Thoughts on Cannabis Market Consolidation
Written on 23 June 2023
by Ruth Fisher, PhD
- Overview of Market Consolidation
- Factors Predictive of Consolidation in Cultivation Markets
- Speed of Market Consolidation
My general sense is that what's currently happening in cannabis grow markets is the following.
As each new state opens to legalization, it faces a few years of hyper growth as supply ramps up to meet demand. It generally takes a few years for most of the initial batch of grow and dispense licenses to be issued and for supplies to make it onto store shelves and available to consumers. At that point, the limits associated with Schedule I (i.e., all cannabis activity must remain within the state) and realities of regulation (e.g., licensing caps, high taxes, competition from illicit markets) kick in, and the budding new companies realize they can't easily make a profit within their respective states and/or expand into other regions or states.
Add to that the utter lack of enforcement of the rules, together with all the inherent corruption that is naturally associated with "addiction/vice markets" (e.g., lab shopping, product diversion to/from unlicensed markets, cartel activity), and you get a huge amount of nefarious activity, which makes it almost impossible for businesses that are playing by the rules to survive.
Meanwhile, in the background, you have the big players in established markets (states) trying to position themselves to be large players if/when federal legalization occurs. If/when that happens, cannabis will be able to freely move across states, that is, organizations will be able to sell cannabis grown in any state to consumers any other state. These organizations are causing a lot of disruption in the industry from two separate angles.
First, these ambitious organizations continue to ramp up supplies in existing markets. Their increases in supply are being dumped into already oversupplied markets, which is causing prices to quickly drop. Of course, this is great for customers, but it’s not so great for smaller suppliers who cannot cover their expenses at the prevailing prices. Current prices are substantially lower than those that existed when many suppliers first entered the market, so that realized margins are way lower than those expected when new entrants were drawing up their business plans. Much of the excess supplies are being diverted to illicit markets, enabling unlicensed activity to thrive. What it comes down to is that in more mature legal states, the large suppliers are driving out smaller local growers.
And second, the ambitious organizations are also battling to be first in line to get licenses for new markets (states) opening up to legalization. These organizations are more experienced with, and often have greater resources to fund, the licensing process. As a result, the large multi-state operators are squeezing out potential smaller local suppliers in newly legalized states.
Given all this, there is much talk about how the industry will quickly consolidate once cannabis becomes legal at the federal level, that is, when markets become national, rather than regional, in scope. Many point to the consolidated beer and/or beverages industries as models for where they think cannabis is headed: According to a 2022 Treasury Department report,
...[T]wo brewers [Anheuser-Busch InBev and Molson Coors] have dominated the U.S. markets since 2008 and today account for an estimated 65 percent of the beer market nationwide, as measured by revenue.
The purpose of this examination is threefold. The analysis:
- Provides a general overview of the market consolidation process,
- Considers the economic factors at play in the operating environment predictive of cannabis industry consolidation, and
- Examines the historic path of consolidation in the beer industry to see how long it took for that industry to consolidate.
When a new market opens up, there’s generally a flurry of entry by suppliers seeking to take advantage of the profit opportunity that the new market offers. New businesses of all shapes and sizes enter and open up for business.
Next comes a period of shake-out, in which consumers enter and choose from the various alternatives offered by the suppliers, where each alternative is a product with a particular price and set of characteristics (form of use, profile of compounds, store location and hours of operation, nature of customer service, etc.). During the shake out, we see which products – and associated characteristics – consumers are buying. The suppliers offering the most desirable products at the lowest prices (these could be either high margin, low volume products and/or low margin, high volume products) will generate the most profits and will thus survive, while suppliers offering less desirable products will fail and exit the market.
The most profitable enterprises will then expand in size, gaining market share in the process, unless or until they get to a point in which costs of further expansion exceed revenues (e.g., they may run out of some resource needed to further expand, such as access to land or skilled labor). Notably, in many start-ups, the early entrants who generate the most sales might not yet be profitable. However, these generally well-funded enterprises will continue to expand and gain market share, in anticipation of eventually being able to convert large market share into large profits at some point in the future.
Successful Firms Become Larger
Since most industries involve some forms of fixed costs (costs that don’t scale with output, such as license fees, equipment and/or technology systems, professional services requirements, etc.), then larger firms will generally have some sort of cost advantage over smaller firms. It follows that as markets mature, more successful firms will generally grow in size, either organically and/or by buying up competitors. In other words, as markets mature, they will generally consolidate, ending up with fewer larger suppliers in the industry over time.
