Scotts Miracle-Gro Co (SMG) 2004 Q4 法說會逐字稿

Good morning, welcome to the The Scotts Company's fourth quarter 2004 earnings release conference call. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. To ask a question, please press star 1. Today's conference is being recorded. If you have any objections, you may disconnect at this time. Now, I will turn the meeting over to Mr. Paul Desantis, Vice President, Corporate Treasurer. Mr. Desantis, you may begin, sir.

Thank you, Elaine. Good morning, everyone. And welcome to our year-end and fourth quarter conference call. As Elaine said, my name is Paul Desantis, Scotts Corporate Treasurer, and with us this morning is Jim Hagedorn, our Chairman and CEO; and Chris Nagel, our CFO. I want to remind everyone that our comments this morning are likely to contain forward-looking statements. As such, actual results may differ materially. Due to that risk, Scotts encourages investors to review the risk factors outlined in our form 10-K, which is filed with the Securities and Exchange Commission. If you did not receive a copy of this morning's press release, can you find it on the investor relations portion on our website at www.Scotts.com. As a reminder, this call is being recorded and an archived version of the call will be available on the IR portion of the website. If we make any comments this morning related to non-GAAP financial measures not covered in the press release, we will provide those items on the website.

Before we start, I want to invite all of to you attend our December 8 investor meeting in New York. We will be having the meeting at the have it at the Intrepid Sea, Air, and Space Museum. It's a great venue. At the meeting, which will begin at 8:00 a.m., we will provide 2005 financial guidance, outline our plans, and make key members of our management team available for you. I encourage all of you to attend. If you have not received an invitation, please contact Peg Gordon at the Scotts Company. Let me give you her phone number. It's (937)578-5645. That's (937)578-5645. We look forward to seeing you all there. With that, let me turn the call over to Jim Hagedorn to discuss our performance. Jim?

Thanks, Paul. Good morning, everyone. It's pretty obvious from our press release this morning that Scotts reported another outstanding year in 2004. We strengthened our team, outperformed the rest of the lawn and garden industry, and made an acquisition in Smith and Hawken that creates new growth opportunities. All of this while on our way to recording another year of record sales, earnings, and continued strong free cash flow.

You heard me say in the past I don't believe there is a better business to be in. Once again, I think we have shown why that's true. If you haven't seen our announcement yet, let me give you a quick summary of what we reported. Record companywide sales of over $2 billion, which does not include Roundup. In a season that was both cool and wet in the East and often hot and dry in the West, we demonstrated the benefits of our geographic and product diversity as every major business in North America reported higher sales. Consumer purchases of our products increased by another 7 percent for the full year. I can't think of another category in the consumer products universe that continues to grow at this rate.

Record service levels and financial performance from Scotts LawnService, which regained its momentum to post a 22 percent increase in revenue and a 56 percent increase in profit. Gross margins improved 80 basis points due to a strong product mix and despite pressure on raw material prices. Return on invested capital improved once again as we slightly exceeded our target of 9.5 percent. We continue to strengthen our financial position, opting to pay down an additional $100 million in debt, refinancing our debt to take advantage of improving balance sheets and favorable interest rates. Our key debt ratios continue to improve, a trend we expect will continue. Free cash flow also remained a great story for Scotts. When we issue our 10-K in December, we expect free cash flow prior to the cost of refinancing to comfortably surpass what we reported in either of the last 2 years. And finally, we reported record adjusted net income up 18 percent from 2003, which is well above our original and revised projections.

By any measure, 2004 was a great year, and our success was due largely to the depth and breadth of our team, which remained focused on its goals throughout the year, and executed against them. For example, our purchasing team did an outstanding job keeping costs-of-goods in check. Even in the face of rising raw materials costs. Rising costs in materials related to natural gas and oil were tempered by favorable plant productivity and excellent warehouse management. Our sales team continued to show why it's such a great competitive weapon for us. From our business development teams to our field sales team, every area of sales worked to improve our results and those of our retail partners. We work closely with our partners to improve customer service and managed down inventories. We've proven POS growth through improved product assortments, coordinated promotional efforts, and by leveraging our team of in store counselors. The team's work was critical in helping us reach a point where for the first time, our selling and POS were in sync. That balance helps us to maximize the return for both Scotts and our retail partners. And changes in our marketing team brought a new perspective to Scotts in 2004. They brought a higher level of energy to this group, one that has become infectious throughout the Company. Excuse me, a drink of water.

The changes in marketing speak to a broader issue, the continued evolution of Scotts. As we grew through acquisition in the late 1990s, we were focused mostly on the integration of our dispret [ph] business units. We then shifted that focus on becoming a more reliable vendor to our retail partners. To do this, we invested in new technology that gave us better insight into our business. We invested in expanded capacity to give us that flexibility. We increased the size of our sales force and opened business development offices to work more closely with our largest accounts. These were investments that our competitors couldn't match. And collectively, they help explain why we continue to improve customer service and help our retail partners improve their returns, both of which make us a more valuable partner for them.

During that time, we also improved the breath and depth of our finance team. We became more focused on the issues that drive value in our business, especially return on invested capital, which allowed us to put programs in place to raise the performance bar. Now, marketing is getting the spotlight and already, the results are becoming apparent. A year ago, Bob Bernstock hired Eugene Sung from Coca-Cola and McKinsey, who's had a great impact on our business. It was in the last several weeks, Rich Sirota [ph] has joined us as a second general manager in marketing. He comes to us from Royal Philips Electronics and Proctor [ph]. You will have a chance to meet with Bob, Eugene, and Rich in December as we share some of our marketing programs for 2005. For now, though, I'm going to stay focused on our successes in 2004, and as you'll see, improved marketing played a key role.

I want to start by discussing what we saw with the consumer. The point-of-sale data, or POS, we received from our largest U.S. retail partners showed a 7 percent increase in consumer purchases of our products for the full year. We saw increases in every category, the highest of which was in controls, where consumer purchases of Ortho products were up 16 percent. The results in Ortho were due largely to a well-conceived marketing strategy that was focused on conveying a stronger and more relevant message to the consumer, and it worked. We have known for a long time that consumer confusion is a problem in the controls business. Consumers simply want a product that is easy to understand, easy to use, but still affective. In both non-selective weed control and outdoor insect businesses, we think we accomplished that goal. We started by repositioning these products to better communicate purpose and efficacy to the consumer. Ortho, SuperEdger Plus became Ortho's season long grass and weed killer with the promise that one simple application will eliminate weeds for an entire season. And Ortho Bug-B-Gon evolved into Bug-B-Gon MAX, a simple change that described a more powerful product, one that resonates with the consumer who just want bugs dead all season long.

