Scotts Miracle-Gro (SMG) Q1 2019 Earnings Conference Call Transcript

I wish I could have predicted the contraction of the California cannabis market, but no one else saw that coming either. And in the U.S. Consumer segment, the start to the 2018 season was historically bad. There's nothing we or our retail partners could have done differently to change that fact.

Sometimes things happen. That's not an excuse; it's just reality. The share price was, to some degree, one of those things. The euphoria around Hawthorne and a legally authorized cannabis production is what took our share price to $110.

That wasn't solely based on our performance clearly. A portion of that valuation was speculative. Likewise, when the share price fell to $57 last month, it was clear we were swept up into the overall volatility of the market. That valuation didn't make much sense to me either.

What was encouraging is that we saw some of our largest and longest-tenure shareholders, those who really understand our business, increase their positions in November and December. I suspect those shareholders believe we still have a lot of upside in front of us. We agree. I am not suggesting that we were simply victims over the past year.

That's not true either. We missed our numbers and not by a little. When you miss your numbers, you get dinged. And when you miss your numbers after a major shift in strategy, one that results in higher leverage, you get dinged even worse.

And that's even more true when the market is already jittery, I get that. So my challenge to the team after our strategic planning review was a simple one: we must improve our execution and be willing to be held accountable when we don't. And that starts with me. I have a great team, and I have full confidence in their ability, but I know I am the one ultimately accountable to all of you listening today.

That's why I want you to know that I have been personally involved in visiting customers, in challenging our execution, questioning our planning assumptions, spending more time with our emerging leaders, pushing for even more progressive thinking about our brands, our products and our relationship with consumers and in making sure we stay focused on the right performance metrics, especially cash flow. That's also why I can tell you with confidence that I haven't felt this good about our prospects in quite some time. Coming out of Q1, there are also a lot of encouraging signs. So let me just jump right into it, starting with Hawthorne.

My comments here will be brief but noteworthy. During our last call, we said we believed the worst was behind us. This was based on the fact that our rate of sales decline on a comparable basis went from nearly 40% in Q3 to a little more than 30% in Q4. Using that same process, comparable sales in Q1 declined by less than 10%.

However, the Q1 numbers masked a better story as U.S. hydroponic business started to show growth in the back half of the quarter. That positive trend continued in January with growth in every product category. The highest growth rate was in lighting.

So we've reported a positive comp in two of the last three months. On a year-to-date basis through January, we're back to flat on an apples-to-apples basis in the U.S. hydroponics business. More importantly, we're getting good feedback that our customers have also begun to see a recovery.

If our run rate exiting January holds, we would expect to see positive top line for Q2. Let's be clear, I'm not claiming victory. We have a long way to go for that to happen, and we've learned the hard way that this industry has a lot of ups and downs. Hawthorne has clearly benefited as the cannabis industry has grown in both the U.S.

and Canada. The industry is changing rapidly, and what's important is that we're changing with it. Markets like Canada, Massachusetts, Michigan and Florida don't look like the Western United States. There are fewer limited licenses in these markets, which means fewer growers but larger ones.

That's likely to be true as new markets open in places like New York and New Jersey, both of which have committed to using the legislative process this year to allow for adult use. The evolution of the market requires greater commitment to innovation, to technically proficient sales force, to a world-class customer service. Due to a series of organizational and process changes we've made over the past several quarters, I believe no one in the hydroponics industry is better positioned than Hawthorne. But as I said earlier, our focus has to stay on execution and accountability.

One last point on Hawthorne is the integration of the Sunlight deal. Nothing has changed. The integration is going as planned, we're achieving the cost savings we expected, and the year-over-year benefit to Hawthorne's bottom line remains on track. We know that the interest in this business is high.

Randy and Jim King will be out on the road a good bit in March, including a conference that will allow us to provide a public update. Our intent is to let you know where things stand and to keep you updated on our progress. Let me shift gears and talk about why I'm also encouraged by what I see in all retail channels in the U.S. Consumer business.

