Stacks of Cash: The Perceptions Versus Realities of Investing in the Cannabis Industry
Jeffrey Friedland (firstname.lastname@example.org Tel 1 646 450 8909)
A week doesn’t go by without someone saying to me, “I want to invest in the cannabis industry. I’ve seen those stacks of cash on TV. I want in.”
My standard response is always the same. “There are often bigger stacks of cash going out than coming in!”
It’s easy to understand how videos and photos of cannabis businesses with piles of cash have led many to assume that this industry is incredibly profitable and that investments in the industry are a sure thing. I refer to this as the “Breaking Bad Syndrome,” which I named after the TV show’s episodes that showed stacks of cash in a mini-storage facility.
These piles of cash exist for one primary reason. The U.S. cannabis industry generally lacks access to the banking system. With the difficulty of finding a bank friendly to the cannabis industry, depositing the cash is a challenge.
This cash creates an illusion that an investment in a cannabis business will be very profitable. As a reality check, it’s important to realize that stacks of cash don’t indicate that a business is cash flow positive or profitable. The cannabis industry is just like any other business. There are some growers, processors, dispensaries and retailers who are making a profit, but many others are not.
It’s Ultimately All About the Plant
Most individuals investing in the cannabis industry are focused primarily on the plant. It is true that producing a healthy, viable plant is important. It is not true that growing, processing and the sale of cannabis may be the best option for investors.
If you’re considering a cannabis-related investment, it’s vital that you take a much longer term and broader view of the industry. Many of the opportunities in this emerging market offer significantly greater returns and are more lucrative than growing, processing or retail sales.
The Cannabis Industry as an Emerging Market
Why should you, as an investor consider the cannabis industry? Rarely have I seen a new industry generate as much media attention as this one. News about cannabis is frequently in mainstream publications. It seems that a week doesn’t go by without the Washington Post, the New York Times and the Wall Street Journal each publishing stories about cannabis, and the industry is the subject of frequent reports on local and national television.
Before my involvement in the cannabis industry, I worked in “emerging markets” focused on entrepreneurial companies for several decades. My experience in China, Brazil and Southeast Asia allowed me to draw a parallel between the newly emerging cannabis Industry in the United States and these other markets.
The challenges of managing a business where government regulations are written ‘on the fly’ and may change at a moments notice are similar to what I experienced working in China twenty years ago. This familiarity with the fickle and unpredictable business environment in emerging markets provided me with a unique insight into the new cannabis industry.
Emerging markets are risky, but they often provide investors with tremendous opportunities. There are advantages to being on the ground floor of the cannabis industry. Largely because of the illegality of the industry at the federal level, only a few major corporations have started to stake a claim in this new industry. This allows an opening for today’s start-ups and early-stage companies to become tomorrow’s household names.
In some U.S. states, those that I refer to as “advanced cannabis states,” most of which are in the western part of the country, the industry is evolving quickly. However, with rapid expansion comes a host of issues. For example, in Colorado in 2013, when the state only allowed medical cannabis, it was questionable whether anyone in Colorado’s industry was operating profitably. Very few cannabis-related businesses had verifiable track records. Financial statements were rarely available, and internal financial controls were essentially non-existent because of the lack of access to the banking system.
In many states that have relatively recent medical cannabis programs, the industry is at a very early stage. These states include Illinois, Massachusetts, New York, New Jersey, Connecticut, Rhode Island, Pennsylvania, Florida, and Maryland. Many cannabis entrepreneurs in these states are trying to implement business plans or strategies that in other cases have failed in the advanced cannabis states. These entrepreneurs have many of the same challenges that similar cannabis businesses had in Colorado, Oregon, Washington or Nevada a few years ago. If a business model didn’t work in Colorado or Washington, it doesn’t necessarily doom a similar business direction in Maryland or Illinois, but it should serve as a warning for investors.
The number of cannabis business license applications recently submitted for growing, processing and selling cannabis in just one state, Arizona, is indicative of the perception that the growing, processing and sale of cannabis is a sure thing. Arizona’s Department of Health Services recently indicated that it processed 750 applications for licenses and that it intended to award only 31 additional dispensary licenses, in addition to the 92 dispensaries that were currently in operation.
Ultimately it’s all about dollars, and America’s legal cannabis industry is projected to generate revenues of more than $7 billion this year, an increase of approximately 25% over last year. Of this $7 billion, one state, Colorado, which has both medical and recreational cannabis, will account for an estimated $1.2 billion. Estimates for this year’s illegal sales are as high as $40 billion. This 25 percent growth rate has placed the industry on many investor’s radar screens.
The online publication, Marijuana Business Daily, has projected legal sales of $40 billion by 2020. This is a tremendous revenue projection for an industry that only had a minimal existence a few years ago.
Investments in Licensed Businesses in States That Have Medical or Recreational Cannabis
There are numerous challenges in investing in businesses that grow, process or sell cannabis in the states that have legalized medical or recreational cannabis.
