TCNNF - Innovative Industrial: Cannabis Market At Risk To Worsening Macroeconomics

Summary

• While vice industries have boomed during the pandemic, we are already seeing a rapid reversal in some mature cannabis markets, with wholesale prices declining by -50% YoY.
• The illicit market may remain a drag on the legal market's profitability as well, due to the elevated cannabis taxes of up to 20% in some US states.
• The market sentiment is further worsened by the omission of the SAFE Banking Act from the recently proposed cannabis bill.
• While IIPR has performed well thus far, it remains to be seen how the whole cannabis market may perform during the uncertain macroeconomics in 2023.

We have previously covered Innovative Industrial Properties, Inc ( IIPR ) here as a pre-FQ3'22-earnings article in October 2022. Its previous financial and projected performance through FY2023 were discussed in detail, together with the prospects of state-level legalization. At that time, many market analysts already predict a prolonged federal cannabis legalization progress, which may only happen from 2025 onwards.

For this article, we will be focusing on IIPR's FQ3'22 performance, with an in-depth discussion of the uncertain cannabis sales post-reopening cadence. The stock is likely to suffer moderate headwinds in the intermediate term as well, due to tenants' continuous compression of profit margins, significantly worsened by the recent political developments.

Investment Thesis

IIPR YTD Stock Price

IIPR has previously recorded an excellent 41.26% recovery from its previous September bottom, buoyed by the market-wide optimism and the excellent FQ3'22 earnings call . This is further aided by the upbeat November CPI and the Fed's 50 basis points hike, breaking the fourth consecutive 75 basis point hike.

However, with the recent development in the National Defense Authorization Act , IIPR stock has naturally declined by -15.75% from its recent peak of $124.44 on 05 December 2022. Legislators have decided to omit the SAFE Banking Act from the proposed bill, thwarting legal cannabis businesses' access to US financial institutions. This is significantly worsened by the reduced equity financing for the US cannabis market YTD by -96.3% to only $78M. Since IIPR leases real-estate properties to state-licensed cannabis operators, this explains why its rally has been consequently digested.

One of IIPR's tenants, Trulieve (TCNNF), has been struggling with profitability due to its rapid expansion to multiple states. Trulieve has reported sales of $1.24B over the last twelve months [LTM], increasing excellently by 33.33% from FY2021 levels. However, the company incurred expanding losses of -$240.56M simultaneously, compared to FY2021 levels of $18.03M. The situation was made worse by its growing long-term debts by 16.79% YoY to $548.24M, while its Free Cash Flow declined by -17.22% YoY to -$343.74M. As a result of the challenging funding environment and the unfortunate rental default of Kings Gardens back in July, it is unsurprising that Mr. Market is undecided about IIPR's future execution.

The path toward federal cannabis legalization has been convoluted, with multiple setbacks thus far. The recent mid-term election has induced mixed responses from various states, indicating further headwinds to the process. While President Biden has recently pardoned more than 6K offenders with federal charges of possession, cannabis is still federally classified as a Schedule 1 drug . This indicates the highest regulatory level with no accepted medical use and a high potential for abuse.

John Hudak, Deputy Director at the Center for Effective Public Management at the Brookings Institution, remains uncertain about the visibility of cannabis legalization ahead:

The idea that the number of states passing legal cannabis will suddenly shift something in Congress just has not been borne out in the experience of cannabis policy in the United States. We have three-quarters of American states that have legalized medical cannabis that has not moved medical cannabis policy at the federal level. ( TIME )

The Uncertain Cannabis Demand May Undermine IIPR's Excellent Execution

In the meantime, IIPR continues to deliver a stellar financial performance in FQ3'22 . The company reported excellent revenues of $70.9M, exceeding consensus estimates of $68.4M, despite the absence of $5.7M from two tenants in California. King Garden and Vertical failed to pay their contractual rents for the quarter, comprising $5.3M in base rents/property management fees and $369K in tenant reimbursements for property taxes/ insurance.

