HEARD ON THE STREET Legal Grass Isn’t Always Greener for Cannabis Companies Canada’s messy pot market is a warning to investors who think recent moves by the White House could solve the U.S. marijuana industry’s problems A worker harvests cannabis plants on the Dabble cannabis farm near Duncan, British Columbia. JAMES MACDONALD/BLOOMBERG NEWS By Carol RyanFollow Oct. 14, 2022 5:30 am ET SAVE SHARE TEXT 41 Listen to article Length (6 minutes) Queue Canada’s legal cannabis industry turns four on Monday. Its pitiful state is a reminder of the risks U.S. players face if America follows its neighbor’s lead. Earlier this month, President Biden said he will pardon federal cannabis offenses and order a review of how the drug is classified. This isn’t likely to lead directly to the end of federal marijuana prohibition, but might set the country on the road to further reforms that could benefit U.S. pot growers, who operate in a weird legal limbo. Today, they aren’t allowed to make deductions for normal business expenses so effective tax rates can be as high as 70%. They are also largely barred from accessing many financial services, something that a bill called the SAFE Banking Act proposes to fix. Canada is still one of the only developed countries that U.S. politicians can look to for guidance on how to go fully legal. Official data shows that four years after opening up on Oct. 17, 2018, one-third of Canada’s cannabis sales still happen in the black market. That’s hardly ideal, but the situation is improving as legal sellers do a better job at attracting customers. In Ontario, cannabis costs just 2% more than what is available in the illegal market, according to an EY report. “It’s clear that legal cannabis can compete with illegal sellers if stores are convenient, prices are competitive, and the products are good quality,” says Michael Armstrong, professor of operations research at Brock University in St. Catharines, Ontario. Investors have been razed, though. Since enthusiasm about the cannabis industry peaked in 2019, around $35 billion has been wiped from the market value of seven major Canadian cannabis companies listed on New York’s stock exchanges, an 85% drop. Individual investors who used to prop up share prices are mostly gone. Weekly net purchases of a basket of Canadian cannabis stocks by retail traders total around $2.3 million today, compared with a peak of $429 million in February 2021, according to VandaTrack data. Advertisement - Scroll to Continue The original pitch was that these marijuana companies, with their access to deep pools of investor cash, were going to dominate the global cannabis market as countries went legal one after another. “The dream didn’t work out,” says Andrew Carter, cannabis analyst at Stifel Financial. “Everybody got funding and they burned it all.” Corporate casualties include brewer Constellation Brands and tobacco giant Altria, who rushed to buy stakes in Canadian pot stocks only to lose billions of dollars on their investments. The lesson for investors is that competition will likely intensify if and when cannabis goes legal nationally in the U.S. In a free market, there may be no limit to the number of licenses handed out. In Canada, more than 700 facilities grow cannabis for a relatively small 4.3 billion Canadian dollars, the equivalent of about $3.1 billion, of annual adult-use retail sales. As more entrepreneurs pile in, big listed Canadian stocks are losing market share. Advertising restrictions and plain packaging rules make it hard to build brands that customers are loyal to, as most products look the same. NEWSLETTER SIGN-UP Heard on the Street The first word on what Wall Street is talking about. Preview Subscribe Some U.S. cannabis growers have reason to worry that full legalization would allow exports over state lines, which is currently forbidden even in the more than 35 states that have at least partially legalized marijuanna. Amply supplied markets like Colorado and Oregon could flood other states with products and drive down prices. States that went legal early like California, are already experiencing the same pricing trend as Canada: For the three months through September, prices of cannabis in California fell 23% compared with the same period of last year, data from HeadSet shows. U.S. companies also need Washington to avoid making the same mistakes as Ottawa. In Canada, federal excise taxes for cannabis are set at a minimum of one Canadian dollar a gram. That seemed reasonable to authorities, who assumed prices would stay at around 10 Canadian dollars a gram. However, competition cut prices in half, doubling cultivators’ tax burden. A levy based on a percentage of retail sales would help American growers to avoid this scenario, although tax revenues would be volatile. U.S. pot companies do have an efficiency edge over their Canadian neighbors. As they aren’t allowed to list on American stock exchanges, they have learned to be disciplined with cash. Several names including Green Thumb Industries are already profitable, while no major Canadian player is generating positive cash flow yet. Another positive is that expectations for U.S. cannabis stocks are already low. Cultivators that have facilities in multiple states have an average valuation including debt equivalent to 7.8 times projected earnings before interest, taxes, depreciation and amortization, analysis by Stifel shows. When Canada went legal in 2018, its listed growers fetched an over-hyped 27 times. Four years into Canada’s legal cannabis experiment, there is one clear winner: Smokers can enjoy a legal high today at half what it cost them back in 2018. For U.S. cannabis investors, an end to America’s federal ban would solve some headaches, but it would unleash plenty of new ones too. Write to Carol Ryan at carol.ryan@wsj.com MORE