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Beverage can labels seen during a tour at a Canopy Growth facility that produces cannabis derivatives in Smiths Falls, Ontario, Canada October 29, 2019. Canopy Growth Corp. and Aurora Cannabis Inc. report financial results.

BLAIR GABLE/Reuters

Over the past several months, the Canadian cannabis industry has shifted from a position of shortage to oversupply. That fact will shape a crucial week of earnings, as many of the largest producers report financial results amid a severe stock market sell-off and warnings that revenue growth has stalled.

The amount of legal cannabis being grown now outstrips the volume being sold in legal retail stores, and analysts are warning of wholesale price declines, fewer purchase orders from provincial buyers and potential inventory writedowns.

Investors will get their first industry snapshot on Tuesday when Tilray Inc. and Cronos Group Inc. report quarterly earnings. The real bellwether comes on Thursday, when both Canopy Growth Corp. and Aurora Cannabis Inc. report financial results.

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If Canada’s two largest cannabis companies show strong revenue, the slide in the value of pot stocks could start to turn. If Canopy and Aurora stumble, the sector could crash to new lows. Both stocks are down more than 45 per cent since the end of May.

Analysts are taking a mostly negative view and several have cut their stock-price targets ahead of the earnings announcements.

“Our industry channel checks have revealed an even more challenging third quarter than previously contemplated. This is primarily due to market dynamics in Ontario, where an oversupply of products for which there is limited demand has created an industry bottleneck,” wrote Canadian Imperial Bank of Commerce analyst John Zamparo in a note on Friday.

A number of large greenhouses have come online in the past six months, significantly increasing total legal supply. The problem is a lack of channels in which to sell this product, particularly in Ontario and Quebec, where there are fewer than 50 legal cannabis stores combined.

The pace of store openings has been faster in Alberta and British Columbia, but the legal market is still struggling to compete with a well-entrenched illicit cannabis industry on price and quality.

Douglas Miehm, an analyst at Royal Bank of Canada’s capital markets unit, estimated in October that only 12 per cent of all cannabis sales are happening in legal channels. He also estimated that legal producers have sold twice as much product to provincial wholesalers as the wholesalers have sold on to retail stores in recent months. That sets up the prospect of product returns and declining wholesale prices.

In a follow-up note published last Thursday, Mr. Miehm added that prices are also dropping in the business-to-business wholesale market. “One company noted that bulk purchase prices have gone from more than $3.50 per gram in Q2/19 to as low as around $1.00 per gram in late September but bounced somewhat in October,” he wrote.

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Investors got something of an earnings preview in late October, when Quebec’s largest grower, Hexo Corp., reported $15.4-million in quarterly sales – 40 per cent lower than it had forecast – and a net loss of $56.7-million.

The loss included a $16.9-million writedown on inventory. Hexo had purchased cannabis on the wholesale market, but was unable to sell it profitably as prices dropped.

“Purchasing that product happened before we had full visibility on [retail] store count,” Hexo chief executive Sébastien St-Louis said on the company’s Oct. 29 earnings call.

Hexo also cut $3.8-million from its reported revenue to account for the expectation that some product will be returned unsold. Canopy revealed a similar $8-million adjustment in August, saying that it expected oil and gel-cap products to be returned.

Aurora, for its part, has already signalled that it expects little growth this quarter. On the company’s last earnings call in September, Aurora’s chief corporate officer Cam Battley said there will be a “plateau between now and the advent of the cannabis legalization 2.0 products.”

The chief concern for Aurora is that its business-to-business revenue, which accounted for $20-million in sales last quarter, could drop significantly. Eight Capital analyst Graeme Kreindler wrote last week that he expects Aurora to report only $1.75-million in business-to-business revenue.

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Because Aurora and Canopy had relatively strong sales in the first year of recreational cannabis, their challenge is maintaining momentum.

Other companies that started slower have more room to increase revenues, Bank of Montreal analyst Tamy Chen wrote in a note last Monday. But they could still find growth curtailed by a build-up of product inside provincial vaults.

“We have heard that limited warehouse capacity at Ontario and Alberta may have already resulted in product returns, with potentially more to come,” Ms. Chen wrote.

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