UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

 

 

 

The Scotts Miracle-Gro Company

(Exact name of registrant as specified in its charter)

 

 

 

Registrant’s telephone number, including area code:     937-644-0011

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ   Accelerated filer o  Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of Common Shares (the only common equity of the registrant) held by non-affiliates of the registrant computed by reference to the price at which Common Shares were last sold as of the last business day of the registrant’s most recently completed second fiscal quarter (March 31, 2006) was approximately $2,102,627,000.

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: The number of Common Shares of the registrant outstanding as of November 28, 2006 was 67,413,056.

 

 

DOCUMENT INCORPORATED BY REFERENCE:

 

Portions of the definitive Proxy Statement for Registrant’s 2007 Annual Meeting of Shareholders to be held January 25, 2007, are incorporated by reference into Part III hereof.

PART I

 

 

Company Description

 

The Scotts Miracle-Gro Company, an Ohio corporation (“Scotts Miracle-Gro” and, together with its subsidiaries, the “Company”), traces its roots to two businesses launched by entrepreneurs. In 1868, Civil War veteran O.M. Scott launched a seed business in Marysville, Ohio, based on the conviction that “farmers shall have clean, weed-free fields.” Beginning in 1907, the Company expanded its reach by selling grass seed to consumers and eventually exited the agricultural market. By 1988 — both through innovation and acquisition — the Company had become a leading marketer of lawn fertilizer, grass seed and growing media products within the United States.

 

Separately, Horace Hagedorn and his partner Otto Stern launched Stern’s Miracle-Gro Products, Inc. in 1951 in New York. Their easy-to-use plant food quickly revolutionized the gardening category. Through aggressive and innovative marketing, Miracle-Gro^® eventually became the leading plant food product in the gardening industry. In 1995, The Scotts Company combined with Stern’s Miracle-Gro through a series of merger transactions, marking the start of a significant evolution for the Company.

 

In the late 1990’s, the Company launched a geographic and category expansion. It acquired companies with industry-leading brands in France, Germany and the United Kingdom. In fiscal 1999, the Company acquired the Ortho^® brand in the United States and exclusive rights for the marketing and distribution of consumer Roundup^®* brand products within the United States and other specified countries, thereby adding industry-leading controls to its portfolio. The Company has rapidly expanded into the lawn care service industry with the launch of Scotts LawnService^® in 1998. Since fiscal 2002, the Company has invested nearly $100 million in the acquisitions of local and regional lawn care businesses to provide a platform for our rapid expansion throughout the U.S. In October 2004, the Company entered the fast growing outdoor living category with the acquisition of Smith & Hawken, Ltd. The Company entered the North America wild bird food category in fiscal 2006 with the acquisition of Gutwein & Co., Inc. and its Morning Song^® brand of bird food.

 

As Scotts Miracle-Gro celebrates its 100th Anniversary in selling products to consumers, we own the leading brands in nearly every category of the lawn and garden industry. A list of some of our North America leading consumer brands is as follows:

 

 

In addition, we have the following significant brands in Europe: Miracle-Gro^® plant fertilizers, Weedol^® and Pathclear^® herbicides, EverGreen^® lawn fertilizers and Levington^® growing media in the United Kingdom; KB^® and Fertiligène^® in France; Celaflor^®, Nexa-Lotte^® and Substral^® in Germany and Austria; and ASEF^®, KB^® and Substral^® in Belgium, the Netherlands and Luxembourg (the “Benelux countries”). Roundup^® is also a significant brand in the United Kingdom, France, Germany and other European markets.

 

Business Segments

 

In fiscal 2006, we divided our business into the following reportable segments:

 

 

 

*  Roundup^® is a registered trademark of Monsanto Technology LLC, a company affiliated with Monsanto Company.

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These reportable segments are consistent with the Company’s structure and the management of these units. Financial information about these segments for the three years ended September 30, 2006 is presented in Note 21 of the Notes to Consolidated Financial Statements.

 

North America

 

In our North America segment, the Company manufactures and markets products that provide easy, reliable and effective assistance to homeowners who seek to nurture beautiful, weed- and pest-free lawns, gardens and indoor plants. These products incorporate many of the best technologies available. In addition, we manufacture and market a broad line of professional products designed to meet the specific needs of commercial nurseries, greenhouses and specialty crop growers in North America. The North America segment sells products in the following categories:

 

Lawns A complete line of granular lawn fertilizer and combination products which include fertilizer and crabgrass control, weed control or pest control is sold under the Scotts^® Turf Builder^® brand name. The Turf Builder^® line of products is designed to make it easy for do-it-yourself consumers to select and properly apply the right product in the right quantity for their lawns.

 

Gardens A complete line of plant foods is marketed under the Miracle-Gro^® brand name. In fiscal 2006, we introduced Miracle-Gro^® LiquaFeed^®, an innovative product that allows consumers to easily feed and water their outdoor plants simultaneously. In addition to our high-quality water-soluble plant food, we have liquid plant foods, and a continuous-release line of plant foods for extended feeding and convenience.

 

Growing Media A complete line of growing media products for indoor and outdoor uses is marketed under the Miracle-Gro^®, Scotts^®, Hyponex^®, Earthgro^®, Nature Scapes^®, Whitney Farms and SuperSoil brand names, as well as other labels. These products include potting mix, garden soils, topsoil, manures, sphagnum peat and decorative barks and mulches. The addition of the Miracle-Gro^® brand name and fertilizer to potting mix and garden soils has turned previously low-margin commodity products into value-added category leaders.

 

Grass Seed We offer a broad line of grass seed products for both the consumer and the professional user. The fiscal 2006 acquisitions of certain brands and assets from Turf-Seed, Inc. and Landmark Seed Company allowed for the integration of these companies’ extensive professional grass seed sales and distribution networks with the Company’s existing professional presence and industry-leading brands in the consumer grass seed market. Our leading grass seed products are sold under the Scotts^® Pure Premium^®, Classic^®, Turf Builder^® and PatchMaster^® brand names in the consumer market and the Scotts Turf-Seed^tm and the Scotts Landmark^tm brand names in the professional market.

 

Controls A broad line of weed control, indoor and outdoor pest control and plant disease control products is marketed under the Ortho^® brand name. Ortho^® products are available in aerosol, liquid ready-to-use, concentrated, granular and dust forms. Ortho^® control products include Weed-B-Gon^®, Bug-B-Gon^®, Home Defense MAX^®, Ortho MAX^®, Brush-B-Gon^®, RosePride^®, Ortho-Klor^® and Orthene^® Fire Ant Killer.

 

In fiscal 1999, the Company entered into a long-term marketing agreement with Monsanto and became Monsanto’s exclusive agent for the marketing and distribution of consumer Roundup^® non-selective herbicide products in the consumer lawn and garden market within the United States and other specified countries, including Australia, Austria, Belgium, Canada, France, Germany, Holland and the United Kingdom. (See the “Roundup^® Marketing Agreement” discussion later in this Item 1 for a more detailed explanation of the Company’s agreement with Monsanto.)

 

Wild Bird Food Effective November 18, 2005, the Company acquired Gutwein & Co., Inc. (“Gutwein”). Through its Morning Song^® brand, Gutwein is a leader in the growing North America wild bird food category, generating approximately $80.0 million in annual revenues. Morning Song^® products are sold at leading mass retailers, grocery, pet and general merchandise stores.

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Other Consumer Products The Company also manufactures and markets several lines of high-quality lawn spreaders under the Scotts^® brand name — Deluxe EdgeGuard^® spreaders, SpeedyGreen^® rotary spreaders, AccuGreen^® drop spreaders and Handy Green^®II handheld spreaders. We sell a line of hose-end applicators for water-soluble plant foods such as Miracle-Gro^® products, and lines of applicators under the Ortho^®, Dial ’N Spray^®, and Pull ’N Spray^® trademarks for the diluted application of control products sold in the concentrated form.

 

The following businesses are also included in the results of the North America segment:

 

North American Professional The Company sells professional products to commercial nurseries, greenhouses and specialty crop growers in North America, the Caribbean and throughout Latin America, the Far East, New Zealand and Japan. Our professional products include a broad line of sophisticated controlled-release fertilizers, water-soluble fertilizers, pesticide products and wetting agents which are sold under brand names that include Banrot^®, Miracle-Gro^®, Osmocote^®, Peters^®, Poly-S^®, Rout^®, ScottKote^®, Sierrablen^®, Shamrock^® and Sierra^®.

 

Canada The Company believes it is the leading marketer of branded consumer lawn and garden products in the Canadian market. We sell a full range of lawn and garden fertilizer, control products, grass seed, spreaders, and value-added growing media products under the Scotts^®, Turf Builder^®, Miracle-Gro^®, Killex^®, and Roundup^® brands.

 

Scotts LawnService^®

 

Through this segment, the Company provides residential lawn care, lawn aeration, tree and shrub care and external pest control services in the United States. These services consist primarily of fertilizer, weed control, pest control and disease control applications. As of September 30, 2006, Scotts LawnService^® had 77 company-operated locations serving 44 metropolitan markets and 82 independent franchises primarily operating in secondary markets.

 

International

 

In the International segment, the Company sells consumer lawn and garden products in more than 25 countries outside of North America. We also sell a broad line of professional products throughout Europe to commercial nurseries, greenhouses and specialty retailers.

 

International products and brand names vary from country to country depending upon the brand name strength and the nature of our strategic relationships in a given country. For example, in the United Kingdom, we sell Miracle-Gro^® plant fertilizers, Weedol^® and Pathclear^® herbicides, EverGreen^® lawn fertilizers and Levington^® growing media. Our other International brands include KB^® and Fertiligène^® in France, Celaflor^®, Nexa-Lotte^® and Substral^® in Germany and Austria, and ASEF^®, KB^® and Substral^® in the Benelux countries. As noted earlier, Roundup^® is also a significant brand in Europe.

 

For information concerning risks attendant to our foreign operations, please see “ITEM 1A. RISK FACTORS — Cautionary Statement on Forward-Looking Statements — European Economic Conditions and Foreign Currency Exposures.”

 

Corporate & Other

 

Smith & Hawken^® Effective October 2, 2004, the Company acquired Smith & Hawken^®, a leading brand in the fast growing outdoor living and gardening lifestyle category. Smith & Hawken^® products, which include high-end outdoor furniture, pottery, garden tools, gardening containers and live goods, are sold in the United States through its 58 retail stores, as well as through catalog and Internet sales.

 

Competitive Marketplace

 

Our major customers include home improvement centers, mass merchandisers, warehouse clubs, large hardware chains, independent hardware stores, nurseries, garden centers, food and drug stores, commercial nurseries and greenhouses, and specialty crop growers. Each of our segments participates in markets that are highly competitive and many of our competitors sell their products at prices lower than ours. The Company attributes its market leadership and continued success in the lawn and garden category to our industry-leading brands, innovative products, award-winning advertising, supply chain excellence, highly knowledgeable field sales and merchandising organization, and the strength of our relationships with major retailers in our product categories.

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In the North American consumer do-it-yourself lawn and garden markets and pest control markets, we compete primarily against “control label” products as well as branded products. “Control label” products are those sold under a retailer-owned label or a supplier-owned label, which are sold exclusively at a specific retail chain. The control label products that we compete with include Vigoro^® products sold at Home Depot, Sta-Green^® products sold at Lowe’s, and KGro^® products sold at Kmart. Our competitors in branded lawn and garden products and the consumer pest control markets include Spectrum Brands, Bayer AG, Central Garden & Pet Company, Garden Tech, Enforcer Products, Inc., Green Light Company and Lebanon Chemical Corp.

