Scotts Miracle-Gro Company (NYSE: SMG) — FY2017 Form 10-K
Reporting period: Fiscal year ended September 30, 2017. This is an annual filing, not a standalone fourth-quarter report. Unless noted, financial results below reflect continuing operations. The company sold its International Business on August 31, 2017 and reclassified it as discontinued operations; the Scotts LawnService business had been contributed to the TruGreen joint venture in 2016.
Business context
Scotts Miracle-Gro sells branded lawn and garden products, including Scotts, Miracle-Gro, Ortho and consumer Roundup products, and operates Hawthorne, a growing indoor and hydroponic gardening business. Its reportable segments are U.S. Consumer, Hawthorne and Other. The business is highly seasonal: more than 75% of annual sales typically occur in the second and third fiscal quarters combined.
Key financial metrics
| Metric | FY2017 | FY2016 | Change or context |
|---|---|---|---|
| Net sales | $2,642.1 million | $2,506.2 million | Up 5.4% |
| Gross profit / margin | $972.6 million / 36.8% | $900.3 million / 35.9% | Margin up 0.9 percentage points |
| Income from operations | $433.4 million | $447.6 million | Down 3.2%; operating margin 16.4%, versus 17.9% |
| Income from continuing operations | $198.3 million | $246.1 million | Diluted continuing-operations EPS was $3.29, versus $3.98 |
| Net income | $218.8 million | $314.8 million | Includes discontinued operations; FY2016 included a gain on the SLS contribution |
| Cash from operating activities | $354.0 million | $237.4 million | Up $116.6 million |
| Capital expenditures / free cash flow | $69.6 million / $284.4 million | $58.3 million / $179.1 million | Free cash flow is a non-GAAP measure |
| Cash and debt at year-end | $120.5 million cash; $1,409.7 million debt | $50.1 million cash; $1,221.9 million debt | Debt increased; $1.3 billion available under credit agreement, subject to covenants |
| Liquidity and leverage | Working capital $337.2 million; current ratio 1.6; leverage ratio 3.04 | Working capital $325.8 million; current ratio 1.5; leverage ratio 3.10 | Interest coverage ratio was 7.54 |
Material changes and drivers
- Acquisitions contributed materially to growth: consolidated sales rose 5.4%, including a 5.8% contribution from acquisitions. Hawthorne sales increased 137% to $287.2 million, primarily from acquisitions and higher volume.
- U.S. Consumer sales declined 2.0% to $2,160.5 million, with lower volume, particularly in mulch, partly offset by pricing and stronger grass seed and Roundup for Lawns sales. Segment profit increased 5.6% to $521.5 million.
- Gross margin improved on lower fertilizer-input costs and pricing, but was partly offset by acquired businesses’ mix and lower net sales associated with the Roundup marketing agreement.
- Operating income and continuing-operations income fell despite higher sales and gross margin. Factors included higher SG&A, increased interest expense, a $29.0 million equity loss from unconsolidated affiliates, and a $13.4 million non-operating charge related to the planned Gavita buyout. FY2016 operating results included substantial insurance recoveries related to Bonus S fertilizer claims, making year-over-year comparison less straightforward.
- Operating cash flow improved with better working-capital management, lower inventory use of cash and customer-receipt timing. Investing cash flow included $180.3 million of proceeds from the International Business sale, while acquisitions and capital spending were significant uses of cash. The company spent $246.0 million on share repurchases and paid $120.3 million in dividends.
Outlook, risks and unusual items
- Management said FY2018 capital expenditures were expected to be consistent with recent spending levels and allocations. It expected to remain within credit-agreement leverage and interest-coverage covenants under its current operating assumptions; the filing does not provide a clear numerical earnings or revenue forecast.
- The International Business sale generated a $32.7 million pretax gain. The company provided the buyer a $29.7 million, seven-year loan and recorded contingent consideration with a fair value of $18.2 million; post-closing adjustments remained subject to finalization. The company also retained certain pension obligations.
- Consumer Roundup is strategically significant. FY2017 net sales associated with the marketing agreement were $125.0 million, including commissions and reimbursements. The agreement provides for annual payments of $18.0 million to Monsanto and could be terminated under specified circumstances; termination could remove a significant earnings and overhead contribution.
- Customer concentration is high: Home Depot, Lowe’s and Walmart together represented 61% of FY2017 sales and 60% of year-end accounts receivable. Home Depot alone accounted for 35% of sales.
- Principal risks include weather and seasonality, raw-material and fuel costs, competition and retailer bargaining power, acquisition integration, debt and interest rates, environmental and pesticide regulation, product safety and reputation, and uncertain regulation and demand for hydroponic products that may be used in cannabis cultivation.
- Legal contingencies include asbestos-related claims and a certified class action concerning bird food products subject to a 2008 voluntary recall. The company said it could not reasonably estimate probable losses and recorded no accrual for these matters. It had accrued $4.8 million for environmental matters.
- Subsequent to year-end, the company acquired the remaining 25% interest in Gavita for $72.2 million and acquired Can-Filters assets for approximately $72.2 million, increasing Hawthorne’s exposure to acquisition execution and integration.
Most important facts for investors to verify
- How much FY2017 earnings and cash flow reflect continuing operations versus discontinued operations and transaction-related gains, charges or recoveries.
- Whether Hawthorne can sustain profitable growth as acquisition contributions mature, given its rapid sales expansion and acquisition-related costs.
- Underlying U.S. Consumer demand, especially mulch and other volume trends, and the effects of pricing and retailer promotions.
- Debt trajectory, seasonal borrowing needs, covenant headroom, and the capacity to fund acquisitions, dividends and repurchases while managing leverage.
- Final International Business sale adjustments, the collectability and terms of seller financing, and performance-based contingent consideration.
- Developments in the Roundup agreement, major-customer relationships, and the asbestos and bird-food litigation exposures.