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Case 3

Pot of Gold? The US Legal Marijuana Industry*

By 2018, the legal marijuana industry had established itself as a significant component of both the US agribusiness and medical sectors. Retail sales of legal marijuana in 2017 were estimated at $9 billion by BDS Analytics—most of it for medically‐approved use. The 2017 US marijuana crop was valued (at wholesale prices) at $5.7 billion by Cannabis Benchmarks—as compared to the US wheat crop of $7.4 billion. For the states in which marijuana was legally cultivated and distributed, the benefits included 121,000 direct jobs and $1.2 billion in tax revenues.1

Medium‐term projections for the industry pointed to continued strong growth. ArcView—a marijuana information, consulting, and investment firm—forecast that, by 2021, US consumer spending on legal cannabis would total $20.8 billion, and that the industry would generate 414,000 jobs and more than $4 billion in tax revenue.2

Like most growth industries, the industry has attracted considerable financial interest. Some of the venture capital and private equity funds investing in the industry are listed in Table 1. Investment in the marijuana sector was also facilitated by ArcView Group's intermediating role in linking investors with marijuana entrepreneurs had generated a buzz of excitement about this “new gold rush.” By October 2017, its network of angel investors had invested $125 million in 157 cannabis‐sector companies.

The transformation of the marijuana business from one controlled by criminal gangs to a legitimate business activity supported by an infrastructure of consultants, information providers and investment funds had generated a buzz of excitement about this “new gold rush.” However, there remained perplexing questions over the industry's potential to generate attractive profits. Would the industry offer the sustained high profitability associated with the two other heavily regulated industries supplying recreational drugs—alcohol and tobacco—or would it suffer the squeezed margins and low returns typical of the agricultural sector?

Legalization

In 1996, California became the first state to legalize the sale of marijuana for medical use. Then, in 2014, Colorado and Washington became the first states to legalize the production, sale, and consumption of marijuana for recreational use. At the beginning of 2018, the sale of marijuana the sale of was legal in 30 states and, for recreational use by adults, in nine states (Colorado, Washington, Oregon, California, Nevada, Massachusetts, Maine, Alaska, and Vermont).

Yet, amidst continuing concerns over the physical and psychological dangers of marijuana consumption, the impetus to change federal law was weak. Continuing illegality of the production, sale, and possession of marijuana under federal law was a major handicap for the industry. In particular, firms engaged in producing and selling marijuana had limited access to the US financial system. Banks were fearful that involvement with the industry might contravene drug‐racketeering or money‐laundering rules. In the United States as a whole, law enforcement against consumers and suppliers of marijuana continued to be active. In 2016, there were 653,249 arrests throughout the United States on marijuana‐related charges, down from 693,481 in 2013. Close to 90% of these arrests were for possession.

Moreover, the approach to enforcing Federal laws against marijuana had shifted considerably in the transition from the Obama to the Trump administration. In January 2018, US Attorney General Jeff Sessions rescinded the Obama‐era guidelines, known as the “Cole Memo,” which discouraged federal prosecutors from taking action against state‐licensed marijuana businesses. As a result, banks and credit unions became increasingly wary of transactions involving companies engaged in marijuana businesses.

The Market for Marijuana

The US market for marijuana can be segmented between legal and illegal sectors and between medical and recreational use. Table 2 provides some data.

Marijuana is the most commonly used illicit drug (22.2 million people have used it in the past month), according to the 2015 National Survey on Drug Use and Health. Its use is more prevalent among men than women—a gender gap that widened in the years from 2007 to 2014. Marijuana use is widespread among adolescents and young adults… Among the nation's middle and high school students, most measures of marijuana use by 8th, 10th, and 12th graders peaked in the mid‐to‐late 1990s and then began a period of gradual decline through the mid‐2000s before levelling off. Most measures showed some decline again in the past five years… In 2016, 9.4% of 8th graders reported marijuana use in the past year and 5.4% in the past month (current use). Among 10th graders, 23.9% had used marijuana in the past year and 14.0% in the past month. Rates of use among 12th graders were higher still: 35.6% had used marijuana during the year prior to the survey and 22.5% used in the past month; 6.0% said they used marijuana daily or near‐daily.

