Originally published May 30, 2021
With Curaleaf ($CURA) Chairman Boris Johnson (‘BoJo’) musing about interstate commerce happening in 3-5 years, I thought I would run some math on what that could potentially mean to business models. But in addition, I decided to also add a federal excise tax of 10%, the timing of WHEN the excise tax is calculated, and how that might impact the value of verticality.
This is just math. You can use your own versions of Gross Margins/Mark Ups, how they would be reallocated in a 3-tier model, vary interstate product costs, and vary Excise tax percentages. I encourage you to do so.
I have drawn excerpts from James Rice, Managing Partner of KAYA.IO (one of our experts on our Ask Me Anything on 3-Tier Alcohol implications for cannabis) as applicable for greater detail or to justify assumptions.
If federal excise tax is charged like in alcohol and tobacco (and outside the Bureau of Engraving, Alcohol and Tobacco Tax and Trade Bureau -TTB – is the only federal agency under the Treasury Department that has a tax collection mechanism… meaning, TTB is the likely place for cannabis federal excise tax collection) it would be charged at “first sale”, and that first sale cannot be to a buyer with common ownership as the seller.
James Rice: “Both MORE & RMRA Section 5903.C.2.b define “Arms-Length” which precludes sales to the same controlled group & sales made through special arrangements between producer & purchaser (aka Management Agreements). This section slams [the] door hard on Vertically Integrated Entities somehow circumventing the Three-Tier Model through Wholesaler ownership. If the IRS can prove the “Controlled Group” owns the Producer, Wholesaler, AND Retailer, they pay the tax on the RETAIL Price.”
That first sale is also usually delivered to a bonded warehouse for calculation of excise, which would present a whole host of problems for verticality (assuming they handle it like alcohol or tobacco), as the retail establishment would then need a bonded delivery area. But that is beyond the scope of the economics we will discuss below.
The Federal excise tax is calculated at first sale in alcohol/tobacco. This might seem innocuous until you run some math.
I used $100 worth of flower to the consumer and then added the excise as the end state “Flower Retail Sale”. You can re-run the model with excise buried earlier if you like. This model is just cleaner for showing the differences.
I have used a 10% excise.
The MORE act section 5901 has excise as follows:
- Year 1: 5%
- Year 2: 5%
- Year 3: 6%
- Year 4: 7%
- Year 5: 8%
Whereas MRRA section 5901 has excise as follows:
- Year 1: 10%
- Year 2: 10%
- Year 3: 15%
- Year 4: 20%
- Year 5: 25%
Vertico is your vertical MSO on the east coast. They own cultivation, processing, distribution, and retail. I have used $100 worth of Flower Retail Sale and availed a 65% Gross Margin for the entire vertical. Given Trulieve, the most vertical of the MSOs, is at 70% Gross Margin, it is roughly comparable.
3Tier Co is three different companies that make up the supply chain. To determine “Mark Up” I used the following and pulled in data from our Ask Me Anything on 3-Tier as guardrails:
- 30% GM for the Cultivation to Distribution sale (Ohio: out of $100 bottle of wine winery gets approx. 20% of revenue stream and 45% GM. I have increased this to 50% of revenue with a 30% GM to make it more conservative in favour of present cultivators.)
- 23% GM for the Distribution to Retail sale (Ohio: wholesaler distributor has a GM of 28%)
- 35% GM for Retail to Consumer sale (Ohio: for wine the state requires a minimum of 33% mark up)
In this scenario the excise tax on Vertico is $10, as their first sale is to the Consumer. Whereas, 3Tier Co first sale (Cultivation Sale) was at $50 to the Distributor, which leads to an excise tax of $5.
3Tier Co has an end price to consumer of $105 versus Vertico of $110. The timing of the collection of excise tax alone tilts a 4.5% price differential in favour of non vertical.
In Scenario #1, we have held Vertico the same as Base Case, but we have brought in an Interstate supply to 3Tier Co in the second panel on the right at $20 cultivation cost and $29 sale price versus $35 and $50, respectively, in the Base Case. We held cultivation Mark Up virtually the same at 31% vs 30% for 3Tier Co in the panel to the left (I could have set it at the exact same 30% Mark Up as Base Case but I did not want to deal in pennies.)
California pounds are approximately $1,200 wholesale with premium $2,000 versus East coast 4x that. So, we think a 42% reduction in cultivation sale price ($50 to $29) in West Coast vs East Coast is conservative.
We have also held the Flower Retail Sale to consumer sale constant at $100 and added excise after the fact (as in Base Case). This latter requirement had us playing with Distribution Mark Up, which could have easily been spread over Cultivation and Retail as well, but we only wanted to move one item AND we wanted to keep Mark Up for 3Tier Co from Base Case to Scenario #1 virtually the same percentage.
Vertico is still at $110 to the consumer but now 3Tier Co has dropped their excise tax as that first sale is now cheaper due to input costs being cheaper. 3Tier Co now comes in at $103 or $7 better than VertiCo’s $110 a 6.3% benefit to non vertical.
As you can see the Total Gross Margin ((Retail Sale not including excise LESS Cultivation Costs)/Retail Sale not including excise) increases in Scenario #1 for 3Tier Co. It increases from 65% in Base Case to 80% in Scenario #1… which leads us to…
We think if the input costs change, so should the cost to the end consumer. So, we redistributed $ savings to consumer, while looking to match % Mark Up at each tier to Base Case.
In Scenario #2 we held the Mark Up % virtually the same in the panel to the right as in Base Case panel on the left. We manipulated the Sale $ amounts such the Mark Up for 3Tier Co were virtually the same % wise as the Base Case.
This greatly decreases the Flower Retail Sale, as we allow the cost savings from interstate cultivation to flow throw the entire supply chain. 3Tier Co can now sell that same quality of flower at $62 versus VertiCo’s $110.
3Tier Co now holds a $48 (43%) advantage to VertiCo.
What is the cheapest scenario for a store and/or customer to buy from?
Here is a graphic from late in 2020 on the cost of 3.5 grams in various states.
California retail cost is 58% cheaper than Pennsylvania weed. PA is medical and undersupplied versus demand. The supply demand imbalance is not going to last forever.
The timing of the excise tax may alone impact verticality, but when combined with a lower cultivation source it blasts verticality of the cultivation costs of an MSO who is producing above the cost of west coast suppliers.
And California, Oregon, Washington, and Colorado have a LOT of weed. Those still standing in those markets are lean and efficient.
When interstate hits, and it eventually will (the reintroduced MORE Act has it embedded), it will change the landscape of the vertical MSO’s. They might build “moats” with their brands but the competition for consumer dollars will change the landscape, and interstate commerce coupled with when the excise tax is levied are a drawbridge waiting to come down.
When 75% of a stock price is derived from years five and out… the above will cause a disturbance.