Description

We recommend shorting shares of Scotts Miracle-Gro (NYSE: SMG). The company has taken on excessive leverage to fund an ill-conceived bet on the cannabis market through its Hawthorne hydroponics subsidiary. This has left SMG with an over-levered balance sheet with limited operational flexibility. Meanwhile, the core consumer lawn care business faces intensifying competition, pricing pressure from key retailers, and obstacles to drive volume growth needed to hit management's aggressive revenue and EBITDA targets. We believe consensus estimates remain too high and that SMG will miss 2024 guidance. With the stock trading at 13.7x NTM EBITDA or 20x TTM EBITDA, we see 40% downside as the company's precarious position becomes apparent. 

Business Overview

SMG is a leading marketer of branded consumer lawn and garden products, with key brands being Scotts, Miracle-Gro, Ortho and Roundup. The U.S. Consumer segment makes up 80% of revenue. SMG also owns the Hawthorne hydroponics business (12% of sales) which supplies the cannabis industry.

The company relies heavily on a few key retailers, with Home Depot and Lowe's accounting for 43% of sales. The business is highly seasonal, with 75% of revenue in fiscal Q2 and Q3.

Thesis Highlights

1. The core U.S. Consumer business faces challenges, including intensifying competition, pricing pressure from key retailers, and challenges to volume growth.

2. The Hawthorne hydroponics business has been a cash sinkhole and is expected to continue losing money.

3. SMG's balance sheet is over-levered, with net debt at ~7x EBITDA, limiting operational flexibility.

4. Despite cost-cutting efforts, SMG lacks sufficient levers to hit its EBITDA and FCF targets.

Investment Thesis

1. Challenging outlook for core U.S. consumer business

SMG's U.S. consumer revenue shrank for 3 straight years on double-digit volume declines. To hit their 2024 HSD sales growth target, they need unrealistic 10% volume growth to counter LSD price declines forced upon them by retailers.  10% volume growth would require a large change in consumer behavior from the last few years, as seen in the chart below. Untenable assumptions underpinning 10% volume growth include: 1) 2% growth in response to a 2% price decline, 2) 8% growth from expanded shelf space, including new product launches such as the MAX Fertilizer (green lawn), Miracle-Gro Organics, private label soils and Dual Action Roundup.  While more shelf space bodes well for some volume growth, expert calls have indicated that SMG has attempted to enter the organic space before but their efforts have failed to resonate with consumers. We question the likelihood of success with Miracle-Gro Organics.  Additionally, private label is sold at a lower price point with lower margins and therefore, private label growth will challenge their gross profit margin growth guidance. Lastly, SMG faces increasingly fierce competition and growing interest in food gardening and organics, where SMG lacks a deep product portfolio or brand recognition.   

In Q1, the Company reported pricing down 4% and volume down 13% while POS was reportedly up 8%.  On 4/4, they issued a press release indicating YTD POS trending to mid-teens percent growth.  The gardening season is just kicking off and April to early May are the critical months to determine reorders in late May.  It is too soon to make a call.  And there are a number of factors influencing this positive YTD POS value. Easter is a key weekend for gardening purchases.  Easter fell in Q1 this year on 3/31 vs. Q2 last year on 4/9.  Additionally, early warm weather likely benefited March sales.  However, a cold snap running through the country during the first week of April has softened early Spring weather enthusiasm.  We find the timing of this press release, which had no new incremental information other than a positive POS announcement, peculiar given the calendar. 

As seen below, SMG has underperformed the gardening category at Home Depot in 5 of the last 7 years and is losing share to smaller, more innovative brands like Kellogg Garden Organics and Sequoia-backed Sunday lawn care. Not only is SMG growing more slowly than the gardening category at Home Depot, but indoor gardening, where Scotts is less exposed, is growing faster than outdoor gardening, leaving SMG behind.

