Twists And Turns

Greetings,

The opening line of the immortal The Odyssey is an epithet introducing our hero Odysseus: “Sing to me of the man, Muse, the man of twists and turns.” This line is meant to foreshadow, not only the personal complexity of the titular hero, but also his stormy journey into the unknown – that it will be anything but straightforward. In pondering our cannabis missive for this quarter, we think that this passage perfectly crystallizes the current moment in the industry’s evolution.

In our previous missives, we’d grown quite cautious on the industry, especially California, given the well-documented regulatory issues hamstringing operations. As we pointed out, stock prices of public enterprises were now sharing this pessimism.

But wait, is a reversal of fortune upon us? On June 29th, California signed into law AB-195 by a Senate vote of 34-0 and an Assembly vote of 69-1. This law eliminates the cultivation tax starting July 1st, as well as provides for certain tax credits and other moderate support. For a while now, we (like many industry participants) have been railing against the tax structure in California cannabis as both untenable and a driver of poor economics. Particularly toxic has been the cultivation tax, which levied a fixed dollar per pound tax on growers irrespective of market prices. This tax structure left producers suffocating under spiraling effective tax rates when wholesale prices collapsed in recent years.

Well, what does this mean – smooth sailing from here or still choppy waters ahead? For starters, this measure dramatically improves the economics of cultivation, eliminating the high effective tax rates in a low wholesale price environment. Secondarily, it also reduces a competitive disparity between outdoor and indoor growers, given their relatively different wholesale price points. Third and perhaps most importantly, it should flow through the supply chain to lower consumer prices and make legal products more competitive with the illicit ones – the biggest issue for the industry. To illustrate, let’s consider an outdoor grower with a total cost per pound of $375. The cultivation tax was $161 per pound, boosting total cost by 43%. Adding profit margins for cultivators, distributors, and retailers as well as applying the excise tax of 15%, the final price to consumers is approximately $485 per pound higher solely from the cultivation tax! Or to quote fictional character Clay Davis from HBO’s The Wire“ssshhhiiiyyyaattt.”

Before any industry participants declare victory and light the proverbial cigar, let’s take stock of a few significant remaining headwinds. First, the excise tax was not only left in place but also frozen for the next three years, eliminating the possibility of near-term reform. Additionally, the state left open the possibility of increasing the tax if overall revenues from cannabis slip. Second, there was no change to retail permitting rules, allowing many localities to continue blocking cannabis retail and choking the industry’s growth. Third and finally, the state provided limited additional support for social equity licensees, leaving those participants in an extraordinarily difficult competitive situation versus better funded incumbents (more on this in a future newsletter).

So, while we are enjoying the brief respite from the storm via the cultivation tax relief, we are not convinced that the worst is behind us. Whether it’s the Federal, state, or city rules, we are certain this highly regulated industry has more twists and turns in store for us before we reach calm waters. But, turning again to The Odyssey for inspiration, we call out Odysseus’s defiant message to his enemy Calypso: “Much have I suffered, labored long and hard by now in the waves and wars. Add this to the total – bring the trial on!”

Thanks for tuning in, and until our next update, please stay safe and healthy.

Cheers,

Mike, Kip, and Austin

Co-Managers, Presidio View Capital