Atrophy: gradual decline in effectiveness or vigor due to underuse or neglect
I type this currently hobbled on a walking boot from a torn calf muscle. The only cure for this particular injury is plenty of rest and easing back into activity. One interesting observation is how quickly the muscles surrounding my actual injury have atrophied after only a short period of rest. The phrase “use it or lose it” is often said but rarely understood until the effects are extreme and impossible to ignore.
That exact premise is playing out across the country in various cannabis markets. In many states, the profit pools are decided less by market forces and more by the supply/demand imbalances created by regulatory structures. For example, in states where retail licenses are scarce but production is bountiful - most of the influence and profit accrues to the owners of the retail segment since that is the artificial chokepoint created by the rules (the exact opposite happens in other states that have more retail and less production). The following is a very simplistic overview of what tends to occur in these markets.
EXAMPLE 1: Scare Retail + Abundant Production =
* Retailers have captive customers in their area and thus aren’t incentivized to provide great service. When you’re the only dispensary for 50 miles around you don’t HAVE to be best in class - you only have to be “good enough”.
* Retailers enjoy great margins as they don’t have to pass along lower prices to the customer. There is less competitive pricing threat from nearby stores so they can keep prices as high as the market will accept.
* Producers are locked into competitive battles with one another to get into stores. Price and product differentiation are key to getting into stores so producers become extremely well honed and run lean operations. Only the best survive.
* Producers learn and employ sophisticated sales strategies to make sure they are able to get into stores. Shelf space is at a very high premium so sales teams are very adept.
Atrophy: Retailers in this market suffer atrophy as they get used to above market margins and power. They don’t provide the best prices or service to their customers simply because they don’t have to. How will they respond when there is a sudden influx of retail licenses?
EXAMPLE 2: Abundant Retail + Scarce Production =
* Retailers fight for customers with aggressive pricing, product differentiation and customer service.
* Retailers become very strong at serving their customers and running lean operations. Only the best survive.
* Producers enjoy above market margins and influence. When product is scarce it doesn’t have to be great - only “good enough”. Producers keep prices as high as the market will handle and don’t push other form factors or innovation since they simply don’t need to.
* Producers don’t employ sales teams because the scarcity of their product sells itself.
* And pressure is exacerbated on independent retailers when many of the larger producers in a market are allowed to be vertically integrated.
Atrophy: The producers in this market suffer atrophy in the product innovation and cost side of their business. Why decrease costs or push forward product innovation when you don’t “have” too? Producers in these markets will spend most of their time and energy on increasing production capacity (not necessarily quality) as that is the easiest near term return on incremental dollars invested. Also, since product is so scarce, producers don’t need to invest in a rigorous sales and marketing engine. They will thus have no experience in competitive sales processes. How will they respond when prices fall or new supply comes online?
The above examples are highly simplistic and purely illustrative. However, the point remains that many businesses aren’t ready for shocks due to regulatory changes or competitive pressures. If a company has only operated in one type of environment and all of a sudden the ground shifts beneath their feet - their skillset and experience will prove inadequate to deal with some of these challenges. It's already happening in many states as more production and retail assets start to come online. We are seeing companies face competition in real time like they never had before. These aren’t easy fixes either. You can’t simply change a production facility that was designed one way to produce in a different manner overnight. You can’t wave a magic wand and hire a sales team or change your retail experience to better serve customers.
The good news is that there are operators who have actually fought these battles in other states. We think the best businesses will seek to “future proof” themselves by leaning into the lessons learned from competitive markets and proactively apply them to their own (the alternative is waiting too long until you’re behind the proverbial 8 ball). Right now the market is very concerned about reading the tea leaves in D.C. and attempting to ascertain what the potential impacts may be. Instead of attempting to predict the future - we believe it's much smarter to hedge the various scenarios with smart M&A or JVs so that these various atrophied muscles can be built up with reps.
If companies are able to do that now then they’ll be prepared for the future no matter what twists and turns await. It's not a question of if the markets will get more competitive - it's a question of when. We advocate for companies to embrace the inevitable and build up the necessary institutional knowledge now in order to take advantage of the changes when they occur.