Scotts' Reduced Cash Flow Guidance, CFO Change Increase Uncertainty for the Dividend

On August 31, Scotts lowered its full-year free cash flow guidance and named David Evans as CFO on an interim basis.

Mr. Evans serves on Scotts' board of directors and worked as the firm's CFO from 2006 to 2013. He spoke at an investor conference last week to provide more color on Scotts' guidance and turnaround.

Scotts now expects full-year free cash flow to range from negative $325 million to negative $275 million, down from a prior forecast of negative $150 million.

Mr. Evans attributed the shortfall to a forecasting error made with "a forward-looking model" that did not properly reflect unique relationships (e.g. Scotts' major build in inventory earlier this year) between several different balance sheet accounts.

This has nothing to do with Scotts' historical financial statements or internal controls, according to Mr. Evans. But it is not a timing issue either – the $150 million or so incremental cash flow deficit is real and will not reverse next year.

For context, that is equivalent to one year's worth of dividends.

While Scotts reaffirmed the other components of its full-year guidance, every dollar of cash flow matters as the company works to restore its balance sheet.

The firm's leverage ratio (i.e. debt-to-EBITDA) is now expected to top 6.0x at fiscal year-end, well above Scotts' long-term target closer to 3.0x to 3.5x.

While Scotts remains in compliance with its debt covenants, which include a maximum leverage ratio of 6.5x, Mr. Evans expressed urgency to "reduce debt more quickly" and noted several times that his job is "to look at everything" with a fresh perspective.

Scotts has paid dividends without interruption since 2005. But a fresh set of eyes in the CFO role, increased motivation to restore the balance sheet as soon as possible, and a material reduction to free cash flow guidance widen the range of outcomes facing the dividend.

As a result, we are downgrading Scotts' Dividend Safety Score from Safe to Borderline Safe.

There is now a chance management decides to significantly reduce or even temporarily suspend the dividend later this year to maximize Scotts' ability to pay down debt.

But Mr. Evans also shares our belief that the issues weighing on Scotts are temporal in nature.

Excess inventory will get cleared. Weather conditions will normalize. The cannabis market will eventually rebalance. Costs will be cut. Margins will improve in the next couple of years. And Scotts lawn and garden products (two-thirds of sales) will remain in high demand.

Scotts can support its current dividend level whenever business conditions normalize, and an improvement in earnings is the fastest and most powerful way to address leverage.

Free cash flow is expected to cover the dividend next fiscal year as excess inventory is sold, but the dividend's safety increasingly hinges on how aggressively Scotts wants to pay down debt while waiting for profits to rebound.

If we owned shares of Scotts, we would probably continue holding with expectations that the challenges impacting the business could take several years to lift fully.

Should a dividend cut materialize, shares of Scotts could face even more pressure. While we shy away from most stocks cutting their dividends, this could prove to be a buying opportunity given our view that Scotts has a stable long-term outlook and strengthening balance sheet.

Value could also be unlocked in the future if Scotts separates its branded consumer products from its cannabis-focused Hawthorne subsidiary, which generates much more volatile cash flow but has brighter long-term growth prospects.

Overall, we think Scotts remains a good business with fixable, short-term problems. The most recent developments have created some uncertainty for the dividend, with the next payout historically declared in early November.

We will continue monitoring Scotts' turnaround and provide updates as needed.