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Understanding & Analyzing Vertically Integrated Cannabis Businesses

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May 31, 2020

 

Vertically-integrated cannabis businesses participate in each part of the cannabis market: here's what you need to know to set one up.

  • When vertical integration works, the consumer typically gets a higher-quality, fresher and cheaper product.
  • You own all parts of the supply chain, and therefore control costs along the way, dictate the final price of products, and capture all of the value created from beginning to end.
  • Specialization has its benefits too – like providing a service more efficiently, and typically at a lower cost than competitors. 

Speak to one of our experts to learn if vertical integration is right for you. 

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With cannabis business licensing you have many options such as cultivation, manufacturing and processing, distribution, and retail.  One business model that doesn’t get covered as much though is vertical integration which means operating a business in every vertical.

In this video, we will explore vertical integration for cannabis businesses, the benefits, compare it to specialization and explore how to know if your vertically integrated cannabis business is profitable.

What is Vertical Integration?

Vertical integration is a business model where a company controls a product from creation to distribution to retail where they sell to the end-user.  You may have heard terms like Farm to Table or seed to sale.  Essentially you grow the cannabis, process it, distribute it and sell it to the customer all on your own.

How it is actually implemented in cannabis is not consistent across states.  For example, in Washington state’s recreational market, vertical integration is prohibited, and in New Mexico’s and Florida’s cannabis market, it’s required. 

Other states, such as Colorado and Oregon, allow vertical integration but don’t mandate it.

And sometimes it is not even possible to vertically integrate, especially when certain cities stop licensing for certain license types such as cultivation or retail businesses.

And not everyone is in favor of vertical integration. When vertical integration is allowed, it starts to put pressure on craft growers or small scale businesses that serve specific niches in the industry.  If vertical integration is required, then it pushes out those who don’t have enough capital to start a cannabis empire.

The opposite of vertical integration is specialization, where you focus on one specific vertical and be the best at just that one aspect of the supply chain.  

So the big question remains, should you vertically integrate or specialize in a certain vertical?

Benefits of Cannabis Vertical Integration

Better, cheaper products

When vertical integration is working well, then the consumer typically gets a higher-quality, fresher and cheaper product.  The key term is “working well”, because when there are major inefficiencies in a vertically integrated cannabis business, you have waste and products can cost more.  And if they don’t cost more, the company will run out of money and have to cut certain verticals or close up totally.

Business captures all the margins throughout the value chain

When you own all parts of the supply chain you are able to control costs along the way, dictate the final cost of products, and capture all of the value created from beginning to end.

This can give you a more defensible business and you are not at the mercy of what the general market will charge you for inputs to your business.  

Can control product quality from seed to sale

In the cannabis industry, aside from simply creating a product, it needs to pass testing for a variety of contaminants such as pesticides, heavy metals and other things.

One nuance to understand is that cannabis businesses cannot test any of their products and must get it tested by a third party.

And when you purchase a product from a third party, say you are buying flower to make oil, you typically make the sale contingent on passing testing because you cannot trust anyone on their word that the cannabis is clean and this can eat up precious time in creating your product.

So when you own the entire supply chain, you can have a bit more peace of mind that you will be getting a clean product (if you have good practices) and that you will get a consistent product for your customers to purchase and you get consistent ingredients to create derivative products from.  

Dependable supply availability

The cannabis industry still goes through droughts in product. It’s not a well-oiled business with tons of product and when you hit one of those dry spots, non-vertically integrated businesses get left out of the market because no one will sell them product at a fair price.

So when you’re vertically integrated, you always have a stream of consistent, quality product that you can depend on.  You’re not at the mercy of other businesses selling product to you.  And if you have excess product, you can off-load that to other businesses if that’s permitted in your state or local jurisdiction.

Can be more nimble in operations and product offerings

When you are vertically integrated, you get access to all of the information from cultivation operations to retail customer feedback; and it’s data you can trust because it’s from within your business.  This makes it easier to capitalize on trends in consumer tastes.  

