The Scotts Miracle-Gro Company (SMG) Earnings Call Transcript & Summary

Good afternoon, everyone. Thank you for being here. I'm Gaurav Jain, Barclays' Head of Global Tobacco and Cannabis and EU small and mid-cap companies. With me here is Matt Garth, Scotts' Chief Financial Officer. Thank you, Matt, for being here.

Thank you, Gaurav.

So Matt, just to start out, you started at The Scotts this year, the company was -- it has the value label. A lot of investors [indiscernible] is a special situation, what attractive is the opportunity? And what do you see at The Scotts?

Yes. First and foremost, again, thank you for the opportunity. I am an avid gardener, a lawn enthusiast and that took place over the course of a lifetime. There is a passion and a love interest that people associate with Lawn & Garden. And I shared that even before Scotts reached out to me. Looking at the situation, probably the way most people see it today. I know you've written this way a bit, some questions. I've seen it as a great opportunity with a highly recognizably branded company that has things we need to be contend with. Leverage being 1 of them, margin recovery being another, you have some -- we can improve the market positioning further strengthening the future. So if you're kind of a corporate leader and you're sitting back and saying, I want to be challenged, I want to be excited and I want something that's [ coming ] to what I appreciate, and I do every day. Yes, The Scotts Miracle-Gro for me was a home lawn. So to your question, I'm extremely excited to be here. And for the past 10 months, I worked with Jim and the rest of the team, given you know all of our associates across the company. It is a phenomenal place to be with a differentiated culture that I'm now proud to be a part of and represent. So it's been great.

Sure. Thank you. Now at your Q3 results, there were a number of interesting comments you made on the call. So first of all, the company cut guidance quite significantly this year for EBITDA, and you highlighted the weakness in consumer, Hawthorne was taking share to recover. And then you had a lot of interesting markers for next year, and I think you almost highlighted a $3.50 to $4 of EPS potential year. So could you just actually explain to the audience who are not that familiar this concept what exactly has happened this year? And then how do you see massive EPS over next year?

Okay. So let's [ condense ] a kind of our last conference call into new sound bites. We came into '23 expecting growth year-over-year. We expected 1 of the things that people talk about is a 10% units growth in our lawns business versus '22, and that would have been getting back about half of what we've lost versus '21. We expected Hawthorne to also kind of hold its own and we expect that the rest of the portfolio on a unit basis to be flat. What we've seen so far this year is a change in that mix. So right now, I think overall [indiscernible] is probably down about 1% versus last year. That's a combination of really good performance in Gardens, and soils and the controls are offset by weakness in Lawns. We just didn't see in Lawn this year, the consumer pick-up that we were expecting. So those of you who are looking at your analysis beginning of the year, first half of the year really superb execution from the [ team ] in every single category. We positioned ourselves extremely well with all of our retail partners. That led to a second half approach where we were locked in. We have media capable to help bring consumers to the marketplace and take stuff off the shelves, didn't happen. And we talked about on the call, and I think a lot of you have seen in other retail conversations, what's taking place with the consumer, where they're putting their dollars. They are price sensitive. They are focused on experiences. They are traveling. And for us, that means they're spending more time out of the home. And so therefore, away from their lawns and away from their gardens. So that set up kind of a need to readjust our perspective for the second half of the year and has grown enough points to while we were doing that, I put out a marker for '24 to say, well, this was a tough year. I think and I don't know what your analyst is -- what your estimate is for '23. I apologize. But consensus kind of a buckish, you back out the one-timers, it's probably $1.25 whether we'd over-deliver in Q4, I said that on the call, I'll say it here again today. I'm less concerned about. I am acutely focused and the rest of the organization is and delivering the most value in '24. Now Gaurav is asking, okay, what does that mean? It means some modest margin recovery. And we're going to end the year kind of 23-ish percent, we're pointing to a '24 that would see margins in the 25.5% range. We see some top line growth coming. I said mid-single digits, but the range that we gave on EPS -- so that's kind of the range with growth year-over-year and without it. So that explains sort of top line, your gross margin. SG&A, we said would be down in dollars, and we said we'd be kind of closer to 14-ish percent and 15% to 16%, which is how we would normally model it. And so that helps to drive some of the gap. I think that people were asking about lower tax rate, lower interest expense, all delivers higher profitability year-over-year. Now the question is that everyone is asking us, you just said you can do $1.25, how do you going to get the $3.50 to $4, and it is coming from, again, expected top line growth, working with our retail partners, extending our positions on profits that are meaningful to us and consumers. Looking at ways to continue to expand margin. We have a lot of those levers in place. We will continue to attack those and then just good old-fashioned blocking and tackling on SG&A. We don't expect that we will need to pick up the spend in SG&A on a year-over-year basis.

