short smg at $51 -...

Short SMG at $51

Doug Bennett

August 2, 2013

sholker [printed: August 29, 2007 8:03 AM] [saved: August 29, 2007 8:19 AM] C:\Documents and Settings\sholker\Desktop\Sholk\Presentation\Sholk Molecular Diagnostics Presentation Final.ppt

1

Thesis

• A confluence of factors suggests the near-term operating income improvement

priced into SMG stock might not be realized, which could cause the share price to

drop 30%-40% within 12 months

• As improvement is already priced into the stock, it would take an unlikely upside

surprise to drive meaningful upside in SMG stock from the current price of $51

(back-of-the-envelope valuation work suggests 15% max upside)

• Given reasonable and mounting evidence that the bear case scenario has a

realistic chance of occurrence, a short position in SMG offers an asymmetric

reward-risk opportunity

• Upside of 30%-40% in the SMG bear case (share price drops to $30-$35)

• Downside of 10%-15% in the SMG bull case (share price rises to $55-$60)


2

Situation overview

• The Scotts Miracle-Gro Company (SMG) held its FY2012 fourth quarter conference

call on the morning of November 8, 2012

• James Hagedorn, Scotts’ Chairman, CEO and member of the Hagedorn

Partnership (owns 27.5% of the company), said in regard to uses for free cash:

“And I think in the absence of something better to do with the money, we're biased and I personally am

biased to return that money to our shareholders…and just personally today, I'm probably more biased on

one-time dividends than repurchases”

• When Hagedorn finished on alternative uses of cash, he asked CFO Dave Evans,

“Dave, anything you want to add?” to which Evans responded, “No. I think you've

captured it very well.”

• Later in the call, when CFO Evans was asked his opinion about uses of cash, he

offered, “But my job would be to be fairly agnostic as to which one it is based on

whatever makes sense at that particular time, based on our current share valuation,

based on tax policy…”

• SMG shares closed at $44.06 the day before the call and had traded in the $42-$44

range over the previous month


3

SMG buyers at $51 are buying from the CEO

• Between the November 2012 earnings call and the shares climbing to close at

$51.65 on August 2, 2013, the Hagedorn Partnership reduced its position by half a

million shares

• The selling has accelerated since the most recent share price run-up


4

Rational actor assessment summary

• While insider selling alone is not enough to initiate a short position, the behavioral

clues in this case suggesting the stock is overvalued are strong

• SMG management has stated in conference calls that it carefully monitors the

value of its stock and with the stock price at $44, both the CEO/largest shareholder

and CFO confirmed they’d rather return cash to shareholders through a dividend

than buy back SMG stock

• Put differently, the most knowledgeable SMG shareholders would rather

receive cash now, pay taxes on it immediately and presumably reinvest it into

other inflated asset markets rather than have the company buy stock from

other shareholders in the open market

• As the stock has risen past $50, the Hagedorn Partnership has sold stock almost

daily, with the daily sales accounting for between 1/6 and 1/3 of SMG’s average

daily trading volume

• Therefore, one might assume the stock is fairly valued in the SMG owner’s best

case scenario and overvalued otherwise, which implies buyers at $51 are at best

locking in a market return


5

People problems

• A string of senior executive and director departures has also occurred since the

November 2012 earnings call, which could suggest knowledgeable SMG insiders

don’t envision nearly the benign future implied by SMG’s current stock price

• CFO Evans “surprised the shit out of” Hagedorn by resigning in January 2013

to take a position with a non-profit research group

• Three board members resigned in June 2013 following “a unanimously-

supported reprimand of Hagedorn that stemmed from the use of inappropriate

language”

