Scotts Miracle-Gro Company (The)

Good day, and welcome to the 2020 Q1 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jim King. Please go ahead.

Good day as well. Thank you, John. Good morning, everyone, and welcome to the Scott Sparrow First Quarter Conference Call. With me this morning in Marysville, Ohio, is our Chairman and CEO, Jim Hagedorn, and our CFO, Randy Coleman. Also present is Mike Lukemeyer, our President and Chief Operating Officer, Chris Hagedorn, the general manager of our Hawthorne Gardening subsidiary, and several other members of the management team. In a moment, Jim and Randy will share some brief prepared remarks regarding our Q1 performance as well as other matters. Afterwards, we'll open the call up to your questions. In the interest of time, we ask that you try to keep to one question and one follow-up. If you have any questions that we don't get to in the call, please call me directly at 937-578-5622, and we'll set up some time to get together as quickly as possible. Before we move on, I'd like to take care of a couple of pieces of housekeeping on the IR front. On March 2nd and 3rd, Randy and I will be attending the Raymond James 41st Annual Institutional Investors Conference at the Grand Lakes Resort in Orlando. We'll conduct one-on-one meetings on both days and conduct a webcast presentation at 2.50 p.m. on Monday the 2nd. We'll be issuing a press release closer to the event. Two weeks later, the week of March 16th, we'll hold one-on-one and small group meetings in several European markets, including London. Those meetings will be coordinated by William Blair & Company. Investors interested in meeting with us at either of these occasions should contact the respective firms directly. With that, let's move on to today's call. As always, we expect to make forward-looking statements this morning, so I want to caution that our actual results could differ materially from what we say. Investors should familiarize themselves with the full range of risk factors that could impact our results, and those are filed for their Form 10-K with the FCC. I want to remind everyone that today's call is being recorded, and an archived version of the call will be available on our website.

So let's get started, and to do so, I'll turn it over to Jim Hagel. Thanks, Jim. Good morning, everyone. If you've had a chance to review the first quarter results we announced this morning, it's evident the momentum we enjoyed in fiscal 2019 carried into the early months of fiscal 2020 as well. Not only did we see strong performance in Q1, but the early weeks of Q2. Because of strong cash flow, we've reinitiated our share repurchase activity. So, we're feeling good about the strong start to the year and have a high degree of confidence in our full year guidance. It's easy to look at the results, though, and get carried away. So, I just want to remind everyone that Q1 constitutes less than 10% of the year. While the growth rates we reported in both the U.S. consumer and Hawthorne units were well ahead of our full year guidance, it's important to remember we expect to return to more normal growth rates in the months ahead. I'll keep things brief this morning, but I want to start by focusing on Hawthorne, which grew 41% in the quarter. Obviously, the engine of Hawthorne business is the United States hydroponics and indoor growing businesses, which was up 66%. Better yet, the growth in the quarter was completely driven by organic growth. Hawthorne continued to see strong growth in nearly all product categories. Lighting sales for the entire segment grew by 27%, driven by sales in the United States, which increased more than 100%, from 2019 levels. While lighting sales declined 30% in our European professional horticulture business, that decline was baked into our full-year expectations due to the timing of some lighting installations in 2019 that we knew would not repeat this year. We still expect this business to grow on a full-year basis. On the consumable side of the business, we reported 36% growth in nutrients and a 78% increase in growing media sales. The geography of our U.S. sales is also encouraging. California was up 58%, and Colorado grew by 57%. When you move east, Michigan more than doubled, as did Illinois, Florida, New Jersey, and Alabama. On average, our top 11 markets grew by 64% in the quarter. It's worth adding that Hawthorne team also pulled off a successful launch of SAP during the quarter at what was Sunlight Supply. This is no small feat. In fact, it was probably the most complex SAP implementation we've ever undertaken. Sunlight has thousands more SKUs than our U.S. consumer segment as they were both manufacturers of their own product lines as well as distributor of dozens of others. Now that we have every one of the Hawthorne acquisitions using the same platform, we see opportunities to significantly improve our service levels, consolidate SKUs, and take more costs out of the business. Hawthorne also posted sharply higher profits in Q1, keeping us on track to achieve our goal of at least a 10% operating margin on a full year basis. Before I move on, I think it's fair to provide some context around Hawthorne's first quarter. Remember that the business was still in recovery stages this time last year from the challenges we experienced in 2018. That means we had a pretty easy comp in Q1. Regardless, the momentum we've seen over the last year has been outstanding. While we expect the growth to moderate in the months ahead, Randy will discuss the details, we feel really good about the progress Hawthorne is making and the success it's had in positioning itself as the clear industry leader. As we look longer term, we continue to be optimistic about the potential of the overall marketplace. We believe as many as 10 states could hold ballot initiatives this year to create new or expanded state-authorized cannabis markets. One of those markets is New Jersey, where Senate President Steve Sweeney Perhaps the most thoughtful politician in America on this issue is leading the effort. And in New York, Governor Cuomo is once again pushing for adult use legalization of cannabis through the budget process that's being managed by the state legislature. It's impossible to know which states will be open and when. But what I do know is no one is better positioned than Hawthorne to take advantage of these opportunities when they present themselves. Okay. Let's switch gears and focus on the U.S. consumer segment. We reported 8% sales growth in the quarter. On a real-time basis entering February, consumer purchases are up 5% from the same period last year driven primarily by lawn care and gardening products. However, controlled products, especially weed control, while down slightly on a year-to-date basis, has been extremely strong in the past month in the early breaking markets. even against double-digit comps from last year. I'll let Randy take us through the details, but the same issues that drove our growth in fiscal 2019 are still playing through the business in Q1. More importantly than our absolute performance in Q1 was the work being done to ready ourselves for the upcoming season. As it relates to our outlook for the U.S. consumer business this year, I think it's important to understand why our initial guidance for this business is higher than it's been in several years. I want to start with the relationship with our key retailers. In a word, fantastic. The home centers continue to see this as a primary traffic driver in the spring, and they are positioning themselves for another great season. They are leaning into this category and our brands with aggressive and creative program support that we believe will continue to drive the entire industry. It may sound trite to say our relationships in this channel have never been better, but it's true. In the mass retail channel, our major customers continue to return to a strategy of using our brands to drive their lawn and garden business. Over the past two years, we've taken big steps to be a better partner. I've personally been engaged in that effort. Together, we continue to believe there is meaningful growth on the table, and we're working collaboratively for the benefit of both parties. We also expect strong performance out of the hardware channel again in 2020. Merchants in this space have had tremendous success with our brands over the last several years. We've become one of the most important vendor partners for them, and the strength of the relationship should allow us to build upon our momentum again this season. We don't often talk about our retail partners outside of the big four, but this group will be critical in our plans for 2020. We expect at least a full point of our growth in the U.S. consumer segment this year will come from increased listing support in both the club channel and farm and fleet. In every traditional retail channel, I believe our retail partners are increasingly seeing lawn and garden as a strategic opportunity to differentiate themselves from retailers who are operating exclusively online. That's made us more important and a more strategic partner in driving their success. That's not to suggest we're ignoring our partners who operate online. The highest growth rates in the U.S. consumer continue to come from those relationships. While some of our products don't play well on the online space, we've been able to modify our approach in recent years to capture those consumers who prefer to shop online. and we'll continue to evolve our direct consumer efforts in 2020 to take advantage of what will clearly remain a strategic opportunity for years to come. I want to pivot for a moment because we're also optimistic about future developments on the new product front. Product stewardship, especially in the pesticide category, is something we have always taken seriously here and have shown the flexibility when we believed it would help alleviate consumer confusion or concern. Lawn and garden consumers are not chemists. They are homeowners with kids and dogs who don't worry about the products that they use to create a beautiful and healthy lawn and garden outdoor space. Over the last 20 years, we have reformulated our fertilizers, improved our application devices, some of our pesticide formulations and sometimes even walked away from certain active ingredients. We sometimes did this even when the scientific findings showed the products were safe for use and not harmful to the environment when used as directed. It was our direct relationship with the consumer and understanding of our role as an industry leader that drove those decisions. There is not a single one of those actions that I regret, even though some of them didn't fit well with others in our industry and didn't make good economic sense in the short term. But those kind of actions are exactly what's necessary to instill a deeper level of trust with all of our stakeholders, not just consumers and retailers, but NGO and government leaders as well. That approach to product stewardship is why we created a new formulation using our GroundClear brand last year. The product, which works fast and is listed for use around organic gardens, exceeded our sales expectations in 2019. We remain bullish on the opportunity around GroundClear again in 2020, which is why we're expanding the product offering and marketing support for this season. We're also entering year two with Performance Organics, and the storyline here is very similar. This new technology, groundbreaking technology, gave consumers expanded choice when it was successfully launched last year. We see more opportunities for performance organics in 2020 as we continue to see this as one of the most important new products we've ever introduced. With these products, as well as much of the rest of the portfolio, we will continue to rapidly evolve our approach to marketing. Our investment in television advertising continues to decline and the percentage of dollars being spent on digital outreach continues to increase. But it's how we're evolving our digital efforts that matter the most. I expect us to have literally thousands of pieces of creative this spring to better leverage weather, retail promotions, even quirky news events to more narrowly target the right consumers at the right time. We made big strides in this area in 2019, mostly in support of GroundClear. This year, the effort will be more widespread. You'll likely see us ramp up the visibility of our company too. Scott's Miracle-Gro is an organization driven by a set of values that we believe is shared by our consumers. We know our story goes beyond just our brands, and it's time we share that story with a wider audience. I can go on all morning about our plans for the year, but what will matter the most is our execution. Assuming unforeseen issues and extended weathers doesn't get in the way, I feel extremely confident in the plans we have in place, not just for 2020, but in the years to follow.

