There's a good chance that when this year comes to a close, investors will be referring to 2018 as the Year of Cannabis. And there's a good reason for that: Canada became the first industrialized country in the world to legalize recreational marijuana in mid-October, opening the door to what could be billions of dollars in added annual sales once the industry is fully ramped up.
But don't overlook what's happened in the United States, either. During midterm elections, two new states approved broad-based medical pot initiatives, with voters in Michigan choosing to green-light adult-use marijuana (the 10th state to have done so). Investors also witnessed numerous pot stocks uplist from the over-the-counter exchange to major U.S. exchanges like the Nasdaq and NYSE and stood in awe as the U.S. Food and Drug Administration approved the first cannabis-derived drug in June.
Despite this, not every marijuana stock has found itself a winner in 2018. Take Scotts Miracle-Gro (SMG 2.25%) as an example. Year to date, Scotts' shares have lost a third of their value, which is disappointing considering just how much momentum it brought into the year. The company did, however, make waves with one marijuana move that could drive its top- and bottom-line growth for the next couple of years.
The markets' safest pot stock?
As a refresher, Scotts Miracle-Gro isn't just a marijuana stock. In fact, it relies on the cannabis industry for only a small percentage of its business. First and foremost, it's a lawn and garden company tasked with improving yield and aesthetics for enterprises and retail consumers. For its recently ended fiscal year, $2.11 billion in sales was derived from its U.S. consumer segment, representing 80% of total sales. Although this is a business segment that's prone to occasional weather-related hiccups beyond Scotts' control, it's been a pretty steady driver of long-term growth.
However, the management team at Scotts Miracle-Gro is looking for more than just low- to mid-single-digit sales growth -- and that's what cannabis brings to the table. The company's Hawthorne Gardening subsidiary provides hydroponic solutions (growing plants in a nutrient-rich water solvent, as opposed to soil), along with lighting, nutrient, and soil products, to U.S. cannabis growers in an effort to improve yield. In fiscal 2018, Hawthorne was responsible for $344.9 million in sales, or 13% of total revenue.
The buy thesis on Scotts Miracle-Gro has been twofold up to this point. First, there's the idea that even if the marijuana industry fell flat on its face and was hyped beyond belief, Scotts could always fall back on its core lawn and garden operations and remain healthfully profitable on a full-year basis. This makes it, arguably, one of the safest pot stocks.
And second, with more and more U.S. states choosing to legalize pot in some capacity, the market for Hawthorne Gardening is growing.
Scotts Miracle-Gro's big cannabis deal
Scotts' subsidiary Hawthorne Gardening, in its desire to chase the higher-growth weed industry, took the bull by the horns in 2018 and acquired Marysville, Ohio-based Sunlight Supply for $450 million, which included $425 million in cash and $25 million in stock. Sunlight Supply is primarily a provider of hydroponic solutions to the cannabis industry.
Acquiring Sunlight Supply made sense for a variety of reasons for Scotts/Hawthorne. To begin with, it broadened the company's product portfolio, giving it greater access to small and medium-sized grow operations. With a larger selection of products focused on improving yield, this deal could even appeal to larger cannabis operations.
The potential for cost synergies also drove this combination. Since the two companies sell similar products and target roughly the same enterprise customers, combining their operations should result in at least $35 million in peak annual savings. That would lead to an annual earnings boost of $0.63 per share, assuming other aspects of revenue, expenditures, and outstanding share count were static.
And, of course, the combination provides even greater exposure to the burgeoning U.S. marijuana industry. For instance, California has the potential to generate more in annual sales from pot than all of Canada. Tack on billion-dollar markets like Washington, Colorado, Florida, and Massachusetts, and there's plenty of opportunity ripe for the picking. Ultimately, this acquisition may more than double the company's exposure to the cannabis industry.
The positives outweigh the negatives
Of course, things haven't worked out as well as investors would have hoped for this year. Whereas organic growth had driven Scotts Miracle-Gro in fiscal 2017, it was a major drag in 2018. Despite 20% sales growth being recorded at Hawthorne as a result of its acquisition, organic sales would have declined by 27% without Sunlight Supply.
Why the rapid drop in organic sales? Scotts placed most of the blame on California's cannabis market, which has been drowning in supply and slowed by red tape associated with the dispensary-licensing process. With growers struggling to find the demand necessary to gobble up their supply, the outlook for hydroponic and growing solutions has dimmed a bit.
However, this negative looks to be nothing more than a short-term speed bump. The marijuana industry has demonstrated that it is indeed a viable business model, and placing more weight on its Hawthorne subsidiary in terms of total annual sales should work out nicely for Scotts Miracle-Gro over the long run. When combined with cost synergies, it wouldn't be out of the question for Scotts to grow its earnings per share by approximately 10% on an annual basis, in my opinion, over the next five years. That'd make it a modestly attractive stock for investors who want exposure to the marijuana industry -- without an overabundance of risk.