Good day, everyone. Thank you for holding, and welcome to the Scotts Miracle-Gro 2013 third quarter earnings conference call with your host, Jim King. Today's conference will begin with a presentation, followed by a question and answer session. Instructions on that feature will follow later in the program. I would now like to turn the call over to Jim King. Please go ahead.
Thanks, Jimmy. Good morning, everyone, and welcome to our third quarter conference call. With me this morning are Jim Hagedorn, our Chairman and CEO; Barry Sanders, our President and Chief Operating Officer, who's calling in remotely; and Larry Hilsheimer, our CFO. Jim and Barry will provide an overview of the current state of the business, both in the context of our Q3 results as well as our overall progress. Larry's going to walk through the financials and the implications of today's results on our full year outlook. After their prepared remarks, we'll open the call to your questions. In the interest of time, we ask that you limit your questions to one and to one follow-up. If there are questions that we don't address, I'm glad to handle those with you separately offline.
With that, I want to move on to the call and remind everyone that our comments this morning will contain forward-looking statements. As such, actual results may differ materially from what we state. Due to that risk, we encourage investors to review the risk factors outlined in our Form 10-K, which is filed with the Securities and Exchange Commission or our most recent 10-Q. With that, let's get over to business, and let me turn the call over to Jim Hagedorn to discuss our performance.
Thanks, Jim. Good morning, everyone. I hope that it's obvious why I'm pleased with the news we announced this morning. Our team has every reason to take pride in what we've accomplished this year, and the shareholders should take heart that we have a good handle on the state of the business and that we're executing according to our plan. Most importantly, the news we announced this morning makes good on the commitments we made to our shareholders a year ago. Let me quickly touch upon the headlines and then turn things over to Barry to look more deeply at the business. After a slow start to the season, we've had an extremely strong recovery. Entering Q3, consumer purchases of our products were down 28% from 2012 levels. As I sit here today, that deficit is almost entirely erased. On a year-to-date basis, POS is now essentially flat.
After two years of gross margin declines, we've successfully reversed the trend, renewing our confidence in a long-term goal to get our margin rate to 40%. Year one of Project Max, our cost-out and productivity initiative, has been a success, allowing us to reduce SG&A at an even quicker pace than we first projected. Even with pricing increases and reductions in spending, we've maintained our aggregate market share. Speaking of our overall performance, we now see the business trending toward a midpoint of our full-year guidance of $250-$275 per share. As we've seen in recent years, hurricanes and other unforeseen events can negatively impact our fall business. For that reason, we're not changing the overall range. Regardless of where we land within the range, we also expect to exceed our cash flow guidance of $250 million.
As a result of our performance, we've reduced our leverage ratio below our internal goal of 2.5 times. As we began discussing during our Q3 call a year ago, we're in a position to start returning cash to shareholders. The 35% increase in the quarterly dividend that we announced this morning puts us solidly in the top quartile of our benchmark companies. As we said in the press release, we will also continue to consider other shareholder-friendly actions, the most likely of which will be in the near term to restart our share repurchase efforts. Larry will provide more detail in a few minutes of how we arrived at this level of increase for the recurring dividend.
I want to stress that the increase should be viewed as a strong vote of confidence from both the management and the board in the underlying fundamentals of the business and our ability to continue generating significant levels of cash. I also want to stress that we have plenty of flexibility to fund the needs of the business, including acquisitions, while maintaining our targeted leverage ratio. There's a lot to feel good about right now, and I'm not afraid to say so. Our focus throughout the year was to improve the quality and strength of our financials. We've improved our margins. We've strengthened our balance sheet. We've put ourselves in a position to show even more improvement in 2014. Are we where I want us to be? Are we where we need to be? The answer to both those questions is no.
While we've had a solid year, I don't want to get ahead of ourselves. Our number 1 long-term goal has to be growth. We can't cut our way to success, and we know that. As I said during this call a year ago, and based on our experiences in 2012, we're not going to struggle too hard against broader macroeconomic trends. Our outlook for the consumer hasn't really changed all that much. While our business had a solid year in the DIY and hardware channels, we've not fared as well in the mass merchant channels, where retailers got off to a slower start. Consumers in that channel also remain less engaged in our category, a trend that began in 2011.
Until the broader consumer feels better and starts opening their wallet with more frequency, no matter where they shop, then we still believe unit volume growth will be tough to get in the core business. That's not to say that we can't get growth in the overall business. We believe that low single-digit top-line growth is achievable in 2014, but we see it mostly coming from pricing, a slight rebound in our international business, growth in Scotts LawnService, and perhaps some modest acquisition in adjacent categories. We're not going to provide any further guidance today for next year, but I will say that we see the potential for another strong year of earnings growth in 2014, getting us closer to our near-term goal of returning to 2010 levels of profitability.
I want to stress once again, our long-term focus is driving the category and achieving a higher level of sales growth. The combination of improved consumer insights, product innovation, and smarter retailer programs will all play a role in reigniting our organic growth. Then we can supplement that growth with partnerships and small acquisitions. I believe that that focus, combined with improved margins and a commitment to returning cash to shareholders, will allow us to deliver a higher level of total shareholder returns. Before I turn it to Larry to run through the numbers, I want to take a step back and put the results we're seeing this year into perspective. I'm not going to blame weather for the shortfall given the strong recovery we've seen in the third quarter. The fact is that the delay we saw in March was clearly related to weather.
