Everyone talks about the importance of vertical integration in cannabis. They even have snazzy terms for it: “Seed to Sale”, “Soil to Oil”, “Ground to Pound”. Ok, that last one I made up, but you get the idea.
The thing is, not every vertical is created equal. Some will command higher profitability than others. Right now, the cannabis industry is in a growth stage, but it won’t be there forever. Eventually, supply will approach demand, putting downward pressure on prices. Add to that the elimination of the risk premium that came from the unknown legal consequences of possessing a federally controlled substance. As commoditization happens, picking which part of the process to focus on will be an important factor to lasting success.
To analyze which parts of the industry will be able to sustain high margins I want to introduce the smiling curve. I can’t say that I came up with it. It was created in 1992 by Stan Shih, the CEO of Acer, and was originally applied to consumer electronics. I was introduced to it by one of today’s most prominent tech analysts, Ben Thompson. I highly recommend his blog Stratechery and his podcast Exponent.
So the theory goes like this: the two ends of the value chain – conception and marketing – command higher values added to the product than the middle part of the value chain – manufacturing. While it is designed to help understand the IT-related manufacturing industry, I think it has a lot of validity when applied to cannabis as well. So, let’s get into it.
The graph looks like this:
The X axis represents the products path along the value chain, from idea to consumption. The Y axis represents how much value the activity adds and thus how much of the profit can be extracted from it. There are no real numbers to associate with, it is more of a rough graphical representation of a product’s lifecycle.
I think the best place to start is at the bottom of the curve since I think it will draw the most controversy.
Growing is the very bottom of this curve. It is the process that will become completely commoditized as the market tightens. Don’t get me wrong, growers will still make a lot of money. A professional commercial-scale grower is in charge of crops worth hundreds of thousands of dollars. Any small mistake can lead to product or quality loss. They will be even more challenged when regulating bodies decide to enforce pesticide testing requirements. One of the dirty secrets of the industry is how prevalent pesticides and fungicides are in cannabis products, but that is a topic for a whole other conversation.
Commercial growers will have to make money on the volume that they can produce as the margins decrease. Boutique, top-shelf growers would be a little higher on the value graph as there will always be a demand for a luxury product. I talk to a lot of growers raising money for their expansions and EVERY one of them tells me that they will grow only the highest quality product. There are lots of talented growers out there, but, by definition, not all of them will be able to have a position on the top shelf of a dispensaries display. It is a sliding scale so, no matter how good someone’s cannabis is, only 20-30% of the total supply will be able to command a deluxe position. Often, it is not only the quality but also the brand image that makes something a luxury product. More on that later.
Extraction falls into two categories, bulk extraction, and secondary processes. Bulk extract is what is created from the extraction process (be it supercritical or solvent based). It creates an oil that is usable but often needs extra refinement (winterization, fractional distillation, additives) to change its qualities or increase potency. The second processes vary greatly by the producer, so this part has more value add.
From here, for both grower and processor, the only way to get into the higher part of the value curve is to establish a brand. This means having an identifiable brand image (marketing) and creating sufficient reach (marketing/distribution). In California, most cannabis flower is sold in bulk to dispensaries and stored in jars. In rec states like Washington, both for branding and regulatory purposes, all of the products are stored in bags pre-sealed by the grower. I see this as an inevitability as producers start to try to distinguish themselves and compete for shelf space. There is a group of products that can’t be sold in bulk, though.
