Description

This one was written up last year but we think timing is better now.  Of course, hopefully we won't fall victim to the old adage "fool me once..."   Calendar Q1 may still be a bit squishy when reporting (carryover inventory limiting retail ordering ahead of the season, plus weather as per CENT/POOL), FCF doesn't typically inflect until the 2H, and of course 'macro' considerations investing in a levered entity amidst banking stress (i.e. caveat emptor).    Big picture, this is a quality asset that will work its way out of a hole that has been dug and should provide an attractive return to shareholders from these prices.  Significant inside ownership also aligns incentives between management and equity holders.

Company Background

The US Consumer business for Scotts is a leading manufacturer and marketer of branded consumer lawn and garden products in North America.  Key brands include Scotts, Turf Builder, Miracle-Gro, Ortho and Tomcat.  The company is also an exclusive agent of Monsanto for the marketing and distribution of certain Roundup branded products.  The company’s Hawthorne segment is a leading manufacturer, marketer and distributor of lighting, nutrients, growing media, growing environments, and hardware products for indoor and hydroponic gardening in North America.  Key brands in this segment include: General Hydroponics, Gavita, Botanicare, Agrolux, Can-Filters, Gro Pro, Mother Earth, Hurricane, Grower’s Edge, HydroLogic, and Cyco.

The company utilizes a direct salesforce, e-commerce, and a network of brokers/distributors to sell to home centers/mass merchandisers/warehouse clubs/hardware stores, nurseries, garden centers, and specialty distributors/retailers.  Home Depot and Lowe’s together accounted for ~43% of sales in fiscal 2022.   The business is highly seasonality, with ~75% of annual sales occurring in the 2^nd and 3^rd fiscal quarters.  Orders are typically received late in the winter and continue through the spring season.   Historically, substantially all orders are received and shipped in the same fiscal year.    The core of the company’s lawn and product categories can be broken down into the following applications:

• Lawn Care – products include fertilizer, grass seed, weed/pest/disease control as well as spreaders and other durables
• Gardening & Landscape – products include plant foods, potting mixed, garden soils, ground cover and mulches, pest and disease control, seeding solutions as well as growing media/nutrients in the hydroponic segment
• Hydroponic Hardware & Growing Environments – durable goods to grow such as growing systems, trays, fans, filters, humidifiers, dehumidifiers, timers, instruments, water pumps, irrigation supplies, and hand tools
• Lighting – provide growers with a selection of lighting systems and components for hydroponic and indoor applications.  Products include sensors, controls, fixtures, reflectors, lamps, cords, and hangars. 
• Controls – protection products targeting pests (e.g. rodents, insects) as well as weeds
• Marketing Agreement – the company provides certain consumer and trade marketing program services, sales, merchandising and other selling and marketing support for certain Roundup products.  Annual commissions totaled $133 in 2022, or 3.4% of sales.  The gross profit contribution was $65 million in 2022, or ~6% of sales, which is up from 5% in 2020 as core business gross profits declined.

Consumer Business -- What Happened Here/Outlook?

There are multiple issues that have affected the business that need to be unpacked.   We’ll approach these one at a time.

