Scotts Miracle-Gro: Hold Recommended Until 2024 Q2 Results (NYSE:SMG)

The Scotts Miracle-Gro Company (NYSE:SMG) (“Scotts”) is at a turning point, navigating through a turbulent period. While Scotts is trending in the right direction, its stock price seems to have gone much further ahead than the actual business recovery. Since February 7, 2024, when the 2024 Q1 financial results were released, Scotts’ stock price jumped up by more than 31% as of April 5, 2024. Based on 2024 Q1 financial results and outlook alone, if the stock price were to stay the same since my previous analysis, I may have moved closer to a “Buy” position from “Hold”. However, the “Hold” recommendation is more appropriate at this time amid the misalignment between the pace of business recovery and the current valuation. It will be prudent for investors to assess Scotts’ valuation in early May after analyzing 2024 Q2 financial results, given Q2’s ultra-significance.

Recap from Previous Analysis

Scotts, an established player in the lawn, garden care, and indoor hydroponic gardening markets since 1868, has been struggling to recover its business from the mishap betting on the emerging cannabis sector.

Although Scotts generated over $438 million in free cash flow in 2023, a significant increase from the previous year, and its stock price trading at an all-time low, the future of Scotts is swamped with challenges.

The company’s venture into the cannabis sector through its Hawthorne segment initially propelled Scotts’ hyper-growth. Through acquisitions, Scotts built up a significant amount of debt while interest rates were increasing sharply. This success was short-lived, as revenue from Hawthorne plummeted from its peak starting in late 2021, significantly impacting the company’s overall profitability and overshadowing the relatively consistent U.S. Consumer segment.

The decline of Hawthorne was exacerbated due to factors such as the sluggish cannabis sector, continued 280E taxes in the United States, and lower spending by consumers and businesses amid sustained high-interest rates. Hawthorne’s excess inventory from aggressive acquisitions has further complicated Scotts’ situation. While the company showed a substantial increase in free cash flow in 2023, this was primarily due to liquidating inventory below cost, a tactic that is not sustainable.

As a result, the company’s situation may worsen before any improvement, and the recovery may take a long time. Therefore, despite the low share price, positive 2023 financial results, and attractive dividend yield at the time of my previous analysis, my recommendation was to “Hold” reflecting the considerable uncertainties and risks that Scotts faces.

Q1 2024 Financial Results

Q1 typically makes up a very small portion of annual activities at about 15% with natural seasonality when consumers need to purchase lawn and garden care products.

For the three months ending December 31, 2024, revenue continued its decline in 2024 Q1 for both the U.S. Consumer and Hawthorne segments compared to 2023 Q1.

Total revenue declined to $410 million from $527 million in the same quarter last year.

The U.S. Consumer segment saw a decline of 17% in revenue, while the Hawthorne segment saw a decline of 39% in revenue.

While these figures look horrible, they are better than expected, demonstrating just how pessimistic the market was toward Scotts.

Management explained that part of the revenue decline is expected as the company works to restructure its business to focus on fewer but more profitable brands, and the rest is driven by continued pressure on the industry as a whole.

Not only did revenue decline significantly, gross margin declined even further. Gross margin for 2024 Q1 was at 15.2% compared to 18.2%. If the company is restructuring to focus on more profitable brands, the gross margin should increase significantly. However, it went the other way. This is likely due to the continued liquidation of old inventory at cost or at a loss, driving gross margin downward.

While total revenue and gross profit were down by 22% and 47% from Q1 2023 respectively, unfortunately, despite Project Springboard to save costs, SG&A only decreased by 11% to $114.8 million from $128.5 proving it difficult to downsize the business operations entirely when restructuring unprofitable brands.

Scotts’ total debt under the credit agreement and various senior notes was $3.02 billion as of December 31, 2023. Interest expense remained very high at $42.8 million in 2024 Q1 similar to 2023 Q1 despite slightly lower debt load due to higher weighted average interest rate. The weighted average interest rates on Scotts’ debt were 6.0% and 5.2% for the three months ended December 30, 2023, and December 31, 2022, respectively.

Although Scotts’ net debt to adjusted EBITDA ratio was 7.2 within the required 8.25 for 2024 Q1, it is still in the danger zone. The difference of 1.05 before exceeding the required ratio represents about just $53 million in annualized adjusted EBITDA on a 4-quarter rolling basis. For 2024 Q2, the required ratio drops to 7.75, assuming that the net debt level remains the same at $3.02 billion, it means that 2024 Q2 must contribute about $394 million in adjusted EBITDA to continue meeting this covenant.

Of course, not meeting this covenant means that the net debt is in default immediately. Since Scotts doesn’t have sufficient cash on hand to fulfill the entirety of the debt, Scotts will have to seek creditor protection, which means that the value of its common stock goes to virtually $0. Certainly, Scotts’ management team doesn’t expect this to happen and believes that 2024 Q2 should be able to generate more than $394 million in adjusted EBITDA to continue meeting this covenant. However, it will be prudent for fellow investors to wait until 2024 Q2 results before adding positions in case of significant downside risk.

