Data Analytics for the Cannabis Industry

EA:
Beau, how did you first get into this industry? It doesn't seem somebody would wake up one day and say, "I'm going to follow the cannabis and hemp industries."

BW:
Yeah, I was teaching economics at the University of Phoenix, and one of my students in my classes was asking about the cannabis space. Actually, he was asking about how to start up businesses, not even hinting at the cannabis space. And finally, I got around to asking him and I said, "What industry are you in?" And he said, "I'm in the cannabis industry." I said, "How large is that industry?" He goes, "I don't know. You're the economist. You tell me." And it piqued my curiosity.

And so I started looking into this. This is in 2014, right when Oregon was considering a vote on legalization for adult use. And I realized that there was this huge market out there that nobody was really talking about in the mainstream media and the mainstream economic community. And so I saw an opportunity and I went for it.

EA:
Beau, what makes this industry different from most other industries?

BW:
Well, what makes this industry so much different is the fact that there's this nuance between federal illegality and state legality. And as a result, there's some systems in place that support the market and some systems that are not in place that inhibit the growth of the market.

For example, there's really no data collection to speak of at the federal level. There's no banking to speak of, although some banks have entered into this space and credit unions have. And there's no real interstate commerce, and so everything is confined in the boundaries of one state or another. These are obstacles that make challenges.

Oh, and I'd be remiss if I didn't mention the fact that there's heavy taxation at the federal level despite the federal illegality. So all these obstacles are in place that are challenges to the cannabis industry, and other industries don't necessarily face them.

EA:
280E is certainly an issue that we deal with every day, so we know that well.

BW:
With respect to 280E, that's a federal tax provision that really was trying to dissuade people from conducting illegal activities at the federal level or at the state level, what have you. And so the taxes are really punitive in nature. That tax policy came about 40 years ago and hasn't changed, despite the fact that the cannabis industry has multiple times.

And in an analysis that my firm did just recently in 2022, the cannabis industry paid 1.8 billion dollars more in taxes than they would've paid if they were treated like an ordinary business. And this year, it's projected to be even larger, 2.3 billion. So that's 2.3 billion dollars that's taken out of the pockets of the operators that they would normally use to hire more people, lower prices, do marketing campaigns, and the like. That would increase not only the consumer demand, but also the taxes associated with this.

So it cannot be stressed enough that this 280E tax is a real big weight, an anvil around the neck of the cannabis operators across the United States.

EA:
And many people come into this industry because they think there is a pot of gold at the end of the rainbow, no pun intended. How far is it for a cannabis company, a business to be profitable?

BW:
Well, it's been getting increasingly more and more difficult to be profitable in this space. My firm puts out surveys to cannabis operators around the United States, and we've been doing it for a couple years now. And the amount of firms that are stating that they're profitable has been declining precipitously over the last couple of years. Last year or the year before, 42% of the industry said that they were profitable. Now, this last year, only 24% said that they were profitable. So that means that 76% are either just barely breaking even or not making any money at all.

EA:
And why is that? Is that the price of flour going down so significantly, or are there are other factors?

BW:
Well, what's making the challenges is that this is a new industry. It's heavily taxed, it's heavily regulated, and there hasn't been a good model for the deployment of regulatory programs, and there's not a model for legislatures to go by. And so it's a big experiment that's going from state to state to state, and these states are replicating the mistakes of previous states over and over again.

And so there's not much improvement on this. So you've got heavy taxation. You've got oversupply in terms of being over capacity because regulators haven't figured out that they need to deploy, licenses in a controlled manner rather than handing them out to anybody that qualifies. So there's a lot of supply. It's driving down prices because there's more supply than demand.

Things would change a little bit if there was interstate commerce. But right now, the way that the state by state structure is that there's oversupply, falling prices.

