Prepared by GMP Securities L.P. See important disclosures on the last page of this report

Equity Research

US Cannabis Industry July 24, 2018

US cannabis industry primer In our view, the US cannabis sector presents a rare opportunity to gain

exposure to an industry in its infancy, but due to supportive regulations,

simultaneously offers a legal path to capturing a large, existing illicit market.

Why we like the US cannabis industry

1. Large markets. The US offers the largest addressable cannabis markets in the

world. At ~US$6b in sales currently, the US cannabis sector is already roughly

as large as the expected market size of Canada in 2022. We project retail

sales from the 33 currently legal US states to grow by a 5-year CAGR of

~27% to reach ~US$20b in 2022. Under a federally legal scenario, we

estimate the market size grows to ~US$50b+ at maturity.

2. Strong economics. With many states offering good barriers to entry from

limited-license regimes, the ability to vertically integrate, and effectively

build brands, we believe that at scale, US cannabis companies have the

potential to generate strong economics. EBITDA margins should reach ~40%–

50% at maturity for fully vertically integrated players.

3. Attractive valuation gap. We estimate that including readily addressable

international export opportunities, the public Canadian cannabis sector is

currently valued at ~2x–3x industry sales at maturity in 2022. Applying this

multiple to a 2022 US cannabis industry sales estimate of ~$US20b, we

derive an implied aggregate public market valuation of ~US$50b for the US

sector, or ~10 times higher than currently.

Key investment considerations

1. Market selection is key. In addition to restrictions on interstate trade,

conditions in each state are impacted by a number of differing factors

including: market structures, licensing regimes, and regulatory and legislative

changes. Operating conditions can vary in each jurisdiction, making state

selection a key investment consideration in our view.

2. Pricing impact. While price deflation is an important risk factor for the US

cannabis sector, market data suggests that even in the most mature

recreational states, the impact can be partially mitigated. Despite wholesale

prices in CO, WA, & OR declining ~50% since 2016, cultivator margins on

avg. have remained at ~25%, reflecting sound profitability.

3. Legislative and regulatory. The legislative environment is likely to evolve

continuously, however recent congressional actions suggest cannabis laws

are not easy to pass. Hence, issues such as onerous taxation could persist

near-term. On the regulatory side however, potential favourable changes

in several states (opioid replacement therapy, conversion to recreational

sales) have the potential to boost their respective markets by 2x–5x.

Bottom line. The US cannabis industry offers an attractive risk/reward profile,

hence we believe investors should actively pursue exposure to the sector.

Robert Fagan, CFA (514) 288-0318

rfagan@gmpsecurities.com

Synopsis:

The US cannabis sector is currently composed of 33 states with some form of legal access to regulated cannabis markets. Ten states have combined medical and recreational access, and 23 states are medical-only access.

Similar to Canada, the US cannabis sector allows investors to leverage the strong, secular growth trends which are characteristic of the legalization of cannabis, except in end-markets which are ~5x–10x larger. In aggregate, we project sales from currently legal US states to grow by a CAGR of ~27% over the next five years to reach ~US$20b in 2022.

The US cannabis industry is highly fragmented due in part to restrictions on interstate trade, historical challenges to access capital, and some states’ attempts to promote greater competition. This results in a competitive supply environment for the US overall, but also a robust M&A opportunity for well-capitalized, experienced industry players.

States with legal access to cannabis for medical or recreational purposes

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Table of Contents

Why we like the US cannabis industry ....................................................................................................................... 3 Large markets ................................................................................................................................................................. 3 Strong economics ........................................................................................................................................................... 5 Significant valuation gap ................................................................................................................................................. 6 Key investment considerations .................................................................................................................................. 8 Market structure ............................................................................................................................................................ 8 Demand drivers ............................................................................................................................................................ 10 Pricing impact ............................................................................................................................................................... 11 Federal legislation impact ............................................................................................................................................. 12 Potential favourable regulatory changes ..................................................................................................................... 13 Banking and taxation issues.......................................................................................................................................... 15 GMP’s state ranking system .................................................................................................................................... 16 US cannabis 2022 outlook ........................................................................................................................................ 18 Appendix A: Legislative case study – The STATES Act............................................................................................... 20 Appendix B: State-level data sets .................................................................................................................................. 21

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Why we like the US cannabis industry

In our view, the US cannabis sector presents a rare opportunity to gain exposure to an industry

in its infancy, but due to supportive regulations, simultaneously offers a legal path to capturing a

large, existing illicit market. Similar to Canada, the US cannabis sector allows investors to

leverage the strong, secular growth trends which are characteristic of the legalization of

cannabis, except in end-markets which are ~5x–10x larger. In aggregate, we project sales from

currently legal US states to grow by a CAGR of ~27% over the next five years to reach ~US$19.6b.

Throughout this report we use the Canadian cannabis sector as a benchmark for comparison,

highlighting in our view the numerous advantages of investing in the US cannabis industry.

Our US cannabis 5-year outlook status-quo largely prevails. While there is no consensus on

when federal legalization could occur in the US, most industry participants we’ve spoken with

believe it could be anywhere from ~2–5 years away. However, with Republicans in control of the

House and Senate, uncertainty over mid-term election results, and the limited success thus far of

passing sweeping federal cannabis reforms, we believe the more likely scenario is an extension

of the current status-quo over the next five years, albeit with some changes (see US cannabis

2022 outlook). This should allow US cannabis companies to remain insulated in the near-term

from competition from larger, better-capitalized industries (alcohol, tobacco, CPG, etc.), while

fortifying their operations and capitalizing on the growth of large domestic markets.

Large markets

US markets are already large at ~$6b. The market size for all US states with legalized access to

either medical (MED) or recreational (REC) cannabis is already quite large, estimated at ~$6b for

2017 according to Marijuana Business Daily. To put this in context, US cannabis sales today are

already roughly as large as our expected market size for all of Canada (MED & REC) in 5 years.

