Good morning, welcome to the fourth quarter 2012 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then number 1 on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Jim King, you may begin your conference.
Thanks, Amber. Good morning, everyone, thanks for joining the Scotts Miracle-Gro year-end conference call. With me here in Marysville this morning are several members of our executive team, including Jim Hagedorn, our Chairman and CEO, Barry Sanders, our President, and Dave Evans, our CFO. Jim will get started shortly with some brief remarks about the results we reported today, as well as our thoughts entering fiscal 2013. Dave will walk through the financials. When they're done, we'll take your questions, Barry and others will join us for the Q&A. As many of you know, we have moved up the timing of our annual Analyst Day to December 14th. Given the proximity of that meeting to today's event, we will not be providing any direct guidance related to our 2013 outlook.
We would ask you to keep that in mind during the Q&A session, keep your questions confined to the topics related to the results we announced today. Speaking of Analyst Day, the event will be held at the Waldorf Astoria in New York. We already have about 80 people registered for the event. If you haven't already done so, please register by sending us an email at investor@scotts.com, or you can call my assistant, Heather Scott, at nine three seven five seven eight five nine six eight. We expect the meeting to begin at about 9:00 A.M. Presentations will conclude prior to lunch, we'll conduct a Q&A session with management near the end of the lunch session. We're still getting some of the details put together, we'll communicate more to you in the weeks ahead. With that, let's move on with the call.
I want to remind everyone that our comments this morning will contain forward-looking statements. As such, actual results may differ materially. Due to that risk, Scotts Miracle-Gro encourages investors to review the risk factors outlined in our Form 10-K, which is filed with the SEC. If you did not receive a copy of today's press release, you can find it on the investor relations portion of our website. As a reminder, this call is being recorded, an archived version of the call will be available on the website as well. If we make any comments related to non-GAAP financial measures not covered in the press release, we will provide those on the website. With that, let me turn the call over to Jim Hagedorn to discuss our performance.
Thanks, Jim, good morning, everyone. I do want to take a quick moment before I get going on the script, just to kind of remind everybody how bad things are in New York. I can tell you at our house, we still don't have power. My aunt, who's 90 years old, lives in the road in a cold house with no power. There's no gasoline to buy there. Everything is four-hour-long lines if you want to get gas. Most people don't have enough gas to go to the gas station at this point. We had six inches of snow last night, so it's just one thing after another. I just think the next thing is locusts or something. I'm not sure how the people can help except it's just been a terrible response.
I don't think most people are seeing it, which is that the electric grid is just smashed, at least on the North Shore Long Island. Anyway, back to business. The results you saw this morning for the quarter and full year were in line with what we told you to expect at the end of the third quarter. There's not a lot of news there. The story that played out over the course of 2012 is an important one for us, one that will inform our plans for 2013 and keep us focused on getting our earnings back to an appropriate level. I want to share some of the headlines from the year and help you better understand what worked, what didn't work, and how we're adjusting.
I'll start by giving you a quick recap on the year and discuss progress we've made over the last 90 days to shape our plans for the year we're in. Excuse me. I'll start by discussing the U.S. and touch upon our international businesses, where sales for the year were down 4%, but flat when excluding foreign exchange. I'll discuss lawn service, where our sales were up 4% for the year. Since Analyst Day is just five weeks away, we'll hold back on providing many details around our 2013 plans until then. As for 2012, consistent with the revised guidance we provided in August, sales in the global consumer segment were flat for the year and up 1% in the quarter. Sales in the U.S. side of the business were up 1% for the year and down 3% in the quarter.
Consumer purchases for our products in the U.S., as measured by POS data from our largest retailers, were up 2% for the year. It was a strange year in the U.S. consumer business. Of that, there's little doubt. We got out of the gate strong with high levels of consumer engagement in March, in fact, record levels. From there, consumer activity in the U.S. was well below expectations until we got to the end of the year. Consumer purchase of our products related to fall lawn and garden activity, which is typically August through October, were up 7%. Even though our full year growth was below what we had planned, we're pleased to see strong market share gains in almost all categories. That's a point I want to emphasize. We continued to outperform the category.
In fact, that was one of the goals we had entering the year. What you're seeing is that consumers will walk away from the category before they walk away from our brands. Part of the reason they stick with us is because we have a history of providing them with better solutions, and that was evident again in 2012. Where we had innovation, we saw strong consumer response. POS in Ortho was up 13%. It was a solid season for controls across the board, and we were aided by strong consumer interest in our new battery-operated sprayer. Retailer support for the brand remains high, and we continue to see the applicator as driving consumer activity. Another area where innovation was in the spotlight this year was our lawn fertilizer business. The nationwide rollout of Snap was largely in line with the internal goals we'd established entering the year.
Satisfaction rates remain extremely high, which we believe will translate into a strong level of consumer support going forward. We remain confident in the Snap system, and it will become a significant part of our lawns business over the next three to four years. Overall, consumer purchases of branded lawn fertilizer were up 1% for the year. While this was a bit less than we had hoped for, it was a good story nonetheless. As we said going into the season, we had seen multiple years of unit volume declines in this category. We see the reversal of that trend as good news heading into 2013. Quickly looking at the rest of the U.S. businesses from a POS perspective, consumer purchases in our mulch business were up 16%. Throughout the season, our retail partners were highly promotional with mulch.
Consumers clearly saw the great value they were getting, with some offers as low as four bags for $10. While this is a good news, bad news story for us, while mulch represented our greatest area of growth, it's also a product that is dilutive to our margin rate. Our supply chain has been working to drive margin improvement in mulch for both 2013 and 2014. As I mentioned, POS in Ortho was up 13% for the year, and Roundup had another solid season with an increase of POS of 6%. The battery-operated sprayer will be an important part of the Roundup offering in 2013. We're optimistic about the continued performance in that business. Grass seed POS was down 9% for the year. As we've said in the past, we expected the business to be soft in 2012 after a strong year in 2011.
While we spent heavily on advertising in this category, we felt it was necessary to combat the competitive advertising that targeted our brand with bogus claims. While it's frustrating that some of our competitors feel more compelled to attack us than to drive more consumers into the category, we want shareholders to know that we will always defend our brands. Not only did we do it last year, but we'll do it again this year if we have to. There was good news in grass seed at the end of the season as well. Not only did we take 350 basis points of market share in units, we saw POS of grass seed increase 20% in the fall, which is not unusual after a hot, dry summer. While history would suggest that this activity would carry over into the spring, it's too early to make that call right now.
