Good day and welcome to The Scotts Miracle-Gro Company's Third 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 Kelly Berry, Vice President of Investor Relations. Please go ahead.

Good morning, everyone. I'm Kelly Berry and I'd like to welcome you to The Scotts Miracle-Gro third-quarter earnings conference call. I've stepped in to lead Investor Relations after a long career in finance at the company. I'm proud to succeed Jim King, Executive Vice President and Chief Communications Officer, who has retired from Scotts Miracle-Gro after a 21-year career at the company. Jim has agreed to stay around over the next few months to help transition as needed. I've had the pleasure of meeting many of you already and I look forward to meeting all of you over the coming months. Today's remarks from Jim and Cory have been prerecorded. Once we conclude the prepared remarks, we'll open the call to live Q&A. After the Q&A, an archived version of the call will be published on our website. Joining me for the Q&A this morning is Chairman and CEO, Jim Hagedorn; Chief Financial Officer, Cory Miller; as well as our President and Chief Operating Officer, Mike Lukemire; Chris Hagedorn, Group President of Hawthorne and several other members of the management team. Before we begin the remarks, I want to let everyone know that the management team will be attending the Barclays Global Consumer Staples Conference in early September. We'll publish more details related to the date and time of the event, a couple of weeks in advance. With that, let's move on to today's call. As always, we want to make you aware that we will be discussing forward-looking statements on the call today. I want to caution everyone that our actual results could differ materially from what we say. Investors should familiarize themselves with the full range of risk factors that could impact our results and those are filed in our Form 10-K. I'll now turn the call over to Jim Hagedorn.