• COVID – lockdowns & working from home associated with COVID provided a natural tailwind to the company.  An expert we spoke with indicated 20 million incremental households came into the category from the 2018/19 baseline.  The net result was a big lift in sales.   What is normally a low single digit growth business within the consumer segment jumped 25% in fiscal 2020 and another 11% in 2021.   While some growth is tied to pricing to keep up with inflation, the benefit is clear.   As the world normalized in 2H 2021, sales initially decelerated and then started declining by 4Q 2021.   The sales decline continued throughout 2022 with sales for the consumer business falling (8%).  After accounting for inflation and a higher cost curve, consumer segment sales may still have a little bit of giveback (5%-10%) to get back to pre-COVID trends; however, conversations with industry participants suggest that 2/3rds of the incremental consumers picked up during COVID are still shopping the category albeit with lower aggregate frequency and normalized basket size.   Thus, we believe it is reasonable to conclude that most of the COVID hangover from a top-line perspective is behind the company and the business will revert back toward trend-line growth, which is to say 1%-2%.
• Weather / Inventory – The business is highly seasonal as shown in charts below, and weather can have an impact at the margin.  In 2022 poor spring weather and elevated inventory at retail (across numerous categories not isolated to lawn & garden) combined to exacerbate dynamics associated with the COVID hangover for Scotts.  First, poor weather caused a slow start to the season, which had the effect of reducing higher margin fertilizer sales.   Second, even as retail consumer point-of-sale normalized throughout May & June, retailers curtailed replenishment orders.   The latter was a combination of lower sales velocities than anticipated due to the COVID hangover as consumers shifted their buying habits, thereby allowing retailers to reduce their level of inventory; and, per management, an over-correction in inventory at retail because other categories with lower sales velocities (e.g. grills, outdoor furniture) were tying up capital and it was easy to reduce working capital in places like lawn & garden as an offset.   Scotts was not prepared for the curtailment of retail orders, which in turn led to a significant surge in inventory on their balance sheet.  
• Cost Inflation – Urea and diesel fuel / trucking prices were the largest headwinds in 2022, and to a materially lesser extent packaging costs and chemicals.  In terms of understanding the magnitude, a company executive described it to us as Urea being 20%-30% larger than freight, and Freight 40%-50% larger than packaging.  Regarding what happened, in the immediate aftermath of the Russian-Ukraine war natural gas prices (key input for Urea) spiked to almost $10 in the US and multiples that in Europe as supply had to be curtailed once it became uneconomic to produce.  Over the summer diesel prices also effectively doubled from $2-$2.50 per gallon to $4.50.  Because the business tends to turn inventory 3x-4x per year (with some hedging of inputs), the time until the cost inflation is felt in the P&L is quick.   For Scotts this created substantial margin headwinds in 2022.  Rather than trying to price to recover the margin %, management made the decision to raise prices to cover the $ impact of inflation in the short-term in order to be mindful of price points to consumers as well as price gaps with private label.  As an example, if we were to assume that their basket of COGS went up 40%, pricing to offset the dollar impact would result in a headwind of ~700 bps to margin. 

Of these issues affecting Scotts over the past 1.5 years, most are either starting to or are on the cusp of normalizing.   First, the consumer shift in spending back toward services has clearly happened domestically (we first flagged this here in 2021), and while there may be some further moderation in goods spending the bulk of it is likely behind us; second, inventory at retail in response to said shift in spending has happened while management has articulated a plan to address working capital in fiscal 2023 for Scotts; and third, we believe gross margins can recover over time.   Certain aspects of cost inflation have subsided (Urea, trucking rates), and the company is pricing to catch up to the higher cost curve as well.    As a producer of private label product for HD/LOW, contracts ‘temporarily’ protected the retailers last year from inflation to the detriment of Scotts margin.   Those pricing discussions typically happen at the beginning of the year, so adjustments on this business should also be forthcoming in 2023.  All that said, considering the bloated and likely higher cost inventory on the company’s balance sheet, the path to gross margin normalization will take some time and is unlikely to be linear.   Based on our research, there is no reason to believe that the SMG consumer business cannot structurally make it back to the 22%-24% segment margin range. 

Hawthorne -- Is There Any Hope?

Scotts Miracle-Gro was, for a time, viewed as a ‘safer’ way to play growth in the cannabis market.  Effectively the company is selling the “picks-and-shovels” to the gold miners, or in this case the growing equipment and consumables to the cannabis market.   Given the multi-year trend toward state legalization of marijuana, it was a boom time for growers and for the company’s Hawthorne business.  Hawthorne grew from a $287 million business in fiscal 2017 to $1.4 billion in fiscal 2021 representing ~400% growth or a CAGR of 49%.     While it is difficult to track supply and demand, we can follow the US Cannabis spot market index to track pricing to assess the balance between supply & demand.   The cannabis benchmark in the US trended down throughout 2022, though is showing tentative signs of bottoming currently.  The result of price degradation (among other factors) was a significant retrenchment on the supply side of the industry.   Hawthorne sales are ~50/50 tied to durables (e.g. lighting, growing environment) versus consumables (e.g. nutrients) per some of our checks and company disclosures.   Not surprisingly then, the business saw sales drop (50%) in fiscal 2022 and segment profit drop from $160 million to a loss of ($21) million.  Hawthorne alone accounted for 50% of the drop in segment profitability in 2022 despite only accounting for ~30% of company sales in 2021.

Hawthorne was built for growth, so it is not surprising to see the big deterioration in profits in 2022.   The company had an operating structure that would ostensibly allow it to be spun off as an independent entity.    In response to the cannabis downturn, Scotts is in the process of restructuring Hawthorne.  Management is targeting $65 million of annualized cost savings by closing distribution centers, selling certain assets (e.g. lighting) and reducing the workforce.   The business will also become more integrated (e.g. back-office) into Scotts.  Management effectively plans to retrench to ride out the oversupply situation.  

Due to the lack of visibility in the cannabis market and ‘when’ it will recover, we are effectively forecasting that the business stabilizes at current levels (down 50% from peak), though profitability moves to slightly positive as costs are taken out of the business.   We believe there is option value to an eventual recovery as the overall cannabis industry is expected to grow ~50% between 2022 and 2026, but we do not want to embed that when underwriting the stock.  

