Focusing on Vertical Integration in the Cannabis Industry

If we had to pick the most complex investment themes we cover, synthetic biology and gene editing would be at the top. So would cannabis. Legalizing marijuana for adult use in various states while keeping things illegal at the federal level has created a very complex environment to navigate. As with any thesis, our goal is to find the market leader and place our bets. To do so, we isolated the top six multi-state operators (MSOs) and then started evaluating each.

Six cannabis firms with a combined market cap of just $20 billion - Credit: Nanalyze
Six cannabis firms with a combined market cap of just $20 billion – Credit: Nanalyze

Our simple screening method looks at metrics such as intangible assets on balance sheets (a lower number is better), ratio of cash to liabilities (more cash is better), and of course the absence of any red flags. So far, Trulieve appears to be the most desirable MSO based on these criteria.

Throughout this exercise, we’ve learned just how complex the cannabis industry is which has raised lots of question. For example, one subscriber asked how we might go about valuing licenses that MSOs can’t stop buying up. That’s nearly impossible to do because there are so many factors involved. Even if you could value licenses, that doesn’t mean much. Owning a license doesn’t mean you’ll then be able to operate a profitable dispensary. There are also limits on the number of dispensary licenses you can own in some states. That was news to us.

Types of Licenses

Historically, we’ve considered licenses to be of three types:

  • Dispensaries
  • Distributors
  • Growers and processors

Turns out that the types of licenses on offer – including vertical licenses – differ by state. For example, Massachusetts offers nine types of cannabis business licenses: marijuana cultivator, craft marijuana cooperative, marijuana product manufacturer, marijuana retailer, marijuana research facility, independent testing laboratory, marijuana transport, marijuana microbusinesses, and marijuana delivery. Each license comes with requirements for applying, maintenance costs, and limits.

Perhaps the most visible licenses are for dispensaries. We have – perhaps naively – been focusing on how many retail outlets an MSO has open as a proxy for market leadership. That’s also because the MSOs make this a focal point in their investor decks. But for some states, there’s a limit on how many licenses an MSO can hold. Here’s a chart from the latest CRESCO Labs investor deck where they show their progress against a handful of states with limits:

Bar chart from the latest CRESCO Labs investor deck where they show their progress against a handful of states with limits. Credit: CRESCO Labs
Credit: CRESCO Labs

In looking at how many dispensaries Curaleaf has in each of the States with caps (IL, MA, MD, NY, OH, and PA), they have the maximum allowed open dispensaries in every state except Pennsylvania where they only have 12 of 15. This spray-and-pray approach puts the maximum amount of skin in the game. After that, it comes down to who can build the best brand by satisfying customer demand while competing against the black market.

However, that’s only on the retail side. Another good slide by CRESCO shows how the margins in retail are slim while growing the product itself provides nice fat margins.

Slide by CRESCO shows how the margins in retail are slim while growing the product itself provides nice fat margins.
Credit: CRESCO Labs

Wholesale grow operations are the strategy some MSOs are taking where they try to tout how many square feet of growing capabilities they have in each state. One might propose that for an MSO to extract the most value from any state, they need vertical integration. That is, they need to operate the entire supply chain – growing, distributing, and selling.

The Importance of Vertical Integration

The only way an MSO can sufficiently displace the black market is if they can compete on cost which can only happen through vertical integration. We already know this to be true. The closer you get to the grower, the better deals you get. Unfortunately, each state has different rules about whether or not you must be vertically integrated (Colorado) or you can’t be vertically integrated (Oregon). States that oppose vertical integration say that businesses will grow too strong, customers won’t have much variety to choose from (as if), and it suppresses competition. States in favor of vertical integration argue that it’s easier to regulate and brings the cost of cannabis down. As MBAs, we only care about perceived advantages for MSOs, and vertical integration seems to come out ahead in that respect.

Bailey Campbell (Wharton School, Class of ’23) put together this interesting chart which shows which states allow vertical integration and which don’t.

Bailey Campbell (Wharton School, Class of '23) put together this interesting chart which shows which states allow vertical integration and which don't.
Even the Mormons are doing the puff puff give – Credit: Wharton School

The only way to reduce operational complexity is for MSOs to start narrowing their focus on select states where the biggest opportunity exists. A simple proxy for potential market size could be population, and that’s what this table by CRESCO Labs shows us.

