Why Scotts Miracle-Gro Remains A Solid Long-Term Play

Source: company website

A lot of the recent commentary concerning Scotts Miracle-Gro (NYSE:SMG) must be taken with a grain of salt, as it caters primarily to traders and not long-term investors.

The main catalyst that has generated a weaker outlook for the company was the cooler and longer-lasting spring which cut significantly into Scotts' sales for the important season.

Even the release of solid lawn and garden sales for May, climbing to a record $565 million, wasn't enough to move the needle much for a company that has dropped by over 20 percent since the beginning of 2018. The record sales still wasn't enough to overcome the weak numbers in the first half.

Raymond James also recently downgraded Scotts, citing "the elimination of $20M annual payments from Bayer-Monsanto due to a revised marketing agreement, $20M higher commodity and transportation costs, $20M more in incentive compensation, and $20M more in wage and benefit inflation."

While I agree this could have some potential to put downward pressure on the shares for the remainder of 2018, I don't see it being as important in the long term.

Even though the added costs will endure, the company is adding more revenue streams and should be able to lower commodity and transportation costs going forward.

Another temporary dilutive factor is the acquisition of Sunlight Supply's hydroponics business, which isn't expected to be accretive to the company until 2019.

With the market focusing on short-term catalysts, I see this as a good time to take a position in, or add to an existing position in Scotts Miracle-Gro, as once it takes off, it'll be a long time before the opportunity to get in at this bargain price will occur again.

Latest earnings

Sales in the most recent quarter dropped to $1.01 billion, down from $1.08 billion year over year, or 7 percent. The bulk of that came from the late start to the lawn and garden season, and the weakness in the Hawthorne segment, which dropped 29 percent to $41.8 million.

The main issue surrounding Hawthorne is the cannabis market in California, which accounted for 55 percent of that segment's sales last year.

What's happening is a very complex licensing system that is moving much slower than Scotts believed it would. As of the earnings report, only 12 of the 58 counties in California granted licenses to producers and dispensaries, with about 3,200 licenses issued at the time.

The problem is each community is making individual decisions concerning zoning requirement, many of which are different from county to county. Even the regulations could be different in each community.

Consequently, the company sees the best-cast scenario for Hawthorne for 2018 will be for sales to end flat for the year.

As a result of lower sales, gross margins dropped to 40.4 percent, a decline of 240 basis points. Other factors attributing to that were higher distribution costs and an increase in trade program expenses.

Another challenge was the abundance of supply in 2017, which exceeded demand, according to industry experts the company talked to. For the above reasons, Hawthorne will probably weigh on the performance of the company for the remainder of 2018. For the fiscal first half, sales from Hawthorne were down 4 percent to $118.5 million. During the same period, gross margin was 35.9 percent, down 290 basis points.

SG&A expenses came in at $274.2 million, down 3 percent.

How to think of Scotts Miracle-Gro

For a long time, Scotts had been a business almost solely dependent on lawn and garden sales in the spring for its performance. Anything that disrupted that meant it would struggle for the year.

So it wasn't surprising to hear the company underperformed because of the cooler and longer-lasting weather conditions, which caused consumers to put off their spring purchases, and in many cases, lower the amount spent on supplies.

That said, the company has been transitioning to a picks and shovels company for the hydroponic and cannabis business, and that will help alleviate some of the overall dependence on spring sales for the company, because cannabis and hydroponics are usually year-round operations.

Its Hawthorne division, which will fold Sunlight Supply into it, is projected to grow in the range of 25 percent to 30 percent for fiscal 2018. Excluding Sunlight, the unit is projected to have sales finish the year modestly down.

This aligns with the already-mentioned impact from weather, but also reinforces my thesis that the company will increasingly be less reliant on spring sales as the major catalysts for revenue. This will be from improved product mix and consistency of sales in the cannabis and hydroponic industries.

In the short term, the real risk would be if there is another cold and prolonged spring, which would once again eat into company sales. After the first half of 2019, I don't see that being as risky to the company as it has been in the past. That's not to say lawn and garden sales in the early part of the year aren't important, only that they won't have the negative impact in a down year as they have before the transition to an expanded product mix.

Something else to take into account is that this was one of the worst springs in a long time. Chairman and CEO Jim Hagedorn said this:

��The start to this lawn and garden season has been delayed to a greater extent than we have seen in recent memory....��

That suggests it's unlikely we'll see something as prolonged in the near future. And even if there is, as mentioned, the company is shrinking its exposure to spring with its changing business strategy.

Also take into consideration this wasn't unique to Scotts. Other companies with spring lawn and garden exposure like Lowe's (NYSE:LOW) and Home Depot (NYSE:HD) also suffered lower sales. What I mean is there isn't something systemic within Scotts that caused it to lose sales in the spring; it was nothing more than the weather not cooperating.

Cannabis exposure

The future growth segment of the company, as it stands today, is in its supplying of the cannabis industry with various products for production purposes.

Some of the uncertainty in the U.S. market continues to weigh on the company in that regard, though the trend, even with pot remaining illegal at the federal level in the U.S., is moving toward more acceptance for medical and recreational marijuana use.

It's inevitable that many more states will legalize cannabis, and Scotts is positioned well to grow along with that market. With all the focus on Canada recently because of the legalization of recreational pot, the U.S. market is far larger in potential, and because of the legal issue at the federal level, has been held back significantly in a number of ways, including sentiment.

What's important to me, beyond the obvious growth potential, is the fact this isn't a seasonal industry. Scotts will be able to consistently sell into this market for many years, and as that product mix increases in percentage, it will level out its quarterly performances, taking a lot of uncertainty and volatility out of it.

Lawn and garden sales will continue to be important; they just won't have the impact they have had in the past when the weather is colder than normal for a longer period of time in the early part of the year. It'll take a couple of years at least to get to that place, but once it does, there should be predictable and sustainable growth for some time into the future.

Conclusion

For the latter half of 2018, Scotts will be under some pressure, as it recently lowered its full-year adjusted EPS guidance. It now expects it to be in a range of $3.70-$3.90 per share, including the dilution associated with the acquisition of Sunlight. It also downwardly revised its guidance for its gross margin rate from a decline of 50-100 basis points to a decline of 250-300 basis points.

Approximately 100 basis points of that is attributed to the Sunlight deal. Other elements were lower volume and distribution costs being higher than previously expected.

In my view, volume will definitely increase, and the company is already working on cutting costs, which I think it will successfully execute. That and the upcoming increase in sales to the cannabis industry implies to me that the company is in a temporary holding pattern that will turn around in 2019, assuming there isn't another prolonged cold spring.

For those reasons, I think Scotts is at a good entry point, and for the patient investor, it should provide some nice returns over the long term. In the short term, it's going to struggle to gain any traction.

Scotts isn't going to be a good stock for traders, but a very good one for those holding on to it.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.