Scotts Miracle-Gro Co (SMG) Q4 2021 Earnings Call Transcript

Good day, and welcome to The Scotts Miracle-Gro Company’s Fourth Quarter Earnings Conference Call. As a reminder, today’s call is being recorded. At this time, I would like to turn the conference over to Jim King. Please go ahead.

Good morning, all of you, and welcome to the Scotts Miracle-Gro’s fourth quarter conference call. By now, you’ve likely seen our fourth quarter and year-end press release in which we announced full year results as well as our initial guidance for fiscal 2022. We've a lot of ground to cover this morning with prepared comments from Chairman and CEO, Jim Hagedorn; CFO, Cory Miller; as well as Hawthorn Division President, Chris Hagedorn. After their comments, we'll take your questions and for the Q&A session, we'll be joined by President and COO, Mike Lukemire. In the interest of time, we request that you ask only one question and one follow-up. I'll be available after the call and throughout the days ahead to answer any questions that we don’t have time to address or need further follow up. I want to remind everyone that our comments today will include forward-looking statements and so our actual results could differ materially from what we discuss, I'd refer you to our Form 10-K, which was filed with the Securities and Exchange Commission so that you might familiarize yourself with a full range of risk factors that could impact our results. This call is being recorded and an archived version of will be stored on the Investor Relations portion of our corporate website, scottsmiraclegro.com. Without further delay, we'll get started and I'll turn the call over to Jim Hagedorn to begin. Jim?

