CASE: Mihi Cannabis: Planting the Seeds for A NewRetail Cannabis Business InCanada

Question 1 - How might Mh leverage the service-excellence framework to establish a differentiated value

proposition within the retail cannabis industry?

Question 2 - Conduct a sensitivity analysis for Mh that addresses (a) the different levels of market demand that

Dyck is interested in assessing, (b) the range of operating expenses, and (c) product mix and margin

IVEy Publishing W25665 MIHI CANNABIS: PLANTING THE SEEDS FOR A NEW RETAIL CANNABIS BUSINESS IN CANADA Peter Kerr wrote this case solely to provide material for class discussion. The author does not intend to illustrate either effective or ineffective handling of a managerial situation. The author may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized, or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, NOG ON1; (t) 519.661.3208; (e) cases@ivey.ca; www.iveypublishing.ca. Our goal is to publish materials of the highest quality; submit any errata to publishcases@ivey.ca. Copyright @ 2022, Ivey Business School Foundation Version: 2022-03-29 In June 2018, the government of Canada passed the Cannabis Act, paving the way for the legalization of recreational cannabis cultivation, acquisition, possession, and consumption on October 17 of that same year. This move set off a flurry of activity as existing companies, private equity firms, and entrepreneurs sought to establish an initial position within the burgeoning industry. One critical aspect in the formation of the industry would undoubtedly be how cannabis products would ultimately get to the end consumer. Cannabis ( ), a newistart-up, was planning to establish itself as a key player within this part of the Canadian industry's value chain. Thomas Dyck, the recently appointed chief executive officer (CEO) of Mihi (Latin for "me"), was busy developing a retail concept and strategic plan that he could take to his investors. He knew that the challenge for the company and its competitors would be to establish a strategy that adequately addressed the plethora of external factors influencing the industry and its growth potential. THE GLOBAL CANNABIS INDUSTRY Cannabis (also known as marijuana, pot, and over 1,200 other slang terms?) had been cultivated from the flowers of cannabis plants for thousands of years and used throughout history for both social-recreational and medical purposes. The earliest physical evidence of cannabis use by humans was discovered in 2008 by researchers in China, who uncovered a 2, 700-year-old Caucasian shaman grave containing 700 grams of cannabis.' Two of the 113 cannabinoids produced from the flowers of the cannabis plant generated two psychoactive effects when heated or smoked: tetrahydrocannabinol (THC), responsible for getting people "high," and cannabidiol (CBD), which relaxed people.* These same cannabinoids slowed messages that travelled through the nervous system to detect things such as pain and touch, and were, thus, also responsible for the observed medical benefits of the drug, including reduced inflammation, lowered blood pressure, improved sleep, and the calming of post-traumatic stress disorder symptoms.' Combined, the recreational and medical cannabis markets were estimated to be US$150 billion annually in 2017, generated from 219 million global users. Notwithstanding this popularity, the drug remained Distributed by The Case Centre North America Rest of the world www.thecasecentre.org t +1 781 239 5884 t +44 (0) 1234 750903 case centre All rights reserved f +i 781 239 5885 +44 (0) 1234 751 125 e info.usa@thecasecentre.org e info@thecasecentre.orgPage 2 W25665 prohibited in most countries as of 201 8, with legal cannabis accounting for only 8 per cent of total sales.7 Historically, the criminalization of cannabis in Europe and North America had appeared tied to immigration, foreign worker, and slavery issues. For example, the British attempted to ban cannabis in the 1800s, as they believed it reduced productivity on slave plantations, whereas in the United States, the criminalization of cannabis was used as part of a rallying cry against immigration.8 More modern opponents to legalization pointed to the fact that cannabis, when legally cultivated using new technologies, significantly raised the percentage of the psychoactive component in cannabis from its historical levels of 5 per cent to over 30 per cent, potentially inducing mental illness, paranoia, and violent psychotic episodes.9 In contrast, several societal trends appeared to be responsible for the slow liberalization of cannabis globally, including (a) a younger population more accepting of the drug than older generations; (b) the rise of high-profile cannabis-using social media inuencers; (c) growing research into the benefits of using cannabis for specific treatments; and (d) reduced interest by the public in continuing the "mar on drugs" and a search for alternative approaches, including its regulation and control.10 Thus, global consumer views with regard to cannabis legalization remained divided, and individual countries and communities were left to manage their constituents' varying perspectives. THE CANADIAN RECREATIONAL CANNABIS MARKET In Canada, cannabis was made illegal under amendments in 1923 to the Opium and Narcotic Drug Act. Since then, over two million people had been arrested for cultivating and selling pot. 11 Views as to the rationale behind this prohibition were mixed, with some historians attributing it to a book written by Emily Murphy, publis hed during the same period, that claimed "marijuana turned its users into homicidal maniacs.