Successful Firms Are Low-Cost Providers
In healthy markets, the firms that are profitable early on and expand to become market leaders are generally the most efficient firms, that is, the lowest-cost providers of products (at the quality offered). (In “unhealthy” markets, inefficient companies may outlast more efficient competitors due, for example, to the need for bribes, the existence of cronyism, an inefficient licensing process, the use of subsidies, etc.) If the market leaders aren’t the most efficient firms, then, theoretically, a more efficient (lower-cost) firm could enter and offer the same product at a lower price and beat out the original firms. What this means is that even if we don’t know the actual costs of the suppliers (i.e., who the most efficient suppliers are), we can look to see which market competitors are most successful (i.e., have the most sales) and generally infer that they are the most efficient providers. Likewise, we can generally look at market prices and infer that the organizations charging the lowest prices are the most efficient providers.
Cannabis can be grown either outdoors, in greenhouses, or indoors. For a discussion of the differences between the different grow environments, see my earlier blo g on the subject. Suffice it to say that due to differences in technology and resource requirements, growing cannabis outdoors is much less expensive (roughly one-third to one-half the cost) than growing cannabis indoors, with the costs of greenhouse grows falling in the middle.
All else equal, since low-cost providers tend to win out in markets, I would expect larger grow operations to evolve toward lower cost methods, namely outdoor or greenhouse grows. Yet, a look at some of the larger grow operations in cannabis (see Figure 1) indicates that larger growers across geographic locations often use greenhouse and indoor grows more than outdoor grows. This suggests that for larger scale operations, despite the fact that outdoor grows yield lower-cost cannabis, having the greater control over the grow environment enabled by sheltered operations seems to be worth the costs. Of course, the early establishment of many of these operations could explain why there are so many indoor grow sites: perhaps earlier operations were required to be enclosed, due to regulatory or security requirements.
Yet, I’m still curious as to the large number of indoor grows. Greenhouses seem to offer most of the benefits with the huge added advantages of being able to tap natural sunlight, while requiring lower total costs. I would therefore expect to see substantially more greenhouse grows than indoor operations. Perhaps indoor grows are used in operations (i) established before greenhouse technology had been well-developed, and/or (ii) without access to much direct sunlight, and/ or (iii) located in areas where security is an important factor.
Cannabis is a highly regulated industry, which means the nature of regulations will be one of the more important determinants – perhaps the most important determinant – of market concentration.
Generally speaking, anything that
- Raises the costs of doing business, such as high license fees, high tax rates, or high costs of regulatory compliance; or
- Otherwise restricts entry, such as vertical integration requirements or license caps; or
- Makes it more difficult to compete, such as high rates of corruption or low rates of enforcement
will tend to
- Decrease licensed market entry and thus promote market concentration, and also
- Increase licensed market prices and thus promote unlicensed activity.
Cannabis markets tend to involve high regulatory costs (e.g., fees, taxes, reporting requirements) and tend to be rife with corruption, illicit market activity, and/or lack of sufficient enforcement of laws and regulations. All this makes it a difficult market in which to compete, and if current conditions persist, will tend toward market concentration over the long run.
Governments in each state that opens up to new activity generally claim that their legalization frameworks will eliminate illicit markets. Yet, high licensing fees and taxes, delays in processing applications, bottlenecks in supply, lack of enforcement of unlicensed or noncompliant activity, etc. create chaotic environments. In such markets semi-licit and illicit activity thrive, while licensees generally find it extremely difficult to survive when playing by the rules.
The only way to enable healthy licensed markets to develop while also damping down on unlicensed activity is make the regulatory environment as inclusive and transparent as possible. Specifically, there must be ample availability of licenses throughout the state, reasonable fees and taxes, timely completion of regulatory processing, and clearly defined and well-enforced regulations. Of course, even if markets are healthy and well-functioning, they may still consolidate, depending on other factors (described below). However, when the market environment is murky and chaotic, generally speaking, only those with plenty of resources to help them navigate excessive bumps in the road will survive.
The second factor determining whether or not markets will become concentrated is the optimal size of suppliers relative to total market demand. Specifically, market concentration will tend to be higher either when the optimal size of suppliers is larger relative to total market demand.