Thank you, Jim, and good morning. For the last month, I've been thinking about the key themes I wanted to cover today. And I also spent a lot of time thinking about who exactly I wanted to target with my remarks. I won't spend a lot of time focusing on the quarter or the past year, but it is worth pointing out that we just finished our third straight record year and remain extremely optimistic. It's worth mentioning that our 11% growth in US consumer was against a 24% comp and a 39% growth in Hawthorne was against a comp of 64%. I know there are obvious questions to address: our stance on pricing, the commodity outlook, excess inventory in the cannabis market, and our thoughts about capital allocation. We will cover all these topics as well as share our thoughts about fiscal '22. But I've been a public company CEO for 20 years now, and too often, I've seen the markets focus on short-term issues overwhelm the bigger picture. So I want to spend most of my time focused on more than our current results. Frankly, there are a lot of great things happening at the company right now. Some of them I can't share with you, but they're very exciting. Our business is at an important inflection point, one that could transform what we look like five years from now. We have the opportunity to make this company stronger, to create a wider and deeper moat around our business, and to empower a new generation of leaders to shape it through their eyes, not just mine or my executive team's. We also see the current volatility in the market as an opportunity. If you're willing to lean in during times like this, there's potential to capture opportunities that others can't, and an opportunity to further strengthen your competitive advantages. Leveraging those advantages is what drives long-term shareholder value. So I want the real takeaway from today to be a better understanding of the journey we're on and I'll be honest, my target audience is pretty narrow. To our sell side friends, I appreciate the need to get your models refined and to share that information with your clients. We're committed to giving you what you need, but my comments are not aimed at you. My comments are also not aimed at short-term investors. I'm not going to get pulled into a rabbit hole about our quarterly splits, the spot market price of commodities or a bridge to year-over-year SG&A. I do, however, want to speak to those investors who see the long-term opportunity in SMG shares. I want you to know where we're headed and why we're confident our efforts will create shareholder value. I won't ignore the key questions about fiscal '22, but weave them into a broader context of how we're operating the business rather than the confines of how it impacts the P&L. In order to look ahead, I need to look backwards for just a moment. For the five-year period we completed on September 30, our strategic plan assumed a relatively mature core business and enterprise growth of roughly 4% to 6% driven by the higher growth at Hawthorne. We sought to achieve a consistent shareholder return of 10% to 12% by leveraging the P&L, repurchasing shares, and maintaining a roughly 2% dividend yield. We also set a five-year target of cumulative free cash flow of $1.5 billion. We exceeded each of those goals. While we are proud of the achievement, we know that the strategy has run its course because the opportunities are different now and we're different too. Thus, the next step in our evolution will reflect these realities. We've defined five distinct pillars of growth for the next five years. Three of the five are related to the US consumer business, and the other two are related to Hawthorne. First, we see a higher level of sustainable growth with our existing brands and our core business based largely on our ability to reach a new generation of consumers. Second, further growth of our direct-to-consumer efforts is there for the taking if we invest in people, brands, partnerships, and infrastructure. Third, live goods remain a meaningful growth vehicle and a gateway for a more direct relationship with gardeners. Our goal remains the same: for consumers to see us as a gardening company, not a gardening supply company. Fourth, to support Hawthorne's future growth, we must continue to put the commercial grower at the center of everything we do. This means further strengthening a model driven by innovation and technical solutions. Fifth, there is no doubt: the cannabis industry will continue to evolve and grow. And there's little doubt that those companies creative and courageous enough to step into that pool early have the potential for a first-mover advantage. We've shown our willingness to do this when we created Hawthorne, and as I'll describe later, we intend to do it again. As we pursue these pillars, we are strengthening our team, focusing on succession planning, and ensuring our ESG efforts are embedded into our operations and also better understood by our key stakeholders. We debated as a team and with our board whether to pursue all these opportunities at once; we all agreed we had to, but we recognized that succeeding against all these pillars requires us to reorganize and empower a new generation of leaders. While there are no plans for me or any member of the current team to step away, nearly every member of my team has made changes to their organizations. The level of oversight needed to succeed against these efforts requires Mike Lukemire to spend more of his time on strategy and in the fastest-growing areas of the business. He has reshaped this organization so that each of these pillars reports directly to him; therefore, he has given up most of his day-to-day responsibilities in the US consumer segment to Josh Peoples and Dave Swihart, who will effectively serve as co-leads of that business. On the corporate side, Cory has fortified his leadership team with an infusion of outside talent, and Denise S. Stump and Jim King have realigned their teams to better meet the needs of the business. In addition, most of the M&A opportunities we are pursuing include a management team that can further strengthen our own. If everything we see manifests itself, we could double the size of Scotts Miracle-Gro within five years. That's not necessarily the goal, but the magnitude of the opportunity could be game-changing. Let me briefly tell you how we expect to execute against these pillars, or where I can. I'll talk about them in the context of our expectations for next year. Between the first two pillars, we believe the US consumer segment can achieve sustainable long-term growth of 2% to 4% annually. Our previous strategic plan assumed growth of 0% to 2%. If we can sustain growth at this higher level, those added two points carry significant P&L leverage and improve cash flow. It's worth noting that the guidance we set for next year assumes flat to slightly declining growth in the US consumer segment. This is based on an assumed reset of the business in a post-COVID world. Specifically, we're planning for a decline in unit volume offset by pricing. You'll remember from our Q3 call that we took roughly five points of pricing effective in August. In recent weeks, we've communicated to our retail partners about a second price increase effective in January. This more targeted increase will range from mid-single to low double digits, depending on the product line in total. We now expect pricing in '22 to be on the high single-digit side with the goal of covering commodity prices. While we believe our sales assumption for '22 is a prudent way to plan, the trends suggest a better outcome. Here's why: consumer POS and units in fiscal '21 were six points higher than in 2020. More importantly, it was 21 points better than fiscal '19 and actually got stronger later in the year. Consumer volume during the fourth quarter of fiscal '21, while down seven points from last year's record performance, was 35 points higher than the same period in fiscal '19. Consumers are showing us that lawn and garden are essential parts of their lives. Every cut of the data tells us they have stayed with the category. Our brands throughout this past season, those trends have continued in October, which, while it's a relatively small month, is an important conclusion to the season, especially in the Midwest and Northeast. POS and units were up 4% in October compared to last year's record result, and up 42% compared to fiscal '19 as we enter the off-season. The POS numbers won't tell us much until February, and obviously, we won't know until next summer how much of the COVID bump we retained, but I'm confident we'll have a significantly higher base to grow from. We continue to invest with that in mind. Millennial homeowners have clearly become a demographic tailwind and are more than offsetting baby boomers who are leaving the category. This group of consumers care more about gardening than their parents and see the category as more rewarding and purpose-driven as well. A 30-year-old couple buying a home today and entering our category for the first time has the potential to stay with us for 20 years or longer. We must operate with that timeframe in mind. We don't want our marketers to worry about hitting a target for Wall Street. Their job is to drive consumer engagement, brand loyalty, and market share, and we're going to give Josh Peoples and his team the tools to get that done. The same holds true for our direct-to-consumer pillar. This area is approaching 10% of our US consumer sales and will only grow higher. When we think about direct to consumer, it goes beyond selling items on our website. It also means collaborating closely with our retail partners to support their online efforts. It means finding new partners who can help us boost the appeal of gardening and have their own digital platforms that we can leverage. Patty Ziegler is one of our brightest and most creative leaders and directs our direct to consumer effort. In addition to the efforts I've already mentioned, she and her team have launched native online brands like Green Digs and Knock Knock. One of their greatest successes has been with AeroGrow, thanks to Patty's leadership and with the infusion of our R&D and marketing capabilities. We took a declining business and tripled its sales since 2019 to nearly $100 million. Patty's been a champion for the potential of our direct to consumer platform since day one and continues to reimagine the future of this business. Succeeding in our direct-to-consumer effort also requires improving our IT and supply chain infrastructure. Dave Swihart, whose role has recently been expanded to lead both supply chain and R&D, is driving towards that goal. We need to improve our ability to ship directly to consumers, especially in categories like live goods, which have significant online potential. Until recently, our direct-to-consumer efforts didn't warrant your attention, but that's changed. While it remains too early to gauge the ultimate potential of this pillar, it will be a significant contributor to growth as we go forward. I'm equally convinced our third pillar, live goods, will be even more important. Live goods are the gateway to lawn and garden—a category that has historically been highly regional, poorly marketed, and highly commoditized. We believe we can do better. We've got a great start with Bonnie and its leader, Mike Sutter, and we're working with Bonnie's other owner, Alabama Farmers Co-op (AFC), to pursue other growth opportunities that hold significant potential. Together, we believe we can better meet the needs of gardeners and our retail partners through innovation, marketing, and supply chain. We've already made tremendous progress improving the Bonnie business, and even there, we've only scratched the surface. The other two pillars are related to Hawthorne. Chris will spend more time discussing the current environment, but I want you to know I'm not obsessing about the sales in Q4 or what we think about Q1. I believe Chris's team has a good handle on the current environment, and more importantly, I believe they're navigating the choppiness in the market while keeping their eye on the long-term opportunity. If the market is challenged for a couple of quarters, expect them to take advantage of it. We won't chase sales, but we will take an aggressive stance to further solidify Hawthorne and strengthen its market position. For example, expect us to further enhance our innovation efforts. I finally visited our new R&D facility in British Columbia last week. It's amazing. I've recently visited field stations in Oregon, Florida, and, of course, Ohio. What's been the takeaway? The work we're doing on hemp and cannabis research is changing the industry—from lighting to nutrients to growing media. Our research is not just focused on continuing to improve our product offerings, but more importantly, to help growers get a better and more cost-effective outcome. Our unique understanding of plant science and the nuances of cultivation is unmatched. Not only is no one in the industry doing what Hawthorne is doing, but our competitors can't even try to replicate that model. I think you should keep that in mind. We also are likely to use this period as an opportunity to step up our M&A efforts. We continue to be disciplined in our M&A efforts, but the economics of some of our deals have become more attractive. Recently, the final pillar of our strategy is embedded into the recent creation of a new subsidiary called the Hawthorne Collective. I've been alluding for months to the opportunities to invest in emerging areas of the cannabis industry, but this is my first opportunity to discuss the effort in detail. It starts with our recent investment in Riv Capital, a Canadian-based publicly traded company that owns or invests in a series of cannabis-related businesses. We share a common vision with the other major investors at Riv to create a fully integrated business based on the acquisition of licenses for cultivation. From there, we can partner with some of the most well-managed brands in the cannabis industry. There's a lot of speculation regarding the potential for new brands to prosper as the market expands in categories like beverages. However, too few people are focused on existing brands in traditional categories. This is already a multi-billion dollar market with brands operating in the silos of individual states. We're convinced there is tremendous potential for some of those brands to flourish more broadly as the market expands, and our investment in Riv reflects that belief. We believe that our unique level of expertise in the cannabis industry gives us the right to win in areas beyond our existing portfolio. However, today, we cannot make direct investments in those areas. In fact, we can't even have a direct ownership stake in a company that does, but we can create an ownership option, which is what our convertible loan to Riv capital reflects. In the near term, we do not expect to see an impact from the investment in Riv on our P&L, and the amount of capital we've employed ($150 million) does not impact our ability to invest in other areas or return cash to shareholders in the intermediate term. It is possible Riv may seek further capital infusions, and we could be interested depending on the opportunities. I'm not going to speculate on how much we might invest; the honest answer is it depends. Just as we did when we purchased General Hydro, Botanicare, CTA, and Can Filters, we're willing to make investments others might avoid until there is more clarity about the future. If you're a short-term investor, you may not like it. That's fine, but the long-term potential is real and significant. Ultimately, if we convert our financial interest in Riv into equity, which is definitely the goal, it may prompt us to reassess our current capital structure. Many of you have asked if we'd break Hawthorne off as a separate company. I've said we'd only consider doing that for strategic reasons and not to chase valuation, and that's still true. Over the past year, we've worked to understand what a potential separation would require. I believe we're capable of pulling the trigger on such a move if we decide it makes sense. Let me be clear: we have no near-term plans to do this, but could it become a viable option? I think the possibility is growing. As I transition to Cory, I want to emphasize that I'm just as confident about our near-term plans as I am about our long-term strategy. The US consumer business is performing well, and our consumers continue to demonstrate how important they see this category in their lives. At Hawthorne, while we continue to expect top-line pressure through Q1, I'm confident in our team's ability to power through it, and we still expect sales growth on a full year basis. I appreciate your patience this morning. As I know my prepared remarks are longer than normal. Are there more challenges out there right now than a year ago? Yes. Am I thrilled with the equity price right now? No. We're on a path to build a better and stronger business, and we won't be distracted by the noise around us. I mentioned earlier that we exceeded all the financial targets we set with our previous strategic plan. The goal is to remain on a path that allows shareholders to continue benefiting from the opportunities I outlined in our new plan and the pillars that I discussed. The confidence we all have is part of our decision to increase our share purchase efforts. I told you last quarter we had allocated $250 million for that purpose. We now expect to add another $100 million to that total, and we hope to acquire as many of those shares as possible in the next two quarters. There's still a lot to cover this morning, so I want to step aside for now. Cory, why don't you pick it up from here?

