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The Scotts Miracle-Gro Company (NYSE:SMG)

F1Q10 (Qtr End 01/02/10) Earnings Call Transcript

February 2, 2010 9:00 am ET

Executives

Jim King – SVP, Corporate Affairs

Jim Hagedorn – Chairman and CEO

Dave Evans – EVP and CFO

Mark Baker – President and COO

Barry Sanders – EVP, North America

Analysts

Olivia Tong – Banc of America/Merrill Lynch

Bill Chappell – SunTrust Robinson Humphrey

Doug Lane – Jefferies & Company

Joe Altobello – Oppenheimer

Sam Darkatsh – Raymond James

Mark Rupe – Longbow Research

Alice Longley – Buckingham Research

Jon Anderson – William Blair

Connie Maneaty – BMO Capital Markets

Operator

Good morning and welcome to The Scotts Miracle-Gro Company's first quarter 2010 earnings conference call. (Operator instructions) Now I will turn the meeting over to Mr. Jim King. Sir, you may begin.

Jim King

Thanks Ashley. Good morning everyone, and welcome to discuss Miracle-Gro first quarter conference call. With me today are Jim Hagedorn, our Chairman and Chief Executive Officer; Mark Baker, our President and Chief Operating Officer; and Dave Evans, our CFO.

Jim and Dave will both share some brief prepared remarks about our results for the first quarter, then Jim, Dave and Mark will be available for questions. Given the fact that our annual Analyst Day is just two weeks away, our comments this morning will be brief and focused on our first quarter performance. We will provide a broader look at the business on February 17th, when several other members of the management team will also be on hand.

Given the timing of events, we would like to continue the Q&A session this morning to our first quarter results and the issues that are directly related to them. Speaking of our Analyst Day event, I want to remind everyone that we will be hosting the meeting this year in Boca Raton at the Boca Raton Marriott. Let me point out that the venue has changed since we first announced the meeting in December. It will not be held at the Boca Raton Resort as previously planned. However, if that is where you are staying, our meeting will be held just a few miles away.

We will start our discussions on the 17th, promptly at 8 A.M. with a series of presentations from management. At approximately 10:15, we will depart for store tours of local lawn and garden apartments at major retailers in the area. We expect to be back at the hotel about two hours later, and then at that point we will host a group luncheon and Q&A session.

Because the store visits will be conducted in small groups, it is important for us that we have an accurate count of attendees. So if you plan to attend and haven’t contacted (inaudible), I would ask that you do so by February 9 that is a week from today. You can do so by e-mailing us at investor@scotts.com or by calling Ashley Gullion, manager of investor relations, at 937-578-5217.

Okay, let us move on to the business at hand, and I want to remind everyone that our comments this morning will contain forward-looking statements. As such, actual results may differ materially. Due to that risk, Scotts Miracle-Gro encourages investors to review the risk factors outlined in our Form 10-K, which is filed with the Securities and Exchange Commission.

As a reminder, this call is being recorded and an archived version of the call will be available on our investor relations website, and if we make any comments related to non-GAAP financial measures not covered in this morning's press release, we will provide those on the web site as well. With that, let me turn the call over this morning to Jim Hagedorn to discuss our performance.

Jim Hagedorn

Thanks Jim. Good morning everyone. I think it should be pretty obvious that we are pleased with the results we announced this morning. We did better than we expected on both the top and bottom line in our core consumer business, especially in the United States where sales increased 17%. It was a great way to end the previous lawn and garden season, and even better way to begin a new fiscal year.

Looking further ahead into 2010, we will build upon the successes that worked so well last year. And I can say confidently in both US and Europe, we are in even better shape entering the upcoming gardening season than we have been in the past. In fiscal year ‘10, we will continue to maintain our competitive messaging to consumers, but spend an even greater percentage of our media on local advertising. We’ll continue to work with our retailers on strong promotions, and expect that we will see even more support from them than we saw last year. And we will continue to leverage our strong in-store presence, while servicing an even greater number of retailers.

In addition to the steps we are taking to drive the business, we have a good handle on our commodity costs, and we're focused on lowering SG&A beyond the benefit of simply having lower variable comps in 2010. Dave will discuss these issues in further detail. While factors beyond our control can always have an impact on the outcome of the season, I believe we are in great shape when we look at the things that are within our control.

With that said, I want to spend a few minutes focusing on the quarter, and then I will give a broad sense of what you’ll hear from us in Boca. Since that discussion is only two weeks away, we won’t spend too much time today focusing on broad strategic issues, so my comments this morning will be brief. Even though the first quarter is a small component to the year, it shouldn't be dismissed.

In fact, we saw some important trends develop in the quarter that reinforced our confidence in the strategies we have shared with you in the past. The improvement in the United States follows a consistent pattern led by strong consumer demand. Consumer purchases of our products in the US, as measured by the POS data that we see from our retail partners increased 14% in the first quarter. We saw improvements in 49 states with only North Dakota being the outlier. And we saw double-digit gains in 38 states.

The main driver in the quarter was lawn fertilizer, up 32%. I want to take you back to our last two conference calls, where we said we would aggressively spend to support our fall business. Well, it is pretty clear that that investment paid off. The year-over-year improvement was the strongest gain for lawn fertilizer we have seen in any quarter for quite a while, and although Q1 is our smallest quarter, the success we saw at the end of the season reinforces our belief that we need to continue supporting the fall business going forward.

The science is pretty clear cut; fall is by far the best time for homeowners to feed their lawn. The fall feeding not only prepares the grass for winter, but also gives it a jumpstart when the spring weather breaks. Consumers have always been more engaged in the spring lawn care season than the fall, and our historic marketing efforts have only reinforced that behavior.

But by investing more to support fall lawn care, we believe we can create incremental sales and drive the fall business for years to come. And while it is early in the process, we are encouraged by the POS trends we saw related to fertilizer in the South West and West Coast regions. In both areas, POS improved by more than 40%.