Thanks, Kelly, and good morning, everyone. There's a lot to cover on the call today. The current performance of both major business segments, the implications of that performance in our fiscal '22 results and the steps we're taking to manage the higher-than-expected leverage we will carry into next year. I will say at the outset, we are not providing guidance today for fiscal '23; we plan to do that in November as we normally do. While some of the finer points of our operating plan for next year are still being finalized, there are some tailwinds and headwinds already coming into focus. So, we'll share some of those details today where we can. In terms of my comments around our current performance, I'll spend more of my time on the U.S. consumer business. Obviously, it's the biggest driver of shareholder value. But I also believe it's easy to misread what's happened over the past few months and I want to make sure you understand why we remain optimistic. Before I address these topics, I want to clear the air. I told you on previous calls that I was focused on our long-term strategy and would not manage on a quarter-to-quarter basis. I also said I try to ignore the stock price and market fluctuations. But there are times and circumstances that require an exception and this is one of them. As you know, my family and I are the largest shareholders in this company. None of us are pleased with our current performance or the equity value. I understand the rest of our shareholders aren't either. You shouldn't be, especially those who supported the shares at much higher levels than we're seeing today. There were some challenges that emerged this year, several of them actually that we could not have anticipated. In other cases, especially with Hawthorne, we misread the market which drove investment decisions that I'd reverse if I could, but I can't. What I can do and will do is focus on the proactive steps we can take to get this business back to an acceptable level of profitability. So, to our more recent shareholders and those still doing research, we appreciate your interest and share the belief of many of you that there is an opportunity for significant upside from today's levels. I'm not just the largest shareholder; I'm the CEO, so I'm accountable to all shareholders and I accept that. Whether our results this year are due to factors beyond our control or missteps that we made, it doesn't matter. What matters and what you'll hear from me today are the steps we're taking to get back on track. There are three things I hope you take away from this call. First, is confidence that we understand the challenges in front of us and are moving with urgency. And while we've been forced to make dozens of tough decisions in a compressed time frame, including a headcount reduction of hundreds of people, we're also protecting our competitive advantages and securing the leadership pipeline we need for the future. Second is a belief in the underlying and undeniable strength of our U.S. consumer franchise. It is critical for shareholders to look beyond the financial performance of this business in the second half of the year. The fundamentals are still there. The consumers remain engaged and the future remains bright. And third is an understanding of why we're confident we can restore the business to our historical margins, generate significant cash flow and recapture the financial flexibility we need to drive growth and enhance value. Much of the improvement is within our control and we are working quickly to make it happen through an effort we are calling Project Springboard. The first phase has been largely reactive and is designed to adjust to our near-term reality. The next phase is about returning the business to a proper level of financial performance and ensuring we are well-positioned to take advantage of the opportunities we believe still lie ahead. On this call 90 days ago, I could not have predicted that we would be where we are right now. We outlined the impact of lousy weather in April and said we would claw back some of the consumer engagement we lost in the early weeks of the season. We were mostly right in that assumption. In any other year, we would have seen replenishment orders keep up with the surge in consumer POS that occurred throughout May and June. But by late May, it became clear those orders were not coming. The single biggest change since May is the way retailers are managing their inventory. I'll elaborate on this point later in my remarks. That shift translates directly into lower sales of our U.S. Consumer segment, negative fixed cost leverage in our P&L and higher levels of our inventory than we expected. And that combination is driving our leverage beyond where we want it and is prompting us to focus on debt reduction as our primary use of cash over the next year. We are aggressively managing those issues in real-time and I'll return to this discussion again shortly. First, though, I want to update you on the performance of both business segments. I'll keep my comments at a high level and leave the details around the numbers to Cory. Despite the unexpected challenges in our U.S. Consumer segment, I remain confident in the strength and stability of this business. Household penetration for our products this year is on par with 2020, that's the year 20 million new customers entered the category. More importantly, our total consumer base got younger again this year due to the continued influx of millennial and Gen Z consumers who are buying homes and entering the category. And finally, we kept a higher percentage of those younger consumers this year than we did in either of the previous two years. The demographics of this business continue to get better. That gives us and our retail partners a great deal of enthusiasm as we look forward. While total POS units are down 8% year-to-date, that performance is in line with the guidance we provided going into the year. Given our aggressive pricing actions, we initially expected POS dollars to be flat on that volume. However, POS dollars are down 5% but still in line with 2020 levels. The recent decline in POS dollars is twofold. First, retailers were more aggressive promoting low-ticket categories like mulch and soil. Meanwhile, units of higher-priced and lesser-promoted categories, specifically lawn fertilizer and grass seed, are down nearly 20%. I want to elaborate on those two categories because there's a lot to understand and it's easy to misinterpret the data this year. Let's start with the fact that we included a volume decline in our initial guidance. If you normalize for that, POS units in these categories are still down about 12% more than expected. It is possible that some of that decline is related to elasticity, although that appears to be minimal. If elasticity was the primary issue, we would have expected to see a significant decline in market share. We didn't. We lost about two points of share but the gap between our products and opening price point products was well above normal this year. Let me explain. You'll recall we implemented four price increases this year in our branded products. It doesn't work that way in private label. Prices are set once a year and that contract holds all season. That price gap will normalize next year with higher price increases in private label. So while we currently believe the share decline is not a big issue, we're watching it closely. There are two major factors we believe drove the other 10 points of decline. The most impactful was weather which impacts fertilizer and grass seed more than anything else we sell. In March and April, it was cold and rainy in nearly the entire eastern half of the country, including critical early-season markets like Texas. And in the Western United States, drought conditions also created a headwind. Weather created two challenges. First, it kept consumers out of the store in April, our most important month for fertilizer sales. Second, the wet and cool conditions meant lawns looked great in May. In our research, more consumers than normal told us they didn't see the need for fertilizer or grass seed this year. The other major issue was a lack of promotional activity. Instead of using highly visible promotions to drive traffic, as they've done in previous years, some key retailers adopted an everyday low price strategy in those two categories. Experience tells us that EDLP has not worked in the past, and it didn't work this year either. As we look ahead, we expect the return of early and well-timed promotions in these categories next year. Fertilizer and grass seed are the earliest breaking products for us and we need to be working with our retailers to get consumers off the couch and into the backyard. Right now, the scorching summer heat is having a negative impact on consumer lawns. That should benefit this category in the fall months, and we're hoping to get our first clean read on both fertilizer