The Scotts Miracle-Gro - Earnings Call - Q3 2011
August 8, 2011
Transcript
Speaker 5
Good morning. My name is Ashley, and I'll be your conference operator today. At this time, I would like to welcome everyone to the third quarter 2011 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Mr. King, you may begin your conference.
Speaker 2
Thank you, Ashley. Good morning, everyone, and welcome to the Scotts Miracle-Gro third quarter conference call. With me today are Jim Hagedorn, our Chairman and CEO, as well as Dave Evans, our Chief Financial Officer. Jim will start with a review of the current state of the business and also provide some early thoughts about fiscal 2012. Dave will walk through the financials and update our four-year outlook. After they've prepared remarks, Jim and Dave and other members of the management team will take your questions. In the interest of time, we ask that you have one question and one follow-up. If you have unanswered questions afterwards, I'm glad to spend one-on-one time with you. With that, I want to move on to today's call and remind everyone that our comments today 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with the Securities and Exchange Commission, or our most recent 10-Q. As a reminder, the call is being recorded, and an archived version of the call will be available on our website. If we make any comments related to non-GAAP financial measures not covered in the press release, we will provide those items on the website as well. With that, let me turn the call over to Jim Hagedorn to discuss our performance.
Speaker 3
Thanks, Jim. Good morning, everybody. I know we have a lot of ground to cover this morning: our third quarter performance, our full-year outlook, and our early thoughts about 2012. Before I address any of those points, I want to make some opening comments. I'm not going to sugarcoat the reality of the season. It's been disappointing, to say the least. Some seasons bring good weather, and some seasons bring challenging weather, but in my entire career, I'm not sure I remember a season quite like this. Setting weather aside, competitive issues also impacted the business this year, especially in the mass merchant channel. Frankly, we've also made our own share of mistakes. I'll elaborate on all of these shortly. Whatever the reason, the results were not what we had planned. We revised our full-year guidance and now expect adjusted earnings of $2.95 to $3.05 a share.
By no means am I suggesting you dismiss our results this year. However, I'm also not sure there's much benefit to overanalyzing them. I'll give you my straightforward assessment in a few minutes, and then Dave will provide some additional details. Let me say this first: unlike other shareholders, I have a unique benefit of looking at the business from the inside out and from the top down. I can assure you that I remain confident in the fundamental strength of the category, our brands, our strategy, and our team. Though we have some cost headwinds to deal with next year, we have tailwinds as well. Weather clearly should be helpful, as should new product introductions, the continued benefits of regionalization, significant SG&A initiatives, and improved customer outreach strategies. I also want to stress that our long-term financial goals are unchanged.
While we'll have to push our targets out by at least a year, we are no less committed to those goals, and neither is anyone else around here, including the board. Their decision to increase our dividend by 20% speaks to our continued confidence in the business and our commitment to use our flexibility to fund future growth and return cash to shareholders. Let me switch gears and spend a few minutes talking about the 2011 season from two perspectives. First, the issues that drove our results, and second, and frankly more importantly, the key learnings we took from the season. Let's start with what drove our results. The first and most obvious thing is weather, which I'd say drove at least half of our miss. It doesn't really matter what region you're talking about. The northern half of the U.S.
went from soggy and cold to record heat, and the season never really materialized there. The southern half of the U.S. started strong. The season got off to a good start both in Texas and in Florida, but by mid-spring, both markets were seeing severe weather. In fact, Texas is in the midst of one of the worst droughts ever, and the Pacific Northwest was just lousy all year. There is good news within the numbers. Although consumer purchases for the year are down 3%, we saw solid growth throughout May in the first half of June. Remember, the consumer purchases were up 13% through mid-March. When the weather cooperated, consumers were engaged in the category. This is especially true in the Home Center channel, where about 50% of consumer purchases are made each season.
Overall, the channel was about flat from last year, not a bad result considering the weather. The problem was that we just couldn't string together enough consecutive weeks of positive POS to build any momentum. The second issue is that we made some big bets midway through the season that did not pay off. After a slow April, we worked hard in May and early June to jumpstart the season. We put more promotional dollars in place and worked hard with our retail partners. I don't remember a season like this. The third issue that impacted the season was the performance of our business in the mass merchant channel. All of our research indicates that consumers who shop in this channel want to participate in the category. What's also clear is that a higher percentage of these consumers are economically stressed.
As a result, some retailers in this channel put more focus on opening and mid-tier price points than our national brands. That cost us shelf space and both us and those retailers market share. I'm going to come back to this issue in a few minutes because we have some major learnings about our presence in this channel and some steps needed to improve. Those are the three root causes of the shortfall this year: weather, our bets, and the economic impact being felt in the mass merchant channel. We also saw some important successes. We had told you we expected a good grass seed season, and that's what we saw. Consumer purchases are up 15% so far this year, and we continue to improve the bottom line of this business. Innovation continues to be part of this story.
We continue to see evidence that Easy Seed has permanently changed the grass seed market. Our competitors are already following with similar packaging and designs and copycat products, albeit ones that have inferior quality. The impact of the innovation goes beyond the U.S. The strength of our grass seed businesses helped the international component of our global consumer segment. This business had a solid year. We saw good growth in most markets, driving a 3% increase in top line for the quarter net of FX. That growth rate includes our largest international market, the U.K., which was flat after the unexpected bankruptcy filing of a major retailer there. We've also seen continued momentum with Scotts Lawn Service. I'm extremely pleased with their performance and the opportunities going forward. We're on pace to report another year of record profits.
We believe we've improved our market share this year, and we also continue to make good progress in keeping cancellations under control. The business model we've created at Scotts Lawn Service is definitely scalable. As we continue to see top line growth, I believe we will continue to see the opportunities for better operating margins as well. All in all, company-wide sales in the quarter are down 10% and down 4% year to date. The more important question is what we learned from the 2011 season. I'll tell you, there are three primary insights. First, we need to free up dollars to invest more behind our brands. I've said for years that advertising matters in this category. This year, we saw our competitors advertise more, which helped drive this grass seed category in particular.
