Scotts Miracle-Gro Company (The)

Good day, and welcome to the Scott's Miracle-Gro Company's Third Quarter Earnings Conference Call. As a reminder, today's call is being recorded. At this time, I would like to turn the conference over to Kelly Berry, Vice President of Investor Relations. Please go ahead.

Good morning, everyone. I'm Kelly Berry, and I'd like to welcome you to the Scott's Miracle-Gro Third Quarter Earnings Conference Call. I've stepped in to lead investor relations after a long career in finance at the company. I'm proud to succeed Jim King, Executive Vice President and Chief Communications Officer, who has retired from Scott's Miracle-Gro after a 21-year career at the company. Jim has agreed to stay around over the next few months to help transition as needed. I've had the pleasure of meeting many of you already, and I look forward to meeting all of you over the coming months. Today's remarks from Jim and Corey have been pre-recorded. Once we conclude the prepared remarks, we'll open the call to live Q&A. After the Q&A, an archived version of the call will be published on our website. Joining me for the Q&A this morning is Chairman and CEO Jim Hagedorn, Chief Financial Officer Corey Miller, as well as our President and Chief Operating Officer Mike Lukemeyer, Chris Hagedorn Group President of Hawthorne, and several other members of the management team. Before we begin the remarks, I want to let everyone know that the management team will be attending the Barclays Global Consumer Staples Conference in early September. We'll publish more details related to the date and time of the event a couple weeks in advance. With that, let's move on to today's call. As always, we want to make you aware that we will be discussing forward-looking statements on the call today. I want to caution everyone 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 in our Form 10-K. I'll now turn the call over to Jim Hagedorn. Jim?

Thanks, Kelly, and good morning, everyone. There's a lot to cover on the call today, the current performance of both major business segments, the implications of that performance on our fiscal 22 results, and the steps we're taking to manage the higher-than-expected leverage we will carry into next year. I will say at the outset, we are not providing guidance today for fiscal 23. We plan to do that in November as we normally do. While some of the finer points of our operating plan for next year are still being finalized, there are some tailwinds and headwinds already coming into focus. So we'll share some of those details today where we can. In terms of my comments around our current performance, I'll spend more of my time on the U.S. consumer business. Obviously, it's the biggest driver of shareholder value. But I also believe it's easy to misread what's happened over the past few months, and I want to make sure you understand why we remain optimistic. Before I address these topics, I want to clear the air. I told you on previous calls that I was focused on our long-term strategy and would not manage on a quarter-to-quarter basis. I also said I try to ignore the stock price and market fluctuations. But there are times and circumstances that require an exception, and this is one of them. As you know, my family and I are the largest shareholders in this company. None of us are pleased with our current performance or the equity value. I understand the rest of our shareholders aren't either. You shouldn't be, especially those who supported the shares at much higher levels than we're seeing today. There were some challenges that emerged this year, several of them actually, that we could not have anticipated. In other cases, especially with Hawthorne, we misread the market, which drove investment decisions that I'd reverse if I could. But I can't. What I can do and will do is focus on the proactive steps we can take to get this business back to an acceptable level of profitability. So, to our more recent shareholders, or those still doing research, We appreciate your interest and share the belief of many of you that there is an opportunity for significant upside from today's levels. I'm not just the largest shareholder. I'm the CEO. So I'm accountable to all shareholders, and I accept that. Whether our results this year are due to factors beyond our control or missteps that we made, it doesn't matter. What matters, and what you'll hear from me today, are the steps we're taking to get back on track. There are three things I hope you take away from this call. First is confidence that we understand the challenges in front of us and are moving with urgency. And while we've been forced to make dozens of tough decisions in a compressed timeframe, including a headcount reduction of hundreds of people, we're also protecting our competitive advantages and securing the leadership pipeline we need for the future. Second is a belief in the underlying and undeniable strength of our U.S. consumer franchise. It is critical for shareholders to look beyond the financial performance of this business in the second half of the year. The fundamentals are still there, the consumers remain engaged, and the future remains bright. And third is an understanding of why we're confident we can restore the business to our historical margins generate significant cash flow, and recapture the financial flexibility we need to drive growth and enhance value. Much of the improvement is within our control, and we are working quickly to make it happen through an effort we are calling Project Springboard. The first phase has been largely reactive and is designed to adjust to our near-term reality. The next phase is about returning the business to a proper level of financial performance and ensuring we are well positioned to take advantage of the opportunities we believe still lie ahead. On this call 90 days ago, I could not have predicted that we would be where we are right now. We outlined the impact of lousy weather in April and said we would claw back some of the consumer engagement we lost in the early weeks of the season. We were mostly right in that assumption. In any other year, we would have seen replenishment orders keep up with the surge in consumer POS that occurred throughout May and June. But by late May, it became clear those orders were not coming. The single biggest change since May is the way retailers are managing their inventory. I'll elaborate on this point later in my remarks. That shift translates directly into lower sales of our U.S. consumer segment, negative fixed cost leverage in our P&L, and higher levels of our inventory than we expected. And