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Good day, and welcome to the Scotts Miracle-Gro 2018 First Quarter Earnings Conference Call. Today’s conference is being recorded.
And at this time, I’d like to turn things over to Jim King. Please go ahead, sir.
Thanks, Joanna. Good morning everyone, and welcome to the Scotts Miracle-Gro first quarter conference call. With me this morning in Marysville, Ohio is our Chairman and CEO, Jim Hagedorn; our CFO, Randy Coleman; and also joining us for the Q&A session is Mike Lukemire, our President and Chief Operating Officer.
In a moment, Jim and Randy will experience some brief prepared remarks, afterwards we’ll open the call for your questions. I see that we already have quite a number of people in the queue. So in the interest of time, we ask you keep the one question and a one follow up. I’ve already scheduled time with many of you today to fill on some of the gaps, and anyone else who wants to set up some follow up time can call me directly at 937-578-5622.
With that, let's move on to today's call. As always, we expect to make some forward-looking statements, so I want to caution everyone that our actual results could differ materially from what we say this morning. Investors should familiarize themselves with full range of risk factors that could impact our results those are filed in our Form 10-K, which is filed with the Securities and Exchange Commission. I want to remind everybody that today's call is being recorded, and an archived version of that call will be available on our Web site.
With that, let's get started and I'll turn things over to Jim Hagedorn.
Thanks, Jim. Good morning, everyone. By now, I'm sure most of you have seen at least the headlines from our press release. So it’s obvious we have a lot of ground to cover. Before I get into the results, I want to some context for my remarks and has to do with the story I read last week in Wall Street Journal. The piece focused on the challenging growth environment for companies in the consumer products to universe. It challenge companies for non-investing enough in growth, same they can need to save their way to prosperity nor buying out shares to satisfy investors in the perpetuity, I couldn't agree more.
Our goal in designing project focus was to embrace the truth about the slow growth of our core categories, and that’s why we decided to invest wisely in adjacent categories like live goods and indoor gardening, as well to make transformational investments in areas like hydroponic growing products. Our primary focus since then has been to use our cash and balance sheet to fund growth. To improve our margin structure through reconfigured portfolio that required both acquisitions and divestitures to increase our commitment to driving free cash flow and to supplement our shareholder returns not drive them by repurchasing shares and paying dividends.
We’ve never been a company that manages from quarter-to-quarter. We try to take the long view, we don't get too excited about boom years or frustrated during downturns, but project focus went much farther than that. To a large degree, we reinvented ourselves. So when I read that story last week, it reinforced to me that the path we’re on is the right one, one that will allow us to continue to enhance shareholder value in 2018 and beyond.
Enough for my setup, let's take a look at Q1 results and dig a little deeper into the stories behind the numbers. In our core business, things remained steady and we’re tracking exactly as we would have expected at the end of Q1. Our performance is consistent with the trends we saw last year. Right now, we’re mostly focused on being ready when the snow melts and the season breaks. Hawthorne obviously saw different outcome in the quarter than we were expecting. The entire hydro segment is seeing a logjam in California due to changes in state law and the downstream impact of the implementation of new rules at the local level.
We’ve told you in the past that this business could see significant quarterly short-term swings, and this is one of those times. I'll come back to discuss each of the business segments in a few minutes with a particular focus on Hawthorne. As always, I'll leave the numbers to Randy and I'll focus on broader strategic things.
Before I do that though, I want to talk about the revised EPS guidance we provided today related to our expected lower tax rate. If you haven't seen the press release, we've moved our guidance for adjusted EPS to the range of 460 to 480 from a range of 415 to 435. As most of you know, Scotts Miracle-Gro had the higher effective tax rate of any company in our peer group. As we said in our press release this morning, we expect a roughly 700 to 800 basis point decline in our tax rate.
Many of you’ve asked what we’ll do with the tax benefit, so let me touch on that. During the tax debate, President Trump said he hope that corporate cuts would be shared with workers, and that's part of what we’re doing with these proceeds. We've always prided ourselves on innovative compensation and benefits program, as well as our ability to maintain a family culture in a publicly traded company.
When I walked the halls and talk to our younger associates, essentially those who have been out of college for less than a decade, I'm troubled by the burden that many of them are carrying from student loan debt. So the proceeds from a lower tax rate will allow us to explore new programs that will help relieve that burden. Also, many of these same people are at a stage of their lives when they are starting a family. So they’re challenged by trying to find the right work life balance. So we're going to also explore the possibility of investing in subsidized onsite day care.
More broadly, I'd like to see all of our associates save more for their retirement. Well, I believe we already have a generous 401(k) match, we’re going to look to expand it further. Like many companies, we’ll also share the proceeds more directly through pay raises targeting many of our hardworking hourly associates, as well as some of our up and coming leaders. On an annualized basis, I would expect these investments could equal about 20% of the total benefit.
We’ll hold some funds back for these purposes this year, but I suspect most of these investments will come in 2019. Frankly, I'm glad to see so many CEOs making public statements about reinvesting in our people. It's the obligation too often overlooked by Wallstreet, not all of this money should go directly through our shareholders. As you can see by our guidance, shareholders will benefit the most. We won't necessarily do anything differently than what we've laid out in designing project focus, but we’ll benefit from having more cash at our disposable to help fund U.S. based acquisitions and share repurchase activities.