But it's not just the plans that matter, but the people driving them.

And I just want to take a moment to acknowledge that the work Mike Lukemeyer and Chris Hagedorn have done, not just in delivering near-term results in the US consumer segment in Hawthorne, but for positioning both businesses for long-term success. It's not just the operating staff that are driving our results. It's the corporate team as well. Randy's done an outstanding job driving our capital strategy, but he is more than just my finance partner. He's done a tremendous job navigating our relationship with Monsanto, as well as directing our strategic planning efforts, which have taken a big leap forward under his leadership. Denise Stump, who leads Global Human Resources, has been leading a major effort focused on identifying and preparing future leaders of this company. All of you typically hear just from those of us on the call today, but let me assure you, we have tremendous bench of young and diverse future leaders. Ivan Smith, our general counsel, has also been critical to positioning us for future success. He, too, has played an important role in reshaping our buyer relationship and helping us maintain our freedom to operate. He has been critical in helping us navigate a path forward for Hawthorne given the complications of state and federal law. All of us here rely on his counsel. And Jim King, who most of you know because of his role overseeing investor relations, has been a critical voice in making our corporate reputation a strategic imperative. He's also led our efforts to establish a leadership voice on legislative issues in Washington and in state capitals around the country that will affect our business for years to come. It's important that our shareholders understand just how strong this group is. The focus is almost always on the CEO. I get that. However, this leadership team is the strongest I've had around me in my 20 years on the job. They are raising their game year after year, and they're the ones driving this business, and I'm grateful for their efforts. You should be, too. They've put us in a great position as we enter the most critical months of the year, and I'm bullish on our ability to deliver a great result in fiscal 2020 and maintain our momentum to drive enhanced shareholder value. For now, let me turn the call over to Randy to discuss the numbers.

