Is Scotts Miracle-Gro Company a Buy?

Shareholders of Scotts Miracle-Gro (SMG -1.80%) are definitely ready for 2018 to be over. The company's stock price has slipped nearly 30% since the beginning of the year following an onslaught of headwinds from its two business segments.

Consumer products got off to a slow start in the United States -- now the company's only geography -- due to a lingering winter. That's been compounded by the fact that growth at Hawthorne, the historically high-growth hydroponics unit, has unexpectedly stalled out due to a slower-than-expected rollout of marijuana legalization across the United States.

While weather and state-by-state politics are factors outside of management's control, on the fiscal third-quarter 2018 earnings conference call, investors learned of some internal friction between the company's top brass and the team leading Hawthorne. In fact, CEO James Hagedorn cursed out the subsidiary and voiced his frustration that the team didn't seem to be on the same page when it came to the overall company's near-term financial targets for 2019 and 2020.

The outburst may have been unusual, but it was also an honest moment of frustration that provided critical behind-the-scenes insight for shareholders and investors alike. Given all the moving parts, is Scotts Miracle-Gro a buy, or is there too much drama?

Image source: Getty Images.

By the numbers

There's no denying that the business is at least a little behind where it would like to be. A combination of headwinds has forced management to reduce its full-year 2018 guidance more than once. After originally expecting full-year revenue growth of around 5% and adjusted earnings per share in the neighborhood of $4.25, the latest full-year guidance calls for sales growth of just 1% at the midpoint and adjusted EPS of around $3.80. In fiscal 2017 the business delivered adjusted EPS of $3.94.  

Nonetheless, the expectation for year-over-year total revenue growth to be flat at worst suggests that the fiscal fourth quarter of 2018 is going to be very strong for Scotts Miracle-Gro. 

Data source: SEC filing.

As the table above shows, the consumer segment hasn't suffered that big of a pullback from last year, but its significance to the overall business -- representing 84% of total revenue through the first nine months of fiscal 2018 -- makes even small percentage gains and losses have a big impact. Meanwhile, the uncharacteristic performance at Hawthorne is difficult to digest. After all, the hydroponics unit posted year-over-year revenue growth of 152% in 2016 and 137% in 2017. 

Management is optimistic that the company can end fiscal 2018 on a high note. The expectation is for consumer segment revenue to decline 1% to 3% from last year, while Hawthorne revenue is expected to jump 25% to 30% compared with fiscal 2017. While that may look unreasonable at first glance, it factors in the recent $450 million acquisition of Sunlight Supply, which has the potential to double annual revenue for Hawthorne once fully integrated. 

That said, investors may be doubting management's optimism -- specifically because management seems to be doubting the ability of Hawthorne to meet the company's expectations.

Image source: Getty Images.

Causes for concern?

When the acquisition of Sunlight Supply was first announced, Scotts Miracle-Gro stated that the Hawthorne segment would be on the path to generating operating income of $120 million in fiscal 2020. That would mark a huge leap from the $35.5 million delivered last year. However, on the fiscal third-quarter 2018 earnings conference call, CFO Randy Coleman walked back those expectations, stating: 

We're still in the midst of finalizing plans for next year, so it's too early to provide more details at this point. I do want to point out, however, that the goal we announced in April of segment income of $120 million in 2020 is unlikely to be achieved without greater volume increases than we're currently planning. I will provide some updated long-term thoughts in a future call.

Investors didn't have to wait for a future call. When an analyst asked about the sudden change in expectations during the Q&A portion of the most recent call, Coleman provided a simple explanation, stating that sales volumes in the first 100 days since the acquisition simply were lower than management expected. But Hagedorn followed up with his own colorful remarks that suggested there's some miscommunication between Scotts Miracle-Gro brass and the team leading Hawthorne: 

And Randy and I have talked about a lot of this just this week, which is we are -- and so I went back to Hawthorne and said, 'You guys show us like where you're going.' And dude, those [expletive] are gun-shy as [expletive] right now, OK? So I'm kind of -- I'm just telling you, real-time, living my life, what do you expect they're going to throw back at us? So they throw these numbers back at us, and it's like, what the hell?

In the same statement, Hagedorn said he realized that the team at Hawthorne had a huge workload and that, as part of a high-growth start-up, was used to working "head down, day-to-day." Either way, the public thrashing of the company's high-growth unit could make investors a little worried that slower-than-expected marijuana legalization isn't the only headwind facing the segment's growth.

In a completely separate issue, Scotts Miracle-Gro could see one of its prized consumer lawn care brands suffer from being in the news cycle for all the wrong reasons. In August a jury in California awarded $289 million to a former school groundskeeper who argued that extensive use of the weed killer Roundup caused him to develop lymphatic cancer. While the scientific literature doesn't quite support that cause-and-effect sequence, the brand may be in damage-control mode at the moment. 

It could be worse, as Monsanto (now Bayer) is the entity on the hook for lawsuits. Scotts Miracle-Gro is the only exclusive marketing agent for the consumer products of the Roundup brand. That said, investors should consider the possibility that the recent ruling in California could have no effect at all, as Roundup has endured in the marketplace despite its connection to Monsanto and its controversial active ingredient (glyphosate) over the years.

Image source: Getty Images.

Uncertainty and turmoil, but still worth the long-term growth

Sure, things appear to be pretty bad at Scotts Miracle-Gro right now. However, investors who keep a cool head during these dark days will be able to scoop up shares at a phenomenal price, especially given the long-term potential. The stock currently trades at just 24 times earnings -- cheaper than the stock market -- and 17.5 times future earnings. The dividend yield at current prices has shot up to 2.9%. 

The long-term growth of both segments remains intact. The consumer lawn and garden market in the United States was only tripped up by a prolonged winter, but has ample opportunities in craft brands, organic brands, and, yes, even legacy brands like Roundup. Meanwhile, I think investors should chalk up the internal struggles at Hawthorne as nothing more than growing pains. Even if the segment drags its feet on achieving annual operating income of $120 million, the long-term opportunity in marijuana markets is too large to pass up -- and few companies are as well positioned as Scotts Miracle-Gro. This stock is still a buy.