So let me shift gears and focus on our business results. I want to start with Hawthorne. When we decided to begin investing in Hawthorne in 2014, we never thought we were chasing a one or two year. We believe the long-term trends remain favorable and we’re confident that they will help drive Hawthorne's growth. That said, we've told you in the past we expect some choppiness from time-to-time and we saw that in Q1. Hawthorne reported 20% growth in the quarter due to acquisitions. Excluding acquisitions, sales declined $12 million in the quarter. We have continued to see negative pressure on sales throughout January, a trend we now expect to see continue for at least another month and perhaps longer.
Let me explain what we believe that has occurred. There were a lot of headlines in the last few months about California's new system for authorizing and regulating production and sale of cannabis. Many of those same-stores also reported that county governments are behind schedule in setting up their local rules for issuing licenses for growers and retailers. It appears this has contributed to a short-term slowdown, aggravated by some natural disasters that worked its way into our pipeline late last year.
Given the size of the California market compared to the other states in the Hawthorne sales mix, this issue clearly impacted our results. I can't tell you with certainty when we’ll see the number of reverse. Obviously, we didn’t expect the softness when we provided our full-year guidance on our last call. I can tell you we no longer expect to see 10% volume growth for Hawthorne that was outlined in our original guidance.
For now, you should assume that the number to be flat, perhaps even down from last year depending on the second half of the year. Obviously, we continue to expect year-over-year growth from acquisitions. From a bottom line perspective, Hawthorne team is accelerating some of its integration efforts and contingency plans to offset the shortfall. As always, we have other companywide contingency plans if it becomes necessary. So I’d encourage you not to overreact here.
In fact, there is likely a silver lining for us. Given the breadth of our product line and our financial strength, we are better positioned than anyone in the hydroponic growing supply space, not just the weather our temporary downturn in the market, but to potentially benefit from it.
I’m not going to predict the future, but I will say that our competitors simply don’t have the capital structure that we do. Additionally, recent trends could actually make the M&A environment more favorable. Because of our long-term optimism about the hydroponics business, we’ll be opportunistic if the right deal present itself.
A final thought before I move on because context does matter here. California clearly has stumbled a bit as it try to put more structure around an industry that was pretty loose in the past. But in the long-term that structure will add legitimacy, and that legitimacy ultimately helps drive the overall market higher, both in California and throughout the United States. So even if the slow down last the couple of quarters, we’re still confident in the long-term opportunity.
Let’s move onto the core business, which as I said, is performing in line with what we expected. The first quarter usually represents 5% to 7% of our full year results. Because the numbers are so small, you often see large percentage swings from year-to-year. This year, however, sales remained in the quarter flat, which is what we have expected. And the trends we saw through fiscal 2017 remained in place in Q1, which really represents the end of last year’s lawn and garden season.
When it came to consumer to purchase for our products, we continue to see modest single-digit growth in homes centers and hardware collectively. And we continue to see double-digit decline at mass retail, so the net result was flat POS in the quarter. But as I said, those numbers mark the end of last season. As we look ahead to this spring, we believe the trend at mass retail, while still negative, won’t be a bigger drag as it was last year and the support we continue to get from the rest of our retail channels gives us confidence that POS will be a positive number this year.
Part of the retailer support comes from extremely strong line up of new products. I’ve told you on past calls that our R&D and marketing teams were better aligned than ever, and that our new product introductions this year are evidence of that. When we extended the round up agreement in 2015, we told you we hope to bring our first brand extension to the market by 2018. We were ahead of that goals when we introduced Roundup for lawns last year.
This year, we’re introducing two more brands extensions, Round Weed Preventer and Roundup Bug Destroyer. I think the names are pretty self-explanatory. Both of these new products have strong listing support in 2018. We also have strong support for a variety of new lawn care products. Our Triple Action fertilizer products are regionally specific. In the south, it’s a combination of fertilizer, weed control and fire ant control. In the north, it’s fertilizer, weed control and crabgrass prevention.
As we move closer to the season, our supply chain efforts are ramping up. Shipments are beginning to gain momentum with each week of this year being bigger than the previous one. As always, we expect retail displays to be set in all parts of the country by early March, and then we will begin to replenish as the season kicks in. This is the time of year when we're finishing up our new marketing campaigns, locking-in media buys, conducting sales training and ramping up our manufacturing efforts. So while the peak at the lawn and garden season is still a couple of months away, there's plenty of activity going on around here. We only need the weather to cooperate.
As Randy told you on our last call. We expect to see modest growth in our core this year and strong G&A controls. Higher trade program expense, commodity inflation and the impact in M&A, will put some pressure on our gross margin rate, but we don’t see these as long-term issues, I'll leave the detail to Randy.
As I close, I want to come full circle where I started. A little more than two years ago, my team and I shared with you a new vision for Scotts Miracle-Gro based on the realities in the marketplace, the current configuration of our company and the opportunities we knew were on the horizon. It was the right plan at the right time. And in the total return basis, shareholders have nearly doubled their money since project focus. Yes, the stock market is stronger and yes we’ve shared that benefit; but today, our growth outlook is stronger; our margin structure is better; our free cash flow is at record levels; and our team is having one hell of a good time running this business.
Randy?
Thank you, Jim and good morning everyone. I'm not going to spend too much time on the numbers this morning. For the first time in a long time, we don't have to worry about the impact of reconfiguring our business or changes in our segment reporting. The numbers are pretty straightforward this quarter, and I'm sure you like me, we will find it easier to follow along.
