Pot Lots Part 2: The Business of Big Cannabis

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1:44Americans have changed their minds about weed. It's estimated that demand for recreational marijuana could be as big as$45 billion a year. That's bigger than both wine and chocolate. It's no secret marijuana is no longer a budding business. It's booming. Sales in North America totaled$6.7 billion in 2016, an unprecedented 30 % increase. Absolutely. And this is the headline everybody wants to hear. The marijuana market could be about to boom big time. The new frontier data says that legal cannabis could expand the national market to about $21 billion by the year 2020. That's up from$5.7 billion last year and an expected$7.9 billion this year.

2:33That was the buzz leading up to 2018 when investors around the world were caught up in the craze for cannabis stocks. Pot was on its way to being legalized in Canada, and there were rumblings of a similar move in the U.S. Shares of companies like Tilray, a Canadian pot company, soared by more than 1 ,000 percent that year before crashing down to earth soon after. We will soon have a new system in place, one that keeps cannabis out of the hands of our kids and keeps profits away from organized crime. Today, I'm also pleased to announce that the new recreational cannabis regime will officially come into force on October 17th of this year.

3:11In October of 2018, Prime Minister Justin Trudeau announced that cannabis was legalized in Canada. Since then, numerous states in the U.S. have taken steps toward legalizing a drug that was once vilified literally as the devil's lettuce. But despite all these tailwinds, pot stocks are still struggling and there is huge question marks over just how the rollout of this brand new market is going to go. This is our cue to welcome you back to Potlots, our deep dive into what's going on with the legalized marijuana market. In our last episode, we talked about what was happening in New York and the tension that currently exists between the illicit market for weed and the new legal one.

3:52On this episode, we'll dive a bit more into the business model of legalized marijuana before getting into the efforts at creating social equity in our third and final episode. It's not every day that you get to witness the birth of a new market and all of the pains and hiccups and weird logistical and existential issues that come with it. And that's what really interests us here. What is the state of the New York cannabis industry right now and where is it headed? Is it being designed in a way that's fit for its purpose? Will legal cannabis sellers be able to make money? Will they be able to compete with the illicit market guys who have been in this business for a long time?

4:26And will investors still be interested? Can the market live up to the hype?

4:35To understand where things are going, we are going to begin by checking up on what's happened so far. Remember, not that long ago, there was once a ton of investor excitement around cannabis. We had a bunch of new companies created, several cannabis-focused exchange-traded funds were launched, Joe and I recorded a couple episodes on the industry, but all that excitement, and the share prices as well, they seem to have stagnated since then. The lines on the chart have moved down and to the right. It's been a rough couple of years for the cannabis space. You're talking about a lot of operators, a lot of pioneers, a lot of entrepreneurs who have been working for four or five years and not gotten paid.

5:12That's Todd Harrison, the founding partner and chief investment officer of CB1 Capital, an investment firm specializing in cannabis. He describes what the mood is like amongst pot investors and the big cannabis companies known as multi-state operators or MSOs after a tough few years. For some reason, cannabis entrepreneurs, the MSOs, the pioneers are viewed with disdain by some politicians and others in small business. It's a bit oxymoronic, right? These are entrepreneurs that figured out and are working toward building a U.S.-based industrial complex, right? U.S. supply chain, homegrown, and something that I think we can all agree should not be illegal, should not be a reason that people are put in jail, and should not be something that's used against somebody, whether they want to get a job or whether they want to run for office.

6:04Todd's own interest in cannabis was formed during a big moment in New York and U.S. history. He worked on Wall Street for more than three decades at Morgan Stanley and Galleon, and even Jim Kramer's old firm. And he was working on Fulton Street the morning of 9-11 when the World Trade Center towers came down.

6:23What are those people going to do? We were a few blocks from the World Trade Center. It was really the time after 9-11 where I explored it after personal use with the PTSD associated with 9-11 having been down there. I really did a deep dive into the science, into the history, into the benefits, the efficacy, and became fascinated with the opportunity and ultimately the market opportunities that it would present. And that's really what started this journey some 10, 11 years ago. There's such a wide chasm between the popular perception of cannabis as a vice and history and cultures have demonstrated for 10 ,000 years that cannabis is a wellness solution.

