Good day and welcome to the Q4, 2022 Scotts Miracle-Gro Company Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask a question. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Kelly Berry. Please go ahead.

Good morning, everyone. Welcome to The Scotts Miracle-Gro fourth quarter earnings conference call. Today's comments from Jim and Dave have been prerecorded. After their comments, we'll take your questions. I want to remind everyone that our comments today will include forward-looking statements. And so our actual results could differ materially from what we discussed. I'd refer you to our Form 10-K, which is filed with the Securities and Exchange Commission so that you may familiarize yourself with the full range of risk factors that could impact our results. This call is being recorded, and an archived version of the call will be stored on the Investor Relations portion of our corporate website scottsmiraclegro.com We have a lot of ground to cover, so I'll turn the call over to Jim Hagedorn to begin. Jim?

Thanks, Kelly. And good morning, everyone. I don't think I have to revisit everything we faced this past fiscal year or in the previous two, we're an unusual times. During the pandemic, we responded to the unprecedented challenges with winning strategies to manage all the craziness that came with it. We did so by delivering record results. Now we're in the aftermath of the peak COVID years facing record inflation, supply chain disruption, war in Ukraine, and a steep downturn in the cannabis industry. It's a messy situation. But here's what I know. We get it and the leadership team is on it. We have our organization headed in the right direction. My confidence stems from the work we did in the back half of fiscal '22 to improve our cost structure. It also is grounded in their plans for '23. If there is doubt about our willingness to take bold and decisive steps to orient our company to the realities of today, I can assure you we're doing what's necessary to reduce debt and restore acceptable levels of profitability. I'm optimistic we will remain within the bounds of our bank covenants. I know you're looking for guidance, Dave Evans will explain how we see the year shaping up in the U.S. consumer and Hawthorne segments. Were focused on hitting EBITDA and free cash flow targets. In fact, our management incentive program for fiscal '23 is based on leverage related metrics. For fiscal '22, we finished six times a debt to EBITDA, we're comfortable with our leverage trajectory to remain compliant for the first six months and have a clear path into the fours by the end of the fiscal year. The personal goal of mine and Michael Lukemire is to get to 4.5%. This will position us to move…

Thanks, Jim. I'll take a deeper dive into the P&L and balance sheet for fiscal '22 and provide direction for fiscal '23. As you likely know, this is my second time stepping into the CFO role at Scott's. My previous experiences is in relationships have allowed me to hit the ground running. It's clearly been a challenging time for the business. But over the past two months I've been here, it's been inspiring to see the commitment and dedication of our associates. I understand that predictability and credibility and our financial projections are important drivers for market performance are repeated changes to guidance in fiscal '22 in the late summer correction to free cash flow primarily resulted from the unexpected and sudden volatility in the U.S. consumer market and the pace in which we reacted, driving down costs and implementing operational changes. We're bringing more rigor to our sales and cash flow forecasting and improving processes to better translate changes in operational assumptions, balance sheet forecasts. This is imperative when running in strain manner. We can now better assess our position at an early stage and respond in a swift and coordinated manner. Moving on to results, U.S. consumer sales were down 18% for the quarter, ending the year down 8%. This was in-line with our fiscal year guidance of down 8% to 9%. I'll spend a few moments on this, if it's particularly important context for fiscal '23. The 8% decline in fiscal '22 sales was driven by a 15% decline in volume and mix offset by a 7% benefit from year-over-year pricing. The 15% decline related to volume and mix is a function of unifying declines across most categories. The most pronounced and our most weather sensitive categories, lawn fertilizers, and grass seed. It also reflects a challenging…

Certainly. We will now begin the question-and-answer session. [Operator Instructions] And our first question comes from William Reuter with Bank of America.

Good morning. My first question is with regard to inventory levels at retail and preseason orders. I know last year, we came into the year heavy. Can you give us a little more color on where they are right now? And I think last time you've been -- last quarter, you've been optimistic that since POS was pretty decent that we'd have a pretty preseason order, did that shake out how you expected it to?

