2021 Quicktake #8: Cannabis Industry

A bet on an industry which could be growing for a long time...

Sep 27, 2021

Trying to understand an industry which has just started and with little information on what is going to happen is just tough.

Like venture capital investing, it takes a leap of faith.

The industry looks interesting and the only way for us to play the game is to ensure that we have a foot in the game.

That means that we are going down the path of taking a small position in the industry through an ETF. As investors, we would like to be position where growth is nascent and we are able to see the future of the industry.

The next question is why an ETF?

In 2019, I saw a clear trend of supply destruction in commodities and wanted to bet on the rebounding of the commodities cycle. I went full time researching into commodities in 2019/2020 trying to learn all about the industries and companies and the only conclusion is that it is an impossible task to do.

Tackling a whole industry which you are unfamiliar with is really tough and picking the best within the industry is even tougher. Too much analysis lead to ton of paralysis. For your information, I only bought Uranium Participation Corp (or currently known as Sprout Physical Uranium) for all that work!

If you believe that the trend is in favour, it is often better to just buy the whole industry. As long as the direction is right, the returns should be decent.

Currently, the industry that is being bankrolled now in the United States is

is a legalisation play.
not much of a technology.
the extension of a very old industry.

And that means that they are not world changing like biotech and could be profitable pretty quickly.

The industry is Cannabis. We like the cannabis sector as

There is less competition as the competition in within the states line now allowing the companies within the state to grow with some protection.
It is a retail or consumer product company concept which is closer to our circle of competence.
The critical point is that institutional investors are not exactly in the trade and there is still some juice left.

Note: This article is written in early May 2021. Since then prices had dropped by 25% - 50% and is increasingly looking like an opportune time to stake some money on this sector.

This following ETF is place in the Statistical Portfolio.

Type: Growth

Arbitrage: Possibly legal and possibly financial

Possible Catalyst: US Congress legalise cannabis which should still be a pipe dream

Holding Period: Tentatively 5 years, maybe up to 10 years

Synopsis:

The thought is to take an initial stake in the marijuana sector in the United States. While technically the sale of cannabis is still illegal on the federal level, various states had legalised the sale of cannabis within them. That lead to an odd situation where competition is limited allowing certain brands to build regional presence. Similar to the early days of the cigarette industry, there should be multiple players who will do well. Growth and margin expansion should continue strongly into the next decade.

Like a consumer product company with a need for retail branding, all the cashflow is being diverted to organic growth or M&A activities.

There is also multiple legislation catalyst which may happen which could dramatically increase sales, bring down cost and increase margins.

Valuation is currently crazy now and thus we are taking a tiny stake in AdvisorShares Pure US Cannabis ETF.

I am ready to average down when the price falls. So be ready for prices to fall by 50%.

Definition:

In the cannabis world, cannabis can be categorised into marijuana and hemp. Both are from the same plant but are differentiated through

their application
their cultivation method
tetrahydrocannabinol (THC) level

THC is a responsible for the feeling of being “high”. Hemp has very low THC level compared to marijuana, thus leading to usage of hemp in many other applications.

We will be using cannabis when we are addressing the industry as a whole and using marijuana when it is focus on the medical and recreational usage.

Legislation:

Cannabis as an industry is currently being legalised in a few part of the world but the main area of activity is within Canada and the U.S. and that is where we will be focusing on.

The U.S. is years behind Canada on legalisation and that is where the arbitrage opportunity arises.

The difference between Canada and the U.S. is the size of the market. Colorado topped USD 2b in sales in 2020 through state dispensaries putting it on par with the whole of Canada.

Marijuana remains a Schedule I substance to the Controlled Substances Act and is therefore illegal on all accounts at the U.S. federal level. To bypass the issue, a growing number of states have authorised cannabis firms to produce and sell cannabis within their borders, but not across state lines. By the end of 2020, more than thirty states had legalised cannabis containing THC for at least some purposes. Many of these legalisation states have barred nonresidents from owning local cannabis firms and thus making the commerce of cannabis almost entirely intrastate.

Implication: Without the barriers that states have erected to protect local firms, a new breed of large, national cannabis firms concentrated in a handful of cannabis-friendly states is likely to dominate the cannabis market.