We project the US market to grow by a CAGR of ~27% over the next five years to reach ~$19.6b

in 2022, driven mainly by expansion of existing REC states. This estimate is based on forecasted

growth for existing MED or REC states, hence there could be substantial upside from 1) more

states adopting legal access regimes, 2) existing MED states converting to REC sales, or 3) full

federal legalization.

• Large markets ~$20b by 2022 from existing states, $50b+ under full federal legalization

• Strong economics True vertical integration leads to strong EBITDA margin potential up to ~40% - 50%

• Attractive valuation gap Aggregate US public market cap. could reach $50b, ~10x current value

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Figure 1. Estimated US cannabis retail sales: 2017–2022

Source: GMP Securities estimates for 2022, Marijuana Business Daily for 2017 actuals

Federal legalization could create ~$40–55b market. We assess the potential size of the

federally-legal US market using high level assumptions for average spend/month/person and %

of users in the population. Assuming that at maturity between ~10%–12% of the US population

consumes cannabis once per month and spends ~$100–120/month on average (standard metric

for existing REC states) then we derive a market size estimate of ~$40–55b, roughly 8x the

expected size of the Canadian national MED & REC market.

Figure 2. Estimated US market size with federal legalization

Source: GMP Securities

Arizona medical market bigger than Canada’s. To demonstrate the large market potential of

individual states, we would highlight Arizona; a MED-only state which is currently generating

~$400m+ in annual retail sales. To put this in context, Arizona’s market size is ~30% larger than

Canada’s entire medical market with a population of ~7m, just 1/5th the size of Canada.

There are currently 33 states with some form of legal access to cannabis, 10 with combined REC

and MED access, and 23 MED-only states. In addition, another 17 states have legal access to CBD

only. All states which are at an earlier stage of development are projected to experience strong

growth of 30%+ over the next five years. Mature REC states (CO, WA, OR) and MED states (MI,

AZ, NM) are expected grow more slowly.

3,2505,600

2,750

14,000

6,000

19,600

0

5,000

10,000

15,000

20,000

25,000

2017 2022

An

nu

al s

ales

in U

S$, m

illio

ns

Medical

Recreational

CAGR~27%

Low High

US population (m) 326 326

Prevalence of use 10% 12%

Spend/month/person ($) $100 $120

Market size (US$,m) $40,000 $55,000

Estimated US retail cannabis market size

under federal legality

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Figure 3. Estimated retail sales and growth rates for select US states (2017-2022)

Note: Estimated retail sales combine medical and recreational sales. 5-year CAGR applies for all states except for PA, MD,

and OH where retail sales are expected to begin in 2018, 2018, and 2019 respectively.

Source: 2017 estimated actuals - Brightfield Group, Marijuana Business Daily, 2022 estimates - GMP Securities

Strong economics

True vertical integration. Unlike Canada where the majority of distribution and/or retail

operations for REC sales are monopolized by provincial liquor boards, there is no state

intervention in the supply chain in the US (MED or REC). True vertical integration is thus possible

in most states, with some state regulations even requiring it (FL, NY, NJ, ME, AZ). This translates

into higher potential margin capture for US operators as compared to Canada.

Limited licenses in some states creates barrier to entry. While there are no caps on licenses in

most REC states (except Washington), licenses in the vast majority of MED states are limited by

regulations. As a result entry for new potential competitors in these states is limited to either

winning a new license, or acquiring an existing one. With access to capital somewhat constrained

for US cannabis companies, this creates certain barriers to entry for incumbent operators, and

supports pricing in these states.

EBITDA margins of ~40–50% are possible. With the ability to vertically integrate, and strong

pricing in many states, we believe US cannabis companies are positioned to generate higher

profitability (on average) than their Canadian counterparts. Production costs at scale for a typical

indoor growing facility in the US are similar to Canada at ~$1.50–2.00/gram as per Marijuana

Business Daily. Hence, we estimate vertically integrated US operators have the potential to

generate EBITDA margins of ~40%–50% at maturity. We expect cultivation margins to be similar

to those projected for Canada at ~25%–30%, with the ability to participate in retail adding

another ~15%–20% of EBITDA margin.

State 2017 2022

Select states with recreational-use laws

California 1,670 6,263 30% VT 0.44997

Colorado 1,100 1,901 12% AK 0.295393

Nevada 296 1,821 44% ME 0.551408

Washington 965 1,728 12% MA 0.510907

Oregon 400 820 15% OR 0.15

Massachusetts 96 724 51% WA 0.12

Maine 24 216 55% NV 0.44

Alaska 38 137 30% CO 0.12

Vermont 9 60 45% CA 0.30259

Select states with medical-only laws

Florida 31 956 176% CT 26%

Pennsylvania n.a. 830 98% NM 15%

Michigan 515 736 7% NJ 47%

Arizona 417 573 7% MD 46%

Illinois 90 398 37% OH 77%

New York 58 477 37% NY 52%

Ohio n.a. 236 77% IL 35%

Maryland n.a. 188 46% AZ 7%

New Jersey 23 158 47% MI 7%

New Mexico 72 148 15% PA 95%

Conneticut 31 99 26% FL 99%

Estimated retail sales (US$,m)

45%

30%

55%

51%

15%

12%

44%

12%

30%

VT

AK

ME

MA

OR

WA

NV

CO

CA

5-year CAGR*

26%

15%

47%

46%

77%

52%

35%

7%

7%

95%

99%

CT

NM

NJ

MD

OH

NY

IL

AZ

MI

PA

FL

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Figure 4. EBITDA profile at maturity – vertically integrated vs. cultivator

Source: GMP Securities, industry sources, Marijuana Business Daily

Fewer branding restrictions could support margins. US operators enjoy more expansive

branding capabilities than Canadian LPs, with fewer advertising limitations, largely unrestricted

packaging rules (with the exception of edibles), and ability to leverage social media platforms

and websites to promote brands. In a commoditized environment for dried flower, US operators

focus their branding efforts on extract-based products, providing some differentiation and ability

to boost margins. Given the nascent state of the US cannabis industry however, product markets

remain highly fragmented, with no brands yet achieving more than ~15% market share across

major REC markets (CA,CO,WA,OR), according to Brightfield Group data.

