Illicit to Essential: Cannabis in a Post COVID-19 Pandemic World
The way we do business and conduct our lives generally will forever change in many ways as we hopefully emerge and continue to recover from the initial impact of the COVID-19 pandemic. The world has changed dramatically due to COVID and will continue to be challenged by it. Innovation and adaptation will drive new models and modes of successful operations in many sectors for many years, no different than what is occurring in many industries throughout the economy and the society we each live within.
Focusing solely on the cannabis sector, 10 of the 11 states that allowed access to legal, regulated recreational cannabis before the November 2020 election results and as many as 20 of the 28 states that allowed for medical access to cannabis deemed access to legal, regulated marijuana an essential service during the onset of the pandemic pause. As of this date, the United States has a total of 17 states and the District of Columbia that either currently allow some form of recreational access and 37 states that allow some form of medical access or are actively in the process of implementing rules within their respective jurisdictions to allow for and to regulate this access.
On November 3, 2020 voters in Arizona, New Jersey, Montana, and South Dakota approved the following ballot initiatives to legalize recreational marijuana in their respective states:
Arizona – Proposition 207: The Smart and Safe Arizona Act
New Jersey – Public Question #1
Montana – CI-118 and I-190
South Dakota – Amendment A and Measure 26, which effectively approved both medical and recreational access at the same time.
Mississippi voters also approved Initiative 65, and this actually might be the most significant of all five of these states that are moving to implement rules and regulatory frameworks to allow access to marijuana. Mississippi is arguably one of the most conservative states in America, and its legislature was none too pleased when Initiative 65 qualified for a spot on the ballot last November. This led lawmakers to drum up Initiative 65A, a substantially more restrictive measure that would have allowed medical cannabis only for terminally ill patients which conservatives had hoped would siphon support from Initiative 65. The November 2020 medical access initiative was nonetheless passed by the citizens of Mississippi only to be hung up as Republican Governor Tate Reeves continued to stall on calling a special session of the legislature to overcome some hurdles added by the state Supreme Court in May 2021. Finally, in September 2021 a framework was agreed to which may be instructive for other conservative states as medical and recreational cannabis continue to make inroads. As an example of how regulations are evolving and adapting to local social norms with specific states and jurisdictions, the new Mississippi rules include the following components:
Cities and counties can opt out of having cultivation or dispensaries in their jurisdiction, but the citizens of these jurisdictions have a process to call for a special vote to approve licenses, whereby voters can gather 1,500 signatures, or signatures of 20% of voters, whichever is less, and force a referendum on the local city or county licensing limitation issue.
Mississippi has mandated THC potency limits of 30% on flower, 60% on concentrates and infused products. Any product above 30% THC will require a warning label.
Medical marijuana will be subject to sales tax and an excise. The state’s sales tax, currently at 7%, would be levied on medical marijuana, as well as a $15 an ounce additional excise tax.
Physicians, nurse practitioners, physicians’ assistants and optometrists would be allowed to certify a patient’s use of medical cannabis. Under the voter-approved Initiative 65, only physicians could do so. The proposed framework requires a ‘bona fide doctor-patient relationship’ for the issuance of a 12-month medical cannabis certification and will also require a six-month follow up examination for suitability.
Preference will be given to in-state companies. Cultivators will be licensed in tiers — from “micro cultivators” to large ones, based on square footage of canopy space. Micro growers, under 2,000 square feet, will need to have to be “100% Mississippi resident participation.” Larger ones initially would have to have 35% Mississippi ownership, but that requirement would be repealed after one year.
Outdoor growing will not be allowed, nor home growing. A myriad of reforms and initiatives to enhance access also generally met with approval at municipal and county levels in those states that already allow for medical and recreational access. The include increased access through home delivery, on-line ordering, and curbside pick-up.
Moving the image of legal cannabis from illicit to essential has been huge and brought about changes that would not have happened nearly as quickly as they have in a post COVID-19 era. A Pew Research Center study conducted in September found that 67 percent of Americans feel cannabis should be legal, while 91 percent feel it should at least be legal for medicinal purposes3. According to a recent article by James Williams in the September 2021 Marijuana Venture magazine, the evolution of marijuana in the United States can be segmented into phases:
The First Wave was the awakening or beginning of decriminalization. This phase is about illicit market participants advocating for therapeutic uses of cannabis. We see this as generally beginning in the 1960s and continuing to accelerate today.
The Second Wave was characterized by the early days of medical adoption above all else. This might be seen as beginning in 1996 when California voters approved Proposition 215 by a 56 to 44 margin.
The Third Wave was marked by the money rush set off by adult-use legalization in 2012 and the “vertically integrated” rush of 2016-2018.
