The legal cannabis industry has experienced a major transformation over the past three years. Massive shifts in the business environment have changed the industry landscape in a variety of ways. The American population’s increasing support for the legalization of cannabis has been a primary driver of this rapid change, with the trend being validated by the Gallup Poll released in October 2015 showing that 58% of Americans are in favor of legalization, a 7% increase from 2014. The accelerating momentum of support has given rise to the passage of new cannabis regulations in many states, as well as multiple law reforms that are currently underway in others.
In the past year, eight new states plus the District of Columbia have approved new medical cannabis sales regulations, which include Massachusetts, Illinois, Connecticut, Vermont, Delaware, New Hampshire, Minnesota, and most recently New York. With the new legislation in place, the total number of states permitting medical cannabis use has risen to 23. Moreover, on January 1, 2014, Colorado and Washington became the first state in the nation’s history to implement recreational cannabis use policies. With these states benefitting from substantial tax revenue from these inaugural policies, many experts estimate that seven to fourteen new states could attempt to enact similar recreational use policies by 2017. In the November 2014 midterm election, Oregon, Alaska and the District of Columbia successfully passed legislation to legalize recreational cannabis. This will help propel the cannabis sector in several key ways, from increasing the flow of capital into legal cannabis companies to setting up a 2016 legalization push in California and other states.
Oregon and Alaska now join Colorado and Washington State, which legalized recreational cannabis in 2012. Oregon’s recreational market became operational on October 1, 2015 and has already experienced early success, generating an estimated $11 million during the first week of sales. The rapid pace of recreational sales in Oregon has already surpassed the dollars spent on cannabis compared to Colorado’s first week of recreational sales, at $5 million. Moreover, it took Washington State a month to sell its first $2 million. Alaska has not experienced the same speed to market as Oregon, with Alaskan state officials currently in the process of creating the administrative system for cannabis sales, which are expected to begin by 2016. Voters in the District of Columbia passed what has been called “soft legalization,” which allows citizens to possess and grow small amounts of cannabis, but does not create cannabis stores.
The successful legislation in Oregon, Alaska, and the District of Columbia, along with the close result in Florida, make 2015 another critical year for the cannabis industry. These midterm results will offer lawmakers in other states the confidence to introduce new initiatives for action in 2015 and placement on 2016 ballots. This trend will be accelerated if the sale of recreational cannabis in Colorado and Washington State appears to be a success.
To date, 23 U.S. states and Washington, D.C. have legalized medical marijuana, and similar laws have been passed in Canada. According to the Marijuana Business Daily’s Marijuana Business Factbook 2015, sales of legal marijuana grew from $1.6 billion in 2013 to between $2.0 billion and $2.4 billion in 2014, with sales on par to surpass $3 billion in 2015.
These sales figures, however, only account for marijuana sales to end users. They do not include revenues generated by the cultivators selling to wholesalers, wholesalers selling to retail dispensaries, or many of the other value generating businesses and activities in the cannabis industry. The cannabis industry, when considering all of the products and services that go along with it, added between $6.1 billion and $7.6 billion to the U.S. economy in 2014.
Cultivation and retail companies are looking to capitalize on the anticipated growth of the cannabis market as new legislation opens additional jurisdictions for business growth and further market penetration. Cannabis use has been widespread in the U.S. for decades, but recent initiatives driven by popular support have instigated policy changes that have, in turn, led to the development of legal cannabis production and sales. Numerous polls have cited the rising support of cannabis cultivation and sale, particularly for medical purposes. Furthermore, while politicians have been slow to adapt to the changing views of their constituents, the resulting tax revenues and other secondary effects such as reduced incidences of drunk driving and prescription drug deaths resulting from the loosening and/or removal of laws surrounding cannabis production and sale have increased momentum in legalization movements and have pushed legislators to reconsider their previously held positions on cannabis.
The Capital Markets Take Notice
The Viridian Cannabis Stock Index identifies and tracks 80 publicly traded companies in the emerging cannabis industry that we believe have the potential for growth. These companies are categorized across eleven different sectors. The Viridian Cannabis Stock Index was recently cited by Barron’s as the benchmark index for the cannabis industry (Barron’s, “‘Alternative’ Investments: Marijuana and Climate Change”, June 9, 2015).
