Cannabis Investors: Will Excise Taxes Push Demand to the Black Market?

As we approach legalization day for cannabis, investors and businesses alike wait with some nervousness about what rules and regulations will be put in place. One of those issues seems to have been resolved, as the federal government recently came out with details on how it plans to tax recreational marijuana, and it’s significant.

Excise tax could significantly increase costs

The proposed tax would see sales of less than $10 being charged $1 per gram, while sales of more than $10 would be taxed 10%. Given that producers are getting anywhere from $7 to $15 a gram for medical marijuana, at the lower end of that price, that represents 14% of the sales price. Even a low-cost producer like Aphria Inc.  (TSX:APH), which develops marijuana at a cost of just $1.11 per gram, would see a big impact, as an additional dollar would almost double its cost and significantly erode its profitability. However, this development makes Aphria an even a more attractive investment option because of its low cost and ability to charge a lower price than its competitors.

Canopy Growth Corp.  (TSX:WEED) also has an advantage by having more of a global footprint and potentially having less exposure to the Canadian market. Pot growers that have high costs and that are entirely based in Canada will be hit the hardest by these taxes.

Excise tax will increase sale prices and diminish demand for legal cannabis

The tax will likely result in pot growers simply increasing the price of cannabis. Once you start adding sales tax on top of the excise tax and on top of retail pot prices, you could see a situation where the black market becomes a cheaper alternative, without all the red tape either. This is what makes excise tax a delicate topic, because despite what the prime minister may claim, a big incentive is to generate a lot of tax revenue from the new and potentially lucrative industry. However, if prices become too high, then the potential for the industry will be limited, because demand may go the route of underground dealers.

What this means for the industry

Unfortunately, these developments should not come as a big surprise, since we were expecting to see some sort of tax on the industry. However, the amount of the tax is significant and could hurt the overall growth prospects for the industry given the low price that cannabis sells for. The big challenge with investing in the industry is that we won’t know the full effects of the excise tax or other regulatory restrictions until once cannabis is legalized and we get an idea of how strong demand is, and how it compares with expectations.

What this means for investors

Investors right now are buying into hype and expectations, and although these developments may make investing in cannabis less appealing, that shouldn’t be the case. Aphria is one stock that should become more valuable since its low-cost model will make it easier to handle these increasing costs, as it will still be able to price its product very competitively. Companies that are deep in the red with a lot of debt will be the ones that will face the greatest challenges, while better-managed companies could still provide sound investment options.

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Fool contributor David Jagielski has no position in any stocks mentioned. 

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