Edited Transcript of SMG earnings conference call or presentation 1-May-19 1:00pm GMT

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James S. Hagedorn, The Scotts Miracle-Gro Company - Chairman & CEO [3]

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Thanks, Jim. Good morning, everyone. Yesterday, I had laryngitis pretty bad and couldn't speak. So I'll try to get through the script. If I need help, Randy may pick up. So just heads up. So here we go.

There was a morning a couple of weeks ago when I was walking into the office and I realized that spring was finally here. The grass was green again, the leaves were opening on the trees and the flowers were in full bloom. And it dawned on me right then what I wanted to talk about today. I doubt that many of my peer company CEOs walk outside in the morning and get inspired about their business. But that experience means something here. Spring is our season, the time of year when the spotlight shine the brightest on our business. And at the risk of sounding a bit corny, I consider ScottsMiracle-Gro the undisputed leader of spring. It's hard to argue that point this year with POS up 13% in our U.S. Consumer business and strong performance in nearly every category in which we compete.

But I don't want to focus on today's press release on the strong start to the season. What I'd rather focus on are the real efforts that enabled those results, and I want to target my comments to those shareholders who are not just interested in the latest quarterly scorecard but those who, like me, are focused on what we're doing to create long-term shareholder value. That effort goes well beyond how we're executing on a day-to-day basis. It's about how we're pushing ourselves to develop new and more creative ways to strengthen our multigenerational relationship with our consumers. It's about bringing energy and new approaches to the table to keep our retail partners engaged. It's about creating and implementing an interesting -- industry-leading approach to the hydroponics space. It's about driving value for our shareholders by focusing on cash flow over EPS and sustained and predictable performance over periodic burst of energy. And it's about creating a corporate culture that is both energetic and inviting, the kind of place that will allow us to attract the young talent that we need to maintain the momentum for years to come.

A lot of folks have started asking me if I'm contemplating a slower pace or maybe even retirement. The truth is I haven't had this much fun at work in years, and my level of engagement is actually increasing, not decreasing. The reason, I suspect, is twofold. First, the issues we're working on, the evolution of Hawthorne, changes in how we communicate with consumers, the challenges regarding Roundup, our commitment to improving cash flow, the development of our next generation of leaders are critical to our success in both the near and long term. And second, frankly, I'm just energized by what we're trying to do. All of our efforts are paying off so far this year, so I'll just hit a few of the highlights.

Sales to retailers in U.S. Consumer are up 8%. 5 of the last 6 months at Hawthorne have been up double digits on a comparative basis. And we've once again been able to get our leverage ratio below 4x. Someone will probably ask the question later, so I'll just say it upfront. Yes, we are running better than we expected entering May; and no, we're not changing our guidance at this time.

While there's a lot of optimism falling through the building right now, it's May. We've been here too many times to declare a victory at this point. There's a lot of season ahead of us, and we have to stay focused all the way through to the finish line. Like I said, I don't want to dwell on the numbers. What I rather do is focus on the real efforts that allowed us to deliver those numbers.

A year ago, there wasn't much celebrating going on here. We had a terrible start to the season, and changes to California cannabis laws wreaked havoc on the hydroponics space. It would have been easy to panic as the stock price fell, and some investors questioned our strategy. We could have scrambled to restructure, pull back on innovation or said investments in marketing could wait for a better day. We actually may have known some of those very things a decade ago, but this is a different company today, and we didn't do any of that. Instead, we stayed focus on the play we called and kept executing. In fact, while we were sitting on this call a year ago talking about the challenges of the 2018 season, our teams were head down, already focused on the 2019 season. And that approach is evident in the results we announced this morning, both in our U.S. Consumer segment and in Hawthorne.

Looking at our lawn fertilizer business, where POS is up 10% entering May. The biggest drivers in this category are product that didn't even exist 3 years ago. A decade ago, this category was in a deep slide, but we took the time to understand why that was happening. We found new ways to engage with the consumer, created trade programs that rallied our retailers and launched products that exceeded our expectations.

One of those products is Scotts Triple Action. It feeds your lawn, kills weeds and even prevents crabgrass or controls bugs, depending on a reasonably specific product that you buy. Another example is the Scotts Thick'R, which contains soil enhancements, fertilizer and grass seed all in a single bag. It's been blowing the doors off with consumers. Grass seed is up 35% this year and was one of our high-performing categories last year as well. Over 90% of the online reviews for Thick'R carry a 5 star rating, further proof that the innovation we're bringing to the market is driven by understanding and adapting to consumer needs.