Thank you, Jim, and good morning, everyone. It's a straightforward quarter in terms of covering the numbers, so my comments this morning will be brief. Clearly, it was a good quarter, but I want to reiterate Jim's comments that Q1 results should be viewed in the proper context. Most of the U.S. consumer purchase activity in the quarter occurs in October and is really a reflection of how we completed last season. And the statements in our U.S. consumer business reflect a very small portion of the year, usually 5 or 6%, so it's difficult to extrapolate anything for the balance of the year. But as I said, it was a good quarter. Company-wide sales increased 23% to $356 million. As Jim said, that number was driven by a 41% increase at Hawthorne, which reported sales of $199 million. As you know, these results are often easy comp given the decline to 2018. However, Hawthorne sales on a rolling 12-month basis are essentially back to where we were in 2017, And that leaves us encouraged by the momentum we're seeing in this business. Based on the current run rate, we believe hotline sales will likely increase approximately 20% in Q2. In the second half, we expect the growth rate to slow considerably as we're stopping 49% growth in Q3 and 38% growth in Q4. However, there's no reason at this time to believe that the business will significantly decelerate in the second half. so I'm reinforcing Jim's comments about the conservative nature of our full-year guidance for Outlook. There's really no additional color to add right now, but I think it's fair to expect a more robust conversation on this topic when we announce our Q2 results. Moving on to U.S. consumer, sales increased 8% to $147 million. Remember, Q1 results included last year's pricing model, which drove about half of the growth in the quarter. The balance was due to a combination of new product launches, and higher retail inventory levels, which are the same storylines that were prevalent throughout last year. As we look ahead into the upcoming season, we believe retail inventory levels have stabilized and are in a good place. So, the growth we expect in 2020 will be from a combination of new pricing, which will be about 75 basis points, as well as the new listing support and continued modest increases in consumer engagement. Let's move down to P&L. where the adjusted non-GAAP gross margin rate improved 250 basis points to 14.9%. Again, the main factor here was the rollover effect of 2019 price increases, further complemented by better fixed cost leverage in the quarter. Commodities are turning favorable to our plans, but we still see the aggregate impact of commodities to be a headwind. Remember, we are somewhat insulated from market movements within the fiscal year due to our hedging programs. As of today, about 75% of our commodity costs are locked in for the year. Also, many of you have been asking about the impact on tariffs after the signing of the recent trade deal with China. Yes, there is a slight benefit for us, but not really enough to move the numbers, so the net effect of tariffs remains a headwind too. The one area within gross margin that may continue to improve is distribution, but we need more time for better visibility. There's really not much to talk about regarding SG&A, which is up 3% to just under $120 million. We've been very disciplined in managing our expenses here for quite a while. I believe you'll see that again throughout fiscal 2020, although we will be investing in media, marketing, selling, and R&D in both of our major business segments. Our gap operating loss in the quarter improved 26% from last year to $62.6 million. The biggest driver was the $13.9 million Figma Profit Hotline, which is more than triple the 4.4 million from a year ago. The operating margin for Hoffman was 7% compared with just 3% last year. Jim mentioned earlier that we remain committed to a full-year operating margin of at least 10% in 2020, and we remain on pace to deliver against that goal. Moving below the operating line, interest expense of 20 million was 5.2 million lower than a year ago and slightly better than we originally expected. GAAP net loss from continuing operations was $71.3 million or $1.28 per share compared with $82.6 million or $1.49 per share last year. On an adjusted non-GAAP basis, which is what we used for our guidance, the loss in the quarter was $62.4 million or $1.12 per share compared with $77 million or $1.39 per share a year earlier. The results in the quarter were slightly ahead of our internal plans And I know they were also better than what was expected by those of you who published publicly available models. I'd rather be ahead of the game than behind after the first quarter. I'll come full circle for my opening remarks. We have a long way to go. More than 90% of consumer POS is still ahead of us in the U.S. consumer business. And we're still waiting to see how much momentum we're carrying in the second half of the year with Alphorn. I'm not trying to tamp down expectations either. I feel very good about our prospects this year. and I believe everyone sitting around me today shares that optimism. I'm simply saying that it's too early in the season to get carried away and we'll have much better visibility in 90 days. There's one more item that I want to discuss before I close, and that is to elaborate on a point Jim made at the opening of his remarks. Earlier this month, we received our $112 million payment from Bayer for the sale of our Roundup brand extension. That money was immediately applied to our debt. Even before considering this payment, we achieved our target leverage of 3.5 times on a rolling 12-month basis at the end of Q1, much earlier than we expected several months ago. As a result of our improved leverage position, we have filed a 10D51 and have been repurchasing shares in the second quarter. We still have almost $300 million available on our existing share repurchase authorization, and we expect to discuss whether the Board's potential for a new authorization later this week. Consistent with our historic approach, If something materializes in the M&A pipeline that meets our strategic and financial requirements and that we determine to be a better use of cash, then we may slow down or pause our repurchases and instead invest in those opportunities. Jim and I agree that three and a half times leverage is a good place for us to be. While we're willing to edge above that level for a short period of time, our preference is to be at or below that level going forward. Based on what I know today, I'm confident we'll be able to maintain a balance of investing both profitable growth and returning cash to shareholders for the foreseeable future. So with that, let's open the call up for your questions, and I'll turn things back to the operator. Thank you.

Thank you. If you would like to ask a question, please signal by pressing star 1 on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press star 1 to ask a question. We will take our first question from Chris Carey of Bank of America. Chris, your line is open. Please go ahead.

Hi. Good morning.

Just a quick question. Jim, you noted that trends had remained strong into the opening weeks of 2020. And I wonder if you could just separate those comments the U.S.

consumer segment and perhaps what you're seeing in Hawthorne on a year-to-date basis? Well, the Hawthorne numbers are pretty amazing.

