Scotts Miracle-Gro Is A Bargain But May Not Be Right For Everyone (NYSE:SMG)

There are lots of bargains on the market right now, and in some ways value investors may feel like a kid in a candy shop. While no one can tell when the market bleeding will end, I believe those buying quality names now will thank themselves when all is said and done. This brings me to Scotts Miracle-Gro (NYSE:SMG), which has gotten dirt cheap (pun intended) as of late. This article highlights the pluses and minuses of buying into this enterprise today, so let’s get started.

Why SMG?

Scott Miracle-Gro is one of the largest global marketers of branded lawn and garden care products for consumers. Its market-leading brands include Scotts, Miracle-Gro, Ortho, and through its subsidiary, Hawthorne Gardening Company, provides nutrients lighting and other materials used for indoor and hydroponic growing.

Current investors and followers of the stock know that SMG has gotten really cheap over the past year. As shown below, SMG has fallen by 73% over the past 12 months. At the current price of $40, SMG is down significantly from its 52-week high of $180. From purely a technical perspective, I find it hard to believe that a non-meme stock, which investors happily paid upwards of $180 per share for within the recent year is now worth just $40.

Of course, a stock doesn’t fall by this much without its share of headwinds. This includes the revised guidance on for full year free cash flow from -$275 million to -$325 million. The company said that this revised guidance is a more accurate estimate of certain balance sheet items at the end of the current fiscal year, including a YoY decline in accounts payable that hadn’t been fully factored in.

Moreover, SMG saw sales decrease by 26% YoY during its fiscal third quarter, driven largely by a 63% decline in its Hawthorne unit, and a 14% decline in U.S. Consumer. This was driven in part by fewer orders from retailers as they lowered their inventory levels in anticipation of an economic slowdown.

Nonetheless, SMG remains a long-term growth play, due to its hydroponics growing segment led by Hawthorne. This of course, hinges largely upon the fate of cannabis legislation in the U.S., and President Biden seems to have made a recent step towards that, by pardoning those with cannabis possession offenses and directing the Department of Health and Human Services to review marijuana’s status as a Schedule 1 controlled substance.

Moreover, I see plenty of long-term growth potential for SMG due to its natural exposure to the housing industry. While this industry is pressured by higher interest rates at the moment, the fact remains that housing is undersupplied in the U.S. and the industry should resume growth after interest rates normalize. These positive long-term trends were highlighted by Morningstar in its recent analyst report:

Future demand for gardening products will depend on growth in the housing industry. We expect housing starts to average around 1.5 million per year through 2030. While housing starts alone should increase demand for gardening products, we see some secular trends that will offset the growth. Living preference shifts to smaller lots and urban centers should result in less need for gardening products.

Additionally, a greater proportion of gardening products will be sold online. Currently, the vast majority of sales occur at brick-and-mortar retail. Even if Scotts increases its online sales presence, it may lose some pricing power as many products in the gardening industry shift away from brick-and-mortar retailers to online platforms, where Scotts will likely face more lower-priced competition.

The Hawthorne segment, which includes indoor gardening, hydroponics, and lighting equipment, contributed a little under 30% of revenue in fiscal 2021. Its growth is closely tied to the legalization of cannabis in the U.S., as its products are frequently used by licensed growers. Recent acquisitions in the business should position Scotts to take advantage of growing demand from states where cannabis has been recently legalized.

It’s worth noting that SMG isn’t for the faint of heart, as it does have a relatively weak balance sheet, with a BB- credit rating from S&P and a debt to EBITDA ratio of 5.1x. This is due to SMG’s track record of using debt to pay for acquisitions. This risk, however, is somewhat offset by the fact that gardening is generally not a cyclical sector, and therefore is more economically resilient than most other industries. Management plans to deleverage the company over the next 24 months, as noted during the recent conference call:

The recent amendment to our credit facility provides flexibility for leverage up to 6.5 times debt-to-EBITDA at our expected peak, but, clearly, we are taking aggressive steps to reduce leverage as quickly as possible,” said Cory Miller, executive vice president and chief financial officer. “We are committed to getting leverage back to our target of 3.5 times debt-to-EBITDA within 24 months. We intend to provide more details around these efforts in early November when we announce year-end earnings and discuss our initial outlook for fiscal 2023.

While investors are well compensated with a high 6.5% dividend yield that’s protected by a 64% payout ratio (based on full year EPS guidance of $4.10 at the midpoint), I believe the dividend is at risk of being cut in order to help pay for debt reduction. Income investors should be mindful of this risk.

Lastly, when all is said and done, there’s no ignoring the fact that SMG is very cheap on a historical basis. Below, I use EV/EBITDA, since Enterprise Value factors in debt. As shown below, SMG’s EV/EBITDA of 10.7 sits at the low end of its historical range over the past decade. Analysts have a consensus Buy rating with an average price target of $84, and Morningstar has a fair value estimate of $120, implying the potential for very strong returns.

Investor Takeaway

While Scotts Miracle-Gro has come under pressure as of late, I see the long-term trends remaining intact and the company is positioned to continue growing with the undersupplied housing market. Plus, recent positives around the potential steps towards cannabis legalization puts SMG’s Hawthorne unit in position to succeed. I view SMG as being a speculative strong buy for risk-tolerant investors who are willing to wait for the deleveraging story to play out and for a normalization of the business.