The tax benefits and the slow start to Hawthorne are requiring us to refine our guidance in a few places, and I'll point that out along the way. Looking at Q1, Jim already explained that’s a small quarter and he shared with you already the story behind what has been happening with the topline at Hawthorne during the quarter. He also explained that the U.S. consumer segment is right where we expected it to be. So I’ll just say that on a companywide basis, we’re up 7% for the quarter, which is only a little behind what we expected because of the backlog at Hawthorne. On a full year basis, we originally guided for sales growth of 46%, we now believe 2% to 4% is a more reasonable expectation.
So let me move on to the gross margin story. Remember, we said we expect to the gross margin rate for the full-year to decline 50 to 100 basis points due primarily to higher trade program accruals, higher commodities, slightly lower market pricing and the first year dilution from the impact of M&A. All of that remains true, but the impact is magnified in Q1 simply because it's a small quarter. We saw 240 basis point decline in the gross margin rate for the quarter to 15.3%, largely due to the volume and mix impact from our Hawthorne business. The rate will get better as the year progresses and we see more leverage out of our fixed cost. And as the higher gross margin U.S. consumer business begins to accelerate in our much larger second and third quarters.
I told you on the last call that I expected the modest uptick in commodity prices would probably cost us about $0.05 a share this year. Since then, commodities have continued to strengthen, especially fuel cost, creating a few more cents of headwind for the year. We’re nearly 80% locked at this point on all of our costs, so we have pretty good visibility here for the rest of the year. Our full year guidance for gross margin rate remains unchanged. We expect it to decline 50 basis points to 100 basis points.
SG&A is up 4% so far this year due primarily to acquisitions. Keep in mind that the actual change is only $4 million, again showing the impact that the small quarters can have on our percentages in Q1. We originally guided for full-year SG&A to be up 0% to 2% for the full year. We're now looking at the low end of the range, so call it flat year-over-year. Remember that the big numbers in SG&A are linked to our U.S. consumer business where we have disciplined controls in place. And as Jim said, Hawthorne is also using contingency planning to help make up for the expected sales shortfall.
Moving down to P&L. It's worth pointing out the change on the equity income line. We reported GAAP equity income of $600,000 in the quarter compared with a loss of $13.2 million a year ago. Prior year non-GAAP equity income was a loss of $3.6 million. Remember that our investment in TruGreen will not be included in equity income this year, as we’re now in a negative investment position with the JV. Last year's results are not removed, however, so you'll see large year-over-year swings each quarter, especially in the second and third quarters.
As you may know, Mike Lukemire and I are on the TruGreen board. I want to stress that the cost savings we expected from the JV have been fully realized. The business is slightly behind where we had hoped, but I would attribute that the integration challenges. We remain confident that TruGreen is making progress and gaining momentum, and will earn EBITDA approaching $200 million in fiscal 2018.
I also want to make sure you understand that our negative investment position in TruGreen is simply due to the fact that we've taken roughly $290 million of cash out of the business since the JV was established. This is essentially the equivalent of the value we placed on Scott farm service going into the deal. The future value that accrues to us based on our 30% ownership is not affected by the accounting rules as dictate whether the income shows up on our P&L.
Moving back to the P&L. Interest expense increased to $17.8 million in the quarter from $15.3 million. Our leverage ratio at the end of the quarter on a rolling four quarters basis stood at 3.1 times. I continue expect that ratio to approach 3.5 times prior this year as we renewed our borrowing capacity to fund both share repurchase activities and acquisitions. On the bottom line, the loss from continuing operations in the quarter on a GAAP basis was $20 million or $0.35 per share compared with a loss of $58.1 million or $0.97 per share last year. The difference is broadly due to the fact that we recognized a net deferred tax benefit of $46 million on results of the non-cash revaluation or reduction of deferred tax liabilities due to the recent tax law changes.
Adding to this is the favorable accounting impact attributing, which I discussed earlier. On an adjusted basis, excluding impairment, restructuring and other one-time items, we reported a loss of $62.2 million or $1.08 per share compared with $52.6 million or $0.88 per share a year ago. To reconcile last year's Q1 to this year, the largest items are non-operating in nature. In the last quarter, the impact of lower tax rates and lower share count is actually negative, which was worth about $0.15 in aggregate. The true operating change in the quarter as you can find Hawthorne, which Jim already discussed at length.
As you saw on the press release and as Jim discussed, we raised our full year adjusted EPS guidance to a range of $4.68 to $4.80 as a result of the tax law changes. At a high level, here is the story. As you know, the federal statutory rate declined from 35% to 21% effective this year. Because of our September 30th fiscal year-end, we will start from a blended statutory rate of 24.5%. We believe our overall effective rate on a non-GAAP adjusted basis will likely wind up at 26% to 27% for fiscal 2018, once we include state taxes and a few other minor items.
Beyond 2018, we believe our overall non-GAAP effective rate will still be 26% to 27%, and here is why. First, the majority of our products are manufactured in the United States, domestic manufacturing expense was deductible under the old rules, but to help fund the decline in the statutory rate, Congress eliminated that deduction. Congress also limited the deduction related to performance based executive compensation work. We’ve described in detail that the significant changes we made last year to our long-term executive pay plans. We were able to deduct most of those costs in the past because the plan was provided to both cash flow performance and total shareholder return. Unfortunately, the majority of those expenses will also no longer be deductible in the future.