So I think we're super happy with that. If you say, you know, this U.S. hydro space, I think plus 60-something. So, you know, I think when I look at it, if you look at the sort of the period, whether it's monthly or quarterly. You know, I think we were, back in 18, we were all modestly suicidal, largely based on what happened politically, I think, and regulatory point of view from California. But the trend of positiveness that really started, you know, over a year ago, I think continues to accelerate. And that's I think what feels really good about it. At the same time, what I like about Hawthorne is they got SAP done and, you know, with a much more complicated one than we did here when we did one-face to the customer. They are continuing to get their technical sales force in. And while I stayed home and sort of ran the show from Ohio while they all went out to the big show in Vegas, My understanding from that was that the industry is starting to look at us not as like newcomer, big company, you know, Monsanto. They're starting to look at us as a real partner in the space who, you know, have been there working to make the space better for like five years. So I think the trends just continue to be good and in a way that is – I think makes us all feel good about this. And then if you say, what's happening on the voter initiative side is like at least a half a dozen states that are going to have voter initiatives. And that's still at least half a dozen. So, and some of those are big ones, you know, where, you know, we've been talking about Jersey and New York and Connecticut for quite a while. Let's hope that They all get across the – I mean, the polling data looks good. So I feel really good about that. The consumer business, we don't have a ton of detail. The Southwest is kind of an important market, you know, to begin, you know, largely herbicide market. And that business is booming. And that was against a very challenging – good result last year at the same time where the weather comes together. And so, you know, I'm going to say very positive, small market, but big indicator of sort of how people are feeling about the brands, you know, I'm going to say active ingredients. So I feel pretty good about that. And then largely, on the consumer side, it's kind of the promise of the year. And I don't know, I don't want this to sound like a bunch of bullshit, but Mike and I have sort of started saying, kind of, this is our time. Our retail relationships are like really good friends. It's like that. And they trust us. They appreciate what we do. We understand what they do. I think this battle of the internet and, you know, direct sales and, you know, home centers and hardware and the clubs and farm and fleet really sort of trying to hold their space. They need partners like us and I think they appreciate us when we are on their side too. And so, we have just great programs right now where you know, at this point, we just have to wait for the weather to happen and our marketing programs. You know, in addition, we're, you know, a lot of people talk about digital and, you know, I have to admit, I sort of couldn't stand sort of this whole discussion of this movement toward digital marketing, reduction in our spend on sort of cable and broadcast. But we've really changed how we do that. You know, we're working with this guy, Gary Vaynerchuk and his company VaynerMedia on basically very precision marketing, you know, on YouTube and Facebook and Instagram and all this stuff. And I actually feel really good about it for the first time. It worked for us last year. We did it in a very focused way on this ground-clear launch, and it really worked for us. So, you know, it's a long – I'm sorry I went so long on this, but the bottom line is the trend data on Hawthorne just keeps getting better and better. And, you know, I think we're just trying to say it's got to probably slow down. But right now it feels pretty good, and everything is kind of coming together. And I think the same is true on the consumer side. Everything is kind of coming together so that – it's hard to imagine it being much better than it is right now. And so the weather could screw us up, I think. Politicians could probably screw this up. But I think right now, we're just, all we need is the weather to start cranking and starting to see POS. And where we are seeing it, the Southwest, the numbers look really encouraging. So I don't know if that answers the question, but it's,

Chris, this is Randy. Let me jump in with a few numbers to be specific about. So on January, like Jim said, you know, continued momentum for Hawthorne that we saw over November, December to January. We expect to see it in February as well. But March last year is where the comps or where the business really took off last year where the comps started to become challenging. So I think that will be, you know, key month for us for Hawthorne. When we look at the U.S. consumer business, our POS was up 3% through December. We sit here today and it's up about five. So good momentum. But again, I want to take a lot away from that. January is one of our smallest months. And to remind everybody, April, May, June are our biggest months, followed by March. So a lot of POS ahead of ourselves. And on retail inventory, it continues to be really strong through the quarter. It's a little bit lower now at the end of January, like you'd expect, because our major retailers are closing out their year. But As we look at February and the orders in the book right now to de-ship, things look really positive. So I think it's all good.

Thank you both. That was very comprehensive. And then just a one quick follow-up on the Hawthorne margins.

I understand that you took some pricing in the business in early January.

Would you expect that to start flowing through? in this fiscal Q2 and just how you see the cadence rolling out over the next few quarters.

That's it to me. For the quarter, Chris Hawthorne, our promotions and our aggressive plan very much carried forward from last year. So we did not reduce anything in the first quarter. We are taking a little bit of pricing here starting in Q2. We don't expect that to have any kind of a dampening effect on Q2. on our top line. And you look at our bottom line, you know, we grew, you know, 400 basis points in Q1. We expect to grow, you know, our guidance is just a couple hundred for the full year versus last year. But I'd say the watch outs are perhaps on a mixed basis. That's true, whether you're talking about a consumer business or Hawthorne, but pricing should be a positive. There's a lot of synergies that we feel confident delivering at least 10 million for Hawthorne. And, you know, the pricing for our U.S. business as well will more than offset the commodity impacts and some of the tariffs that we're seeing. So I'd say I'm slightly more confident in our margin rate than I would have been three months ago, but, you know, there's still a long way ahead of us.

Okay. Thank you both.

We will now take our next question from John Anderson of William Blair. Please go ahead. Your line is open.

Hey, good morning, everybody.

I wanted to ask, and maybe Jim, you talked quite a bit in the prepared comments about corporate values and how the organization is perceived by customers and consumers and regulators, et cetera, and then also kind of talked about it in the context of some of your new product launches, but specifically Ortho. ground clear. You know, how should we be thinking about the commitment to round up any decisions that may need to be made around, you know, round up and, yeah, what you're thinking about that, you know, at this point in time? I'll put it as a good question. You know, I have a A note from the lawyers. Here's what I would say.

What do I think? I think that Bayer is at a real sensitive point right now.