 

With respect to growing media products, in addition to nationally distributed, branded competitive products, we face competition from regional competitors who compete primarily on the basis of price for commodity growing media business.

 

In the North American professional horticulture markets, we face a broad range of competition from numerous companies ranging in size from multi-national chemical and fertilizer companies such as Dow AgroSciences Company, Uniroyal Chemical Corporation and Chisso-Asahi Fertilizer Co. Ltd., to smaller, specialized companies such as Pursell Technologies, Inc., Sun Gro-U.S. (a division of Hines Horticulture, Inc.) and Fafard, Inc. Some of these competitors have significant financial resources and research departments.

 

We have the second largest market share position in the U.S. do-it-for-me lawn care service market. We compete against TruGreen-ChemLawn^®, a division of ServiceMaster, which has the leading market share in the U.S. lawn care service market and has a substantially larger share of this market than Scotts LawnService^®, as well as numerous regional and local lawn care services operations.

 

Internationally, we face strong competition in the consumer do-it-yourself lawn and garden market, particularly in Europe. Our competitors in the European Union include Bayer AG, Kali & Salz (which owns the Compo, Algoflash brands) and a variety of local companies.

 

The International professional horticulture markets in which we compete are also very competitive, particularly the markets for controlled-release and water-soluble fertilizer products. We have numerous U.S. and European competitors in these international markets, including Pursell Industries, Inc., Compo GmbH, a subsidiary of Kali & Salz, Norsk Hydro ASA, Haifa Chemicals Ltd. and Kemira Oyj.

 

Significant Customers

 

Approximately 70% of our worldwide net sales in fiscal 2006 were made by our North America segment. Within the North America segment, approximately 30% of our net sales in fiscal 2006 were made to Home Depot, 16% to Wal*Mart and 15% to Lowe’s. We face strong competition for the business of these significant customers. The loss of any of these customers or a substantial decrease in the volume or profitability of our business with any of these customers could have a material adverse effect on our earnings and profits.

 

Competitive Strengths

 

Strong Brands

 

By far, the Company considers its industry-leading brands to be its single largest competitive advantage, though hardly its only advantage. The Company believes it has the leading market share in every major U.S. category in which its North American business competes. The Company also owns many of the leading brands in the European marketplace.

 

Scotts Miracle-Gro has helped to build the awareness of its brands through a continuous increase in its investment in advertising. As a result, consumer awareness of the Company’s key brands — especially in the United States — rivals that of nearly any other consumer products company. The strength of the Scotts^® brand, in particular, has been a critical aspect of the success of Scotts LawnService^®. The Company believes it has successfully grown its service business because of the high level of consumer confidence associated with the Scotts^® brand.

 

Trademarks, Patents and Licenses

 

The Company considers its brands, patents and licenses all to be key competitive advantages. We pursue a vigorous brand protection strategy consisting of registration and maintenance of key

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trademarks and proactive monitoring and enforcement activities to protect against infringement. The Scotts^®, Miracle-Gro^®, Hyponex^®, Smith & Hawken^® and Ortho^® brand names and logos, as well as a number of product trademarks, including Turf Builder^®, Osmocote^® and Bug-B-Gon^®, are federally and/or internationally registered and are considered material to our business.

 

As of September 30, 2006, we held 95 issued patents in the United States covering fertilizer, chemical and growing media compositions and processes; grass varieties; and mechanical dispensing devices such as applicators, spreaders and sprayers. Many of these have similar patents which have also been issued or are pending internationally, bringing our total worldwide patent portfolio to 419 United States and International patents and applications. The issued patents provide protection generally extending to 20 years from the date of filing, subject to the payment of applicable governmental maintenance and annuity fees. Accordingly, many of our patents will extend well into the next decade.

 

In addition, we continue to file new patent applications each year covering new, commercially significant developments conceived by our R&D associates. Currently, we have 137 pending patent applications, worldwide, including 19 pending U.S. applications some of which have been allowed for issuance of patents. We also hold exclusive and non-exclusive patent licenses and supply arrangements with various active ingredient and raw material suppliers, permitting the use and sale of additional patented fertilizers, pesticides and mechanical devices.

 

During fiscal 2006, we were granted 3 United States and 31 foreign national patents. Representative of the patent coverage provided by these new patents are coated fertilizers that are specifically formulated to act as starter fertilizers for new plantings; containers having metering apparatus for control of liquid dispensing; and the design of spray devices. Internationally, we continue to extend patent coverage of our core fertilizer technologies including controlled-release and water-soluble products and the like. We also are extending protection of our developments in regard to growing media and mechanical devices such as applicator, sprayer and spreader technologies to additional countries within our Canadian, European, Asian/Pacific and South American markets.

 

Eight United States patents expired in fiscal 2006. These expired patents covered sulfur coated fertilizer compositions; granular controlled-release coated fertilizers; Kentucky Bluegrass and St. Augustine Grass plant varieties; and various mechanical devices. The loss of these patents is not expected to materially affect our business.

 

Supply Chain and Sales Force

 

Because the Company sells a substantial majority of its products to a small number of retail accounts, it is critical to maintain strong relationships with these partners. We believe our supply chain and sales force have become major competitive advantages that have allowed us to build relationships with our key retail partners that is unrivaled in the industry.

 

Major investments in technology have allowed the Company’s supply chain to be a more efficient supplier to its key retail accounts. The Company considers its order fill rate — which measures the accuracy of shipments — to be an important measure of customer service. In fiscal 2006, the Company achieved a customer service rate of 99.2 percent in its core North American business, its highest ever. Additionally, the supply chain has helped the Company to significantly improve its inventory turns over the past several years, as well as those of its retail partners.

 

The Company’s nationwide sales force is another major competitive advantage. By increasing the size of the sales force over several years, the Company has taken a more proactive role in helping our retail partners merchandise the lawn and garden department and maximize the productivity of this space. In addition to working closely with our retail partners on building merchandising displays, taking orders, etc., our sales force works directly with consumers as well. By serving as “in-store counselors” on weekends, our associates help consumers answer their lawn and garden questions, which, we believe, drives higher sales of our products.

 

Research and Development

 

As the Company views its commitment to innovation as a competitive advantage, the Company continually invests in research and development to improve existing or develop new products, manufacturing processes and packaging and delivery systems. Spending on research and development was $35.1 million, $38.0 million and $34.4 million in fiscal 2006, fiscal 2005, and fiscal 2004, including

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registrations of $8.2 million, $7.5 million and $6.8 million, respectively. The Company’s long-standing commitment to innovation is evidenced by a portfolio of patents worldwide that supports many of our fertilizers, grass seeds and application devices. In addition to the benefits of our own research and development, we benefit from the research and development activities of our suppliers.

 

Our research and development worldwide headquarters is located at the Dwight G. Scott Research Center in Marysville, Ohio. We also have research and development facilities in the United Kingdom, France, the Netherlands and Sydney, Australia, as well as several research field stations located throughout the United States.

 

The Company’s biotechnology program is evidence of its commitment to responsible research in search of more effective and easier-to-use products that are preferred by consumers and are better for the environment. By employing technology already proven in agriculture, the Company is working to develop turf varieties that could one day require less maintenance, less water and fewer chemical inputs to resist insects, weeds and disease.

 

Before a product enhanced with biotechnology may be sold in the United States, it must be “deregulated” by appropriate governmental agencies. Deregulation involves compliance with the rules and regulations of, and cooperation with, the United States Department of Agriculture (the “USDA”), Animal and Plant Health Inspection Service, the United States Environmental Protection Agency (the “U.S. EPA”) and/or the Food and Drug Administration (the “FDA”). As part of the deregulation process for any product enhanced with biotechnology, we are required to present evidence to the USDA in the form of scientifically rigorous studies showing that the product poses no additional toxicological or ecological risk than products of the same species that have not been enhanced with biotechnology. We are also required to satisfy other agencies, such as the U.S. EPA and the FDA, as to their appropriate areas of regulatory authority. This process typically takes years to complete and also includes at least two opportunities for public comment. Therefore, any enhanced product for which we seek commercialization through submission of a petition for deregulation will be subjected to rigorous and thorough governmental regulatory review.

 

We submitted a petition for deregulation of a non-residential turfgrass product enhanced with biotechnology to the USDA on April 14, 2003. This turfgrass has been shown, through our research trials, to provide simple, more flexible and better weed control for golf courses in a manner we believe is more environmentally friendly. The USDA has a variety of options in adjudicating a petition to “deregulate” a biotechnology-derived plant product. The USDA has decided to employ the formal Environmental Impact Statement (“EIS”) process to judge the acceptability of our petition for deregulation. We welcome this process as the most thorough evaluative step available to the USDA.

 

We believe there is a substantial market for turfgrass products enhanced with biotechnology, and our product, if approved, can capture a significant portion of this market. However, there can be no assurance our petition for deregulation of this product will be approved, or if approved and commercially introduced, this product will generate any revenues or contribute to our earnings.

 

Roundup^® Marketing Agreement

 

Under the terms of the marketing agreement with Monsanto, the Company is Monsanto’s exclusive agent for the marketing and distribution of consumer Roundup^® products (with additional rights to new products containing glyphosate or other similar non-selective herbicides) in the consumer lawn and garden market within the United States and other specified countries, including Australia, Austria, Belgium, Canada, France, Germany, Holland and the United Kingdom.

 

Under the marketing agreement, we and Monsanto are jointly responsible for developing global consumer and trade marketing programs for consumer Roundup^®. We have assumed responsibility for sales support, merchandising, distribution and logistics for consumer Roundup^®. Monsanto continues to own the consumer Roundup^® business and provides significant oversight of its brand. In addition, Monsanto continues to own and operate the agricultural Roundup^® business.

 

We are compensated under the marketing agreement based on the success of the consumer Roundup^® business in the markets covered by the agreement. We receive a graduated commission to the extent that the earnings before interest and taxes of the consumer Roundup^® business in the included markets exceed specified thresholds. Regardless of these earnings, we are required to make an annual contribution payment against the overall expenses of the consumer Roundup^® business. For

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fiscal 2006, and until 2018 or the earlier termination of the agreement, the minimum annual contribution payment will be $20 million.

 

The gross commission earned under the marketing agreement, the contribution payments to Monsanto and the amortization of the initial marketing fee paid to Monsanto are included in net sales in the Company’s Consolidated Statements of Operations. For fiscal 2006, fiscal 2005 and fiscal 2004, the net amount earned under the marketing agreement was income of $39.9 million, an expense of $5.3 million (including a $45.7 million charge for contribution payments previously deferred under the marketing agreement), and income of $28.5 million, respectively. For further details, see Note 3 of the Notes to Consolidated Financial Statements.

 

The marketing agreement has no definite term, except as it relates to the European Union countries. With respect to the European Union countries, the term of the marketing agreement has been extended through September 30, 2008. The parties may agree to renew the agreement with respect to the European Union countries for two successive terms ending on September 30, 2015 and 2018, with a separate determination being made by the parties at least six months prior to the expiration of each such term as to whether to commence a subsequent renewal term. However, if Monsanto does not agree to either of the remaining renewal terms with respect to the European Union countries, the commission structure will be renegotiated within the terms of the marketing agreement.

 

Monsanto has the right to terminate the marketing agreement upon certain specified events of default by us, including an uncured material breach, material fraud, material misconduct or egregious injury to the Roundup^® brand. Monsanto also has the right to terminate the agreement upon a change of control of Monsanto or the sale of the consumer Roundup^® business. In addition, Monsanto may terminate the agreement within specified regions, including North America, for specified declines in the consumer Roundup^® business.