and grass seed in September and October. When you look at POS and you look at our sales to the retailer, there is clearly a greater gap than we planned. Some of you have suggested that means retailers are less enthusiastic about this category. That is not the case. Planning for the '23 season is well underway and there is continued enthusiasm. Retailers know what we know; in times of macroeconomic distress, consumable lawn and garden products remain one of their strongest categories. So let me explain what is happening. If you walked into stores in late May and June, you would have seen an unusually high amount of seasonal durable products like grills and outdoor furniture. Those categories just weren't selling. What was moving? Our products. POS of our products in May and June was the second highest on record. So it was easy for retailers to reduce their seasonal inventory by carrying less safety stock of our products and reduce their replenishment orders. Sitting here today, retail inventory of our products measured in units is down 12% from last year and we expect it to drop a few more points further by the end of the year. The opportunity is that retail inventory will be significantly lower going into the spring. Based on our ongoing conversations with our retail partners, we expect strong and predictable sell-in at the start of the season. We expect retailers to be more aggressive next year using consumable lawn and garden categories to drive foot traffic and therefore, are more likely to be aggressive at the start of the season in early breaking products like lawn fertilizer. Moving on to Hawthorne. The story has not changed much. Cannabis prices remain significantly lower due to excess inventory produced by cultivators. As the challenges continue, it is increasingly clear the role public policy has played in fueling the problem. Some states licensed far greater levels of cannabis production than their citizens could consume. The combination of loose regulation and limited enforcement has fueled the illicit market and created a hurdle the legal market is struggling to overcome. We believe we are seeing a reset in the industry right now, with some cultivators simply walking away because of the tough business climate. While new East Coast markets continue to grow, it is not enough to offset the declines in the established ones. There are a few good things to take away as we plan for next year. We will begin to lap some low numbers within a few months and we're hopeful to start posting modest growth in fiscal '23. We also remain confident that our competitive position has remained strong. Even in the face of aggressive cost controls, we've stayed focused on maintaining our advantages in areas like innovation and technical sales. Others in the industry have not. The translation is that we remain committed to this industry and our vision. While it's been a tough year, we'll be there when the dust settles. We'll continue hitting the pavement and staying in front of our retail customers, cultivators, and our vendors, and we will collaborate with them to meet their needs and ensure they are in the best position possible when the market does return. This will translate into everything from our sales programs to our R&D pipeline. Already, the market is evolving to one where large-scale innovative growers are most likely to succeed. We've expected that from day one and it plays to Hawthorne's strength. The most pressing task at hand, though, is restoring Hawthorne's profitability. While industry performance has been obviously a headwind, some of our previous investment decisions have been as well. We clearly overbuilt the infrastructure of this business, and I'm not going to sugarcoat it. The difference in the cost of what we have versus what we need is roughly $65 million a year. While we are moving aggressively to reduce Hawthorne's supply chain footprint, it won't happen overnight. The goal is to return Hawthorne to its previous margin structure within two years. Beyond that, we remain focused on achieving an operating margin of 15%. The final Hawthorne item I want to discuss relates to its future as a stand-alone business. Ideally, we would separate the business today for a variety of reasons, not the least of which is the impact of volatility the cannabis industry has on the equity value of SMG in total. But our analysis tells us that now is not the right time for this move. This is not the kind of market in which a full or partial IPO makes sense, and we're not going to sell the business when its earnings are at a multiyear low, and we have a clear and achievable plan for improvement. We explore the notion of combining the business with someone else; but that means sharing the synergies with another investor base after paying bankers, consultants, lawyers, and others. In a best-case scenario, we end up as good, if not better, by controlling our own destiny and allowing 100% of the upside of our restructuring efforts to accrue to SMG shareholders. The best course of action is to fix the business and wait for the industry to recover. So for now, that's the end of the discussion. I want to spend the rest of my time coming back to some of the themes I discussed earlier. While my team and I remain resolute in our vision, we realize our current focus needs to be on taking the right short-term actions to enable it. That means we must get the business back to an acceptable level of profitability. It means we must be laser-focused on sustainable free cash flow, and it means we must strengthen our balance sheet and reduce leverage. So we will hit the pause button on M&A and share repurchases. We remain committed to using the strength of our brands to help offset inflation, and we will reduce as much expense as possible without impacting the health of those brands. Regarding our leverage ratio, which stood at 5.1x at the end of Q3 and is almost certain to go higher. Remember, our leverage is calculated on a rolling 4-quarter basis. As we look ahead, we would expect leverage to peak in the March quarter at approximately 6x. From that point, we would expect it to decline quickly. I'm not sure if we can get back to 4.5x by the end of fiscal '23, but that's the goal. It's likely to be fiscal '24, however, before leverage is below our preferred long-term target of 3.5x. Given the recent amendments to our credit facility, we are comfortable we have the room to navigate. And while I'm on the subject, I want to thank our syndicate banks for their support and flexibility. The challenges in the business emerged so suddenly this year, we were forced to reopen discussions with our lenders only a few weeks after finalizing a new facility. They recognized the unusual circumstances and encouraged us to seek even more flexibility, given the uncertainty in the broader economy. I will tell you what I told them. We know what this business can accomplish and we are committed to getting it back to where it belongs. Our U.S. Consumer business should have operating margins in the mid-20s, not the high teens. We still have conviction that Hawthorne can achieve a mid-teens margin and we should also be able to deliver free cash flow productivity consistently near 100%, though next year, that performance should be significantly better. In fact, over the next two years, our goal is to generate at least $1 billion of free cash flow, the vast majority of which should be generated in fiscal '23. I'm confident we can get back to the level of performance that we and our shareholders expect and deserve. And rest assured, we will hold ourselves accountable. No one on the management team is receiving a bonus this year, and the equity grants we've made in recent years have taken a significant hit as well. Earning a bonus next year will require dramatic improvements in targeted areas, especially cash flow and leverage. The goals we set will be focused on driving value for our shareholders and not merely delivering modest improvements off an unacceptably low base. We know what needs to be done, and we're focused and committed to getting it done. Each of us on this team knows the power of this business and our brands. We know the resilience of this category and, mostly, we know the dedication of our associates. On that note, I want to take a moment to recognize our people and thank them for their efforts this year. We've encountered challenges we never expected, and we're forced to make changes that caught many of them off guard, especially only part of the company with so many of our former colleagues. It's important that all our stakeholders know that my team and I remain optimistic about the future. We know our collective strengths and competitive advantages will get us back on track. That gives us confidence that we'll once again deliver for our shareholders the results and value creation that they deserve. With that, let's shift gears. Let me turn things over to Cory.