We believe more localized marketing efforts and in-store merchandising support helped to drive that performance. The other big win in the quarter came from our Ortho business, which saw a 43% increase in consumer purchases. This was largely a result of our entrance into the rodenticide category, especially with our mousetraps. We believe our advertising was the significant support ever provided in this category.

The spots were clear and compelling. They explained to consumers that our products are clean, safe, effective and easy-to-use. Our early successes here give us confidence that we really have developed a better mousetrap. We remain positive about the ongoing impact we can make in the rodenticide category having already established about a 10% market share position in our first year.

I want to stress that we still have very limited distribution in this space, and we are confident there is plenty of room for growth, if we remain focused on innovation and marketing. For the record, let me touch upon the other United States categories. Consumer purchases of Roundup improved by 10% in the quarter, growing media increased by 7% and plant food by 4%. Our grass seed business was essentially flat for the quarter.

We continue to be pleased with what we are seeing from our branded bird food business. While the overall category was down in the quarter, consumer purchases of our value-added bird food increased by 65%. While part of that gain is attributable to new listings, we saw improvement of nearly 30% in comp stores that have carried the products for more than a year.

What is especially encouraging is that only now are we starting to get the kind of distribution that we envisioned for this product line. Our Scotts branded premium bird food will be available nationwide at both Home Depot and Lowe’s in 2010, and we have expanded distribution at Wal-Mart as well. We have got a great team in place driving this business, and I've got more confidence than ever that we can in fact continue to evolve this commodity category to have more of a value-added focus, just like we did with our growing media business.

Let me briefly talk about the European consumer business, where growth is roughly in line with what we expected. The team there continues to do a good job driving the business, especially in the UK and France, the two largest and most important markets for us. We continue to see solid organic growth opportunities coming out of Europe this year, and I believe our innovation and marketing initiatives will allow us to continue driving our market leadership there.

Just like in the US, we are seeing a strong level of retailer support and in-store inventory levels are appropriate entering the season. I will let Dave elaborate a bit more about the global consumer business as well as our results from both Scotts lawn service and Global Professional. I want to switch gears for a minute or two to give you a sense of what to expect when we meet with all of you down at Florida in two weeks.

As we’ve told you in the past, this will not be an overly formal affair. We have about two hours of presentations, then we break into small groups for about two hours of store visits. We will then return to the hotel for lunch and a broader group Q&A session. What you will hear is that we will be focused on our consumer business because that is where our strongest opportunity to drive shareholder value lies.

While we remain committed to Scotts lawn servicing and Global Professional, we're making a deliberate choice to focus our resources where we are best positioned to drive growth, margin improvement and shareholder value, and clearly that is within our Global Consumer segment.

Seeing the growth and achieving it are obviously two different things. And so that is what we will focus in Boca, sharing with you how we are changing our model to drive the business. We will go beyond talking about the what and why around regionalization, we will give you examples of precisely how these efforts are beginning to take hold and help us drive growth in individual markets.

While we believe the regionalization model itself is a home run, the efforts in any given market are unlikely to be. The beauty of this initiative is we don't have too swing for the fences each time at that. Instead by focusing locally, we will be able to succeed with the continued series of singles and doubles. Each one of them driving growth in the category and continuing to improve our market share.

You will also hear me elaborate a bit on some of the intangibles that I believe will be critical in allowing us to succeed. If you go back a decade or so, you can see how our focus has evolved. In the 90s, we were focused on acquiring the portfolio brands that we have today, which make us number one in nearly every major category in nearly every major country in which we compete.

In the 2000s, we were focused on building our supply chain and sales force. This was a substantial effort that made us not only the best supplier in our industry, but one of the best in any category of consumer goods. Over the past several years, we have been focusing on driving productivity for our retail partners, and distancing ourselves from the competition.

As we look at the landscape today, I can say we have succeeded in each one of those major steps in our journey. But the next step getting closely in line with consumer will require our culture to evolve significantly.

So you heard us talk about the mindset we're working to create and the investments we will be making to help ensure our success. Suffice to say that I believe you will find the time to spend on February 7th well spent. I think you will walk away with continued confidence in our ability to execute, as well as believe that we are taking the right steps to profitably grow our business over the long term.

But that let me turn the call over to Dave.

Dave Evans

Thanks Jim, and hello everyone. I want to reiterate what Jim said about the strong start to the year. I can tell you that consistent with the first quarter, our January sell-in to the trade has remained strong, and we are increasingly confident that our retail partners will be well positioned for the start of the season. We have every reason to believe they'll continue the strong support of both our brands and the overall category.

Before I walk through the numbers, let me set the foundation with a brief comment on Smith & Hawken. Having substantially completed the Smith & Hawken closure process in our first quarter, we are now presenting the business as a discontinued operation. They still are intent to provide additional disclosure or discontinued operations for past three years annual results as well as the prior two years quarterly results at some point in the near future. Speaking of Smith & Hawken, I can also share that we executed the sale of the intellectual property in late December.

The sale resulted in a P&L gain, which substantially offset first-quarter charges resulting from Smith & Hawken lease terminations. All activity related to Smith & Hawken, including this gain is included within our discontinued operations, and as a result is excluded from both our adjusted earnings in full year guidance. One final housekeeping note, you may have noticed some small shifts first quarter 2009 results reported for Global Consumer and Professional segments. The shift of sales and earnings between the two segments follows recent changes to management reporting structure. On a full-year basis for fiscal 2009, these changes represent a shift of around $30 million in sales and about $1 million of operating income from pro to consumer. With that housekeeping, let's move on and discuss the quarterly results.

We reported a seasonal net loss of $57.7 million for the quarter, essentially flat to a loss of $57 million for the same period a year ago. To bridge a reported net loss to the adjusted loss from continuing operations, we exclude two items. Losses from discontinued operations that is Smith & Hawken, and costs related to product registration and recall matters. After excluding these two items, we have an adjusted loss from continuing operations of $48.1 million or $0.73 per share in 2010 as compared to a loss of continuing operations of $48 million or $0.74 per share in 2009.

