Better Buy: Scotts Miracle-Gro Company vs. Innovative Industrial Properties Inc

How popular are pot stocks right now? Well, on Sept. 19 shares of cannabis producer Tilray surged nearly 100% to hand the company a market cap of $25 billion. There wasn't any news. And the business generated $17.6 million in revenue in the first half of 2018.

On the one hand, investors are right to be excited about the potential of the cannabis industry. On the other, emotions and hype are influencing the judgment of many investors -- and that probably won't end well.

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That said, investors don't have to avoid the industry altogether. If history is any guide, then it's worth remembering that lists of the biggest winners of a new field or technology vertical often include businesses on the periphery. That's what makes Scotts Miracle-Gro (NYSE: SMG) and Innovative Industrial Properties (NYSE: IIPR) so intriguing. Both are brand-agnostic, profitable, and sitting in front of a massive opportunity. Which marijuana stock is the better buy?

The matchup

Scotts Miracle-Gro began building a cannabis strategy years ago with the acquisition of The Hawthorne Company, which provides hydroponics products to customers that cultivate crops in large indoor facilities. The niche market is now dominated by the fast-growing cannabis industry -- and it has shown. Well, the key word is "has," as the Hawthorne business segment appears to have hit the snooze button during the company's fiscal 2018.

In the first nine months of fiscal 2018 (ending June 30), the Hawthorne business unit was responsible for $193 million in revenue, or 9% of the company's total. That's roughly equivalent to the performance from the same period of fiscal 2017, which is admittedly a bit of a head scratcher given the astronomical growth achieved by that business segment in recent years. Worse yet, the segment generated an operating loss in the most recent nine-month period as it focused on getting back on the path of growth.

While the poor performance at Hawthorne was the subject of an expletive-laden rant by CEO James Hagedorn on the most recent quarterly earnings conference call, the important thing to remember is that there don't appear to be any long-term concerns regarding the fundamentals of the business. The growth opportunity remains intact. The trajectory simply took a breather in fiscal 2018, and that just so happened to coincide with weakness in the U.S. consumer market, which is the company's core business.

Wall Street analysts seem to forget it, but Scotts Miracle-Gro generated 83% of total revenue and 99% of all profits from selling consumer garden and lawn care products. That's a good thing as far as investors are concerned. The steady and predictable cash flow from reputable brands ranging from Roundup to TomCat to Scotts provides plenty of financial flexibility to take a long-term approach with Hawthorne -- and that's exactly what management is doing.

Innovative Industrial Properties is also looking to tap into the growth of the cannabis industry through indirect means. The company manages an industrial real estate portfolio aimed at cannabis growers licensed to grow the medicinal plants for medical purposes. As legalization efforts bloom across the United States and Canada, the business should find ample opportunities for growth.

So far so good. In the first half of 2018, the company delivered year-over-year revenue growth of 135%. It achieved an operating margin of 33% in the first six months of the year and 37% in the second quarter of 2018. That resulted in diluted EPS of $0.27 per share in the first half of the year.

Of course, it's important for investors to know that those are merely the headline numbers. The $320 million company generated just over $6 million in total revenue through the first six months of 2018. That hasn't stopped Innovative Industrial Properties from recently declaring a 40% increase in its quarterly dividend from $0.25 per share to $0.35 per share. While the payout greatly exceeds EPS, the company generally points to funds from operations (FFO) as a better indicator of financial strength. In the first half of 2018 the payout totaled $0.50 per share and FFO settled at $0.45 per share.

While investors are clearly looking forward to the company's growth potential, there's no denying that the dividend is unsustainable given the current business performance. In fact, Innovative Industrial Properties has only been able to fully fund the distribution -- and, more importantly, its ambitious acquisition strategy -- by more than doubling the number of shares outstanding in the last year. It needs to grow quickly to find balance, or it could run into trouble down the road.

By the numbers

While it's always important for investors to dig deeper into the numbers driving a business forward, that's especially true when evaluating a marijuana stock. Hype is running laps around reality at the moment -- and often times, the numbers simply don't support the gaudy market valuations being doled out across the cannabis industry.

Scotts Miracle-Gro sports a more favorable valuation on several important metrics. Although that has a lot to do with the fact that the bulk of all sales are derived from consumer products, let's not forget Hawthorne put up $193 million in revenue in the first nine months of fiscal 2018 -- well above the performance of popular marijuana businesses in that period.

Innovative Industrial Properties sports a higher dividend yield, but it pays out significantly more than it generates when it comes to profits per share, hinting that the yield is unsustainable without extra financing. Scotts Miracle-Gro, on the other hand, has paid out just 55% of its profits per share as a dividend. The remainder has been reinvested in the business through acquisitions and share repurchases.

The better buy is...

Hat tip to Innovative Industrial Properties for finding a unique and profitable niche in the cannabis industry that should position the business for growth, but the better buy in this matchup is Scotts Miracle-Gro. The company's size, diverse operations, and financial strength make it a low-risk way to invest in the emerging opportunity in marijuana. While imperfect and reeling after a difficult year affected mostly by factors outside of management's control, the business is well-positioned to support the long-term growth of cannabis growers. Opportunistic investors may want to give the beaten-up stock a much closer look.

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Maxx Chatsko has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.