Stillwater - Diamonds in the rough...
With equities in free fall, it's time to start looking for companies that are being unduly punished. Can Scotts make its current dead grass self green again? That's our bet.
Diamonds in the rough? How about dead grass that needs a little love and care, and an unlevered balance sheet, to get back to its emerald hue? We will take both but are going with the latter because it frames our story. Who knows, maybe there is a lost diamond ring in that rough.
And what story is that we look to tell? Scotts Miracle Grow (Symbol: SMG), a company that has been a stable growth specimen for years because of the durability of the basic model of selling staples in the gardening world that you simply had to have for your lawn, flowers, and garden bed. While out in California, where front lawns are entering a phase of tabooism, in the rest of the country, it’s pretty much a game of keeping up with the Jones, Jacksons, Johnsons, and Jim Bobs of the world. This family clearly takes home the ‘Most Patriotic’ award.
It’s that core piece of fertilizers being a necessary staple that makes the story so attractive, but the stock got caught up in the pandemic moment during which it was invited into the Covid-19 ‘working remotely means taking care of the remote home office’ party. The stock might as well have been Zoom, Roku, or Peloton, as they all traded the same. Like many of these themes from April 2020 to November of 2021, they became overhyped on the upside, and have been punished accordingly on the downside. The music stopped, and there simply weren’t enough chairs.
Part of the long thesis on Scotts is that the mood has changed so much from the ultra-bullish of the dissembled economy, to extreme bearishness today of ‘what were we thinking’? Diamonds in the rough abound in the pro-pandemic stocks, and it’s time to start picking through the slag heap. Keep in mind, they didn’t call this SumZero competition ‘best ideas ever that won’t go down no matter what’. It’s ‘Diamonds in the rough’, and I went mining.
No clue if the Peloton fad has a future, but I do know that once things wash out, SMG does indeed have a real business, with real earnings, and real cash flow. This is what almost a decade of consistency looks like. Free cash flow is a gorgeous thing, and the company consistently had produced plenty of it.
And this is where consensus estimates stood a month ago. Last week the company lowered full year guidance to $4.50 - $5.00 per share. You read that right, about 20 days ago full year estimates were something around $8.00, and now you are looking at losses for the next several quarters. One of the sell side Street lemmings said in the 20 years of covering the stock, he had never seen anything like this. While I haven’t covered the company for that long, this kind of evisceration of earnings expectations is also something I’ve never seen before.
With that brief primer on what to possibly like about Scotts hope and promise, let’s turn to what the Street doesn’t like about the company. The list is not short. Thankfully, that shows up in the analyst ratings, which time immemorial has been a good place to wear the hat of a contrarian, leaning the other way of course. The fact that half of those who follow the company are at a hold fits our ‘diamond in the rough’ narrative. This is what we want, as there is only one way to go from a ‘hold’ and that’s a ‘buy’, because nobody on the sell side is smart enough to ever properly time a ‘sell’. No offense, I was one of you at one point.
The coups de gras? Even Wall Street’s most ubiquitous gadfly, the one and only Jim Cramer, says avoid the stock. His reasoning was soft and hinged on two analysts, one at JP Morgan, and the other at Stifel, having a difference of opinion. Again, zero understanding as to why this makes the stock an ‘avoid’. What he did get right though it the fact that the company went from a Steady Eddy maker of fertilizer into a cannabis play, and that has not panned out. When you get to the end of this research piece, you will read why that fits our ‘diamond in the rough’ narrative.
Now let’s deep dive on the bigger challenges Scotts faces. First up, the company has an inventory problem that they will need to work off for the next several quarters. Point of sale in store sales were down 6% in dollar terms, and 9% in units last quarter. It’s not completely clear to the company why sales have been sliding so much during the spring planting season. We would estimate that there is a combination of somewhat poor weather in key regions of the country, but more importantly, just like at Target, Wal Mart, Best Buy and all the other big box retailers, sell through of bloated inventory is a giant problem that has emerged in the last 30 days. This chart of broad business inventories is through May of this year, and it’s getting worse.
So called inventory bloat has caught everyone in retail flat footed as the year started off very healthy and has degenerated quickly. How quickly? Here is the chart of the combined Target, Walmart, Home Depot, and Best Buy stocks. These are some of the biggest losses on record for otherwise ‘stable’ retailers. So don’t tell me markets are efficient. On May 14th, not everything was in the stocks.
