Shares of Scotts Miracle-Gro Company (SMG) surged to a new all-time high on better than expected quarterly earnings. The market leader in consumer gardening and lawn-care products has seen strong growth this year supported by a boom in home improvement trends during the pandemic. Indeed, the stock is up nearly 60% year to date with momentum across several categories. The company's exposure to the cannabis industry with a portfolio of products such as horticulture lighting, grow-room ventilation systems, and specialty hydroponic equipment has also been a bullish theme this year. We highlight favorable marijuana legislation passed in the 2020 election supporting positive sentiment for new high-growth opportunities. SMG has overall solid fundamentals and we are bullish with upside in the year ahead.

SMG Fiscal Q4 Earnings Recap

Scotts Miracle-Gro reported its fiscal 2020 Q4 earnings on November 4th with non-GAAP EPS of $0.06 which was in-line with estimates. Revenue at $890.3 million was impressively 78.9% higher compared to the period last year and slightly ahead of the consensus.

The impressive growth has been a continuation of trends over the past year. U.S. consumer segment sales, representing about 55% of the total business, climbed by a massive 90% y/y to $498 million while sales in the "Hawthorne" segment which includes the hydroponics business increased 68% to $352 million. The company saw positive trends across all product categories, geographies, and retail channels.

For the full fiscal year, revenues climbed 31% y/y to $4.1 billion while adjusted EPS of $7.24 was up from $4.47 per share a year in 2019. The top-line momentum along with the benefit of scale supported higher margins in the period. 2020 gross margin at 32.6% climbed from 32.3% in 2019 with sequentially stronger trends in recent quarters. Management sees upside in margins with a continued shift in the product mix and capturing market share in key categories supporting pricing gains. Overall, it was a solid quarter for the company capping off a record fiscal year. Management highlighted the positive trends during the conference call:

Starting with sales, I've never seen growth from my 22 years here, like we had in Q4. In the consumer business POS growth was 38% in the quarter. And as Jim said, the growth was everywhere. The other thing that was happening now, retailers were working to rebuild depleted inventory levels, and that is what drove the 90% growth in shipments. We ended the year with retail inventory about 15% higher than a year ago. Also with customers continue to buy aggressively at the end of October and planning for a big early spring.

The company generated $767 million in adjusted EBITDA along with $495 million in free cash flow for the fiscal year. This compares to a balance sheet long-term debt position of $1.5 billion. The liquidity position is a strong point in the investment profile supported by consistent cash flow generation.

Management Guidance and Consensus Estimates

Management is targeting 2021 revenue growth in the low single digits between 0% to 5%. This would be based on a combination of strong momentum from Hawthorne with sales climbing between 15% and 20%, while the consumer segment sales may be flat to down 5% on a y/y basis.

One of the challenges for the company is that the sales were so strong in 2020 that it creates difficult comparables for the year ahead. By this measure, the momentum from Hawthorne and the hydroponics business will balance the consumer segment which faces a growth wall against the pandemic boost of this year.

Within the management guidance, a target for 6% to 11% decline in SG&A along with a lower interest expense will support a target 2021 EPS between $8.00 and $8.40, which at the midpoint implies a 13.3% y/y growth rate. Current consensus estimates are consistent with the company's outlook.

Investments in the cannabis industry

While the consumer business got a boost this year as the pandemic drove people to stay at home and focus on projects like gardening, a more positive long-term trend for the company are its opportunities in the Hawthorne segment. As mentioned, the products here focusing on hydroponics and professional grow operations have been a strong point for the company in recent years and is benefiting from trends in the cannabis industry.

An important point here is that Scotts Miracle-Gro takes a more discrete marketing approach to the segment compared to other "cannabis-first companies". It's clear that the products here are used, in large part, for cannabis cultivation which is a quickly evolving market. The company has been investing in the category and recently opened a research and development facility. Products like LED lights, hydroponics systems, plant nutrients, and advanced grow ventilation systems are in high demand. From the conference call:

If you look at 2020, was a great story everywhere. We kind of opened our in hydro business, we doubled our lighting business during the year driven by about a $100 million worth LED lights. This was a category didn't even exist for us two years ago... LED sales were more than 100% higher than we expected going into the year.

One of the storylines from the election this week was the passage of measures on ballots in Arizona, Montana, New Jersey, and South Dakota that legalizes the possession of marijuana. Separately, voters also approved medicinal cannabis in the state of Mississippi. Our take is that SMG stock is benefiting from some of the positive sentiment towards the industry.

Responding to an analyst's question during the conference call, management commented on the news that New Jersey had voted to legalize recreational marijuana. The company believes that the development could be a catalyst to accelerate a movement in the Northeast region.

I think New Jersey is more exciting not only for its potential, but the way we think it's going to drive the rest of the northeast market, which is Connecticut, New York, New Jersey, Pennsylvania, just relative to those kind of west, who was extremely positive, we've talked about this in the past, the research that we've done and whoever meets the road and we'll see how it actually plays out so that Northeast cannabis consumers that have a higher per capita consumption area than California.

Our point here is that Scotts Miracle-Gro offers exposure to the cannabis industry through a high-quality company with potentially stronger fundamentals and lower risk compared to traditional marijuana stocks. The company is well-positioned to continue benefiting from growing demand and its market leadership position supports a bullish case.

Analysis and Forward-Looking Commentary

Taking a view that traditional consumer gardening and lawn-care products are a relatively mature market with an expectation of steady growth, we are bullish on shares of SMG given its exposure to cannabis. In many ways, the stock deserves a premium now with strong trends in key product categories that are essential for the commercial grow operations which will likely expand over the coming years as relaxing marijuana legislation drives consumption.

In terms of valuation, SMG trading at a 20.8x forward P/E multiple appears inexpensive compared to a 5-year average of 25.5x for the valuation ratio. Other metrics like a forward EV to EBITDA multiple of 13.2x based on a consensus EBITDA estimate of the fiscal year 2021 and a price to free cash flow multiple of 19.6x are attractive relative to the stock's historical trading range. We think the stock deserves a higher multiple and growth premium given the evolving market opportunities.


Final Thoughts

We rate shares of SMG as a buy with a price target of $220 representing about 30% upside from the current level. Progress over the coming year in implementing the legalization of marijuana in markets like New Jersey and Arizona should support sentiment in the industry. To the upside, the ability of SMG to continue capturing market share and expanding margins is bullish for the outlook.

Risks to watch here beyond a deterioration to the macro environment include the ongoing regulatory environment for cannabis. While legislation has been positive, a setback would be negative for the industry and force a revision lower to long-term growth estimates. For the upcoming quarter, monitoring points include the ability to expand margins which is important to support the expected earnings growth. If SMG underperforms expectation, the stock could face a selloff with a renewed bearish sentiment.

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