Thanks, Jim. I'm going to spend a few minutes on the big themes from our Q4 results, especially around sales and gross margin. I'll share some thoughts about the guidance we provided this morning for fiscal 22. In between, I'll turn things over to Chris to provide some color on Hawthorne. Starting on the top line, you saw this morning, companywide sales growth for the full year was 19%, which was in line with the updated guidance we provided a few months ago. US consumer sales did better than we expected, finishing up 11% compared to the 7% to 9% growth we expected. At $3.2 billion, sales grew by nearly $900 million in the last two years. The supply chain team deserves a lot of credit for their ability to deliver this growth. The targeted investments we have made and will continue making in this area will prove to be key. Consumer engagement remained extremely strong through the fourth quarter, and that kept our retailers equally engaged. Although US consumer segment sales declined 28% in Q4, we were up against a plus 92% comp. Also, remember that Q4 had six fewer days this year than last year; adjusting for that, sales in the quarter would've declined 23%. At Hawthorne, the calendar shift cost us seven points for the quarter. While year-over-year sales declined 2%, the segment would've been up 5% on an apples-to-apples comparison. In the US, Hawthorne business grew by over 10% last year in Q4, given the same comparison. Finally, recall that Hawthorne was up against a plus 64% comp in the same period a year ago. On a full-year basis, Hawthorne grew 39% to $1.4 billion. I'll remind you that number was $640 million in fiscal 2019. We have more than doubled the sales of that business in two years, and all of that growth was organic. On the segment profit line, Hawthorne earned $164 million in fiscal 21 for an operating margin of 11.5%. The profit was up 46% from last year and more than 200% from 2019. We've said repeatedly that we're trying to strike a balance between growth and improving profitability. I think the results speak for themselves. As many of you know, I served as the finance lead at Hawthorne almost since the inception of that business before joining the corporate team. As CFO, as you look at the Hawthorne results, I encourage investors to look deeper than the numbers; while the growth and profit improvements have been impressive, the improvements we've made to how the business operates tell an even better story—from the integration of seven separate businesses to the implementation of SAP, the revamping of our sales force, and the creation of the world's only cannabis-focused R&D program. The efforts of this team have been outstanding. I know all of you want to know more about the current state of the business, so let me take a pause here and turn the call over to Chris for a few minutes.

