Author: Ben Tewey
Published: 6/29/21
Introduction
A highly cyclical, consumer product business with pricing power that pays the sizable amount of its free cash flow to shareholders? That sounds an awful lot like one of Warren Buffett’s favorite businesses, See’s Candy. Scotts Miracle-Gro ($SMG) is no candy vendor but those surface dynamics looked sweet to me. But does it hold up under a deep dive?
We believe that the 2-4% growth rates guided by management in the recent earnings calls for the U.S. Consumer segment and the 15% growth rates in the Hawthorne segment are too conservative. Scotts will blow through the Street’s expectations as on-boarded customers from the quarantine-induced home improvement craze will continue to seek out Scotts’ iconic brands in the mid term. However, the limited opportunities for reinvestment and margin expansion, low returns on capital, the business’s small appetite for capital and the high debt employed in the business make us uneasy in the long term. Our expected IRR of 9% is not enticing enough to warrant an investment in Scotts Miracle-Gro at the current valuation. We intend to wait for a higher margin of safety.
The Dirt on Scotts
Scotts Miracle-Gro is in the unglamorous consumer lawn care and gardening products industry. They own the popular Scotts and Turf Builder grass seed brands, the Miracle-Gro plant food product and the Ortho insect, weed and rodent control brand. The company also has a subsidiary in the indoor gardening industry and has rights to sell Roundup herbicide. Investing in simple, unchanging industries has always been our preference. I will paraphrase Mr Buffett here in that it is much easier to forecast future cash flows in stable industries than make an attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we (now) know it. Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge. In this case it may be more apt to ask how many plants will emerge from the dirt.
Scotts derives the majority of their revenue from their U.S. Consumer segment. In 2020, U.S. Consumer accounted for 2.8 billion, or 68%, of Scotts 4.1B total revenue. This segment also has the highest net income margin at 24%. It is an incredibly simple business model: they buy commodities and sell brands. This has long been a successful model for Wrigley since 1891, Coca Cola since 1886, and Scotts since 1868. The cost of Scotts expenses are reliant upon the price of commodities. This is really the most basic business model one can dream up, Scotts is not much more complicated than the lemonade stand my neighbors set up across the street last weekend.
Over time Scotts will do well as long as they invest in their brand, maintain high standards for customer experience and keep costs down. Competitive advantages in this business come through branding, cornered resources, cost cutting, and customer relationship primarily with large distributors.
As commodity prices have soared higher, Scotts has increased the price of their products accordingly. Typically Scotts steadily increases prices by 1.5% annually. However, management stated on their most recent earnings calls that they plan to hike prices 6-7% starting in August in order to preserve the gross margin structure in the business. Now that is some untapped pricing power!
Make Hay While the Sun Shines
As you can see in figure 1-1 the consumer lawn and garden business is highly seasonal, with approximately 75% of Scotts annual net sales occurring in the second and third fiscal quarters combined. Generally, Scotts records losses in the fiscal 1st and 4th quarters. Heavy seasonality is not a bad characteristic in a business, but it forces management to be temperate. They must cut costs in the off season, advertise judiciously, and not get carried away hiring in the peak.
This business has variable costs associated with it: as volume increases so does COGS. This anchors margins in place as evidenced by the 34% gross margins since 2016. Business owners can make money in 2 ways: sales increase or expenses fall. Both, cerberus paribus, cause more cash to drop to the bottom line. For Scotts the latter is out of the picture. In fact, due to the quick growth in the lower margin Hawthorne segment we believe margins will actually compress. Therefore in order to return more cash to shareholders management has started looking toward increasing revenues by searching for new growth engines.
Since 2015 Scotts has spent 1.02B in mergers and acquisitions to bolster their Hawthorne subsidiary, but in the process has employed large amounts of debt to do so. Hawthorne is engaged in the burgeoning hydroponic and indoor gardening industry which focuses on growing plants with little to no soil. Some of the most popular plants grown hydroponically are tomatoes, cucumbers, peppers, and spinach. The thesis here is that because hydroponic gardening is the go-to in urban areas as the battle against food deserts rages on, areas will increasingly turn toward hydroponic gardening to solve their issue. As Hawthorne’s growth continues to outpace the growth in the U.S. Consumer segment we believe margins on a company wide basis will fall by 40 to 90 basis points.