We hope they and all of our competitors continue to advertise and do more to drive overall category growth. As they step up their investment, we must do the same. We'll take a big step in that direction in 2012, which is a point I'll revisit in a few minutes. The second lesson: we need to do more if we want to keep price-sensitive consumers in our franchise, and we have to work more closely with our retail partners in that process. Over the past two seasons, we've seen significant adjustments in merchandising strategies of retailers that are focused on these consumers. During that time, we've also made changes to our leadership team that works daily in this channel.
This is a channel of trade where I believe lawn and garden must have a stronger focus, and we're stepping up our efforts to work with our partners in this space to make that happen. The third insight is linked to the second. In order to provide consumers with value and protect our margins, we must refine our innovation strategy. We don't want to change it, but we just need to make some adjustments. Given the continued economic uncertainty, including the volatility of commodities, we have to do a better job of taking costs out of our products. Let me be clear. Our primary focus will remain moving consumers up the value chain. We believe consumers will continue to pay more for real innovation, and in fact, it will be an important part of our 2012 plan. We also have to be more focused on value at the same time.
With that, let me transition and talk about some of our plans for 2012. I want to start with innovation. In 2012, we're going forward with a major innovation: the nationwide rollout of SNAP, our proprietary new spreader and lawn care system. We saw good results from our test this season from SNAP, and our confidence in the product has increased significantly. Consumers who purchase SNAP consistently praise the product and its performance. They tell us it makes lawn care easier and faster. That's exactly what we were hoping to hear. More importantly, they were applying lawn food more frequently. With a price point of $29 for the SNAP spreader itself, we're looking at this as a razor and razor blade model. After two years of testing, we've made some changes in the packaging and price point.
We're seeing that consumers typically use nearly three bags of lawn food, a nice step up from the number of bags purchased by consumers of our traditional product. Also, and this is important, nearly half of the SNAP users were new to the category or had been out of the category for at least the last year. It's too early to give sales projections, but our retail partners are excited by the launch and encouraged by the potential of the product. Our team is working on new in-store displays and highly visible marketing campaigns. This will be one of our biggest marketing initiatives in years, and we're confident it will resonate with consumers. While I'm talking about our lawn food business, many of you have questioned whether we will introduce MAT-28 next year as planned.
If you aren't aware, MAT is a new active ingredient we're planning to bring to the market next year. There is no doubt it delivers far superior performance to anything on the market today and represents a major breakthrough in its environmental profile. However, DuPont, the maker of MAT, made a professional version of the product available this year and has since acknowledged that trees were damaged by the herbicide. In fact, they announced a return of the professional product last week. While this action does not affect our registrations, we do want to do more research before we bring it to market. Obviously, we want to work in a responsible way, not only with DuPont, but with the EPA and the states to make sure that the product is appropriate for home use.
While we think our testing will show that it is, we will take a conservative approach and work closely with both DuPont and our regulators. Some of you have speculated that the lack of a national rollout would materially affect our earnings next year. It won't. This is a replacement to an existing active to be used in our market-leading products: Turf Builder Plus 2 in the north and Bonus S in the south. While I believe MAT-28 has the potential to grow the category, we did not plan for a sudden spike in sales as a result of the introduction. Before I turn things over to Dave, I want to give you some other high-level insights about how we're approaching 2012. We feel pretty good about the top line potential of the business next year.
Between normalized weather, new product launches, improved marketing campaigns, and a modest price increase, we should have top line growth of somewhere north of 6%. I'm not giving guidance today. I'm just saying that I think it's a reasonable expectation. Let me also give you an update on our approach to pricing next year. We have taken some pricing but have chosen to be more conservative than over the last couple of years. Our goal is to drive category growth and market share over the long term. We've been pretty aggressive in pricing in the recent years, but given the increased economic uncertainty and consumer jitters, we just don't think it's the right move for 2012. You'll see some pressures in the gross margin line next year, depending on where commodity prices go. I don't see this as a long-term issue, but rather a conscious short-term strategic decision.
Most of you already know that we'll have some G&A headwinds as well. Given the shortfall in our business this year, variable comp has been effectively eliminated. Restoring that expense is something we'll have to overcome next year. While I'm on the subject of SG&A, I want to spend a few minutes talking about a major initiative to change our expense structure. You'll see in today's press release that we took a $3 million restructuring charge in the quarter due to some severance. Typically, we don't treat severance as a restructuring charge and wouldn't do it this quarter if there wasn't more to come. You've also heard me say repeatedly that we need to recalibrate our cost structure so we can invest more on advertising and innovation and spend less on the bureaucracy of running our business.
To that end, we'll be making other organizational changes over the next two months that will result in full-year restructuring charges of as much as $15 to $20 million. These charges should result in annualized savings of approximately $25 million. The team here have also been working on a significant effort to drive savings in both indirect purchasing as well as non-revenue-generating SG&A. Over time, these savings could equal the benefit we get from the restructuring effort. Nearly all of those savings will be reinvested back into the business to drive growth. I want you to understand these actions are not a result of a challenging season this year. We've been working since last summer to identify the savings, understand the implications, and put a plan in place to capture them.
As I said at the beginning, we remain focused on our long-term goals and are not going to let the results from 2011 be an impediment to our progress. In fact, quite the opposite is true. There are dozens of people walking around this place with a major chip on their shoulders right now, and that includes me. I see this as a huge positive. We're not accustomed to years like this. We're used to setting a goal, exceeding that goal, and then repeating the process. We're focused on getting back to that cadence. With that, let me turn the call over to Dave.