When the weather broke, the season took off. Our retailers stayed engaged and helped drive the season, and I want to thank them for that commitment. Even with their full engagement, when you look at our year-to-date results by geography, you can see that the late-breaking markets never fully recovered. Personally, I believe our team deserves a better result than we've seen this year because their execution this season was as good as I've seen in many years. When we designed our plans this year, we knew the results would be second-half loaded, that March of 2012 represented a nearly impossible comp, and we knew the majority of our gross margin and SG&A benefit would not take hold until Q3 and Q4. After a late start to the season, it would be understandable if our team entered Q3 with a bit of nervousness.
Under Barry's leadership, the team exercised patience. They understood what was happening and didn't spend excessive money chasing the season. They didn't pull the trigger on unplanned promotions, and they didn't lose faith in the strength of our brands and the resilience of the category. I want to recognize the work done not just by Barry, but also Mike Lukemire, Jim Lyski, Dave Swihart, as well as the thousands of people who work in their organizations. They maintained confidence in our plans, they stuck to their guns, and they executed as well as I ever recall seeing. They're not to the finish line yet, a point I want to continue reminding them. The performance we've seen from our people this year is something that requires the attention of our shareholders, and I wanted to make sure that I gave them the credit they deserve.
With that, let me throw things over to Barry to discuss some of the details.
Thanks, Jim. Jim already gave you the headline regarding consumer purchases. Let me be more precise. POS in the quarter was up 15%, with year-over-year gains in every category. In our largest and most profitable business, lawn fertilizer, consumer purchases were up more than 40% for the quarter and now are up 1% on a year-to-date through last week. Within those numbers, we continue to see strong consumer acceptance of Snap. Purchases of spreaders were up 31% in the quarter and are trending in line with what we saw during the introduction last year. Purchases of Snap Pacs are higher than a year ago. Consumer excitement for the product remains high, and users of the product continue to feed their lawns at a significantly higher level than users of our traditional product. Mulch has been highly successful for the year again.
POS was up 17% in the quarter and 9% year-to-date. More importantly, we have had great success in improving the profitability of this business. We told you during our Analyst Day meeting that we were moving to a more vertically integrated manufacturing process in this business, and that change has resulted in higher margins. While mulch is still dilutive to our overall margins, the growth we're seeing is important, and we expect to see further margin improvement next year. I also want to talk to you about the performance of our gardens business. Consumer purchases of Miracle-Gro branded soils and potting mixes were up nearly 10% in the quarter and 1% year-to-date. Overall, POS in soils is down slightly, that's to do with the loss of some lower-margin private label listings. It's worth focusing on growing media for a reason.
Many of you probably recall that this is a business that had a challenging year in 2012 and caught us off guard when the spring didn't materialize as we had expected. This year, however, even with the late spring, consumers are more engaged in the peak weeks of this year, not just in buying our products, but flowers, vegetables, and other live goods as well. As is true with the rest of the business, we won't fully recover from the slow start, but we're satisfied with the result given the circumstances. The same holds true in our controls portfolio. Recall that both Ortho and Roundup had strong performances in 2012. They did not have an easy comp. While both are still negative on a full-year basis, both have been coming in strong in recent weeks.
Roundup in particular has been doing well, posting increases of nearly 20% since June as consumers try to fight off the weeds that have been aided by high levels of rainfall in much of the U.S. Ortho has been about half that rate of growth over the past two months due to need for both selective weed and insect control products. Switching gears a bit, retail inventory in the U.S. has been a bit of a roller coaster this season, but we're seeing inventory now that is pretty much in line with what we expected prior to selling end product for the fall season. As we get ready for fall, we continue to see strong retailer support, and we have a high degree of confidence in our marketing programs.
The broad trends we've seen in the U.S., a slow start followed by consistent momentum, has also been the story in Europe. After a slow start, also delayed by weather, we've seen a strong recovery. The business there should come close to meeting their original plan for the year, and I'm pleased with their overall progress. The European team has fully embraced Project Max, and we've started the restructuring efforts we discussed on previous calls. We expect to start seeing the payback from those efforts in the next year. Finally, let me touch upon Scotts LawnService. This business remains on track for mid-single-digit top-line growth we expected, as well as another year of record profits and improved operating margin. Our customer count is now at an all-time high, so is our customer satisfaction scores.
All of this is true despite the fact that significant Midwestern markets like Chicago and Minneapolis have struggled this year because of weather delays. On a separate note, the SLS team continues to get good learnings from the pest control test markets in Florida and remain confident that the long-term opportunity from such a product extension is both real and significant. We'll move cautiously, but I do see this as an important growth area as we look ahead. I agree with Jim's assessment. Our performance in the third quarter was extremely solid, and I feel highly confident that we'll hit the bottom-line targets that we've outlined back in December. The early discussions we've had with retailers regarding 2014 are encouraging, and once again, we expect Project Max to help drive leverage in the P&L next year.