The cultivation and retail sector of the Viridian Cannabis Stock Index has been the second best performing of the 11 sectors in our Index, returning 97.5% in 2013, 84.6% in 2014, and 102.1% in Q1’2015, before declining 29.0% in the second quarter of 2015. The cultivation and retail sector, as of the release of this report, contains eight companies. The sector’s strong stock performance and high exposure over the past few years has attracted the attention of the public and investors alike. In 2014 and through the first half of 2015, the cultivation and retail sector raised the second most capital among the eleven sectors in our Index. Over this same period of time, this sector had the fourth highest level of M&A activity. However, these figures do not include the capital raises or M&A activity of the private companies in this sector, which is much greater given that private companies make up the vast majority of the cannabis cultivation and retail sector. The availability of capital in the public markets and in private equity, in addition to large public interest, is driving the increasing number of new public and private companies focused in this sector.
We believe that the first significant strategic acquisition in the industry will come from “Big Tobacco”, major brands in the tobacco industry that are likely to acquire or partner their way into the cultivation and retail opportunities in the cannabis market. Early acquisitions will likely target those companies that have established early market share leadership in cannabis cultivation, product processing for sale, quality control and quality assurance, and wholesale or retail sales with established distribution channels.
The Business Opportunity – a $35 Billion+ Market
Cultivation and retail companies are looking to capitalize on the steady process of moving marijuana growth and sales “into the light”, in other words, the conversion of cannabis enterprises from illicit businesses run largely by criminal empires to legitimate ventures that operate within the proper legal and financial frameworks. Estimates of the legal cannabis industry’s sales to end users in 2014 vary between $2.0 billion and $3.0 billion. According to an article published on HuffingtonPost.com in October 2014, if all 50 states and the federal government were to legalize medical and recreational cannabis sales, the market would rise to around $35 billion per year within a decade. Other estimates for the total value of cannabis sales in the U.S., both legal and black market, vary widely, from Harvard economist and Cato Institute affiliate Jeffrey Miron’s 2010 estimate of $14 billion to George Mason University professor and marijuana reform activist Dr. John Gettman’s estimate of $120 billion, but many center on a range of $35 billion to $45 billion.
The Capital Markets in the Cannabis Cultivation and Retail Market
Despite lingering concerns of breaking federal law keeping the majority 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 high enough risk appetite to position themselves as direct handlers. As the cannabis market matures and federal laws loosen, this sector will begin to see increased competition, which will help to spur growth. 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 in the industry.
In a move that could bolster investor confidence in businesses directly engaged in the emerging and growing Legal Marijuana Industry, the U.S. Securities and Exchange Commission has allowed a share registration to proceed for Terra Tech Corp. (TRTC) The revelatory aspect of this registration is that the company’s business model includes cultivation and sale of marijuana. The ease in which this was accomplished, and apparent lack of pushback or action by the SEC could allow similarly situated companies access to the equity market and be seen as a precedent in future registrations of businesses in the legal marijuana industry.
Positive developments at the state and federal levels have started to stabilize the business environment and accelerate market growth. As the legal cannabis markets have grown, so too has the size of cultivation operations. This rapidly growing market combined with the current legal uncertainty has created a window to invest in an emerging industry with extraordinary growth potential at a time of limited competition both in terms of capital and management. Eventually, the legal barriers, in the form of prohibition, will be removed, significantly increasing competition and in turn eroding the substantial opportunity seen in today’s emerging cannabis industry.
Today, there are over 25 publicly traded companies that can be classified as cultivation and retail plays in the cannabis sector. Several of these companies trade on Canadian exchanges (CSE and TSXV) and represent companies that are licensed producers under Health Canada’s Marihuana for Medical Purposes Regulations (MMPR) or that are seeking to obtain a license through the MMPR process.
The company with the highest market capitalization in the cultivation and retail sector is Canopy Growth Corp. (TSXV:CGC), the largest licensed producer in Canada that was created through a merger between Tweed Marijuana, Inc. and Bedrocan Cannabis Corp. in August 2015. As of market close on December 7, 2015, CGC had a market capitalization of $275.05 million CAD (approximately $203.62 million USD).
The Commoditization of Cannabis
Shift in Pricing Dynamics for Cannabis in Colorado
One major factor impacting Cannabis pricing in Colorado is the end of the mandatory vertical integration in Colorado, which expired in October of 2014. This policy required state licensed marijuana businesses to obtain both a cultivation and retail license and imposed a requirement that state licensed business had to produce 70% of their total product sold, and allowed only a 30% margin for wholesale. The end of vertical integration has created a significant catalyst for the growth of the wholesale market, changing the dynamics of industry to a more favorable environment for the consumer, with lower prices, increased variety, as well as quality.