Speaker 4
Thanks, Jim, and good morning, everyone. As I walk through our results this morning, I'll focus primarily on third quarter adjusted results from continuing operations, unless otherwise stated. As I walk through the numbers, I'll place extra focus on three areas. First, the declining gross margin rate is turning out to be greater than we expected. I'll explain why and give you an update on our early thoughts for 2012. Second, we closed on our new credit facility in the third quarter. I'll provide color on what it means to our interest expense, capital structure, and priorities for uses of cash going forward. Third, lower than expected earnings will adversely impact operating cash flow for 2011. While that does not alter our long-term expectations or our commitment to investing in the business and returning cash to shareholders, I'll provide an update on our expectations for the year.
Before I begin my comments on the quarter, I'd like to reiterate what Jim said relative to our dividend. The increase approved by our board is consistent with the long-term capital structure strategy we've described before, and reflects our continued confidence in the structural competitive advantages of our business and continued attractiveness of the overall category. With that brief introduction, I'll now begin with a quick look at our top line performance. Consumer purchases of our products at our largest retail partners in the U.S. have clearly been softer than originally expected, down 6% for the quarter and 3% on a year-to-date basis. As a result, replenishment has been soft as well, leading to a 10% decline in company-wide net sales for Q3. Global consumer sales declined 12% or 14% when excluding the impact of foreign exchange rates.
Scotts Lawn Service increased by 1%, and the corporate and other segment reported a third quarter sales increase of $19 million. As a reminder, sales reported in the corporate and other segment relate to two activities: sales of professional seed in the U.S., which were excluded from the sale of the Global Pro Business, and sales of professional products supplied to ICL. Both activities in the corporate and other segment have minimal margins, which leads me to the next topic: gross margin rates. Adjusted gross margin rate for the quarter was 37.9%, down 320 basis points from a year ago. For the first nine months, gross margin rate was 37.8%, down 60 basis points from a year ago. Explanations for the decline in rate for the quarter and year to date are substantially the same, though the relative impacts vary.
For the quarter, just more than half of the decline was driven by unfavorable mix. The remaining decline was driven collectively by higher commodity costs, increased trade promotions, and reduced leverage on fixed manufacturing and storage costs. Cost productivity improvements planned and realized by our supply chain were a partial offset to the significant headwinds we saw in the quarter. The negative impact of mix was significant, as sales declines in the consumer business were disproportionately in higher margin lawn fertilizer and weed control products, including Roundup. The impact of these declines was magnified by sales increases related to U.S. Pro Seed and sales to ICL, both at minimal margin. About 40% of the negative sales mix in Q3 is explained by the combined impact of reduced Roundup commissions and higher sales in corporate and other. I realize we've moved the goalposts on gross margin rate twice since the spring.
While the impact of higher trade promotion spending and commodities has remained substantially unchanged since our most recent update in June, mix and volume have continued to negatively influence our gross margin rate. While I'm on the topic of gross margin rate, let me look briefly ahead to 2012. We told you during the last call that we expected inflation of about 10% to 13% on the one-third of our cost of goods sold that are commodity sensitive. Based on recent outlooks, that range still looks appropriate, though we are clearly in an environment of higher volatility across many of our commodities. Global economic conditions could result in an easing of some of those costs. We expect to offset the dollar value of currently forecasted commodity increases in 2012 through a combination of pricing, reduced trade promotion spending, and aggressive cost reduction initiatives within our supply chain.
While we expect some tailwinds in 2012 from favorable mix driven by stronger lawn fertilizer and weed control sales, assuming more normal weather, it's unlikely we'll hold gross margin rate flat in 2012, short of some easing in commodities from levels we've seen this summer. After we finalize pricing and programs with our retailer partners and get increased clarity on commodities, we'll provide more color on this and the rest of the P&L for 2012. With that, let me get back to the 2011 results. SG&A declined $7.7 million in the quarter, down nearly 4% versus last year. While there are a number of puts and takes, the decline was primarily driven by lower variable compensation expense, partially offset by modest increases in a number of other areas. For the full 12 months, we still expect SG&A to be essentially flat to last year.
I'll now shift below the operating line and talk about interest expense, which is $14 million in the quarter, up $2.8 million from a year ago. We still expect interest expense for the fiscal year to be around $51 million, up about $8 million, as higher rates attributable to our recent long-term financing activities offset the benefit of lower average debt outstanding. The news here is our new credit facility, which we closed on at the end of June. This is a $1.7 billion facility priced at LIBOR plus 200 basis points through the end of this calendar year, reverting to a leverage-based price grid in calendar 2012. At 2% to 2.5% times leverage, our rate remains at LIBOR plus 200 basis points. Below 2 times leverage, our rate will be 25 basis points lower.
The closure of our new revolving senior credit facility completes the reconfiguration of our long-term financing structure. We moved from a single source of financing, all bank debt, to a combination of bank debt and bonds. We moved from a single maturity date for all debt, staggered maturities that come due in 2016, 2018, and 2020. Including the interest rate swaps we have in place, we have fixed either the absolute rate or the underlying LIBOR rate on 60% to 70% of our average expected debt for the next four years. With our financing needs now secured for the foreseeable future, I want to reiterate our philosophy on uses of cash. First, let me update you on our operating cash outlook for 2011. Operating cash flow has historically been relatively steady and predictable. This year is an exception. We project operating cash flow of about $120 million for fiscal 2011.
Adjusting for the sale of Global Pro, operating cash flow will be about $210 million. That represents a decline from what we originally expected, nearly $300 million, with the difference primarily attributable to the drop-off in earnings. We expect next year's operating cash flow to return the trend, plus some, as cash payments for variable compensation, the bulk of which typically occur in our first fiscal quarter, will be significantly less than the norm in Q1 of fiscal 2012. Despite the drop in earnings and operating cash flow this year, we like where we're at right now on debt leverage, about 1.9 times at quarter end. Our go-forward objective is still to maintain leverage between 2% and 2.5 times. Based on this, we do not anticipate debt repayment as a significant priority for future use of cash.