SAFE banking act prevent companies dealing with cannabis from receiving ordinary financial services.

Green Thumb Industries, which this week reported 90% comparable sales growth in the first quarter, recently secured the first debt deal by a big listed U.S. marijuana cultivator at a sub-10% coupon. The Illinois-based business got a three-year loan at a 7% interest rate, or 9.1% factoring in warrants, based on calculations by Viridian Capital Advisors. Rival Curaleaf got a credit facility at 10.25% without an equity sweetener earlier this year.
-WSJ

Without the banks supporting, marijuana growers are paying “lower” rates at 9.1% when interest rate are at all time low.

Implication: When the SAFE banking act no longer applies to the marijuana growers, financing rates will plunge leading to lower cost and higher profit. In addition, the dispensaries will no longer need to deal only in cash.

The Section 280E of the tax code reads as such:

“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I or II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”

The law denies cannabis businesses any U.S. federal income tax deduction for ordinary and necessary business expenses, despite being duly licensed as a legal business in their state of operation.

Implication: When the U.S. federal legalise marijuana on a federal level, Section 280E will no longer applies leading to improved profitability.

Timing:

The US lawmakers had just elected to reintroduce the Marijuana Opportunity Reinvestment and Expungement (MORE) Act to Congress, which would eliminate the federal ban on cannabis.

The MORE Act was passed by the House of Representatives in December 2020 but left to languish by the-then Republican-controlled Senate. The upper chambers of Congress are now controlled by the Democrats, and the MORE Act is likely to enjoy significant support from the Democrats.

“Experts” has indicated that any further federal legislation would have to wait for mid-term election in 2023. So there is a good amount of wait left.

Industry Mental Model:

The industry mental model we are using will be base on the 2 oldest vices in the U.S. We will run through the alcohol and tobacco industry.

Alcohol:

At the turn of the 20th century, the beer industry was booming. Local brewers often had ownership ties to the taverns - selling to them on extended credit terms, furnishing them with equipment and supplies, charging low or no interest, and paying rebates for pushing their brand or carrying it exclusively. This relationship became known as "tied-houses." Competition for control of the retail outlets was fierce and tremendous pressure was exerted on retailers to maximise sales without regard to the well being of customers or the general public. These abusive practices led to a campaign for laws prohibiting all drinking. In 1919, the 18th Amendment to the United States Constitution was passed beginning a 14-year dry spell known as Prohibition.

In 1933, the 21st Amendment to the United States Constitution repealed Prohibition and also gave states the authority to regulate the production, importation, distribution, sale and consumption of alcohol beverages within their own borders. A new regulatory system known as the Three-Tier System was created. This system was established to eliminate tied-house abuses. "Tied-houses" would no longer exist - instead beer would be sold through independent distributors.

This provided states with the power to regulate the production, distribution, sale, and consumption of alcohol within their boundaries.

John D. Rockefeller Jr. commissioned scholars Raymond B. Fosdick and Albert L. Scott to help state legislators forge a path into the world of alcohol regulation. Fosdick and Scott concluded that states should either run state monopolies over their share in the alcohol market, or license the sale and distribution of alcohol in a manner that creates wholesalers who can stand between brewers and retailers. Nearly every U.S. state adopted the latter option, thus creating the proposed three-tier system.
-A Case For Why the Three-Tier System’s Regulations Stir Competition, Boost Diversity, and Protect Consumers

The three-their system prohibits the production, distribution, and retail sectors of the alcohol market from commingling. Alcohol production companies include distillers, vintners, wineries, and breweries. These production companies must sell to wholesalers and distributors. Wholesalers and distributors sell the alcohol to retailers, which are locally licensed centers that include bars, restaurants, liquor stores, drug stores, and grocery stores.

Under the three-tier system taxes could be levied at three levels of the beer distribution process. Breweries pay a federal excise tax. Wholesalers and distributors are taxed by the states, and then retailers have to pay a sales tax.

Application to marijuana sector:

Like the alcohol industry, the legalisation of the marijuana industry will drive

the demand from illegal to legal marijuana, leading to huge growth in the revenue
clear taxes on the federal and state level allowing the various players to derive pricing and costing plans.