Thanks, Cory. I'll leave the details around the numbers to Cory, but I know you guys are wondering about the current state of the industry and how we're navigating it. So let me address that for a few minutes. We're obviously seeing some disruption in the market right now, but we expected it to be temporary. Our field sales team began seeing the signs of potential slowdown in late June. We got smarter about the issues in July, and that allowed us to share some of those insights on our third-quarter conference call in August. That's when we cautioned that the growth would be significantly slower in Q4 than we'd seen for the rest of the year. Since then, many of you have been asking whether this will be a replay of 2018. We don't see it that way at all, and we're not alone. Some of you were in Las Vegas a couple of weeks ago for the MJBI conference; it's the largest cannabis trade show in the world. If you were there, you saw first-hand that this is not an industry that's worried about the future. Consumer demand for cannabis products continues to grow, and the market continues to expand. As it relates to the current environment, what was clear to me in Vegas was that the industry is becoming increasingly adept at navigating choppiness—that's inevitable in a market like this. What's happening right now is pretty straightforward: in California, there's simply too much cannabis harvested in the past few months, especially from outdoor growers in the northern part of the state, on top of a strong harvest from the first turn of crops earlier in the year. Many growers harvested their second crop of cannabis earlier this season due to concerns about wildfires and drought, and in the case of the legacy market, fear of increased enforcement efforts. The combination of too much product and relatively poor quality has put downward pressure on wholesale cannabis prices. However, that issue should solve itself once the current supply makes its way through the marketplace because the legacy market remains a big part of what's happening in California. The available data isn't great, so that makes it hard to give you a precise answer on how long it will take for the current oversupply to work itself through the market. That's why we're currently forecasting Hawthorne sales to decline in the first quarter. That said, the single most important fact is that the end market for cannabis continues to expand, and we expect to start seeing growth again in the new calendar year. Virtually no one is expecting that fact to change for the foreseeable future. In fact, many high-end growers have told us the current market issues are not impacting them at all, and they continue to flourish. Another important fact to remember is that, unlike in 2018, there are no regulatory issues getting in the way right now. Three years ago, California badly botched the rollout of the recreational marketplace. That overwhelmingly was the issue that impacted the market back then; it was nearly impossible to get a license to operate legally, regardless of whether you were a cultivator or a dispensary. While the current marketplace in California remains more expensive and bureaucratic than other states, it is vastly improved from what we've seen in the past. The legal market there continues to grow. Some of you are also wondering whether the current situation will result in some consolidation. The answer is pretty simple: yes, of course it will. But those kinds of ebbs and flows are exactly what we expect to happen. It's what happened in Colorado back in 2015; it happened in Oregon when it went legal, and it's likely to happen in California to some degree. In fact, that's also what we're seeing right now in Oklahoma. Like many new markets, Oklahoma experienced explosive growth right out of the gates and probably got a bit overbuilt. We expect a pause there before growth resumes. We've told you repeatedly over the years that this industry is likely to be choppy from time to time; this is not the first time the industry has seen an oversupply of cannabis, and just to be clear, it will not be the last. What's important for Hawthorne is that we keep running our play. The growth will be there in the long term; I'm not worried about that. Instead, I want to make sure that we're doing everything we need to in order to distance ourselves from the competition. Jim has already told you that we won't slow down our innovation efforts, which by the way go much further than just new product development. That brings me full circle to the MJBI conference a couple of weeks ago in Vegas. Like most major trade shows, MJBI was canceled last year due to COVID, so we haven't seen the industry all in one place for over two years. What was clear to us, and frankly nearly everyone we interacted with, is how far Hawthorne has come in those two years and how much we've distanced ourselves from the competition. We have fundamentally changed our approach to selling, and that transformation is continuing. We've brought new products to the market that have improved the results for growers by both increasing their yields and lowering their operating costs, and we've used the innovation to help us in more qualitative ways, like the establishment of the Hawthorne Social Justice Fund within our corporate foundation. While I understand the questions you all need to ask about the step down in our growth rate, I would urge you not to lose sight of the bigger picture: there is no doubt that we are clearly in the industry, our competitive advantages are unique, and the cannabis industry still has miles of runway ahead of it. So, looking ahead at fiscal '22, I'm not worried about a few speed bumps; rather, I'm excited to see how much further we can push this business and continue to lead the way in the industry that remains poised for years of growth. With that, Corey, let me turn it back to you.