The way we're talking to consumers also continues to evolve. We're not just investing more heavily this year, we're evolving our approach, and the actions we've taken so far are just the tip of the iceberg. A decade ago, I've spoken in an analyst day meeting in New York and criticized our digital marketing efforts. Yes, we were doing a great job with TV and radio, but our digital efforts were way behind the curve. We were doing almost nothing with social media, and our online comments -- commerce efforts were nonexistent. Today, our digital efforts are greatly improved, and I want to acknowledge our team for their work. But the digital marketplace is ever-changing. And if we were lagging in this space in the past, I want us to be leading in the future. More of our spending needs to move to digital, but our efforts have to be focused on inspiring the consumer. We have to be clever, provocative and innovative. We also have to be willing to challenge our own thinking. That's why we've enhanced our internal efforts through the engagement [history] with Gary Vaynerchuk, an acclaimed online influencer who has become one of the country's most sought after digital marketing authorities. He and his colleagues at VaynerMedia have helped us launch our successful new Ortho GroundClear campaign and have been heavily engaged with our team on using our social media presence more creatively.

I mentioned Gary's work with us, not just in the context of marketing but through the lens of creating long-term value. Consumers are changing fast, and if we hope to enjoy our relationship with them in the future, we have to change, too. I'm committed to revolutionizing our approach to marketing, positioning both our company and our brands in a way that instills trust with the next generation of gardeners and allows them to see us as a relevant and necessary part of their lives season after season.

Speaking of being relevant, I want to spend a few months -- it feels like it -- moments talking about what's happening with the launch of our new GroundClear product and also provide an update on Roundup. First, on the Roundup front. You saw in the press release, the POS is up more than 20%. That's obviously good news, and we're particularly thankful for the strong retailer support the brand is continuing to receive. On the past 2 calls, I've hinted that we were talking to Bayer about the structure of our relationship with them, and we've made tremendous progress in recent weeks. First, you may recall we entered into a JV with Monsanto a couple of years ago that resulted in Scotts acquiring a 51% stake in a professional, nonselective weed control product business. In recent weeks, we sold our interest back to Bayer and have exited that business. It negatively impacts the P&L by a few cents per share, but the cash proceeds of $37 million will go straight to paying down debt. Additionally, we've already reduced our debt by about $140 million using the proceeds from our sale of our minority interest in TruGreen. These 2 transactions have allowed us to get below 4x leverage in the quarter, and we should remain at that level through the end of the year. If we stay in our current path, we would expect to get back to about 3.5x leverage next year. This would allow us to get back to one of our major pillars of project focus: to return cash to our shareholders.

A second development is Bayer has agreed to a $20 million reimbursement this year. We have been anticipating this payment for several months as reimbursement for investments we didn't anticipate entering fiscal 2019. In other words, I would caution you against adding this to your models.

Our counterparts at Bayer have been committed to working with us. We've been working collaboratively to further make amendments to our agency agreement that gives us more flexibility going forward. I'm cautiously optimistic and will obviously have more to say as things move along.

As for GroundClear, it's the story behind the story that I think matters the most here. We've brought this innovative herbicide to the market in less than a year. That's unheard of in the pesticide lines. Nearly every major function in the company touched this product, and the process ran with near perfection. GroundClear serves 2 important purposes. First, it provides an alternative to consumers who might have otherwise decided to leave the category. But this is also our first OMRI-listed nonselective weed control, so it can be used around organic gardens, and it is extremely effective and fast. This opens up an entirely new segment of audience for us and allows us to expand in the category. In fact, if you look at the nonselective category in total, that's Roundup and the entire GroundClear line, consumer purchases are up nearly 30% entering May.

GroundClear is an example of turning the organization on its head and getting something done with urgency. Sometimes the process doesn't work like that. Sometimes bringing a product to market takes patience, and that's what we demonstrated with Miracle-Gro Performance Organics. In a slow-growth category like lawn and garden, it's easy to consider reductions in areas like R&D as a potential pathway if you're looking to save your way to success. That approach could have made sense in this instance since our soil products are already the #1 product line by a wide margin. But consumer sentiment is evolving. If we didn't create the ultimate organic product, we knew someone else would. So we spent 4 years working on Performance Organics, and the result, the creation of an organic fertilizer to perform every well as bit as synthetic was worth the wait. Retailers' support has been fantastic, consumer engagement has been strong and the entire growing media category is up 10% on a fiscal year-to-date basis entering May. And that's before we get to the peak gardening weeks of the year.

