We often get asked about which sector of the cannabis industry is and will be the most profitable. So much so that we decided to write this op-ed piece about how to apply a model used in the technology industry to understand where the power, and therefore margins, would ultimately reside. The idea is called the smiling curve and it was originally created by Stan Shih, the CEO of computer maker Acer, in 1992. Stan saw that the two ends of the supply chain generally become more valuable than the middle. Put another way, the closer a company operates to the ideas behind a technology or to the consumers of the technology, the more valuable they can demand. The middle part is just manufacturing, which commodities as player compete on price alone.

We feel that this same thinking can be applied to cannabis, or at least to where the industry is headed. In the early, medical days every part of the cannabis supply chain carried a risk premium. Since the grower and distributors were operating without the clear consent of the authorities, there were relatively few brave and skilled enough to attempt it. Plus, the industry was artificially fractured. Any skilled operator would not be able to expand past a certain point in order to not bring too much attention from the wrong authority. This kept any major players from taking advantage of the economies of scale that exist in most industries. 

Obviously, a lot has changed since the early medical era. Recreational permits are being issued across the country and a more normalized industry is starting to coalesce. Now cannabis companies have millions in their coffers from their offerings on public stock exchanges. Growing operations went from hundreds of square feet to hundreds of thousands.

We think that the commoditization of certain areas of production will make the cannabis industry resemble the technology industry in that the value will be distributed via the smiling curve. Here is where we think each sector of the industry is on the curve:



Right off the bat, you probably noticed that growing is on the very bottom. It should be said that there will always be value in being a premium product, like is the case with the fashion industry, but being that top shelf product will be harder and harder to obtain. It is amazing that almost every investment that we see aims to be a top shelf producer The problem is that all of them will not be able to be, realistically the title of “luxury” will only go to about 10-15% of them.

As grows get bigger and cannabis flower become cheaper, the value will start to drop out of that category. Some of the value will go to secondary processors that create branded products. This is true for many fast moving consumer good categories like grocery. No one pays a premium basted on their brand of their apple but they are happy to pay a premium for a quality applesauce. Extraction and are easier to brand then produce product like cannabis, so they will likely benefit from the falling prices of their most expensive ingredient.

The retail outlets like dispensaries are also able to profit from an increase in supply. Many municipalities don’t allow retail locations to be located too close to each other, so many dispensaries have a very defensible business model. The consumer is used to paying a certain price, so as costs of inventory drops the retail prices will likely stay relatively unchanged, as we have seen in saturated markets like Washington and Colorado.

Even the retailers are not immune to competitive forces. As they fight for market share they will be forced to invest in lead generation tools. Google and Facebook are not options for advertising yet, so other cannabis specific marketing platforms have been popping up everywhere. There is also increased competition from large delivery apps like Ease. As more consumers prefer to have their purchases delivered companies like Ease could become as disruptive of Amazon, sitting in between the seller and buyer and taking a cut.

On the other side of the smiling curve is the supply and technology side of growing cannabis. Companies like Scotts Miracle Grow have focused investment on this side of the industry. Also, genetic producers and automated grow technologies have been able to increase prices to help keep growers compete. They will probably become more profitable as growth tapers off and growers start to battle for market share.

We are always analysing this thesis to see if outside forces like federal oversight or changes in tax law change our assumptions. If the industry continues to normalize the way it has been, we believe we will see the value in the industry more-or-less resemble the one thing we all get when we find a profitable investment: a smile.