Pot companies are in trouble. Survival tips here!
Hurry up and wait
The list of challenges that cannabis companies face is daunting, from deadlocked policy to slumping prices for marijuana. That has hit share values of publicly traded cannabis companies, and it’s safe to say much of the earlier optimism around the industry has faded to frustration.
So what does the near-term future hold for the industry? Bloomberg Intelligence analyst Ken Shea answers questions about the outlook and offers his view on what companies should be doing to navigate the difficult environment. He sees companies moving beyond dried flower for higher-value products, and further consolidation in Canada.
Revenue seems to be declining for most big companies. At the same time, legal cannabis sales overall continue to grow. Can you talk a bit about that divergence? Are there factors beyond oversupply? Why can’t the big cannabis companies take advantage of this global growth?
The dichotomy that seems to be increasingly evident is the divergence between the expanding market size of legal cannabis sales worldwide and the recent revenue trends of the large public cannabis-producing companies. I attribute much of this to price compression in the highly competitive adult-use (or recreational) markets in Canada and the US.
In Canada, this is being exacerbated by a resilient illicit market, which is placing intense pressure on the price of dry flower, which is still the most prevalent product sold. In fact, adult-use cannabis retail prices are nearly 30% below their level four years ago, shortly after Canada legalized the marketplace, according to Health Canada data.
We expect pricing pressures in Canada’s adult-use market to remain intense for the foreseeable future. On the bright side, the long-awaited shake-out of weak competitors seems to be near, which could act as a stabilizing factor to prices.
In the US, some mature and oversupplied markets like California are also placing heavy pressure on producer revenues.
In our view, producers need to move up the value chain by emphasizing branded ancillary products like edibles, beverages and topicals. Competing in the dry-flower category appears to be an uphill climb for most companies.
So with sales growth harder to come by, is it realistic for companies to do anything beyond treading water for now? What measures can they take to survive amid the US federal policy inertia?
For US companies, a disciplined approach to expansion will be more critical than ever to survive what will likely be a producer consolidation, though on a longer timetable than in Canada, in my view. Maintaining sound financial management to ride out the current storm means aspiring to generate free cash flow while maintaining a strong balance sheet. That can give these companies the staying power to survive while allowing them to capitalize on acquisition opportunities when the time is right.
My advice to US operators is to emphasize their operations in states that are apt to limit the number of licensed producers, have an industry-friendly taxation scheme and where the illicit market may be a manageable factor. These states include Illinois, New Jersey and Florida. And, while there is potential for international markets to open — especially in Germany — the costs and management attention associated with pursuing them appear to be too high to reap a near-term payback.
There are reports that the federal review of cannabis is supposed to be done this year. What does this updated timeline mean for companies? Is there anything concrete companies can do in anticipation?
I do not envision the federal prohibition of cannabis to end during the current administration, given the divisive politics in Washington, so US cannabis companies ought to factor that into their planning.
That said, a potential Biden second term might offer the increased policy flexibility that lame-duck politicians generally do. A more accommodative Congress would certainly help on that front.
You said recently you saw a 40% chance of the SAFE Banking Act passing this year. Even if it passes, you argue that big banks most likely will continue to avoid the industry. How come? Without their support, would passage of the bill change much for cannabis businesses, in practical terms?
According to Bloomberg Intelligence senior government analyst Nathan Dean, passage of the SAFE Banking Act by the US Senate still faces low odds of success, as enough Republican leaders still do not appear to be on board. He also believes that even if SAFE were to pass, many of the nation’s largest banks would likely hold off on providing marijuana firms banking services until marijuana is legalized federally, based on their lingering fears that such activities might run afoul of other federal compliance regulations.
As I see it, SAFE wouldn’t be enough to change the near-term revenue or profit trajectory of most cannabis firms anyway. SAFE does not address more-pressing barriers including IRS 280E — which would allow producers to deduct traditional business expenses. In addition, SAFE does not address their inability to conduct interstate commerce or gain access to major stock exchanges, like the NYSE and Nasdaq.
Unfortunately for US cannabis producers, they will need to be patient and financially disciplined until federal legalization occurs, which I believe actually has a good chance in the next presidential administration.
The reward? Potential early access to an industry that could someday rival the sales other large US consumer products industries including alcoholic beverages, tobacco and even many over-the-counter medical products.