Among adults, marijuana consumption was most prevalent among young males between the ages of 18 and 34; however, the fastest growth in marijuana use was among older Americans—especially those over 55.4

Development of Legal Marijuana Industry

The two lead states in legalizing recreational marijuana were Colorado and Washington; hence, the industry's development in these two states offers pointers as to how the legal marijuana industry might develop elsewhere—even though the structure and conduct of the industry will depend greatly upon how each state frames its regulations. In the future, California—because of the size of its market and extent of both legal and illegal cultivation—will have the biggest impact on the fortunes of the marijuana industry at the national level.

At present, entry into the industry depends critically upon the allocation of licenses. The availability of licenses depends upon the restrictiveness of eligibility criteria and whether the state imposes a limit on the number of licenses. In Colorado, eligibility criteria are strict: licensees must be US citizens, state residents, have clean criminal records, and meet other standards, but there is no quantitative limit on licenses issued. In Washington, a fixed number of licenses are available, and their allocation is by lottery. In California, eligibility criteria are relaxed and there is no quota on the number of licenses that can be issued. As a result, Cannabiz Media predicts that, by the end of 2018, California could grant as many as 10,000 licenses for marijuana businesses.5

However, in all states, receiving a state license is dependent upon local authorization—in Colorado, Washington, and California—many counties and cities have decided against permitting marijuana businesses. As a result, most businesses are concentrated in relatively few locations. In Colorado, over one‐third of the state's 500+ dispensaries are in the Denver metropolitan area. In California, four cities—Oakland, San Jose, Sacramento, and San Francisco—accounted for 30% of all licenses in April 2018.6

In addition to the conditions for obtaining a license, the industry is subject to a vast array of regulatory requirements. All marijuana facilities have to have elaborate security equipment installed, including surveillance cameras and precautions against theft. In addition, every marijuana plant is subject to an elaborate system of tracking that includes RFID tagging. The physical movement of marijuana is also highly regulated—including specifications for the vehicles that can be used to transport marijuana.

The issuing of separate licenses for different types of marijuana businesses—growers, distributors/transporters, manufacturers, retailers, and testing labs—tends to reinforce fragmentation along the industry's value chain. Most states encourage small businesses—including social enterprises—in the development of their marijuana industries. However, the evidence in Colorado, Washington, and California shows an increasing role of large enterprises. In Colorado, dispensary chains include Native Roots (21 stores), LivWell (14 stores plus growing and processing operations), The Green Solution (11 stores), Green Dragon (11 stores), and Starbuds (10 stores). In California, multiple license holders include Honeydew Farms LLC (29 licenses), Harborside (12 licenses), KindPeoples (12 licenses), and CA Systematize (8 licenses).7 Vertical integration from seed to retail dispensary is a feature of several of the larger players.

The development of the industry has been accompanied by the development of an infrastructure of support services. For example, MJ Freeway offers “seed‐to‐sale” tracking software that meets states' regulatory requirements and assisted operations management; Advanced Cannabis Solutions lease real estate to large commercial growers; Waste Farmers supply soils for cannabis growing; and ArcView Group is a hub for data, investment, media, and consulting. Table 3 shows some of the main features of the legal marijuana industries of Colorado, Washington, and

California.

Notes:

aBy 2018, Colorado has highly developed marijuana industry with extensive infrastructure. Marijuana generated over $200m. in taxes and licensing fees for the state.

bThe state has had a highly developed illegal marijuana market for decades with substantial production in the east of the state and imports from British Columbia.

cTotal production approx.13.5 million pounds per year; consumption approx. 2.5 million pounds—hence massive (illegal) exports to other states.

The Economics of the Marijuana Business

Cultivation

Growing marijuana, whether for the medical or the recreational market, requires, first, a license, and then the acquisition of a growing facility. Marijuana is grown primarily in indoor, climate‐controlled buildings under artificial light, but also in greenhouses and outdoors. Although greenhouse and outdoor cultivation offers economies both in set‐up and operating costs, these advantages are mitigated by the need for extensive security equipment for all marijuana‐growing facilities. More importantly, the key advantage of indoor cultivation is the ability to have multiple growing cycles each year. The average size of an indoor facility is 18,300 square feet; that of a greenhouse is 39,000 square feet.8

The growing process involves the following stages:

Establishing stage: cloning new plants from existing female plants and allowing the new plants 7–12 days to become established.