We expect that the impact of these two provisions alone will more than offset the further reduction in our applicable federal rate from 24.5% blended rate in fiscal 2018 to 21% in fiscal 2019 and beyond. Like most companies, we continue to digest the changes and apply them to our internal models. So if we need to fine tune later in the year, we’ll keep you apprised. As for the impact on our capital allocation strategy, I don’t see a change here. We don’t have significant CapEx needs right now, and I don’t see big investments in our business that we weren’t already planning to make. But that said, every bit helps.
The tax changes likely will improve our free cash flow by roughly $30 million to $40 million. As I said a moment ago, we still expect our leverage ratio to reach 3.5 times, so the extra cash just allows us to move a bit faster than we would have previously.
One other change in our model. We originally guided a share count 58 million to 59 million shares. As we refined our modeling since we spoke last, we now believe we’ll gain the low end of that range potentially to get slightly better depending on the timing of future repurchase activities.
Let me close by saying that I encourage all of you not to read too much into our Q1 results. The peak of our years past approaching and I’ve confidence in the plans we put in place and the ability that Mike and his team to navigate the ups and downs of the seasonal in lawn and garden business. I also share Jim’s optimism about the continued long-term prospects for Hawthorne. As I’ve shared with many of you in person, my optimism is not just about the opportunity for top line growth at Hawthorne, but also our ability to begin driving efficiencies from the acquisitions we made and it made significant improvement to our margin structure.
With that, I’ll conclude now and turn the call to the operator so we can take your questions. Thank you.
Thank you [Operator Instructions]. And our first question will come from Jason Gere with KeyBanc Capital Markets. Please go ahead, sir.
I guess, I’ll start actually, just my one question will be on gross margin and just overall looking at the outlook. I get it that you guys are sticking with the 50 basis points to 100 basis points decline, and I know some of the trade program expense reversals play in there. But it sounds like you’re getting less leverage on Hawthorne, just with some of the issues going on there. And then higher commodity cost. So I guess really the question comes back to the pricing that you’re able to take this year. I know most year reversing some back. So can you maybe talk about the ability to take more pricing this year in an environment where I think you’ve led off saying that the consumer, it’s a little bit tougher of a consumer environment, that’s been the theme that we’ve been hearing through HPCs so far. Thanks.
Jason, this is Randy. Regarding pricing, the way the sequence works is it’s essentially negotiated with retailers over the -- beginning of spring over the summer into the fall. And once it’s negotiated in the marketplace it sticks. So we don’t have any concern from that end. And as far just overall gross margin rate confirming our original guidance of 50 to 100 basis points. When you think about the volume decline we’re calling down as a company that’s 100% focused on Hawthorne. We really don’t have a lot of fixed cost in our manufacturing base for Hawthorne, so it’s a much more variable manufacturing operation than what we see in our U.S. consumer business. So we don’t have big absorption issues that you’d see similar to our U.S. business. So that's largely why we’re able to confirm 50 to 100 basis points.
But Jason, I would also say that the probability we’re taking pricing for '19 is 100%, so.
Yes.
And those negotiations will begin just in a few months.
And I was just going to ask just trying to know what we heard during the peak of the season was just a little bit more push by some of your retailers on private label, so that's why I was just talking about the ability to how much the pricing goes through, the inelasticity to volume if you’re seeing other retailers looking at doing a bit more private label outside of the big one that we heard in the Mass channel last year. So I was just wondering maybe as you're looking towards the resets for this year, how that plays into shelf space and what you're gaining with new products, but the pricing element just like are you seeing more private label coming in in that…
Jason, this is Mike Lukemire. We’re seeing about the same private label. And you got to remember we do $300 million of private label ourselves our own label. And so the spacing at the home centers is actually better this year for us not less, and then mass is about the same of what we saw the previous year. So we were looking at that to level out and home center to be up . And so our confidence is actually -- and a indication through the end of January, we’re actually up in our shipments by about more percent over a year ago and in load. So of course February is the biggest month. So I don’t see any real risk there.
Our next question will come from William Reuter with Bank of America Merrill Lynch. Please go ahead.
Just following up on the last comments that you just made there about mass. You commented that you expect that mass is about the same in terms of your spacing there. However, in your prepared remarks, it sounds like you expected that to continue to decline and that that’s going to be offset by growth in the home centers. So maybe if you can just talk a little bit more about what those mass customers are doing and whether they’re reallocating to private label or take away from the category, a little more help.
Mike, you want to take it.
Yes. So when we look at the store sets and the combinations, we pick combinations in certain areas like lawns and gardens and maybe lose some in control. So as that reconfigures, it averages out to be about normal. And so what you saw on the first quarter is a continuance of what happened last year. So you’re getting the end effect of last year, which is a little bit of the negative and then it begins to stabilize for the rest of the year. So it’s a combination of last year and this year, is really how that you bridge at.
My view is that all you have to do is read anybody who is selling consumer goods and the story of mass is told by everybody. The good news for us is that it's a relatively small portion of our sale at this point compared to home centers and hardware. And so I don’t think we're seeing that, but I think we're also -- it is what it is, which is decisions they made. But I think we believe it’s fairly stable at this point and then it’s just going to be a matter of where the consumer shop and their share of the lawn and garden marketplace. And I think that's part of the story as well.
So I think time will tell, but I think everybody is pretty chilled here that things are what they are and we’re pretty happy we’re not selling detergents and other things where mass represent such a larger share of the business relative to us.