 

The Company has rights similar to Monsanto’s to terminate the marketing agreement upon an uncured material breach, material fraud or material willful misconduct by Monsanto. In addition, we may terminate the agreement upon Monsanto’s sale of the consumer Roundup^® business or in certain other circumstances, in which case we would not be able to collect the termination fee described below.

 

If Monsanto terminates the marketing agreement upon a change of control of Monsanto or the sale of the consumer Roundup^® business prior to September 30, 2008, we will be entitled to a termination fee in excess of $100 million. If we terminate the agreement upon an uncured material breach, material fraud or material willful misconduct by Monsanto, we will be entitled to receive a termination fee in excess of $100 million if the termination occurs prior to September 30, 2008. The termination fee declines over time from in excess of $100 million to a minimum of $16 million for terminations between September 30, 2008 and September 30, 2018.

 

Monsanto has agreed to provide us with notice of any proposed sale of the consumer Roundup^® business, allow us to participate in the sale process and negotiate in good faith with us with respect to a sale. In the event we acquire the consumer Roundup^® business in such a sale, we would receive credit against the purchase price in the amount of the termination fee that would otherwise have been paid to us upon termination by Monsanto of the marketing agreement upon the sale. If Monsanto decides to sell the consumer Roundup^® business to another party, we must let Monsanto know whether we intend to terminate the marketing agreement and forfeit any right to a termination fee or whether we will agree to continue to perform under the agreement on behalf of the purchaser, unless and until the purchaser terminates our services and pays any applicable termination fee.

 

Strategic Initiatives

 

The Company has developed a strategic plan that focuses its efforts and capitalizes on its strengths to further own the relationship with its consumers and distance itself from the competition. The execution of this strategy will sustain future growth and further secure the Company’s franchise. The critical elements of this strategy are as follows.

 

Profit and Marketing Improvement Plan

 

In fiscal 2005, we initiated a plan called Project Excellence to significantly strengthen the Company which led to a significant reduction of purchasing and selling, general and administrative costs by reducing headcount and implementing better business processes. Savings from this program allowed

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the Company to increase advertising and promotional expenditures in the North America consumer business by approximately 18 percent in fiscal 2006. The Company estimates the program also resulted in approximately $25 million in pre-tax profit improvement for the year.

 

Exploiting New Lawn & Garden Opportunities

 

We believe that the power of our brands provides us with significant opportunities to expand our business into adjacent lawn and garden categories. In October 2004, we acquired Smith & Hawken^®, a leading brand in the fast growing outdoor living and gardening lifestyle category. The addition of the Smith & Hawken^® brand and its network of retail stores, catalog and Internet sales will be the foundation for our future expansion into “outdoor living” categories. In November 2005, we acquired Gutwein whose Morning Song^® brand is a leader in the North America wild bird food category. This is the Company’s first entrance into this attractive and growing category.

 

Strengthen our International Business

 

We have explored the strategic options for our International business and determined that the best option for maximizing shareholder value is to sharpen our focus for the business by: (i) improving our competitive position; (ii) reducing costs in the business to improve profitability and to allow for marketing investments; and (iii) aligning the organization by category rather than by geography to better leverage our knowledge of the marketplace and the consumer. We plan to achieve these goals through a variety of initiatives, including reducing the complexity of the business and the product portfolio, improving supply chain efficiency and effectiveness, and aggressively pursuing new business opportunities.

 

Expanding Scotts LawnService^®

 

The number of lawn owners who want to maintain their lawns and gardens but do not want to do it themselves represents a significant portion of the total market. We recognize that our portfolio of well-known brands provides us with a unique ability to extend our business into lawn and garden services and the strength of our brands provides us with a significant competitive advantage in acquiring new customers. We have spent the past several years developing our Scotts LawnService^® business model. The business has grown significantly from revenues of $41.2 million in fiscal 2001 to revenues of $205.7 million in fiscal 2006. This growth has come from geographic expansion, acquisitions and organic growth fueled by our highly effective direct marketing programs. We invested $4.4 million in lawn service acquisitions in fiscal 2006. We anticipate continuing to make selective acquisitions in fiscal 2007 and beyond. Significant investments will continue to be made in the Scotts LawnService^® business infrastructure in order to continually improve our customer service throughout the organization and leverage scale economies as we continue to grow.

 

Returning Cash to Shareholders

 

Given the Company’s strong performance and consistent cash flows, our Board of Directors has undertaken several actions over the past eighteen months to return cash to our shareholders. We began paying a regular quarterly cash dividend of 12.5 cents per share in the fourth quarter of fiscal 2005. In fiscal 2006, our Board launched a five-year $500 million share repurchase program pursuant to which we have repurchased 2.0 common shares for $87.9 million.

 

Most recently, on December 12, 2006, we announced that we intend to implement a recapitalization plan that would expand upon and accelerate returns to shareholders beyond the current $500 million program (which has been canceled) by returning $750 million to our shareholders. Pursuant to this plan, we intend to repurchase up to $250 million of our common shares with the remainder paid as a special one-time cash dividend during the second quarter of fiscal 2007. These actions reflect management’s confidence in the continued growth of the Company coupled with strong and consistent cash flows that can support higher levels of debt.

 

Seasonality and Backlog

 

Our business is highly seasonal with 70% to 75% of our annual net sales occurring in our combined second and third fiscal quarters.

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Consistent with prior years, we anticipate significant orders for the upcoming spring season will start to be received late in the winter and continue through the spring season. Historically, substantially all orders are received and shipped within the same fiscal year with minimal carryover of open orders at the end of the fiscal year.

 

Raw Materials

 

We purchase raw materials for our products from various sources that we presently consider to be adequate, and no one source is considered essential to any of our segments or to our business as a whole. We are subject to market risk from fluctuating market prices of certain raw materials, including urea and other chemicals as well as paper and plastic products. Our objectives surrounding the procurement of these materials are to ensure continuous supply and to minimize costs. We seek to achieve these objectives through negotiation of contracts with favorable terms directly with vendors. When appropriate, we will procure a certain percentage of our needs in advance of the season to secure pre-determined prices. Occasionally, we hedge certain commodities to improve predictability and control costs.

 

Manufacturing and Distribution

 

We manufacture products for our North American consumer business at our facilities in Marysville, Ohio, Ft. Madison, Iowa and Temecula, California, as well as use a number of third party contract packers in the United States and Canada. In addition, the Company manufactures growing media products in 26 regional facilities located throughout North America. The primary distribution centers for our North American consumer business are managed by the Company and strategically placed across the United States.

 

We also manufacture horticultural products for our North America and International professional businesses at a leased fertilizer manufacturing facility in Charleston, South Carolina and a Company-owned site in Heerlen, the Netherlands. The remaining products for our professional businesses are produced at other Company-owned facilities and subcontractors in the United States and Europe. The majority of shipments to customers are made via common carriers or through distributors in the United States and a network of public warehouses and distributors in Europe.

 

We manufacture the non-growing media products for our International business at our facilities in Howden, the United Kingdom and Bourth, France. We also utilize a number of third party contract packers. The primary distribution centers for our International businesses are located in the United Kingdom, France and Germany and are managed by a logistics provider.

 

The growing media products for our International segment are produced at our facilities in Hatfield, the United Kingdom and Hautmont, France and at a number of third party contract packers. Growing media products are generally shipped direct without passing through a distribution center.

 

Employees

 

As of September 30, 2006, we employed 4,718 full-time employees in the United States and an additional 1,002 full-time employees located outside the United States. During peak sales and production periods, we utilize seasonal and temporary labor.

 

None of our U.S. employees are members of a union. Approximately 45 of our full-time U.K. employees are members of the Transport and General Workers Union and have full collective bargaining rights. An undisclosed number of our full-time employees at our office in Ecully, France are members of the Confederation Francaise Democratique du Travail and Confederation Generale du Travail, participation in which is confidential under French law. In addition, a number of union and non-union full-time employees are members of works councils at three sites in Bourth, Hautmont and Ecully, France, and a number of non-union employees are members of works councils in Ingelheim, Germany. In the Waardenburg office in the Netherlands, a small number of the approximately 130 employees are members of a workers union, but we are not responsible for collective bargaining negotiations with this union. In the Netherlands, we are governed by the Works Councils Act with respect to the union. Works councils represent employees on labor and employment matters and manage social benefits.

 

We believe we have good relationships with our employees in the United States, and both unionized and non-unionized International employees.

10

Environmental and Regulatory Considerations

 

Local, state, federal and foreign laws and regulations relating to environmental matters affect us in several ways. In the United States, all products containing pesticides must be registered with the U.S. EPA (and similar state agencies) before they can be sold. The inability to obtain or the cancellation of any such registration could have an adverse effect on our business, the severity of which would depend on the products involved, whether another product could be substituted and whether our competitors were similarly affected. We attempt to anticipate regulatory developments and maintain registrations of, and access to, substitute active ingredients, but there can be no assurance that we will continue to be able to avoid or minimize these risks. Fertilizer and growing media products are also subject to state and foreign labeling regulations. Our manufacturing operations are subject to waste, water and air quality permitting and other regulatory requirements of federal and state agencies.

 

The Food Quality Protection Act, enacted by the U.S. Congress in August 1996, establishes a standard for food-use pesticides, which standard is the reasonable certainty that no harm will result from the cumulative effects of pesticide exposures. Under this Act, the U.S. EPA is evaluating the cumulative risks from dietary and non-dietary exposures to pesticides. The pesticides in our products, certain of which may be used on crops processed into various food products, are typically manufactured by independent third parties and continue to be evaluated by the U.S. EPA as part of this exposure risk assessment. The U.S. EPA or the third party registrant may decide that a pesticide we use in our products will be limited or made unavailable to us. We cannot predict the outcome or the severity of the effect of these continuing evaluations.

 

In addition, the use of certain pesticide and fertilizer products is regulated by various local, state, federal and foreign environmental and public health agencies. These regulations may include requirements that only certified or professional users apply the product or that certain products be used only on certain types of locations (such as “not for use on sod farms or golf courses”), may require users to post notices on properties to which products have been or will be applied, may require notification to individuals in the vicinity that products will be applied in the future or may ban the use of certain ingredients. We believe we are operating in substantial compliance with, or taking action aimed at ensuring compliance with, these laws and regulations.

 

State and federal authorities generally require growing media facilities to obtain permits (sometimes on an annual basis) in order to harvest peat and to discharge storm water run-off or water pumped from peat deposits. The state permits typically specify the condition in which the property must be left after the peat is fully harvested, with the residual use typically being natural wetland habitats combined with open water areas. We are generally required by these permits to limit our harvesting and to restore the property consistent with the intended residual use. In some locations, these facilities have been required to create water retention ponds to control the sediment content of discharged water.

 

Regulatory Actions

 

In 1997, the Ohio Environmental Protection Agency (the “Ohio EPA”) initiated an enforcement action against us with respect to alleged surface water violations and inadequate wastewater treatment capabilities at our Marysville, Ohio facility and seeking corrective action under the federal Resource Conservation and Recovery Act. The action related to discharges from on-site waste water treatment and several discontinued on-site disposal areas, which date back to the early operations of the Marysville facility that we had already been assessing and, in some cases, remediating, on a voluntary basis. We are remediating the Marysville site under the terms of a consent order under the oversight of the Ohio EPA.

 

We completed negotiations with the Philadelphia District of the U.S. Army Corps of Engineers regarding the terms of site remediation and the resolution of the Corps’ civil penalty demand in connection with our prior peat harvesting operations at our Lafayette, New Jersey facility. A final consent decree was entered into on October 18, 2004 that required us to perform five years of wetland monitoring, and the completion of additional actions if after five years, the monitoring indicates the wetlands have not developed satisfactorily.

