Cannabis: The Spectrum of Profitability
The march towards federal legalization is accompanied by capital inflows from increasingly sophisticated sources. An inevitability for this sacred plant is agricultural commoditization with implications for each component of the supply chain along with their respective business eco-systems. While much work remains in the areas of entourage chemistry, endocannabinoid receptor effects and genome based personalized medicine, focus on this margin march is imperative in an environment in which relative opacity dictates that interest and capital generally outpace knowledge.
Mature markets exhibit oligopolistic tendencies while emerging markets such as cannabis are highly fragmented. In a federally legal environment, cannabis businesses face three outcomes: the majority will not survive, a lucky few will get acquired and even fewer will remain independent. Steering an investment portfolio towards the latter categories can have an outsized impact on risk-adjusted returns.
“It is a poor business that makes nothing but money”
Sector and time based tactical tilts are an important step in portfolio optimization:
Cultivation: Price declines in states with mature legal markets remain consistent as larger cultivators flood the market to establish consumer loyalty. Cultivators are well-served to embrace agricultural technology solutions for cost reduction and yield optimization, while for investors an understanding of flower commoditization’s sector and margin impact is imperative. Given the increased vertical integration efforts for margin protection, it is of little surprise that this sector ranks amongst the highest for cannabis M&A activity. Local testing, compliance and taxation requirements have an outsized impact in certain states; short-term debt instruments and special situation funds are an effective way to capitalize on the arbitrage opportunities afforded in this market.
Extraction: Concentrates are the fastest growing consumables category, with vaporizer products representing over 80% of the segment. Relative feature-based pricing strength supports margin growth given declining input material costs and increasingly technology-driven yield optimization. Concentrates afford convenience, discretion and portability without combustion, and consumer preferences are evident in the consistent category growth. While fractional distillation offers compelling scalable processes, the 1,500+ vape pen manufacturers pose investment destination identification challenges.
Manufacturing: The growth in shared-use facilities has led to manufacturing eco-systems that allow brands to launch without incurring the often-costly licensing and real estate expense. The cannabis industry exhibits high growth, high fragmentation and high attraction to new entrants. As such, we expect a large growth in local brands prior to an eventual consolidation and right sizing in the market. Manufacturing facilities with professional anchor tenants provide needed incubation environments for new entrants and may enjoy sustainable margins for years to come.
Testing: Strict and mandated testing requirements drive high profitability for licensed and equipped testing centers. Equipment shortages drive long lead times while limited licensing drives high profitability. Testing demand generally outstrips supply and supports high prices for timely testing. A high percentage of returned product means a high percentage of wasted testing expense, and this bottleneck has contributed to the development of mobile and on-site testing equipment.
Distribution: While an asset heavy business, this sector can be profitable for those who achieve the economies of scale needed to compete in a mature market. While cannabis advertising restrictions are modeled after tobacco, its distribution laws are modeled after alcohol and gambling. As the gatekeeper to retail, large distributors can maintain healthy margins and many are also entering the manufacturing space to supply their own SKUs into the dispensary channel.
Retail: Physical retail stores play an integral role in consumer education as well as reduction of the stigma long associated with this plant. These factors have a limited lifespan, as mature market retail share has already dropped below that of delivery. Retailers that provide communal experiences provide consumers reasons to return, and significant growth in lounges, coffee shops and gaming arcades that offer on-site consumption is inevitable as social consumption continues its dramatic rise.
Delivery: Cannabis is not immune to the broad replacement of brick and mortar market share with delivery, and states such as California are already witness to delivery share at greater than 50% of sales. Last mile logistical efficiency continues to be driven by data and technology, and several software platforms have gained enviable market share in this area.
Granular supply chain margin analysis is an essential precursor to alpha generation. Tactical tilts help normalize portfolio margins while diversification serves as a hedge against unpredictable regulation. While an optimally constructed portfolio continues to be driven by core investment tenets, fragmented legislation can impact the best-laid plans. Industry opacity makes informed investment decisions difficult, and investors are well served to understand the various moving parts prior to capital deployment.