All right, good afternoon, everybody. Thank you for joining us for our next presentation, from Scotts Miracle-Gro. Scotts is a leader in the U.S. consumer lawn and garden industry, with brands that include Scotts and Miracle-Gro, obviously, as well as Ortho and Roundup. In addition, its Hawthorne hydroponic segment is a leading supplier to cannabis cultivators, both in North America and Europe, and across nearly every product category. The past few years have been quite challenging for the company as it's had to confront several headwinds, including raw materials cost inflation and a softening of demand across the hydroponic industry. Here to help us sort through all of this, is the company's CFO, Matt Garth. Welcome, Matt.
Thank you.
So let's just dive right in, I suppose. My first question has to do with your fiscal 2024 guidance, no surprise, which you, you first provided back in early November. One of the aspects that I think did catch us by surprise, some of us anyway, was the outlook for high single-digit sales growth in your U.S. consumer business, after back-to-back declines in 2022 and 2023. Can you walk us through some of the underpinnings of that outlook? How much is coming from base business growth versus new listings, and, and how much are you giving back in terms of pricing?
Yeah, and I think, Joe, the way that you started that off was very nice, which is we are the market leader. We define lawn and garden. We have retail partnerships that extend back decades, and the past couple of years have been tough. They've been tough because of, frankly, self-inflicted conditions, right? We have a over-leveraged balance sheet, and we are directing cash flow, expense reduction, all effort towards getting to a more flexible financial situation. Okay. Coming out of 2022, we looked at 2023 and said, "Hey, wouldn't it be fair for the lawn component of the market to grow by 10%?" Well, fair, given that it had dropped 20% the year previously. So getting back half of that well, actually, it went the other way. It was down 10%. So in 2023, we had a pretty big surprise in lawns. Was it the consumer?
Was it us? Was it the state of affairs? It was a mix of a bunch of things. Primarily, consumers focused on vacation vengeance during the summer. They spent their money outside the home on entertainment and on travel. And they were okay garden and lawn aficionados. They weren't exceptional, but they were okay. And so coming into 2024, we sat back and said, conservatively, what do we want to look at as a projection for how the consumer and how the market is going to change? And what we said is really zero growth in the market, so no different than it was in 2023, which, remember, was a disappointing lawn season. And then from a consumer POS perspective, no change either.
So the baseline coming into 2024 for us was zero market growth, zero consumer change, which, frankly, again, from a lawn's perspective, it was a pretty disappointing consumer. When you move through to the top-line guide of high single digits, there's a lot of components. And that's why, like you said, you and I have talked about it about 800 times, other sell-side analysts about 900 times. Joe seems to get things a little bit better than the rest. Shameless plug. Anyway, so when you dial it back, what we started with is a recognition that some of our SKUs were more highly priced than what the market could bear, what we wanted our SKUs to be at, particularly in grass seed and things like that. And so some of the price downs that we are driving in 2024 are directed at resetting price at the shelf.
The other components of our price downs are, no surprise, our retail partners have seen deflationary impacts in our cost structure, and they want a piece of that. Now, you go back a couple of years, we've absorbed nearly 1,700, 1,800 gross margin points on inflationary costs in our cost structure. We've offset that with pricing, but on a net gross margin basis, that's kind of dilutive. And our margins need to get back to, in the U.S. consumer side of the business, the mid-30s. And that's the trajectory that you and I think we'll fight over here later. But continue on the growth side. So price down, correct, prices for certain SKUs at the shelf, price down, give some relief from deflationary costs to our retail partners. Now, what does all that gain us? We were early on in the conversation with our retail partners.
We, we expected this to happen. And we said, "If we're going to give you anything, we are going to take significant structural, strategic positions on the shelf and in the lawn and garden center that we haven't had previously. And we're going to do it by expanding promotional activity, expanding our listings, bringing new listings to market. And by the way, we're going to support that with marketing activity. And you, the retailer, are going to benefit from it." So if you look at down 2%+ 10% to get to that net high single digits, let's just call 8%, that's really what it is.
