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HIGHLIGHTS
  1. StatsCan added cannabis to its GDP calculations for the first time, finding legal pot accounts for roughly 20 per cent of Canada’s total cannabis market
  2. Compared to U.S. states where recreational cannabis has been legal for years, one policy expert is impressed by the progress Canada has made in just a few months
  3. Investors using higher illegal market conversion projections in order to justify high valuations could be in for a disappointment, analyst warns

Canada is making more progress towards eradicating the sale of illegal marijuana than the latest data might suggest, experts say, even if the infiltration of legal pot is not happening as fast as some investors had hoped.

Last week, for the first time ever, Statistics Canada included legal cannabis in its GDP calculations. The agency found, on an annualized basis, Canadians spent $5.9-billion on marijuana in the final three months of 2018, with $1.2-billion or roughly 20 per cent of that money being spent legally.

While Bay Street analysts have long warned that consumers are not being enticed away from the illegal market fast enough to justify the enormous market values of Canada’s largest pot companies, Rosalie Wyonch says the growth of Canada’s legal marijuana looks pretty good when compared to other places where legalization has been in place much longer.

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“The numbers we are seeing are well within what we would expect, but they are leaning toward the better side of the average and so that is encouraging,” said Ms. Wyonch, a policy analyst at the C.D. Howe institute who has covered the rise of the nascent legal cannabis industry. “It is a new market and we knew that all demand wasn’t going to shift over from the illegal market right away, Colorado, for example, has had a legal market since 2014 and they still have a certain amount of illicit activity.”

Projections from BDS Analytics say illegal cannabis will continue to command a roughly 34 per cent market share in Colorado this year, which the research firm notes is actually the lowest proportion among jurisdictions in the United States with recreational cannabis markets.

Legal cannabis versus illicit cannabis market share (est.)

20182019
% legal% illicit% legal% illicit
California17.70%82.30%21.60%78.40%
Colorado 66.60%33.40%66.00%34.00%
Massachusetts10.30%89.70%23.70%76.30%
Oregon51.80%48.20%58.60%41.40%
Washington61.00%39.00%65.00%35.00%

Source: BDS Analytics

There is no official data tracking the size of the illegal cannabis market, notes Tom Adams, managing director of industry intelligence at BDS, but the firm incorporates “state-by-state usage percentages, and our point-of-sale tracking in six states gives us a good read on per consumer units and spending levels,” Mr. Adams said.

“So then we estimate from there, but it is all cross-checked against law enforcement data on arrests and cannabis seized, and government estimates of grow capacity.”

Statistics Canada was also forced to rely on guesswork to some extent, particularly given its illegal market data is based in part on self-reported crowdsourced information gathered online. That makes it difficult to assess the accuracy of the figures reported last week, particularly given the agency previously said prior to recreational legalization taking effect, legal medicinal marijuana sales accounted for roughly 10 per cent of Canada’s total pot market.

It is very hard to tell how much of the market is currently made up of medical patients, Ms. Wyonch said, as “there are a certain number of people who are accessing cannabis illegally but for medical purposes.”

“Since legal cannabis is actually more expensive, there may be medical patients that choose to access the market illegally simply because of the cost,” she said, noting medical users tend to be among the most regular consumers of cannabis, adding to costs which, controversially, got even higher with recreational legalization as all legally-purchased cannabis - even for medical purposes - became subject to federal excise taxes.

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Investors, meanwhile, are on the hook for what some see as much slower-than-expected progress. Assuming 80 per cent of the illegal market is overtaken by legal sales, Veritas Investment Research analyst Stuart Rolfe estimates shares of Canada’s eight largest publicly-listed cannabis companies are trading at approximately 24 times their expected 2020 earnings. Drop that assumption to 40 per cent illegal market conversion, and that ratio jumps to 64 times next year’s projected earnings.

For comparison, Corona-maker and major Canopy Growth investor Constellation Brands trades at roughly 17 times its expected earnings and Altria Group, which owns a major stake in Canada’s Cronos Group, currently trades at about 12 times expected 2019 earnings.

“Growth multiples in these competing sin stocks should be enough to convince more than a few cannabis bulls that many of the current equities are expensive,” Mr. Rolfe told clients in a report originally published in October, 2018.

Two months later, on Dec. 21, Mr. Rolfe published another report warning legal cannabis would only capture about 40 per cent of the Canadian market by 2020, down from his original estimate of 60 per cent, arguing balance sheets will suffer the slower progress.

“As provincial monopolies pressure producers costs over time, the layered tax structure should disproportionately hurt producer margins,” Mr. Rolfe said.

There is ample reason to believe legal pot will continue infiltrating the criminal market in the coming months, C.D. Howe’s Ms. Wyonch said, noting Ontario still has yet to roll out brick-and-mortar retail stores and supply shortages continue to persist across the country, limiting incentive for consumers to switch. The faster those incentives can be created, she said, the better.

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“These current numbers make me cautiously optimistic, but I still think they aren’t good enough to say this will all take care of itself and we shouldn’t worry about it,” Ms. Wyonch said. “It is encouraging, yes, but it also shows there is still quite a lot of work to be done.”

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