To be more specific about both, let me now turn the call over to Larry to discuss the numbers.
Thank you, Barry, and good morning, everyone. I have three objectives this morning. First, I want to recap our results for the quarter and where relevant to the broader story, our year-to-date performance. Second, I want to help you better understand the implications of today's announcement on our full-year guidance. Third, I want to build on Jim's comments regarding our dividend announcement this morning. I'll provide more comments on the strength of our balance sheet and our planned uses of cash going forward. With that, let me address our results. Sales in the quarter rose 9% year-over-year to $1.15 billion, driven primarily by the strength of the consumer business in the United States. Sales in the overall global consumer segment were up 10% to $1.05 billion.
Within the segment, sales in the U.S. were up 8% during the quarter, while sales elsewhere increased 21%, excluding the impact of foreign exchange rates. As Jim said at the outset, weather had a big impact throughout the business in Q2, and that impact was most pronounced in Canada and Europe. Those businesses all rebounded well in Q3, leading to the strong sales I just outlined. Finally, Scotts LawnService increased 2% during the quarter. On a year-to-date basis, sales in the global consumer segment are still down 2%, while sales at SLS are up 4%. Company-wide year-to-date sales are -2%. You'll recall that we adjusted our full-year sales guidance in June and said we expected the result to range from +1% to -1%. Our nine-month performance is indicative of that outlook.
In terms of the full-year results, it seems most likely that we'll be flat to slightly down on the top line. As Jim already said, the team's performance with cost-out efforts and SG&A leverage provides more than enough support to make up that miss in the bottom-line results. Let me move down to gross margin, which, as we expected, was a very good story for us in the quarter. The adjusted gross margin rate in the third quarter improved 360 basis points compared to prior year, a result of improved leverage of our fixed manufacturing and warehousing costs, in addition to favorable commodity costs, pricing, and other cost efficiencies. We expect gross margin improvement will continue through the fourth quarter. You'll recall that we said entering the year, we expected the gross margin rate to improve by up to 125 basis points.
That top level of improvement is unlikely due to the volume miss we're going to see. Based on our updated sales guidance range, a full-year improvement of 60 to 100 basis points is still achievable. Let's move on to SG&A, which has been a good story all year, especially so in the third quarter. During the quarter, SG&A decreased to $8.1 million, a decline of 4% compared to a year ago. The year-over-year savings were primarily due to benefits of our Project Max initiative. Those decreases are partially offset by higher year-over-year costs for variable comp. With that said, variable pay, while still trending toward a targeted payout, will be less than what we had hoped. We had actually been accruing at higher levels earlier in the year in anticipation of hitting some stretch goals.
Even though the variable pay will be lower than our original goals, we'll still see a targeted payout this year. I agree with Jim's comments this morning. Our team has done an outstanding job in executing our plan. Let me pause for a moment and try to help you with your models. When we updated our guidance in June, the biggest change was in SG&A. Our original target entering the year was to reduce SG&A by 1%-3%. In June, we increased that target to a range of 3%-5%. With just two months left in the year, we expect to be on the high end of that range. Below the operating line, everything is in line with what we expected. Interest expense in the quarter was essentially flat at $16.8 million.
The tax rate for adjusted earnings for the quarter was 36.5%, and we ended the quarter with a diluted share count of 62.6 million shares. All of that translated into adjusted income from continuing operations of $153.9 million or $2.46 per share during the quarter. That compares with $100.8 million for the same quarter last year or $1.62 per share. During the quarter, we had severance costs related to our European restructuring efforts of $8.5 million, which were adjusted out of earnings. We expect a less significant level of restructuring in Europe in the fourth quarter. When you include these one-time items, our GAAP earnings were $148.2 million or $2.30 per share, compared with $96.4 million or $1.55 per share a year ago. What does this mean for our full-year earnings?
Jim has already said we are trending to the midpoint of the range, and we hope to do slightly better. July was a good month for us, and August is relatively soft but has started strong. Our September results and the kickoff to the start of the fall lawn and garden season will be important. Fortunately, our retail partners are engaged, so if the weather cooperates, we expect to have a strong finish to the year. If you move on to the balance sheet, two things stand out and are worth discussing. First, the change in accounts receivable is simply a function of the timing of shipments related to the higher sales volume. Secondly, and more importantly, we're really pleased with the year-over-year change in inventory levels.
We said going into the year that managing inventory lower would be a priority for our supply chain for the next two years, and so far, they are doing even better than we expected. While I'm talking about supply chain, let me anticipate one of your questions related to the current commodity environment. I know that many of you have been calling in in recent weeks to ask about the favorable trends in urea prices. We have been taking advantage of these trends and have locked in about half of our urea needs for 2014. We're not going to disclose our average price, but we do expect the amount to be lower than 2013. I know that begs the next question, which is about pricing for 2014. As Barry said, we continue to move forward with modest price increases in our 2014 planning.