And I know mostly this by reading the paper, but we're very tight with them in communicating. I think the theme of what you're saying is does this matter and will this pull through to the roundtable? I think the answer is yes, but the bottom line is that I'm electing not to spend a lot of time talking about Roundup. We didn't talk about it really in the script at all, except thematically in this view of how we view stewardship in our relationship with our consumers. It's really important. I think Bayer shares that view. I do. But I think that I don't, you know, the choices of what happens on a go-forward basis with that business is theirs. We've given them our point of view, which is private. I think there'll be a lot more to talk about probably next quarter or the quarter after. But I'm really trying to be respectful of the fact that I think this is not a lot of time where, you know, my view is weird noise comes out of Marysville, Ohio, when they're trying to do something important. But I think the answer is yes, okay? Okay. No, that's fair. I really appreciate it. Understandable. The sensitivity. As a follow-up on Hawthorne, can you talk, has there been any, have you seen any impact or how are you thinking about any potential impact, some of the noise around, you know, one of the methods of, you know, consuming cannabis, vaping? And then if I could tag on something in addition to that. What's your updated thought on the long-term margins for Hawthorne? I understand 10% is where we're headed this year. But, you know, if you look out two or three years, what do you think a sustainable margin rate is for that business? Thanks. All right. Randy, when I'm done, will deal with sort of margin issues. You know, we put a lot of effort into this issue, largely because we see vaping and any sort of disease issues that are called injury issues as a result of that, it's kind of an overhang. You know, it is a very popular way of people consuming, whether it's CBD or THC. So we put quite a bit of our science staff, I think there's probably no one in this industry who has a bigger sort of PhD group than we do, including toxicologists. We've also gone to our outside proxetologists. So, you know, I have to admit, so our view is that this, I think it's vitamin E acetate, is the issue. There's science that I think will be published soon. I'm surprised, and I've got to say disappointed, This has not been widely published. We've been trying to communicate with governments, including the feds, on we think that there's science out there that shows it for sure is vitamin E acetate, and that if you burn vitamin E acetate, you create a gas called ketene, and ketene is an extremely toxic gas that is a near- warfare, like gas from back in the day, like World War One kind of gas. And so, you know, I think it's, you know, when you talk to government people, maybe they think Scott's is like some little company and can't figure stuff out. But the, you know, in our discussions with the federal government about it saying, we think we figured it out. And with some scientists not quite published yet with our professional team of scientists and outside scientists. I think we know what's happening here, but, you know, I think the bottom line is this vitamin E acetate is a diluent that is extremely dangerous. especially if temperature control in a vape pen is not correct. And I think this is mostly black market product. This is not regulated product. So for all the people who are saying this is dangerous and shouldn't be out there, this is generally not regulated product. And, you know, so... It's weird that this call is kind of becoming the call where it's Keating and hopefully somebody who actually gives a shit is listening because it is vitamin E acetate. We think we figured it out. Well, it's basically by discovering science out of Ireland that is, I think, in sort of pre-publishing stage and, you know, scientific review. But I think it's correct. What does it mean? Don't use that product. The regulated market, I think, is a safer market. Chris, I think, wants to say something. Yeah, I'm chomping a bit here. Hey, guys, Chris Hagenhorn. So what I'd say is we feel pretty confident that we've, along with a lot of other people, worked really hard on this because it's important to have gotten to the bottom of what is the cause of most of these injuries. The important thing as it relates to our business, and I'd say the sort of legal cannabis industry as ingredient. As Jim said, it's a cutting agent that's added into this product to stretch out their supply of actual cannabis extract. So I'd say as far as consumers go, this is not something that they should be afraid of in the regulated market. As far as investors go, this is not a sort of systemic component in vaping. It's an additive that can be easily avoided. So I think this, to me, the big thing here is this is a call for regulation. This is something that the government needs to look at. This is something we can save people's lives by engaging with this industry and regulating it properly. I mean, in the Fed, it's not like they don't care, but, you know, in my discussions with them, and, you know, I was on the CDC board for quite a while, their CDC foundation board. I think they just want to get it right, and they have to do a lot of research that they're sensitivity to being long is a lot higher than mine is. I don't think we're wrong. But I think that we led into this thing, can we try to help figure this out? It's an overhang to our equity, we think. You know, you hear noise about vaping injury, and I think we see it in our equity pricing. So therefore, I think we got a dog in the fight, and we have scientists, and we're, I think, the market leader, at least in the supply side. And so could we at least participate in trying to figure it out? And I think what's the surprising part is I think we did figure it out. That hasn't been published yet, but I think, you know, Our thesis and other people who've been involved directly in the science side probably gets published soon, I think. But, you know, so vitamin E acetate, I think I agree with what Chris said. And I think what this shows is that like we're a leader on the consumer list of garden states, I think we take pretty seriously leadership on the cannabis side of the market, especially when you're dealing with consumer safety issues. And I feel really good that we were at least, I think, involved in trying to figure out what happened here. And I think we're right. It's ketene gas that's a byproduct of burning vitamin E acetate. And the question on other products, including tobacco, is are there any other acetates? Because I think it's the acetates burning that can create this ketene. So there's a lot of work that has to happen with ketones. other products that get vaped to see if there's an effect there as well. But I feel really good about actually our participation in this space. So sorry about that.

Hey, John, picking up on the second part of your question about margin rates, you know, last year we were at 8% operating margin rate for Hawthorne. This year we've got it to at least 10%. And our outlook is that we should be in the mid-teens in 2022. And a lot of drivers behind that. So I mean, we've talked about synergies, and integration of popcorn in the Scots and a lot of the benefits from that volume benefits are obvious as well. We have a lot of innovation that will come down the road as we develop our R&D function, more so in Canada, so that will help our mix. And then there's a lot of opportunity with pricing and trade programs as well to help create a more rational environment and show some leadership there. We can continue to take market share, grow our top line aggressively, and we'll expect to do that, but I think we can take our profitability up as well. So I think we can have our cake and eat it too, and that's what I expect.

Great. Thanks for all the colored insight. Very helpful.

We will take our next question. from William Reuter of Bank of America. Please go ahead. Your line is open. Hey, Bill.

Hey, guys. How's it going? It's Mike. I'm actually for Bill. Just a quick one here. On the last call, you guys noticed that you now have an active pipeline for M&A, despite always looking. Has this changed? And how should we think about, you know, your commitment to that leverage target you talked about in future M&A opportunities? Thanks.