A lot of this has to do with the quick ramp in interest rates and the rapid decline in consumer confidence and spending. Joe and Josephine Six Pack are sitting tight on their wallets as this is the first time the Federal Reserve has gone on any sort of real quantitative tightening campaign, and most on Wall Street have never seen one with this force.
And why is this a problem today? Because the level of QE thrown at the market during the pandemic didn’t match the size of the liability on the balance sheet. What you wound up with was an extraordinary amount of ‘shareholder equity’ being created that found its way into the real economy balance sheet. As the asset side of the balance sheet shrinks, so does what remains for shareholders. The mechanics of which, increases the liability side. Since everything must balance on a balance sheet, it gets no more straight forward than this. So, just ask yourself, is it good when your liabilities go up because assets and shareholder equity are going down? Generally speaking (always), no!
Current Assets Current Liabilities
- Going Down + Going Up
Shareholder Equity
- Going Down
This is clearly coming through in home sales, which have just hit the wall as well. Why is this a problem for Scotts? You buy a house, you put some money into it. You put some money into it, chances are you landscape. You landscape, you for sure are buying product that helps maintain what you just plunked down thousands of dollars for. With certainty, this is weighing on Scotts, and everything else home improvement related.
Next up, the company’s cannabis focused Hawthorne business didn’t just hit the wall this year, it sprayed parts all over the place. Instead of the hoped-for stabilization of the business, the ongoing rise in inventories has slammed demand for Hawthorne products to support growth and cultivation of the hippy lettuce.
If you want an incredibly prophetic look at how the decision to enter the cannabis market was built on the shakiest of foundations, read Cannabis Capitalist from Forbes in 2016. This could be the start of a business school study on what happens when hubris clouds the mind. And if there was ever a man with hubris, it’s the CEO and son of the founder, Jim Hagedorn.
What has happened to the cannabis business is easy to describe, product availability caught up with demand…in size. In the most recent mark down of expectations, the division is now projected to see a 40% to 45% decline in revenues for the year. Yes, that is not a typo. Sales of product into cannabis producers is going to get cut in half this year. Why? Because what happens when you have too much inventory? You start discounting product to get it moved, and that’s what we are seeing today. And what business owner with half a brain wants to put more inventory into a saturated market? Not one who wants to stay in business.
Hawthorne has been a challenge for Scott’s for the better part of four years, if not longer. Hagedorn let loose on the company back in 2018 when he found the division adrift, and unable to make deliberate decisions. If the guy wasn’t the son of a cop, we would be asking if he was off his meds as this is what he dropped on an earnings call.
“Let me kind of tell you, like, the journey a little bit for me, and it’s real time, Hawthorne’s on their own long-term plan and they’re clearly off their first year. And, dude, those bastards are gun-shy as s--- right now, OK, I’m just telling you real-time, living my life. What do you expect they’re going to throw back at us? So, they throw these numbers back at us, and I was like, what the hell?”
“When people ask me what you think about those numbers that came back from Hawthorne, I said ‘it’s a f---ing negotiation’ – sorry for the language. It’s a f---ing negotiation and they’re gun-shy at the moment, do not over-commit. Our credibility matters. I get where our stock price is at. OK? I’m not all freaky on it,”
While he might not have been ‘freaky’ on the stock then, he should be now, as you can buy all the SMG you want for the same share price you paid four years ago. If that isn’t a busted story, we don’t know what is.
And finally, to complete the story of a once stable growth story going down the wrong path, we give you a balance sheet that while not busted, is not a thing of beauty. The company has been forced into a position where it needs to negotiate for higher gearing, and a more onerous rate of interest on that gearing. This is what happens when the bottom falls out on the cannabis rollup strategy. This is the CFO’s spin on what a ‘brother can you spare a dime’ conversation with lenders looks like…
“We have stated for years that our comfort zone for leverage is 3.5 times debt-to-EBITDA and current facility allows for leverage up to 4.5 times. Given the external factors currently impacting the business, we are seeking to adjust our debt covenants to allow for up to two additional turns of leverage in the near-term to maintain the appropriate level of flexibility in navigating the current market conditions. Obviously, we are focused on implementing aggressive plans to improve cash flow, reduce debt, and return leverage to our target levels as quickly as possible.”
“The decisive steps we have taken to reduce expenses will result in a year-over-year decline of 12 to 13 percent in SG&A for fiscal 2022. We would expect to incur restructuring charges in both the third and fourth fiscal quarters as a result of these actions which we would remove from our adjusted earnings for the year, consistent with our long-held practices related to these non-recurring costs.”
