Pros and Cons of Vertical Integration

Vertical integration (legal in some markets) allows cannabis businesses to capture both the wholesale and retail margins on product and provides opportunities for product exclusivity and competitive differentiation. A recent survey of cannabis retailers found vertically integrated recreational retailers reporting profitability at more than twice the rate of stand-alone retailers.[1] That additional margin potential comes with the cost of significant regulatory, operational, and competitive complexity.

Continued state-by-state and eventual federal legalization is almost guaranteed, and several pieces of legislation currently under consideration would legalize cannabis commerce between states. As the regulatory environment changes, growing and processing will shift from the outskirts of major cities like Los Angeles, Seattle, and Denver to lower cost regions of the country and eventually the world. The inevitable result: a tsunami of mergers, acquisitions and bankruptcies as the thousands of small growers and brands unique to each state are suddenly exposed to national competition. As of mid-2020, five states (CA, CO, OK, OR, WA) had issued an incredible 13,000 cultivation licenses!Canada has issued just over 350 cultivation licenses, and consolidation is already happening there.  

Over the next 5-10 years, the value and supply chains in the cannabis industry will evolve in roughly the same fashion that the broader consumer products industry has over the last two centuries. We transitioned from largely disconnected economic communities, where almost everything was made by hand locally, into today’s interconnected global economy where very little is made locally. There will be thousands of winners and losers, but a few brands should emerge from this battle as the cannabis industry’s version of Anheuser-Busch InBev ($134 billion market capitalization), Phillip Morris ($145 billion) or Starbucks ($138 billion).

Cultivators and Processors

If you’re currently a cannabis cultivator, processor, or consumer products brand, then vertical integration might be in your best interest. Ultimately you have a choice between going horizontal (doing what you do in more places) and going vertical (owning more of the supply chain in your current market). 

There is a place in the market for purists, artists, and anyone truly brilliant at their craft. Personally, I hope the best breeders, growers, extractors, and product formulators will stay focused. If you have the best process for producing extracts that express the beauty of the flower, then please be a contract extractor and get rich while raising the quality of extracted products internationally.

Most cannabis businesses are not ready to be the best in the market at what they do today, and would be made stronger and more profitable by vertical integration (where allowed of course). The cannabis supply chain is guaranteed to change in dramatic and predictable ways over the next five years. Growers and product brands will be thrown into competition nationally and maybe even internationally. Many companies on the west coast in particular will be too small to compete effectively with the much larger operations currently forming on the East Coast. 

Our recommendation for smaller cultivators and processors is to grow where possible, but focus on brand building over pure wholesale revenue. Those that are able to build a strong brand by consistently delivering on their customer promise should be able to adjust their supply chain as needed. Brands can grow their reach and profitability while changing where and how their product is grown, extracted, and manufactured as their business and the market grows. Make your customers happy, grow your reach, and your brand will have power and value regardless which segments of the supply chain you operate in. 

Retailers

Retail offers the best risk-adjusted ROI in the cannabis market. Modern logistics put product brands and everyone in their supply chains at risk of significant additional competition come legalization. It’s likely that cannabis retail will always be carefully regulated in ways that both limit the number and location of stores and prohibit e-commerce (because shipments may be received by those under 21). Even if cannabis is treated like alcohol, all markets will require licensing, and many will restrict their number and location. Even in markets with home delivery, retail stores drive the vast majority of the revenue (and can typically themselves make deliveries and thus expand their reach). 

Local growth in cannabis retail competition will be limited in many if not all markets. As a result, cannabis retailers face the prospect of significant revenue growth as current consumers abandon the illicit market and public consumption continues to grow broadly.

While vertical integration does offer additional margin potential, there are two reasons a proficient retailer might choose to vertically integrate:

  1. Tax strategy. 280E prevents retailers from taking deductions for common business expenses like inventory storage and handling, security, and compliance. Vertical integrated companies can pay for a portion of those expenses through the production side of the business and therefore reduce a company’s overall tax liability. While tax treatment has a significant impact today, it’s unlikely that 280E will remain an issue for long. Several bills currently under consideration at the federal level, including one originally co-sponsored by Vice President Kamala Harris, would resolve the issue and allow all cannabis businesses to deduct all standard operating expenses.
  2. An inability or unwillingness to expand geographically. There’s a special romance and beauty to a local small business that operates seed to sale. While these will never be giant companies, they will always have a place in the market and the hearts of consumers, much like local craft brewers with a few retail outlets.

Most retailers benefit from being a customer’s trusted and independent source. A retailer in many markets can buy from a large range of growers and product brands and is free to change their assortment at will. Once you have your own product line, you lose the veil of impartiality, lose the option of simply not buying a low-quality harvest, and expose your business to risk even if the retail channel thrives.


[1] Marijuana Business Daily

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