873. This means there is just one retail location for every 41,878 residents. Contrast this number with 2,835 unlicensed (read black market) outlets and it’s clear to see the black market is dominant in the Golden State.
The dominance of the black market in California has been attributed to the lack of licensed retail outlets. Los Angeles is accused of dragging its feet issuing licenses to applicants. The city has received more than 1,600 applications to operate legally, but it has licensed only 187 so far this year with another 100 license issuances expected later in 2019. However, despite the difficulties presented by excessive regulations, the slow roll out of retail locations and the dominance of the black market, an article published in the LA Times on August 15, 2019, claims the state managed to record $2.5 billion in cannabis sales in 2018 and is on track to hit $3.1 billion in 2019.
How Does Canada Compare?
Canada, which is approximately a year behind California, has a lot of room for improvement with one retail location for approximately every 75,000 residents. Presently, the majority of these locations are in Alberta. The black market also claims the majority of cannabis sales due primarily to accessibility and price. But things seem to be looking up as the second year of legalization gets underway.
British Columbia will soon be adding 93 stores to its 87 stores currently in operation. An article published in the Toronto City News on November 6, 2019, states Ontario is making moves to allow retailers to sell products online or over the phone for in-store pick-up and they will allow licensed producers to have stores on their production sites to sell directly to the public. In addition, they are adding 50 new retail locations to the 24 already operating by the end of 2019.
A more recent article in the Financial Post, November 19, 2019, written by Vanmala Subramaniam states “The Ontario Cannabis Store will move ahead with a “hybrid” wholesale model that will allow the private sector to be involved in storing and distributing cannabis…”. Read the full article here .
Furthermore, in an article published November 21, 2019. BNN Bloomberg reporter David George-Cosh went on record stating a reliable source in connection with the Ontario government has informed him of a plan to launch an online licensing process in hopes of opening as many as 1000 new stores in Ontario. The province will abandon the lottery process and create a website where applicants can submit an application and after passing a background check will receive their license to open a store. This is a huge step forward for the Ontario Government and should have a significant impact on the number of future retail outlets in 2020.
With these imminent improvements coming in Ontario one can only hope Quebec will follow suit and increase its retail locations from the existing 21. It is likely we can expect to see continued growth in sales revenue in calendar year (CY) 2020. In fact, sales forecasts for 2020 are expected to exceed 3 billion. CY 2019 medical and recreational sales combined are on track to exceed 2 billion.
If government regulations are killing the cannabis industry in Canada, the numbers certainly don’t indicate it.
Packaging and Promotion Restrictions
One of the goals of the Cannabis Act is “to keep cannabis out of the hands of youth”. To this end, the Federal Government has placed what many believe to be excessive restrictions on the packaging and promotion of cannabis. The results are plain packages and containers that look more clinical than anything. The rationale being it will be unappealing to youth and children. Given the launch of edibles this strategy may not be such a bad idea. Imagine a child seeing a brightly coloured package of candies or gummies that was carelessly left on a table and happily eating the contents. The outcome could be tragic.
It’s interesting to note that Washington State has now adopted similar regulations with regard to packaging of edibles. In a message posted on the Washington State Liquor and Cannabis Board website the board takes a strong stand against marijuana-infused products that are especially appealing to children. Specific laws being changed are regarding packaging of the products.
Wrapped in Red Tape
It’s easy to point to overregulation by the Federal and Provincial Governments and Health Canada as reasons for the lagging cannabis sector. But if you read through the Cannabis Act you will realize that it is really a comprehensive approach. Lyle Hauser of statnews.com had this to say about the Canadian Cannabis Act, in an article titled “Canada’s legalization of marijuana offers a blueprint for the U.S.” Published March 9, 2019.
“The Canadian government took the time to assemble a federal task force to help craft a bill that anticipated and addressed many of the issues that could result from legalization. The legislation is deep and comprehensive, yet manages to leave the majority of regulatory decisions — such as where cannabis can be sold and consumed — in the hands of its provinces, an approach I believe the U.S. will want to emulate.”Lyle Hauser, Canada’s legalization of marijuana offers a blueprint for the U.S., Stat News, March 9, 2019
This isn’t to say the legalization of recreational cannabis in Canada has been perfect. But legalization of recreational cannabis in Colorado and Washington, the first of the US States to legalize recreational cannabis, faced similar forms of government interference. According to the previously mentioned study, “Early Impacts of Marijuana Legalization: An Evaluation of Prices in Colorado and Washington”, numerous state laws and regulations created additional roadblocks hindering the rollout of the newly formed cannabis industry.