Our gardening business was the biggest frustration in the U.S., especially our soils business, where full-year POS was essentially flat for 2011. As we discussed on the last call, this is a business that typically peaks in May. Unfortunately, this was about the same time when the consumer went into hibernation. As a result, the second half of the lawn care and most of the gardening season, when we sell some of our highest margin products, was soft. I'll come back to this point later because it's important in understanding how we view the business right now. Wrapping up the U.S., I'm also pleased with our partnership with S. C. Johnson. While the economics remain modest right now, we are clearly seeing the benefit of distributing Raid and Off! in the DIY channel and having them deliver our products in grocery and drug.
Let me shift gears and talk about advertising for a moment. As most of you know, we made a big bet this year with our decision to dramatically increase our advertising investment in the United States. We've already said we'll reduce ad spending in 2013. Essentially, we're reducing the year-over-year increase from 2011 to 2012 by about half, so that the 2011 to 2013 difference will still be significant. While I'm on the subject, I want to say I'm really pleased with the improvement on our consumer marketing team has made in 2012. Those of you who know our story well have heard me say that we have to greatly enhance our efforts here if we're going to win with the consumer. Since our third quarter call, we've received a full data set related to the past season, and we like what we see.
The strongest results were from our Scotts advertising campaign, which featured Scotty the Scotsman. The campaign tested extremely well in terms of being memorable with consumers and having higher persuasion scores than we had anticipated. One of the reasons we think the campaign is working is that we've done a good job of integrating it into nearly all of our lawns programs. We've used Scotty on TV, radio, print, as well as in store and online. We were also able to effectively use him to help drive our Major League Baseball sponsorship, which we're planning to do again in 2013. Going into the season, Jim Lyski also talked to you about our increased investment in digital. We saw good progress there as well. Traffic to our homepage was up 57%. Mobile traffic was up 270%, and search traffic had increased 80%.
In some regards, 2012 was a good year, an important year in terms of consumer engagement. There's lots of good things to take away from the season and to build on for next year. I want to transition for a moment to our international business. I told you already that sales outside the U.S. were down 4% for the year. That's true even though we had strong performances in both Canada and Australia. In Europe, however, we had a tough year. Sales in the U.K. were down 13%, and in France, we were down 9%. We believe weather was the overwhelming factor in Europe, as rain and cold temperatures were the norm throughout the spring. We saw some strength in the late spring and early summer, but it was just too little and too late to make a difference.
In addition to the weather, we're seeing the same thing everyone else in Europe is seeing right now, a weak consumer and a stagnant economy. Although our European business had been doing well over the past few years, and we expect improvement in 2013 from what we saw this season, we still believe this business will be under stress from the macroeconomy. Getting our European profitability back in line is a major priority for us. Let me talk briefly about Scotts LawnService, which grew 4% for the year. We saw a 240-basis-point improvement in customer retention levels, and customer satisfaction levels stayed near all-time highs despite a hot, dry summer. The team also continued to make good progress in improving route density, which is key to driving improved productivity in this business. We still get questions about SLS, so I want to reiterate our view.
We see this business as a core and strategic part of Scotts Miracle-Gro. We're committed to it for the long term and see both organic and inorganic growth opportunities in the space. Let me change gear here. I want to close the loop on our assessment of the past season and tell you what it means for 2013. I also want to talk a little bit about our agenda for Analyst Day. On the last call, I told you that we were surprised by how the season unfolded, and that at the time, we weren't quite sure what to make of it. While I don't think we'll ever have a precise answer, the benefit of time has helped us better understand our business in the context of the broader marketplace.
First, when you look at weather over the course of the entire season in the U.S., it definitely posed challenges in some markets during the late spring and summer. In March, the weather was fantastic everywhere, which allowed us to get off to a strong start. It turned in May, especially in the Northeast and Midwest. There were cool and wet weekends during May in the Northeast, and that certainly didn't help. Here in the Midwest, lawns became pretty stressed and browned out by midsummer. A lot of consumers just stepped away from lawn and garden care in the midst of the drought. Like most seasons, weather helped us at times and challenged us at times. Was it the big issue? I don't think so.
For sure, some of the softness we saw in April and May was due to the strong start and pull forward of some consumer purchases. Weather was an issue in some markets as well. I've been in this business long enough to know the challenges this spring were more than weather. We've worked to better understand whether it was a structural issue with our business or something broader. We're convinced it was something broader. Consumer spending in most sectors of the economy was up across the board in the U.S. in February and March. Not only were we up during these months, we had a record month in March. Consumer spending for April, May, and June declined. These happened to be the biggest months of the year for us, with well over half of POS occurring during that period.
The weakness that we saw persist, particularly in May, not only occurred as overall retail spending fell, but as gas prices increased and the stock market declined. We had stated in the past that we thought our business was resistant to economic downturns and at times almost appeared to be enhanced by recession. That didn't appear to be the case in 2012, as we found ourselves trending more in line with swings in consumer sentiment. In fact, if you look at how our business performed during the spring and look at what other CPG companies reported, the results were remarkably and unusually similar. While this does not impact our long-term confidence in the category, it does impact how we're approaching next year. We have baked in a low single-digit price increase to our plans for next year. In hindsight, we don't think we got much from holding pricing last year.
Our retailers have been supportive of the increase. We don't expect this big enough for consumers to react negatively. With that said, we're still assuming zero growth in unit volume and zero improvement in market share. Are both of those measures still important to us? Damn right. I'm actually cautiously optimistic that we'll see upside from our plans. We will not build a business plan or a budget around that assumption. I'm not going to spend a lot of time revisiting decisions we made in 2012 about pricing and advertising. Given the facts at the time, I was confident in that decision. With the benefit of hindsight, I think we could have taken a 2% or 3% price increase. We continue to believe the advertising investment was appropriate based on the historical track record of the category versus the overall economy.
Over the last two seasons, we've seen much more fragility on the part of the consumer. When the weather, the economy, and consumer sentiment are all trending favorably, then we benefit. When any one of those factors slip, we tend to feel it. Even though we have an excellent program in place for next season, we're taking a conservative stance in regard to our 2013 budget. If we see upsides to our assumptions, our bias right now is to allow that money to drop straight to the bottom line. By focusing on what we can control, we expect to see improvement on both gross margin and SGA, so we'll get good leverage without much volume increase.