7:04But even if attitudes towards pot are changing, as evidenced by the fact that 21 states have now legalized its use, there remain challenges to the actual business of legal weed. One of the very things that's driving cannabis legalization, the potential for tax revenue, is also arguably hindering the industry's growth. Pot is still classified as a Schedule I drug at the federal level. The DEA defines this as drugs or substances with no currently accepted medical use and a high potential for abuse. Some other substances that are in the same bucket as cannabis are heroin and LSD, but not cocaine.

7:41Interestingly enough, that's Schedule II. And so that means even if you're growing and selling pot legally within a state, federal law treats it as an illegal business. Yep. And Section 280E of the Internal Revenue Code prohibits taxpayers who are engaged in the business of trafficking certain controlled substances, which in this case includes marijuana, from deducting typical business expenses associated with those activities. That amounts to an extra tax on the business, even if the state says it's legal. Here's Todd again. The 280E tax code, which paradoxically is going to end up hurting the competition for a lot of the U.S.

8:18cannabis players because it's going to ultimately create an environment where social justice and small business can't compete because there is an effective tax rate of 70 percent in the cannabis space. We don't know if that's going to go away anytime soon. There is speculation that it's being addressed. But if it does not go away, the strong will get stronger. This was something we heard from a lot of investors in the space. The combination of the tax code and the patchwork of different laws between states and at the federal level makes it difficult for players in the pot industry to really scale their businesses effectively.

8:53Emily and Morgan Paxia are a brother and sister duo who founded the cannabis investment company Poseidon. As they point out, a 70 percent effective tax rate has done some interesting things to legal cannabis companies so far. When I look at these companies, I see strong fundamentals. And there is this thing called 280E. It's a tax code that's applied to this industry. And just to be very broad about it, these operating companies see tax rates, effective tax rates of about 70 plus percent. In spite of that, though, you're seeing really strong gross margin profiles, really strong EBITDA profiles and growth.

9:29And so you have the fundamentals of these businesses that are almost running in a completely opposite direction of their stock charts. So it's been a really extraordinary time when you see some of the top 10 MSOs retrading back to their IPO price. And yet these companies have quadrupled in sizes over these years. There are ways for states to mitigate some of the impact of Section 280E. And Morgan points to Michigan as an example of a state that's building a less onerous tax regime even in the face of federal restrictions. Michigan has, I think, one of the better tax codes we've seen in our industry.

10:03So it makes it more economical, right, to build a business like, say, versus like a California that is a very expensive state. It's also a lower cost state from a real estate perspective. So it allows these businesses to get, you know, built and scaled in a much more high ROI kind of way, even with a lower price point at the flower level, you know, that's kind of like a metric we look at for, you know, kind of get a sense of where the wholesale pricing is. So I think that's an advantage for them. One unique thing about their tax code, some of the other states are doing this too, is at the state level, they actually have a 280E offset.

10:38So they're trying to help limit some of that federal burden. That's translated into lower pot prices in Michigan and a growing market. Michigan is one of the most interesting states in this whole journey of the legal, the adult use cannabis industry in the United States, because they've had some of the most significant price compression. So in September 2022, year-over-year wholesale prices were down 46 percent. But total adult-use sales growth was positive 26 percent. So that tells you how strong the unit growth was. But because prices have reached such a low level, we think that is a high conversion rate from the illicit market coming into the legal adult-use market.

11:18But that isn't the only issue stemming from the fact that pot remains federally illegal. While Michigan's state-level 280E offset has helped, New York, so far, doesn't have a similar tax code. When it comes to facilitating the market, there's still a huge question mark over banking services for cannabis businesses and also custodying shares of cannabis companies. For a normal business, this would be done by big custodian banks like BNY Mellon or J.P. Morgan. But since there's so much confusion around federal versus state laws for weed, there are very few banks willing to provide these services.

11:57From what we hear from investors, it's the banking laws that really need to change or the banking position our federal government takes toward the industry. So this plays out in a number of ways. We were just talking about the stock action around these companies. And a lot of that has to do with the lack of liquidity because they're generally on the bulletin boards, right? They're not on the listed exchanges. So not having access to the listed exchanges is an incredible limiter. And then there's also a lack of custody for these assets. And so that's what really keeps the institutional capital on the sidelines.

