Weeding Out The Illicit Market

SUMMARY:

We reviewed and analyzed cannabis confiscations and related activities recently published by various state and federal agencies.  This enables us to determine a floor value for the illicit market. Its growth seemingly outpaced that of the legal market post pandemic and is much greater than we originally assumed (now likely exceeding $100B); California continues as the artery for its distribution (>80% from CA). 
California’s recreational use market has been disadvantaged by its haphazard rollout but, as the industry continues to evolve, we believe the strength of the illicit market will begin to dwindle as: 

1. The larger, well-capitalized concerns begin to ramp up and the promise of large-scale cultivation comes to fruition, facilitating the manufacture of a higher-quality, lower cost product at a more competitive price point.
2. California moves to eliminate a 15% cultivation tax and other onerous tax structures.
3. Law enforcement works more closely with the industry to combat illicit sales as both have a common interest to maximize revenues ( i.e. state/federal taxes, stakeholder returns).
4. Interstate commerce eventually becomes permissible. While each state must now operate under the confines of a closed economy, the illicit market continues to cross state lines.

KEY POINTS:

• The Drug Enforcement Agency (DEA) recently published its annual “Domestic Cannabis Eradication/Suppression Program Statistical Report,” which we reviewed and analyzed in conjunction with comparable information provided by other state and federal agencies.  While the illicit market is virtually impossible to accurately size for obvious reasons, ongoing law enforcement efforts (seizures, etc.) provide a reasonable basis from which we can quantify a floor value.
• The DEA indicates that it destroyed 5.5M plants in 2021 (+21%) vs 4.5M in 2020 (+13%) and seized 743K lbs of flower (+181%) vs 265K (-27%).  In 2019 and 2018 (pre-pandemic) the activity was lighter (4.0M and 2.8M respectively).  Admittedly, we can only speculate on the reason for the uptick, but one possibility is heightened demand for a less expensive, non-regulated product (which excludes taxes and other regulatory costs, etc.).  Also we note that beginning in 2020, the DEA provided data on ounces of THC confiscations (edibles and waxes/oils).
• A similar trend was noted by the State of California’s Department of Fish and Wildlife, and likewise, consistent with the narrative of decelerating revenue growth reported by the publicly-traded MSOs over the past three quarters.  We note that in March 2020, and on a few other occasions, we expressed concern that disposable income levels could fall as the COVID pandemic began its assault on the U.S. economy and, to that end, legal cannabis revenues could be pressured as the illicit market offers a less expensive alternative.  In fact, on its Q4 ‘21 investor call, Curaleaf CEO Boris Jordan acknowledged:“…[a] recent forecast from the Conference Board estimates that real disposable income in the U.S. will decline by 3.2% in 2022. Taking these factors into consideration, we expect the recent trend of softer industry growth, which began in third quarter of last year, will continue through the first quarter of 22.”  
• In total, we estimate our analysis represents ~ $34.0B and ~$37.2B of the illicit market in 2021 and 2020 respectively vs pre-pandemic levels of $16.2B in 2019 and $13.1B in 2018. While arbitrary, we use a 3x multiplier to account for remaining market volumes (arguably conservative), which brings the totals to ~ $102.0M (2021), $111.6.B (2020), $48.5B (2019) and $39.4B (2018).  Legal sales in the U.S. increased from ~ $13B in 2019 to ~$25B in 2021 (24% CAGR). In our calculation, we think it reasonable to assume each plant will yield one pound of flower and the average retail price is twice that of the wholesale value (as determined by Cannabis Benchmarks). The retail value of the Edibles/Waxes/Oils, (2021 and 2020), is based upon an average price of $0.25 per mg.

• Most of the illicit market continues to originate/flourish in California; in 2021, the state accounted for ~86% of all plants destroyed by the DEA , up from 82% in 2020, 80% in 2019 and 64% in 2018. As we indicated in 2020, the DEA began to disclose seizures of Edibles/Waxes/Oils; Indiana accounted for 1.8M ounces of THC in 2020 (a significant amount) which dropped precipitously to 22.5K in 2021.

• California is uniquely challenged, as it was the first to implement regulations of a recreational use market without initial oversight of medical use purchases. The state established a legal but unregulated medical marijuana program in 1996 and it was not until 2016 that recreational use permissions were granted.  For nearly two decades, the Emerald Triangle (Humboldt, Mendicino and Trinity counties) established themselves as the arteries supplying much of the country, making the transition to a regulated system uniquely challenging in California, particularly with the combination of high taxes, oversupply, and limited storefronts.
• We believe the strength of the illicit market will begin to dwindle as the bigger, well-capitalized players ramp up and as California implements a lower tax structure. Several MSOs are now ramping up in California and the promise of large-scale cultivation will soon come to fruition, facilitating the manufacture of a high-quality, lower cost product at a more competitive price point, particularly as the state moves to eliminate a 15% cultivation tax.
• Most notable is Glass House Brands which is  close to unveiling its new, state-of-the-art ~6M square foot cultivation facility that is expected to produce over 1.5 million pounds of flower per year.  The capital and business resources behind this movement, coupled with a collaborative effort with law enforcement, could dramatically weaken the illicit market. We also point out that Glass House Farms CEO, Kyle Kazan is a former/retired police officer of the Torrance Police Department in Los Angeles County. During his tenure, he gained recognition as an expert in gang and drug identification and eradication. As such, if anyone can disrupt the illicit market, we believe it is Mr. Kazan.
• We think interstate commerce will become permissible sooner than later. While each state must now operate under the confines of a closed economy, the illicit market continues to cross state lines.  California has always been known for high-quality cannabis and much of its illegal grow is sold into other states.  The ability to expand production and sell into other juristictions should further pressure illicit market activity. Furthermore, upon implementation of a federally legalized cannabis market, the introduction of a major exchange traded pricing mechanism (trading cannabis on the CME) will serve to mitigate price fluctuations. When that time comes, it will be necessary to demonstrate an ability to take delivery (as with all forward contacts) which cannot happen unless interstate commerce is permitted.