I'll start and hand it to Randy. This is one where, I don't know, in some ways, the most important part of my job is sort of allocation of capital and resources to the businesses. We have a board meeting really starts today. It'll run through Friday. And so we're going to have this conversation. So I don't really want to get way ahead. of the board. But one of the things that Randy and I are trying to do is we look at kind of when we first started this concept of kind of project excellence, I think is what we call it, you know, which is basically, who do we want to be? But before we got sort of heavily into sort of deciding one of the purchase rate in hydro, it was kind of sell non core, buy back a bunch of shares. And It hasn't worked exactly that way. We have a lot of our shares out, but we also spend over a billion dollars on the Hawthorne acquisitions. And if you look at the returns, you know, I think actually it's been great for shareholders. And so as Randy and I are looking to the future, which is, you know, sort of beyond what this long-term incentive plan we have, it's called Big Bet, as we look beyond that, we're trying to say what's the proper balance of continuing to sort of steward the business and a very deep commitment to what we call shareholder friendly here. And I don't know that we have an answer yet on that. I think it would be fair to say we're absolutely committed to our leverage targets. And that may be the answer you're looking for or not. And we don't have a massive pipe of acquisition targets at the moment. But we are trying to balance the sort of health of the business on a go-forward basis with the sort of idea of shareholder-friendly, which, you know, is if we don't need the money, we send it home. I don't know, Randy, how you'd pick that up.

Sure. When we look at our numbers internally, sometimes we just beat the heck out of ourselves because we've tracked behind business cases in the past depending on the deal. When you look at everything holistically, we've created value through M&A over the last five years. We feel good about that. Being an industry leader, companies come to us with technology ideas or acquisition ideas. We're the natural place for for companies to start if they want to, you know, enter Bonengard and commercialize their ideas. So pipeline, you know, is always robust. But unless something really has the right strategic fit and either fits in our capabilities or adds to our capabilities and the price is right, you know, we're very happy generating a lot of cash and executing well and returning cash to shareholders. But you have to keep that in balance and, you know, we'll see. But, you know, right now there's nothing active in the pipeline that I would say is something that we're planning to do.

I would just add that... Never say never. You know, our January board meeting has a very much of a strategic and so, you know, I don't know if you all care, but, you know, we tend to have a telephonic board meeting that go through committee reports and all that, you know, sort of the standard, you know, I'm not going to say BS, but You know, a lot of the meat and potatoes that a board has to do, we deal with the telephonic. In this case, it was on Monday. When we get together Thursday and Friday, we are only talking about the business. And because the January meeting has very much a strategic element that leads to the next big strategic meeting for us, which is August 11th, we're going to be sort of highlighting this issue of, you know, stewardship of the business and what's the right balance to keep the business healthy and the commitment, you know, on capital structure that we have made promises to guys like you on. And so we're just in the middle of that discussion. I wouldn't expect anything, any big change out of that. But I think that we're sort of – I think in some weird way the most important thing that kind of Randy and I do is sort of try to sort of make sure that the business has the money it needs to run but be committed to this idea of shareholder friendly.

Great. Thanks so much and good luck in the upcoming months.

Thanks. We will take our next question. from Bill Chappelle of SunTrust, Robinson and Humphrey. Please go ahead.

Thanks. Good morning. A couple questions for Randy to start. Just on two metrics kind of tying into the last call, three and a half times target for leverage. That was pulled up maybe three, four years ago from three just with the thought that there were going to be acquisitions and more aggressive share repurchase. Now it seems like, as you said, most of the acquisitions are done, and the share repurchase is going to be, I assume, fairly normalized pace. Do you think about bringing that back down to three times, or on the share repurchase front, is it going to be back to a more aggressive over the next year or two? Well, Bill, you're right. We formally said three times, but we've been saying also we were trying to get our leverage up to three and a half times, and We divested our international business. That brought our leverage down. Then we divested our long-service business to TrueGreen, and that brought our leverage down. So we're really where we have been targeting for quite a few years, and we're comfortable given the interest rate environment and the flexibility we have with our credit agreement that three and a half times is a comfortable place to be.

And then, Bill, just the only thing I would add to that is, again, We are sort of walking out of here into a board meeting. We've got a couple committees that still meet today and then four more tomorrow and Friday. So this is a question that – so I think we're very comfortable three and a half times. Then it's a matter of taking a look at our cash flows and saying how – I mean, if we don't do something, the leverage is going to decline. So if we're happy at three and a half, it puts questions to the board that in due course we'll be able to fill you guys in on.

And on the cash flow point that Jim made, we've delivered about $300 million of free cash flow three years in a row. I expect to do the same this year. So if you go back and look over the six, eight, ten years before that, it was very much seesaw up and down and And I'm proud of the progress we've made in being a very consistent cash flow deliverer and gives us more confidence about our leverage as well. I know. I appreciate the color. And on that theme, just my nitpicky, but I feel like in years past you were a little more hedged on commodities, more than 75% by this time in the season. Is that by design or am I just got that wrong? I don't want to tell you you're wrong, Bill, but – We're about where we've always been. So there's no real big change, you know, whether you look at urea or resin or fuel. We're on that, you know, 70, 75, even a little bit higher.

I'm saying, you know, if there was a year we could have been less hedged, then we would have made more money. Come on, Jim. We're doing some predictability.

We saw pricing. It's all consistent.

That's what he told me a couple days ago when I said, dude, we're like mark to mark in these hedges negative, you know.

Last question for me. Last question for me. So this time last year was when we started to really see the retailers step up their inventory levels probably higher than than we expected, and maybe you expected, and they maintained that throughout all of 2019. Are you seeing any real changes? Is there a further step up? Are they comfortable at these levels? And in particular, Walmart, you know, it seems like there's an improved in-stock inventory level going into the season. Is that fair? That's fair. I would say they're stepping up.

Some are even leaning into different markets. Everybody wants to be early. They don't want to miss anything. With the good weather in January, that actually has accelerated a little bit.

Got it. Thanks so much.

We will now take our next question from Carla Casella of J.P. Morgan. Please go ahead. Your line is open.

