Times of transformation can make for huge opportunities, particularly when they involve major shifts in the law. Take, for instance, the familiar tale of Joe Kennedy. As the end of prohibition neared, Kennedy moved to secure distribution contracts for European liquor brands. Using his company Somerset Importers, Kennedy became the lone distributor for Gordon’s Gin and Dewar’s Scotch in the United States. When prohibition was repealed soon after, Kennedy made a mint.
Now, the United States approaches the end of its second great prohibition. It has, year after year, become increasingly clear that the criminalization of cannabis is a largely arbitrary and irrational legal standard. The signs that marijuana will be legal for a significant portion of the American population within the next few years are increasingly hard to ignore, as more and more US states look to have ballot measures to legalize cannabis. And in this sort of atmosphere, with seemingly inevitable change looming on the horizon, opportunity abounds.
Like Joe Kennedy, investors today have a chance to enter into a massive, existing market at a huge discount. Today’s savvy cannabis investors could very well have a chance to invest in the next Anheuser Busch (BUD) for pennies on the dollar. Except that, in this case, the opportunities aren’t limited to recreational use by adults. Cannabis has a range of applications in the medical field that scientists are only just beginning to understand, and a variety of related industries poised for rapid growth as marijuana legalization efforts continue to gather steam.
For any investors interested in taking a shot at some huge returns, it’s time to take a deeper look at the legal cannabis industry, both in its current state and with an eye towards its future.
Legalization Rolls Across the U.S.
The legal marijuana industry has experienced a major transformation over the past 20 years, one that has rapidly accelerated in the past three years, and it’s the American people’s increasing support for the legalization of marijuana that has been the primary driver. A Gallup Poll released in October 2013 showed that 58% of Americans are in favor of legalization, a 10% increase from 2012. The accelerating momentum of this support has given rise to the passage of new marijuana regulations in many states, with major legal reforms currently underway in several others.
Chart 1: United State Legalization Timeline
It’s likely that 2014 will be remembered as a turning point in the battle for legalized cannabis. It’s the year that the industry became a consistent focal point for national media outlets and captured the public’s attention in unprecedented fashion. In the past year, eight new states, plus the District of Columbia, have approved new medical marijuana sales regulations, including Massachusetts, Illinois, Connecticut, Vermont, Delaware, New Hampshire, Minnesota, and most recently New York, raising the total number of states permitting medical use to 23.
Chart 2: Cannabis Legal Status by State
Moreover, on January 1, 2014, Colorado and Washington became the first states in the nation’s history to implement policies for legal adult use of recreational marijuana. Since Colorado’s recreational market went live, the state has licensed more than 300 recreational dispensaries, generating an estimated $700 million in marijuana revenues, including just under $386 million in medical marijuana sales and more than $313 million in recreational revenues. In 2014, Colorado is estimated to have collected nearly $70 million in tax revenues from its cannabis industry.
The impact of tax windfalls for states that have passed medical and/or recreational legalization is a major driver for additional states to adopt legalization initiatives, as is the overwhelmingly positive experience “on the ground” in Colorado. Since legalizing adult use, the Centennial State has seen unemployment decline, driving fatalities decrease, hospital admissions for narcotics overdoses decline, and property values rise.
In the November 2014 midterm elections, Oregon, Alaska, and the District of Columbia joined Colorado and Washington in successfully passing legislation to legalize recreational cannabis. Additionally, more than a dozen states are currently evaluating legalization initiatives, and it is believed that 7-12 of these will have legalization on the ballot for the 2016 election. Importantly, the state of California is one of them, which, based on population alone, would increase the size of the legal cannabis market by up to 20%.
Cannabis Becomes One of the Fastest Growing Markets in North America
The total market for cannabis, legal and black market, is estimated to exceed the economic value of corn and wheat, which is why it is widely considered to be the largest cash crop in the United States. According to a report by the Associated Press in July, it is estimated that the value of the total domestic cannabis market ranges from $35 billion to $50 billion.
Even though it is illegal in most of the nation, the legal cannabis industry is among the fastest-growing markets in the United States, with it already being valued at approximately $1.43 billion for 2013 and growing 77% to $2.7 billion in 2014. And even that could itself be a conservative estimate due to the potential undercounting of ancillary products and services.
