The Scotts Miracle-Gro Company $SMG

My Investment Checklist

1.      Is the company undervalued?

EV/EBIT: 13.81

EV/Sales: 1.48

Price/Book: 17.87

$SMG is trading at near historic lows in regards to earnings and sales, with management forecasting growth across the board in 2023.  Having said that $SMG is up to their eyeballs in debt and don’t anticipate the situation getting better until the back half of 2023.  In fact $SMG is dangerously close to breaking their debt covenant, which almost surely will cause pain for shareholders.  On the other hand $SMG is a well know brand with pricing power and has shown the ability to generate impressive FCF.  If earnings normalize and $SMG is able to pay down debt, investors could see above market returns. 

2.      Can I easily explain what the company does?

Yes, they manufacture lawn, garden, and horticulture products.  $SMG has 3 business segments; U.S. Consumer (74.6% of sales), Hawthorne (18.2% of sales), and Other (7.1% of sales).

3.      Does the cash flow statement line up with income statement?

Yes, cash from operations has been a tick higher than reported income although very underwhelming:

Most of their cash used went towards the acquisition of Luxx Lighting, share repurchases, a build up of inventories, dividends paid out, a decrease in accounts payable, and capital expenditures.

              There’s a lot to work thru here but the acquisition of Luxx Lighting is probably the best place to start.  The company was purchased for $215M at the end of 2021 as a bolt-on for their hydroponic business unit Hawthorne.  Unfortunately Hawthorne has been a disaster this year, with sales down 50% and posting a $21M operating loss.  It’s quite possible that $SMG top ticked the market with this purchase, which no doubt has destroyed shareholder value.  Management actually stated that Luxx should add $75M in revenue for 2022, which has unequivocally been proven wrong.  The only saving grace here is that management has signaled an unwillingness to do any more M&A for the foreseeable future.

              Moving on to the core business $SMG raised $680M of net debt in 2022 to fund operations and return capital back to shareholders.  I honestly have no clue why management paid out any dividend or repurchased shares (at significantly higher levels mind you).  Frankly speaking that seems reckless given the leverage in their business.  However the inventory buildup and capex spend don’t seem unreasonable as the business is cyclical and that comes with the territory.  All in all awful grades for management regarding capital allocation.

4.      Is the Balance Sheet Healthy?

Total Cash: $86.8M

Total Debt: $4.14B

Current Ratio: 2.06

The balance sheet in my opinion should be the most important concern for investors.  For example $SMG’s debt-to-EBIDTA ratio is at 6 in the most recent quarter.  Furthermore this is expected to tick higher in the first half of 2023.  Additionally because $SMG took on more debt, net interest payments are expected to come in at ~$158M next year.  That’s only 2.65X net interest coverage on last year’s operating earnings, which again is problematic.  In fairness EBIT is expected to grow, but only slightly which doesn’t impact this ratio meaningfully.

              To further exacerbate these issues, $SMG is within a whisker of breaking their 6.5X debt-to-EBIDTA ratio covenant.  When pressed on the issue the outgoing CFO gave the following answer:

“David Evans

Eric, you're looking at it a way -- I'm not sure I can answer that live on this call here. I just -- I just haven't looked at it that way. I can just tell you that the EBITDA growth that we have built in our plan is today, I mean, we're not presenting a plan that says we're going to be in default. I mean, we are presenting a plan physical as we will be in compliance.”

This ranks up there as one of the worst answers ever given on a conference call.  Mr. Evans is essentially saying, “If we think we’re fucked, we’re not gonna let you know”.  It’s astonishing that the CFO didn’t have an answer prepared for this painfully obvious question.  In summation if earnings don’t improve by the end of Q2 2023 $SMG is up shit’s creek.