The Fourth Wave, from 2019 to present, can be recognized as the cannabis bubble bursting, with sudden deflations in investor expectations, market saturation and over-competition.
The Fifth Wave can be characterized by the stratification of the industry into large multi-state fully integrated operators and boutique players focused on specific points within the overall supply chain. We see this continuing to evolve somewhat comparable to how the wine and beer industries have evolved with major regional and possibly sometime soon, nationwide vendors and brands, but with a continued portion of the overall market continuing to be served by local artisans and entrepreneurs as long as they can sufficiently differentiate their brand to warrant the lack of economic efficiencies due to smaller scale operations.
According to a recent report published by Deloitte Canada and BDSA Analytics4, global sales of legal, regulated cannabis reached $21.6 billion in 2020, an increase of 50% over 2019 reported sales, and are forecast to be $62.1 billion in 2026 for a Compound Annual Growth Rate (CAGR) of 15%. U.S. sales reached $18.0 billion in 2020 and are forecast to be $47.6 billion in 2026, a CAGR of 13.8%. By comparison, in 2019, the U.S. beer industry sold about $120 billion in beer and malt-based beverages to U.S. consumers through beer retail establishments. However, in 2020 retail sales fell to $100 billion due to widespread closures of restaurants, bars, stadiums, and other on-premises accounts. The domestic U.S. wine industry was estimated at $88 billion in 2020, according to BusinessWire.
According to a BSDA Consumer Insights survey, 27% of respondents identified low price as a key driver of their product choice within the legal recreational and medical markets, while a Deloitte study of the Canadian cannabis market showed 70% of respondents who continued to patronize the illicit market stated that lower prices was a key reason that they continued to turn to illicit market purchases. The BSDA survey also noted that 37% of respondents thought taste/flavor was a key attribute and 33% were focused on high THC content as a key factor in their purchasing decisions. The survey identified several other factors that influenced consumer quality considerations, including: THC or CBD content (57%), Quality of High (48%), Taste (36%), Smell (35%), Duration of High (34%), Lack of Negative Effects (32%), Flavor (29%), How Well it Smokes/Vapes (25%), and Bud Density (20%). The survey also focused on how consumers are becoming more astute with many willing to pay premium prices for what they perceive to be craft brands and unique features, such as CBD additives to gummies and craft dried flower which commands a price premium of 16% to 41% in the Canadian market, depending on THC content. Lastly, the survey notes that Branding strategies still require time to educate consumers to appreciate why higher prices are worth it and compares the journey cannabis consumers are on to entry level blended whiskeys, and how many whiskey consumers eventually evolve to premium single-malt whiskeys.
We sense that we will see a continued bifurcation of the cannabis industry between smaller boutique brands who will continue to be pressured by national players as more multi state operators leverage technology, access to capital and sheer economies of scale to expand their footprints into new markets. The current M&A acquisition binge we are witnessing is evidence of this and we expect it to accelerate as the potential for federal legalization becomes more promising, even if it still appears to be on the distant horizon.
In August 2021, Senators Chuck Schumer (D-NY), Cory Booker (D-NJ) and Ron Wyden (D-OR) introduced the Cannabis Administration and Opportunity Act6 in the U.S. Senate which is essentially an omnibus bill that roles all three of the legislative initiatives7 that have been passed in the U.S. House of Representatives into one massive piece of legislation for Senate consideration.
The Cannabis Administration and Opportunity Act automatically expunges federal non-violent marijuana crimes and allows an individual currently serving time in federal prison for non-violent marijuana crimes to petition a court for resentencing. The legislation also creates an Opportunity Trust Fund via a new federal cannabis excise tax to reinvest in the targeted communities. The legislation also ends discrimination in federal public benefits for medical marijuana patients and adult use consumers. The legislation preserves the integrity of state cannabis laws and provides a path for responsible federal regulation of the cannabis industry. Similar to current federal regulations on alcohol, states can determine their own cannabis laws, federal prohibition will no longer be an obstacle.
Federal regulatory responsibility would be moved from the U.S. Drug Enforcement Agency (DEA) to the Alcohol and Tobacco Tax and Trade Bureau (TTB); and the Bureau of Alcohol Tobacco Firearms and Explosives (ATF); as well as increasing the involvement of the Food and Drug Administration (FDA) to protect public health. On this last, one we add, “be careful what you ask for” as this, itself, could be a total game changer for the regulated cannabis industry, both positive and negative.
