California's Marijuana Industry Is a Mess, New Data Shows

On the surface, the marijuana industry looks like the greatest thing since sliced bread to hit Wall Street. We're talking about an industry that's been collecting tens of billions of dollars under the table for decades and is now stepping into the light of legality. After generating $12.2 billion in worldwide revenue in 2018, some Wall Street investment firms foresee legal weed sales hitting up to $75 billion a year globally by 2030.

Last year, we witnessed a number of firsts for the green rush. Canada lifted the veil on nine decades of adult-use prohibition by becoming the first industrialized country to legalize recreational marijuana. We also saw a handful of U.S. states wave the green flag on medical cannabis, and California, the fifth-largest economy in the world by gross domestic product, open its doors to adult-use consumers.

Superficially, everything should be going well for the marijuana industry. Unfortunately, that's not the case. Supply-side issues have constrained sales in Canada, while California's marijuana industry is an absolute mess, according to new data from the state.

California's pot industry is a disaster in the early going

Last week, the office of Gov. Gavin Newsom (D-Calif.) released state budget documents showing that his administration has cut cannabis tax revenue projections by a whopping $223 million through 2020. Mind you, California has already reduced expectations for cannabis tax revenue on numerous occasions.

The latest budget documents, according to USA Today, call for $288 million in excise tax revenue from cannabis in fiscal 2019, and $359 million in fiscal 2020. Just for some context, estimates in 2016 following the passage of Prop 64 were calling for more than $1 billion in annual excise tax revenue not long after the full ramp-up of the industry. Thus, California's marijuana industry isn't even living up to a third of its long-term potential, according to these new state projections.

How could such a blatant miscalculation by state regulators be possible? Three reasons.

First, regulatory red tape is making life in the Golden State difficult if you're a cannabis business. The state has been slow to review and approve retail and distribution licenses. There's been little issue getting supply in place, but growers have struggled to get what they have grown into dispensaries in California.

The second problem is that California is absolutely taxing the daylights out of its consumers. Aside from having the highest base sales tax of any state in the country, California imposes a 15% excise tax on recreational weed, as well as a cultivation levy of $9.25 per ounce on cannabis flowers, or $2.75 per ounce on cannabis leaves. All told, consumers could be on the hook for an aggregate tax of up to 45%, depending on the city. These added costs make it really difficult for legal channels to compete with the black market.

And thirdly, blame the black market. Illicit growers don't have to wait for sales permits or cultivation licenses, won't pay an excise tax, and won't have to cover state income taxes on their under-the-table profits. The cannabis black market has been around for a long time, and it's going to take aggressively low tax rates to reduce its stranglehold on California's cannabis market.

California's woes could hit these marijuana stocks the hardest

In terms of sheer sales potential, California is still the cannabis king. But given the amount of premium already priced into the industry by Wall Street and investors, these early-stage hiccups could be bad news for pot stocks with a clear focus on the California market.

Origin House (NASDAQOTH: ORHOF), which is in the process of being acquired by vertically integrated multistate cannabis company Cresco Labs in an all-stock deal valued at $823 million (when announced), would be one candidate to take it on the chin. Origin House has been actively acquiring companies with cannabis distribution licenses in California and is angling to become a niche middleman. However, with the black market remaining more dominant than expected, the amount of legal weed working its way from licensed producers to dispensary stores should be lower than forecast. That's potentially bad news for Origin House's bottom line, and Cresco Labs, which is paying a king's ransom to acquire Origin House.

Another possible loser is upscale cannabis dispensary operator MedMen Enterprises (NASDAQOTH: MMNFF). Even though MedMen is best known for its California dispensaries generating sales per square foot that are on par with Apple stores, the company's preliminary third-quarter sales hint at a sizable slowdown. MedMen notes that organic sequential sales growth for its 10 Southern California locations (open during the fiscal third quarter) was a meager 5%. That's not great news for a multistate dispensary operator that's been losing money hand over fist.

Long story short, California is going to have to get serious about adjusting its tax policy if it has any chance of uprooting the state's mammoth black market. Until we see serious tax policy changes, California could be more trouble than it's worth to investors.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Origin House. The Motley Fool has a disclosure policy.