Now, at the same time, based upon the surveys, we're seeing input costs, the cost of production, the cost of manufacturing, and the cost of deploying products to market, we're seeing those prices going up. So you've got supply chain issues, you've got increased labor costs, you've got all this stuff. So your bottom line costs are going up at the same time that your top line prices are going down. So operators in this space are getting squeezed in the middle along with heavy state taxes, heavy federal taxes. As a result, they're not able to make a go of this, and it's very, very challenging to become profitable.

EA:
It's a bad combination, lower revenue and more expenses. That usually doesn't work out well in the long run. Beau, do you favor limiting the number of licenses issued?

BW:
So in terms of favoring the number of license issued, I think that there's a great debate right now between unlimited licenses and limited licenses. Now, my firm tracks the number of licenses that are issued by each state regulator. We track that every month. And so we're able to see the flow of which state is increasing licenses versus which ones are softening.

But the great debate is limited licenses where it seems almost arbitrary that you set at a limit and then that's it. It limits access to market. It limits the supply. It limits opportunities for participation in the space. That's limited licenses. And as a result, it jacks up the price of those licenses to the point where it excludes certain portions of the population from participating in the cannabis operations.

Then on the other side is unlimited licenses, where, as I just described, there's oversupply generally. There is not enough demand to satisfy and make all of those licensees profitable.

But what I've found is that there's a sweet spot in the middle where you can, with data, analyze the market, determine how much capacity you need to satisfy the demand within that state, and then peg your licenses accordingly to that supply capacity and the demand. And so I've been trying to work with state operators, state regulators to ascertain what is the sweet spot and then drive the licenses to that number. And so each year, it'll be different, because as states evolve and markets evolve, there is more and more and more participation.

But I have really good predictive tools that can say, "In year one, you need this many licenses and this much supply. And in year three, you need that much and additional supply, capacity," et cetera, et cetera. So I'm in favor of limiting the licensing, but using data and using my models in order to ascertain what the sweet spot is.

EA:
We've also spoken about some of the industry issues that are facing the cannabis industries. We've talked about taxes. We've spoken about oversupply. What other industry problems do you see that is draining this industry?

BW:
Well, there's three or four key issues at the federal level, and then there's a bunch of issues at the state level. At the federal level, we talked about the impact of 280E taxes, federal taxes on the state operators. We talked about the lack of interstate commerce, and that would open up the demand, normalize prices. It'd give more opportunities across the country rather than limiting the demand to that one individual state.

There's also the lack of access to financial services and banking. That's in part due to the federal illegality, but it's also due in part to the fact that banks don't know how to regulate this or ascertain the risks. And so as result, a lot of them just don't participate.

And then there's also social equity and social justice issues. And so it's like how do you bring in minority communities into the system so that they can benefit from the growth and development of this nascent market?

So those are the federal issues. Those are the four main issues. There hasn't been necessarily a model that's emerged at the state level to address these, because it's really tough to address a federal issue at the state level.

At the state level, the fact that they're trying to influence federal policy through state policy, those models just aren't working either. And a lot of times, local politicians and local regulators, they don't incorporate federal issues along with their state issues when they develop their policy. For example, it may seem innocuous to impose a one or two cent per gram tax at the local level on operators. But when you combine that one or two cent program tax at the local level, combine that with the state level, and then combine that with the federal level, at the local level you may be taxing these operators out of existence and making them uncompetitive.

For example, in some countries, the price on the wholesale market for cannabis is $11 a kilo. That's a penny a gram. If the state officials impose a one penny or two penny a gram tax on the cultivation, then they're already not competitive on a global basis when things open up. The average cost in the United States ranges between 25 cents and 50 cents a gram. I've seen some instances where it's 10 cents a gram on outdoor. But if already the US market's cost is 25 times that of the wholesale price globally, then one has to be mindful at the state level of this situation, the global situation, so that they don't make their cultivators and operators and licensees uncompetitive once things open up on a global basis.

EA:
What are some of the key metrics to this industry?