More recently, an amendment to other legislation was introduced by U.S. Congressman Ed Perlmutter (D-CO), a longtime advocate of the SAFE Banking legislation in the U.S. House of Representatives in an effort to move federal banking reform forward separately. In September 2021, Perlmutter succeeded in getting the SAFE banking legislation attached to a defense spending package, the National Defense Authorization Act (NDAA) of 2022, but in early December, the amendment was taken out along with several other unrelated side car measures that had been tagged onto the NCAA. This could have resulted in a quicker pathway for federally legal banking to be realized, as compared to the inclusion of this federal legislative change within the much broader Cannabis Administration and Opportunity Act. Other reform advocates have indicated that they opposed separate banking reform that would have potentially favored the larger MSO operators until such time as other reforms, such as those embodied in the MORE Act, are also enacted.
Separately, Justice Clarence Thomas, a Justice that historically and rarely comments or asks questions, issued a stern warning to the other branches of the Federal Government in his June 28, 2020 statement as part of the denial of Cert in the Standing Akimbo v Commissioner case8. In his statement, Justice Thomas noted:
“Once comprehensive, the Federal Government’s current approach is a half in half out regime that simultaneously tolerates and forbids local use of marijuana.”
If the Congress and Executive don’t get their act together then the Supreme Court will likely take up a future case.
The Supreme Court will likely uphold federalism, the Federal Government’s right and power to overturn state law and enforce Federal law as the supreme law of the land. “If the Government (Federal) is now content to allow States to act “as laboratories” and try novel social and economic experiments, then it might no longer have authority to intrude on the States’ core police powers…to define criminal law and protect the health, safety and welfare of their citizens.”
“A prohibition on intrastate use or cultivation of marijuana may no longer be necessary or proper to support the Federal Government’s piecemeal approach.”
The legal, regulated side of the cannabis industry is a great example of how COVID-19 has brought about radical lasting change in how business is conducted generally. On-line ordering and curbside delivery protocols are part of a tidal wave of change that have allowed many cannabis retailers to be experience 2020 revenue well in excess of 2019 for what was a record setting year for total medical and recreational sales. Colorado, for example, reported its first month of regulated sales in excess of $200 million dollars in the month of July 2020 during the height of the pandemic pause and ended the year as a $2 billion dollar industry. Keep in mind, this is just for the legal, regulated medical and recreational sales, as compared to the illicit market which is estimated nationally to be about the same size, if not larger, in terms of dollars spent on cannabis products.
In 2021, year over year sales growth tapered off in many adult-use cannabis markets during the summer months indicating that the demand spike experienced during the second half of 2020 was exceptionally robust and likely motivated by pandemic buying patterns and the added liquidity many had from stimulus monies, unemployment benefits, and inflated asset prices while being away from full time work routines. Many vendors reported challenges keeping shelves stocked during this time.
Speaking of shelf space, the pandemic has launched a whole new delivery channel with home delivery now in vogue and an intriguing sales option in many jurisdictions. As a result of the pandemic pause, Planet 13 in Las Vegas is reported to now have 30 vehicles and over 100 drivers delivering product 24/7 throughout the Clark County jurisdiction they serve. Given the valet parking, turn styles at the entry point to their dispensary and stations for up to 50 bud tenders this new distribution channel, along with curbside delivery, has been a salvation to their investment in the most amazing, “only in Vegas” facility they put in place prior to COVID-19. The pandemic has also compelled retailers to create more robust online ordering platforms that allow consumers the ability to shop and research products on the web, place an order and streamline their transaction time. E-commerce will likely play a larger role in the industry going forward.
Jurisdictions like Los Angeles10 are in the process of awarding licenses for as many as 100 new dispensaries that will be non-store front delivery-only operations. This means dispensaries that have no retail presence other than online orders will be able to deliver to consumers in other jurisdictions creating more competition in CA.
Awarding new licenses for dispensaries and cultivation of cannabis has also taken a huge turn with many jurisdictions, like the City of Los Angeles among others, implementing new frameworks to assess how best to award license rights using new expanded criteria that emphasizes social equity components. Illinois, for example, has used a 250 point scoring system that evaluates and awards points for having sufficient capitalization and management competence, but also awards points for being a veteran, diversity, and other social equity criteria, such as locating operations in disadvantaged neighborhoods and for having lower level prior marijuana convictions on the applicants record11.
It is critically important to recognize that access to legal cannabis, be it recreational or medical is highly dependent on local and municipal rules and regulations. Many of the states that have legislated legal access or had it approved by voters still have significant limitations on access due to a lack of municipal approval. As more local city and county governments continue to evaluate their involvement in either or both medical and recreational cannabis, citizens and advocacy groups are demanding added considerations for how licenses get awarded in recognition of a myriad of social equity elements that can be radically different from one jurisdiction to another. This is especially true for the retail segment with respect to the emerging home delivery, non-store front licenses, consumption lounge segments, as well as with traditional dispensary models. Social equity is also becoming a larger element of licensing for cultivation, and MIPS processing in various markets.