Let's move down the P&L now to the gross margin line. Like nearly all other CPG companies, we continue to see pressure from higher commodities and distribution costs. However, the year-over-year change in the margin rate during Q4 requires some additional context. The adjusted gross margin rate in Q4 of fiscal '21 was 17.4% compared with 24.3% in 2020, but companywide sales in Q4 of last year were up nearly 80%. So the fixed cost leverage in a relatively small quarter drove a massive improvement in the margin rate. If you compare the Q4 gross margin rate in '21 versus '19, you'll see the difference is only a hundred basis points, and that difference is a combination of segment mix and higher commodity costs. On a four-year basis, the gross margin rate declined 270 basis points to 30.3%. The year-over-year increase in commodity costs of about $85 million, nearly all of which was unplanned, was the primary reason for the decline, followed by higher distribution costs. As you know, we did not adjust our prices this year until August in the US consumer business, so we had limited ability to offset the commodity inflation during the first three quarters of the year. That story will change significantly in fiscal '22, which I'll explain further when I cover our guidance for next year. Higher volume was able to drive improved fixed cost leverage and conversion to help offset the commodity cost increases. SG&A came in two percentage points lower in fiscal '21 at $743 million. It declined 21% in the quarter to $161 million; lower variable compensation was the main driver. Also, in Q4 of 2020, we used some of our strong earnings upside to significantly increase our annual contribution to the Scotts Miracle-Gro Foundation, which we did not repeat in fiscal '21. Interest expense was $5 million higher in Q4 compared with a year ago, but essentially flat on a full-year basis. Remember, we issued $900 million of bonds in the second half of the year, which drove an increase in the quarter. On the bottom line, adjusted net income, which excludes restructuring, impairment, and onetime items, was up 28% to $528 million, or $9.23 a share. That's just a penny shy of a $2 per share increase in a single year and more than twice the $4.47 a share we earned in 2019. The EPS number is on the high end of the revised range we set in early June, and is a major accomplishment given the difficult comps and some of the cost hurdles we've had to clear in the second half of the year. We're obviously glad to answer any of your questions regarding our Q4 or four-year results, but instead of spending more time on those details, I want to switch gears and share our thoughts about fiscal '22. As you saw in the press release this morning, we see company-wide sales next year of about flat to plus 3%. This assumes the US consumer segment is flat to minus 4% and that Hawthorne grows 8% to 12%. None of those ranges assume the potential impact from acquisitions in US consumer. We are going into the year with the assumption that unit volume will decline high single digits. Roughly half of that decline is expected from lower shipments in the first half of the year. Remember that last year's Q1 was up nearly 150% as retailers worked hard to remedy depleted inventory levels. Since current retail inventory levels remain higher than a year ago, we likely won't see a repeat of that kind of initial load in. We're also, for planning purposes, assuming modest declines in consumer takeaway in fiscal '22, mostly driven by the different comps we face in the first half. As Jim already indicated, consumer POS has been stronger than we expected in recent months and has actually been positive for the fall season. It's easy for us to lean in to meet the higher consumer demand if it comes, but the prudent play is to assume a slight decline. Most, and perhaps all, of the planned unit volume decline should be offset by pricing. You should see some benefit from pricing in Q1 from the August price increases, and the balance will begin during our Q2. As it relates to Hawthorne, we're planning for 8% to 12% growth on a four-year basis. We expect to see continued pressure in Q1; as Chris said, it's hard to be precise regarding the current inventory supply issues in the industry, but we're hoping to see a return to growth sometime in Q2. Let's move on to gross margins. We expect to see gross margin rate decline by 100 to 150 basis points on a full-year basis. We are cautiously optimistic that our pricing moves will offset expected commodity pressure. That said, we expect about 65 to 70% of our costs to be locked in by the end of the calendar year, so we'll still have some exposure if costs move higher than the planned increases. We are assuming the two biggest pressures on rate next year will come from a lower fixed cost level and segment mix. We would expect some leverage out of SG&A, meaning this line can range from a 6% decline year-over-year to a slight increase, maybe 2%. There are no major moving pieces in SG&A, and we are committed to investments we believe will drive the business, not just in fiscal '22, but in the years to follow. Below the operating line, interest expense should be roughly $25 million higher based on the full-year impact of our recent bond offerings. Our guidance also assumes no offsetting earnings impact from acquisitions, which is a pretty conservative starting point. All of this rolls up to a guidance from range for adjusted EPS of $8.50 to $8.90. I also want to talk about cash flow for a moment. For the year we just completed, free cash flow—that's operating cash flow minus CapEx—came in at $165 million. While that is low from historical standards, there are three main reasons behind the year-over-year decline. First was variable compensation that was earned in '20 but paid out in fiscal '21; that was about a $60 million impact. Second, we increased CapEx by about $45 million. Third, inventory levels were up $500 million from fiscal '20. While most of this increase was paid during the year, we did lean on our vendor partners more than in the past to achieve extended payment terms. As we looked at fiscal '22, we're aiming for free cash flow of up to $300 million. We expect CapEx to increase again, and we also expect inventory levels, while flat on a unit basis, to be higher overall because of the increased cost. These investments are necessary to continue meeting the required service levels to our customers, which is the higher priority. But as it relates to inventory, we find ourselves in a very good place right now in both US consumer and Hawthorne. We believe some competitors will have a hard time meeting demand, and in the consumer business, we expect the market to see shortages of grass seed and peat moss, the key ingredient used in growing media. We do not expect to be impacted by those issues, and we do not expect to have any problems getting our customers the appropriate inventory levels either. Before we open the call for your questions, I'll offer a final bit of commentary. I agree with Jim's assessment: we've got a lot of moving pieces right now and several active initiatives that could require us to update our outlook as we move through the year. But even in the unlikely event that none of those efforts come to pass, I believe the business is in a great spot. The challenges we're seeing on the cost of goods line are pretty consistent with what you've been hearing from other companies over the past two weeks. And just as we said we would, we've taken aggressive action to stay ahead of all those and protect the profitability of the business. When I think about how far this business has come in such a short period of time, it's hard not to feel good about where we sit right now. And with that, let me turn things back to the operator so we can take your questions.