Thanks, Jim, and good morning, everyone. Jim gave you a high-level overview of the trends we saw during the quarter in this commentary. I'll use my time to take a deeper dive into the P&L and balance sheet results to give you some additional insights. I'll start by saying that overall, our results for the quarter were mostly in line with the revised outlook we gave you in early June. There was one area where results were unfavorable to our expectations: U.S. Consumer top-line sales. Jim mentioned the shift in retailer focus to inventory reductions that we've been experiencing since May. We had adjusted our full-year outlook for the U.S. Consumer sales to account for this, but the trend has continued and accelerated. In the third quarter, POS units were down 6%, while our shipment units into retail were down 18%. Our third-quarter sales were down 14%, and we expect a similar or deeper decline in the fourth quarter. This means our full-year sales outlook is now down 8% to 9%. While there is clearly noise in the numbers this year from retail inventory actions, I want to remind you that POS results are generally in line with what we guided at the beginning of the year. POS units were up 6% in 2021. So our performance this year means that we are just slightly behind 2020 results and well above 2019 levels. Hawthorne sales were down 63% for the quarter. The run rate for that business did decline slightly in the quarter, in line with the revised guidance we provided in early June. The decline was driven by less outdoor growing in the third quarter than we originally had expected and further delays in capital projects for indoor growers, both driven by the oversupply in the cannabis industry. It's also important to note that we were comparing against record results. The third quarter of 2021 was the highest quarter of sales in Hawthorne's history. We expect the run rate for Hawthorne to improve in the fourth quarter, driven by innovation in our horticulture lighting business in Europe and Canada. We recently launched the WEGA, a new LED product developed specifically for the greenhouse applications in the vegetable and flower markets. Just like our previous LED innovations, it uses less power and delivers optimal light output. The return on investment proposition has been clear to the growers in the space, who appreciate the energy cost savings combined with superior results. Early orders for the product have exceeded our expectations. Moving on to gross margin rate. The adjusted gross margin rate in the quarter was 530 basis points below last year, which brings the year-to-date decline to 300 basis points behind prior year. The principal driver of the decline in the quarter was fixed-cost deleverage stemming from the volume miss in both segments. Warehousing and manufacturing costs are largely fixed in the short term, and these fixed costs were spread over fewer units in the quarter. The fixed-cost deleverage impact was included in our latest guidance on gross margin rate for the full year. The gross margin rate decline in the fourth quarter will be higher than what we saw in the third quarter. This is primarily due to an aggressive pullback in production that will result in more costs falling through to the bottom line in the fourth quarter. As expected, commodities also weighed heavily on the gross margin rate for the quarter. Almost all of our commodities experienced new highs after the Ukraine invasion. Urea has recovered recently after experiencing extreme spikes in the spring. This recovery helped lessen the pressure in the quarter but will not provide much relief in the balance of the year. Commodity changes from this point on will primarily impact us in next fiscal year as we are 95% locked on our commodities for fiscal 2022. The extreme pressures of deleverage and commodities were partially offset by pricing and favorable segment mix due to lower sales in the Hawthorne segment. SG&A was significantly lower for the quarter, down 30% from prior year. Three key items drove these results. The first was variable compensation. As Jim mentioned, no one on the management team is getting a bonus this year. The full-year impact of variable compensation is worth approximately $60 million. The second driver of SG&A savings was the restructuring effort that we announced last quarter. We told you that we had set a target to reduce our overhead structure by 10%. This restructuring effort became the first initiative for Project Springboard. The targeted reductions were achieved, and some of that favorability was realized during the quarter. Finally, spending reductions across the company drove further SG&A savings in the quarter. Every cost center was evaluated for potential reductions and we identified opportunities to cut or delay spending in each of them. We were aggressive with these actions, but we also maintain a strong point of view on the activities that contribute to our competitive advantages. For example, we took care to preserve research and development in both businesses and our U.S. Consumer field sales team. The favorability we experienced in the third quarter will carry through to the fourth quarter, prompting us to adjust our outlook for SG&A from down 13% for the full year to down 15%. With these factors now baked into our expectations for full-year adjusted EPS, we now expect to finish at $4 to $4.20 per share. Shifting gears now, I'll cover the impairment and restructuring charges we recognized during the quarter. Jim covered the challenges we have been facing in the Hawthorne segment related to oversupply in the cannabis industry. Those challenges, combined with the overinvestment in the Hawthorne supply chain, led to a noncash impairment charge of $633 million related to goodwill and intangible assets. Additionally, we recognized a $46 million inventory write-down associated with the discontinuation and retirement of our Sun Systems brand. Lastly, the restructuring efforts that we discussed above resulted in charges of $41 million related to employee termination benefits and fixed asset impairments. Below the operating line, interest expense was $9 million higher in the quarter and $26 million higher year-to-date. The change is driven by higher borrowing levels. Those higher borrowing levels, combined with lower earnings in the business, resulted in a leverage ratio of 5.1x at quarter end. Jim gave a good amount of detail on this topic in his comments, so I won't elaborate further. We expect our full-year adjusted effective tax rate to be approximately 22% this year. The favorable rate is due to a benefit of discrete items related to the vesting of long-term share-based compensation awards. Though we aren't giving guidance yet on 2023, I want to call your attention to some headwinds we will be facing next year below the operating line. The tax rate will likely be a headwind as we expect to return to a more normalized rate closer to the 24% we’ve seen in the prior few years. Interest rates will be a headwind due to higher variable interest rates as well as higher spreads from the recent amendment to the credit facility. EPS could also face pressure due to share count. Since we aren't planning on share repurchases in 2023, we will see some dilution from equity awards. On the bottom line, we had a GAAP loss per share of $8.01 compared with earnings of $3.94 last year. This number includes the impairment and restructuring charges that I described earlier. Non-GAAP adjusted earnings per share which excludes impairment, restructuring and other nonrecurring charges was $1.98 in the quarter compared with $3.98 a year ago. I'll switch gears now to the balance sheet and cash flow. We've made some progress on our inventory reduction goals, even considering the further decline in U.S. Consumer replenishment orders. Inventory at quarter end was $445 million higher than this time last year. This was an $84 million improvement from where we ended the second quarter if we exclude the Sun Systems write-down. We have pulled back on production in all of our manufacturing facilities and will continue to limit production and dramatically reduce our inventory levels throughout 2023. This decision will put pressure on our gross margin rate in the short term but aggressive inventory reductions will allow us to act quickly on rightsizing our distribution network and get our long-term margins back to an acceptable level. We've also lowered our expectations for CapEx. We are now planning to spend about $135 million, down from an original target of $200 million. We will lower our CapEx spending further in 2023 as part of our plan to decrease leverage. The changes that I just covered on the balance sheet and CapEx were already built into the revised cash flow guidance of flat that we communicated in early June. However, the additional decline in U.S. Consumer sales will put further pressure on our free cash flow. We are now expecting negative free cash flow of $150 million for the year. Jim mentioned his confidence in cash flow going forward, and I certainly agree. Reductions in working capital will provide a strong tailwind next year; improved performance and reductions in CapEx will likely bring the full-year number close to $700 million, if not higher. As we look at capital allocation, no changes are planned for the normal quarterly dividend. And as Jim mentioned, all other uses of capital are on pause, including M&A and share repurchases. Project Springboard is working to establish detailed targets for leverage and capital allocation that we will share with all of you next quarter. Without a doubt, reducing our leverage and getting the business back to acceptable levels of profitability is our most important goal. There's no doubt that this has been a difficult year. It would be easy to lament the factors that impacted us. Instead, we are squarely focused on the things that we can control in forging a path forward. I'm confident that our plan has been designed with the shareholder value creation in mind as our guiding principle. Rest assured, we understand that the true proof of our strategy will be seen in the results that we deliver and we will hold ourselves accountable for those results. Now I'll turn the call over to the operator for your questions.