There's a common thread in all the products (inaudible) have highlighted this morning. In each case, it's been about addressing the changing needs and attitudes of consumers. To truly address those changes, we need the support of our retailers. This season in particular, we strengthened our relationship with them by having critical, timely and honest conversations about the challenges and opportunities in our category. The transparency of those conversations has helped strengthen those relationships and trust and drive the announced -- the results we announced today and positioned us for continued success in 2020 as well.

I'll cover more about the U.S. Consumer business in Q&A if you'd like, but in the interest of time, I want to shift gears and talk about Hawthorne a bit. Clearly, we're pleased with what we're seeing. We had double-digit growth throughout the quarter, with strong growth in both durables and consumables. And we're seeing growth in both emerging and mature markets. I'll leave the rest of the facts of numbers to Randy.

On the last call, someone asked me why we're so confident we would win in this space and what we would bring to the party that gives us the right to win on the professional side of the industry. There was a clear implication that some folks believe our experience as a consumer company somehow impedes our ability to be successful here. When you run a public company, it's hard to plug your ears sometimes. That was one of those times. Because the notion that we have the wrong products or skill set to win in the professional grower market is just flat out wrong.

I'll start reminding you that a every small percentage, we believe likely less than 5% of our hydroponic products, are used by people growing plants at home. Said differently, more than $500 million worth of our products will be used by commercial operators this year, including the largest growers in the world. In fact, we have a dedicated team that focuses exclusively on that segment. While it's become cool and fashionable to invest in companies that are affiliated in the hemp and state-authorized cannabis industries, we were the first major player and certainly the first public company to enter the space. We've been bullish in this category from day 1, including a year ago when I felt like the sky was falling. I've suggested many times that last year was an aberration, the kind of result that occurs sometimes when a business is still in the adolescent stage. But the results we posted in Q2 and the momentum we've seen so far in Q3 is showing once again that this industry has great potential and we are better positioned than anyone to win.

First, the results we report today demonstrate that large commercial operators in the industry see us as a critical part of their success. And the approach we've taken with them has allowed us to expand our market position. Over the past year, we've taken an aggressive approach to promotions, and it's not because we lack confidence, it's because we have confidence. In a moment of frustration last year, I made a comment on one of these calls that the team was gun-shy. They've taken a great pride in proving me wrong.

Our goal is to be the perfect supplier to growers in both the U.S. and Canada. And so we have been investing as we plan to do to build our customer base and distance ourselves from the competition. We're succeeding. The #3 player in this space has exited the category in recent months, and we have further distanced ourselves from the #2 player. We have demonstrated to our customers that we are just as committed to their success as we are to our own. To be the perfect vendor, we can't simply sell products. We have to sell performance and be viewed as a trusted resource. This is especially true as the market continues to evolve and the financial stakes growers continues to climb.

We have to help them understand how to use our systems in a way that delivers the best results in the most cost-effective way possible. To be the perfect vendor, our customers can't see us as a vendor. They have to see us as an indispensable partner to their success. To achieve that goal, there is a clear near-term trade-off that we're making. Our margin rate is clearly not where we'd like it to be right now. In the near term, however, by engaging in aggressive promotional strategy, we have solidified our market leadership, which I believe creates the best environment for more attractive level of profitability over the long term.

Sustained success will require us to continue to further improve our product portfolio. We need to expand our technical capabilities and ensure that our R&D pipeline is focused on performance, costs and speed. We have to be mindful that as fast as this industry is evolving, much of it remains the same. Just as we do in our U.S. Consumer business, we need to respect the culture that the pioneers in this industry created and help them continue to succeed alongside the larger players who are now coming in.

I want to wrap up and turn things over to Randy, but I first want to reiterate how good I feel about the way we're running this company. As I said earlier, creating long-term value requires a lot more than getting a good break from mother nature or hitting the occasional home run with a new product. It starts with a mindset and a commitment, and it requires investment in both the right people and the right processes to get things done.

