Scotts Miracle-Gro (SMG 1.85%) sells lawn-care products to Home Depot (HD 0.25%). Home Depot sells those products to consumers like you. They are tied together in this way, but they are very different businesses. Which one, if either, is the better buy?
It's not an easy question, and there are a few important wrinkles to examine before you make a final call. Here's a quick primer on what you need to know about Scotts and Home Depot.
1. Retailer and supplier
The biggest difference between Home Depot and Scotts is that one is a retailer and the other a supplier. If you are specifically looking for a retail stock, then Scotts probably won't be a great fit for you and vice versa. That said, there are some other issues to think about here.
For example, lawn care, which made up around 75% of Scotts' business through the first nine months of fiscal 2019, sees fairly consistent demand. It varies a little, but maintaining a lawn isn't something you can just stop doing if you want it to look good. Home Depot, on the other hand, sells a lot of different products. That includes things for home maintenance (which would include lawn care) and for home improvements (lumber, for example). There is a stable underpinning to its top line, but some of its products are tied to economic activity. That means sales can weaken materially when the economy hits a soft patch. Put simply, you probably don't need to build that extra room onto your house even if you do have to fix a leaky roof and maintain your yard.
This shouldn't necessarily give Scotts an edge over Home Depot, but it is something to keep in mind. The businesses are very different in some important ways.
2. A key partner to many
Which brings up another factor. Home Depot is a bet on Home Depot's ability to sell the products in its stores (and, of course, online). An economy-wide problem, like a recession, is something that the company can't control. But a company-specific problem could also become an issue for investors. Historically speaking, Home Depot has been a well-run company, but it has stumbled before (in the early 2000s) and could do so again. Retailing is not an easy business.
Scotts sells its products to many retailers. A problem at any individual customer would likely be offset by the others with which it works. To be fair, Home Depot, its prime competitor Lowe's, and Walmart accounted for roughly 60% of Scotts' sales in 2018. So some of its customers are far more important than others. If any of these companies faced company-specific struggles, it could impact Scotts, but the hit wouldn't be as focused as if you owned a troubled retailer directly. That's one of the benefits of being a pick-and-shovel play, which is a way of saying that Scotts is supplying a market instead of being in that specific market.
3. A little spice?
This is an important factor to consider here because nearly 20% of Scotts' top line comes from its Hawthorne division. This is a relatively new group within the company, and it sells hydroponic products. Management jumped into this niche sector so it could be a supplier to the fast-growing marijuana industry. Although the painful declines in the leading pot stocks suggest the hype around marijuana has faded, that doesn't actually mean the growth potential of supplying to the industry is any less of an opportunity.
While I'm sure marijuana growers frequent Home Depot, it really doesn't offer this kind of extra growth engine. The problem here is that Scotts built this additional pick-and-shovel business via a series of acquisitions.
4. Different balance sheets
It costs money to buy other companies, and Scotts heavily leveraged its balance sheet to build Hawthorne. The company's financial debt-to-equity ratio spiked to more than 0.6 times in 2018 before starting to drop in 2019. An asset sale earlier in the year helped to push that ratio to a more normal 0.35 times. That, however, is still relatively high when you compare it to Home Depot's 0.12 times. This difference is pretty consistent over time. Scotts has historically used more leverage, which is something more conservative investors should be looking at closely.
You can examine this issue in different ways, too. For example, Home Depot's financial debt-to-EBITDA ratio is around 1.5 times, roughly half of Scotts' 3.2. And Home Depot covers its interest expenses 15 times over, versus 5 times or so for Scotts. Put simply, if you are looking for a rock-solid company, Home Depot has the edge. And that solid financial foundation means that it should easily survive if the economy hits a soft patch or the company faces a self-inflicted wound. Scotts isn't exactly a financial weakling following the asset sale that toned down its debt levels, but it doesn't have the same level of financial muscle, either.
5. No yield advantage, but...
For dividend investors, the yields here won't help you make a call. Home Depot and Scotts both have dividend yields around 2.3%. That's a little better than what you'd get from an S&P 500 Index fund but still not a huge number. Both companies, meanwhile, have increased their dividends annually for a decade. No difference there. Where things start to get a little more interesting is the historical dividend growth rates. Home Depot's annualized dividend growth rates over the 1-, 3-, 5-, and 10-year periods are all between 15% and 20%. Scotts' 10-year annualized growth rate is about 15%, but over shorter periods, it has fallen off. Over the trailing 1- and 3-year periods, the dividend was increased in the mid-single digits. To be fair, that drop-off has a lot to do with its efforts to expand into the marijuana space. However, investors looking for consistent dividend growth over time should clearly favor Home Depot.
6. Some value issues
Another area to consider when comparing these two names is valuation. Home Depot, quite simply, looks expensive compared to its own history. For example, price to sales, price to earnings, price to cash flow, and price to book value are all above their five-year averages -- in some cases meaningfully so. Scotts, however, doesn't look all that much better. Its P/S and price-to-cash-flow ratios are above their longer-term averages. And while P/E and P/B are below their five-year averages, it's hard to suggest Scotts is a bargain today. At best, investors are probably paying full rate for the stock.
A big winner?
When you add up the puts and takes here, there isn't really a clear answer. Both Home Depot and Scotts have positives and negatives that need to be considered. And that goes beyond the basic differences in their business models. Value investors will probably want to avoid both names. Those looking for high-yield stocks will probably take a pass, too. Dividend growth investors may favor Home Depot, but the premium price suggests the name belongs on a watch list, not a buy list, today. Meanwhile, those looking for some indirect exposure to the marijuana industry should do a deep dive on Scotts. But it isn't the only game in town if you are looking at suppliers to that industry. All in all, neither Home Depot nor Scotts Miracle-Gro really stands out right now.