Cigarette:

Similar to cigarette, marijuana need to be be grown and packaged. The need to standardise the product meant that growers will be growing at one place, manufacturing and then before being distributed around the country. That meant that consolidation and manufacturing will most likely happen at the cheapest place of production.

In 1881, James Bonsack, an avid craftsman, created a machine that revolutionised cigarette production. The machine chopped the tobacco, then dropped a certain amount of the tobacco into a long tube of paper, which the machine would then roll and push out the end where it would be sliced by the machine into individual cigarettes. This machine operated at thirteen times the speed of a human cigarette roller
-Burns, Eric. The Smoke of the Gods: A Social History of Tobacco. Philadelphia: Temple University Press, 2007. Pg 134

The idea of specialisation and automation would not have surprised anyone, but so is marketing. Similar to cigarette, the industry ability to drive down cost and improve margin allow the marijuana players to up their marketing spend with the best branded consumer products gaining the most market share and profitability.

Camels were a hit. Sales started out briskly and improved every week for the first several months. Assuming that advertising made the difference, Reynolds was quick to put its money where its faith was, in 1916 spending the unprecedented sum of 2 million dollars for appeals to consumers in various newspapers and magazines. As a result, at least in part, the following year Camels accounted for 35 percent of all cigarettes sold in America.
-Burns, Eric. The Smoke of the Gods: A Social History of Tobacco. Philadelphia: Temple University Press, 2007. Pg 171

Application to marijuana sector:

Like the cigarette industry, the proliferation of the marijuana industry will drive

improvement in manufacturing and packaging of marijuana leading to improvement in gross and net margin
marketing become increasingly important leading to regional and national brands which will dominate the market.

Possible Outcome:

The highly outcome is that the various states would want to control the growth of the marijuana industry, keep some jobs within the state and make sure that taxes continue to be collected.

The marijuana industry will most likely specialised, gain economies of scale and finally grow nationally through marketing. While we cannot predict who will be the ultimate winner, we knew that in the early days of cigarette growth, every player makes good money despite falling prices and increasing competition. The same economics should apply to marijuana.

Ignoring state taxes, prices for marijuana should continue to tread towards the lowest price among all the states.

The three with the highest average price are District of Columbia ($597.88), North Dakota ($383.60), and Virginia ($364.89). These are places where marijuana use is somewhat restricted: In D.C. it is illegal to purchase, in North Dakota it’s only legal for medical use, and in Virginia it’s not legal at any level. The three least expensive states for marijuana, however, are all in the West region and all allow for legal recreational use: Oregon ($210.75), Washington ($232.90), and Colorado ($241.74). The national average is $326.06.
-Oxford Treatment Centre

Instruments:

We could pick and choose the various marijuana players on the market or the real estate1.

Familiar names include

Cresco Lab
Curaleaf
Green Thumb Industries
Trulieve

In total for 20204Q, each of them are making sales of around USD 500m per year with growth of around 100% over the last year. Growth of 20 -30% could continue into the next decade as more people warm up to having marijuana at home, in the office or at the bar…

With the possible legalisation, long term average net margin should hover between 5-7% margin.

Valuation is crazy at current level. Trulieve which has one of the nicer ratios are trading at between 45x - 80x PE.

No matter how we normalise their earnings, the valuation will remain very high.

The problem remains that there is no way to value all these players properly.

Like other naive investors who are jumping into the cannabis industry, I am comfortable to project out into the far away future where the whole cannabis industry could rival the size of the annual U.S. cigarette industry at USD 80 - 90b.

We would not be surprise if all the players continue to survive and do well through the years and there would be a Altria and Reynolds in their midst.

The idea is to start really small and average heavily when the price falls by 20 - 50%. Over the very long term, the result should be satisfactory.

Somehow, when an industry growth is well recognised, the valuation will never fall to bargain level.

Oh yah, did I mentioned that even if the legalisation comes much later the existing players would continue to do very well through organic growth and M&A.

If legalisation comes earlier, the existing cannabis companies would be M&A targets making this sector a boomtown.

Life is always good when you can win both ways.

Weighted Capital

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