\"12 Regardless, the popularity ofcannabis grew in the 1960s and '70s, resulting in increased arrests for simple possession. In 2001, the Canadian government began a medical marijuana program allowing those with a medical prescription to grow their own cannabis or receive the drug directly from Health Canada until a regulated industry could be developed. At the time, medical cannabis was being used to treat a number of ailments, including easing the pain, spasms, and spasticity associated with multiple sclerosis, aiding in behavioural improvement in patients with Parkinson's disease and in memory preservation in patientswith Alzheimer's disease; and suppressing tumours and relieving nausea for cancer patients. The use of cannabis was also linked to other benefits. In one study, 82 per cent of respondents indicated that they had reduced their alcohol consumption through the use of cannabis, while 73 per cent had reduced their tobacco usage, 86 per cent had reduced their use of anxiety-related medication, and 95 per cent had reduced their use of opiates. 13 However, these benefits were in stark contrast to warnings coming from the Centre for Addiction and Mental Health about the negative effects of cannabis14 and a report from the Canadian Automobile Association indicating that "two-thirds of Canadians are concerned that roads will become more dangerous with the legalization ofmarijuamt."r15 Overall, Canadian public opinion and the negative criminal stigma surrounding cannabis were changing for the positive. According to a 2016 Nanos Research study, seven in 10 Canadians were in favour of legalization.16By 2016, cannabis usage in Canada was strong, with 3.8 million to 5.2 million regular users expected by 2021,17 approximately 10 1-4 per cent of the Canadian population. This expanding base of users increasingly did not tit the traditional \"stoner\" stereotype profile often associated \\\\ ith cannabis Usage (see Exhibit 1). New users were older, were more likely to be married with children, and had higher levels of income.18 Recreational cannabis was being used for a variety of stated reasons, including to help relax or sleep (66 per cent), to reduce stress or anxiety (62 per cent), and to have fun with friends (58 per cent) Page 3 W25665 (see Exhibit 2).\"; Despite changing attitudes, most users continued to hide their consumption from others. This was particularly true for new consumers. One challenge the industry faced was getting existing cannabis users to switch to legalized channels of distribution. Among other factors, existing users indicated that they would switch if (a) product quality was better (55 per cent), (b) there was a range of price points for every budget (54 per cent), and (c) products could offer a range of potency (47 per cent) (see Exhibit 3).20 Those looking to use legalized cannabis indicated a strong interest in buying from a retail store (48-51 per cent) as opposed to growing their own (27 per cent) or purchasing through a website (2833 per cent) (see Exhibit 4).21 One likely reason for this was the importance consumers placed on knowledgeable instore staff above other factors, to educate and help them with their purchases (see Exhibit 5). Even long-time, regular cannabis users indicated that their product knowledge was quite limited and that they would like to learn more. With the establishment of a legal and regulatory framework for the production, distribution, and possession of recreational cannabis on October 17, 2018, Canada became only the second nation to legalize cannabis for recreational use. Overall, the market was forecasted to grow to CA$23 billion, plus an additional CA$2.7 billion for cannabis edibles, topicals, and drinks, which were legalized one year later.22 Given the size of the opportunity, a number of competitors were expected to enter the industry. Competition was predicted to come primarily from ve different groups. Licensed Producers These organizations were originally formed to provide medical-grade cannabis, as prescribed and overseen by Health Canada. They built facilities to turn cannabis into oil, gel caps, and other product types as both a producer and manufacturer of cannabis products. They had access to signicant pools of capital, had a wealth of product experience, and could take advantage of the economics of full vertical integration. However, gitcn their potential poucr mcr the industry: \\aluc chain. it \"as expected that signicant regulatory restrictions would be placed on their ability to establish private retail outlets.23 Enthusiasts As there already were established grey and black markets for cannabis across the country, many retail stores existed that actively ignored current regulations and sought to meet the needs of their existing customer base as efficiently as possible. These businesses had access to black market supply, often at significantly lower prices than the prices for cannabis available through government supply chains. While regulation and compliance averse, it was expected that these businesses would ultimately transition to legal retail outlets. While being extremely knowledgeable about the products they sold, these competitors had little access to capital or the business acumen to expand signicantly.24 Landlords Superior retail locations very quickly became the critical scarce commodity Within the industry. Because of this, commercial landlords realized that they had an opportunity to stake a claim in the industry. While they controlled key locations, they had no day-to-day experience managing a retail business, particularly one Within a highly regulated industry.25 Page 4 W25665 Private Liguor In British Columbia and Alberta, private liquor distributors were expected to leverage their existing retail distribution networks and supply chain expertise to get into the cannabis industry in a big way. While they had experience managing a regulated retail business, they had little knowledge and experience with cannabis and the unique needs of the cannabis consumer.25 Private Retail The nal group of competitors included a mix of rms singularly focused on the retail cannabis market. Some were entrepreneurs, intent on becoming operators of one to three stores, who lacked retail or cannabis- specic experience. Others, like\\ Ulliad access to signicant sources of early-stage funding from private equity rms interested in investing in the sector. The value of these early entrants skyrocketed, creating large capital pools that ultimately trickled down to smaller rms. Several were able to leverage their early entrance to amass a significant capital position and build management teams with extensive retail expertise. These included Kiaro Holdings Corp., Decibel Cannabis Company Inc., and Tokyo Smoke.27 While opportunities within the cannabis industry looked promising, the overall economic outlook for Canada in 2018 was less positive. Strong economic growth over the past decade was expected to subside due to slower employment growth and high consumer debt levels.