• EVP, General Counsel, Corporate Secretary, and Chief Ethics & Compliance

Officer Vincent Brockman “resigned” with severance on July 11, 2013

• These resignations come as the company works on reversing its failed FY2012

strategy to drive lawn and garden category growth through increased advertising;

instead, SMG is now focusing on driving gross margins through price increases and

cost-out initiatives, further expanding operating margins through aggressive SG&A

cuts (3%-5% this year), and driving additional operating cash flow through inventory

cuts


6

Market sees no smoke

• Hagedorn’s top-down lever pulling could be causing people problems and his goals

of reduced inventory, price increases and product and labor cost-outs increase the

risk that SMG damages its long-term relationships with consumers and a highly

concentrated retailer customer base

• Despite this risk, market participants are currently valuing the SMG enterprise at a

rich multiple of trailing adjusted operating earnings, in apparent expectation of a

swift rebound in operating income in the next two years (consensus estimates also

imply this)

Comparable company analysis Enterprise LTM EBIT Cons. Cons. EV/ EV/ EV/

Value ($b) ($m) 2013E EBIT 2014E EBIT LTM EBIT 2013E EBIT 2014E EBIT

Fortune Brands Home and Security 7.14 217 376 503 32.9x 19.0x 14.2x

Masco 9.89 344 650 826 28.8x 15.2x 12.0x

The Scotts Miracle-Gro Company 4.31 196 306 349 22.0x 14.1x 12.4x

Spectrum Brands 6.16 333 470 550 18.5x 13.1x 11.2x

Stanley Black and Decker 17.84 1,088 1,397 1,607 16.4x 12.8x 11.1x

Newell Rubbermaid 9.75 705 771 831 13.8x 12.7x 11.7x

Central Garden and Pet Co. 0.93 74 78 95 12.6x 12.0x 9.9x

Jarden Corp. 8.39 611 712 779 13.7x 11.8x 10.8x

Energizer Holdings 8.28 742 750 783 11.2x 11.0x 10.6x

Helen of Troy 1.59 150 149 143 10.6x 10.7x 11.2x

Whirlpool 12.23 1,164 1,296 1,598 10.5x 9.4x 7.7x

ACCO Brands 1.76 173 212 234 10.2x 8.3x 7.5x

Source: Bloomberg, SEC filings

Median 13.8x 12.3x 11.1x

Average 16.8x 12.5x 10.8x


7

Recent strategy change is risky

• Hagedorn indicated on the May 2013 earnings call that he’d tasked COO Barry

Sanders and “EVP of Business Execution” Michael Lukemire with getting SMG to a

40% gross margin and “to quickly get to that level”, up from a trailing 12-month

margin of 34.5%

• A 40% gross margin would be 210 bps higher than that realized in the extraordinary

2010 fiscal year when SMG’s material costs fell, selling prices rose and retailers

were promoting the category

“What happened after [2007-

2009] is, remember, we took a

bunch of pricing on lawn

fertilizers, commodities came

down. So lawns even though

unit volume was declining over

time, we were just making

shitpiles of money, okay?

In addition, retailers coming out of aid really

jumped on the lawn and garden bandwagon,

okay? So you had retailers just spending a lot of

money promoting because the only things we're

selling were really low-cost home improvement

projects – paint, lawn and garden. And so these

were really good times for us. So when I look

back at 2010 saying that was the sort of ultimate

expression of good times for us, it was 2010.”

-CEO Hagedorn

SMG gross margin trend Year ended Year ended Year ended LTM ended

Sept. 2010 Sept. 2011 Sept. 2012 Jun. 2013

Global Consumer segment sales:

Lawn care 927.4 861.3 863.3 ND

Growing media 768.4 785.3 837.9 ND

Home protection 371.0 329.3 355.5 ND

Roundup Marketing Agreement 132.5 126.7 152.4 ND

Wild bird food 79.5 76.0 50.8 ND

Other, primarily gardening and landscape 371.0 354.6 279.3 ND

Global Consumer segment sales 2,649.7 2,533.2 2,539.2 2,489.8

Add: Scotts LawnService sales 224.1 235.6 245.8 252.1

Add: Corporate and other -0.8 30.9 41.1 32.8

Total sales 2,873.0 2,799.7 2,826.1 2,774.7

Less: adjusted cost of sales (excludes extra charges / recall costs) 1,784.4 1,769.0 1,864.4 1,816.5