And we'll proceed to our first question from Chris Carey with Wells Fargo.

Can we review the cash flow expectations in more detail? I appreciate the information you shared, especially regarding the significant cash generation expected for next year. However, achieving the 4.5x leverage target for fiscal '23 suggests a considerable profit recovery as well. This indicates confidence in the business. First, could you help us understand the anticipated success of carrying over inventory from this year to next, which seems crucial for your working capital? Secondly, you mentioned some gross margin pressure from carrying that inventory. Is that the only significant impact expected, or will you need to take additional steps to make that inventory more current? Should it be ready for the fiscal '23 season? I have a quick follow-up as well.

Chris, it's Cory. So a couple of things there. When we look at free cash flow for next year, we see two factors that will drive us to get to a number that is around $700 million. One will be the normal rate of cash flow that we see on a kind of year-on-year out basis of about $300 million. So we think that the earnings we'll generate next year will allow us to kind of normally generate that level of cash flow. The second item that will increase the cash flow that we'll see next year above what we'll see going forward after that will be the reduction in inventory that we're going to experience by the end of '23 which should be around $400 million. So combining those two things together, you get to the $700 million. And then on a go-forward basis after that, we won't repeat the benefit that we get from reducing inventory, but we should still be able to be at that roughly $300 million normal run rate. So I think in Jim's comments, he said $1 billion for two years, that's kind of how you get there. I gave $700 million as the number for next year. Second part of the question is on gross margin pressure. If you look at the pressure we've experienced this year, you kind of have three things that net down to the pressure that we felt of 300 basis points year-to-date and expectation for about down 400 basis points for the year. First would be the cost of our inputs going into that, into the products. So pressure related to that. We also had pressure related to volume coming down. That affects us because our fixed cost leverage across our distribution network, our manufacturing footprint and just on the normal costs that run the business all are on fewer units. So those two things are the biggest pressure, offsetting that pressure is the pricing that we've taken this year which about offsets the dollars we incurred on our input costs going up. So we took enough pricing to cover the dollars. That alone has decreased an effect on the rate and then the fixed cost leverage makes the rate a little worse yet. So those are the three things that kind of net down to this year's gross margin rate pressure. As we go into next year, we're taking more pricing. We're also expecting to see more cost increases, even though the costs have come down recently, our average cost for next year are still planned to be above the cost that we've experienced this year because of the timing of when we bought inputs and when those inputs get sold out. So that's the rate pressure that we're looking at for next year. And we haven't forecasted the entire year yet. We're obviously not giving guidance on it but we're just pointing out that there will be a pressure point.