that combination is driving our leverage beyond where we want it and is prompting us to focus on debt reduction as our primary use of cash over the next year. We are aggressively managing those issues in real time. And I'll return to this discussion again shortly. First, though, I want to update you on the performance of both business segments. I'll keep my comments at a high level and leave the details around the numbers to Corey. Despite the unexpected challenges in our U.S. consumer segment, I remain confident in the strength and stability of this business. Household penetration for our products this year is on par with 2020. That's the year 20 million new customers entered the category. More importantly, our total consumer base got younger again this year due to the continued influx of millennial and Gen Z consumers who are buying homes in entering the category. And finally, we kept a higher percentage of those youngest consumers this year than we did in either of the previous two years. The demographics of this business continue to get better. That gives us and our retail partners a great deal of enthusiasm as we look forward. While total POS units are down 8% year to date, that performance is in line with the guidance we provided going into the year. Given our aggressive pricing actions, we initially expected POS dollars to be flat on that volume. However, POS dollars are down 5%, but still in line with 2020 levels. The reason POS dollars are lower is twofold. First, retailers were more aggressive promoting low-ticket categories like mulch and soil. Meanwhile, units of higher-priced and lesser-promoted categories, specifically lawn fertilizer and grass seed, are down nearly 20 percent. I want to elaborate on those two categories because there's a lot to understand, and it's easy to misinterpret the data this year. Let's start with the fact that we included a volume decline in our initial guidance. If you normalize for that, POS units in these categories are still down about 12 percent more than expected. It is possible that some of that decline is related to elasticity, although that appears to be minimal. If elasticity was the primary issue, we would have expected to see a significant decline in market share. We didn't. We lost about two points of share, but the gap between our products and opening price point products was well above normal this year. Let me explain. You'll recall we implemented four price increases this year in our branded products. It doesn't work that way in private label. Prices are set once a year, and that contract holds all seasons. That price gap will normalize next year with higher price increases in private label. So while we currently believe the share decline is not a big issue, we're watching it closely. There are two major factors we believe drove the other 10 points of decline. The most impactful was weather, which impacts fertilizer and grass seed more than anything else we sell. In March and April, it was cold and rainy in nearly the entire eastern half of the country. including critical early season markets like Texas. And in the western United States, drought conditions also created a headwind. Weather created two challenges. First, it kept consumers out of the store in April, our most important month for fertilizer sales. Second, the wet and cool conditions meant lawns looked great in May. In our research, more consumers than normal told us they didn't see the need for fertilizer or grass seed this year. The other major issue was a lack of promotional activity. Instead of using highly visible promotions to drive traffic, as they've done in previous years, some key retailers adopted an everyday low price strategy in those two categories. Experience tells us that EDLP has not worked in the past, and it didn't work this year either. As we look ahead, we expect the return of early and well-timed promotion in these categories next year. fertilizer and grass seed are the earliest breaking products for us, and we need to be working with our retailers to get consumers off the couch and into the backyard. Right now, the scorching summer heat is having a negative impact on consumer lawns. That should benefit this category in the fall months, and we're hoping to get our first clean read on both fertilizer and grass seed in September and October. When you look at POS and you look at our sales to the retailer, there is clearly a greater gap than we planned. Some of you have suggested that that means retailers are less enthusiastic about this category. That is not the case. Planning for the 23 season is well underway and there is continued enthusiasm. Retailers know what we know. In times of macroeconomic distress, consumable lawn and garden products remain one of their strongest categories. So let me explain what is happening. If you walked into stores in late May and June, you would have seen an unusually high amount of seasonable, durable products like grills and outdoor furniture. Those categories just weren't selling. What was moving? Our stuff. POS of our products in May and June was the second highest on record. So it was easy for retailers to reduce their seasonal inventory by carrying less safety stock of our products and reduce their replenishment orders. Sitting here today, retail inventory of our products measured in units is down 12% from last year, and we expect it to drop a few more points further by the end of the year. The opportunity is that retail inventory will be significantly lower going into the spring. So based on our ongoing conversations with our retail partners, we expect a strong and predictable selling at the start of the season. We expect retailers to be more aggressive next year using consumable lawn and garden categories to drive foot traffic and therefore are more likely to be aggressive at the start of the season in early breaking products like lawn fertilizer. Moving on to Hawthorne, the story has not changed much. cannabis prices remain significantly lower due to excess inventory produced by cultivators. As the challenges continue, it is increasingly clear the role public policy has played in fueling the problem. Some states license far greater levels of cannabis production than their citizens could consume. The combination of loose regulation and limited enforcement has fueled the illicit market and created a hurdle the legal market is struggling to overcome. We believe we are seeing a reset in the industry right now with some cultivators simply walking away because of the tough business climate. While new East Coast markets continue to grow, it is not enough to offset the declines