For example, if you see a certain strain is picking up sales, then you can direct feedback to your cultivation team and they can plant more for next harvest.

Or maybe you start to see a trend in a new type of edible or product being sold or pitched to your retail location. You can relay that back to your product development team to explore these options so you don’t have to pick up these items from a third party supplier, lose margins and cannibalize your current product sales.

Lastly, another example is when you start to see prices move earlier in the supply chain such as price per pound increase, you can quickly relay that info up to the retail who can then adjust prices or take other actions on products they can suggest to customers.  

Knowledge is power and vertically integrated cannabis businesses have a lot of it.

Control over product retail price

When you are not vertically integrated, retailers hold a lot of leverage over your brand.  This is especially true when it comes to wholesale price negotiations and terms of payment. 

One aspect to know is that it doesn’t matter if they decide to carry your product, it depends on if they make it actually accessible to the consumer you are targeting.  

Dispensaries price your products to customers so with their markup, it may make your product ‘out of reach’ to certain customers.  Or they may start to charge slotting fees.  

Having direct access to customers is such an incredibly important aspect of the cannabis industry that you cannot overlook.

Attractive to big investors

If going for M&A play with your cannabis business, then vertical integration is attractive to the biggest players in the game.  

Bigger investors want plug and play models that are proven to work and this typically leads them to look at vertically integrated businesses and offer them premiums.  

It’s a headache to build a cannabis supply chain piece by piece, having to integrate teams, systems, financials, licensing headaches and everything else that comes along with business combinations.  

It’s incredibly important that you have excellent cost tracking and revenue attribution systems so you and your business partners can show the profitability of your business overall, each segment, and where the true value lies in the business. 

Make it a layup for the investors to see the value and you have a slam dunk business.

Benefits of Specialization

Provide comparative advantage

This means that you can produce a product or provide a service more efficiently, and typically at a lower cost than competitors.  For example:

  • Cheaper cost per pound
  • Better margins at retail
  • Better yields in manufacturing

When you focus, you can leverage economies of scale to get higher profit margins in just that one vertical that you are the best, or relatively the best at.  

This is not always true, but in most cases, you get to a comparative advantage faster than a vertically integrated business.

Which leads us to the next point.

Potentially Better ROI 

Vertical integration is very capital intensive and it’s quite easy to have waste with a budget that big and vision so large.  

And ROI is directly correlated to how much money you put into the investment, so with specialization, you can deploy less cash to focus on just one vertical. 

And instead of juggling five lines of business, you can focus on crushing it financially in just that one vertical.

This specialization will, again, allow you to leverage economies of scale, capture bigger margins, then generate cashflow to parlay into an acquisition of another line of business.

Less cash outlay, better performance, better returns.

Strategic Acquisition Target

Any business has the potential to be acquired whether vertically integrated or specialized, but it just depends on who your suitor will be.  

With cannabis being federally illegal, companies need to have a footprint in each state they want to compete in.  

That footprint needs to extend to all parts of the supply chain, so yes, cultivators, manufacturers, and distributors can be nice targets to acquire.

But it is well understood that retail operations have huge control over customers.

So big retailers that have high revenues and large customer bases are attractive targets to cannabis multi-state operators (MSOs).

When you’re going into specialization with the intent of being acquired, look at the relative amount of licenses in a market and see which parts of the business could potentially be the most valuable within your exit time horizon.  

You also need to pair this up with your skill set too.  If you can’t keep a houseplant alive, then you probably don’t want to go into cultivation.

Is cannabis vertical integration profitable?

This is going to be an incredibly simplified overview of a very complex process.  Most companies look at consolidated statements and just know if more money is coming in than going out and very few, besides sophisticated operations, take the time to break down each profit center to know where the inefficiencies are.

