Slowly, but surely, cannabis is emerging from the shadows. Although the industry has undergone its ups and downs that are not uncommon among young, high-growth industries, it’s a sector that is here to stay. In fact, cannabis is forecasted to be one of the fastest growing industries worldwide over the next 5-10 years. According to market research firm BDS Analytics, the global legal marijuana market size is expected to reach roughly USD 20 billion in 2020 and climb to almost USD 50 billion by 2025, growing at almost a 35% CAGR from 2018. Fueling this growth is a global increase in the legalization of cannabis for both medical and recreational use. We should caution, however, that timing and potential market size is very difficult to determine given the impact politics will have on the industry.
Today, the US is the largest legal cannabis market with an estimated USD 12.2 billion in sales last year. According to BDS Analytics, that number is expected to grow at almost a 23% CAGR from 2018 to almost USD 35 billion in 2025. Driving this growth will be a vast majority of states having at least a medical cannabis program during this time period with almost half expected to begin legal adult-use cannabis sales by 2025. When looking at individual states, California actually has the largest legal marijuana market in the world with over USD 3 billion in sales last year. However, California’s legal cannabis industry has faced numerous challenges since legalization took effect, including a lack of access to capital, heavy tax and regulatory burdens and a large illicit market, which is estimated to be close to USD 10 billion.
Canada, where cannabis is legal for both recreational and medicinal purposes, is the second largest market in the world with close to USD 2 billion in sales last year followed by Europe and Latin America. Within Europe, Germany and the UK are the market leaders while almost 80% of legal cannabis sales in Latin America are attributable to Mexico and Uruguay, the first country in the world to formally legalize the cultivation, possession, acquisition and consumption of cannabis and its by-products.
Cannabis refers to the plant family that has three primary classifications: indica, sativa, and ruderalis. For this report we only focus on the first two as ruderalis plants are small and yield relatively little in the way of cannabinoids. Cannabinoids are naturally occurring compounds found in cannabis that mimic compounds produced in the human body. The most well-known among these compounds is the delta-9-tetrahydrocannabinol, or THC, which is the main psychoactive ingredient in cannabis. Indica and sativa plants differ not only in their physiological effects, but also in their appearance. Marijuana is a member of both indica and sativa while hemp is only a member of the sativa family. As such, cannabis is most often used as an umbrella term to describe both hemp and marijuana.
Hemp plants are part of the cannabis family. While hemp and marijuana are close relatives, it is important to note the differences between the two. Hemp is non-psychoactive and contains no more than 0.3% THC, the psychoactive compound that is found in higher concentration in marijuana. On the other hand, hemp naturally has higher levels of CBD. In fact, hemp-derived CBD is fast becoming one of the most popular forms of CBD on the market today. Finally, hemp plants are almost always cultivated outdoors, as opposed to marijuana plants, which are typically planted in a greenhouse or other indoor type of setting.
The 2019 Farm Bill legalized the cultivation of hemp production in the US, which has led to many more farmers turning to hemp farming. Hemp, which is the strongest natural fiber in the world, can be used to make items including paper, clothing, food, furnishing fabric, rope and building materials. The whole hemp plant, from stalk to seed, can also be used to make fuel and feedstock.
Marijuana also belongs to the cannabis plant family and is a term used to classify varieties of cannabis that contain more than 0.3% THC. The plant can contain up to 30% THC content, although you can also find other cannabinoids in varying amounts. Unlike hemp which is typically grown outdoors to maximize its size and yield, marijuana is selectively bred in controlled environments that are designed to optimize the breed’s characteristics and produce female plants that yield budding flowers.
CBD, short for cannabidiol, is a natural compound found primarily in the flowers and leaves of the hemp plant and is one of over 80-plus cannabinoids that can be extracted from hemp. While CBD lacks the intoxicating effects of THC, it has been purported to have therapeutic benefits, including pain relief, anti-inflammatory properties and a decrease in anxiety to name a few. In fact, the US Food and Drug Administration approved a CBD treatment for epilepsy under the brand name Epidiolex in 2018 June.
