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Raising Our Scotts Miracle-Gro FVE to $160 on Improved Near-Term Outlook; Shares Remain OvervaluedRaising Our Scotts Miracle-Gro FVE to $160 on Improved Near-Term Outlook; Shares Remain Overvalued Seth Goldstein Senior Equity Analyst Analyst Note | by Seth Goldstein Updated May 05, 2021 Scotts Miracle-Gro generated strong second-quarter results, as operating income was up 20% year on year. The growth was driven by strong results in both the U.S. consumer and Hawthorne segments. In light of the second-quarter results, we have increased our fiscal 2021 outlook and now expect the company to exceed the high end of management's EPS guidance of $9 per share. After updating our model to reflect these changes, we raise our fair value estimate to $160 per share from $145. Our narrow moat rating is unchanged. At current prices, we view Scotts as materially overvalued, with shares are trading at nearly 50% above our fair value estimate. Shares trade just below our bull-case fair value estimate of $240 per share. This scenario assumes there is no drop-off in consumer gardening demand after the pandemic and that the Hawthorne business is able to grow revenue in line with the cannabis industry while increasing pricing power to expand segment profit margins above 20%. As such, we think nearly all of the upside is already priced into the stock. We continue to think U.S. consumer sales will fall in fiscal 2022 as consumers return to their prepandemic activities and move away from socially distanced activities, such as gardening. While some consumers who have moved into homes during the pandemic will likely continue to garden, we contend that fiscal 2021 will represent a pandemic peak. After the pandemic, we think sales will resume the traditional low-single-digit growth rate after falling in fiscal 2022. In the Hawthorne segment, revenue was up 66% year on year on strong demand. While we see revenue growth slowing in the second half of the year, we think Hawthorne can maintain an average annual revenue growth rate above 20% through the mid-2020s as more states legalize cannabis. However, our base case assumes profit margins remain in the low teens, below management's long-term guidance. Business Strategy and Outlook | by Seth Goldstein Updated May 05, 2021 Scotts Miracle-Gro is the largest and most recognizable name in the U.S. consumer lawn and gardening market. The firm sells a wide array of products aimed at helping consumers grow and maintain their lawns. The U.S. consumer segment, which consists of lawn and gardening products, generates just under 70% of total revenue. Historically, Scotts has generated healthy margins on its products through effective branding that allows it to maintain favorable product positioning and shelf space in the largest mass-market and home improvement retailers. Scotts has also been able to charge a premium over competitors because of its strong brand equity. While actual product differentiation in the industry is limited, consumers have been willing to pay up for Scotts' products. Future demand for gardening products will depend on growth in the housing industry. We expect housing starts to average over 1.5 million per year through 2030, above our forecast of 1.475 million in 2021. While housing starts alone should increase demand for gardening products, we see some secular trends that will offset the growth. Living-preference shifts to smaller lots and urban centers should result in less need for gardening products. Additionally, a greater proportion of gardening products will be sold online. Currently, the vast majority of sales occur at brick-and-mortar retail. Even if Scotts increases its online sales presence, it may lose some pricing power as many products in the gardening industry shift away from brick-and-mortar retailers to online platforms, where Scotts will likely face more lower-priced competition. The Hawthorne segment, which includes indoor gardening, hydroponics, and lighting equipment, contributed a little over 25% of revenue in 2020. This segment's growth is closely tied to the legalization of cannabis in the U.S., as its products are frequently used by licensed growers. Recent acquisitions in the business should position Scotts to take advantage of growing demand from states where cannabis has been recently legalized. In 2020, 44% of companywide sales came from Home Depot and Lowe’s. However, as the Hawthorne segment grows, this should decline. Economic Moat | by Seth Goldstein Updated May 05, 2021 We assign a narrow economic rating to Scotts Miracle-Gro because of intangible assets from the company's portfolio of well-recognized brands. Based on our midcycle forecasts, the moaty U.S. consumer segment will account for around 60% of companywide profits, with the no-moat Hawthorne segment accounting for the balance. Regardless, we believe returns on invested capital for the no-moat Hawthorne segment will converge with the company’s cost of capital over time while the U.S. consumer segment continues to deliver steady returns safely above Scotts’ cost of capital. As a result, we contend that Scotts will more likely than not generate economic profits on a companywide basis for at least the next 10 years. The company’s flagship U.S. consumer segment operates as the largest player in the U.S. gardening industry with a market share greater than 50%. Key brands under the Scotts umbrella include Scotts, Miracle-Gro, Ortho, Tomcat, and Roundup. Scotts is able to charge materially higher prices than its competition because of brand recognition among