Prior to the domestic outbreak of COVID-19, the U.S. cannabis industry was in the midst of a liquidity crunch. Publicly traded companies experienced falling stock prices in multiple phases throughout 2019 and Q1 2020. Companies depleted available operating cash faster than could be replenished, with ever fewer capital sources to reload. Existing capital providers largely pivoted from equity to expensive, and often onerous, debt structures. Some companies took proactive and timely steps to conserve cash, consolidate operations and monetize assets like real estate through sale-leaseback arrangements before there was a hint of an oncoming pandemic. Others did not or could not.
Many companies expanded too quickly and thinly across geographies without growing their existing businesses with a focus on internal capitalization, making a shakeout in the industry inevitable. Following this pandemic, hopefully, a more mature industry will emerge with more efficient companies focused on organic growth and accretive deal-making.
COVID-19 has affected every person and every business in the U.S. in some small or tragically large way. Further, the virus is likely to upend efforts in several states looking to legalize cannabis through ballot measures in the 2020 election cycle by hindering signature gathering and diverting focus away from this issue.
But not all of the effects on the cannabis industry are negative. Most medical and adult-use cannabis businesses have initially been deemed “essential businesses” by states with regulated cannabis programs that have also issued emergency orders. In addition, demand for cannabis shows signs of being inelastic, suggesting that the industry may be resilient to economic downturns. The pandemic will exacerbate existing liquidity issues as investors go into safety mode.
Concurrently, the downturn may accelerate the demise of some companies, while creating opportunities for stronger companies and risk-loving private investors. Unfortunately, those small to mid-sized private companies who saw institutional-level capital availability on the horizon will be competing with 20-40% discounted blue-chip stocks with 3-6% dividend yields for attention in the eventually rebounding capital markets. Repriced former line-leaders whose previous valuations set the bar for private companies, will now be used to a comparative detriment to those raising capital in a pinch.
Cannabis Businesses Deemed Essential
One of the most significant developments for the cannabis industry to arise from this pandemic is the growing recognition that cannabis businesses provide important services to citizens of legal cannabis states. This recognition is evident in governors’ (and the District of Columbia mayor’s) decisions regarding which businesses are permitted to stay open and which non-essential businesses are ordered closed.
Of the states that have issued stay-at-home orders (as of early April), eight states deemed adult-use and medical cannabis businesses to be essential (AK, CA, CO, IL, MI, NV, OR and WA) and twenty states, the District of Columbia and Puerto Rico, deemed medical cannabis businesses to be essential or exempt as critical parts of the health care sector. Massachusetts is the only state that has both medical and adult-use cannabis but choose to deem medical, but not Adult-Use, businesses essential. Calls have gone out to Massachusetts’ Gov. Charlie Baker to reverse the decision and allow adult-use cannabis businesses to reopen. To date, the calls have landed on deaf ears while thousands are threatened by unemployment and revenues have dropped by draconian measures— all the way to zero for adult-use-only facilities.
These economic circumstances arising from the pandemic are potentially causing an acceleration of the industry shake-out that was building before the virus emerged.
At the heart of the essential business orders is the recognition that medical cannabis programs serve patients who use cannabis as an alternative to pharmaceuticals to treat medical conditions, and a majority of adult-use consumers have self-prescribed to avoid paying high fees for medical cards. This recognition can bolster the movements to legalize medical cannabis in states without such programs and to expand the programs in states that have limited programs treating few conditions with limited forms of cannabis. Additionally, there is an implicit recognition that allowing medical and adult-use cannabis businesses to continue to operate prevents the black market from filling existing demand; prevents interruption of important supply chains; keeps citizens employed, and generates significant tax revenue during a time when other commercial activity is severely constrained. Smaller industry participants’ ability to continue operating gives them a fighting chance at remaining going concerns. Without the “essential” designation, many of these operators would have faced uncertain futures almost overnight, as companies are experiencing in Massachusetts.
These essential businesses still face challenges that existed prior to the pandemic. In H2 2019 and Q1 2020, aging accounts receivables already threatened dozens of companies large and small. Now, additional challenges arise surrounding employees feeling safe at work as not to be faced with the difficult prioritization of their safety over continued employment. An employer’s failure to provide employees with facts, compassion and purpose can allow fear and negativity to predominate, which will weaken their workforce. The difference between mediocre and great management is currently being illustrated across the industry by the call-out levels ranging from 5% to 40% of entire workforces calling in sick or simply quitting.