The two biggest components of that volume up are those new promotional activities that we are taking from others and then new and expanded listings, some of which are new innovations that we're bringing to the market a little more quickly than we would have. So this is proper maneuvering in a time where we have the optionality of growing. So that's what we're doing.
And we're probably a little early since it's still early March. But in terms of gaining those new listings, are they playing out as you anticipated?
Yeah, this is a this is a great question, actually. They're all great questions from you, Joe. The planning of the shelf, as you know, actually takes place kind of November, October, November. So, so by this time, you've already been locked in and you've been producing and, and you're delivering based on that plan that you have to fill out that lawn and garden center. And so, yes, as of where we stand today, we are executing to plan the positions that we expected to gain. We have gained. And as we move into the end of the first half, as you know, and for those of you who don't know, our year is really broken down into the first half, which is where we get the orders, we produce, and we ship, and we set the shelves at the retailers.
And then the second half is really the consumer taking all of those products away, right, in season. So beginning now through kind of June, July, that's really the heart of our season. And that's consumer POS that we measure to, to understand how that's moving. So the load-in, production all going to plan and feeling good about it. The early season markets, which I know look, what are the early season markets? It's Florida, Texas, California, some of the Southwest. It's been rainy in some areas of the country. It's been cold. That's led to wet conditions, which a lot of weeds, a lot of bugs. And so what's been booming for us, it's been Roundup and all of your Ortho products aimed at, controlling bug populations. So we've been seeing the benefit from early season markets opening up.
We expect, once this weather passes, that you'll see kind of lawns follow.
Got it. You talked about on your last earnings call about inventories in the channel being maybe a little bit heavy. How does that factor into your outlook?
We are expecting retailer inventories to drop by about 2 percentage points. Our inventories are dropping by net $275 million, which would be kind of 30%. And so there is a huge takeout of inventory on our side and on their side. And that's coming at the detriment from our production. Now, you'll probably remember this, but for the crowd, we've been running about 20% lower in our operations than we had in 2022. And that's to absorb all of this excess inventory. Now, that's fixed cost leverage that we're not getting. So I'm just going to hit on gross margin real quick, if you don't mind, Joe. Two big core gross margin components for us. One, as we look at our cost structure now, I just said we gave back 2% in pricing. Some of that's going to our retail partners.
But there is a whole swath of percentage points to get hundreds of percentage points on a gross margin basis to get from the deflation of our cost structure. So those raw materials that we bought in the pandemic highs that we've been kind of drawing out the past couple of years, once they're gone, we'll flip to the new lower cost raw materials. And there's, you know, 400-ish, 500-ish type basis points that are available to us. You got to manage what's happening from a price perspective, but we'll talk about that in a little bit. The other side of the coin is that fixed cost leverage. And when we talk about the fact that our U.S.
consumer margin is behind where it should be by almost 1,000 basis points. These are the components, you know, fixed cost leverage, getting back to operating at high rates, and then driving through that lower cost structure.
Now, in terms of pricing, I mean, I get this question a lot, by the way. Is there a risk that your retail partners ask for more pricing next year, or how much leverage do you have with the Home Depots and Lowe's of the world, for example?
Remember what we do, right? We define lawn and garden. What is lawn and garden and the lawn and garden center to the retail partners? It is the entrance to their store. It is the foot traffic driver during the season. That's where people come. Why do they go there? They go there for Scotts Miracle-Gro products because they pick brands off the shelf first. Price is usually pretty low. That's why we can sell at a premium to most private label products. Again, some of those private label products, we produce ourselves. So there's always going to be pricing pressure. I think I think we recognize that. The fact of the matter is we've absorbed significant gross margin hits over the pandemic period that we need to recover. It's a very strong, long-run partnership with our retailers that at times it may benefit them.