And then just to make sure, you didn’t speak at all about a change in your expectations for leverage in terms of your target of 3.5 times. Should I assume that that's still where you guys stand with that expectation?
We actually did say that's our plan for this year is to continue to get the 3.5 times. We've actually said that over the last years. So we received dividends from the TruGreen business and we sold our international business and pulled back a lot of cash. So good news bad news, that's why we've been able to keep our leverage lower, but we actually would like to be little bit higher and continue to pursue both share repurchases and acquisitions, so that's our plan.
We’ll move now to Bill Chappell with SunTrust.
Just give me a little more color on the Hawthorne. I am just trying to understand, I guess with regards to the trends, is it on the commercial side, is it on the consumer side? And then also, you’ve talked just about California that would imply that was the rest of business the rest of the country affected and maybe how much is California of that total business?
You've got a lot in there. So if I don’t get everything just remind me. California is about 55% of the domestic market, so that tells you the size of it, I would say that it's all parts of the market California. So if you look and say, let's say so the rest of the country I think is fine. It's not as easy to tell as you would think in part because we sell through effectively call it three distributors, and they are national. So that I think what we believe we've talked to in our knowledge to the market is that it's primarily a California situation.
If you look and say where do I think the market is going, I think you look at Canada and I think you look at the rag changes that are occurring in California. And I think -- and we’ve said this before that this is an industry that will professionalize and get larger, and I think we're seeing that for certainly in Canada and to our benefit, by the way, much larger capital spend. And so I would say that what’s occurred is that as California win adult use. They really are looking to have much more of a, or I view, Colorado is state of the art as far as how they’re managing within the state. California was a much loser environment where these care givers -- it's a weired environment where this medical market was hallow it was growing. So they’ve said okay, we’re going to regulate it and it’s going to look more alike Colorado. The counties also have the ability to set in.
And we think the bias is going to be more toward mid and large grows and grows that are for individual use and that who gets squeezed is the small or local care giver grows. And I think we’re pretty tight on this. So our view -- my view is that this is a big issue in California that’s what’s happening. It’s part of them growing up and making a much more professional environment. My understanding and this is as of yesterday, and so our numbers are I think as good as anybody, if maybe better, is that of the existing grows in California, less than 10% of them are now licensed in the state, that’s it how long its taking. And the majority of the counties are trying to get their own regulations in order, which they have to do to make these permits happens, these permits to grow or retail.
And like nine out of 10 counties haven’t done anything yet to get those rules promulgated. And there is long backlogs in places like Humboldt and other like large North California Counties. So we’re talking to Chris who’s Head of Sales, who is a long time Scotts guy. Who said only California could screw up a great market. I think our view is this is a -- while it’s a little bit of a pain in the ass, it’s what needs to happen as the country moves toward normalization of this product. And long term, we think it’s good and it’s important for us.
I think we also mentioned that certainly things we’re looking at, the pricing are not going up. I’m talking good businesses. But I would say the information you’re getting now it’s probably as good as you’re going to get from us, it’s as good as you’re going to get anywhere that I think this is one of the things that why you guys maybe more concerned than we are here is, I think we see what’s happening. I think we’re a little surprised by the magnitude of it how long it’s taken and how many people are no risk than not pursuing real grow permits and there’s moratoriums on most counties, you can check all this stuff. And you will not find that we’re -- I’m giving any like who do here.
So I think we continue to believe this is the right place for us to be, and our M&A is looking cheaper than it was and we’re pretty excited about that. I think this is a pretty impactful event for the industry. And therefore, I think this is one where size and capital structure are very much to our advantage now and in the long-term. So I think we’re pretty confident. I do think that your side of the business, the analyst community is not as tight to the market as you guys would be in lawn and garden. And listen, this is one of my recommendations coming out of this is that we think about getting together with you guys and taking you out to the market, so you can see what we’re talking about. Just because I think that for a lot of the people who follow our company, they are more consumer people than they are hydroponics. And I think it would make sense for us to give you a guided tour.
So that you like us would look at us and say, shit happens, one, and two, I think you would share our view that if you’re a consolidator in this space, the world just got better for us as long as you believe in the market, and we do. And that you believe that this is a California specific thing that works itself out in the short-term. And therefore, we're still confident. It’s a long answer, but I think it will short cut a lot of people who want to ask questions later on. I don’t know Bill if that helped you.
That helps. I guess just for clarification, it sounds like if the average consumer is still walking in and starting generating one growing their own in California, it's more of the -- more commercial customer is postponing entering the market, is what you’re saying due to the uncertainty about regulation. Is that the right way to think of that…
Not really. I think -- I've learned a lot in last week. I can tell you about how that market grows. It is a version of home grows almost that supplies a lot of that market, this care giver thing. These would be -- I just call it small to medium grows. I think the benefit will probably unfortunately go to larger grows just because -- I think that it's going to be the people who can afford to make these applications to get lawyers to speed through to follow the paper trails that has to happen. And if I was -- could get an appointment tomorrow with Governor Brown, I would say dude, you got to fix this because you’re going to run a lot of small people out of town, and its going to turn into I think a little more like Canada, which I don’t think was their original intent.
So I think that the future is probably better for the mid to large grow. I think the pain and suffering right now was on the smaller grows, not just -- I'm not saying smaller, I'm not talking about somebody growing from the sales, I'm just talking about something where you would see it in its -- it’s in the house or it’s in a small building. I think that’s what's being impacted the most. But the bottom line is even on someone looking to buy product today, my understanding is there is only 90 dispensaries in the entire state that have qualified so far for this adult use ability to sell through that space.