In other words, our adjusted loss was also essentially flat between the years. You might recall we said during our last call, we expected our first quarter loss to grow. One reason was that we had a tough sales comp. This last year we saw some retailers accelerate purchases in the first quarter in advance of the January 2009 price increase. Given the absence of a January price increase this year, our forecast anticipated sales to retailers could migrate back into the second quarter.

In fact, we saw our global consumer first quarter sales increase 14% to $214 million. Excluding changes in FX, growth was 10%. This double-digit increase in sales is favorably influenced by strong consumer pull through with consumer POS up 14% for the quarter. The growth in our Q1 sell-in was also favorably influenced by our southern retailers preparing for the season earlier than they typically have, an early indicator of the success of our three new deep south regional offices.

These were the principal two reasons for growth in Global Consumer sales, which was the principal reason why our first quarter consolidated loss was lower than we originally expected. In Scotts lawn service sales decreased 15% to $33 million. This decrease was primarily due to the decline in customer count we experienced earlier in the season, combined with a reduction in customer purchases of extra services, especially over-seeding due to good agronomic conditions. Our full-year plan does not contemplate top line growth in Scotts lawn service segment this year. So the first quarter decline in sales was not entirely unexpected.

Global pro reported sales of $55.4 million, down 7%. Excluding changes in currency decline was 12%. About half of this decline or 6% is due to price reductions. Recall that in the first quarter last year selling prices in the pro segment were reaching their peak. In fact, prices in Q1 of fiscal 2009 were up 23% as compared to 2008. Subsequent to our first quarter of 2009, prices declined for the balance of calendar year 2009 in pro as the market fell.

As we've described in the past, this cycle is creating a difficult comp for sales growth, gross margin rates, and operating income for this pro segment. We expect our second and third fiscal quarter operating income for pro to be much closer to parity to the prior year, with a sizable pickup in the fourth quarter, as we’ve recognized some mark-to-market charges in 2009 related to professional grass seed. So by the end of the year, operating income for our pro segment should be close to parity with fiscal 2009.

Let's move on to the gross margin line and let me start by stressing that the result we reported this quarter is consistent with our expectations. We may see unfavorable gross margin comparisons again in the second quarter so much more modest in size, before seeing year-over-year improvements in the back half of the year. Large swings in both year-over-year pricing in our global pro segment, which I just described and inventory costs across all segments are the principled reasons why we are seeing the unfavorable gross margin comparisons in the early part of fiscal 2010.

Despite that we still believe our consolidated gross margin rate for the full year will be about flat to the prior year with our confidence increased by the reduced volatility in the cost of our commodities for the last several quarters, and by now having locked in over 60% of our total commodity needs. If you take anything from this discussion, it's that the improved gross margin rates we expect to see in the back half of the year after both pricing and cost normalized with be more reflective of the longer-term expectations.

Let's move down the P&L to look at SG&A, which was down 1% in the quarter and it represents good story for us across the company. We are extremely focused throughout the company and instilling increased levels of spending discipline. It allows us to drive more leverage out of the P&L. Not just this year, but in future years as well. Recall that we expect overall SG&A dollars to be flat for the full year, while still increasing spending in areas that build our competitive advantages such as media and the three new regional offices, both of which are tactics consistent with executing our increasingly consumer driven operating model.

Moving down to interest expense, the $5.6 million reduction in the first quarter is the combined result of lower borrowings and lower rates. Our quarter end debt is down over $170 million from last year. We finished the quarter with the leverage ratio of about 3.1, well within our debt covenants, and we expect our leverage to continue to improve throughout the year finishing well below three times. When we meet for our annual investor conference later this month, I will walk through our thinking about long-term capital structure and future uses of cash.

But while I am on the subject, let me divert just a moment and address our recent debt offering. As you probably saw in January, we issued $200 million of 8-year senior debt with a coupon of 7.25% at a yield of 7.375. The proceeds were used to pay down our revolver, which flows at a much lower rate. The reason is pretty straightforward. Our current credit facility expires in two years and we want to be both proactive and opportunistic getting our financing needs met well in advance of that deadline.

We also want to begin diversifying both our sources of liquidity and debt maturities. When we established guidance for the year, we told you we expected interest expense of $50 million to $55 million, but then we also intended to file a shelf registration. This guidance contemplated a bond offering sometime later in the year, because we saw an attractive opportunity to issue bonds and that occurred early in the year. We now expect interest expense at the top of our original range, because it is still within the range though we are not changing the full-year outlook for adjusted EPS provided last November.

Before I wrap up, let me touch on the balance sheet. Receivables are down $46 million, about half of that decline was driven by 2009 change in the law in France, which legislated 30 days terms. The other half resulted from a number of factors with the net effect in material improvement and days sales outstanding. Inventories are up about $41 million or 7% from last year. The increase is substantially the result of higher cost finished goods that rolled over from fiscal 2009, and new private label inventory.

Remember that we didn't begin to build private label fertilizer until the second quarter of 2009, and December is the major month in the production cycle. So the results for the quarter are pretty straightforward. With that we're ready for your questions. Before we start though, I want to reiterate what we said at the outset. Since we plan to meet again in two weeks, we want to confine the discussion in Q&A session today to the current quarter relevant subjects. We'll spend as much time as needed on February 17th discussing specifics for full-year outlook and longer-term expectations. With that let's open the call up for your questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions) The first question will come from Olivia Tong with Banc of America/Merrill Lynch. Your line is open.

Olivia Tong - Banc of America/Merrill Lynch

Hi, thanks, good morning. Just want to first talk about consumer sales. Clearly, a 14% growth rate, much better than you guys expected. But you -- I'm assuming you're keeping the three to five on the top line -- well, first, you're keeping the three to five on the top line for the total company. I'm assuming you're keeping the three to five top line on consumer as well and if so, what sort of happens in the back half of the year of Q2 through Q4 that suggests a pretty big deceleration on easier comps at least in Q2 and then, you know, in the second half as well?