Right now, the external consensus is slightly above 250 per share. I feel confident in saying we should be able to do at least that well in 2013, assuming we see flat unit volume. In terms of being more specific, that's all we have to say regarding guidance today. We will, however, provide a range for EPS during our meeting next month in New York. Speaking of that meeting, let me tell you what else you'll hear. Over the course of the summer, we've been working aggressively at examining every opportunity that exists to improve gross margins through pricing, cost-out initiatives, and to more fully leverage our SG&A. We've seen progress in all areas. We'll describe in more detail some of the cost-out initiatives that we believe will help drive gross margins.
We'll also discuss some of the organizational changes we've made as we continue to keep a sharp eye on SG&A. Our content for the meeting will be mostly focused on 2013. We will focus on steps we're taking to drive profitability and the momentum that will allow us to make even more progress in 2014. We'll talk a bit about our aggressive goals for cash flow and our desire to resume shareholder-friendly initiatives as we de-lever in the second half of 2013. While we'll provide a reminder of some of our longer-term initiatives, we won't elaborate much. We recognize the need to restore our profitability and our credibility in the near term, and that's where we'll spend the majority of our time at this meeting. With that, let me turn things over to Dave to share the financials.
Thanks, Jim, and good morning, everyone. I'll provide some color on our fourth quarter and full-year results. Before discussing our results from continuing operations, I wanted to highlight that, as previously anticipated, we did complete the wind-down of substantially all operational activities of our professional seed business in Q4. As an outcome, ProSeed is now classified as a discontinued operation. We will update prior year's quarterly and annual financial results from continuing operations to reflect this change when we file our Form 10-K later this month. With that housekeeping, I'll now focus the balance of my comments on adjusted results of continuing operations. I think starting with a bit of context helps. Fourth quarter sales have historically represented about 14% of our full fiscal year sales. Given our relatively fixed cost structure, the fourth quarter has historically been a loss quarter.
This reflects the seasonality of our business. From a macro level perspective, Q4 of 2012 was no different. Sales represented 14% of the full year. We reported an adjusted net loss of $0.59 per share. While the fourth quarter was in line with our guidance, it was nonetheless a larger loss than 2011, when we reported a loss of $0.41 per share. Given that, my comments for the quarter will be focused on factors contributing to that increased loss and begin to provide some visibility on actions we're taking to drive significant improvement in earnings in 2013. The fourth quarter headlines for 2012 are very similar to our third quarter, with the year-over-year increase in loss attributable to declines in gross margin rates, along with modest growth in SG&A. With that, let me start at the top.
Net sales for the fourth quarter were flat to prior year at $401 million. Consolidated net sales for the full year were up 1% to $2.83 billion. Changes in FX rates had a nominal impact on consolidated net sales for both the quarter and the full year. For the fourth quarter, sales for our global consumer segment were up 1%, and excluding FX, up 2%. Sales for the full year were flat and excluding FX, up 1%. Breaking this down geographically, at constant FX for the full year, sales within the U.S. increased 1%, while international sales were flat. The 1% increase within the U.S. was consistent with POS growth at our largest U.S. retailers, which had ended the year up 2%. The difference of 1% between our sales and POS reflects the drawdown of inventory at our largest retailers at our fiscal year-end.
This drawdown had a larger proportionate impact on our fourth quarter, explaining the divergence of POS growth in Q4 of 3% and our total U.S. consumer sales in Q4, which declined 3%. For the year, we saw double-digit growth in our sales of mulch and controls products within the U.S. These increases were substantially offset by declines in wild bird food, grass seed, and plant food products. Jim already touched briefly on international and Scotts LawnService. I won't spend additional time on these businesses. As Jim has already articulated, we've constructed a balanced plan in 2013 that assumes flat unit growth plus low single-digit price increases. We believe this is an appropriate approach considering the current uncertain environment. Moving on, gross margin rate contracted 200 basis points for the quarter, ending the year 280 basis points below fiscal 2011 at 34%.
The causal factors for the full-year decline are relatively unchanged from those I articulated last quarter, with the most significant relating back to increased year-over-year product costs. At the onset of the year, we expected this product cost headwind to be partially offset by modest pricing, favorable mix, and distribution cost benefits. As we stated last quarter, we didn't realize the full benefits of these expected tailwinds. While our gross margin rate continued to contract in Q4, the rate of decline slowed, in part due to a moderation of commodity cost increases. While we don't expect a full recovery of gross margin rate in 2013 to 2011 levels, we do expect significant improvement based on discrete actions we've taken. Namely, we'll see some benefit from price increases, and we'll also realize initial benefits from the product cost out and productivity initiatives we launched a year ago.
You may recall Dave Swihart spoke of this initiative last February at our Analyst Day. We still expect modest headwinds from increased commodity costs, though these are more a function of legacy costs from 2012 than any increase in expected acquisition costs in 2013. Through the end of October, we've now locked about 46% of our commodity costs for 2013. This is up from a year ago. SG&A in the quarter was $148.6 million. The year-over-year increase of $12 million was attributable to increased advertising, plus some charges we took for restructuring activity and additions to reserves for doubtful accounts. For the full year, SG&A was $705.7 million. The year-over-year increase of $19 million was driven by a roughly $30 million increase in advertising. I mentioned restructuring charges. I want to comment on those.
We incurred about $3 million in charges in our fourth quarter to make changes we believe appropriate to reduce our cost structure, strengthen our organization, and outsource certain non-core capabilities. These actions reflect some of the steps we're taking to adjust our cost structure to improve our near-term profitability while still balancing the need to invest and grow capabilities essential to our long-term growth. We'll spend more time on these initiatives in December to give you greater confidence in our plan. Moving on, the rest of the P&L is pretty much in line with expectations. Interest expense in the quarter was $12 million, compared to $13.7 million a year ago. As expected last February, interest expense for the year was about $62 million, or $11 million higher than fiscal 2011, primarily a result of higher average year-over-year debt.
