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California's high on its billion-dollar 'green rush'
State voters likely to get a chance to fully legalize cannabis in November.
By Heesun Wee, special to CNBC.com
CNBC.com

California is one of the world's largest diversified economies. From farmlands in the Central Valley to tech hubs including Silicon Valley, the Golden State is a massive economic machine. It boasts the world's eighth-largest economy, with annual GDP over $800 billion. Now the state is working on growing another emerging growth industry: cannabis.

A California measure to allow for recreational adult use of marijuana will appear on the Nov. 8 state ballot. California already allows for medicinal marijuana use. The new initiative would allow adults ages 21 and older to possess, transport and use up to an ounce of cannabis for recreational purposes and would allow individuals to grow as many as six plants.

Democratic Lt. Gov. Gavin Newsom and other supporters of the measure have kicked off a campaign for voter approval of the Adult Use of Marijuana Act in May.

California would join Colorado, Washington, Alaska and Oregon as states that allow recreational use of marijuana. Eight other states also have marijuana measures on their ballots this year.

A cannabis farmer applies fertilizer to a crop of plants in Humboldt County, California.
California's ballot initiative for recreational cannabis use is modeled after efforts in Washington state and Colorado. The California framework would include infrastructure to legalize, sell and tax cannabis like alcohol. It places a 15 percent tax on retail sales of the drug. If passed, the rollout of the adult-use market would add an estimated $1.4 billion in revenues within the first year of a fully operational cannabis market, according to ArcView.

About 60 percent of likely voters say that, in general, marijuana use should be legal, and 37 percent say it should not be legal, according to survey and data released in May from the Public Policy Institute of California.

"If adult-use legalization passes in November, there's going to be a massive increase to the size of the California market," predicts Troy Dayton, chief executive of The ArcView Group, a research firm that specializes in cannabis. "With the prospect of legalization on the helm, we're looking at the total market for legal cannabis in California to grow from $2.7 billion to $6.6 billion by 2020." Currently, the state holds the lion's share of the $5.7 billion industry.

This could open the business floodgates for large-scale cannabis ventures — everything from marijuana cultivation to related ancillary businesses. And the state's cannabis industry could outsize the profits of even Washington state and Colorado, the first states to approve recreational use.

Legalization could also spark the creation of new business models and infrastructure other states could emulate, according to Morgan Fox, a spokesman for the Marijuana Policy Project. "It will also give the rest of the country even more opportunities to see that regulating marijuana works and learn from the best practices being used there," Fox said.

But not everyone supports marijuana legalization and commercialization. "Legalization is about one thing: making a small number of businesspeople rich," according to Smart Approaches to Marijuana, or SAM, a vocal opponent of legalization. The group and other opponents say marijuana is both addictive and harmful to the human brain, especially when used as an adolescent.

A marijuana mecca

From growers to investors, California is an attractive marijuana market because of its sheer size and consumer potential. It's the most populated state, with more than 39 million residents.

In California marijuana remains illegal under federal law. That means if you're a cannabis business owner and want to grow your customer base, you're limited within state boundaries. But California makes creating larger businesses of scale possible because of the market's size in a single state.

"So if you've got an edible company, chain of dispensaries and you're trying to get some economies of scale to be able to lower cost and reach a larger audience, you only have that state to go on," Dayton said. "Having a business here in California, you can, as an individual operator, develop the levels of scale."

From large-scale cultivators to private laboratories devoted to testing medicinal marijuana, cannabis is already looking like big business in some pockets of the state. Some desert towns, like Adelanto and Desert Hot Springs, have permitted for commercial marijuana cultivation in search of tax revenues.

The measure is supported by many associations and groups, including the California Medical Association and Drug Policy Alliance.

"If adult-use legalization passes in November, there's going to be a massive increase to the size of the California market."
-Troy Dayton, chief executive, The ArcView Group
In 1996, California became the first state to allow for medical marijuana use. State voters approved Proposition 215, the law that made it legal for doctors to recommend cannabis to patients.

Some two dozens states now allow for some form of legal marijuana. More state ballot measures in states — including Florida, Maine and Nevada — are slated for this year to potentially ease rules.

In California the weather conditions are ideal for cultivating cannabis outside, while a lot of marijuana is also grown indoors in massive warehouses. The state's marketplace is also known for its decades-long experience developing cannabis strains. Third-generation growers and breeders have some unparalleled knowledge of the plant and of the related regulatory environment compared to other states.

But in the 20 years since legalization of medical marijuana, California's market has undergone growing pains. Few initial rules for the medical marijuana business had frustrated growers, dispensary operators, governments, patient groups and law enforcement officials. There were limited market standards for product safety and quality. There was lack of centralized data and reporting.

In the years since medical legalization, consumers have become more educated and sophisticated about products, and the state's medical market is relatively saturated. Consumers have high expectations for quality, according to ArcView research.

Then, in 2015, Gov. Jerry Brown signed three bills that toughened regulations for medical cannabis businesses and sought standards for documentation and testing. The bills are known as the Medical Marijuana Regulation and Safety Act, or MMRSA for short. Collectively, the legislation also paved the way for medical cannabis businesses to turn a profit.

The legislation is impacting marijuana business models in other ways. The laws have eliminated the idea of home-based dispensaries. Going forward, according to ArcView, more cannabis delivery businesses are likely to be mobile operations that partner with standing medical-use dispensaries. Entrepreneurs may apply for small, delivery-only licenses.

Cannabis sold to patients is also subject to new requirements that include testing for potency and contaminants. And this changing regulatory environment is a big opportunity for testing- and analytic-focused marijuana businesses, like Steep Hill Labs.

Given California's potential market size and tax revenues at stake, other states and cannabis start-ups — from testing to other ancillary businesses — will be watching the California experiment roll out, learning and ready to duplicate any successful models.

"When California sets the standard, the rest will follow," said Steep Hill Labs CEO Jmîchaeĺe Keller. With locations in California, Colorado, Nevada, New Mexico and Washington — and plans to open a lab in Alaska— Steep Hill Labs works with cultivators and manufacturers to test and ensure the safety and potency of cannabis products.

"California is the sixth-largest economy in the world. Legalization of marijuana will mean billions for the economy and explosive tax revenues for the state," he said. "When other states see this impact, they will have to follow."

What's next?

Looking ahead, total legal cannabis sales are forecast to surpass $22 billion by the end of the decade, with adult-use sales comprising about 53 percent of the total legal market.

And a big chunk of that growth will be driven by ancillary businesses like those involved in cannabis testing.

"I ultimately think that the businesses that are going to do the biggest amount of business, going on 100X return for investors, they're going to be the ancillary businesses," said Dayton. "The businesses that do the infrastructure play — not the ones that are selling cannabis."

Sounds a bit like California's gold rush in the mid 1800s. "It wasn't the miner who made the most money," Dayton said. "It was the people who had the picks, shovels and jeans."

As the broad marijuana market grows and matures, detailed information and packaging can help companies differentiate their products and essentially create the foundations of cannabis brands.

Those who are bullish on cannabis also see a potential global market down the line in which U.S. cannabis companies, including those from California, will be able to market and sell their specific brands of products for export to overseas markets.

"[California is] where the genetics are, where the best cultivators are. It's where some of the best climate is for it," Dayton said. "I think people see California as somewhat of an icon."

— By Heesun Wee, special to CNBC.com

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