Jim Hagedorn

Well, good morning Olivia.

Olivia Tong - Banc of America/Merrill Lynch

Good morning, Jim.

Jim Hagedorn

You know, I’ll start by saying that it's a good start to the year, okay, and I think it makes us more confident that we got these numbers made. You know, I think the season hasn't really begun yet. I mean, I think we are dealing with like, I don't know, less than 2% of our total year POS occurs in January. So you know, at this point we're just kind of feeling good. I think retailers are set. We got great programs but I don't think you're going to hear from us, I mean I’ll hand it over to Mark but I don't think what Mark is going to do is call the numbers up and you know, it sort of depends on what, I think we sort of believe in don’t overpromise. So, I don't think we're going to start overpromising now, and it's too early to call the numbers up based on you know, small, small periods, but...

Mark Baker

I think Jim is right. I mean, you know, the first quarter was less than 9% of our total sales. We're very excited about the really confidence that the retailers have and the exuberance that they have about going into the lawn and garden season, and we're just beginning to you know, recycle the private label anniversary of those sales, which we got in the first quarter this year. We didn't have in the first quarter last year. So, well I think we are cautiously optimistic for the year, there is a lot of year ahead of us, and we feel very good and the confidence that the retailers have and the promotions that they plan will bear themselves out in the next 90 to 120 days. That's what we see.

Jim Hagedorn

But, you know, I would say it's up to you guys to figure out how you like to string all the stuff together. I'd say we are feeling pretty optimistic here at this point though. It's -- I mean my dad had a view that is you do all the preparation, you launch your missiles. At that point they're kind of ballistic and you hope they land in the right spot. So how you guys string your numbers together, it's kind of up to you. I would say we feel pretty darn comfortable about what we're seeing, but it's all going to come down to you know, basically I think you know, there's a good weather and these are some we didn’t figure on.

Olivia Tong - Banc of America/Merrill Lynch

Got it. Thanks. And then on SG&A, just kind of wondering, you know, again, sort of similar line of questioning. You kind of kept it pretty flattish this year despite the sales growth. Other than the increased media spend and going -- or you know, support behind the products in Q2 through Q4, are there other things that we should be thinking of that will be driving SG&A upwards rather than you know, the cost containment type things that you're doing?

Jim Hagedorn

Look, you know, this is a, you know, for those people who have been following us for a while you know, there is this -- we put all this stuff together. We had what we call one face to the customer Scotts North America, whatever you want to call it. These were all very major projects we spent a huge amount of money sort of building our army, building our distribution system to support the sales becoming the vendor, which we think we are, which is you know, a world-class vendor and a very violent seasonal business, and we are going to a very interesting point right now, which is really basically saying, we're going to change how we market and we're going to change how we sell.

And this whole approach to the business, which is sort of pushing power out into the field is going to change how Marysville operates, and it is going to change how we look at G&A, and so you know, what I would say to you is it's beyond evolutionary, where we're headed as far as how we're going to run our business, and this is a good thing and it is not risky and complicated, but it basically says we are going be spending a lot more money on good G&A and less money, I want to say a lot but less money on what we would consider sort of non-operational G&A. And so, you know, I think that you'll hear more about this and see more of it as we go forward, but maybe with that being said, I'll let handle to Dave to say anything within sort of the fiscal year.

Dave Evans

Now with the, I think, we saw in the first quarter is very consistent with what our guidance was which was why SG&A for full-year and within that context, we are seeing increased spending in areas related to marketing media establishment in regional offices. So we're finding ways to reduce spending elsewhere. Recall that this year we also have -- we have a bit of a tailwind, which was the non-recurrence of the variable comp over targets from last year. So that's kind of helping us get to this point in time. But we think we're doing the right things and making the right investments to continue to sustain those things that make Scotts so unique.

Olivia Tong - Banc of America/Merrill Lynch

Got it. Thanks a bunch.

Operator

Bill Chappell of SunTrust, your line is open.

Bill Chappell - SunTrust Robinson Humphrey

Good morning.

Jim Hagedorn

Hi.

Bill Chappell - SunTrust Robinson Humphrey

I guess maybe you can give us a little idea on pricing for both the consumer business and the lawn service business for 2010. Did you get any price increases? Are there decreases, you know, specifically in Lawn Service if that's going to hurt the numbers this year?

Mark Baker

Bill, I’ll take the first part of that and you know, we’ve guided to -- but basically there was little bit of put and take in the consumer side on pricing, but basically it's flat for 2010. So we're expecting. Barry, if you have any thoughts on SLS, but we remain competitive, but I think it's a flat there.

Barry Sanders

Yes, I think we adjusted our pricing last year to be more competitive than we expected to be flat to where we were last year in Scotts Lawn Service.

Bill Chappell - SunTrust Robinson Humphrey

Got it. And then, I think this is the first time I can remember that you talked about retailers kind of pushing up or ordering earlier for the upcoming garden season. Is there any like macro change or is that more select retailers getting excited about the season?

Jim Hagedorn

Well, it's probably I would say more of the latter. I don't think there is any sort of structural changes. I think we've got better programs, we've got more guests sort of the programs, and I think there is a lot of enthusiasm for what came out of the '09 sort of, call it, gardening year and people saying you know, this is an area where the consumer, you know, because it's not all of lawn and gardening, it would be consumable products in lawn and garden, and I think probably paint turned out to be sort of the big star categories, and I think people are, the retailers are behind it, and I think even for us we are very satisfied with sort of the level of support we are seeing of getting the store set early than is more than before, and that's a just thing because you know, the retailers are running I think it's like end the January is their, sort of when their year ends, and so generally we've seen a lot of reluctance to build inventory on their balance sheet before the end of their fiscal years, and the fact that they are supporting the business when they should be, which is getting these stores set now is a really good sign. I don't know Mark, if you have anything to answer that

Mark Baker

Bill, it is commensurate with as Jim mentioned, the US sales mix, you know, for quarter-on-quarter now continue to lap ourselves with double-digit increases at retail. Consumers engaged in this category. The retailers are more excited about this category, because they need the footsteps and our brands bring footsteps like no other, and that continued confidence in the way they are building their programs, I think set us up for a pretty good spring as long as the weather is there.

