Shares of The Scotts Miracle-Gro Company (NYSE:SMG) rose 10% in February according to data provided by S&P Global Market Intelligence. The stock has been on something of a run lately, with a two-month gain of an incredible 33% to start 2019. However, even that massive advance wasn't enough to offset the damage over the last year or so, with the stock still down nearly 24% from its early 2018 highs. That said, the February rally was underpinned by good news on the next to last day of January.
On Jan. 30, Scotts announced earnings. The lawn care company's business is highly seasonal, as you would expect, so the quarterly loss of $1.49 a share wasn't all that shocking. What was more important was that management reaffirmed its full-year guidance for revenue, earnings, and cash flow. That, however, needs a little dissecting.
The company's core business is lawn care. On that front, there were some puts and takes in the quarter, but Scotts anticipates a decent year, with price increases helping offset rising operating costs. The bigger issue is the company's aggressive shift into the hydroponic sector as it attempts to take advantage of the ongoing legalization of marijuana. Acquisitions led this business, called Hawthorne, to a year-over-year sales gain of 84%.
In recent quarters, the rapid, acquisition-led growth has smoothed over weakness at its ongoing hydroponic business. For example, in the fourth quarter of fiscal 2018, the company took a $94.6 million impairment charge to write down the value of assets it acquired to build out the Hawthorne division. That left investors wondering if Scotts' fast-paced efforts to build scale in the hydroponic space had led to it overpaying for acquisitions. Investors were also wondering if there was more bad news to come, since the company reported a 27% sales decline in the division in fiscal 2018 when excluding acquisitions.
The fiscal first quarter didn't include any write offs, and the company noted that the Hawthorne business had returned to growth in the second half of the quarter. That upbeat news reassured investors that Scotts isn't heading down the wrong path in its efforts to build a marijuana-related business.
With the company's big bet finally looking like it is heading in the right direction, investors have rewarded Scotts' stock. That makes complete sense given the huge growth potential expected for the marijuana industry. In that regard, Scotts, operating as an industry supplier, is an interesting way to play the space. However, if you do a deep dive here, make sure to pay close attention to the company's leverage. It has made extensive use of debt to build its Hawthorne business, and at some point, it will need to deal with that issue (long-term debt makes up a worrying 90% of the capital structure). Prudent investors, in fact, would probably be best off avoiding the stock and looking at more conservative options in the niche until leverage starts to move lower again.