The end of vertical integration has already had a significant effect on the cannabis market, with the volume of available retail wholesale cannabis increasing rapidly, almost six-times, and downward pressure on prices, resulting in an over 30% decrease in price of recreational cannabis.
Cannabis prices are further drawn down due to the increased competition in the wholesale market. Initially only medical marijuana operators were eligible for recreational licenses. Now that the state is issuing new retail licenses, the massive increase in operational licensed retailers has created additional downward pressure on prices. This pricing pressure stems from the new retailers entering the market with aggressively low prices to gain meaningful market share.
The lower cannabis prices have already created increased consumer demand, with Colorado experiencing a record amount of cannabis sold in January 2015. Based on the Colorado Department of Revenue data, $36.4 million of recreational cannabis was sold in the first month of 2015, more than double the $14.69 million sold the same month last year.
The implication is Cannabis will become a Commodity
The Change in Colorado Pricing Dynamics indicates that as legalization pushes forward, we should begin to observe the pricing for Cannabis Flower move from prices based on the illegality/prosecution risk to a more commodity driven dynamic. What this means is Cannabis flower will move towards a transparent, competitive market similar to other agricultural commodities such as soybeans, corn, and cotton.
Catalysts for Cannabis Becoming a Commodity
More States Moving Towards Legalization
One of the most significant developments in the space during the last several years have been the increasing number of states implement legal and regulated cannabis markets. Within state markets, Colorado is a great example of a regulatory environment that has continued to loosen its restrictions on the cultivation of cannabis. This has dramatically increased the square footage of canopy under production, putting significant downward pressure on wholesale prices. As additional, larger recreational markets open up in the next few years, such as California and Nevada, we expect to see a substantial increase in large-scale cultivation. As with any other industry, cannabis cultivation experiences economies of scale, rewarding larger grows with a lower the average production cost per pound.
Rapidly Growing of Infused Products and Extracts
Legalized recreational marijuana sales in Colorado and Washington has driven the market growth of these products as many dispensaries, particularly in tourist areas, report that edibles and extracts are a significant portion 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. As more state begin to legalize the use and sale of marijuana, transparency, technology and education will increase demand by consumer, helping to stimulate and sustain growth in the sector. In both medical and adult use markets, the ever-increasing variety of dose specific cannabis infused products is changing the way consumers think about using cannabis. For the small, indoor cultivation operator, this trend is a severe operating risk. Infused products are created using cannabis oil, which is derived from the conventionally less desirable parts of the plant, such as trim and stems. More importantly, lower quality (lower THC %) flowers can very effectively be used to produce this oil. As a result, labor and energy intensive indoor cultivation, used to produce boutique quality flower, has no added value for producing oil to be used in infused products, since it is more expensive for the same result.
The industry is experiencing an influx of outdoor agricultural production of cannabis, which we believe will continue to rapidly increase. This will be the primary driver of commoditization over time, as production costs will be driven dramatically lower than the most efficient indoor grows could yield. With the market share of cannabis infused products increasing, it will be very justified for cultivators to stand up Outdoor Large-Scale Grows solely for the oil, which has already been observed in Colorado and Washington State.
Effects of Cannabis Becoming a Commodity
The limited number of state licenses being awarded will protect high wholesale prices in select states for now. However, as more markets open up, investors will need to be very careful in financing indoor cultivation facilities that could quickly become obsolete. In the long run, federal rescheduling of cannabis will result the ability for cannabis and cannabis oil to cross state lines (interstate commerce) like any other commodity, creating a very dangerous environment for and company operating in the wholesale market.
The Canadian Markets After Trudeau Elected
On October 20, 2015, Justin Trudeau, the Liberal Party candidate in Canada, was elected prime minister. Part of the policies on which he ran was a promise to realign Canada to its progressive stance on the legalization of marijuana, something the previous, Conservative-dominated government had fought against.
In the seven weeks since Trudeau was elected, publicly traded cannabis companies on Canadian exchanges have closed on nearly $38 million CAD, a great show of investor approval and improved confidence in Canadian cannabis companies.
You can read more from our special program The Future of Cannabis here. To find out why Equities.com and Viridian Capital Advisors launched this program, be sure to read What is The Future of Cannabis?? This program was made possible by the support of our sponsors.Click here for a full list of our sponsors.