Significant valuation gap

Excluding international, Canada appears valued at ~6x steady-state sales. To determine the

relative valuation of the Canada and US cannabis sectors, we first compare total EV of the 10

largest players in each country (industry proxy), to potential domestic market size at maturity

(expected 2022). With an estimated total EV of ~C$25–30b for the top 10 Canadian LPs, using a

projected addressable market (MED & REC) of ~C$4–5b in 2022, this suggests the Canadian

cannabis sector is trading at ~5x–7.5x steady-state sales.

This multiple (midpoint ~6x) arguably overstates Canadian LPs valuation as it does not reflect the

opportunity from international exports. However even if completely ignoring international, we

consider this valuation for Canadian LPs could be defendable given global alcohol companies

trade at ~4.5x 2022 EV/sales on average, while cannabis offers stronger secular growth and

industry disruption potential.

Figure 5. EV/sales valuation (2022) for global alcohol players

Source: Bloomberg, GMP Securities

For the US sector, assuming only a ~US$18–22b US cannabis market in 2022 (based on existing

states with legal access), the 10 largest public US operators, with total estimated EV of ~US$4.0–

4.5b currently, are trading at just ~0.2x – 0.3x sales – a ~6x multiple discount to Canada. We

25%-30% 25%-30% 25%-30%

15%-20%

40%-50%

0%

10%

20%

30%

40%

50%

60%

US cultivator US verticallyintegrated

Canada cultivator

Wholesale margin

Retailer margin

Global alcohol companies EV/sales 2022

Heineken NV 2.5x

Diageo plc 5.4x

Constellation Brands Inc. 5.0x

Anheuser-Busch InBev 4.6x

Average 4.5x

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acknowledge this analysis does not account for the potential for new larger US cannabis

operators to enter the public markets.

Figure 6. Cannabis industry valuation summary – Canada vs. US

Source: GMP Securities, FactSet

US aggregate public market valuation could reach ~$50b. Modelling on the evolution of the

medical program in Canada, we can derive a high-level estimate for the addressable European

medical cannabis market reaching ~C$5–10b by 2022, assuming all countries adopt programs

and supply is largely dominated by Canadian LPs (admittedly optimistic). Adding this to the

addressable market for Canadian LPs brings the valuation range for the Canadian sector down to

~2.0x–3.0x 2022 EV/sales, plausible in our view as it would be roughly in-line with the valuation

of the broader Canadian technology sector. Applying this multiple to the US cannabis sector, we

can derive an implied aggregate public market valuation of ~US$45–55b. This is ~10x the sector’s

current EV, highlighting the strong potential valuation upside for the US.

Discount factors abating, revaluation in US sector should narrow gap. US cannabis companies

have historically traded at a discount to Canadian peers given factors such as more limited

access to capital, risks of violating federal laws, and social stigmas. However, we view most of

these risk factors abating in the near term due to several recent developments described below.

1) Capital access improving. Investor demand for US cannabis assets has been growing

recently, with several oversubscribed public offerings, and large direct investments by

private equity. The conduit through listing on the Canadian Securities Exchange has also

boosted US companies’ access to capital markets.

2) Favourable public opinion growing. Public approval levels for cannabis recently reached

their highest levels ever, in a June 2018 poll by the Center for American Progress (CAP)

showing 68% of all participants favour legalization. This highlights the continuing trend of

growing consumer acceptance, and reduced stigma, with Gallup polls showing more than

50% public support for legalization since 2013.

Valuation analysis Low High Low High Low High Mid

Domestic-only analysis

Canada C$25,000 C$30,000 C$4,000 C$5,000 5.0x 7.5x 6.3x

USA US$4,000 US$4,500 US$18,000 US$22,000 0.2x 0.3x 0.2x

Valuation gap (Canada vs. US) 6.0x

Including European opportunity

Canada (domestic + Europe) C$25,000 C$30,000 C$9,000 C$15,000 1.7x 3.3x 2.5x

US implied public EV @ 2.5x sales 45,000 55,000

Addressable market in 2022

($,m)Industry implied EV/salesEV of top 10

companies ($,m)

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Figure 7. Gallup poll on cannabis legalization

Source: Gallup

3) Evolving legislator attitudes. We estimate a total of 55 marijuana reform bills are facing

federal legislators in 2018 (up from 35 in 2017), including at least five bills calling for

cannabis de-scheduling. This combined with more states voicing intentions to convert to REC

sales, and historically conservative states like Oklahoma and Louisiana legalizing medical

marijuana are all examples of how legislators’ attitudes are becoming more lenient towards

cannabis. Favourable laws being enacted could remove risks and boost sector valuations.

4) State protections could to be formalized. President Trump recently voiced support for

proposed legislation (STATES Act – see Appendix A) which would formalize federal

recognition of state cannabis laws. In our view, this increases the chance that federal

prosecutions risks could be eliminated before a full implementation of federal legalization

occurs, a positive for US sector valuations.

We believe the above, combined with the prospect of federal legalization in coming years to

liberate banking and capital flows, remove interstate restrictions, and open international export

opportunities for medical marijuana should allow the valuation gap vs. Canadian LPs to be

resolved mainly through an upward revaluation in US cannabis companies.

Key investment considerations

In addition to restrictions on interstate trade, market conditions in each state are impacted by a

number of differing factors including; market structures and licensing, pricing levels, and

regulatory and legislative changes. As a result, the US cannabis sector is more of a collection of

state industries, each with their own idiosyncrasies which give rise to several key investment

considerations.