BW:
Well, I look at the amount of supply relative to the consumer. I look at the percentage of illicit activity versus legal or regulated activity. I look at the average sales per retail unit. And I also look at basket size or how much each transaction amount is worth. And we do that by state, by state, by state. I also look at the amount of illicit supply relative to legal supply. And that's important because there's this very, very large unregulated market that's supplying a lot of the states regardless of if they have a legal program or not. And so one has to be mindful of the influence of the unregulated market just as much as they have to be mindful of the policies being promulgated by the regulators in each individual state.

EA:
Regarding the economics of this industry, what do you expect to see in the coming year or two?

BW:
What I expect to see in the next year or two is prices to continue to fall, especially in the mature markets and now these markets that have recently deployed. I expect to see the new markets, like New York in particular, and New Jersey to a lesser extent, I expect to see them struggle, because the prices to get interest rates on loans are more expensive due to the Federal Reserve increasing interest rates. Input costs are higher. Costs of machinery is higher. And so I anticipate and I'm forecasting the fact that new businesses will struggle to open their doors.
What this will also entail is the fact that the growth rate of the cannabis market nationally will slow it. It'll still be positive growth rate. It just won't be the growth rates that we are used to seeing pre-pandemic. And so with that, it's going to take a couple of years. We're forecasting seven to eight quarters, basically 2025, before we see a resumption in the accelerated growth in the market.

So for right now, prices will fall, costs will go up, the industry will continue to struggle unless the federal policies change and the state policies change to be more accommodative towards businesses and less so on tax revenue, and then we'll see a resumption of that fast-paced growth in 2025. By that time, the Federal Reserve will have lowered interest rates. We're forecasting that they're going to lower interest rates in 2024 to unwind what they're doing right now, and that'll take a little while to attract additional investments into this space.

And that's a forecast not only for the adult use of medical markets, but also on the industrial cannabis or hemp markets as well.

EA:
What are investors' current appetite for this industry?

BW:
Well, in terms of investor appetite, it's a lot easier to invest your money getting high interest rates, now that the interest rates are going, and have that secured by the federal government. It's a lot more appealing to have that scenario rather than invest in a high risk uncertain type of industry like cannabis or hemp.

And so investors are, especially the institutional investors, they're pulling back and sitting on the sidelines. In addition, those investors have experienced losses, especially in the public markets. They've experienced losses that they need to absorb or address with their existing capital. And so a lot of the investors are shoring up their current operations and current investments rather than investing in new ones. And so that's a difficult environment for the states that are deploying new regulatory programs like in New York, because there's just not a whole lot of capital out there.

And so this I don't think will change in the near term unless there's some type of change to the paradigm right now, either changes to banking to reduce the risks and reduce the cost of banking and financial services to a reduction in the tax levels, 280E reform, or allowing the market to conduct interstate commerce. Unless something changes federally, then the market is going to continue to struggle. And because it continues to struggle, investors will have a pause in terms of their appetite and willingness to invest in this space.

EA:
The next question kind of goes hand in hand with investors' appetite. How hard is it for somebody who wants to be a part of the industry, become a member of the industry?

BW:
Well, in terms of entering into this space right now, because there's a lot of distressed assets, one has to be really disciplined when they try to look into this market and either begin a new operation or invest in one. So while it's not all that difficult to enter, it's difficult to succeed in the market.

And so what the mistakes were made early on in this space is that there was a lot of excitement and enthusiasm and investment on the hopes and dreams of the people that were in the space already. Right now, there's a tremendous amount of a lot more discipline in terms of what it takes to enter into the space, invest in the space. There's a lot more discipline, and it's much more of a hardcore business rather than investing and operating based upon potential.

