Scotts Miracle-Gro: The Growth Story Is Falling Apart (NYSE:SMG)

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Miracle - Gro plant food with garden feeder

skhoward / iStock Unpublished through Getty Images

Investment thesis

Scotts Miracle-Gro (NYSE: SMG) is experiencing a sharp slowdown in its growth. This includes a sharp drop in projected revenue for the company’s key growth segment. The stock price has dropped along with the declining prospects, but it’s still well above a price I’d like to buy or hold. Also, I think the company is not in a good financial position to deal with these obstacles effectively.

The last cut of orientation

On June 8, Scotts Miracle-Gro announced the latest in a series of major targeting cuts. The company downgraded EPS estimates to $ 4.50 to $ 5.00, up from $ 8.50 to $ 8.90 late last year.

The guide predicts a decline in overall sales as well as strong pressure on margins due to rising raw material costs. This is expected to hurt profitability in combination with the company’s high fixed cost structure.

The most stable segment of Scotts Miracle-Gro is its lawn and gardening business, which it calls the “US Consumer” segment. Management predicts a 4% to 6% drop in sales, largely due to bad weather and an unfavorable product mix. That’s the focus of a lot of discussion, but I don’t find it to be the main cause for concern. After all, a year of bad weather is only a short-term headwind.

The Hawthorne gthe story of the rowth collapses

One of the most critical pieces in the company’s growth history is its indoor gardening and hydroponics segment of the business, which the company refers to as the “Hawthorne” segment. The cannabis industry is a major revenue engine for this side of the business.

This is the part of the business that is most excited about growing investors. And this with good reason; The growth of the Hawthorne segment has been phenomenal over the last five years. From 2016 to 2021, the segment grew its revenue by 50% CAGR.

Scotts Miracle-Gro revenue breakdown by business segment 2016-2021

Created by the author using 10K file data

In 2016, the Hawthorne segment accounted for an insignificant 4.8% of revenue. In the last fiscal year he was responsible for almost 30% of revenue. An important part of the company’s growth history depends on this segment, so it was very alarming when the most recent management guide projected a 40% to 45% drop in sales for the year. fiscal.

This coincides with a general slowdown in the cannabis space. The industry has shrunk, and many listed traders have seen double-digit highs in stock prices. Federal legalization seems increasingly unlikely to happen at the current convention. Many major markets are even seeing a large surplus of cannabis, which could mean less capital spending on new equipment.

The long-term outlook for the Hawthorne segment is less clear, but I think this sharp decline shows that the previous growth rate in this segment is unsustainable and unstable. In the latest earnings call, the CEO indirectly acknowledged this, telling analysts that “even though we knew long-term growth was unsustainable, we never predicted the level of rapid investment we’ve seen.”

Bad position

What strikes me as most alarming is how these strong headwinds seem to have taken a completely unexpected turn. They spent most of 2021 adding capacity and building new inventory. The company spent a year making too much product and now sales are lower than expected. As a result, there is this huge surplus of unsold inventory on the balance sheet. At the end of the most recent quarter, the business had more than $ 1.6 billion in unsold inventory, nearly $ 600 million more than the year before. I see this as a major issue during a period when the company preferred to have cash.

In the latest earnings call, management clarified that $ 300 million of this $ 600 million surplus is related to the troubled Hawthorne segment. They plan to sell this surplus aggressively to turn it into cash. I think this pressure to sell can lead to more discounts and reduced margins in addition to already bleak sales prospects.

To make matters worse, I don’t think the company has done enough to combat the rising costs of raw materials. Yes, the start of the war in Ukraine sent many unexpectedly higher key entries. But in the latest earnings call, management projected that the increase in the prices of uncovered commodities will cost the business between $ 25 million and $ 30 million. That number has continued to rise and I can only hope that management has covered at least some merchandise.

May be get worse

The management of the company has tried to give the news as positive a turn as possible. His actions, however, paint a picture of a company in damage control mode. To illustrate how dramatic this investment is, you only need to compare management’s outlook for the past fiscal year with its current direction.

In the third quarter of 2021, earnings call management detailed plans to increase capital spending and add capacity to all of its business lines. Less than a year later, the company announced that it is trying to reduce sales, general and administrative costs by up to 12% to 13% this year. In the latest earnings call, the CEO pointed to the Hawthorne segment as the target of cost cuts. Both the capacity of the segment’s supply chain and its workforce are now shrinking.

In the first quarter of 2022 earnings call, management described its recent acquisitions as “the most robust mergers and acquisitions pipeline we’ve had in 25 years.” Now, they have “a very limited appetite at this time for M&A.”

At the end of the last fiscal year, the company planned more than $ 300 million in share repurchases. About $ 175 million of shares were withdrawn during the first months of the year. Management then abruptly stopped repurchases and announced that it had no plans to use the remaining $ 125 million authorized.

This drastic change in operations indicates to me that the business is moving to keep as much cash as possible. This seems to be preparing for several years of possible headwinds.

Increasing debt burden

One piece of information that I am particularly concerned about is the debt burden of the company. At the last quarterly presentation, its balance sheet showed $ 3.8 billion in debt. This is extremely high compared to the $ 500 million in net income or $ 164 million in free cash flow that the business reported during fiscal year 2021. At this rate, debt alone would consume more of two decades of free cash flow.

At the bottom of the press release announcing the targeting cut, the company announced that it is trying to move forward. to increase this debt:

Our comfort zone for leverage is 3.5 times the debt on EBITDA and the current facility allows leverage up to 4.5 times … we are looking to adjust our debt pacts to allow up to two additional short-term leverage turns to maintain the right level of flexibility to navigate current market conditions.

By the way, I prefer to invest in companies with a maximum debt-to-EBITDA ratio of 2 to 3. Scotts Miracle-Gro is potentially increasing its leverage to a ratio of 6.5! Returning to a more normal leverage ratio will require diverting a significant amount of cash flow, potentially for years. I think this would reduce reinvestment in the company and create a more negative impact on the company’s growth prospects during this time.

The rating is still high

Following the company’s relatively optimistic fourth-quarter outlook, shares were trading at around $ 180. As this outlook could not materialize, the stock price fell by almost 50%, compared to a 12% drop in the global market. This is even lower than the pre-pandemic levels, which would indicate that some of my bearish analyzes have a price.

But according to the latest guidance, Scotts Miracle-Gro is still trading around 20 times the long-term gains. I don’t think this valuation is low enough to warrant a reassessment of my investment thesis. I think this is just too rich for a company whose growth depends on a very unpredictable segment like Hawthorne.

Final verdict

Scotts Miracle-Gro faces severe headwinds. Its growth prospects have been called into question. Sales in its most promising segment will fall. To make matters worse, management seems to have been completely blinded by the recent drops in demand.

Honestly, the dubious prospects for business growth, the unsustainable debt burden, and the inconsistent orientation of management make me hesitate to buy these shares at any price that is not ridiculously cheap. I currently have no position in these shares, but if I did, I would be looking to sell them at any rally and redistribute my capital elsewhere.

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