The last few months have worked wonders for the U.S. cannabis industry. After the November election, 36 U.S. states have now legalized medical marijuana and 15 allow recreational marijuana. And now that the Democrats have control of the Senate, hopes for federal marijuana legalization (or at least decriminalization) are high.
While the entire U.S. cannabis sector has been buoyed by these tailwinds, the fact remains that not all companies will prove to be good investments, even if legalization happens. However, I think I've found two fundamentally strong pot stocks, Innovative Industrial Properties (NYSE:IIPR) and Scotts Miracle-Gro (NYSE:SMG), which are better positioned than others to leverage excitement around pot and offer handsome returns to retail investors in 2021.
1. Innovative Industrial Properties
Shares of specialty real estate investment trust (REIT) Innovative Industrial Properties have run up 73% in the past year. Cannabis companies, which are unable to source capital from banks and institutional investors since cannabis remains illegal at the federal level, turn to Innovative Industrial for physical manufacturing space. Innovative Industrial provides spaces to these companies through sale-leaseback transactions. Innovative Industrial purchases real estate properties from state-licensed marijuana companies and then leases them back to the same companies in 10 to 20-year lease agreements.
Innovative Industrial owns 67 properties across 17 states, with 5.8 million square feet of rentable property. The company enjoys high revenue visibility, considering that 100% of its rentable property is leased with a weighted-average remaining lease term of 16.7 years. The triple-net lease structure (a lease agreement where the tenant is responsible for all expenses such as maintenance, insurance, and taxes) allows for much of the company's revenues to flow through as profits. Innovative Industrial has also managed to build a credible tenant list comprised of reputable multiple state operators (MSOs) such as Harvest Health & Recreation (OTC:HRVSF), Trulieve (CNSX:TRUL)(OTC:TCNNF), Cresco Labs (OTC:CURLF), and Green Thumb Industries (OTC:GTBIF).
The business reported phenomenal financial numbers in 2020. In the first nine months of 2020, the company's revenues rose over 195% year over year to $79.8 million. Adjusted funds from operations (AFFO) also rose over 223% to $66.7 million in this time frame. AFFO, which adjusts net income for non-cash charges such as depreciation and amortization, capital gains, CAPEX, and maintenance costs, is a better measure of a REIT's profitability. Innovative Industrial also pays a handsome dividend yield of 2.3%, above the S&P 500's average of 1.6%. The company is a dividend investor's dream, considering that it has increased its dividend payout by over 700% since late 2017 to $1.24 per share.
However, investors are now becoming increasingly concerned about Innovative Industrial's business model. In the face of cannabis legalization in the U.S., the company is expected to see a dramatic decline in the pace of sale-leaseback transactions, since marijuana companies will have more access to traditional sources of funding. Investors also expect a hit to Innovative Industrial's profitability due to reduced base rent and annual rent escalations.
While these worries are not fully unjustified, they do seem a bit exaggerated. First, the chances of cannabis companies completely foregoing the sale-leaseback form of finance seem low, considering that it is still a relatively quick and easy source of funding. Second, the improved access to funds will be a net positive for the entire marijuana industry, including Innovative Industrial. An increase in funds will allow the company to pursue even more deals, albeit at lower profitability.
With a forward price-to-earnings (P/E) ratio close to 38, Innovative Industrial is not a cheap stock. However, it is very well-positioned to benefit from the rapidly growing global medical cannabis market set to be worth $44.4 billion by 2024 -- and to continue to deliver solid earnings and share price performance in the coming quarters.
2. Scotts Miracle-Gro
Scotts Miracle-Gro is an indirect and much safer way of gaining exposure to the risky marijuana sector. Traditionally a major North American gardening supplies company, it also sells hydroponics systems (tools and equipment required to grow plants without soil) through its Hawthorne subsidiary. With the U.S. slowly but surely opening up to the medical and recreational cannabis sector, licensed producers are increasingly opting for indoor facilities instead of dedicating huge swathes of costly land to grow marijuana. This tailwind is being reflected in the share price of this otherwise sluggish stock, which has gained over 80% in the last year and over 7% so far this year.
In the first quarter of fiscal 2021 ended Jan. 2, Scotts' revenues jumped over 100% to $748.6 million. Scotts' net income of $22.2 million is also a departure from the norm. It's the first time ever that the company reported a profitable first quarter in any fiscal year.
Scotts is witnessing robust demand for its hydroponics systems from established and new marijuana producers, both in developed markets like Colorado and California, and markets that recently legalized marijuana, such as Oklahoma and Michigan. Hawthorne, which accounted for 41.3% of the company's total sales in the first quarter, grew revenues by 71% year over year to $309.4 million. The company has guided for fiscal 2021 Hawthorne revenues of at least $1.2 billion.
Scotts is differentiating itself from other hydroponic system suppliers by going beyond product distribution and developing holistic solutions to help cultivators improve plant yield and quality. The company has been investing in research and development (R&D), including plant genetics, to improve cannabis and hemp cultivation.
But all the top line growth has not come from Hawthorne. In fact, it was Scotts' traditional consumer lawn and gardening business categorized under the U.S. Consumer segment that grew much faster than expected and saw first-quarter revenues spike year over year by 147% to $408.8 million. The COVID-19 pandemic, which forced people to stay at home, has sparked a renewed interest in gardening. Retailers have also been building inventory ahead of the spring season. Scotts has also taken a keen interest in the rapidly growing area of edible gardening, shown by its acquiring a 50% stake in Bonnie Plants.
Scotts Miracle-Gro is facing some bottom-line pressure due to increasing input costs and marketing expenses. However, the market opportunity for this stock overshadows these challenges. The U.S. cannabis market is expected to grow annually at a CAGR (compounded average growth rate) of 28% to $90.4 billion by 2026. As 13 U.S. states make plans to legalize marijuana for medical or recreational use in 2021, Scotts' addressable market will expand by multiple times. In this light, Scotts Miracle-Gro -- a company that offers the best of both worlds by combining a solid underlying gardening business and fast-growing cannabis-related hydroponics business -- can generate solid and safe returns for retail investors in the coming quarters.