As a result of all of this, there's a lot of emotion as well. Investors and operators alike are frustrated. They're beat down. And as a result, things can get really emotional. So I'm starting to see that in the commentary by investors, in the commentary in the state houses by operators, and you're starting to see it more in the courts through litigation. And so I'm getting a lot of business as an expert witness in this space because of the fact that the bro hugs, where there's no documentation and partnerships that are based upon a bro hug, those bro hugs are breaking down right now and you're starting to see a lot of emotion, a lot of lawsuits going back and forth between operators and partners and friends and the like.

EA:
Well, I guess you should always document, document, document.

BW:
Absolutely. It's just like any other normal business. For some reason, cannabis operators, because of the origins of this industry, documentation was generally frowned upon. But now that it's an established industry, we're forecasting just shy of 30 billion dollars in legal sales this year. It's a legitimate industry. And as such, your business practices and operating practices need to reflect that.

EA:
And we always tell people in this industry, "It's a different industry. It's a new industry. It's an emerging industry. But it's still a business, and you have to run it like a business."

BW:
I couldn't agree more. In fact, one of the reasons I experienced successes early on as an operator in this space was because I brought those business practices and supply chain practices and branding practices into the companies, and we were able to capture large amounts of market share as a result of just having good operational discipline. And so that operational discipline, doing more with less, really being lean, and looking at all aspects of your cost structure and your revenues and the like, having that operational discipline is really key right now in order to lay the foundation for success in the future.

EA:
And that operational diligence that you talk about is for all businesses in this industry, not just the small mom and pop. The big MSOs also have to do this the right way as well.

BW:
Yeah. I mentioned earlier that some of the regulators are making the same mistakes as previous regulators. Investors are making the same mistakes as previous investors. But I think the MSOs have made similar mistakes to what occurred in Canada by the large licensed producers there in terms of installing way too much capacity, getting a little bit over their skis in anticipation of increased demand. And now, as a result of that lack of discipline, they're starting to pull back and not hire and close down operations and the like. They're starting to exit markets.
And a lot of this is, from my perspective, is rather predictable. But you need to ask those questions before you enter into the market, not after you've invested tens of millions of dollars into that market already.

EA:
Where do you see the greatest demand for talent in this industry?

BW:
Well, I think where I see the greatest demand for talent is in the high skilled areas. The unskilled labor is rather transitory in nature. You have trimmigrants. There's a term called trimmigrants, where trimmers go from one operation to another to another during harvest season. That's unskilled labor. That's generally transient in nature, moves from firm to firm to firm.

Where the greatest demand is is for those high skilled laborers like chemists, like technicians to run the extraction machine, like confectionary individuals that know how to formulate edibles and the like, and then also executive leadership that can balance the corporate world with the cannabis world and can straddle that fence. So those higher skilled labor positions are the ones that are the most difficult to find. It was very evident in our surveys this last year that that was the area that was of focus by a lot of operators.

And then once they acquire those individuals in those positions, then they pay them well and they keep them around. They don't let them go. They're not transient in nature like the trimmers and the other operators, the bud tenders and the like.

EA:
We talked a little bit earlier about the price of flour. What factors dictate the price of flour, and do you see that price stabilizing a bit in 2023 or 2024?

BW:
Well, the price of flour is determined by a couple of different things. One is the amount of capacity that's online, and then two, the amount of retail outlets that one has in order to distribute. And price is a big factor in all that, because if there's limited supply, then prices remain elevated, but that hurts demand. If you have lower prices, it's great for the demand, but you're not as getting as much and your margins are compressed.

Oh, and all of that is dependent upon the regulatory structure that's deployed in each individual state. If I were to predict just in general averages in the national market, I would say that prices are generally going to go down because of oversupply and overcapacity. Right now, based upon my supply analysis, there's already enough capacity that's licensed in the United States in the medical and adult use markets to satisfy all of the demand for cannabis, illegal or legal. So we're already over capacity. So I anticipate prices will go down.