Gross profit 1,088.6 1,030.7 961.7 958.2

Gross margin 37.9% 36.8% 34.0% 34.5%

SMG raised prices, commodities declined,

retailers heavily promoted the category (there

is some fixed cost leverage in cost of sales)

Lukemire, who was just promoted in Feb. 2013 and tasked with “[taking] cost

out of the system…without screwing up what we’ve built”, sold 9,500 of his

~34,000 SMG shares on 8/8/13 just under $53


8

Recent strategy change is risky

• The contemplated increase in gross margins would require some combination of (1)

substantial price increases against price-conscious consumers and powerful

retailers (2) product cost-outs which might degrade quality/customer perception of

value/market share/retailer support, despite SMG management’s insistence they

won’t

• For example, there are a growing number of cross-geography customer reviews for

Scotts’ potting soils from Spring/Summer 2013 - across Amazon, homedepot.com,

etc. – that suggest there’s been a decline in Miracle-Gro potting soil quality this

year (even marginal unit declines in a portion of SMG’s “growing media” business

[30% FY2012 sales] could blow up expectations priced into the stock)

• Regardless of company justification, Hagedorn’s top-down demand that SMG

quickly get to a 40% gross margin puts the company at increased risk of delivering

an uncompetitive price-to-value proposition to its customers and alienating them


9

SMG stock price floor

• In the case SMG’s recently enacted margin expansion strategies fail, the shares

would take a hit; however, there is a floor to the fall - brands in the consumer lawn

and garden segment still matter to consumers and they help retailers move units

• That said, the retailer is in a growing power position relative to the owners of the

brands - SMG and its peers all cite the growing power of retailers relative to

consumer products companies and the retailers’ increasing sophistication in

securing concessions from CPG companies, including lower prices (passing most

of these on to consumers helps the retailers cement their own market positions)

• This pricing pressure could prove to be especially intense for SMG, as it has

among the most concentrated retailer customer bases of all its peers

Comparable companies Top 3 customer concentration (max)* Top 3 customer

(% of 2012 sales) 10-K reference

Whirlpool ND Not disclosed

Stanley Black and Decker 18%

All US home centers and mass merchants - 18% (down from 40% in 2002 due to

active diversification strategy)

Fortune Brands Home and Security 27% All US home centers (including Home Depot and Lowe's) - 27%

ACCO Brands 28% Staples - 13%, Office Depot + Office Max - 15% (Top 10 - 53%)

Jarden Corp. 30% Wal-Mart - 20%, no other customer greater than 5%

Newell Rubbermaid 30% Wal-Mart - 10.8%

Helen of Troy 40% Wal-Mart - 19%, Target - 11%, no other customer greater than 10% (Top 5 - 42%)

Energizer Holdings 40% Wal-Mart - 20%, no other customer greater than 10%

Spectrum Brands 43% Wal-Mart - 23%, no other customer greater than 10%

Masco 48% Home Depot - 28%, Lowe's 10%

The Scotts Miracle-Gro Company 65% Home Depot - 32.2%, Lowe's 18.4%, Wal-Mart - 14.7% (Top 3 - 65%)

Central Garden and Pet Co. 66% Wal-Mart - 30%, Lowe's 20%, Home Depot - 16% (Top 3 - 66%)

*Where Top 3 customer concentration not explicitly stated, maximum Top 3 concentration implied by individual company 10-K language

Source: SEC filings


10


• A sophisticated/concentrated/powerful retailer customer base should be able to

compute SMG’s pre-tax cost of capital (pre-tax weighted average cost of capital, or

“WACC”) and, given intense competition in SMG’s product categories, bargain for

pricing concessions (such as escalating volume rebates) or value enhancements

from SMG such that SMG’s pre-tax ROIC stays within reasonable proximity to its

pre-tax WACC (this pressure will increase with time)

• With its revolver swapped into fixed rates below 4%, its 2018 and 2020 notes

yielding roughly 5.5% to maturity and equity investors paying big multiples, SMG

investors’ pre-tax required return, or SMG’s WACC, is likely somewhere in the 8%-

10% range

• Why would an increasingly empowered retailer such as Home Depot, Lowe’s or

Wal-Mart pay higher prices for or accept lower quality in SMG’s products going

forward such that SMG generates a 17%-19% pre-tax ROIC (implied by consensus

forward EBIT and fixed invested capital) when SMG’s management, in a weaker

competitive position, might be forced to accept a return closer to 10%?