All told, the long-term growth outlook for the industry is very strong. Based on growth in the current market, and more states moving to allow medical cannabis and/or make recreational use legal, some estimates anticipate growth in excess of 700% to over $10 billion by 2018. Compare that to the domestic beer market, which only grew sales by approximately two percent in 2014.
Table I. Annual Retail Sales by Industry
In comparison to other comparable markets, such as beer, wine, and vodka, the legal cannabis market remains small, as its legal status places severe constraints on growth and development. But, if the government was to legalize the substance on a federal level, the legal cannabis business would have the potential to grow at an explosive pace. Bloomberg estimates that if cannabis was legalized, the US market potential would be between $35 billion and $45 billion.
The market for medicinal use in Canada is estimated at $144 million in 2014, rising to $388 million in 2018 and expected to reach $1.3 billion by 2024. At the end of 2013, Health Canada reported that there were 37,359 patients who had medical marijuana licenses in Canada, up from 477 in 2002. The government estimates that, by the end of 2014, there will be a total of about 58,000 licensed medical users, projected to increase to about 450,000 over the next 10 years, a compound annual growth rate of 24.5% in sales and 27.7% in registered patients. And even these estimates are likely to be conservative, since Canada’s MMPR law enables small businesses to export marijuana to legal jurisdictions throughout the world. As countries progressively migrate their policies toward deregulation, it will position Canadian companies to have a first mover advantage, allowing them to successfully supply the other countries’ marijuana demand regardless of its legal status at home.
The Opportunity for Investors
The rapid growth in the legal cannabis market has driven its own industrial revolution. Thousands of new companies have been started, more than two hundred companies have gone public, and a slew of new technologies, products, and services have been launched. Investors have poured hundreds of millions of dollars into public and private companies, including high profile figures such as Warren Buffet from Berkshire Hathaway ($BRK.A) and Peter Thiel, the founder of PayPal ($PYPL) and a seed investor in Facebook (FB) , and there are nearly a dozen private equity funds that focus exclusively on the cannabis industry. There are even some prominent celebrities helping create celebrity-backed brands, including Melissa Etheridge, Willie Nelson, and the late Bob Marley.
All in all, the cannabis space is an increasingly diverse one, with companies ranging widely in size, region covered, and industry. For investors, that means there are a range of opportunities, from established pharmaceutical companies pushing into the mid-cap range to small, local dispensaries serving a single neighborhood.
Investment Opportunities: Big, Medium, and Small
Business revenues and profitability vary widely across the industry, driven by differing regulations and market dynamics. In addition, the large dispersion of business revenue is also due to the fact that there are three different types of cannabis-related businesses.
Small Local Businesses: Ranging from cultivators supplying inventory for just one small dispensary to edibles producers working out of a small kitchen, these businesses may only generate $50,000 or less in annual revenues. Many are not interested in, or do not have the skill or financial resources, to become larger organizations.
Mid-sized Regional Businesses: These businesses include established dispensaries, consultants and services firms such as lawyers and accountants with a specialized client base. Many of them have past entrepreneurial experience, but may not want, or may not have the ability/resources to grow their business beyond a handful of employees. Their revenues range from $100,000 to about $750,000.
- Large National Brands:These include the largest local dispensaries, especially those with multiple locations, as well as infused product companies with popular brands and ancillary companies that serve the national market. Some are publicly traded companies on over-the-counter markets. Their owners and shareholders are focused on significant growth of the company, including licensing, franchising, and aggressive national distribution at some point in the future.
A Diverse and Varied Sector
New York City-based research firm Viridian Capital Advisors has created the Viridian Cannabis Stock Index in order to track the performance of publicly traded cannabis stocks on an individual sector basis. Here’s a look at the 11 different sub-industries Viridian identified for its index:
Table II. Cannabis Industry Sub-Sectors
As cannabis cultivation becomes more industrialized, the agriculture technology (AgTech) sector is positioned for growth, specifically with regard to newly advanced cultivation products and processes. Cultivators are able to create competitive advantages driven by technological innovation in areas such as automated fertilization systems, modern greenhouse technologies, and LED technology. Technological innovation is driving changes in the way marijuana is grown, allowing cultivation sites to lower costs, boost yields, and maximize production capacity. Downward pressure on pricing will reward low cost producers and eventually push smaller producers out of the market.