This is what the company’s balance sheet looks like as of the last reporting on April 3rd, 2022. Long-term debt of $3,350 versus $2,322 a year ago, leaves $975 in shareholder equity. That’s not a pretty picture given the fact that the company generated $350 million in EBITDA during the quarter. For full year 2021 the company did $750, that puts the company at red line as covenants would allow for $3,375,000 and the company is currently at the number.
Keep in mind, and this is part of my thesis, the consumer product segment has about 22% profit margins, the weed business about 10%. Those are backward looking so you can assume Hawthorne will be losing money for the rest of the year. That said, it does about $1 billion in sales. There is value in the asset, but it needs to either be spun or sold. Preferably the latter, as that would clean up the balance sheet and de-risk the lending facility. Up until now, it was a respectably growing business. That being said, next year the picture is not the same.
While I don’t know much about the 44 brands under their umbrella, I do know that a properly pedigreed banker could put some lipstick on this pig and get it sold. Keep in mind, some nice midwestern board member of Scotts resigned in 2016 when he disagreed morally with getting into the cannabis business. At the time, it was barely legal in this country. Turns out the guy was right, and in his mind, probably for the right reasons,hell hath no fury like shareholders scorned when a business decision goes terribly south.
The pentalamide risk factor, that is more than priced in at this point, the war in the Ukraine has massively disrupted supply chains of certain input costs to Scott’s products. Much of this has to do with natural gas, which is an important element to the creation of such costs as ammonia.
And that is why this chart makes sense. The red line is the upstream producers, and Scotts is a downstream user. For as bad is these charts are, why is this bullish for the long term? Because the war in Ukraine will not last forever, and there are enough users of European natural gas who desperately need it to go down. When it does, the delta in it will narrow, and probably in violent manner. We prefer to be on the other side of that trade right now. Damage done, time to position yourself properly.
Finally, and this is far more esoteric, the American lawn is on the potential (100 years) list of endangered species. Out in California we are starting to see it. And we pride ourselves on being trend setters. The perpetual threat of drought has everyone thinking differently. Lake Mead, the major source of water to the Golden State and other points west, is running so low, they are finding barrels in the dry lakebeds with guys like “Lefty Malone” and “Jimmy Two Fists” skeletal remains in them. Think I’m kidding? I’m not.
With that uplifting note, here is the buy thesis on Scotts Miracle Grow (SMG), and all the green you can make once things turn around.
1. The company is universally disliked right now, unless of course one were to go looking for ‘Diamonds in the rough’. And that’s the name of the game.
2. The lawn and garden side of the business will never die, at least not in the next 12 to 24 months. This provides an anchor to profitability and free cash flow.
3. Sell Hawthorne for a $1b valuation. Scotts gets $800mm in cash to de-lever with. The company keeps a 10% interest on the books as a call option. And James Hagedorn gets the other 10% ownership to save face and continue to play in the cannabis trade.
4. Fade the inventory bloat, all retailers are going through some form of it right now. By next year ‘this too shall have passed’.
5. With the S&P 500 down over 20% on the year, one could surmise that the risk of inflation is now somewhat priced into the market. Fear is for sure in vogue these days. Point being, as the adage goes, be a buyer when there is blood in the streets. And there is.
6. Housing will continue to correct, and it was a huge tailwind for a while. But there are a lot of freshy planted lawns and gardens out there to be taken care of. Don’t let the noise fool you from the signal.
7. The Covid bubble has busted and stay at home stocks are about as popular as the red headed stepchild at the family reunion these days. What will emerge from the ashes are babies with earnings and cash flow that got thrown out with the bath water.
8. Earnings for 2022 have been reduced so much it would be almost impossible not to ‘overachieve’ at this point. If the company can put up $5.00 for the fiscal year, it’s a win. Get rid of what will be a money losing weed business and $7.00 to $8.00 starts to build as the narrative in the out year. Would you pay ten times earnings for that today? I’ll take my chances that in time others will like that idea.
9. At this point it would take an act of God for the company to significantly cut guidance again. If they do, we could see 25% downside at most. The one caveat being the balance sheet leverage situation. If the company doesn’t get the EBITDA to debt ratio worked down, Katy bar the door.
10. Assuming all goes (reasonably) well, and the company can get back to its core, we can assume a 15x on $8.00 in earnings again is worth a $120. If one were to get bullish again, and put a 20x on SMG, the stock is a double from here with a target of $160.
“I’m just an old lump of coal, and I’m going to be a diamond someday”.