And so I think the market is being chocked on all places right now, both at retail and people's willingness to either legitimize current or existing grows and standing by because these moratoriums in the county level to say when can we get an application and do we want to do it within the state. So it's a pretty interesting time -- but it’s I think what has to happen is the state grows up and becomes a more legitimate adult use state.
Thank you. We’ll move to our next caller, Joe Altobello with Raymond James. Please go ahead.
So just a follow-up on Bill's line of questioning on Hawthorne, and Jim your comments about where the market is going. And it sounds like it's favorable toward the larger growers versus the home grower and the smaller grower. Could you just breakout how your business is in terms of your exposure to those larger growers versus the home grower? And if that's the case, because I do think you are under exposed to that larger grower and maybe I'm wrong. But if that's the case, why do you think that things would get better in the second half, because this a secular trend in the industry?
Well, because I know one thing, there is long backlogs like Humboldt just because they gave me the number after talking with the county how many applications or waiting to be processed, which is huge. So I think there is a lot of people applying to be able to cultivate. And so I think that that trend is not scary for us. I think if you look at Canada and the work that's happened with the big growing LPs in Canada, what they can see is a biggest one up there. We have a fabulous relationship with them. I think this is where I think we’ve really learned where we can add value with the size of the product line that we carry, the professional expertise that we can bring to helping them actually be more productive and profitable. So this is not like I think this is I know, which is that Canada has really move forward from a scale and professionalism point of view. It's not a gigantic market relative to California or the United States. But we have very much benefitted from big relationships on across our entire, where our sales force, our tech people, our ability to innovate be creative with programs has come together.
So I think this is one where we view scale as good. And by the way, we’re developing products to deal with areas where we think they’re going to want to save money. But remember, we've talked for a long time with you guys about how at least one layer of distribution has to come out of when something leaves our plants and gets to the ultimate consumer that there is just too many places that's travelling and people who are taking value out of that chain. And that part of what we're doing as we mature our distribution system is to deal with more direct sales. And that's another way to deal with the demands of the larger more professional customer, and it's not something we’re surprised or disheartened by, it's something we know. We're just executing our plans.
So it’s just accelerate that process from a two step to a one step distribution model?
Yes.
Thank you. We’ll move now to Chris Carey with Bank of America Merrill Lynch. Please go ahead.
So actually related to that last comment you said. So clearly, it sounds like M&A is more part of the picture in the very near-term given the slowdown in California. And you mentioned last quarter $100 million per year was what you could envisage doing. Do you see the potential is higher now. Can you give us a sense of size of the deals that maybe out there and what assets you’d be interested in?
I’ll start and then hand it to Randy. Was it a $100 million, I thought it was like – I think what people have told me they’re looking for that we put in the noise range was like $50 million a year just..
$50 million to $100 million.
So that’s in my head where this has been one of those things where I don’t want to take any brief from you guys. I know it will be flying my way if I could expose myself was I keep saying when I close the book on M&A and move toward shareholder friendly activities. And that’s still the case. So I think we’re very much in the terminal phase of our acquisition plans. So to me the question is when the book is closed what’s the number. And I think what people have commenced me is it like $50 million is just a number that you should view as close to zero, Jim, and not freak out that the book has been reopened without your authority and that the business has enough money to make changes, pick up adjacencies, et cetera.
In regard to right now, I think that we’re closing in on feeling that we have consolidated the hydro space pretty well. I think there is still some interesting opportunities on the live good front. And we continue to see good growth at the consumer level in that space. So there are discussions in live goods. And then in hydro, I think we’re almost done but it’s a pretty rich environment right now and prices are down for sure. So given the importance of it to our strategy and the fact that prices are definitely going up in the space that we’re not -- I haven’t said that, but whatever is occurring with us, we have definitely had our antennas up for hard for the last couple of weeks and saying this is an industry wide phenomena.
California, where we said 55%, California is equal to every state in the union combined is equal to California. So this weakness is affecting everybody, and it’s making the opportunity numbers look pretty interesting to us. And Randy I don’t know what you want to add.
No, I would just clarify. We had said $50 million to $100 million is pulled on their adjacent opportunities and as well as it’s a good strategic fit and the price is right, we’ll do deals. We just look at our pipeline for those kind of deals probably not as robust as it’s been in the past. But again, this is creating a good buying opportunity, right now. And there is a lot of interesting things going right now. It’s a dynamic industry and we’re well capitalized and thinking about how we take advantage of that.
I have a follow up. Then just on margins in Hawthorne, obviously, weak. How do you think about expectations for that business to get to mid teens this year as you had previously said, and the 20% long-term? Thanks.
So we expected operating margins for Hawthorne to approach mid-teens. It’s probably a little bit of pressure on that, but we’re working through contingency plans that were already laid out when we started the year. We do that both to our consumer business and Hawthorne. So we have room to navigate so we’re looking at open headcount, discretionary spending plans, investments that right now might not make so much sense. With sales are down, you don’t need to be as promotional, for example. So we’re working through all of that.
I still expect our operating margins to approach mid-teens. And to try and quantify where we expect the business to land for the year, I would still say mid $300 million probably a little pressure on that could be low to mid $300 million is on the top line for net sales, and still expect EBITDA to be in the $50 million range give or take a couple of million bucks. So that’s where we’re looking at right now for fiscal 2018.
