Greetings,
In the 1999 sci-fi hit The Matrix, Laurence Fishburne’s character Morpheus offers the now-famous choice to Keanu Reeves’s Neo: “you take the blue pill, the story ends. You wake up in your bed and believe whatever you want to. You take the red pill, you stay in Wonderland, and I show you how deep the rabbit hole goes. Remember, all I'm offering is the truth. Nothing more.” As viewers find out, the “blue pill” offers a comfortable, but fantastical, existence within a pre-programmed reality, whereas the “red pill” reveals an awful, but true, world. Goosebumps all around! Fun fact #1 – this quote (and probably the groundbreaking action sequences) led to worldwide box office sales of over $460 million on a budget of $60 million. Mr. Anderson, indeed.
Whenever we hear about the contrast between make-believe and reality, we immediately think of the cannabis industry (sans the cool outfits from The Matrix). The original story went as follows: a state’s residents demand legalized cannabis thru a vote or legislative action from their dutifully elected, faithful public servants. The residents don’t see cannabis as (i) a “gateway” drug, (ii) highly addictive, or (iii) extremely toxic. Instead, it helps them relax, sleep, and deal with chronic pain. The dutifully elected, faithful public servants promise both to (i) tax cannabis for new funds and (ii) regulate cannabis for product safety. Consumers will buy from the newly established legal businesses – leaving illegal ones without customers and facing the consequences of the law. Ah, the “blue pill” – it has appeal.
Brace yourself, dear readers, for the truth: in certain states cannabis legalization did the exact opposite of the story above – the illegal market thrives. Focusing on California, we find that research firm New Frontier sizes the illegal market at $8.1 billion, approximately 50% higher than the legal one. And this isn’t just because California is a great place to grow stuff (fun fact #2 – it is; California is #1 in agriculture receipts in the U.S. with 11% of total); illegal storefronts outnumber legal ones in certain areas. Take L.A., for example, which has an estimated 700-1,000 illegal stores versus the 350 licenses ones.
Wait, what is going on? Well, imagine you’re a California entrepreneur tired of crypto that launches a cannabis store. Almost 2/3 of cities have banned such stores, so you need to consider your license location carefully. Let’s roll with L.A. – Lebron James and its 3.8 million residents can’t be wrong (except about competing with the Nuggets – oof). Then, you find out that California charges a 15% cannabis excise tax (2.5x that of the Federal excise tax on beer) plus its general sales tax of 9.5%, while L.A. charges you another 10% cannabis sales tax for … well, just because. After a loud curse word, you pay the state license application fee of $1,000, only to be told the annual renewal is $2,500 to $96,000 depending on your revenue (Wait, isn’t that a tax? Never mind).
OK - time to order product. Before you do, you need to install the specialized inventory tracking software and security hardware required by the state, in case of a surprise inspection by the Department of Cannabis Control or the Department of Tax and Fee Administration, which charge hefty fines per infraction, not to mention lost productivity. Keep in mind that the product you just ordered carries its own regulatory cost burden from lab testing (estimated at 10% of wholesale price), specialized packaging and labelling, and compliance with additional inspections from the Department of Food and Agriculture, Department of Public Health, State Water Resources Control Board, Department of Fish and Wildlife, … you get the idea. Oh, and advertising is heavily restricted in California and banned by most national media companies. Yep – the “red pill” sucks.
Then, you notice that the plain-looking storefront down the block is selling cannabis. You don’t remember another licensee, so you check it out. The store is quite busy with customers and soon you figure out why – prices are 50% lower! You learn the owner is operating illegally, so they are unburdened by the tax and regulatory costs above. But what a crazy risk. Or is it?
If the authorities raid the store, they will seize the inventory (perhaps $750,000 to $1 million assuming 4 weeks sales on hand) and the owner can be subject to a $500 fine and/or up to six months in jail. But that’s if they raid the store and if they elect to arrest you. With understaffed police departments across the state and higher urgency matters like the rapid growth of fentanyl, it is not surprising to see low numbers of cannabis arrests. In 2022, for example, California’s Department of Cannabis Control reported 299 search warrant operations and 175 arrests. Comparatively, the FBI’s Crime Data Explorer placed the California 2021 arrest total at 380. Now, take this probability of arrest and consider the expected risk versus reward: a small chance of a $1 million loss versus a good chance of a successful cannabis store generating $10 to $15 million per year with perhaps 5 to 10% net profit margins. I guess the illegal store count in L.A. isn’t so crazy after all!
We’ve discussed previously the noble goals of cannabis reform and legalization, and we are still supportive of them. And we are obviously 100% against the illegal market (despite what the math says). Sadly, the realization of these goals seems to exist more in the “blue pill” version of things – the world we’d like, not the world that is. The stark reality of business economics, individual incentives, and limited state and city resources have all resulted in a very different outcome – the “red pill” reality we are currently living through. And until we face this truth, we think things are unlikely to change.
Thanks for tuning in, and until our next update, please stay safe and healthy.
Cheers,
Mike, Kip, and Austin
Co-Managers, Presidio View Capital