Black Market Marijuana Is a Big Problem, and This New Survey Proves It

California's cannabis market is leading by example. However, it's not a good example.

by Sean Williams (TMFUltraLong) on Sep 16, 2018 at 1:29PM

The marijuana industry is just over a month away from making history. Following the passage of the Cannabis Act by Parliament on June 19, our neighbor to the north, Canada, is set to become the first industrialized nation to legalize recreational marijuana on Oct. 17. When fully legal, adult-use weed is expected to add billions in annual revenue to the industry.

We've also seen steady growth in the U.S. and global cannabis markets. Despite being illegal at the federal level in the U.S., 30 states have passed broad-based medical marijuana laws since 1996 -- the latest of which was the traditionally Republican-leaning state of Oklahoma. Self-identified members of the GOP generally have a more negative view of cannabis, which makes this legalization all the more notable. Globally, around 30 countries have given the green light to marijuana in some capacity.

In many ways, the ongoing expansion of the cannabis industry is great news. Aside from creating jobs and generating tax revenue for the local, state, and even federal government (at least in Canada), investors are expected to take advantage of the industry's explosive growth potential. It certainly explains why marijuana stocks have catapulted higher since 2016 began.

But what if lofty sale and profit expectations don't come to fruition? Though such an idea might sound preposterous, given the euphoria surrounding Canada's legalization and Europe's push for medical marijuana, it's not as crazy as you might think. That's because the greatest thorn in the marijuana industry's side, the black market, is tougher to get rid of than most folks realize.

Stamping out the black market isn't going to be easy

According to a new survey conducted by Marketview Research in California, out of the 1,419 people questioned, 18% had purchased cannabis from an unlicensed source within the past three months. Of these black market purchases, 85% of consumers reported feeling completely or very satisfied with their purchase, and an equally high 84% said they'd be likely to purchase from the same unlicensed source in the future.

This so significant because California, along with Canada and other legalized states and countries, are counting on tax revenue and competitive legal-weed pricing to drive out unlicensed players. In California, some estimates made before recreational pot's Jan. 1, 2018, launch suggested it could generate $1 billion in annual tax revenue atop what the industry was already bringing in through medical weed sales. Yet early indications are that this figure may fall well short of expectations -- and taxation could be to blame.

In California, a tax of $9.25 an ounce is levied on marijuana flower, along with $2.75 an ounce on cannabis leaves. There's also a 15% excise tax on the price of the product, along with state and local taxes. Altogether, this could work out to a tax rate of up to 45% passed along to the consumer. Mind you, that doesn't include the cost of licensing and permitting, rent, and other expenditures that the legal supply chain needs to abide by to even sell marijuana. 

Meanwhile, the black market has considerably less overhead, since it doesn't have to buy cultivation permits, pay rent, or hand over exorbitant amounts of tax revenue to the state or local government. Sure, it's illegal, but the cannabis these underground individuals and operations produce is considerably cheaper than what's being found in licensed Californian dispensaries. That's a big problem, and it could have an impact on the success of the cannabis industry, as well as the stocks that investors expect to benefit from its growth.

The black market could be bad news for pot stocks. For example, CannaRoyalty (NASDAQOTH:CNNRF) is very much counting on the success of California's marijuana industry to drive its results.

Originally more of an investment company, CannaRoyalty has transformed into a niche distributor. With thousands of brands competing for shelf space in (eventually) hundreds of licensed dispensaries, CannaRoyalty is angling to be the profitable middleman and has been scooping up small distributors over the past year. However, if growers overproduce cannabis because they aren't taking into account the role the black market is still playing, then demand for distribution could prove lumpier than expected, leading to less consistent growth and profitability for companies like CannaRoyalty.

Even upscale retailers such as MedMen Enterprises (NASDAQOTH:MMNFF), which has half of its 16 locations located in California, could find themselves at the mercy of the black market.

To be fair, MedMen is in better shape than CannaRoyalty, given that MedMen's clientele is usually under the impression that they're going to find higher-quality strain products that carry a premium price tag. But that doesn't mean MedMen is immune to the impact of black market prices on legal cannabis channels. Though it's tough to tell, with the company's sales spiking as it opens a number of new locations, it wouldn't be at all surprising if organic growth in existing locations in California disappointed in 2019 and/or 2020 as a result of the black market's presence.

For the time being, investors may need to take a wait-and-see approach with pot stocks to ascertain just how much of the North American cannabis market unlicensed producers can hold onto. If Marketview's survey is any indication, it could be a larger piece of the pie than most folks expect.

Read more at Motley Fool

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