Cannabis: Flower Commoditization Valuation Impact
Investors with their sights focused on the cannabis space are often enamored with the lofty growth expectations rampantly reported by media. While the cannabis industry is certainly experiencing incredible and perhaps unprecedented growth, it behooves capital placement decision-makers to carefully consider cannabis spot price forecasting and its resultant valuation and sector impact.
A commodity is defined as a good or service that has no qualitative differentiation across the market; a product with fungibility. Common commodities include sugar, rice, copper and wheat. Cannabis pricing forecasts that imply a sustained race to the bottom are inevitably accompanied by views that commoditization may be preordained for this sacred plant. There are relevant investment nuggets to be gleaned by looking under the blanket this statement represents.
The median reported price decline expectations over a 5-year period across flower categories (indoor, greenhouse, outdoor) in multiple geographies coalesce to an approximate annual rate of 20%. Despite occurrences of cross-category average wholesale pricing in the $1,200-$1,400 range in mature markets, high-end indoor flower has maintained wholesale price consistency at the ~$3,000/lb level and may even see some pricing support in 2018 as legalization creates additional demand for this superfood.
At the higher end of the pricing spectrum, cannabis flower retails at $50-$60 for 1/8th of an ounce, equating to $6,400-$7,680 per pound. This compares favorably to the national average of $5,100/lb in 2016 and an expected national average of $4,080/lb for 2017. The premium spectrum is likely to experience short-term price support and perhaps even strengthening as branding, strain specificity and terroir play an increasingly important role in consumer decision-making.
While we expect flower sales as a percentage of all cannabis sales to continue their decline, connoisseur cannabis can perhaps command ~15-18% of this category; not dissimilar to the respective share that craft beer enjoys. As the overall cannabis market continues its meteoric ~25%+ compounded annual growth, this share can accommodate and reward many of the best craft cultivators with premium prices for their plants.
The remaining 82-85% of the cannabis flower market is likely to have a much different pricing future specifically as it relates to the spot price of popular cannabinoids THC and CBD. THC distillate and CBD isolate prices have experienced precipitous declines as rapid technological advances impact cultivation, extraction, infusion, distribution and consumption. It may not be too far into the future that one will be able to buy an ounce of extract (currently ~$1,400) for less than it costs to purchase an ounce of gold.
Edibles, tinctures, capsules, sprays, patches, inhalers, oil cartridges and other cannabinoid delivery mechanisms are on a relative retail rise. This rapidly increasing demand reduces the relevance of trichome development, bud density and terpene profiles while also serving to further commoditize specific cannabinoids.
The true race to the bottom may well be in cannabinoid pricing, and cultivators who are wise to leverage the power of technology for financial and operational efficiency may soon have to leverage the same to maintain margins. Investors looking at large-scale cultivation facilities are well-served to understand long-term margin impact from declining spot prices as free cash flows have an outsized impact on enterprise value.
Infused consumer brands that enjoy relative pricing inelasticity will see positive margin impact from cannabinoid COGS declines, while those that serve simply as non value-add cannabinoid delivery mechanisms (gummy bears, brownies, etc.) will suffer both margin compression as well as sales impact as consumers move towards health oriented infused options. Increased availability of infused tea, kombucha, whole-food bars and goods that adults currently consume will certainly eat into candy sales that sometimes are the only option at a dispensary.
An industry where comparable and precedent transaction valuations are challenged by the lack of historical data and LBO analysis is contested by a relative lack of debt leaves investors with discounting expected cash flows to value their investments. For companies, cash-flow forecasting is challenged by reasons including regulation, legislation, taxation, trade restrictions, fragmentation and shifting consumer behavior. Investors with the foresight and fortitude to navigate these challenges will certainly be rewarded with attractive risk-adjusted long-term returns.