We'll go ahead and take our first question from Jon Andersen with William Blair.

Good morning, everybody. A lot of different questions, but let me start with Hawthorne. I understand the situation in California, and thank you for the color on that. I'm wondering, I'd like you to comment on what you're seeing in some of the newer states. Really over the last year, a number of states have legalized adult use cannabis, and yet in some of those states, quite large such that the total population living in states with adult legalization has risen quite a bit. My sense is that you haven't really seen demand from those newer states yet. Could you provide an update on that and when you expect that to kind of kick in? Thank you.

You're absolutely right. We saw a lot of states legalizing adult use, and when you talk about high population states that have seen adult use pass, I assume you're talking about states like New Jersey. We've always liked to give you guys and ourselves, frankly, sort of a year; we think from the passage of laws to say that's when we expect the market to kick in. While I think that's a reasonable estimate in most states, you do have to couch that with the reality that this is dependent on the state legislatures getting the regulatory frameworks for these markets set up. That's something that in a state like New Jersey has taken a lot longer than expected. For example, New Jersey had a big slate of social equity licenses for adult use grow that were supposed to be granted back in 2019, and those licenses were just granted two weeks ago. That's an example of how slowly that state has moved to actually approve what the voters have asked for, and in that state, those adult-use licenses will not be able to sell into the adult-use market for a year after they've been operational under medical. So those growers will have to build out their medical grows and start operating for at least a year before they're eligible for adult use. So, even when they pass adult use, we've seen some regulatory hurdles that just really stretch that timeline out for us. We expect New Jersey to start kicking in; we're seeing some really early results, but it's still a very small state for us. Again, it's a year that has always been our kind of number, but it looks like that may be a little too optimistic in some of these northeastern states that have no existing framework and are figuring it out on the fly.

Great. That's helpful. Appreciate that. Just as a follow-up, maybe I'll stick with something bigger picture. You mentioned live goods several times as a gateway to lawn and garden. It's one of the five pillars that you outlined for growth for the next several years. So what can you just let us know, what have you done and accomplished so far in live goods? A little bit more color around that. And when you look forward, what is it that you haven't done that you want to do in live goods that would be accretive to your growth and earnings, whether that's more with Bonnie, whether it's broadening the relationship with AFC, etcetera? Thanks.

Alright, I think I'll start and then hand it to Mike, who I view as really sort of the author of the strategy, which I'm totally behind. I'll just hit what we have done. I think this year we've stepped in or privates a little bit and learned a lot. I can let Mike talk about that because I think that's what we're going to do. But let's start with what have we done. I think we bought the only national brand in live goods, which is Bonnie, and we worked with them to really begin to professionalize the brand. I don’t think they were unprofessional, but I think we've learned a lot of how we want it to be. Mike has really led that from our side. And if you say where we want to go, we want to participate in the other categories under the same kind of idea of branded national, using our scale. Let's just remember what was our original interest in growing this market. We just don't want to be a lawn and garden chemical company anymore; we want to be regarded as a gardening company that not only sells products but also participates in the gardening experience. And this whole notion of why people garden plays into that. If you look at our core, we think we can kind of double that, which is not saying a lot. I think Mike and I struggled with that, zero to two to two to four. But we're seeing a growth rate in live goods that's at least two times that. So that was the attraction to the business, coupled with this idea of getting involved more in the basics of gardening and the brand side of it that Bonnie brings to us. The question of is like, what have we learned? And Mike, what's your addition on that?

Oh, it's probably 20% to 25% of my time right now. We had a lot going on. We've integrated companies. We've got to integrate those systems. If you remember where Scott's was from eight to six years ago, it really was an isolated supply chain. This is really nationalizing the supply chain of the live goods category and making it more effective. And so we are looking at providing that national infrastructure, which is probably the weakness of every grower in being able to supply nationally those products efficiently and then expand also with direct-to-consumer initiatives.

That's helpful. I'll pass it on and get back into the queue.

We'll take our next question from Peter Grom with UBS.