The optimal size of suppliers is determined by the shape of the average cost curve, that is, the extent to which average costs decrease as sales increase. This happens when there are large fixed costs associated with supplying the market. Cannabis growers incur large fixed costs, due to:
- Large regulatory costs, including license fees (the fees themselves, as well as the costs associated with moving through the licensing process) and compliance costs
- Large facility coststo construct greenhouses and indoor grow rooms
- Large know-how and technology costs, including, for example, establishing standard operating procedures (SOPs) (e.g., learning-by-doing costs) and implementing technologies for seed-to-sale tracking and reporting, grow process management, environmental control, lighting, and irrigation (to name a few)
These large regulatory and fixed costs will tend to provide cost advantages to larger grow organizations.
At the same time, there are also factors in cannabis that are difficult to scale, including growing high quality flower, growing large varieties of cultivars, and perhaps managing multiple grow sites.
Taken together, the nature of cannabis supply suggests that higher quality and/or diverse and/or indoor grow operations will tend to be relatively smaller in size while homogeneous and/or outdoor grow operations will tend to be larger.
There are a couple of other factors that affect the nature of cannabis grow operations.
Access to Scarce Resources
Regions providing natural grow environments for cannabis are found in California, Oregon, Washington, Maine, Tennessee, Kentucky, and Florida. The fact that cannabis grows best in these areas with optimal climates suggests that if and when federal legalization occurs, most cannabis will be grown in these areas.
Due to restrictions on cannabis crossing state and country borders, cultivation sites have been established in every state and country in which cannabis has been legalized. In North America, large grow operations currently exist in locations outside the natural grow areas, including, for example, Canada, Colorado, New Mexico, Arizona, and Nevada.
If and when federal legalization occurs and cannabis is allowed to flow across borders, many of the existing grow sites will be forced out of the market because they won’t be able to compete with prices and qualities coming out of natural grow areas. Yet, many current grow locations outside the optimal locales may persist, if other factors turn out to be more important than natural grow environments. These factors may include, for example, the availability of cultivation technologies enabling good cannabis to be grown indoors or in greenhouses at affordable prices. Another possible factor is the availability of know-how and complementary resources in regions outside natural grows area. For example, Colorado and the Netherlands have both historically produced high quality cannabis, due to the concentrations of master breeders and seed banks located in these areas.
Access to Cannabis Consumers
The ability of growers to access cannabis consumers will affect the size of grow operations. There are two issues in particular currently affecting the ability of small growers and brands to access consumers.
First, there’s the problem of getting onto store shelves. Many growers/brands (jointly “growers”) are having a hard time getting space on dispensary shelves. In many areas caps on dispensary licenses and/or proliferation of brands are creating shortages in shelf space, making it difficult for many growers to reach consumers. In areas where growers use distributors to reach dispensaries, many growers are having problems getting distributors to represent them. Regardless, especially when direct-to-consumer sales are prohibited, growers will tend to consolidate to increase their leverage with distributors and/or dispensaries to ensure they make it onto store shelves and get to access consumers.
And second, in many markets, growers are prohibited from marketing directly to consumers, that is, they are forced to sell their products through dispensaries. Especially in areas where growers lack leverage with respect to distributors and/or retailers (as just described in the previous paragraph), prohibitions on direct-to-consumer markets tend to favor larger suppliers and thus lead to market consolidation.
Adult vs. Medical Use Cannabis
In areas where adult use has been legalized, adult use sales tend to quickly dominate the market and squeeze out resources for medical use customers (for more discussion on this problem, see my previous blog). Medical use will tend to become more subsumed by adult use suppliers – that is, markets will tend to consolidate – when medical use is a smaller portion of the market and/or when regulations enable joint supply of the two segments.
Sources project medical cannabis will eventually comprise about 20% - 25% of the market. However, pinning down the true portion attributable to medical use is difficult because historical estimates generally use sales of cannabis to individuals with a medical card who buy from a dispensary licensed to sell to medical cannabis patients. Estimates of medical use sales do not include sales by users either (i) who have a medical card, but who buy from adult use suppliers or (ii) who do not have a medical card, but who use cannabis for medical purposes. Regardless, I believe medical users will increasingly be under-served by the market – that is, be squeezed out by adult use – unless specific carve-outs are included in cannabis regulations.
Many people believe the cannabis industry will consolidate the way the beverages and/or beer industries have. Based on the market environment described above, a good deal of market consolidation will likely occur. However, people talk as if consolidation will happen in the coming years, that is, relatively soon. I’d like to caution anyone who’s looking to the beer industry as a model and who thus believes market consolidation is relatively imminent that it actually took decades for the beer industry to consolidate. In fact, according to Martin Stack in his A Concise History of America’s Brewing Industry, the number of breweries in the US (displayed in Figure 2) peaked at 3,286 in 1870, then took 110 years to bottom out at 101 breweries (3% of the peak number) in 1980. After that, brewery counts began increasing again, with the launch of the craft beer industry.
