Earnings Call Transcript - SMG Q1 2021

Operator, Operator

Good day and welcome to The Scotts Miracle-Gro Company's First Quarter 2021 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jim King, please go ahead.

Jim King, Senior Vice President, Investor Relations

Good morning, everyone, and welcome to The Scotts Miracle-Gro first quarter conference call. We're taking a slightly different approach this morning as we're managing this call remotely for the first time. In a moment, you'll hear prepared remarks from our Chairman and Chief Executive Officer, Jim Hagedorn; as well as our Interim Chief Financial Officer, Cory Miller. At the conclusion of those remarks, we'll go live to take your questions. Jim and Cory will participate in the Q&A session, as will our President and Chief Operating Officer, Mike Lukemire; and Hawthorne Division President, Chris Hagedorn. Operator provided instructions. I've already scheduled time with many of you after this call to fill in the gaps. Anyone else who wants to set up some Q&A time can call me directly at (937) 578-5622, and we'll work to set up some time as quickly as we can. A couple of IR housekeeping items before we begin. We will be participating in a virtual fireside chat at the Truist Securities Consumer Symposium on February 23. The following week, we will participate in the Raymond James 42nd Annual Institutional Investors Conference. And then later this spring, most likely in early April, we intend to host our own virtual Analyst Day event that will feature recorded presentations from several members of our management team as well as a live Q&A session. The majority of those presentations will likely focus on our Hawthorne segment in order to give you a better understanding of our current business and our future plans. With that, let's move on with today's call. As always, we expect to make forward-looking statements this morning, so I want to caution you 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. Those are filed with our Form 10-K, which is filed with the Securities and Exchange Commission. I also want to remind everyone that today's call is being recorded. An archived version of the call will be made available on our website as well as a transcript of the call. With that, let's get started and turn things over to Jim Hagedorn. Jim?

