The marijuana industry is blossoming before investors' very eyes. Just last month, Canada passed the Cannabis Act, making it the first industrialized country in the world (and only the second country overall, behind Uruguay) to legalize adult-use cannabis. When the industry is fully ramped up, we could be looking at $5 billion in added annual sales. That's a lot of green (pun fully intended).
However, it's not like the expected growth in the legal marijuana industry has come as a surprise to Wall Street or retail investors. With few exceptions, marijuana stocks have been blazing ahead since the start of 2016. In many instances, investors are now looking at forward price-to-earnings ratios in the high double digits or triple digits and hoping that these lofty valuations match expectations.
Pot stocks that have direct involvement in the industry have been among investors' favorites. By direct involvement, I'm talking about growers, processors, distributors, and retailers that are in direct contact with the plant, from seed to sale. It's not hard for investors to wrap their heads or hands around how direct players could benefit from a surge in weed sales.
Are you overlooking ancillary marijuana stocks?
But what often gets overlooked is that there's an entirely different market operating behind the scenes that's crucial to the cannabis industry. Although these "ancillary marijuana stocks" don't come into direct contact with the cannabis plant, they provide everything from financing and consulting services, to packaging and land for lease.
More important, they've mostly flown under the radar of investors, and thus might have more upside left, relative to growers.
Of course, when looking at an industry that's still in the early stages of maturing, losses are common -- even with ancillary marijuana stocks.
For example, packaging and branding company Kush Bottles (NASDAQOTH:KSHB), which just reported a 173% increase in year-over-year sales during its fiscal third quarter, appears to be a no-doubt winner from Canada's legalization. After all, Health Canada has laid out strict labeling and marketing guidelines that producers and retailers will need to follow. That should, presumably, allow Kush Bottles to secure substantial market share by providing the packaging and marketing materials needed for growers to differentiate themselves, while also complying with Canadian regulations. Yet Wall Street still expects Kush Bottles to lose money, at least through the following fiscal year.
These ancillary pot stocks are inexpensive
However, there are two ancillary pot stocks that are incredibly cheap (both have forward P/E ratios of 18) and might be worth a closer look.
Innovative Industrial Properties
One of the most intriguing ancillary marijuana stocks, and a company I'm personally high on of late (yes, another intended pun), is Innovative Industrial Properties (NYSE:IIPR).
Innovative Industrial Properties is a real estate investment trust (REIT) that acquires facilities for the growing and processing of medical marijuana, then leases these properties out for extended periods of time. In doing so, it structures its leases so it can pass along rental increases and property management fees to ensure that it stays ahead of inflation. Then, many decades down the road, it can sell its properties for a profit, should it choose to do so.
Recently, the company closed on two new purchases, bringing its total assets owned up to eight. As of its most recent quarterly report, which only took into account five properties, it more than doubled its revenue to $2.77 million, while reversing a nearly $600,000 net loss from the year-ago period into a better than $600,000 net profit. Plus, as a REIT, the company is required to pay out a majority of its profits as a dividend in order to avoid being taxed like a normal corporation. That's led to a $0.25-per-quarter dividend, good enough for roughly a 3% annual yield.
The beauty of this business model is that it involves a lot of predictability. Seven out of its eight leases are for 15 or 15.25 years (the other for 20 years), meaning it'll be easy for investors to forecast revenue and cash flow for any given year. Likewise, the marijuana-REIT model has relatively fixed costs, since it doesn't require too many employees to maintain the company's portfolio of properties. That's generally a recipe for long-term profits and success, which is what makes the company's forward P/E ratio of only 18 attractive.
The other ancillary marijuana stock that has a reasonably low forward P/E ratio relative to other cannabis stocks is Scotts Miracle-Gro (NYSE:SMG).
Now, to be clear, whereas Innovative Industrial Properties and direct marijuana players are entirely reliant on the cannabis industry, Scotts Miracle-Gro derived only 11% of total sales from its medical-marijuana-focused subsidiary Hawthorne Gardening Co. in fiscal 2017. That's an important distinction, and one that investors would want to keep in mind when comparing Scotts Miracle-Gro to more of a pure-play weed stock.
In recent months, Scotts' stock has come under fire for two reasons. First, there's been the late start in the U.S. to the lawn and garden season. Even though we're only talking about a business that tends to grow by the low to mid single digits, this traditional industry provided 89% of Scotts' total sales in 2017.
The other issue has been slowing sales at Hawthorne. The main culprit here has been disorganization in California, including delayed licensing and retail application approvals. During the second quarter, sales at Hawthorne, which primarily provides hydroponic solutions (for growing plants in a nutrient-rich water solvent) to the medical cannabis industry, fell by a disappointing 29% from the year-ago period to $41.8 million.
If there is a positive, it could be the recently completed acquisition of Sunlight Supply in early June. Sunlight Supply complements Hawthorne's existing products perfectly by adding new hydroponic and lighting solutions to its product line. Even with an adjusted negative impact of $0.30 to $0.40 per share on earnings in fiscal 2018, the Sunlight Supply acquisition, coupled with a maturing California cannabis market, should yield healthier growth from Hawthorne in 2019 and beyond.
Though Scotts Miracle-Gro lacks the incredible top-line growth potential of traditional pot stocks, its forward P/E of 18 could be ripe for the picking.