The next step was to help the consumer find a product on the shelf. We began what will be a 2-year process of breaking up the vast array of green bottles and bags that previously defined the Ortho brand. Season-Long was repackaged in a silver bottle with a dramatic black labeling. Bug-B-Gon MAX abandoned its green bag for one that was metallic red and bold yellow type. This was another simple but well-conceived and very important change. Finally, we supported both products with-in-your-face advertising messages. If you haven't seen the spots, you can find them on our investor relations website. The results of these combined efforts speak for themselves. Consumer purchases of Ortho Season-Long Grass and Weed Killer were up 474 percent in the year. Ortho Bug-B-Gon MAX was up 89 percent. Our efforts with these two products lifted a category that has been sluggish in recent years and made it one of our biggest stars. We clearly outperformed the competition.

What is really encouraging about the success of Season-Long is that Roundup, which is a similar product, also continued to grow. You saw from our results today that our commission from Roundup increased 62 percent this year and consumer purchases were up by 13 percent; even though it's been off patent for several years now, Roundup continues to perform really well in the marketplace, demonstrating the power of the brand. The Ortho strategy will continue to play out in 2005. But this approach is not confined just to Ortho. We will find other areas where improved communication and simple, but smart changes in a product lineup can drive growth. You will see a similar strategy used in our lawns business next year. For example, our MaxGuard product, which was created for southern lawns, will be repositioned as Turf Builder with Fire Ant Killer. The message: Our product promotes healthy turf and kills fire ants all season long. We'll provide more insight to some of these efforts in a few weeks, but I think it was important to let you know that there are significant potential for continued success in all of our core business going forward.

For now, let me move on to gardens where efforts to trade up the consumer continue to pay off. Purchases of premium growing media were up 25 percent. We had tremendous results with our new superpremium product, Miracle-Gro Potting Mix with Moisture Control. This product, which was first introduced in 2002, was supported for the first time with advertising that conveyed a simple message: Take the guess work out of watering, and it worked. Consumer purchases of Moisture Control were up 140 percent for the year. We also had great success this year with premium garden soil and lawn soil, which collectively grew POS by 24 percent. These products received more attention in advertising support in 2004, and will continue to be a large part of our focus on growing media next year as well. In gardens, Miracle-Gro Shake 'n Feed, a product a gardener needs to use just once every 3 months, saw a 16 percent increase in POS. Shake 'n Feed is the best selling of our continuous released plant food, a segment of business we believe will continue to generate solid results for quite sometime.

Our largest North American business, Lawns, also had a solid year. More importantly, this about business continued to demonstrate the competitive advantage that we enjoyed due to both our geographic and product diversity. Consumer purchases of lawn fertilizers were up 5 percent, and high value combination products like Halts, Turf Builder Plus 2, and Bonus S collectively increased by 11 percent. The lawns business also benefited most from our strong geographic diversity. A wet-and-cool season in the Midwest resulted in a slight decline in POS; however, the mid-Atlantic, Southeast and Southwest all outperformed the corporate average. Specifically, we were encouraged by early results of our strategy to ship on fast-growing southern markets where we also have lower market shares. In states like Texas, North Carolina, and Florida, we saw POS increases in lawns of 7 percent, 8 percent, and 8 percent, respectively. I have already talked about the Turf Builder With Fire ant for 2005. In December, you will hear more about our southern strategy.

All in all, Bob's team did an outstanding job of driving the business in 2004. Not only did they achieve their goals for the year, but they positioned the business to continue its momentum into 2005. I'm also pleased with the progress that Tim Portland and his team have made with Scotts Lawn Service. Operating income on this business grew by 56 percent, fueled by a 22 percent increase in revenue. What is truly encouraging about the results, however, is something that doesn't always show up on the financial statements. Our focus on the consumer. By better executing the basics and better partnering and communicating with the consumer, SLS not only helped homeowners have nicer lawns and landscapes, but improved their overall service experience with Scotts. Technicians in the field were encouraged and rewarded to improve customer communication and service, not simply put down as many applications as possible. Sometimes that meant they went slower. Actually, servicing fewer lawns on any given day. But their focus was on getting it done right, not just getting it done fast. This focus was supported by a new compensation program that provided financial incentives to every SLS associate based on customer service, not just growth. Throughout the season, homeowners have endorsed our -- our efforts. At the end of September, we had retained a record level of nearly 74 percent of our customers, 225 basis points higher than last year. This retention rate is significantly higher than the competition's, and includes the impact of a mid-season price increase.

In addition to retaining customers, Scotts Lawn Service also did an outstanding job of attracting new customers. SLS clearly conveyed the power of the Scotts brand and the desire to create a partnership with homeowners. Their early season successes generated higher customer accounts than planned, contributing to our strong revenue growth and positioning us for continued success in 2005. With a new and deeper management team, a clear focus on customer service, and a strong outlook for continued growth, can you see why we remain confident about the potential for this business at Scotts.

Let me switch gears and touch on international for a few moments. We got off to a slow start here due to some product availability issues and then a late break to the season. Halfway through the year, the business called its numbers down and we made a change in its leadership. But the second half of the year was a different story. Profitability trends improved in France and Germany, allowing them to meet or exceed our revised expectations. Top-line growth in the United Kingdom was also stronger this year. Though an array of internal and external challenges caused them to fall short of their profit goals. For the business in total, sales increased 8 percent, but declined slightly when excluding foreign exchange rates. But there are several successes in the business worth highlighting. We strengthened the management team, completed the implementation of SAP, consolidated manufacturing operations, and went through a complex SKU simplification process that will make us more efficient in the long run. Each of these improvements will make the business stronger in 2005.