However, the IIPR management has also partially offset this risk with the application of $2.6M in security deposits from Kings Garden's defaults thus far. As a result of a confidential settlement between both companies, one of six properties has been relinquished and one is about to be leased to another operator. We presume more information will be available as the situation develops. In contrast, IIPR's lack of rental collection from Vertical is attributed to the scheduled rental phase-ins under the contractual lease over the next six to nine months. The latter is a lesser cause of concern, indeed.

Aside from these two tenants, the IIPR management reports an excellent 97% of total rent collection over the past nine months, with an average lease length of 15.5 years. These have boosted its profitability to adj. FFO per share of $2.13, against the consensus of $1.89. Since no tenant represents more than 14% of the company's portfolio, we are not concerned about any default risks for now. Combined with minimal debt maturities through 2026, the company remains well positioned for the uncertain macroeconomics, temporarily supported by its $316.61M in cash/ investments in the latest quarter.

However, recent cannabis trends do not look promising, since some mature markets have reported a drastic fall in sales. Colorado's medical demand is down by -47% YTD, with recreational sales faring slightly better with a -20% decline. Notably, the wholesale prices of cannabis in the state have plummeted by -50% YoY to $658 per pound. Fortunately, other states, such as California, Nevada, Oregon, and Washington, experienced more modest declines of between 3.5% and 6.8%. On the other hand, states such as Illinois, Massachusetts, and Michigan, have reported a remarkable 31.88% growth YoY . In addition, Rhode Island, Missouri, and Maryland have similarly legalized recreational cannabis in 2022, potentially triggering a robust initial demand, as witnessed in most emerging markets.

Market analysts are still confident about the long-term prospects of the US cannabis market , since it is expected to expand at a CAGR of 14.27% to $52.6B by 2026. However, it remains to be seen if demand for cannabis may rebound by 2023, due to the supposed 70% chance of recession. While legal cannabis sales have jumped by 46% YoY to reach $17.5B in 2020, the phenomenon was previously attributed to consumers stockpiling alcohol, cannabis , and other substances to cope with the widespread lockdowns. The market penetration has been remarkably compelling then, with up to 48% of people in legalized recreational US states using cannabis , against the 60% reported for the alcohol segment.

Nonetheless, the profitability of legal cannabis markets is also persistently undermined by the raging illegal (untaxed) markets. While New York may have l egalized recreational cannabis in 2021 , the state’s legal sales are only slated to commence by December 2022 . However, numerous illegal shops have been selling cannabis in New York since 2019, with more popping up over the past year. These may potentially undermine the sales of legal markets, putting further pressure on their profitability due to the high cannabis taxes of 13% there . IIPR investors should be aware of this risk since it is not exclusive to New York. With the rising inflationary pressure further tightening discretionary consumer spending, we reckon there may be more pessimism in the cannabis market and IIPR through 2023.

So, Is IIPR Stock A Buy , Sell, or Hold?

IIPR 5Y EV/Revenue and Price/FFO Per Share Valuations

IIPR is currently trading at an EV/NTM Revenue of 10.97x and NTM Price/FFO Per Share of 13.11x, lower than its 3Y pre-pandemic mean of 13.91x and 23.80x, respectively. The worsening macroeconomics have naturally further moderated its valuations against its YTD mean of 13.87x and 16.42x, respectively. Based on its projected FY2024 FFO/per share of $9.15 and current Price/FFO valuations, we are looking at a moderate price target of $119.95.

However, market analysts are more bullish than expected on IIPR with a price target of $135.67, which would imply a 31.36% upside potential from current levels. This optimism is natural, considering that IIPR has been trading at higher valuations before the worsening macroeconomics. However, with the recent turn of political events and the Fed's determination to tamp down on the rising inflation, we are less upbeat since IIPR may soon be testing its previous support level at the $90s. The lack of equity funding and uncertain consumer demand may trigger more headwinds to its tenants' performance as well, resulting in more volatility in the short term.

Therefore, investors may want to wait for a $90 entry point, before adding this stock to their portfolio. That will provide an improved margin of safety, while also expanding the forward dividend yields to a speculative 8.83%, based on market analysts' projection of $7.95 in dividend payout by FY2024. Even so, we recommend investors proceed with caution, since it remains to be seen when federal legalization may occur.

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