This is Mike Lukemire. The preseason order is pretty well fixed to about the same level of build as we did in the previous year. So it's really not POS based. It's really about being ready for the season to break. So we look at the same levels of shipments basically as we saw last year.

But I'd say we came out of the year, Bill, down slightly. So I would call it a tailwind on inventory. And I think a pretty significant commitment to next year and that build has already started. So I think sort of in line with what we wanted and non-inventory problem exiting the year, if that answers the question.

It does. And then one follow-up. With regard to your input costs, it seems like some of them have come down, some remain relatively elevated you just pushed through a relatively large price increase. Historically, I know you guys didn't do a lot of price increases. Do you feel like the environment is such that if your input costs did rise throughout the season that you would have the ability to go back to retailers with subsequent price increases?

Look, I'll sort of take the beginning and then see who -- if anybody wants to add to it. So Hagedorn here. First, the answer is yes. And so that's the big headline. And it is true that we have not done -- I think maybe in my entire time here, it's a one time other that we took in season pricing and I don't think we've ever taken more than two increases during a seasonal year. I think that -- listen, I'm not into the self-criticism exactly, except that I think we've been pretty decent at covering our sort of dollar costs. The problem is that's been pretty diluted to our margin over the call of last year plus. And -- so I think we're still, there was a good article last couple days in the Times just about large branded companies and sort of trying to remedy sort of similar issues where they've gotten behind on margin. What's clear to me is that, gross margin is our fuel, we need it. We are a consumer branded company. And, we need that for our own activation efforts plus, we help the retailers fund their efforts. And so when we get behind on it, like we've done, I think it's pretty bad. Now, on the other side of that, I've talked to most of our large retailers in the last week at the very senior level, so either the CEO, and or the merchant teams. I think there is a concern, and I don't mean this in a bad way. I just means that nobody really knows what to expect from the consumer and the level of sensitivity to pricing. And I think this is the great question going into '23, not just for us but for other branded good…

No, Jim, I think you just stated perfectly right? Nothing more than --

I would agree with that. So.

Perfect. Very helpful. Thanks for taking the questions as always.

Thank you, sir.

Our next question comes from Jeff Zekauskas with JP Morgan.

Thanks very much. Just three brief questions. Your deferred taxes were I don't know negative $183 million this year. Why is that? And what might they be next year? Second, do you have to drop your production roughly by 10% next year to hit your inventory targets? And then lastly, can you analyze your increase in interest expense of $40 million that you forecast? And if you do break your covenants, what happens to incrementally interest expense?

All right, let me start here, reverse. Let me -- so defer taxes grew a bit this year. You'll see our effective tax rate was also kind of unusually low this year. The biggest single factor driving the change in deferred taxes was the impairments that we took this year. So clearly, as we begin a new year, we're not anticipating warrant impairments. So I wouldn't anticipate a similar type of change in the balance sheet next year on our deferred taxes. The second question was on production. Yeah, so we are targeting a minimum of $40 million reduction in inventory this year. And that will be driving a reduction in our production forecasts. And the reduction in the order magnitude of 15%. So you really got to look by -- you have to make a really super broad number. You have to look at it and understand it for each major product category, because the percentage of fixed costs is different whether you're looking at our own fertilizers or growing media it's a whole different type of model. But broadly to answer your question about a 15% reduction. A third question on interest expense. Yes, so interest expenses is up significantly from '21 to '22. We see a further increase from '22 to '23, principally rate driven. On a year-over-year basis, we would expect her average debt to be down in September 30 '23, relative to '22. So, it is principally rate driven. As we said in our scripts, we anticipate, given the broad array of assumptions that we've made, that our EBITDA and debt levels will allow us to navigate the covenants throughout the year. But I would also say that we're not -- and we are prepared that if changes would occur during the year, we also won't be caught flat footed. Does that answer your questions?

So if the covenants were broken, what would that do to your interest expense?

