The marijuana industry had itself quite the year in 2018. Although pot stocks were somewhat of a mixed bag, with many delivering huge declines, the cannabis industry gained validity like never before.
In October, Canada became the first industrialized country in the world to give the green light to recreational pot. The following month, a handful of U.S. states legalized or expanded the use of cannabis. And to end the year, President Trump signed the farm bill into law, legalizing hemp and hemp-based cannabidiol products in the United States. No longer considered taboo, the legal marijuana industry is ripe for investment.
Wall Street expects these pot stocks to decline
The excitement surrounding the rise of legal cannabis is readily apparent on Wall Street. A screen of more than three dozen pot stocks found that analysts expect nearly every one of them to head higher. And by "head higher," I mean Wall Street's consensus price target for these marijuana stocks is higher than where these companies are currently valued on a per-share basis. But note: I said nearly every one.
Among the sea of green are two pot stocks that have lower consensus price targets than their current prices. Let's take a look to see if Wall Street is right about these companies, or if investment firms are missing the big picture.
Innovative Industrial Properties
You might be surprised to learn that cannabis real estate investment trust (REIT) Innovative Industrial Properties (NYSE:IIPR) is one of the two companies Wall Street believes will head lower. Right now, its share price is 2% higher than analysts' consensus price target.
What makes this so shocking is that Innovative Industrial Properties is one of a very small handful of pot stocks that's profitable on an operating basis. This has to do with the consistency and predictability of the cannabis REIT model. Innovative Industrial currently owns 11 medical-marijuana-growing and/or -processing properties in eight states. These properties are then leased for a period of between 15 and 20 years, with annual rental increases and a 1.5% management fee built into the contracts. In essence, it allows Innovative Industrial to stay ahead of the inflationary curve and deliver steady cash flow. In fact, this is a company that's already increased its quarterly dividend twice since going public in late 2016.
So why might Wall Street not be optimistic about Innovative Industrial Properties' future? Part of the reason could be the stock's monumental run. Since it went public in late November 2016, shares of the company are up 194%. While that makes sense given its profitability, organic growth from leased properties will only be in the low single digits each year. That makes its forward P/E of 27 look a bit lofty.
The other concern is that because Innovative Industrial Properties is generating minimal cash flow from its properties, it'll have to regularly turn to dilutive common stock offerings to raise capital. Last year, the company did just that, with 3.22 million shares sold in January 2018, and 2.99 million shares sold in October 2018. All told, Innovative Industrial Properties walked away with a combined $193.2 million from these share offerings, which it's been using to add new acquisitions to its lease portfolio. Unfortunately, these share offerings can weigh on existing stakeholders and even push down cash flow per share.
While I don't expect this stock to march upward in a straight line as it did in 2018, I do foresee modest upside as it continues to expand and diversify its cannabis portfolio. In other words, I don't believe Wall Street's right about this stock.
The other marijuana stock with a lower consensus price target than its current share price is Wall Street darling Cronos Group (NASDAQ:CRON). Unlike Innovative Industrial Properties, the gap between the consensus estimate and current share price isn't even close. Analysts' consensus target price suggests that Cronos Group will fall 25% from its current level.
Cronos has been all the rage lately after tobacco giant Altria (NYSE:MO) announced it would take a $1.8 billion equity stake in the company. Assuming the investment is approved by regulators (which seems likely), Altria will hold a 45% stake in Cronos, with the warrants it'll receive giving it the potential to increase its ownership to 55% in the future. This deal gives Cronos Group a boatload of cash to execute its strategy, as well as a partner that could help introduce its cannabis products to new markets.
But in this instance, I do believe Wall Street is right to be cautious. For starters, Cronos Group isn't expected to give fundamentally focused investors much to work with. Analysts are calling for just a few pennies per share in full-year profits in the current and following year, which is the result of Cronos Group spending liberally on international expansion, product diversification, brand building, and perhaps capacity expansion. The company's forward price-to-earnings ratio of 329 is a major eyesore, and the upcoming dilution as the result of Altria's equity investment will only make things worse.
Another concern is that Cronos Group isn't exactly producing like a company of its caliber. When the Altria deal closes, and based on Cronos's current market cap, the company would be worth about $4.5 billion. However, it's only on pace to produce around 120,000 kilograms of cannabis at peak capacity. Even though production isn't everything when it comes to pot stocks, investors could buy into growers with similar peak production potential with market caps that are less than a quarter of Cronos Group's.
In short, I do believe Wall Street has Cronos Group pegged correctly and would look for some the air to come out of this balloon sooner than later.