Government Intervention in Colorado
For example, in Colorado a law was introduced that required vertical integration for the first nine months to two years, depending on locality, which meant anyone wanting to open a retail location must also grow at least 70% of the cannabis they sold. It’s difficult to imagine how this was even feasible, unless this was already the model in place for medical cannabis. Ironically, licensed producers in Canada are lobbying to be permitted to sell directly from their production facilities, setting up retail outlets and “tasting” rooms much the same as wineries and craft breweries have.
In addition, in Colorado, only existing medical marijuana stores with a license in good standing were allowed to sell recreational cannabis. Further government regulations specified that the stores had to designate how much of their inventory would be used for recreational sales and how much for medical. They were not allowed to shift inventory from one category to the other based on demand, thereby creating shortages of cannabis in both medical and recreational.
Government Intervention in Washington State
In Washington State, licensees are divided into three categories: producers who grow cannabis crops, processors who turn those crops into products, and retailers. While businesses can have licenses both to grow and process cannabis, producers and processors cannot be licensed to sell cannabis. And like Canada, Washington State, Colorado and California provide counties and cities the option to ban sales of recreational cannabis thereby creating problems for entrepreneurs who want to establish legal operations. As noted earlier, 50 licenses in Washington State have still not been activated due to a ban for the location where the retailer wants to set up a store.
Some critics believe that excessive taxation creates higher prices and drives consumers to buy from the black market. It’s true that taxes increase the price consumers pay but the Canadian government has done a commendable job of creating a modest (yes modest) taxation framework. The excise tax in Canada is either 10% or $1 per gram, whichever is higher. But because the average wholesale price of a gram of legal recreational cannabis in Canada is under $10, the excise tax charged is typically $1 per gram. For example: Aurora Cannabis reported and average sale price per gram of $5.63 while Canopy Growth reported and average sale price of $6.23 per gram.
Of the $1 excise tax collected, the Federal government takes 25 cents and the provinces and territories keep 75 cents. Federal revenues from the excise duty are capped at $100 million per year for the 24 months following legalization. Federal revenues over the $100 million cap will be distributed to provinces and territories. Consumers don’t actually see this tax as it is charged during the transaction between the LP and the wholesale distributor. The tax is built into the price per gram sold then the retailer will mark up the cost to whatever price they want to receive on the product.
Other than the excise tax, regular Provincial taxes apply. The table below is a comprehensive look at how taxes are applied to cannabis across Canada.
If you compare taxes in Canada to those of Colorado Washington State and California, you get a sense of how reasonable the Canadian taxes are. Taxation in the US is really an open can of worms with the option being given to cities and counties to add their own taxes. After the city of Seatle adds its own taxes to the 37% excise tax charged by the state, consumers are paying a whopping 47.1%. The table below shows the breakdown of each state this..
It is human nature to seek understanding as to why things happen. Since May 2019 we have watched as share prices across the cannabis sector fell. Investors looking for reasons point to the Federal and Provincial Governments and Health Canada and criticize how the legalization of recreational cannabis in Canada has been handled. Excessive government regulations! Not enough retail locations! These are the mantras of disgruntled investors. While it is certainly true, more retail locations in the more populous provinces may have helped, I think it’s unfair to blame the current situation on any government body when we can see that this has been a common theme in Colorado, Washington State and California.
The cannabis industry has flourished in these states despite evidence of similar problems and it will flourish in Canada too. I am confident we will see the sector rebound. I can’t predict when, possibly in 2020. But I don’t think the cannabis sector in Canada is dying and I have my reasons for believing this that you can read here.
If you invested in this industry thinking you would get rich overnight you’re probably in the wrong place. If you want guarantees, talk to your bank about a nice GIC or look into the Bond market. The stock market is a white-knuckle flight and always has been. If you believe in this industry then hang on. The pain is likely not over but it will ease up eventually. In the end, we will all land safely and be richer and wiser for our experience.
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Disclosure: I am long on Aurora Cannabis. I have no positions in any other stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Cannabis Investment Group). I have no business relationship with any company whose stock is mentioned in this article.
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