EUR 850.00 For Business Accounts Only

Morningstar | Trimming Our Scotts FVE to $85 on Greater-Than-Expected Near-Term Hawthorne Weakness. See Updated Analyst Note from 01 Aug 2018

Scotts Miracle-Gro had a decent fiscal third quarter as sales in the U.S. consumer segment recovered from a late start to the gardening season. In its earnings release, management maintained the guidance it provided in mid-June of an earnings per share range of $3.70-3.90. This seems achievable; however, we expect Scotts to come in at the low end of the range. Hawthorne segment results continued to disappoint in the third quarter, dragging on companywide earnings. Having updated our model to account for lower near-term profitability in the Hawthorne segment, our fair value estimate falls to $85 per share from $86. Our narrow-moat rating is unchanged. The market reacted negatively to the news, sending shares down roughly 3.5%. We think the market is underestimating Hawthorne segment normalized earnings and view Scotts as slightly undervalued.

The U.S. consumer segment bounced back after a tumultuous start to the year as a cold spring delayed the gardening season. Revenue was up about 1% year on year and total sales through the three quarters are only down around 2%, compared with a sales decline of nearly 6% during the second quarter. Despite the improved third-quarter results, we continue to expect revenue to end the year down 2% in 2018. However, in 2019, we expect sales to recover to normalized levels as we do not assume Scotts will face the same weather-related headwinds. That said, we expect margins to contract, as we don't think Scotts will be able to raise prices to fully offset increased freight costs, commodity inflation, and the impact of U.S. tariffs. Over the long term, we continue to forecast the U.S. consumer segment to increase revenue at a low-single-digit rate with modest margin contraction as the industry faces more competition in an increasingly online marketplace.

The Hawthorne business reported disappointing results as the segment generated a loss for the second straight quarter. Hawthorne continues to be plagued by regulatory challenges in California, which contributes more than half of sales. These challenges stem from the issuance of licenses on the county level, where many of the counties have yet to start granting licenses to growers and dispensaries despite the legalized recreational use of marijuana beginning in 2018. We expect a 2018 fiscal year loss. That said, the businesses' cost-cutting program to fully integrate the Sunlight acquisition is under way and management noted that demand for Hawthorne products marginally increased at the end of the quarter. These factors should help Hawthorne restore profitability in 2019. Although we have lowered our revenue and profit forecast for 2019 as the regulatory headwinds will not fully abate until the end next year, our long-term thesis is unchanged. In the long term, we still expect the segment to deliver the bulk of future companywide growth, as more states legalize recreational marijuana, which will result in greater demand for Hawthorne's products.