The case for cannabis retail

Cannabis Retail offers incredible return-on-investment for investors and entrepreneurs able to time the market and stomach the risk and regulatory complexity. The industry is high-risk and high-reward on average, but seven years after the first recreational retail store opened in Colorado, clear patterns have emerged. Today there is a proven recipe for success.  

The world’s largest cash crop is being legalized in the world’s largest economy. Cannabis brands that achieve broad consumer awareness and loyalty will grow from startups to billion-dollar brands at historic speeds as the obstacles fall away. Every cannabis brand in North American is effectively a startup. Cannabis should be the greatest show on earth for the next decade. The winners in this race will be among the largest consumer brands in the world. 

Opportunity profile

Consumer demand: It’s hard to imagine ANY new product or industry offering the short-term growth potential of legal cannabis. Legal revenues in the US are expected to surpass $20 billion in 2021, roughly doubling over the last three years alone! Despite meteoric growth, the legal market is still only 1/3 the size of the existing illicit market. An estimated $60 billion in US illicit cannabis sales is ripe for conversion as legalization spreads and markets mature.[1]

According to a recent survey, 69% of adults 21+ in legal US states are open to consuming cannabis, and 36% have consumed recently. (By comparison, 54% of adults report having consumed alcohol in the last six months.[2])

In addition, the legalization of cannabis and launch of retail stores is big news in any market, so cannabis retailers benefit from significant press coverage driving high public awareness of these newly legal products and retail outlets. 

Barriers to competition: In most states or provinces, opening a new store requires buying an existing retail license, as no new licenses are allowed. (Canada and California are notable exceptions, though complex bureaucratic processes and municipal prohibitions still represent significant barriers to new competition in many regions.) 

In addition, all markets in the US and Canada require some combination of buffers or setbacks between cannabis retailers and some combination of the following:  

  • Other cannabis retailers
  • Schools
  • Childcare facilities
  • Parks
  • Transit Centers
  • Rec/Community Centers
  • Places of worship
  • Children’s arcades

These buffers, combined with local zoning restrictions, create opportunities to secure prime retail locations with limited local competition from other cannabis retailers.

Economics: Retail profitability varies dramatically: driven by regulatory variations, local market dynamics, and the operating proficiency of each retailer. That said, it’s not uncommon across markets to see proficient retailers deliver per-store revenues of more than $6 million annually, with 25% EBITDA and 15% Operating Income. 

In many markets, revenues are growing far faster than store counts, driving record profits among savvy retailers. Washington state hasn’t granted new licenses in several years, but sales grew almost 30% last year alone.

Cannabis retailers operating successfully under the current regulatory and tax structure stand to profit even more as the market legalizes and normalizes. 

IRS Section 280E prohibits cannabis businesses from taking standard business deductions (only COGS are deductible.) For many retailers, the removal of 280E will effectively double their after-tax profitability. The least efficient retailers will see an even greater benefit, as many are paying federal income taxes on gross margin while booking real world losses. 

Retailers with strong brands are also positioned to take advantage of other forms of market normalization as they occur. Removal of consolidation limits would allow stronger brands to acquire underperforming locations. Legalization of delivery will allow the strongest brands and organizations to reach customers far beyond the footprint of their physical store locations. Relaxation of restrictions on investment and banking will drive even more investment into the best performing brands. 

Risk: As stated at the outset, the incredible opportunities of this market are in part offset by unique risks. 

Regulatory Risk

  • An expansion in the number of available retail licenses would increase competition
  • A reduction or elimination of buffers and setbacks would open new areas to cannabis retail, increasing competition
  • Delivery could be allowed in more markets, increasing competition with local retailers
  • Tax increases could drive sales back into the black market
  • Further restrictions could be placed on cannabis marketing
  • Legalization may never happen

Business Risk & Complexity

  • Investors/Owners/Managers are subject to significant personal financial scrutiny (e.g. several years of tax returns and documentation of all assets, liabilities, and business interests.)
  • Debt investment is difficult to collateralize given regulatory restrictions on license ownership and transfer.
  • Many federally insured banks are unwilling to service property owners engaged in cannabis retail or leasing to cannabis businesses. 
  • Break-in/theft risk is higher than in other industries, and inventory cannot be insured.
  • Regulatory violations may jeopardize license.

While the risks are real, remember that in most markets, licenses were given out by lottery and without regard for business readiness. A meaningful percentage of the cannabis businesses struggling today simply lack the relevant experience or expertise to thrive in increasingly competitive markets. An experienced team can largely mitigate operational risk. Proficient retailers in high-growth markets rarely fail. 

Valuations: Across legal markets, regulations have dramatically restricted the size, reach, potential, and current value of cannabis brands. Licenses are limited; store counts are limited; access to capital is often limited; and sales across state/provincial lines are prohibited. 

Retail valuations across most geographic markets hover around 1x annual revenue, with adjustments made on the margin to reflect unique strength or weakness.  Returning to the WA state P&L example above, the average Washington retail store doing $3 million in revenue would be valued at $3 million, while top performers are often worth $6 million or more.  

As legalization continues, and specifically once 280E is repealed and cannabis businesses are taxed as any other business, normalized valuations would apply. In traditional specialty retail markets, brands are valued with a multiple on earnings. 10x EBITDA is common, with high growth specialty retail industries often seeing multiples of 15x or even 20x EBITDA. 

There is a very real opportunity to acquire retail assets pre-legalization and have them double in value (or more) over the next 3-5 years even with nominal sales growth. 

[1] New Frontier Data

[2] BDSA Consumer Research

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