The full-year tax rate for adjusted earnings was 36.6%, and we ended the year with a share count of slightly more than 62.1 million. Taking it all to the bottom line, adjusted loss for the quarter was $36.4 million or $0.59 per share, compared with a loss of $25.7 million or $0.41 a share a year ago. On a GAAP basis, loss from continuing operations was $36.6 million or $0.60 a share, compared to a loss of $62 million or $1 per share last year. The difference between adjusted and GAAP numbers for the quarter related to some nominal legal costs incurred on the closure of the EPA matter. As you know, during the quarter, we finalized both civil and criminal agreements with the U.S. Department of Justice and the EPA related to certain products distributed and sold through 2009.
As an outcome, we do not expect to incur additional costs related to these matters in future periods. Adjusted earnings for the full year were $2.01 per share, consistent with our guidance in August. Finally, I want to touch briefly on some credit metrics in the balance sheet. Our year-to-date EBITDA leverage ratio is 2.9 times
We expect this ratio to stay around three until we report the third quarter of next year, at which time we should see the ratio rapidly moderate back to our targeted range of 2 to 2.5 times. There's a handful of year-over-year changes in the balance sheet, the most notable of which is inventory, which increased $28 million. When considering the liquidation of ProSeed inventory, inventories increased $57 million. This increase was an outcome of several factors, including lower than expected sales. Regardless, we have established plans to aggressively reduce the level of inventory we exit next season with, and we'll describe initiatives to achieve this in December. In anticipation of your questions, I'm not providing any specific guidance for 2013 on today's call. We'll provide a clearer outlook for the year at our Analyst Day meeting on December 14th.
With that, let me turn the call back to the operator to take your questions. Thank you.
At this time, if you would like to ask a question, please press star, then the number 1 on your telephone keypad. Again, that is star one if you would like to ask a question. Your first question comes from Sam Darkatsh with Raymond James.
One in for Sam.
Go for it.
A few housekeeping questions for me on 13. I know you don't want to provide too much on the consumer or some of the margin area, but could you give us a sense of where you think interest expense and tax will shake out for the year as we get to that 250+?
Look, I think interest expense, unlike the change from 2011 to 2012, where we saw some pretty significant changes. From 2012 to 2013, I'd say my expectations would be for reasonably flat year-over-year in interest expense. I can provide more color on how we get there in December.
Okay. It sounds like-
Sorry. Tax rate. I think if you look at our history-
you'll see that we've generally been 36%, 37%. I wouldn't expect anything different from our history as you look forward to 2013.
I would throw out there that.
Contingent.
All candidates, thank God, are talking about making corporate tax rates more competitive globally. Let's all be hopeful that corporate rates come down as a result of fiscal cliff and whatever permutations there are to that.
Just to make sure I'm reading between the lines properly on some of the shareholder-friendly activities you've talked about in the past. It sounds like de-leveraging is going to be the priority. If you're not going to change the debt to EBITDA ratio until three Q, does that mean we shouldn't expect any actions until four Q? What might those look like? Would you lean towards dividend, share repurchase, or why?
Look, I'll start, and then if Dave wants to add to it. I think it's a good question. I would say I'm not sure. De-levering to the point of getting down. We ended the year with less sales and more inventory than we wanted. As we sort of naturally clean up the balance sheet through the first half of the year we're in, 2013, and we naturally begin to de-lever as we're getting paid. I think my view is that notionally, the range we've sort of set as an interest coverage or whatever, debt to EBITDA you have of, call it, I think we've said two to two and a half times. I'm sort of in the two and a half times category. I think we want to de-lever down to the low twos.
At that point, I think within our credit agreements, we'll have the ability to make some, I'm going to say fundamental moves in regard to what we're calling shareholder-friendly actions, which would be one of two things or some combination of the above, stock repurchase and/or sort of one-time dividends at year-end after we've taken a look at what our requirements are for cash. I think I've been pretty clear to people that we got ourselves into a mode of saying that we believed in sort of significant growth opportunities, call it last couple of years.
I think after 2012, for me, and I know the management team is aligned with me and so is the board, that I just think that the global economic situation is fragile enough that I don't think, and based on the level of activity and fragility of the consumer, that that is a reasonable assumption at this point, that it's a growth environment. That as we've talked before about two-thirds of our sort of our free cash going into growth opportunities, both organic and inorganic growth opportunities. We're going to be biasing that. I'm going to call it roughly the inverse of, call it, about one-third to growth and about two-thirds to
Non-growth. I think in the absence of something better to do with the money, we're biased, and I personally am biased to return that money to our shareholders. That generally, I think, is where we're going. There's a lot of work to do between now and sort of the second half of this fiscal year, both with our board, getting advice from our financial advisors, and then internally kind of looking at what our CapEx and other growth requirements would be for the company. There's some steps to take, but I think directionally, that would be a fair way to look at it. Just personally today, I'm probably more biased on one-time dividends than repurchases. Although, I would say to the shareholder community that's on the phone, I would call Dave, and if you have a bias, tell us what you think.
We're interested in what other shareholders think of how they'd like to affect these shareholder-friendly actions. If people have a point of view, they ought to communicate it to us. It would be useful. Dave, anything you want to add?
No, I think you captured it very well.
Thank you.
Your next question is from Olivia Tong with Bank of America Merrill Lynch.
Hi, Olivia.
How are you?
Good.
Good. Thanks for the sentiments about the hurricane and storm earlier today as well.
It's a pretty disaster. It's like it's unbelievable. I don't think anybody on TV is really seeing how bad it is there. I haven't seen a single Long Island Power Authority truck since we lost power in our community. Not one.
Yeah, a lot of people have had some pretty bad impacts on Long Island and across the region. If I can transition more. Sorry, don't know how to do that.
It's all good. Easily.
If we could talk a little bit about your statement in the press release, about trying to get back to what you saw in terms of earnings two years ago. Now that we have the 2012 base, if my math is correct, it looks like you're looking for about 400 basis points or so of margin improvement, or more importantly, about $100 million decline in cost. You've obviously got pricing plans next year. You've got advertising that'll come down on a year-over-year basis, but presumably variable comp will have some restoration, et cetera. Can you talk a little bit about the puts and takes beyond those three factors that will help drive you closer to potential restoration of EPS closer to targets that you made two years ago? Thanks.