Expert calls corroborate that SMG is slow to respond to shifts in consumer preferences away from lawns towards gardening and small-scale growing. Competitors like Kellogg Garden have disrupted SMG's market share by offering cheaper organic soil. Demand is expected to shift towards smaller gardening categories over the long-term, whereas lawncare may decline as younger consumers pull back. Loyalty data from a large DIY hardware store indicate that the typical customer buying lawn fertilizer is over 60 years old.  Gen X and under are not interested. Thus, innovation and growth investments likely need to be rebalanced.

2. Hawthorne will continue to burn cash

The ill-fated Hawthorne rollup has been a cash sinkhole, with ~$1.5B spent on acquisitions only to see sales plunge as the cannabis market imploded. SMG started acquiring businesses in earnest in 2015 to build up Hawthorne as its own business segment.  In 2017, Hawthorne earned $35mn in segment profit on $287mn in revenue.  By 2021, enthusiasm boomed as legalization started to roll across the country leading to $164mn in segment profits on $1,023mn in revenue.  However, by late 2021 / early 2022, enthusiasm waned as demand failed to materialize and a supply glut in the cannabis market surfaced.  The last sizeable acquisition closed in December 2021 and was supposed to add $100mn in sales.  However, volume over the next four quarters fell 40-70% YoY.  In 2023, revenue stood at $467mn and despite restructuring efforts, the business lost $50M in segment profit. With industry oversupply and pricing pressure persisting, we expect Hawthorne to continue losing money. SMG had previously guided to LSD Hawthorne net sale declines for the full year but they retracted that guide on the last earnings call after volume was down 38% and the guide remains under review.

Expert calls indicate SMG overestimated demand from cannabis legalization. SMG overpaid on acquisitions to capture brand and domain expertise and never integrated these businesses into the corporate parent. 

While it is possible that SMG could just shut down Hawthorne and improve EBITDA by $50mn, we think that takes time and would be a huge black eye for the CEO who brought his son into the business to run Hawthorne.   

3. Over-levered balance sheet, limiting flexibility

SMG's net debt has ballooned to ~7x EBITDA, up from historical levels of 3-4x.  The Company loaded up on debt to fund acquisitions to build Hawthorne. The chart below shows SMG’s covenant compliance since 2022.  They have operated under tight conditions throughout. In the press release issued on 4/4, SMG announced leverage levels of “around 7x” which is about consistent with the Q1 leverage of 7.2x. While it is certainly positive that the company was able to maintain flat leverage in the midst of a covenant step down during a seasonal working capital peak, they are still operating under a thin margin for error leaving them limited operational flexibility.

Expert calls indicate leverage and cash flows are the most immediate threat SMG faces. However, cost cuts to manage profitability under the pressure of tight covenants have damaged long-term health for short-term savings. In mid-2022, SMG began to execute on significant cost savings, targeting a net leverage ratio in the “4s” by the end of 2023.  Cost savings predominately included laying off 25% of its workforce and closing distribution facilities. They handily missed their 2023 leverage target despite increasing their cost savings program by about 60% in mid-2023.  These mass layoffs resulted in huge brain drain. The number one issue we hear facing SMG in the medium term is a lack of innovation in the face of changing consumer preferences away from lawn.  We have also heard that spring shipments this year were late in some cases due to a reduction in the number of distribution warehouses implemented late last year. These cost saving actions likely were conscious decisions amidst limited choices, but detrimental for future growth.

4. Not enough levers to hit EBITDA and FCF targets

SMG is targeting revenue growth of HSD for the consumer business, 250bps of gross margin expansion and a slight pickup in SG&A margin in 2024 to get to $575M in EBITDA (up 30% y/y). However, their plan to raise gross margins is hindered by their reduction in pricing of 1-3%. They say: “We’re committed to significant margin recovery, starting with a minimum of 250 basis points this year. This limits our ability to reduce prices.”