Market structure

Interstate trade prohibited market selection is key. Without federal cannabis laws, US

operators cannot transport cannabis across federal borders, effectively cutting off the export

opportunity to capitalize on global medical markets. Interstate trade is also prohibited, limiting

the pool of available production and creating varying supply/demand balances in each state. In

• Market structure trade restrictions, licensing, and demand drivers make market selection key

• Pricing considerations Price deflation a risk that can be partially managed

• Legislative and regulatory changes Continuously evolving landscape with material impacts expected

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addition, states maintain their own licensing regimes (limited or unlimited) which is the main

driver of each market’s competitive landscape.

States with limited-license programs where there are fewer producers (cultivators & processors)

than retailers (ratio of < 1.0) tend to have more favourable competitive conditions than

unlimited-license states with large numbers of producers. In light of the above, state selection is

a key consideration for US cannabis investors in our view.

Figure 8. Market and licensing structure in selected states

Note: Production licenses include both cultivation and processing licenses.

Source: State health departments, Marijuana Business Daily, GMP Securities

Highly fragmented industry. The US cannabis sector is highly fragmented due in part to 1)

limited participation by large industry consolidators due to challenges to access capital

combined with federal illegality, and 2) many states limiting the number of licenses issued per

entity in an effort to foster increased competition. This has resulted in the US sector being as

much as ~8x more fragmented than Canada, with an estimated ~39,000 people per production

license in the US, vs. ~320,000 people per license in Canada. While consolidation levels differ

state-by-state, the higher overall fragmentation of the US generates a more competitive supply

environment, but a ripe M&A opportunity for well-capitalized, experienced operators.

Figure 9. Industry fragmentation: US vs. Canada

Source: GMP Securities, Health Canada, State Health Departments

Select REC states

California Allowed Unlimited 3,758 1,611 2.3

Colorado Allowed Unlimited 1,029 529 1.9

Nevada Allowed Unlimited 195 172 1.1

Washington Not allowed Limited 1,345 556 2.4

Oregon Allowed Unlimited 1,095 532 2.1

Massachusetts Allowed Unlimited 31 144 0.2

Maine Required Unlimited 8 8 1.0

Alaska Allowed Unlimited 140 59 2.4

Vermont Allowed Limited 5 5 1.0

Select MED states

Florida Required Limited 21 630 0.03

Pennsylvania Mixed Limited 33 198 0.2

Michigan Allowed Unlimited 215 215 1.0

Arizona Required Limited 130 130 1.0

Illinois Allowed Limited 20 60 0.3

New York Required Limited 10 40 0.3

Ohio Allowed Limited 24 60 0.4

Maryland Allowed Limited 37 115 0.3

New Jersey Required Limited 12 36 0.3

New Mexico Allowed Limited 35 71 0.5

Conneticut Not allowed Limited 10 19 0.5

Vertical integration

License

issuance

Est. number of

production licenses

Est. number of

retail licenses

Producer to

retailer ratio

Est. number of

production licenses

Population/

license

Canada 112 321,429

USA ~8,300 ~39,157

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Demand drivers

REC market demand drivers. An important driver of REC market demand is the prevalence of

heavier cannabis users, or those who consume at least 1x per month. These users typically

account for the majority of cannabis market volumes, and as such are a good indicator of the

number of addressable customers for legal cannabis operators. According to data from the US

Substance Abuse and Mental Health Services Admin. (SAMHSA), ~9% of the US population used

cannabis at least monthly in 2015. However amongst western states first to legalize recreational

sales (more accepting cultures), ~12%–15% of the 18yrs+ population used cannabis monthly,

demonstrating in our view the potential upside to prevalence rates for REC use in other states

over time.

Figure 10. Prevalence of cannabis use in mature REC markets (2015)

Source: Substance Abuse and Mental Health Services (SAMHSA)

MED market demand drivers. In MED markets, demand is driven by approved qualifying

conditions, and product forms, with more of either generally translating into higher patient

registrations. Chronic pain is by far the largest qualifying condition for patients in the US, with

~80%+ of prescriptions made for this indication in mature MED states. With a broader list of

qualifying conditions and permitted products, mature US medical markets can experience strong

patient penetration rates reaching ~2.5%. This compares to patient penetration rates for Canada

currently at ~0.8%–1.0%.

Figure 11. Patient penetration in mature MED states

Source: State health departments, GMP Securities, Health Canada

Product restrictions impact market growth potential. While all product forms are generally

available in REC states, several MED states restrict the types of products which US operators can

supply. Most notable examples include bans on smokeable dried flower in New York and Florida,

and bans against edibles in several states including New Jersey and Maryland. Product

restrictions can constrain the addressable market in affected states, but also present growth

opportunities from potential changes in legislation as discussed later in this report.

State low high

California 10% 12%

Colorado 15% 20%Washington 10% 14%Oregon 11% 15%Average 12% 15%

US national average

% of population using cannabis

at least once per month

9%

State Patient count % penetration

California 850,000 2.1%

Michigan 277,000 2.8%

Arizona 169,478 2.4%

Maine 41,858 3.1%

US weighted average % of population 2.3%

Canada patient % of population 0.8% - 1.0%

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Figure 12. Product form permissions in select MED states

Note: In NJ waxes/shatters not permitted, CT prohibits beverages/candies

Source: GMP Securities, State Health Departments

Pricing impact

Across all states, US pricing is relatively strong. Unsurprisingly, wholesale pricing in the US is

lowest in mature REC states (CO, WA, OR) at ~US$1.50–2.00/gram, where production licenses

are most proliferated. However all other states we track exhibit more favourable wholesale

pricing, averaging in the ~US$4.50–7.50/gram range for dried flower, which compares to pricing

Canadian LPs are expected to face in the REC channel of ~US$2.75–4.25/ gram. Pricing in limited-

license MED states is particularly strong (can reach ~US$15– 20/gram at retail) due in-part to less

developed supply chains which often experience shortages, combined with higher black market

pricing traditionally.

