If you're looking to dip your feet into the cannabis investing swamp, you've probably considered the largest licensed producer in Canada, Canopy Growth (CGC -0.52%). American investors leery about owning businesses with a direct hand in activities the federal government still considers illegal make Scotts Miracle-Gro (SMG -0.33%) another popular option.
Which company has the best chance of crossing the hurdles in front of it? Here's what you need to know about the path to market-beating gains in front of both these marijuana stocks.
Predictions about the market for legal cannabis varies, but soaring state-legal sales in the U.S. have led some to suggest it could reach around $150 billion by the end of 2025. To gain a share of nascent markets outside the U.S., Canopy Growth and some of its peers have developed an ultra-risky growth-at-any-cost business model.
It isn't easy for Canadian listed companies to raise enough capital to build enough greenhouses to produce 500 tons of cannabis annually. To make it happen, Canopy listed its shares on a major U.S. exchange and accepted a huge equity stake from Constellation Brands (STZ 1.38%).
Funding rapid expansion in Canada and farther abroad has driven the number of outstanding Canopy Growth shares up 247% over the past three years. This means Canopy Growth needs to generate 3.47 times more profit to provide the same returns investors were hoping for when they bought the stock three short years ago.
Underemployed millennials without lawns or gardens haven't been kind to Scotts Miracle-Gro's consumer goods business. To stay relevant, Scotts Miracle-Gro formed its Hawthorne subsidiary in 2014 and used it to acquire a string of popular businesses that cater to indoor gardening.
Over the past few years, Hawthorne has spent at least $1.0 billion assembling brands that professionals and hobbyists already love, such as General Hydroponics. Borrowing heavily to fund this shopping spree has increased the company's debt level to 7.7 times EBITDA. Typical consumer discretionary companies rarely let this ratio rise above 2.
The hydroponics business hasn't worked out as well as Scotts had hoped. Since the start of 2018, trailing EBITDA for Scotts has fallen from $477 million to just $276 million, and the stock slid 27% lower. Hawthorne revenue rose to $344.9 million during the fiscal year ended Sept. 30, 2018, but the segment also lost $6.1 million during that period.
While things aren't looking great for Scotts, Canopy Growth's fourth quarter was downright terrifying. Just 17 days into the three-month period, Canadians began buying recreational cannabis, which drove total sales 256% higher than the previous quarter to CA$83.0 million. Unfortunately, expenses rose even faster, and as a result operations ended up losing CA$157 million during the period.
What's next for Scotts Miracle-Gro
The Scotts Miracle-Gro brand puts a bad taste in the mouths of cannabis growers for a couple of reasons. First, ruining plants with its eponymous brand of fertilizer or potting soil is a common rookie mistake. Now that Home Depot stocks Hawthorne's Black Magic brand of cannabis-friendly potting soil right next to Scotts' other brands, it probably happens a lot less than it used to.
Moreover, many of Hawthorne's potential customers confuse the licensing fees that Scotts pays for rights to market Roundup as direct ownership and control by Monsanto. When they believe the products they love aren't made by a company they respect, the brands quickly lose some value.
During the three months ended Dec. 29, 2018, sales volume from the Hawthorne segment fell. The company's plan to aggressively trim acquired employees in order to capture synergies isn't going to make the brands it's invested in any more popular.
The road ahead of Scotts looks rocky, but at least it's a profitable business now. Canopy Growth has expanded so quickly that sales, general, and administrative expenses climbed to 110% of revenue during the last three months of 2018. Total licensed cannabis sales only reached an annualized CA$1.2 billion during the last three months of 2018, and Health Canada recently reported January sales that were lower than December's.
Canopy has invested heavily in international sales growth without much more to show for it than soaring expenses. Fourth-quarter international sales were just CA$1.7 million higher than a year earlier at CA$2.7 million. If they don't rocket higher, and soon, the company could be in trouble.
Lackluster growth of licensed cannabis sales in Canada is a result of years of decriminalization. In some cities, Canadians are walking right past stores that stock licensed cannabis and into dispensaries down the street that are technically illegal, but largely tolerated. Unfortunately, Korea and Japan are the only two members of the OECD, a club for rich countries, where you're more likely to go to jail for cannabis-related offenses than in the U.S. With this in mind, it might be a good idea to temper expectations for international sales opportunities.
The relatively better marijuana stock
Right now Canopy Growth's $14.9 billion market cap is being supported by investors excited about licensed cannabis sales that aren't growing fast enough to make anyone rich. Misguided bullish enthusiasm could drive the stock higher, but you don't want to be holding these shares once investors start paying attention to the company's financial statements.
Scotts Miracle-Gro produces a profit, and investors expecting it to grow quickly have driven the stock up to 18.7 times forward earnings. That's above average for stocks in the S&P 500 index and a lot more than anyone should be willing to pay for shares of a business performing so poorly. Scotts has very little chance of outperforming the market, but it's far less likely to lead to losses over the long run than Canopy.