Author: J.T. Culp, Andrew Qiao, and Jerry Yuan
Summary:
Headquartered in Marysville, OH, The Scotts Miracle-Gro Company (SMG) both markets and sells consumer lawn and garden care, as well as horticulture. They manufacture premium grass seed, fertilizers, plant foods, gardening soils, pest control products, as well as a full array of hydroponic growing products in the United States and internationally. It controls an estimated 50% of the lawn and garden market, while also being a dominant player in the hydroponics space.
SMG outperformed the broader market for the majority of the last year before a major pull pack in their share price that started in March. This drop can likely be attributed to some minor risk factors that have arisen in Q3, a shift out of ‘work from home’ stocks, and a drop in marijuana-related stocks. SMG did raise their dividend last year and issued a special dividend, returning 23% more to shareholders than they did in 2019.
Catalysts
Risks
- The hydroponics segment will benefit from a drier West Coast climate
- Continued legalization of marijuana will expand the audience for Hawthorne
- Homebuilders’ backlogs poised to drive growth for the consumer segment
- Higher production costs have the potential to squeeze margins
- Halts in marijuana legalization and state, federal levels
- Possible loss of RoundUp advertising would hurt top-line
Investment Thesis
Consistency of a strong consumer lawn care segment, which still has the potential to expand coming out of the pandemic, paired with multiple growth drivers for Hawthorne, will allow Scotts Miracle-Gro to continue to outperform analysts’ expectations. The continued legalization of both medical and recreational marijuana will be a focus and catalyst given their exposure through Hawthorne and several thematic ETFs.
Segment Outlooks
Consumer Lawncare
After being relatively flat for years prior to 2021, sales from Scotts’ core segment skyrocketed last year, with 24% top-line growth YoY in 2020. This was due in large part to the pandemic, which confined people to their houses, as well as a red hot housing market. Between those who took up gardening as a hobby, or to improve the appeal of their home, use across all products saw substantial growth. Management originally predicted that they would see a slowdown due to the reopening, with expectations for flat or even negative revenue growth. Instead, sales have continued to climb, up 147% YoY in Q1 and 23% in Q2 although Q3 was flat compared to a year ago. This is an indication of the segment’s strength, proving that their strong numbers from last year were no fluke and that their customers have been sticky. Moving forward, we expect the migration from urban areas to suburbs as a result of work from home will benefit SMG on account of more potential consumers with a need for lawn care products. Homebuilders also continue to have strong backlogs, further adding to the number of lawns and gardens that will need servicing. These create moderate catalysts for the continued growth of the segment, and revenues should be recurring given that grass and other plants require continued maintenance. In terms of risks, higher production costs caused by shortages and supply chain disruptions during the pandemic are a primary concern. To offset the potential impact on margins, SMG has already announced they will raise prices for consumers to offset costs, which risks consumers looking for a cheaper alternative. We believe this is unlikely, as this is likely an industry-wide issue given that Scotts has a historically strong supply chain and commodities prices would affect all players. Furthermore, they are the only major name in consumer lawn and garden care, giving them more pricing power than much smaller competitors. Scott’s top-line could see an impact in future years from RoundUp maker Bayer’s (BAYRY) decision on whether to continue selling the weed killer, which could be harmful to human health and even cause cancer. Scotts markets RoundUp along with its own products, so if the line is dropped this would negatively affect their sales going forward. It could offset this with higher sales on account of increased spending on marketing after airing its first Super Bowl ad in February in an attempt to retain its larger audience from Covid-19.
The impact of higher production costs would likely have an effect in the short term, whereas the loss of RoundUp would be permanent, albeit relatively small. These risks don’t impact the belief that a continued interest in gardening, backed by strong numbers from younger generations, along with the aforementioned catalysts will continue to produce positive growth in the coming years and comfortably outperform management’s guidance of 7–9% in FY21.
Hawthorne
SMG created Hawthorne to house its hydroponics acquisitions in 2014 in a move that both reduced seasonality for the overall business and invested in the future of agriculture. This is one of the key decisions that give us confidence in their management team going forward, especially CEO James Hagedorn, who also oversaw the merger of Miracle-Gro and Scotts. That being said, we are incredibly bullish on the hydroponic industry going forward, given its advantages in almost all areas of growth as well as environmental benefits. Hydroponically grown plants grow 40–50% faster on average, produce 30% greater yields, and have higher quality than those grown traditionally in soil. They do this by optimizing the number of nutrients the plants receive, decreasing water usage by 90%, and removing the need for fertilizers. In addition to the advantages in terms of plant growth and quality, these plants can be grown anywhere on the planet at any time without having to worry about climate or soil quality. Lower water consumption and a lack of pesticides also give Scotts ESG potential. The lack of water usage alone is a driver, especially in states like California that have very dry climates and have been forced to decrease their water usage, all while being the top agricultural producing state. The dry climate has continued to cause raging forest fires which have further devastated crop yields across the west coast. As a result, it is no surprise that Hawthorne sales are up 80% YoY in 1H21 in California, and 50% in Oregon and Washington. Hawthorne has expanded its offerings in recent years through acquisitions to supply any product that a consumer could need. This has caused their leverage ratios to mount in recent years, although they now have a Debt/EBITDA of 2.3x, down considerably from recent years. Management remains confident in their capital structure and ability to pay down debt, indicating optimal leverage would be 3.5x.