 

At September 30, 2006, $4.2 million was accrued for the environmental and regulatory matters described herein, the majority of which is for site remediation. Most of the costs accrued as of September 30, 2006 are expected to be paid in fiscal 2007; however, payments could be made for a period thereafter.

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We believe the amounts accrued as of September 30, 2006 are adequate to cover our known environmental exposures based on current facts and estimates of likely outcome. However, the adequacy of these accruals is based on several significant assumptions, including the following:

 

 

If there is a significant change in the facts and circumstances surrounding these assumptions, it could have a material impact on the ultimate outcome of these matters and our results of operations, financial position and cash flows.

 

During fiscal 2006, fiscal 2005 and fiscal 2004, we expensed approximately $2.4 million, $3.7 million, and $3.3 million for environmental matters. There were no material capital expenditures during the last three fiscal years related to environmental or regulatory matters.

 

General Information

 

The Company maintains a website at http://investor.scotts.com (this uniform resource locator, or URL, is an inactive textual reference only and is not intended to incorporate our website into this Form 10-K). We file reports with the Securities and Exchange Commission (the “SEC”) and make available, free of charge, on or through our website, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy and information statements and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

 

On March 18, 2005, we consummated the restructuring of our corporate structure into a holding company structure by merging The Scotts Company (“Scotts”) which had been the public company, into a newly-created, wholly-owned, second-tier Ohio limited liability company, The Scotts Company LLC (“Scotts LLC”), pursuant to the Agreement and Plan of Merger, dated as of December 13, 2004 (the “Merger Agreement”), among Scotts, Scotts LLC and Scotts Miracle-Gro. As a result of this restructuring merger, each of Scotts’ common shares issued and outstanding immediately prior to the consummation of the restructuring merger was automatically converted into one fully paid and nonassessable common share of Scotts Miracle-Gro. Scotts Miracle-Gro became the public company successor to Scotts and Scotts LLC a direct, wholly-owned subsidiary of Scotts Miracle-Gro. The restructuring merger did not affect the new parent holding company’s management, corporate governance or capital stock structure. In addition, the consolidated assets and liabilities of Scotts Miracle-Gro and its subsidiaries (including Scotts LLC) immediately after the restructuring merger were the same as the consolidated assets and liabilities of Scotts and its subsidiaries immediately before the restructuring merger.

 

Financial Information About Geographic Areas

 

For certain information concerning our International revenues and long-lived assets, see “ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” and Note 21 of the Notes to Consolidated Financial Statements.

 

 

Cautionary Statement on Forward-Looking Statements

 

We have made and will make “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 in our 2006 Annual Report, in this Annual Report on Form 10-K and in other contexts relating to future growth and profitability targets and strategies designed to increase total shareholder value. Forward-looking statements also include, but are not limited to, information regarding our future economic and financial condition, the plans and objectives of our management and our assumptions regarding our performance and these plans and objectives.

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The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements to encourage companies to provide prospective information, so long as those statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed in the forward-looking statements. We desire to take advantage of the “safe harbor” provisions of that Act.

 

Some forward-looking statements that we make in our 2006 Annual Report, in this Annual Report on Form 10-K and in other contexts represent challenging goals for our Company, and the achievement of these goals is subject to a variety of risks and assumptions and numerous factors beyond our control. Important factors that could cause actual results to differ materially from the forward-looking statements we make are described below. All forward-looking statements attributable to us or persons working on our behalf are expressly qualified in their entirety by the following cautionary statements.

 

Products

 

Perceptions that the products we produce and market are not safe could adversely affect us and contribute to the risk we will be subjected to legal action. We manufacture and market a number of complex chemical products, such as fertilizers, growing media, herbicides and pesticides, bearing our brand names. On occasion, allegations are made that some of our products have failed to perform up to expectations or have caused damage or injury to individuals or property. Based on reports of contamination at a third party supplier’s vermiculite mine, the public may perceive that some of our products manufactured in the past using vermiculite are or may also be contaminated. Public perception that our products are not safe, whether justified or not, could impair our reputation, involve us in litigation, damage our brand names and have a material adverse affect on our business.

 

Weather and Seasonality

 

Weather conditions in North America and Europe can have a significant impact on the timing of sales in the spring selling season and overall annual sales. An abnormally wet and/or cold spring throughout North America or Europe could adversely affect both fertilizer and pesticide sales and, therefore, our financial results. Because our products are used primarily in the spring and summer, our business is highly seasonal. For the past three fiscal years, 70% to 75% of our annual net sales have occurred in the second and third fiscal quarters combined. Our working capital needs and borrowings peak toward the end of our second fiscal quarter because we are incurring expenditures in preparation for the spring selling season while the majority of our revenue collections occur in our third fiscal quarter. If cash on hand is insufficient to pay our obligations as they come due, including interest payments or operating expenses, at a time when we are unable to draw on our credit facility, this seasonality could have a material adverse effect on our ability to conduct our business. Adverse weather conditions could heighten this risk.

 

Competition

 

Each of our segments participates in markets that are highly competitive. Many of our competitors sell their products at prices lower than ours, and we compete primarily on the basis of product quality, product performance, value, brand strength, supply chain competency and advertising. Some of our competitors have significant financial resources. The strong competition that we face in all of our markets may prevent us from achieving our revenue goals, which may have a material adverse affect on our financial condition and results of operations.

 

Customer Concentration

 

In the North America segment, net sales represented approximately 70% of our worldwide net sales in fiscal 2006. Our top three North American retail customers together accounted for 61% of our North America segment fiscal 2006 net sales and 42% of our outstanding accounts receivable as of September 30, 2006. Home Depot, Wal*Mart and Lowe’s represented approximately 30%, 16% and 15%, respectively, of our fiscal 2006 North America net sales. The loss of, or reduction in orders from, Home Depot, Wal*Mart, Lowe’s or any other significant customer could have a material adverse effect on our business and our financial results, as could customer disputes regarding shipments, fees, merchandise condition or related matters. Our inability to collect accounts receivable from any of these customers could also have a material adverse affect on our financial condition and results of operations.

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We do not have long-term sales agreements or other contractual assurances as to future sales to any of our major retail customers. In addition, continued consolidation in the retail industry has resulted in an increasingly concentrated retail base. To the extent such concentration continues to occur, our net sales and income from operations may be increasingly sensitive to deterioration in the financial condition of, or other adverse developments involving our relationship with, one or more customers.

 

Significant Agreement

 

If we were to commit a serious default under the marketing agreement with Monsanto for consumer Roundup^® products, Monsanto may have the right to terminate the agreement. If Monsanto was to terminate the marketing agreement for cause, we would not be entitled to any termination fee, and we would lose all, or a significant portion, of the significant source of earnings and overhead expense absorption the marketing agreement provides. Monsanto may also be able to terminate the marketing agreement within a given region, including North America, without paying us a termination fee if sales to consumers in that region decline: (1) over a cumulative three fiscal year period; or (2) by more than 5% for each of two consecutive years.

 

Debt

 

We have a significant amount of debt that could adversely affect our financial health and prevent us from fulfilling our obligations. Our debt levels will increase as a result of our plan to return $750 million to shareholders in the second quarter of fiscal 2007. Our substantial indebtedness could have important consequences. For example, it could:

 

 

Our ability to make payments and to refinance our indebtedness, to fund planned capital expenditures, acquisitions, and to pay dividends will depend on our ability to generate cash in the future. This, to some extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.

 

We cannot provide assurance that our business will generate sufficient cash flow from operating activities or that future borrowings will be available to us under our credit facility in amounts sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. We may need to refinance all or a portion of our indebtedness, on or before maturity. We cannot assure you that we would be able to refinance any of our indebtedness on commercially reasonable terms or at all.

 

Our existing credit facility contains, and the new credit facilities will contain, restrictive covenants and cross default provisions that require us to maintain specified financial ratios. Our ability to satisfy those financial ratios can be affected by events beyond our control, and we cannot be assured we will satisfy those ratios. A breach of any of these financial ratio covenants or other covenants could result in a default. Upon the occurrence of an event of default, the lenders could elect to declare the applicable outstanding indebtedness due immediately and payable and terminate all commitments to extend further credit. We cannot be sure that our lenders would waive a default or that we could pay the indebtedness in full if it were accelerated.

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Equity Ownership Concentration

 

Hagedorn Partnership, L.P. beneficially owned approximately 31% of our outstanding common shares as of November 28, 2006, and has sufficient voting power to significantly influence the election of directors and the approval of other actions requiring the approval of our shareholders.

 

Regulatory and Environmental

 

Local, state, federal and foreign laws and regulations relating to environmental matters affect us in several ways. In the United States, all products containing pesticides must be registered with the U.S. EPA (and similar state agencies) before they can be sold. The inability to obtain or the cancellation of any such registration could have an adverse effect on our business, the severity of which would depend on the products involved, whether another product could be substituted and whether our competitors were similarly affected. We attempt to anticipate regulatory developments and maintain registrations of, and access to, substitute active ingredients, but there can be no assurance that we will continue to be able to avoid or minimize these risks.

 

The Food Quality Protection Act, enacted by the U.S. Congress in August 1996, establishes a standard for food-use pesticides, which standard is the reasonable certainty that no harm will result from the cumulative effects of pesticide exposures. Under this Act, the U.S. EPA is evaluating the cumulative risks from dietary and non-dietary exposures to pesticides. The pesticides in our products, certain of which may be used on crops processed into various food products, are typically manufactured by independent third parties and continue to be evaluated by the U.S. EPA as part of this exposure risk assessment. The U.S. EPA or the third party registrant may decide that a pesticide we use in our products will be limited or made unavailable to us. For example, in December 2000, the U.S. EPA reached agreement with various parties, including manufacturers of the active ingredient diazinon, regarding a phased withdrawal from retailers by December 2004 of residential uses of products containing diazinon, also used in our lawn and garden products. We cannot predict the outcome or the severity of the effect of their continuing evaluations.

 

In addition, the use of certain pesticide and fertilizer products is regulated by various local, state, federal and foreign environmental and public health agencies. These regulations may include requirements that only certified or professional users apply the product or that certain products be used only on certain types of locations, may require users to post notices on properties to which products have been or will be applied, may require notification to individuals in the vicinity that products will be applied in the future or may ban the use of certain ingredients. Even if we are able to comply with all such regulations and obtain all necessary registrations, we cannot assure you that our products, particularly pesticide products, will not cause injury to the environment or to people under all circumstances. The costs of compliance, remediation or products liability have adversely affected operating results in the past and could materially affect future quarterly or annual operating results.

 

The harvesting of peat for our growing media business has come under increasing regulatory and environmental scrutiny. In the United States, state regulations frequently require us to limit our harvesting and to restore the property to an agreed-upon condition. In some locations, we have been required to create water retention ponds to control the sediment content of discharged water. In the United Kingdom, our peat extraction efforts are also the subject of legislation.

 

In addition to the regulations already described, local, state, federal and foreign agencies regulate the disposal, handling and storage of waste, air and water discharges from our facilities.

 

The adequacy of our current environmental reserves and future provisions is based on our operating in substantial compliance with applicable environmental and public health laws and regulations and several significant assumptions:

 

 

If there is a significant change in the facts and circumstances surrounding these assumptions or if we are found not to be in substantial compliance with applicable environmental and public health laws

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and regulations, it could have a material impact on future environmental capital expenditures and other environmental expenses and our results of operations, financial position and cash flows.