Sure. Yeah, Olivia, I'd reiterate that kind of the foundation is an assumption of reasonably flat units. The path that we're defining to get there is going to be focused on probably three primary levers. We've talked about pricing. We took some pricing increases for 2013, and we'd say we continue to believe that in a value appropriate way for our consumer, we'll continue to explore opportunities to get greater realization pricing in future years. We're focusing on that, not as an event just for 2013, but kind of building an ongoing capability and capacity to do that moving forward as well. The second lever is really product cost and supply chain productivity above our margin.
Last February, Dave Swihart went through in some detail and articulated a project that we had launched, and these types of things on product cost take a long time to kind of manifest themselves in the P&L. It's a highly coordinated effort between our supply chain, our R&D group, and our marketing group in examining each of our products and identifying opportunities for taking costs out of our products that don't have a commensurate kind of value benefit to our consumer. Some of the benefits from that project we'll begin to see realized in 2013. It's the type of project where you get some momentum up, we would continue to expect to see that favorable outcomes from that in 2014 as well.
From a supply chain cost productivity, if you did look at our CapEx, while we're expecting to be probably a bit more restrictive in CapEx moving forward, I can tell you the area of CapEx that we're not spending less on is CapEx related to cost productivity. The supply chain and the other teams continue to request. We got a nice pipeline of requests for projects to drive increased productivity in the conversion and distribution costs, and COGS as well.
We have three levers that we anticipate we can drive improvement in our margin rate, as well as kind of a continued focus on mix management through both our innovation as well as we've continued to make refinements, improvements in what we call integrated business planning, where we're better collaborating amongst ourselves and with our retailers and focusing our promotional efforts on products that will support an improved mix for both the retailers and us. If you drop below gross margin, SG&A, we took a couple steps that we've already talked about that were kind of a one-time reversal of some of the increases from 2011 to 2012, from 2012 to 2013. Advertising, we're trimming that back, focusing on where we receive the highest value. Our greatest focus now is more on SG&A productivity. We began to take some steps this year.
You did see some very small restructuring charges, which we're not calling out as an adjustment to earnings, but we incurred some costs as we begin to kind of improve the alignment of the organization based on the learnings we've had. There's a fairly significant focus on driving improved productivity throughout all areas of SG&A. We don't see 2013 as kind of the end all of that process. We've laid our plans for 2013, and we're now, right now in Q1 of 2013, focusing heavily on what are the improvements we're going to make in 2014. There's a lot of effort right now on all those levers that's giving us the reason to kind of believe that we can get this profitability back to those levels. In a best case scenario, we can do it by the end of 2014.
That gives you kind of a broad overview of the whole landscape of initiatives we're working on.
Got it. Thank you for the detail. On the restructuring, would you expect to get more aggressive on that? Is there a potential that we see a bigger plan with a bigger charge and some detail around timing and the payback and all that stuff?
I'm just going to sort of jump in for a second, and Dave can pick up the pieces if he has to. You're seeing that Dave and I have made a decision in regard to restructuring definitely within the American business, although we've got a lot of work still to do on saying what's the end state of the European business look like. Within the core of the business, I don't think we intend to make adjustments at this point going forward on actions that we're taking to sort of make the company more profitable and/or increase cash flows. While I think we'll talk about them as we discuss the financials with you guys, we will not be excluding them from our numbers as we've done in the past. I think we're tired of, and maybe you guys are too, of all these constant adjustments.
Because we don't know what it means in Europe yet, we're not prepared to make that sort of commitment for Europe, but for the core of the business, we are. We'll still talk about it. We just won't call it out as being separate sort of adjustments.
That's correct.
I
Got it. Thank you.
Okay.
Your next question is from Bill Chappell with SunTrust Bank.
Hi, Bill.
One, I understand the hope of flat volumes going to next year trying to be conservative. Do you look back and say the only reason that our volumes were as good as they were or bad as they were in 2012 was because of the stepped up advertising, and by cutting it 50% next year, that's going to actually mean volumes could decline?
Look, it would be fair to say that the assumption is based on flat volume. Okay? I mean, it's a sort of a factoid. That being said, do I believe that that would be reasonable? No. It was very much a line in the sand we took on a budgeting point of view to say we just don't believe that we can count on growth, and it really forces us to take, as we budget for 2013 and beyond, I mean, I'm going to say I have directed that the operating community at Scotts use these assumptions for their budgeting drills. I'd be very disappointed if that happens, to be honest, Bill. It forces us to really look at our business, and I've also been very specific on my expectations on what levels of profitability we need to get to.
Barry and I are in lockstep on that. There's not differences of opinion. This is not one where the operators are shaking their heads and saying, "What the hell?" It is a fair thing to say that would be a negative to our plans if unit volume declined. It would also be fair to say that, as usual, we operate this business kind of with three sets of numbers. We have the numbers with you guys, we have the numbers with our board. Then we have our own internal numbers. On top of that, Barry and I have a pretty significant contingency built in. What do I think? I think marginally, we should be able to make sort of our numbers even if our assumptions aren't perfectly correct. I think that's probably fair to say.
Okay. Yep.
I don't think there's a ton of risk in it, put it that way.
Yeah, I'm just trying to understand. Normally when you cut advertising by 50% and don't think that has any effect on volumes.
Whoa. We're not cutting advertising by 50%. We took advertising up, call it 50%, going from 2011 to 2012. Half of that increase we're taking back and reinforcing. It is still going to be roughly, call it 25% more than it was in 2011, which was a high spend year. We weren't looking to save money in regard to advertising then.
2013 will be the second highest advertising spend the company's ever had, just to put it in that perspective.
It's not a decrease of 50%. It is a decrease of 50% of the increase that happened from 2011 to 2012.
Just to make sure I understand on variable comp, can you kind of give us an idea of the lower variable comp, what impact that had on 2012? I assume you're assuming it's a full year variable comp for 2013?
Bill, we've been fairly transparent in these discussions in the past. For 2012, there are areas of the company, for example, our Scotts LawnService business, our Canadian business. There's areas of the company that performed well this year. We've not penalized them for the broader consolidated results. That is a bit of a change from 2011. We have some payouts there, then we also have, as an element of our broader variable comp, a discretionary element. That discretionary element is 20% of our total variable comp, and we're continuing to pay that out. I would say, as you recall, in 2011, we virtually zeroed out our variable comp. In 2012, the payout that we have is probably closer to a third to 40% of our targeted payout, given the factors I just told you.
2013 should be-
Just to be clear on that.
In 2013.