Hey, good morning, everyone. Just a few questions on Hawthorne for me. Maybe just to start, Jim, you alluded to a greater willingness to separate Hawthorne from the legacy business. I know you said that it's not something you expect in the near term, but could you maybe help us understand what is driving that growing confidence that this is something you may consider and then what could actually push you over the line to make that happen?

I'll start there. I could go on for an hour on that one. Let me start with how welcome Hawthorne is within sort of the SMG world. I think Chris has been in this job now for seven or eight years. If you look at what we're doing with supply chain innovation, it really has helped. Our overall strategy has evolved, and we understand that if we can arrange this in a way that allows for greater nexus between the cannabis business and the consumer lawn and garden market, we can drive better value. I would say the goal would be a structural arrangement that yields synergistic benefits to both sides. Moreover, we have spent the last 18 months making sure we have separable financials, as our finance team works on putting together a structure to make this happen. I think we're capable of pulling the trigger on such a move if we decided it makes sense. Let me be clear: we have no near-term plans to do this, but could it become a viable option? I think the possibility is growing.

Okay, no, that was really helpful. Thank you for all of that, but I guess maybe for Chris, I was hoping to get your view on the cadence of Hawthorne. As you look out to fiscal '22, can you maybe just help us understand the magnitude of the negative pressure you expect in Q1? What gives you confidence that it will snap back aggressively to hit this high single-digit, low double-digit target for the year? Is there enough conservatism in your guidance, like should underlying trends take longer to improve? And then just, I know there's a lot here, but just the Oklahoma comment, can you maybe help us understand how big Oklahoma is for Scott's or the broader industry? Thanks.

Yeah, no problem. Oklahoma has become a somewhat material state for us. We've seen some serious growth there over the past couple of years, but we need to prepare ourselves for a little bit of fallout in Oklahoma. Just because you can't see that kind of growth forever—similar growth occurred in states like Oregon back in 2017, which led to end product saturation in those states. Again, I don't think anyone is anticipating this to be the same amplitude; the previous structural regulatory issues do not exist now. In terms of what gives us confidence about recovery, this is a perishable crop, and it's only going to stick around for so long. Additionally, while we face some immediate challenges, we have a good handle on what the high-end growers are telling us: they're continuing to flourish. We think growth will return by the first quarter of next calendar year, and we have been preparing for it.

Super helpful, thank you. I'll pass it on.

Alright, we can go ahead and take our next question from Bill Chappell with Truist Securities.

Thanks, good morning. I'll try to keep it short. First on Hawthorne kind of M&A commentary, could you explain to me the rationale behind the broad base of products? Most of the M&A you've done now in the past year has been really small. I understand that valuations are more attractive, but why bother if you could end up buying 300 different $10 million businesses versus building it yourself? So help me understand why that makes sense versus, kind of a part two to that first question of why didn't you actually repurchase shares in the quarter versus repurchasing them going forward?

Well, I'm just sort of stunned by the repurchase part. Let's just talk real quick about sort of M&A for Hawthorne, not the Hawthorne Collective or what we call Apollo internally because they're quite different. Bill, you've been with us a long time. What we have always called close-in adjacencies in the consumer side—these are businesses that, because of the sunlight connection, have opportunities in distributed products we understand and already sell. If we can bring those in, there are very significant IRRs, and I can tell you that there are branded businesses out there where getting people to change is not as easy as it seems and there are significant opportunities and synergies. Plus we can buy at a fair price and then apply the synergies to the business. If I took you through them—I'm not going to do that right now—you would essentially say, 'Oh, yes, you should do that.' It's not very exciting. I want to go back just to LED lighting for a second. This business didn't exist at a big level three years ago; now it represents a significant category that we built by ourselves, and we're significantly backordered on our LED lights. This represents a huge area of opportunity.

I would like to add that focusing on small deals allows us to increase brand presence in the market while ensuring a seamless integration process. The companies we’ve recently acquired have a natural synergy with our existing business structures. Additionally, repurchasing shares is a priority in our shareholder-friendly approach, and we did buy back about $40 million of shares in Q4, so it wasn't that we were out of the market initially. Now we’re feeling more comfortable with the Q1 results and we think we can buy into the market on share repurchases at two to three times that level and feel comfortable with it.

Got it. Well, I'll leave it there. Thanks so much.

Alright, we can go ahead and take our next question from Andrew Carter with Stifel.

Hey, thanks. Good morning. I just, I guess I wanted to ask, given that the midpoint of your guidance next year suggests that gross margin will be down 430 basis points where it peaked actually earlier this fiscal year. Could you help us understand how the GM will phase for the year’s pricing absorbs inflation? That comment around pricing above inflation, was that a full-year comment, or was that expected to happen at some point? Final comment: just so we can get a sense of the ongoing degradation potential for mix, where does Hawthorne's margin stand today and where do their own brands stand? What's your penetration? Thanks.

But I want to start this. Thank you for asking that series of questions. I was in a meeting this morning with Ivan and I said, I'm at a disadvantage regarding the budget or at least the expectations we're setting. Setting the budget for this coming year was a challenge. We looked at sort of neutral operating '22 versus '21. If we can build a budget that meets your consensus and still fund the things we want to fund responsibly, that is what we focused on. We really feel that we are capable of better performance than what we presented, and I wouldn't be surprised if our actual financial outcomes exceed the performance we're guiding now.

