There is no shortage of answers to the question of what went wrong, but one thing seems certain: there is plenty of blame to go around
In an outdoor parking lot between a shelter and a Tim Hortons in downtown Ottawa, black market cannabis dealer Jay (not his real name) said he can’t think of the last time business has been so good. His pop-up dispensary moves around the capital city from time to time, depending on when he gets tipped off about potential police raids, which he said have tapered off lately. Despite the legalization of recreational cannabis almost a year ago, Jay insists his customer base has remained strong.
“I do my own market research,” Jay said. “I ask people, ‘Why don’t you go to Hobo (a legal cannabis store in Ottawa)?’ They say, ‘Legal product tastes bad. It’s s—t.’ I say, ‘Don’t worry, I got you.’”
Things weren’t supposed to be going this well for the Jays of the world. Dozens of legal cannabis producers, backed by billions in investor capital, were expected to put the black market on its heels, launching Canada to the forefront of an expanding global industry with the promise of mass-produced, high-quality, heavily regulated marijuana.
But scandals, sluggish earnings and executive shakeups have replaced the soaring expectations of a year ago. Government data show that the legal market has only supplanted 14 per cent of the black market since legalization on Oct. 17, 2018, and some are concerned that further inroads may be difficult to come by.
There is no shortage of answers to the question of what went wrong in the cannabis industry’s disappointing first year — among them, mediocre product quality, uncompetitive pricing and a heavy regulatory burden — but one thing seems certain: there is plenty of blame to go around.
“One of the first things that comes to mind for me when I think about the last year is a reality check,” said Aaron Salz, chief executive of the boutique investment firm Stoic Advisory Inc., which has been involved in the industry since 2016. “A reality check for everyone: consumers, the government, producers, the public markets. I wish there was something more positive to say.”
In Salz’s view, one of the biggest problems was that the industry’s early focus on scale — something that others agree was largely a symptom of the push to raise capital ahead of legalization — distracted it from other important considerations.
“There had been such a focus on scale over everything else, that quality in particular got left behind,” he said. “I think the first miscalculation that took place was when larger companies presumed that if they got the big supply agreements and they were first to market, they would capture all this early market share and that would be a huge advantage for them in the future.”
But the early days of legalization were plagued by a massive shortage of product. The bigger producers such as Canopy Growth Corp. and Aurora Cannabis Inc. had signed supply agreements promising a consistent stream of products, but were often unable to keep up. Provinces blamed the producers, but producers pointed towards supply-chain challenges such as the delay in obtaining government excise stamps, which had to be pasted on every product.
“In the early days, retailers just wanted product. Any kind of product they could get,” Salz said.
Eventually, more producers entered the market, supply ramped up and product choice grew. But at the same time, customers who chose to buy from the legal market started becoming more discerning of what they liked.
One example is that of Canopy’s Tweed-branded products. In the weeks following legalization, Tweed dominated the online retail space, and Canopy quickly established a market share of more than 30 per cent. But in its most recent quarterly results, the company had to record a revenue adjustment of $8 million to account for unsold product. Management during a conference call acknowledged that although their adult-use oils and gel capsules had initially sold well, demand has been slipping of late.
Craig Wiggins, an independent industry analyst and founder of The Cannalysts, a popular blog and Reddit channel, agreed with the notion that Bay Street was put ahead of the consumer in the first year.
“The industry relied on hype so much to get its stock price up so it could raise capital at an efficient level, that it thumped its chest on metrics like ‘funded capacity,’” he said.
But turning capacity into profitable production was a different story. Problems associated with scaling up led to write-downs, and mediocre sales growth was not enough to offset rising costs.
To date, most major cannabis companies are still unprofitable. In some cases, profitability was promised within a year of legalization, but those goalposts were perpetually pushed back in favour of international expansion, major acquisitions in the name of securing intellectual property and partnerships with larger companies outside the cannabis space.
To appease the market, changes were made. Canopy founder and co-CEO Bruce Linton, the industry’s most prominent leader, was terminated just weeks after the chief executive of alcohol giant Constellation Brands — which had bet billions on the company’s future — expressed disappointment with Canopy’s continued losses.
The industry’s many scandals didn’t help either. Within two months of legalization, a short seller alleged Aphria Inc., one of the largest licensed producers, was engaging in self-dealing, and inflating the value of its international assets. The company’s stock plunged in the weeks following the report, and several key members of the executive team, including CEO Vic Neufeld departed the company.
Shortly after, Manitoba-based licensed producer Bonify Medical Cannabis Ltd. had its licence suspended by Health Canada, after 200 kilograms of illegal cannabis were found in the company’s vaults.
But it was the CannTrust Holdings Inc. scandal that thrust the industry’s lacklustre corporate governance practices into the spotlight. In an apparent rush to boost output, the licensed producer was caught growing in spaces not yet licensed by Health Canada, apparently with the knowledge of senior management. That led to an Ontario Securities Commission investigation, a licence suspension and an almost complete decimation of the company’s stock.
“When the metric is growth and you’re being rewarded for it by capital markets, governance doesn’t really come into the fold because it is a not a factor in achieving that goal,” Salz said.
But not all the problems the companies faced were self-inflicted. Industry participants argue that achieving profitability would be substantially easier if there were simply more legal stores across the country to compete with the black market.