Sure. So let's now until a lot of what you have just said in a number of -- in the next few questions, but let's first start with leverage with that as sort of a key topic in the minds of a lot of investors. So leverage right now I think 1 thing to keep in mind is that you take last 4 quarters. average net debt number, not last quarter net debt number, but you take the last 4 quarters average net debt number and divide it by trailing 12-month EBITDA, and that is almost close to 7x if I'm not mistaken. So what's your deleverage plan going forward? You said on the call that you want to go down to 3.5x as quickly as possible. So how long do you think that will take?

So you're projecting end of the year, net leverage in that number?

It's like 7x.

Okay, fine. That's your projection, Gaurav. I'm not going to argue with you. Let's just go with that. This is a fireside chat, right? There's heat everywhere. So let's just say that's your ongoing assumption. The math, you're right. It just doesn't -- it doesn't move as functionally favorable as we would like it to. So we're going to pay down $300 million in debt this year. We'll pay down $300 million in debt next year because you're averaging and that net leverage calc doesn't really start to impact you. When we start to talk about the dividend, the same rationale. So the target ultimately is to get ourselves back down the 3.5x and below. Time line to do that, it feels like it's going to be in the '26 range. Now that's a while from now. The execution along that pathway includes margin recovery, getting our performance back to where we want to be, delivering exceptional levels of cash flow, turning that into debt pay down. That's what we'll be doing year in and year out. And so the way points, you're right, kind of starting north of 6x. We now have renegotiated our banking agreements, our credit agreements. Our banking partners work with us in a very forthright manner. We now have room where we don't need to optimize on a quarter-by-quarter basis. We are looking through the years on a longer-term basis to make sure that the outcomes deliver the most profitability, the most value and the most cash flow so that we can delever faster. So I kind of threw out the '26 time frame there. If we can do it faster, we absolutely will. And it comes from yes work on the numerator, which is -- with the denominator side. But -- I'm sorry, which is the debt side, the averaging of that kind of makes it harder, you really need to drive that EBITDA to deliver on denominator side.

Sure. So is then the conclusion that the primary focus of free cash flow generation will be for deleveraging and not for M&A and that the CapEx spend would be almost minimal because I don't know what your capacity utilization is right now. But probably in the 70% range. So your growth -- you really need growth capital for years to come.

So a few components of that. One, the overall philosophy that Jim and I have is one of the balanced approach. Certainly, right now, with that being at the levels that it is we cannot be balanced. We are delivering debt pay down and returns to shareholders. You'll see us kind of year in and year out, generate $300 million of free cash flow in a normal time period. That's probably going to have debt pay down or some type of M&A potential and direct returns to shareholders, if there's nothing from an M&A potential, just all go direct returns to shareholders. CapEx, we kind of target around 2% of sales, which means next year, we'll be looking at around $7 million, if you use this year's sales. That seems to be a good place. We actually have invested a lot over the past couple of years. And so the tail is behind us. We've absorbed the bubble of getting our operations where we want them to be. And as you said, we're right now running about 20% below where we want to be in U.S. consumer from a production perspective. So those assets are in a good place. M&A takes on a whole host of different approaches. Are there things out there that Scotts Miracle-Gro should own? Yes. We are an exceptionally well-positioned brand leader. We have an unparalleled distribution network and capability to source, produce and deliver products that no one in our space, and I think a lot of other competitors in retail can't match. And we have an unparalleled position with our retailers in terms of depth and meaning of our product category to what their consumers are looking for driving that foot traffic being a part of their long-term solution. So there are a lot of brands and products that fit into that mold that we can look at over the longer term. But for right now, 100% of free cash flow earmarked for debt pay down. The open question is on the Hawthorne. You've heard Jim and I over the last 2 quarters talking about Hawthorne is the cannabis side of our house. For those of you that don't know, finding a strategic solution for Hawthorne that does not involve a significant cash outlay. We're working through doing that. We have a very strong position in Hawthorne. For those of you who don't know, when you think of a greenhouse, all of the infrastructure around a greenhouse, being able to develop the genes, the nutrients and the overall systems to produce the highest quality plants at the lowest possible -- or highest possible density at the lowest possible cost. That's with the combination of writing, consumables, other durables and a great understanding how genetics does and that's what Hawthorne is. And so that business, again, a very strong position that we can leverage with other partners. Those conversations are ongoing and centers around doing some type of transaction, cashless in nature, again, where you're combining assets, finding some great commercial arrangement to make the most out of what the situation is and position that business for optimal value creation as people start to respond to the cannabis space again.