Okay. Quick clarification just on that, how much of that inventory reduction is related to U.S. Consumer versus your sales expectation in Hawthorne? And then just a second question here and then I'll jump back in as SG&A is going to be down pretty substantially this year. How much of that reduction do you think comes back in fiscal '23 like comp versus what might be sustainable cost savings going forward?

The current model indicates that the inventory reduction is divided approximately two-thirds from U.S. Consumer and one-third from Hawthorne. We anticipate the inventory levels at the end of next year will still reflect higher cost inputs, contributing to the overall increase in inventory compared to last year. A significant part of this increase is attributable to rising costs per unit. Presently, we are considering a structure of two-thirds U.S. Consumer and one-third Hawthorne. Should costs decrease in the consumable market, we might see further reductions in inventory primarily affecting the U.S. Consumer segment. However, this is contingent on lower costs during production in relation to the inventory we hold at the year's end.

And then just on SG&A?

SG&A costs, obviously, this year are lower than in the past. We talked in the comments about $60 million of this being due to incentive compensation. We are looking to add incentive comp back into the plan for next year. So there will be a cost headwind related to that. If you look at other costs related to people, we don't have any drastic changes in our initial plans now related to people; but incentive is a pretty significant one that we will add back.

Chris Hagedorn here. I want to discuss the Springboard project and our current status. We're internally reviewing Phase 1 and Phase 2 of Springboard. Phase 1 involves the necessary modifications we need to make to maintain stability, especially during our peak borrowing period next March. I believe we've achieved quite a lot, likely exceeding one turn of leverage. The entire company has been actively engaged in this effort. My discussions with Cory and the team are less about EPS in the immediate future and more about keeping our leverage, aiming for around six or less by next March. A significant amount of work has been dedicated to this goal. In terms of business performance, I think you may have received more information than you anticipated. We've surpassed our July projections, marking the first time in about four months that we've done so, which is a positive development. I feel confident about the remaining months of the year, with Mike being comfortable with our outlook. Regarding our sell-in numbers, I'm not ready to provide forecasts for next year, but in Springboard, we are targeting an achievable number that the team feels optimistic about. If Mike meets his goals, there's potential for even better results. We're gaining confidence after a challenging period since Memorial Day. Although consumer sales were satisfactory, reorders were lacking, but we’ve navigated through that. Turning to G&A, I can speak for myself as the business leader. We took decisive action and went into emergency mode, achieving substantial SG&A reductions. Just to clarify, we will do whatever is necessary through March. After that, we expect leverage to decrease quickly, potentially falling below 4.5x. The Springboard target is more ambitious, around 4x or slightly more. These figures are always being updated, but once we have certainty about peak leverage—which should be soon—we will transition to Phase 2, focusing on structuring the company and increasing the value of equity. Many analysts are using 2019 as a benchmark, although we don’t foresee sales returning to those levels. We’ve used 2019 figures in planning for Phase 1 in terms of organization. Moving forward, alongside the team at Hawthorne, we acknowledge that circumstances have changed, and there have been difficult days. We intend to conduct a thorough redesign of our organization. We’ve shifted from a period of feeling unrestricted to one of greater constraints, but that’s manageable. We will evaluate how to build value, and you can expect a more strategic approach in organizational redesign. SG&A will reflect this, though we haven’t fully explored it yet. We have been direct in our actions, though not as refined as I’d like, but it was essential given our situation. As we move into Phase 2, more information will follow regarding our direction. This process will not be detrimental, but it will be more deliberate in improving the elements that create value, understanding the expected growth rates, and supporting those initiatives. Our focus will be on our brands, enhancing in-store presence, sales capabilities, order fulfillment, and marketplace innovation. We are on the right path, but we are just beginning to regain confidence and clarity about where we stand.

Yes. And Chris, I just want to clarify my point on $60 million coming out of the plan or out of this year's results versus last year related to variable comp. That's not what will go in next year. A couple of reasons why we paid out above target a year ago. We have fewer people because of the actions Jim just talked about going into next year. So the number that came out with $60 million. The number that we're looking to add back in is closer to $35 million.

And our next question will come from Peter Grom with UBS.

Good morning, everyone. I hope you're doing well. So I kind of just wanted to just follow up on that last question. And I know you don't really want to provide fiscal '23 guidance. So I may be reaching here but kind of taking a step back and putting together all the different pieces on what you said today, it doesn't really sound like you'd expect EPS growth, I guess, to some degree. So it sounds like the U.S. Consumer business should be okay, Hawthorne moderate growth. And I guess, in your response to Chris' question, it doesn't sound like you expect a lot of margin improvement. And then Cory, you called out a bunch of unfavorable things below the line. So am I thinking about that right, based on where things stand today? Or is there something I'm kind of missing in that broader assumption?

I'm interested in what Cory is going to say now.