Since we did not take any pricing in 2012 when urea moved sharply higher, the pricing we took in 2013, combined with our plans for 2014, now essentially offsets the margin gap. Finally, I want to talk about where we stand from a leverage perspective and also discuss our announcement today regarding the dividend and returning cash to shareholders. Entering Q4, our leverage ratio was 2.46, and we expect it to continue to improve slightly over the next few quarters. You will recall that we have said for the last several years that we view our optimal capital structure to be when our leverage ratio is within a range of 2-2.5 times. That calculation is based on a four-quarter average of net debt divided by trailing 12-month adjusted EBITDA.
We're back within the range, which allowed us to make the announcement about the dividend increase this morning. Let me help you understand the logic with our decision. We decided not to focus on a specific payout ratio or dividend yield. Instead, we looked at what level we felt comfortable with. We also looked at our peers and determined we wanted to stay within the top quartile of benchmark companies from a payout ratio, as long as we were comfortable. This increase puts us within that group. As Jim said, it continues to give us plenty of flexibility to fund the business for the foreseeable future. We assessed our cash generation, considered risk, and we feel extremely comfortable with this recurring dividend level. In terms of near-term uses of cash, our philosophy of two-thirds to shareholders and one-third to the business still makes sense for us.
We've been studying some tuck-in acquisitions in adjacent categories for the U.S. consumer business that look attractive. Our lawn service business also continues to look at those type of deals as well. In all of those cases, we can meet the CapEx needs of our business, fund those acquisitions, return cash to shareholders, and still stay within our 2-2.5 times range. We begin to look at next year, I believe the business has good momentum. I've been here for four months now, and I'm starting to better understand the rhythm of the business and the challenges and opportunities that we face. Like both Jim and Barry have said, we need to get the category growing at a faster rate. I don't believe throwing money at the issue will get us very far.
Our view of the consumer marketplace is mirroring what we continue to hear from peer companies and from our retail partners. You can expect us to continue to manage the business prudently, to set reasonable expectations, and to focus on driving solid shareholder returns. With that, I want to open the call to your questions.
At this time, if anybody does have any questions, please press 1 on your phone. Again, at this time, if anybody does have any questions, please press 1 on your phone. First question is from Joseph Altobello. Your line is live.
Sure.
First question, I just wanted to understand the gross margin guidance a little bit better. In your prepared remarks, you mentioned that it had to do with volumes, I was curious where volumes weren't in line with expectations and what kind of elasticity you saw in terms of the pricing that you took this year.
Let me start with just saying that Joe, this is a pretty big focus for us. We've been spending a lot of time sort of looking at the numbers and seeing what it means. The biggest issue here was just an absorption issue based on the shortfall from our internal numbers that we had, which were probably, I don't know, a couple of percent short of overall, where we had wanted to be. That's the only thing that's really moving. I would say on sort of the pricing side, that probably some puts and takes. Overall, we're not seeing any sort of major share change. We're comfortable with where we are, and we're very comfortable where the progress we're making on gross margins.
I don't know, Barry and Larry, do you want to add anything to this?
Jim, what I would add, the most competitive category that we have is controls. We're evaluating that, looking at what happened this year and evaluating our plans. What I would say, Joe, is it's right where we expected, and we know what the actions that we can take, and Jim Lyski and his team know what the elasticities are so that we can make our pricing decisions.
Yeah.
Okay. That's helpful.
Yeah. I would just add that it's primarily a volume issue relative to where we're short falling, a little bit of mix. Other than that, we're really pleased with what we accomplished.
Okay. Switching gears to SG&A, obviously, you're calling it down 5% this year, look better than what we had thought going in. Can you tell us how much of that decline this year is really sustainable through cost savings, et cetera? How much of that is deferring maybe some investments from fiscal 2013 into 2014? Thanks.
No. We believe that what we have taken out is very sustainable. These are fundamental changes in our business operating structure, really focused efforts on permanent takeout. The takeouts were actually even higher when you consider that we are now paying incentives at a higher rate than we were last year. We believe that we will have additional takeouts next year that will offset what we anticipate to be incentive increases for next year.
Great. Thanks, guys.
Thank you. Our next question is from Olivia Tong. Your line is live.
Hi. Thank you. I wanted to start first on the top-line guidance. Even Larry had sort of said more flat to down 1 as opposed to the -1 to +1 range. First, why keep the top end of that range if it seems sort of unlikely? That's still implying a pretty wide range for Q4. Can you kind of give us a sense what gets you to the top of the flattest range versus the low end of the range? Thanks.
Well-
Go ahead, Jim.
I would say you're thinking too hard, Olivia. I think what we're trying to do is saying that we still believe that the guidance we gave previously is correct and will be within that range. I think that's as much as you need to read through it. We weren't sending a message there except to say, which is kind of what I thought when Larry said it, that the range he gave before, we're still comfortable with, and I think that's the case. We weren't trying to sort of say we needed it, except to say we'll be within it. One of the reasons that I wanted to see if we could get you pushed up in this was your comment on disappointment on the dividend, and I kind of wanted to deal with that, if you don't mind. You okay with that?
Okay.
Look, we haven't changed anything. We spent a lot of time. I ended up sort of in the process of getting a new CFO. I think he wanted to get regrounded with the banks and his advisors on how to do that. Cash flows are good and at or above what we expected. Our split that we have, and I think consistent with over the last year or so, of two-thirds to the shareholders, one-third for the use of the business, we are still good with. It's just a question of the recurring dividend, where should it be given that it's kind of hard to unwind, one.