Bill Chappell - SunTrust Robinson Humphrey

Great and then just Dave, a couple of quick ones. On the inventory, I understand your comment but just trying to think, is Smith & Hawken in that inventory number, because I would have thought that had gone down a little bit and also with lower cost commodities, inventory wouldn't have spiked quite as much and then any comment on the other income being up so much year-over-year? Thanks so much.

Dave Evans

Sure. Yes, Bill you're right. The Smith & Hawken was one of the other contributing factors, and that was placing some downward pressure on the inventory, because it effectively, at the end of this year quarter, the inventory was zero. So yes, the two factors really were more than offsetting that was the addition of the private label inventory and the increasing higher cost. With respect to other income, Bill, we continue to look at idle assets in the company, unproductive assets and find ways to turn them into cash on productive assets, and what we saw on our first quarter was the sale of some idle assets and we recognized gains on their sales. So, they are permanent for the quarter and you know, kind of give us a little bit of help down in that line on a full-year basis.

Jim Hagedorn

You might explain because it's kind of counterintuitive while costs are coming down inventory you know, we're dealing with this high sort of (inaudible)?

Dave Evans

Yes, I mean it's a topic we've talked about many, many times in the past and it's a bit of a phenomenon of fact that we're a company that goes out and buys forward on our commodities. So we are out buying forward, and then we really think about our inventory costs around our production cycle, and because of the call it infrequency of turns, particularly in our fertilizer business, which is where we saw most of the volatility in commodities, and which is also where we typically buy forward farthest, it takes a while to kind of wind through this entire process of the cycle we've gone through over the last 24 months.

I do think, and then that gets back to some of my margin comments in my script that as this will play itself out, in first half of the year there is some spillover in terms of the second quarter and once that happened, then we're going to be in a more normalized world on cost, and we'll continue to see a little bit of the pricing with the pro business as it continues to decline, but we'll start to see more normalization and the rates that we see in our second half of the year, which we better year-over-year, are then consistent with what our long-term expectations are.

Bill Chappell - SunTrust Robinson Humphrey

Thanks so much.

Operator

Your next question comes from Doug Lane of Jefferies & Company. Your line is open.

Doug Lane - Jefferies & Company

Yes, hi, good morning, everybody.

Jim Hagedorn

Hi Doug.

Doug Lane - Jefferies & Company

First question, on the fertilizer sales, up 32% in the December quarter, do you have what that is on pricing versus volumes?

Dave Evans

Taking the question?

Jim Hagedorn

I haven’t taken any questions. So that's all volume.

Mark Baker

(inaudible) It is probably half and half, because we have the pricing that went in, but I think we had, you know, really good US unit sales too, which I'll (inaudible). I'm sure with numbers.

Doug Lane - Jefferies & Company

That's what I was going for. So, in spite of the big pricing, the residual impact of the big pricing, you still got double-digit unit growth, you think?

Dave Evans

That's correct.

Doug Lane - Jefferies & Company

Okay. Secondly, in the wild bird feed, can you give a little bit more color on the business at Wal-Mart? Not only with regards to Scotts, in other words, what do you think your penetration is at Wal-Mart, with Scotts running now and then what's going on with Morning Song? Are they increasing, decreasing listings of Morning Song or how is that brand going vis-à-vis the Scotts brand?

Mark Baker

Well, let me just specifically say I don't want to comment too much on Wal-Mart and specific to certain brands. But I can tell you that we feel very good about how the Morning Song is performing in the premium bird food category, which is relatively new on shelf. And our penetration of the premium branded continues to grow as Jim pointed out, very significant.

Barry Sanders

Yes, I think our Scotts business is growing fairly well. Our Morning Song business, we’ve stepped away for some basic commodity and stuff that we were losing money on, and so that kind of makes up the numbers, but overall our Scotts is gaining national distribution, and which I think crossed 30% in the quarter. So -- and I think that's fairly consistent from retailer to retailer that's accepting the Scotts brand.

Jim Hagedorn

And the only brand that's being advertised electronically, nationally.

Doug Lane - Jefferies & Company

Is the Scotts brand, of course.

Jim Hagedorn

Correct.

Doug Lane - Jefferies & Company

And lastly, I hadn't asked about this before. I've always, you know, the March quarter is really dependent upon the break of the season in the northeast, but with the poor weather we've been seeing in the southeast so far, is that something that we should worry about for the March quarter, particularly Florida?

Dave Evans

Well, clearly you know, we don't think that the US in the month of January, which is called 1% of our total year, it is not a very significant thing and actually we build full enthusiasm around some of this freeze and the moisture in California that can you know, both actually for the lawn and garden season as people need to repair their bedding materials or now have confidence in your moisture, but you know, certainly January has been, you know, a weather challenged month for all of our southern markets, but I think it's actually something we will look forward to because it builds for a very likely solid season.

Doug Lane - Jefferies & Company

Okay. Thank you.

Operator

The next question will come from Joe Altobello of Oppenheimer. Your line is open.

Joe Altobello - Oppenheimer

Thanks, good morning guys. The first question, I just wanted to go back to the 17% improvement in the US. How does that compare to the category? I imagine you guys are still very much outpacing the category.

Dave Evans

Yes, that's consistent with what we have and, you know, we've been gaining shares. So we're well ahead of the category.

Joe Altobello - Oppenheimer

Okay, so in terms of that you know, you talked about retailer support being very good last year. It sounds like you're looking for even better support from retailers this year. Are you seeing disproportionate support for your brands relative to your market shares?

