The Impact of Cannabis on Scotts Miracle-Gro

We recently wrote about how cannabis stocks have been crashing as the industry constituents start to back out of deals citing lofty valuations in an industry that contains an abnormally large amount of risk in the first place. One way to mitigate all this risk is through diversification, and we talked about the two biggest ETFs out there for playing the cannabis theme: the Horizons Marijuana Life Sciences Index ETF (HMMJ:CN) and the ETFMG Alternative Harvest ETF (MJ). When looking at the constituents for HMMJ, we noted that the best performing stock in the top-ten constituents happens to be a $6 billion fertilizer company called Scotts Miracle-Gro (SMG). We want to understand how much the growth of cannabis has impacted this performance in light of other growth trends like indoor farming. Before we do anything, let’s detail the cannabis thesis a bit more.

The Cannabis Thesis

Before the advent of high-tech cannabis grow boxes, you might have simply just used an empty closet along with some soil, some ventilation, some grow lights, and some fertilizer. The biggest capital expense would probably be the lighting setup. If you opted to grow hydroponically (growing plants in water instead of soil), then your biggest expense would be the hydroponics equipment. The investment thesis here is that the legalization of cannabis will result in an increased demand for the materials required to grow indoor cannabis.

In a recent article, we talked about how KEY Investment Partners favors startups that aren’t “plant touching businesses.” Also called “ancillary cannabis businesses,” these are startups with business models that mimic other legitimate companies. In the case of Scotts Miracle-Gro, they’re a legitimate business that supplies the cannabis industry with the tools needed to grow the plants. While 2012 was the year that cannabis was legalized for recreational use in both Colorado and Washington, it’s been legal for much longer than that in Canada. Even prior to legalization, black market growers would still have been buying hydroponic equipment, lights, and fertilizers.

For the same reason that KEY Investment Partners distances themselves from “plant touching businesses,” companies that operate ancillary cannabis businesses make it a point to distance themselves from cannabis by focusing on the broader category of “indoor farming.” One such company is Scotts Miracle-Gro (SMG).

Scotts Miracle-Gro

A Volatile Past

Click for company websiteWith a present-day market cap of around $6 billion, Scotts Miracle-Gro has been around since the 1800s, selling things like lawn care products and pest control solutions. While they’ve been involved in their share of controversies, they’re a successful company in that they’ve managed to survive for so long. (As they teach you in business school, the number one thing any company should be concerned with is survival.) In the past five years, the company’s share price has been extremely volatile:

5-year stock price performance for SMG – Credit: Bloomberg

An article by the Motley Fool explains this volatility as being a result of “a lingering winter, which delayed the start of gardening season,” and the hydroponics segment which saw “year-over-year revenue growth slow,” along with “a surprising loss in fiscal 2018.” (More on these two segments shortly.) Looking at the 10-year performance of the stock (+169%), it does manage to beat the broader benchmark return of the exchange it trades on – the NYSE – which returned +98% over the same time frame. (Bear in mind, we’ve now entered the longest bull market the markets have ever seen.) Past performance is not indicative of future results, but it’s good to know that SMG has been performing well for investors.

Now, let’s look at how the company is exposed to the cannabis investment thesis.

Mentions of Cannabis

Search the company’s 2019 Annual Report for the word cannabis and you will find a small section under “risks” which simply says that end users may purchase their products to grow cannabis and this segment “may not grow or achieve market acceptance in a manner that we can predict.” It goes on to say:

Our gardening products, including our hydroponic gardening products, are multi-purpose products designed and intended for growing a wide range of plants and are generally purchased from retailers by end users who may grow any variety of plants, including cannabis.

In other words, they don’t have any insights into how much of their growth is related specifically to cannabis, but they do acknowledge that growth will impact their revenues. Consequently, we’re better off understanding what percentage of their revenues can be attributed to indoor farming in general.

Three Reporting Segments

SMG breaks down their revenues into three main reporting segments:

  • U.S. Consumer – consists of our consumer lawn and garden business located in the geographic United States
  • Hawthorne – consists of our indoor, urban and hydroponic gardening business
  • Other – consists of our consumer lawn and garden business in geographies other than the United States and our product sales to commercial nurseries, greenhouses and other professional customers.

