The authority when it comes to analyzing the cannabis industry

Revenue – Cost Analysis Part I

We have to thank the State of Massachusetts for making such a wealth of information available to us– we love analyzing it. Let’s take a look at revenues. Basically, the vast majority of MA dispensaries used Colorado’s and California’s historical data to help justify their revenue projections. These projections are required in the applications as part of the business plan.

We examined the top 20 dispensaries with the highest quality business applications that were successful in obtaining licenses. During the first year, they expect to have average revenues of $4.3M per dispensary (with a median of $3.7M). The highest revenue-earning dispensary is New England Treatment Access, of Norfolk county, with an outstanding first year revenue of $11.9M based on 2,000 patients visiting and purchasing an average of 1.6 oz per month. On average, first year expenses are $4.4M, resulting in an average expected net loss of $100k per dispensary. Roughly half of the dispensaries we examined expect net losses in the first year. However, the second operating year is accompanied by very significant revenue growth and lower cost growth, because most of the start-up expenses are incurred within the first year.

For the second year, dispensaries expect their revenues to increase on average ~100% from the first year– that’s right, they expect to double their revenues to $8.5M. The main rationale behind this increase is increasing market penetration: dispensaries expect to go from roughly 50% patient penetration in the first year to almost 100% penetration of the local addressable market (i.e. # patients in county). This also assumes that every patient who needs medical marijuana will eventually purchase it legally from a dispensary. This is true especially as consumption spreads and doctors become more comfortable prescribing cannabis treatment, a story and growth trajectory that has proven true in CO and CA.

On the other hand, costs in year two are only expected to increase by 60% to an average of $7.0M, resulting in an average profit of $1.5M or a profit margin of 18%. During the 3rd and last year of available projections, revenues per dispensary are expected to increase on average 24% to $10.5M, and costs increasing 14% to $8M. Earnings on average rises to $2.5M, a 23% profit margin.

What do you think? Are these growth rates too bullish? Not every state is like CA or CO, only time will tell and growth rates are heavily dependent on number of addressable patients, frequency of visits, and average purchase size. On the profit side, several adjacent industries are more profitable. Look at the e-cigarette business in Oklahoma, a mere $50K initial investment might result in $400K revenue for a single shop. Nevertheless, remember: dispensaries are nonprofit – at the end of the day, your goal is to help those who are ill in the best manner possible, so use those profits to reinvest in your business and beat the competition for the long-term! The most important thing to remember is you’re in it for the marathon, running the first mile may be tough, but there’s 25 more to go!

Elasticity of Marijuana Demand

The elasticity of a product gauges how likely people are to keep on buying as its price changes. If the price of soda increases by 10% but its demand decreases by less than 10%, it’s inelastic— the increase in price isn’t completely offset  by the loss in demand. Conversely, if demand decreases by more than 10%, demand is elastic.

Many studies have been carried out since the 70s, and for the most part, they find marijuana demand is inelastic. These studies make various assumptions and their results should be taken with a grain of salt, but as more marijuana is sold in approved dispensaries and reliable data becomes available, credence should be given to these relatively consistent results. One of the most recent studies claims that, with an elasticity demand between -0.3 and -0.6, “the demand for marijuana appears relatively insensitive to price changes.” This is equivalent to saying that with a 10% increase in general prices, demand would drop between 3% and 6%.

60% of the cannabis examined in the previous study was reported as being of high quality, 33% of medium quality, and 7% of low quality. What this implies is that quality matters extensively, and people are willing to pay a premium for high quality (or the perception of quality, given that classification may be fairly subjective). If the product you are selling is remarkable, market it as such and let people try it for themselves. After it an initial successful “try out” period, it might not be a bad idea to experiment with pricing increases— a single $1 increase on a $15 gram is a 7% revenue increase. Low and medium quality cannabis is more elastic than high quality one (low quality is a bit more inelastic than medium, interestingly), so raising their prices may bit more dangerous to your bottom line. It’s a better strategy to keep these varieties at “safer,” more stable prices and attempting to sell them in large quantities. For reference, Medicine Man charges 20% more for a gram of high quality cannabis than low quality ($17 vs $14; many dispensaries have 2 kinds of quality instead of 3 as the study.)