Hawthorne has grown revenues at a 55% CAGR since 2016 and income from continuing operations before taxes has grown from -6.1mn in FY’18 to 120.1mn by year end FY’20. These numbers, while impressive, are not organic. As mentioned Scotts has spent a substantial amount on mergers and acquisitions in the Hawthorne subsidiary. Through Q2 2021, we have seen 62.8% volume growth at Hawthorne despite a 4.5% increase in pricing. 2021’s movement has been without merger or acquisition. We believe the 40-45% growth rates for full year ‘21 that management laid out at the William Blair Growth Stock Conference in early June are likely to be surpassed and believe Hawthorne will grow sales at 25% in fiscal years ‘22 and ‘23 as new markets come online. This medium term tailwind will be beneficial for the company.
Upgrading the Nest
As a result of the quarantine-induced home improvement craze Scotts experienced increased demand (22% higher volume in the U.S. Consumer segment) for many of their gardening products in 2020. Overall volume in 2020 was up 29% on top of a 9% increase in fiscal 2019. It is logical that because people were forced to stay inside they naturally spent more on their homes. This trend is reflected in increased sales at home improvement stores Home Depot and Lowes, Scotts two largest customers. Combined Lowes and Home Depot make up over 20% of Scotts sales. Retention of the broadened customer base during 2020 will remain high for several years to come. Gardening is not a one-and-done hobby (unless you’re really bad at it) a plant lives for numerous years. Therefore, the new cohorts on-boarded in 2020 will return in the following seasons in order to properly care for their plants. This will lead to Scotts beating COVID-juiced numbers due to increased pricing and new customer retention from increased advertising spend.
As management laid out in the Q2 earnings call, “86% of consumers who entered the category last year told us they would be back. More importantly, 2/3 of them said they would gauge at an even higher level than they did last year.” So far, this has rung true, “entering May, consumer purchases of our soils are up roughly 30%. Our lawn fertilizer business was up 15% year-to-date, and grass seed is up more than 35% entering May. This is the third straight year of double-digit growth in grass seed as we continue to benefit from the tremendous efforts of our lawns’ R&D team. Control products are up approximately 20%.” Increased consumer spending, high customer retention and the flight to the suburbs lead us to believe that U.S. consumer revenues will surprise the Street in the medium term.
Leadership
Scotts is a family business that has a long-tenured team at the helm. Jim Hagedorn is the CEO and Chairman of Scotts Miracle-Gro and has been with the company since 1995 Miracle Gro and Scotts merger. His father, Horace Hagedorn, launched the Miracle-Gro brand in 1951. Mike Lukemire, the COO, has been at the company since 1995 and pioneered the “One Team. One Goal.” motto the company lives by.
Scotts is an employee oriented company. The company provides associates (employees) and their families with a wellness center at their Marysville headquarters and they reimburse fitness club memberships for associates in other locations. Also during COVID, as the company experienced increased demand for their products, Scotts made one-time payments and retirement contributions to their hourly and salaried associates. Treating employees right inevitably leads to treating customers right. When buying commodities customers heed the supermodel who, when asked how she chose between her two billionaire suitors replied, “One had a little more personality.”
Capital Allocation
Scotts does not, however, forget about their shareholders. In Q4 2019, Scotts increased its quarterly dividend from $0.55 to $0.58 per share. In Q4 2020, Scotts approved a special dividend of $5.00 per share and raised the quarterly dividend to $0.62 after their record year.
Scotts is the dominant force in its mundane industry, but investors are not constricted to one section of the market contemplating how to allocate capital. Scotts management recently guided that they expect company wide sales growth in the range of 17-19%. Taking the median we can deduce that sales will be in the area of 4.8B for 2021. On a net income margin of 9.4% (the rolling 5 year average) we can expect net income to be in the area of 440- 475 million. Of course this depends on product mix and numerous other variables, but I’m taking the Keyesian approach on this one: I would rather be vaguely right than precisely wrong.
On that basis Scotts would have a ROIC of 4.8%. Not great when looking at the broader market. This is not a business in which owners (what you become when you buy stock) can deploy significant sums of money and generate adequate returns. Furthermore, the business evidently can’t take all too significant sums. Hence why management is paying large amounts in dividends. It baffles me why management employs so much debt in the business when they have only small growth engines of reinvestment. Management is either foolish or sees something huge in Hawthorne (both if they assume the latter and the former turns out to be true.) Although Ben Gilbert from the Acquired Podcast was talking about Berkshire in this quote I still think it is incredibly apt to Scotts, “If you think about capital allocation, if you think about maybe the way Jeff Bezos does it, ideally there are lots of potential growth engines inside your company to invest in, to allocate your capital to. Otherwise, you have to go and fight it out with every other investor for every publicly available investment vehicle… It’s really hard for them to consume capital internally in a way that would meet any hurdle rate that would be exciting. They have to keep going shopping to deploy capital at this point.” Scotts only slightly outpaces inflation with their current ROIC and those long term prospects don’t make me salivate. In order to generate increasing returns management has to go shopping.
