Earlier this month, cannabis enthusiasts celebrated a green sweep in the United States. Five states placed marijuana legalization initiatives or amendments on their ballots, and every single recreational weed and medical cannabis measure passed. By the end of election night, the number of medical marijuana-legal states had increased to 36, with 15 of these states also allowing for the consumption and/or retail sale of adult-use cannabis.

But more than two years before the United States celebrated its green sweep, Canada was rolling out the green carpet for adult-use cannabis sales. On Oct. 17, 2018, the Cannabis Act officially became law in our neighbor to the north.

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Canada's pot sales just hit a new all-time monthly high

In the initial months following legalization, things did not go well. Sales growth was stymied, with regulatory-based licensing issues at the federal and provincial level taking much of the blame. But over the past two years (October 2018 – October 2020), we've watched legal cannabis store sales more than quadruple. Last month, sales hit $244.9 million Canadian ($186.4 million U.S.), which is up from CA$53.7 million in October 2018 and CA$129 million in October 2019. 

This surge in sales in 2020 is a direct result of two catalysts. First, there's the coronavirus disease 2019 (COVID-19) pandemic. Although the pandemic has been bad news for most industries, we've learned that cannabis is treated like a consumer-packaged good during periods of recession. This pretty much means demand stays the same. With consumers forced to stay in their homes to slow the spread of the SARS-CoV-2 virus that causes COVID-19, they've stocked up on marijuana.

As time has passed, we've also seen more dispensaries opening their doors. This has been especially true in Ontario, the most-populous province in Canada. Until the end of 2019, Ontario had been using an ineffective lottery system to assign dispensary licenses. At the one-year anniversary mark of recreational legalization (Oct. 17, 2019), only 24 retail stores were open. Given Ontario's size and population, it could comfortably house closer to 1,000 dispensaries. Since switching over to a more traditional application vetting process for retail licenses, Ontario's dispensary count has climbed past 160, as of late August.  As more retail stores open, we would expect to see weed sales climbing.

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Here's why Canadian marijuana stocks are struggling so badly

But what might come as a shock to folks is that these significantly higher sales, relatively to where things stood one year ago, haven't translated into improved financial performance for Canadian licensed producers. The way I see it, there are three things responsible for this divergence.

Value-focused cannabis products are mauling margins

First of all, Canadian pot stocks have been forced to go toe-to-toe with black market producers that can easily undercut them on price. Even with the Canadian federal government imposing what it believed to be a nominal 10% tax rate on legal weed purchases, this tax and other legal operating costs have made it very difficult for those who follow the law to compete with the underground cannabis market.

The solution? More licensed producers (LPs) are introducing value-priced cannabis products. With virtually all LPs finished with their cultivation buildout, they're now able to lean on economies of scale to drive down their per-gram production costs. But even with output costs falling, per-gram net selling prices are tumbling even faster, thereby wrecking margins. Here's a quick rundown of the year-over-year decline in average per-gram net selling prices fort two of the most popular Canadian LPs that have chosen to focus on value cannabis products:

• Aurora Cannabis (NYSE:ACB): CA$3.72 in Q1 2021 vs. CA$8.00 (medical cannabis) and CA$5.28 (consumer cannabis) in Q1 2020
• HEXO (NYSE:HEXO): CA$4.07 in Q4 2020 vs. CA$4.74 in Q4 2019

Not surprisingly, these are two companies that look to be years away from generating recurring profits.

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Poor decision-making is limiting some major players

Secondly, some of the blame for the underperformance of Canadian LPs rests with the pot stocks themselves. Even though regulators deserve some finger-pointing (and I'll be getting to that in a moment), LPs did themselves no favors by being overzealous on the capacity front and failing to think their financing plans through.

I know I pick on Aurora Cannabis a lot, but it's the poster child for greed and excess in this industry. At the midpoint of 2019, the company owned 15 cultivation facilities capable of over 650,000 kilos of aggregate weed production each year. The entirety of Canada was only expected to consume around 800,000 kilos -- and that was assuming the industry's launch went flawlessly, which it did not.

Aurora also paid a mindboggling CA$2.64 billion for MedReleaf in July 2018. The expectation had been that this deal would add 140,000 kilos of annual output to Aurora's production total and allow it access to MedReleaf's proprietary portfolio. But after significant expense cuts announced over the past year, all that remains of this CA$2.64 billion deal is 28,000 kilos of annual output and a handful of proprietary brands.

HEXO followed a similar path. It acquired Newstrike Brands in May 2019 for just under $200 million (that's U.S.) in order to boost its output to at least 150,000 kilos a year. Less than a year later, HEXO had shuttered the Niagara facility it had acquired from Newstrike, and it was sold in June 2020 for a meager CA$10.25 million. 

Poor decisions by Canadian LPs have left little financial wiggle room to rapidly improve sales.

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Supply bottlenecks will take time to work out

Finally, marijuana stocks can still blame regulators for their woes. Although Health Canada has finally stopped stepping on toes when it comes to approving cultivation, processing, and sales license applications, provincial regulations have remained a nuisance.

For example, even though Ontario has made excellent headway in approving new dispensaries in 2020, the province is still roughly a year behind schedule, relative to where it should be. Supply bottlenecks in Canada's most-important province aren't going to simply dissipate overnight.

Another problem for pot stocks is that certain high-margin products (ahem, vapes) aren't being allowed in select provinces. Both Quebec and Newfoundland and Labrador have banned cannabis vape sales, with Alberta imposing then retracting a vape ban of its own after a two-month period. Canadian LPs are counting on these significantly higher-margin products to help offset the oversupply and commoditization that comes with selling dried cannabis flower. With avenues to sell these higher-priced pot products closed off, cannabis stocks have had no choice but to lean on lower-margin dried flower even more. 

It's quite possible that as cannabis sales hit record highs for Canada, we could see Canadian pot stocks push toward new multiyear lows.