Bracing for the impact of interstate commerce
I write about the business of cannabis. At heart, I am an analyst, and the cannabis industry is fascinating. It is the only industry that is illegal at the federal level, legal at the state level, and tolerated by the feds via a variety of non-legislative actions.
Very few people within the industry understand, or seem to care about, the industry construct or the interplay with the feds. That is why so many were caught flat-footed when their cashless ATMs stopped working. Understanding the construct is critical to sensing what comes next.
I have been writing about this issue for nearly three years, starting with a tongue-in-cheek article predicting what will transpire when low-cost outdoor-grown flower comes east (from out of state) to compete with expensive indoor grown products. These days, while much of the cannabis industry sees the “big event” as federal legalization, I’m still interested in the ability to safely ship products across state lines—known as interstate commerce.
This industry will turn on a dime when certain events take place. As such, I predict three coming seismic shifts—interstate commerce, decriminalization, and legalization. These shifts will generally happen quickly (not necessarily soon, but rather quickly following a catalyst, possibly legislative, otherwise via the courts)—especially interstate commerce. The adaption curve will be short, and the industry could be turned on its head.
Operators who have not considered these events in their plans will be caught off guard and several could tip over, like Humpty Dumpty. If that happens, neither the investment bankers nor all the court’s men will be able to put Humpty back together again.
In this installment, I’ll specifically address the potential impact of recent federal court rulings on interstate cannabis commerce.
Supply strains
Interstate commerce is the ability to ship cannabis products across state lines. It does not mean legalization, and is unlikely to come as a result of legislative action in Washington, DC. My prediction is it will happen in the courts, and that prediction is bearing fruit—from a Boston federal appellate decision in a case from Maine in August, to a federal district court injunctive relief ruling in New York in November, to another federal case filed in Oregon in November.
Interstate commerce will allow certain products—probably medical ones first—to be shipped on roadways across state lines where the adjoining states have legal cannabis programs; think Washington state, Oregon, California, and Nevada, or Massachusetts, Rhode Island, Connecticut, New York, and New Jersey. To transact business between legal states where there is a non-legal state in between will mean air transport. This will likely take the form of flying products across the country. Legendary smugglers like George Jung must be smiling from the grave.
When that time comes, interstate commerce will crush high-cost indoor grow operations. Indoor cultivation is the most expensive segment of the supply chain; these facilities cost millions, or tens of millions of dollars, to build. Those are long-term investments, so the problem is that the indoor-grown lifecycle will be relatively short. Outdoor flower doesn’t need light beyond the natural sun, and it also doesn’t have costs related to fans, air conditioning, and other equipment and electricity needed to power grows under a roof. Once interstate commerce becomes a reality, many cultivation facilities will quickly—within six to nine months, I suspect—become cost-uncompetitive and obsolete. While the financial drag upon the larger indoor cultivators might be enough to drag them under.
Green Market Report reported in September that the top 10 public multi-state operators (MSOs) owed $507 million in back taxes to the IRS and that, with their negative cash flow, only one of those companies could survive more than 10 months if those taxes had to be brought current. Financing a business by not paying federal taxes is not a wise strategy. Landlords might not be so patient, especially if they have mortgages or investors to pay.
The losers will fall into three buckets: the MSOs that built and operate facilities, the investors (REITs) that purchased facilities and leased them back, and investors who have funded all of this on blind faith that indoor cultivation will be a long-term economic winner. Some big players today could find themselves in receivership (not bankruptcy) by 2024 (see side bar).
Industry players laughed in April when I predicted interstate commerce would happen in the courts, specifically federal court in Boston or St. Louis. But in August, a federal appeals court for the First Circuit in Boston ruled against the state of Maine’s marijuana program and ruled that the commerce clause applies to cannabis. In November, a New York federal district court issued an injunction against the state awarding retail licenses, finding the commerce clause applies to cannabis. The Empire State recently filed a motion to limit the impact of that ruling as to issuing licenses, but the commerce clause ruling looks like it will stand. Also in November, Jefferson Packing House in Oregon sued their host state arguing that lawmakers there cannot restrict them from selling products to out-of-state businesses. It is another commerce clause case and will likely prevail.
As for the impact of all this … if you are an East Coast product manufacturer or retailer, would you rather buy locally-grown flower at $2,000 a pound or lab-tested West Coast weed at, say, $600 a pound? An aspiring cultivator informed me that if prices drop, they’ll just have to match the market, but it will be hard to match the market if outdoor cultivators can grow competitive product and sell it for less than an indoor operator can produce the same. Indoor cannabis cultivation facilities are expensive; all things considered, they could eventually become obsolete.
I have avoided vertical integration for the fear that when the market shifts, it will shift hard and fast. Interstate commerce could even drive several MSOs out of business and crush a few landlords. For the latter, repurposing facilities will become the game, and it is unlikely that other tenants will pay the same premium rates as cannabis operators.
Plan to pivot
Small cultivators all generally say the same thing—they plan to grow small, premium quality craft batches, and they should be fine. That might be true. But the mass market typically represents 70% of an industry and the high end for wine (a good proxy for cannabis) is more like 3%. That means craft cultivators have a much smaller consumer base.
I recently advised a small craft cultivator and processor and suggested they break down their value chain and focus on the high-value tasks—grow mother plants to control the genetics, create the clones, then ship them to a trustworthy cultivator to raise the plants. Dictate lighting, schedules, water, and nutrients and check in on the plants weekly. Monitor progress via a smart phone every few days. Whatever it takes, remember that actual growing is not a high-value task. As for whether that other cultivator will be growing indoors, outdoors, or in a greenhouse remains to be seen.
Many years ago, I had a client who owned a couple of coffee shops on the side. One Sunday morning we went SCUBA diving, and he brought along muffins. Those muffins had heads the size of softballs. He liked the baker, but the baker worked seven days a week and long hours most days. He sold the muffins for 25 cents each and my client sold them at retail for one dollar. As Glenn pointed out to me, the baker paid for all the ingredients, equipment, and utilities. Even if he produced a muffin for as little as 18 cents, he only earned 6 cents each, while Glenn earned 75 cents each.
The baker obviously made thousands of those muffins every day and Glenn bought very few. But the lesson was in which end of that equation had the greater value. My advice to cultivators is to focus on the higher-value tasks and outsource the rest. It may be the only way to compete and survive. Not everyone will agree, but market economics will dictate.
Retail not immune
Retailers that invested heavily in fancy salon-style stores or large sales floors with expensive rents may also become extinct.
If you buy something for $5 and sell it for $10, you have a $5 gross profit and a 50% gross profit margin. If prices drop, as they have in every established market (they’re now plummeting in both Michigan and Massachusetts), retailers could maintain their margins, but when you now buy that same product for $3 and sell it for $6, your $5 gross profit just dropped to $3. You might sell a bit more because prices have dropped, but not enough to make up for the drop in gross profit.
If your overhead costs aren’t manageable, you might not survive. In Massachusetts, we have some select cases of stores being given away for free because the current operators cannot afford the rent.
As cannabis begins to mimic other industries, and as supply and demand come into balance, so must the cost structures. Long-term cannabis premiums for rent, etc. will become unsustainable and will drag operators down.
