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A Wall Street Analyst Just Called This Sector a "Generational Wealth Opportunity"

The Motley Fool logo The Motley Fool 7/14/2021 Billy Duberstein
A Wall Street Analyst Just Called This Sector a "Generational Wealth Opportunity" © Provided by The Motley Fool A Wall Street Analyst Just Called This Sector a "Generational Wealth Opportunity"

U.S cannabis companies are some of the best opportunities in the market today. After all, we haven't seen an entire multibillion-dollar industry move from a shadowy black market into the mainstream since the end of Prohibition in 1933. Furthermore, U.S. cannabis companies are showing strong revenue and EBITDA growth, even in "mature" states that have been legal either on a medical or recreational basis for some time.

Yet U.S. multistate operators (MSOs) still operate under the shadow of federal illegality. That means cannabis companies have to borrow in the private market at much higher rates than a normal business would. In addition, since they are still considered illegal businesses, U.S. cannabis companies can't deduct most operating expenses from their taxes. When you're taxed on your gross margin and not operating margin, it's really hard to make money.

Still, one Wall Street analyst just came out with a long and in-depth report as to why U.S. cannabis companies could be the biggest "generational wealth builder" in the market today, while also pointing out his favorite and least favorite plays. Interestingly, his favorites differ from mine.

This analyst expects U.S. cannabis to grow mid-teens annually over the next decade. © Getty Images This analyst expects U.S. cannabis to grow mid-teens annually over the next decade.

Anatomy of hyper-growth: Legalization, mainstreaming, and disrupting alcohol and pharma

Jefferies (NYSE: JEF) analyst Owen Bennett recently came out with a sectorwide, 300-page initiation on U.S. cannabis last week, covering seven different MSOs and broader market dynamics.

His conclusion? The sector presents a "generational wealth-building opportunity."

In fact, he gives all seven major MSOs a "buy" rating, as all seven have the potential to benefit from the massive growth of the U.S. cannabis industry. Bennett cites three main reasons the U.S. pot industry will grow from $17.2 billion in 2020 to $36 billion by 2025 and $64 billion by 2030, good for a 272% gain and 14% compounded annual growth over a decade.

That type of mid-teens growth is usually only reserved for hot technology growth stocks, but Bennett sees the combination of moving from an illicit market to a legitimate market, the mainstreaming of cannabis use in the U.S., and the potential disruption to both the alcohol and pharmaceutical industries as the reasons behind all this growth.

Yet even that heady growth number is just Bennett's base case. Bennett also thinks cannabis has the potential to penetrate 30% of the U.S. adult population, with potential annual spending per person at $1,750 -- greater than the $1,378 million spent annually on alcohol today. If that happens, the market could grow to as large as $172 billion -- nearly 10 times the market today. No wonder Bennett is calling cannabis a generational wealth opportunity.

Of course, pot stocks have sold off after a big surge earlier in the year, likely due to a combination of rising interest rates, along with impatient investors expecting action on legalization already in this new Congress. Yet Bennett expects some sort of legalization measures over the next 12 months, citing ongoing bipartisan support in both houses of Congress.

a flag hanging on a wooden bench: A U.S. flag with a cannabis leaf where stars should be. © Getty Images A U.S. flag with a cannabis leaf where stars should be.

But Bennett's favorites may be different from what you'd think

When looking at various U.S. cannabis MSOs, I had thought those generating the highest profit margins today would be in better position. That's because since profits and access to capital are scarce throughout the industry, those generating higher profits today would be less risky, and would have to dilute their stock relatively less in order to grow. That's why Trulieve Cannabis (OTC: TCNNF) has been one of my favorites -- though I like plenty of others as well.

Bennett takes the opposite track: His current favorites are Cresco Labs (OTC: CRLBF), Green Thumb Industries (OTC: GTBIF), and Curaleaf (OTC: CURLF) – all of which generate among the lowest EBITDA margins today. That's because these stocks have the widest presence across highly populated states, spreading themselves out across the U.S. without going as deep into single states as others.

Because of federal illegality today, cannabis companies can't ship products across state lines. That means that those with some presence in many states are likely to have lower margins. That's in opposition to a company like Trulieve, which until recently had devoted almost all its efforts to solidifying its leading market share in the single state of Florida. In addition, Bennett likes Cresco for its focus on wholesaling, which brings lower margins today but sets it up for wider brand awareness as regulations come down.

Bennett believes the wider distribution will be more beneficial for establishing national brands once federal interstate commerce barriers come down, which he sees at inevitable. He even likes the stocks that have a bigger presence in California. That's curious, because while California is the largest cannabis state in the country by far, it also has unlimited licenses, and the intense competition combined with high costs have actually led to very low margins for cannabis companies that operate there. Still, Bennett sees it as strategically important, due to the state's size and ability to function as a launching pad for national brands.

a close up of a sign: Buy California pot stocks or stay away? © Getty Images Buy California pot stocks or stay away?

Which to believe?

Bennett's analysis was certainly a refreshing take I perhaps hadn't considered as much as I should have. Of course, one should definitely anticipate the relaxation of regulations in the months and years ahead.

Yet it's pretty unclear as to when that might happen, and to what extent. And even if cannabis is legalized at the federal level, it's also unclear how much each state will regulate cannabis within their specific jurisdictions. After all, each state has its own laws as to how it regulates alcohol, even though alcohol is a fully legalized substance that can be freely transported across state lines. And while Bennett is very bullish on the California market, the rampant oversupply in Canada, which fully legalized cannabis in late 2018, has led to big problems for the Canadian pot stocks.

So, at least to me, it still seems like those stocks with a large presence in attractive, limited-license states are still the safest way to play this space; however, as regulations change, that opinion could also change as well.

Nevertheless, there seems to be a growing consensus that U.S. cannabis sales are in for a decade of very strong growth, and enterprising investors should follow the industry closely to see which stocks will emerge as the durable leaders. As of today, things are still very much in flux.

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Billy Duberstein owns shares of Cresco Labs, Green Thumb Industries, and Trulieve Cannabis. His clients may own shares of the companies mentioned. The Motley Fool owns shares of and recommends Cresco Labs, Green Thumb Industries, Jefferies Financial Group, and Trulieve Cannabis. The Motley Fool has a disclosure policy.

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