\" The Bank of Canada was also expected to gradually raise interest rates to offset inationary pressures, reducing investment stimulus (see Exhibit 6 for other economic indicators captured by the company for planning purposes). Total Canadian retail sales from 2018 to 2021 were forecast to be at,\" while pressure on retail salaries was expected to rise given declining unemployment rates and more-generous provincial minimum-wage policies (see Exhibit 7).30 At the same time, Canadian consumers were continuing to shift their buying habits from traditional brick-and-mortar retail to online purchases, with an estimated compound annual growth rate of 10.5 per cent from 2018 to 2025.31 REGULATORY FRAMEWORK Legalization meant that Canadians could now possess up to 30 grams of dried cannabis and grow four cannabis plants with licensed seeds or seedlings.32 However, it was expected that the majority of users would want to purchase rather than grow their own cannabis. In this regard, the Canadian government, through Health Canada, would control both the quality of supply, through strict licensing of producers, and individual consumption risk, through regulatory control of the product marketing mix (i.e., signicant product, packaging, and advertising restrictions)\" In contrast, each province would be responsible for decisions surrounding the supply chain and retail distribution of cannabis to Canadians?4 This resulted in a complex patchwork of regulations for companies to navigate as they developed launch strategies. In addition, cannabis e-commerce was limited to online purchases made through provincial government websites.35 While private retailers were technically free to set their own prices, in reality, there were numerous pricing constraints at play. First, retailers had to purchase supply at regulated wholesale price points, which effectively set a price oor for all legal competitors. Second, provincial government website prices for online purchases established a price point for legalized cannabis in the minds of consumers. Last, black market sellers consistently undercut the legal wholesale rate, establishing a price range for consumers willing to purchase illegal product.36 Page 5 W25665 The market potential for private retailers was very regionalized.37 Quebec and the Atlantic provinces chose to utilize their own public retail liquor networks to sell cannabis, eliminating any private retail opportunity. Alberta, using its experience in privatizing retail liquor decades earlier, chose to permit private retail distribution. However, the province delegated site selection and building permit decisions to municipal governmentswith mixed results. Some municipalities were quick to establish guidelines, creating an investment frenzy, others chose to opt out completely, and the remainder established excessive restrictions, making it virtually impossible for private firms to operate successfully. British Columbia was slower to establish regulations, already having a stable grey market (not legal, but not enforced), which the province was concerned about disrupting. The guidelines it ultimately established delegated location decisions to municipalities and allowed for only five stores per firm.38 In addition, the province also chose to sell cannabis through its own retail liquor network, which would compete directly with the private retail firms it was offering licences to.\" While most provinces established clear guidelines with minor changes during implementation, Ontario was the most problematic. In early 2018, prior to legalization, the provincial government had indicated that it would be using the province's retail liquor network (the liquor Control Board ofOntario) for cannabis distribution. However, one day after legalization, the Progressive Conservative Party of Ontario won a provincial majority and quickly abandoned these plans in favour of private retail. For those provinces allowing private retail distribution, store licensing procedures were somewhat similar. For example, each firm had to submit an application to the province, which included a non-refundable fee of thousands of dollars per location, and provide evidence that an executed, unconditional retail lease had been signed for each location. Applications also authorized the provincial government to conduct a full criminal and financial check of company officers, directors, and large investors.40 MlHI CANNABIS MIhI was founded in Toronto, Ontario, in August 2018 through a joint ownership agreement between BlackShire Capital Corp. and MTIITS management group. D3ek. the company "s new CEO, was given the mission of developing a world-class cannabis retail chain within the Canadian marketplace. 3ka had just recently retired from a successful 32-year career in banking at Toronto-Dominion 3 ank, where he had held senior management positions in a variety of financial business lines in both Canada and the United States. In Dyclx's last role as executive vice-president ofcommunity banking he was responsible for the bank's commiltnent to delivering a \"legendary bank experience to Canadians,\" leading 25.000 employees in l, l 50 branches. At MIyck would have to create a new organization from the ground up while navigating sig "tificant external hurdlesanearly lSO-degree shift from his experience at the bank. Dyck had already recruited some impressive talent for key management positions. His senior vice-president of guest experience was a seasoned consumer packaged goods and massmarket retail executive and a recognized thought leader in retail innovation, while his chief administrative officer had over 30 years of business and technology experience in highly regulated industries. Other