The outlook of Tilray (NASDAQ:TLRY)has improved due to the shares’ plunge over the last year and the increased potential of the company’s overseas business. Still, the valuation of Tilray stock remains elevated.

The cannabis sector continues to face important structural challenges. As a result, at this point, the shares  are a gamble on U.S. legalization of cannabis. And in my view,  the chances of that occurring by 2022 are less than 50%.

Tilray stock has tumbled 78% in the last 12 months. The plunge came as cannabis investors realized that demand for legal cannabis products would not increase as quickly as many had expected.

I had warned about the negative impact of those challenges in multiple columns published in 2019.

A Closer Look at Tilray Stock

In December 2018, Tilray launched a Latin American subsidiary and said that it would seek ” to distribute Tilray products throughout Latin America.”

In August 2019, the company signed a deal to provide marijuana to a German pharmaceutical company from a new plant it had opened in Portugal.

And on its second-quarter earnings conference call, held in August 2020, Tilray CEO Brandan Kennedy said, “We see a significant opportunity in the medical market in France and continue to aggressively pursue potential market opening opportunities in other countries.”

Encouragingly, Tilray’s international revenue jumped 349% year-over-year in Q2, though its overseas sales still only amounted to $8.3 million.

However, since the company’s total Q2 cannabis revenue only came in at $26 million, its overseas business has actually become a sizable  portion of its overall sales. Moreover, I think that its exports can continue to surge as it enters new markets, some of which probably have a more liberal attitude towards cannabis than Canada.

Two of the larger countries in Latin America –Mexico and Brazil – are in the process of legalizing cannabis, while growing the plant in the region is quite cheap.

But despite its plunge over the last year, Tilray stock continues to  price in a great deal of growth. Specifically, its shares are trading at a still-very-hefty enterprise-value-to-revenue ratio of nearly five, while its trailing price-sales ratio of 2.67 isn’t very attractive either.

Structural Challenges and Tilray Stock

In Canada, the cannabis companies are still having trouble competing with the black market where costs are much lower than those of the legalized market.

Kennedy, Tilray’s CEO, noted that his company had cut costs in an effort to gain share from the black market. Presumably other cannabis makers have followed suit. But he noted that legal companies still had less than a 20% share of the total market in Canada.

Amid competition from the black market and the poor economy, Canadian producers have had to cut their prices and rely primarily on sales of cheap, dried cannabis. Competition from the black market will remain a major problem for Tilray and its peers going forward.

Meanwhile, overall demand hasn’t come close to exploding in Canada as much as the marijuana stock bulls had predicted, as cannabis sales came in at only $173 million in July in the country.

I continue to believe that competition from the black market and relatively low social acceptance of marijuana use will prevent cannabis sales from ever coming close to those of alcohol in the U.S. and Canada.

Gambling on U.S. Legalization

Until the U.S. federal government legalizes cannabis, it will be very difficult for companies to sell pot in the country.

As long as marijuana remains illegal under federal law, U.S. banks are reluctant to loan money to cannabis companies and “transporting marijuana across state lines could result in federal criminal prosecution,” according to FindLaw.

Of course, if the U.S. legalizes marijuana, Tilray and its peers would have a huge new market in which to  sell their products, providing a gigantic boost to Tilray stock and its peers.

There is indeed a chance that the U.S. will legalize cannabis in 2021. For that to happen, Joe Biden would have to become president and the Democrats would have to take control of the Senate. But that’s far from a certain outcome.

Further, even if the Democrats do capture the White House and narrowly win control of the Senate, I’m not sure if they will have the votes in the Senate to legalize cannabis.

If they maintain the current filibuster rule, which effectively requires 60 votes to pass most legislation not having to do with the budget, they will probably have great difficulty recruiting enough moderate Republicans to legalize cannabis.

But even if Democrats abolish the filibuster, they may have difficulty obtaining the necessary 50 votes to legalize marijuana. Given continued concerns from relatively conservative states like North Carolina, West Virginia, and Arizona may find it difficult to vote for legalization.

Providing evidence for that assertion,  last month moderate House Democrats convinced their party’s leadership to delay a vote on a marijuana legalization bill, likely until after the election.

The Bottom Line on Tilray Stock

The shares’ outlook has improved amid the company’s rising overseas sales, lower valuation, nd higher chances for the legalization of cannabis by the U.S. Congress.

Still,  I think, given the sector’s challenges and the shares’ high valuation, Tilray stock probably won’t outperform the market unless the U.S. legalizes cannabis. And as I noted earlier, I think the chances of that happening are below 50%. Therefore, I recommend that investors avoid the shares.

On the date of publication, Larry Ramer did not have (either directly or indirectly) any positions in the securities mentioned in this article. 

Larry has conducted research and written articles on U.S. stocks for 13 years. He has been employed by The Fly and Israel’s largest business newspaper, Globes. Among his highly successful contrarian picks have been solar stocks, Roku, Plug Power, and Snap. You can reach him on StockTwits at @larryramer. Larry began writing columns for InvestorPlace in 2015.