I know many of you will have questions related to this business and our plans for next year. So let me give you an update. While we have not made a firm decision, we are increasingly leaning toward extracting capital out of this business and deploying it elsewhere. We are still working through our options. We've said openly this could mean the sale of the business, but we could also sell portions of the business or seek other arrangements such as a JV, which could allow us to keep significant interest. Regardless, it's important to you -- for you to know that any action we take would not be quick or easy. There are several factors, not the least of which is the Roundup agreement, that could make any action we take pretty complex. This is about all we can discuss on this issue and I will not elaborate on it during the Q&A. We hope to share more insight when we meet in December, but we probably will not announce a firm decision at that point.

Let's talk about the other things you're going to hear us in December, starting with Smith and Hawken. We tried to talk to as many of you as possible since we announced the deal. Let me quickly remind you of the reasons we made the acquisition and why we're excited about it. I'm going to start by talking about where I see the value of Smith and Hawken, which is pretty easy. It's all about the brand. This is a brand that I personally have followed and admired for well over a decade. It's one I believe is the gold standard in the patio-living category, and patio-living is an area where I'm convinced Scotts should be. More consumers every year are looking for ways to create a garden-inspired lifestyle. They look at their garden or their patio as an extension of their living room, and they're also bringing gardening inside their homes as well. Previously, Scotts was enjoying a little upside from what was the fastest-growing segment in gardening. With Smith and Hawken, we now have a seat at the table.

From a product perspective, Smith and Hawken gives us a stronger perspective in pottery, but they also participate in watering equipment, including water gardening, tools, live goods, and outdoor furniture. For your information, each of these categories are growing at least as fast as the core business we're in today. Some are growing at 9 or 10 percent a year. We're extremely bullish on the long-term prospects of our core business, but that doesn't mean we're satisfied. Scotts has been and will continue to be a growth company. And some of that growth will come from outside our chemical-based categories we're in today. In other words, it will probably require some acquisitions.

We said we view the entire lawn and garden industry as our sandbox, so we have been exploring which of those categories offers us a chance to leverage our strengths. Where we think we can add value, we're actively exploring opportunities. Which gets me back to Smith and Hawken. Today, it has about $140 million in sales through about 60 retail stores, as well as its catalog and internet site. Growing the catalog and internet segments will be the focus of the existing business. While we believe the stores remain an important part of the business and will be key in helping establish the tone for the brand, I would expect the store count to remain stable. In terms of retail, our biggest effort will be in finding creative ways to extend the Smith and Hawken brand to the appropriate retail channels in which Scott operates today. Our retail partners know that patio living has the potential to be huge for them. But they're also looking for a strong brand as well as a vendor with the ability to fully leverage the brand. We offer that potential. We have had important discussions with our retail partners and they like the Smith and Hawken brand. Over the next several months, we're going to be working closely with them to develop the right strategy and product offerings that allow us to extend the brand and set the stage for some exciting developments in 2006.

Whether it's Smith and Hawken, the continued growth in North America or the renewed momentum of Scotts Lawn Service, I hope it's easy to see why we feel so positive about our business. All of us here are celebrating the outstanding results we announced this morning, but at the same time, we're not standing still. We have established a high-performance culture at Scotts that allows us to celebrate our success or to focus on tomorrow as well. So what does tomorrow or 2005 hold for us? Without being too specific today, we expect to provide an outlook for you in December that is consistent with our long-term goals to grow sales by 5 to 7 percent a year and to grow net income by 10 to 12 percent. Given some of the strong programs we see coming next year, we feel extremely confident in our ability to remain on a high-growth trajectory. However, like several other CEOs, I have concerns about the overall economic landscape. Please keep in mind there are no leading indicators that suggest our business will be challenged in 2005. And while my crystal ball is no better than yours, I'm uneasy about the macroeconomic outlook. For starters, I do not believe that $54 oil is factored into the economy.

While there have been reports in the last week suggesting there will not be a huge impact from oil prices, I remain unconvinced. So our intention is to build a budget that allows us to meet our bottom-line targets even as the economy begins to slip. Regardless of the economic landscape, I believe our company is in a stronger position than at any time since the Scotts Miracle-Gro merger, nearly a decade ago. I'm extremely encouraged with what we're seeing here right now. Our team keeps growing stronger, our innovation efforts are improving, our knowledge of the consumer is deeper. We continue to outperform the competition, and our relationships with our retailers continue to grow stronger. All of this creates a stronger company, poised for continued growth. Those facts, combined with a focus on expense control, free cash flow, and improved ROIC, provide a great recipe to continue enhancing shareholder value. I'll take your questions in a few minutes, but first, I want to turn things over to Chris to discuss the financials.

Thanks, Jim, good morning, everyone. As Jim said, we're very pleased with the terrific performance we're reporting today. I'm going to highlight both the reasons why our performance was so strong and the affect of foreign exchange where it has significantly impacted our results. Before I get into the details, I want to celebrate our success. Despite upward pressure on commodity costs and execution issues in Europe, we delivered solid top-line growth, substantial gross margin improvement, and adjusted net earnings growth of 18 percent. We achieved these results while we continued to invest in our brands, make important investments for future growth, and improve the Company's financial condition. With those comments, let's move on.

On a year-to-date basis, sales were 2 billion, an increase of 8 percent from 1.9 billion last year. Excluding the impact of foreign exchange, sales increased 5 percent in the quarter and 5 percent on a year-to-date basis. Our top-line results were driven by strong POS growth in our North American consumer business and rapid growth of our Scotts LawnService business. Sales in our international business were down 3 percent, excluding foreign exchange for the full year, but that figure masked some good performance, which I will detail later. Fourth quarter sales were up 7 percent on a reported basis, and 5.5 percent excluding foreign exchange. Again, driven by our North American and LawnService businesses. For the quarter, North American sales were up 6 percent, led by growth of 11 percent in our lawns business. Winterizer and Winterizer Plus 2 enjoyed another sensational fall season, growing a combined 19 percent over last year. Our garden fertilizer and Ortho businesses also had strong fourth quarters, reporting sales increases of 8 percent and 7 percent, respectively.

