Cannabis and Inflation: down but not out

I have been beating the drum on margin compression for the past year, specifically around the cost side of the equation.  Rising costs traced to more expensive input prices, higher interest rates and supply chain shocks. Unfortunately, the cannabis market is also experiencing price declines limiting a firm’s ability to pass along their higher costs to consumers. 

Happily, inflation is subsiding thanks to moderated prices for energy, packaging, hardware and logistics. As of January 2023, the reported US and Canadian inflation rates were off about 30% from their summer 2022 highs of around 9%. According to Haver Analytics, three-month data to January 2023 indicate that inflation is now hovering around 3.5% per year, the lowest level in two years. Many pundits forecast 2024 to begin with an annual inflation rate below 3%.

Too many CEOs, CEOs & CFOs I speak with believe inflation is now under control. Leaders ignore actual inflation at their peril, for two key reasons:

Wage inflation, a key and inflexible component of a business’s cost structure, has not abated and could easily take off for many reasons.  Today’s labour market remains tight (unemployment is near all-time lows) while unionization is increasing.  And experienced cannabis workers still command a wage premium versus their unskilled peers.

Secondly, capital remains expensive and difficult to come by.  Given the tight labour in the broader economy plus high consumer spending, the Fed & BoC are unlikely to ease up on rates this year.  This means that the cost of capital (in the mid-teens for a typical MSO) will remain at historically high levels going into 2024, at least 6 months longer than previously expected.

If inflation does not fall as anticipated interest rates could even rise. This will further spook already vulnerable financial markets, both from a higher discount rate, which mechanically reduces valuations, and through increasing the risk of recession. Established cannabis markets have already seen a slowdown in growth plus there is a danger that cannabis is more price elastic than other sin products like tobacco, alcohol and gambling.

In this uncertain time, prudent decision makers should heed the 3 Rs:

1. Refocus thinking
Capital and labour costs may prove sticky and in fact rise, further crimping margins.  Inflation needs to get back on the corporate priority list;

2. Retrench to core markets
The race to enter every newly legalized market has led to home runs and strike outs.  Pull out of unprofitable markets and look to reengineer & automate operations to reduce COGS.

3. Revamp product portfolios
Many product line ups are bloated and underperforming.  It’s time to cull the low margin, low velocity SKUs. 

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