How will cannabis legalisation impact marijuana stocks?
Joshua Warner November 25, 2021 9:28 AM
The marijuana market’s prospects are underpinned by hopes that federal legalisation will happen in the US. But will this happen and, if so, when? And how would it impact cannabis stocks?
How many US states have legalised marijuana?
Cannabis for medicinal use is legal in 36 states and recreational use is legal in 18 states as of November 2021. However, cannabis is still illegal at the federal level.
California was the first state to legalise medicinal cannabis back in 1996 and more have gradually followed over the years, with Alabama being the most recent, as they recognise the health benefits and look to open up research into an area that has been largely off limits.
Recreational use was first legalised by Washington in 2012 and other states have embraced it as they seek to decriminalise the drug and take advantage of the huge business opportunity this nascent market has to offer. New York, New Mexico, Connecticut and Virginia have all signed bills legalising recreational use of marijuana since the start of 2021 alone.
The US marijuana market: a state-by-state affair
The door to nationwide legalisation of cannabis continues to steadily open, but the fact it remains illegal at the federal level means each state has developed its own isolated market as companies are unable to operate across states. For example, cannabis that is sold in a state must also be grown in that same state. For example, marijuana grown in Alabama can only be sold in Alabama and can’t be sent over the border to neighbouring Florida.
The laws and regulations can also vary wildly state-by-state and what is legal in one place is illegal in another. There are only four states that still have a full ban on marijuana, according to DISA. Some states only allow CBD products, others have only decriminalised use rather than legalised it, while some still only allow medicinal use. This has caused a highly fragmented market.
It is the fact cannabis remains illegal at the federal level that marijuana markets are locked-in and unable to move produce over state lines. This has also forced producers to grow in states where conditions are not ideal as they can’t choose an optimal location and distribute across the country in the same way other industries do.
Meanwhile, the lack of backing from the federal government has also prevented vital financial services from participating in the industry. Big banks are unable to touch them as current laws leave them exposed to the likes of money laundering rules and insurance firms have also stayed away, raising the risk profile of the industry and forcing it to rely on cash and investment from elsewhere. The industry also lacks any federal protection when it comes to things like bankruptcy.
US moves closer to federal cannabis legalisation
For many, the question isn’t whether marijuana will be legalised at a federal level, but when.
Whatever poll you look at, there is little doubt that Americans are embracing cannabis and that attitudes continue to warm towards the drug. One survey by Pew Research Centre conducted in April 2021 suggested just 8% of the population believes marijuana should remain illegal across the board, and that the majority (60%) support it being made legal for both medicinal and recreational purposes, with the rest happy for it to be used medicinally.
Plus, it is not a party-specific issue. Data suggests Democrat voters are more supportive of legalisation compared to Republicans, but the majority on both sides are thought to support it. The fact it is not being treated as a blue or a red issue helps the argument for federal legalisation and raises the likelihood that it will happen eventually.
The fact proposals have been put forward by both sides of the House to legalise and tax marijuana at a federal level is encouraging, with Democrat Senate majority leader Chuck Schumer spearheading draft proposals earlier this year and Republican congresswoman Nancy Mace following with separate plans in November.
Although both parties want to get to the same destination, they disagree on the best route to get there.
There is some agreement. Both parties are keen to decriminalise and legalise the drug but allow states to ultimately decide their own laws, and both recognise that the industry needs to be legitimised so they have access to the banking system and the finance needed to grow.
But there are some significant differences that will require compromise. The proposal put forward by Schumer suggested a considerably higher excise tax rate that would hit as high as 25% within five years of legalisation, while Mace suggested it should be as low as 3% by arguing this would ensure the market can remain competitive, especially against the black market that continues to operate in many states that have legalised the drug. Each proposal suggests a different regulatory body takes responsibility for the market, and they both have different views on the way it should be governed, with Schumer pushing for cannabis to be put under the same umbrella as prescription drugs and tobacco while Mace wants it to be in the same basket as alcohol, which isn’t as tightly controlled. It is worth noting that commentators believe Mace’s proposals were put forward as a compromise to Schumer’s bill in an effort to gain more cross-party support.