5.      How profitable is the business?

Gross Margins: 26.3%

Operating Margins: 10.7%

Net Margins: (11.1)%

2022 was obviously not a good year for $SMG, but the business has been much more profitable historically:

Those numbers don’t look too shabby and reflect that fact that $SMG has pricing power.  For example even in a bad year (2022), they were still able to raise prices.  Although I’m skeptical that margins fully mean revert.  Particularly because Hawthorne is a lower margin business and comprise a good chuck of sales.  It’s truly perplexing as to why $SMG has quadrupled down on their hydroponic business, but setting that aside margins should improve off the current base.  Moving forward I would anticipate ~11.5% EBIT margins on average (assuming they’re still in business).

6.      What is the company’s growth potential?

10-yr Revenue CAGR: 3.5%

10-yr Operating Profit CAGR: (2.06)%

10-yr FCF CAGR: negative infinity

To reiterate 2022 was an awful year, which is obfuscating this data.  For instance EBIT grew at a 9.58% CAGR from 2013-2021.  Granted 2021 was a peak year, but nonetheless $SMG is a growing company and it wouldn’t be a stretch to think that some of their M&A helps topline growth in the medium term.  My base case would be mid-single growth long term for the business.

7.      Is management rewarding shareholders?

$SMG returned ~$390M on net back to shareholders in the last 12 months.  However more than 100% of this was funded by debt as the company had negative FCF.  Management stated that they plan on printing $1B in FCF over the next two years, but I have little faith in that projection.  However management is signaling strength by vowing to stick with their dividend:

“Regarding the dividend, we have no plans to touch it based on what we see today. The truth is that cutting the dividend entirely or even by a percentage does not move leverage that much. We've heard feedback from investors around this topic.”

No offense Mr. CEO but the dividend payout is over $166M, which would reduce total debt by over 4% annually.  That no doubt moves the needle, especially considering that you’re on the precipice of breaking your debt covenant.  I don’t know what is going on with the C-Suite at $SMG, but this is next level hubris by any standards.  Shareholders should prefer having zero capital returned to them until the debt gets under control, because there’s a good chance the business goes insolvent relatively soon.

8.      How does the company stack up against their peers?

Central Garden & Pet Company $CENT is the closest competitor to $SMG:

$CENT EV/Sales: 0.94

EV/EBIT: 12.13

TTM EBIT Margin: 7.8%

$CENT appears cheaper than $SMG, however they are overearning while $SMG is underearning.  On a forward basis there’s not much of a difference in valuation.  I would actually argue that $SMG is a better business, because they have historically been much more profitable.  Conversely $CENT’s balance sheet is head and shoulders above $SMG, which is why I think it’s a better risk adjusted bet. 

9.      What’s the counter argument?

The counter argument is no doubt Scott’s precarious debt situation.

              I’m not gonna beat a dead horse here, but yes I agree with this thesis.  Things need to go right and right away for investors to get a decent return in the stock. 

10.  Is there something I think the market may be missing?

I don’t think so, while $SMG is trading at near lows in regards to sales they’ve traded cheaper in the past.  Moreover the balance sheet has never been worse, which leads me to believe that $SMG a stock down 70% YTD still has room to the downside.

Final Thoughts:

               $SMG is a perfect example of a good company that’s been run into the ground as a result of either overconfident or incompetent management.  There’s no excuse for levering up a cyclical business the way they did.  What’s more troublesome is the lack of accountability from management.  I understand that mistakes happen, but no one is gonna benefit from doubling down on a dumb idea.  There’s irrefutable evidence that they’ve made horrendous capital allocation decisions over the past couple years from; bad acquisitions, to overpaying for share repurchases, to bringing the company’s debt load to absurd levels.  There’s zero discipline here and seemingly no remorse for the shareholder value they’ve destroyed.  For that reason $SMG is a hard pass but something I would revisit if the entire C-Suite was shaken up. 

***Disclosure: I have no position in the security mentioned above, nor do I have any plans to purchase within the next 72 hours.  This article is intended for educational purposes only and in no way should be interpreted as investment advice