Jay, the Ottawa-based black market dealer, said the lack of legal stores — there are only two legal operations in his vicinity — has given him an advantage.
“People text and come to me from smaller towns and reserves around Ottawa and they are saying there’s no place to even buy legal weed,” he said. “So I get it to them, you know?”
Although it has been almost a full year since weed was made legal, Canada’s biggest market, Ontario, still only has 25 brick-and-mortar stores and a government-run online store servicing a population of 14 million people. An additional 50 stores, including eight on First Nations reserves in the province are expected to be in operation by the end of the year, according to the Alcohol Gaming Commission of Ontario. There are no official plans for more stores, as yet.
Another factor that has prevented the legal market from gaining traction has been price.
Since legalization, the price disparity between legal and black-market cannabis has remained significant. The average price of legal cannabis was $10.23 per gram for the third quarter of this year, compared to $5.59 on the illegal market. In the quarter prior, legal weed cost $10.65 per gram, and black-market weed cost just $5.94.
“I don’t think we’ve had an impact on the black market at all,” said Trevor Fencott, chief executive of cannabis retail chain Fire & Flower Cannabis Co. “The customers we are seeing now are not price sensitive. I think they are brand new to the industry, don’t buy from the black market and that’s why they are willing to pay such high prices.”
The industry, to some extent, has also blamed the government’s role as an intermediary in the retail system. Most provinces, such as Ontario, act as wholesalers between the licensed producer and the retailer, a system that almost all industry participants disparage.
“Our relationship with the Ontario Cannabis Store has been the most trying relationship in the country,” said an executive at a licensed producer who asked not to be named. “There was a honeymoon period after the last provincial elections where we thought there would be a move to a more business-friendly model. That was great for producers, but now for us, it’s important to have more than just an online store and a few private retail stores to get our product out.”
Fencott points out that having the government act as a middleman prevents competition.
“We’re all buying from the same government store. Ultimately, prices will go down if we are allowed to directly purchase from the producer or have direct delivery to the consumer,” he said, alluding to Saskatchewan, the only province that does not act as a middleman.
Wiggins argues that the only way to “elbow out” the black market is to reduce the cost of supply.
“There is so much margin confiscation,” he said. “You have the province getting in between this, then the excise tax on every gram, then HST.”
Health Canada has also come in for criticism due to the extensive rules it has imposed on producers. Its mandate is to ensure legal weed sold to Canadians meets the highest safety standards, but some feel that the regulator is perhaps taking its job too seriously at the expense of the government’s ultimate goal of dismantling the black market.
For example, just weeks before legalization, Health Canada was still dealing with a backlog of hundreds of applications for cultivation licences. Just 221 have been approved so far.
“I wouldn’t say that Health Canada purposely chose to slow down the licensing process. To me, they were just a group of bureaucrats overwhelmed with the number of people seeking a licence,” said the cannabis executive.
“They are not incentivized to move faster because that is not their goal. Their goal is to ensure that the product is safe. It is healthy, from the regulators’ perspective, to be slow, because they are turning dials on a brand new policy that could have massive implications down the road.”
But if excessive regulations are proving to be an obstacle in eliminating the black market, then it appears governments still have a long way to go. Cannabis 2.0 — the legalization of edibles, concentrates and topicals that is set to take place on Oct. 17 — is already off to a rocky start.
Health Canada has said that licensed producers will only be able to begin submitting their product applications to the regulator on that date, which means it could be late December or early January before consumers will be able to purchase product, giving the black market yet another reprieve.
A number of analysts, including Wiggins, warn of another problem looming over the industry: a supply-demand imbalance so great that it might lead to the failure of a slew of licensed producers that are unable to deliver the kind of quality product consumers want.
“The biggest problem right now is this massive delta we have between what we are harvesting and what we are shipping,” Wiggins said. His calculations, based on Health Canada data, suggest that the industry scaled up so quickly that it is currently harvesting at a rate of 84 per cent of total overall demand — both legal and illegal.
“Unless we are able to magically sell all that product and get almost the entire black market over to purchase legal product very soon, there is going to be a massive supply glut and plunge in prices,” he said.
The vaping health crisis south of the border — which has called the use of marijuana-infused vape pens into question — has thrown the industry yet another curve.
But Graeme Kreindler, an analyst at Eight Capital, suggests there is another way to look at the vaping problem.
“We could say, look, there are structural challenges, but all these additives south of the border that are causing problems with vaping are not even allowed in Canada because of strict regulation,” he said. “I would argue Canadian companies and our regulatory structure are still looked at abroad as an example of how to legalize. Strict regulation is exactly why Canada will still maintain a first-mover advantage in this industry.”
Kreindler is not alone in maintaining his sense of optimism in the face of the industry’s early struggles.
AltaCorp Capital Inc.’s cannabis analyst David Kideckel also notes that the industry is in its infancy and that sounding the alarm bell just a year after legalization is premature.
“What gets me really excited is the next wave of legalization,” he said. “Of course, there’s going to continue to be learning curves, but if the industry gets it right and puts out high-quality products, we think consumers are ultimately going to find brands that they will be loyal to.”
Even Jay seems to acknowledge that the legal industry will begin to get its act together, eventually. But when it does, he’ll be ready.
“I know that once legal product gets good, I’m going to lose business,” he said. “I gotta switch it up.”
Read more at the Financial Post