M&A Announcement

Apr 17, 2018

Press Release

Everyone. I'm Jim King, Senior Vice President of Corporate Affairs at Scotts Miracle Gro, and I'm joined by our Chairman and CEO, Jim Hagedorn. If you're listening to this message, it's because you're looking for more color on our announced plans to acquire Washington based Sunlight Supply. In lieu of a live conference call and Q and A session, we're providing these recorded remarks. Many of the remarks made in this session are forward looking in nature and so our actual results could differ. The risk factors attached to the press release announcing this transaction also apply to the comments made during these recorded remarks. We encourage you to familiarize yourself with those risks. As always, my team and I are available to members of the investment community and media. Feel free to call us directly at 937-578 5622. Now let me ask Jim Hagedorn to pick things up from here and share his thoughts about this important transaction. Thank you, Jim. I want to start by saying our planned acquisition of Sunlight Supply is one of the most important announcements we've made during my 18 year tenure as CEO of Scotts Miracle Gro. Even in the context of the 150th anniversary of our company, which we'll celebrate next month, I see today's announcement as one of our most important ever. This deal is transformational. It makes us better, it makes us stronger, and it makes us more profitable. It also reinforces a sustainable growth platform in an emerging industry for years to come. It is the final chapter of the reconfiguration of our business under an initiative we've been calling Project Focus. The goal of this effort was to focus on 3 things we believe were critical to driving shareholder value. 1st, to improve both our operating margin and free cash flow. 2nd, to fully utilize our U. S. Consumer business and divest parts of our corporate portfolio that were a drag on those metrics. And third, to invest in higher growth and higher margin adjacent categories that leveraged our core strengths. That reconfiguration led us to divestitures of our international and lawn service businesses. It also led to a series of acquisitions in faster growing adjacent categories. These included areas like rodenticides and live goods. But the biggest investment as many of you know was in hydroponics. Since the launch of Project Focus, we have assembled the best brands in the U. S. Hydroponic products market and put them in our Hawthorne business segment. Before today's announcement, we had invested more than 6 $100,000,000 in building a portfolio that had annualized pro form a sales of approximately $340,000,000 entering this year. I'm not going to spend a lot of airtime selling you on the story of hydroponics. We're obviously big believers. That's why we moved aggressively to build a 1st mover advantage in a category we believe has transformational opportunities, whether it's for growers of plants on their kitchen counter or in greenhouses or warehouses. As we've been building the portfolio, we've also known there was a bigger opportunity out there and it's one that I've discussed with you on several occasions. Because Hawthorne services a different retail channel than our consumer business, it can't officially utilize the existing SMG supply chain. If we created a more vertically integrated business model for Hawthorne, the scale would result in meaningful profit improvement as well as a direct relationship with retailers who sell its products and the growers who use them. We also need to acknowledge that market is likely to evolve over the longer term since users of hydroponic products continue to professionalize their operations and will want an even more direct distribution model in the future. The pending acquisition of Sunlight Supply will instantly change that dynamic. It creates unique competitive advantages for Hawthorne, especially ownership of the largest, most modern and most of cost efficient supply chain in the hydroponic industry. The benefits don't just accrue to us. They make the entire hydroponic industry better. After fully integrating this deal, our goal is threefold. 1, to drive our existing brands as well as the signature brands owned by Sunlight 2, to be known by all of our stakeholders as the ultimate viewing us as the subject matter experts in this space. With viewing us as the subject matter experts in this space. With each of these goals comes a commitment to the best service, the best products, the best innovation and the best price. Simply put, we're working to make everyone in this space more successful. I'll cover all these points in more detail. I realize though there's a lot to unpack here. So I want to divide my comments into 3 areas. First, I want you to understand Sun Life, who are they and how do they make us stronger. 2nd, I want you to understand the strategic advantages that come with this transaction. And 3rd, I want to explain the economics. This deal has significant opportunities to enhance our earnings, our margin structure and our cash flow. Let's start by discussing Sunlight, which is the best and most important distributor in the hydroponics industry. The business is based in Vancouver, Washington, but has a national footprint. It distributes more than 5,000 products to more than 1500 hydroponics retailers across the country. It has 9 distribution facilities across North America, including a new 350,000 square foot manufacturing and distribution facility that is state of the art, not just for hydroponics, but for any product category. In its most recent fiscal year, Sunlight had sales of approximately $460,000,000 and EBITDA of $55,000,000 About 2 thirds of its existing business comes from distribution. Almost every major vendor in the hydroponics industry, including Hawthorne, moves its products through the Sun Life supply. However, the rest of the revenue comes from Sunlight's own portfolio of signature brands, many of them in categories where Hawthorne currently does not play. So if you operate a greenhouse or an indoor growing facility, there is virtually nothing that you need that Sunlight can't provide, whether it's through its own brands, Hawthorne brands or 3rd party brands. Sunlight is run by a truly creative and visionary leader, Craig Hargraves, who founded the business in 1995 and has never looked back. It's fair to say that Craig is the single most influential person in this industry today. The high energy and performance based culture that he created at Sunlight is very similar to ours at Scotts Miracle Gro. I'm confident the combination and integration of our businesses will go smoothly. Members of our Board of Directors, including