We've spent a lot of time looking at other companies and what kind of, I'll use the word, it's not precise, but what kind of pop you could sort of get in the equity, and the efficiency of that as far as saying, if you put too much into the recurring and it doesn't do much to the equity, then what's sort of the perfect place for that to be? I think that between Larry and the banks, and I think really good work, by the way, both the board and myself were convinced that this level is right, but it doesn't change anything. The amount of money we're planning to return is basically, and my number on leverage is more like 2.5. Sort of at 2.5 times leverage, two-thirds of our excess capacity will go to the shareholders, one-third used by the business.
What's left then is specials and repurchases. We have also renewed our authority that was existing but unused, that's like $300 million that we have, just that was already
Kind of on the books with the board, but we've worked with the board, so we have an existing $300 million repurchase availability. As we start moving into the next phase of returning cash to shareholders, it will be some combination of specials.
Buybacks
buybacks. We're just trying to figure out what we think is best. This was the first step of that process, and so we're absolutely committed to what we said before. Really, the level of recurring dividend was just basically saying, what do we think the best place for it to show up in the equity, and the rest will happen through specials and buybacks. I don't know if that helped at all.
It does. By special, do you mean sort of one-time dividends? Then in terms of share purchase, what kind of going run rate are you looking at going forward? Because from the press release, it sounds like you didn't really commit to any particular level, and for four quarters now, we haven't seen any share purchase. Can you give us a sense for what share purchase would look like going forward?
Look, here's my issue with the question, which is, I think that the math is not that hard to say, because the increase in the recurring dividend is not that high, okay? It was designed for what it was, which is, say, at what level do you think we get the max return on the equity, and then the rest will all happen through repurchases and specials. As soon as we have sort of visibility at year-end on exactly what our availability and leverage is, we'll begin that process. I think you'll see it sort of wholesale begin kind of for real in fiscal year 2014.
I think it's purely doing the math, and I think probably my finance team can help on that, but it will be a consistently approached campaign to return cash in those two ways of doing it that will begin as soon as we're ready. I'm saying that we're in that process, but we still got to count our money, figure what we got, what our availability is, what leverage is, and I think you'll see it in a big way in 2014, consistent with what we've said. I don't know, Larry, if you want to add anything.
No, I think you said it as I would've, Jim, and it's just going to depend on our judgment of what we think is the appropriate mechanism to return the money to the shareholders, depending on where our stock price is.
Anyway, I just wanted to take the time to sort of advertise, because we feel really good about it. I feel really good about it. I think that when we took a look at the math on it, would I have liked to seen a higher recurring dividend? Personally, when I say personally, meaning intellectually, I guess, the answer is yes. That said, I think there was a lot of evidence to say there's not a lot of bump in the stock to overpay and over-commit to a kind of recurring forever dividend. We kind of looked and said, "Where's the best point for that?" The rest will just happen.
Yeah, the only thing I'd supplement that with is I did put our team through the paces of stressing, okay, give me all the worst things that could happen to us in the last whatever, and use that to help set a framework for me as to how much I would be willing, because I don't want to lock into something that if the black swan stuff happens, you're sitting there going, "Oh my gosh, why did we do that?" We feel very comfortable at this level.
Got it. If I could just ask one additional question. What was the change in compensation expense? What are you expecting now versus what you had expected going into the year?
I'm sorry. Oh, make sure I have your question correct. Are you asking about how much we reduced from what we were accruing?
I think.
Fifteen.
Got it. Thank you.
Thank you. Our next question is from Bill Chappell. Your line is live.
Good morning. This is Sarah Miller on for Bill.
Hey, Sarah.
Hi. I have a follow-up to Olivia's question and then one other question. On your variable comp for next year, is it going to kind of return to that level 15 above this year, or is it going to kind of build on top of what you expected for this year?
Let me just throw out there that we generally operate with a bunch of different sets of numbers. This is not to be sort of dishonest. It says that we have our own internal stretch numbers. We have numbers we sort of get the board to commit to. That really sort of is our target comp, meaning the bonuses pay at 100%, which is what we'd call target. There's the numbers we conservatively sort of transmit to the investment community. I think what you can see here is that we're in that sort of middle range this year, which is sort of, we believe, at approximately target. Okay?
Okay.
It's hard to say where we end up going forward in our budgeting process because I think the idea of having a management team sort of operating the business toward more stretch goals is a good idea, as long as we don't need it to make our investment thesis to you guys and our commitment to the board. It would not be surprising to me if we started the budget year with more than 100% built into the incentive like we did this year. That does not mean that we're going to be committing to either the board or the street, an exceptional year, if that makes any sense.
No, that's perfect. Thanks so much for that. My second question is, can you just give a little bit more color on the inventories at the end of the season and going into the fall and how that sets you up for next year?
Barry, you want to take that?
I'll take that one.
Thank you.