You should know that I have not seen this level of retailer enthusiasm about our category and brands in several years. The results you saw this morning are a testimony to that. Even in the historically small first quarter, we saw a solid increase in shipments as retailers prepare for the season. That trend accelerated in January.

The flow of the season in both 2017 and '18 would suggest we have pretty easy weather comps as we start the season. That said, the temperatures here in Ohio this week, right now, remain below zero, so I don't want to get carried away in predicting when the season will break. What I do know is that retailers want to be ready. I believe we'll see them all leverage innovation like Miracle-Gro Performance Organics to create enthusiasm among new consumers and expand the gardening category.

I also think they'll use products like Scotts Turf Builder Triple Action to drive lawn-care loyalists into the store. I also expect retailers to hit the ground running at the beginning of the season with a focus on Scotts-branded products. Right now, it looks like we'll see an even greater focus on branded mulch, probably higher than our original expectations. That could have some top line benefit, but as you know, mulch is a low-margin product.

Regardless, the fact that we expect retailers to come out of the gate hard is definitely a good sign. I know that many of you continue asking whether our price increases will stick and whether retailers are moving away from brands and toward private-label offerings. I can tell you that I've personally been engaging with our retailers leading into this season, and literally none of them have raised those issues. In every channel or trade, retailers need vendors like ScottsMiracle-Gro.

They want partners who remain committed to R&D, to brand support, to supply chain excellence and to in-store execution. They continue to place value on the role of industry leaders like us, partners who can help them grow. That's why three of the four largest partners we have named us Vendor of the Year over the past 18 months. Over the past month, one of those partners named us their vendor for the -- vendor of the year for the second consecutive year.

We don't get this kind of recognition because retailers think we're good people. It's because we can help them win. Part of the reason we're winning with our retailers is our successful track record when it comes to innovation. About a year ago, I began talking to you about this year's introduction of Miracle-Gro Performance Organics.

I still believe this is the most important organic product our industry has ever seen. It was years in the making and provides consumers with results that are on par with synthetic fertilizers. The other breakthrough we have this year is a new product under the Ortho GroundClear brand. It is our first nonselective weed control product that is OMRI listed and certified for use in organic gardens.

I mentioned the product briefly to you on the last call. Since then, we've received enthusiastic support by every major retail partner and strong display space commitments entering the season.The goal with GroundClear is twofold. First, we see the product as complementary to Roundup. We know more consumers than ever are interested in organic gardening, and this version of GroundClear provides them a viable and effective solution.

In that regard, the product offers us an opportunity to bring in new consumers and expand that category. Second, we recognize some consumers may be unsure about using traditional weed control products like Roundup given recent headlines about the product and the advertising being run by plaintiff law firms across the country. We would be negligent to ignore that reality. And so in that regard, GroundClear allows us to keep that subset of consumers engaged in one of the most important categories in lawn and garden and one in which we are the unquestioned leader at retail.

For the record, Roundup is off to a very solid start. Yes, it's a small sampling, but it's still an encouraging early sign. I also want to stress that all of our top four retail partners remain committed to the Roundup brand, and all of them have also listed the new GroundClear product. We know of at least one retailer, one with a more organic focus, that has decided not to carry the Roundup brand this year.

Based on the demographics of their consumer base, I understand and respect that decision. But I'm also glad that the new GroundClear product will be on their shelves this season. I want to stress that we respect Bayer's defense of the science around glyphosate and their commitment to the Roundup brand. We also remain fully committed to the Roundup brand, our role as Bayer's agent in the marketplace and our belief that the product is safe for the consumer when the product is used as directed.

But our understanding of the science isn't what's relevant here. We have an obligation to meet the evolving needs of the consumer marketplace, to provide service to our retail partners, a vibrant workplace for our associates and to return value to our shareholders. Or more simply, we have to control our own destiny. Along those lines, because of the current uncertainties about the upcoming season, we remain engaged with the Bayer team about potential adjustments in our relationship with them.