James Hagedorn, Chairman & Chief Executive Officer

Thanks, Jim, and good morning, everyone. Three things are clear when looking at the results we announced this morning: first, the business continues to benefit from America's renewed love of gardening that resulted in millions of new customers entering our category last spring; second, that the team is doing an excellent job of execution; and third and most importantly, we've taken the right steps over the years to put ourselves in a position to take advantage of the moment that's in front of us now. To post a profit in both the fourth quarter of 2020 and the first quarter of 2021, quarters in which we have historically posted a loss, is something none of us would have predicted in the past. I've done enough of these calls to know that some of you are already looking to ask about comps we'll face next year. Please don't. That's not on the radar screen right now. Instead, we remain laser-focused on driving as hard as we can in 2021. That attack-plan mentality is working. Entering February, both major business segments remain ahead of our best-case scenarios. In our U.S. Consumer business, sales increased 147%, and consumer purchases at our largest retail partners were up 40% in the first quarter and up 35% entering February. So consumers remain engaged. But shipments are significantly outpacing POS right now as retailers build inventory ahead of the season. As you'll hear later from Cory, we are also building more inventory. If there is upside to our year, we don't want to find ourselves where we were last year and leave sales on the table. But if the upside doesn't materialize, we're confident in our ability to manage inventory levels at year-end. Even if we do end up with a little more inventory, I'm okay with that, too. It's not just on the cost of goods side where we're making investments. We're increasing our marketing investment with a simple yet aggressive goal in mind: to retain the millions of consumers who entered or reentered the lawn and garden category last season. We'll do that with focused and hyper-targeted social media campaigns and complement those efforts with traditional media, including our first ever Super Bowl spot. I'll delve more deeply into all of this again in a few moments. At Hawthorne, Q1 sales increased 71%, and it was another period of strong growth across the entire product portfolio. And we're already confident enough to increase our full-year sales guidance for Hawthorne. The strong growth we continue to see is even more encouraging as we make progress on other long-term initiatives, too. We've always viewed this business through a long-term lens that is focused on establishing ourselves as a true industry leader by driving value for our customers, the cultivators. I'll elaborate on this point later in my remarks and also address some of the other industry dynamics I know are on the minds of many of you. Cory will provide a detailed explanation of the numbers in a few minutes. First, though, I want to remind everyone that the first quarter is typically a small part of the year. We know we have a lot of work still ahead of us this season, and we are heads down right now and focusing on execution. This morning, I want to give you an update on the steps we've taken since our last call to drive the business, not just in 2021, but in the long run. Before I do, I want to share just a few thoughts on some of the organizational changes we've made recently. I welcome Cory to this call, and I'm confident in telling all of you he's an extremely qualified and capable member of this team. As the finance lead at Hawthorne since its inception, he probably knows the nuances of that business better than anyone and has been a true hands-on partner for Chris and the entire operating team. I'm sure you'll all soon discover that Cory will add a lot of value to these calls. While he's serving as interim CFO, he will also be a candidate in the search process, which we will conduct over the next several quarters. The rest of the moves we announced last month, with the exception of Randy Coleman's departure, were all part of a long-standing talent management and succession planning effort. One of the most important aspects of a CEO's job and one that too seldom gets discussed with Wall Street is around human capital management. We've delivered outstanding results over the last several years because our business has been operating with a higher level of effectiveness. And we've been operating with an unprecedented level of intensity over the last 12 months, in particular. Clearly, the company we're managing today is different than 5 years ago. And 5 years from now, it likely will be different again. One of the things that's become clear in the COVID environment is that there will be a permanent change in how all of us work, one that requires a different level of flexibility and collaboration than in the past. That requires us to put a team in place that maximizes our likelihood for continued success, and it also means making tough choices at times. Over the past few months, we've done both. Beginning in November, we made a series of organizational changes that ultimately resulted in the departure of three senior members of the team. It also resulted in more than a dozen people being moved into new or expanded roles. They are all part of a diverse group of roughly 25 leaders who we had previously identified as the brightest and most talented people in the company. Our goal is to expand our capabilities and give them a better understanding of the breadth of the organization. We're supplementing their real-life work experiences with a data-driven assessment process that allows them to further leverage their strengths and shore up their weaknesses. In addition to the changes we announced on January 11, Chris Hagedorn was promoted last week to Executive Vice President of Scotts Miracle-Gro and Division President of Hawthorne. Dan Paradiso was named Senior Vice President and Chief Operating Officer of Hawthorne. Chris and Dan have been working closely together as partners for the past two years. Hawthorne was established as an operating segment in fiscal 2017 and had revenue of $287 million that year, double the year before because of acquisitions. Our guidance for 2021 would suggest Hawthorne revenue this year of at least $1.2 billion, and we haven't done an acquisition since 2018. The business has become more complex, and the industry is clearly at an important inflection point with an incredibly bright future. Chris has demonstrated the vision and leadership skills we believe are needed to take Hawthorne to the next level. Having Dan at his side as his operating partner will give Chris more freedom to refine our strategy for Hawthorne while also ensuring we meet the near-term needs of the business and our customers. Every single person who has taken on a new or expanded role in recent months will be part of the group leading this company in the future. These moves are purposeful. They are power plays and are all about creating the next generation of executive leadership. So let's turn the conversation back to running the business and an update on our activity. Let's start with U.S. Consumer. We told you on our last call that we were striving to overdeliver on the guidance we provided for the full year. We're increasingly optimistic we can accomplish that goal, and our team has been working hard to do so. They remain confident in our ability to retain the millions of consumers who joined the lawn and garden category last season as well as invite another new group to that movement. This Sunday, during the second quarter of the Super Bowl, you'll see our first ever TV commercial, especially created for this event. It will feature a series of A-list celebrities and athletes who all enjoy their backyards and the outdoors and will help us communicate a simple message: keep growing. Our CMO, Josh Peoples, told you last quarter we were evolving to have a year-round conversation with consumers. And we didn't simply want to talk about our brands, we wanted to focus on the activity of gardening. We've been engaging with consumers throughout the winter, spending three times more in media last quarter than we have ever at this point in the year. Keeping those consumers engaged and motivated is the goal of the Super Bowl initiative, which is part of an eight-week kickoff to the biggest lawn and garden season ever. As you know, the reality of COVID has certainly created a tailwind for our business. While we believe some level of remote work will be permanent, including for Scotts, a lot of people will eventually go back to their offices, back to their kids' soccer games and once again, head off on summer vacations. But that doesn't mean they'll have to give up their garden or their lawn. We're working hard to make sure they don't. We view the broad reach of the Super Bowl as a good investment, especially given the