the governance and nominating committee have met with Craig throughout the course of our discussions. They've been impressed with the business he built and the way he operated it as CEO. Our expectation is that Craig will stay on in a highly visible corporate role that helps ensure the successful combination of our businesses and helps to shape our strategy at Scotts in the years to come. It is also expected that his brother, Doug Hargraves, will be Chris Hagedorn's Chief Operating Partner. I'll spend more time talking about the strength of the Sunlight team later in my remarks. Now let me turn the page to discuss my second major theme, the 3 primary strategic advantages that are an outcome of this transaction. The first and biggest benefit is that Hawthorne will have unmatched scope through a vertically integrated operating model that will ship directly to retailers. Combining the complementary Hawthorne and Sunlight portfolios clearly will be more efficient than today's operating model. And the benefit of those economies of scale will definitely appeal to our current and future strategic partners who are also selling products into the hydroponic retail channel. Outreach has begun for the largest of these vendor partners already, and we're encouraged to see that they are excited about the benefits this combination will deliver once the transaction closes. Those partners who say yes to us as their distributor should know these three things. 1st, no one will work harder or smarter to drive their business. 2nd, we care about the long term health of this industry. We're not a PE firm looking to make a quick buck. And third, the unparalleled commitment we have to your success also applies to the retailers and growers who rely on our products. To our retail partners, that commitment will be evident on day 1. We'll design integrated selling solutions that allow retailers to benefit from innovative promotional programs. And together with Sunlight, we'll employ the industry's best sales force. We intend to invest heavily behind this team to further enhance their skills as well as their product knowledge and technical expertise. We will also bring a commitment to R and D that no other hydroponics supplier in the world can provide. We know the ultimate success of Hawthorne, our vendor partners and our retail partners is dependent upon providing growers with the tools they need to be successful. Delivering on this commitment has been a core strength of Scotts Miracle Gro for decades. We already possess without question the most sophisticated innovation capabilities in the lawn and garden industry. Much of that knowledge, especially in areas like fertilizer, organics and growing media directly relates to the needs of growers in the hydroponic industry. In addition, several weeks ago, Hawthorne Canada announced plans to build a 50,000 square foot R and D facility in partnership with Flower, a Canadian based professional licensed cannabis producer. When that facility is complete, we believe that Hawthorne will have the most sophisticated cannabis research capabilities in the world. Beyond just product innovation, the business model we're building will be forward looking, which means innovation will also apply to our go to market strategies in the future. It's unclear the role that e commerce will play in this industry except for one thing, we'll be the ones leading the charge. These are the kinds of investments that we believe will set us apart. The second benefit from this deal is that Hawthorne will have more clear visibility to what's happening in the marketplace. By creating more vertically integrated platform, we will now own the relationship with our retail partners. This will give us a better understanding of the effectiveness of certain promotional programs and have better insights regarding the inventory levels of our key customers. This level of understanding would have been beneficial over the past year. While there is nothing we could have done to prevent the disruptions in the California marketplace, had we owned a more vertically integrated business a year ago, we might have seen the current challenges in California sooner. This could have improved our planning efforts and allowed us to manage expectations more effectively with our stakeholders. The 3rd benefit coming out of this deal is defined in a single word, people. We're not just buying Sunlight because of its facilities and customer list. A big part of the deal is related to its people. In fact, as we explore this opportunity, we slowed down the financial diligence at one point, so we could better understand their corporate culture and the ability to integrate it with ours. After doing so, we weren't just convinced of the fit, but we insisted that management stayed on to help lead the combined businesses. We also realized we wanted more than the management team. Our goal is to keep as much of the Sunlight team as possible. We also anticipate integrating some of our Hawthorne operations in Washington to maximize the world class facility that Sunlight opened last year. The plant was built with an eye to the future, which meant it currently has excess capacity. The integration and scale that we envision for Hawthorne will make use of every square foot of this facility. Doug and Craig Hargraves are outstanding operators and highly respected in the industry. Both their sales force and supply chain teams are equally strong. But when I look at their team and I look at the strength of the Hawthorne team assembled by Chris Hagedorn, I have 100% confidence in the people in the front lines of this business. The level of experience of the combined teams will rival, maybe even exceed the experience of the team running our U. S. Consumer business. I know I've referred to this team as young in the past. That was a disservice. While the Hawthorne business is young, the people behind it have definitely earned their stripes. There's another benefit here for Hawthorne. It doesn't come from the deal itself, but it comes from being part of Scotts Miracle Growth. In the late 1990s, we ran a very similar play in our U. S. Consumer business. We acquired a portfolio of the best brands, created an integrated distribution network and invested in technology with SAP. That's when we also ramped up our R and D efforts creating new products that benefited our consumers. The combination of all these factors allowed us to become one of the most reliable suppliers to some of the biggest retailers in the world. We also became a distributor at that time, a fact that remains core to our business today. Remember, we don't own the Roundup brand, Monsanto does. We market and distribute