Hi. I'm Hawthorne. Impressive growth this quarter. Can you give us a sense for when you look at that market, the mature markets, are they stabilizing out at a more mature growth rate yet? Are they still above trend? And then are the newer markets that you mentioned, emerging markets, following the same growth trajectory that you saw with Colorado and California?

Hey, Carla. It's Chris Aguilar. So what we're seeing in places like Colorado and California is still pretty significant growth. You know, California is still getting back, I think, just now, kind of getting back to where it was before the kind of 2018 downturn that was caused by the 2016 election. So we're still seeing, I'd say, higher than kind of maturity-level growth rates there, the same is true in Colorado. In newer states, and, you know, there we're looking at, Florida, Michigan, Oklahoma, we're seeing, you know, triple-digit growth in those states, or quadruple-digit growth in the case of Oklahoma, which is, and, granted, that's off a small base, but the growth rates are pretty significant there. So we're seeing, you know, growth from really kind of a zero basis in those states, which we haven't seen in Colorado, and certainly California, which has had a strong hydroponics and cannabis market for over 20 years.

Does that answer your question?

Yeah, that's great.

Do you see it stabilizing? Yeah, I mean, as far as stabilizing the future, look, at some point, I think, you know, logic dictates the market will stabilize and reach a state of maturity for this industry. I think that's probably at least minimum five, more likely closer to ten years out, considering just the sort of speed of legalization. And, look, the 2020 election could change things, depending on how that shakes out, and that's anyone's guess. I think, you know, we've given guidance on these calls in the past that we expect a sort of stabilized growth rate for Hawthorne to be kind of high single digits. I think that's probably still a reasonable place to expect. But I think we've got some years before we reach that place. And until then, we'll be significantly higher.

Okay, great. And then on the margin front, you're kind of guiding to ultimately that business to be a mid-teen type margin. Are you seeing that yet in those mature markets or more mature markets like Colorado and California?

You know, we have a lot more visibility today, state by state, customers, product lines than we had before SAP. So we spent a lot of time looking through analytics, you know, the last few months. It's interesting when you look at state by state, though, you don't really see a lot of variation. So, you know, I expected we would, and we thought maybe there's opportunities from a distribution or supply chain point of view, but we really haven't seen a lot of variability. So I think now we've confirmed that we're running a business as well as we thought, and there's still opportunities, but there haven't been any huge ah-has on a state-by-state level.

Look, I think one of the ah-has is we liberated the sales force and the management team to get the job done, to take market share, to be extremely competitive in out there. And I think what we recognize is that as our position becomes more entrenched, that we don't have to promote as heavily as we have, plus there's a lot of ability to synergize this business. I think it's just the more and more we go forward, the more comfortable it's obvious that the hop on management team is relying on some of the stuff here that allows them to focus on driving the business and coming up with new products and lots of good things happening. But I think we, you know, when we talk margin, we do have to remember of where we've been, which is just banging this market like hell. And that unwinding that slowly over time, you know, it's hard on the sales force. You know, people get used to operating that. And we also don't want to, like, you know, lose gains we've made from a market share point of view, which I think have been pretty substantial. So we're trying to sort of become less addicted to promotional. And I think that's part of the reason you're seeing sort of across the country is we didn't really – say you can fight hard here, but don't fight hard here. I think we've been just, we, I don't know. We sort of said, go out and kill people. I mean that, you know, like in a military sense and they've been out doing their job. And now we're saying, Hey, like you don't have to use that many bullets. Can you like, you know, do the job with a little more precision. And that's kind of where we are right now. So I, I just, I just think when you look at margin, you have to understand the journey we've been on from like suicidal, you know, a lot of competition to a much more rational, I think, market position, which allows us to then say, okay, let's start promoting, but be precise about it. Do it for a reason. and sort of back out of that. And I think there's a lot of opportunity there in that regard. But it's, you know, if anybody on the call has ever run a sales business, you know, that's hard to do. It's hard to convince salespeople who are getting great results and they have a lot of promotional tools to say, can we back out of that a little bit? And, you know, we're just going to have to sort of let that happen in time, but it will happen in time. Crystal, if you want us to talk. Yeah, just one thing to add and agree with everything that Jim and Randy said. Just for a little more context, we've already talked about the insight that the SAP integration has given us into the business. You know, something that I personally hadn't fully appreciated how little visibility we really had into how all of these businesses operated at a pretty detailed level. Getting SAP online, it's been online since October 1st. we've really started to realize how complex our pricing was, how many different unique deals we had with different retailers and different vendors. So collapsing a lot of that complexity, getting a much more streamlined approach, it's allowing the sales guys to just want to be a lot more precise, move a lot more quickly, and just have a better visibility to what our margin is by product line and category and by retailer. And those are benefits that we're going to start to see a lot more of the balance of the year and then the years moving forward. So we feel pretty good about where we're at, but certainly getting some more sort of detail on how the business is actually operating down at the lower levels has been really important for us.

That's great. Thank you so much.

Now take our next question from Eric of Cleveland Research Company. Please go ahead.

On the Hawthorne profitability, the commitment or what you spoke to this morning is basically doubling that margin over the next three years. You ran through a bit of a list of things you're doing to improve profitability. What was the margin improvement of that degree? What are the one or at max two things that you have the most conviction in? that allow you to make that magnitude of improvement.

So in the short term, Eric, the most immediate things are integration with supply chain, you know, popcorn into Scotts, whether it's on my DCs or manufacturing and so on. So we delivered a lot of synergies last year. We'll be at least $10 million more this year. And then volume benefits is the volume bounces back. We'll get absorption from that. We're seeing, um, that we expect more. So those are the two most immediate. A little bit farther out would be what Chris was just talking about as far as pricing programs that are a little bit easier for us and probably a lot easier for our customers. And then innovative new products and improved mix we'll get from that. So we'll see some of that this year, but to me that's more of a 2021 and beyond type of benefit.