The parts of the company that naturally would have performed had it not been for our sort of corporate number that would've caused it to zero out, we elected with the board to pay those out where the business units performed. In addition, there's a sort of personal performance fraction of it that we funded, and that's the 20% that Dave's talking about. Those are the pieces that got funded, were the personal component and those businesses that naturally were in the money. We just took the corporate number and pulled it out and paid them as they would have paid as if the company had performed, which we thought was the right thing to do for them.
Got it. Thanks so much.
Your next question is from David Macgregor with Longbow Research.
Just to explore pricing, I'm just trying to get some clarification here. If we should get into next year and the consumer, let's say, explore the scenario where the consumer's a little bit better, the weather's a little bit better, you realize maybe you've got a little more pricing power at that point than you anticipated. Do you have the opportunity to go back and revisit pricing, or is it pretty much cut in stone based on the negotiations you're holding right now?
Generally, David, the pricing is an annual activity, so we go through that when we do line reviews with the retailers so that they can plan their season. For the most part, it's an annual activity.
Okay. Secondly, if you mentioned this, I missed it, I'm sorry, but raw material inflation for the full year 2012?
The way I'll answer the question is tell you how it affected our P&L. It's always a little bit tricky because you talk about what the current markets are, and the current markets, because of the inventory turns we have, don't necessarily translate into the P&L. What we saw for the full year in terms of increased material cost running through our P&L was around $70 million in 2012 relative to 2011.
Thanks very much.
Your next question is from Carla Casella with JP Morgan.
Morning.
Carla, your line is open.
Move on.
Your next question is from Joe Altobello with Oppenheimer.
Joe.
Thanks. Just first question, I guess I'll just follow up on the raw materials question that you said David was up about $70 million in 2012. Given that you've locked in almost half of your cost for next year, and given where current spot rates are, what would that number look like, in 2013?
Joe, the current market prices that we're seeing would imply the cost of materials as we buy them in 2013, will be reasonably neutral to what we would've bought them at 2012. Okay. What we're going to see in 2013, particularly because we are carrying more inventory than we ideally like to have at this time, is we'll continue to see as that inventory rolls out and is sold in 2013, we'll see the remnants, kind of the legacy of those increased costs, in the early parts of 2013. Probably Through the first two quarters of 2013, we'll continue to see some year-over-year costs, which are a reflection of turning out that inventory that's on our balance sheet at the end of September.
Once we get beyond that, based on what we see in the markets today, it should be kind of closer to flat year-over-year.
Okay. Flat in the back half and up a little bit in the first half is what you're saying, in terms of the P&L impact?
Correct.
Okay. Just turning back to advertising, just so I understand, I apologize for beating this to death, advertising was up $30 million last year. You said you're taking back half of that increase, advertising in dollars will be down $15 million in 2013?
Just a little bit of correction. Some of the advertising that we did that was focused on certain retailers, we ran through basically sort of above line. Okay? The number you're seeing in advertising is not totally right because of some programs we did that were advertising, we did it through a retailer. I think the number is probably not right, if you, say, call it that the increase was about $40 million, the decrease will be about $20 million. Okay?
Got it. Okay. Just one last one in terms of inventories and not necessarily your inventories, but kind of how retailers think about inventories heading into next year or 2013. Obviously, this year was a tough year for everybody. Would you expect retailers to be a little more conservative on inventories in 2013 versus 2012, given what they experienced? Or has that already happened, given the fact that POS was better than selling?
I'm going to ask Lukemire or Barry to sort of jump in here, but my view is that I keep hearing all this sort of crap about inventory. What happened this year is every time there's a crappy year in lawn and garden, if you were a merchant or I was a merchant. Hold on, I got to make my phone stop making a noise. One of the ways to sort of solve a problem in a year is to not have a problem with your balance sheet. Okay? I think merchants tend, in sort of poorly performing years, to want to pull inventory and end as clean as possible, and they work pretty hard at that.
There tends to be more focus in a bad year on inventory management at year-end, as you approach the fall and they're cleaning up for either back to school or Christmas. What I don't sense is that there's a lot of pressure on reducing inventory in the spring. I think that pressure and I would expect it to continue, to be honest, which is that just like we are looking at our balance sheet, retailers look at balance sheets and try to say, "How can we run the business with less inventory and still sell products?" So I don't think that the bias toward ending is going to really change. I just think that in a bad year, there's more intensity around it, and I don't think it affects shelf set in the spring. I don't know, Mike, if you agree with that or.
No, I agree with that. We're getting to the point where we're starting to see in-stocks suffer at retailers, and we're seeing some retailers go back to focusing on in-stock. We know the levels of inventory are approaching levels that may even actually hurt the retailer.
Got it. Okay. Thanks, guys.
You're welcome.
Your next question is from William Reuter with Bank of America Merrill Lynch.
Hi. Most of my questions have been answered. I guess I was just curious whether you guys see any potential acquisition activity over the next year or two, or whether that's not something that's really a focus at this point.
Well, I would say I can take the last part, which is it is not a high focus item for us right now. Okay. I think we're pretty clear on this call that both for our own personal stakes, for our reputation, for the reliability of our earnings, we're highly focused on earnings and cash flow for 2013 and 2014. That is not to say that there's no activity, though. It would have to be within sort of the bias that I talked about earlier, which is that about one-third of our cash flows can be used by Barry and Dave and the teams on what we call growth opportunities. It would not be fair to say none.
No, I agree.
Okay. Would any acquisition that you would complete, do you think you would still keep yourself in that kind of leverage goal of 2 to 2.5 times, or could there be a potential huge or larger acquisition that would push you up above that?
Yeah. Consistent with what Jim just described, the types of deals we're looking at would be opportunistic and not significant. I wouldn't see these types of deals being the types of deals that would cause us to raise our leverage above what we do kind of independent of an acquisition.
I just want to sort of say what I think is sort of the obvious in these times, which is based on the fragility of the global environment in regard to economics and the consumer. It's sort of a stupid question to ask, I don't personally think that higher leverage is the right answer in that period. As we become more comfortable that growth is righteous and that the world is a safer place to be economically, I think our tolerance for higher leverage will be higher. That's not the case today.
Okay. All right. Thank you very much.
You're welcome.
Your next question is from Alice Longley with Buckingham Research.
Hey, Alice.