We remain encouraged by their positive response, and we'll communicate to you all if anything changes. Our product innovation is also leading us down a new path with marketing support. Both of our new products, Performance Organics and GroundClear, will be supported by a more contemporary campaign that blends consumer lifestyle and product performance messages. We'll also be using our social media platforms more aggressively than ever to test multiple approaches simultaneously.

We'll invest more heavily in traditional media buy behind the spots that do best on our social platforms. During the spring, you'll also see a complete redesign and relaunch of our corporate properties, starting with our website, scottsmiraclegro.com. We know all of our stakeholders expect more from companies these days than sales and profits. They want to know the companies they do business with, whether as a consumer or a shareholder, stand for something and use their business to advance a social purpose.

Those values, which have been part of our DNA for decades, will be more clearly defined as we move ahead. So as I said at the outset, I believe the flurry of all season activity has us well-positioned for a good year. You saw in the press release that we are reaffirming our guidance for sales, EPS and cash flow for the year. But more importantly than that, as a team, we are reaffirming our commitments to shareholders.

We remain committed to the path outlined three years ago. The goals we outlined in Project Focus, while perhaps delayed, remain our goals. We will continue to leverage our competitive advantages in the U.S. Consumer business and supplement our performance in faster-growing categories like live goods and hydroponics.

We can continue to leverage the P&L to improve our operating margins and to drive earnings even higher. We can continue to combine our earnings power with improvements in working capital to drive free cash flow and cash flow productivity. And while we'll use that cash for the next year or so to reduce leverage, we remain fully committed to a long-term strategy of returning cash to shareholders. If I sound enthusiastic this morning, it's because I am.

We can't control when the snow will melt and whether Mother Nature will make this a better year for lawn and garden. But in the areas that we can control, I am a lot more positive than I've been in a while. We see 2019 as a bounce-back year for ScottsMiracle-Gro and look forward to proving it. I feel good about our business, about our plans and our team.

I also feel good about the commitments to you. I look forward to your questions, but for now, let me turn the call over to Randy to talk about the numbers.

Randy Coleman -- Chief Financial Officer

Thank you, Jim, and good morning, everyone. All of you know that Q1 is a disproportionately small quarter for us, so I would be remiss if I didn't caution you against extrapolating too much from today's press release. Given the size of the quarter, a small dollar change can have an exaggerated impact on the percentage change. Also, the fact that it's the last quarter means that good stories below the operating line, like a lower share count or effective tax rate, actually have an adverse effect on EPS.

I'll reiterate Jim's comments related to what I consider the main themes. First, our U.S. retailers are highly engaged in getting ready for the lawn and garden season. Second, the trends at Hawthorne continue as we expected, and we're starting to see positive year-over-year results.

Third, we remain confident in our full-year outlook for sales, earnings and cash flow. As you saw this morning, sales in the quarter increased 35% on a companywide basis. The 9% increase on the U.S. consumer segment represented just an $11 million year-over-year increase.

While the number is small, there's a bigger story here. Retailers in total reduced their inventories during the period, as we've seen in the first quarter over many of the past few years. However, as we sit here today, retail inventory levels are now ahead of last year, a good signal to us that they intend to have their stores ready well in advance of the warm weather. At this point, given our expectation that our largest retailers will be more aggressive in loading stores this year, we now believe our first-half net sales for U.S.

Consumer will approach $100 million higher than a year ago. However, our outlook on consumer takeaway is currently unchanged, so we expect this is only a shift in timing. Consumer purchases were essentially flat in the quarter. On a more real-time basis, they're up about 4% entering February, led by the strong performance of Roundup that Jim alluded to as well as the more than 20% jump in grass seed purchases.

The other important top-line story is within Hawthorne. The 84% increase in revenue to $141 million is primarily driven by the addition of Sunlight, though our European professional hort business, which made up about a little more than 20% of overall Hawthorne sales, grew about 8%. AeroGrow saw a decline of about $5 million as Christmas sales fell short with several retailers. That leaves us with the North American hydroponics business.

Jim already mentioned the comparable year-over-year results, but let me provide a little more context. Remember that Hawthorne discontinued sales to other distributors after the Sunlight acquisition. When we make adjustments for changes to the business model, the comparable decline was about 10% on a year-over-year basis. It's important to understand there's some emphasis into these numbers.