While investing in state-licensed cannabis businesses can be considered to be the wild west of investing, it doesn't have to be. In many states that have legalized cannabis, the regulations are evolving and in some states, very defined. The more developed the regulations, the easier it is for investors to evaluate the regulatory environment as it impacts a potential opportunity.
It is important for an investor to determine whether the state’s regulations and the regulators themselves are truly “friendly to the plant.” While a state such as Colorado has very well-defined regulations and regulators who are generally friendly to the industry, the regulations of many other states including Illinois, New York, and New Jersey are challenging for the new industry and add a layer of complexity to establishing a viable business.
Most states have limited the number of licensed cannabis businesses. On the surface, less competition may be seen as a real advantage in establishing a new business. But if these states make it difficult or nearly impossible for patients to be approved to purchase cannabis, or severely limit the number of medical conditions, and diseases cannabis can be used for, it may significantly limit the potential of success.
Supply, demand, and pricing are also a consideration. It could be argued that Colorado, with over 2800 licensed cannabis businesses, consisting of both medical and recreational licenses, has too many industry participants. Many investors have recently been asking whether any Colorado grower, processor or retailer is operating profitably. A few weeks ago a colleague, somewhat jokingly, told me that he thought that every cannabis dispensary or retail store in Colorado was likely for sale.
The competition in Colorado has reduced the retail price of the lowest priced cannabis flower to around $100 per ounce in the Denver area. The wholesale price in the state has dropped to around $1000 a pound. It’s questionable whether growers can generate a profit selling at $1000 a pound and whether retailers or dispensaries can generate a profit selling flower at $100 per ounce.
This pressure on Colorado’s cannabis industry, based on supply, demand and pricing have increased the demand for value-added products that have a substantially greater profit margin. These include premium strains, various extracts, and edibles. I’ve concluded that the future viability of Colorado’s cannabis businesses is to a large extent, dependent on these value-added and higher-margin products.
In every state, a significant challenge is finding a satisfactory business location. Many local jurisdictions, through zoning and business licensing regulations, have made it difficult to obtain locations. In an advanced cannabis state such as Colorado, many local jurisdictions have banned cannabis businesses completely; others may allow growing or processing, but not the retail sale. This adds an entire set of challenges for cannabis entrepreneurs.
Compounding the difficulty in obtaining a satisfactory location is the inability of many building owners to lease to a cannabis business. Because of the illegality of cannabis on a federal level, If the building owner has a loan from a commercial bank, the loan provisions often do not allow leasing to an illegal business. This severely limits potential locations for cannabis entrepreneurs.
Dispensaries and retail stores also have an IRS issue. Section 280E of the Internal Revenue Service Code, states:
“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 and 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.”
Because of 280E, retail stores and dispensaries can only deduct their cost of goods sold to arrive at taxable income. Operating expenses including rent, salaries, utilities and advertising can not be deducted. I question whether there is any business in the U.S., in or outside the cannabis industry, that can operate profitably if it has to pay income taxes on its gross revenue minus only its cost of goods sold.
Investing in Service Businesses that “Don’t Touch the Plant”
Ten’s of thousands of new jobs have been created in states where cannabis has been legalized. While some of these are directly related to growing, processing or retail sales, an increasing number are in peripheral service businesses.
These service businesses include marketing and branding services, packaging design, security, financial services including equipment leasing, and a variety of online and social media related services. A variety of consulting and professional businesses have also sprung up around the cannabis industry. These include consultants to assist with governmental compliance, and lawyers and accountants who are specializing in cannabis businesses.
Service businesses can potentially be very lucrative. It is important for investors to evaluate this type of business by determining whether the business model has worked in the non-cannabis world. As an example, if an online marketing strategy has failed for general businesses, it’s unlikely that it will work for cannabis-related businesses.
Publicly-Traded Cannabis Stocks
A key advantage of investing in publicly-traded stocks is the liquidity, something that investments in privately-held businesses don’t typically provide.
The creme of the crop of publicly-traded companies in the cannabis industry are listed on the Nasdaq Stock Market and are involved in pharmaceutical development.
At the top of the list is United Kingdom based GW Pharmaceuticals (GWPH), the 800-pound gorilla of cannabis publicly-traded companies. GW Pharmaceuticals has developed a cannabinoid medicine, Sativex, for the treatment of spasticity due to multiple sclerosis. Sativex has been launched in fifteen countries including the United Kingdom, Spain, Italy and Germany, and is approved in an additional twelve countries, but not the United States. GW Pharmaceuticals is also developing a treatment for some forms of pediatric epilepsy including Dravet syndrome and Lennox-Gastaut syndrome with its cannabis-based drug, Epidiolex. Epidiolex, which is a liquid formulation of plant-derived Cannabidiol (CBD) is undergoing clinical trials in the United States. GW Pharmaceutical’s stock market capitalization is over $1.8 billion.