Well, I was going to stress your first point that we're not giving guidance today. So the range that we would give you would be very broad. I think where we're looking to call this year at $4 to $4.20, you look at next year, and we don't expect significant decline or significant growth; we'd be in a range that is kind of around where we're at this year. It would be my early read on it. A lot of things to come together. But again, I don't expect drastic deviation from where the finish is expected to be this year.

That's very insightful. Jim, you talked about the significance of margin recovery in your prepared remarks. Could you clarify the timeline for this? You referenced 2019, and currently, our revenue is about 30% higher than that, but our EPS is lower. How should we view what a normalized earnings figure might look like and when we might achieve that, as it seems unlikely to happen next year?

Cory is like making face that me too; come on.

Well, if you look at the market today, I'd say there's...

We need to take a moment to reflect. I want to clarify that we developed a footprint for what we call a $1 billion Hawthorne business, which was intended to support a business of at least $1.5 billion, possibly even more. I believe that the associated costs are around $65 million annually, which includes inventory and other related expenses. A significant part of improving our margins will involve eliminating this burden, which impacts nearly half of the profitability of that segment. Additionally, we need to focus on selling lights, as that is our primary category with better margins, and we expect that to recover over time. Indoor growing remains the most crucial segment of the Hawthorne business. However, wholesale prices need to reach a level that justifies the capital investment for upgrading and expanding cultivation space. On the consumer side, we experienced a couple of years where we simply distributed inventory without constraints. Mike and I decided it was time to address this by building adequate inventory, which may appear questionable in hindsight but seemed reasonable at that time. We've reduced inventory by approximately $150 million since our peak, although we had around $600 million in excess inventory not long ago. This reduction has had a negative impact since we significantly reduced our output, leading to a substantial decrease in margins. Recently, we implemented a price increase of nearly 10%. I believe that as these factors stabilize—meaning prices are set, we return to normal manufacturing operations, and our inventory reaches appropriate levels—we should see positive results. Cory, I’m not sure how you want to proceed from here, but I don't think the situation is overly complicated; it involves relatively few actions on our part.

Yes. And the timing of when all those things can show us benefit in the P&L will be important. The other factor that wasn't mentioned is cost increases. While costs have come down recently, our average cost for inputs next year still looks to be higher than what we've experienced this year. So the pricing that we just put in place this week will help to offset those increases, but we're still seeing increases. As we get further into the year, we hopefully can turn that around. We hopefully can get costs that are more in line with kind of historical levels and that what we've seen in the last six months here. I think it comes down to timing. We're making all the moves to get our gross margin rate back to where we want it to be, but it takes time for all this stuff to flow through the P&L and show in increased margins. That would be my biggest question, Peter.

And our next question will come from William Reuter with Bank of America.

The first question on the comment you just made about the recent 10% increase in prices. I thought on the previous call you guys had through four rounds of pricing increases by an aggregate of 10%. So are we now at 20% year-over-year? Or where are we sitting on a year-over-year basis at this point?

Luke, you can take this gain?

I don't know what the aggregate. I think it's 18%. Based on how it runs through by month, you get into an average for the year.

And that's Michael Lukemire talking just by the way.

Yes. So, but the 10% is definitely incremental.

Yes, you're going back over more pricing actions. So you're going to last August and rolling forward those pricing averages across different categories that are getting different levels of pricing but the average is 10% right there around 18%.

Okay. And then there were a couple of different comments about leverage. At one point in the prepared remarks, you talked about potentially there being a challenge to get to 4.5x next year, but then Jim seemed to express enthusiasm that you guys could actually get to 4x. I guess, what are the things which are going to dictate that number? How much of your costs are you locked in for 2023 at this point? I guess, is it basically thinking about elasticity which, Jim, in the prepared remarks, you mentioned you felt was relatively low at least this year?

Let me pass some of this over to Cory and Luke if he wishes to add. It's important to note that our peak leverage occurs before we start selling to consumers, as it's primarily about retailer load. Given the current inventory levels and the expectations from retailers, we have a solid understanding of what they're likely to need. At this peak leverage point, elasticity isn't a significant concern. Our focus is mainly on sell-in, and the main risk is tied to sales volume. We have a good grasp of our own costs, and we are closely monitoring them. Luke's number reflects a high level of confidence, and we believe there is potential for upside. The anxiety we've experienced over the past month and a half has mainly stemmed from consumer performance rather than from Hawthorne, which hasn't shown signs of recovery. We don’t need to dwell on that. The situation with retailer inventories has led merchants to be very cautious in their ordering. They are still supportive and placing orders, but there's little to no excess inventory, which we see as an opportunity for next year. The challenges over the last couple of months have largely been related to consumer performance, specifically around reorders.

Yes. This is Mike again. They are resuming their replenishment systems, and that is primarily what is driving the reorder rather than pushing certain initiatives to generate activity, although we will implement some strategies.

Okay. And then just one last question on that. It sounds like you have been given no indications that the retailers are any less excited about the season for next year. And given that, I think you mentioned inventories are lower by 12% on a unit basis year-over-year at this point. We should expect that next year, the sell-in would be very strong. Is that your expectation from your conversations?