For the year, North American sales were up 7 percent, led by growth of 16 percent in our Ortho group. The success stories, driving our Ortho group this year were many. We relaunched our non-selective weed killer offering as Season-Long Grass and Weed Killer, growing our non-selective sales by 40 percent. We repackaged Bug-B-Gon Outdoor Insect Control as Bug-B-Gon MAX, reenergized the advertising message, and regrew the brand by 73 percent. National advertising and in-store promotions drove our Bug-B-Gon business up 18 percent this year. A tremendous amount of credit goes to Eugene Sung and his entire Ortho marketing team for the business's outstanding performance this year, and they are posed to continue driving this business again next year with more exciting growth initiatives. We look forward to sharing some of those with you at our investor's conference in early December.

Sales for our lawns business grew by 5 percent this year, but this doesn't convey the true story behind their results. Our branded, higher-margin lawn fertilizer products grew 7 percent as a result of outstanding sales increases for Turf Builder with Halt, up 26 percent; Turf Builder Plus 2, up 18 percent; Bonus S up 15 percent; and Winterizer Plus 2 up 29 percent. Partially offsetting this strong performance was our spreaders business, which was flat year-over-year and our grass-seed business which was down 1 percent. The relatively cooler wetter weather this year in many parts of the country made for a great season for growing grass, resulting in reduced demand for grass seed. In fact, unit volume in grass seed was down 15 percent versus last year, and given the favorable growing conditions this fall, we think it's unlikely we'll see a significant improvement in grass seed sales next year. However, sales of grass seed represent less than 7 percent of North American sales, so our product line and geographic diversity helps to minimize our risk from this category. Sales of growing media were up 4 percent over the prior year, but the story for this group continues to be the improvement we made in gross margins as we trade consumers up to value-added products, which grew by 7 percent. I'll provide more detail about our gross margin improvement in just a moment.

Our Canadian business also had a great year, increasing sales in excess of 16 percent, excluding the affect of foreign exchange as we saw the benefits of expanded listings and from our successful bilingual consumer promotional programs. The LawnService business grew by 17 percent in the quarter, and 22 percent for the year, reaching 135 million in sales. Approximately 3/4 of the sales increase is driven by organic growth, while the remaining 1/4 of sales growth reflects the full-year affect of prior-year acquisitions. Our strategy of improving customer focus metrics is proving to be successful. Our customer count is 20,000 greater than it was at the end of last year, contributing to our ability to increasingly leverage the fixed costs in this business. In addition, our customer retention rate at the end of the year was just under 74 percent, an improvement of over 225 basis points for the year, and considerably ahead of our peer competitors. Additionally, we took successfully a low single-digit price increase in July, which had a minor impact on customer retention. All of these results tell us that our customer service proposition for this business is paying off.

International sales increased 2 percent in the quarter to 63 million. Excluding the impact of foreign exchange, sales decreased 6 percent for the quarter. Strong top-line performance in France and central Europe was not enough to offset decreases in the UK as it coped with sales losses resulting from the ban of the active used in the Weedol and Pathclear book [ph] brands, and the affect of discontinuing a low margin growing media line in our professional business. For the year, international sales were 420 million, up 8 percent. Excluding foreign exchange, international sales were down 3 percent. Sales for the consumer business were flat to last year while the professional business was down about 12 percent due to the discontinuance of the low margin growing media business previously mentioned. We are encouraged by the full-year top-line performance of our UK business, which was up 3 percent over last year, driven by growth in the lawn care, pest, and disease categories. However, earnings for the UK business were down compared to last year, due to significant manufacturing issues, related to our aggressive supply chain rationalization plans, resulting in product availability issues and cost-over runs. While this was a difficult experience, we're confident that those issues are behind us, and that we will see much better performance going forward. Compared to last year, sales for our business in France were up 1 percent. Sales for our other international businesses including central Europe, other European countries, and Australia were down slightly compared to last year.

Full-year reported gross margins are up 130 basis points from 36.5 percent to 37.8 percent. Excluding nonrecurring charges, gross margins increased from 37 percent to 37.8 percent. Gross margins for the forth quarter as a percentage of sales, excluding restructuring charges, declined by 90 basis points to 33.9 percent. I am pleased to say that every one of our business segments realized improvement in gross margins excluding restructuring charges this year. North America increased its margin by 60 basis points, driven by the higher margin new products introduced this year in the Ortho product line, by better mix in our lawns business and a continuation of the trade-up strategy we have pursued for growing media products. Margins in our Scotts LawnService business improved by 220 basis points over last year, due to increased productivity. In addition, the significant growth in our LawnService business, which enjoys higher margins than our other segments, contributed approximately 10 basis points to our overall margin improvement. Despite the margin issues I mentioned for our UK business, gross margin for our international business increased 40 basis points over last year, excluding nonrecurring charges. This increase was primarily driven by the professional business, which realized a dramatic margin improvement due to the discontinuance of the low margin product line. The gross margin for the consumer business declined year-over-year. Good margin improvements were recorded in both France and central Europe as they began to see the benefits of our growth and integration plan. These increases were able to partially offset the execution issues experienced in the UK.

Roundup had another great year. Consumer take away increased 13 percent for the year, driving a significant increase in profitability. Net Roundup commission in the quarter was flat to last year at 4 million. However for the year, the commission was up from 18 million last year to 29 million this year. Advertising for the year grew 7 percent to 105 million, slightly below our reported sales increase. As we planned, SG&A spending has increased this year. Excluding stock options, Scotts LawnService and restructuring costs, SG&A increased 15 percent this year to 369 million. Approximately 12 million, or 25 percent, of the increase is due to the affect of foreign exchange rates. The remainder is primarily driven by increased variable compensation, increased legal expenses, and additional investment in research and development. While we recognize that this level of spending increase is not sustainable, the increase came in below the expected range excluding foreign exchange, reflecting our acknowledgement of the need to control spending. We look forward to providing greater insight into our plans to further control the growth and SG&A spending in early December.