Jim Hagedorn

Let me take a little stab at that. I think the point is that we have some brands recognized like no others in this category, and retailers use our brands to create traffic, and I think because of our unique appeal and the confidence that consumer has on our brands, we probably wind up with a disproportionate share of level of communication for the retailers.

Dave Evans

Yes, I think to support is not only relative to our specific category, but driving the overall category for the retailers. So they are going to use our brands to drive foot traffic what Mark and Jim has talked about, but that foot traffic also advise plans and other things associated with it. So they are using our brands not only to drive the lawn and garden consumables, but I think to drive the entire category.

Joe Altobello - Oppenheimer

Got it. Ok. And then secondly, moving to global pro, I think Dave touched on this a little bit, but just getting a little more color there. Your sales were down $4 million year-over-year and the EBIT was down about $13 million. So, just curious what was going on the cost structure in that segment?

Dave Evans

Yes, so this gets back to -- it's both pricing and cost. So, you know, last year prices in 2009, I'm sorry in 2008 were going up month after month after month, and they're really reaching kind of their peak in Q1 of FY09. Then recall what happened is the market started to turn and then we had a series of price reductions throughout calendar 2009 getting us to our first quarter of 2010. So the pricing line you really had you know, last year sales prices were at their zenith. This year sales prices are at, you know, much lower levels.

So that's creating the first dynamic that's challenging. As time marches on, we're going to start to anniversary those pricing changes from last year, and so the impact that will become more minimal as we march through each proceeding month, but at the same token the cycle on cost is what I was describing just a few moments ago to Bill. Our pro-businesses is primarily a fertilizer business, and fertilizers are where we saw a highest cyclicality in the commodities, okay.

So those are working their way through this as well based on our production cycle. I think to me the point you need to think about on our pro business is this business has seen a lot of cyclical short term changes based on those two dynamics. And I would tell you that we believe structurally long-term, the business is still a good business and we're seeing kind of these two cycles distorting some of the optics of our short term earnings. So that's why I wanted to say in my script very carefully that we saw a big decline of operating income in the first quarter, we expect that to normalize more in our second and third quarters.

We will be closer to parity to prior year, and then in the fourth quarter, we're actually going to have a sizable pickup and I'll refresh your memory on why that is, and let us recall this past year in our fourth quarter, we had a mark-to-market adjustment on professional seed. That mark-to-market adjustment gives us a nice comp in the fourth quarter. So it's a complicated story. We're down the first quarter. We're going to be up a lot in the fourth quarter, and we're going to be about parity in the quarters in between. In the long term structurally, this business is still a good strong business.

Joe Altobello - Oppenheimer

Got it. Okay. So, that makes a lot of sense because it seems like the global pro business is a good microcosm for what's going on at the corporate level in terms of the cost of goods flow. But I guess lastly on advertising, you talked about moving the advertising spend more locally. What are you looking for overall in terms of advertising spend year-over-year. Would it be flat to modestly up this year?

Jim Hagedorn

Yeah, I would, go ahead.

Dave Evans

Yes. It'll be up this year. You know, we did a very good job at managing our spend month to month, but we'd expect to be up consistent with what the same percentage we did last year.

Jim Hagedorn

And it is part of our long-term plan to have, you know, this just gets back to you know, if you'd asked my dad at any meeting of the board for instance, he would said the advertising works. I think what we discovered in sort of the fall with our lawn fertilizer business last year, I think where we spend behind our brands, especially where the message is right, we get good results.

I think this is very encouraging from my point of view. If you look at the business to say, we haven't tapped anything out yet, and so our strategic plan, which we presented to the board was at last week or week before, it is time close together. I would say it dates back to kind of my old man's day, which is advertising works and we don't believe we are spending enough and our strategic plan requires us to spend at a higher rate than we are seeing on sales growth driving the business.

Dave Evans

I would also state that mix is changing and continues to change every year. three years ago we were 90% plus national. This year we'll be 60% regional and so that buy is a less efficient buy. So the buy is more expensive but we think it's more effective, but we also look at number of impression and intent on increasing those number of impressions, even though we are at a more regional spend, and so overall we would say going forward, we're going to continue to drive the spend up.

Joe Altobello - Oppenheimer

Okay. Great. Thank you.

Operator

Sam Darkatsh of Raymond James. Your line is open.

Sam Darkatsh - Raymond James

Good morning Jim, Mark, Dave, how are you.

Mark Baker

Good.

Jim Hagedorn

Thanks Sam.

Sam Darkatsh - Raymond James

Most of my questions have been asked and answered. The only question I would have, Jim, it appears as though you have been exercising a fair amount of options of late at an accelerated pace than what you normally do. Just if could give some color as to your incentive to do so?

Jim Hagedorn

I just bought a new house in Florida and you know, I'm saying as I get closer to the end of my career here. I'm just sort of dealing with my own personal balance sheet. So there's nothing going on. I and the family remain committed to the business and it is just personal stuff I'm doing is I look at my life going forward.

Sam Darkatsh - Raymond James

Very good. Thank you.

Operator

Mark Rupe of Longbow Research. Your line is now open.

Mark Rupe - Longbow Research

Good morning, guys. As it relates to the EZ Seed product, I know last year you had some limited capacity, and you obviously increased that but are you positioned to meet the demand from the past in distribution point heading into the season?

Barry Sanders

Let me take the first part, it is Barry. I think we built a lot of capacity running in flat-rate as we speak at our new plant. We made the investment in. You know, we built for a significant growth here, two or three times over what we did last year, and I think there is more capacity and it's a great product and the retailers are very excited about it and again this is the first time it's going to be national.

Dave Evans

We have no capacity constraints on how much we could sell this year.

Mark Rupe - Longbow Research

Okay. And then secondly, on the comment on the southern retailers setting up a little bit early, I think you mentioned alongside that the original offices down there. With that an actual contributing factor to some of the better maybe set-up or is that just something that you left alongside it?