key management positions included a policy guru with previous experience working for government regulatory teams across North America, a product manager with 15 years of experience in consumer packaged goods product and sourcing, and a brand leader with over 20 years ofexperience developing some ol'Canacla's most recognized brands. Initial revenue and cost planning had also begun. In terms of a build-out, Dyck estimated that each store would cost between CA$1 million and CA$l .3 million to set up, including the initial working capital needed to Page 6 W25665 operate the store. On average, he wanted to achieve a minimum 30 per cent return on store capital annually. Dyck felt that his competitors' product mix would likely be 80 per cent cannabis and 20 per cent cannabis- related accessories. Based on the regulated costs of acquiring product from suppliers, his competitors would likely generate cannabis gross margins of 28-32 per cent. Conversely, gross margins on cannabis-related accessories were forecast at 50-60 per cent and would form the balance of store revenue. Dyck firmly believed that a top-tier retailer could achieve a higher gross margin than the industry average through smarter product mix and price management decisions (see Exhibit 8). Total operating expenses, including lease, staffing, and store-related expenses, were expected to run between CA$650 and CA$800 per square foot. " EARLY CHALLENGES The regulatory frameworks established at the federal, provincial, and municipal levels created significant challenges for early industry development and the conversion of existing cannabis users to legal channels. At the federal level, initial regulations only permitted the sale of plant- and oil-based products," which represented about 40 per cent of traditional cannabis usage," leaving much of the market out of reach for industry players. In addition, delays in the licensing of cannabis production, as well as the regulatory complexity established, created a significant production learning curve, resulting in supply shortages in the first year of legalization." Conversely, the black market offered a full line of products and no supply shortages. The product packaging and dosage regulations imposed by the federal government did not match what consumers had been used to prior to legalization. For example, edible products could only contain 10 milligrams of cannabis per package. If the container included five gummy bears (the most popular form), each gummy could only contain 2 milligrams of cannabis; in comparison, the black market used an average dosage of 15-25 milligrams per candy. Given the importance of these factors in the consumer's purchase decision (see Exhibit 9), concerns were raised that demand for legal cannabis might be softer than originally anticipated. At the provincial level, retail licensing guidelines caused a massive "land grab" as competitors realized they needed to secure locations to meet licensing application requirements. During location scouting, Dyck observed that commercial landlords were receiving multiple bids for the same retail locations and so quickly increased their lease rates by three to five times the normal price per square foot, significantly affecting industry business models.4 In addition, landlords revealed that they would not permit firms to break their lease despite the uncertain regulatory environment. This meant that each cannabis retailer had to decide how much risk they were willing to accept, based on the number of leases they were prepared to sign before knowing whether their retail licence would ultimately be approved. Retailers wanting to operate in multiple provinces faced even greater challenges. For example, each firm had to manage and negotiate with separate supply chains in each province. In addition, store location planning had to consider the fact that overall customer demand, store potential, and even the prices consumers were willing to pay appeared to have regional variations (see Exhibits 10 and 11). MOVING FORWARD Unlike his previous roles, Dyck's position at made him responsible for launching a company in an industry that did not exist yet. There were few opportunities to learn from others, even in other countries. Both the industry players and the various levels of government were learning in real time. He knew that he needed to flush out a strategy for moving forward. In particular, he needed to make decisions with regard to which markets to enter and how big a retail footprint to initially establish. While many of the traditionalPage 7 W25665 elements of the product marketing mix would be common across all competitors due to industry regulation, Dyck knew he still needed to develop a strong value proposition that would both differentiate the company and support the normalization of the industry in the eyes of the communities in which it operated. His choice of value propOsition would ultimatcl} dri\\ c the compan} '5 business model and put greater pressure on certain organizational capabilities over others. Given potential market volatility, Dyck knew that conducting a store-prot sensitivity analysis was going to be a critical component in his decision-making. The data he had gathered could easily be used to calculate the average industry revenue per store; however, these calculations would be misleading, as they did not take into account the vastly dijferent retail formats that would emerge in the industry. For example, Dyck expected that .VlTlu' would likely see revenues two times the industry average, given its larger retail footprint (2,100 square feet); the use of higher-cost prime locations; and the overall marketing strategy he was planning on developing. One area of concern he had was the possibility that market demand would be lower than forecast while provincial governments might still license the maximum number of stores. This would result in a reduction in the average industry revenue per store. Thinking about this further, he felt that he could use a 25 per cent reduction in market demand in his sensitivity analysis to account for this potential volatility