Metropolitan Denver is an excellent example. While the state of Colorado has almost 600 operating licensed recreational dispensaries with roughly 350 of those being in the City and County of Denver, surrounding suburbs have been a study in contrast in terms of municipal approval. Smaller municipalities like Edgewater and Lakeside have embraced cannabis dispensaries and have flourished from a municipal budget standpoint due to the significant boost in cannabis related license fees and excise tax revenues. Others cities like Golden, Arvada and Littleton have continued to advocate a “not in my back yard” position, although in November 2020 Golden voters narrowly passed a resolution to allow consideration of recreational licensing and its implications for city revenues and beyond. Other cities like Lakewood, has allowed limited medical access for several years, and has seen voters approve recreational access, limited to only those operators that are already established as medical dispensaries. The small municipality of Glendale, wedged between goliaths Denver and Aurora, has been a hotbed of cannabis dispensing but partly due to their municipal rules that allow for dispensaries to stay open until midnight while Denver and Aurora, the two largest cities in the state, must close by 10 pm. Some stores in Glendale have reported that over 50% of their daily sales occur between 10 pm and midnight but now the larger contiguous jurisdictions are evolving with more liberal hours of operation and access.
Lastly, at least from the Colorado landscape, the little town of Trinidad, which is in Los Animas County, the largest county landmass wise in the state, has over 25 licensed and operating recreational dispensaries. What makes this unusual is that there are only 15,000 people in Los Animas County of which 9,000 are in Trinidad. The town of Trinidad is located 11 miles north of the New Mexico state line on I-25, the major north/south interstate running from Albuquerque and Santa Fe to the south, to Pueblo, Colorado Springs, Denver and on to Cheyenne, Wyoming to the north. It is estimated that over 90% of the business conducted in the 25 Trinidad dispensaries comes from traffic originating south of the Colorado state line and from jurisdictions that do not offer legal access to recreational cannabis. Now with New Mexico authorizing recreational access which will ramp up in 2022, the windfall recognized by cross border access in Trinidad and other locations like Durango, will have to rebalance their points of access accordingly.
Testing regimens are also evolving to now include heavy metals testing12 of state legal, regulated product, in addition to the traditional testing for pesticides, potency, mold and microbial contamination. Residual solvents have also emerged as a key area of testing in concentrates and edibles, in addition to potency. Independently owned and operated laboratories are becoming a legitimate ancillary industry. More recently, recalls have had a big impact within some markets, most notably the massive recall by the Michigan Marijuana Regulatory Agency in November 2021. A recent article by Beau Kilmer14 identified 14 considerations, all beginning with the letter P that highlight what needs to be evaluated in conjunction with successful sustained success in the cannabis sector.
These are: 1) Production, 2) Profit motive, 3) Power to regulate, 4) Promotion, 5) Prevention and treatment, 6) Policing and enforcement, 7) Penalties, 8) Prior criminal records, 9) Product types, 10) Potency, 11) Purity, 12) Price, 13) Preferences for licenses, and 14) Permanency.
All of these factors are in play in most every jurisdiction that allows legal, regulated access to cannabis. The cost of producing cannabis will plummet with increased legalization and the amazing evolution of technology and process improvements. The eventual lifting of the federal prohibition based on the Controlled Substances Act of 1970 will mean many producers no longer need to hide in the forest or in the basement of a rented home. In a post CSA landscape, competitive forces will continue to be front and center for many operators as state and local governments allow rapidly consolidating multi-state operators with access to sufficient capital to compete and grow on industrial-sized outdoor farms and, more importantly, to eventually engage in some form of intrastate commerce, all while developing policy to protect the precious tax revenue being generated by cannabis activity in each state. Its difficult to determine exactly how the industry will evolve in the coming years however, many public companies in this space are posting strong sales growth and more and more operators are finding a path to positive cash flows despite myriad challenges. Cannabis’ acceptance is growing rapidly, and pervading all segments of society with a variety of different form factors and it’s tough to envision a scenario where the industry’s trajectory slows dramatically near-term. COVID-19 was a net positive for the industry which seemed to accelerate several aspects of its development and we are excited to continue our coverage of the industry and the proverbial reading of the cannabis tea leaves.
For help with cannabis and hemp valuation and economic assessment issues, please reach out to Ryan Cram (ryan.cram@cpavalue.com), Chelsea Seigneur (chelsea.seigneur@cpavalue.com) or Ron Seigneur (ron.seigneur@cpavalue.com).
*See PDF for references and citations.