Hi. Good morning. I think this is fairly new that you're going back to talking about some enthusiasm for one-time special dividends. Could you elaborate on that? Because I know that in the past, of course, you did it once in a big way, and you noted that it gives you a boost, and then it goes away, as opposed to raising your dividend on a more sustainable basis. Also, if you do pay a one-time special dividend, what's the thinking about doing it, maybe pushing your leverage ratios and doing it this calendar year because of possible changes in dividend tax rates?
I would say we're definitely not doing that. Although, if our leverage was lower, like if we were sitting at 1.0 right now, I probably would say, "Hell yeah." At the moment, whatever we do, I think to some extent, needs to be based on our agreements. Needs to be in the second half of fiscal year 2013 as leverage ratio gets down. Dave was very enthusiastic to answer the question. I'm not quite sure what he's going to say, so I'm sort of saying, "Let me hear it, dude.
Well, look, I think it's hard to answer based on some hypotheticals of what might happen to tax rate environment and when that might happen. I would just say that in terms of shareholder returns, it'll be in the context of the leverage range that we've been describing. I think there are some biases, but my job would be to be fairly agnostic as to which one it is, based on whatever makes sense at that particular point in time, based on our current share valuation, based on tax policy. We'll look at all that when that time comes, and hopefully, we'll get to that sooner rather than later in the second half of next year.
I can tell you that where I stand now, Alice, is I don't see sort of a massive recap like we did. What I see is in this period of where this company is going to be extremely conservative and predictable. I see the year-end dividend as being a very convenient way to sort of sweep money out of the company at year end, once we understand sort of how things have gone for the previous year. We spent a lot of time this summer looking at value creation. I think in periods of what we keep calling shareholder-friendly periods in this company's sort of economic history and share price history, our share prices tend to perform very well, and we've created a lot of value when we've been in these periods of shareholder-friendly actions. I think maybe it wasn't a surprise to Dave.
It was a surprise to me. There was such a high correlation between the two. I think that in at least for the period, I'm going to say 2013, 2014, with the proviso that everybody understand that there's still a lot of work to do with my internal team, with the board, our financial advisors, to make sure that we think this is right and how to affect it. I feel very positive about it, that it's the right thing for us to do, and is a very safe thing for us to do, and basically gives credit to the owners of the company and says the best person to hold onto money that we don't see a use for is our shareholder.
My next question is about margins, sort of the direction for how we should be thinking about next year, because you've kind of gone back and forth on cost increases. I guess costs go up in the first half of the fiscal year and then are flat, and pricing, it looks like, gives you about $50 million. Is the gross margin expansion for next year mainly on the difference between that pricing and cost, or is it more driven by your cost-cutting programs?
Alice, I'd say we'll provide more details in December, it's not heavily skewed towards one or the other. It's maybe more balanced than we've given you the impression it is.
Okay. Similarly, in SG&A, we've got this maybe $20 million reduction in advertising from a real high level in FY 2012. You've said before that the variable compensation, you were going to make sure is up to people who haven't been paid for two years. Of that $20 million benefit in advertising, about how much of that's going to be sucked away in compensations?
The two, in broad strokes, they're going to be offsetting.
If they're offsetting, where do we get the SG&A ratio benefit? Is that all cost cutting?
Yes, ma'am. You saw some of that with the restructuring that we took in the fourth quarter. We're beginning to do some real and sustainable cost cutting in other areas of the SG&A.
Then my final question is, you talked quite a bit this last year about the unfavorable product mix because mulch was so strong and its margins are low. What kind of mix do you think that you're going to get this coming year, and which products are you counting on driving whatever volume growth you do get, and what will that do for mix? Thanks.
Yeah. It's a good question. Alice, I'd like to kind of defer on that one until we get to December. I think then we can share more broadly some of our thoughts on the mix.
I think, Alice, that the scripts that we read kind of lay the breadcrumbs out there, okay? That the primary impact of whatever occurred, and you heard my view, which is some combination of the consumer and weather really impacted sort of the second half of the lawn and garden season, which sort of chopped out the second half of the lawn fertilizer business and virtually the entire garden business. The pest control business, the weed business did pretty well, as did the first half of the lawn business. Second, mulch was an important component within the business this year. We expect it to continue to be a growing category. In addition, we would expect a more normalized season where you would get sort of a more typical garden season in the second half of the lawn season.
I think those are the crumbs that you can use to sort of take a look at what your assumptions would be on mix.
All righty. Thank you.
You're welcome.
The next question is from Connie Maneaty with BMO Capital.
Hi, Connie.
How much European profitability declined? It's not segmented, so I guess I want really more to focus on the part of your business that's so important to U.S. To do that, I guess it's useful to know whether or not how far European profits fell, if you're making or losing money there, and then I have a follow-up.
Well, we make money in Europe, but the margin rate in Europe is significantly lower than the margin rate in the U.S.
Okay. How much did the European pressure cost you in earnings this year?
It's probably order of magnitude, I'll say $0.10, $0.15.
Okay, that's helpful. Secondly, can you give us your perspective on where regionalization fits into the cost structure? Did it add to costs in the shortfall, or are you finding it an efficient structure?
Well, look, I'll take at least part of that, and then again, this is one where people can either correct me or add to it. We didn't do it to save money. We did it because we looked at market shares around the country, and particularly in the growing southern markets, and I'm talking from the West Coast all the way to the East Coast. We were seeing market shares that were sort of, call it five, 10 points lower than what we had in our kind of more legacy markets, which would be Midwest, Northeast, Mid-Atlantic. I think if you were to look back at over sort of the three or four years we've been doing regionalization, I'm sure it's added cost to the business.
We've gone from sort of five regions to four regions, and the latest iteration of it is combining the Southwest and the Western regions, so effectively we're down to three regions. If you went back from the beginning and looked at our sort of national sales structure prior to regionalization, we're probably getting pretty close to what it was, I would guess. I think since we started, there has been an investment, and we're not shy about saying that because it was about chasing that sales down. We've made progress in every region against it, and particularly in our Southwestern region, made huge progress, but made progress in all regions against it.
All we're looking at now is in a period where we think growth is harder to get, and not just for us, for all consumer companies that operate in North America and Western Europe, we're looking to take cost out of the system. Mike's job is to try to figure out how can he contribute to that cause without screwing up what we've built and the progress we've made. I don't know if you want to add anything to that.
No, I think we've just streamlined our focus on the key opportunities that are still there and we're still developing. We just prioritize them more.