While the Farm Bill legalized hemp production in the US, it only cleared the way for hemp-based CBD to be included as an ingredient in a range of non-food products. Nevertheless, the retail market has been flooded with CBD-infused products including tinctures, snack bars, beverages, oils and pain-relief salves. CBD products have become quite popular in the US. According to BDS Analytics, CBD sales totaled USD 2.6 billion in 2019 and are on pace to reach USD 18 billion by 2024.
Worldwide legal cannabis industry expected to reach almost USD 50 billion by 2025
In USD billions
According to a recent poll by Quinnipiac University, 93% of American voters support the legalization of medical marijuana. The medical community, meanwhile, has increasingly begun to acknowledge the therapeutic properties of cannabis. In February 2019, the World Health Organization recommended that cannabis and its key components be rescheduled under international drug treaties after an analysis of their epidemiological, pharmacological, chemistry, toxicology and therapeutic impacts. Since California voters enacted Proposition 215 in 1996, which permitted marijuana to be used for medicinal purposes, 32 other states followed suit in addition to another 13 states legalizing the use of cannabis oil with some level of THC.1
More recently, recreational use of the drug has been the subject of widespread debate in the US. Advocates argue that state governments stand to benefit from the tax revenue generated by the regulated sale of cannabis-related products. Opponents contend that the consequences for public health and safety far outweigh the fiscal benefits. A recent Pew Research Center survey shows public opinion on the legalization of marijuana has continued to increase over time.2 This positive trend in public opinion has driven the approval of 11 states and the District of Columbia for the use of recreational marijuana.
Currently, a total of 33 states, as well as the District of Columbia, Guam and Puerto Rico have legalized medical cannabis. Of those, 11 states plus the District of Columbia have also legalized cannabis for adults 21 and older. Nationally, more than three million patients have registered with state medical cannabis programs. We expect legalization measures to remain politically topical as a number of measures are on the ballot this November—adult use in Arizona, Montana and New Jersey, medical use in Mississippi, and both in South Dakota. According to BDS Analytics, if all of these proposals pass they will push the population in medically legal states to 241.1 million (71% of the country) and the number of adults in adult-use legal states to 83.3 million (34% of the country). We should note that Pre-COVID, it appeared that citizens in as many as 12 states would have had the opportunity to vote on medical or adult-use cannabis this November. Unfortunately, the inability to gather signatures in person put on hold some ballot initiatives.
In regard to federal legalization, marijuana remains an illicit substance at the federal level. It has a Schedule I classification meaning that it's entirely illegal, considered prone to abuse and not recognized as having any medical benefits. Companies that sell a Schedule I substance are subject to Section 280E of the US tax code, which keeps cannabis businesses in legalized states from taking any normal corporate income-tax deductions except for cost of goods sold. As such, this results in very high effective tax rates for profitable cannabis companies compared to other businesses.
Passage of the STATES (Strengthening the Tenth Amendment Through Entrusting States) Act could alleviate these issues. Introduced by Senators Warren and Gardner in 2018, this piece of bipartisan legislation would end the federal enforcement of prohibition in states that have reformed their marijuana laws.
Perhaps a bigger issue with cannabis's Schedule I classification is the lack of access to traditional forms of financing. Federally regulated financial institutions are reluctant to provide credit lines or loans to these types of businesses as it could lead to financial and/or criminal penalties. Some businesses can't even gain access to a checking account. However, progress is being made on this front. Late last year the Secure and Fair Enforcement (SAFE) Banking Act became the first standalone marijuana bill to be passed by a House floor vote with strong bipartisan support. The bill would enable banks to offer loans and other banking services to marijuana businesses, including contractors and vendors who never touch the plant, as well as provide access to US capital markets. However, the bill is currently languishing in the Senate due to opposition from Banking Committee Chairman Mike Crapo, who may look to introduce his own bill to address some issues he sees with the House version such as potency and restricting use among young people. Nonetheless, there does appear to be growing support from Senators willing to pass the bill and the lead sponsors of the banking bill from both parties in the House are pushing to put the bill up for a vote. Although the election outcome in November could lead to the passage of marijuana reform in both chambers of Congress, it is more likely that pressure from legalization on the state level could force Congress's hand.
