It would be hard to exaggerate the excitement many investors felt when cannabis was legalized and its many investment opportunities presented themselves — the growing, the processing, the product production, the retailing, and so on. All that excitement seems to have subsided the past few years, as the many realities surrounding the business appeared to staunch the unbridled growth investors anticipated.
But things are not always as they seem. Consider that several cannabis companies are headed toward $1 billion in sales, and there are many reasons for optimism, according to Michael Apstein, principal founding partner at Primary Growth Partners (PGP), and interim CEO of PGP Brands.
What is the current state of the cannabis industry?
At the top of the list, it’s important to recognize that cannabis has been normalized. Adult use is now legal in 18 states, and medical use is legal in another 19. Cannabis was declared an essential business during the pandemic, a big boon to the industry. The reasons for consumption keep expanding — relaxation, pain management, improving sleep, digestive aid, treating a medical condition, overall wellness. Multiple pieces of cannabis legislation are under consideration at the federal level, including adult-use legalization. Cannabis company stocks are now traded on both the NYSE and Nasdaq, in addition to the Canadian exchanges. So, cannabis has been normalized.
Next, it’s big, and it’s still growing. 2021 estimated sales in the United States are $97 billion, which exceeds spirits as an industry, and will soon overtake beer ($107 billion). Half of consumers report daily usage, and they’re not who you think they are. The average metropolitan U.S. consumer is 46 years old, half of them own a home, half of them have kids, and over half are or have been married.
Finally, it’s still a nascent industry. Adult-use cannabis is only a 6-year-old industry, and even medical-use legalization is less than 25 years old. Deeper research on its multiple uses and benefits has only begun in the past couple of years. On the positive side, nascency means tremendous upside still to be gained; on the negative side, it means significant issues still to be resolved.
Where is it gaining ground, and what are its primary challenges to reaching full development?
My favorite cannabis stat is sales were up during 2020 in every cannabis product category, across every generation, and every gender. That might be a first in the history of consumer packaged goods. Nine states have legalized adult use in just the past two years, doubling the number of adult-use states, and there are currently five or six states in the process of converting from medical use to adult use. Forty-four percent of the U.S. population now has access to adult-use cannabis for recreational purposes. So, it’s gaining ground everywhere.
Primary challenges remain the federal Schedule 1 drug classification, which prevents most banks from doing business with cannabis companies and imposes IRS tax code Section 280e on the industry, a damper to growth. Next would be the high excise taxes imposed in many states, which sound right in theory, but in practice give the unregulated portion of the industry a competitive advantage by driving higher prices at the licensed, legitimate businesses.
Several cannabis companies are headed toward $1 billion in sales. What does that tell you about the industry and its players?
That it’s an early packaged-goods industry. We’re seeing significant amounts of M&A activity up and down the chart in terms of company size, and the acquisition multiples (a recent transaction at 21-times EBITDA) certainly indicate buyers believe there is upside growth ahead. Most mature consumer goods industries tend to have two to three multinational publicly traded companies dominating the industry, and only a few private or public companies in the $250 million to $500 million annual sales range, and then a few handfuls of companies under, or well under, $100 million. Cannabis is not there today, but it’s where it’s headed.
What aspect of the cannabis business is performing best thus far?
On the product side, flower (the cannabis itself) remains the best performing category in most areas, with pre-rolled joints usually second. Newer formats continue to grow (including vapes, edibles, beverages, topicals and tinctures), but do not appear poised to overtake flower or pre-rolled joints. If you look at other human life-altering substances (salt, sugar, coffee, tobacco, alcohol), they all tend to still be consumed most in their original format. I think cannabis will follow suit.
On the business side, we continue to see growth across the board in cultivation, manufacturing, distribution, retail and delivery. It’s still too early to say which operating model is most effective — vertical integration where one company is, in all aspects hopefully, creating less pipeline vulnerability and greater margins, versus specialists concentrating on being best at one aspect.
Big tobacco and big alcohol have invested in cannabis. What has the impact been?
The biggest impact might be the news coverage when those investments were made. If you look at the companies which took in those investments three or four years ago, they’re not the current leaders of the pack. There’s been an expectation that other big industries (tobacco, alcohol, pharma) would step in and take over cannabis, perhaps because they have significant capital and experience operating in highly regulated industries. But cannabis is proving to be a unique animal, with complexities different than those industries. While I wouldn’t want to bet against the bigs, I think there’s a real possibility cannabis will be a stand-alone industry that doesn’t get bought out by others, at least for a while.
How is the SPAC/SPV investment sector in cannabis faring?