11


• In the worst case scenario, which is unlikely and would take major strategic

blunders, SMG would lose some of the brand value that’s driven its historically high

EVA (ROIC less WACC) and eventually use their still-valuable assets (known

brands, efficient manufacturing and supply chain capabilities, established

distribution channels, R&D) to move toward a “branded value” model similar to

peer Spectrum Brands (SPB)

• Under a “branded value” strategy, a CPG company sells quality, customer-relevant

branded products to retailers at low enough prices such that retailers make more

gross profit dollars selling them vs. other premium brands and private label (for

example, see Wal-Mart consumer battery category leader Rayovac, owned by

SPB)

• In SMG’s worst case, SMG management might be compelled to recognize the

competitive dynamics and cooperate to help the retailer make more money selling

its units (by reducing its own gross margin)

• Due to recent market share losses at Wal-Mart (15% sales), Hagedorn has

already tasked SMG’s product development teams with creating “branded

value” products for Wal-Mart (i.e. Scotts branded products at $5 price points

vs. $7-$10 - he did not elaborate on how these aren’t gross margin dilutive)


12


• In this worst case scenario, SMG’s invested capital would likely generate pre-tax

returns in the 10%-12% range, similar to those earned on SPB’s capital over the

last few years

Pre-tax ROIC (Adjusted EBIT / Average invested capital*) LTM ended

2007 2008 2009 2010 2011 2012 Mar. 2013

Masco 6.7% 1.0% 1.7% 0.7% 3.2% 5.7% 6.3%

Fortune Brands Home and Security 2.1% 5.6% 2.4% 5.7% 6.9%

Central Garden and Pet Co. 6.9% 8.5% 12.6% 12.8% 9.3% 8.1% 8.0%

Stanley Black and Decker 13.9% 11.9% 8.9% 9.0% 7.7% 8.5% 8.3%

Jarden Corp. 8.2% 10.1% 9.4% 10.4% 10.5% 10.0% 9.8%

Spectrum Brands 12.6% 10.8% 10.3% 11.3% 10.8%

ACCO Brands 11.4% 8.9% 11.7% 13.5% 14.1% 9.6% 12.0%

Helen of Troy 9.3% 8.8% 12.3% 13.0% 12.4% 11.9% 12.0%

The Scotts Miracle-Gro Company 17.7% 14.6% 17.8% 23.5% 20.6% 14.9% 12.2%

Whirlpool 13.2% 8.2% 9.0% 11.2% 9.8% 11.9% 12.5%

Energizer Holdings 19.9% 17.9% 12.1% 13.0% 11.9% 11.9% 12.9%

Newell Rubbermaid 16.0% 11.8% 12.9% 13.7% 13.9% 14.6% 14.5%

Note: Spectrum Brands, Scotts Miracle-Gro, Energizer and Central Garden Co fiscal years end on Sept. 30, while Helen of Troy's ends the following Feb. 28

All other fiscal years end on Dec. 31

* Invested capital estimated by subtracting non-interest bearing current liabilities from total assets (average FY end IC used for work efficiency - despite seasonality)

* LTM ROIC measured using invested capital for fiscal year ended 2012 to preserve comparability

Source: Bloomberg, SEC filings


13


• If SMG fully acquiesced to retailer power over time and earned the ~11% average