Jim Hagedorn

You know, I try to look at things like simply good, bad, or neutral. It didn't hurt, I'd put it that way. So I think that this would be one where it was neutral deposit of. So you know, I think that is the regional offices play out, establish relationships with the regional management team, so the retailers they're making sure they're well prepped. This was a major fact or major focus that I know Mark had last year was making sure that our southern markets were, I mean in a year where, remember go back to a month.

We were all nervous like, you know, really nervous last year, and said, you know, the best thing we can do is make sure that the southern markets are ready to go when the season breaks and we make, you know, we take care of every opportunity we get to drive the business. I think that is just happening kind of in space right now, as everybody really wants to be prepared because this is a category that I think people figure has legs.

Mark Baker

What Jim says is right on, and I do think our relationships with the local leaders, whether it be independence, whether it's some smaller general retailers or more localized, and clearly the nationals is so much better in terms of reminding them that a consumer is alive in January and February in some of these southern markets, and we're leading promotions locally to do that, and they might as well jump onboard buying the inventory. So I think it had a positive effect.

Mark Rupe - Longbow Research

Great. Thank you.

Operator

Alice Longley of Buckingham Research. Your line is open.

Alice Longley - Buckingham Research

Hi, good morning. So, you said your shipments for global consumer ex-currency were up 10%, and I guess they were up 17% in the US. So, what was the number for offshore, Ex-currency?

Dave Evans

I think there was, Alice it is Dave, I can’t off the top of my head. I believe it's a very small decline primarily due to those timing of orders with French laws. Yes, recall what I've talked about on receivables change in 30-day terms. As an outcome, some our retailers are also pushing their shipments back later in the season.

Jim Hagedorn

But you know, Alice (inaudible) is in China right now, but he is very enthusiastic about what he is seeing through the end of January with the business. So the retailers are in a really good place. He is feeling really good about the international consumer business right now. So you know, I would say the story only gets better with time with that business.

Alice Longley - Buckingham Research

Okay. And then the 17% increase here, how much of that was pricing? And then I suspect pricing goes away, but you probably got it in the first quarter? Well, we know you got it in the first quarter because you did fertilizer.

Jim Hagedorn

Those people -- go ahead.

Dave Evans

About a third and a half.

Jim Hagedorn

Probably just over a third. Okay.

Alice Longley - Buckingham Research

Okay. And it's on -- are Home Depot and Lowe's, either of them or Wal-Mart, actually, giving more space to lawn and garden this year?

Mark Baker

I think what you'll find is that with their support of promotions that they are running and the support of the Scotts promotions, there will be a lot more promotional stack ups. I think that's increasing on a space in-line in the shelving as such, but --

Jim Hagedorn

More concrete.

Mark Baker

More concrete on the floor, and more impulse areas, we feel very good about that.

Alice Longley - Buckingham Research

And you're -- they're putting more of their promotional dollars behind lawn and garden even than last year?

Mark Baker

We believe that the consumer side of lawn and garden was benefited for the traffic and we think that they'll -- they'll know what they did last year with some growth.

Jim Hagedorn

I think they are excited about lawn and garden, and I think they are excited about our line of products and our support both in the store and sort of across media of our product line.

Alice Longley - Buckingham Research

Okay. And I guess my last question is what do you think the products or innovations you have for this year are most important for driving your growth this year? What's the most exciting? What's going to drive the consumer?

Dave Evans

Number one, I think Jim already asked the question. It's ECC. You know, we expect that product line to be substantial this year and 3 or 4 times the volume of what it was, and actually the thing that's exciting about that is it's not cannibalizing growth of the other grass seed. It is incremental for the category.

Jim Hagedorn

You know, Alice, really across the business, you know, this idea of the sort of singles and doubles to really like it, because it doesn't require to take these sort of high risk bets. You know, so -- like this rodenticide business is pretty cool. The bird food business, pretty cool. These are both significant categories. The grass feed business clearly we got ahead of steam. The lawn business is going really well and there is a lot of good innovations coming down the pipeline. So I would say that just in general, 10, 11, and beyond, there is a lot of good stuff in the pipeline. We'll share more of this with you guys as we sort of walk the stores and triangles buy and these things become more sort of eminent, but just a lot of really good stuff coming down the line, and probably as good a pipeline as we've ever had on kind of low risk, easy, high margin, value-added kind of products, which is I think where we've always done really well, and we just have a good concentration of coming down the pipe.

Alice Longley - Buckingham Research

Great, thank you.

Operator

Jon Anderson, William Blair. Your line is open.

Jon Anderson - William Blair

Good morning guys.

Jim Hagedorn

Hi.

Jon Anderson - William Blair

I was just wondering if your plans for 2010 include more in-store merchandisers and counselors and you know, if so, how those will be deployed. Are you reaching more stores of existing customers or expanding the in-store counseling to additional retailers?

Mark Baker

The good part of what we're doing with regional sales. The answer is yes, we are increasing it, but the good part of what we're doing with regionalization. We used to manage that nationally out here in Marysville, now we're pushing that out to the regions. So taking a national approach and taking it down to a DMA by DMA level and then the business managers running those DMAs can determine where the resources go, how do we deal with retailers and what resources are necessary to drive it. So I think not only are we spending more, but I think the effectiveness of the spend by the local people that are driving that business is going to be much better than it has in the past.

Jon Anderson - William Blair

And the fertilizer growth number in the first quarter, 32%, much of that I think double-digit unit growth was how you characterized it. Was there a benefit there from private label and if so, to what degree? I think you didn't necessarily have private label ramped up a year ago as of yet?

Mark Baker

That's our brand business.

Barry Sanders

The private label business is growing very nicely for us, but that was all branded.

Mark Baker

Yes. That is all brand numbers.

Barry Sanders

The POS is all brand numbers. Our shipments include the private label.

Jon Anderson - William Blair

Okay. Last question. I guess, I'm just curious on your thoughts on you know, assuming we have a more value conscious consumer, kind of an aggregate at the moment. You know, Scotts ability to kind of trade up consumers to higher price point, higher margin of products in both 2010 and beyond, how you feel about the company's ability to continue to do that. Thank you.