Well, that we're driving down.

Yeah. And we're going on the basis that we're not going to break the covenant. Because we've got a plan that either. We believe our plan will result in that. And should -- we should we find ourselves down the road. Then we're readily prepared to ensure we don't break the covenants by taking other actions.

You said that you generate about $1 billion in free cash flow over the next two years? Can we do a split? What's in '23 and what's in '24 any rough talks ?

Yeah, we're really not. Look, I'm going to be fairly precise on this. Because there's so many changes in variables. But I'd say what you'll see is that $1 billion clearly will be front loaded to '23, because a good portion of $1 billion relates to inventory reduction. So provided, we achieve our operating plan with the sales and production plans that we have today, we would see a large majority of that happened this fiscal year.

Thank you very much.

Our next question comes from Carla Casella with JPMorgan.

Thank you, Bill and Jeff asked a couple of my questions already, specifically on that cash flow. But have you said how much of the $1 billion cash flow is from the working capital release alone? And is it mostly just inventory or do you see a significant increase from the payables as well?

We look over a period of two years, we think anywhere from 40% to up to 50% of the $1 billion could come from inventory reduction. We'd really anticipate working capital to move fairly in line with our volume.

Okay, great. So the second third quarter then waited as well.

For certain we would see our inventory. Look, we'll start to see a decline in Q2, but then we should really see a big decline in inventory in Q3, and then Q4. You're going to see any meaningful change in inventory from September 30 to December 31 as we prepare for the season.

Okay, great. And then you did that sale leaseback at Hawthorne. And you mentioned it sounds like you're not looking to do asset sales right now, but you could consider in the future. So just wondering, can you give us a sense for what are your kind of the biggest chunks of assets that you could look to if you need to in the future?

Yeah, Carla great question. And I would say that, we've done a fairly exhaustive review of our assets to try to identify potential opportunities. And here the sale leaseback was actually executed in a late summer months. So that was actually a facility that we aimed to get out of in kind of near to midterm anyways. So what we effectively were able to do through the sale leaseback is accelerate the cash benefit to move that to today. In general, we're not on a broad brush basis looking to kind of sell and just refinance our assets that are core to our business. This was kind of a different situation. We are looking at other assets that are core to our business. And we've taken some other modest actions to divest those, but nothing that's individually significant. We've talked in the past about other assets that we have. And I just give you the assurance that management and the board are looking at all those things that commonly come up our Hawthorne, Bonnie Plants. And I would just say that, as a team, we feel very committed to those assets at this point. We feel that they're critical to our strategic vision for the future. And we also feel that when we're going to looked at the amount of value that we could get in today's market, and the speed with which we can monetize them, really didn't make them attractive opportunities for rapidly delivering our balance sheet. So, I think the message is twofold. One, we did an exhaustive review. And two the conclusion that is, at this point today, we don't see any big items. We're looking at smaller items.

Okay, and then so do you own aside from those broader like brand assets do you own most of your any of your distribution warehousing manufacturing facilities that might be to like available for sale leaseback?

A differentiate distribution is primarily a wholly leased. Manufacturing is, look, we contract produced some of our some of our items that the vast majority we produce. And what we produce its own right.

Okay, great. And then if I can just to follow up on, you talked about fixed costs and low about fixed costs, leveraging and deleverage. Can you talk about what -- how you look at this now, what percentage of costs are fixed? Or I mean, given this, so many of the other costs of moving around giving commodity inputs? Maybe is there a way to look at dollar amount of costs that are fixed? There get a sense of versus to compare, versus $85 million in savings expects to generate this year from Project Springboard?

Yeah, just like in broad strokes, I would say in the near term, 30% to 35% of our production asset of our manufacturing and distribution costs are fixed. Okay. But that's a very near term look, because through Springboard, we're looking at effectively, we're testing everything as if it were variable. And we're attacking these items. And in part, that's why some of our Springboard savings won't even be realized entirely in '23, because to the extent that we're addressing these near term fixed costs is longer term variable costs. We are resizing that supply chain footprint and reducing some of those costs.