However, at the end of the day, you need to realize how closely these dynamics apply to your customer base. If your customers tend to be on the younger side, pricing might be more important to them as their income might be more restrictive, so you might want to focus on making special deals with low and medium quality cannabis. In CO you have dispensaries in the same geography charging significantly different prices, likely because they cater to different customers ($17/g  vs. $12/g). If your customers generally fall below poverty levels, perhaps offer them additional discounts. Several Massachusetts dispensaries have detailed “hardship” pricing programs in place especially if you have a medical condition. At the end of the day, medical dispensaries have to allow patients to affordably purchase medicine.

Knowing your customer base should always be a top priority, you are running a business to help them fulfill their needs, and knowing how to best cater to them will give you the necessary edge to bring back the clientele over and over.

What Cannabis Commoditization Means

In the wise words of Wikipedia, commodities are a class of goods for which there is demand, but which is supplied without a qualitative differentiation across a market.  Apples, rice, oil, and wheat are all commodities— products that we consume, for which we can’t really justify different prices between them. Is marijuana a commodity? Maybe not fully, yet… but let’s analyze it further.

If I live in a country where apple growing is highly regulated, and I’m one of the few apple growers, I can charge a premium and make high profit margins. As regulations are scaled back, more people realize entering the industry is viable and more competitors sprout up. They start charging less for their product in order to remain competitive, and in return I have to as well.

Commoditization is occurring— everyone’s growing apples now, and my product isn’t differentiable. Unless I can grow an apple that no one else can grow, I cannot justify charging higher premiums. Sure, I can offer organic apples or even apple pie (think: edibles), but guess what? Anyone can offer those too. Low margins mean only one thing: marijuana will be a numbers game. Over the years, the truly successful businesses will be those that can sustainably service and retain a large clientele.

Studies show that if the U.S. completely legalized cannabis, marijuana could be grown for $10 dollars a pound—that’s 62 cents per ounce, or 2 cents per gram. Think mass production on the scale of Big Tobacco. Right now, high-end strains sell for $50-70 a quarter ounce, and experts estimate that with widespread legalization prices could drop to as little as $3 per ounce. Uruguay, the state sells the cannabis at only $1 per gram. While making $50-70 a quarter ounce might sound significant, you need to understand that roughly a third of that can go to taxes, another third to production costs, and what’s left of the other third would be your gross profit, as a few very successful dispensaries have been able to report.

In Colorado and Washington, many businesses have had low single-digit profit margins  (grocery stores on average have 20% margins) and many have even failed – an estimated 40% of cannabis businesses in Colorado founded in 2010 failed by 2013.  As time passes and more states begin legalizing marijuana, better prepared and equipped groups will start competing fiercely in the industry, and margins will only continue to decrease. Back in 2010, an eight in Colorado was $50, today it’s around $25.

Furthermore, growing is very expensive; mold, pest, and mildew can destroy entire crops. Good growers are in high demand and can leave you at any point to join a more profitable business. You may get drowned in legal fees if authorities decide to pick on you. All these cases can result in hefty one-time expenses/losses of income that, without the proper existing capitalization, a low-margin business might not be able to withstand.

We are not trying to dissuade you from entering the industry, we are just trying to give you a realistic view of what you should take under consideration before acting. If you are serious about becoming a cannabis businessman, you need to understand it will not be easy. To be successful, you need to ensure that you work with a group of competent people who, just like you, must thoroughly know the dynamics of the industry and of the growing process, while offering a product of consistent high-quality. Care and caution are in order, but you should not be afraid. As Andrew Carnegie said, “anything in life worth having is worth working for.”