Innovative Industrial Properties: Currently Undervalued With Rising Revenue

Thesis

With the entire cannabis industry anticipating rescheduling and subsequent sector-wide rally, I have been looking into potential buy targets. A few weeks ago I published an article where I looked at the margins and growth rates of the highest revenue companies in the industry. I intentionally excluded Innovative Industrial Properties, Inc. (NYSE:IIPR) because it is a REIT and not a pure play. However, because its fate is tied to the sector it services, I decided to take a look at it separately. After looking over its financials and valuation, I rate Innovative Industrial Properties as a Buy.

Company Background

Innovative Industrial Properties, Inc. was founded in 2016 and is a REIT that focuses on the acquisition, development, and management of industrial facilities leased to state-licensed cannabis operators.

Statements made during their most recent earnings call indicate their dividend payout ratio of 80% in line with the Board’s targeted payout ratio of 75% to 85% of AFFO. They have no debt maturing this year or next year, with $300M of their debt not maturing until May 2026. They stated that they believe they are well positioned to continue helping the industry grow.

Financials

Revenue has experienced temporary pullbacks, but overall is trending upward. Operating income, EBITDA, and net income have all been relatively flat for the last four quarters.

Operating and net margins are both consistently strong. Operating margins peaked at 74.23% in Q3 2021 and have been declining since then. This most recent quarter, operating margins were at 57.03%, while net margins were at 54.01%.

The share count continues to rise. In Q3 2020 it was 22.2M, by Q1 2023 that had risen to 28M. This represents a 26.13% rise in share count. Over this same time period operating income rose from $20.4M to $43.4M, representing a 112.75% rise. So far, this dilution has been highly accretive. If the pace of income growth ever falls behind share count growth, this dilution has the potential to become toxic. Long-term investors should keep a close eye on this trend.

Their debt obligations are relatively small.

The ratio of net interest expense to quarterly operating income was falling from Q2 2021 to Q4 2022, but rose in the most recent quarter.

When comparing their total debt to quarterly operating income, we can see that it peaked in Q2 2021 and has since stabilized at around 7x. Typically, I look for this ratio to be below 3x when compared to annual operating income, or below 12x when looking at it on a quarterly basis. 7x is well below 12x, so overall this looks like a sustainable amount of debt.

Their total equity has been growing. In Q3 of 2020 it was at $1,270M, this most recent quarter, it had risen to $1,958.1M.

Their return on invested capital has been rising. In Q2 2020 it was at 1.28%, by this most recent quarter that had risen to 1.73%. By adding their four most recent quarterly ROIC values of 1.70%, 1.59%, 1.76%, and 1.73%, we can produce a value of 6.78% for annual ROIC. Their return on equity values are a bit stronger. When summed, their quarterly ROE values of 2.03%, 1.91%, 2.11%, and 2.09% come out to an annual ROE of 8.14%.

Valuation

As of May 12th 2023, Innovative Industrial Properties had a market capitalization of $1.99B and was trading for $69.42 per share. They currently have a forward P/E of 12.71x, an EV/EBITDA of 9.62x, and a Price/Cash Flow of 8.31x.

Even though Seeking Alpha lists their forward per share dividend growth at 9.13%, their dividend growth history is following a logistic growth curve. For this reason I will produce two discounted cash flow estimates.

Using the present annual dividend of $7.20 per share, a discount rate of 9%, and assuming growth is maintained at about 9% for the next 5 years before leveling off to zero, a discounted cash flow estimate for fair value comes out to $116 per share.

If we instead assume that the 9.13% projection is wrong and that dividend growth will remain flat for the next 20 years, then the discounted cash flow estimate comes out to $80 per share.

Risks

Although unlikely, the cannabis industry may experience a sudden downturn due to factors such as changes in consumer demand or governmental regulation. IIPR may one day be forced to abandon its intended customer base and shift the orientation of its business model.

In addition to being affected by the ebbs and flows of the cannabis industry, they are also subject to changes in commercial real estate. It is possible that a crash in the valuations of commercial real estate would negatively affect the company. Especially if it happened during a time when their cash on hand was low and they were unable to use the opportunity to expand cheaply.

Catalysts

Although it will be affecting their customers and not IIPR directly, Biden set in motion a process where the DHHS is currently looking at rescheduling cannabis away from Schedule-1 and toward a designation that makes more sense based on available evidence. When this news hits, the entire sector will experience inflows. The last cannabis sector rally carried IIPR into all-time highs, I believe it will also participate in future rallies.

Conclusions

Many cannabis investors view this company as a picks and shovels play. I have also seen it show up in both sample and real portfolios purely for its yield. With rising revenue, strong margins, and low debt, the company is well positioned financially. Because they are considered part of the cannabis industry, they are likely to participate in the next sector-wide rally. While I cannot guarantee that the share price won’t get any cheaper over the short run, today’s price looks like an attractive buying opportunity.