Is Scotts Miracle-Gro Really the Way to Invest in the Legal Marijuana Industry?

In this segment of the MarketFoolery podcast, host Chris Hill is joined by Foolish investor-at-large Tim Hanson to consider the case for buying shares of Scotts Miracle-Gro (NYSE: SMG) now. The company didn't have the best spring quarter -- the generally cold weather across the U.S. was not friendly to its core gardening and lawn care businesses.

But it has been building a greenhouse growing unit that covers everything that a marijuana grower needs to get their operation up and running. The Fools dig into its brands and the opportunities that this new market presents.

A full transcript follows the video.

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This video was recorded on May 15, 2018.

Chris Hill: You mentioned Scotts Miracle-Gro, which is a company we don't talk about very often. It is a stand-alone public company, ticker symbol SMG. You had mentioned how they reported recently, kind of a tough spring for them as well. But, you mentioned something to me this morning about Scotts Miracle-Gro being a way to play the growth in the marijuana industry.

Tim Hanson: Yeah!

Hill: And somebody on Wall Street may have tapped your phone or something, because sure enough, a firm came out this morning and upgraded Scotts Miracle-Gro to a buy, put a buy rating on it, specifically for that reason.

Hanson: I think a lot of marijuana legalization stocks, obviously, have been part of a market where there's been a lot of hype, there's a lot of overvaluation, there's a lot of outright fraud, so on and so forth. A lot of pump and dump schemes have been in this space.

Hill: A lot of penny stocks.

Hanson: A lot of penny stocks. But obviously, as marijuana is legalized in places, there are business opportunities associated with it. What makes Scotts interesting is that the core business is a very stable, branded gardening business, which is Miracle-Gro, Scotts Turf Builder, those sorts of things. This is a business that generates a lot of free cash flow every year, has pricing power, people use the products every day, so on and so forth.

Then, attached to it, they've quietly been using that free cash flow and taking on some debt to build a vertically integrated greenhouse growing business, which can easily be applied as a picks and shovels play on marijuana agriculture, were people to start growing that in significant quantities. It's things like hydroponics, seed starting kits, indoor soil, lighting, air filters, things of that nature.

It's a couple hundred million dollar revenue business now, and if you look at the potential growth rates in the industry, this is one of those opportunities where marijuana as a commodity, predicting the price there and the demand and the supply is very difficult. If you know that growers are going to be coming into the industry, the people who supply the growers with the things they need should do pretty well. And like I said, they've assembled a pretty interesting portfolio of brands to service that market.

Hill: Far more brands than I would have expected, and some of them I've never heard of.

Hanson: They're niche. Niche to the gardening community.

Hill: I mean, Roundup, which, controlling weeds that you don't want.

Hanson: On the retail side, yeah.

Hill: Ortho. But, a phenomenal brand which I had never heard of until you mentioned it this morning is something called Black Magic.

Hanson: This is gardening for the cool kids. Black Magic. They sell the products at Home Depot, and it's seed trays, seed starting soil, everything you need to get started. I start my own seeds. I actually experimented with Black Magic products this year, not to grow marijuana but tomatoes and cucumbers and whatnot. But, it's a hellaciously cool brand. It has a great logo. If they have T-shirts, I want a T-shirt.

Hill: Yeah. First of all, you tell me. "I'm going to do some shopping this weekend." "Where are you going?" "I'm going to Black Magic."

Hanson: Get some Black Magic.

Hill: There are so many ways you can go. That could be an amazing pizza place.

Hanson: [laughs]

Hill: It could be any number of things. But, the fact that it's built right into the Scotts Miracle-Gro umbrella of brands is fantastic.

Hanson: You know what's neat is -- the majority of acquisitions in corporate America fail to create value. That's pretty well-known, particularly as they get big. But, what's interesting about Scotts and acquiring these small, niche gardening brands, is that they have distribution. They can put Black Magic into Home Depot at a higher price point than Miracle-Gro, and all of the sudden, you have a very interesting share of the shelf space in that retail environment, which is, you have a premium product, you have a mainstream product, you have a discount product, and you're touching the gardening process at beginning, middle and end.

The last time I went to the store, I had to buy seed starting soil, potting soil, I got peat moss. All that is taking share of my wallet, and I'm giving it to one parent company. So, I think it's a good strategy. Some analysts in the past have been concerned about the leverage they've taken on in order to execute it. But, I think they have more than enough cash flow to pay for it all, and I think it'll be pretty interesting. If marijuana legalization doesn't come to the masses, it's still a pretty reasonable valuation.

Hill: And you look at the track record so far. Putting the products aside, look at the job this company has done in terms of capital allocation, and they've built up a nice track record.

Hanson: Yeah, it's not a huge company, but they've done a solid job.

Hill: If you've ever wanted to invest in Black Magic --

Hanson: Now's the time.

Hill: -- now you actually can.

Chris Hill has no position in any of the stocks mentioned. Tim Hanson has no position in any of the stocks mentioned. The Motley Fool has the following options: long January 2020 $110 calls on Home Depot. The Motley Fool recommends Home Depot. The Motley Fool has a disclosure policy.