“Veg” (or growing) stage: two months under constant light.

Flowering stage: about two months with a daily cycle of 12 hours of light followed by 12 hours of darkness.

Processing stage: hanging the plants upside‐down, then harvesting their buds and leaves.

Curing stage: drying the buds and leaves.

Early estimates of revenues and costs suggested that marijuana is a highly profitable crop. For example, Motley Fool estimated that a 10,000‐square‐foot growing facility with five annual growing cycles could produce 1250 pounds a year, with a wholesale value of $2.75 million. With production costs of $1.25 million (i.e., $1000/lb.), this implies a margin of 55%.9 However, estimates of production costs are highly variable: one study estimates a range of $70–$400/lb10, while another study puts them as high as $1606/lb.11

As the industry develops and spreads to more and more states, more reliable estimates of revenues and costs have become available. Table 4 provides estimates based on data available during the first half of 2017.

Notes:

aEquipment and real estate accounted for 60% of start‐up costs, licensing, and security for a further 20%.

bWages accounted for 30% of operating costs, rent/mortgage for 18%, utilities for 16%.

cBecause of quality and consistency, indoor grown marijuana sells at a price premium.

dAfter‐tax, net margin.

Over time, production costs change. While increased productivity from technological advances and greater operational efficiencies reduce production costs, these are offset by rising real estate costs due to a shortage of suitable facilities and increasing wage rates for marijuana workers—these wage rates tend to be above those for workers in similar horticultural and retail sectors. In Colorado, Oregon, Alaska, and some other states, employees in marijuana businesses are required to have state occupational licenses.

Most estimates of the profit margins on marijuana growing have failed to take account of the many risks affect the industry. These include: diseases, natural disasters (California's wild fires of 2017 and 2018 wiped out many producers), and other sources of crop failure. In addition, there is the ever‐present risk of crime that affects all cash‐based businesses and the risk of closure or loss of license resulting from failure to comply with state or local regulations.

The greatest uncertainty in projecting future profitability relates to prices. In the wholesale market, prices are determined by supply and demand. Prices vary over times due to spikes in demand (demand peaks during summer and holidays) and seasonal variations in supply (supply from outdoor and greenhouse cultivation increases during the fall). Longer term, there has been an overall downward trend in prices as growth in supply has outpaced growth in demand. Figure 2 shows prices between 2015 and the end of 2017. This downward trend has continued during the first half of 2018. During mid‐August 2018, the average US spot wholesale price was $1130 per pound compared to $1486 at the beginning of the year. These averages masked considerable price variation both between quality grades and localities. During the first half of 2018, wholesale prices in Oregon were approximately 55% higher than those in Colorado.12

Retailing

There is a huge diversity in the retail outlets supplying marijuana and marijuana processed products. There is a distinction between medical and recreational outlets, with the latter present in only nine states, compared to 30 for medical. Variations in regulations among states mean differences in size, operating practices, costs, and competitive conditions. In addition, some retailers are stand‐alone, other backward‐integrated into cultivation. Some indications of average revenues and costs are shown in Table 5.

Competition

Competition in the legal market for marijuana is highly dependent on the ease with which licenses are available. Typically, because of the visibility of marijuana retailers and the often‐hostile attitude of local residents, states are more restrictive over retail licenses than cultivation licenses. Indeed the steady decline in Colorado wholesale marijuana prices during 2016 and 2017 was attributed by many observers to the large number of cultivation licenses that had been issued.

Like most agricultural products, marijuana is essentially a commodity product at the wholesale level, although there are many different types. Marijuana comprises two species: Cannabis indica and Cannabis sativa, each with distinctive characteristics and each comprising many different strains. Leafly.com (“The World's Cannabis Information Resource”) has listed and reviewed some 800 strains. There are also quality differentials: in general, indoor‐grown marijuana commands a price premium of about 25% over outdoor‐grown marijuana.

