Legal marijuana is expected to be a huge growth business, with some projecting a market opportunity of as much as $166 billion. That's many years away, since the industry is still largely in its infancy. But the projection shows just how excited Wall Street is about legal weed.
The problem is that investors have a bad habit of getting too excited in the early days, pushing story stocks up to unrealistic heights. The recent declines in marijuana growers suggests that's happened again. Here's why Scotts Miracle-Gro (SMG 0.72%) didn't get hit, and why it may be a better option for long-term investors interested in the space.
The picks and shovels
When you buy a marijuana grower like Canopy Growth, you are making a direct bet on the future of legal pot. It is a notable player in the space, but its future won't be nearly as bright as hoped if legalization doesn't continue to spread across the United States. Its entire future is basically tied to more people taking advantage of the legal opportunity to use marijuana. That's not bad or different from any of the other pot stocks; it's an issue they all face as they compete for market share.
That last point is important: There are a lot of companies looking to get a piece of the marijuana market. Sure, Canopy is a big player, but it isn't the only player...which is where Scotts Miracle-Gro comes in. This company has long served the slow-and-steady lawn care market, helping people grow and maintain pretty yards and flowers. A few years ago, management decided it wanted a piece of the marijuana market, too.
However, instead of growing the plant, it stuck to its knitting and bought its way into the hydroponic supply space. The facilities in which marijuana is grown generally use hydroponic systems. At this point, Scotts is one of the biggest players in the hydroponic niche, with sales of $176 million in its hydroponics-focused Hawthorne division in its most recent quarter. That's an annual run rate of around $700 million. This is a big business -- and it's growing, with management estimating that organic sales were up nearly 20% year over year through the first nine months of fiscal 2019 (recent acquisitions have pushed overall sales at Hawthorne up even more).
A winner either way
What's exciting is that it doesn't matter who is winning the marijuana market-share war; Scotts can provide them all with the tools and supplies they need. As pot companies come and go, it will still benefit from increasing end-market demand, which brings up an interesting statistic.
It seems that legal marijuana hasn't been as big a game changer as many expected. According to industry watcher BDS Analytics, in 2018 90% of marijuana sales in Massachusetts were illicit. In California, the number was nearly 80%. In Oregon and Washington, illegal pot sales were estimated to account for around 50% of the total. Although many thought legal marijuana would push illegal marijuana out of the market, that just doesn't appear to be happening -- at least not quickly.
The big issue is most likely cost. Without having to deal with taxes and regulation, illicit marijuana is cheaper. It's similar to the idea of buying cigarettes from lower-tax regions to sell in higher-tax ones. It's not legal, but evading taxes leads to lower selling prices and/or higher profits for the cigarette seller. Since illegal marijuana growers were already breaking the law before pot was legal, the fact that they are continuing to meet the demand for low-cost weed shouldn't be surprising. But it could be a thorn in the side of companies that are hoping to see huge growth in the legal marijuana market.
Scotts Miracle-Gro, on the other hand, benefits either way. Sure, it would rather sell to people who are operating on the up and up. But anyone can buy hydroponic supplies from the company, which means that Scotts not only wins as legal marijuana production grows (no matter which companies end up being the big players), but can also benefit from illegal marijuana growers fighting to stick around.
Worth a second look
Scotts Miracle-Gro doesn't offer the earnings growth potential of a pure-play pot stock, since slow-and-steady lawn care is still roughly 75% of its top line. But if the marijuana market continues to grow as Wall Street expects, Scotts offers a way to play the space without the need to own a grower. After all, the grower you pick may or may not end up a winner in a highly competitive market that still includes some growers playing outside the bounds of the law. Add in the fact that Scotts has started to reduce the leverage it took on to build its hydroponic business, and the company is probably worth a deep dive if you are interested in the marijuana space. Income investors, meanwhile, will likely appreciate the company's 2.1% yield.