Plus, the Senate has proven a constant barrier even when the House has been able to come to an agreement. Numerous cannabis bills have passed the House but been blocked by the Senate, where there simply is not enough support to reform marijuana laws. The SAFE Banking Act, which was designed to open up financial services to the cannabis industry, has been voted through the House five times but has never passed the Senate.
Legalisation of cannabis in America: when will it happen?
The US could theoretically legalise marijuana at the federal level as early as 2022 or 2023 if action was taken now, but it is likely to be much longer than that. The appetite and desire is there, but there are a myriad of headwinds that are likely to prevent anything happening soon.
Mace’s proposals have been filed but it is highly unlikely to pass, especially with the clock running down to the 2022 midterm elections. This will provide insight into how big an issue it is for voters, and therefore politicians, heading into the next session. But, as has been the case for years, there are likely to be much bigger issues to campaign on than reforming marijuana laws as the US continues to grapple with the pandemic and the volatile economic recovery.
Barclays threw cold water on the idea that anything will happen so long as Joe Biden is in the White House earlier this month, stating ‘we don't think cannabis will become federally legal in the United States under the current Biden administration’. That would mean no progress would start to be made until 2025 at the earliest, or 2029 if he wins a second term. Biden agreed with the idea of decriminalising marijuana and widening its medicinal uses, but has not been so keen on the idea of fully legalisation. And, even if he has a change of heart, there is still the problem with the lack of support in the Senate.
The consensus is that Democrats and Republicans will eventually agree on a way to legalise the marijuana market at a federal level, but it may be years before that happens.
Marijuana stocks: is cannabis legalisation already priced-in?
Cannabis stocks soared in the week after news broke that Mace was putting forward fresh proposals to legalise marijuana n early November, but quickly gave back those gains and collapsed when Barclays and others threw doubt on it happening anytime soon.
The City Index Cannabis Index, which tracks 20 of the largest cannabis stocks, rallied as much as 17% in the days following news of the proposal, but dropped 18% the week after when expectations were tempered.
This gives an idea of what kind of reaction we can expect to see when legalisation looks to be on the horizon in the future, but, more importantly, it demonstrates how vital federal legalisation is for the marijuana market. The entire industry’s prospects are largely underpinned by the expectation that this will happen, and many would argue that this has therefore already been priced-in.
The fact most publicly-listed cannabis stocks are still in the red makes it harder to gauge a valuation and demonstrates how much value is being assigned to prospects rather than here and now. But even the ones forecast to be profitable this year trade at large PE ratios. For example, Innovative Industrial Properties trades at 56x its forecasted EPS this year, while Canopy Growth trades at 92x.
Plus, in the meantime, it means lofty valuations are being assigned to companies with prospects reliant on something that may not happen. Although we are seeing other opportunities arise – with Germany reportedly considering legalising recreational use and Malaysia having just started to allow cannabis to imported for medicinal purposes – the US is the big ticket prize and, without it, the industry’s prospects look far bleaker for the bigger players that are listed.
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How will US federal legalisation impact cannabis stocks?
Federal legalisation is the door that needs to be unlocked for the marijuana market to take off and, while it is understandable to be enthused about the strong prospect of a major new market opening up, it is more complex and nuanced than thinking every player in the market is a winner.
Legalisation would radically change the market, potentially at a rapid speed, and rewrite the rules of the entire industry. Although many of the major players are already making moves to ensure they are ready to go if and when federal legalisation happens, they can only do so much when it comes to anticipating the eventual compromise both sides of the house will have to make for any such legislation to pass. The devil will be in the detail – and the winners will be those able to swiftly adapt.
But, based on the proposals put forward so far, we can highlight some of the events that will be sparked by federal legalisation.
Bring on the big banks
Big banks have been unable to engage with the marijuana industry due to a lack of federal legalisation, leaving the industry reliant on other sources of finance. Regardless of the contents of any bill that paves the way for federal legalisation, it would have to legitimise the industry and remove those barriers to allow mainstream finance to pump cash into the industry. The same goes for the insurance industry that provides the vital guarantees any business needs to take risk. It is also likely to encourage more investors into the space.
