It has been a very long time since I looked at shares of Scotts Miracle-Gro (NYSE:SMG), in fact, it was back in 2018 when the company announced the acquisition of Sunlight Supply to boost supply of products to the cannabis industry.
In the years which followed, the company enjoyed a boom following the pandemic and the rise of the cannabis industry, but the retreat is very painful here amidst too much leverage and stubborn capital allocation skills.
Despite the low optical share price, I am very careful, even at these levels given the debt involved and the associated interest costs, together with the soft operating performance.
Creating Some Perspective
In 2018, Scotts Miracle-Gro announced a $450 million deal to acquire Sunlight Supply in order to add $460 million and $55 million in EBITDA to its business, obtained from selling hydroponic products. That deal was a bit complicated as Sunlight obtained a portion of its sales from Hawthorne which was an existing Scotts unit, which among others made the deal be dilutive at first.
These activities were added to the collection of brands which SMG owned to keep yards, lawns and gardens in good shape. This includes products to grow food, grass, as well as products which were used to grow cannabis and recreational drugs.
Despite its leadership business, the business has not really performed up to standard as a $3.0 billion business in 2008 has actually seen sales fall 10% to $2.7 billion a decade later, although that operating margins have risen from levels around 10% to the mid-teens.
A $2.64 billion business in 2017 posted operating earnings of $433 million (for 16% margins) as net earnings came in at $218 million, equal to GAAP earnings of $3.33 per share. With shares trading at $83 in the wake of the deal for Sunlight, and a profit warning being issued, a 22-23 times earnings multiple looked quite rich. Net debt of $1.73 billion would jump to $2.15 billion following the deal, for a leverage ratio of over 4 times. All of this made it hard for me to get too upbeat on the shares at these levels.
Believing that if the company could perform at a higher level, with earnings potentially seen at $4.50-$5.00 per share, I would consider buying at $70, but somehow I lost the interest in the shares.
As it turned out shares of Scotts Miracle-Gro fell to the $60 mark later in 2018, after which a big rally started with shares peaking around the $250 mark in 2021, in part aided by boom times induced by the pandemic. Ever since, shares have collapsed as they fell below the $100 mark in spring of 2022, after shares hit lows of $40 in October of last year.
After a recovery to the $80 mark in February of this year, shares have seen a renewed sell-off to the $50 mark here. The company saw sales peak at $4.92 billion in the fiscal year which ended in September 2021. Despite the boom year, the company posted operating profits of $723 million, for margins of 14.7% of sales, which is actually not that impressive given the peak sales. Net earnings were reported at $512 million, for diluted earnings of $8.96 per share.
The results took a huge beating in the fiscal year 2022, as sales fell 20% to $3.92 billion. Amidst huge gross margin pressure and a $693 million impairment and restructuring charge, the company posted a large loss. Adjusted for that, adjusted earnings fell from $9.23 per share to $4.10 per share.
The company guided for slight improvements in 2023 as the $558 million adjusted EBITDA number was looking a bit soft, while net debt of $2.88 billion was substantial, for a leverage ratio of 5.1 times. This came amidst poor operating cash flow generation, dividends being paid, acquisitions being made and shares being bought back as well.
Trends only worsened in 2023, with first quarter sales down 7% to $526 million, as a substantial loss was reported in the seasonally softer first quarter. Sales are now seen down by low single digits for the year, although the company still expects modest improvements in EBITDA. Similar trends were seen in the second quarter, with sales down 9% to $1.53 billion in the key growing season. This was accompanied by big declines in earnings as well with revenue declines focusing on the Hawthorne business, as the company now sees declines in the full year EBITDA number as well.
By August, the company posted another set of soft third quarter results. Quarterly sales fell by 6% to $1.19 billion, with full year sales now seen down 10-11% to about $3.5 billion. Worrying is that EBITDA is set to fall by about a quarter which does not bode well for the fourth quarter, after revenues to date are down 7%. Amidst the poor performance to date, net debt has ticked up to $3.0 billion, with the net debt load exceeding the market value of $2.8 billion based on 56 million shares trading at $50 per share.
Leverage ratios are seen above 6 times here, in fact a 6 times leverage ratio requires half a billion in EBITDA which looks optimistic here. This makes it very easy to get concerned on the financial future of the business, as debt costs are rising rapidly here, and operating profit pressure is seen, even ahead of rapidly rising interest costs.
While I missed the huge rally in recent years it has been a reversal of post-pandemic trends and turmoil in the cannabis market which has hurt the business, as usage of debt has been too high, and capital allocation has been questionable.
Given these conditions, I find it very easy to avoid shares here and while I missed out on the boom, shares on a net basis are nearly cut in half from 2018, when I last looked at the shares five years ago.
The problem is that of incredibly poor capital allocation, with even a quarter of a billion in stock bought back this year so far, and even $9 million in the past third quarter. The company still posts a $0.66 per share quarterly dividend, for a near 5% yield, but this does not allow any room for badly needed deleveraging, as quite frankly the dividend is under risk here.
While the cannabis business has shrunk to about 10% of sales here, no longer causing a huge headwind on total sales growth, the outlook is very dire, even if the company targets $200 million cost savings, as the hole is deep and management is reacting way too slow to react.
Hence, this is not my kind of situation to get involved in as insiders clearly underestimate the severity of the situation here, making me very cautious here, as all options are on the table here.