1 Cannabis Stock With Leading Consumer Brands to Watch in 2019

Check out the latest Scotts Miracle-Gro earnings call transcript.

For better or for worse, Scotts Miracle-Gro (SMG -1.25%) has been labeled as a marijuana stock. That association worked out for the better leading up to fiscal 2018. The company's Hawthorne segment, which sells hydroponics, lighting, and other equipment used to cultivate cannabis, was growing revenue and operating income at a triple-digit clip each year. Wall Street took notice and handed the company a healthy premium.

In the last year, the association with the marijuana industry has not worked out quite so well. The Hawthorne segment saw year-over-year revenue slip 27% in fiscal 2018 when the benefit from $600 million worth of acquisitions is excluded. It reported an operating loss for the year. The disappointing performance was a significant factor contributing to Scotts Miracle-Gro shares losing 42% of their value last year. 

Despite the recent hiccups, individual investors may find it easier to be patient with Scotts Miracle-Gro than Wall Street analysts. Why? The company's portfolio of leading consumer lawn and garden brands, which generated 79% of total revenue and 98.9% of total segment operating income in fiscal 2018, are the overlooked financial engine of the business.

Image source: Getty Images.

Stable, mature market providing strong cash flow

It's not that Hawthorne is unimportant to the long-term value for Scotts Miracle-Gro. It's just that the marijuana narrative hanging over the company has become a little detached from reality. Management currently views the Hawthorne segment as an adjacent, high-growth opportunity that compliments the consumer brands in the lawn and garden market. The results from the last three fiscal years supports that perspective: 

Data source: SEC filing.

While the consumer segment had an off year in fiscal 2018, the table above shows it was hardly catastrophic and continues to deliver consistently strong operating cash flow. The only blemish last year was the fact that a stubborn winter led to a late start for the U.S. gardening season, which meant sales in mid-April were 15% lower than the same period of the previous year. However, the segment stormed back to just below normal purchasing activity by mid-June and finished the year with revenue that was only 2% lower than in 2017. 

The consumer segment's swift recovery was made possible by the company's leadership position. Scotts Miracle-Gro is responsible for roughly 85% of the lawn and garden industry's advertising spend in the United States, with one-third of that now parked in digital media. Meanwhile, it's the only company on the planet that funds research and development in the consumer lawn and garden space. 

Taken together, that ensures the business maintains its relevance with customers and keeps a steady pipeline of new product formulations to launch within its market-leading brands, which include Scotts (lawn fertilizers and grass seeds), Miracle-Gro (plant nutrients and soils), Roundup (weed control), Ortho (weed and insect control), and Tomcat (rodent control). The strategy has proven successful: Products launched on the market in the last three years accounted for 15% of total revenue in fiscal 2018. That's more than Hawthorne. 

Image source: Getty Images.

Returning to growth in 2019

New product launches will continue in 2019. This year, Scotts Miracle-Gro will be focused on the successful launch of its best-in-class organic fertilizer product, a high-margin product that has a shot at beating the segment's typical operating margin of 20%. While it won't have a significant impact on the overall business in its first year on the market, management expects a solid year ahead due to strong all-around operations.

The company's full-year fiscal 2019 guidance calls for sales growth in the neighborhood of 10% compared to last year, with the consumer segment responsible for 1% to 2% and Hawthorne responsible for nearly 9%. Management expects inventory decisions from retailers to provide some headwinds for the consumer segment, while certain litigation settlements and a 6% increase in selling, general, and administration expense will drag down operating cash flow to around $295 million. That's lower than the level of cash flow achieved in 2017 or 2018 but much higher than levels achieved in preceding years. 

Cannabis provides upside, but the core provides stability

Investors will be looking forward to the return to growth this year following a rough 2018 -- or they should be. After shares dropped 42% last year, Scotts Miracle-Gro stock trades at just 14.4 times future earnings (near a multiyear low) and boasts a dividend yield of about 3.3% (an all-time high). Investors with more patience than the typical Wall Street analyst may see a long-term opportunity to tap into the upside of the marijuana industry, all while reaping the benefits of the leading consumer lawn and garden brands in the United States.