I guess the

to ask the question better, when it is 15% versus the 7% or 8%, I understand there's $10 million of integration, but this is a lot of money that you're talking about improving margin. Is pricing the biggest thing that is different that gets you from here to there?

I'd say going forward, pricing, trade programs, just how we go to business.

I think it's more broad than just picking invoice sales prices up. It's how we develop programs. you know, make things more coherent for, you know, both sides, both for us and for our retailers. And I think potentially there's a lot of confusion out there that I think we can simplify. We play a leadership role and just make it a lot easier. And I think as we do that, it will help our service rates as well. We become a much better supplier and it just becomes, you know, a virtuous circle and we become an even more obvious leader in the industry. So, There's a lot that goes along with that, but I think pricing and trade programs is definitely a big piece of that. But I also want to discount, you know, innovation as we roll out new products with higher margins, and mix will help as well. So, I don't know. I think it's all good as we look forward.

And then just a follow-up for Chris. You commented greater visibility with SAP, especially around pricing. In the last three or four months, how much – of what makes sense to do are you having your sales guys implement in terms of pricing and trade programs? In other words, how much of the higher price, less promotion have you done relative to what you want to do, and what have you observed in terms of the customer response and market share impact of making those changes?

Yeah, I'd say we're still pretty early on in actually applying in the marketplace kind of what we've learned and what we believe is possible. You know, we did take pricing, as Chris Carey mentioned at the beginning of the Q&A, we did take pricing at the beginning of this calendar year, at the beginning of the month. And, you know, a week after we took pricing, we set a record for our highest order day ever. So I think the market has been receptive to the pricing changes. You know, this rising tide that we're experiencing is It's also rising up, you know, bringing up our customers, the retailers and the growers. So I think everybody has a tolerance for where this is going and the moves that we've made there. That being said, going back to my earlier point, I think we're pretty early on in our journey of applying the learnings and how we plan to take action on that. So I'd expect to see continued sort of upward pressure as we move forward from the pricing and some of the other programs.

Thank you. John, if I can jump in here for a second.

We're running up against the clock a little bit, so in the interest of time, let's just have one more question, and then I'll follow up with others offline right now.

We can take our next question from Alex Morosia from Barenburg. Please go ahead.

Good morning, guys. Thanks for taking my question. You noted earlier on the call that some of these larger cannabis players are starting to believe in the Hawthorne products and start to take you guys seriously. Can you just talk a bit about what your market share is looking like right now and what the opportunity is there versus competitors?

Yeah, you know, it's an interesting question and a little bit of a challenging one just because we see old competitors fall off and new competitors enter. We talked last time about how some of our kind of historical adversaries of the hydro distribution side have gone away. We're starting to see some new entrants from the sort of more traditional ag and horticulture side. We feel pretty confident in our market share. If you look at it blended across all of our categories, it's well over 50%. We think our offering, both from a product perspective and a service perspective, is unmatched. I mean, that's something I'm extremely confident in saying. So, you know, we continue to modify our approach as we deal with competitors who are approaching the marketplace and our customers in different ways. So, you know, the specialty ad guys are going to come at it with a – I think sort of their attack on us will be from a pricing perspective. We're going to counter that with service. And we'll continue to be as agile as we need to be to work against new competition and the ways, however they attack us. So again, I feel pretty confident. It's hard for us to really pin accurate market share the way we're used to in a core business in Hawthorne, just because it's just such a volatile emerging industry. But again, can you just sort of talk about, because you and I have talked about it, Chris, which is, How did you feel the industry looked at you guys this year in Vegas? Yeah, look, you know, this is something we've always, I think, ever since we entered, been accused of kind of being carpetbaggers and, you know, we bought our way into the space. We don't have any historical legitimacy here. And, look, I have always rejected that idea because we're a company that's been helping people grow plants for over 150 years. I don't think there's anyone who's got more of a reason to be in this space than we do. That being said, the industry saw it differently. They saw us as newcomers who didn't have any authority or legitimacy. Now we've been doing it for five years, longer than five years, since our acquisition of GH. I think the industry started to turn a bit. And I think to see us as we've, to an extent, we've paid our dues. And look, we've got customers and growers who have paid their dues in a way that we never will. Guys who were pushing this industry ahead when it was fully illegal in every state and dealt with all of the risks that came along with that. And we're never going to have that degree of authenticity. But we've been here. We've been committed. We put a lot of money into this industry, more than anyone else. And you're starting to see the benefits of that. And Jim said when we were out at the MJBiz convention in Las Vegas, which is the biggest industry trade show that there is, What we're starting to see is a lot more of these customers who have been critics of ours, who come to the booth, start to give us a little bit more credit for remaining committed. You know, we fought through, along with the rest of the industry, a really hard time over the past 18 months. And everyone's starting to come out the other side and feel a lot better about it. And I think our continued commitment throughout that period gave us – I think it earned us a lot of credit with growers and with retailers. So I think we've kind of turned the corner on being the new guy. And at this point, you know, look, the challenge is still there. We've got to keep on proving that we belong here, that we can be a contributor to the space and not a detractor of it. And that is the commitment I've got. That's the commitment my management team here has. We have the support of the SMG management team and the board, and I believe our investor base. So we've got a lot of plans over the next couple of years to bring new products into space, to bring new services. I think that will all help strengthen our position. both just in the marketplace and in the eyes of our customers.

But that's been a big change over the past, I'd say, two years, kind of 18 months. Awesome. That's super helpful. Thanks for the comprehensive answer. It's all from me.

Got it.

Thanks, Alan. Thanks, John, and everybody listening today. As I said, we're running up against the clock here a little bit, so I know there are a few people who are still in the queue. I've got your contact information, and I'll be reaching out to you proactively later in the day. For those of you who want to follow up further with me, again, you can call me directly at 937-578-5622. And just as a reminder, March 2nd and 3rd, Randy and I will be at the Ray J Conference in Orlando. That will be a webcast event. So you can get an update then if you'd like. Thanks for listening in today and have a great day.

This concludes today's call. Thank you for your participation. You may now disconnect.