- The announcement last week by the department of Health and Human Services (HHS) that it is now recommending the rescheduling of cannabis from schedule I to III, marks a significant inflection point for federal cannabis reform. The timing of the Drug Enforcement Agency (DEA) approval is unknown but could be centered around next year’s presidential race.
- Even though cannabis remains illegal at the federal level, it has been a de facto industry for years, with a myriad of forces that have affected its profitability. Since 2014 when the legalization of recreational use cannabis was introduced in Colorado, billions of dollars have been deployed into the sector. Additionally, the economic benefits that have been realized over the years is significant and public support in favor of cannabis reform remains strong. For these reasons alone, we think the federal prohibition on cannabis will eventually end.
- Nonetheless, there remains several unanswered questions as to how the industry will ultimately be regulated given the widespread acceptance of recreational use cannabis and its existence, alongside a new path for medicinal applications. The investment risk associated with this uncertainty has not been thoroughly alleviated by this news, and due to the inherent complexity of this subject matter, some statutory ambiguity may continue for some time before a final consensus becomes prevalent. It is possible that a “new set of rules” will apply opening the doors for Big Alcohol and Tobacco in addition to Big Pharma.
With the eventual participation of Big Pharma, we continue our belief that medical marijuana (as it exists today) will be recalibrated and redefined as the pipeline of new, more targeted medicaments become available with precise dosage and efficacy guidelines.
- We believe there will eventually be a tipping point as the medical profession gains more comfort in “pushing” a targeted marijuana treatment (Schedule III) rather than a patient having to “pull” a recommendation. At this juncture, we think it likely that existing medical and recreational use markets will combine with regulatory oversight under one regime, quite possibly in similar fashions as alcohol.
Until such time as Schedule III cannabis medicines become commercially available, we expect state regulated markets to continue status quo. We expect the industry as a whole to move.
forward at a steady and deliberate pace guided by a continued patchwork of federal reform measures that include:
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Near-term
1. SAFE Banking Act which provides protections for depository institutions that provide financial services (includes lending) to legal cannabis businesses. Additionally banks could ease restrictions on lending. This month a Senate Committee vote is expected and could even be brought to the floor by year end. (passed in the House on several occasions but stalled in the Senate). Passage of this bill mitigates some level of operational risk for the industry and could provide badly needed liquidity for many smaller cannabis businesses that are struggling for survival.
2. A Garland Memo (update to Cole Memo) which could address interstate commerce, up-listing of securities on major exchanges and other nuances.
Longer -Term
3. PREPARES ACT (drafted in both the House and Senate) to “engage on cannabis reform by creating a fair, honest, and publicly transparent process for the federal government to establish effective regulation to be enacted upon the termination of its 85- year prohibition of cannabis”. This could include a national protocol on product testing and packaging, driving impairment testing and other areas that impact public safety.
4. STATES Reform Act (Rep)/MORE Act (Dem) – Both versions would essentially decriminalize cannabis at the federal level.
NEAR TERM EXPETATIONS
Political Posturing Could Determine the Timing of the DEA’s Decision.
The DEA will undergo an extensive review process that includes consideration of the conclusions drawn by The Food and Drug Administration (FDA), which is an agency of HHS. The U.S. Attorney General (AG) ultimately approves any modification to the Controlled Substances Act since the DEA reports to the AG. Timing is unknown but a decision could come as we get close to next year’s presidential election. From that point, there is a public comment period before the CSA classification officially moves to Schedule III.
Schedule III will eliminate IRS Section Code 280E for cannabis companies.
In general plant touching businesses are precluded from deducting normal operating expenses in the determination of net income. The ability to subtract these costs will significantly improve cash flow profiles throughout the industry. The lost 280E tax revenues could ultimately be replaced with a federal excise tax which we estimate could be in the range of 10% – 12% of retails sales as we illustrate below:
A LONG TERM VIEW
(Excerpts from “The GreenWave Report: The State of the Emerging Marijuana Industry – Current Trends and Projections.” October 2014)
Combing Existing Medical and Recreational Use Markets.
While the first stop on the road to reform is rescheduling, we do believe that eventually full legalization will occur that will serve to not only provide universally clear standardization but will in most probability merge the medical and recreational use markets. Once Schedule III products become available, the existing medical marijuana process (i.e., obtaining a card etc.) becomes irrelevant.