customers. Additionally, Scotts’ branded products command considerable shelf space in the gardening sections of major retailers, including Home Depot, Lowe’s, and Walmart. These entrenched retail relationships further enhance the company’s brand intangible asset. In support of its pricing power, Scotts has been able to raise prices 2%-3% nearly every year over the past decade. With U.S. inflation averaging only 1.5% over the same period, the company’s real price increases have supported margin expansion. The ability to maintain premium pricing for its branded products has allowed Scotts to consistently generate healthy operating margins and earn returns on invested capital above its weighted average cost of capital. Although Scotts’ products are not highly differentiated from those of its competitors, the company’s brand equity has created a perceived quality difference among consumers. For example, Scotts can charge an average of 50% more per pound for its Turf Builder grass fertilizer versus four of its competitors’ similar grass fertilizers. When comparing Miracle-Gro’s plant food with that of a competitor, the two have identical ingredients, yet Scotts charges a premium for its products. Scotts’ customer base skews toward affluent homeowners with larger lawns. Because lawncare and gardening are recreational activities, and the result (an attractive lawn) becomes a status symbol, many consumers are willing to pay a premium for a product they perceive to be more effective. Given the power of its brand equity, we’re confident that Scotts will continue to outearn its cost of capital over the next decade. The Hawthorne segment sells hydroponic growing equipment used primarily for cannabis cultivation to distributors in the U.S. or directly to cannabis growers in Canada. Through acquisitions, Scotts has established a first-mover advantage in this nascent industry and commands an estimated 40%-50% market share, depending on the product. Given our outlook that the cannabis industry will grow 9 times from 2018 to 2030, Hawthorne is well positioned to drive significant growth. However, we do not see a sustainable competitive advantage for this business, and we assign a no-moat rating to the segment. For companies in the cannabis equipment industry, intangible assets, cost advantage, and switching costs would be the most likely moat sources to apply. Although the intangible asset moat sources could be derived from product differentiation, patent protection, or brand strength, we essentially view cannabis cultivation equipment as commodities. Therefore, intangible assets do not apply to the Hawthorne segment. Further, we do not see brand recognition for Hawthorne's products supporting sustainable pricing power over competitors. Cost advantage could come from hard-to-replicate economies of scale. As the largest hydroponic equipment producer with the biggest distribution network, we see traces of scale-based cost advantage for Hawthorne. However, we have yet to see this result in higher profit margins, and we view the scale as replicable over the long run in this highly competitive market. Finally, switching costs could be achievable from a razor-and-blade model, whereby the company works with cannabis growers to set up an entire growing system that uses only Hawthorne products and, in turn, requires high-priced replacement parts that could be furnished only by Hawthorne. However, Hawthorne has yet to integrate all of its products in such a manner that would render a customer unable to easily switch to a competitor. Hawthorne's key products, such as light fixtures, tubes, and fans, come in standard sizes. This dynamic is unlikely to change as the company strives to capture additional market share. Therefore, although Hawthorne will drive healthy long-term profit growth for Scotts, a no-moat rating seems most appropriate for the segment. Fair Value and Profit Drivers | by Seth Goldstein Updated May 05, 2021 Our fair value estimate is $160 per share. We apply a 8.3% weighted average cost of capital. Our valuation assumes a roughly 1% annual revenue growth rate in the U.S. consumer segment from fiscal 2021 through 2030 as a sales decline in 2022 offsets growth. We assume a mix shift toward online sales will weigh on Scotts’ pricing power and cause operating margins to slightly contract to 23% by 2029 from 24% in fiscal 2020. In the near term, we anticipate significant growth in the U.S. consumer segment as many have taken up gardening as an at-home yet outdoor activity amid COVID-19 stay-at-home restrictions. We also see no impact to the Hawthorne business as cannabis demand continues to grow. Our long-term outlook is driven by our U.S. housing forecast of nearly 1.5 million housing starts per year, on average, through 2030. While our outlook for U.S. housing growth should increase demand for Scotts’ products, several emerging trends damp our outlook. Consumers in areas affected by water supply constraints, such as Texas and California, contribute 75% of revenue to Scotts Miracle-Gro. As they shift from green, spacious lawns to ones suited for drier climates, demand for Scotts' premium lawncare products will falter. In 2019, Scotts announced an updated consumer Roundup marketing agreement with Bayer. Under the previous agreement, Scotts was able to develop non-glyphosate-based products using the Roundup brand. In January, Bayer purchased these products for $112 million. Under the new agreement, Scotts will continue to market all consumer Roundup products and will receive half of all consumer Roundup profits, up from roughly a third. As a result, we forecast