Legal cannabis on the skids

California’s legal cannabis industry hopes 2020 will turn out better than last year. Compliant businesses are financially hurting from a vape cartridge scare, excessive regulations and high taxes. Their plight is compounded by a struggle to compete against a dominant unregulated market, where prices are significantly lower and availability is widespread.

Flow Kana, a major Mendocino cannabis company, laid off 20% of its workforce last November, while Sonoma County's Canna Craft followed with a 16% layoff. Eaze, a major Northern California delivery company, fired its CEO and laid off 30 workers last fall.

Medmen, a California chain of dispensaries, has not been paying its suppliers, and may enter into Chapter 11 bankruptcy, according to Grizzle.com. A share of Medmen stock, which reached $6.49 in October 2018, traded as low as 40 cents in late January.

Last March, Sacramento consultant Jacqueline McGowan raised concerns and warned SN&R of several “extinction events” that she said would make 2019 a volatile year for the industry (Read “Cannabis, interrupted,” March 21, 2019.) An extinction event is any law, regulation or enforcement action that could financially harm or destroy thriving cannabis businesses.

As a local cannabis consultant for five years, McGowan combines 18 years of experience as a Wall Street stock broker with an obsessive approach toward research.

McGowan was right on several predictions such as the effects of California's Phase 3 testing and its impacts on manufacturers, an increase in taxes on cannabis and the difficulties of navigating the Track-and-Trace System.

So, SN&R asked her to reflect on 2019 and explain what might be coming for 2020.

Vape cartridge scare

McGowan correctly predicted there would be a health concern caused by vape cartridges. But her specific concern was over lead contamination and its long-term health problems, rather than counterfeit products that made users quickly sick.

“I don't think anyone could have predicted that people would start dying from vaping,” McGowan said.

As deaths mounted across the country without a solution, public reaction evolved from a general concern into what McGowan described as “hysteria at the local level.” Contra Costa County, for example, banned all THC and nicotine vaping products.

McGowan said there will be new legislation at the state level as well.

“We will see no less than 12 anti-vaping bills at the Capitol this year,” she said. “It needs to be addressed, but through regulations, not from banning.”

According to McGowan, the cannabis industry will be on the defensive, fighting off different types of bans.

“It's a reality that we could see an entire vaping ban in the state, and that would wipe out a good amount of manufacturers,” she said.

Under such a ban, Sterling Harlan, founder and co-owner of Silverstreak Solutions, estimated that his Sacramento delivery service would lose 10% of its sales.

“The vaping market would shift to the black market, only making the situation more dangerous,” Harlan said.

McGowan is still concerned about lead leeching out of cheap vape cartridges. “It has not been seriously studied,” she said. “We are testing oil for what's going into the cartridge, but not for what's coming out of the cartridge.”

Advocating for a test that the United Kingdom mandates for e-cigarettes, McGowan said that testing “vapor emissions,” instead of contents, would give a more accurate result. If any leeching were to occur, an emissions test would reveal that.

The ‘Track-and-Trace’ System

All legal cannabis sales in California are monitored through computer software that tracks and traces the life of a product to its final sale. In 2019, California began to phase in METRC, a complicated tracking program using radio identification tags. Dispensary workers needed a special designation as “account managers” before being trained to use the software.

Last year McGowan correctly predicted that the statewide scale-up of METRC would cause problems, due to its input-intensive requirements.

By last November, 407 cannabis businesses had not even signed up for training, and the state temporarily suspended their licenses. No sales or transfers of cannabis products were allowed until they came back into compliance.

More METRC compliance deadlines are approaching in 2020, and a new round of suspensions could happen.

“The people who started last fall are doing fine,” McGowan said. “The people just starting now are not.”

Proposed tax changes in 2020

Meanwhile, California's unregulated market, the largest cannabis market in the world, had a stellar year. With no taxes to charge, small overheads and lax law enforcement, unregulated vendors cashed in on hidden “sesh” markets throughout the state.

“Everything's going good right now, so I'd rather you didn't write about us,” said a local vendor who also asked to remain anonymous.

“Under the current tax climate, legal businesses are barely turning a profit, and most are operating at a loss,” Harlan said. “Simplifying the tax structure should be combined with lowering and eliminating some taxes.”

Harlan suggested eliminating the tax on cultivation is a good place to start.

McGowan also believes tax relief is the most effective way to help legal businesses.

“The regulated market cannot compete with the illicit market on price point,” she said. “If it cannot compete with a market that is three times its size, the only thing that would work is an elimination of taxes.”

In some California cities, the total tax on legal cannabis products can be as high as 40%. McGowan wants a one-year holiday on all taxes, so that the legal market can strengthen itself.

“Most important of all is tax reduction,” said John Oram, CEO and founder of NUG brand cannabis products. “We are getting that [from proposed legislation], but what we are actually getting is a shift of the excise tax from the wholesale transaction to the final sale to the consumer.”

Oram went on to explain that, under the proposed changes, consumers would see the tax broken out as a line item in their receipt.

“This will allow the consumers to better understand just how outrageously high the tax is,” Oram said. “Ultimately, I believe it will create the political will to fix the tax issues.”

McGowan said that's possible, but it's more likely that California legislators will shift to a “potency tax.” While nobody knows exactly how a potency tax would be implemented from one cannabis product to another, McGowan said that because tax rates would be calculated by the milligram, legislators might allow higher potency edibles to be sold.

Surviving the future

According to McGowan, vertical integration (owning the product from inception to final sale) makes businesses more likely to succeed. But she cautions that some cannabis businesses will still fail because there are too many of them.

“We don't need one distributor, one manufacturer and two cultivators for every one retailer in the state,” she said. “That's not sustainable, so those numbers are going to dwindle.”

In addition to tax relief, Oram said that “streamlining the permit process, limiting local control and enforcement of the illicit market are the most important changes required to keep the industry viable.”

McGowan summed up the legal market like this: “It's a game of musical chairs, but instead of chairs, there are bags of money, and every time the music stops, an operator is no longer in the licensed market.”