As we think about future uses of operating cash flow, directionally, about two-thirds will be targeted for growth, equally divided between capital reinvestment and modest acquisitions. The balance will be returned to shareholders. In the absence of attractive acquisitions, the amount returned to shareholders could be higher. You're seeing our commitment to capital discipline through execution of our current share repurchase plan. We've remained active purchasers of Scotts Miracle-Gro shares. During the third quarter, we repurchased 2.2 million shares, bringing our total repurchases to 4.5 million shares since this program was initiated in the fourth quarter of fiscal 2010. In fact, we increased our repurchase program this year by an amount roughly equal to the after-tax proceeds from the sale of Global Pro.
We now expect to finish the year with a fully diluted weighted average share count, slightly more than 66 million shares, with a more dramatic decline in fully diluted share count next year when we get full credit for shares repurchased in fiscal 2011. As a reference point, we expect to end fiscal 2011 with approximately 61 million shares outstanding before diluted common share equivalents, which will be the starting point for diluted EPS shares in fiscal 2012. I'll conclude my remarks by moving to one final item: some details regarding the difference between our adjusted earnings and our GAAP earnings. Adjusted earnings for the quarter were $126.7 million, or $1.91 per share. That compares with $110.6 million, or $1.67 per share on a GAAP basis. During the quarter, we recorded about $8 million for product registration and recall matters. On a year-to-date basis, that number is now $12 million.
The charges in the quarter reflect both ongoing costs and reserves established for the anticipated resolution of these matters. There are two other charges excluded from adjusted earnings this quarter: impairment and other charges of $10.3 million related to our U.S. Pro Seed business, and $3.5 million for restructuring. The Pro Seed charges are non-recurring in nature and represent the termination of several contracts related to this business, the most significant of which related to the settling and contingent purchase price element for a fiscal 2006 acquisition. We expect to be fully out of the U.S. Pro Seed business sometime in 2012. The restructuring charge relates to initial steps taken in the broader restructuring effort that Jim has already described, which we expect to conclude in our fiscal fourth quarter. We're currently projecting $15 to $20 million in charges for the fiscal year as a result of this effort.
With that, let me turn the call back to our operator so we can take your questions. Thank you.
Speaker 5
Once again, ladies and gentlemen, if you would like to ask a question, please press star and the number one on your telephone keypad. That is star one to ask a question. Our first question comes from a line of Bill Chappell with SunTrust.
Speaker 0
Good morning.
Speaker 3
Hey, Bill.
Speaker 0
I guess first, just looking into what you're seeing at the mass merchant channel side and kind of what changes you're expecting going into next year, just trying to understand, you know, are you permanently, I guess, impaired at some of that channel and focusing more of your efforts at more of the Home Depot, Lowe's? How should we look at that?
Speaker 3
I mean, I'll talk for a bit and hand it over to Barry, and he can pick it up from there. The answer is no. You know, mass is an important channel for us, and we need to succeed there. The issues in the channel, which you know I think probably you could say belong to both us and the retailers, are something that we're having good dialogue on and making progress on, sort of the merchandising strategy for the channel. It is something that we can't sort of walk away from, and we don't want to. The retailers don't want us to. You know, I think we're making progress on it, but we're disappointed in it for sure. I don't think that the channel's happy with the numbers either.
Speaker 0
Bill, this is Barry. I would add two things. One, that channel would have a higher proportion of economically distressed consumers. We're evaluating our opening price point in our mid-tier products to give them some better offerings. The other is a differentiated merchandising strategy. They tend to be non-destinations, so better convenience items and a merchandising strategy that makes sense for the channel. The third area is how to effectively promote in that channel, given that it's a non-destination channel. Our relationship's good. They intend on winning, and we're partnering with them, and we expect that to turn around going forward. Okay. Switching gears to kind of gross margin and the outlook for next year, Dave, I understand that you can recover the penny profit but not the margin in terms of pricing.
Just trying to understand why gross margins overall would be pressured, because I would imagine some of this year had to do with the operating leverage and less volume going through, which presumably would be recovered with a 6% type growth next year in revenue.
Speaker 4
I agree that part of the sales mix issue we saw this year, we should see some recovery on, assuming normal weather. I think that where we're going to be more challenged next year is the commodity cost. Because of the inflation that we're currently expecting, though clearly it's pretty volatile right now, that will overwhelm the benefit we'll get from the higher volume that will give us more leverage and the improved mix. It's just a matter of the scale of the numbers that will drive that conclusion.
Speaker 0
Do you look, I mean, I know you lock in urea starting pretty soon, but do you look into kind of oil, diesel, some of the other things that are pulling back now that maybe lock in a little bit longer than you normally would?
Speaker 4
Yeah. We're fairly fluid on our strategy for locking in. We've been staying on the sidelines until just recently. I would tell you that just in recent days, we've now been getting into diesel for next spring. Within the last couple of weeks, starting to get in the market for urea. We've been standing down, and I think that's proven to be a good strategy based on what I see today. We're now engaging to try to get those locked in at a pace more consistent with where we've historically been.
Speaker 0
Okay. One last one. I know you're not giving specific EPS guidance for next year, but I thought somewhere variable comp kind of related to like 10% earnings growth. If we're assuming that variable comp is coming back next year, should that be at least a floor?
Speaker 3
is nodding his head.
Speaker 0
I hope he's nodding a yes.
Speaker 3
The answer is it doesn't assume things stay where they are, put it that way.
Speaker 0
Okay, thank you.
Speaker 3
You bet.
Speaker 5
Our next question comes from a line of Olivia Tong with Bank of America.
Speaker 1
Good morning. Thanks. I was wondering if you could give more details on what is sort of going to that 6+% sales number. How much did you expect for the new products versus just a sort of normalized weather year and maybe some other things that go into that number? Thanks.
Speaker 4
Yeah. Olivia, at this point, we still feel good about our longer-term guidance of total growth over the course of the business cycle, 4% to 6% annually. Given the pressure we saw from weather this year, we feel confident that we're going to be at the high end or above the high end of that range next year. At this stage, though, in August, we're not prepared to provide a more detailed bridge of a clear range of lawn growth for next year, other than to say we think that we're going to be at the high end or slightly above the high end of that range next year.