Outside of traditional crops, hydroponics is also incredibly popular for growing marijuana because of its ability to produce higher-quality plants by optimizing the nutrients and amount of light they receive. Because of this, the legalization of cannabis for medical and recreational use continues to be a major growth driver for the segment. 37 states now allow for use of marijuana; 18 recreationally after NY, CT, and VA passed legislation this year. These open the potential for new markets filled with the demand that must be met. There are typically cultivation licenses granted to a few companies at first, with that number expanding yearly along with dispensaries. This will allow the hydroponics market to sustain growth for years, as more states look to push through legislation this year or add it to ballots in 2022 to capture badly needed tax revenues. There is also a possibility this process is expedited and the legalization occurs at the federal level, although bills like the one introduced by Chuck Schumer are unlikely to pass, as they would need 60 votes in the Senate and to be signed by the president.
Scaling in 2020 allowed Hawthorne to grow their profit margin 38% in 2020 to 11% as they further established and improved operations in the segment. This already hit 13% in Q1, approximately doubling YoY. This is coupled with strong top-line growth of 95% and 61% the previous two years, giving us further confidence in their ability to beat guidance of 40–45% this year.
A potential high upside move in the space would be increased adoption of urban farms. These vertical farms take up entire office buildings and skyscrapers to reach peak production, which although expensive has several benefits for companies and consumers. By removing long-distance transportation from the equation, there will be less waste and lower overall costs, which benefit both parties involved. With many businesses utilizing a hybrid model or even full-time work-from-home beyond the pandemic, paired low Tennant rates, urban farms have the potential -albeit a small one- to take over these spaces and produce food for an ever-growing population that is emphasizing healthier offerings with fewer chemicals.
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Financial Analysis and Valuation
Results and Expectations
As previously stated, we expect Scotts to outperform management’s guidance, driving strong upside for their share price. Given that many analysts agree with these expectations, SMG will have to post beats in upcoming quarters to drive short-term performance. They have posted beats on revenue the past 11 quarters, with an average 8% surprise. These results were better than earnings over the same period, where they only beat expectations 7 of 10, with some large misses when they did. Revenues proved to be dominant in terms of determining investor reactions, with their stock price gaining on all ten quarterly earnings, leading to a 6% price change on average. These historical beats generate confidence in their ability to do so in the future but also lead to expectations of posting solid beats in order to produce the same market reactions. Their management team is also experienced, especially CEO James Hagedorn, whose father founded the company. Hagedorn led the merger with Miracle-Gro in 1995 and started investing in hydroponics after becoming CEO in 2001. SMG’s consumer segment has already matched last year’s sales and will look for another relatively strong Q4 to drive segment growth over the high single-digit projections. Hawthorne has grown 71%, 66%. and 48% in the first three fiscal quarters, as it too is poised to outperform guidance. SMG also paid additional dividends last year, bringing their dividend yield to over 4% in the past 12 months. Although this is more likely to be in the 1–2% range going forward, it showed an emphasis on returning additional earnings to shareholders.
Valuation
Investors’ key focus for SMG’s earnings will be on revenue growth for its two major segments, Consumer Lawncare and Hawthorne, along with margins after they announced they have higher production costs. Management has raised guidance during the year, although we at Tenjin AI predict they will continue to outperform these historically conservative forecasts. Share price and valuation will be ultra-sensitive to top-line growth and the multiples attached to Scotts’ two main segments. Our model builds revenue growth assumptions based on growth in FY21, adding emphasis to SMG’s ability to grow their top-line and outperform guidance and estimates, especially for Hawthorne. A sensitivity analysis shows the theoretical impact on our price target. For example, if their segments grew 45% and 8%, the implied share price would be $188.
Assuming 50% top-line growth for Hawthorne in FY21 and 13% for consumers are both above guidance of 40–45% and 7–9% for the segments. The higher levels of growth indicate a fair value of $209, representing a 30% upside.
Our model also uses a blended exit multiple (EV/EBITDA) to value SMG as a sum of its parts. Using different multiples to value the segments, we can get a better idea of Scott’s intrinsic value. We settled on a 14x multiple for the consumer segment. By using comparables from both the home improvement and chemical/fertilizer sectors such as Sherwin-Williams and Ashland Global. We then used a 21x multiple for Hawthorne. We did this using their only public comparable, Hydrofarm Holdings. Hydrofarm has an EV ~42 times EBITDA, we then scaled this down based on growth expectations to come to a 21x multiple. For the remaining revenues, we used a 12x multiple and weighed each based on expected future EBITDA contribution. We came to a blended multiple of 17.3x, which along with the revenue assumptions above gave us our price target. Changes in the way investors value these segments will impact share price, as seen below.
Summary
Recommendation
Scotts Miracle-Gro makes for a high upside long-term investment on account of the combination of their cash flow generating consumer lawn and garden products and high growth hydroponics segment make for an attractive business model poised to capture growth across multiple areas of agriculture. Ties to cannabis and several related ETFs add exposure to an industry with immense upside potential, with less downside risk because Hawthorne is an ancillary player rather than a pure-play marijuana company. We believe their stock has been oversold in recent months, with a disconnect between the potential impact of risk factors and market reactions. This creates an attractive entry point for a company with great fundamentals and growth on both top and bottom lines to limit downside risk. Because of this dual ability to generate cash flow to return money to shareholders while also offering high upside to investors, we have initiated a BUY rating for Scotts Miracle-Gro with a price target of $225.
