Value investors rarely get a chance to participate in fast-growing trends. The momentum behind areas poised for rapid growth—say, artificial intelligence, electric cars or battery technology—typically means a higher valuation than a value investor can justify.
Cannabis stocks are no exception. Even after a substantial correction in cannabis share prices, many of the available opportunities in that space are still selling at sky-high multiples based on traditional valuation metrics.
We’ve previously highlighted situations where value investors are able to invest alongside expert capital allocators. Doing so helps investors take advantage of these experts’ foresight and strategic positioning. If you’re a value investor looking for an entry into the cannabis market, you might want to look toward Jim Hagedorn, who serves as the CEO of Scotts Miracle-Gro
A tricky entrance to a fast-growing market
The cannabis market’s quasi-legal status makes it challenging for corporate entities to get directly involved in the industry. Legalization at the state level has created a burgeoning market, which is expected to grow rapidly, from an estimated $20 billion in 2020 to nearly $200 billion by 2028. Because the federal government hasn’t legalized cannabis, however, current tax law won’t allow companies that cultivate and sell marijuana to write off normal overhead expenses beyond their cost of goods sold. Operating without half of a normal P&L is a non-starter for most established companies. “Anybody who’s gone legal can’t make money,” Hagedorn recently told me on my World According to Boyar podcast.
SMG’s strong base business in the home and garden sector made it a category leader even before COVID-19 produced an uptick in gardening activity. The company is poised to continue to benefit as people continue to leave cities behind for suburban homes with lawns and gardens.
On top of that, SMG has already benefited indirectly from the cannabis boom: Cannabis cultivation is, in essence, a large-scale gardening project. Not only are SMG’s traditional line of products extremely useful to the market, the company’s hydroponics arm, Hawthorne Gardening Company, has become a primary equipment supplier to the cannabis industry—though the people buying its products haven’t always said as much publicly.
“You talk to people and they’d say, ‘Dude, it’s giant. These people are coming in once a month, they’re paying cash, they don’t negotiate, they buy huge quantities,’” Hagedorn said. “You’d ask, ‘What are people growing […] and they’d look you right in the eyes and say, ‘Tomatoes.’”
The “tomato” business produced about $1.5 billion in sales for Hawthorne in fiscal 2021 alone. Its revenues have risen 100% over the past two years.
How Hagedorn plans to hit the ground running
During the Gold Rush, there was a lot of money to be made selling picks and shovels to gold miners. With cannabis, Hagedorn sees supplies as the tip of the iceberg. “We think the majority of the money is going to be consumer brands,” he said. Consumer brands are in SMG’s wheelhouse, as a number of the key brands in its gardening business boast market shares in excess of 50%.
To position SMG for future partnerships with growers, the company has made strategic minority investments in the cannabis industry through its Hawthorne Collective subsidiary. Hagedorn estimates it has provided approximately $350 million in convertible loans to RIV Capital, an investment and acquisition company focused on the cannabis industry. Those loans can be converted to equity when the taxation and legalization environment make it financially attractive enough for SMG to hold an equity stake in a cultivation operation.
But a minority stake isn’t what Hagedorn is ultimately after. Hawthorne Gardening Company could provide the leverage SMG needs to build a portfolio of cannabis brands. Spinning it off could provide the capital necessary to secure a majority stake in a partnership with one or more high-quality growers—which Hagedorn sees as the most likely path to creating a large-scale consumer operation rapidly when the time is ripe.
“Hawthorne is the most valuable business in the pot industry. If we aren\’t willing to use Hawthorne as a currency, we\’re going to be overwhelmed and not be able to maintain control of it,” Hagedorn said on my World According to Boyar podcast.
A potential value play in a trendy space
From a value investor’s point of view, SMG could offer an opportunity to piggyback on Hagedorn’s bet. He’s arguably making what amounts to a value play in the cannabis market:
· Access to capital is difficult to come by for growers because of the complex regulatory and tax environment.
· Providing legal supplies for the industry means he has growing relationships with cultivators that will become more valuable if and when federal legalization or cannabis banking reform takes place.
· The catalyst is legalization, which isn’t guaranteed but looks increasingly like a foregone conclusion.
With Hawthorne, Hagedorn is making a long-term bet that he will be well-positioned to take advantage of legalization if and when it comes to pass. Importantly, he has the patience to wait for that to happen, especially since the business is already making good money. As a result, this potential upside doesn’t require investors looking at SMG to take on any more risk than they would by investing in an already-thriving gardening business at a reasonable multiple. The cannabis part that you receive for zero cost represents real “value” in my book.
The author and/or certain Boyar Asset Management clients own shares in Scotts Miracle-Gro either individually or through pooled vehicles the firm manages. For additional important disclosures, please visit: www.lp.boyarvaluegroup.com/disclaimer