Scotts' U.S. consumer profits to be slightly higher as the company receives a greater proportion of consumer Roundup profits. We think the Hawthorne segment is well positioned to take advantage of increased demand for indoor gardening equipment stemming from the legalization of cannabis and the rise in urban gardening as a recreational activity. We expect Hawthorne’s revenue to grow nearly 4 times over the next decade as hydroponics, indoor gardening, and vertical farming experience significant growth. Scotts is pursuing a volume-over-price strategy by offering discounts on its Hawthorne equipment in order to gain market share in the hydroponics industry. We expect Hawthorne’s margins will expand from 11% in 2020 to 13% over the next several years, below management's long-term targets in the midteens. Risk and Uncertainty | by Seth Goldstein Updated May 05, 2021 Scotts faces customer concentration risk. Home Depot and Lowe’s constituted 44% of the company’s total revenue in 2020, with Home Depot accounting for 26%. Scotts would be significantly affected if either of these retailers stopped carrying its products. A risk for Scotts is regulatory uncertainty around cannabis legalization. The company has invested heavily in cannabis growing equipment used by licensed growers in U.S. states where the crop has been legalized. Currently, 36 states have legalized some use of high-THC cannabis with 16 states plus D.C. permitting recreational use. Under U.S. federal law, cannabis is illegal. If the federal government decided to overrule state laws, the Hawthorne segment’s customer base of legal indoor or greenhouse cannabis growers could disappear. If cannabis is legalized on a federal level, as a greater proportion of cannabis could be grown outdoors or Hawthorne may also face increased competition from traditional agricultural input producers and retailers that may begin serving larger cannabis growers. As an agriculture chemicals producer, Scotts faces environmental, social, and governance risks, mostly related to emissions and the environmental impact of its products. Emissions regulations would increase costs for Scotts, but it would likely be able to pass along cost increases. As such, we see a moderate probability but low materiality to the company. Regulations on its products, such as a ban on certain chemicals, represent a risk to Scotts, as it would have to reformulate products. We see a moderate probability and moderate impact from this risk. Further, Scotts faces risks related to Roundup, as Scotts markets it under an agreement with Bayer (Monsanto). Roundup is glyphosate-based and Bayer is facing numerous lawsuits over the commercial version of Roundup. While Scotts is indemnified from any legal liabilities, the headlines could turn consumers away from using the consumer version of Roundup. Capital Allocation | by Seth Goldstein Updated May 05, 2021 We assign a Standard capital allocation rating to Scotts Miracle-Gro based on our framework that assesses the balance sheet, investment decisions, and shareholder distributions. Scotts has a strong balance sheet. While most of its total debt is due over the next three years, we think Scotts should be able to refinance and could likely pay down some with excess cash flow. As such, we think Scotts' debt is manageable and that it should have no issue meeting its financial obligations. We see management's investments as fair. We are in favor of management's investment in more environmentally friendly products, such as Ortho GroundClear and organic fertilizers, which should allow Scotts to maintain market share as consumers demand more environmentally friendly products. We also think some of the company’s recent acquisitions, such as Gavita, AeroGrow, Vermicrop, and Sunlight Supply, will prove accretive for shareholders by positioning Scotts to expand its product portfolio to take advantage of emerging trends in the gardening industry. Most of the company’s acquisitions have also been relatively small, and we don’t think management has significantly overpaid. Given the imminent changes in the industry, we think Scotts Miracle-Gro would be well served to continue developing a greater online presence in order to maintain market share as the home gardening industry sees a shift to greater online sales. However, we question management's focus on market share versus maximizing price and profits. We view Hawthorne products as a no-moat business and would prefer management focus on creating a sustainable competitive advantage, such as the development of a razor-and-blade model, instead of focusing on maximizing volumes. Finally, we think distributions are appropriate. The company pays a stable dividend and uses excess cash flows for either share repurchases or special dividends. However, these uses of capital are typically prioritized after reinvesting in the business, which makes sense to us. Jim Hagedorn has been CEO since 2001. Before that, he was a senior vice president at Miracle-Gro and worked to integrate Miracle-Gro and Scotts when the two companies merged in 1995. Hagedorn is also chairman of the board and the largest shareholder, owning over one fourth of total shares outstanding. Management’s executive compensation is based on adjusted EBITA, adjusted free cash flow, and total investor return. While the total investor return metric aligns management with shareholders over a short-term period, we would prefer compensation metrics to include return on invested capital to encourage management to position the business for long-term success. |
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