The Brewer’s Association provides more recent counts of breweries (see Figure 3), which shows how dramatically growth in the number of breweries has been during the past decade, almost entirely accounted for by craft beer. According to the Brewer’s Association, the craft beer industry currently accounts for 13% of US beer sales by volume and 25% of sales by revenues.
The pace of industry consolidation suggested by Figure 2 is a bit deceptive, since it does not capture differences in brewery size. By the end of the 19th century, a handful of breweries started increasing their scale of production relative to other brewers. As Martin Stack reports,
Until the 1870s and 1880s, American breweries had been essentially small scale, local operations. By the late nineteenth century, several companies began to increase their scale of production and scope of distribution. Pabst Brewing Company in Milwaukee and Anheuser- Busch in St. Louis became two of the nation’s first nationally-oriented breweries, and the first to surpass annual production levels of one million barrels.
The industry continued to evolve, and Blatz, Pabst, and Anheuser Busch made prescient investments in several areas during and after Prohibition, which enabled them to grow rapidly in newly-reconfigured markets once Prohibition was repealed. So, while it took 110 years for the number of breweries to bottom out, the presence of large numbers of smaller breweries clouded the true nature of market consolidation. Most of the consolidation actually occurred during the 30-year period between the mid 1940s and the mid-1970s (see Figure 4).
Even so, if the consolidation of the beer industry is any indication of what might happen in cannabis, it will be a while before the cannabis grow market becomes substantially consolidated.
Fun Facts: As per the US Treasury report cited in the introduction, despite the currently large number of breweries currently in the industry, as of 2022, two company, ABI and Molson Coors, jointly account for 65% of national beer market sales.
Although ABI and Molson Coors continue to dominate the market, the number of breweries has increased significantly. Indeed, in 1983, there were fewer than 100 breweries. At the end of 2020, there were 6,406 breweries reporting beer production in the United States. Many of these breweries are small. In 2020, for example, more than 90 percent of these 6,406 U.S. breweries made fewer than 15,000 barrels of beer.
So, while ABI and Molson Coors dominate the market, consumers benefit from the availability of beer supplied by thousands of local and regional small breweries, who are providing quality and variety products that the two dominant firms may lack.
The history of the beer industry suggests that even if the cannabis industry does consolidate, (i) it may take longer than many anticipate, and (ii) there should still be room for a significant craft cannabis industry to thrive by serving consumers seeking quality and variety in cannabis.
Over about the past half-dozen years or so, licensed cannabis activity has been slowly advancing and taking hold in the US, but it’s been a bumpy ride. Based on M&A activity, one could say the industry is bottoming out after either its second or its third cycle (see Figure 5).
My sense is that the industry is moving along a series of hype cycles, much like those described by Gartner (see Figure 6).
Source: Jeremy kemp at English Wikipedia, https://commons.wikimedia.org/wiki/File:Gartner_Hype_Cycle.svg
The industry is having a particularly difficult time taking hold, due to its Schedule I classification, which has created tremendous barriers to commercializing licensed cannabis activity in the US, as well as more globally. Unless or until the Schedule I classification is changed, commercialization of licensed cannabis activity will continue to face headwinds. A large contributing factor to the turbulence is the fact that so many organizations are participating in local markets while positioning themselves for national markets. This is creating a mismatch between the rules of the game and the game being played.
Presumably the value of activity in each successive cycle is increasing because more people are understanding the true potential of cannabis and are thus choosing to participate in the industry. Many people believe cannabis is now unstoppable, in which case total industry activity will continue to increase into the future.
As for the structure of the industry, I believe it will continue to consolidate. Cannabis activity will always be regulated to some extent. The fixed costs associated with regulation, together with the other fixed costs inherent in cannabis operations (e.g., facility, technology, and know-how costs), not to mention the desire to gain leverage vis-à-vis distributors and retailers, create economies of scale that push toward relatively fewer larger organizations supplying mass market cannabis products. At the same time, I think the craft beer industry provides an example for how craft cannabis can continue to supply a significant portion of the market for people seeking higher quality and/or variety cannabis products. Yet, if the beer industry experience is any indication, it will take time for the cannabis industry to consolidate.
Perhaps the biggest complication associated with expectations for a successful cannabis industry is the illicit market. Since the size of the unlicensed market is largely dependent on the nature of regulations, governments will minimize illicit activity only by establishing regulations that are as inclusive as possible.
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