Stock option expense for the year-to-date period was 7.8 million, up 3 million. This move to make our financials more transparent dilutes the earnings per share by 15 cents this year, and reduces adjusted earnings growth by almost 2 percent. Scotts LawnService reported SG&A for the year of 57 million, up 23 percent from last year. This increase was driven by the full-year affect of last year's acquisitions, as well as increased support and incentive costs. Restructuring charges in both gross margin and SG&A totaled 10 million for the year, compared to 17 million last year. The overall decrease in charges reflects charges taken in 2003 in connection with our North American distribution restructuring and lower spending this year on our international growth and integration plan as it enters its final phase. Interest expense has continued to be favorable for us this year. For the year, interest expense, excluding refinancing charges, is down from 69 million to 49 million. Slightly more than half of the decrease in interest expense compared to last year is due to lower interest rates resulting from market conditions and our successful October 2003 refinancing. As a result of our significant cash generation, we elected to prepay 100 million of our term debt in the third quarter. In August, we also refinanced the remaining 400 million of our term loan facilities, the benefits of which we began to see in the forth quarter. During the year, we incurred 45 million in pretax cost associated with these two refinancings, which provided significantly improved pricing and flexibility.

Over the past four quarters, we have also significantly improved our balance sheet. We've reduced our average net debt by 116 million, despite the adverse impact of foreign exchange rates that have added almost 13 million to the average. That translated into a leverage ratio of 2.4 at year-end, a sharp improvement from 3.0 last year. We also have improved our interest coverage ratio to 6.4 from 4.1 a year ago.

Free cash flow is an important success story again for us this year. Excluding the cash costs of refinancing, we generated free cash flows in excess of prior years, driven by strong earnings, control over capital expenditures, and good balance sheet management. I'm frequently asked about our intended use of our high levels of free cash flow. We're targeting a leverage ratio of 2 times as a strong crossover metric. So we'll continue to delever our balance sheet. However, our improved flexibility allows us to pursue acquisitions to support growth opportunities where appropriate. We are also frequently asked if we would consider returning some of our cash to our shareholders in the form of a dividend or stock buyback. We're actively evaluating our plans for the longer term use of free cash flow, and look forward to providing further insight in the coming year.

Depreciation was 46 million and amortization was 12 million for the year. Capital expenditures for the year were 34 million. Capital expenditures were below last year, as we had no significant IT, infrastructure, or manufacturing capacity projects in 2004 like we did in 2003. Despite our lower level of spending for 2004, we continue to believe that our normalized level of capital expenditures is in the 50 to $60 million range. Adjusted net income for the quarter, excluding restructuring and other charges, was 2.6 million or 8 cents per share, compared with 700,000 or 2 cents per share last year. Including restructuring and other charges, the net loss in the quarter was 1.7 million, or 5 cents per share, compared with a loss of 3.1 million or 10 cents per share last year. We believe that increasing fourth quarter profitability will continue to balance our seasonality and improve the consistency of our business.

On a year-to-date basis, adjusted net income was up 18 percent to 135.3 million or 406 per share. Reported net income was 100.9 million, or 303 per share, compared with net income of 103.8 million, or 323 per share for the same time last year. It's important to note that our annual share count increased by almost 1.2 million shares compared to the prior year. Which impacts the year-over-year EPS comparison by 15 cents, or 4 percent. Under the balance sheet, you will see that accounts receivable are flat with procedure year. Excluding the affect of foreign exchange, accounts receivable has declined slightly. Inventory is up almost 5 percent, half of which is due to foreign exchange. The remaining increase is driven by the international business as it prepares for next season. Return on invested capital improved again this year from 19.2 to 9.5 percent, up from 8 percent in 2001. ROIC is a major focus for us, and we continue to support only those initiatives that provide an appropriate return on employed capital.

I also wanted to point out we're showing net income from discontinued operations due to the sale of our professional growing media business in the U.S. during the year. As a result, we have restated the quarterly year-to-date numbers in both 2003 and 2004. If we take a moment to reflect on our accomplishments over the past few years, we think our results deserve notice. Since 2000, we have grown sales and adjusted earnings compounded annually by 5 percent and 17 percent, respectively. Over the past 3 years, we have generated nearly half a billion dollars of free cash flow, allowing us to reduce average debt from almost 1 billion to 731 million, and improving leverage from 3.9 to 2.4. The consistency of our performance gives us, and should give all of you, the confidence that we can continue to deliver outstanding financial results going forward. With that, I will turn the call over to the operator so we can answer your questions.

[Operator Instructions]. Ron Tillis [ph], Banc of America Securities.

Hi, guys.

Hey.

On the control gains, how much of that is just new shelf space? Because I think you've been a big retailer, and how much of it is just better sell-through?

Bob, you want to answer that one?

Yeah, we have had with one of our large home centers, we've had fairly significant shelf gains. But I would estimate at least 80 percent of it is consumer sell through.

Got you. And you talked about some price increases in a customer retention issue. Is that -- should we take that to mean you that lost a little bit of shelf by increasing price?

No, no, I think you're -- that we're talking about LawnService and what we're saying is, we had a significant increase in retention in our LawnService business, I don't know what it was, 225 roughly, basis points even including a price increase, which had a minor affect on retention. So, no, I think we feel really good on the consumer -- North American consumer side of the business. We feel really good about the listings we have for next year. So I think the program sell-in for the year has been a really good story for us and we'll talk more about that in December.

Got you. And on the Smith and Hawken side, have any of your retailers voiced their displeasure, you know, with your potential competition? Do they do it that way or not, have you been successful in convincing them otherwise?

I would say we have been as successful as we can be. Not using weasel words there.

Yeah.

I think we have been pretty successful. I would say, they would like to not see us -- not a retailer.

Yeah.

And we would like to see them out of the private label business. That being said, I think that we're in a good position with a our retailers. The majority of the retailers, by the way, encouraged us to move forward with this, and expanding and using this brand in outdoor living. It was really only one retailer that had some questions about it, and I think we worked really closely with them to make them as comfortable as they're going to be. At the end of the day, I think all the retailers are going to look at how we want to sort of deploy the brand out to the retail environment, both the independent retailers and sort of the mass retailers. So, no, we're not in any trouble as a result of that.

Hey, Jim, if you're going to sell something, where would the cash end up going, you think?

Oh, man. That's a good question. I would say, you know, we -- you know, I know there's some high-yield folks on, too. My view is that there is probably stuff to buy out there, but it ain't a big list.