You brought up the total company margin rate. We guided to a decline of 100 to 150 basis points. If you look at the components that make that up, segment mix will have a natural effect as Hawthorne grows faster than the US consumer business. This will create an enterprise-wide decline in our margin rate. On pricing versus costs, they basically offset each other, so we expect margin neutrality in our plan, but we have to remain cautious regarding what happens in commodity costs over the next calendar year.

Great, thank you. This might be a difficult question to answer, but you've cited the pull forward of the crop in the outdoor season in California, which I guess the potential upside is that the October results are really bad. So could you quantify for us then, like maybe how the earlier pull—not selling to growers in August, September—may have hit numbers, whatever product lines that might've affected nutrients? Just so we can kind of think of a back half headwind that hit this year and could potentially come back next year. Thanks.

You already said it; the slowdown has affected our consumables business significantly more than our hardware business. So nutrients, growing media, and certain categories have seen much more downward pressure than hardware sales. We're still seeing strong demand for our new Gavita LED lights, for example. We're looking forward to the back half of the year when we expect a heavy influx of consumables sales, as we drop innovation on the hard side. We're anticipating that to come back strongly again, as we continue to build facilities and respond to market dynamics.

Great, thanks. I'll pass it on.

Okay, well go ahead and take our next question from Joe Altobello with Raymond James.

Hey, thanks, guys. Good morning. So Chris, just want to follow up on that last comment regarding California. How quickly can these indoor growers ramp up their operations once pricing starts to improve?

Pretty rapidly. It depends on what stage of build-out they're at. We've gotten good intel that there are a number of largely built-out grow facilities available now for acquisition. We know that numerous growers that are sitting there, kind of half-built or mostly built are not finishing until the market recovers. We expect a recovery in demand, and once demand becomes robust again, we expect them to come online quickly—within six months or less.

That's always been the case. To the extent that we have visibility to the legal status of the people consuming our products, we sell through retail, and where it goes from there is somewhat anyone's guess. We are aware that there's a lot of black market growers out there. If they aren't seeing rewards for their activities that outweigh the risk they're taking, they may pause and after a quarter or so, return to production quickly to meet rising demand.

Okay, helpful. And just one more for Cory, what's the anticipated incremental commodity and logistics headwind in '22 in dollars? And it sounds like, correct me if I'm wrong, that the price increases—the high single-digit price increases—call it not only offset that dollar-for-dollar, but you're maintaining your margins in both businesses as well.

If we look at the rates that we're putting into the plan for each of the segments, we are basically maintaining margin at the levels we've planned. The headwind we've experienced so far—of about $85 million in added costs—will get annualized as we go into '22. However, the pricing actions we are taking are designed to negate those increases effectively without deteriorating margins.

And we'll take our next question from Eric Bossard with Cleveland Research.

Thanks. Trying to understand the importance of pricing on the Hawthorne business. I'm talking about end product pricing. I thought Chris, your comment was interesting that your exposure is to the high-end. Yet it seems that the business is softer right now not among the high-end producers. Can you help explain that?

Our focus remains on the high-end, but we have pretty broad exposure here. High volume products are used across the quality spectrum. Wholesale prices absolutely matter to us. When we completed a review of what happened back in 2018, we identified wholesale cannabis pricing as a key factor. The high-end growers have been somewhat insulated from downward pricing pressure, but they're still not fully shielded. Significant price depression has impacted all segments, albeit at varying levels. We sell plenty of products that service both the middle and late market as well; it is not specific to any one group. Our core, however, remains those high-end growers; on average, we are equipped to approach product demand more steadily.

Okay. And then for Jim, given that you made a comment that there's a chance to double the business size in five years, is this a collective Apollo? Is this the path that you're speaking to that to accomplish this?

Yes, it encompasses everything we expect across the five pillars as we work on our organic growth. We believe our consumer business has sustainable growth opportunities. The growth over live goods will also be coupled with the strong future we expect at Hawthorne. If everything falls into place, those are the avenues paving the way to that milestone.

In the interest of time, we'll just pick one more question here, and then we'll wrap it up.

Thanks very much. When you read some of the press accounts in California, it claims that the California market is about 2 million pounds, and there's 6 million pounds of capacity—it's two to three times oversupplied. Is that a fair characterization? Secondly, do your raw material costs continue to rise? Do you expect them to be higher in the December quarter and higher in the first quarter of next year? How do you manage that conversation with your customers if that is the case?

So look, I think saying the California capacity is three times what they're selling domestically in that state is a fair assessment. California has been the cannabis breadbasket for years, serving a large portion of the legacy market. These dynamics can lead to odd looks unless you account for that black market involvement, which is very real. Regarding raw material costs, they are indeed at multi-year highs for some commodities, and we're seeing that affect our business. We anticipate higher costs through the next few quarters but are optimistic we can manage discussions about pricing increases with our customer base effectively.

So, remember, these are public conversations. It's important that we communicate the potential cost adjustments wisely. I believe we are in a solid position compared to a lot of our competition regarding our offerings and value propositions. However, inflation in the consumer sectors is worrying, and we have to keep a close eye to ensure our consumers can sustain their needs adequately, as price pressures escalate.

That concludes today’s call. Thank you all for your participation. You may now disconnect.