other PR and marketing activation that comes with it. And the timing is right, too. Consumers are getting restless this time of year. They want to get back outside. They want to do yard work again. The ability to talk to most of the country at one time makes sense and is a strong complement to the hyper focus of our digital outreach efforts. On that front, we continue to invest behind our analytical capabilities to drive effective and more targeted messages to specific demographic groups. The delivery of those messages will be more precisely timed to coincide with seasonal growing patterns, retailer promotional efforts or more simply, the weather outside. We will coordinate our outreach with many of our retail partners, making sure our efforts complement theirs and also leverage promotional activity we expect throughout the season. As it relates to our retail partners, we can't say enough about their engagement. They're leaning into a greater degree than we've ever seen, and that's true in all channels. They see lawn and garden as one of their most attractive categories in 2021. That means greater support for our brands, which is why a significant portion of the 147% sales growth in the first quarter was related to improving retail inventory levels. The pace of shipments remained strong through the first month of Q2. We remain confident that we'll be well ahead of our full-year guidance at the midway point of the year. And as I said earlier, we're increasingly optimistic about the ability for the U.S. Consumer segment to grow again in 2021. I'll remind everyone that the tough comps don't arrive until May and June, and about half of U.S. Consumer POS has historically occurred from May through our fiscal year-end in September. As a result, we're going to take a conservative approach before reassessing our current guidance. One more item before I switch gears. We closed on the Bonnie Plants deal at the end of the calendar year and now have a 50% equity stake in that business. This is a big deal for us and speaks to a level of commitment to a category of lawn and garden that we see is critical to our future success. Live goods is what draws consumers into the broader lawn and garden space. It has broad demographic appeal and an emotional component that is different from the other products we sell. Bonnie is the best in the world at what it does, edible live goods. And Mike Sutterer, who leads that business, used to be one of the leaders at Scotts Miracle-Gro. He's done a great job at Bonnie, and I'm convinced the JV between our two companies will drive a lot of value for both. While Bonnie is an on-ramp, especially in the area of edible gardening, there are other areas of live goods that we find just as attractive and like the idea of having a larger and more strategic presence in the overall live goods space. Among other things, live goods allow us to better leverage the native brands we're building like Knock! Knock!, Lunarly and Greendigs, which also builds more momentum for our direct-to-consumer efforts. We're willing to accept the fact that the economics of live goods are not as strong as our traditional products, but they are getting better. But that's not the point. As we look to our future, it's a strategic imperative to own the relationship with consumers. To do that, those consumers must view us as a gardening company, not just a gardening products company. Live goods is key to that goal. Okay. Let's switch gears and focus on Hawthorne for a few minutes. This is the fourth consecutive quarter in which Hawthorne reported sales growth of at least 60%. While the rate of growth will likely slow in the months ahead, we're still planning to see growth through September. That's why we're confident enough to raise our sales guidance just four months into the fiscal year. The growth we're seeing is coming from across the country, with established growers and new ones. It's occurring in more developed markets like California and Colorado as well as newer authorized markets like Michigan and Oklahoma. It's coming in all product categories as well. Lighting, however, continues to be the biggest driver of growth in North America, up 126% in the quarter. Many of you have asked how we're different than some of the other players in our space that have been successful in going public. I'll tip my hat to all of them. They are solid operators with nice businesses. But our business is different from theirs, significantly. Yes, we distribute products just like others, but we don't view ourselves as a distributor because we don't operate like one. Instead, we operate as a partner to the cultivators who use our products. We know our success requires their trust in the technical solutions that we provide. And we realize that doesn't simply mean buying a light or a nutrient mix at the cheapest price. They need to operate efficiently to have the best quality and plant yields possible and to continue improving their own operations. Because of this, we embrace our responsibility to innovate. That's why in Q1, we opened the world's first R&D facility in Canada that's focused exclusively on growing cannabis. That's why we also expanded our R&D efforts in Ohio and Oregon related to the hemp market, which we see as a proxy for the cannabis plant. It's why we're working on new nutrient formulations, better controlled products and better cultural practices. And it's why we're also leveraging our world-class talent in plant genetics to develop better plants. A distributor just doesn't do that. Our leadership role also requires us to manage and improve the marketplace and our freedom to operate in it. That's why we're investing more than anyone else to influence the political discussions around this industry and why our corporate foundation is supporting social justice issues related to cannabis reform. I'm proud to say I believe we've earned a reputation as one of the smartest, most comprehensive and most strategic companies to have navigated this space. And we're far from done. We've never viewed Hawthorne as a quick way to run up our stock price. Instead, we view this as a strategic opportunity to drive long-term shareholder value. To that end, we've had an ongoing discussion for years amongst ourselves and with our Board about whether our current corporate structure is appropriate given the potential value of Hawthorne. Right now, we're comfortable that it is. And while nothing is off the table in terms of considering our future options, we're not inclined to make a change unless we see a financial advantage or a business advantage that results in more optionality to grow our business. I'm also not going to sit here and hypothesize on whether the current market valuations for Hawthorne are appropriate. The market will answer that question. But I will tell you this. Six years after we've entered this industry, we are just now hitting our stride. We've become stronger, smarter and more strategic, and we have plenty of financial flexibility to invest in the future. What does that mean? It could mean a lot of things. Clearly, we like our portfolio right now, but we're actively looking at adjacent categories to further strengthen it. We also may look to acquire capabilities we don't currently have that improve our knowledge base or skill sets in areas, for example, like plant genetics. While it's pretty easy to see this industry has tremendous upside, it's difficult to predict the pace of that change. Our banks have been tremendous partners, and we appreciate their support as we've been pioneering in this space. That partnership will remain important as we explore a wider array of options to explore where and how to put money to work. Our continued free cash flow, coupled with our borrowing capacity, gives us the ability to pursue M&A in both Hawthorne and the U.S. Consumer business while also maintaining the flexibility to return more cash to shareholders. We also have the ability to invest in areas like marketing, R&D and supply chain to take advantage of the opportunities right in front of us while also better positioning our businesses for the future. And we have the benefit of our deep bench of talent being nurtured as our future leaders. Those of you who know me also know that I don't obsess about our near-term results, but I truly feel bullish about where we stand right now. I'm highly confident in our guidance and our near-term outlook, but I feel even better about what the future holds. A big part of my optimism is due to my partnership with Mike Lukemire who continues to excel at running the business every day. His leadership on the operational side of the business has allowed me to focus more time on strategy and issues like capital structure and talent management. Mostly though, it allows me to focus more time on the significant opportunities that we see in front of us to drive shareholder value. With that, I want to turn the call over to Cory to discuss the financials.