Now, prices on one coast are low, like on the West Coast, and prices on the other coasts are relatively high on the average. So what I envision over the next couple of years is a normalization of the prices. So you have lower prices that are in line with... On the East Coast, lower prices. Then they're in line with what's going on in the West Coast. And so I see a normalization of prices. And this will actually raise prices on the West Coast at the same time that prices are lowering on the East Coast. And once that occurs, then that will be a good thing for the industry, because it'll make revenues, it'll make your cost structure, it'll make everything much more predictable. And then it'll also... Once things stabilize price wise, then that will give investors greater confidence in their investment.

Now, will that happen in the next year or two? Probably not. Will it happen over the next five years? I'm very, very convinced that it will.

EA:
And allowing interstate commerce will have a significant impact as well.

BW:
Yeah, once that normalizes the price. I just posted recently on LinkedIn that the valuations of businesses will actually go down. The value of the market will go down, counterintuitive, because of the fact that prices are going to go down. And so if prices go down, revenues go down. May be the same amount of supply, but it's just gleaning less in the marketplace. And so the valuations are going to go down in the United States overall as a market. At the same time, prices and valuations in Europe and Africa and Asia and South America will go up, because those prices will normalize as well relative to the North American market.

EA:
We talked a little bit about before on the other side, the cost side. Will we see continued cost-cutting? And also, will we see mergers and acquisitions in 2023 and 2024?

BW:
In terms of the costs and reducing costs, there's only so far that the current operators can go in terms of cost reduction. So at some point, operators are either faced with less profits, cutting costs, or going out of business. And so at some point, the price for labor, price for infrastructure, the price for electricity and the like, a lot of that has a lower bound and you just can't go below it.

Will we see more mergers and acquisitions? Absolutely. We're starting to see individuals and corporations taking over distressed assets for pennies on the dollar in a lot of these mature markets and oversaturated markets. And people are just tired and they're beat down and they want to get out. And as a result, they're doing so at a significant discount relative to what they've put into their operation.

So mergers and acquisitions, yes. Business failures, yes. Taking over of distressed assets, absolutely. I think in the next couple of years, the market will look much different than it does today.

EA:
And finally, Beau, when do you foresee, if at all, federal legalization?

BW:
Well, I've always joked that... Now, I've been in the cannabis industry for nine years now, approaching my 10th year. And I've heard every year that full federal legalization is five years out. And I'm still hearing that today.

EA:
And it's still five years out. Yep.

BW:
It is still five years out. So your guess is as good as mine. But I recently spent some time in D.C. I recently spent some time in Europe. The markets are intertwined from a policy perspective. I provide inputs into a lot of these politicians.

And so what I'm seeing is that there's a lot of priorities that are present in the decision making process of legislators at the state and federal levels. And cannabis just isn't one of those. And it's unfortunate, but seeing wholesale reform, I'm not predicting that. There may be some type of tinkering with rescheduling, but I'm seeing even struggles with state banking. Legislation was passed 10 years ago and still hasn't gotten across the finish line. So I'm not generally overly optimistic that there's going to be some type of wholesale change and full federal legalization. I think there'll be a lot of incremental change, or there'll be some incremental change, not even a lot of it, and a lot of trimming around the edges.

Now, the trimming around the edges from a policy perspective when it relates to full federal legalization is problematic for the United States market, because there's other countries that are being much more aggressive with their views on legalization. Germany and the Czech Republic come to mind, some countries in Africa and South America. So unless the US federal level legislation gets its act together, the US may lose its leadership position and give that leadership position to the European Union or other continents rather than the United States or North America. So it's a big risk. It's a big risk to the market.

EA:
Well, thanks for joining me here today, Beau. And thanks for listening to CannaCast as part of the EisnerAmper Podcast Series. Visit www.eisneramper.com/cannabis for more information and podcasts. Also, please visit www.whitneyeconomics, W-H-I-T-N-E-Y-E-C-O-N-O-M-I-C-S, .com for more information about Whitney Economics and Beau. And join us for our next CannaCast podcast, where we'll discuss other budding issues. Thank you.

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