Thank you. We’ve move now to Jon Andersen with William Blair. Please go ahead.
Sticking with Hawthrone for a minute. Do you still see the potential for -- I mean, is the target longer-term for the business to approach the profitability of your core U.S. lawn and garden business? And can you talk a little bit about what are some of that near-term discretionary spending decisions you can make in that business, but some of the longer-term profit improvement and efficiency opportunities that you’re starting to work on or you anticipate realizing over a longer period of time? Thanks.
I'll take the first part and then I'll leave Randy with the math. I see in talk to Chris what I think is maturing well and definitely under fire, at the moment. The work we’re doing now, both in our acquisition planning which includes the business process of running post acquisition and the pressure there under from California right now as actually a really good catalyst to make the changes faster than I think they might have done if they weren’t under pressure right now.
So from my point of view, I see the team is actually eyes wide open, functional, I've been in this company plenty of times where things have not been awesome. And sometimes it seems like people run around in circles and bite each other in the ass, and it’s like any family under pressure to get to little dysfunctional. I'm not seeing that. I’m seeing actually very functional work happening. But they’re accelerating the kinds of things that you're referring to that would really be consolidation of their sales, consolidation of their selling programs, consolidation of their tech support, consolidation of their manufacturing and supply chain. And these are good things that happened.
I would say just broadly speaking to-date what we’ve essentially done is collect businesses that we really like that were growing really fast with high margins. We’ve integrated them well We put an SAP as a platform, so we can start to do what we did 20-25 years ago with our U.S. consumer business where products can ride together to retailers and make it much more easier to do business with. So we are going to be moving the integration and optimization, which was the plan anyway. But given the circumstances in California, we’re going to move a little bit fast now.
And then with distribution in particular, we've talked about is really three options; one, we can just negotiate better fees than what we pay today, which is arguably over the industry norm; we could build our own network and go to direct ourselves, which is probably the best ROI in the long run, but would take time; and then the final option is to invest and/or buy 100% of one of the distributors. So if we go down that route, it could be one excess of the $50 million to $100 million that we're talking about that’s really earmarked more for buying new brands or different businesses similar to what we've done today. So that's the one potential outlier that we should keep in mind. But again, nothing is eminent at this point and we're going to do a lot of deep thinking right now.
And just, Jon, one more area. This is just broadly the group. We went into this year as we always do under promising. And so I'm looking right now at the board in my office that we have been using for the last few weeks to track motion in the forecast and what we look at the full year P&L to look like. And we have not modified our number down. So that between contingencies that Chris and his team have things that they can accelerate and get into plus contingencies we have, we’re sticking with an eyes wide open sticking with our numbers and not digging also into the Trump tax cuts. So we're actually like more children you would think based on where we are at the moment.
I would say we typically go to the process usually, April or May time period when we see how the business is shaking out, but this is something we’re used to doing we do this every year, we just don’t always do it in middle of January. But we're feeling showing good about the revised guidance we have provided.
One quick follow-up just one the core business or the business in aggregate, it's a seasonally small quarter for you. But are you seeing -- to what extent, are you seeing logistical cost increases transportation distribution and how are you thinking about that impact? Is there an inflation that you’re experiencing to what extent and how are you embedding that in your margin guidance for the year? Thanks.
So we anticipate a bit of that in our original margin guidance. So I’d quantify right now $2 million to $3 million, largely fuel. Jim said we're definitely taking price next year. We know we're going to have commodity headwinds. So we started out the year thinking it would be a few million bucks, it’s going to be a few million bucks more than that for '18. And I expect the trend that continue to go up next year. So we have it under control for current year. We have offsets within supply chain that we can manage through it. But obviously, as pricing is an important lever to this business and something that we're going to have to do next year.
Mike, anything you want to add?
No I think that's it…
You covered it. We’re 80% covered and we have offsets and retailers are facing that same problem in stuff they’re picking up. So maybe they've got that problem as well on stuff they come and pick-up from us. So everybody is facing that, but I think we get that covered to this season.
Thank you. Our next will come from Eric Bosshard with Cleveland Research. Please go ahead sir.
Question for you on the California situation, I’m trying to understand that this is a pause while they process these new regulations or if this is a structural change. And the reason I asked, I’m a little surprised to hear that acquisition prices are declining as a result of this and a little bit surprised to see you either rightsizing or optimizing your business, if this is just a hold your breath for six months and then it returns to normal. And so I guess the core of my question is, does the world look different after this and that’s what people are responding to in different words or different words for some people that’s what I’m trying to get some context too?
Well, I know you’d dig into our business. So you would be one of the top guys in the list say, let’s go out and visit and talk to people, because I think this will be a really good -- you're one of the best diggers we have. And so I think that we need to help you become familiar with this. I think different is different not different is good or bad. And I think it’s a pretty important structural change that’s occurring. And I don’t think for the worst, because I’d start by saying you know the state, the size of the California that goes adult use, that’s good, okay. Then to start with the simple part, that’s good, okay.
Now they want to regulate and you have an environment where so much of the growing was done in a fairly unregulated fashion. And now everybody is going to be licensed and everybody is going to have paperwork and the counties have the ability to make their own rules. And you got -- the fees are pretty heavy, the regulatory burden is pretty heavy. I think you’re going to -- I think you’re going to see structurally a different grower. I don’t think it’s good by the way. But when I say good, it’s just because I like small businesses. And I think it’s -- you go out and visit California, it’s a really interesting place in this market. And I’ve told you guys it’s only seem to me that it’s really aspiring. You got out there and you see this like people who like all kinds of weirdo people who are like running really cool little businesses, and I think it’s going to hard for them. Because I think a lot of them just have never faced the challenge of operating in businesses that are much more regulated like the State of Colorado for instance or Nevada.
