Greetings,
In a news conference on August 12, 1986, then President Ronald Reagan remarked to reporters: “The nine most terrifying words in the English language are: I’m from the Government, and I’m here to help.” Stripping away the sarcasm (our favorite) and tempering political passions (a tough ask) calls attention to a much larger message behind Reagan’s words – that we, knowingly or unknowingly, are every day in the trenches of a great philosophic battle between the forces of individual self-determination and external systematic controls. Or put more simply, how much freedom should we yield to our government, and can the government effectively and responsibly wield this power on our behalf? Whether it’s building a house or labelling a medicine, this battle is everywhere and ongoing. So, it’s no surprise to find it at the center of the cannabis industry, much like a burning ember ready to set things ablaze.
Given cannabis’s history as an illegal (and feared) substance, government regulation has had a central role since its early days. While each state has taken a different approach, we’d like to focus on California – as it’s the biggest market, an early adopter, and the home for some of our own investments.
California started with basic principles, which, in isolation, seem innocuous and even admirable. First, the sale of cannabis should generate meaningful tax revenue for the government, which can fund critical social programs, like education or poverty alleviation. Second, cannabis must abide by strict healthy and safety standards to protect the consumer. Third, the government’s “war on drugs”-mentality should end, lessening criminal penalties for cannabis and paving the way for social equity. Fourth and lastly, since cannabis is a divisive issue, it should not be forced upon people; localities should have a choice. Sounds good so far, eh?
Fast forward to today. California has imposed extremely high taxes and regulatory costs relative to other states and comparable products such as alcohol that, in turn, have inflated retail prices to uncompetitive levels with the black market. The black market, in turn, has stepped up to meet this demand with increased supply, as there are fewer penalties and enforcement actions initiated by the state to scare them. Due to weak demand, retailers have been unable to sell their inventory, leading to a pile of unpaid bills from vendors (growers, wholesalers, distributors), the government (taxes, fees), and ancillary service providers (marketers, lawyers, etc.). Without financing, retailers have been prioritizing cash, paying the government first to stay in business and leaving others delinquent (though this is even starting to hit the government’s bills now). Vendors have been caught with the difficult choice of fighting for repayment (remember that bankruptcy rules don’t apply in cannabis) while needing to quickly turn their perishable inventory. Vendors also must pay their own taxes, regulatory fees, and working capital, all while facing limited options for distribution, since many localities opted to ban cannabis retail from their jurisdictions.
Much like a traffic jam on Route 101, the California cannabis industry has stalled. But instead of cars and delayed commuters, we have millions of dollars in unpaid bills with employees and investors hanging in the balance. Industry observers estimate this swelling financial tidal wave at ~$600 million, with some concerned it’s far greater. A quick scan of the industry shows that this is not simple fear mongering. Take advertising company Weedmaps, which recently reported widespread customer delinquencies forcing ~500 cannabis advertisers to be dropped or put on payment plans. Or consider property firm Innovative Industrial, who highlighted its struggles with several California cannabis tenants in a recent earnings report. And finally, there’s mega MSO Curaleaf, who threw in the towel and completely exited California due to its inability to turn a profit.
So where does this leave us? Well, for one thing, California cannabis regulators seem to have proven Reagan correct. The government came to help but instead destroyed jobs, strengthened the black market, and failed on “social equity” promises. The revenue they reportedly have raised from taxes is more akin to a wealth transfer from investors since the underlying businesses themselves never turned a profit.
It's unclear why California set up the system as they did – our best guess is that they tried to satisfy too many competing interests at once, instead of just acing a narrower mandate. What is clear, though, is that we cannot return to the “war on drugs” – there isn’t the political will for a broad-based illegal market crackdown to help boost the legal market. We also likely cannot legislate our way through via such “next big thing” ideas as interstate commerce pacts. Thanks to Reagan, we now see the great chasm that exists between smart-sounding plans from politicians and well-executed actions. So, we believe the best choice amongst bad choices is for California to take immediate steps to inject liquidity into the industry via tax forgiveness and/or long-dated tax payment plans. Such a financial jolt should help unclog the “traffic jam,” allowing money to flow more freely in the supply chain. Next, the state should significantly reduce sales tax and compliance fees, addressing the fundamental problem of an uncompetitive legal market product. Without such targeted and decisive actions, we continue to worry about the future of California cannabis.
Thanks for tuning in, and until our next update, please stay safe and healthy.
Cheers,
Mike, Kip, and Austin
Co-Managers, Presidio View Capital