Cory Miller, Interim Chief Financial Officer

Thanks, Jim, and hello, everyone. I appreciate Jim's kind words. It's a privilege for me to talk with all of you today, and I'd like to start by taking a moment to introduce myself. While I've been the finance lead at Hawthorne from the early days of that business, I've been at Scotts Miracle-Gro for over 20 years in various finance roles. Most of that time has been spent supporting the U.S. Consumer business. However, I also worked in our external reporting group and as the Head of Internal Audit. Although I've not had a public-facing role, I have a comprehensive understanding of the financials and a deep knowledge of the business. I've worked alongside previous CFOs, including Randy, to help them understand the details of the business and to prepare for their interactions with all of you. I want to take a moment to acknowledge Randy myself and to thank him for his support and mentorship. My goal here today is to pick up where he left off, adding color and context to the results we announced today in discussing our outlook for the balance of the fiscal year. So let's jump in. Jim said on our last call that this year could be difficult to predict at times. He also said we'd keep you apprised of any changes to our outlook and adjust our guidance as needed. It only took one quarter for that prediction to prove true. The headline for the first quarter is that sales growth was significantly higher than we expected in our U.S. Consumer business. That was due in part to the timing of preseason inventory builds by our retailers. That volume also meant our gross margin rate in the quarter was unusually strong. Those benefits were tempered a bit for two reasons. First, we started to see the impact of emerging input costs. Second, we decided to further increase our marketing investment. We expect both of those trends to continue. I'll come back to these topics later, but I want to start by going straight to our bottom line. In Q1, we reported adjusted net income of $22.2 million or $0.39 per share. This compares to a loss in the same quarter last year of $62.4 million or $1.12 per share. This is the first time we've reported a profit in the first quarter. The quarter was driven by the 147% sales growth we reported in the U.S. Consumer segment. We had expected sales growth to be in line with or slightly ahead of the 90% growth we reported in Q4. POS growth remained strong in the first quarter, up 40% versus last year. We saw consumer support of all of our brands, Scotts, Miracle-Gro, Ortho and Tomcat as well as Roundup. What we underestimated in Q1 was the magnitude of preseason inventory build by our retailers. Throughout the quarter, but especially in December, retailers aggressively stepped up their ordering. While a positive indicator of retailer commitment, we are assuming, for now, this represents a shift in the timing of sales between quarters rather than a full year increase in sales. One other item to note is that the fiscal calendar shifted this year. As a result, there are five more days in the first quarter and six fewer days in Q4. The impact of that shift was about $24 million in the U.S. Consumer segment in Q1. At Hawthorne, the 71% sales growth was led by a 77% increase in our North American business. We saw triple-digit growth in markets like Oklahoma and Michigan, which were up 178% and 133%, respectively. Sales increased 80% in California. Hawthorne also benefited from an additional five days in the quarter, which impacted the top line by $17 million. North American sales of our own brands like Gavita, General Hydroponics, Botanicare and Can-Filters, which we call signature brands, were up 97%. Sales of distributed brands grew by 47%. Signature brands are expected to approach 70% of total Hawthorne sales this year. This percentage is significantly higher than our closest competitors, who primarily sell third-party products. Our improving mix is due in part to our continued strength in lighting, which is driven by a firm commitment to R&D. Mix also remains aided by SKU rationalization that became easier to execute with insights gained by launching SAP last year. From a product category perspective, North American hydroponic lighting grew 126%. Growing environment products were up 83%. Nutrients increased 53%, and growing media was up 40%. Favorable product mix in Hawthorne helped contribute to a 340 basis point improvement in gross margin rate for the segment in the quarter. However, fixed cost leverage was the primary driver of rate improvement for both Hawthorne and the U.S. Consumer segment. In fact, it led to a nearly 1,200 basis point improvement on a company-wide view to 26.7%. While the gross margin rate is off to a great start, the Q1 result is not representative of what we expect for the full year. The fixed cost leverage is due primarily to warehousing costs. The doubling of sales volume in the quarter meant warehousing was a significantly lower percentage of overall costs in the first quarter than normal. This benefit will reverse in subsequent quarters. Let's move on to SG&A, which was up 31% in the quarter. The single biggest increase was related to the timing of marketing spend. However, we are planning to increase our marketing investment for the full year to a higher level than what we communicated back in November. Still though, we continue to expect SG&A to decline in aggregate for the full year. Segment profit at Hawthorne is a frequent area of questions, so let me address it proactively. As you saw in the press release, segment margin in the first quarter, which is based on EBITDA, was 13% or nearly double a year ago. This is an area where I was particularly focused while working inside Hawthorne, and I'm pleased that we're making real and lasting improvement here. Jim and our Board have been appropriately patient in allowing Hawthorne to get to the right level of profitability over time. If we force this issue tomorrow, I'm confident there's at least another 200 to 300 basis points of segment profit available to us. However, we continue to make smart investments in sales, supply chain, marketing, R&D, public affairs and in simply building a deeper and better bench of talent. Jim's comment a few minutes ago about taking a long-term approach to driving value in Hawthorne is right on point. We're building a moat around the business and behaving like a true industry leader. I'm convinced the business can gain further market share and also take advantage of emerging markets on the East Coast. Before I wrap up comments on the quarter, I have a couple of housekeeping items worth pointing out. First, you may notice share count is 1.3 million higher than a year ago. This is due to using diluted shares in the current quarter because we reported a profit. We used the lower basic share number in the prior year, which is required when reporting a loss. And finally, Jim mentioned that we recently closed on the Bonnie transaction and now have a 50% equity stake in the business. At that level of ownership, Bonnie results will not be consolidated into our financials. However, the income we earn from the business will run through the P&L differently than in the past. Our previous stake was based on a financing arrangement, and our earnings from the business were derived from commission, royalties and interest. These showed up on three different lines of our P&L. Commission affected the sales line, royalties were recorded as other income, and interest was recorded as other nonoperating income. Beginning in Q2, everything will run through the earnings from equity line on the P&L. The actual year-over-year impact on the 2021 adjusted EPS is likely in the range of $0.12 to $0.15. In Q4 of last year, consistent with prior years, we recorded a noncash fair value adjustment related to the annual revaluation of our option to buy a portion of Bonnie. That was a benefit to our 2020 P&L of $12 million and will not repeat in this fiscal year. The Bonnie discussion is actually a good transition for an update on our full-year guidance. So let me provide you an update on where we stand. We remain committed to the fiscal year 2021 adjusted non-GAAP EPS of $8 to $8.40 per share. To be clear, the Bonnie transaction was not in our previous guidance. In addition, based on our strong start and current outlook for Hawthorne, we are increasing our guidance for sales growth in that business to a range of 20% to 30%. This compares to our previous range of 15% to 20%. The likely increase in commodity cost, however, coupled with previous unplanned increases in SG&A, is expected to mostly offset these benefits. We now expect SG&A to decline 3% to 8% from last year's level. Previously, we said SG&A would decline 6% to 11%. The company-wide adjusted gross margin rate, which we initially said would decline about 50 basis points in fiscal 2021, is now expected to decline 125 to 175 basis points compared to 2020. We expect the gross margin rate pressure to become apparent in the second quarter. Since our Q4 call, we have increased our internal forecast to further build our own inventory. While about three quarters of our total commodity costs are locked entering February, we're behind our normal monthly pace on urea and resin due to this higher inventory forecast. In addition, we're seeing cost pressures from those two commodities, in particular, and also see some emerging cost pressures related to distribution. These cost pressures will likely decrease the gross margin rate in our U.S. Consumer business, which we previously expected to be flat. We still expect Hawthorne gross margin to be in line with our original guidance for the year. However, the higher sales growth in the Hawthorne segment puts even more negative pressure on the company-wide gross margin rate. We would expect both segments to see strong sales growth in the second quarter, but below our Q1 growth rates. U.S. Consumer sales will likely increase upwards of 20% during that period. Hawthorne sales will likely grow at twice that rate. Before we take your questions, I want to say I share Jim's optimism about our full-year outlook. We are well ahead of where we expected to be four months into the year. And we expect to be well ahead of our full-year guidance when we report Q2 earnings in May. Given last year's record second half, we know we have our work cut out for us in the months ahead. Still, the momentum in Hawthorne continues to drive that business to new levels. And we're also taking all of the right steps in the U.S. Consumer business with the peak of the lawn and garden season fast approaching. Thank you for your time this morning. Let me turn things back over to our operator so we can open the line up for your questions.