Since “chronic pain” (loosely defined), is the most common ailment among medical marijuana users it is more likely that this consumer sector will amalgamate with recreational users who can readily purchase marijuana without great difficulty (in legalized states). Accordingly, it can be argued that this merged market already exists in medical marijuana states.
As an example, if we look at Colorado, which some consider the cannabis industry bellwether because it was the first state to legalize recreational use. As the chart illustrates, medical sales are shadowed by recreational use; the number of cardholders has also fallen. We note similar states in every other state that has maintained a bifurcated med/rec market. (Some exceptions during the COVID pandemic).
Pharmaceutical (“Big Pharma”)
Medical marijuana is perhaps considered a low-cost substitute by the pharmaceutical industry for some of its existing drugs and for obvious reasons, is threatened by the possibility of widespread legalization (i.e., marijuana may become more popular among patients to treat qualifying conditions). Big Pharma has lobbied heavily against marijuana reform in the past, though the tide is turning. One example is Pfizer, which announced in 2021 its $6.7B acquisition of Arena Pharmaceuticals, a biotech company that is developing cannabinoid-type therapeutics.
However, like any other prescription medication on the market, a rigorous (and costly) review process by the FDA is required. This could result in substantial delays in the implementation of legislation intended to make marijuana and derivative products more expediently available to the public.
A decision to manufacture and distribute marijuana products could dilute Big Pharma’s existing profitability. With no experience cultivating in mass quantities, it may find it necessary to partner with an industry that has expertise.
Because the tobacco industry is in the decline, we think it could make sense from an economic standpoint for a strategic partnership or takeout. However, we believe the social issues associated with such a combination would draw pushback from various activist groups, politicians and the general public. The reason we think is obvious – cigarette smoke has contributed to many deaths and illnesses and Big Pharma has made billions of dollars selling drugs to treat these conditions.
Alternatively, the agriculture industry could be considered as a partner because it can provide scale and intrinsic expertise. In the event Big Pharma finds a way to economically source marijuana, then it still faces the task of developing new products which will be subject to the same protocols followed with any other drugs Seeking FDA approval. These protocols involve an ability to demonstrate the manufacture of consistent dose and potency level — this is difficult with marijuana in its original state because it involves dry flower that is smoked.
As we have discussed in the past, other marijuana products could possibly meet these requirements. If legalization does require oversight by the FDA, regulations might resemble those states which only allow consumption through vaporization or edible products – this could make the FDA approval process less cumbersome.
In addition, clinical trials are very expensive, and payback occurs when a drug is approved and has patent protection – an existing plant such as marijuana cannot be patented. If a plant is genetically engineered, then the possibility exists that Big Pharma could step in – but, even if it could, it doesn’t suggest that it would – potential profitability would make that determination.
If Big Pharma were to walk away, its desired end result would be achieved naturally in the marketplace. That is, if the FDA cannot find an alternative to satisfy its manufacturing and distribution requirements, the market for medical marijuana goes away which is exactly what we think Big Pharma wants. The likelihood of a new entrant into the marijuana industry, under an FDA framework, is remote because of the high barriers to entry.
Alcohol
Likewise, liquor companies oppose adult use marijuana reform because they too fear a loss of market share. However, we would argue that the two products are not mutually exclusive – many consume both alcohol and marijuana concurrently. Arguably, there are some who will prefer one over the other and make the switch completely – rightly so, this is what concerns the alcohol industry. Existing companies in this sector may reasonably be expected to find their own entry paths into the marijuana ecosystem. We have observed this dynamic in Canada with Constellation Brands investment in Canopy Growth, as one example.
Eventually, the federal government could regulate the manufacturing and distribution of marijuana, in a manner similar to the alcohol industry, through its Bureau of Alcohol, Tobacco, Firearms and Explosives and the Alcohol and Tobacco Tax and Trade Bureau.
Tobacco
The tobacco industry is becoming less significant as consumers have become increasingly more aware of the long-term health risks associated with tobacco consumption. Longer term and drawing a comparison to Philip Morris’s acquisition of Miller Beer, we would not be surprised to see some of the dominant players in tobacco leverage their resources and diversify through acquisition of some of the emerging marijuana companies. We believe that the tobacco industry’s long-term survival is largely dependent upon the success of the marijuana industry. Again, from the Canadian playbook, Altria’s investment in Cronos.