(December 18, 2017: Article featured on the Globe & Mail: TSX short sales: What bearish investors are betting against)
This post applies to the recent December 5, 2017 press release by the British Columbia government regarding how they plan on implementing marijuana regulations in the province.
Saving you from reading the actual release, they plan on having a sole wholesaler (the BC Liquor Distribution branch) and a private/public retail distribution mechanism.
This is very similar to how liquor in other major provinces are distributed – the government gets to keep the lion’s share of the profit on the wholesale side.
In British Columbia, liquor retailers can purchase product from the government monopoly wholesaler at a 16% profit margin for licensed retail stores. These stores will have to then sell enough volume in order to pay for the usual business expenses (leasing a physical location, maintaining inventory, staffing, etc.).
Using the liquor analogy, profits from the retail end of things will be minimal. The best example is Liquor Stores NA (TSX: LIQ) which, despite booking 25% gross margins on their product, when things are good, earn a 3% operating profit margin (not before financing costs, but this is after depreciation expenses).
People following this company will shout out that they are undergoing a significant restructuring, but the central theme still sticks – it is a very low margin industry when your only supplier is government-controlled and has every incentive to maximizing its own profit and not yours.
This is a miserable business climate to be in.
Another, much smaller, example is Rocky Mountain Liquor (TSX: RUM). They operate retail entirely out of Alberta. Cherry-picking their best results in the last year, they are earning a 2% operating profit margin (and this is BEFORE financing and depreciation expenses).
Is marijuana going to be any different than liquor?
I would float the claim that retail marijuana profitability will be even worse than liquor because people can easily grow their own product sufficient for their own consumption. Federal legislation actively encourages people to grow their own marijuana plants at home (4 plants that you can now grow larger than the original 100cm proposed in the initial draft of Bill C-45).
This leaves the question of wholesale – there will need to be suppliers of this. I will also make the claim this will be a race to the bottom, with the exception that the “grow it at home” market will erode profits to the point that wholesale will nowhere near justify the 3.6 billion market capitalization seen from Canopy Growth (TSX: WEED) today – even assuming they captured the entire Canadian marijuana market.
The hype is marijuana producers will be able to achieve tobacco company margins – Rothmans was the last publicly traded Canadian tobacco company and they achieved roughly 50% operating margins (before financing and depreciation). It won’t be happening this way again – this margin will be siphoned by the government from the very beginning.
So the questions would be:
1) What was the Canadian regulation around tobacco distribution that allowed 50% operating margins? Why didn’t Canada clamp down on that as well?
2) How do the Canadian wholesale and retail distribution of Cannabis in the few US markets that support it compare against the Canadian model? Colorado would be the early mover for legalization in the US
1) This is probably a function of the history of tobacco (both in Canada and the USA). You don’t have a “tobacco control board” that controls the distribution of tobacco, for example. Governments got jealous and did the class action thing, but that whole history can be researched if you wish…
2) Colorado: https://www.colorado.gov/pacific/revenue/colorado-marijuana-tax-data
WA State: https://dor.wa.gov/about/statistics-reports/recreational-and-medical-marijuana-taxes or https://data.lcb.wa.gov/stories/s/WSLCB-Marijuana-Dashboard/hbnp-ia6v/ for more interesting data.
Notably in the USA you cannot grow marijuana at home.
In CO and WA the structure is much closer to tobacco than it is to liquor in BC or Ontario.
Since WA state is culturally like BC in a lot of ways, one can also infer how things would go here and it is pretty obvious that WEED/APH, etc., are all trading as if we’re going to be exporting this stuff like Pablo Escobar in the 80’s.
Its worth noting that according to the Economist in November (https://www.economist.com/news/united-states/21731450-hazy-regulations-encourage-american-marijuana-firms-list-canada-price-cannabis), wholesale prices have been clobbered by the “race to the bottom” to $3.70 per gram. This is less than half of what WEED thinks is pretty good.