Inventory right now is down a little bit year-over-year. What we would expect for the balance of the quarter is around 10% POS increases, and that will drive roughly flat inventory to slightly up. As we look at last year, and you have to look at the business year-over-year and the decisions that were made. The retailers were conservative going into the fall. We had great comps in August and September, which had a lot of pull-through in October. This year, from a planning standpoint, we're planning on the fall being up, but operationally, we're going to ship most of the shipments about two weeks earlier. We expect that with the strong run we're having on POS right now, that'll consume that. They'll end the inventory roughly flat to last year at the quarter, and we'll go into October in good shape.
Yeah, just to clarify, Barry's talking about retailer inventories. Our inventories will be down in the target range that we identified.
Right.
Thanks so much.
You bet.
Thank you. Our next question is from David MacGregor . Your line is live.
Hey, guys, this is Zorn in for David. Thanks for taking my questions, congratulations on the results.
Thank you.
I guess first, I was just hoping to get your thoughts on market conditions in Western Europe. Clearly had a very good revenue growth in that market this quarter. A number of companies operating and building products and consumer goods industries have indicated during this earnings season that market appears to be bottoming or even trending up. Understanding that your business is subject to seasonality, could you just talk a little bit about the environment there and maybe what your expectations might be for the region over the next 12 months?
Barry, let me just throw in my spin, if I could. Look, I think that primarily what we're seeing in Europe is a rebound from just really crap weather in the beginning of the season. I think they've ended up where it's been actually pretty nice and followed the U.S. as far as warm. My forward view of Europe is possibly, I guess that it's bottoming up, but I don't think that here in Marysville, there's a lot of view that there's a ton of upside on consumer demand in Europe until, I'm going to say, the entire economies start to feel a little better. I don't personally see that, and talking to other senior executives of European-based businesses, I'm not sure they do either. I think that for us, a lot of what happened was weather.
I think that the consumer has just not been a big help in Europe. Barry, I don't know how you would take that and go with it, but good luck.
I would say there's three things that affect, as I look at macro things, Jim said some of them, the weather, the retailer sentiment, and the consumer engagement. Similar to what you're saying, our point of view is, we had better weather in the summer. The retailers stayed engaged. We had a couple bankruptcies in the previous couple of years that had shifted things around a bit. I think that's normalized. The consumer seems to be engaged. Where I would say we're at and where we're planning is that the business has stabilized at these levels. As Jim has said, we're not planning on big growth from here. We're planning on consistent growth, and that's in line with what we said we were going to do to right-size our cost structure to these levels.
We're planning on the business being relatively flat and right-sizing the business to those levels. As time goes on, we'll watch it, and we think there could be slightly some upturn next year based on exactly what we saw in the U.S. this year, which is weather, but we're going to plan for it at the modest levels.
That's helpful. If I could throw one more in there. I was hoping you could expand your commentary with regard to potential acquisitions in both the consumer and lawn services segment. Specifically, we've seen in the past that you've entered new product categories like animal repellent on your own, just given strong brand awareness for your products. Should we interpret maybe your commentary as a change in strategy going forward, or would you still prefer to enter new categories on your own? Thank you.
That's a really hard question because I think it's situational. I think we spent a lot of time looking at the repellent category, ultimately decided that the best way, for a whole slew of reasons, was to do it ourselves and the use of the Ortho brand. I think that that's going pretty well for us. I think there's other areas where we don't really believe we have the skills to do it. If there's a opportunity that's priced properly, where we can either partner with someone or acquire them, I think we're willing to do that.
I think based on the fact that we've reserved a pretty substantial amount of money relative to what we spent over the last few years, there's opportunities if it's properly priced and it's a category that we're interested in entering, particularly if we see that growth in our core categories is, to some extent, retarded, then I think this is an area where we are interested in where we have availability and the price is right to either enter it ourselves or acquire or partner. I think that probably is different just because we haven't been in sort of that mode of acquisition. As you know, gross margin is something that we're focused on pretty hard. I wouldn't say excessively, meaning we're walking away from business because of margin.
I would say that this idea of sort of 40 points of gross margin is really important to us, and it's something that we're at or ahead of plan on getting to, especially if you take absorption issues that happened in this year as a result of volume shortfalls. Margin is a factor as we look at these categories of what we're interested in and what we pass on. Within lawn service, this is a great gross margin category, both on do it for me lawn service and pest control, where there's much higher margins that we see in our normal U.S. consumer business. This is an area where Brian Culler is competing for money. I was jousting with him a little this morning that he's actually has to have a presentation that is capable of making the sale with me and Larry.
He says he's now ready for that presentation. There is a little bit of competition for candidates within sort of the North American consumer business and the SLS business, which is more money than we've spent in recent past, but it's not unlimited, and based on two-thirds going back to the shareholders. I think that there are opportunities, and we're chasing them, and we have a fairly well-populated, I would say, business development process happening right now, and that's a good thing.
Great. Thanks so much, guys.
Thank you. Our next question is from Alice Longley. Your line is live.
Hi. Good morning. My questions are mainly on gross margin. You've got your favorable urea prices for next year, aren't maybe diesel costs going to be a headwind with rising oil prices and also resin for your jugs? I'm hearing that resin costs are going up a lot. Can you give us the puts and takes to convince us that your gross margins can be up next year in line with that 40 basis point goal that you've got?
