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The Business of Legal Marijuana: People Are Getting Rich. Should You Get In?

By John Maxfield – Jan 12, 2014 at 11:13AM

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It is now legal to buy, possess, and consume marijuana for recreational purposes in the state of Colorado. In this article, Motley Fool contributor John Maxfield digs deep into the industry to reveal who's getting rich from it and whether there's an opportunity for other investors to get in on the action.

This article is the third of a three-part series on the business of marijuana. To read the first two articles in the series, click here and here.

The line stretched nearly around the block. To people passing by on New Year's Day, it looked like a queue for the latest iPhone release or for tickets to a Justin Timberlake concert. Few onlookers strolling down Denver's 16th Street Mall, the epicenter of the state capital's tourist industry, would have guessed they were witnessing the first state-sanctioned sales of recreational marijuana in the United States.

To say that the owner of this small but opportunistically located cannabis shop appeared overjoyed would be an understatement. He was in the zone, racing up and down the line, managing crowd control, and handing out tickets that preserved customers' spots in line -- there wouldn't have been enough room in a Whole Foods to absorb the crowd, much less in his roughly 2,500-square-foot store.

"We're on track to do $130,000 in sales today," he tells me, requesting anonymity like the other unnamed sources in this article for fear of being targeted by federal law enforcement, state regulators, or prospective burglars. On an annualized basis, that equates to three times the productivity of an Apple store, which generates more than twice the sales per square foot of the next most productive retailer. Needless to say, in an almost exclusively cash-based business, that's a lot of dough.

"The genie is out of the bottle," Roberto Lopesino of Advanced Cannabis Solutions told me earlier in the week, before legal selling began. And by the looks of it, he was right.

The promise of riches

It's difficult to describe the exuberance that pervades a new industry, particularly one that involves the cachet of a newly legalized drug like marijuana. Of the two dozen or so people I spoke with in the business, every last one of them was convinced that they were on the road to riches. Over and over again, these eager entrepreneurs made analogies to the Gold Rush of the 1860s, which originally populated much of the region, and to the growth of the Internet. "The only thing that even comes close to this," a penny stock operator with designs on the industry told me, "is the craze leading up to the dot-com bubble."

The examples of this are legion. One, a successful building contractor from Las Vegas, lost everything during the financial crisis and moved to Colorado to try his hand at growing pot. "We're not in it for the size," he tells me. "We're here to build the largest distribution network in the country," saying that it's his goal to have licenses in more states than any other cannabis cultivator. Another, a line cook at a ski resort less than five years ago, grew his operation into one of the largest dispensaries in Southern Colorado. And a third went from owning a successful janitorial company to being one of the biggest pot barons in Denver, harvesting nearly 300 pounds a month.

The exuberance stems from one thing: money. It costs the best operations no more than $800 to grow a pound of marijuana that can then be sold through their own retail stores for upwards of $3,000 a pound -- dispensaries in Colorado must grow at least 70% of what they sell. That translates into more than $7 million in profit before taxes for a 20,000-square-foot cultivation facility like the one I visited last month for research on this three-part series (for the first two articles, click here and here). At that rate, just one year's profit is more than three times the total capital expenditures needed to retrofit a property this size into the money-making machine that it is today.

It's not all gravy

This isn't to say that the money is necessarily easy. Plants, by nature, are susceptible to a variety of maladies. There are mites and molds that can ruin a cannabis crop over the course of a night. If a single light cycle is mistimed, a plant can "go hermaphrodite," meaning that it changes from female to male. It could then cross-pollinate the rest of the crop, ruining it for productive use. And if both the temperature and humidity aren't gauged precisely, the yield can be so low as to eliminate all profitability.

Moreover, simply getting into the industry can be an almost impossible hurdle. Licenses run in the tens of thousands of dollars and require the applicants to submit to laborious background checks and give up numerous constitutional rights. "They can search my personal residence without a warrant anytime they want," a grower told me. And even if you get past this initial stage, it's almost impossible to raise outside capital. Because marijuana is still illegal at the federal level, banks are prohibited from lending to operations and out-of-state investors can't put up equity for fear of running afoul of the feds.

But for those able to navigate these impediments, the world is their oyster. There are few industries that offer more protection from competition than the marijuana trade. Participants are insulated from deeper-pocketed out-of-state competitors due to the remaining federal proscription, which affects everything from banking to merchant services to taxes. Meanwhile, new in-state competitors are throttled by the same laborious licensing process and the challenge of raising capital. To top things off, many of the people who have successfully made it into the industry have little to no idea what they're doing. As one participant put it, "The industry knowledge is not deep."

A window of opportunity

How long will this opportunity last? That remains to be seen, but one thing is for certain: the countdown has begun.

"We're already seeing a commoditization in the industry," Lopesino told me. "Cannabis will ultimately be like beer. Most people most of the time drink Coors or Budweiser; only on special occasions do they drink more expensive microbrews."

In fact, according to his statistics, a full 80% of customers care about price more than quality, leading a handful of large operators to prioritize volume and thereby reduce the cost to consumers. Driving around Denver or Colorado Springs, the state's two largest metropolitan areas, it isn't uncommon to see signs advertising $99 ounces of marijuana.

It's for this reason that many industry observers are recommending that investors look to peripheral players as a source of long-term, sustainable profits. It wasn't the miners who made off like bandits during the Gold Rush, the adage goes, but rather the businesses that sold picks and shovels.

Lopesino's Advanced Cannabis Solutions provides one such example. Its business model is predicated on owning the real estate that's leased to large commercial growers at a premium of two to three times the typical market rate -- the premium reflects the legal uncertainty involved with marijuana production. ACS then supplements this with revenue from consulting services sold to prospective tenants and other, less knowledgeable industry participants.

Another example is Waste Farmers, a company founded and run by John Paul Maxfield (who also happens to be my cousin). While Waste Farmers originally started out by collecting and composting waste from commercial restaurants like Chipotle, it sold that business and used the proceeds to develop soils that can be used by, among other potential customers, indoor cannabis farmers, who now account for 70% of Waste Farmers' revenue.

"The growth of the industry has been tremendous," John Paul told me over lunch one day. "And it's not going away anytime soon."

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. John Maxfield owns shares of Apple and is the cousin of John Paul Maxfield, who is mentioned in the above article. The Motley Fool recommends Apple and Whole Foods Market. The Motley Fool owns shares of Apple and Whole Foods Market. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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