Figure 13. Wholesale dried flower pricing by state (for June 2018)

Source: New Leaf Data Services, GMP Securities

Retailers fare better in oversupplied states. Wholesale prices have generally trended down

across all states since 2016, with more pronounced declines in mature REC states. We believe

the impact to industry profit margins has been more focused on wholesale cultivators, as more

of the value chain has accrued to retailers. As per New Leaf Data Services, retailers in

Washington (arguably highest price deflation state) have only seen their gross margins decline

by ~9% between Jan. 2016–Oct. 2017, despite wholesale prices which were down ~28% over the

same period.

Selected MED statesSmokeable dried

flowerEdibles

Vape/

concentrates

Florida No No Yes

Pennsylvania Yes No Yes

Michigan Yes Yes Yes

Arizona Yes Yes Yes

Illinois Yes Yes Yes

New York No No Yes

Ohio No Yes Yes

Maryland Yes No Yes

New Jersey Yes No Mixed

New Mexico Yes Yes Yes

Conneticut Yes Mixed Yes

$1.47

$1.95

$2.03

$2.54

$3.93

$4.02

$4.25

$4.31

$4.53

$5.59

$5.56

$6.40

$6.95

$6.79

$6.82

$6.90

$9.13

$0 $2 $4 $6 $8 $10 $12

Washington

Oregon

Colorado

California

Arizona

Michigan

Maine

Nevada

Washington D.C

Massachusetts

Rhode Island

New Mexico

Illinois

Conneticut

New Hampshire

Vermont

Alaska

Dried flower wholesale price (US$/gram)

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Figure 14. Washington changes in retail margin & wholesale price (2016-2017)

Source: New Leaf Data Services

Cultivators offset some price deflation through cost reductions. While we believe the impact of

price deflation has been more pronounced for wholesale cultivators, market data shows that

cost reductions have helped partially mitigate the impact. As per New Leaf Data Services,

average wholesale prices in mature REC states (CO, WA, OR) have declined ~50% since Jan. 2016,

from ~US$1,800/lb to ~US$900/lb as of April 2018. However as per Marijuana Business Daily,

average profit margins for wholesale cultivators in these states was ~25% at the end of Q1/18,

reflecting good profitability in our view despite pricing pressures. The above suggests in our view

that while price deflation remains an investment risk for the US cannabis sector, the impact is

potentially less dramatic than feared, with some ability to manage this risk.

Federal legislation impact

Continuously evolving legislation. For the 2018 legislative session alone, we estimate there are

~55 cannabis-related bills awaiting passage through the committee stage at the federal level.

These bills cover a wide range of topics such as creating new REC or MED laws, decriminalization

laws, and modifying regulations in existing legal frameworks. The significant volume of proposed

cannabis bills suggests the legal landscape for the US cannabis sector is likely to continuously

evolve in coming years.

Passing laws is not easy. According to govtrack.us, historically only ~3%–5% of all bills

introduced during each session of congress actually end up becoming law. This is in-part due to

the multiple points along the legislative process at which new bills can die. A new bill typically

receives a minimum of four votes (two in committee, two on chamber floor) before being passed

to the President (or governor at state level), who also holds the power to veto. In addition we

note that at the federal level, the current Senate and House are Republican controlled,

presenting an obstacle for cannabis laws to pass given the conservative posture of the party.

House Republicans habitually block votes on marijuana bills. Over the past ~18 months, despite

over 30 marijuana reform amendments having been introduced in Congress, none of them have

been given consideration through votes on the House floor. This is primarily due to political road

blocking by the leader of the House Rules Committee, Texas Republican Pete Sessions, who is

renowned for his anti-cannabis stance. Examples of proposals which have been blocked include:

expanding research on marijuana’s medical benefits, protecting state laws from federal

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intervention, and relieving marijuana businesses from onerous taxation, to name but a few. Pete

Sessions is up for re-election this November, however if he retains his seat any cannabis-related

amendments at the House level are likely to continue to be stymied. This poses another obstacle

to legislative reform, as lawmakers need to rely on the Senate, and mutual agreement from

bicameral conference committees to have some hope of advancing bills to the President.

Key legislation to watch. There are currently several bills at the federal committee stage which

call for a variety of significant reforms, ranging from preserving state rights, to full de-scheduling

of cannabis and hemp from the Controlled Substances Act (CSA), to opening the doors to

interstate trade. Of these bills, the STATES Act (see Appendix A for more details) seems to have

the lowest hurdles to be enacted, and has gained momentum recently with the most bipartisan

support, and a nod of approval from the President. We provide a summary of key federal

legislation to monitor below.

Figure 15. Key legislation to watch at federal level

Source: GMP Securities, Govtrack.us

Potential favourable regulatory changes

MED to REC conversion can increase market size by 5x. Politicians in several MED states (incl.

NY, NJ, IL, & MD) have been quite vocal recently about their intentions to legalize recreational

use within their jurisdictions. We believe the conversion from MED to REC can have a dramatic

effect on market size which we can estimate based on expected changes in users, and monthly

spending rates. We estimate the average patient penetration rate of all existing MED states is at

~0.8%–1.1% currently. By comparison, ~9%–10% of the adult population in the US consumes

cannabis at least monthly according to the National Survey on Drug Use and Health (2016).

Figure 16. Est. change in market size from MED to REC conversion

Source: GMP Securities, State Health Departments

The above suggests that once conversion to REC reaches maturity, it could increase the number

of consumers by an average factor of ~10x. Adjusting for the generally lower spending of a REC

vs. MED consumer (~$100-120/month vs. $200-250/ month), we estimate the net impact from

REC conversion could be a 5x increase to market size (on average).