12:30We do have a very enthusiastic individual investor or retail investor base. And we know there's institutional capital sitting on the side, but that's really what they're waiting for. On 280E, the way I view that is if these companies can build strong businesses, and Morgan was just talking about it with me frequently about how these companies are moving toward a free cash flow profile. That's a new thing we're going to be looking for going into 2023 and 2024. If they can achieve all of that with those tax rates, these businesses are going to look tremendous once 280 goes away. So I view that as just optionality to the upside.

13:05So we're looking at from a federal perspective, you're talking about banking access, which also brings custody and potentially exchanges. And then we're talking about social justice. Late in 22, we did see President Biden make a big step forward at the federal level, at the executive level, moving forward with some of the social justice pieces. So that really does help the industry stay very focused with the legislative branches to get some kind of banking reform done. And if that should be resolved from our perspective, as you know, just mentioning about valuations being so low, they're underpriced.

13:36Like it is structurally at a discount. And if we have access to banking and exchanges and more institutional capital. We think there's just even a repricing just to get it back to even a fair value. That is pretty significant.

13:55Of course, the scaling problem isn't just about the discrepancy between state and federal taxes or banking regulation. When it comes to growing cannabis legally, each state also has different rules and requirements that make it pretty hard for multi-state operators in general to keep their costs down, since each individual state might have its own regulation about everything from growing to transporting to selling marijuana. Yep. This is something that came up back in 2019 when we spoke to Craig Wiggins about how the Canadian cannabis market was developing and what that said about the potential for the U.S.

14:30market. Craig has been a close industry observer for a long time and ran a trio of analysts called the Canalysts. And he contrasts a multi-state marijuana operator with a classic conglomerate of the consumer goods industry like Coca-Cola. The regulations that have been brought in, especially in the United States, differ from Canada. Canada has a fully federally legal system. So all the rules are set out. In the U.S., what's happened is it's been a state-by-state battle, usually first for medicinal cannabis and then for adult-use cannabis. And the problems arise that if you're a what's called a multi-state operator in the states where you're in multiple states, you've had to replicate your cultivation in every single state.

15:15You're processing in every single state as well. So it's very tough to get economies of scale when the product that you're making can't travel outside the borders. Think of Coca-Cola. A Coca-Cola in Florida from a 7-Eleven tastes exactly like the Coca-Cola in California from that 7-Eleven. Cannabis grown in Florida, the exact same cultivar strain grown in Florida and grown in California are not going to be the same. So trying to figure out what works in your state environment, and Florida is very humid, California isn't. When I look at the complexity of it, think of what you have to do in a company to change the gross margin of a large company when you have 35 different production facilities and 35 different cultivation facilities selling into 35 different markets with all different pricing.

16:11It becomes very difficult. You have to steer one state at a time to your destination. So what we've seen is as these states launch, there's a lot of money to be made very early, but the decay starts right away as well. So because of the patchwork of state regulation around legal cannabis use, you can't really have a Coca-Cola of cannabis because a pot company can't grow one product for an entire country or even a region. Each state is different, which means each market is different. Let's go back to Florida. In Florida, as Craig points out, you have to be completely vertical, which means owning every process in the pot supply chain from cultivating to processing and selling only through your stores.

16:53Even though there's another store down the street that's fully legal, you can't ship your product there. So Florida, so this is the most extreme one. Florida is the most extreme. I think North Carolina is looking to come in like Florida right now too, which would be a shame. So there's only about 15 major companies in Florida, limited competition. Think of the capital you need to not only run your own cultivation, but run all your processing and then all your stores. And this product, as I mentioned, is not homogeneous. So you're selling a product in your store, your competitor's selling, say it's Blue Dream.

17:30You're selling Blue Dream in your store that you've cultivated. The competitor's selling Blue Dream in their store. It's not the same Blue Dream. And at the end of the day, the amount of money you need to fund a fully vertical operation is huge. Florida is really an outlier right now. They have zero social equity. I don't think there's been a license, a vertical license given to a social equity firm yet. Then you have Illinois. Illinois has more cultivators and Illinois has been locked in a battle for almost three years to get the next set of licenses out. So Illinois went vertically, but you could sell your product wholesalely to another retailer.