Upheaval of operations
Current rules mean any marijuana legally sold in a state must be grown in the state. This has forced companies to operate on a state-by-state basis and to grow cannabis in locations where there are not ideal conditions, and to create separate distribution and retail networks. However, federal legalisation would change everything. Companies could move operations to grow marijuana in states that offer optimal conditions such as California and then establish national networks to distribute it across the country. They will also have a choice of where to set up shop, allowing the industry to seek states that offer the most competitive costings when it comes to labour and energy, or those that charge lower taxes. This will make the industry far more competitive and should allow them to drastically reduce costs by improving yields and scaling-up.
State vs state competition will intensify
One of the reasons the number of states to have embraced marijuana over the years has steadily increased is because they have seen the benefits in neighbouring states. Those that have managed to tax the industry, attract investment and create jobs have made other states want to get in on the action knowing full well they could be losing out. But, while two neighbouring states can largely co-exist without competing with one another under the current system, federal legalisation will change that.
The removal of state barriers will have consequences. For example, states like Oregon that boast better growing conditions will have a natural advantage over states that don’t, which is likely to attract investment and jobs away from some states that have managed to establish their own industry under existing rules. That, in turn, could see production become concentrated in a handful of states and then shipped to other states where they will be able to undercut local producers. Meanwhile, some states have pricey medical marijuana programmes that could struggle to be sustained if there are cheaper alternatives being offered from over the border.
And some states are worried that the mom and pop industry promoting smaller businesses will unravel if federal legalisation happens because the biggest players will be able to swoop-in and takeover smaller, less competitive rivals to rapidly expand and consolidate.
But, in true American style, this should lead to individual states competing to entice marijuana companies to set up shop using a variety of tools and this will only benefit the industry.
Expect a wave of M&A if federal legalisation happens. The rewriting of the rules will require companies to shift operations around the country and scale up as quickly as possible. Smaller companies and those boasting strong positions in advantageous locations will be ripe for takeovers, while the larger players will be keen to be consolidators. However, no company currently has the scale needed to take the entire US by storm, which means we could even see some mergers between the largest players.
Some of the larger players in the market have already signed M&A deals designed to be triggered as soon as any bill is fully approved, demonstrating the level of confidence but also the caution being paid toward the likelihood that federal legalisation will get the green light.
This could be one area that could be targeted by the details of any bill, with many states and politicians keen to protect smaller businesses and prevent the big boys snapping up all the business. If protections are offered to SMEs in any bill, then they may hold an advantage over the largest players when it comes to navigating the complex regulatory and political channels.
Canadian marijuana stock vs US marijuana stocks
Uruguay was the first country to legalise marijuana back in 2013, but it was Canada’s approval in 2018 that really kickstarted the industry. The result has been that Canadian companies dominate the legal marijuana market.
It is important to understand that the lack of federal approval in the US causes some severe restrictions. A number of large Canadian companies have been able to list on US exchanges because their businesses are legal where they operate, but have been unable to dive into the US market without breaking listing rules in Canada because it is still technically illegal. Meanwhile, a number of US-based companies have become what are known as multi-state operators (with operations in several US states where it is legal), but those that directly handle actual cannabis have largely been unable to list on US exchanges because their businesses are still prohibited at a national level, forcing them to trade Over-the-Counter (OTC). Businesses that avoid physical contact with the marijuana plant, such as Innovative Industrial Properties which focuses solely on properties leased out to cannabis companies, have been able to navigate the rules and list in the US.
With this in mind, the current state of play is that Canadian producers operate in the largest market where marijuana is federally legally, but the US is still the largest market in the world despite being federally illegal. Canadian producers are desperate for the US market to open up as they face increased competition, regulatory issues and supply chain problems in their home country, but are restricted in their ability to prepare for federal legalisation until it actually happens. What this could mean is that Canadian companies will have to tap-into US operators to swiftly capitalise if legalisation happens, but some analysts believe the value will be more attributed to the US firms than their Canadian investors. Companies like Tilray and Canopy Growth have already signed deals to raise exposure to the US market using complex financing deals that will be triggered if legalisation happens.
For now, Canadian companies are the largest in the market, but attention could swiftly move to US companies if the US marijuana market is reformed.
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