Ancillary Products & Services
The ancillary products and services sector is something of a catch-all sector, encompassing various offerings that are complimentary to the cannabis industry. This sector displays a wide variety of products and services, ranging from laboratories that test the cannabinoid content and contaminant levels to marijuana breathalyzers for police. Going forward, other ancillary products/services, including insurance, packaging, and tourism services are likely to emerge.
With 14 component companies, the Biotech sector is the largest in the Viridian index. Biotechnology companies are looking to capitalize on the anticipated growth of the cannabis-derived pharmaceutical market by levering the mounting data on the therapeutic effects of cannabis and deploying rigorous testing for quality, safety, and efficacy. Cannabinoid research, historically led by scientists in Israel, has lately garnered much interest in the United States. Numerous studies have been initiated to investigate the potential effects of cannabinoids in the treatment of a wide array of ailments, including but not limited to cancer, diabetes, and neuromuscular disorders. While natural plant extracts cannot be patented, FDA approval will guarantee seven years of market exclusivity for specific formulations of various cannabinoids or their derivatives that have certain indications for the remedy of target diseases. These formulations can lead to a strong intellectual property portfolio from which products can be subsequently developed and/or licensed.
The complexity of legal marijuana markets in regard to licensing, zoning, and operations, has created demand for consulting and advisory services in various different aspects of the industry. These services are designed to help entrepreneurs develop comprehensive strategies based on market need and growth opportunities by addressing everything from site selection and design to license procurement and facility build-outs. License procurement consulting services is one of the areas experiencing the strongest demand. The complexity of the licensing process, its variability by state, and its high cost have driven investor groups to engage consultants to lead them through the process. With the industry’s dynamic regulatory landscape and financial limitations, these services are invaluable to companies looking for a smooth entry into the industry.
With the increasing acceptance of marijuana in society, alternative devices for consuming marijuana have experienced rapid growth. One of the fastest growing types of consumption devices is the vaporizer, which utilizes a battery-powered or electric atomizer that heats loose cannabis leaves, cannabis wax, or cannabis oil until the cannabinoids evaporate into a gaseous vapor that can be inhaled while leaving many of the non-active ingredients behind. However, vaporizer brands market their products’ wellness pedigrees carefully since they are prohibited from making outright public health claims.
To successfully market their products, many companies emphasize the intensive R&D efforts that go into their production processes. In addition, health trends go hand-in-hand with style, which is a major factor in the rapid growth of vaporizing over traditional smoking methods of marijuana. Not only has vaporizing, or more colloquially “vaping,”, become more popular as an alternative to smoking marijuana, but in some states such as Minnesota, vaporizing is making its way into medical marijuana laws as the preferred way of consuming the medicinal drug. The law in Minnesota does not allow medical marijuana to be smoked, although it will be available in a pill form, oil form, or a form that can be vaporized.
Cultivation and Retail
Despite federal law keeping most of publicly traded cannabis companies away from the direct production or sale of cannabis in the U.S., there has been a growing number of companies with a risk tolerance high enough to position themselves as direct handlers. Production is growing on a massive scale, with larger and larger grow facilities being developed. Economies of scale in production will create competition, driving down raw flower prices and pushing many small- and medium-sized operations out of the market. If these first movers are able to successfully refine their operations, they will be strategically positioned to generate high returns and capture significant market share.
Infused Products & Extracts
Legalized recreational marijuana sales in Colorado and Washington have driven the market growth of infused products and extracts as many dispensaries, particularly in tourist areas, report that edibles and extracts represent an increasing percentage of their sales. With cannabis purchases by out-of-state visitors accounting for an estimated 44% of all retail sales in the Denver area and about 90% in mountain resorts, infused products and extracts are experiencing soaring demand. The industry is also seeing the convergence of brands of vapes and infused products, as providers are expanding into additional states.