Sure. On the $300 million free cash flow number that you are talking of. So earlier, Scotts used to say that $300 million free cash flow is like per annum number on a longer-term basis. But the [indiscernible] next year, the free cash flow generation will be almost $1 billion because cash raised from inventory. Is that still the -- is it like the $300 million is the long term number...

It's $1 billion over 2 years, right? So your underlying free cash flow was about $300 million right. we came into '23 with about $400 million of excess inventory. That's why the production rate is lower. And so we're going to eat half of that in '23, half of that in '24. By having a lower production, you're going to sell it through. And so that's what's creating the higher working capital release in these 2 years. So yes, the target, by the way, is still $1 billion over 2 years.

And then this goes into the margin expansion question. So there's clearly -- urea prices you have cited, they were at $800 or $900, 2 years ago, now they are at $350, and we did this analysis in one of our reports, I think, last year where it was almost like your margins had inverse correlation to urea prices that -- it was always like higher highs and higher lows that you add depending on how the urea cycle trends. First of all, is that correct -- simplistic, but is that the right way to think that you could actually go beyond prior highs, if urea prices remain where they are number one. And number two, within that, [indiscernible] sell-through right now [ whether the ] inventory dynamics or capacity utilization is lower, which means that your unit costs are probably higher than what presumably just as inventory runs down? So can you just explain how much could that lead to margin expansion of your capacity utilization went up in line with sell-through trends?

Yes. So there's a number of ways to explain this dynamic first and foremost. We took on 1,700 basis points of inflationary cost increases over the past couple of years. We fully offset that with pricing. So I know that there's a pricing question here, pricing this year will be up mid-single digits, but that's embedded in 17% price increases over the past couple of years. And when you get to what's been happening on net margin impact from these commodity increases versus the pricing, which isn't margin accretive in itself, right? It is dollar for dollar. To get the margin back. It's been 500 basis points we've been talking about between where we are now and where we want to get, part of that bridge back or build back is 500 basis points of additional margin coming out of raw material costs. So that will happen as you said, we're putting in a layer of low-cost inventory now for '24 that is. That will work itself by the back end of '24, we'll start to see the benefit of that in '25 is when you will meaningfully see the margins start to accrete higher based on those lower raw material costs.

And the utilization rate improvement that will also happen in FY '25?

Correct, which is the other part of how we get back, right? So you're now pointing to a '25, '26, where what we said is target margins for this business are 30-plus percent. And so coming out of this year, 23%, 24%, looking at 25-ish percent in '24, you got room to get with it, costs have moderated significantly, and we're going to be producing more, which all will create margin expansion.

Sure. So [ $3.5 ] while the EPS jumps from whether [indiscernible] people have $1 or $1.5 actually are closer to $2 to go back -- but it goes up to [ $3.5 to $4 ]. There is still a massive jump, which could happen even after that because the margins, as you are saying, will continue to improve, all else equal, I know that's a very big statement to make....

All else to be equal, Right? So I get this question all the time, which is this is a company that earned $9 change. How are we now earning roughly $1 per consensus. Yes, I mean, you and I have talked through a lot of the dynamics that are happening post-pandemic or observing a lot of cost, as you can tell by our work on Springboard, we've taken out or will have taken out north of $300 million in '24. So we are acting on everything that we can control across the company very rapidly. Is there more to do? Yes, we're going after it, right? That was what Springboard 3 was all about. But as we move forward, being leaner, having proper positions around our brand strength, that will all occur to a margin level that is consistent where we were which is sorry, where we think it should be over the long term.

Sure. And now coming to Project Springboard, this is Springboard 3 and you've already cut a lot of costs. And 1 time when I had the conversation, I think, about a year ago then what I learned is that almost -- there have been like almost a 25%, 30% reduction in the number of personal in that quarter. So that is a very high number and still you have a Springboard 3. How lean was the organization now?

Let me give you an indication of what happened. And we said it in the third quarter call, but I've gotten much more comfortable with it over the past couple of weeks. One example, Hawthorne was a business that was approaching $1.5 billion in sales. It had a distribution, sales, operations network that was built for continued growth. So kind of in excess of $2 billion. This year, you will [indiscernible], but it's got to end up the year kind of like 500 all in, including the ProHort business. That's a quarter of what it was built to do. So when we talk about Springboard 1 and 2, which was kind of $200 million-ish, north of half of that all came out of Hawthorne. Just resetting the network back down, taking out positions that were related to growth that wasn't happening. And so are we leaner? Absolutely. Are we holding back positions now for growth? Not necessarily. I think that there are efficiency optimizations that we're going after, there is job stacking that is happening. There's responsibility management, there is, what should we be working on versus what we are working on. All of those initiatives are underway to help get further cost out of the system. And that's part of Springboard 3.