Yeah. And, you know, Chris is pretty serious as am I, about basically saying where do we want to be as of credit, and I think that's about two times leverage. We're pretty close to that at this point, so I think if we were sitting on a bunch of cash, we would consider seriously, either dividend or share repurchase. Now, this is not a discussion that the Board has approved yet, but it's something that we intend to pursue, just because if we look at, you know, we look at our balance sheet going out, it's clear we probably have more cash service capacity than we need. So, the question is how do we use it, and I think as we have sat down with both our strategy group and our outside advisors on the M&A side, this is not that big a universe of stuff to buy. Okay? Right, and I think one of the goals of the leveraging was to get to investment grade. Some of us out here kind of scratch our heads about that.

But, I don't think that's the case. I think that Chris and I have been pretty clear that -- I'm going to use sort of Hag-talk, okay? I'm going to say being a crumby -- a low-end investment grade, where we're worried and getting gray hair over about maintaining that is not probably where we want to be. We would rather be a really good quality, consistent high-yield, and if you look at our debt, I think it trades kind of like we're high-yield -- or an investment grade player. So, I don't think we look to be an investment grade. I think we'd like to be kind of what Chris Klennet [ph] calls a crossover, that I think means a really excellent quality, high-yield player.

Got you. And then finally --

Is that good or bad?

It is what it is. [ Laughter ]

Okay. Thanks for that.

And, finally, on the accession front, I think historically, we have observed and you have commented that, you know, on the chemical stuff it's always -- it's for the most part been lower quality, lower price point, which doesn't necessarily jive too well with your sort of placement market is, you know, has that changed at all or do we have it wrong?

I think you kind of got it wrong, I would say.

Okay.

I -- we would think very carefully about whether we want to make more acquisitions on the control side of the business. And that's not to say we're afraid of it, we don't like it. But I think we got the brands that matter, with Ortho and Roundup. And I 'm not sure we don't need to do anything there, we're probably more interested in having great relationships with the active suppliers that we say, You don't need anybody else besides us to take new actives to the market. If we were to make acquisitions in that space -- and this would be extremely limited, and I got to tell you, if there is a list, it's a very short one. These would not be margin dilutive, so, I think -- what it says is, I'm not interested in margin dilutive chemical acquisitions.

Thanks, guys.

You bet. Thank you.

John [ph] Tate, Raymond James.

Good morning, guys, I'm on the on behalf of Sam Darkatsh, he's out of the office today. I was wondering if you guys could give me some color on urea prices year over year in the fourth quarter as far as costs.

Well, let me be able to just talk about kind of the year and what we look at the future, instead of being -- sort of talking the fourth quarter.

Okay.

I would say if you look at '04 compared to '03, the cost of urea is up significantly. It's a commodity, I think it actually trades or is limited trading. The natural gas and urea kind of follow each other.

Right.

I'm going to say unfortunately, I'm not sure it's right or not, natural gas and oil tend to follow each other, and I think everyone knows that story. Now when we spent time with you guys, I think it's last December, this was probably like a show stopper, damn near, when people were saying, you know, waving the urea flags around and saying, How are you going to cover this? Well, we did. Okay? And we did it because we operated our business well in the face of, I'm going to say pretty significant increases in the cost of a basic raw material at Scotts. Where are we today? I think we feel like urea's probably not going down very much. That's fair. We, you know, I'll sort of hand it over to Mike Kelty, I think, or Mike Lukemire, whoever wants the questions. But I would say -- kind of my -- where we are is we've got a lot of our stuff made for next year, or we've got contracts or bulk on the ground. So, I would say we don't have significant risk over what's already in our budget. But I think we will continue to look to improve our gross margin in 2005, and so I got to say, I ain't too worried about yet, although I'm really glad we took pricing for the seasonal year in '05. Because I think without it, I wouldn't be saying what I'm saying, which is that we expect to sort of be, have a good margin story next year. So, I mean, which Mike wants this?

I will take it. Mike Kelty. We find ourselves going into this new fiscal year very much the same place as we find ourselves going into '04. Jim just mentioned that. The percentage increases in our raw materials that we're likely encounter this year are quite similar to last year. We were able able to negate the negative effects of pricing, of increased costs last year in three ways primarily. One was our -- in purchasing. We -- I shared last year at this time that we had a purchasing strategy on the energy-related items, where we locked in, we got our -- [ Indiscernible ] We made them early and that helped us get predictability in our cost-of-goods. We mined other raw materials to get cost savings, we were successful there, and we got significant savings in our distribution and in manufacturing. These savings in distribution and manufacturing directly stem from investments that we made previously in planning. We put in a system called menujistics [ph] awhile ago, and we can really plan our business much more effectively. So, an example of our benefit there is, we're more affective in the load building. We can use low-cost ways of getting materials like intermodal freight. We could never do that in the past, so we're able to save money. Also, we're able to plan our manufacturing more effectively and we've saved a lot of money there. So, collectively, we're able to counteract the negative effects and I think in '05, we're just going to have to do the same. I think we have plans in place where we can cover most or all of the unfavorable pricing and costing that we see.

Thank you. One more question. If I could. I was going to ask about advertising spins going forward and what you guys were looking for there, 2005 versus '04.

Well, let me kind of throw out, because I'm going to sound look I'm talking out of both sides of my mouth, which I don't know if people didn't like it or not. We'll see. What Bob Bernstock and I believe about the business is that a company like ours should have an A to S, I'm not sure if A is probably the right one, but it's a sort of media spend of sales about 7 percent. That's what we believe kind of world-class marketing companies spend at that level. What do we know? We know that where we have invested we have seen a response rate. This year, okay? So we continue to plan to increase our spend and advertising strategically to try and get to the 7 percent level where we're -- I don't know, call it 5.5 or something like that, roughly today. So let me go out the other side of my mouth. I got to tell you. I'm worried about $54 oil. It's not we don't have our cost covered, it's does the consumer have their cost covered that I worry about. And so Chris Nagel and I have been very difficult budgeteers or at least managing that budgeting process going forward, and I would say we're pretty much on a war time budget around here. Basically, we got our rear ends covered kind of both on the revenue side and on the cost side, and I think that hopefully we'll make people feel comfortable. We'll be prepared to sort of overspend when we start to feel better, but the budget that we're starting the year out with is a tight budget that probably doesn't move the needle much on increased A to S ratios, but long-term, we do think it's important, but until I see that the consumer is alive and well, I think we're just going to sort of not get too exposed. So that, Bob, you want to add anything on that?