However, the positive characterization of cannabis businesses as “essential” by numerous states is likely to have a positive effect on the industry long after this terrible pandemic ends. Cannabis businesses being allowed to continue to operate in order to serve patients and customers may raise awareness and acceptance of the industry on Capitol Hill and in parts of the country that remain cautious of legal cannabis and accelerate the political and social acceptance of cannabis, particularly medicinal cannabis.
Discovering that Cannabis Has Characteristics of Being Counter-Cyclical
Counter-cyclical (or non-cyclical) businesses or industries maintain demand for products or services during economic downturns. “Vice” industries, like alcohol and tobacco, have demonstrated a tendency to weather economic downturns without losing sales and, in some circumstances, by increasing sales. On the heels of the 2008 Recession and during a time of high unemployment, sales of alcohol increased by as much as 10% according to one report. Consumers may opt for less expensive brands or consume alcohol at home instead of in bars or restaurants, but history suggests they continue their consumption habits. Interestingly, many of the current stay-at-home orders likewise deem liquor stores essential and allow restaurants to sell alcohol only on a carry-out basis only. Pharmaceuticals are also considered by some to be non-cyclical or recessions resistant.
No industry is recession-proof and history cannot be drawn upon to evaluate the cannabis industry because it was too young to have been significantly impacted by the last recession that began in 2008. The fact that cannabis businesses have been deemed essential suggests that cannabis has demand characteristics that would help the industry be recession-resistant and that sales could remain steady.
For example, cannabis sales in Illinois dispensaries were reported to be up by 13% in March. Caution should be exercised when drawing comparisons between cannabis and vices or cannabis and pharmaceuticals. Justifications for cannabis use can be akin to a bad habit but strong evidence exists surrounding the health and wellness reasons for consuming cannabis. Whether Adult-Use cannabis is compared to a regulated vice like alcohol or Medical cannabis is compared to pharmaceuticals, the comparisons are to industries that tend to fare better than most during economic downturns. Only time will tell if the cannabis industry can avoid significant declines in demand and/or prices caused by the current crisis.
Investors may consider a distinction between a cannabis company’s relative stability compared to small and mid-sized enterprises in other industries from a target company’s share price being attractive under the circumstances. Historic trading activity does signal a greater susceptibility of emerging industries to decreased market capitalizations compared to legacy industries’ resilience.
Business Challenges and Investment Opportunities
No business, including those in the cannabis industry, are immune from the effects of COVID-19. Consumer facing cannabis businesses will have to adjust to circumstances that may impact sales, such as sales by delivery only, curb-side order pick-up, limits on the number of customers in stores and the reduction in interstate travel that affect their customer-base. Dispensaries located in central business districts, in locations frequented by tourists or that rely on foot traffic, for example, may temporarily or permanently close depending on how long self-isolation orders persist.
Consequently, not all cannabis businesses, from cultivation to dispensaries, will be capable of weathering this storm without assistance. And no assistance will be available for the cannabis industry from the recently enacted Coronavirus Aid, Relief and Economic Security Act (CARES Act) because of the federal illegality of cannabis.
These economic circumstances arising from the pandemic are potentially causing an acceleration of the industry shake-out that was building before the virus emerged. Smaller operators unable to survive the downturn, rather than being acquired by multi-state operators as they were in the past, will fold and have creditors to deal with without the ability to avail themselves of bankruptcy protections. Unfortunately, participants in economic empowerment or social equity initiatives may be adversely impacted by the disruptions caused by COVID-19 as they continue to manage account receivable issues and lenders, while creditors and landlords become less forgiving given the pressures they will be subject to.
The consequences of the pandemic will test the operational expertise and soundness of many companies. Those with the resources to manage the economic downturn while optimizing operational efficiencies will be well-positioned to lead the industry into its next phase and may see opportunities for consolidation. The future may see continued consolidation through merger and acquisition activity that focuses on gradual growth, cash flow neutral or better companies, depth rather than breadth through regional clustering and a hyper-focus on lowest cost production. There very well might be operators ready to throw in the towel after years of teetering on or near the cash flow positive line who will be candidates for cashless mergers in order to get some compensation for their years of hard work.
COVID-19 is disrupting nearly every aspect of personal lives, business and government. No one is immune from its effects. However, the cannabis industry finds itself in the unanticipated position of being deemed essential—proving its importance in many U.S. citizens’ daily lives and activities. In the long-term, the cannabis industry may emerge from this crisis with more mainstream acceptance and with stronger and financially healthier market participants.