in the established ones. There are a few good things to take away as we plan for next year. We will begin to lapse some low numbers within a few months and we're hopeful to start posting modest growth in fiscal 23. We also remain confident our competitive position has remained strong. Even in the face of aggressive cost controls, we've stayed focused on maintaining our advantages in areas like innovation and technical sales. Others in the industry have not. The translation is that we remain committed to this industry and our vision. While it's been a tough year, we'll be there when the dust settles. So we'll continue hitting the pavement and staying in front of our retail customers, cultivators, and our vendors. And we will collaborate with them to meet their needs and ensure they are in the best position possible when the market does return. This will translate into everything from our sales programs to our R&D pipeline. Already, the market is evolving to one which large-scale, innovative growers are most likely to succeed. We've expected that from day one, and it plays to Hawthorne's strength. The most pressing task at hand, though, is restoring Hawthorne profitability. While industry performance has been obviously a headwind, some of our previous investment decisions have been as well. We clearly overbuilt the infrastructure of this business, and I'm not going to sugarcoat it. The difference in cost of what we have versus what we need is roughly $65 million a year. While we are moving aggressively to reduce Hawthorne's supply chain footprint, it won't happen overnight. The goal is to return Hawthorne to its previous margin structure within two years. Beyond that, we remain focused on achieving an operating margin of 15%. The final Hawthorne item I want to discuss relates to its future as a standalone business. Ideally, we would separate the business today for a variety of reasons. not the least of which is the impact of volatility the cannabis industry has on the equity value of SMG in total. But our analysis tells us that now is not the right time for this move. This is not the kind of market in which a full or partial IPO makes sense, and we're not going to sell the business when its earnings are at a multi-year low and we have a clear and achievable plan for improvement. We explored the notion of combining the business with someone else, but that means sharing the synergies with another investor base after paying bankers, consultants, lawyers, and others. In a best-case scenario, we end up as good, if not better, by controlling our own destiny and allowing 100% of the upside of our restructuring efforts to accrue to SMG shareholders. The best course of action is to fix the business and wait for the industry to recover. So, for now, that's the end of the discussion. I want to spend the rest of my time coming back to some of the themes I discussed earlier. While my team and I remain resolute in our vision, we realize our current focus needs to be on taking the right short-term actions to enable it. That means we must get the business back to an acceptable level of profitability. It means we must be laser-focused on sustainable free cash flow, and it means we must strengthen our balance sheet and reduce leverage. So we will hit the pause button on M&A and share repurchases. We remain committed to using the strength of our brands to help offset inflation, and we will reduce as much expense as possible without impacting the health of those brands. Regarding our leverage ratio, which stood at 5.1 times at the end of Q3 and is almost certain to go higher, remember our leverage is calculated in our rolling four-quarter basis. As we look ahead, we would expect leverage to peak in the March quarter at approximately six times. From that point, we would expect it to decline quickly. I'm not sure if we can get back to 4.5 times at the end of fiscal 23, but that's the goal. It's likely to be fiscal 24, however, before leverage is below our preferred long-term target of 3.5 times. Given the recent amendments to our credit facility, we are comfortable we have the room to navigate. And while I'm on the subject, I want to thank our syndicate banks for their support and flexibility. The challenges in the business emerged so suddenly this year, we were forced to reopen discussions with our lenders only a few weeks after finalizing a new facility. They recognized the unusual circumstances and encouraged us to seek even more flexibility given the uncertainty in the broader economy. I will tell you what I told them. We know what this business can accomplish, and we are committed to getting it back where we belong. Our U.S. consumer business should have operating margins in the mid-20s, not the high teens. We still have conviction that Hawthorne can achieve a mid-teens margin. And we should also be able to deliver free cash flow productivity consistently near 100%, though next year that performance should be significantly better. In fact, over the next two years, our goal is to generate at least a billion dollars of free cash flow, the vast majority of which should be generated in fiscal 23. I'm confident we can get back to the level of performance that we and our shareholders expect and deserve. And rest assured, we will hold ourselves accountable. No one on the management team is receiving a bonus this year, and the equity grants we've made in recent years have taken a significant hit as well. Earning a bonus next year will require dramatic improvements in targeted areas, especially cash flow and leverage. The goals we set will be focused on driving value for our shareholders and not merely delivering modest improvements off an unacceptably low base. We know what needs to be done, and we're focused and committed to getting it done. Each of us on this team knows the power of this business and our brands. We know the resilience of this category. and mostly we know the dedication of our associates. On that note, I want to take a moment to recognize our people and thank them for their efforts this year. We've encountered challenges we never expected and were forced to make changes that caught many of them off guard, especially when we parted company with so many of our former colleagues. It's important that all our stakeholders know that my team and I remain optimistic about the future. We know our collective strengths and competitive advantages will get us back on track. And that gives us confidence that we'll once again deliver for our shareholders the results and value creation that they deserve. With that, let's shift gears. Let me turn things over to Corey.