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Calif. weed industry is '$25 billion opportunity'

USA TODAY logo USA TODAY 11/19/2016 Rosalie Murphy
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LOS ANGELES — MedMen likens itself, as many cannabis companies do, to an early tech startup. Its West Hollywood dispensary looks a bit like an Apple store, with samples of product in polished glass cases and information about each on iPads. In a grow facility in Sun Valley, north of Los Angeles, marijuana plants grow in coconut fiber, sustained by drip irrigation and marked by thin plastic labels stuck in soil. Beyond the dispensary and cultivation center, the company offers "turnkey management services" to others in the cannabis space and boasts a $100 million venture capital fund.

This is the future of legal marijuana in California: Diversification, slick branding and professional investment.

Marijuana is already as big a business as coffee and Indian gaming, with analysts estimating $30 billion in annual consumer spending. The trouble is, only one in every five of those dollars are currently spent on legal products. The rest, some $24 billion annually, ends up in black-market pockets, according to a 2016 cannabis report from the Cowen Group, a New York-based market research firm.

But more and more of that money will come out of the shadows in the next two years. This month, voters legalized recreational marijuana use in four states and medical marijuana in four more. California, home to 12 percent of Americans, is expected to triple the size of the legal market when the state begins issuing licenses in 2018. Vivien Azer, a cannabis analyst with Cowen, believes the nation's legal market will grow ninefold over the next decade, with consumer spending on recreational and medical marijuana hitting $50 billion by 2026.

"Formalizing the informal market alone is a $25 billion opportunity," Azer wrote in a September report.

Part of that growth will come from black-market customers moving into the legal market. And some will come from new customers, who were uncomfortable seeking prescriptions for the drug or have never used it at all. There's a similar industry evolution already underway. While some mom-and-pop growers, operating for years in a "gray zone" without regulation, struggle to come out of the shadows, companies are circling the enormous California recreational market — some with millions in the bank already.

Mainstreaming an industry

Even before California voters passed Proposition 64, the state's medical marijuana market was two decades old and fairly sophisticated. California marijuana has apps, wealthy investors and companies that specialize in packaging and branding. But even now it lacks some key resources: For example, many banks won't serve cannabis businesses while the drug remains illegal at the federal level.

"Something people forget is that medical marijuana has been around in Cailfornia for two decades now," MedMen communications director Daniel Yi said. "I think we are at an inflection point in our industry now where it's going from legacy growers — people who were in the trenches at the beginning of the medical marijuana fight — and it's becoming more and more business-like. Some people see negative connotations in that, but this has become more of a mainstream industry."

The current patchwork of laws have kept the largest investors — entrepreneurs mentioned Goldman Sachs and tobacco giant Phillip Morris — out of the market for now. Azer, the Cowen analyst, believes those companies will start acquiring or investing in cannabis companies only after the drug is legalized at the federal level. But private investors are already eagerly seeking opportunities in cannabis, eyeing high returns.

MedMen launched a $100 million private equity fund this summer, and Chris Leavy, a former BlackRock executive, invested soon after. He's interested in cannabis because he knows the customer base already exists — nearly one in ten Americans admits to using cannabis, according to Cowen estimates, and many of them are shifting from illegal to legal use now — and because, in the absence of large institutional investors, cannabis investments are relatively accessible.

"As investors became aware of the likely legalization of recreational use for California and a few other states, I think two things happened in investors' minds," Leavy said. "One is the obvious growth in the industry that comes with legalization. But I also think there's a strength in that current... that reduces the risk that the trend toward legalization gets reversed."

The industry, Leavy predicted, will increasingly have winners and losers — companies that make it and those that don't. He thinks the winners will be those with innovative manufacturing processes, brand awareness and the ability to scale.

Scaling will be necessary. According to a 2016 report from ArcView Market Research, recreational marijuana sales more than tripled from 2014 to 2015 as Colorado and Washington's markets matured, reaching $1.2 billion in 2015. California's population is more than three times larger than Colorado and Washington combined. In 2020, when ArcView predicts recreational sales will hit $12 billion nationwide and medical sales will top $10 billion, MedMen plans to be there.

"We are years ahead now," Yi said. "Say somebody with $100 million wakes up tomorrow and decides they're going to get into the marijuana business. They'll have a learning curve. It takes a lot of time to prepare all that, and we've been doing this for years."'

A variety of medicinal marijuana buds in jars are pictured at Los Angeles Patients & Caregivers Group dispensary in West Hollywood, California, on Oct. 18, 2016.© REUTERS/Mario Anzuoni A variety of medicinal marijuana buds in jars are pictured at Los Angeles Patients & Caregivers Group dispensary in West Hollywood, California, on Oct. 18, 2016.