 

European Economic Conditions and Foreign Currency Exposures

 

We currently operate manufacturing, sales and service facilities outside of North America, particularly in the United Kingdom, Germany, France and the Netherlands. In fiscal 2006, International net sales accounted for approximately 15% of our total net sales. Accordingly, we are subject to risks associated with operations in foreign countries, including:

 

 

In addition, our operations outside the United States are subject to the risk of new and different legal and regulatory requirements in local jurisdictions, potential difficulties in staffing and managing local operations and potentially adverse tax consequences. The costs related to our International operations could adversely affect our operations and financial results in the future.

 

Restructuring Activities

 

In June 2005, we commenced a long-term strategic improvement plan, focused on improving organizational effectiveness, implementing better business processes and reducing selling, general and administrative (“SG&A”) expenses. This reorganization places significant pressure on many SG&A functions to reduce headcount and streamline activities. While management believes these efforts will ultimately generate even stronger financial results, there can be no assurance that the plan will achieve all of its expected savings.

 

Cost Pressures

 

Our ability to manage our cost structure can be adversely affected by movements in commodity and other raw material prices, such as those experienced in fiscal 2006. Market conditions may limit the Company’s ability to raise selling prices to offset increases in our input costs. The uniqueness of our technologies can limit our ability to locate alternative supplies for certain products. For certain materials, new sources of supply may have to be qualified under regulatory standards, which can require additional investment and delay bringing the product to market.

 

Manufacturing

 

We use a combination of internal and outsourced facilities to manufacture our products. We are subject to the inherent risks in such activities, including product quality, safety, licensing requirements and other regulatory issues, environmental events, loss or impairment of key manufacturing sites, disruptions in logistics, labor disputes and industrial accidents. Furthermore, we are subject to natural disasters and other factors over which the Company has no control.

 

Acquisitions

 

From time to time we make strategic acquisitions, including the October 2004 acquisition of Smith & Hawken^®, the October 2005 acquisition of Rod McLellan Company (RMC), the November 2005 acquisition of Gutwein (Morning Song^®), the May 2006 acquisition of certain assets of Turf-Seed, Inc. and the June 2006 acquisition of certain assets of the Landmark Seed Company. Acquisitions have inherent risks, such as obtaining necessary regulatory approvals, retaining key personnel, integration of the acquired business, and achievement of planned synergies and projections. We have approximately $880 million of goodwill and intangible assets as of September 30, 2006, primarily related to prior acquisitions. Uncertainty regarding the future performance of the acquired businesses also results in the risk of future impairment charges related to the associated goodwill and intangible assets.

 

 

None

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We lease land from the Union County Community Improvement Corporation in Marysville, Ohio for our headquarters and for our research and development facilities. We own property in Marysville, Ohio for our manufacturing and distribution facilities. Combined, these facilities are situated on approximately 875 acres of land.

 

The North America segment owns two additional research facilities located in Apopka, Florida; and Gervais, Oregon. We own a production facility, which encompasses 27 acres, in Fort Madison, Iowa and lease a spreader and other durable components manufacturing facility in Temecula, California. We also lease a controlled-release fertilizer manufacturing facility in Charleston, South Carolina. We operate 26 growing media facilities in North America — 19 of which are owned by us and five of which are leased. Most of our growing media facilities include production lines, warehouses, offices and field processing areas. We lease sales offices in Atlanta, Georgia; Troy, Michigan; Mooresville, North Carolina; Rolling Meadows, Illinois; and Bentonville, Arkansas. We also lease a facility in Mississauga, Ontario that serves as the headquarters for our Canadian subsidiary.

 

The Company owns an office in Albany, Oregon for Landmark Seed.

 

Scotts LawnService^® conducts its company-owned operations from 77 leased facilities, primarily office/warehouse units in industrial/office parks, across the United States serving 44 metropolitan markets.

 

Smith & Hawken^® operates 58 retail stores, which are all leased facilities primarily in shopping centers across the United States. It leases its main headquarters in Novato, California.

 

The International segment leases its U.K. office, located in Godalming (Surrey); its French headquarters and local operations office, located in Ecully (Lyon); a German office, located in Ingelheim; an Austrian office, located in Salzburg; and an Australian office, located in Baulkan Hills (New South Wales). We own manufacturing facilities in Howden and Hatfield (East Yorkshire) in the United Kingdom. We also own a blending and bagging facility for growing media in Hautmont, France; and a plant in Bourth, France, that we use for formulating, blending and packaging control products for the consumer market. We lease a research and development facility in Chazay, France. Our site in Heerlen, the Netherlands is both a distribution center and a manufacturing site for coated fertilizers for the consumer and professional markets. We own the land and the building for the manufacturing facility, but lease the distribution center building. The International segment leases its professional office, located in Waardenburg, the Netherlands. We own research and development facilities in Levington and Bramford in the United Kingdom. We lease a sales office in Sint Niklaas, Belgium.

 

We lease warehouse space throughout the United States and continental Europe as needed.

 

We believe that our facilities are adequate to serve their intended purposes at this time and that our property leasing arrangements are satisfactory.

 

 

As noted in the discussion in “ITEM 1. BUSINESS — Environmental and Regulatory Considerations” and “ITEM 1. BUSINESS — Regulatory Actions,” we are involved in several pending environmental matters. We believe that our assessment of contingencies is reasonable and that related reserves, in the aggregate, are adequate; however, there can be no assurance that the final resolution of these matters will not have a material adverse affect on our results of operations, financial position and cash flows.

 

Pending material legal proceedings are as follows:

 

U.S. Horticultural Supply, Inc. (F/K/A E.C. Geiger, Inc.)

 

On November 5, 2004, U.S. Horticultural Supply, Inc. (“Geiger”) filed suit against the Company in the U.S. District Court for the Eastern District of Pennsylvania. This complaint alleges that the Company conspired with another distributor, Griffin Greenhouse Supplies, Inc., to restrain trade in the horticultural products market, in violation of Section 1 of the Sherman Antitrust Act. Geiger has not specified the amount of monetary damages it is seeking. On June 2, 2006, the Court denied the Company’s motion to dismiss the complaint. The Company is currently engaged in discovery relating to Geiger’s claim. The deadline for fact discovery is March 8, 2007.

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The Company intends to vigorously defend against Geiger’s claims. The Company believes that Geiger’s claims are without merit and that the likelihood of an unfavorable outcome is remote. Therefore, no accrual has been established related to this matter. However, the Company cannot predict the ultimate outcome with certainty. If the above action is determined adversely to the Company, the result could have a material adverse effect on the Company’s results of operations, financial position and cash flows. Because Geiger has not specified an amount of monetary damages in the case (which may be trebled under the antitrust statutes) and discovery has not yet concluded, any potential exposure that the Company may face cannot be reasonably estimated at this time.

 

The Scotts Company LLC v. Liberty Mutual Insurance Company

 

On October 25, 2006, Scotts LLC sued Liberty Mutual Insurance Company in the U.S. District Court for the Southern District of Ohio. In the suit, Scotts LLC seeks damages and the rescission of a 2000 agreement between Scotts and Liberty Mutual that purports to be a complete buyout by Scotts of any insurance policies that Liberty Mutual might have issued to Scotts LLC (the “2000 Agreement”).

 

As alleged in Scotts LLC’s complaint, in 1998, Scotts tendered certain claims to Liberty Mutual, one of its primary-layer insurers, in connection with costs incurred by Scotts LLC for environmental liabilities. Scotts believed that it had coverage from Liberty Mutual for at least 10 years beginning in 1958 but could only locate a single policy from 1967. Liberty Mutual responded to Scotts LLC’s tender by stating that, after conducting an internal search, Liberty Mutual did not have sufficient evidence to establish that it had ever insured Scotts LLC before 1967. Based on Liberty Mutual’s representations and Scotts LLC’s inability to locate any additional Liberty Mutual policies in Scotts LLC’s own files, Scotts LLC eventually entered into the 2000 Agreement. According to Scotts LLC’s complaint, in Fall 2006, Scotts LLC discovered evidence confirming that, contrary to its representations during the negotiations leading to the 2000 Agreement, Liberty Mutual provided liability insurance to Scotts LLC beginning in at least 1958 and, in fact, paid claims to third parties on Scotts LLC’s behalf during that period.

 

The complaint seeks rescission of the 2000 Agreement and seeks damages based on Liberty Mutual’s breach of fiduciary duty, fraud, breach of the implied covenant of good faith and fair dealing, and bad faith denial of coverage. Scotts LLC intends to prosecute these claims vigorously. Liberty Mutual has filed an answer that denies the complaint’s allegations. Discovery recently began in the case and the Court has not set a trial date.

 

Other

 

The Company has been named a defendant in a number of cases alleging injuries that the lawsuits claim resulted from exposure to asbestos-containing products, apparently based on the Company’s historic use of vermiculite in certain of its products. The complaints in these cases are not specific about the plaintiffs’ contacts with the Company or its products. The Company in each case is one of numerous defendants and none of the claims seeks damages from the Company alone. The Company believes that the claims against it are without merit and is vigorously defending them. It is not currently possible to reasonably estimate a probable loss, if any, associated with the cases and, accordingly, no accrual or reserves have been recorded in the Company’s consolidated financial statements. There can be no assurance that these cases, whether as a result of adverse outcomes or as a result of significant defense costs, will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows.

 

The Company is reviewing agreements and policies that may provide insurance coverage or indemnity as to these claims and is pursuing coverage under some of these agreements, although there can be no assurance of the results of these efforts.

 

We are involved in other lawsuits and claims which arise in the normal course of our business. In our opinion, these claims individually and in the aggregate are not expected to result in a material adverse effect on our results of operations, financial position or cash flows.

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There were no matters submitted to a vote of the security holders of The Scotts Miracle-Gro Company during the fourth quarter of fiscal 2006.

 

SUPPLEMENTAL ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT

 

The executive officers of The Scotts Miracle-Gro Company, their positions and, as of November 28, 2006, their ages and years with the Company (and its predecessors) are set forth below.

 

 

Executive officers serve at the discretion of the Board of Directors and pursuant to employment agreements or other arrangements.

 

The business experience of each of the individuals listed above during at least the past five years is as follows:

 

Mr. Hagedorn has been serving as the Chairman of the Board of the Company since January 2003; as Chief Executive Officer of the Company since May 2001 and as President of the Company since November 2006 and from May 2001 until December 2005. The Scotts Miracle-Gro Company became the public company successor to The Scotts Company which was merged into The Scotts Company LLC in March 2005. He also serves as a director for Farms For City Kids Foundation, Inc., Nurse Family Partnership, The CDC Foundation, Embry Riddle/Aeronautical University, Northshore University Hospital (New York), Scotts Miracle-Gro Foundation and the Intrepid Sea-Air-Space Museum, all charitable organizations. Mr. Hagedorn is the brother of Katherine Hagedorn Littlefield, a director of The Scotts Miracle-Gro Company.

 

Mr. Evans was named Executive Vice President and Chief Financial Officer of The Scotts Miracle-Gro Company on September 14, 2006. From October 2005 to September 2006, he served as Senior Vice President, Finance and Global Shared Services of The Scotts Company LLC. From October 2003 to March 2005, he served as Senior Vice President, North America of The Scotts Company and from March 2005 to September 2005, he served in the same capacity for The Scotts Company LLC following the merger of The Scotts Company into The Scotts Company LLC. From June 2001 to September 2003, he served as Vice President, Finance, North America Sales of The Scotts Company.

 

Mr. Nagel was named Executive Vice President, North American Consumer Business of The Scotts Miracle-Gro Company on September 12, 2006. He served as Executive Vice President and Chief Financial Officer of The Scotts Miracle-Gro Company from March 2005 to September 2006. Mr. Nagel was named Executive Vice President in February 2003 and Chief Financial Officer in January 2003 of The Scotts Company, which was merged into The Scotts Company LLC in March 2005. From August 2001 to January 2003, he served as Senior Vice President, North America and Corporate Finance of The Scotts Company. From September 1998 to August 2001, Mr. Nagel served as Vice President and Corporate Controller of The Scotts Company.

