The last few months have seen a whirlwind of consolidation in the cannabis industry. There have been high profile moves like PharmaCann’s purchase of LivWell and TerrAscend’s purchase of Gage Cannabis. But there’s also been many smaller acquisitions of companies with three dispensaries and a cultivation site. Moves by public companies get the ink, but quite a few medium-sized companies have been making deals too.
If you’re an operator of any size cannabis company, you can’t not pay attention to what’s going on. And if you’re a manager or employee in the business, you can’t help wonder if your workplace is going to become part of one of these transactions.
To better understand what’s happening, I talked to eight investors and analysts this past week, and I asked them, “What’s driving the industry right now?” Here, boiled down from hours of discussion, is what they told me.
- The market is only going to get bigger – and quickly.
“We estimate in 2021 a market that’s $23.5 billion,” said Andrew Partheniou, a cannabis industry analyst at Steifel GMP. “This could be a $100 to $150 billion industry over the long term. There is a lot of room for new players to come in – for existing players to grow bigger. The market is expect to be big enough to have many winners.”
That’s a sentiment many shared with me, to the point where massive growth in the industry is assumed among investors and analysts, and only when I asked about it directly would people expound. Also, almost everyone questioned the idea that the “big” cannabis companies are really that big.
“If you add up the enterprise value of the top six MSOs, it adds up to about $25 billion. That’s nothing,” said investor Mark Cozzi, who heads up CentoVentiCinque. “In five years from now, they may not exist.”
Mark was pointing out that there is still going to be a lot of mergers and acquisitions in the coming years, and the big companies we see today, might still be overtaken by others we’re not really paying attention to yet, or haven’t even been started yet.
Citing fast food as an example, Mark points out that, “at one time there was just Wendy’s, Burger King, and McDonalds. Think about all the changes in the industry since then.”
- Access to capital is the biggest driver for companies
“One of the biggest differentiators in cannabis right now is who has access to money,” said Scott Delgado of Hawkeye Capital. Scott pointed out that in 2017 and 2018, there was a brief boom as companies went public on the Toronto stock exchange, as Canada legalized cannabis nationally and fever spread to American investors who figured U.S. legalization was just around the corner. New public companies, flush with cash, bought up licenses and smaller players to expand their reach. With cash, they could buy not only licenses, but also good talent, marketing – everything needed to grow.
But then in 2019 stock prices crashed from skyhigh valuations, as investors realized the U.S. wasn’t legalizing any time soon.
“Because it was driven by the investment banks, they didn’t care if [the stock offerings] were preposterous. They figured we could just buy assets to get their revenue to get to ridiculous multiples,” said Scott Battenburg, Chief Investment Officer at Cliintel Capital. Now that companies can’t buy their way to success, said Battenburg, “Sour investors have been seeing the revenues coming back to earth,” and dumping cannabis stocks.
Since then, cannabis leaders have been scouring the Earth, looking for sources of capital. For instance, they’ve been do lease-back deals on their properties, selling dispensary and cultivation buildings to Real Estate Investment Trusts (REITs), who then lease the properties back to them on long-term leases, unlocking capital for the cannabis companies at a relatively low cost.
While most operators can do lease-backs, that’ll only get you so far. The biggest differentiator has been which companies can get access to debt capital.
- Debt capital is only available through private lenders, and is now the difference between big companies and everyone else.
“The biggest challenge is the differences between cost of capital. That’s the primary reason you’re seeing consolidation between the large players,” said Nick Gastevich of V. Gastevich Investments, who points out the role private lending has begun to play in the cannabis industry. Because cannabis is federally illegal, traditional banks won’t lend. But now private lending has stepped into the cannabis business in a major way.
These private lenders, sometimes called “shadow banks” because their lending activity isn’t regulated the same way traditional banks are, are essentially groups of high net worth investors who offer debt to companies secured by some kind of asset. In cannabis, the security might be licenses or real estate.
For the biggest cannabis companies, private lenders are offering debt at 7 to 9%, investors tell me. Medium-sized companies, such as those limited to a single state, or a small string of dispensaries and a cultivator, might be offered 15 to 20%. But for the smallest, mom and pop operations, with just one or two dispensaries, this kind of lending isn’t available at all.
“It’s creating a division line between the big operators and mom and pops. If you’re a small operator, you have a lack of scale, then plus 280E taxes, and then a difference in terms of what kind of interest rates you can get on loans. All of that makes operating as a small guy quite difficult in this market,” said Gastevich.