ROIC realized by SPB over the last 4 years, run-rate EBIT would be somewhere in

the $200m-$210m range vs. the $300m-$350m consensus forward estimates

• Using current SPB forward multiples, shares would be worth somewhere in the

mid-$20’s in the worst case, down ~50% from the current price

SMG's bear case SPB-implied EBIT

SPB's 2009-2012 average adj. ROIC 11.2%

SMG invested capital* 1,837

SMG implied run-rate EBIT 207

*Average invested capital over last 4 quarters

SMG's bear case SPB-implied value

SMG implied run-rate EBIT 207

SPB current EV/ forward EBIT (2013E and 2014E) 13.1x 11.2x

SMG implied enterprise value 2,707 2,312

Less: seasonably-adjusted net debt (average over last 4 quarters) 858 858

Implied SMG equity value 1,849 1,454

FD common shares 63.9 63.9

Implied share price $28.94 $22.76

Current share price $51.65 $51.65

Potential downside -44% -56%


14

SMG value in a less drastic retailer power scenario

• In a less drastic scenario but one more in line with competitive realities, if the SMG

enterprise earns closer to the 11%-15% pre-tax ROIC’s that its peers have earned

over the last few years, SMG would generate annual EBIT of $200m - $275m going

forward, below the consensus estimates of $300m - $350m

• Comparable company analysis suggests the shares could fall 30%-40% to the $30-

$35 per share range if retailers were able to restrain SMG’s EBIT to the midpoint of

this ROIC range

SMG implied EBIT assuming retailer pricing power

Revised pre-tax ROIC range 11% 13% 15%

SMG invested capital* 1,837 1,837 1,837

Implied forward EBIT 202 230 276

*Average invested capital over last 4 quarters

SMG implied stock price assuming EBIT disappoints

SMG EBIT midpoint (~13% ROIC) 230 230 230

Current EV / LTM EBIT multiples (~11x-14x for slower growth peers, 13.8x median) 12.0x 14.0x 16.0x

Implied SMG enterprise value 2,756 3,215 3,674

Less: seasonably-adjusted net debt (average over last 4 quarters) 858 858 858

Implied SMG equity value 1,898 2,357 2,816

FD common shares 63.9 63.9 63.9

Implied share price $29.69 $36.88 $44.07

Current share price $51.65 $51.65 $51.65

Potential downside -43% -29% -15%


15

Potential risk to the SMG short

• SMG management stated this year it has gone to a harvest strategy based on a

zero unit growth assumption (with price increases planned to track inflation) for the

foreseeable future

• Therefore, even if one assumes EBIT rises as expected and SMG’s retailer

customers are unable to restrain SMG from earning 17%-19% pre-tax ROIC’s, a

back-of-the-envelope valuation suggests the shares have at most ~15% upside in a

rational market

Back-of-envelope valuation - SMG bull case SMG bull case valuation relative to current stock price

SMG LTM adjusted EBIT (for comparison) 196 Present value of equity:

11% discount rate 1,599 1,657

Consensus forward EBIT estimates (2013E & 2014E) 306 349 9% discount rate 1,960 2,069

Implied future ROIC 16.7% 19.0% 7% discount rate 2,528 2,718


Less: interest expense 50 50

Taxable income 256 299 Implied current SMG value per share:

11% discount rate $25.01 $25.93

Less: taxes @ 36% 92 107 9% discount rate $30.67 $32.37

Net income 164 191 7% discount rate $39.55 $42.53

5% discount rate $55.55 $60.88

Add: D&A 65 65

Cash flow from operations (excluding WC changes) 229 256 Premium / (discount) to current share value:

11% discount rate -52% -50%

Less: annual "maintenance" capital expenditures 50 50 9% discount rate -41% -37%

Run-rate "perpetual" free cash flow 179 206 7% discount rate -23% -18%

5% discount rate 8% 18%

Future equity value of SMG perpetuity assuming:






16

Reward-risk summary

• A realistic bear case scenario could send SMG shares down 30%-40% to $30-$35

• While forecasting SMG quarters is difficult, any cracks would likely become

apparent within a year as potentially quality-reducing product cost-outs and

pricing pressure from retailers this year could lead to negative unit sales and

margin surprises during next year’s spring/summer season

• A potentially realistic bull case is apparently priced in with the stock unlikely to climb

more than 15% past $60

• Therefore, an SMG short at ~$51 appears to offer a positive asymmetric reward-

risk opportunity