Phoenix-based Insys Therapeutics (INSY) is also traded on Nasdaq. The company has a proprietary sublingual spray technology and is developing pharmaceutical cannabinoids. These include a generic version of Dronabinol, which is a synthetic form of THC. Dronabinol is used to treat nausea and vomiting resulting from cancer chemotherapy and is also used to treat loss of appetite and weight loss in patients with HIV. The Food and Drug Administration has approved the company’s Syndros. Syndros is an appetite-boosting drug, which helps patients deal with the weight loss symptoms of cancer and AIDS-related weight loss. Insys Therapeutics’ stock market capitalization is slightly over $1 billion.
Nasdaq-listed and Connecticut-based, Cara Therapeutics (CARA) is in preclinical development with its CR701 formulation. The company describes CR701 as a novel therapeutic approach for neuropathic pain. The company’s stock market capitalization is $145 million.
Zynerba Pharmaceuticals (ZYNE) is also traded on Nasdaq. The company has developed a cannabidiol or CBD gel, CR701, which the company describes as the first and only synthetic CBD formulated as a patent-protected permeation-enhanced gel. It is currently being studied for use in treating refractory epilepsy, Fragile X syndrome, and osteoarthritis. Zynerba indicates that CR701 will provide consistent, controlled drug delivery transdermally with convenient once or twice-daily dosing. Zynerba’s stock market capitalization is $77 million.
In addition to these Nasdaq-listed cannabis stocks, there are nearly 200 over-the-counter traded companies whose business is exclusively tied to the cannabis industry, and approximately 150 other over-the-counter stocks that have some business involvement in the industry.
Many of these over-the-counter stocks have limited liquidity, low stock market capitalizations, and low daily trading volumes. Most are considered to be “penny stocks,” which the U.S. Securities and Exchange Commission considers to be risky investments. But, despite the over-the-counter status of these companies, and their startup or early-stage status, many have intriguing business models worthy of investor consideration.
Investments in Cannabis Research in Israel
Widely acknowledged as the “cannabis superpower,” Israel is the world leader in advanced medical cannabis policy, medical cannabis research, cannabis breeding, plant sciences and medical cannabis delivery systems.
Medical cannabis was first approved for use by the Israel’s Ministry of Health in 1992, and an expanded protocol for its use was established in 2007. All major Israeli hospitals and research universites are currently involved in some aspect of cannabis research.
The country’s proactive regulatory system facilitates patient access to cannabis for medical use and enables major medical institutions to conduct clinical studies. In contrast to the United States, where cannabis is illegal federally, the cannabis industry in Israel has the full support of the Israeli government. Some Israeli companies are focusing on plant sciences including genetics and breeding. Others are researching specific cannabis-derived formulations for specific medical conditions and disorders. Others are designing intriguing delivery systems for cannabis-based medicine.
The history of cannabis research in Israel goes back to 1963 when Professor Mechoulam of the Hebrew University in Jerusalem isolated cannabidiol (CBD), a chemical compound that is a key to many of the medical properties of cannabis.
A year later, Mechoulam and his team were the first scientists to isolate tetrahydrocannabinol (THC), the main physiologically active compound in cannabis, which is responsible for the plant’s consciousness-altering effects and many of its medical benefits.
Twenty years later, Mechoulam and his team concluded that THC interacts with the largest receptor system in the human body, the endocannabinoid system. Mechoulam’s team then found that the human brain produces its very own form of cannabis – a chemical that they named anandamide after the Sanskrit word ananda, translated as bliss.
CNN medical correspondent Dr. Sanjay Gupta described Israel as “the medical marijuana research capital” in his documentary “Weed.” He dedicated a portion of his CNN program to Israel’s advances in cannabis research. Gupta was also amazed to see how seamlessly Israel had integrated cannabis into its health-care system.
More Israelis have PhDs, MDs, and other advanced degrees on a per-capita basis than any other nation. Israel is one of the top five countries for per-capita scientific publication output. An increasing number of the country’s scientists have become active in cannabis related research.
Many cannabis companies based in Israel who are researching cannabis-based medicine are seeking strategic alliances worldwide. Some intend to use the results of their medical research and clinical trials in Israel to propel clinical trials in the U.S. under Food and Drug Administration (FDA) protocols. Others are interested in pursuing relationships with American cannabis businesses to expand their research programs on a state-by-state basis.
Yes, the cannabis industry is ultimately about a plant, a plant that has been very misunderstood for decades. There are challenges in this new emerging market. But, the cannabis industry is here to stay. And yes, investors should place America’s fastest growing new industry on their radar screens.
Copyright 2016 Jeffrey Friedland. All Rights Reserved.
Author: Jeffrey Friedland (www.jeffreyfriedland.com, email@example.com, Tel. 1-646-450-8909.) His book, “Marijuana: The World’s Most Misunderstood Plant” is available at Amazon in print and Kindle editions. Mr. Friedland is active in the cannabis industry in the United States, Canada and Israel.
© 2015 Jeffrey Friedland