Consolidation or Confusion?

For years I’ve heard about the upcoming “consolidation of the industry” from every corner. Is it finally here or are we just watching more chaos and confusion? Unpacking this question is top of mind for investors as we look to place bets for the next stage of industry growth. We’ll start by clarifying why consolidation generally makes sense, and instances where it doesn’t.

Auto manufacturing is an accessible example of a consolidated industry. There are a small number of auto company, all of them large. Why? Quite simply it’s a matter of cost efficiencies. Building cars requires extensive infrastructure that is very expensive and defraying those costs across a larger revenue base makes sense to everyone. Another key aspect is marketing expenses and benefits. Marketing across a large customer base is efficient for cars because they are the same in every market. They also are a large purchase and it’s important to do marketing to lay the groundwork for the customer’s purchase decision (e.g., brand awareness and trust).

So, we’ve identified a couple of key reasons to consolidate:

·      High infrastructure cost

·      Strong benefits from centralized marketing

What about instances that don’t make sense for consolidation? One that comes to mind is liquor stores, of which there are many thousands. Why would liquor stores buck the trend of bigger is better?

First, liquor stores and the alcohol business in general are highly regulated by local governments. This creates a significant burden that does not lessen with an increasing number of stores. In other words, it’s a non-scalable problem with each store simply requiring additional work at the same (in)efficiency level as previous stores. Contrast this with the manufacturing of automobiles where the factory’s per car costs decrease as the count goes up.

Second, liquor is a low-cost purchase that benefits little from marketing of the store itself (versus the alcohol brands). What this means is an individual can stand up a liquor store with a small amount of capital and do quite well even compared to a much larger store nearby. Customers will value convenience and service, and simply request reasonable prices so they don’t feel ripped off.

We can throw these ideas into a quick and dirty quad chart to help visualize how an industry’s characteristics will push for (or against) consolidation.

Focusing on a couple of the key reasons against consolidation:

·      Non-scalable cost structure

·      Minimal benefits from centralized marketing

What About Cannabis?

Now let’s pull apart the cannabis industry to better understand how consolidation may take place by evaluating the relative cost structures and marketing efforts. We’ll start with cost structures.

The cannabis supply chain has three primary elements, cultivation, manufacturing, and retail. Of these, cultivation and manufacturing require a fair degree of capital but nothing on the order of a hard goods manufacturing facility. CAPEX in the order of millions or perhaps tens of millions is more than enough to build a very large facility of either type. Many facilities launch with just tens of thousands in CAPEX and still create high quality goods. Retail is similarly low cost from a CAPEX perspective with real estate being the primary expense, and most important single consideration (location, location, and location).

On the marketing front we see a similar model to alcohol where brands need to build substantial awareness with potential shoppers and build trust, but the retailers, manufacturers (white label, not branded), and cultivators do not have a path to dominate through marketing. Convenience (location), price, and product availability will likely determine the shopper’s selection of a retail location despite the marketing efforts of a larger chain. The same goes for brands where the old adage that distribution (availability) is king still holds true for cannabis. If it’s not on the shelf it won’t sell.

So where does this leave cannabis? Will it consolidate or stay fragmented?

My guess is we’ll see an industry similar to alcohol where a few large companies form but there is a massive segment that stays fragmented with craft brands and small retailers. This bifurcation is likely to remain for the foreseeable future due to the low cost of entry and low value of centralized marketing. Changes will occur as products evolve and the industry’s state-specific walls fall.

Federal legalization, or at least interstate commerce, will change the game with larger companies benefiting from cost efficiencies. This is especially likely in cultivation and manufacturing. I see a future with centralized cultivation similar to other crops, and centralized manufacturing similar to natural products. However, with little progress at the federal level it’s likely to be many years before the business environment needs to shift to accommodate interstate commerce. For now, we’ll focus on state-specific markets and the limitations they bring.

How Should I Invest?

Investing in this landscape is very challenging because of rapidly changing dynamics. We cannot know the future, nor is trying to predict it a useful exercise. Better to focus on making sound investments for today with the flexibility to leverage those into good investments tomorrow. Strong fundamentals are always important and more so in times of chaos. Cannabis wealth is generational, meaning it is both a massive opportunity and it takes a long time to develop. Unlike tech, there’s no quick path to building a massive and profitable cannabis company. Put your energy into due diligence and finding very strong companies that excel at one or two aspects of the industry whether that is cultivation or manufacturing or retail. Stick with them and be observant of changing dynamics as markets evolve and shopper preferences develop. And most of all, remember to enjoy the ride because this is only happening once!

More to follow next week as we continuing exploring the bifurcation of the industry into big and small.

Feel free to reach out with questions or comments.