CA Cultivation Tax Elimination, Meaningfully Eases Pricing Pressures And Likely Drives Consolidation

July 6, 2022: Last week, California’s onerous cultivation tax ($161/lb.) was officially eliminated. While far from solving all the issues for California operators, the tax change meaningfully reduces the break-even threshold for growers and particularly those with the biggest scale in capacity. In California, scale permits a meaningful wholesale price premium as retailers and distributors are typically willing to pay up to consolidate relationships as well as a lower total cost of production on greater volumes. The other driver of premium wholesale pricing is branded products. Brand power also tends to come with scale of operation given that brand success in the space is still largely predicated on distribution.

Some savings are likely to be passed on to distributors and retailers however without that we believe the total cost of production for outdoor growers is reduced by more than 40% with the elimination of the tax and the breakeven price for wholesalers is lowered from ~$375 to $214. The average price of outdoor grown flower in the state today is approximately $400/lbs and has been as low as $300 earlier this year.

Stocks for California operators have outperformed in recent months, in part on this expected law change. We expect stock outperformance to continue in the near term as market conditions for operators become more tenable which will translate to better earnings results than we have seen in the past and give investors greater confidence in long term opportunities. We also expect easier market conditions will accelerate consolidation in the state given the advantages of scale and the fact that larger operators now have more capital available to spend. Of public currently California-centric names, we expect 4front FFNTF, Glasshouse, Harborside HBORF, Lowell LOWLF, Parent Company and Planet 13 PLNHF with each having already been acquisitive prior to the change.

The lower break-even threshold and seemingly more accommodating regulatory environment may also be the catalyst that finally brings the biggest MSOs into California. At some point, California as a market is too big to avoid and given the fact that California centric names continue to trade at meaningful valuation we expect entry to come through M&A. All of the above mentioned public operators along with smaller public companies including: Body & Mind BMMJ, Fiore FIORF, Unrivaled UNRV and Vibe are in play to be acquired in the near term and thus warrant further investor consideration. Within our coverage, we suspect that Ascend AAWH, AYR AYRWF, Jushi JUSHF, Schwazze and TILT TLLTF are likely to be the most interested in new California expansion.

Investment Highlights:

• California flower cultivation tax to be eliminated.
• Wholesale prices remain challenging at roughly 15% of East Coast states but the tax change meaningfully lowers the breakeven threshold for cultivators and permits some breathing room on operations.
• Expect further consolidation as scale proves even more beneficial and market conditions promote MSOs to meaningfully enter the market.
• Stocks of CA exposed companies are dispropionately cheap. Expect outperforming stock returns in the near term in correction of the discount as conditions seem now tenable.
• Outdoor growers dispropionately benefit.
• View biggest winners of tax change in our view are large CA cultivators including Glasshouse, Lowell Farms, Harborside, Parent Co and Planet 13.