And so I think it’s going to fundamentally change it but I think underlying is the state that there is really great environment for that market. And I don’t see that changing. But I do think that different is different and the cultivators who come out of that are going to be probably more professional and proficient in doing paperwork and dealing with the regulatory burden. And I think that’s going to phase out quite a few of those people. I’m honestly I’m sad about that, just cause they’ve been great customers.
I look at where the market is in Colorado, because I put Colorado as a very, I wouldn’t say very mature, but I’d say a mature state in regard to cannabis sales. And it’s a great business environment for us, it’s just very small relative to the size of California. So where the market goes for us, I think is more like just a gigantic version of Colorado. And that’s good for us, not bad for us. It’s just I think there's -- in the air force, we would say change is the result of a significant emotional event. And without that emotional event, we don’t have change. I think this is a pretty significant emotional event for the California cultivation market.
And I think it would be great to take you on a visit and others who are interested to actually see it yourself and talk to bunch of these people and try to get a feel for what's happening. It’s not all FUBAR and scary. I think it's just probably bigger that we thought and I think the effect of the local county regulations and the fact that I was shown a math yesterday of counties that aren’t even accepting applications right now. And that’s the vast majority of cultivation permits in the state of California or in counties that have not gotten the rules together yet. And it should be soon within the next couple of months. But that’s what's occurring and that's affecting peoples’ build outs and that affects peoples’ willingness to buy lights and other fixed products, benches and trays and all those things that we sell. So I don’t know if that answers your question sir.
I understand the change I guess the follow on is that your portfolio and position that was to deal with the small local guy now becoming for the bigger professional cultivator. Do you have to do anything materially different with the portfolio to service a different customer and/or does that invite different competition to consider as the end market customer is changing?
Look, I'm not going to try to editorialize on competition. I don’t think there is anybody better positioned than we are by far. I think there is people struggling out there, and that ain’t us. So I think we’re looking to round out the portfolio. I think the biggest challenges for us is, I'm not sure if Randy or Mike talking about it, but we all agree on this. And Chris was on the phone with us, he would say I agree, which is -- because we’ve seen it in Canada, which is when you’re dealing with these big LPs, these are companies what Scotts doesn’t work. It bring the entire portfolio together with technical support the ability to help them design to install program sales that are all way from license and nutrients. And right now, we have been very successfully not pushing the full integration too far.
I think to deal with the future marketplace, and maybe the future is upon us, I think they’re going to have to actually be what we had always planned to be, which is one -- it’s due to Scotts North America, it’s one phase to the marketplace that’s in that environment maybe with a little bit here and there with either partnerships with other companies and a few more product categories that we’re interested in, which is not gigantic money. I think we have everything we need to be the powerhouse of this industry and to really support the large growers. We’re seeing it -- it is our advantage in Canada when we put this consolidated effort forward just like we did in retail in the United States.
Yes, I think Hawthorne is the complete solution for this category, so all the things we put together all the technical capability. So now you’re dealing with the grower or small grower and you are actually been able to provide them all the help to have great success. And basically what we put together is that capability with the technical services. And so we’re ready to go either way. And to your point about six months but it’s slow, we have list the things we wanted to integrate we just accelerated them. So it actually should help us when it breaks loose. And then if there’s pent up demand, it actually could go the other direction fairly quickly as far as do we have enough in supply, we’ll be much better situated to handle that. So on the operations, I am very optimistic when we come out of it. But the question is when do we come out of it and how much can we get ready when it comes out.
Thank you. Our next question will come from David Stratton with Great Lakes Review. Please go ahead.
When we look at your interest expense this rising rate environment that we’re seeing right now. Can you break out how much your exposure is to a fixed versus floating and your overall interest expense at this point and what you see or possibly doing to prevent any downside in the future if rates were to continue to increase at their recent pace?
We’re about 60% fixed at this point for the current year. We've put on some new fixed rate swaps in the last quarter. And your points in the past, we've been a little bit higher than that. But part of our luck is to go much higher at this point is we have access to receivables facility that is actually beneficial to us from an interest rate perspective. And we can tap that particular facility and borrow at cheaper rates, especially during the peak of the season. So we really like where we’re at right now. And when you go out beyond 2018, we're still on that 50% or so lock position for the next couple of years. So we think we're appropriate and like where we’re at.
And can you tell what's your weighted average rate is right now?
It's in the mid fours at this point, it's creeped up as you expect over the last few months, but getting closer to five. It's been probably just 20 bps or so higher than what we saw on average over the last year. But we’re still yearly in the year expected to be 4.5 to 5 by the end of the year. And that’s weighted average, including bonds and everything else, our whole debt story.
Thank you everyone. That will conclude our question-and-answer session for today's call. At this time, I would like to turn the conference back to Jim King for any additional or closing remarks.
Thanks Joanna. Obviously, lot of questions today. So if people have follow-ups again, you can call me directly today and tomorrow, 937-578-5622. Thanks for joining everybody and we will talk to you again soon.
That will conclude today's conference. Thank you all once again for your participation and you may now disconnect.