Quick, what company grows the apples you eat? No idea? Me either. Now, what company makes your applesauce? Probably Motts, but either way you knew it offhand. Edibles and medicinals have a lot of specific qualities that, while limiting their overall market, allow them to be represented well by a brand. These products will be able to command high margins because, well because branding is hard. The human element of branding makes is the softest of sciences. Like art, even the creators often don’t fully understand how and why it resonates with its audience. But, a brand is only as good as its reach and to get that even the best-marketed goods need distribution. In essence, most products we buy have to pass the test of the B2B market first since buyers have to agree to put them into their locations. Which leads us into the next sector…
Retail is the sleeping giant of the sales funnel in my opinion. The reason is that the retail landscape has been artificially fractured. For the 20 odd years that medical cannabis has been legal, dispensary owners have been the one under the most scrutiny. They had advertised locations, multiply regulating bodies (Board of Equalization, Department of Industrial Relations, Fire Dept., Ect.) and the threat of federal indictment. This caused dispensary owners to limit their exposure by owning only a select number of locations. Even still, very few dispensaries have multiple locations under the same brand.
Compare that to the other fast moving consumer goods industries like grocery, pharma, or convenience. They all have had massive consolidation that results in a small number of players. The root cause of this consolidation is the economies of scale that are gained from increased buying power and control of shelf space. In grocery stores, products have to pay for their shelf space, including premiums for the ones closest to eye level. That is why there is so many store branded products. They have a built-in competitive advantage: access to discounted shelf space.
When we start seeing headlines like “The Walmart of Cannabis” and “The CVS of Pot” then we will know that the retail sector has awoken and is ready to establish itself at the top of the food chain. There is still one category that sits higher still than the stores that sell to the end user.
Retail can hold its margins because reach is costly, but even it is beholden to the customers that come or call. They will gladly give up a part of their high margins to services that help them grow their client base. I am thinking of companies like Eaze, an app that allows for near seamless delivery. Also, there is an army of marketing/advertising/promotional servicers that any storefront owner has to choose from. This category also has the advantage of not touching the plant itself, so it is easily scalable, even across state lines.
We have yet to touch on the whole left side of the graph, so starting backward from growing we have our next category
The companies in this group are the ones supplying the growers, extractors, and producers. Soil, fertilizer, extraction equipment, grow lights; these all will be able to command somewhat of a premium because the growers and extractors will be squeezed from competition. In turn, they will have to invest in cost-cutting initiatives like upgrading technology. This category has seen big moves by Scotts Miracle-Grow, as they see opportunity in this link of the product chain.
The one part of this category that I do not see a lot of future growth in is the grow shops. As cannabis because cheaper, the economics for home grows will dissipate. The supplier market will become mostly a wholesale industry. There will always be enthusiast home growers, but I imagine most of them will grow outdoors and not dedicate square footage in their homes for small indoor grows.
Marketing for suppliers isn’t about creating a great brand. Business to business sales is usually won by a product’s merits. In order for suppliers to compete against each other, they will have to spend on R&D. They will also be competing for the innovation economy where the next segment lives.
Innovation is the plankton of this ecosystem. Organizations that can innovate create energy from seemingly nothing and bring new life that every other organism can use. But, doing this is not for the faint of heart. The human capital needed is rare and expensive, the capital expenditures happen over long time spans and there is a huge risk that nothing will be created at all. For this, companies that do innovate are (hopefully) able to carve out a huge margin when they have a success. They also have the benefit of having their valuations be many times what they are able to make in a year – which is often nothing. I group genetics in this category because they are one of the main innovators on the biological side of the industry. A huge part of staying on top of the technology game is having an information pipeline that can lead to further conclusions. I would look at companies that are doing the best job of collecting data to predict who will be the most cutting edge in the future. I am thinking about companies like Grownetics and Front Range Biosciences. As Gordon Gekko from the iconic 80’s movie Wall Street puts it, “the most valuable commodity I know is information.”
I hope that applying the smiling curve to the cannabis industry has been a useful exercise. Obviously, I in no way am saying that vertical integration is not a good thing. It can be the only way to ensure that quality controls are met (flashback to my statement about pesticides). It can also be a great business strategy. But, I think that it is important to extrapolate future outcomes of current trends in order to make the best possible decisions. These, after all, are just my predictions. If any of you readers thinks I am wrong, I accept any cordial responses. The important thing is not whether I am right or wrong about what the future holds, but that we are thinking about it in the first place.