Get off my Lawn!
As mentioned, businesses differentiate themselves in the consumer lawn and gardening industry through their branding, cornered resources, cost cutting, and relationship with large distributors.
Scotts has the most recognized brands in the lawn and gardening industry. The cornered resources and IP protected through their patents prevent competitors from disrupting the cash cows of the business. In effect, this allows Scotts to experiment and innovate in other areas because they have such reliable cash flows from the fertilizers, mulch, grass seed, and control products.
To increase share of mind, Scotts has consistently invested 4-5% of the U.S. consumer net sales into advertising. As they continue to outspend their competitors, Central Garden and Spectrum Brands, on an absolute dollar basis we can expect Scotts to increase their already significant (30%) market share.
Lastly, Scotts began their Project Catalyst, a company-wide restructuring effort to reduce operating costs, in 2018. This will allow Scotts to pass savings through to their customers thereby strengthening customer loyalty. From there, Scotts can leverage the customer loyalty to negotiate better deals with retailers such as Lowe’s and Home Depot.
There are Greener Pastures
Scotts trades at a 5% free cash flow yield. While the 50% return on equity is impressive on the surface, the company employs significant debt (270% of equity). The 14 million of cash on the balance sheet is not enough to service the 212 million in current debt. In order to service this debt Scotts must rely on payments of accounts receivable. I much prefer being able to go on vacations and leave my phone in the hotel room instead of worrying about whether or not Scotts Miracle-Gro will go bankrupt because of their account receivables not being paid. I’m glad I don’t have to swing at every pitch in investing. Scotts’ closest publicly traded competitors are Spectrum Brands’ Home and Garden segment and Central Garden & Pet Co.
Spectrum is a significantly smaller operation than SM’s U.S. Consumer segment and only did 551mn in net sales in 2020 compared to the U.S. Consumer segment’s 2.8 billion. Let’s do some back of the envelope math. Home and Garden’s $91.2 million operating makes up ~22% of Spectrum conglomerate’s total earnings. Spectrum has a 3.5B market cap, so let’s be conservative and say that Home and Garden would sell at 20% of that on the market as a stand alone company. Vis a vie, Home and Garden would have a $774 million market cap and sell at 8.4x operating income of $91.2 million.
Central Garden & Pet Co’s garden segment earned 136.2 million in operating income in 2020 which contributed 46% of total operating income. From there we can deduce that as a stand alone company the Garden Segment would sell for a market cap of 1.24 billion based on the total company’s market cap of 2.7 as of the close on June 23rd. At this valuation the garden segment would trade at 10.9x 2020 operating profit.
*Note, I am not using EBITDA as Central Garden & Pet Co. Does not disaggregate segment EBITDA.
Let’s be conservative here and say that the U.S. consumer segment would trade at the high end of this range because of its iconic products and higher margin (24%). Slapping an 11x multiple on the 686.1m in profit in 2020 would value this business at 7.5 billion.
Because there are no publicly traded peers to Hawthorne, making it tough to value on a peer basis we are going to turn to a DCF. Postulating that revenues at Hawthorne will grow at 40% this year and 20% for the next three years and sticking a 10% IRR on the company with a terminal growth rate of 3% we come up with a fair value of 2.9 billion.
Buying Scotts today would in effect give us the “other” reporting segment for free, and that is a good price for anything. Considering today’s market capitalization of $10.5 billion and our appraisal of the Hawthorne and U.S. Consumer segments at 10.4 billion we see Scotts as fairly valued considering the other segment provides little incremental value. Therefore, because we would be buying at little discount to today’s intrinsic value the expected return on the investment is our earnings yield plus future earnings growth. Earnings yield (simply an inversion of the traditional P/E ratio) at today’s value is 5%. We project earnings to grow at 4% for the long term. We believe there are better opportunities than a 9% IRR.
Disclaimer
I do not own shares of Scotts-Miracle-Gro. I am not a financial advisor. These articles are for educational purposes only. Investing of any kind involves risk. Your investments are solely your responsibility and we do not provide personalized investment advice. It is crucial that you conduct your own research. I am merely sharing my opinion with no guarantee of gains or losses on investments. Please consult your financial or tax professional prior to making an investment.
Conclusion
Scotts will likely surprise the market with faster, sustained revenue growth because of light secular tailwinds and high customer retention in the short to medium term. However, over the long term, margins will come down as Hawthorne becomes a larger percentage of the revenue pie. The company also has a shaky balance sheet with significant debt and does not earn high returns on invested capital.
Bibliography
June Update at William Blair Growth Stock Conference