Key things to watch for in the year ahead

Last year was a rough one for the cannabis industry — it started with high hopes pinned on the incoming administration of President Joe Biden and ended with gridlock and an extended decline in stock prices. 

This week, Bloomberg Intelligence analyst Kenneth Shea talks about the key areas to watch in 2022. Shea published a research note last week on how progress is needed on the reform front if the industry’s fortunes are to shift. 

Things change a lot in a year. Was it clear that investors were overly optimistic about legalization prospects under a new government? Looking forward, what can we learn from that experience?

Yes, with the benefit of hindsight, it is clear that investor expectations were overly optimistic — yet understandably so — regarding imminent U.S. federal regulatory reform on multiple industry fronts that could have enabled it to compete on a much fairer playing field than they do today. I’m obviously referring here to the industry’s current disadvantaged access to traditional banking services, punitive taxation policy, and inability to conduct interstate commerce, among others.

Although I still think that it is a matter of when — not if — these issues will be resolved, an important lesson we’ve learned is the same lesson we are learning from watching state legalization at the ballot box: that victories at the ballot box serve as a necessary, but insufficient first step. Interested parties need to then prepare for additional protracted battles among legislators and the courts to move real changes in laws forward.

Legalization legislation in Congress appears to have bipartisan support — but what do you think are the real prospects for passage this year?

U.S. federal marijuana legalization support in Congress may be best described as “lukewarm,” as Bloomberg Intelligence Senior Policy Analyst Nathan Dean sees it, given the legislative body’s other deemed higher priorities and uncooperative spirit between the chamber aisles. Even the SAFE Banking Act bill — an effort to reduce basic banking restrictions on cannabis companies — is having difficulty gaining bipartisan support at this time.

Do you expect more deals that are contingent on U.S. legalization, like Canopy-Wana?

Canopy Growth’s agreement to acquire cannabis-edibles producer Wana Wellness, pursuant to an option triggered upon federal permissibility of THC-based cannabis, represented its most recent transaction structured that way as a means to gain a strong foothold in the U.S. upon legalization. We suspect Constellation Brands-backed Canopy is still hungry for more such deals.

Also, given Tilray Brands’ similar arrangement in acquiring an interest in U.S. multistate operator MedMen via its purchase of its convertible debt, we expect other Canadian-based firms seeking a meaningful role in the future U.S. legal cannabis market to strike additional contingent deals.

Do you expect cannabis companies to make progress this year on improving profitability?

Net profits are likely to remain elusive for two of the three biggest sub-groups within the cannabis sector, which are: Canadian licensed producers; U.S. multistate operators; and the ancillary product participants. Leading Canadian licensed producers such as Canopy Growth, Aurora Cannabis and Tilray Brands are likely to remain unprofitable on an after-tax basis as more work needs to be done in refining their business models that had been too capital intensive.

Some leading MSOs, such as Trulieve and Green Thumb, are on course to post net profits, yet the group is beset by paying extraordinarily high taxes owing to IRS Section 280E, which prohibits them from taking normal operating-expense deductions.

Many ancillary companies — meaning they do not directly engage in cannabis operations — such as Scotts Miracle-Gro, GrowGeneration and Innovative Industrial Properties are likely to remain profitable since they are much better capitalized than most Canadian licensed producers and MSOs, and are much less dependent on the vagaries of the economics of cannabis cultivation.

In terms of competition, what does the situation look like in states that have more mature markets? Is there now a surplus of supply? Are there new products or categories of products that could emerge to boost demand and shake things up?

Large suppliers of cannabis growing equipment, fertilizer, etc. are cautious that commercial orders may continue to trend weakly as some markets experience heavy supplies of cannabis that is weighing on prices. This is leading to deferred purchases, notably in states including California, Colorado and Oregon.

While the industry waits for the U.S., is adult-use demand likely to turn around in Canada, or are we in for price competition that could shake out some companies?

Canada’s legal cannabis market is growing, with sales that may reach $5 billion this year, according to market tracker BDSA, up from about $4 billion last year. Yet the impact of the pandemic has in recent weeks reduced the ability for consumers to frequent retailers, which may lead to a downward revision in that estimate, in our view, if this trend persists much longer.

Also, many producers including Canopy Growth and Tilray Brands are losing market share in the adult-use (recreational) market due to increased competition from small competitors seeking to establish market share through offering low-priced flower. We expect these and other large producers to react by introducing an expanded assortment of value-added (higher-potency) products while reducing some prices.

Our expectation is that this should lead to a shake-out of many small entrants by the end of the year, which would be a positive development for the total market to grow longer-term, as we see it.