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It May Look Pricey, But This Profitable Cannabis Stock Can Still Make You Rich

By John Bay - Updated Mar 25, 2021 at 8:07PM

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This hyper-growth real-estate stock is expanding fast.

The cannabis industry is booming, but that doesn't mean every player in the space is destined for success. As global legalization progresses and consolidation -- such as the upcoming Aphria-Tilray merger -- continues, we will see a group of deep-pocketed players coming to compete for a finite number of dollars. Currently, many of the biggest companies, Tilray among them, are experiencing ballooning losses because of lower gross margins, unfavorable inventory valuation adjustments (presumably due to cost-cutting spurred by competition), and high sales, marketing, and research costs.

Such losses are not uncommon in commodities or industries that mimic commodities, because traditionally, there are no moats protecting a commodity producer. In the case of a marijuana distributor or grower, what is to prevent any other player -- legal or otherwise -- from slashing prices to the bone to starve its rivals of profit?

A green streetlight shows a marijuana leaf.

Image source: Getty Images.

The other side of the statement

Is it possible that the best way to play this trend, currently, is from the cost side of the industry's income statements? After all, pure-play cannabis players seem to have no problem growing revenue; Tilray's sales rose by 25% in just the past year. And there's one absolutely necessary expense for each of these companies: Rent.

A revolutionary real estate investment trust (REIT) called Innovative Industrial Properties (IIPR -3.84%) is taking advantage of this situation with an experienced management team comprised of leaders who co-founded multiple other REITs. (REITs have a special legal structure which requires them to distribute 90% of the income they generate back to shareholders and invest 75% of their assets in real estate.)

Innovative Industrial Properties offers triple net lease properties, meaning that the tenant pays the cost of taxes, insurance, repairs, and other costs, to fully licensed medical marijuana distributors. Unlike the pure-play marijuana stocks, Innovative Industrial Properties is profitable right now, and its net income was up 163% in 2020.

So what's the catch?

When I hear friends in the investment industry criticize Innovative Industrial, it's usually not on the basis of the company's business model, which is sound, or its moats, which are wide and growing (as I'll go into momentarily). Rather, the elephant in the room is valuation. 

It's undeniable that compared to the market average, Innovative Industrial is expensive. Its current price-to-earnings ratio (P/E) of 55 is more than double that of the S&P 500. Even compared to other REITs, it's pricey. But in the context of the company's own history, in which the P/E has ranged between 25 and 280, the current level is cheap -- even below the median of 60.

And I'd argue that this is how it is supposed to work. Stock price appreciation has two components, one of which is earnings growth, the other of which is P/E multiple expansion. In a higher-quality company, as earnings growth expands, the value of a share should rise (rather than earnings-multiple expansion driving growth).

That's what's happening at Innovative Industrial Properties, where the bottom line nearly tripled from $23 million in 2019 to more than $65 million in 2020. (And that's in the year of COVID-19, when many companies showed little if any year-over-year growth.)

Show me the moat

Innovative Industrial Properties isn't the only REIT out there with triple net leases, so what gives it an edge? In my opinion, it's management. Executives have worked on several REITs across multiple industries, including a medical REIT. Having done this successfully before, management knows that securing favorable leases from tenants is key to success.

Better leases mean longer-term contracts, and Innovative Industrial Properties has achieved those, with a current average lease term of 16.7 years. Think of these leases almost like a bond payment, something that the customers are legally bound to fulfill.

This speaks highly of those companies' confidence in their future, given that a flimsy business with uncertain prospects is unlikely to enter into a long-term contract. The strength of these longer-term contracts also allows REITs to secure favorable financing terms if and when they need to take out debt.

Speaking of which, Innovative Industrial's debt load is very manageable, with roughly $135 million of debt compared to over $1.5 billion of equity. (Most REITs are the opposite, with much more debt than equity; mall stalwart Simon Property Group, for instance, has $25 billion of debt versus $2.5 billion of equity.)

The implication here is that Innovative Industrial could probably lever up quite a bit, creating a lot more future earnings and free cash flow by securing more properties and earning more rental income. In the first nine months of 2020, the company paid $182 million to acquire 16 additional properties -- approximately 25% of its entire portfolio of 63 properties and a 33% growth rate for the year.

Finally, there's Innovative Industrial's unique position as a cannabis REIT. Management estimated that the industry grew by 50% between 2019 and 2020 -- and that's only about a third of the growth Innovative Industrial saw in revenue and earnings.

As long as marijuana remains federally illegal in the United States, banks are hesitant to lend cannabis companies the money they need to build and expand. In buying these companies' properties and immediately leasing them back to the businesses in question, Innovative Industrial Properties fills a growing niche, providing much-needed access to capital that can be difficult to find. That's one reason its customers are so loyal and its leases are so long.

Poised to bloom

In the end, Innovative Industrial's favorable competitive positioning comes down to experienced management using a prudent and conservative capital structure, which gives them plenty of firepower to take on more debt to acquire more properties and enter more favorable long-term leases. Their existing leases are already some of the best in the business, with 100% of their properties leased and an average contract life of 16.7 years. Add to that an industry which could easily continue to double or triple the U.S. GDP growth rates for many years to come, and the future looks bright.

Unlike most REITs, Innovative Industrial Properties has no exposure to malls, retail, or other commercial properties facing a decline in customers. Investors who want exposure to the growth potential of cannabis without the risk of a pure-play business would be wise to consider this REIT. 

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Stocks Mentioned

Innovative Industrial Properties Stock Quote
Innovative Industrial Properties
IIPR
$133.16 (-3.84%) $-5.31
Tilray Stock Quote
Tilray
TLRY
Aphria Stock Quote
Aphria
APHA

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