SMG

Business Context and Reporting Period

Company: The Scotts Company (SCOTTS MIRACLE-GRO CO)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: December 29, 2001 (First Quarter of Fiscal 2002)
Business Overview: The Company manufactures and sells lawn care, garden, and professional horticulture products globally. Operations are divided into four segments: North American Consumer, Scotts LawnService(R), Global Professional, and International Consumer. The business is highly seasonal, with the majority of sales occurring in the second and third fiscal quarters.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 11.2% to $163.0 million, driven primarily by a 16.5% increase in the North American Consumer segment (notably a 61% surge in Lawns sales due to strong Fall product offerings) and a 77.6% increase in Scotts LawnService(R) revenues.
• Margin Compression: Gross profit margin declined to 19.1% from 21.6%. This was attributed to a shift in product mix toward lower-margin growing media sales and lower margins in the LawnService segment due to fixed costs during the low-revenue winter season.
• Improved Operating Loss: The operating loss narrowed to $57.8 million from $64.0 million. This improvement was aided by higher sales, lower selling expenses, and a significant reduction in goodwill amortization ($1.8 million vs. $6.8 million) following the adoption of SFAS No. 142.
• Restructuring Costs: The quarter included $1.8 million in restructuring charges ($1.0 million in cost of sales for inventory relocation and $0.8 million in SG&A for personnel relocation), compared to no such charges in the prior year quarter (though $75.7 million was recorded in late fiscal 2001).
• Agency Agreement Costs: Net costs associated with the Monsanto Roundup(R) agency agreement increased to $5.9 million from $4.7 million, reflecting a higher required contribution payment to Monsanto ($20 million vs. $15 million).

Guidance, Outlook, Risks, and Contingencies

Outlook and Accounting Changes:

• The Company expects the full-year fiscal 2002 effect of adopting SFAS No. 142 (elimination of goodwill amortization) to exceed $21.0 million in expense reduction.
• Management anticipates environmental capital expenditures and expenses for fiscal 2002 will not differ significantly from fiscal 2001 levels.
• Seasonality remains a key factor; working capital needs and borrowings typically peak in the second quarter to fund spring inventory.

• Customer Concentration: The top 10 North American retail customers accounted for ~70% of fiscal 2001 sales. Kmart, a top customer, filed for Chapter 11 bankruptcy on January 22, 2002. The Company continues to ship to Kmart but notes potential adverse effects if Kmart fails to reorganize successfully.
• Legal Proceedings: Significant litigation includes antitrust and breach of contract claims by AgrEvo (seeking unspecified damages) and Central Garden & Pet Company (seeking damages in excess of $900 million in counterclaims). The Company believes it will prevail but notes potential material adverse effects if outcomes are unfavorable.
• Environmental Matters: A Consent Order with the Ohio EPA requires a $275,000 fine and remediation of the Marysville facility, with estimated total costs of approximately $10 million. The Company has accrued $6.2 million for environmental matters as of period end.
• Debt Covenants: The Company carries substantial indebtedness ($1.02 billion) and is subject to restrictive covenants regarding leverage and interest coverage ratios. Breach could result in default and acceleration of debt.
• Patent Expirations: Patents for Roundup(R) (glyphosate) and Scotts Turf Builder(R) (methylene-urea) have expired, potentially increasing competition.

• In January 2002, the Company issued $70 million of 8 5/8% Senior Subordinated Notes due 2009. Proceeds were used to pay down borrowings on the revolving credit facility.

Investor Verification Checklist

• Kmart Exposure: Verify the current status of Kmart's bankruptcy proceedings and the adequacy of reserves for receivables owed by Kmart.
• Legal Reserves: Confirm the status of the AgrEvo and Central Garden litigation and whether the Company's assessment of "no accrual" remains valid given the magnitude of counterclaims.
• Environmental Accruals: Review the assumptions behind the $10 million estimated cost for the Ohio EPA remediation and the $6.2 million total environmental accrual.
• Debt Covenants: Monitor the Company's leverage and interest coverage ratios to ensure compliance with the Amended Credit Agreement covenants.
• Goodwill Impairment: Watch for the results of the initial SFAS No. 142 impairment test required by the end of the second fiscal quarter of 2002.