That is definitely our expectation. We're being cautious in predicting what that will be. However, it's important to note that it's not driven by point of sale. We're prepared for the season and will begin earlier with fertilizers and seeds, returning to more traditional levels, and we will promote those activities. We plan to be much more proactive in getting started sooner, while the load end remains fairly standard. Even looking at this year, we followed our plan after the first half, which is influenced by retailer engagement. What happens later depends on point of sale and consumer behavior during those months.

Yes. I believe we are experiencing a continued reduction in retail inventory as we approach the end of our fiscal year. It's likely around 3%. Some estimates suggest it could be down by roughly 15% by year-end. Our plans reflect that we are seeing retailers aiming to finish the season with lower inventory.

Jim, I'm still a bit unclear about your comments regarding retail performance for U.S. Consumer and why you believe retailers are optimistic about the category heading into next year. From what you mentioned, they reduced their inventory mid-season for the first time in 20 years due to poor retail management of consumables compared to durables. I'm trying to understand this situation better. I also didn't fully grasp what you see that excites you about sell-in for a strong December quarter, especially since retailers may not be as enthusiastic about the category as they were in 2020 and 2021 when it was thriving. Can you provide more detail or clarification on this?

Let me begin with some general points. First, we are well advanced in our discussions with retailers for the fiscal '23 season, and we can confidently say that they are enthusiastic. We are aware of their decisions regarding shelf space, which favor us, and we have a good understanding of their promotional plans for next year, giving us confidence. I don't believe we are trying to innovate unnecessarily. If I were a retailer, I wouldn't expect a huge demand for patio furniture and outdoor grills next year. We understand the economic challenges and their impact on our business. Historically, during tough times, consumables like lawn and garden products and paint tend to perform well. Lawn and garden is a crucial category for retailers as durable goods may not drive success like consumable products do, which is our specialty. We are optimistic not just due to our discussions but also because of our historical knowledge. Next year will bring some changes for us, many of which are reminiscent of previous strategies. We anticipate earlier promotions. During COVID, we strongly advocated for in-season promotions instead of ahead of the season, as we believed the risks associated with weather made earlier promotions less effective. This year, we want to be proactive with retailers on lawn fertilizer and grass seed, both of which are high-margin categories for us and them. Our teams are actively working on this, and there is enthusiasm from our key accounts. We plan to invest significantly to ensure these high-margin products are activated early, despite the challenges we face.

I believe it's a good process; we just haven't really started yet because we're just now regaining our confidence and have clarity on our current situation.

And moving on, we'll hear from Bill Chappell with Truist Securities.

Jim, I'm still a bit confused about your comments regarding the retail situation for U.S. Consumer and why you feel so optimistic that retailers are excited about the category for next year. From what you mentioned, it seems they destocked in the middle of the season for the first time in 20 years due to poor management of consumables compared to durables. I'm trying to understand that. Additionally, I didn't hear you specify what makes you feel confident about a strong December quarter in terms of sell-in, especially when retailers don't seem as enthusiastic about the category as they were in 2020 and 2021 when it was booming, and why they wouldn't shift their focus elsewhere.

Let me begin with some observations. First, we are well advanced in our discussions for the fiscal '23 season with our retailers. We are not merely hoping they will be enthusiastic; we know they are. We are aware of the decisions they have made regarding shelf space, which favor us, and we have a good understanding of the promotional plans for next year, which gives us confidence. I don’t think we are changing our strategy significantly as some on Wall Street might suggest. I would imagine that if I were a retailer, I wouldn't expect to sell a lot of patio furniture and outdoor grills next year. We have a strong understanding of how challenging economic times impact our business, and I believe many of you on the call are familiar with our history. During tough times for consumers, products related to lawn and garden, as well as paint, have continued to sell well. Lawn and garden is a major category for retailers, and they need it to succeed. I don’t think they will thrive by selling durable products; success will come from selling consumable products, which is our focus. Therefore, we feel confident due to both our discussions and our historical understanding. Additionally, there will be several changes for us next year, some of which will bring us back to previous strategies. I believe we will see earlier promotions. During COVID, we pushed for retailers to promote and engage consumers during the season, rather than before it, due to potential weather risks, but those promotions were only somewhat effective. Our learning this year includes the intention to inform retailers early about lawn fertilizer and grass seed, which is both a crucial and high-margin category for us. Our brand teams and relationship managers with major accounts are actively working on this, and there is excitement about it. We are committed to investing significantly in these early high-margin products and will work diligently to ensure they succeed.

And that concludes the Q&A session. I'll turn the call back over to Kelly Berry for closing remarks.

Okay. Thanks, everyone. So again, a quick reminder that the management team will be attending the Barclays Global Consumer Staples Conference on September 8, and we'll communicate the details as we get closer to that event. In the meantime, feel free to reach out to me if you have any questions. Thanks for joining us today. Have a great day.

And this does conclude today's call. We thank you again for your participation. You may now disconnect.