Yeah. You said well, Alice. There are ups and downs. On an overall basis, we view it as being relatively down. We've locked in about half of our cost, we feel very comfortable. We've been working well with our retailers, we feel comfortable with where we're at in our discussions on pricing with them. We probably are not taking as much pricing as we would have taken, or would have thought we would five or six months ago related to that. We're very comfortable with our trend on gross margin and feel confident that we're going to, over time, get to our 40% gross margin.
Probably not gonna get to the level that we'd hoped by the end of next year related to being back at that fiscal 10 level, just because we don't see volume and leveraging of our fixed cost by that point, we will make significant strides.
A couple of follow-ups to that. You've locked in half of your urea costs. Have you locked in half of your resin and other costs as well?
Yeah. If I wasn't clear, it wasn't 50% of our urea, it's 50% of our total hedged commodity portfolio.
Of the total hedged. Do you hedge resin and transportation costs?
Yes. We hedge across the board.
Okay. I misheard you earlier. What is your target for annual gross margin expansion?
We haven't locked down our target for next year yet. We're still in the budgeting process. Alice, what I would say on that is we are at or above the trends. As I said, the way that I'm gonna say Barry Sanders and Dave Swihart and myself, now Larry Hilsheimer, is the pass down for me is within our strategic plan, where we wanna get to. I've told you our goal there is, call it 40-ish. In the journey down the road toward the gross margin we're looking for, we are on or ahead of plan. Okay? It's a little bit hidden in this year because of a volume shortfall, which drove an absorption issue. If you were to exclude that, we're at or above plan. The approach for next year is we are very positive on our costs compared to where we thought we were going to be.
Enough so that we've been somewhat more flexible in our pricing than we would have been had that not been the case. I think that the guys can take you offline through sort of more of the details on costs, but the bottom line is we're favorable based on the commodity market to where we thought we were going to be. I don't think there'll be any issue convincing you that our gross margin targets are achievable.
Okay, I might have missed this earlier, but in your guidance for let's say flattish sales for this year, what would be the components in FY 2013 of volume, price, and mix?
I think I mentioned that. As far as the fractions, I'm not going to get into that, and if other people decide they want to do that offline, that's up to them. I think what we've said is recovery in Europe, continued growth in lawn service, and modest sort of low single-digit pricing in the U.S. consumer business. Those are the components of-
That means one to two?
That's fair.
Okay. What's your ad ratio doing this year?
Advertising ratio
Yeah
in comparison to last year, is that what you mean?
Right. Yes.
We're down about one point on ratio. We're in the, call it the 5.5, 8 as ratio area.
Is that something that you cut because volume was a little weak, or did you plan that at the beginning of the year?
Yeah, we are on plan throughout this entire year, so it wasn't really volume driven at all. It's really a matter of promoting our highest margin products and our innovation coming out the door.
This is consistent with a 50% increase, then backing that down to sort of a 25% increase from 11.
Okay. Thank you very much.
You're welcome.
Thank you. Our next question is from Jon Andersen. Your line is live.
Good morning, everybody.
Hey, Jon.
I just had a follow-up on the commodity question and how it relates to gross margin. With, I guess the net commodity basket favorable relative to your expectations at this point and the forward purchasing that you've done or hedging, how does that roll out as you look into 2014 and into 2015? My understanding is there's some carryover, the effect that would not only benefit 2014 but potentially 2015. I'm trying to get an understanding for the timing when we might see substantial benefit from lower urea prices. Also, if you can just provide a little more clarification on your pricing commentary. Are you now kind of deviating from your plan to take about 2% of price a year, given the changing cost environment, or is that something that's still kind of your long-term plan and objective?
Let me just take the second part and then leave to other smarter people than me when the benefits of lower commodities, how long it takes before it rolls out into the P&L. Yeah, I would say it's a very slight deviation, is that we talked earlier about I like an environment where everybody's taking pricing, and when not everyone's taking pricing, and we take a look at what's happening, especially in competitive categories like our controls business, this would be Ortho. I think that this is an area where what the consumer is willing to bear relative to how other people are pricing does matter, where it's a more competitive set. We have basically shown some flexibility in the negotiations with the retailers where we're still making our margin goals happen.
I would say this is a very small deviation, but it's meaningful within sort of the negotiations as far as the retailers being clear that we're making our margin targets, which are a pretty significant expansion from where we were, call it the end of last year, that when the commodity news is good, there's some more flexible view of it, as long as we're making our goals. Those are important to me. In regard to sort of rolling it out over time, when that happens, Larry?
Yeah. Jon, a couple pieces of information. When you look at our inventory cost and our cost of sales, raw materials is basically 19% on commodity sensitive stuff, and on packaging it's 6%, and you got a little bit of 3% in transportation. All in, that's just 28% of our cost of sales. In terms of when it will roll through, with our inventory turns, basically all of that's going to go through one year. In terms of what quarters, I don't have all that at the top tip of my tongue. We'll make our standard cost adjustments at the beginning of the year. That'll roll through the first six months of the year, just as it did this year, but everything will play through in 2014.
Well, it's also positive.
Yeah.
If we start 2015 with lower cost products than we had anticipated in our strategic plan, it's got to be a positive for us.