Bill name Sponsor Co-sponsors DescriptionCurrent

stage

Last ation

date

- Removes marijuana from all CSA schedules

- Allow import/export wherever state approved

- Removes marijuana and THC from Schedule 1

- Allow interstate trade

- Exempts states with local laws from provisions

of the CSA Act. Legalizes industrial hemp

- Decriminalizes marijuana at federal level

- Deschedules from CSA, permits interstate trade28-Jun-18

Marijuana Freedom and

Opporunity Act

Chuck Schumer

(D)8

In

Committee

STATES ActCory Gardner

(D)22

In

Committee7-Jun-18

Hemp Farming Act of 2018James Comer

(R)13

In

Committee12-Apr-18- Legalizes industrial hemp and CBD

Marijuana Justice Act of

2018Barbara Lee (D) 40

In

Committee8-Feb-18

Regulate Marijuana Like

Alcohol ActJared Polis (D) 26 24-Apr-17

In

Committee

MED program REC program

Penetration %

Low 0.8% 9% 11x

High 1.1% 10% 9x

Monthly spend/

customer $200 - 250 $100 - 120 0.5x

Estimated market size change factor from REC conversion 5x

Change factor

REC vs. MED

14

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Introducing flower category could boost some MED states. Historically several MED states such

as NY, FL, PA, and others have prohibited sales of smokeable dried flower products. However the

Pennsylvania Health Department changed regulations in May to permit smokeable flower sales

to begin, and recently in Florida a circuit judge ordered that the state’s ban on smokeable flower

products be lifted (now subject to Health Department appeal).

Figure 17. Overall product mix from all REC and MED states (2017)

Note: Concentrates category primarily includes vaporizable products such as wax, and shatter.

Source: Brightfield Group, Headset

We note that in fully matured MED states like Arizona and Michigan, despite a wide range of

available product forms, dried flower retains strong market share at ~50%. Given its resilient

market share, we believe regulation change to permit dried flower in states such as New York

and Florida has the potential to boost existing market sizes by ~50%–100%. This would account

for some existing patients switching their current use of extract-based products back to dried

flower once permitted.

Adding opioid replacement therapy could significantly increase patient counts. In light of the

opioid crisis in the US, several MED states (incl. NY, IL, and PA) have recently changed regulations

to permit opioid replacement therapy (“ORT”) as a qualifying medical condition, with

implementation expected to occur this summer. According to the Centers for Disease Control

and Prevention (CDC), prescriptions for opioids are widespread with ~58m adult patients (>20

years old) in 2016, or ~24% of the population base. In addition, SAMHSA data suggests 4.5% of

the US population aged 18yrs+ had an opioid use disorder in 2016. In our view, these dramatic

statistics suggest adding “ORT” to MED states’ qualifying conditions could be a game changer for

patient penetration rates.

Figure 18. Opioid prescription rates by state

Source: Centers for Disease Control and Preventions (CDC)

Chronic pain is by far the largest qualifying condition for medical cannabis patients (~80% of Rx)

in mature MED states, and the majority of people receiving opioid prescriptions use the drug to

Flower 53%

Concentrates22%

Edibles 23%

Others 2%

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manage pain, hence the addition of “ORT” should open a large new pool of potential medical

cannabis patients. As patient penetration rates in mature MED states have reached over 2%

without opioid replacement, in light of the SAMHSA prevalence data, we believe inclusion of

“ORT” could rapidly push medical cannabis penetration up to ~3%–4% in mature states, and to

~2%–2.5% in earlier-stage MED states.

Banking and taxation issues

Electronic payments access more pertinent than access to banks. The number of US banks and

credit unions servicing marijuana operators has risen steadily in recent years. This has been

driven by clarified guidance from the Financial Crimes Enforcement Network (FinCEN) in 2014,

permitting financial institutions to service marijuana-related businesses so long as they ensure

clients are properly licensed by state authorities, and possible criminal activity is reported.

According to FinCEN, as of Sept. 2017, ~400 institutions were actively banking the US cannabis

industry, representing a ~30% increase YoY.

Figure 19. Number of depository institutions serving marijuana businesses

Source: GMP Securities, FinCEN

The more pertinent issue for US marijuana operators is the general lack of access to electronic

payment methods, requiring most transactions to be conducted in cash. In turn, cannabis

businesses often need to incur costs associated with the use armored transport vehicles, and

carry risks associated with having large amounts of cash on hand at dispensaries, which are

susceptible to robberies. We note that should the STATES Act

Regulation 280E creates high tax burden. Under section 280E of the federal tax code, the only

expenses plant-touching marijuana businesses can deduct for tax purposes are the cost of goods

sold, or the direct costs associated to production. This essentially results in cannabis businesses

being taxed at the gross margin level, creating an effective tax rate which can be ~2x that of

normal statutory rates. This high tax burden is a direct reduction to cash flows, and is often more

pronounced for retail-only operators as compared to vertically integrated players. With House

Republicans recently blocking votes on amendments proposed to lessen the tax burden on

marijuana operators, there is little visibility on when Regulation 280E could be relaxed. As such

the high tax burden placed on US cannabis operators is likely to continue to be a cost of doing

business, in an otherwise lucrative industry.

285

305319 317

340

374387

400

200

250

300

350

400

Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17

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Figure 20. Impact of Regulation 280E on effective tax rate for cannabis operators

Note: SG&A and financial expenses not deductible for tax purposes for cannabis businesses

Source: GMP Securities

GMP’s state ranking system

Method for identifying the most attractive states. We have established a state ranking system

to determine which states are most attractive from either an operational or acquisition target

perspective. We evaluated states on the basis of two rankings; one for market attractiveness and

the other gauging competitive environment. Market attractiveness rankings were calculated

across a range of variables including population/patient levels, wholesale pricing, and qualifying

medical conditions amongst others. Competitiveness was assessed primarily on the basis of

licensing structures, number of retail and production licenses issued, and associated ratios. The

main takeaways from our analysis follow below.