- Regulatory caps are limiting how big the big companies can be, but also making room for medium companies and for more “big companies”
You’d think that since big companies have the most access to capital, and can buy talent and marketing, they’d be dominating everything, right? Cannabis investors are quick to point out that state regulations are actually keeping that from happening.
“States like Massachusetts have put in [speed] governors to limit mass consolidation by the big players. And you’re starting to see other states like New Jersey and New York and Connecticut start to enact similar rules, where they are really geared towards local entrepreneurs and social equity applicants that limit vertical integration,” said Michael Hennessy of Lineage Capital.
As a result, where an unregulated market might allow a few large players to acquire or stamp out all but the smallest companies, cannabis regulation has effectively created a greenhouse for medium-sized companies able to raise private capital and to innovate.
“There’s always room for better,” said Patrick Rea of CanopyBoulder. “There are a number of privately-held MSOs in development that aren’t necessarily getting the headlines that are having influence on the market.”
But, medium-sized companies often have a very different business strategy than the biggest cannabis companies, says Michael Lucas, a partner at Green Equity Collaborative.
Medium-sized companies are, “a group that focuses on profitability, versus the groups that are somewhat well capitalized. The investors [for these companies] are not as well capitalized as those who understand the long runway towards profitability that comes with grabbing share,” he said.
Lucas thinks there will always be three tiers to cannabis companies. The top, which is focused on market share and builds their strategy around how to obtain that share. The middle, which is profit-centric, driven by a small group of investors who want to enjoy the proceeds sometime soon. “They are interested in growing,” and being acquired, he said.
At the bottom are mom and pops, who essentially operate “lifestyle” businesses, with a small collection of dispensaries or cultivators, that serve a consistent, niche clientele.
- Most companies still don’t know how to play the game right yet.
Every investor I spoke to pointed out that most companies – even the biggest ones – haven’t figured out the right strategy, or haven’t figured out how to execute consistently. But nobody wanted to say that on the record, for fear of offending someone.
Even the biggest cannabis companies haven’t figured out how to create consistent products across state lines, which means consumers might have individual stores they like, but they can’t recommend a product to someone that lives in another state.
“If you are selling flower in multiple states it is impossible to make the same plant in each state. Which means you don’t have a brand, you have a label,” said Battenburg.
There are ways to create consistent products for processed products, says Battenburg, but not for flower. Still too many companies are focused on flower, he says, because that’s what drives revenues right now. But the future is in creating a consistent brand that has an emotional connection with consumers – and is portable across state lines – something almost no company has done yet.
- There is still room for everyone to grow.
For an industry that everyone expects to maybe quintuple over the next ten years, why fight over who gets what piece of the pie, when the whole pie keeps growing anyway?
“This is a brand new industry, in that it’s recently legal, we believe this is going to be with us for a very, very long time. The companies that we’re seeing right now, yes they are the largest, but the landscape could likely change if you look 15 years down the road,” said Partheniou.
And, since large companies are essentially capped in size, that means many more medium-sized companies could merge to become big companies.
“It takes just one transaction to change all that. A couple of transactions and you can leapfrog into the competitive landscape. It’s the Trulieves and the Curaleafs,” said Rea.
This creates an environment where mergers and acquisitions are constantly happening, and even medium-sized companies need to be paying attention – all the time – according to Rea.
“What’s hiding in the tall grass? You need to surround yourself with a network of people that are watching your flanks, your back, and you have those relationships where they are giving you the heads up. Companies should be operating and knowing their competitive landscape. It ain’t easy.”
- There’s still not a lot of hope for federal action – but everything will change when it comes
This week has drawn some hope for federal action by the introduction of a bill that would decriminalize and deschedule cannabis by GOP Congresswoman Nancy Mace. The idea that a Republican introduced a possibly bi-partisan bill is exciting, but this reporter, who started his career in Congress and as a Washington lobbyist, thinks it’s unlikely that cannabis legalization will get priority over the debt ceiling, immigration, and Biden’s Build Back Better effort.
Until feds take action, investors say we should expect the industry to continue to be skewed by lack of access to debt capital – no bank loans – as well as major investors from other categories that want to get into cannabis as soon as it’s federally legal.
“These guys have their faces on the glass. They are going to be looking for M&A deals to consolidate these companies as fast as possible,” said Battenburg. “The tidal wave of money is not going to be little companies asked to do an IPO, it’ll be big food, big ag, big tobacco, and they’ll go to investment banks asking, do you want to raise a ton of money [to do deals]?”