 

Mr. Aronowitz was named Executive Vice President, General Counsel and Corporate Secretary of The Scotts Miracle-Gro Company in March 2005. He was previously named Executive Vice President, General Counsel and Secretary of The Scotts Company in October 2001, which was merged into The Scotts Company LLC in March 2005. He was Senior Vice President, Assistant General Counsel and Assistant Secretary of The Scotts Company from February 2000 to October 2001.

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Ms. Stump was named Executive Vice President, Global Human Resources of The Scotts Miracle-Gro Company in March 2005. Ms. Stump was named Executive Vice President, Global Human Resources of The Scotts Company in February 2003, which was merged into The Scotts Company LLC in March 2005. She was named Senior Vice President, Global Human Resources of The Scotts Company in October 2002. From July 2001 until October 2002, Ms. Stump served as Vice President, Human Resources North America, of The Scotts Company. From September 2000 until July 2001, Ms. Stump served as Vice President, Human Resources Technology and Operations, of The Scotts Company.

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PART II

 

 

The common shares of The Scotts Miracle-Gro Company (“Scotts Miracle-Gro”) trade on the New York Stock Exchange under the symbol “SMG.” The quarterly share prices have been adjusted to reflect the 2-for-1 stock split distributed on November 9, 2005.

 

 

On June 22, 2005, Scotts Miracle-Gro announced that its Board of Directors had approved the establishment of a quarterly cash dividend. The $0.50 per share (adjusted for the 2-for-1 stock split distributed November 9, 2005) annual dividend has been paid in quarterly increments since the fourth quarter of fiscal 2005. The payment of future dividends, if any, on the common shares will be determined by the Board of Directors of Scotts Miracle-Gro in light of conditions then existing, including the Company’s earnings, financial condition and capital requirements, restrictions in financing agreements, business conditions and other factors. See discussion of a recapitalization plan announced on December 12, 2006 in “ITEM 7, MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.”

 

As of November 28, 2006, there were approximately 49,000 shareholders including holders of record and our estimate of beneficial holders.

 

The following table shows the purchases of common shares of Scotts Miracle-Gro made by or on behalf of Scotts Miracle-Gro or any “affiliated purchaser” of Scotts Miracle-Gro as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934, as amended, for each of the three months in the quarter ended September 30, 2006:

 

 

 

21

 

22

 

Five-Year Summary(1)
For the fiscal year ended September 30,
(in millions, except per share amounts)

 

 

 

23

 

 

24

A numeric reconciliation of net income to Adjusted EBITDA is as follows:

 

 

 

The purpose of this discussion is to provide an understanding of the Company’s financial results and condition by focusing on changes in certain key measures from year to year. Management’s Discussion and Analysis (MD&A) is organized in the following sections:

 

 

On November 9, 2005, The Scotts Miracle-Gro Company distributed a 2-for-1 stock split of the common shares to shareholders of record on November 2, 2005. To enhance comparability going forward, all share and per share information referred to in this MD&A and elsewhere in this Annual Report on Form 10-K have been adjusted to reflect this stock split for all periods presented.

 

On December 12, 2006, The Scotts Miracle-Gro Company announced that its Board of Directors approved in concept a plan of recapitalization encompassing the following actions:

 

 

The recapitalization is expected to be consummated during the second quarter of fiscal 2007. These actions reflect management’s confidence in the continued growth of the Company coupled with strong and consistent cash flows that can support higher levels of debt.

 

Executive Summary

 

We are dedicated to delivering strong, consistent financial results and outstanding shareholder returns by providing consumers with products of superior quality and value to enhance their outdoor living environments. We are a leading manufacturer and marketer of consumer branded products for lawn and garden care and professional horticulture in North America and Europe. We are Monsanto’s exclusive agent for the marketing and distribution of consumer Roundup^® non-selective herbicide products within the United States and other contractually specified countries. We entered the North America wild bird food category with the acquisition of Gutwein & Co., Inc. (“Gutwein”) in November 2005, and the outdoor living category with the acquisition of Smith & Hawken^® in October 2004. We have a presence in Australia, the Far East, Latin America and South America. Also, in the United States,

25

we operate the second largest residential lawn service business, Scotts LawnService. In fiscal 2006, our operations were divided into the following reportable segments: North America, Scotts LawnService^®, International, and Corporate & Other. The Corporate & Other segment consists of the Smith & Hawken^® business and corporate general and administrative expenses.

 

As a leading consumer branded lawn and garden company, we focus our consumer marketing efforts, including advertising and consumer research, on creating consumer demand to pull products through the retail distribution channels. In the past three years, we have spent approximately 5% of our net sales annually on media advertising to support and promote our products and brands. We have applied this consumer marketing focus for a number of years, and we believe that we receive a significant return on these marketing expenditures. We expect we will continue to focus our marketing efforts toward the consumer and make additional targeted investments in consumer marketing expenditures in the future to continue to drive market share and sales growth. A portion of our selling, general and administrative cost savings from our long-term strategic improvement plan initiated in fiscal 2005 has been reinvested to strengthen our brands and relationships with consumers. Our spending on advertising in fiscal 2006 increased 12.1% over fiscal 2005 and when combined with promotions, increased 15.2%.

 

Our sales are susceptible to global weather conditions. For instance, periods of wet weather can adversely impact sales of certain products, while increasing demand for other products. We believe that our past acquisitions have somewhat diversified both our product line risk and geographic risk to weather conditions.

 

 

Due to the nature of our lawn and garden business, significant portions of our shipments occur in the second and third fiscal quarters. In recent years, retailers have reduced their pre-season inventories placing greater reliance on us to deliver products “in season” when consumers seek to buy our products.

 

Management focuses on a variety of key indicators and operating metrics to monitor the health and performance of our business. These metrics include consumer purchases (point-of-sale data), market share, net sales (including volume, pricing and foreign exchange), gross profit margins, income from operations, net income and earnings per share. To the extent applicable, these measures are evaluated with and without impairment, restructuring and other charges. We also focus on measures to optimize cash flow and return on invested capital, including the management of working capital and capital expenditures.

 

The long-term strategic improvement plan (“Project Excellence”), initiated in June 2005, is focused on improving organizational effectiveness, implementing better business processes, reducing SG&A expenses, and increasing spending on consumer marketing and innovation. Net Project Excellence savings are estimated to have increased fiscal 2006 pre-tax earnings by approximately $25.0 million. We incurred approximately $9.7 million in restructuring charges associated with Project Excellence during fiscal 2006 and approximately $36.0 million since the inception of the project.

 

Improving the performance of our consumer International business continues to be a challenge. This is evidenced by the impairment charges for this business in the first quarter of fiscal 2005 and the fourth quarter of fiscal 2006. Over the past several years, we have reorganized and rationalized our European supply chain and increased sales force productivity. Current efforts are focused on improving our competitive position, continuing to reduce supply chain and SG&A costs within the business, and realigning the organization to better leverage our knowledge of the marketplace and the consumer. We are working towards pan-European category management of our consumer product portfolio. Overall, we have moderated our goals for the consumer International business to reflect the realities of the marketplace.

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We continue to view strategic acquisitions as a means to enhance our strong core businesses. Effective October 3, 2005, we acquired all the outstanding shares of Rod McLellan Company (“RMC”) for $20.5 million in cash plus assumed liabilities of $6.8 million. RMC is a leading branded producer and marketer of soil and landscape products in the western U.S. This business has been integrated into our existing Growing Media business. Effective November 18, 2005, we acquired Gutwein & Co., Inc. (“Gutwein”) for approximately $78.3 million in cash plus assumed liabilities of $4.7 million. Through its Morning Song^® brand, Gutwein is a leader in the growing North America wild bird food category, generating approximately $80 million in annual revenues. Morning Song^® products are sold at leading mass retailers, grocery, pet and general merchandise stores. This is our first acquisition in the wild bird food category and we are excited about the opportunity to leverage the strengths of both organizations to drive continued growth in this category.

 

In late May and early June 2006, the Company invested cash of $16.2 million and assumed $5.5 million of liabilities to consummate two acquisitions designed to strengthen the Company’s overall global position in the turfgrass seed category. First, the Company completed the acquisition of certain assets, including brands, turfgrass varieties and intellectual property, from Oregon based Turf-Seed, Inc. (“Turf-Seed”), a leading producer of quality commercial turfgrasses for the professional seed business. The transaction includes a 49% equity interest in Turf-Seed Europe, which distributes Turf-Seed’s grass varieties throughout the European Union and other countries in the region. Based on future performance, additional contingent consideration estimated at $15.0 million may be due in 2012. Second, the Company completed the acquisition of certain assets of Oregon based Landmark Seed Company, a leading producer and distributor of quality professional seed and turfgrasses, including its brands, turfgrass varieties and intellectual property.

 

Given the Company’s strong performance and consistent cash flows, our Board of Directors has undertaken several actions over the past eighteen months to return cash to our shareholders. We began paying a quarterly cash dividend of 12.5 cents per share in the fourth quarter of fiscal 2005. In fiscal 2006, our Board launched a five-year $500 million share repurchase program pursuant to which we have repurchased 2.0 common shares for $87.9 million.

 

Most recently, on December 12, 2006, we announced that we intend to implement a recapitalization plan that would expand upon and accelerate returns to shareholders beyond the current $500 million program (which has been canceled) by returning $750 million to our shareholders. Pursuant to this plan, which has been approved in concept by our Board of Directors, we intend to launch a “Dutch auction” tender offer in January 2007 to repurchase up to $250 million of our common shares. Following the consummation of the tender offer and subject to final Board approval, we intend to declare a special one-time cash dividend during the second quarter of fiscal 2007, currently anticipated to be $500 million in the aggregate but subject to revision based on spending for tendered common shares.

 

In connection with this recapitalization plan, we have received a commitment letter from JPMorgan Chase, Bank of America and Citigroup, subject to the terms and conditions set forth therein, to provide Scotts Miracle-Gro and certain of its subsidiaries the following loan facilities totaling in the aggregate up to $2.1 billion: (a) a senior secured five-year term loan in the principal amount of $550.0 million and (b) a senior secured five-year revolving loan facility in the aggregate principal amount of up to $1.55 billion. The Company will have the ability to increase the aggregate amount of the revolving and term loan facilities by $200 million allocated on a pro rata basis, subject to demand in the syndication process. The new $2.1 billion senior secured credit facilities would replace our existing $1.05 billion senior credit facility. In connection with the recapitalization plan, we also intend to use proceeds from our new credit facilities to repurchase our 65/8% senior subordinated notes due 2013 in an aggregate principal amount of $200 million.

 

These actions reflect management’s confidence in the continued growth of the Company coupled with strong and consistent cash flows that can support the higher levels of debt necessary to finance this plan, as discussed in the Liquidity and Capital Resources section of this Item 7. Even with an increase in borrowings under the new credit facilities, we believe we will maintain the capacity to pursue targeted, strategic acquisitions that leverage our core competencies.