Speaker 1
Is it fair to think then that any actions you may take in the mass merchant channel will be more than offset by the easier comp relative to a normalized year?
Speaker 4
I do not understand. Could you say again?
Speaker 1
Yeah. Sure. Is it fair to assume that anything that you do next year to sort of build up the mass merchant channel again, potentially hurting the mix on that side, that's more than the impact of poor weather versus, say, normalized weather next year, that's enough of an offset?
Speaker 4
Olivia, I think there's an assumption in your question that what we would do would be lower margin to build that up, and I think that's a wrong assumption. As we offer them merchandising and merchandising strategies, we need to do that effectively at what we would consider good margins for our business. I don't think it would be an offset.
Speaker 1
Got it. Thanks. How do you think about spending next year? Sort of thinking about the mass merchant channel primarily, do promo levels have to increase next year? Maybe you could give a little bit more color on some of the things that you are thinking about doing for next year, realizing that plans are not necessarily set yet.
Speaker 3
We are going to be taking costs out of sort of, I think, what we call the bureaucracy of the business, but call it Marysville, to fund more innovation work and completion of regionalization, although that's mostly done, and more marketing/advertising. That we are going to do. What was the other part of the question?
Speaker 0
Promotions.
Speaker 3
Listen, this is one of the areas that I would say we're not totally sure of what we're seeing out there. For sure, we believe in the lawn and garden business. There was a lot of promotional activity in fiscal year 2011, and consumers were taking advantage of that. I think one of the questions we have is how easy is it to wean. What we're looking at is saying the level of promotional activity within a category needs to decline. That money is better spent on what we would think is more sort of traditional brand-building activities as opposed to discounting. I think generally, the retailers agree with that. I don't see a significant increase in the amount of promotional activity.
I think, particularly in mass, it has to be done better, more efficiently, and it has to be more impactful on driving volume, which, in fiscal year 2011, it was not. I think there's a lot of work going into our, at Scotts Miracle-Gro and within our BDTs and our retail partners in making that promotional spend more productive than it has been.
Speaker 0
Barry.
Speaker 1
Thanks a bunch. I'm sorry.
Speaker 4
Olivia, I would say we'll be less promotional, and like Jim said, we'll put more money into building our brands. I think as far as our partnerships with our retailers, we're going to work hard at growing the category rather than trading footstep, which was, I think, an issue this year.
Speaker 5
Our next question comes from a line of Joe Altabello with Oppenheimer.
Speaker 0
Guys, good morning. There's a couple of quick questions. First for Dave, in terms of the commodity costs you've locked in for next year, what % of your raw materials need is locked in now, and what does that number look like at this time last year?
Speaker 4
Joe, the % we have locked in right now is south of 10%. The number at this time last year was probably hovering around 10%. We're low single digits this year. We're just starting to begin buying in the urea, and we literally just last week started buying into diesel. Last year, at this time, we were further ahead because the market looked very different last year. We were much further ahead on urea than we are today.
Speaker 3
Okay, it's not that much of a difference, it sounds like, versus last year.
Speaker 4
It's not that big. I mean, historically, urea is the biggest item that we're buying ahead at this time of the year. We generally start with diesel in October. We're actually starting earlier on diesel, but later on urea.
Speaker 3
Okay. Fair enough. In terms of the commodity headwinds for next year, it sounds like you're still implying about $60 million, $70 million, $80 million of headwinds next year. Is it fair to assume that about half of that is going to be offset by pricing?
Speaker 4
Seventy, eighty based on what we see today. You know, Joe, I think it's a combination of both direct and indirect pricing. It's pricing and revisitation of some of our trade programs are going to cover more than half of that cost increase. The balance of that cost increase will be coming from the cost productivity initiatives, which, you know, I think we've got a long track record of delivering cost increases in our supply chain. Those are being further accelerated this year as we're also exploring some of the other things that we're exploring in our broader SG&A cost structure.
Speaker 3
Okay, so more than half coming from pricing, it sounds like.
Speaker 4
Definitely.
Speaker 0
There's a nodding of yes.
Speaker 3
Okay. Just one last one. If I said in terms of restructuring, could you give us a little more color on what you're doing there and how quickly you might see that $25 million of savings?
Speaker 4
We are currently underway with that. We will take actions this quarter, and we would expect to get that value for next year.
Speaker 3
All of it for next year. Okay.
Speaker 0
Okay, great. Thank you.
Speaker 5
Our next question comes from a line of Jeff Zakofskas with JPMorgan.
Speaker 4
Hi, good morning.
Speaker 0
Morning.
Speaker 4
Urea is really up quite a lot. You spoke about 6% sales growth next year, but to offset your urea costs, you're going to have to raise price about 6%, at least if urea costs stay where they are. Why isn't your sales forecast much higher, or are you banking on a decline in urea costs?
Speaker 0
Joe.
Speaker 4
I'm sorry, Jeff. Right now, we're looking at the basket of our commodities going up in the range of $70 million to $80 million. On sales of $3 billion, we'd be looking at just north of 2% to 3% pricing. What we've told you is that, just in the last question, we're expecting to cover between pricing and programs something just north of that. I think it gives you a sense that the pricing we're looking at isn't anything close to, I think you might have used the number of 6%. It's low single-digit pricing.
Speaker 0
Isn't urea up $200 a ton year over year?
Speaker 4
Right now, we're seeing urea in between $450 and $500 NOLA. Last year, as I recall, it was a moving average, but we were probably in the lower $300s. It's up, what, $100, $150 a ton.
Speaker 0
Okay, thank you very much.
Speaker 5
Our next question comes from the line of Alice Wongley with Buckingham Research.
Speaker 1
Hi. Good morning. Can you just clarify this is fiscal 2012? You're saying gross margins will probably be down, and you're going to restore compensation, I guess, despite whatever the results are, and your advertising ratio will go up. Am I assuming?