At times it may benefit us. These past couple of years, we've been in a different position where we've needed help, which is not comfortable for us, right? This is a very high free cash flow enterprise, and those free cash flows should be going to a proper balanced capital allocation philosophy. They're going to debt paydown right now, and that's not where we want to be. And so getting out of there faster means more free cash flow, which means holding on to that gross margin, which means making sure that our retail partners understand that the marketing, the innovation, and the unique sales force that we have comes with higher gross margins.
Got it. So since you mentioned gross margin, I'll go there next. I can remember when your gross margins were in the mid-30s.
You liked it.
You were now in the kind of mid-20s to be nice. So you've talked about trying to get back to that, you know, low to mid-30s range. Some of it's coming this year, I think, 250 basis points or more this year. That's about a third of the way, call it. So maybe talk to us about what's driving the 250 this year, and then maybe more importantly, what's driving the other 600 or so beyond that.
Yeah, the $250 this year, and you'll be happy to hear this, is mostly coming from cost actions that we've already taken. So when we talk about reducing the size of the distribution network, when we talk about driving costs out through Springboard, all of that is embedded in the $250. This is not new and unique maneuvering that we're getting, nor is it thinking that we are going to get higher volumes that are going to drive fixed cost leverage and also tapping into that lower cost raw material opportunity that we have. That is 2024. All of the cuts that we've made, shrinking our network, getting more efficient in our operations, driving down cost expenses, all of that accruing to gross margin. And then, you know, on the SG&A line, we've also taken that from kind of 19% down to 15%-16%.
So proper actions and activities and structuring the P&L going forward in 2025, 2026, that's when we expect to see the benefit from fixed cost leverage improvements. So getting back to operating at 100% and then also driving through those deflationary raw material factors that we've already seen in our purchase rates this year. But because of the high cost inventories we have, you won't see them come through until beginning next year.
Is it too aggressive to think that we could get to a three handle on gross margin by 2026, or is that sort of the base case?
By 2026 or in 2026?
In '26.
I have not gone out that far publicly, Joe. You like, and you know that I'm not going to not answer it. So I do think it's proper that everything that we are doing is to accelerate as quickly as possible the margin recovery. And frankly, for anybody in this room, your level of impatience is probably half of what mine and Jim's are, however, what the right grammatical term is. We want to move extremely quickly, and that is getting back to the durability of this model that grows at 3%, has 35% margins, 15%-16% SG&A, throwing off 20% EBITDA, turning that into free cash flow. That's 8%-10% of sales, and then driving that to continued financial flexibility and shareholder-friendly returns, ultimately creating 8%-10% EPS growth. That's what this company should be doing.
Getting there as soon as possible is the drive that we have. By the way, when you see the proxies, that's what we're incentivized to do. That's a long way of saying I'm going after it, Joe.
Okay. You mentioned SG&A earlier. Yeah, it has been in that 19%-20% of sales range. It's now 15%-16%, actually toward the lower end of that range at this point. Where do the savings come from? Because you still spend a lot of money on advertising and promotion. But where do the savings come from? Number one and number two, is that a sustainable level, or might we see some of those cost savings come back?
Yeah, I think it's a very sustainable level. Look, it's a percentage of sales. We're expecting the company to grow. And so dollars may grow, especially in the three areas I'm going to talk about as we move forward. But let's just talk about it now. Where are the areas that we're investing? It's marketing, innovation, and sales. Remember, our sales force is different. It is unique. We have 2,000+ seasonal associates that are on retailers' floors every single day addressing our product, ensuring that it's at the front of the shelf, it's clean, it looks good, that it's fully stocked. That's what our sales force does. On the innovation side of the house, we've spent about $25 million a year. There are opportunities for us to improve on that and increase that. There are new innovations that we need to bring to the market. We will.
On the marketing side, you will see a completely different approach to marketing this year than what you've seen previously. Look, last year, I think Jim's the chairman. He'd be the first to say, we misstimed. Actually, he did say it on the last conference call. We misstimed our marketing last year. Yeah, we did a huge upfront marketing event. It is spring, you know, Daylight Savings, sorry, which kicks off daylight savings. And Daylight Savings, Daylight or daylight savings starts in the south, and it's properly warm. It's the spring. It's snowing in Ohio, where we are, probably in the rest of the Northeast and other parts of the country. That's not the time to be doing a great spring kickoff event. So we've gotten much more regional this year.