the product. In the home center channel, we don't own RAY or OFF brands, SC Johnson does. But as our retail partners in those channels can attest, we represent those brands as if we own them. Everything I just mentioned applies to Hawthorne from this point forward, and I'm heartened that we don't have to learn as we go. We can leverage our past experience. The 3rd topic for this message is the terms of the deal and the financial implications. We've agreed to acquire Sunlight for $450,000,000 Assuming the deal closes in the next 45 days, we expect about $0.30 to $0.40 of non GAAP adjusted earnings dilutions this year. This is largely a one time issue related primarily to non cash purchase accounting adjustments, deal costs and additional interest expense. Effective day 1 after closing, we will launch an initiative I'm calling Project Catalyst. Just like the word focus had meaning for our team over the past 3 years, so does the word catalyst. We're going to be moving fast to combine these businesses and to drive shareholder value. Our goal is to drive no less than $35,000,000 of synergies from this deal by the end of calendar 2019. We would expect restructuring charges of approximately $15,000,000 to $20,000,000 during that timeframe to achieve these synergies. In fiscal 2019, we expect full year net sales for Hawthorne to approach $650,000,000 The year over year adjusted earnings benefit from this deal is expected to range from 0.60 dollars to $0.80 per share. Our goal by the end of 2020 is to report Hawthorne segment profit of $120,000,000 and operating margins in a range of 17% to 18%. Remember, I said a moment ago, we are striving for cost the incremental margin benefit would be meaningful. We would also expect the addition of Sunlight to substantially benefit our annual free cash flow. This deal is being financed primarily with cash $425,000,000 and another $25,000,000 of equity. Assuming we achieved the $35,000,000 of synergies, the multiple is less than 6 times based on expected fiscal 2018 earnings. That's an outstanding value given the profit objectives I laid out a moment ago. The financing of this deal will take our leverage to slightly over 4 times, which will temporarily put us about a half term higher than our original internal target. But if you look strictly at the economics of the deal, the leverage ratio would be roughly 3.8 times. The difference comes from purchase accounting adjustments. We would expect to lower our leverage ratio to 3.5 times in 2019. So the financing of this deal will likely slow our share repurchase efforts for the next several quarters. It does not however change our long term commitment to returning cash to shareholders. When we announce earnings in 2 weeks, we'll help you further understand the implications of this transaction on your 2018 modeling assumptions. Even with the attractive valuation, I know some of you are wondering about the timing of this deal given the recent challenges we've seen in California, which is the biggest market for both Hawthorne and Sunlight. Because of the challenges in California, we now believe Hawthorne sales prior to completion of this deal would have been about flat for the full year even with the benefit of previous acquisitions. We're not happy about that and I know you're not either. That said, we continue to believe the issues in California are temporary. I'm a big believer that the future outlook for hydroponics remains strong as hydroponic food growing continues to expand and as more states change their laws to authorize cannabis cultivation. That support is continuing to grow in Washington DC. Just last week, the White House confirmed that President Trump will support legislation that protects the rights of states to license and regulate cannabis cultivation and use. We're pleased to see the President's support, not just in this area, but also in areas like tax and regulatory reform that are benefiting our business, our associates and our shareholders. On a related note, former Speaker of the House, John Boehner, who had been on record as opposed to cannabis use, last week called for it to be descheduled and joined the Board of a cannabis company. Most of you probably also know that several high profile investors are looking at hydroponics to help improve food production in urban settings. So whether you're growing cannabis or cantaloupe, the support for hydroponic growing seems to be poised for continued growth. So we're not slowing down our strategy because of a bad quarter or even a bad year. In fact, we see the downturn in California as an opportunity to accelerate our strategy at an extremely attractive price. About a year ago, I started suggesting publicly that Hawthorne's next big step was improving its supply chain. We had 2 options available to us. We could either build our own vertically integrated model or acquire 1. We studied both options extensively. In the end, acquiring Sunlight was the only option that made sense and we're instantly better for having made this deal. Before I close, I want to touch on one more area, Hawthorne's long term prospects for growth. Once we start to see things normalize or is it 15%? Our or is it 15%? Our financial modeling assumes the lower end of that range, but history tells us we can do better than that. But remember that history also tells us the future of Hawthorne will not be a straight line. This is likely to be a choppy business going forward. While I've said that in the past in hindsight, I wish I would have reinforced it more strongly than I did. I want to emphasize that we run Scotts Miracle Gro for the benefit of long term investors. We're not chasing rainbows here. We're not looking for some pot of gold that results overstated and unsustainable valuations on this business. Over the last 2 decades, we've created and then fully leveraged a set of unique competitive advantages in our U. S. Consumer segment. With today's announcement, we've created a similar set of competitive advantages at Hawthorne. That team now has to deliver. I've laid out aggressive goals in these comments and by doing so, I'm inviting our shareholders to hold us accountable. And you have my commitment, we'll get the job done. We're energized by the acquisition of Sunlight for reasons that I hope you now fully understand. Scotts Miracle Gro is an extremely different company than it was prior to the launch of Project Focus. As I said at the outset, we're a better, stronger, more profitable company than we were at the start of this effort. I look forward to speaking to you live during our May 1 earnings conference call. For now, I'd ask you to direct any of your questions to Jim King. Thanks for listening.