REC states – Massachusetts and Nevada rank well. MA and NV’s top rankings amongst REC

states mainly reflects their strong growth potential in light of sizable population bases (NV has

40m visitors/year), solid pricing levels (~$10–15/gram at retail), and lesser proliferation of

licenses which eases competition levels. While new REC licenses are set to be issued in MA,

many towns have bans on dispensaries, suggesting the market could remain more consolidated

near-term. Nevada has only issued ~195 production licenses, which compares to 1000+ in more

mature REC states such as CO, WA, and OR.

Vertical-Int. Retail-only

Revenue 1,000 1,000 1,000

COGS 300 500 500

Gross margin 700 500 500

SG&A* 200 200 200

Financial expenses* 50 50 50

Accounting EBT 450 250 250

Taxable EBT 700 500 250

Taxes 175 125 63

Effective tax rate 39% 50% 25%

Net earnings 275 125 188

Income statementCannabis business Traditional

retailer

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Figure 21. Selected REC state rankings

Source: GMP Securities, State Health Departments, New Leaf Data Services

REC states – California attractive but competitive. CA is undoubtedly expected to represent the

largest US market with good growth potential given REC sales only began in Jan. 2018. However

the state is expected to be highly competitive with already ~3,750 production/processing

licenses and ~1,600 retail licenses issued. With legal producers outnumbering retailers by more

than 2x, and hundreds of well-entrenched black market suppliers, pricing has already come

under pressure, with wholesale prices currently at ~US$2.50/gram. Given this competitive

environment, we believe operating profitably in California could be challenging.

MED states – New York, New Jersey, and Illinois are most attractive. States denoted with green

dots (IL, NY, NJ, & MI) are those with the highest potential to convert to REC sales in coming

years, which explains their more favourable market attractiveness rankings. The NY State Health

Department recently issued a report recommending the legalization of REC sales, while the NJ

governor’s office is set to draft REC legislation this summer. In IL, the Democratic nominee for

governor, favoured to win in this November’s gubernatorial elections, has campaigned on a

pledge to legalize REC use in the state. We estimate MED markets can increase in size by 5x

when converting to REC sales.

NJ, NY, and IL are also set to permit opioid replacement as a qualifying condition (likely a 2x

boost to patient penetration), while the limited-license structures of these states supports

strong pricing (estimated US$15/gram+ at retail). Lastly with only 118 retail licenses issued

across the three states, amid a population of ~42m, there is just one dispensary per ~350,000

people, making NY, NJ, and IL less competitive than the typical MED state where there is one

dispensary per ~150,000 people on average.

California

Colorado

WashingtonOregon

Nevada

Massachusetts

AlaskaMaineWashington D.C

Vermont

2

2

2

2

3

3

3

3

3

4

4

1 2 2 3 3 4 4

Mar

ket

Att

ract

ive

ne

ss R

ank

(sca

le 1

-4

)

Competitiveness Rank (scale 1 - 4)

High potential - Lower competition High potential - Higher competition

Lesser potential - Lower competition Lesser potential - Higher competition

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Figure 22. Selected MED state rankings

Source: GMP Securities, State Health Departments, New Leaf Data Services

US cannabis 2022 outlook

Our view of US cannabis in 2022 status-quo largely prevails. While there is no consensus

view on when federal legalization could occur in the US, most industry participants we’ve spoken

with believe this could be anywhere from ~2–5 years away. With Republicans in control of the

House and Senate, uncertainty over mid-term election results, and the limited success thus far of

passing sweeping cannabis reforms at the federal level, we believe the more likely scenario is an

extension of the current status-quo over the next five years, albeit with some favourable

expected changes described below.

Envisioning federal recognition of states’ rights occurs first. Our view is that legislation with

lower hurdles to enactment (do not require federal legalization) such as the STATES Act (see

Appendix A) have greater odds to become law and usher in changes. Under this scenario, states’

rights to legalize cannabis would be federally recognized, lowering risk premiums associated

with federal prosecution, and liberating some capital flows into the industry. This in-turn could

boost valuations and foster greater industry consolidation. Restrictions on trade between some

states could also be relaxed, opening larger addressable markets and reducing supply/ demand

imbalances, resulting in more stabilized pricing. With federal recognition, more states would

likely implement access regimes to limit societal damages and collect needed tax revenues,

hence we would not expect significant changes to current burdensome taxation policies.

Overall favourable operating environment. Overall, our view of a slightly modified status-quo

prevailing over the next five years would be a significant positive for the US cannabis industry. It

would afford existing and new players an opportunity to fortify their operations without

significant competitive threats from larger, better-capitalized industries such as tobacco, alcohol,

and consumer packaged goods. As such, in our scenario US cannabis companies could remain

New Jersey

Michigan Illinois

New York

FloridaPennsylvania

Ohio

Arizona

Minnesota Montana

Conneticut

New Hampshire

New Mexico

Hawaii

Rhode Island

Maryland

2

2

3

3

3

3

3

1 2 2 3 3 4 4

Mar

ket

Att

ract

ive

ne

ss R

ank

(sca

le 1

-4

)

Competitiveness Rank (scale 1 - 4)

High potential - Lower competition High potential - Higher competition

Lesser potential - Lower competition Lesser potential - Higher competition

19

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relatively insulated while capitalizing on the growth of large domestic markets and gaining

stronger positioning to compete in a globalized environment over the long-term.

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Appendix A: Legislative case study – The STATES Act

In June, Senators Gardner (D-CO) and Warren (D-Mass) introduced Senate bill “Strengthening

the Tenth Amendment Through Entrusting States” or STATES Act. A companion bill was

simultaneously introduced in the House as well. The STATES Act essentially aims to amend the

Controlled Substances Act (CSA) to exempt state-legal marijuana activity from its provisions.

