Marijuana is expected to be a huge growth business, with some on Wall Street projecting that legal pot sales could eventually reach a massive $166 billion a year. If that forecast proves anywhere close to accurate, there could be a lot of upside for both marijuana companies and the companies that provide them with vital products and services. Which is exactly where Scotts Miracle-Gro (SMG -0.47%) and Innovative Industrial Properties (IIPR 0.01%) come in. If you can't stomach the idea of owning a marijuana stock, then these two industry suppliers are worth a close look. Picking between the two, meanwhile, is getting more difficult.
What they do for marijuana growers
Scotts operates primarily in the lawn care sector -- a slow and boring business. However, a few years ago it decided to branch out into the hydroponic space to take advantage of the increasing legalization of marijuana. The subsidiary it launched to cater to cannabis growers, Hawthorne Gardening Company, has been growing quickly, and now accounts for around 20% of Scotts' sales. So far, most of that growth has been driven by acquisitions. However, management reported that in the company's fiscal third quarter, Hawthorne's organic sales growth would have been nearly 50%, factoring out a big acquisition made in mid-2018. That's impressive.
Innovative Industrial Properties is a real estate investment trust (REIT) that owns grow houses in which marijuana companies operate. So it provides places for the producers to grow their cannabis, but its business is more nuanced than that. It has been able to expand by acquiring facilities from marijuana companies, then renting them back to the grower under long-term leases. This provides liquidity to the growers that they can use to expand their businesses, so it's a win/win situation. Innovative increases the scale of its portfolio while simultaneously supporting the cannabis industry's long-term growth.
What if the marijuana sector doesn't grow as predicted?
The first thing to note about Scotts is that its business remains mostly focused on lawn care. That's the foundation on which the company is building out its Hawthorne subsidiary. On the one hand, that reduces the company's growth opportunity, since the bottom-line impact of the fast-growing hydroponics unit is diluted by the slower-moving lawn care operation. However, there's also some safety in that diversification. If legal marijuana doesn't turn out to be as big a deal as Wall Street is expecting, Scotts will still have a stable business to fall back on.
Innovative Industrial Properties is all-in on the marijuana niche. If its lessees start to close up shop, it will have a problem. That said, it currently has, basically, 100% occupancy, so it's in pretty good shape today. And, in a worst-case scenario, the physical properties it owns could be repurposed. Grow houses are specialized, so the time and costs involved in those sorts of transitions would be an issue. However, Innovative does have a fallback position if it needs one, though it might not get the same rents as it does from its current tenants.
A tougher call
Although Scotts has a sizable legacy business to backstop its hydroponics investments, it built Hawthorne through acquisitions. That required the company to take on a lot of debt. At the end of fiscal 2018, long-term debt made up 90% of the capital structure -- a balance sheet statistic that should trouble even the most aggressive investor. But over the next three quarters, Scotts got that number down to 66% -- still on the high side, but not unreasonable. And the swift improvement shows that management is well aware of the need to address its leverage issue. (For context, it sold a stake in a joint venture and put the cash toward debt reduction.) As a result of its efforts, Scotts stock is much more attractive than it was just a year ago, though truly conservative investors should probably still avoid it.
Innovative, meanwhile, has gone the opposite direction to some degree. At first, the REIT focused on equity sales to fund its growth, which left it with a pristine balance sheet. That, however, wasn't a sustainable approach (or a desirable one, for that matter) and the company has now started to issue debt. The new notes it issued have pushed debt to roughly 33% of the capital structure. That's not unreasonable at all and the REIT could easily handle much more.
However, investors need to keep an eye on the company's growth efforts. If it overextends itself by acquiring too many assets too quickly or starts to overpay for assets, it could end up destroying shareholder value. Debt is the rocket fuel that could allow management to make those blunders, especially in a sector that's being heavily hyped on Wall Street. So while there's no need to be afraid of owning Innovative today, there are reasons to worry that management might get sucked in by the hype around its industry.
Which way to go?
At this point, for investors who are seeking portfolio exposure to the legal cannabis sector, but who prefer not to get it by owning actual pot stocks, Innovative looks like the better option. It is more focused on the space, has a strong balance sheet, and could reposition its assets if lessees vacate its properties. That said, investors are clearly aware of its success, and have bid the stock up significantly over the past year. Scotts shares have advanced, too, but not nearly to the same degree. That might make the stock appear more desirable to some, but remember that while its leverage situation has improved, it remains a notable issue. Still, given its strengthened financial position, investors looking to hedge their bets on pot might want to take a second look at Scotts.
Conservative investors, however, should probably avoid the marijuana space altogether. If history is any guide, the rosy predictions being made on Wall Street today may not come to pass. The massive share price declines some big-name pot stocks experienced this year only serve to highlight the real risk that the market may have gotten irrationally excited about the profit potential of the legal cannabis sector.