Once considered taboo, the marijuana industry is no longer. Following the legalization of recreational cannabis in Canada, and the waving of the green flag of medical marijuana in 33 U.S. states, North America has become a hotbed for cannabis industry growth.
While growth estimates vary wildly, there appears to be a consensus among the various projections that the compound annual growth rate of the global pot industry should remain in the double digits through the end of the next decade. That offers plenty of opportunity for long-term investors to realize sizable gains.
This under-the-radar cannabis stock saw its price target soar in June
If you were to glance throughout the industry, most marijuana stocks that have received coverage from Wall Street have price targets that are higher than where they currently trade. Then again, this is pretty common for stocks outside of the cannabis industry, too.
But not all price targets are necessarily higher. Even in the fast-paced pot industry, Wall Street sees companies that might be overvalued, based on its price modeling. One such stock that had overstepped its bounds, at least based on share price, is marijuana-based real estate investment trust (REIT) Innovative Industrial Properties (IIPR -0.05%).
Throughout May, Wall Street's consensus price target on Innovative Industrial Properties, which is also known as IIP, was $85 a share. With the company's share price vacillating around this price target for much of May, the idea was that IIP was fairly valued. But IIP roared higher in June, hitting a closing high of $131 this past Tuesday, June 25. That would potentially have made IIP the most overvalued pot stock in the industry, based on its $85 price target... save for one fact: Wall Street's price target has increased by a lot in June.
Although only two investment firms offer coverage on IIP, the consensus price target for the company rocketed higher by 81% in June to $154 a share, representing a nearly 18% upside from where it closed on Tuesday.
Here's why Wall Street had no choice but to dramatically boost its outlook for Innovative Industrial
Even in the high-growth and rapidly changing cannabis industry, it's unusual to see a company's price target increase 81% in a single month. Yet, a quick look at what IIP has been up to from a business perspective shows that Wall Street had little choice but to up its outlook to align with the company's improved growth prospects.
Since the year began, IIP's portfolio of assets has doubled in size. As a cannabis REIT, IIP acquires land and facilities (grow farms or processing sites) that are used by medical marijuana growers in legalized U.S. states. It then leases these assets out (and occasionally develops facilities on land that it's purchased for its tenants) for long periods of time, thereby reaping the rewards of rental income. Many years down the road, should it choose to, IIP can sell its assets for a profit that can be reinvested back into new properties with a potentially higher yield.
Generally speaking, the more properties Innovative Industrial Properties has in its portfolio, the higher its net operating income (NOI) should be. With the company acquiring 11 new properties in 2019, six of which are in California, and pushing its portfolio to 22 properties, profits should soar in the year that lies ahead. After generating $0.75 in earnings per share (EPS) in 2018 -- keep in mind that EPS and NOI aren't the same, with NOI taking higher precedence with REITs due to their dividends -- Wall Street's consensus is for $1.82 in 2019 EPS and $2.78 in 2020 EPS.
In addition to increasing its top line by adding new properties, Innovative Industrial also passes along annual rental increases of 3.25%, and ties a 1.5% management fee to this higher rental base. Thus, the company is able to generate very modest organic growth, too, as its property portfolio expands.
There's a caveat to this growth
Expanding the size of IIP's portfolio is the key to its future growth and the reason its quarterly dividend has grown by 140% over the past year. But here's a caveat to this growth that works against investors: The only way Innovative Industrial Properties can increase its portfolio is with boatloads of cash via common stock offerings.
Even if IIP were to continue growing its portfolio, there would likely only be enough cash flow to fund one or two acquisitions a year. However, this is a company that's made 11 acquisitions in just the first half of the year. Therefore, like most REITs, IIP turns to selling its common stock from time to time to raise cash for future acquisitions.
On the bright side, these property additions are what drive NOI and dividends higher over the long run. But selling stock can wind up having an adverse impact on existing shareholders. It tends to dilute the value of existing shares, and since NOI has more shares to be divided into, it can make a REIT appear more expensive.
Make no mistake about it: At 45 times forward earnings, IIP isn't "cheap." And with the company aggressively acquiring new properties, the likelihood of another cash infusion, especially with its share price soaring in recent weeks, is growing.
While I do remain bullish on Innovative Industrial Properties' long-term prospects, its parabolic rise in the near term is unlikely to continue.