We've gotten much more tactical with our new team. We've made a lot of investments in technology. We've mirrored that up with where weather information is coming. We can time our marketing and our promotional activity within 2-3- weeks out based on weather right now. And so that is a massive, powerful step from what we've done previously. So those three things, we'll invest in the things that we want to invest in. Me, we're going to drive efficiencies across overheads. And that is something that I've done in my career. It's not new to the company. We've done that from time to time. But let me give you a good example. We had 60 vice presidents 2 years ago. We now have 18, right?
We are shrinking the overall structure of the company to be much more highly powered and effective and efficient across the resource functions while giving that power to marketing, innovation, and our sales force.
All of that sounds structural.
That is structural. Okay. Yeah. There's hard caps on headcount. There's hard caps on spend. And I watch every penny and dollar. And so does the rest of the company.
You know, I should have probably asked this earlier, but maybe give our audience a flavor for what your competitive landscape looks like.
Sure.
I don't think that some of them may recognize the dominant market shares you have in your categories.
Well put. So there is no natural one-stop meets all, one-shop meets all for Scotts Miracle-Gro. You have lawns, which we have a little bit of Central Garden & Pet where they have some seed and maybe some fertilizers. You have Spectrum, which is on the control side of the house. And then throughout soils, mulches, growing media in general, it's a lot of moms and pops. It's a lot of regional players. And where we really differentiate ourselves, part of Scotts's strategic capability, you just said dominant share positions. Yes, but those dominant share positions are built on strength of brand, right? So if you're going to a lawn and garden center, you're most likely going to pull off a Scotts Miracle-Gro product because you know it works, number one.
Number two, we have a network that's able to create, develop, produce, and deliver these products to every store that a retailer may require us to do so. And then we have a sales force that is on the ground every day making sure that it's right. So it's hard if you're a competitor because you can't replicate that scale of production, distribution, and sales force. And the products themselves, we are unique in driving innovations and creating new opportunities for people in the lawn and garden space. Those innovations cost money. And given our relatively superior margins, even now, Joe, I know they're not where we want them to be. That allows us to do that. And so the competitors, they are fighting for position with us. But it's, as you said, it's at the margin.
It's great to have others in the market filling key areas and helping consumers create their own experience. But we're going to define lawn and garden and drive the new innovations.
I suppose we have to talk about Hawthorne, which is your hydroponics business. 2021, that business did $1 billion in revenue. And I think my model for 2024 has it at $340 million. So it's coming a little bit. Maybe help us understand what's caused that. Maybe more importantly.
You just got cute. You're not cute. Don't get cute.
What can drive growth in that business again at some point?
Yeah. Yeah. Look, you had a massive step change, is what you're saying. So cannabis market blew up and then it blew up, right? That's what I, how I talk about it. And where's the bottom, which is part of that conversation? And you're kind of trickling along the bottom right now in terms of just if you look at daily sales rates for the Hawthorne business and what is Hawthorne, hopefully everybody knows it's our hydroponics business. So everything from growing media to nutrients to infrastructure for a cannabis grow primarily is what we offer. And that is a technical solution and opportunity that growers highly value. And so we have a very good place in that market. But like you said, the cannabis market is in structural oversupply and that's going to persist. And when that ends, not quite sure yet. What do we require of Hawthorne?
We require it to be cash generative. We require it to be producing profitability for the company on an EBITDA basis. It will do those types of things. That comes from massive cost outs, from massive prioritization, from working the business every single day to know where the top line is and make adjustments as we need to. That's what we're doing. The value potential that exists in the business, and I've met with many of you, I meet with investors all the time. It's an embedded zero cost option value. You know, for me, it's the you can't you could value me on past decisions. Great. I have massive forward value to create. Hawthorne has the potential to be a part of that in multiple ways. One, it could stay inside Scotts and just grow EBITDA over time. Its algorithm is different.