Operator, Operator

Operator provided instructions. And we will take our first question from Bill Chappell with Truist Securities.

William Chappell, Analyst, Truist Securities

Can you help me understand the gross margin bridge and how it works? I believe typically you lock in about 75 to 85 percent of your commodities by September or October, then move to pricing agreements with retail customers in November, which gives you good visibility into the next year. But it sounds like a decision was made to increase inventory to capture what could be another big season and retain those customers. As a result, you weren't covered for that excess inventory you built, and at the same time inventory and commodity costs rose. You said pricing had already been set. Is that the right way to think about it? I just want to make sure I understand the dynamics.

James Hagedorn, Chairman & Chief Executive Officer

Cory, Mike, you guys want to take that one?

Cory Miller, Interim Chief Financial Officer

Yes. This is Cory. I think you got parts of that that are on. If you look at where we're at today with our commodity costs, we are about 75% locked for the year. But we are looking at building inventory over the second half of our year to get in a position to better fulfill the needs of the customers. So as we are looking to build our own inventory, our forecast went up, which will require more urea and resin and additional internal distribution costs than we had when we built the forecast. Those are the areas where we're seeing some pressure. So as we have an outlook from this period of time going forward, we're making sure that we have a conservative approach on pricing in those areas for those inputs and feel like we've captured what we think the gross margin rate will be in the go-forward plan.

Michael Lukemire, President & Chief Operating Officer

Okay. So think about it as if we're flat, we pretty much have business as usual. We're building that it could be higher. And so those costs could come into play. I'm an optimist. I want to be ready. And so if the sales aren't there, then I think we're more than usually covered. But if the sales are there, then there are cost pressures at a higher rate.

William Chappell, Analyst, Truist Securities

Got you. But just to kind of finish the thought, and at the same time we're in February. So while you have the excess inventory and/or excess costs on the forecast, you're not baking in upside to sales at this point because we haven't really kicked off the season. Is that fair?

Michael Lukemire, President & Chief Operating Officer

That's fair. Those pressures are out there as sales would increase.

James Hagedorn, Chairman & Chief Executive Officer

Bill, Hagedorn here. What I would throw out there is that we've talked about this plenty of times: we sort of run with three set numbers. One is the numbers we tell you guys. One is the numbers that we build our incentive plan off of with the Board. And one is, call it, Mike's internal operating plan, which would be the highest of them. Mike is operating somewhere toward his own plan. I agree with it, and you would too if you were completely familiar with it. Mike's bigger concern, honestly, based on how we feel about this year, is that we can't make enough product for this year. So I think that if you try to back into it from that point of view, you'll find it easier to understand what we're talking about.

William Chappell, Analyst, Truist Securities

Okay, that's great. I think I understand. And then just one follow-up for Cory or Chris, if he is on. There's a lot of noise about legislation on cannabis, and I think the most impactful changes would be on the commerce side and in banking laws. Can you give us your thoughts: if we do see something over the next two to three months, when would you start to see any benefits? Or would you see benefits from that this year?

