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

Marijuana is a hot sector, with some analysts projecting massive growth for the plant's demand. The hype surrounding the burgeoning pot market, however, is likely to lead to the typical Wall Street response -- a bubble. Already some are warning that marijuana companies are pushing a little too hard for growth, potentially overpaying for acquisitions. If you like the idea of jumping on the marijuana story but are too concerned to buy a company growing the drug, then you should look at Scotts Miracle-Gro (NYSE: SMG) and Innovative Industrial Properties (NYSE: IIPR), two suppliers to the industry that sidestep some of the concerns of owning a marijuana grower. But which, if either, is the better option?

How they are similar

What sets Scotts and Innovative apart from a typical marijuana stock is that they don't actually grow plants or sell cannabis products. They provide plant growers with what they need to do that. In the case of Scotts, that means hydroponic supplies. Hydroponics have long been the core technology underpinning grow houses, even when marijuana wasn't legal. This is a relatively new division for the company, which really only started expanding in the space in 2016 via its "project focus." After a series of acquisitions, the hydroponic division is now called Hawthorne, with the last major acquisition (Sunlight Supply) pushing Scotts into the top position in the industry.

Innovative Industrial Properties is a bit more complex. It is basically a start-up (it IPO'd in 2016) real estate investment trust (REIT) that owns the specialized industrial properties in which marijuana is grown. However, it didn't just happen to own a bunch of grow houses; it has been largely buying these properties from marijuana growers and then leasing them back to their former owners. This is something of a financing transaction for the growers, who use the cash they raise to invest in their businesses. As competition heats up and banks continue to avoid the legal implications of marijuana, Innovative is not only a landlord but a valuable source of investment capital for pot companies.

Although Scotts and Innovative go about supporting the marijuana industry in different ways, their stories are roughly similar. They both offer investors a way to gain exposure to the marijuana market without the need to invest directly in a marijuana stock. Moreover, because they provide services to more than one company, their businesses are inherently more diversified than any single pot stock. But they aren't magic bullets; they both come with risks.

How they are different

The biggest risk for Scotts today is the leverage it took on to build the Hawthorne division. To be fair, the company's core lawn care business is still the larger operation, representing around 80% of revenues when you look at a full 12 months of results (lawn care is seasonal, so 12 months of results is more telling than any single quarter). That said, over the past five fiscal years, long-term debt has grown from around $490 million to $1.9 billion. As of the most recent quarter, long-term debt stood at roughly $2 billion. That massive jump pushed long-term debt from a reasonable 40% to a worrying 75% of the capital structure as of the latest quarter.

To be fair, Scotts appears to be handling the debt load reasonably well, covering the interest expenses roughly five times over in the latest quarter. However, an asset writedown last year related to the acquisitions that built Hawthorne (specifically the Sunlight deal) pushed trailing interest coverage down to just two times in late 2018.

There are two takeaways from this. First, Scotts appears to have gotten caught up in the marijuana hype and spent more than it should have for an important acquisition. Although it believes the hydroponic assets it owns give it an industry-leading position, there's a risk that the purchase prices bake in a lot of positive expectations. If those aren't met, more write-offs could be in the cards. And second, with so much debt, disruptions to the company's income and cash flow could quickly turn the leverage taken on into a heavy burden. Unless you are willing to watch Scotts Miracle-Gro's balance sheet and business very closely, you should probably avoid the now-debt-laden company.

When Innovative Industrial buys an asset, which it funds with debt and stock sales just like any other REIT, it gets a physical asset and a tenant. On the whole, that means that a problem with any individual renter can be solved by simply jettisoning the lessee and replacing it with another company. That's an inherently strong position. And at this point, Innovative's debt is roughly a third of the capital structure, though it is likely to rise over time as the portfolio grows.

On the whole, Innovative looks like the better option of the two pot industry suppliers here. However, it isn't risk-free. The company owns just 19 properties, so it is very small. It is also expanding aggressively, buying eight properties in the first four months of 2019. So there's a risk of an overstep as the REIT looks to continue its expansion efforts.

Moreover, investors need to think carefully about the backstop of owning property. While there is inherent value in that, the assets Innovative owns are highly specialized. The only replacement tenant that would want to occupy one of its assets "as is" would be another marijuana company, which means that there could be material costs to repurpose an asset if it becomes vacant and Innovative can't find a pot company to fill it. Investors still need to monitor tiny and fast-expanding Innovative very closely.

Not for the risk averse

To be honest, most investors should probably avoid the marijuana industry. It's very new, it still faces legal uncertainty, and Wall Street's sky-high expectations have a habit of not being met (that's true for almost all "hot" sectors).

That said, the massive increase in debt at Scotts is a troubling development that should make most investors think twice about jumping aboard its stock. Yes, it has its lawn care business to backstop the Hawthorne division, but that doesn't change the fact that it has leveraged its future to pot. Innovative Industrial Properties, owning physical assets that can be repurposed (even at high cost), seems like a more secure option in the space. But, again, it isn't risk-free, since the REIT is small and still growing rapidly. You'll need to watch it closely if you decide to buy -- so only more aggressive types should be looking at it.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool recommends Innovative Industrial Properties. The Motley Fool has a disclosure policy.