Sure. Let's go into each of the businesses, the U.S. consumer business and the Hawthorne business. So the U.S. consumer business -- pre-covered, it used to grow 1% to 2%, COVID, massive jump. Everyone, including the retailers over projected growth. We have seen it across industries. And then since then, there has been a COVID in mind. What do you think is the steady state growth of this business? Back to 1% to 2% growth or there will be a continuous unwind as more and more work from home happens every year and the percentage work from home keeps on decreasing.

It's okay. But I was hoping that people work from home. I love it, but that's accounted to anything else over here, I'm sure, from the rest of the senior leadership in this conference. So the way I write it on the white board when Jim and I talk, the business has an opportunity to grow at 2% to 3% a year. That has been demonstrated in a 1% to 2% growth rate over that time or pre-pandemic time period that you're talking about. What's the difference? The difference is getting lawns into a position of stability, continuing to grow in gardens and penetrate more deeply with consumers, which we are and bringing innovation that should be worth about 100 basis points of growth year in and year out to the table. So we're not far off from that prior trend. We're not expecting 6% to 8%, right, but it is north of where it was historically. And the solve for lawns, and you heard Jim talk a lot about this. And being a person who's passioned about my lawn, I am a 4-step user. I apply a minimum 4 times a year, and I know what I'm doing. The next generation, bringing them along and getting them to understand that the care and maintenance and the feeling of connecting to a beautiful yard, takes a little more, and you're in the midst of that generational change right now. So millennials are coming in, they're all buying homes, they're overwhelmed with costs, and they're still wanting a lot of outside the home experiences. That will all moderate over time, right? And so people will look at their yards again, and that will help the lawns business. Gardens, again, people who have been -- whether it's flowers, vegetables, all through our Bonnie network into soils and having plants that are thriving in their yards, the business has been performing very well. And then you get into the whole control side, we feel very good about that and the future prospects of that as well. So you have this dynamic where get lawns to settle, continue to grow in gardens. That leaves you with a Hawthorne business, which for right now, let's just say you have to assume it's not going to have any growth.

Sure. And could you talk a bit more about what has happened in the Lawns business it seems you have lost share versus private level. So why have you lost share in Lawns and not in Gardens? What are the price gaps? How much do you need to close the underperformance in Lawns?

Yes. Let's make a correction there. Lawns, you need to separate into fertilizers and seeds. And in fertilizers, we did not lose share. We actually gained share. If people are going to pull a fertilizer product off the shelf, they were pulling a Scotts bag. We also participate in private label, and we saw our private label business down kind of twice what we saw in our branded products. So we have more than just hearsay and understanding what was taking place there. On the seed side of the business, and this goes back to some of the early commentary you and I shared around the sensitivity of the consumer, where they're putting their money, where they're finding value. And on the seed side of the house, we had some instances where we were basically kind of 100% higher than a competitive product. And normal premium should be in the 30% to 50% range. So it was kind of 2x what it was historically. So that needed to be worked on, and that value needed to be driven back to the consumer. And so the share there are feeling temporarily lost because of the fact that we were kind of mispriced. But you've already seen so far in the second half of the season, there have been price adjustments and the numbers are turning more favorable to branded products, our products again because people know that, that's the product that it's going to work.

Great. So as we look ahead now to FY '24 and in terms of like if you were to separate the volume price mix dynamic. So is it fair to say that price mix will probably be negative as we look forward into FY '24 when the trends will be much better? So the top line growth might not be much, but there will definitely be sort of a margin expansion, which happens, which takes us to this $3.50 to $4 kind of EPS number?

Let me do it in my way. I expect based on the conversations we've been having with our retailers and how the team is motivating around 2024 to see higher volume in '24. With that will come a decent mix. I mean it should be neutral to slightly positive or negative. So let's call it neutral on a year-over-year basis, which lends to your last question, what happens with pricing. Pricing, too -- what we're seeing right now is the -- is where we are actually lifting price are being offset by price declines. And so outside of programs which we naturally run, the table speak is kind of flat. But when you get through the programs and how we're moving with our retail partners, you would see pricing down year-over-year to your point.

Okay. I want to just open it up to the floor if there are any questions. Otherwise, I have a longer list of questions here. Full room.