Speaker 3
Come on. What's the matter with you? You're trying to pick a fight here. I think we told Bill that the answer was not no matter what the results are. I think we are looking to get back on what we around here call the CFO plan. There is an expectation of significant progress getting back to where we should have been. The answer is no. The incentive is based on some relatively challenging goals.
Speaker 1
Are operating margins going to be down next year? It sounds that way.
Speaker 4
Operating margin rate down next year, is that what you're asking?
Speaker 1
Yes, percentage of sales.
Speaker 4
It's going to be, we're going to see some pressure in the gross margin rate, and we might see some leverage in the SG&A rate. I'd say it's unlikely to see growth next year. I think it's too early to say how much, what the range of any decline would be.
Speaker 1
Probably down, but the SG&A ratio providing some positive leverage, partly offsetting the gross margin decline?
Speaker 4
Yes.
Speaker 1
Okay. I was unclear about what you were saying with shares outstanding. You said something about 56 million shares. What should we use for shares outstanding for next year? The numbers seemed quite different from what I've been using.
Speaker 4
The 66 million shares, what I said was for this year, slightly more than 66 million.
Speaker 1
Okay.
Speaker 4
I didn't give a precise number for fully diluted share count for next year, though what I said was we start the year with around 61 million shares outstanding. Those are basic shares outstanding, Alice.
Speaker 1
Okay, you add about $1 million for dilution, right?
Speaker 4
There are common stock equivalents that get added back. The other two parts are equity dilution, and we have an offset for continued share repurchases next year.
Speaker 1
Some of the share repurchases offset the option. You know, is a good number for next year to use the 62 million diluted shares outstanding or something lower because the shares repurchase will more than offset the option in exercising, maybe?
Speaker 4
This would be very tentative because, you know, we're still making assumptions about a share repurchase program for next year. Tentatively, I think a number, you know, $61.5 to $62.5 for next year is probably a reasonable place to be at this early date.
Speaker 1
Okay. What would the interest expense line look like for next year? I know that's going up. I've been using $63 million. Is that still good?
Speaker 4
Yeah. We really weren't planning on giving detailed line-by-line guidance on this call going down the P&L. Alice, I'm not sure that anything that I've said in prior conversations when we gave longer-term guidance would change at this point. In February, the comments we made are probably still pretty good targets. We saved more this year because we deferred the facility later in the year, but it really doesn't impact next year. The growth year over year is probably going to be a little bit bigger than what we said in February. The absolute number for next year, that's a good place to start going back to what we said in February.
Speaker 1
I guess my last question is, obviously, you know, we're all concerned about weak demand right now, and yet weak demand is coming from, is coming along with falling commodity prices. In making those comments about gross margin for next year probably being down, are you using all prices sort of where they are now, or what is your assumption?
Speaker 4
I conditioned the caveat of my comments. You know, they've been moving fairly quickly. We've seen diesel for next spring move subsequently just in the last three to four business days. The numbers we're using that we've been talking through are not up to date in terms of the last couple of business days. I'd also say it's a little premature to try to read longer-term trends into what's happened in the last two to three business days. What I did say was that global economic conditions could result in the easing of some of our commodities, and that would be helpful. We have not built that the last two to three days into these.
Speaker 1
You've been working with sort of $90 oil?
Speaker 4
Can you repeat that question?
Speaker 1
Have you been assuming $90 oil?
Speaker 3
Probably somewhat north of that, Alice. Okay.
Speaker 1
Okay. Is there more urea?
Speaker 3
I want to throw in there this idea of easing demand. Maybe you're talking on commodities. I think on consumer demand, what's important for everybody to remember is how the business performed when the spring was behaving normally. I want to get back to consumer demand in regard to lawn and garden products and to say, we went into, call it, April 1, almost up 15% POS. I got to say, while gasoline prices went up and I think there was a fall in sort of people's attitude about the world and the economy in general, a lot of what we had expected to see, we did see when the weather was good. Our hope is that we're not seeing any sort of fundamental change in consumer demand or attitude toward lawn and garden.
In fact, our research shows that people continue to view lawn and garden as a kind of refuge and something they can do in cocoon and at home, etc. It's just really difficult to read what's happening right now. You look at it all based on the weather, or at least what we think the major component was weather and sort of a channel issue.
Speaker 1
If that's true, and POS is down 3% this year, why would you assume it's only up 6% next year? Why wouldn't you assume a stronger, you know, compound annual sales growth rate over two years?
Speaker 3
Because I'll tell you what, I remember riding around in a car with you somewhere out in, like, the Rockies, I think, where you said, "Never make the promise of, you know, or never overpromise." You remember that?
Speaker 1
Yeah.
Speaker 3
I think this is a number where we feel pretty comfortable with, but listen, we came out of this feeling beat up pretty hard out of this year and not used to seeing this. You know, we just got done with a board meeting where we're trying to explain what happened. I think we feel pretty good about it, you know, that we understand it. I hope we do. You know, there's a lot going on in the economy right now, and we're just not trying to sort of get ahead of ourselves.
Speaker 1
Okay. Just one final thing on the urea. Could you give us an update on this idea that more capacity is coming on stream? Urea prices will at some point fall a lot?
Speaker 4
Yeah, Alice, what we said in the past, we still believe to be the case, which is we see starting later in 2012 more global capacity coming online, which, holding all other variables constant, is going to be a positive in putting some downward pressure.
Speaker 1
For fiscal 2013?
Speaker 4
For fiscal 2013, because of the way we hedge and the turns we get, as you're aware, we always see a delayed impact on that. Yes, it's more realistic to expect that benefit in 2013.
Speaker 1
Okay. Super. Thanks a lot.
Speaker 5
Our next question comes from the line of Jim King with CL King and Associates.
Speaker 0
Good morning, everyone.
Speaker 3
Hey, Jim.