Investments & M/A
The Investment/M&A sector of the cannabis market will continue to develop as the market undergoes a natural consolidation process and new investors enter the space. There’s reason to believe that consolidation will occur in both public and private companies, as public companies seek to bolster growth through acquisition and private companies look to go public through an acquisition by a public company. Furthermore, the shake-out of poorly capitalized companies in the industry may continue, leading to increased investment and M&A activity as stronger companies move to acquire the assets of those companies that do not have the necessary capital to monetize these assets.
The grey nature of the cannabis industry has created a cash-only environment. Because banks are federally chartered, they are wary of the risks of providing services to the cannabis industry due to its classification as a Schedule 1 drug. As a result, credit card companies and banks will not legally service marijuana dispensaries, necessitating a very high level of security to manage the large amounts of cash. This has positioned security as one of the most crucial aspects of cannabis business operations. Businesses need security system solutions not only to protect business assets, but in many cases also to comply with state regulations. As a result, security providers and consultants are emerging. These security-consulting companies assist in security and transportation logistics for legal marijuana business and provide on-site compliance verification to ensure that local business owners are operating lawful and inspection-ready establishments.
As more states establish regulated medical and recreational marijuana markets, the market for zoning-approved real estate for cannabis entrepreneurs is increasing. When applying for a dispensary or cultivation license, each applicant must have property for the dispensary or cultivation facility attached to the license application. Due to the scarcity of real estate that meets the stringent zoning requirements, these properties are valuable and difficult to obtain. As increased demand from entrepreneurs seeking to open cultivation sites and dispensaries causes prices for such properties to increase, companies have opportunities to acquire these real estate properties and lease them out to potential operators at premium rates.
Some states with legal marijuana markets have implemented policies with the aim of preventing marijuana from being diverted (“grey market”) or transferred into states where it is illegal or being purchased from or sold by non-licensed producers. An emerging policy is the requirement to utilize a comprehensive “seed-to-sale” tracking system that provides a “chain of custody” from cultivation to end sale. Washington and Colorado have adopted statewide marijuana tracking systems that have been increasingly deployed by the constituent dispensaries and growers in each state. We expect continued adoption of such systems from the state level down to commercially licensed entities.
With seed to sale software, each plant and room is assigned a unique identification marker that allows for effortless tracking, for business owners as well as regulators, of the product through its lifecycle process. For states that enforce maximum marijuana production limits, the software can assist cultivators in staying within the legal limits through automatic patient to plant assignment. The raw cannabis materials that are converted to edible, pre-rolled, and/or pre-packaged items are able to be traced back to the original plant from which they were derived, even if a new identification marker is generated. Another benefit of these tracking systems is one which directly affects business owners’ bottom lines. The tracking functions allow growers and/or distributors to analyze the data generated to determine profitability and also to project future yields. This advanced technology, alongside integrated weighing methods and redundancy systems, has aided in maximizing profitability for many marijuana business owners by controlling inventory use of each plant down to the gram.
A Growing Business Ready for the Future
All in all, the legal cannabis industry is in a unique place. Cannabis remains a Schedule I drug in the United States, something that clearly limits its short-term growth. But it’s also abundantly clear that this can only be the case for so long. Four states and Washington, D.C. have already legalized cannabis, and about half a dozen more appear poised to do so next year. By the time the last ballot is counted for the 2016 elections, as many as one in four Americans could be living in a state that has approved legal adult use of marijuana.
And even if efforts for legalization were dealt a wildly unpredictable blow between now and then, the exciting research into the endocannabinoid system and the potential for cannabis extracts and products to become an important part of treating a wide variety of diseases seem to indicate that cultivation of the plant, even if just for medicinal purposes, will continue for the foreseeable future.
It’s the sort of market opportunity that doesn’t come along often. This sort of cultural shift is rare. For the investor looking for big returns, today’s legal cannabis industry could represent the sort of early in that doesn’t frequently present itself. Much like Joe Kennedy saw a chance in 1933 to take a calculated risk with a chance at a huge return, today’s cannabis investor has the chance to move before the rest of the market gets wise.
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