The first thing we want to look at is the revenue breakdowns and growth across these segments. Here you go:

One way to express the growth of the Hawthorne segment is to look at what percentage of total revenues it constitutes over time. Here’s what that looks like:

  • 2017 – 11%
  • 2018 – 13%
  • 2019 – 21%

About a fifth of SMG’s revenues could be attributed to the growth of cannabis and indoor farming. That’s a meaningful number that’s growing over time, and that growth is happening organically and through acquisitions. Beginning in fiscal 2015, the Hawthorne segment made a series of key acquisitions, including General Hydroponics, Gavita, Botanicare, Vermicrop, Agrolux, Can-Filters, and AeroGrow. In June of 2018, Hawthorne acquired Sunlight Supply, previously “the largest distributor of hydroponic products in the United States.” It’s clear that they’re building this business to offset the stagnant growth of the U.S. Consumer segment – which just so happens to be very profitable.

In the above table, we see how the U.S. Consumer segment is the low-growth cash cow that fuels the high-growth Hawthorne segment which will eventually become a cash cow that fuels the next high-growth segment that comes along. Incidentally, SMG’s top five retail partners – Ace Hardware, Lowe’s, Costco, The Home Depot, and Walmart – together accounted for 80% of their fiscal net sales.

If we enter a recession and consumer spending drops, both segments could be affected as people become less obsessed about having the best lawn in the neighborhood and professional growers reduce their production and consumption of consumables in the face of a decrease in demand for recreational cannabis.

Scotts Miracle-Gro is building a dominant position as a supplier of indoor growing equipment and consumables which benefits from the growth of cannabis and indoor farming. The success they’re seeing in the growth of hydroponics is also being shared by other companies selling similar products. We decided to meet with one of these companies, a lesser-known New Zealand company called Bluelab, to see if they could provide us with some color around the impact of cannabis on their business.

New Zealand’s Bluelab

Click for company websiteDuring our recent exploration of New Zealand’s exciting agtech industry, we came across a company called Bluelab that’s been selling their wide range of indoor farming products across the globe. We traveled to their office in Tauranga and sat down with the Head of Innovation & Strategy at Bluelab, Jono Jones, who walked us through the company’s rapid growth and how they bring innovation to the front of that. Like Scotts Miracle-Gro, Bluelab uses their cash cow – in this case, their entire business – to fund future growth through innovation. One example of innovation was the Pulse product Mr. Jones showed us which solves a real pain point for farmers who use potted plants.

In order to gauge the moisture levels in a potted plant, the traditional way has been the old “finger, kick, or lift.” Each of these ways involves a human making a quick decision as to how much moisture is contained within a potted plant. Getting this wrong can have a major impact on the health of your plants. As for guessing nutrients, the method used to involve sampling 150 plants out of a million and making decisions based on that. Today, it’s as simple as using a single device that uploads all the results into the cloud.

Bluelab Pulse
Bluelab Pulse – Credit: Bluelab

3D printing was used to prototype the device, and machine learning algorithms are used to make the measurements more accurate. It’s a great example of how innovation and technology can drive down costs for indoor farmers which makes their products more affordable.

Innovation at Bluelab is being driven by the rapid growth in sales of their products with 99% of all sales coming from international customers. Mr. Jones sees indoor farming falling into a number of categories. What we read about in the news are widely marketed success stories which involve tech companies growing crops. The middle ground is made up of smaller enterprises that have looked at the potential of indoor farming and believe that it’s economically viable. As for cannabis, the company wasn’t overly keen to discuss how it impacts their business for a number of reasons, mainly that they don’t particularly have – or even want to have – visibility into the extent their products are being used to grow a plant that remains illegal at a federal level in the United States, a place where they recently opened up an office. Bluelab seemed like a great example of the type of bolt-on acquisition that Scotts Miracle-Gro might look at for future growth.

Conclusion

In a past article on the growth of indoor farming, we looked at 11 Indoor Farming Companies Taking Agriculture Indoors that have collectively taken in nearly $1 billion in funding. All of these companies are focused on displacing traditional farming with more environmentally friendly methods of food production. And there’s a price premium associated with that. In our article on The Economics of Container Farming in Nauru, we looked at how indoor farming produce isn’t economical at a smaller scale. When a recession hits, people will be less likely to buy overpriced “farm to table” greens from supermarkets or restaurants. Perhaps by that point in time, indoor farming at scale will be producing cheaper products than what’s being shipped in from farms and SMG will continue to flourish.

For retail investors who are trying to understand the impact of cannabis on a stock like Scott’s Miracle-Gro, it’s tough. When all the capital spending in the cannabis industry dries up because we encounter an over-production problem like Canada has, then that will have a direct impact on companies that were benefiting from all those capital expenditures. The question still remains as to how much that potential impact could be.

Here at Nanalyze, we hold the lion's share of our investing dollars in a portfolio of 30 dividend growth stocks. Find out which ones in the Quantigence Dividend Growth Investing report freely available to Nanalyze Premium subscribers.

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