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Results of Operations

 

The following table sets forth the components of income and expense as a percentage of net sales for the three years ended September 30, 2006:

 

 

Net Sales

 

Consolidated net sales for fiscal 2006 increased 13.8% to $2.70 billion from $2.37 billion in fiscal 2005. Acquisitions, foreign exchange rates and a Roundup^® deferred contribution liability charge in fiscal 2005 significantly impacted the rate of sales growth in fiscal 2006, as detailed in the following table:

 

 

The adjusted net sales growth of 7.3% was driven by strong growth in our North American consumer business and the Scotts LawnService^® business. In contrast, the lawn and garden market has been difficult in Europe as net sales are down 1.7% after adjusting for the effect of exchange rates. North America segment sales grew 14.8% to $1.91 billion, or 7.9% excluding acquisitions. Volume growth contributed 5.8%, pricing 1.9%, with the balance due to the effects of foreign exchange rates. Scotts LawnService^® net sales were $205.7 million in fiscal 2006, up 28.7% from fiscal 2005. Volume growth drove approximately two-thirds of the increase with the balance from pricing and acquisitions. International segment sales declined 5.1% to $408.5 million in fiscal 2006, with one-third of the decline due to volume and the balance due to a decline in average foreign exchange rates.

 

In fiscal 2005, worldwide net sales totaled $2.37 billion, an increase of 12.5% compared to fiscal 2004 or 4.7% excluding the impact of the Smith & Hawken^® acquisition. Positive impacts from foreign exchanges rates contributed 1.2% to sales growth, while the impact of net selling prices added 1.9% to sales growth.

 

Gross Profit

 

As a percentage of net sales, gross profit was 35.4% of net sales for fiscal 2006 compared to 36.3% for fiscal 2005. Adjusting for the effect of the Roundup^® contribution charge (see the following paragraph and Note 3 to the accompanying Consolidated Financial Statements), the fiscal 2005 gross profit rate

28

was 37.5%, a decline of 210 basis points. Acquisitions accounted for 70 basis points of the decline, as the margins of these businesses are below our historical average. Product mix adversely affected margins by 80 basis points, due in part to significant increases in sales of lower margin grass seed and garden soils. Increased costs for fuel and commodities exceeded price increases, resulting in 90 basis point decline in gross margin as a percentage of net sales. The offsetting 30 basis point differential is comprised of miscellaneous other items.

 

Fiscal 2005 gross profit margins declined 130 basis points compared to fiscal 2004. The Roundup^® marketing agreement contribution charge of $45.7 million recorded in fiscal 2005 reduced gross margin by approximately 90 basis points. Smith & Hawken^® gross margins, which were below the Company’s average, accounted for approximately 30 basis points of the decline. From an operating segment standpoint, North America gross margins increased 50 basis points, primarily on a higher net Roundup^® commission, while pricing offset increased commodity costs. Scotts LawnService^® gross margins improved as frontline labor and supervisory productivity and fleet management improvements offset higher fuel costs. Gross margins declined in the International segment primarily due to higher commodity and supply chain costs.

 

Selling, General and Administrative Expenses (in millions)

 

 

Advertising expenses in fiscal 2006 were $137.3 million, an increase of $14.8 million or 12.1% from fiscal 2005. On a percentage of net sales basis, the advertising expense was 5.1% in fiscal 2006 compared to 5.2% in fiscal 2005. Some planned increases in traditional media advertising were shifted to consumer directed promotions funded via programs with our retail partners, which are accounted for as a reduction to net sales. The combination of higher advertising spending and consumer promotions led to an 18% increase in spending for the North American consumer business. In fiscal 2005, advertising expenses increased $17.5 million from fiscal 2004. Excluding the impact of Smith & Hawken^®, advertising expense was 5.0% of net sales in fiscal 2005 and fiscal 2004. Increases in media spending in North America and Scotts LawnService^® were offset by more focused International media spending.

 

In fiscal 2006, Selling, general and administrative expenses spending decreased $17.9 million or 3.7% from fiscal 2005. This decrease reflects the savings generated by our Project Excellence initiative coupled with a $10.1 million benefit from an insurance recovery relating to past legal costs incurred in our defense of lawsuits regarding our use of vermiculite. Increases in SG&A spending occurred in our rapidly expanding Scotts LawnService^® business in the amount of $16.6 million and our wild bird food acquisition which added $4.2 million in spending.

 

SG&A expenses in fiscal 2005 were $486.6 million compared to $419.6 million in fiscal 2004. Excluding Smith & Hawken^®, SG&A spending was $450.3 million, an increase of $30.7 million or 7.3%. This increase was primarily the result of outside legal fees associated with litigation matters, Sarbanes-Oxley associated compliance costs, expansion of Scotts LawnService^®, foreign exchange rates and incremental North America selling expense (primarily for increased home center support), partially offset by lower non-restructuring severance costs in North America and International.

 

We began expensing share-based awards commencing with grants issued in fiscal 2003. The majority of our share-based awards vest over three years, with the associated expense generally recognized ratably over the vesting period. As such, fiscal 2005 was the first year to be impacted with the expense associated with three years of grants. Prior to the fiscal 2006 adoption of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment,” forfeitures were recognized as incurred, which reduced fiscal 2005 expense by approximately $2.2 million. Our stock-based compensation expense now includes an estimate of forfeitures starting at the grant date.

 

The $5.8 million increase in stock-based compensation in fiscal 2006 as compared to fiscal 2005 relates to two items. First, there was an increase in the number of awards granted to key employees and

29

the value of each grant has increased commensurate with our stock price. Second, the departure of several key executives in fiscal 2005 resulted in a high level of forfeitures, reducing the related share-based awards expense in that fiscal year.

 

Amortization expense was $15.2 million in fiscal 2006 compared to $14.8 million in fiscal 2005. The increased amount of amortization is associated with recent acquisitions. The $6.5 million increase in fiscal 2005 as compared to fiscal 2004 primarily results from a comprehensive review of intangibles and corrections to the accumulated amortization of certain intangible assets. Recent acquisitions also contributed to this increase.

 

Impairment, Restructuring and Other Charges, net (in millions)

 

 

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, goodwill and indefinite-lived intangible assets are no longer amortized and are subject to impairment testing at least annually or more frequently if circumstances indicate a potential impairment between annual testing. We conduct our annual assessment at the end of our first fiscal quarter. Our assessment in the first quarter of fiscal 2006 resulted in an impairment charge of $1.0 million associated with a tradename no longer in use in our U.K. consumer business. Category declines in the European consumer markets during the 2006 season resulted in a decline in the profitability of the consumer component of our International business segment in fiscal 2006. After an evaluation, management reached the conclusion that the projections supporting first quarter 2006 impairment testing for the consumer component of our International business segment were unlikely to be met. Management engaged an independent valuation firm to assist in an interim impairment assessment of the indefinite-lived tradenames and goodwill associated with this business. As a result of this evaluation in the fourth quarter of fiscal 2006, we recorded a $65.4 million non-cash impairment charge, $62.3 million of which was associated with indefinite-lived tradenames that continue to be employed in the consumer portion of our International segment. The balance of the fiscal 2006 fourth quarter impairment charge was in our North America segment and consisted of $1.3 million for a Canadian tradename being phased out and $1.8 million related to goodwill of a pottery business we exited.

 

In the first quarter of fiscal 2005, we recorded an impairment charge of $22.0 million associated with indefinite-lived tradenames in the U.K. consumer business, reflecting a reduction in the value of the business resulting primarily from the decline in the profitability of its growing media business and unfavorable category mix trends.

 

Restructuring activities in fiscal 2006 and fiscal 2005 relate primarily to organizational reductions associated with Project Excellence initiated in the third quarter of fiscal 2005. As a result of this program, approximately 110 associates accepted early retirement or were severed during the last four months of fiscal 2005. Approximately 110 additional associates exited in fiscal 2006. We continue to evaluate our organization and operating efficiencies. As a result of these ongoing evaluations, there may be further restructuring charges in future quarters.

 

Litigation related income is attributable to two separate matters in fiscal 2005. In the fourth quarter of fiscal 2001, as a result of collection concerns, we recorded a reserve against accounts receivable from Central Garden & Pet Company (Central Garden). This charge was recorded in impairment, restructuring and other charges, net. After nearly five years of pursuing collection of these receivables via litigation, we received payment totaling $15.0 million on July 14, 2005. As a result, we reversed $7.9 million of the Central Garden reserve recorded in fiscal 2001. In September 2005, we reached a settlement with sanofi-aventis related to our litigation of matters related to the Aventis business. In relation to this matter, we received a net $8.9 million settlement on September 30, 2005.

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Other Income, net

 

Other income, net was $9.2 million for fiscal 2006 and was comprised primarily of $6.8 million of royalty income. Other income, net for fiscal 2005 resulted primarily from $4.1 million awarded to us as part of the Central Garden judgment discussed above and royalty income, partially offset by foreign currency losses. Other income, net in fiscal 2004 was attributable to royalty income, gains on foreign currency transactions, Scotts LawnService^® franchise fees and cost subsidies related to the sale of peat bogs in the United Kingdom, for which a portion of the cost benefit was historically recorded as other income (fiscal 2004 was the final year we received such subsidies).

 

Income from Operations

 

Income from operations in fiscal 2006 was $252.5 million, compared to $200.9 million in fiscal 2005, an increase of $51.6 million. Income from operations in fiscal 2006 was negatively impacted by $66.4 million from impairment charges and an additional $9.4 million of restructuring charges. Income from operations in fiscal 2005 was negatively impacted by the following charges: (1) $45.7 million related to the Roundup^® deferred contribution charge; (2) a $22.0 million charge for impairment of U.K. intangibles; and (3) $26.3 million in restructuring charges. These were partially offset by $16.8 million of litigation related income as discussed above. If these unusual factors were excluded from year-over-year comparison, fiscal 2006 would show an 18% improvement over fiscal 2005. Higher net sales and Project Excellence savings, offset by a gross margin rate decline and growth in advertising spending, were the major contributors to the 18% growth in income from operations.

 

Income from operations in fiscal 2005 declined $51.9 million from fiscal 2004. In addition to fiscal 2005 charges detailed in the preceding paragraph, the change in income from operations is attributable to higher net sales and gross profit margins, and significantly higher earnings from the Roundup^® marketing agreement, partially offset by higher legal and Sarbanes-Oxley compliance costs and sales force investments in North America.

 

Interest Expense and Refinancing Activities

 

We have refinanced our debt arrangements several times over the past two years to take advantage of our improving financial position and favorable market conditions. In October 2003, we tendered nearly all of our $400 million then outstanding senior subordinated notes that bore interest at 85/8% and issued $200 million of new senior subordinated notes bearing interest at 65/8%. At the time, we also secured a new credit facility at more favorable terms than our previous arrangement. Refinancing costs associated with these transactions were $44.3 million, including premiums paid on the redemption of the 85/8% notes, write-off of previously deferred financing and treasury lock costs and transactions fees. In August 2004, we refinanced the term loan facility under a new credit agreement with new term loans, providing for improved terms and borrowing costs. Costs charged associated with this refinancing were $1.2 million.

 

In July 2005, we entered into a new credit agreement that provided for a significantly increased revolving credit facility and allowed us to repay our outstanding term notes, again providing for improved terms and borrowing costs. Costs charged against income from operations associated with this refinancing were $1.3 million.

 

Interest expense decreased from $41.5 million in fiscal 2005 to $39.6 million in fiscal 2006. A $3.6 million increase in expense due to an increase in rates on the variable rate portion of our outstanding debt and an increase in average debt outstanding was more than offset by hedging strategies, the impact of foreign exchange rates, and miscellaneous other items. In fiscal 2005, interest expense decreased $7.3 million compared to fiscal 2004. The decrease in interest expense was primarily attributable to a $113.9 million reduction in average borrowings, coupled with a nine basis point reduction in our weighted average interest rate to 5.83%.