Speaker 0
Jim or Dave, could you, even in broad strokes, attempt to quantify the % contribution to the profit shortfall of the weather versus inefficient promotional spending versus your performance in mass merchandisers?
Speaker 3
Yeah. I mean, you know, this is major, major swag, you know, but I think we said that we think that slightly more than half of the miss is related to the weather. Of the remaining, call it something less than 50%, probably split about 50/50 between sort of things we worked on that didn't work out as well as we'd hoped. This was, and my view on that, just so we're clear, is the team was highly motivated to try to recapture sales. I think had we seen the weather correct, we would have caught that back. It didn't. We put it down as an error, but we tried. I'd say about the other, so if that was about half of the half, I'd say the channel was probably the other half or call about 25% of the miss.
Speaker 0
Jim, within mass merchandisers, could you rank order the promotional intensity by category in terms of where the opening price point competition is impacting your business?
Speaker 3
Jim, this is Barry Sanders. I would say really in two, the primary area would be the bug in the wheat area, and then a whole different scenario with what happened with grass seed this year.
Speaker 0
Okay. Okay, Barry. Jim, thank you very much.
Speaker 3
You bet. Thank you.
Speaker 5
Our next question comes from the line of Connie Manidi with BMO Capital Markets.
Speaker 1
Good morning.
Speaker 3
Hi, Connie.
Speaker 1
I also have questions about the SG&A and restructuring savings. They seem like very big dollar amounts, but there still isn't a whole lot of detail. What are the projects in the restructuring that you're doing? You said you were saving $20 to $25 million in SG&A, but that's separate from the restructuring. What's happening there, and what's the timeframe on those savings?
Speaker 3
Let me just deal with the first part of the question, which is what is the detail on the first part? We've been working really hard. I'd say with Denise, Barry, and Dave Evans, who is responsible for the strategy group now, on what we'd call spans and layers. As we have simplified the business and gotten rid of things that we didn't think were sort of core to us, we've also taken a look at how many bosses do we need around here? What's the span of control? How many layers do we have, and what's the span that each, sort of, call it, Director and up has? The first component, which was the approximately $25 million taking the charge in this quarter, that's a headcount, and that is certain. It's really just related to the project of what we'd call spans and layers here.
We think it's important to making the business sort of more controllable and putting, I'm going to say, the senior folks, including myself and Barry, closer to the action. We think the business can be made simpler. We think we can make decisions faster. That agility, we think, is good for all kinds of reasons and frees up money to invest in things that we think are more productive. The other part of that is what we'd call indirect savings. Dave, if you were to take that one.
Speaker 4
Yeah. The indirect savings are something that what Jim talked about earlier is not something we're expecting to realize entirely in 2012. That's going to be more of, I'd say, over a two to three-year period. We expect to realize an amount up to or equivalent in value to the restructuring side. An example of the type of activity we're looking at there is trying to streamline the number of vendors we use across a variety of spending areas where, if we do an analysis of our spend, we'll find we've bifurcated the spending across a very large population of vendors. It's a simple process of trying to consolidate those, leverage our scale, and competitively bid out the product or service that we're purchasing.
It's been a detailed process of going through all of our spending, quantifying and prioritizing those efforts, and then examining where, how long the current duration of commitments we have are today, which is what allows us to schedule out what we can expect to realize in 2012, 2013, and what may take even into 2014 to get in that area.
Speaker 1
Okay. On reducing the complexity, how many layers of management did you have, and what are you going to, and what's the either headcount reduction number or % that you're going to?
Speaker 4
Connie, this is Barry Sanders. I would say, as we looked at the layers, we were up to nine layers. We've taken steps to take that down one or two immediately, and we're going to continue to reevaluate that going forward. What I would also say is it tends to be skewed to the higher-level people in our organization. I'm not going to go through a specific headcount reduction, but it tends to be the more highly compensated people, as Jim has said, that as we've streamlined our business model and our portfolio, we don't need as many director-level and above to manage our organization.
Speaker 1
If I could ask one different question on SNAP, the spreader price of $29, it seemed to me that when you put it in test, you were looking at price points of $39 to $79 for the spreader. At this lower price point, did you need to redesign it? Are there fewer features, or do you take a loss on the spreader and make it up on the bags that get put into it?
Speaker 4
I'm going to add a little bit, then I'm going to ask Jim Lyski to clarify what I'm going to say. We did go out at those higher price points, Connie, and what we discovered was that the spreader itself, as we spoke with consumers, was following more of a durable lifecycle replacement than a new product introduction on other products that we've had. What we found is that when the consumer buys the product, we're getting phenomenal scores on the satisfaction with what the consumer is actually using the product. We found that they tend to buy and put down more applications of product than on our traditional bag. What we've said is we need to accelerate getting the number of spreaders out there. It puts them in our franchise.
It's a proprietary interface and will allow us to accelerate the lifecycle of the product and ultimately ramp up the sales much faster than keeping it at that $39 or $49 price point.
Speaker 3
Yeah. Barry, I think that's spot on. I'd only add that the reason we did test it was to test multiple price points to identify how to maximize the value of the consumer in this franchise. The number came out to be, if we could get to a net $29.99 number via promotion, that's the number that maximizes our total return over the lifetime of the product.
Speaker 1
Great, thank you.
Speaker 5
Our next question comes from a line of Mark Scheiwer with Longbow Research.
Speaker 0
Just follow up on the SNAP lawn care system. I know that when you're testing it, it's obviously a different SKU, and the retailer has to probably position it a little bit differently on the floor, I guess, different shelf space and the like. How did the stores in the markets that you tested this year, how did they manage the inventory? Was it any different than your regular business, and just expectations on the kind of the inventory management of that product as you roll it out nationwide next year?
Speaker 3
Yeah. This is Jim King again. We saw a whole range of ways to merchandise this product, and that was another benefit of conducting the test. We saw everything from just putting it onto the shelf to an end cap to a total, you know, kind of on-floor, you know, full-in merchandising display. We saw different takeaway rates at the different display types. We've identified that there's a couple of good places to have this, i.e., like an end cap or kind of an on-floor display where the uptake is much, much smaller. Sure.
