What The Cannabis Industry Can Learn From History

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Includes: BUD, CGC, COKE, CRON, CURLF, CWBHF, PEP, STZ, TAP, YOLO
by: SKK Investments
Summary

We believe cannabis investors can learn two lessons from the history of the alcohol industry: price actions and growth tactics.

Price actions of alcohol companies surrounding the era of prohibition should be a cautionary tale on overvaluation.

Cannabis companies mirror three main growth tactics used by Anheuser-Busch and Coors: vertical integration, innovation, and marketing.

The question now becomes what growth tactics will prove valuable to the company and shareholders.

Alcohol and cannabis stand as perhaps two of the most controversial consumer goods in recent history. After exploring the history of the alcohol industry during the period of prohibition, we found two lessons that could be applied to the cannabis industry.

Price Actions: A Spike and A Crash

The first lesson would be what investors are more focused on: stock price action. It's worth reading this recent article from Barron's, which explains the price movement of alcohol companies during the period surrounding the end of prohibition. Essentially, the stock prices of alcohol companies spiked leading up to it. People were overly excited about the potentially explosive growth of the industry from the (re)legalization of alcohol. Unfortunately, prices tanked shortly after the repeal.

(Source: Barron's)

Before coming to any conclusions, two things are worth noting here:

  1. These so-called "alcohol" companies were literally alcohol companies. Back in the early 20th century, only industrial alcohol companies were allowed to produce consumable hard alcohol in the US. We don't have price actions of alcoholic beverage companies like AB InBev (NYSE:BUD) or Constellation Brands (NYSE:STZ) to do an apples-to-apples comparison with what a pure-play company would've looked like during this time. However, it's worth noting that the price charts of some of these industrial alcohol companies show downward trends before the news of the potential end of prohibition became public. Once the news spread, stock prices hit an inflection point and spiked back up. The general market sentiment most likely drove their prices, rather than something more fundamental and innate to the companies themselves. This explains the pullback in prices once the hype surrounding legalization wore off.
  2. Alcohol companies were diversified in the use of their products. Cannabis companies are much more focused nowadays in the sense that consumers aren't going to be using cannabis oil to oil the engines in their cars. Yes, the hype might be even more exaggerated in pure-play companies, but for individual cannabis companies, the potential to become THE dominant player in a growing industry is actually there. Unlike the alcohol industry after the end of prohibition, when established companies came back into play, the current cannabis industry is essentially a free-for-all. We humbly suggest that a better outlook for the cannabis industry as a whole would be the long-term growth of the alcohol industry after the end of prohibition. The long-term growth post repeal was significant, and major players like Anheuser-Busch and Coors came to dominate the market; Anheuser-Busch became the largest brewer in the US in 1957, 24 years after the ban was lifted.

With that being said, investors should take caution when investing in cannabis in the current market environment. As mentioned in our first article, total sales for Canadian cannabis companies in 2020 are expected to be $2.7bn, while that of US cannabis companies are expected to be $4.8bn. Nonetheless, Canada cannabis companies are valued three times as much as those in the US. This is not surprising considering that Canada was the first to the race in terms of federal legalization.

The current valuation of Canadian cannabis companies is reminiscent of the price spike of alcohol companies towards the end of prohibition. Yes, there is potential for significant top-line growth, but it would be foolish to blindly throw your money into them when there are better alternatives available in the US. Share prices not only reflect the premium that must be paid for their market share in the legal Canadian market but also the premium for the potential federal legalization of cannabis in the US. The latter isn't cheap right now, but the former is irrefutably expensive. Furthermore, the prices most likely reflect the overly optimistic synergies that Canadian cannabis companies are expected to achieve from the legalization of the plant in the US. We believe a US-focused pure-play cannabis company is the best value for investors right now.

Three Crucial Growth Tactics

The second lesson to be learned is growth tactics. There are some lessons to be learned here from Anheuser-Busch, now a part of AB InBev, which has become a household brand in an industry that carries a certain stigma, not unlike the cannabis industry.

Vertical Integration

Budweiser tastes great, but you know what tastes even better? An ice-cold one. Anheuser-Busch started using refrigeration to keep its beers fresh during transportation. The company eventually invested in both a rail car company and a railway company. Although the present form of the company doesn't own any of these legacy companies anymore, it still maintains its vertical integration through a global distribution network that not only distributes its own brand of beers but also distributes contracted third-party brands like that of Craft Brew Alliance (NASDAQ:BREW).

Many cannabis companies, such as Aurora Cannabis (OTC:ACB) and Curaleaf Holdings (OTCPK:CURLF), are vertically integrated. It's hard to say whether vertical integration or specialization is the best strategy due to the fairly young legal cannabis market. However, one of the commonly seen vertical integrations of cultivation and processing makes sense when considering the potential disruption in the supply chain and the significant reduction in transportation volume from dry flowers to oil/concentrates. For example, Curaleaf's recent acquisition of Eureka Investment Partners gives the company access to Eureka's cultivation facility in Salinas Valley, which is in close proximity to Curaleaf's manufacturing facility in Davis, California.