SPACs and SPVs were the darling investment vehicles in cannabis during 2020 and 2021, but their sparkle has faded a bit due to underperformance. There is still about a billion dollars out there in these financial vehicles, expiring over the next year or so, in the hunt for cannabis investments. It’ll be interesting to see what they can find. The same underperformance has been the primary problem with the publicly traded stocks, and the reason their prices have been punished. While there are a couple of outliers, true bright spots performing well, there have been considerably more growing pains than most operators expected.
Talk about the difference between indoor versus outdoor growing and cultivation of cannabis. What is the difference in terms of quality and revenue potential?
There are three unique environments for cannabis cultivation: indoor, outdoor and mixed light (also called light deprivation or greenhouse). All three have their adherents, as well as pros and cons, often dependent upon geography. For every connoisseur who says they will only smoke indoor, you can find one who says they will only smoke outdoor. Indoor has tended to command higher prices, primarily due to what I think has been an industry misstep. Early on, the industry glommed onto THC percentage as an indicator of experience, with a higher THC number expected to drive a better or stronger experience. Indoor tends to generate higher THC percentages, and has led the way in pricing. Sophisticated consumers, companies and brands are recognizing THC is not the best indicator of experience, so I think we may see that formula begin to change.
During a recent investment conference references were made to “sophisticated” versus “unsophisticated” marijuana users. What is the difference between the two?
I don’t think there’s a universal definition, but I define unsophisticated consumers as shopping cannabis by potency and price comparison. In other words, what’s the highest THC (they’re thinking stronger) they can get for the least amount of money. The problem with that limited approach is they might consume a 30 percent THC product where the effects only last for an hour, versus an 18 percent THC product where the effects last three or four hours. So, which is actually stronger if that’s the sole measurement?
Sophisticated consumers are aware THC is not the best indicator of experience, and the categories indica, sativa and hybrid don’t mean much of anything. Sophisticated consumers are looking at flavor of cannabis, which can be described as fruit, floral, earth and fuel (fuel being the big driver of today’s high THC products), and even more at the terpene swirl, meaning the mix of the dominant terpenes that really drive what the experience is likely to be.
Where do brands fit into the cannabis equation?
Ultimately, cannabis is a consumer good, and we know brands dominate in consumer goods, so we know brands are going to be a crucial part of the cannabis equation, which makes it very interesting that brands have not been a big part of the equation thus far. While there are a few recognizable brands in cannabis today, as someone who has built two top-1,000 brands in the United States, I’d argue none of them are limbic brands, meaning they have not emotionally embedded themselves with their consumers to create any kind of real ongoing loyalty. I don’t think most cannabis companies even understand that aspect of the equation, nor how to do it. That shortfall is the precise reason I got into the cannabis business — the significant opportunity I saw to create real brands, limbic brands, targeting specific demographic groups with unmet needs. In consumer goods, brands ultimately prove the test of time, and create long-term value for their companies and investors.
What about consumption lounges? Is there such an animal?
Consumption lounges do exist; there are a handful across the United States, three or four of them in my home state of California. There would be more if not for the pandemic having obviously slowed most forms of socializing the last couple of years. Given the social nature of cannabis consumption, many people in the industry, myself included, believe this segment will grow. My company partnered with the political operative group that laid the regulatory groundwork to allow the first consumption lounge in the United States, toward opening more municipalities to this type of cannabis consumption lounge license.
There is still a black market for marijuana. How big an issue is this, and what can be done about it?
The illicit market remains an issue in the cannabis industry, but every year we see the regulated market growing and the illicit shrinking, with those operators often falling out of the industry. While there may always be some holdouts, it’s just a matter of time and effort until its size is no longer a factor in the overall industry.
Cannabis investors have been seeing what kind of return on investment?
It depends on what type of investment, and when it was made. The early investors in the companies that went public obviously did quite well. More recent investors have not seen those public company stock prices drive much return. Those investors who hold the right positions as the industry matures will see strong returns based on the significant level of M&A activity. For me personally, I think today’s greatest return opportunities are in earlier-stage and emerging companies with strong management teams, innovative products, and thoughtfully developed brands. Finding them can be the tough part.
What pot stocks are in your personal investment portfolio?
In terms of publicly traded, I hold Cresco, Trulieve, GTI and Curaleaf. But the meaningful cannabis investments in my portfolio are the intellectual property licensing companies we’ve created at PGP Brands, which meet the investment criteria I find most important after five years of working in this industry non-plant touching so no application of IRS tax code Section 280e, readily scalable across North America with low capital expense requirements, generate largely passive income from IP licensing, and make an attractive acquisition target.
Where do you expect the cannabis industry to be in five years?
Bigger and better. While it still may not be resolved federally, 40 or so states will have approved adult use. Industry size in the United States is likely to be $150 billion to $200 billion, with multiple companies over the $1 billion mark. Products will be more precisely targeted, for highly beneficial uses. Recreational products will be able to largely assure what the consumer experience will be. And there will be real brands.