While at the local hardware store over the weekend, I wanted to buy some grass seed for the mud pit also known as my backyard. While perusing the aisle, I noticed that the space was dominated by a company called Scotts Miracle-Gro (NYSE: SMG ) . The sales associate nearly guaranteed a great lush, green lawn by spring. It was at that point I decided to find out just how great the company is from an investment perspective.
A good starting point
My first line of research was to pull up the ticker on the Motley Fool site, where Fool co-founder Tom Gardner highlighted the company in an article titled "A Small Cap for the Long Run." In a nutshell, he pointed out a couple of investment maxims he searches for when finding recommendations for his Motley Fool Hidden Gems newsletter: underloved companies operating in boring industries and CEOs with long tenures and/or significant ownership interests. Lo and behold, he listed Scotts as one such boring company and mentioned CEO James Hagedorn's long tenure and 32% ownership stake. In other words, a good start regarding Scotts' investment appeal.
Tom also highlighted the fact that Scotts has grown in excess of 16% for at least the past 10 years. Additionally, the company reports annual returns on invested capital in excess of 10%, has been paying down debt, which recently stood at about 35% of total capital, and has also had decent net margins of 6.4% for the trailing-12-month period ended July 1, 2006.
Other investment merits
Better yet, over the past three fiscal years Scotts has reported operating cash flow of more than double reported net income. Annual capital expenditure needs and business acquisitions exhaust a portion of that cash flow, but still leave plenty for paying down debt, repurchasing shares, and paying a dividend. Management just started paying a dividend last year and committed to buying back about $500 million of its shares.
Also, I can't find many direct public competitors to Scotts. Syngenta (NYSE: SYT ) , Monsanto (NYSE: MON ) , and Archer Daniels Midland (NYSE: ADM ) are all involved with agriculture, crop and seed protection and development, but are more focused on the larger farming market worldwide. Scotts is perhaps the only pure-play public company in the consumer lawn and gardening space, and it also is an exclusive marketer and distributor of Monsanto's popular Roundup lawn care product.
Still sounds promising, so why is the stock currently trading 16% off its highs over the past year? Ah yes, short-term worries about the economy and housing market. Investors are currently concerned that rising interest rates, which are causing a cooldown of an arguably overheated market for new housing, will dent the gardening and lawn care industry.
A longer-term perspective
And while short-term concerns are very real and also increase Scotts' product costs, they are likely already discounted into the stock price. As legendary investor Bill Miller advocates, one can turn short-term pain into long-term gain by looking past current worries and making a judgment on what the next three to five years may hold for a firm. It's a philosophy he recently referred to as time arbitrage, and worthy of consideration if Miller's track record is any indication; the Legg Mason Value Trust he manages has outperformed the market for 15 years straight.
If we look out past the next several quarters for Scotts, what does the future hold? While we can't predict the future, a good starting point is to try and discern what the market expects; this can be done by calculating the implied growth in a stock, or the growth baked into the current share price. Based on last year's free cash flow numbers, I estimated that to justify the current stock price, Scotts needs to grow free cash flow at just under 12% annually for the next 10 years. Major inputs include a rather aggressive 15% discount rate and terminal growth rate of 3%, or growth in the overall economy.
The Foolish bottom line
Based on Scotts' historical track record, 12% annual stock growth looks like an achievable number. Demographic trends could also be in the company's favor as baby boomers increasingly pursue gardening with their additional leisure time, as a recent Wall Street Journalarticle (subscription required) pointed out while calling Scotts a potential value play. Finally, other consumers are embracing recreational farming and rural lifestyles to blow off steam, with companies like rural retailer Tractor Supply Company (Nasdaq: TSCO ) also benefiting from this trend. Of course, for the investment to pay off, Scotts must grow in excess of 12% per year for the next decade.
Short-term fluctuations may provide a better stock price and larger margin of safety to invest in Scotts, but then again, commodity prices have moderated quickly, potentially leaving extra dough that consumers can spend on lawns as gas prices fall. In other words, where Scotts trades in the next couple of quarters is anybody's guess, but barring any serious crab grass or dandelions, the long-term picture looks to favor Scotts Miracle-Gro.
For related Foolishness:
If you're interested in seeing what other small caps Tom Gardner has highlighted, take a free 30-day trial of the Motley Fool Hidden Gems newsletter. You'll get access to all of the newsletter's recommendations, along with the research and analysis behind each one. Click here to start today.
Fool contributor Ryan Fuhrmann is long shares of Tractor Supply but has no financial interest in any other company mentioned. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.