Does that answer your question, Carla?

Yeah, that's helped. Thank you. And then just to 35 production, manufacturing distribution and fixed that's mostly then cost of goods sold?

Yes, it would be embedded within our cost of goods sold. So that is like our manufacturing facilities would be an example of that.

Okay. Great. Thank you.

Our next question comes from Eric Bosshard with Cleveland Research.

Good morning.

Hi, Eric.

Hi. Two things that I could. First of all the 5% EBITDA, growth guidance for '23. I'm just trying to understand sort of what the key pressure points are the key drivers to support that. Dave, you're pretty clear about the 15% production cut. And there's obviously also higher costs still embedded in inventory that you're working through. I understand Springboard on the other side provides benefit to this. I guess as I look through it to the consumer demand, your guidance on sales and price seem like those are the key variables of achieving that 5% EBITDA growth. Is that the right way to think about that, or how do you think about the key achievements in getting into that 5% EBIT da growth guidance for '23?

I'll start and hand it over to Dave. I think that the sales assumptions and the Springboard savings are probably the things that are what are being worked. The assumptions in sales, at least, I think from our point of view, and again I've talked this through with retailers. We just looked at last year, Eric is being just a pretty tough year. We had a approach on our advertising as I think most people are aware that not to do the sort of heavy early season like we're going to be doing this coming year. And work more, when the weather is good. We spend the advertising we activate and we do this all based on sort of two weeks ahead kind of look at the world, which was a much more real time approach to sort of promotion at the retail level. I was having a conversation with a retailer last night. And it was if we're sniping, kind of and how we marketed previously, it felt like we came home with not having hitting any bad guys. And with all of our ammo still in our sort of containers. We just didn't get clean shots last year. And that was California, Texas, again, this is so easily checked that I don't think I'm saying anything that most people don't know. Texas was very cold, kind of until it wasn't. The Midwest and Northeast a Polar Vortex sort of was unforecasted hit us and sort of late March and didn't really warm until toward the end of April. So when we look at the forecast and we say flat to last year, and we get half of the decline back and lawns, which we think was like their core season was really how important the Midwest Northeast is…

Look, so I think in the end here, I mean, I think the team has built tremendous plans to give us confidence and the top-line for next year. But as a CFO, I'm saying, yeah, but I want to have some hedge against this. And so I go back to Springboard is kind of our insurance policy. And I'd say Springboard is we're doing the right thing for the business to exit this cycle, as a stronger, better leaner company. But it's also getting us more insurance. And I just want to emphasize, I've been extremely tough on the team here, with Springboard, that Eric, Springboard savings, they're real, you will see them on our P&L. If you look at the $100 million that we took and Springboard 1.0, and you look at the '21 P&L to '23 P&L, you'll find those, this isn't just some offsetting inflation, kind of minimizing the rate of increase. These are real reductions. At the same time, I'd say what we're committing to the next $85 million of which we're well along, but we still have work to do. Those are real savings. And so that to me, takes a little bit of a herd edge off of if we're just slightly off on the top-line, because of this uncertainty, we've got some insurance against that. And that's why specifically not providing detailed guidance on sales margin SG&A because we're going to manage down to EBITDA. And we're going to take out insurance where we're going to be able to offset some risks if they in fact do come.

Okay, can you just square for me, you talked about a conservative forecast. Can you talk about the consumer that's apprehensive. And then the guidance assumes, I think seven points of pricing U.S. consumer in '22 and another seven to nine in '23. It seems like the pricing assumption for an apprehensive consumer is optimistic. Tell me your perspective on math if you want?