Growers have had limited success in establishing their own brands—not least because of the inability to register trademarks for marijuana‐based products with the US Patent and Trademark Office. At the retail level differentiation has been greater—in addition to differentiation by geographical location, individual dispensaries can use quality and customer service to build customer loyalty.

Competition extends beyond the boundaries of the legal market for marijuana. Consumers, both medical and recreational, have the legal option of growing their own (in Colorado and Washington, adults can cultivate up to six plants). In addition, there is illegal marijuana. Illegal marijuana is produced domestically and imported from Mexico, Canada, and other countries. Mexico and British Columbia are major foreign sources. In the case of Mexico, outdoor production and low‐cost labor gives producers a huge cost advantage that is only partly offset by the costs of clandestine, high‐risk transportation and distribution. Nevertheless, the supply chains and distribution networks for illegal marijuana are well established and the lack of sales tax and regulatory compliance more than compensates for their inefficiencies. However, domestically grown illegal marijuana is a bigger threat than imported marijuana. A report in January 2018 by the California Growers Association estimated that, of the state's estimated 68,150 cannabis growers, only 534 were licensed to cultivate cannabis. 13

According to data from Price of Weed, marijuana prices in states where recreational marijuana is illegal, but laws are lightly enforced, are similar to those in Colorado and Washington with a well‐developed legal marijuana industry. However, in states where marijuana laws are strongly enforced (e.g., Alabama, Louisiana, North Dakota, and Iowa), prices are about 50% higher than states with light enforcement. 14

Marijuana also competes with a host of other recreational drugs. These include cocaine, amphetamine, methamphetamine, ecstasy, and a number of other organic and synthetic drugs.

The Future

The major determinant of the development of the US marijuana industry in the coming years will be government policy. In 2018, there was a clear divergence between policy at the state level and at the federal level, where there was a renewed commitment to enforcing the existing legislation against marijuana. What happens at the federal level is critical to the industry's future development. So long as marijuana remains classified as an illegal drug, the industry will have limited access to the banking system and intellectual property protection, and businesses will find it difficult to expand across state boundaries.

However, even under the uncertain situation existing in early 2018, some trends were clear; although the industry remained fragmented in all states where legalization had occurred, there was a trend towards consolidation both in retail and production. This was partly the result of competition—i.e., expansion among the better‐managed businesses—and partly the result of the flood of investment funds into the industry, resulting in individual venture capital funds controlling more marijuana businesses.

Should the federal government drop its opposition to marijuana, then Canada offers some pointers as to how the marijuana industry might evolve within the United States. During 2017 and 2018, the Canadian marijuana industry appeared to be consolidating at a rapid rate. The biggest producer, Canopy Growth, was planning to increase its output from 31 metric tons in 2017 to over 90 metric tons in 2018 as it expands from medical into recreational marijuana. It was already the world's biggest exporter of medical marijuana. 15  In January 2018, Canada's second biggest marijuana company, Aurora Cannabis Corp., acquired CanniMed for $1 billion. 16  In August 2018, there were 22 marijuana supplying companies listed on the Toronto stock exchange and three on US stock exchanges: Tilray Inc. (valued at $13bn.), Canopy Growth (valued at $11bn.), and Cronos Group (valued at $2bn.).

Another feature of the Canadian marijuana industry has been the interest shown by tobacco and alcohol companies in the business. Tobacco and alcoholic beverages are the most developed industries offering intoxicating and addictive products that are harmful to health and highly regulated. In the case of tobacco, it is interesting that—despite falling consumption, tight regulation, litigation, and heavy taxation—it remains one of the world's most profitable industries: the leading companies (Altria/Philip Morris, BAT, Japan Tobacco, and Imperial Tobacco) earned an average return on equity of 52% during 2014–17. In October 2017, US beer and wine giant, Constellation Brands, acquired a 10% stake in Canopy Growth, with a view to developing marijuana‐infused beverages. 17  Big tobacco has kept a watchful eye on the marijuana market for decades. In 2017, tobacco company, Imperial Brands, added a medical marijuana executive to its board. 18

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