Description

Background

• Scott’s began in the 1800s and Miracle-Gro was founded in 1951. Scott’s Miracle-Gro is the culmination of the merger between these two companies which occurred in 1995.
• Market cap of $9 B, with reasonable analyst coverage. Recently they seemed to be in the “news” a lot.  
• The CEO and chairman is Jim Hagedorn, who is the son of the founder of Miracle-Gro.
• The Hagedorn Family owns ~26% of the company through a trust. The sister of the CEO is a director on the board and his son (Chris, 35) is executive VP and president of the Hawthorn segment and is expected to be the CEO one day.
• Executive compensation is based on EBITA, adjusted FCF, and total investor return metrics. Management tries to focus on the long term during earnings calls.

How do they make money?

·         The company reports 3 segments:

o    U.S. Consumer: manufactures lawn and gardening products primarily sold through brick and mortar retailers. Lowe’s and Home Depot make up more than 50% of segment sales and 39% of total sales. Sales are seasonal with 75% occurring from January to June. This segment distributes to over 20,000 stores. Sales can somewhat be considered reoccurring.

o    Hawthorne: manufactures and distributes indoor growing equipment and materials sold through 3^rd party retailers and their own e-commerce website. This segment does not directly sell to the cannabis market, but it is likely the primary driver. Sales are more project-based and less reoccurring.

o    Other: this segment encompasses international lawn and garden sales as well as sales to commercial greenhouses and nurseries.

·         Scott’s sold most of their international consumer business in 2017. Today, international makes up 8% of sales. Hawthorn is ~25% of international sales while consumer is ~75%.

·         Included in the U.S. consumer segment, Scott’s maintains an agreement with Bayer to market and distribute Roundup products. Scott’s receives half of the profit from sales and is indemnified from any legal liability under the arrangement.

·         Excluded from the above, Scott’s has 50% ownership in a joint venture, Bonnie Plants, with Alabama Farmers Co-Op. 25% was acquired in 2016, then another 25% was acquired at the end of 2020. The 50% ownership is accounted for using the equity method and reported as income from unconsolidated affiliates. Bonnie sells live plants (including vegetables and herbs) to Home Depot, Lowe’s, etc.

·         Excluded from the above, the company created a new subsidiary during 2021 referred to as the “Hawthorne Collective” through which they make investments into the cannabis market. So far, this subsidiary has invested $150 million into RIV Capital (TSX:RIV) in the form of a convertible preferred note. RIV Capital themselves invest in cannabis companies. If the note was exercised they would own 42% of the company. Also, Scott’s has made $43 million of investments in 13 other companies focused on the cannabis industry.

Competition

The consumer segment sells premium brands which have 40-60% market share in their respective categories. Competitors are often lower priced and include private label brands from the retailer. Management has noted that they believe that the retailers they sell to are their primary competition. However, compared to other products that compete against private label, the “outdoor” category has not seen private label market share growth continue. Generally, they seem to have brand strength as research suggests they have continued to generally maintain their market share and raise prices by ~2-3% annually over the past decade. More specifically, Scott’s competes against Spectrum Brands (SPB) who owns insect and pest control consumer brands such as Cutter, Hot Shot, and Black Flag.

Hawthorne sells indoor growing equipment and materials. Competitors include many companies which exist outside the realm of gardening supplies due to their sales of light bulbs, filtration, etc. They believe they have the highest market share for cannabis equipment in the U.S. with 18% national share and 45% share in California (considered the largest cannabis market in the world). 2/3rds of the products that they sell are propriety. Their largest customer is GrowGeneration (GRWG) a retailer with brick and mortar and e-commerce operations in states where cannabis is legal. Hydrofram (HYFM) is likely their largest direct competitor.

Acquisitions and Divestments

Over the last ~10 years, Scott’s has made 23 acquisitions ($2 B) and 6 divestments ($1.1 B). The majority of their acquisitions have been small tuck-in brands over their history, however, some of the more recent acquisitions have been larger. Most of these acquisitions have been funded by cash on hand or debt. Their divestments have been larger than their acquisitions and included their lawn service business, and a number of international operations from 2016-2019.

Most of larger recent acquisitions were focused on building out the Hawthorne product offering. This Hawthorne business essentially began with the acquisition of a 75% interest in Gativa Holdings ($136 M) in 2016 which sells indoor lighting for greenhouses and hydroponic operations. More recently, they acquired Sunlight Supply, a distributor of hydroponic products, in 2018 for $459 M (their largest acquisition ever), and Luxx Lighting in 2022 for $215 M.

The cyclicality of the cannabis market has led to acquisition opportunities. When Sunlight was acquired in 2018, valuations in the cannabis market had become depressed due to lower grow rates during that year.  Today, California is dealing with an oversupply of cannabis which has reduced industry growth and valuations have declined. This is likely why we have seen several acquisition announcements in the past few months, and it is possible that this will continue, particularly with leverage below management’s target.

