Ready or not, the green rush is underway. Last year, Canada ended nine decades of recreational marijuana prohibition and, as of Oct. 17, 2018, rolled out the red carpet for adult consumers and investors alike. This recreational weed legalization, along with two-thirds of U.S. states having now legalized cannabis in some capacity, has paved a path to rapid growth in the North American pot market.
Just how rapid, you ask? Though it's a matter of source and opinion, a recent report from Arcview Market Research and BDS Analytics is calling for 38% global sales growth in 2019 to $16.9 billion and a more than doubling in global sales between 2018 and 2022 to $31.3 billion.
Canadian cannabis consolidation is occurring at a snail's pace
Clearly, there are going to be big winners from the rise of legal cannabis. Then again, there are also going to be losers and lollygaggers; and it's impossible to tell which companies are going to fall into which categories as of yet. About the only certainty, as with practically any high-growth industry, is that it's overcrowded. Consolidation among marijuana companies is a must over the next couple of years in order to ensure branding and pricing power, cost controls, and margin integrity.
Yet, truth be told, we haven't seen much in the way of consolidation. Sure, we've seen the acquisition-hungry Aurora Cannabis gobble up its fair share of cannabis growers since the beginning of 2018, but we really haven't witnessed a lot of consolidation on the growing side of the equation, at least in Canada. According to Health Canada's data as of Feb. 8, it's issued 50 cultivation licenses. Even with some of these licenses being for secondary grow sites by the same company, or acquired properties, there are still more than three dozen unique licensed growers in Canada, with many more applications in backlog and awaiting licensing.
In fact, if we take a hard look throughout Canada's cannabis industry, there hasn't been much consolidation in any area in particular. Mind you, that's not damning to investing in Canadian pot stocks, but it could eventually weigh on profitability if the field isn't narrowed.
But this isn't the case with the U.S. marijuana industry -- or, I should say, more specifically, within one area of the American pot industry: vertically integrated dispensaries.
Marijuana consolidation is picking up among U.S. pot dispensaries
Whereas Canada's provinces offer a hodgepodge of government-run and private dispensaries, which creates little need for consolidation, this isn't the case in the United States where large corporations to mom-and-pop families own retail stores.
Making matters more complicated, marijuana isn't legal at the federal level in the United States. As a Schedule I drug, it's wholly illicit, prone to abuse, and not recognized as having any medical benefits. It's also not allowed to cross the borders of a state where it's grown. This means U.S. dispensaries that want to control their vertical supply chain must also construct, lease, or acquire cannabis grow farms and/or processing facilities in the states they're operating in. Canadian dispensaries simply don't have these worries, with the federal government having legalized the drug.
With 33 states having legalized weed in some capacity, you can also bet that each legal state tends to have its own process for reviewing and licensing dispensaries for retail sale, grow farms for cultivation, and processing facilities for the finishing of raw cannabis products. The cost and time it can take for a vertically integrated dispensary to obtain all of the pertinent licensing necessary to conduct business can be prohibitive to organic growth. This is why acquiring smaller, or in rarer cases similar-sized businesses, in the dispensary space that already have their licenses in place has been a faster means of expansion than the organic file-and-wait approach.
Deals aplenty in the U.S. vertically integrated dispensary space
This past week, the largest marijuana deal to date in the U.S. closed, with iAnthus Capital Holdings (NASDAQOTH:ITHUF) ponying up north of $600 million for MPX Bioceutical. Following closure of the deal, iAnthus now has 19 open locations spanning 11 states (it only had a presence in six states prior to the deal), but has retail licenses in place to open as many as 63 retail locations. What's more, the combined company now has 210,000 square feet of aggregate grow space, but is targeting a near-tripling in this amount to 600,000 square feet, spread across the states it conducts business.
By the fourth quarter of 2019, it's expected that MedMen Enterprises (NASDAQOTH:MMNFF) will dethrone iAnthus for the largest deal in U.S. cannabis history. In October, MedMen announced its intention to acquire privately held PharmaCann for $682 million in an all-stock deal. Having at the time of its announcement had a licensing presence in six states, five cultivation and/or processing facilities, and just over a dozen open dispensaries, the combination as of late January (had it hypothetically closed) would double MedMen's presence to 12 states, boost its retail licenses to 77, lift its cultivation and processing facilities from five to 13, and give it 31 open dispensaries. That's a quick way for MedMen, a company with higher sales per square foot than Apple stores, to improve its visibility.
Of course, not all acquisitions have to be in the hundreds of millions of dollars to have an impact. Trulieve Cannabis (NASDAQOTH:TCNNF), a profitable dispensary with two dozen open stores in Florida's medical marijuana market, recently acquired Life Essence in Massachusetts and Leef Industries in California. When Trulieve made the announcement of these acquisitions back in November, Life Essence had already applied for three dispensary licenses and a 126,000-square-foot cultivation and processing facility. Meanwhile, Leef received one of 12 fully permitted annual licenses by the state of California. This puts Trulieve Cannabis in the driver's seat as it makes its move beyond Florida.
The point being that no matter where you look, vertically integrated dispensaries are aggressively making acquisitions to improve visibility and get around the lengthy process of obtaining all necessary licensing.
Two concerns to be wary of
Though the vertically integrated dispensary model in the U.S. looks exciting and could be very profitable at some point in the future, there are also two points of concern that should be at the forefront of investors' minds.
The first is that it's going to cost a lot of money to execute these expansion plans. Opening or constructing retail stores, and building or retrofitting grow farms, isn't going to come cheaply or happen overnight. It's still a lengthy and costly process, meaning investors will need to have patience.
To build on this first point, it's almost certainly going to require that vertically integrated dispensaries turn to the secondary market to raise capital. With these businesses being predominantly cash flow negative, raising capital by selling stock could become commonplace. That's often a recipe for share-based dilution and unhappy investors.
The second issue is that there's no guarantee these dispensaries, in their overwhelming desire to expand and improve visibility, won't grossly overpay for the businesses they're acquiring. For example, iAnthus has seen its goodwill rise from 7.2 million Canadian dollars as of Dec. 31, 2017, to CA$75.9 million as of Sept. 30, 2018. That's 55% of the company's total assets on its income statement, which suggests it's grossly overpaid for its previous acquisitions.
In other words, while this consolidation is very much needed, it's going to take time to sort out which companies purchased their way into good deals and which ones did not.
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