The legal use of marijuana is on the rise, be it for medicinal purposes or for one's recreational enjoyment. Many companies are looking to supply consumers with the product. That, in turn, is opening up opportunities for companies like Scotts Miracle-Gro (NYSE:SMG) and Innovative Industrial Properties (NYSE:IIPR), which are supplying growers with the tools they need. It's a modern-day gold-rush scenario, in which big money can be made selling picks and shovels to miners -- only in this case it's hydroponic equipment and grow houses. One of these two companies, however, is making a much riskier bet.
Built from scratch
Scotts didn't have a material presence in the hydroponic space a few years ago; it only started to mention it in its quarterly earnings releases in 2016. Part of the company's project focus effort, the hydroponic division, now known as Hawthorne, was built via acquisition. Historically, Scotts made lawn-care products under the Scotts, Miracle-Gro, and Ortho brands, among others. However, seeing an opportunity in the marijuana space, management decided to start building something new.
The growth of the Hawthorne segment has been swift, going from essentially zero to 47% of Scotts' fiscal first-quarter revenue. To be fair, that's not really an apples-to-apples comparison, since the company's revenue in the lawn-care segment is seasonal. The full-year contribution of the Hawthorne division is likely to be much less significant. In fiscal 2018, the division represented about a third of revenue. However, it's hard to pin down a solid number here because acquisition-led growth is still a big piece of the equation.
To put a number on that, fiscal first-quarter revenue at Hawthorne advanced 84% because of an acquisition. Still in growth mode, the only call that can clearly be made here is that Hawthorne will be an increasingly important source of revenue. But there's a problem, because Scotts has to pay for its acquisitions somehow, and that's meant taking on additional debt. Long-term debt has increased from roughly $700 million at the end of fiscal 2014 to nearly $2.2 billion at the end of the fiscal first quarter of 2019.
Now add in the nearly $100 million noncash impairment charge Scotts took related to some of the hydroponic acquisitions it made. Those write-offs reduce shareholder equity and suggest that the effort to quickly grow Hawthorne may have led the company to overpay for the assets it acquired. But there's a tap-on effect here, with long-term debt making up a very troubling 90% of the capital structure at the end of the fiscal first quarter, helped along by a roughly 50% decline in shareholder equity in 2018.
Scotts can certainly continue to operate with this much leverage, but it doesn't leave the company much leeway on the balance sheet. For most investors, there's just too much risk here.
Building the buildings
Innovative Industrial Properties has taken a vastly different approach to the marijuana space. This real estate investment trust (REIT) owns the properties in which pot is grown. Like Scotts, it's building this business from the ground up. However, there are some important differences.
First, from a high-level perspective, Innovative's industrial assets could, at least theoretically, be used for other purposes. So if there is a vacancy, it could simply repurpose a property it has acquired. Second, the company is actually something of a funding source for marijuana growers, often buying a property from a grower and then instantly renting it back under a long-term lease. That should provide Innovative with a unique pipeline of opportunities as companies look to expand.
Third, and perhaps most important, the REIT model involves passing most income generated on to shareholders. Funding acquisitions requires going to the capital markets and selling equity and debt. Up until the first quarter of 2019, Innovative had no long-term debt -- it had funded its growth by selling additional shares. Demand for marijuana-related stocks has definitely eased the processes of selling shares. Although it has yet to report first-quarter results, the company did announce that it sold roughly $150 million in long-term debt in early 2019 when it reported fourth-quarter earnings. Put that against the approximately $260 million in shareholder equity at the end of the fourth quarter (long-term debt would be about a third of the capital structure), however, and it's easy to see that Innovative's balance sheet still has far less leverage than Scotts'.
There are clear risks here, of course. For example, there are many small growers trying to establish themselves in the marijuana industry. If things don't work out as planned, Innovative could end up with empty facilities. Yes, they can repurposed, but that will take time. And since the marijuana space is still something of a land grab, Innovative could get caught up in the excitement and overpay for assets. Or it could simply overreach, leveraging itself to the point where its balance-sheet strength becomes a balance-sheet risk. However, as it stands today, Innovative appears to be a better option than Scotts.
Be careful with hot trends
The truth is that marijuana is a big story on Wall Street right now. Unfortunately, history teaches us that excess often follows big stories when it comes to investing. For that reason alone, most investors are probably best off avoiding Innovative and Scotts. However, if you want to buy one of these two industry suppliers, Innovative's model appears to be financially more stable today.