Jim Hagedorn

You're welcome. You know, Hagedorn here, I feel good about it. I think it's how we present it, what kind of value it creates for the consumer but, you know, Mark has these tears of you know, simple but sustainable and whatever, but, you know, these sort of pillars are, they're important for us and you know, while the commodity business is good, it's all about moving -- you know, for us to grow our business going forward, it's going to be about growing these categories and taking share.

It's kind of always been the story where a deeper company today than we've been in the past. You know, Chuck [ph] and I, you know, as I went through the script this morning, Chuck a lot of the same words, you know, sort of drive the categories, take the lion’s share of that growth. We're still doing that. We are deeper in that we're doing a lot more privately labels than we've done in the past. So I think we're managing a larger slug of the business for the retailers, which I think makes us more efficient.

That being said the values being created for this company on the value-added side, and I think we feel very comfortable that being said. You know, this is not $100 dollar bag fertilizers. You know, this is a sort of value added within reason and explaining in a way that tells the consumer where they're going to get bang for the dollar. I think where we sort of probably made a little bit of a mistake, I'm not even sure it was a mistake, but I'm not sure the consumer was ready for it, was in 2008 kind of our grow time, which was about sort of lifestyle and what sort of intellectually you get from the garden as opposed, and when we move back to last year and for sure this year is why by paying more you get more than it's worth it. So we feel good about it I guess is the bottom line. Anybody got anything else?

Mark Baker

Ashley, do you have any other callers in the queue.

Operator

Yes, the next question will come from Connie Maneaty of BMO Capital. Your line is open.

Connie Maneaty - BMO Capital Markets

Hi, good morning.

Jim Hagedorn

Hi, Connie.

Connie Maneaty - BMO Capital Markets

I was hoping -- good morning all. I was hoping you would just elaborate a little bit more on the impact of the inventory on the gross margins. I mean, I'm staring at some of the things I wrote. I'm wondering if in the second quarter, the gross margin should be flattish given the kind of costs that are running through, but the third and fourth quarters are up considerably over last year, which is the time when you also realized your biggest gross margin gains. Is that right?

Dave Evans

Yes, I think you've got it right Connie. You know, I think we start splitting it up by quarter. You know, we can only get so precise because product mix has some influence on level of sales, but directionally I think got slightly down in Q2, because we start to turn this ship, and then in Q3, Q4 definitely we should see some growth over prior year bringing this back on a full-year basis back to roughly flat.

Connie Maneaty - BMO Capital Markets

So, does that change in the gross margin then get the fourth quarter which in the old days, whenever those were, used to be a flat quarter and recently it has been a down quarter. Does the change in the cost structure turn that to a flat quarter this year?

Jim Hagedorn

Connie, I am not -- I don't think today (inaudible) start getting into providing that to the quarterly guidance, but I think what you’ve heard are definitely some nice tailwinds for the fourth quarter. I mean -- because we also talked when we talked about our professional business, how last year in our fourth quarter, we took a mark-to-market adjustment on proceed. You know, obviously our expectation is that doesn't recur, and that is going to also help augment our gross margin rates.

So we think we have some good things going on in the fourth quarter. You know, last year we spent a lot of time talking about a variable comp. So it's always something that is a variable on the fourth quarter as well as you see how the year is progressing. That's when you're typically adjusting all of those types of things. So I really don't want to be any more specific about the fourth quarter than we already have been, other than say margin rates ought to be much, they ought to be better in this year's fourth quarter.

Connie Maneaty - BMO Capital Markets

I guess another way to look at it or to think about it is as you go through this year with all of the -- part of the commodity cycle run through or the, you know, the unusual commodity cycle run through, will 2010 then represent what we should think of as a normal year in terms of delayed sales fall in the way the costs fall?

Mark Baker

Yes, I mean that's a pretty broad statement. I think we are going to talk next week about some broader long-term expectations, but I do think that when you look at the back half of the year, that's going to be more representative of what we believe the business has been long-term from margin rate perspective, and I think this is a first year too, where -- five years we haven’t taken a pricing of any substance. See you've also got a year now where it flowed more naturally without that distortion. So you know, I think you can start piecing together a little more a longer term puzzle with those facts.

Connie Maneaty - BMO Capital Markets

Okay. Just a separate question on the sales increase in US consumer in the first quarter, can you break down what percentage of sales went to fall gardening and what relates to the early start in some markets for retail selling?

Jim Hagedorn

I will just take a stab at it. Generally you know the retailers buying in the first quarter this year, buying into fill in based on the fewer sales that they had from a very strong first quarter results, and that because it wasn’t a price increase, it wasn’t a whole bunch of if you will loaning going in on the December period. So I feel like it's got a good run rate with the maybe small exception in some of these very southern markets where there were some promotions planned for January and February, but large majority of it was built on good south sales.

Connie Maneaty - BMO Capital Markets

Okay. Thanks.

Barry Sanders

Hi Connie, this is Barry, and we'll clarify those numbers in a couple of weeks, but roughly speaking, two-thirds of the POS for the quarter was October, and about half of the sales. And so you got timing. All the December shipments were primarily getting ready for the season versus the October. So I think that's roughly the way, half and a half.

Connie Maneaty - BMO Capital Markets

Okay, great. Thanks very much.

Operator

There are no other questions. With that, I would like to turn the call back over to Jim King.

Jim King

Thanks Ashley. Thanks everybody for joining us here this morning, and again a reminder that if you want to join us in Boca on February 17th, please let us know over the next several days. Again you can e-mail us at investor@scotts.com or contact Ashley Gullion at 937-578-5217. With that we'll wrap things up and we'll see you all in a couple of weeks. Thanks. Have a great day.

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Source: The Scotts Miracle-Gro Company F1Q10 (Qtr End 01/02/10) Earnings Call Transcript
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