A simple proxy for potential market size could be population, and that's what this table by CRESCO Labs shows us.
Credit: CRESCO Labs

But as anyone who dabbles knows full well, there are some states where it’s more socially acceptable to puff the devil’s lettuce. Research firm New Frontier Data provided information on estimated sales in key states for 2020 which ended up on a Curaleaf investor deck that we “leveraged” to produce this table which shows cannabis sales – medical, adult, and illicit – in USD billions.

California13.4
Florida5.2
New York5
Pennsylvania3.5
Illinois3.5
Michigan3
Massachusetts 2.72.7
Ohio2.6
Arizona 2.5
Colorado 2.5
New Jersey2.2

We’d like to see MSOs start to focus their communication on a handful of flagship states where they want to establish leadership. That’s what Trulieve has done with their “regional hubs” approach which focuses on three key states – Florida (#2), Pennsylvania (#4), and Arizona (#9).

Trulieve Narrows Focus

Last month Trulieve published a fresh investor deck which defines three regional hubs – Southeast, Northeast, and Southwest – which presently consist of 11 states in which they operate, three of which are cornerstones.

  • Florida – 111 medical dispensaries out of 396 approved dispensaries – so 28% market share in that respect. 22 vertical licenses in Florida of which an unknown number belong to Trulieve. We’re assuming they have at least one which should be all they need?
  • Pennsylvania – Pennsylvania market has 50 retail permits (3 locations per permit), 25 grower/processor licenses, and up to 10 research/clinical permits. Trulieve has “18 affiliated retail locations” and “wholesale distribution to 100% of the PA market.” So this information doesn’t mesh with what we mentioned earlier – PA doesn’t allow vertical integration and caps dispensaries at 15. Is the whole “affiliate” thing how Trulieve gets around this?
  • Arizona – Trulieve operates 17 retail dispensaries supported by 320,000 square feet of cultivation. Arizona has 130 core vertical licenses, 13 rural/underserved county licenses, and 26 future “social equity licenses,” whatever that means. Again, we would assume that Trulieve owns at least one of those vertical licenses because we’re not told otherwise.

We really like how Trulieve is communicating information about licenses in the context of total licensees available and state-specific restrictions, but it’s not enough information. Investors shouldn’t have to dig through this regulatory complexity to try and deduce their leadership position. It’s good progress towards providing us with the information needed to make informed investment decisions, but not quite there yet.

An MBA Case Study

Our thesis is that now might be a good time to invest in cannabis stocks, and we’ve made one bet so far. Before making any more bets, we want to take a holistic look at the industry and try to deduce what business model might come out ahead in the end. We would argue that vertical integration may be the way forward as that’s the only way an MSO can operate a profitable business while being able to compete in the black market.

Another conclusion we’re arriving at is that the spray-and-pray approach of trying to canvas every state where cannabis is legal may present too many complexities for investors to keep track of, not to mention the MSO that’s trying to execute on such a strategy. Perhaps a better approach might be to pick a handful of states that appear most promising for vertical integration and then target them while providing more specific communication to investors along the way. That’s the direction that Trulieve is taking now and we’re liking it.

Figuring out how many MSOs to invest in has been a challenge. Investing in just one stock brings too much company-specific risk while two stocks will double the amount of capital we’re allocating to a very risky and ever-changing space. As a next step, we’ll cover Colombia Care – the only MSO we haven’t looked at recently – and see where we are after that.

Conclusion

Invest in what you know. What’s simpler than growing weed and selling it? On the black market, it’s always been very straightforward. Don’t engage with shady people, don’t front, don’t burn anyone (you’ll get ratted out), and most importantly, don’t attract attention to yourself. People have been operating this way for decades at extremely high levels of efficiency – how may dealers worry about ad spend?

Today, legalized cannabis comes with an enormous amount of regulatory complexity. There’s medical cannabis, then there’s adult cannabis coming in over the top of that, then there are state-level idiosyncrasies that are difficult to navigate because they’re so new. The best approach to take might be to pick states where you can vertically integrate (the only way to compete with the black market), then focus on becoming a market leader while communicating progress to investors concisely and simply. Maybe it’s time to stop acquiring and start focusing on vertical integration.

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