Leverage Concerns

The company finished fiscal 2022 with a debt/EBITDA ratio of ~6x (net debt of $2.9 billion), though management sees a path into the mid-4x range by the end of the next fiscal year and back to the normal 3x by the end of fiscal 2024.  Credit amendments allow maximum leverage to step-up to 6.25x-6.5x for the second and third fiscal quarters given seasonal requirements.  Importantly the company does not have any outstanding maturities until 2026-2027, and 50% of the debt is at a fixed rate (implication is that the company can prioritize paydown of variable debt given the rising cost of capital).

Management projects $1 billion of two-year ‘cumulative’ free cash flow by the end of 2024.  Notably the company expects to release ‘at least’ $400 million this year by limiting production and selling through existing inventory.   A simple analysis of net working capital as a % of sales suggests that normalization to 18%  would release upwards of $600 million of capital from the balance sheet.   It is also important to note that inventory in this category carries over from season-to-season as innovation tends to be on a 2-3 year cycle and the product is easily warehoused.  For fiscal 2023, SG&A is budgeted to be below 2019 levels, and M&A is on hold in order to prioritize debt paydown.  Thus, while the balance sheet looks weak today it is poised to inflect positively over the course of 2023.  Management also updated the market that net leverage will be "comfortably below" the credit facility covenant for the March quarter, the seasonal trough in cash flow.   

Given the big working capital release + expected normal cash generation of the business, we are looking at a fairly imminent (i.e. within 6 months) inflection in the financial profile (cash flow, balance sheet) of this business.    That said, the pace and magnitude of the improvement is still uncertain and weather can affect the business as it is highly seasonal.  Note that ~80% of the sales are concentrated in the fiscal 2^nd and 3^rd quarter (March & June) and the cash flow is more than entirely generated in the 2H.  The reason for the 2H cash flow is tied to the required investment in working capital during the year whereby it builds in 1H and releases in 2H.   There is reason to be hopeful that cash flow will look better in the 1H than normal because working capital is already elevated, though that is not to say that we should expect a large improvement in cash flow until the June quarter.  If we take consensus sales as the starting point for 2023 and look at the average working capital required to run the business, the implication is only a modest need for incremental injections in the first half of $200 million compared to an average of $700 million in the 4 years preceding COVID. 

Management

While this is a long-tenured management team which has done a reasonable job steward Scotts in a mature category over the years, we obviously have some reservations on capital allocation and prior more favorable perceptions are tainted by recent performance.  Perhaps the most redeeming factor here is that the CEO eats his own cooking.

• CEO – James Hagedorn – Son of Horace Hagedorn who launched the original Miracle-Gro in 1951.   Former fighter pilot.  Helped orchestrate the merger of Miracle-Gro with Scotts in 1995.  Became CEO in 2001.  NOTE – the Hagedorn family is the largest shareholder of Scotts at 25% ownership.  The business is the “family legacy.” Management is committed to do “whatever it takes” to set the company up for “ongoing success and long-term shareholder value.”
• President & COO – Mike Lukemire – Named to COO role in 2014 and President in 2016.  Responsible for marketing, sales, supply chain, IT and R&D.  Joined the company in 1995.  Prior to SMG he worked at Nabisco, Kraft-General Foods, and Kroger
• CFO – Matt Garth – named to current role effective December 1, 2022.  Most recently he was the CFO for Minerals Technologies, and held senior financial roles at Alcoa.

Valuation

We use an EV/EBITDA multiple to value this business given the leverage on the balance sheet.  Apply a 12x NTM EBITDA multiple, which is roughly the recent average excluding the bubble period, one can reasonably target a return to $100-$110, representing a ~75% return.  That contemplates ~$1 billion of debt paydown, eliminating losses at Hawthorne, and returning the consumer business to normal margin yielding EBITDA back up around $700m.    Because this is a low-growth asset and most of the incremental value being ascribed is attributable to the reduction in leverage and margin recovery, a 1- & 2-year holder period should capture most of the upside.   Current consensus estimates understate the potential for recovery; but understandably it is likely to be lumpy.  

Risks

• Weather - we already know from CENT and POOL that it was bad in CQ1, especially on the West Coast
• Inventory - if the inventory correction at retail is deeper than perceived, follow-on seasonal orders this year could be weaker and elongate the thesis

Catalyst

• Margin inflection - SMG is already running in positive territory on pricing vs. material costs.  Volume deleverage from cancelled orders / inventory correction will abate and business returns to 'normal'
• Cash flow inflection / debt paydown