Innovative Products

Anheuser-Busch's famous Budweiser brand of beer originated from a pilsner beer that was brewed in Budweis, Czech Republic. Anheuser-Busch was also the first American brewer to use pasteurization to keep beers fresh, while Coors was the first American brewer to use an all-aluminum beverage can and sterile filtration technique. Anheuser-Busch's vertical integration of rail cars and railways, as well as refrigeration, can also be considered innovations.

So far, for the cannabis industry, there have been plenty of innovative products, but the first one that comes to mind is CBD extraction. With all of the patents surrounding CBD products, including those for pharmaceutical use, and the explosive popularity of the cannabinoid in recent years, CBD extraction can be considered to be one of the most crucial innovations within the cannabis industry right now. Charlotte's Web (OTCQX:CWBHF) even patented a new strain of hemp plant called "CWA2." Scientific corroboration for the potential uses of CBD is still in its infancy, but the cannabinoid has the potential to spearhead the explosive growth of the cannabis industry worldwide.

Another up-and-coming innovation in the cannabis space is aeroponics. Aeroponics is an indoor vertical farming technique that allows crops to be grown with no soil and minimal water use. The roots stay exposed to the environment, and by replacing traditional water with mist, which also contains the necessary nutrients for the plants, aeroponics producers are able to use 95% less water vs. traditional farming techniques and 40% less water vs. hydroponic systems.

(Source: Grow Opportunity)

Cannabis is one of the most water-intensive plants, requiring at least 6 gallons of water a day. To put that into perspective, citrus plants require a little over a gallon and banana plants require about two. Water needs also change based on growing conditions, such as sunshine, temperature, humidity, and wind speed. By growing plants indoors and using mist to water them, the aeroponics system is able to substantially cut cost rising from water use. This will be crucial for companies with cultivation sites in California, which continues to struggle with droughts and water shortages. Aeroponics also yields 300% more yield than outdoor farming. No pesticides are required since the absence of soil prevents contamination from pests and molds.

(Source: Financial Times)

Some companies have already incorporated aeroponics to their cultivation operations. Just Kush, which is 60% owned by Liberty Leaf Holdings (OTCQB:LIBFF), has a production facility with an aeroponics system that recently received its Confirmation of Readiness Notice from the Cannabis Licensing Division of Health Canada. James E. Wagner Cultivation Corp. (OTCQX:JWCAF) has also established itself as one of the biggest aeroponics players in the cannabis space, with a projected annual production capacity of about 69,000 lbs of dry flowers at an average cost of less than $1/gram (vs. industry average of around $2/gram)

"Agriculture is the last of the large industries to really adopt new technologies and business models." - David Perry, CEO of Indigo via the Financial Times

Innovation will be a crucial differentiating factor in an industry that has hundreds of brands to compete against, and cannabis companies that are able to come up with innovative products can be expected to stand out among both customers and potential investors.

Marketing

In order to grow, Anheuser-Busch invested significantly in its marketing campaign, introducing a series of advertisements and giveaways in the late 19th century. The biggest hit for the company was a lithograph print of a painting called Custer's Last Fight, which depicted Lieutenant Colonel George Custer during the Battle of the Little Bighorn. Thousands of prints were distributed to bars as a marketing tactic, and over a million copies were produced in the US, making Custer's Last Fight one the of the most popular paintings during the era.

(Source: iCollector.com)

Similarly, marketing and the resulting brand awareness will be crucial for cannabis companies to stand out among their competitors.

In Canada, where it is difficult to develop brand awareness and marketing due to regulatory restrictions, companies like Canopy Growth Corporation (CGC) has differentiated itself by focusing on educational initiatives and the positive press coverage resulting from them. Cronos Group (CRON) has taken on similar initiatives by using its "Rise, Reflect, and Rest" campaign to educate the public on the different strains of cannabis and their appropriate uses.

Strategic partnerships with established brands (like that of Canopy Growth Corporation/Constellation Brands and Altria Group/Cronos Group) will also play a key role in establishing a consumer base for cannabis companies. PepsiCo (NASDAQ:PEP) and Coca-Cola Consolidated (NASDAQ:COKE) have expressed interest in the cannabis space, but we expect these players to enter the market once cannabis becomes federally legal in the US.

When it comes to marketing, it ultimately comes down to finding creative ways to get your name out there. With cannabis, we expect the next big marketing tactic to revolve around social media, as mentioned in our previous article, due to our current inseparable relationship with the medium.

Closing Thoughts

Mark Twain is often attributed with the quote, "History doesn't repeat itself, but it often rhymes." No two industries will ever be the same, but investors can learn a lesson or two from the alcohol industry and apply that knowledge when investing in cannabis. When looking at the future of the cannabis industry, we have a strong conviction that cannabis will be federally legalized in the US, and we believe it will eventually replicate the success of the post-prohibition alcohol industry.

Investors will have to demonstrate patience and prudence in choosing a company that is fairly valued, with the potential to become a dominant player in the cannabis space. We see a combination of vertical integration, innovation, and marketing to be a differentiating factor in the future.

The big question now becomes where to allocate one's capital at this moment. So far, we like Curaleaf Holdings for its solid growth potential, market position, and relatively low valuation, but we'll continue generating ideas and conducting due diligence to find the best cannabis companies that are poised to take advantage of the massive developing market.

Disclosure: I am/we are long CWBHF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.