I want to tip my hat to Mike Lukemire. He's done a great job as Chief Operator, and his team is performing at an extremely high level. What's really exciting is that I'm confident they've got a lot more in their tank. I also have to give a nod across the table to Randy. In my 20 years as CEO, he's been the best operating CFO I've ever worked with. It's been rewarding to see him expand his role to take on strategy, to help us navigate M&A and to drive our discussions with the team at Bayer.

It's also been great to see the momentum which is back on our side at Hawthorne. Even though politicians, mostly at the federal level, are ridiculously slow to embrace changes that Americans clearly want, it's encouraging to see positive changes in states where voters are getting a say. In those places, state laws are helping our business. Growers are finding it profitable to grow again, and retailers are feeling more comfortable taking inventory because they're feeling the tailwinds as well.

It's not hard to be pleased with the results we announced today. It always feels better when people are stressed to keep up with demand instead of being stressed to create it. There is a renewed sense of confidence and enthusiasm throughout the company this year, and it's palpable. We can feel it. I can feel it. I hope you guys can as well.

So let me turn things over to my partner to run you through the numbers. Randy?

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Thomas Randal Coleman, The Scotts Miracle-Gro Company - Executive VP & CFO [4]

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Nice job, Jim.

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James S. Hagedorn, The Scotts Miracle-Gro Company - Chairman & CEO [5]

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Thank you.

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Thomas Randal Coleman, The Scotts Miracle-Gro Company - Executive VP & CFO [6]

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I know that was a struggle. Hopefully, everybody listening appreciates that.

So good morning, everyone. We clearly have a great deal of good news to cover today, and I want to start by reinforcing the confidence Jim just expressed about where we stand right now. I'll discuss our guidance in more detail near the end of my prepared comments, but I'll just say out of the gate that I feel optimistic about our ability to deliver on the commitments we made at the start of the year.

I'm not going to go line by line to the P&L. We'll cover things in Q&A if there's an area we need more explanation. But I will hit the highlights and try and anticipate some of the questions you may have that may not be answered by simply looking at the numbers.

On the sales line, let me touch on a couple of items. We said the U.S. Consumer business would be up 1% to 2% for the year and we're up 8% in the quarter and year-to-date, and we're now at the midway point of year. Two things you should know. First, a lot of the mulch sales we're seeing this year were not contemplated in our original guidance, at least $35 million worth. The other point is remind you what I said on our last call. We've seen some of our retailers take a more aggressive approach to filling their stores earlier this year. That's exactly what happened. So more -- so then in most years, the balance of 2019 is really about replenishment, and that means it's really about consumer engagement and POS from this point forward. But we and our retail partners remain extremely active in trying to drive consumer engagement. Remember, though, we have a plus 28% comp in May, so we're likely to give back much of the POS growth we've seen year-to-date. In addition, historically speaking, we still have about 50% of the POS here still in front of us. If POS is plus 4% or plus 5% in mid-June, I'll be very pleased with that result.

The other thing working out there right now is that retail inventory levels are up from last year's levels. There is clearly less focus on that metric at this point in the season than we saw a year ago. But season inventory is really what the retailers historically tried to manage. When anticipated going into the year, that retail inventory reductions could put downward pressure on our top line number by the end of the year. Even though that's not manifesting itself right now, we're not going to move off of this assumption until much later in the year.

Hawthorne total shipments, up 21% in the quarter and 5% year-to-date on an apples-to-apples basis, also look a bit better right now than our guidance would have suggested at the midway point in the year. Even more encouragingly, we are also up over 20% in the U.S. hydroponics business for the month of April.

I'm usually a margin hawk, but I'm totally aligned with Jim's comments about our near-term focus to reenergize the top line at Hawthorne. My bias actually stems from a dozen of shareholder meetings I participated in over the past year. I believe getting this business to once again just sustainable growth is our #1 near-term priority. However, looking into the future, we will be shifting our focus next year to create a margin profile that allows us to drive the kind of value from the business that our shareholders expect.

On a company-wide gross margin line, our rate had decline 60 basis points in the quarter and 160 basis points year-to-date on a non-GAAP basis. While our gross margin dollars are up almost $65 million so far this year, we obviously have some ground to make up to get our gross margin rate to flat by year-end as we had originally planned.

Right now, as expected, the impact of the Sunlight deal and more specifically the lower-margin distribution side of this business is the biggest drag in the rate, but that begins to anniversary in June.