What do I think? I didn't know this question would come from you. But like, I feared in the shower this morning, it would come from someone. And I can tell you last night was a really great night for me. I got out of this place I went and visited with the very senior members of one of our most important retail partners. The apprehension for sure is there. And I think you can read it anywhere you want. But nobody knows the answer to that. We took pricing in last summer. I think that's our only tranche of pricing. I think you're saying when this show up, products will be more expensive, but I think products are more expensive. Anywhere you go. And that's really the issue, which not just us. The problem with our pricing, Eric is, we've covered our dollars pretty well. It has been pretty significantly elusive after all this time on our margin rate. And for sure, products are more expensive. And they are with everything, a cup of coffee, a gallon of gasoline, a kilowatt hour of electricity, natural gas, I don't care what it is. That's the world we're living in. We didn't take enough pricing to cover our margin percent. And so should everybody be nervous about it, I guess. But that's really the world we're in. And we're not unique there. Does involve some, I think moderate risk. Yes. We're going to be promoting significantly harder. We're going into next season, we are going to be from emotionally levered with our retail partners. And so people will get value relative to sort of sticker price. Lots of things are happening that I think will sort of offset that. And I think we look at this and say, somebody buys a bag of fertilizer, and it's a couple of bucks more expensive. Is that enough to not do it? We did not see a shift to private label. And, Dave is writing me a note, just throw it out there, eight to 10, which is during the last recessionary period, people were driven toward cheaper home improvement projects relative to cabinetry and appliances, and all the other expensive projects people could do. So, look, I think we have a reasonable history to look back up. I think we look at our products and say, when people buy something once or twice a year, does it -- it's more expensive. Is it enough not to buy it? I don't think we have history on that. But we're going to know, sort of seven-eight months from now.

Okay, fair enough. That's fair enough. I understand that. Last, just housekeeping item for Dave. The EBITDA growth, is that pretty consistent through the year in order to sustain the leverage ratio where you are now? Or is it more back half loaded?

Do you mean the delta between operating income and EBITDA or?

I mean, I assume that sustain the 6x leverage you're at now through the year, especially through the first half were leveraged normally increases, and currently it won't this year. The map I think, suggests that the EBITDA growth quarter to quarter has to be consistent each quarter has to show some degree of EBITDA growth. Am I thinking about that right? Or am I missing something?

Eric, you're looking at a way? I'm not sure I can answer that live on this call here. I'm just I just kind of looked at it that way. I can just tell you that EBITDA growth that we've built in our plan is, we're not presenting a plan that says we're going to be in default. I mean, we're not presenting a plan that says we will be in compliance.

But I also don't think we're saying it stays at 6x either. I think it stays within 6.25 and 6.5 limits that we have with our bank.

Yeah, that's exactly right. So look, it's kind of it's going to hang north of six around six until we get to the third quarter of the season. And I'll just remind you that our leverage covenant goes up to 6.5 starting next quarter. So we'll get a little bit more room here in Q2 goes to 6.5. So that's the answer.

Okay. Thank you. Thank you.

Our next question comes from Chris Carey with Wells Fargo.

Hi. Just quick ones, for me. Is the POS number that you put out there flat, is that a volume number? Or is that a value number? And then I can't quite tell are you basically saying POS flat and you'll see how inventory shake out. You can't really predict that from a shipment standpoint. Thanks.

Yeah, Chris. let me try to answer that. If you're talking about '23 when Jim refer to in the script flat or plus 10 and for [indiscernible] he's referring to POS. And it's POS units. Okay. So then -- if you go back and kind of read my script again, I was trying to kind of translate from POS units to our sales by that incorporating in assumptions regarding retail inventory and pricing, the other elements of that. Does that answer your question, Chris?

Operator?

Excuse me, Chris Carey, you may proceed.

Chris, you still there?

All right. Next question, please.

This concludes our question-and-answer session. I would like to turn the conference back over to Kelly Berry for any closing remarks.

Thanks, Priscilla. And thanks, everyone, for joining us today. I know we didn't get to some of your questions. So please feel free to call me directly or email me in the coming days and we'll get to you. Have a great day.

The conference has no conclude. Thank you for attending today's presentation. You may now disconnect.