Matt, can I just -- I ask the question because it's something that's kind of hard to have some insight into. But just with the dynamics this year with some of the -- would seem like some supply load in earlier in the year to help with some of the debt covenants and whatnot, where you talked about working with retailers to accomplish that and then kind of the weakness in sales that we've talked about. Can you kind of give us any insight as to what retailer inventories look like, what retailer supply looks like and what that means and how you're thinking about that for '24?

Yes. Retailer inventories are up right now, and it comes from a few different things. One, Walmart has a higher scheme position which is beneficial. It's mostly on sort of the control side as we go late into the season. And then as we look at Home Depot, you're seeing that they also -- when we talked about this on the call, we had a large load in kind of like a few days after the quarter, it could have swung in the quarter. So they actually have a higher than what we thought position. But we do believe those are going to get worked down. You're starting to see that in the order pattern here today. It is commensurate with ending the overall year down from a retailer inventory perspective, which I think earlier in the year, we would have told you, it will be down maybe high single digits. It's probably mid-single digits where we're going to see retailer inventory positions. And what does that mean for '24? Well, it means you're starting with potentially a higher inventory position going into '24, which the governor there is what we do on the production side. We're not going to compromise our free cash flow position. We are anticipating that we would bring some selective production back, but we're going to moderate that based on where we see retailer positions going into the year.

So coming back to the overall question of the enterprise and the leverage and what are the potential options that are there to reduce the leverage. So you have spoken about Hawthorne, and you're evaluating strategic options around Hawthorne. But as you said, Scotts, the core business is a great business, great cash flow dynamics and you could argue leverage is temporarily high. So if there were to emerge like an opportunity to get an external investor within the core consumer business. Is that like something which you are also exploring?

Let me give you the high-level answer, and then I'll dig in. One, the work we did with our credit agreement gives us, no one can never say ample space, gives us room to maneuver and optimize across the year. Two, it gives us room to continue to pay the dividend and make the investments necessary to sustain increasing cash flows in the business. Does that mean that I feel the pressure is off of us from a credit perspective? No, because the numbers tell themselves to your point. It's a very highly levered position right now versus where this company should be. We recognize that. But it's temporary. Equity is permanent. And I guess it's the same statement on the dividend. I don't want to make a near-term, short-term event to solve a short-term issue, but will have a long-term consequence for current shareholders and for the company going forward. So no, I'm not looking at paying an additional equity raise nor is Jim. And we believe with the credit agreement that we have in place, the cash flows in the company and our path forward that we're able to continue to pay the dividend, pay down debt and return to the type of profitability that investors expect of us.

Sure. No, you had mentioned Hawthorne. You have Hawthorne then you also have equity investments and some cannabis entities like RIV Capital, et cetera. So when you're looking at a transaction around Hawthorne, it includes all the cannabis facing businesses or it will just be Hawthorne and you could still continue to own...

It might. Again, there's a lot going on right now that we are in discussions about. I would say it this way, Gaurav. And maybe it was tied to your last question, and I stepped over it, and I didn't mean to. Is the company looking to motivate assets of value into areas where value can contribute back to the company? Of course. Are those assets valuable? Well, kind of the discussion that Jim and I have been having with you all over the last 10 months has been there's modest value in cannabis, if any. And you saw that return in a heartbeat with note that was sent from HSS -- HHS to the DEA on moving the scheduling of cannabis. The cannabis equities are up 20%, 25%, and we participated as well. There is excitement around that. And so we're continuing to monitor that, and we'll make decisions as we move forward. But ultimately, Jim said it on the last call, the best place for Hawthorne to be is as a separate stand-alone company.

Sure. And let's say that and the last question and then we'll go to the breakout session. So there's clearly a lot of focus on immediate issues within the company, leverage, but let's take a longer time in terms of Gardening business as well. It's a great business. And we keep hearing about a lot of trends around smart gardening, automated gardening. Are you still looking at all those long-term growth options or the focus is just so much on getting to an order that all those longer terms...

No, no, no, Gaurav. It is the opposite of what we're doing and everything inside the company we are trying to keep people motivated around the future. The investments in R&D, maintain the investments in our capabilities, maintain understanding the consumer growing. And so we are doing everything for the Lawn & Garden of the future that is expected of us because that's our franchise. That's our business. As we talk about Lawns & Garden, my view, that defines lawn and garden for the consumer. So making sure that we have appropriate positions, appropriate understanding, appropriate innovation, we're going to continue to invest in that.

Sure. Thank you. We are out of time. Thank you so much, Matt.

Thank you all.

We'll be going to the breakout session. So please come there, and we'll see you there.

Great. Thank you.