Speaker 5
We have worked with our sales force now to identify those best practices and push those out during the 2012 season.
Speaker 2
Okay. On expand and grow, any learnings on the tests that you had in the select markets this year?
Speaker 5
Yeah, we also had learnings on that, too. The first one was, once again, merchandising matters. It's a competitive advantage that we have, and when we merchandise effectively, we have a good takeaway rate with that product. The second one is that we're expanding the Expand and Grow test to the state of Texas this year. As you guys probably all know, they've had a very difficult weather year, with a, you know, 100-year drought. When Expand and Grow is added to the soil in gardens, we see a tremendous performance benefit. We're going to be positioning the product to be much more oriented towards a soil amendment or just a fly-out garden soil next year in the state of Texas. We'll see how that test goes. All indications are it'll be a smash hit in that positioning.
Speaker 2
Yeah, I mean, I just want to add sort of my two cents. One, I think we were using the product in Europe and saw pretty good results. Second, from an R&D point of view, we have never seen sort of growing media results this good, particularly as a soil amendment. This Texas work we're going to do next year is to really focus the product a little more on being a soil amendment and sort of reducing the confusion as to what is this product. It's just important to remember this is a product we have seen crazy good results from, sort of how plants grow in this product when it's used correctly. This is a major innovation in sort of home lawn and garden agronomy, call it.
We're just spending a lot of time trying to understand and make sure the consumer understands what the product does and then price it accordingly because it's a major innovation. Lastly, how are you guys or how are the retailers approaching the fall business given the difficult summer?
Speaker 3
From the fall business, you know, it's a brand new season. The weather's taken its toll on the lawns, and I would say that they're going to approach it the same as they have in the past. We expect that the business will be up this fall again, the way it has been in previous years. Part of the advantage of the fall is relative to the spring business, it's always been a much lower size business. There's tremendous upside, and the consumer gets the best results if they fertilize in the fall. We're going to go out with normal promotional activity, and I expect our retailers are going to do the same.
Speaker 2
Perfect. Thank you, guys. Good luck.
Speaker 3
Thanks.
Speaker 4
Our next question comes from the line of Jason Geer with RBC Capital Markets.
Speaker 0
Good morning.
Speaker 5
Hey.
Speaker 0
Hey, guys, I guess I just wanted to talk a little bit more about regionalization, you know, just where you kind of need to keep tweaking the model. It's still in its infancy. Talk about the best practices of some of the regions performing better. I guess the way to look at it is the last couple of years, the weather's obviously been in favor, and regionalization certainly has played out well. This year, obviously the weather was adversely playing with you. Regionalization, I just want to get a more bigger color. Like, is there bigger tweaks, or do you think it's broadly online with what you set out a couple of years ago?
Speaker 2
Let me start only because I got a sort of big attitude on this one. I would say that the biggest thing that is going to happen or needs to happen is that the Regional Presidents are, you know, this was a year where we just had terrible weather, and everybody was just working really hard to sort of survive. The changes that have to happen as we streamline Marysville and continue to push up the regions gets back to regional products, or maybe you could change the words to local products designed for local consumer needs. That is really just beginning to happen now. If you looked at sort of what Lyski and R&D are working on, on products or within sort of the M&A side that Dave and his group are working on, what you're seeing is much more of a focus on meeting those needs.
That ultimately is when you're going to see regionalization really work or not, is when we have products in the Southeast that are different than the Northwest. That really hasn't happened yet. I would say we need a little more ornery dudes who are not fighting for their life and actually able to demand the products that they need, but Marysville has to change as well to be responsive to those products. The work that happens in the regions and the work that's going to happen in our marketing group as we recommit money out of sort of call it the bureaucracy of spans and layers into sort of consumer intelligence, which is an area where we are going to spend more money, is getting smarter on the consumer and both doing that locally and out of Marysville marketing. I think that's when you're really going to see the difference.
That's hugely important. I don't know what you'd add. I think that was a pretty good answer.
Speaker 3
Yeah, maybe I'll just add a little, Jim. I would say regionalization is, in itself, a change to our business model going from a centralized organization to a decentralized organization. Two of the five regions in the U.S. were brand new this year, and they really got their learnings in a really bad business condition. I think the weather, to Jim's point, set us back as far as getting to the model and the behaviors that we want. If you go back to the original business case of what we're trying to accomplish, of getting closer to the local consumer, better retailer relationships with the people that are regional retailers, and then responsiveness, and deploying the ability to manage out into the field, all of those things we remain committed to, plus the original business case of those market share opportunities that are out in the region are still there.
We're building that business, the business model to be able to do that. I could go through a list of things that were good this year, much better relationships with the local communities, the local influencers. We're building regional capability to better partner with the states and their regulatory agencies, as well as some specific wins across all of the regions with some local retailers. To Jim's point, the flow of product ideas that are coming in here, it's a matter of how much capacity do we have because there's so, so big of opportunities coming through that we need to prioritize those. We remain committed. The business case is still there, and we had some learnings this year, and we'll move on and make it better next year.
Speaker 0
Okay. That sounds good. Thanks for the answers, guys.
Speaker 5
Yeah.
Speaker 4
Our final question comes from the line of Reza Bahadzada with Barclays Capital.
Speaker 0
Actually, my questions have been asked and answered. Thank you.
Speaker 2
Thank you. You're welcome.
Speaker 0
You want to do one more, or?
Speaker 3
No, that was actually the best way to end.
Speaker 0
All right. Thanks, everybody, for being with us this morning. If there are follow-up questions or things that we didn't get to, you can feel free to give me a call directly. This is Jim King, 937-578-5622. Otherwise, we will talk to you again when we report our year-end results in early November. Thanks, and have a great day.
Speaker 4
Thank you, ladies and gentlemen. This does conclude today's conference call. You may now disconnect.