As a Schedule I substance, cannabis is not allowed to be transported between states, even if those states border one another and both have legalized the substance. As such, cannabis companies that are vertically integrated, multi-state operators are required to establish duplicate operations in every legalized state that they operate. For example, one multi-state operator, which has a presence in 19 states, needs to also open processing sites and cultivation farms in each of these states to control the seed-to-sale process. Needless to say, this will not help the company achieve profitability.
Case study: Colorado
As the first state to legalize adult-use cannabis in 2014, Colorado has put the tax revenue generated to good causes such as public health, education and infrastructure. Medical and recreational cannabis sales hit a record USD 1.75 billion in 2019, up 13% from 2018, according to the state's Department of Revenue's Marijuana Enforcement Division. Since recreational sales began in 2014, Colorado marijuana sales have reached USD 7.79 billion and the state has generated over USD 1 billion in tax revenue from the legal marijuana industry. During the COVID-19 pandemic, recreational sales of marijuana have set records in the state with monthly sales eclipsing USD 150 million for the first time in June. In fact, combined recreational and medical sales in Colorado are on pace to easily exceed last year's level.
US public opinion on legalizing marijuana
The cannabis market and economic impact
According to Arcview Market Research and BDS Analytics, the US legal cannabis industry is projected to total roughly USD 16.3 billion in 2020, although total cannabis demand in the US is estimated at roughly USD 75-100 billion when including markets served illicitly. For the most part, the cannabis industry has been highly fragmented with small players on a state-by-state basis. However, over the past few years as more states have legalized the use of cannabis, we have seen the rise of multi-state operators (MSOs) that are typically publicly traded and have more access to capital. These companies have significant advantages over single-state operators as they own cultivation facilities, extraction/processing facilities and retail venues. Multi-state operators are typically structured as holding companies with separate state subsidiaries that hold state licenses for seed to sale activities. Although these companies are unable to bring cannabis and cannabis-derived products across state lines, they can share intellectual property, equipment, branding and employees across states.
State governments generate tax revenue from various sources. The most important are the personal income tax and the statewide sales tax, although the relative importance of each varies by state. The remaining third of state revenues, in the aggregate, are derived from various sources including federal monies and other taxes and fees, including those assessed on the purchase of cannabis.
Broadly speaking, states typically tax cannabis products in three ways: 1) percentage of price, 2) weight, and 3) potency. These taxes can be levied on the cultivator/wholesaler, the consumer or some combination of both. It is also common for states to charge a general statewide sales tax in addition to allowing local governments to tack on a local tax, which is generally capped at a certain percentage of sales.
Only a small number of states levy taxes on medicinal marijuana and such revenue generally accounts for a small portion of overall revenue. We've focused our analysis on the states that have legalized adult and recreational usage as these states account for a majority of cannabis tax revenues.
The tax methodology differs from state to state, but the resulting revenue still accounts for a very small percentage of state revenue (typically less than 1%). That being said, legalization of recreational marijuana is still a relatively new trend and it often takes state governments several years to establish a permitting regime and thereby generate revenue. Total marijuana tax revenue has increased every year since Colorado first started collecting recreational taxes in 2014.
The Institute on Taxation & Economic Policy forecasts that legalizing recreational cannabis in every state and applying levels of Washington State's taxation could generate USD 11.9 billion in state and local consumption tax revenue per year. Though sizable, this estimate is the equivalent of less than 1% of state and local tax revenues nationwide or in between 2016's collection of excise tax on alcohol and tobacco products of USD 7.3 billion and USD 18.4 billion respectively.3
States have legalized cannabis usage and sales via both voter initiatives as well as through legislative means.4 Despite public opinion positively transforming over the last 40 years, many local governments are still resistant to local sales fearing detrimental social effects, resident opposition (not in my backyard), and potential legal backlash.