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Systems are necessary

You may not think this, but cannabis companies need to be incredibly diligent about implementing systems to track every aspect of their business.  

The quality and detail of your accounting and tracking systems directly impact the quality of the data you can analyze.

You will need a detailed cannabis chart of accounts, the ability to code every expense to different cost centers because it is important to separate out direct vs. indirect costs due to IRC 280E.

So before you can assess profitability for each business unit, you need to implement proper systems first.

Start with cannabis retail profitability

You always want to start by looking at the retail level.  This is typically the easiest part to analyze because most companies have this data readily available through their POS system and invoices to purchase products from their other business units and 3rd party vendors.

So you start with pulling in all of your POS data and then assign expenses to each of your dispensaries (if you have multiple outlets).

You need to account for taxes as well because they are the steepest at the retail level. 

Once you have determined the retail profitability, next is to pull apart each vertical which is where it can get quite complicated and messy.

Analyzing each profit center

Each vertical is considered a profit center in your business such as cultivation, processing, lab, distribution and kitchen for edibles.  Each one will have revenues and expenses.

First, you will need to analyze sales at your retail store or stores. 

As you know, each product came from a certain line of business so you want to assign certain sales to each of those profit centers.  So if you sold 1,000 cartridges for $50 each, then $50,000 of sales goes to the manufacturing/lab profit center.  

Do this for each product that you sell that is your own.  Obviously you will not do this for 3rd party products. 

Once you’re able to assign sales to each profit center, you then need to allocate expenses and this is the most complex part.

Allocate Direct Expenses

Direct expenses are easy to assign, but indirect are where it can get complicated because these are expenses that are shared by the entire organization.  We will touch on indirect in a moment, but let’s stick to just direct cannabis CoGS expenses so that we can get your gross margins.

You will need to perform a detailed costing analysis for each product.  These numbers will be the CoGS for each profit center.  

And this is where the detailed expense coding and software really comes into play.  You will need to have costs and yields dialed in so you know the flow of products and how those translate into costs for other units. 

For example, you need to know the cost to produce a pound of flower, but you then also need to understand how much that yields in terms of grams of oil once it gets over to the manufacturing aspect of the business.

Again, this is a very simplified walk-through, but in this step is where it truly pays to have the data captured properly because going back an estimating will only get you an estimate and not exact outputs.

Once you have the sales and the direct expenses, you can now see the gross profit/loss and gross margins for each profit center.

This gross margin is what you use to cover your overhead expenses, things like rent and payroll. 

So let’s dig into that.

Allocate other indirect expenses

Some of these are easy to trace back to the profit center such as rent, utilities, and payroll.  

But other indirect expenses such as advertising/marketing, insurance, professional services, and executive salaries need a reasonable methodology to allocate them properly.  

There are a few ways to do these allocations, but we typically do it based on the relative size of the total revenue for the entire business.  So if cultivation brings in 25% of the revenue, it absorbs 25% of the overhead indirect costs.

Compare the margins of each profit center

Now after you or your external accounting team have plowed through creating this analysis of your vertically integrated cannabis business, you can then see the margins for each profit center.  

This will help you decide which lines of business to keep and which ones to cut.  But cutting is not as easy as just looking at profitability.  You then need to look at synergies between the lines of business.

For example, having an edible kitchen in the back of your dispensary can actually offset some rent costs for space that would have been unnecessary or too much of a burden for the dispensary.  If you cut the ‘unprofitable’ kitchen, you could then make your dispensary unprofitable.  

It’s important to not only rely on numbers, but also understanding how the lines of business interact with each other, their capacities and how their costs and sales relate to each other. 

For example, maybe it is simply a scaling issue within the kitchen; it’s not hitting full capacity. But if it were to hit that threshold, it could then be profitable.  So make a plan on how to bring those production numbers up and execute against the plan.

Get help with analyzing your specialized or vertically integrated cannabis businesses today.

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Post Tags: Business, Finance, Accounting

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