STATES Act considered highly progressive. The STATES Act is considered to be amongst the

most progressive cannabis bills introduced to date, given its solid bipartisan backing and

apparent support from President Trump. In addition, 12 state governors (6 Republican, 6

Democratic) voiced their support for the bill in a letter to congressional leaders. We consider the

STATES Act as a strong potential positive as it could eliminate federal prosecution risk, improve

capital access, and further liberate flows into the sector, all factors which would boost valuation.

At the same time, the STATES Act would not require overall federal legalization thereby creating

a lower hurdle to enactment. Below we review the bill’s potential wide-ranging implications:

1) Risk of federal prosecution removed. The STATES Act would create an exemption from the

provisions of the CSA pertaining to cannabis, and allow state laws governing either

recreational or medical cannabis to prevail. As such US operators in compliance with

applicable state laws would no longer be contravening federal laws, thus removing the risk of

federal prosecution for illegal activities. This would remove a certain risk premium for US

operators in our view, without requiring overall federal legalization of cannabis.

2) Cannabis becomes de-facto legal in certain states. Under the STATES Act, cannabis would

become essentially legal in certain states resulting in a range of implications including; 1)

likely greater capital flows into the industry as some investors are reassured by no risk of

federal prosecution, 2) possible opening of interstate trade between states where cannabis is

legal, providing more market access, and 3) possible increased competition from foreign

operators (such as Canadian LPs) under the scenario TMX Group relaxes is listing regulations

for US-exposed cannabis companies as a result of greater legal clarity.

3) Increased banking access. The STATES Act also specifies that compliant transactions are not

trafficking and do not result in proceeds of an unlawful activity. This would free more banks

to engage in the sector, and could also result in changes to restrictive taxation rules (280E)

which prevent cannabis companies from deducting operating expenses.

4) Hemp legalization included in bill. The STATES Act also seeks to amend the CSA definition of

marijuana to exclude industrial hemp. This would create federal legality of industrial hemp

(cannabis with THC content < 0.3%) across all US states. In our view, if hemp-based CBD

extracts become federally legal, this could open a large addressable market not only for US

hemp operators, but foreign competition as well (from Uruguay or Colombia for example).

5) Challenges to passing the STATES Act. Although the STATES Act seems to have good

momentum currently, the US House and Senate are currently controlled by Republicans,

which have in the past blocked votes pertaining to protection of states’ rights to legalize

cannabis use in June 2017. In addition, House Republicans recently blocked votes on

proposed amendments to legalize industrial hemp, and expand banking access for cannabis

companies. So the STATES Act still has several steps to take before we get greater clarity on

the likelihood of it passing

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Appendix B: State-level data sets

Figure 23. Selected REC state data

Source: GMP Securities, State Health Departments, New Leaf Data Services

Figure 24. Selected MED state data

Source: GMP Securities, State Health Departments, New Leaf Data Services

RECREATIONAL STATES

California 39,536,653 1116 1,611 24,542 3,758 2.3 Unlimited

Colorado 5,607,154 940 529 10,600 1,029 1.9 Unlimited

Washington 7,405,743 659 556 13,320 1,345 2.4 LimitedOregon 4,142,776 966 532 7,787 1,095 2.1 UnlimitedNevada 2,998,039 2060 172 17,430 195 1.1 UnlimitedMassachusetts 6,859,819 2493 144 47,638 31 0.2 UnlimitedAlaska 739,795 4227 59 12,539 140 2.4 Unlimited

Maine 1,335,907 1870 8 166,988 8 1.0 Unlimited

Washington D.C 693,972 2072 6 115,662 9 1.5 Limited

Vermont 623,657 3086 5 124,731 5 1.0 Limited

State PopulationWholesale

Price/lbs

Population/

RetailerLimited

Licenses?

Production/

Retailer

Retail

Licenses

Production

Licenses

MEDICAL STATES

New Jersey 9,005,644 25,000 0.3% n.a. 36 250,157 12 0.3 Limited

Michigan 9,962,311 277,000 2.8% 1824 215 46,336 215 1.0 Unlimited

Illinois 12,802,023 36,800 0.3% 3058 60 213,367 20 0.3 LimitedNew York 19,849,399 62,256 0.3% 5600 40 496,235 10 0.3 LimitedFlorida 20,984,400 129,929 0.6% 2813 630 33,309 21 0.03 LimitedPennsylvania 12,805,537 30,000 0.2% n.a. 198 64,674 33 0.2 LimitedOhio 11,658,609 n.a. n.a. n.a. 60 194,310 24 0.4 Limited

Arizona 7,016,270 169,478 2.4% 1696 130 53,971 130 1.0 Limited

Maryland 6,052,177 46,710 0.8% 2850 115 52,628 37 0.3 Limited

Minnesota 5,576,606 10,738 0.2% n.a. 8 697,076 2 0.3 Limited

Montana 1,050,493 25,725 2.4% n.a. 135 7,781 135 1.0 Unlimited

Conneticut 3,588,184 25,028 0.7% 2975 19 188,852 10 0.5 Limited

New Hampshire 1,342,795 4,753 0.4% 3105 6 223,799 6 1.0 Limited

New Mexico 2,088,070 50,954 2.4% 2857 71 29,409 35 0.5 Limited

Hawaii 1,427,538 20,869 1.5% n.a. 16 89,221 16 1.0 Limited

Rhode Island 1,059,639 18,728 1.8% 2458 15 70,643 24 1.6 Unlimited

Medical

Penetration

Population/

RetailerState Population Patients

Wholesale

Price/lbs

Production/

Retailer

Production

Licenses

Retail

Licenses

Limited

Licenses?

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