Its revenue trajectory is different. There are partners that we can find in the marketplace where we can strengthen the size of this business, the scale, take out efficiencies, gain synergies, and move forward from that perspective. That may yield itself in a separate entity, which has its own ability to grow valuation over time. If you're a shareholder, you know, that can accrue back to you either through shares directed to you or if Scotts Miracle-Gro owns a component of that, you know, drawing it through into the P&L. So I feel really good, believe it or not, about the position of Hawthorne, what we're doing and the overall hydroponics business.
It's just there's some timing components here as to where it goes and how we partner with people to optimize value in this period is going to be very important because once it comes back, we've already seen it. Anytime someone mentions rescheduling, descheduling, any type of positive federal, state type of support for cannabis, the valuations in those entities move significantly. So there will be a recovery. Timing is the question. And in the meantime, we'll keep Hawthorne tight and focused on delivering value.
Does it require rescheduling or the SAFE Banking Act getting passed, for example?
Oh, now you're ripping off the Band-Aid. Let's just go into it. Jim and I, well, why not just say all of Scotts Miracle-Gro and anybody who is related at all to the cannabis market will tell you that it is so anti-capitalist what has happened there. And it is so just wrong how the rollout has been done at a federal and at a regional government, state government level where the oversupply conditions, the over-licensing, the just taxation rules, you're not incentivizing a highly illicit market that has been in the country for decades to move towards the legal market. Why would you? Because you're going to pay an 80%+ effective tax rate if you are a legal leaf touching entity. If you are illicit, guess what your tax rate is? Zero.
So why not make a low-level, normal business operational activity a part of the process where you tax them as real companies? And maybe that incentivizes them to move to the legal side. And it grows the overall tax base. And local governments can stand behind that. And the most dangerous thing that Jim talks about is the fact that the market's not regulated. And regulation comes down to ensuring that the people that are buying it and selling it are licensed and appropriate. So you're not in a bodega in New York selling it to teenagers. That shouldn't be happening.
If we're here a year from now, if you were a betting man, is Hawthorne still a part of Scotts? Is it merged into another entity?
Oh, wow. No, that's just I say, oh, wow, because it's profound that one, I'm not a betting man. I'm very deliberate. Two, if we were talking four months ago, I would have said likelihood is that Hawthorne is out of Scotts. Today, with everything that we know and with the overall state of the market, I'd say Hawthorne is in a leadership position in developing the future of the industry, which could mean it's either part of someone else within a year's time or we've added to the base and grown scale and current profitability in that time. So there's deals to be done. It's just whether it's in or out.
We've got a couple minutes left, and I want to make sure I hit on your balance sheet.
Sure.
You were a little over 7x that leverage at the end of December.
Seven, two.
This is usually the quarter when your leverage peaks.
Correct.
Yet the covenant maximum is actually ticking down this quarter. About a month ago on your earnings call, you were, you know, feeling fairly comfortable that you'd be in compliance. Do you still share that comfort? Number one and number two, what sort of levers do you have, you know, just in case, you know, break glass in case of an emergency?
Got it. Okay. Like you asked a question, I need to answer it. So 1, I feel comfortable. Two, this drives the urgency in all of us at Scotts Miracle-Gro from the board to the shop floor on wanting to get out of this as quickly as possible, right? This level of debt for this company is not appropriate. So that's why gross margin matters. That's why free cash flow matters, right? Get out of this situation as quickly as possible. Feel okay. Feel good about maintaining compliance at 7.75. And I think the path forward will allow us to delever in a way that we get to our target area by the end of 2026, which is what we said we'd be around 3.5. But everything that Jim said on the last call and that we are trying to do is to make that happen sooner.
Okay. Well, super. I think we're just about out of time. So let me end it there. Matt, thank you.
Thank you.
Thank you, everybody. I hope everybody enjoys the rest of the conference.