'Big Canna'

There are thousands of people who have been operating marijuana businesses for years — and unlike MedMen, most have been operating illegally. They risk arrest, but they also avoid taxes and the cost of complying with regulations.

They might not survive.

"If you're a small pot grower and you don't have the money and resources to turn into a bigger player... then unfortunately you're not going to be around," Yi said. "Nobody wants to see people lose their businesses and lose their jobs, but there's the flip side — you either have this gray market forever and ever, or you institutionalize that and become mainstream. A lot of these folks might be able to find jobs in the evolving industry, but the business model is not going to survive unless they adapt."

Ata Gonzalez, founder of G FarmaLabs and a longtime player in the industry, said he's been getting some heat lately from so-called "gray market" growers — who supply dispensaries selling to legal customers but aren't licensed themselves — who perceive him as "big canna." Gonzalez said he and his colleagues started like everybody else in the industry, growing small amounts of cannabis for dispensaries. But then they kept growing.

After Washington legalized recreational marijuana in 2012, the Anaheim-based company began contracting with manufacturers there to serve recreational customers. Gonzalez is now planning a cultivation facility on 7 acres in Desert Hot Springs, set to open in 2018.

"(Small growers) fear it, and I don't think they should fear it, I think they should embrace it, I think it's going to create a lot of opportunity for a lot of people," Gonzalez said. "But I think that's their biggest fear, the big guys coming in and wiping us out. I fear it as much as them. I don't have the firepower to keep Phillip Morris from actually coming in here and spending a billion dollars, how do you fight that? But I have strategy and experience in this industry. I see them come in, I see them blow the money, and I see them walk away."

Ancillary businesses

Marijuana products need packaging, which is often governed by strict regulations. Dispensaries need scales and specialty gloves. Users need pipes and rolling paper.

Kush Bottles, with offices in Denver and Santa Ana, is trying to provide all these products. With 50 employees, the six-year-old company says it raked in $8.2 million in revenue in fiscal year 2016. In January, the company started trading stocks "over the counter" — using a network of stock traders less formal than the NASDAQ, but still allowing out-of-state investors to buy shares.

"There aren't a lot of large companies in the cannabis space, but there's a huge appetite in the investor community wanting to participate in the cannabis space," CEO Nick Kovacevich said. "We're doing well in our niche markets, but we're only in three or four markets heavily, and we see this thing being 50 markets, and hopefully pool-able expansion. In order to prepare for that, we knew we would need access to capital... While we're waiting for these (newly legalized) states to implement, we use our public vehicle to make sure we're ready to take advantage of it and capitalize on these new markets."

Cowen analyst Vivien Azer often compares the cannabis industry to tobacco — and if the federal government legalizes marijuana, she expects to see a great deal of overlap between the two. In the meantime, she thinks tobacco companies can focus on developing products like e-cigarettes for cannabis users.

She identified Kush Bottles as one of the industry's most interesting companies.

"I really like their business model because they're arms-length," Azer said. "I think they've really carved out a niche and are keenly aware of the headwind going forward."

'Barriers to entry'

Proposition 64 allows California to start licensing sellers of recreational marijuana on Jan. 1, 2018. But because marijuana remains illegal at the federal level, it can't be transported across state lines — meaning it will have to be California grown.

One cultivation facility is already online in Desert Hot Springs; MedMen and G FarmaLabs are both building facilities in the desert town two hours from Los Angeles. Industrial land prices in the city have spiked as would-be growers try to secure space and start selling medical products, though recreational sales are still 14 months away.

In Colorado, demand spiked when licensing began in 2014, driving prices way up. But as more growers and sellers joined the industry, prices plummeted. Joshua Haupt, co-owner of Colorado's Superfarm, a 2-facility cultivation company, said marijuana there sells for $900 to $1,200 per pound — down from about $4,000 a pound right after legalization. He thinks California's large population will keep prices higher for longer, but eventually, margins will shrink.

Haupt said Superfarm takes in about $1.1 million in revenue on about 1,000 pounds of marijuana per month. They pay more than $250,000 in taxes and spend about $350,000 on production. The rest is overhead, salaries for 80 employees and, of course, profit.

"If you're getting in now and only have a few hundred thousand dollars and a genius grower who's been growing under four lights in his basement... they're so stuck in the world of the black market, they've done incredibly well in the black market, and they think it's going to transfer into the legit industry, and that is an incredibly large mistake on their part," Haupt said. Taxes and regulatory costs are high; profits can shrink in the legal market even as the customer base grows. "It's one thing to run four lights in your basement. It's another thing to run 400 lights in a 25,000 square foot grow. Is it too late? Absolutely not, but the barrier for entry has gotten much higher."

Investor Chris Leavy, considering the state of the industry, summarized, "I think we're at the end of the beginning."

Follow Rosalie Murphy on Twitter: @rozmurph

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