I don't think it's really out of both sides of your mouth more as long-term and short-term. Long-term, we're committed to moving towards, probably not just direct television media, but all alternative media included to about 7 percent. In the short-term, we've got some tough challenges, and clearly, we'll be spending advertising at the same level as revenue. But unlike the past, we're not starting with a plan to be at a higher level than revenue growth. So, we should maintain but not increase is the plan going into the year.

Okay. Thank you guys. It's a perfect answer.

Great. [ Laughter ]

Joe Norton, Banc of America Securities.

Hi, thanks. Jim, probably kind of a follow up to what you were talking about, but I am interested in your comments on the economy. When you, it sounds like the -- kind of a contingency plan for next year is mostly from advertising and marketing, or just when you say, you know, we have plans in place to make our budget no matter what. Is that -- is that kind of what you mean, or can you elaborate on that anymore?

The latter part, I would say, we're --I think we're going to be a pretty flexible organization to be able to withstand sort of the hits on both the revenue side and on the cost side. And be able to not look like too big of idiots to you guys and our shareholders. So let's kind of start with that. Do I think advertising is the last place we're going to go to look to mine money. You know, the budget process was very -- and which is -- I think we completed like almost all of it this morning at 7:30, was pretty much a death march, okay? So I think what we're looking for is to -- if it doesn't add value to the operating business like it's got to be delayed or ain't happening at all, and -- so some of the things which are projects that we would like to get done that might not be, you know, a positive to the P&L, I think, are things that we'll look at the season or, you know, in this and make some decisions on like how things look. So, no, I don't think it's fair to say that we're digging into the advertising budget and -- and I -- what we didn't add is that the purchasing -- Bernstock is getting more and more scientific in the kind of consultants he chooses, and the -- how he applies the knowledge we get from that in the purchasing of advertising. And raising sort of the, you know, I think -- it's not about totally dollars. I think that's kind of the experience we have with Ortho. The message of sort of purpose and efficacy when it comes to controls, for example, to something I talked about earlier. That's not so much about money. It's about message. And there's a lot of efficiency in the message that you can get and the better our message, it requires less sort of capacity to throw at it. So, again, we're not decreasing the spend and it's not fair to say we're digging into that pocket to make the numbers. I think we're basically just mugging everybody else and we're spending money and where are the big places of spending money? That are kind of untouchable? I would say sales, advertising and R&D. R&D, why? Innovation for new products going forward. Okay?

Okay. Good. Thanks. And then just a housekeeping item, Chris. Could you -- was there any kind of a one-time benefit in taxes this quarter? I just -- I wasn't quite clear on what the tax rate was. Or if you could just tell us on the adjusted earnings what the taxes were.

Well, before Chris goes to that, I am just going give sort of my editorial on Sarbanes. Damn! That's all I can say. Man, you know. For those people who are getting to be older guys and have had like proctological exams, I'll tell you what, man. It's getting to be a very serious, like -- you best have anesthesia. You know, what's the result is is that people are looking at everything and down to kind of like a much lower threshold of dollar value and, you know, people may say that's good. I was with a very senior member of the House of Representatives a couple of nights ago and I said, you know, any other ways to make us less competitive in the global marketplace, because it's costing us a lot of money and it is making us a lot harder to look at our numbers, but -- you know, so, Chris, go ahead. Take it away, man.

Oh, Joe, I don't know how I follow that analogy. But I can tell you it was sort of a long and arduous audit, but a couple of things to your point. We did go back and do a pretty hard scrub at some tax reserves that we had on the books for a long time for potential exposures. I think in light of the environment we're operating in now, it's probably a fresh look as to, you know, having to find a really good balance between, you know, being conservative and aggressive. So, there was -- there was some tax reserves that came back through the tax provision during the fourth quarter and so, obviously, impacted the year. I would say in total, though, we had, a fair number of adjustments going the other way that we were booked in SG&A that don't qualify as -- as restructuring that -- so in total, they sort of offset one another. But you're right to sort of highlight that there was some impact on the tax -- the affective tax rate this year that will not be sustained going forward. We'll give you some greater insight into the tax rate here again in early December.

Can you just say what the EPS impact of the tax benefit was in the quarter?

No, like I said, Joe. I don't want to get into's lot of detail on that. Like I said, I think the fair way to look at this is really, at the end of the day, we had a fair number of adjustments that we thought were fair to make working with our auditing, with PWC to, you know, take a really fresh look at some outstanding items and get things as fairly stated as we could in light of -- in light of the environment we're operating in. None of them were really material individually and in total. They really netted out. So at the end of the day, we would have actually reported about the same thing we did report, so there are a lot of netting going back and forth. And I guess I would like to leave it at that.

Okay. Thanks.

Thanks.

Joseph Altobello, CIBC World Markets.

Thanks, good morning, guys.

Good morning.

A quick question. You guys touched on your price increases and that you don't expect to lose some shelf space. How would you expect the retailers, some of your competitors to respond and do you expect them to pass through that price increase on to consumers?

Well, probably early to tell, but -- I don't think it's early to tell. I think all the people in North America would like me to stick a sock in my mouth right now. But I'm not going to do that. The -- I don't think it's too early to tell and it's my understanding as we've talked to other colleagues in the industry, we ain't the only one. So, you know, my view is the --we've been talking about this for some months with the retailers. I haven't been called on the carpet into anybody's office yet. At the end of the day, we'll know like total stickiness, probably when we start shipping in January. But so far so good, and -- so, I don't think it's too early and I don't think we're out of the norm, particularly. I don't know what other people are doing, but I do know in the sort of M&A world as we've talked that like when we asked, You guys take any pricing, they're saying, Yeah. So, you know, that's what I know.

Okay, so the fact that you haven't been called to the carpet yet probably means that retailers are going to be passing that through? Is that fair to say?

Yeah, I think gross margin matters to the retailers, and they don't want to see it decline.

