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Forget Short-Sellers! This Is the No. 1 Enemy of Pot Stocks Right Now

Sean Williams, The Motley Fool

When looked at over many years, the marijuana industry has been virtually unstoppable. Cannabis stock valuations have soared with the expectation that global legal sales could hit as high as $75 billion by 2030, if Cowen Group's forecast proves accurate.

But if the time frame is narrowed a bit, things haven't been nearly as green for the pot industry of late. After a blistering start to the new year, the first tradable cannabis ETF, the Horizons Marijuana Life Sciences ETF, shed 13% of its value in the second quarter, with 25 popular pot stocks losing at least 20%.

Why the sudden shift in sentiment?

Part of the blame might be cast on short-sellers -- i.e., investors who make money by betting against a stock. Short interest rose for a majority of pot stocks listed on the New York Stock Exchange or Nasdaq during the second quarter. A growing number of shares held by pessimists would appear to imply a changing tide of sentiment among marijuana stocks.

However, rising short interest looks to be nothing more than a symptom of an even bigger enemy for marijuana stocks: Health Canada.

A cannabis leaf laid within the outline of the Canadian flag's red maple leaf, with rolled joints and a cannabis bud to the left of the flag.

Image source: Getty Images.

Health Canada is responsible for crushing pot stock valuations

Health Canada is the regulatory agency that's tasked with overseeing the legal cannabis industry. Pretty much since the passage of the Cannabis Act by Canada's parliament, it's been causing marijuana stocks and investors nothing but headaches.

The biggest issue with Health Canada is that it's responsible for reviewing and approving all types of licensing applications, including cultivation, processing, and selling. According to Marijuana Business Daily, Health Canada was contending with a license application backlog of more than 800 at the end of 2018. All the while, it's approved fewer than 190 applications to date since late 2013. Feel free to run the math, but it means an exceptionally long wait time for growers to get the green light on their cultivation projects.

In May 2018, it was taking many months for the average cultivation applicant to be granted a growing license by Health Canada. Meanwhile, the average sales license took 341 days to be granted. All told, some growers were looking at up to a two-year turnaround simply to get the OK to grow, and then sell, cannabis.

Health Canada has announced changes designed to help it work through this mammoth backlog. Rather than allow growers to submit cultivation license applications in advance of completing their greenhouses, the agency now requires all grow farms to be complete and ready for inspection prior to license application submission. Though this should help move many of the underfunded operations out of the way, it'll still take numerous quarters to work through the funded backlog.

This waiting game for marijuana growers is one reason supply has been constrained throughout most of Canada.

A label that says edibles and a single cannabis leaf lying atop cookies and brownies.

Image source: Getty Images.

The launch of high-margin derivatives will have to wait

More recently, Health Canada struck again by laying out the timeline of when cannabis derivatives would hit the market. Derivatives are non-flower options, such as vapes, edibles, topicals, concentrates, and nonalcoholic infused beverages.

Very early in 2019, Health Canada and government officials had implied that derivatives would hit the market no later than the one-year anniversary of adult-use legalization (October 17). But this tone has changed, with the regulatory agency noting that only the laws governing derivatives would go into effect by then. The actual alternative consumption options won't begin hitting cannabis store shelves until two months after the one-year anniversary (mid-December), at the earliest. And even then, many of the supply-side issues that have impacted dried flower are likely to keep derivative supply from meeting demand.

This announcement was especially hard for cannabis stocks and the investment community to stomach given that derivatives are a considerably higher-price, higher-margin product. With this delay, it'll likely be the second quarter of 2020, which is when marijuana stocks begin reporting their calendar year first-quarter operating results, before we see any significant bump up in sales and margins for cannabis stocks. This is a big reason why I expect the most popular pot stocks to again lose money in 2020.

A half-emptied hourglass on a desk.

Image source: Getty Images.

Health Canada is having a tangible impact on quite a few top-tier growers

While there are a few growers that have successfully managed to get a good portion of their projects licensed -- e.g., Canopy Growth has more than 4.8 million square feet of its 5.6 million square feet licensed for cultivation -- most pot cultivators haven't been so lucky.

Three months ago, CannTrust Holdings (NYSE: CTST) announced plans to acquire up to 200 acres of land that it would use solely for outdoor growing purposes. Though some of this outdoor-grown cannabis would wind up in licensed dispensaries, most of it would be used for extraction purposes to create higher-margin derivative products. Three months after its announcement, CannTrust is still twiddling its thumbs as it waits on Health Canada to grant its outdoor cultivation permit.

In an update last week, CannTrust announced that its initial 75,000-kilo estimate for 2019 outdoor grow from an 81-acre purchase in April is now out the window. The lag in permitting has reduced its peak outdoor grow potential in 2019 to just 15,000 kilos -- and this, too, goes out the window if the crop isn't planted by Aug. 5, 2019. After this date, CannTrust anticipates no outdoor harvest for 2019. While the company stands by its estimate that outdoor growing can yield 100,000 to 200,000 kilos of production a year, it's up to Health Canada to first give CannTrust the green light. 

The same story is true of Aphria (NYSE: APHA), although the pain it's experienced waiting for the go-ahead from Health Canada is arguably even worse.

Aphria could wind up being Canada's third-largest grower by peak annual output at 255,000 kilos, depending on how much outdoor cannabis CannTrust generates each year. Aside from 5,000 kilos of yearly output from Broken Coast Cannabis, Aphria has two main campuses: Aphria One and Aphria Diamond. Aphria One is an organically built, 110,000-kilo-a-year facility that's fully licensed. Meanwhile, Aphria Diamond, which is a joint venture with Double Diamond Farms that involves retrofitting existing greenhouses, has been waiting longer than a year for its cultivation license from Health Canada. That's 140,000 kilos of annual production potential sitting on the sidelines for more than a year.

You can blame short-sellers all you want for raining on the cannabis parade, but it's Health Canada that's done far more for the pessimists' cause than short-sellers have.

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Sean Williams owns shares of CannTrust Holdings Inc. The Motley Fool recommends CannTrust Holdings Inc and Nasdaq. The Motley Fool has a disclosure policy.