There simply isn't much good news for the cannabis industry these days. It's not just cannabis operators that have been impacted by market issues; ancillary companies supporting the cannabis industry have also been affected.
Is the stock a smart pick to buy on the steep pullback or one to avoid altogether? Here are the arguments for and against investing in Innovative Industrial Properties (IIP) from two Motley Fool contributors.
Bull case: Still a tremendous growth opportunity
Keith Speights: Some of the first words out of IIP CEO Paul Smithers' mouth on the company's second-quarter conference call were: "Industrywide sales revenue continues to increase, and legal sales of cannabis are expected to top $52 billion by 2026, nearly doubling 2021's total of $27 billion." His point is that there's still a tremendous opportunity for the cannabis industry -- and for IIP.
Keep in mind that IIP is still performing quite well despite facing multiple headwinds. The company reported 44% year-over-year revenue growth in Q2. Earnings jumped 37%. IIP also raised its dividend by 25%. Its dividend yield currently tops 7.3%.
The company now owns 110 properties in 19 states. The cannabis markets in many of these states are in their early stages. There are also another 18 states with legalized medical cannabis where IIP doesn't currently operate. Cannabis operators still don't have access to full banking services, and IIP's real estate capital provides an excellent way for these companies to raise cash.
You'll hear the bear case against IIP below. And there are some pretty good arguments why investors should avoid the stock. However, they all focus on the short term. Over the long term, IIP should be able to continue delivering impressive total returns for investors just as it has over much of the past five years.
Bear case: An unfavorable environment for cannabis landlords
George Budwell: Innovative Industrial Properties' stock experienced a meltdown this year. The bad news is that this cannabis REIT stock may have a lot further to fall before it finds a bottom.
IIP's troubles stem from a multitude of interrelated issues. As a cannabis landlord, the company's growth plan is predicated on an aggressive expansion strategy that entails buying and subsequently leasing new properties. Until recently, this business strategy has been a successful one. But cracks are starting to show. During IIP's 2022 second-quarter report, for instance, the company noted that Kings Garden recently defaulted on its lease. This single tenant accounted for approximately 8% of IIP's total rental income.
While one tenant defaulting isn't the end of the world, this Kings Garden setback could be a harbinger of things to come. The cannabis industry is in a precarious phase right now. Oversupply, changing customer preferences, and burdensome government regulations have all weighed on profit margins in recent times. What's more, capital markets have been considerably less friendly for publicly traded marijuana companies since the start of the ongoing bear market roughly 11 months ago. Taken together, these two headwinds will likely result in more tenant defaults across the fledgling cannabis industry.
Another key issue to consider is IIP's stately valuation. At present, the company's shares are trading at over 11 times sales. In the past, investors have been willing to pay this heavy premium because the company was posting blistering levels of top- and bottom-line growth. But if this growth slows down due to tenants struggling to pay rent, IIP could lose its top-notch valuation in a hurry.
The bottom line is that tighter capital markets and falling profit margins could prove to be major overhangs for cannabis landlords like IIP -- at least in the short term.
The long and short of it
IIP stock is likely to remain volatile this year and probably into 2023. The issues mentioned in the bear case against the stock probably won't disappear quickly. However, the biggest problem for the cannabis industry and IIP -- oversupply -- should only be a temporary one. This is an example where both bulls and bears could be right. IIP stock could be one to avoid over the short term yet still be a winner over the long term.