Okay. The other question I had --

Just so you know, I got a bag of Turf Builder on my wall from like 1962 or something like that. That was like $5 a bag back then. Okay. So the value the consumers are getting is a very high value and all of our research shows a, you know, pretty darn low sensitivity or, you know, to pricing. It's a once-a-year purchase and our average stuff is less than $10 a bag.

That's on your wall, Jim?

What's that?

This is on your wall?

Yeah, yeah. I got an old Turf Builder bag. But I just -- if you look at what the value the consumer is getting today compared to -- then back in the '60s, it's a tremendous value for the consumer.

Okay. And the other question I had, obviously you have done a good job growing sales in North America, and you have talked a lot about the impact of $54 oil, I guess, on the consumer. How much of your North American sales growth, if can you quantify it, came from the trade-up to superpremium brands and is that at risk if oil stays where it's at, and other commodity goods stay where they're at?

I'll let Bob or Dan Paradiso, who runs Bails [ph] North America answer the question. But I would say that from a top-line, it probably didn't add a tremendous amount to the top-lone. Like you look at dirt. If you look at dirt, you see kind of low-single digit growth rate, and that's kind of what we have been seeing throughout there. What you're seeing is a huge margin impact as a result of the tradeup. So, you know, I think the -- it shows up in gross margin than it does in sales. Not to say it's not there in sales, and there is definitely a move in the mix side. I mean we know that the best-selling products in lawn tend to be the high-value and I use that word not only is it high-value to the consumer, but it's high-value to us. But I think that's a tremendous climate going on anyway. So, --

Is there a concern that that could reverse next year and that people will trade down to the premium, not superpremium brand?

We have done a lot of work, and this is -- before September 11th 2001, but a lot since then. That says, you know, what happens when the consumer's stressed? Both stressed on a sort of -- psychologically from the tension of the threat of terrorism to they're economically stressed. And what we don't see in sort of either of those things is that they abandon lawn and garden. They tend to spend even more time at home, they tend to want their house to look beautiful. They tend to go to amusement parks and movies less, and spend more time gardening. And I don't think we know anything different than that going forward. So, you know, we know that we tend to be -- I'm not going say like proof, but I would say recession-resistant. And that's both through economically and from a terrorism point of view, I think, that people tend to, you know, continue to spend and that's our experience.

The only thing I would add is that we have had this year some phenomenal tradeup, double-digit tradeup to the premium products across a lot of brands. We have been a bit more conservative in constructing a plan for next year. We expect the trade-up to continue but not quite at the rate it did this year.

Okay. Fare enough. Great. Thank you.

Operator, we have time for one call. please.

Bill Chappell, SunTrust Robinson Humphrey.

I'll try to be brief. On the Smith and Hawken acquisition, I guess first, in your guidance you have there a 5 to 10 percent -- I mean 5 to 7 percent long-term growth, top-line and 10 to 12 bottom. That doesn't include Smith and Hawken for next year, is that correct?

Bill this is Chris. By and large it does.

It does include --

We'll give you some greater insight in early December, but for right now, we're comfortable with that.

Okay, I'm sorry. So you're saying you're looking for 5 to 7 percent top-line growth, which includes 140 million in sales from Smith and Hawken?

Well, I'll say more confidentially, we'll give you a greater insight on the top-line in December. I would say on the bottom-line, 10 to 12, we're comfortable with.

Okay. So it does -- the bottom line does includes the dilution of Smith and Hawken and top-line may or may not?

Yeah, by and large.

Okay, I'll swing back on that offline. Also, on Smith and Hawken, can you maybe help me understand if you're not reinvesting in terms of putting out new stores and it looks like most of the reinvestment is on the catalog business, which imagine is high margin, why it would be dilutive in the first year?

Well, listen. I'll take that. When we say dilutive, it's so marginally dilutive even in the -- what is laid out there today, I think those were also based on earlier numbers. Smith and Hawken numbers do look better based on the budget that I, like I said yes to. I would say it probably ain't dilutive. What could make it dilutive is making investments in that business, which I plan to do. To improve the catalog operation, improve the shopping experience in the stores, and make the internet site a better site. All which of requires investments, but I don't think you're going to see that being dilutive, and I think if you call it neutral for now, we're probably okay.

And one last thing just to follow up on the urea costs, I think this time last year, you had purchased, or purchased about 50 percent of your urea needs. It sounded like in your commentary that you're -- have done more than that this time this year. Is there a change or what do you look in terms of buy?

It's slightly more. Not significantly greater.

Okay.

It ain't less.

And I think it's a little more.

But I mean, you have a pretty good idea what your urea costs are for next year?

Yes.

Lukemire, you want to add anything to this?

Yes, we do.

Okay, that's brief. Okay. Listen, you're the last guy. You have another one you want to throw out there in.

I'm just trying to -- yeah. I'm look for -- if we're looking at the urea costs, I guess, versus the price increases. Can you quantify -- I mean, I know price increases were going to be 3 to 5 percent. Can you, and urea costs probably a little bit greater. Do you have an opportunity to raise prices again throughout the year, or is it just kind of a one-time shot?

I would say one-time shot. I would be called on the carpet then, to start with that one. The exception I would make would be depending on the price of diesel fuel. One of our businesses, our dirt business, is highly sensitive to freight. That big factor there is going to be diesel fuel. I doubt at this point if prices of oil stay where it is, that there's a truck we'll move that doesn't have a fuel surcharge to it. Depending on what happens, I just want to throw out there so, like, everybody's heard it. Depending on what happens, an area we may go is fuel surcharges on our freight, specifically in our dirt business where freight is a much higher percentage of the sort of invoice value, and we'll take a look and see how the -- as we start to move dirt, what diesel fuel looks like. But if we're taking big hits, it's probably -- it's possible, I mean, it's a better word. It's possible we'll go for a fuel surcharge. I tried to tell our sales force to make sure that they start getting the word out that it could happen.

Okay, great. I can go on all afternoon but I'll stop.

All right, guys. Listen, thanks a lot, guys.

Okay, operator. That wraps up the call for today. And I want to remind anybody who's still left on that we'll be in New York on December 8 for our analyst meeting and we hope you join us there. Thanks, have a good day.

This concludes today's conditions. Thank you for joining.