James Hagedorn, Chairman & Chief Executive Officer

All right. I'll start with that one, and then Chris can pick it up. While I'm a bit cautious when I look at people talking about taxation and such, I think the Democrats in both the House and the Senate are much more open-minded. The Banking Committee is now chaired by Senator Sherrod Brown from Ohio. We've spent a lot of time talking to both delegations to the Senate, particularly on the Democratic side. I think we're pretty comfortable over time that you're going to start to see normalization. We discussed a lot as we prepared for the call about the environment, and I think, as usual, politicians are slower to act. When it goes to the people, voters decide; for example, New Jersey voters were strongly in favor. So we do think things are getting more positive. It is hard to predict the pace of legislative change, but it would be a significant benefit to this industry if companies were taxed like normal businesses and had normal banking access and credit. The question of how long after laws change until we start to see benefit is something Chris spends a lot of time on.

Christopher Hagedorn, Executive Vice President & Division President, Hawthorne

Bill, Chris here. Yes, we think about this closely and pay attention to states that have changed their legislation and do postmortems on when our business starts to see impact. Typically, it's about 12 to 18 months from laws passing to the regulations being put in place and then us ultimately seeing an uptick in our business as cultivators start to build out. That's the time line we typically operate on. As far as the taxation and banking laws, obviously, those would be huge benefits. We're lucky enough to have scale and influence to get in the room to talk to legislators and change-makers. It's an outrage that cultivators who follow the rules are penalized by the crippling tax rate under 280E. We're going to push hard to see change. Predicting movements at the federal level is difficult right now, and it's easier at the state level, but federal change is where we need more progress. We'll continue to do what we can, but it's hard to predict precisely.

Operator, Operator

And we'll take our next question from William Reuter with Bank of America.

William Reuter, Analyst, Bank of America

A first question is I didn't notice any free cash flow guidance. Prudent to say that it has been $325 million for the year. Is that the same? Or will input cost inflation and inventory build that's going to be a little more aggressive reduce that number?

James Hagedorn, Chairman & Chief Executive Officer

Cory, why don't you take that one?

Cory Miller, Interim Chief Financial Officer

Yes. The free cash flow guidance of $325 million is what's currently out there today. We're going to confirm that guidance going forward. As we look at consumer takeaway of products, what we ship into different customers and the inventory required to hit those service levels, we'll continue to weigh inventory levels against any pressure we might see on that cash flow number. If we get into a situation where we're building inventory, sales are probably in a really good spot as well. We'll be weighing those things against each other and will talk more on guidance in the May call.

William Reuter, Analyst, Bank of America

And then on Jim's comments around M&A, you mentioned plant genetics. Previously in the last call, you said that any M&A would probably not be that large or wouldn't increase leverage substantially. Are there some targets there or other targets that may have changed that outlook and that M&A could be, I guess, larger in scale than you previously expected?

James Hagedorn, Chairman & Chief Executive Officer

Good question and fair. We went through a process recently assessing capital and leverage. Based on everything we know and where we think the business will come in, even with a fairly robust pipeline of M&A opportunities on both Hawthorne and Consumer sides, plus shareholder friendliness roughly similar to last year, we expect to remain below about 3.5x leverage. We're in a good position. We're in Q2 now and would look to time anything meaningful into the second half when we have more visibility on cash flow. We're not looking to overreach, but we have a robust pipeline. We're comfortable with the ability to pursue M&A and return cash to shareholders. We're leaning more toward a special dividend rather than share repurchases at this point, though not finalized. We won't overpay; we feel comfortable where the business is and have money to do what we want. We have good visibility into interesting opportunities that would be strategic for the future.

Operator, Operator

We'll take our next question from Joe Altobello with Raymond James.

Joseph Altobello, Analyst, Raymond James

I want to go back to the SG&A guidance for a second. And I guess the increases from your previous guide or lower — decrease, I should say. Is that all marketing? I guess number one. And number two, if it is, can you help us understand how your thinking has evolved in the past three months? Is it simply that you see a greater opportunity this year and want to capitalize on it as much as you can? Or did that come through conversations with your retail partners? Or both?

James Hagedorn, Chairman & Chief Executive Officer

Mike, why don't you talk about how you view the opportunity landscape for 2021, the relationship with the big retailers. Then Cory can address SG&A in general. It's a very exciting time to be at Scotts. I don't think we've ever had better or more optimism amongst our partners.

Michael Lukemire, President & Chief Operating Officer

This landscape has totally changed. You really can't think about it like we traditionally did with seasonal bursts. The activity is now a continual conversation with consumers. We're constantly talking to them and engaging. We're seeing lift: they want to garden, they want to take care of their home. The marketing we used to do would be hundreds of pieces; we're doing millions now. It's a daily conversation. We're making investments, engaging, tying it back with the retailers, changing the way we're promoting. It's more targeted and specific. We build it across all channels. We're focused on convenience, keeping them engaged, and supporting home health and wellness. We see an opportunity every day to engage with them and talk about gardening in and around the home. The engagement on spend is dynamic relative to consumer interaction, and we'll continue to build that. I don't see it as a one-time event; it's continuous improvement to capture growth.

Joseph Altobello, Analyst, Raymond James

And where do you see your... It's always been enormous. I'm curious, it sounds like it's going up.