Complicating matters, many states instituted additional levels of governmental control allowing for or prohibiting operations within a given town or county. Though California legalized recreational marijuana in 2016, local governments were required to "opt in" allowing cannabis business to operate within its boundaries. Currently 70% of the Golden State's localities still prohibit its operations depicting a possible cause for the state's large illicit market as compared to its peers.5 Massachusetts and Michigan have also faced resistance with a majority of their local governments banning cannabis sales. To incentivize local government participation, certain states have authorized for a local level tax.
As part of the approval process, it is common for lawmakers to earmark, or set aside, funding for various spending initiatives. It's customary for revenues to first be directed to cover administration and implementations costs of the program. Net revenues are then disbursed in each of the various states. As one would imagine, the earmarking is often a political endeavor which aids in the legalization process.
The Tax Foundation forecast that COVID-19 will cost states an estimated USD 121 billion over the next two years with other experts such as Moody's forecasting a higher range of USD 275 billion.6 Similarly, the National League of Cities is also projecting sizable revenue losses of USD 360 billion over a three-year period.7 With these types of revenue shortfalls, balancing budgets is going to become a more challenging endeavor, leading legislators to seek new sources of revenue to support expenditures.
Recently reported statistics are showing that more consumers are seeking legal ways of attaining cannabis products fearing the coronavirus contagion affiliated via the illicit market. The increased anxiety related to pandemic worries coupled with relaxed operation rules including delivery and curbside pickup are expected to drastically increase sales this year.8
Combining the need for additional revenue with positive public opinion trends, we anticipate further advancements of the legalization and taxation of cannabis products in the remaining US states. Diminishing governmental revenues will likely accelerate these discussions despite historical political opposition. Regardless, we continue to believe that these revenues will continue to account for only a small portion of state and local government revenue bases.
In addition to tax revenue, legalized cannabis also offers the potential for jobs. According to Leafly, a cannabis publication, "Massachusetts has more legal cannabis workers than hair stylists and cosmetologists. Nevada has as many cannabis workers as bartenders. Illinois has twice as many cannabis workers as meat packers." Over the 2018-2028 period, job growth in legal cannabis is expected to climb 250%, by far the fastest job growth sector in the US.
Cannabis has been broadly deemed an essential service during the COVID-19 pandemic, with states offering this designation including California, Delaware, Illinois, Maine, Maryland, Michigan, New Jersey, New York, Oregon, Pennsylvania, Washington, and DC. Also, several states have liberalized how patients and consumers access their cannabis, permitting curbside pickup and delivery when these were previously not allowed. Not surprisingly, cannabis sales have soared as shown in Illinois, which commenced recreational use sales earlier this year. In the first six months of the year, the state gained about USD 52 million in tax revenue—easily exceeding its estimate for the first half of USD 28 million. Sales then eclipsed USD 60 million in July, setting a new record for the state, topping May and June, which also set records.
US cannabis industry employment estimates
Takeaways for investors
At the present time we are unable to provide investment recommendations within the cannabis industry as marijuana remains illegal under US federal law. Financial institutions in the US are required to follow anti-money laundering regulations and are forbidden from making transactions involving proceeds from federally prohibited businesses. As such, Canada has become the leading financial market for the industry since the country legalized recreational use and most cannabis stocks are listed on Canadian exchanges. However, there are a few instances of publicly traded companies in the US that have invested in cannabis businesses.
Cannabis legalization is going to remain a hot-button topic, and we plan on closely monitoring and providing insight on this fast growing and rapidly changing industry. It’s our opinion that we are likely to see changes at the federal level sooner rather than later, especially given potential tax revenue generation. In fact, the House of Representatives is set to vote on the MORE Act by year end, which would officially remove cannabis from the list of federally controlled substances. According to the bill’s text, it would also expunge federal marijuana convictions and arrests, and approve the allocation of resources for communities affected by the war on drugs. A Democratic sweep in November’s elections could usher in changes even faster than expected, and we believe that investors need to stay informed on the topic.
With President Joe Biden inaugurated and the 2020 election cycle complete, our focus now turns to the new administration’s policy agenda and what it means for investors’ portfolios. For our current views throughout this presidency, visit ubs.com/cio-potus46.
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