Cannabis industry growth is driven by the legalization of existing habits rather than the creation of new demand. A projected ~27% five-year CAGR (Compounded Annual Growth Rate) makes it one of the highest growth industries in the country today. Growing pains generally accompany rapid growth and legacy companies across the supply chain are certainly not immune. Regulation, taxation, price decline and competition are amongst the many factors affecting supply chain businesses and especially small cultivators who have borne the brunt of the risk historically associated with industry participation.

The cost of indoor cultivation combined with the associated legal risk has led to an environment where the national average retail price of cannabis is ~1,350 times that of spinach and over ~300 times that of its closest cousin, the hop plant. Legalization, regulation and taxation continue to affect pricing with a disproportionate impact on smaller producers that don’t benefit from economies of scale. Consolidation in this type of environment is inevitable and favors large producers in advantaged geographies.

Outsized challenges birth outsized opportunities

Migration away from indoor cultivation is driven by a financial need to reduce energy consumption and is aided by technologically driven labor mitigation. Small cultivators with high fixed costs will be challenged to compete in a market with declining prices, increasing taxes and greater costs of testing and compliance. It is not uncommon for businesses to estimate hundreds of thousands in licensing cost alone. Secondary market license values are also highly varied and can trade at prices as high as $48,000,000. These kinds of barriers are only surmountable by the largest cultivators as compressing margins continue to have a disparate impact on smaller participants.

While legal supply is expensive and increasingly concentrated, consumer demand is impaired by effective tax rates as high as 45%. While many suppliers and consumers continue to interact in the black market, the increasing availability of tested and dosed products such as edibles, tinctures, sprays, patches, strips, inhalers and cooking oils are appealing to new consumers whose relative lack of product and pricing experience perhaps make them less sensitive to the tax burden.

Low margin, high-volume producers historically contribute the vast majority of revenue for CPG (Consumer Packaged Goods) companies. While production volume certainly has a positive impact on COGS (Cost of Goods Sold), licensed producers that want to expand beyond state lines currently face many costly compliance challenges as licensing, testing, packaging, dosing and tax regulations can be unique to each government. In many cases, generous funding and liquidity are necessary to enter these markets, again favoring larger businesses.

In many rapidly growing industries, the largest players will withstand pricing burdens to gain market traction. While associated cost does accompany consumer mindshare, the investment is returned many times over for those who enter the oligopolies which will ultimately command the lion’s share of their respective markets. Regulations are continually refined to serve the industry while higher valuations encourage consolidation and market share concentration. Well-capitalized businesses that can survive the growing pains of regulation will be positioned to thrive as business conditions adjust.

Businesses that successfully navigate these complex hurdles will emerge as market leaders and investors will be rewarded as the inevitable resolution of the state-federal conflict brings about large buyers from mature industries. Big liquor, tobacco and pharma are already losing market share to the cannabis industry and will find it more appealing to purchase earnings growth than play defense. Big food, hospitality, agriculture, travel and entertainment are undoubtedly attracted to the synergistic benefits of combining their consumer experience with cannabis. Investors who understand this evolution are at an advantage in constructing an appropriate capital placement cadence geared towards liquidity and return.

The confluence of lower prices, increased entry costs, higher taxes and a fragmented regulatory marketplace means that sound and scalable business practices are essential to the maintenance of a competitive advantage. Competent legal, financial and regulatory practices are needed to move businesses through a market that has gone from black to grey on its journey to becoming highly desirable and increasingly liquid. While regulatory compliance remains a challenge, the alternative will only prove to be myopic for those who aren’t willing or able to embrace these obstacles. Extensive diligence into a company’s practices will aid those investors looking to place well-informed long-term bets into this alternative asset class.

Embrace obstacles in your life, for they are bridges worth crossing.