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Legalization’s Impact: Growing Revenue, Narrowing Margins

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The legalization’s of cannabis throughout North America has created many opportunities for companies and investors, but the increase in supply has made the industry less profitable over time. While the cannabis industry is expected to soar to more than $20 billion in just five years, driving significant potential revenue, prices have fallen anywhere from 25% on the retail side to nearly 50% for wholesalers, which has put a strain on profit margins.

In this article, we will take a closer look at these trends and how they could play out for companies operating in the burgeoning industry.

Significant Revenue Opportunity from Legalization’s

ArcView Research estimates that the North American cannabis industry will triple in size to more than $20 billion in five years. In addition to recreational legalization in Canada, California, Nevada, Maine, and Massachusetts’ recreational legalization will be key revenue drivers. Many companies have already benefited from these trends in both the U.S. and Canada and could experience even greater revenue growth over the coming years.

Canopy Growth Corp. (OTC: TWMJF) (TSX: CGC), Canada’s largest producer under the AMCPR regulations governing the industry, reported fiscal Q2’17 revenue that increased 245% year-over-year to $8.5 million as its patient base grew nearly 50% sequentially, according to a recent press release. The company’s stock has responded by soaring more than 200% over the past 52-weeks, bringing its market capitalization past the $1 billion mark.

Many U.S. growers are also positioning themselves in future markets. For instance, GB Sciences Inc. (OTC: GBLX) recently announced the opening of a new 28,000 square foot cultivation facility located in Las Vegas, Nevada. The company plans to generate near-term cash flow through the production of medical marijuana, while developing pharmaceutical products over time to treat a variety of medical conditions.

Potential Profitability Concerns Due to Legalization’s

The cannabis industry may present a significant opportunity to generate revenue, but profit margins are being squeezed through the increased competition. According to Cannabase, the wholesale price of cannabis in Colorado has fallen nearly 50% to $1,300 per pound since legal sales started in January 2014 while BDS Analytics reckons that retail prices have dropped a less-severe 25% to $6.61 per gram over the same time frame.

These trends are likely to continue moving forward as a growing number of producers enter the market, although the increase in supply will be partially offset from higher demand from legalization’s initiatives across North America. Producers of raw cannabis are expected to see the greatest competition given the potential commoditization of the product, while developers of extracts could enjoy some protection given the complexity and proprietary formulations.

The upshot is that revenue growth could be strong enough to offset the decrease in profit margins. In other words, many companies should still witness strong growth in their bottom-line net income even with lower profit margins given the higher revenue. The increase in supply should also diminish over time as the market balances out, which means that the significant declines seen early on may be less dramatic in future years.

Takeaways for Companies & Investors and Impact of Legalization’s

The challenge for cannabis companies will eventually shift from growing revenue to improving profit margins through innovative new technologies or new techniques.

Companies like Urban-Gro and Heliospectra have developed solid businesses around providing more efficient growing and lighting systems for cannabis clients. Of course, established companies like Scotts Miracle-Gro Co. (NYSE: SMG) have also capitalized on the opportunities in the space to increase yields. According to one research note, the company’s hydroponics systems could grow from 6% to 10% of total revenue thanks to the cannabis industry.

Other companies have focused on developing naturally-low- cost production techniques. For example, Aphria Inc. (OTC: APHQF) (CVE: APH) leverages outdoor greenhouses rather than indoor hydroponics facilities to realize profit margins of 75% to 80% and a low all-in cost of $2.22 per gram, as of mid-2016. These kinds of efforts could help lower production costs, but could result in lower yields than highly-optimized indoor conditions.

In the end, companies will likely be focused on cutting costs using new techniques and techniques, while investors will begin to more closely scrutinize profit margins as the market continues to evolve over the coming years.

By Ryan Allway

Disclosures: GB Sciences Inc. and Heliospectra is a current client of TDM Financial dba CFN Media Group and several other companies mentioned in this article were former clients. See disclaimer.

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