James Hagedorn, Chairman & Chief Executive Officer

We learned a lot last year. I would say we were essentially the dominant share of voice last year when other companies weren't communicating. This year we'll have other companies in the space, but we're not messing around. The relationship we have with our retailers today is much healthier. The marketers on both our side and the retail side are super engaged and working together daily. Store operations teams are now in the conversation more and add significant value. That collaborative approach among merchants, marketers, and store ops is driving a healthier environment where everyone relies on each other to drive the business. It's exciting and it's improving not just lawn and garden but other parts of retail engagement and digital use. I think broadcast and cable are down as people get more intelligent about online spend. Mike is operating on a very aggressive point of view, and I think it's the right thing to do. If you look at our sales forecast, our original consumer forecast was conservative and we don't accept it. Retailers didn't accept that either. We see us having lost a lot of potential sales last year because we couldn't ship product. We want to keep and grow the customers we gained. Our current first-quarter POS of +40% and through the end of the month +35% give us a lot of faith that the consumer is responding. Where weather is good, POS growth is strong. It's a pretty exciting time.

Cory Miller, Interim Chief Financial Officer

Looking at SG&A changes, the vast majority of the increase is in media and marketing. We also have additional dollars to invest in real-time analytics to improve our media marketing efforts as well as improvements in our supply chain and our sales team. So if you look at the increases we called out, the majority is within media and marketing.

Operator, Operator

We'll take our next question from Eric Bosshard with Cleveland Research.

Eric Bosshard, Analyst, Cleveland Research

Maybe just a little bit of clarity. What I hear you doing is taking kind of 100 basis points out of gross margin versus the old guidance and adding $25 million to SG&A and doing nothing with the sales guide. And so it's almost like you're giving us the worst case on the margin and nothing on the sales line. So my question is, like what you're outlining on the margin line kind of only happens if the sales line ends up being better. Or is there a greater cost of doing business?

James Hagedorn, Chairman & Chief Executive Officer

That's a complicated question. When we set guidance, there was a lot of uncertainty around COVID. We purposely set conservative public guidance relative to our internal plans. That created a big gap, especially for Hawthorne, but it was necessary given the unknowns. What you're seeing is that conflict becoming more visible now. For Hawthorne, they kept blowing through numbers and we had to adjust the top-line expectation. For Consumer, we were closer and had internal debate about it. Part of what you're seeing is that tension. We don't want to underdeliver, but we also don't want to set overly aggressive public guidance without visibility. We're increasingly optimistic and think we can exceed the prior ranges, but we didn't want to change cash flow and EPS guidance yet until we have more visibility. I recognize the challenge and am sympathetic. We expect to provide greater clarity as the year continues.

Eric Bosshard, Analyst, Cleveland Research

Okay. Second, a bit unrelated. In terms of promotions last year, the retailers backed way off. The sales were good. What is the current plan or expectation in terms of their engagement promotion this year? Does that matter for your profitability? And what do you think that means for the influence that has on volumes in Consumer in 2021?

James Hagedorn, Chairman & Chief Executive Officer

It's huge. If we make Mike's numbers, our results will look much better. Retailers are not just buying inventory because they want it; they want to sell it, and they're planning to move it off the shelf. Promotions are more sophisticated now. Black Friday-style early promotions in the past were costly and often mistimed because of weather. Today's view is much more sophisticated: targeted promotion tied to analytics, timing, weather and seasonal patterns. Retailers have learned a lot from COVID and are planning better. We also see supply chain constraints for some seasonal items, which actually helps our space since our products are available. I think overall the promotional environment will be more effective for both us and the retailers.

Michael Lukemire, President & Chief Operating Officer

They will promote and do it differently and more effectively. They learned a lot last year. I think it will be better for both retailers and Scotts.

Operator, Operator

We will take our next question from Jon Andersen with William Blair.

Jon Andersen, Analyst, William Blair

I wanted to ask about the newer consumers or households you've acquired since the start of COVID. How much do you know or what have you learned about these new or reentry consumers and their commitment to the category? I'm asking to understand what gives you the confidence in keeping them post COVID.

James Hagedorn, Chairman & Chief Executive Officer

Good question. If you look at results over the past few years, we hired demographers and saw trends change even before COVID. Our prior assumptions for Consumer growth were conservative, but we began seeing higher growth prior to COVID. COVID amplified interest in home and garden: people valued home, yard, family time, and gardening. Survey data indicates the vast majority of people who participated plan to garden again and often more ambitiously. AeroGarden indoor growing and edible gardening among younger people have seen very strong growth. We're seeing real demand across demographics. We're focused on retaining those customers and inviting new ones. Mike, you can speak to how we're engaging these customers.

Michael Lukemire, President & Chief Operating Officer

We're talking to them every day and have much better analytics. We're engaging them differently: focusing on convenience and providing direct-to-consumer options. We are creating digitally native brands that resonate with different consumer segments, such as Knock! Knock!, Lunarly and Greendigs. Our marketing is tied to innovation and product development. The data shows engagement and growing interest, and we're tailoring products and communication to capture and retain these consumers.

Jon Andersen, Analyst, William Blair

Makes sense. Second, on Hawthorne: you touched on signature brands moving to about 70% of the business. Where has that been historically and where do you think it goes in the future? On margins in Hawthorne, you reported about 13% segment EBITDA this quarter. What kind of longer-term objective do you have for profitability in that part of the business? And how do you weigh sales growth through aggressive pricing versus profit expansion through more rational pricing?