Great. That's helpful. Thank you.
You bet.
Your next question is from Jim Barrett with C.L. King & Associates.
Good morning, everyone.
Hi, Jim.
Morning.
Jim, how excited are you about your new products pipeline, or will 2000 be a year where you further emphasize existing new products like Scotts Snap?
Well, look, I'll give you my bias, which part of this is I'm not talking to you, I'm talking to my own team. A lot of the stuff we've done has been good. I think we continue, as a lot of product development work goes, to be dealing with legacy product development, meaning stuff that we started two, three years ago. I want to continue to sort of tell the group, "Good job." It would be nice to make equivalent or higher margin on innovation, not lower margin. I think part of our core sort of convictions is we have to be the lowest cost operator with anything we're doing, and that needs to be factored into innovation, is we cannot be at a disadvantage on an innovation, especially if it's not proprietary.
I'm really talking like these pump sprayers, which clearly are selling, and application devices generally, whether it's Ortho or Roundup, or the Raid or Off! business are really important. The other products that I care about is that what you saw with market shares are really important to us. We've seen like 200-plus basis points of market share improvement year-over-year, which is probably as high as I've ever seen since I've been in this business. Really surprising to me. I don't know. I'm sort of looking at everybody around the table. They don't know exactly what I'm going to say, but people didn't step away from brands. They made decisions that they wouldn't use a lawn and garden product because it was not a move to private label. Basically, people stepped out of the market.
You look at a flat market where we had some unit volume growth and took pretty significant share. It tells you what's really happening in the space, at least in 2012. What we need to be doing, unless people believe that Obama's programs, which I don't, are going to sort of make the consumer rich, is say, how do we provide branded products to consumers and sort of be able to do it, sort of my view, $5-ish, maybe it's $10, but for a lower sort of how many bills they got in their pocket with a branded product. That is an innovation requirement that I've passed to Lyski that he must satisfy. In addition to that, just going forward, this is pipeline discussion now.
Natural lawn and garden products are important to the future of this business. It's another requirement that I've passed to Jim and his brand team that we need to further accelerate that, both with our existing brands and with, I'm not going to use the word non-branded, but not our core brands. In addition, innovation in regard to plants, meaning our unregulated biotech program, will continue to be funded, because it is something that I think we're the only people in the world, at least the U.S., who have found a way to do what would be considered biotech, I think, but in a way that is not regulated by the U.S. government. They've agreed that this is not regulated.
This is an opportunity to have very significant innovation over the next, call it decade, that is proprietary and nobody else has figured out how to do. To me, there's a lot of opportunities in active ingredients. What would I say in the next couple of years? Besides sort of our secondary branded products, natural products, some application devices, and naturals, I think that's what you're going to see over the next couple of years is kind of limited to that. I don't know, Jim, if you agree with that or not.
I'd say, just to reiterate, we're going to put a lot of support behind our year two product innovations. The retailers demand multiple year support, and they've been very favorable about getting behind Snap and the wand, especially with the wand associated with Roundup. It's a natural pair. We're going to introduce a couple new products this year. A repellents line that's been seeing very good retailer pickup. It's a natural line to Jim's point, very consumer friendly. Second generation of grass seed, coated seed is a big game changer in the seed business, and it's where we have a substantial lead on all competitors. To Jim's point, you're also going to see a $5 and under lineup that's been rolled out. SCJ has been able to get this placed at every account that they're managing for us. Very good pickup there.
We'll have a couple tests on plants, not the biotech kind, but on other plants that we'll be testing out. If those go well, you'll see an effort in 2014 and beyond on those.
Okay. Thank you. A brief follow-up. Why do you think you gained market share in the fall on grass seed?
Well, the conditions were right. The economy came back a bit. The consumer was engaged. Retailers reentered and started promoting the product, and our product is vastly superior.
I'll throw out there, we also spent ridiculous amounts of money advertising in a declining category based on the fact that we knew we were coming out of a very wet fall and that there was not a lot of stress on lawns coming into 2012. We spent because we had to, because we were getting, I think, unfairly whipped on by kind of negative advertising, and we needed to respond, probably like Romney should have. I think the effect of not only what Jim said, but the fact that we had spent quite a bit on advertising behind it means that advertising works. It's just what's the payoff?
Well, thank you both.
You bet.
Our final question is from Jason Gere with RBC Capital Markets.
Questions have been asked, I guess just thinking about getting back to that 2010 operating margin a couple years from now. Is that rate of margin sustainable if the economy doesn't get better, if we see really sluggish type sales in the next 4 years? Can you talk about that? Secondarily, while we've heard kind of in household products and many of the companies today are really kind of focusing on the next wave of restructuring, cost-cutting efforts, they kind of benchmark against each other. When you guys think about where gross margin should be, where SG&A should be optically over the next couple of years, who do you benchmark yourself to, and how do you think about that? Thanks.
Yeah. It's a good question. It's one we spend a lot of time on internally. I'll tell you, we generally look at benchmarking against other peer group CPG companies. In that peer group company, we look at our gross margin rate and believe that we must and should do better. We're also benchmarking our SG&A against those companies, understanding that there's unique differences between each of us and how we go to market and why we spend where we spend. I'd say, though, most importantly, the number that we're most focused on is the operating margin rate. Because there's a lot of ways to get there.
At the end of the day, that operating margin is what we're really focused on improving, and it's one that we've seen decline quite a bit over the last 2 years, and one that we're very focused on trying to drive back up over the next 2 years to get closer to that peer company average. The types of changes we're making, we're making them in a way that we believe should be sustainable and have some longevity to them.
Since this is the last question, Barry, you want to add anything to that?
I agree with Dave. When we look at where we've been, I think, you have to look, we have been talking gross margin, but if you look above and below gross margin, we're making improvements. I think they're balanced, and I think the operating margins need to be in the mid to higher teens, and we think that that's sustainable on the business model that we have right now.
Okay, great. Thanks.
Thank you. I'd now like to turn the call back over to Jim King for any closing remarks.
Thanks, Amber, and thanks everybody for joining us. Again, we will see you on December the 14th. If you've not registered for the meeting yet, please just reach out to us, investor@scotts.com. We will see you then and look forward to the meeting. Thanks for joining us today. Goodbye.
Thank you for participating. You may disconnect at this time.