18:11So there are more retailers in Illinois than just the vertical companies. And 185 licenses have been held up in court for social equity for over two years. So Illinois has been stuck at 110 licenses for almost two years. They're finally, next year, we should start seeing the opening, or maybe even this year, the opening of those 185 new social equity licenses. But if you can imagine the constraints, there's a store in Northern Illinois, that's disclosed through one of the MSOs, that's doing$80 million a year out of one store 17 miles away from the Wisconsin border. Why? Because Wisconsin isn't legal.

18:51So you get people rolling down from there. So you have all these different models. Craig can go into the weeds for each individual state, but for many new players in the industry, it's not so simple. In New York, for example, retailers must be separate from producers, essentially banning vertical integration in the cannabis space. We'll get into this more in episode three, but for right now, it's clear to see how messy things can get for someone trying to enter and navigate the space as an operator or a grower. Since everyone's working with different laws and regulations, it has been and will probably continue to be a bumpy ride.

19:29So it's really been interesting because each state, depending on what their regs are, It's either been a sprint or it's sort of been like the godfather where you only have five licenses and you can do what you want as long as everyone plays nice with everybody. So it's really been a tough industry as an analyst to take a look at. Each state is absolutely different. And because you can't scale, if you're doing well in Massachusetts, it doesn't mean you're doing well in Nevada. It's really a struggle for all these companies to get into the market, make their money before more competition arrives and the decay starts.

20:09And the decay usually starts when supply starts creeping up to demand. Aside from regulation, there's a more technical reason that the legal cannabis industry has been tough to crack. And that has to do with the actual growing of the weed. Now, neither of us have any personal experience doing this. But the cliche throughout recent history has been, you know, small scale growers in a basement or a closet and a set of grow lights and the plants that thrived were the ones most suited to those conditions. And they tended to pack the most potency. We spoke about this a little bit in our first episode with Jason Wild, who runs an MSO, and he described how different growing locations can create vastly different products.

20:49If something is illegal, you're not going to really do it out in the open. it seems like there's a lack of experience and larger growing operation. And while it seems hard enough to grow weed in a closet, Craig Wiggins points out that the history has had a lasting impact on the ability of the industry to scale up the actual growing of cannabis. Folks often wonder why it has been so difficult to scale the cannabis plant. And that's really because for the last three decades before it was legal, you had to grow cannabis plants fairly clandestinely if you didn't want police knocking on your doors.

21:26So you had people out there growing small batches that they like in a container in a sea can or in a small warehouse. Nothing big that would attract attention. For decades and decades the plant has had to be grown clandestinely and the focus of the plant has been on producing THC or CBD because those were the two elements that were desirable for the end consumer. So there's another 100 cannabinoids in the plant that really haven't been bred into the plant in any meaningful way. And we're starting to see that right now. But because of the clandestine fashion, anyone who's good at growing is good at growing a certain amount.

22:09Now, when the greenhouses came along and the bigger facilities, it takes at least two years to dial in. okay what cultivar is going to work in this greenhouse or in this space so you run five crops a year indoor so you're learned five times a year so it's always an iteration and you might have to go back to the beginning if that particular cultivar which was really good in that sea can hidden in a forest in british columbia it's a little different when it's in a million square foot greenhouse it's just not going to react the same way so it's really about genetics and the genetics were designed to breed smaller quantities, high THC or CBD plants until genetics catch up.

22:54And it takes time for those genetics to catch up. Until genetics catch up, the scalability will be very difficult.

23:05On the next episode of Potlots, we'll take a closer look at the illicit market for pot in New York and what it means for the states to allow legal cannabis sellers and its goal of using those licenses to make right some of the injustices of the past.

23:24Potlots is hosted by me, Joe Weisenthal. You can follow me on Twitter at TheStalwart. And me, Tracy Alloway. You can follow me on Twitter at Tracy Alloway. Follow our producer, Carmen Rodriguez. She's on Twitter at CarmenArmin. Dashiell Bennett is our associate producer. He is at Dashbot. Our sound engineer is Blake Maples. Sage Bauman is our head of podcasts. And special thanks to Moses Adnan. For more Bloomberg coverage of the legal marijuana industry, you should definitely check out The Dose, Tiffany Carey's weekly newsletter about the business of cannabis and psychedelics. You can subscribe at Bloomberg.com.

23:59Thanks for listening.