James Hagedorn, Chairman & Chief Executive Officer

We do distribute products and have important vendor partners. Our aim is to rationalize the line and own where it makes sense, but not to cut off strategic partners. The competitive environment is more intense with other players in the public markets, and we're prepared to compete. My bias is toward growth; we want to drive share and not sacrifice long-term opportunity for short-term margin, while being mindful of cost pressures such as plastics, ocean freight and domestic freight. We're biased towards sales growth with smart margin management and simplification of programs to keep promotions effective.

Christopher Hagedorn, Executive Vice President & Division President, Hawthorne

Our signature-brand ratio of owned products to distributed products moving toward 70% is about where we want to be; that's roughly 20 points higher than historically. Prior to the Sunlight Supply acquisition, Hawthorne mostly sold our own products. Since the acquisition we've been transforming the business to the model we want. There are categories where we won't manufacture certain products and will partner with strategic vendors. We're balancing growth and profitability; we've been at this for about six years and are still in the early stages of the industry. We're biased toward being aggressive in maintaining or taking share. At the same time, we've simplified promotional programs — fewer, more targeted promotions — so we can promote more precisely and defend share. We intend to keep promoting while improving profitability. Cory, do you want to add on long-term margin objectives?

Cory Miller, Interim Chief Financial Officer

Jon, we've previously talked about trying to get Hawthorne segment earnings to about 15%. We're still targeting that. We're balancing the march to 15% against investments in promotions and capturing additional share. We want to grow the category and Hawthorne within it. One reason signature brand mix has risen is the innovation in our products, such as LED lighting we introduced a little over a year ago. Growth in lighting has driven signature brand growth. We think 70% is about right and are not looking to deviate significantly from that.

Jon Andersen, Analyst, William Blair

That's helpful. One more: any update on Roundup and the relationship with Bayer? Any milestones or plans on that business?

James Hagedorn, Chairman & Chief Executive Officer

Yes. We had an option to exit the relationship and had extensive Board-level review. Management recommended letting that option expire, and we elected to remain in the relationship. We independently believe in the safety of the product; we've done our own work and have an EPA expert on our Board who has provided input. We're generally supportive of Bayer's efforts to resolve outstanding matters and believe the product is safe. We evaluated the contribution Roundup makes to our business versus the value of the option to leave and elected to continue. The business continues to perform well through the first quarter.

Ivan Smith, Senior Vice President, Corporate Affairs

No, I think that's well put. We've been in conversation with Bayer over months, and we're comfortable with how they're handling risk. We continue to see good retail engagement and consumer acceptance. For those reasons, we're comfortable with the decision to continue the relationship.

Operator, Operator

We'll take our next question from Alex Maroccia with Berenberg.

Alexander Maroccia, Analyst, Berenberg

My first one's for Chris. Obviously, the recent news focus for Hawthorne has been the cannabis opportunity. However, can you give us a sense of the current vertical farming market and discuss any growth in your partners there?

Christopher Hagedorn, Executive Vice President & Division President, Hawthorne

Vertical farming is on our radar. It was one of the initial guiding tenants for Hawthorne, but candidly, it's not grown as much as we hoped. It's difficult to grow food profitably in current vertical farm models. We're seeing more capital and new entrants, and we encourage innovation. Many of our products are applicable to vertical farming, but right now it's not a material part of our business. In Europe the dynamic is different: you're seeing more indoor production and greenhouse food production, and our European business has strong growth in lighting for those uses. But in the U.S., vertical farming is still nascent and not yet a major driver.

Alexander Maroccia, Analyst, Berenberg

Okay. That's helpful. And then shifting gears a little bit. How will you be assessing the return on the Super Bowl commercial investment versus other marketing you've done in the past? It's the most watched broadcast annually, but I'm just trying to see how the audience overlap significantly differs from the normal targeted ad spend and how you will measure impact on retailer traffic and product sales?

James Hagedorn, Chairman & Chief Executive Officer

I'll take this. The Super Bowl has exceptional reach and certain demographic advantages, including younger viewers and male viewers, which are useful for parts of our business. When you look at cost per thousand, it's similar to other high-reach buys, but the activation behind the Super Bowl gives us an eight-week campaign with sweepstakes and multiple talent-driven elements. Each talent has different demographics we can target. It fits well with our retention and reengagement strategy for new consumers. We'll measure it as part of an integrated campaign with our digital, social and retail activation. The marketing team has built a full plan to extend the campaign before and after the spot.

Michael Lukemire, President & Chief Operating Officer

The Super Bowl allows us to reset the gardening conversation and cascade messaging to new consumers. It sets the tone for our broader engagement strategy. I'm optimistic it will be very effective and our analytics suggest strong results.

James Hagedorn, Chairman & Chief Executive Officer

Just to clarify from earlier: we have stayed in the relationship with Bayer on Roundup and did not exercise an option to exit the relationship. We elected to continue working with them.

Jim King, Senior Vice President, Investor Relations

Catherine, I believe that is all the questions that we have in the queue today, so we appreciate everybody joining us. We'll be issuing press releases in the next couple of weeks regarding our participation in both the Truist and Raymond James events. And again, if people have follow-up questions and want to reach out to me directly today or anytime during the week, I'm at (937) 578-5622. Thanks, everybody, for joining us, and we'll talk to you again soon.

Operator, Operator

That concludes today's presentation. Thank you for your participation. You may now disconnect.