With our more muted topline outlook of LSD growth for the consumer business, which is in line with our channel checks, incremental margins would need to be significantly higher than historical levels to bridge the gap. That doesn’t seem plausible without major price increases or continued massive cost cuts.

Furthermore, inventory reduction is a major part of SMG’s 2024 cash flow guide, with the Company planning to cut inventory days from 117 to ~80 to free up $350M in cash to pay down debt by year-end. This would be an unprecedented reduction well below historical levels and seems very aggressive.  If the Company is unable to work inventories down this much, it would jeopardize their deleveraging plans.

Additionally, the Company has recently employed a number of one-time maneuvers to boost cash flow. Notably, stock compensation more than doubled from $30mn in 2022 to $68mn in 2023 as SMG paid for both short-term variable incentive compensation and director compensation in stock rather than the typical cash payment.  They also paid for advertising expenses in stock which is something we have never heard of.  In the December 2023 quarter (Q1 2024), SMG sold $140mn of receivables which they have never done before.  Combined, these measures point to building desperation. 

If we normalize the receivable number by adding back the receivable sale, their quarterly DSOs continued to increase YoY.  This is particularly worrisome as elevated DSOs indicate that retailer inventory is ballooning and/or sell-out is weak.  On the last call, the company indicated that POS (sell-out) increased by 8% in Q1 and retailer inventories were down LDD.  Yet, revenue (sell-in) declined by 17% for the same quarter.  They also claim that they have gained shelf space with retailers which would imply they are actually growing retailer inventories.  It is hard to reconcile their commentary with their financials. The enthusiasm around positive POS and shelf space that sent their stock up ~30% over the last month seems unwarranted.  Interestingly, over the same period, consensus has downgraded their Q2 estimate from flat revenue to a decline of 4% and has shifted outperformance to the back half of the year.

note: adjusted accounts receivable add back $140mn of receivable sales in the December 2023 quarter.

Additional Concerns

CEO Jim Hagedorn has an intense, no-nonsense leadership style stemming from his military background that has alienated employees in the past. Former employees we have spoken to indicate he is pragmatic and direct but can be callous and focused intensely on profits. There is some question as to whether he is flexible enough to navigate recent upheavals. He is the son of the founder and the family controls the company. This has led to questions/concerns over the amount of capital spent on Hawthorne, which is under the leadership of Chris Hagedorn, Jim’s son. The above, combined with a 25% reduction in the workforce over the last 2 years and financial pressures have deteriorated internal morale and momentum.

Since 2020, SMG has gone through 4 different CFOs.

Valuation and Price Target

SMG currently trades at 13.7x NTM EBITDA or 20x TTM EBITDA, despite its highly levered balance sheet and operational challenges. SMG traded below 9x TTM EBITDA as recently as October 2022 when it reached ~$40. Before they carved out Hawthorne as a segment in 2015 and began an acquisition spree in the cannabis market, SMG traded in a range of 7.5x to 11x with a 9.2x average multiple.  While there are no great comps to SMG, there is a hydroponic cannabis player called Hydrofarm Holdings (HYFM) that debuted at a $1.5bn market cap in 2021, promptly traded above $3bn and today sits at just under a $50mn market cap.  The cannabis premium has clearly faded but SMG still trades at the high end of the range. We estimate that SMG will miss 2024 EBITDA guidance by ~10% or by ~15% if you back out the unordinary stock comp related to advertising expense and director compensation. When its issues become more apparent, we see the stock re-rating to 10x TTM EBITDA, in line with more challenged discretionary names. This would yield a price target of $40, representing 40% downside.

Key Risks

The main risks to our short thesis are: 1) home sales rebound significantly leading to better than expected volume and pricing, 2) animal spirits around a rebound in the cannabis market driven by federal legalization. We believe these risks are more than offset by the material downside in the stock if the company misses estimates and is forced to address its balance sheet.

Catalyst

- Earnings Miss

- Competition impacts US consumer outlook

- Limited Hawthorne options

- Long timeline to delever