That said, we've been using the same process and methodology since the Sunlight deal closed, and that is what gives us confidence in the trends that we are seeing. More recently, January performance for the U.S. hydro business has been double digits above year-ago levels. I don't want to be too specific today.

Let's wait and see how the entire quarter comes together. I'm less concerned about the specific number than I am about the trend, and right now, that's really encouraging. I'll also point out that we expect Hawthorne earnings to increase over the next three quarters largely due to higher sales and the realization of the cost synergies from the Sunlight acquisition. Let's move on to the gross margin line.

The GAAP numbers are outlined in the press release, so I won't spend time there as our guidance is based on the adjusted non-GAAP numbers. On an adjusted basis, the rate declined 290 basis points in the quarter to 12.4%. Our guidance for the full year is that the gross margin rate will be flat, so I want to make sure you understand the differences in the quarter. Higher distribution expenses account for the vast majority of the decline.

However, most of the distribution pressure we saw in Q1 will reverse itself later in the year. Half of the higher cost came from mark-to-market adjustments related to fuel hedges. As that lower-cost fuel flows to the P&L later this year, it will offset that adjustment.The second matter is related to higher distribution expenses associated with our decision to close our liquid manufacturing facility in Mississippi and combine it with our primary facility in Iowa. In the short run, this may result in near-term distribution challenges, which we expected related to higher inbound freight costs.

We will more than offset those challenges later in the year, however, with lower manufacturing costs. In fact, the overall project will be accretive to the gross margin rate by the end of the year. Finally, you might recall that we made a decision last year to invest in a small fleet of trucks this year to have more predictability in our cost structure. This also will be accretive on a full-year basis, but it was dilutive in Q1.

The balance of the gross margin rate decline was related to anticipated higher distribution costs, which were assumed in our guidance. Moving on, there really isn't much color related to SG&A, so I won't elaborate here. We're up 7% in the quarter due primarily to the impact of acquisitions. That is what we expected.

Let me jump below the operating line. Again, no major news, but certain items significantly impacted EPS numbers in Q1. First, interest expense was roughly $7.5 million higher in the quarter due primarily to the Sunlight acquisition. As a result of higher borrowings, our leverage ratio, which is based on a rolling 12-month average, was 4.5 times at the end of the quarter.

As I've told you in the past, our primary use of cash for the next several quarters will be to de-lever. Based on the way the calculation works, I would not anticipate the leverage ratio moving below four times this year. However, that will change in 2020 when our expectation is to move to about 3.5 times. The final headline in the P&L is the effective tax rate.

There was a discrete entry in the quarter that lowered our rate on the Q1 loss to a few percentage points less than our full-year expected rate of approximately 25%. And that has not changed. The lower rate in the last quarter is a headwind to EPS. When you bring it all down to the bottom line, the GAAP loss for the quarter was $79.6 million or $1.49 per share compared with $21.2 million or $0.35 per share.

The difference is largely due to the fact that we recognized a net deferred tax benefit of $42 million last year as a result of tax reform. On an adjusted basis, excluding impairment, restructuring and other one-time items, we reported a loss of $77 million or $1.39 per share compared with $62.2 million or $1.08 per share. Let me as well point out again that only $0.07 of the $0.31 decline from last year is due to operating items and the remainder is due to higher interest expense and the unfavorable impact of tax rate and share count during the last quarter. We also ended slightly better than our own internal operating targets.

I'm always cautious about getting too carried away this time of year. That said, I am encouraged by the way things are lining up. In U.S. Consumer, our retailers are approaching the year with enthusiasm, we expect our new products to be embraced by our consumers, and our internal teams are executing well in key areas like supply chain, sales and marketing.

In Hawthorne, the trends also remain encouraging. As Jim said, it's too early to declare victory, but the market trends we're seeing reinforce our belief that we'll see the business back in the win column in 2019. With that, let me turn things back to the operator, so we can take your questions. Thanks.