On the last earnings call, the CEO had mentioned they could consider spinning off the Hawthorne business if they do not believe the value is sufficiently reflected in the Scott’s stock price over the next year or two.

For the consumer business, they acquired another 25% of Bonnie Plants for $202 M in late 2020. The consumer business is focused on building out their live plant offerings, including indoor plants and succulents, as well as more traditional Bonnie offerings of vegetables and herbs.

Management has stated that they historically have paid 8 times earnings for acquisitions over their history. The more recent Luxx lighting acquisition had a valuation of 2 times sales and 11 times operating income.

Despite these acquisitions, ROIC has increased over the past 5 years.

Growth Plans

The Consumer business is a more mature business with growth in the low single digits expected going forward. Management is expecting 2-4% growth annually over the next 5 years. The broadest long term driver for this business is household formations as 77% of U.S. households partake in some form of gardening; more houses = more lawns and gardens = a greater need for Scott’s products. COVID provided a sizable increase in sales due to interest in activities around the home like gardening. Research suggests that 16 million or more new people became gardeners during COVID, which has led to higher sales for the industry and may remain elevated versus Pre-COVID if consumers continue this habit. Also, adoption of gardening may continue to increase as millennials increase their proportion of the housing market, as research suggests that 70% of millennial homeowners are gardeners. For things the company can control, they are trying to lengthen their selling season. Management has focused on live plants, which can be grown all year long as one way to do this.

The Hawthorne business is riding the wave of growth in the U.S. cannabis market. They primarily sell products that allow new growing operations to be set up. As new states legalize cannabis in some fashion, new operations are set up in those states, which could require Hawthorne’s equipment and supplies. Hawthorne’s sales are more project based than reoccurring, so growth is dependent on the expansion of growing operations.

Financial Strength

·         Their bank debt is inclusive of a $800 M term loan and a $1,500 M revolver (undrawn). They also have public corporate bonds. Scott’s has a BB issuer rating from S&P and Moody’s and a BBB rating from Egan Jones

·         Management targets 3.5x leverage.

·         Covenants: tied to the LOC and term loan. The covenant calculation is reasonably straight forward for EBITDA (adjusted for anything non-cash) then uses average 4 quarter debt in the numerator.

o    Maximum leverage of 4.5x.

§  Current (9/30/2021) was 2.7x.

o    Minimum interest coverage of 3x.

§  Current (9/30/2021) was 10.6x

·         They have a “receivables facility” that allows them to sell receivables up to $400 M from 3 specific retailers (likely the big 3 LOW,HD, and WMT). Any sale is accounted for as ST debt and the A/R is kept on the balance sheet.

o    They have not used this facility in a significant way historically.

·         They have a decent bit of purchase obligations extending from 1 year to 1-3 year, the total of which is $876 M

·         They have $300 M of lease obligations for ~$70 per year.

Risks

·         Market share erosion in the consumer business and/or lower margins.

o    The consumer business is supported by brands that command premium prices. They have increased their advertising spend to 4-5% of sales to support the brands and keep gardening top of mind for longer to hopefully lengthen their selling season.

·         Lowe’s, Home Depot, and Walmart make up a significant amount of overall sales. Management has mentioned that this has been lessening as consumers go to more places like Tractor Supply.

·         Any negative changes to the legality of cannabis. Scott’s seems to operate in a weird legal grey area with their investments and operations in this industry.

·         There is a mention of potential PFAS issues. Fertilizer is often made with “bio-solids” from sewage that have been known to contain PFAS, but is considered acceptable under certain thresholds. 

·         Near term, cost inflation is negatively impacting margins which they hope to offset by higher prices and higher inventory is negatively impacting cash flow.

Why is it interesting?

Strong double digit ROICs for a staple-like/reoccurring business (consumer segment) that has been able to maintain their premium brand and high margins over a long history. Lawn and gardening have shown solid growth over the last 10 years, as evidenced by category sales at Lowe’s and Home Depot, suggesting the interest in these products continues to be relevant for consumers.

The cannabis industry seems to have the potential for long term growth as legalization of some form continues for other states in the U.S. and their Hawthorne unit seems well positioned to participate in that growth. Also, there could be hidden value in their Hawthorne unit which could be more easily revealed through a split of the companies.

Valuation

We split up the Hawthorne and Consumer businesses for valuation purposes. Hawthorne is a cyclical with high growth, while consumer is more staple like albeit with lower growth. Then we add in their minority interest investments (Bonnie and RIV) at cost. 

We value the consumer business (including corporate costs) using a DCF with essentially no growth in normalized FCF over the next 4 years then a terminal growth of 2% and discount rate of 9%. We use a 16x EBITDA multiple for Hawthorne or about 2x last years sales. 

Catalyst

The ability the maintain sales in consumer (gardening) and a rebound of the cannabis market, which shows the value in their opportunistic acquisitions. Spin-off of the Hawthorne business(?)