Shares of Scotts Miracle-Gro (NYSE:SMG) have been a rollercoaster over the past year, trading between the mid-$40’s and mid-$70’s, even as they are essentially flat from a year ago. Much of this volatility has been driven by its large debt load and retailers’ inventory destocking, as well as ongoing weakness in its cannabis supply business. After being somewhat cautious on SMG, I upgraded shares to a “buy” in April based on an encouraging operational update ahead of its critical second quarter, which put its deleveraging plan on a clearer footing. I believed progression of this plan could push shares into the $80s.
Since then, however, SMG has lost about 15% even as the broader market has rallied. My confidence in management’s outlook proved mistaken, as just two months after offering an encouraging update, it cut its EBITDA guidance. These significant shifts increase concerns that management does not have much visibility into the business’s trends, which undermines confidence and credibility. Having been once burned by SMG’s management, it will take time to regain my trust. This necessitates re-evaluating SMG stock and determining whether, with recent weakness, shares are attractive or if investors should cut losses.
SMG now expects to generate $530-$540 million in EBITDA this fiscal year, from $575 million previously. This lowered guidance is primarily due to slower US consumer sales growth of 5-7% from “high single-digit,” as gross margins are still set to expand by at least 250bps.
While cutting these parts of guidance, it did maintain its expectation that Hawthorne, its cannabis business, will be cash flow breakeven by year-end. There is no correlation between consumer gardening demand and cannabis activity, so I am unsurprised to see the guidance here unimpacted. It also reiterated it will achieve its $300 million run-rate cost savings by year-end; given lower EBITDA, focusing on costs is even more important.
Notably, management reiterated its 2023-2024 free cash flow forecast of $1 billion, implying $560 million over the rest of the year. This means debt/EBITDA leverage would still end below 5x. The company is being aided by a 1% lower tax rate than initially assumed. With lower EBITDA, it will now need nearly $300 million of working capital improvement from $260 million previously. Now with a slower pace of sales, SMG will likely be reducing inventories further as there is less need to hold as much product on hand.
Ultimately, free cash flow and debt reduction is a good thing, but working capital improvement is more of a one-time lever, as companies typically cannot destock inventory every year; assuming sales stabilize, there is a natural floor here. Investors, in my view, should put more weight on the lower EBITDA guidance and underperformance of its core US consumer unit than on its free cash flow guidance, as that is more relevant to the long-term value of the business.
Looking to Scotts financial results, in the company’s second quarter, revenue was flat at $1.5 billion with US consumer sales up by 2%. Hawthorne declined by 28% as it continues to focus on proprietary brands where margins are better. On the positive side, we do continue to see margin improvement as adjusted gross margins rose by 60bps to 35.3%. Thanks to Project Springboard, SG&A fell by 4% to $179 million.
Scotts generated $396 million of EBITDA in Q2, down 2%. There is significant seasonality to the gardening business. It essentially generates all of its profits in Q2 and the first two months of Q3 with Q4/Q1 seasonally soft. Given this guidance update in June, I believe, even with its dampened credibility, fiscal year 2024 results should come in line with guidance, as there is less variability in results after July that materially impact fiscal year results.
The challenge is that the company is not seeing the return on investment that it was expecting, and its cost structure is burdensome, in part due to the collapse of the cannabis business. The company boosted peak season marketing by 33% this year. Even as it was cutting operating costs, it was boosting marketing to help grow US consumer sales, and we are not seeing the sales pulling through, with the second half of peak season clearly slowing down.
One challenge is that while its promotional activity is boosting volumes, we are not seeing follow-through on revenues. Through May, point of sales unit growth was up 16%. New listing units rose by 11% though revenue was flat and inventories at retailers rose by 19%. With unit growth of 11%, I would want to see at least 6% revenue growth; instead, it has cannibalized volume growth entirely with price cuts. Even faster retailer inventory growth also leaves me concerned that they may reduce orders to Scotts as they work off inventories.
SMG books revenue when it sells products to a retailer, like Lowe’s (LOW), not when a retailer sells to the consumer. As such, SMG has seen slower sales as retailers with excess inventories have curtailed orders to suppliers. As you can see below, inventories in the garden space remain quite high, about 10% above pre-COVID levels, relative to sales. My previous optimism that we were through the worst of retailer inventory-destocking was likely a little early, and I would expect SMG sales to lag point of sales activity by 5+%. I do think this headwind should largely be complete over the next year.
Beyond retailers holding a bit too much inventory, the other challenge has been that consumer activity has been disappointing. After recovering a bit in February from weather distortions in December, building material and gardening sales have stalled out and ticked back down. They have now been declining essentially for 2.5 straight years. Consumer activity has been a bit disappointing and has likely contributed a bit to SMG’s weaker guidance. One challenge has likely been existing home sales remaining sluggish given elevated rates.
Ultimately, a more subdued US consumer backdrop has created downside to the gardening environment, which can explain some of the downward revision to guidance. Still, its marketing and promotional pricing activity is not generating sufficient volume growth. This weaker sales environment is also elongating the inventory reduction cycle from retailers, which will remain a headwind for a bit longer than expected.
More fundamentally, SMG has a problem of operational bloat. 2024 EBITDA will be down about 4% from 2019 levels, even as revenue is about $700 million higher from its consumer unit. Its cost-cutting program and inventory rationalization efforts should help improve the profitability over time because at its current level of revenue, SMG should be able to generate substantial ongoing cash flow. Increasingly, I believe management needs to consider pulling back on marketing.
SMG is now carrying $824 million of inventories, down by $303 million from a year ago. It should get inventories down toward $600 million by year-end, which will drive the majority of its $350 million planned debt reduction. Reducing its own inventory and debt load are positives, but we are near the end of this cycle. SMG carried $540 million in inventories in 2019. With sales higher today, inventories are actually becoming relatively lean, and there is unlikely to be further working capital gains in 2025.
SMG carries $2.8 billion of debt. It ended Q2 with 6.95x debt to EBITDA, which should fall toward 6x in Q3 and 5x in Q4 as it pays down debt. This is still a heavily levered business. Ultimately, in this rate environment, I would prefer to see closer to 3-3.5x leverage. Having been burnt by over-optimism, I am hesitant to forecast much revenue growth, just given the ongoing caution from consumers. Still, as prior cost cuts take hold and marketing is reduced, this should be a $575 million EBITDA business in 2025 and on. I would want to see it carry no more than $2 billion in debt, vs its ~$2.4 billion year-end level.
SMG is likely a $250-275 million free cash flow business, normalizing for working capital. As such, beyond its dividend which costs about $150 million, it will be steadily reducing debt through 2026 with incremental cash flow. Shares today have a ~7% normalized free cash flow yield, which is not expensive. Still, given the lack of a clear growth trajectory, and limited capital return growth beyond its current 4% dividend, I no longer see a catalyst for shares to rally.
This is especially the case with management needing to rebuild credibility after a mid-season guidance cut. I do not see material downside risks as guidance for this year should be achieved, and with retailers steadily working through their inventory, I view sales declines as unlikely. Further cost-cutting can also support shares. That said, upside is similarly limited given subdued spending. It was a mistake to raise shares from a “hold” to a “buy,” and I am returning them to a “hold.”
I do not see a catalyst or downside risk to require a “sell,” but investors should consider rotating into stocks with more upside, as I would expect SMG to remain range-bound around $60-65 until we see some signs its business is durably improving.