To help make 2024 Q2 a successful quarter, Scotts has added about $289.3 million of new inventory between October and December 2023. In addition, Scotts plans to allocate a significant amount of the annual advertising and promotion budget (about 33%) toward 2024 Q2 along with some creative events and celebrities.

In addition, in March 2024, Scotts signed a deal to have BFG distribute all Hawthorne products so that its Hawthorne segment can focus on developing products and the rest of Scotts’ team can focus on its core U.S. Consumer segment.

What to Expect from 2024 Q2 Financials

Q2 is typically the most significant quarter for Scotts. While 2023 Q2’s revenue made up 43% of its annual revenue, 2023 Q2 contributed $404.8 million in adjusted EBITDA, representing about 90% for the full fiscal year.

Whether Scotts can make it through this recovery from the turbulent past depends on the performance of 2024 Q2 in terms of meeting the annual EBITDA target and the covenant.

As a result, 2024 Q2’s adjusted EBITDA figure is crucial to watch and $394 million is the key target.

In addition, as Scotts works toward generating record-adjusted EBITDA figures, it may try to sell products on better payment terms, resulting in a higher Accounts Receivable balance. So, it will be important to watch out for the Accounts Receivable balance at the end of 2024 Q2.

In addition, as Impairment and Restructuring Charges are not included in the adjusted EBITDA figure, inventory may be written off and some SG&A expenses may be classified as impairment and restructuring charges respectively. So, it is important to watch out whether there is still a high level of Impairment and Restructuring Charges during 2024 Q2.

Valuation

Compared to Scotts’ market capitalization of $3.5 billion as of January 5, 2024, from previous analysis, Scotts’ market capitalization sits at $4.25 billion as of April 5, 2024, increased by about $750 million.

Since Scotts reported a net loss of $380 million for the fiscal year ended September 30, 2023, the PE ratio at the moment is not too relevant as a valuation gauge.

Scotts currently has shareholders’ equity in a deficit position of $385 million, which makes it irrelevant as a valuation gauge as well.

Scotts’ EBITDA for 2023 was a loss of $19 million, so not very helpful to determine valuation as well.

Adjusted EBITDA excludes Impairment and Restructuring Charges, resulting in Scotts reporting a positive adjusted EBITDA of $447 million in 2023.

When using adjusted EBITDA, Scotts’ market capitalization currently is about 9.5 times of 2023 adjusted EBITDA or 7.4 times of 2024 expected adjusted EBITDA.

For a company that is recovering in an economy that is going to have high interest rates longer, 7-9 times of adjusted EBITDA is incredibly rich.

One of Scotts’ peers, The Mosaic Company (MOS), has a market capitalization of $10.6 billion, which is just 4.1 times its 2023 adjusted EBITDA.

Scotts currently has a B- rating in terms of valuation grade by Seeking Alpha. When dived deeper, the B- rating is primarily driven by Price/Trailing Cash Flow and Price/Sales, not to mention that the dividend should have been cut by Scotts a while ago amid the cash needed to help with the business recovery. The previous year’s cash flow and sales were primarily driven by liquidation of older inventory. If not for these two metrics, Scotts’ grade in valuation might have been a C or C-.

As U.S. inflation figures, job reports, and other economic data keep indicating a resilient U.S. economy, the Federal Reserve is projecting to delay and narrow the cut on interest rates in 2024. This is certainly not good news for Scotts given its significant debt load. The interest rate swap agreement representing a $200 million notional amount is expiring in June 2024, which will increase Scotts’ annual interest expense by about $10 million (the fixed rate from this swap agreement is 0.49% compared to Scotts’ weighted average interest rate of 6% at the moment) if interest rate stays high at the current level.

Upside and Downside Risks

The downside risk is quite obvious. 2024 Q2 may be the most significant quarter this year and can determine the pace and state of Scotts’ business recovery. If 2024 Q2 underperforms, Scotts is at risk of defaulting on its debt. In addition, as the S&P 500 Index went up significantly between January and March 2024, caution is currently widespread in the market, which may set back the momentum in Scotts’ stock.

However, there is some upside potential for Scotts. The cannabis sector in the U.S. is recovering, anticipating cannabis to be rescheduled and 280E taxes to be removed in the coming months. Various multi-state cannabis operators in the U.S. have seen their stock prices lifted significantly in the past three months, such as Trulieve Cannabis Corporation (OTCQX:TCNNF). As a result, Hawthorne’s products will be back in high demand again, potentially helping the Hawthorne segment become profitable sooner than expected.

Conclusion

Scotts stands at a critical intersection, with its recent stock price surge before the most significant quarter of the year outpacing the reality of its business recovery. This optimistic market response does not fully reflect the ongoing challenges Scotts still faces and needs to resolve. As such, maintaining a “Hold” recommendation seems prudent, especially with the critical 2024 Q2 financial results on the horizon. These results will be pivotal in assessing Scotts’ ability to meet its debt covenants and annual target.