Yeah, to the extent that it's relevant.
Okay. One quick follow-up. Jim, you mentioned called out the mass channel as somewhat soft, at least in the context of stronger performance in DIY and hardware. As you think about that channel going forward, is it just a matter of waiting for a potential recovery in that lower middle-income consumer? Or are there some deliberate things that you're doing internally to try and turn that part of the business onto a better trajectory? Thanks.
Listen, it's a really good question, by the way. I think the answer is probably both. I'm not going to focus too much on the consumer recovery, but I think it matters, especially in a category where people are more sensitive to pricing. We've opened up our option with cheaper SKUs that are lower priced. That's done really well in the food channel. I think has had a little less merchandising support in mass, but hopefully, we'll get more listings there because it's working pretty well in food. I think that if we look and basically said that the mass channel, so we're kind of avoiding using names, but it's a retailer. I think they got into the business late this season. You show up in sort of middle of April on sort of tax day, and you see stores in the Northeast not set.
That's a big problem. I think that the issues in Bentonville are pretty well known. I don't think we're the only consumer products company that has talked about these sort of issues executing the year. Now, to be fair and positive, Barry and the sales team have done a superb job of working very closely at senior levels within Walmart to rectify that. If you look at their summer business, while it's relatively small numbers, are, I think, exceeding the sort of rate of increase we're seeing at DIY. Once the merchandising plans are being executed at the retail level, I think we do okay. I think they got in late. The peak of the season was kind of, I think, a problem. I think it's two issues.
It's both continued weakness at the bottom end of the consumer sort of marketplace, meaning that demographic, and a sort of failure to execute on time, which is probably our fault too, but I'll take that just as a matter of being fair. Barry and his team have done, I think, a really good job of working about as well as you can with the retailer to sort of say, "Hey, we got to fix this and let's get on it." I think both sides, both Bentonville and Marysville, have really worked hard to sort of solve that problem. I want to give Walmart credit for sort of getting on it and tell them we appreciate it, not only for our own selfish reasons, but it says something good about Walmart.
Thanks for the color and congratulations on really running the business well through a difficult season.
Thank you.
Thank you. Our final question is from Patrick Trucchio. Your line is live.
Hi, good morning.
Hey.
Just a follow-up on the mass market versus the home centers. How much were sales up in DIY and home centers? Did they decline in the mass market? If so, how much did they decline?
Listen, from my point of view, I ain't saying. I think it's fair to say they were better at DIY than in what we call channel business, meaning sort of non-mass, but smaller regional players, and hardware than they were at mass. I think it probably run the numbers and say, I think they're down at mass. That's fair enough, and I would say up everywhere else. It is what it is, and I think I commented on it before, and I view this as, like I said before, in part, just economic issues and in part merchandising execution and retail execution, and on both sides, ours as well. I think everybody's on top of that, and the sales for the summer have looked actually really good there. I think probably, for sure, I can easily say down compared to a year ago.
Just on the share repurchase, how much of the buyback is anticipated for fiscal 2014? Separately from that, why have we been seeing so much more insider selling recently? Will the share repurchase bring the family's percentage ownership of the shares, or will it restore it?
I'll go with the back part of that again. I'm 58. There's four of us, two sets of twins. Everybody's sort of 55 plus. My older brother and sister are 10 and 12 years older, respectively. Within the family, there is a liquidity plan that gives people authority to sell a certain amount of shares. I think some people are kind of setting themselves up for their future. They're doing that. It does not indicate a lack of commitment to our family business or what we see as our family business. I wouldn't read anything into that except that at a family meeting over the late spring, people sort of said what they wanted to do. We, as a group, said, "Well, do what you got to do," and that's what you're seeing.
It's really just people operating within what we call liquidity plan. I think that on the repurchase side, and I probably can speak for not only the Hagedorn family, but for other significant shareholders too, who believe that if the stock is undervalued relative to what we think its sort of intrinsic value is, that using repurchase as a method is a good one, and that it will make all of us, percentage-wise, larger shareholders, sort of relative to people who are sellers. I think speaking sort of for my sister or the other family members, to say that I think it's probably some mix. I think we would anticipate some accretion of our ownership through the repurchase. It would not be fair to say, I don't think, that the family will not be participating at all in a repurchase.
Larry, maybe you want to talk about what your view of timing is.
In terms of timing, as we've said before, our plan is to take advantage of the share repurchase authorization that we have and execute on that to the extent that the value would support that over the next year. We'll also be looking for a supplemental return of the up to two-thirds of our cash flow that we've talked about, which would, again, align to next fiscal year.
That's it for me. Thank you very much.
Thank you. At this time, we have no further questions in the queue. Mr. King, we'll send it back to you.
Okay. Thanks, Jimmy. If there are other follow-up questions or people that we didn't get to, just give me a call directly today, 937-578-5622. One other item before we close, Barry Sanders and I will be attending the C.L. King Best Ideas Conference in New York on September the 12th. As usual, that call will be webcast on our IR website. If you're not there in person, you can listen in. Other than that, we will be reporting our Q4 results and year-end results early in November, and we'll talk to you then. Thanks for calling and joining us. Have a great day.