Last month, when we talked about the $4 trillion potential of a fully realized global cannabis market, we saw how world governments have been trying for more than 100 years to stamp out the illicit drug trade.
Results have been mixed to poor, to put it mildly.
It seems for every victory, like the 1993 downfall of Colombian drug lord Pablo Escobar, there are two defeats, like the vast state resources used to keep 451,000 non-violent drug offenders in U.S. prisons or the low-level drug violence that's killed an estimated 115,000 people in Mexico since 2006.
That's one of the reasons why, across North America, there's a growing socio-political consensus that the war on drugs has been an expensive failure.
That "growing consensus" gets a whole lot broader when it comes to marijuana prohibition.
According to Gallup, support for cannabis legalization in the United States runs steady at 66% right now. That's up 30% since 2005.
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But despite all the progress of the last 10 years, there still exists a thriving, persistently lucrative illegal market for marijuana - even in jurisdictions where it's completely legal. And because the march to full federal legalization is basically inevitable, that black market is doing more than anything else right now to hinder the growth of the legal cannabis sector.
This could be big...
Here's Why the Weed Black Market Still Exists at All
As of late 2019, cannabis is legal in some form or another in 41 of 50 U.S. states, four out of five inhabited outlying territories, and the District of Columbia. It's legal in all 13 provinces and territories in Canada, too.
So you might think the illicit marijuana trade is concentrated in those few remaining jurisdictions where marijuana is still illegal.
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Unfortunately, that's not so. The black market is everywhere, and it's quite robust in places like California and urban Canada.
There are plenty of reasons for this. Regulation and taxation, for instance, don't always favor legal cannabis business - that's been a particular problem in California, though private enterprise and "marijuana reform" have made big strides in fixing the problems.
Forbes called Massachusetts' dispensary licensing process "snail-like." It also reports that Bay State officials estimate 75% of all cannabis sold there this year will be through black market transactions. Remember, Massachusetts is a fully legal "adult use" jurisdiction.
In Illinois, a cannabis license costs at least $225,000 - an eye-watering cost for new entrepreneurs.
In Michigan and Washington, D.C., where - for different reasons - legislators have been unable to come up with a "process" for legalized cannabis, merchants have been "gifting" their cannabis. In some D.C. establishments, one can by a $50 dollar t-shirt, poster, coffee mug, or compact disc... that comes bundled with a "free" eighth-ounce of marijuana.
In Ontario and Quebec, Canada's two most populous, urbanized provinces, legal supply is still too tight to adequately support the legal market. Consumers have to turn somewhere...
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I could go on, but it's sufficient to say the black market "lives" inside the patchwork and shortcomings of legal cannabis regulations across the United States and Canada.
It's thrown a wet blanket of sorts on legitimate cannabis business.
If a customer can get an ostensibly decent (illegal) product at a cheap cost with minimal hassle, well, they'll opt for it every time... to the detriment of a business that has to pay taxes and comply with regulations. The cannabis is often much cheaper - nevermind that it might be dangerously tainted or benefit a blood-soaked foreign criminal cartel.
Hexo Corp. (NYSE: HEXO), a fully legal, perfectly legitimate Canadian cannabis company, aims to compete with the crooks - on price.
This is an interesting experiment, and even if it doesn't work, I'm thrilled someone's trying it...
This Will Go Down in the History Books
Hexo estimates that the average Canadian cannabis consumer pays around CA$4.49 ($3.43) for a gram of black-market cannabis bought, say, in the parking lot of a Calgary 7-Eleven.
A gram of Hexo's new, legitimate "Original Stash" cannabis strain will set you back that same CA$4.49 in any dispensary that carries it. The only catch is customers must buy 28-gram (1-ounce) pouches, for a ticket price of CA$125.70 ($96.11).
That price point puts Hexo's Original Stash firmly in the "bargain bin" product category. It's definitely not a prestige product.
There are a few ways this could backfire on Hexo and its shareholders.
Hexo's costs are still higher than many other Canadian growers; the potential hit to profits could be tough. And Original Stash represents a departure from Hexo's original business plan, which was to charge a premium price for a premium product.
What's more, Hexo recently lowered its sales estimates, in part because it wasn't growing the most in-demand strains. This could be a way to "blow out" unwanted cannabis at a deep discount.
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There is the risk - to companies, at least - Hexo's move triggers a "race to the bottom" in the Canadian marijuana market. Despite early shortages, there exists the real possibility of oversupply of low-grade cannabis there in the next several months.
I don't think prices will go down to the basement levels we see here, in places like Oregon (as of April 2019, Oregon was the cheapest place to buy legal cannabis in the United States), but even at CA$4.49, higher-cost producers like Hexo could see profit margins erode significantly.
With all that said, Hexo's bold risk could prove to be worth it; I'd certainly like it to be...
This Is Big, and Hexo Could Very Well Pull It Off
If Hexo can really make a dent in the illicit market, it will help not just Hexo but all Canadian companies.
As it sells more of that low-cost cannabis, it can bring production costs down. I know some of the larger producers are making cannabis at around CA$1 ($0.76) per gram or less.
Assuming that half of that CA$4.49 per gram goes to the distributors and retailers, a CA$1 cost would give Hexo enviable gross margins in excess of 50%.
We've always known that there would eventually be pressure on lower-quality cannabis prices, so in some senses, all Hexo is doing is getting ahead of the market.
If it can gain a meaningful share of the low-cost market and take even some market share from illicit providers, it has the makings of a very nice business indeed - certainly one in which you'd want an ownership stake.
After all, McDonald's Corp. (NYSE: MCD) makes more money than every high-end steakhouse in the world combined - all at low, low prices.
This is a Canadian cannabis company to watch; great things could be in store.
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About the Author
Greg Miller started working on Wall Street in September, 1987, just a month before the “Black Monday” stock market crash.
During his career there, he became an expert in just about every kind of publicly traded security - from blue-chip and small-cap stocks to municipals, junk bonds, and derivatives. As a portfolio manager, Greg was responsible for over $500 million of assets in mutual funds and insurance company accounts.
After leaving the Street, he designed a successful options trading strategy and made lucrative tech investments for a financial publication. He has also helped develop new products and worked with other editors to hone their strategies. He’s always been dedicated to deep, fundamental research - and he always will be - because he believes buying the very best companies at the right price is the best way to amass wealth in the stock market.