Is There Light at the End of the Tunnel for CA Operators?

Many California cannabis entrepreneurs would like to forget 2021. The second half price implosion of flower combined with an unexpected dip in the market’s growth trajectory left even the most resolute of CA’s participants questioning their future. The driver behind these challenges is best summed up by a lack of access to capital. Unfortunately, capital to fund operations, whether internally generated or from external sources, is inaccessible for most CA operators. Three factors drive this.

1. Over-taxation: An onerous tax and regulatory environment makes the concept of “free cash flow” to fund growth elusive. Sure, many companies show solid EBITDA, but the I (Interest) and the T (Tax) burden impedes the operators’ ability to invest in growth. And let’s not forget the ease with which consumers’ discretionary spending gets directed to the illicit market where prices are tax free and much cheaper.
2. Debt and Equity Financing: Equity financing for the entire cannabis industry is extremely challenging, even for the MSOs. While a few CA operators have managed to close a round of equity financing, the vast majority look on with apprehension. If you can find it, debt financing comes with interest rates north of 20% and many that have accessed debt are suffocating from the repayment terms.
3. Multiple State Operator (MSO) interest: Normally, in cash-strapped industries, growth through M&A becomes an alternative to raising capital. However, California has been “status non-grata” for the MSO that can’t get their arms around regulatory and competitive hurdles and prefer to deploy capital where there is a clear path to market share and profit.

But have the winds of change started to blow?

Tax reform: While there is no magic bullet fix for CA’s burdensome regulatory environment (at least that doesn’t need 2/3rds voter approval), help may be on the way. While several initiatives are being discussed, one major area of focus is eliminating the cultivation tax that is crippling the supply chain. By way of example, the current flat tax on a pound of cannabis is approaching the cost of a pound of outdoor-grown flower. The removal of the cultivation tax is the number one priority of the California Cannabis Industry Association (CCIA) today and would represent a welcome development to the industry. (Note – the CCIA is also focused on expanding access to legal cannabis by reducing the number of retail “deserts”. A possible 200 new retail doors in 2022 could drive an additional $1B in revenue). Governor Newsom has pledged to support the cannabis industry and the hope is that the changes being discussed will be implemented in the second half of 2022.

SAFE Passage: Will the SAFE banking make it through the Senate? This is the million-dollar question. Those in the know are “optimistic” that we will see something pass in 2022 before the mid-terms. CA operators will be high on the list of beneficiaries. Why?

• Debt Financing: Many lenders are anxious to get into the Cannabis industry and provide financing to cannabis companies. Today’s onerous rates are untenable for operators. However, most operators in CA are “asset heavy” and have the collateral (and EBITDA) to backstop a debt raise. If these non-dilutive options become available in CA at more traditional rates, expect many operators to jump at the debt financing opportunity for working capital, capital expenditures or even M&A.
• Equity Financing: Again, if the SAFE Banking act passes, the MSOs are likely to be the primary beneficiaries. However, it is likely that some of the proverbial “capital on the sidelines” will make its way to CA. Equity investors look to back companies that have a proven track record and that are looking to scale. In CA, there are now many large retailers and brands that would be attractive investment opportunities. Put another way, the lack of investment interest in CA is an indictment of the CA landscape, not of its operators.
• MSOs: It is no secret that the focus of the MSOs remains on limited license markets. However, a number of MSOs are seeing changes in their operating models that will require a shift in approach. The first is that the limited license markets are becoming more competitive. As states get comfortable with the benefits of adult use cannabis the pressure builds to open it up to more participants and the “unfair advantage” of the cannabis oligopolies will start to fade.

Recall also that most of the MSOs in 2016-2018 pitched themselves to investors as CPG companies and that owning retail was a necessary requirement to build their brands. Fast forward to 2022 and that transition is just now starting to play out and will be fascinating to watch. For example, in markets that have imposed retail caps (MA/NY), MSOs will have to compete to get their products on the shelves of retailers that happen to be their competitors. Vertical integration has its benefits but successful competition in the trenches is not one. Further, building a national brand without significant penetration in CA would be extremely challenging. Herein lies an opportunity for CA brands to capitalize on their “authenticity” in the face of better capitalized competitors.

Given the events that have transpired since January 2018, California operators are rightfully jaded. However, if a few things change, likely in the second half of 2022, CA operators could very well return to a position of strength in this still very nascent industry. So there is light at the end of this seemingly interminable tunnel. Let’s hope the light gets brighter and shines on Cali. The entire industry will be better off if so.