Ask Our Experts 12/2/2018

Q: There is a lot of discussion about market consolidation being driven by international investments. I thought that the cannabis market was new; why is it consolidating? Are foreign investors getting rich from U.S. investments? 

 

A: There are two dynamics here at play; the first is regulatory, and the second, financial.

Regulatory structures can have a direct impact on the potential for consolidation. If state agencies limit the number of cultivator, processor, or retail licenses, then there is less likelihood of large-scale consolidation. The fewer the licenses, the larger the slice of the pie for each operation. However, in states where licenses are not limited (e.g., Oregon or California), the propensity for consolidation is greater. In Oregon, there are close to 600 existing licensed retail outlets, and another 350 pending applications — all to serve a $750 million market. That averages to between $750,000 and $1.2 million in revenue per store. In a period of declining prices and decreasing per-store sales, only those retailers with access to capital, strong demand, or a low-cost structure will weather the doldrums. In response to market conditions, retailers are banding together to centralize and purchase through economies of scale (i.e., in bulk) to lower costs. As chain stores proliferate, small, less-efficient retailers with generally higher operating costs find it difficult to compete, consequently either going out of business, or themselves either merging with or being acquired by chains. The dynamic is most common in markets without limits on available licenses.

The financial element has to do with businesses’ abilities to survive falling prices and lowered margins. The key issue in the cannabis industry now is having enough capital to maintain operations while also maintaining financial reserves to deploy rapidly whenever opportunities arise for investment and expansion.

As the market faces lower prices and compressed margins, those who are struggling without access to capital will be hard-pressed to survive. Meantime, those with access to capital will be able to acquire other businesses at below-market value.

People often wonder about the degree to which investors from other countries are profiting heavily from U.S. cannabis operations. The question boils down to a matter of risk tolerance among the investors. In reality, whenever an investment is made into a community, most of that money remains in that community in the forms of wages, taxes, and payments to vendors. There is added benefit through the multiplier effect, where an increase in spending from one infusion of money into the economy produces an overall increase in national income, which is multiplied beyond the initial amount. Even if a U.S.-based company is profitable, the direct return of funds to its international investors is a complicated process; typically, monies and profits from the U.S. firm are used to finance other U.S.-based investments or to maintain operations.

Repatriation of funds is complex because it involves two different governments, banking in two countries, and sending currency out of the country. Governments bristle at such, due to fears about supporting cartels, tax avoidance, or other unsavory activities. So, it is not a matter simply of hitting “transfer” on the bank account; transactions must be very transparent, and traceable. The added layers of compliance complicate matters, making such exercises relatively time-consuming and costly. Because of the costs, companies often choose to redirect their profits domestically back into the U.S. rather than trying to go through the process of repatriating them to one’s home country.

Consolidation is being driven by the market and influenced by regulatory structures. Finances from other countries are giving U.S. businesses breathing room and flexibility in a dynamic market, with most of the funds staying where it is invested. Pending federal reform in the U.S. banking policies, look for continued investments from outside the country to help build the U.S. cannabis economy.