 

Income Taxes

 

The effective tax rate for fiscal 2006 was 37.7% compared to 36.5% in fiscal 2005 and 36.6% in fiscal 2004. The effective tax rate in fiscal 2006 was higher than in the prior two years due to fewer favorable developments. In fiscal 2005, our income tax rate benefited primarily as a result of favorable developments related to prior year foreign tax exposures. In fiscal 2004, our effective tax rate benefited from an adjustment of state deferred income taxes resulting from a detailed review of state effective tax

31

rates and increased utilization of foreign tax credits. We anticipate the effective tax rate will be approximately 37.0% for fiscal 2007.

 

Net Income and Earnings per Share

 

We reported income from continuing operations of $132.7 million in fiscal 2006, compared to $100.4 million in fiscal 2005. Income from discontinued operations pertains to the disposal of our professional growing media business at the end of fiscal 2004. Reported net income, including income from discontinued operations, increased from $100.6 million or $1.47 per diluted share in fiscal 2005 to $132.7 million or $1.91 per diluted share in fiscal 2006. As described in the Income from Operations discussion, the benefit from net sales growth and Project Excellence savings, was offset by impairment and restructuring charges in fiscal 2006, while similar factors impacted fiscal 2005, along with the Roundup^® deferred contribution charge. Average diluted shares outstanding increased from 68.6 million in fiscal 2005 to 69.4 million in fiscal 2006, due to option exercises and the impact on common stock equivalents of a higher average share price, and partially offset by the repurchase of our common shares under the program approved by our Board of Directors in November 2005.

 

In fiscal 2005, we reported income from continuing operations of $100.4 million, compared to $100.5 million in fiscal 2004. Reported net income, including income from discontinued operations, decreased from $100.9 million or $1.52 per diluted share in fiscal 2004 to $100.6 million or $1.47 per diluted share in fiscal 2005. As described in the Income from Operations discussion, the benefit from solid sales growth in fiscal 2005 was offset by the significant Roundup^® deferred contribution charge, and impairment and restructuring charges. Average diluted shares outstanding increased from 66.6 million in fiscal 2004 to 68.6 million in fiscal 2005, due to option exercises and the impact on common stock equivalents of a higher average share price.

 

Segment Results

 

Our operations are divided into the following reportable segments: North America, Scotts LawnService^®, International, and Corporate & Other. The Corporate & Other segment consists of Smith & Hawken^® and corporate general and administrative expenses. Segment performance is evaluated based on several factors, including income from operations before amortization, and impairment, restructuring and other charges, which is a non-GAAP financial measure. Management uses this measure of operating profit to gauge segment performance because we believe this measure is the most indicative of performance trends and the overall earnings potential of each segment.

 

Net Sales by Segment (in millions)

 

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Income from Operations by Segment (in millions)

 

 

North America

 

North America segment net sales were $1.91 billion in fiscal 2006, an increase of 14.8% from fiscal 2005. Excluding the impact of acquisitions, sales improved 7.9%, approximately 1.9% of which was a result of pricing. Each of the core businesses performed well, with lawn fertilizers up 8% and growing media up 17%. Plant food grew 12%, benefiting from the very successful launch of Miracle-Gro^® LiquaFeed^®, while grass seed grew 24%. Ortho^® sales were flat to last year due to a unfavorable season for weed control products.

 

During fiscal 2005, North America segment net sales increased 6.3%. Of the increase in North America net sales, approximately 2.3% was attributable to pricing. Within the North America segment, Gardening Products net sales, which include growing media and garden fertilizers, increased 9.8% with higher sales of value-added Miracle-Gro^® garden soils and potting mix, Shake ’N Feed^® continuous release plant food and Organic Choice^® garden soils. Net sales of Ortho^® products increased by 11.0% in fiscal 2005, driven largely by the successful launches of Home Defense MAX^®, Weed-B-Gon^® MAX^®, and Ortho^® Season-Long Grass and Weed Killer concentrate. Excluding the favorable impact of foreign exchange rates, the Canadian group of North America posted a 23.0% net sales increase in fiscal 2005. Unfavorable early season weather conditions adversely impacted the Lawns group within North America, resulting in net sales that were flat compared to fiscal 2004.

 

In fiscal 2006, North America segment operating income increased $38.1 million or 11.1%. This increased operating income was primarily the result of higher net sales and Project Excellence savings, offsetting a gross margin rate decline and growth in advertising spending.

 

In fiscal 2005, North America segment operating income increased $37.8 million or 12.3%. Higher sales volume and gross profits, product price increases, strong performance in the Roundup^® business and moderate increases in SG&A spending more than offset higher commodity and fuel costs, investments in the home center sales team, and in research and development projects.

 

Scotts LawnService^®

 

In fiscal 2006, we continued the expansion of our Scotts LawnService^® business primarily through internal growth. We invested $4.4 million of capital in lawn care acquisitions in fiscal 2006, and $6.4 million in fiscal 2005. Acquisitions had been a major factor in the growth of the lawn care business prior to fiscal 2004. While we expect to continue making selective acquisitions in future years, we anticipate the majority of the future growth in our lawn care business will be organic.

 

Scotts LawnService^® segment net sales increased $45.9 million or 28.7% in fiscal 2006. In fiscal 2005, Scotts LawnService^® net sales increased 18.2% or $24.6 million. The growth in net sales for both years has been from increased customer counts and revenue per customer, strong customer retention, pricing to cover increased input costs, modest geographic expansion and the full year impact of recent acquisitions.

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Operating income for the Scotts LawnService^® segment increased $2.5 million or 19.1% in fiscal 2006 and $3.7 million or 39.4% in fiscal 2005. These increases are the result of revenue growth offset by investments in personnel and infrastructure to support future growth and service levels.

 

International

 

Net sales for the International segment in fiscal 2006 declined by 5.1% or $21.8 million compared to fiscal 2005. Excluding the effects of currency fluctuations, net sales declined 1.7%. The retail environment in Europe was challenging with category sales down in both the U.K. and France, our two largest European markets. We believe listing improvements have resulted in market share gains; however, these gains did not result in top line growth due to the category declines.

 

Fiscal 2005 International segment net sales increased $24.7 million or 6.1% compared to fiscal 2004. Excluding the effects of currency fluctuations, the fiscal 2005 net sales increase was 1.1%. Lower sales in France and the Benelux countries largely offset higher sales in the International professional business, Central Europe and the United Kingdom.

 

In fiscal 2006, International operating income decreased $5.8 million or 16.9% as compared to fiscal 2005. Lower sales and gross margins were partially offset by reduced SG&A spending, resulting in the year-over-year decline. Operating income grew $5.0 million or 17.1% in fiscal 2005, compared to fiscal 2004. Excluding favorable foreign exchange rates, International segment operating income increased 8.5%. The increase in fiscal 2005 operating income was attributable to modest revenue growth and reduced SG&A spending, partially offset by lower gross margins.

 

Corporate & Other

 

The loss from operations in Corporate & Other was $81.8 million in fiscal 2006, $94.2 million in fiscal 2005, and $70.6 million in fiscal 2004. The increase from fiscal 2004 to fiscal 2005 largely was driven by increased legal and Sarbanes-Oxley compliance costs. While significant reductions in these costs in fiscal 2006 served to reduce the loss as compared to fiscal 2005, a loss in our Smith & Hawken^® business mitigated the impact of these cost reductions.

 

Management’s Outlook

 

We are very pleased with our performance in fiscal 2006. Despite upward pressure on commodity raw material costs and a challenging retail environment in Europe, we delivered record net sales and earnings. Our sales results were driven by strong point of sales growth in our North America business and continued expansion of our Scotts LawnService^® business, as well as recent acquisitions.

 

Our strong results in fiscal 2006 have set the stage for another successful year in fiscal 2007. We are committed to executing the strategic initiatives outlined in “ITEM 1. BUSINESS — Strategic Initiatives,” all of which we believe will increase operating profits, secure future growth opportunities and strengthen the Company’s franchise for our consumers, our retail partners and our shareholders.

 

From a financial perspective, the execution of our strategic plan will also allow us to continue to improve Return on Invested Capital (ROIC) and free cash flows. Our regular quarterly dividends coupled with the special stock repurchase and dividend planned for the second quarter of fiscal 2007, will allow us to return funds to shareholders while maintaining our targeted capital structure and allowing for opportunistic acquisitions.

 

For certain information concerning our risk factors, see “ITEM 1A. RISK FACTORS.”

 

Liquidity and Capital Resources

 

Net cash provided from operating activities was $182.4 million for fiscal 2006, compared to $226.7 million for fiscal 2005, a decline of $44.3 million resulting from the following factors. First, we undertook an inventory build in North America in the fourth quarter of fiscal 2006 to take advantage of a historical trough in urea costs and to increase the predictability of fiscal 2007 costs. Second, Smith & Hawken^® inventories increased as a result of a conscious early season effort to improve customer service; however, sales subsequently did not meet expectations. Third, $43.0 million of the Roundup^® deferred contribution amount was paid in October 2005. Lastly, net payments against restructuring reserves used $9.2 million in cash in fiscal 2006 while non-cash restructuring costs of $10.3 million

34

served to increase operating cash flows in fiscal 2005. These unfavorable cash flow developments were offset by a $34.3 million increase in accounts payable.

 

The seasonal nature of our operations generally requires cash to fund significant increases in working capital (primarily inventory) during the first half of the year. Receivables and payables also build substantially in the second quarter of the year in line with the timing of sales as the spring selling season begins. These balances liquidate during the June through September period as the lawn and garden season unwinds. Unlike our core retail business, Scotts LawnService^® typically has its highest receivables balances in the fourth quarter because of the seasonal timing of customer applications and extra services revenues.

 

Cash used in investing activities was $174.1 million and $60.9 million for fiscal 2006 and fiscal 2005, respectively. Our acquisitions of Gutwein and RMC required a net cash outlay of $98.8 million in the first quarter of 2006, which was financed with borrowings under our existing lines of credit. Our acquisition of Smith & Hawken^® in the first quarter of fiscal 2005 required a cash outlay of $73.6 million, financed in large part through the redemption of $57.2 million of investments. Capital spending of $57.0 million in fiscal 2006 was done in the normal course of business, compared to the $40.4 million spent in fiscal 2005. The increase in capital spending was partially due to approximately $4.9 million spent acquiring peat bogs in Scotland along with $5.4 million in new Smith and Hawken^® stores.

 

Financing activities used cash of $46.9 million and $195.2 million in fiscal 2006 and fiscal 2005, respectively. As noted earlier, in fiscal 2006, we began a program to return cash to our shareholders. To that end, we paid dividends of $33.5 million and repurchased $87.9 million of our common shares financed in part by a net increase in borrowings under our Revolving Credit Agreement of $55.2 million. Prior to fiscal 2006, our focus was on aggressively paying down debt and managing our credit agreements and borrowings to maximize the benefit of our improving capital structure and debt facilities. Approximately $211.2 million of debt was retired in fiscal 2005. We also paid our first ever common share dividend in the fourth quarter of fiscal 2005 totaling $8.6 million. Proceeds from the exercise of employee stock options were $17.6 million in fiscal 2006 compared to $32.2 million in fiscal 2005.

 

Our primary sources of liquidity are cash generated by operations and borrowings under our credit agreements. Our Revolving Credit Agreement consists of an aggregate $1.05 billion multi-currency commitment (increased from $1.0 billion in February 2006), that extends through July 21, 2010. Under our current structure, we may request an additional $100 million in revolving credit commitments, subject to approval from our lenders. As of September 30, 2006, there was $775.9 million of availability under the Revolving Credit Agreement. As of September 30, 2006, we also had $200.0 million of 65/8% senior subordinated notes outstanding. Note 9 to the Consolidated Financial Statements provides additional information pertaining to our borrowing arrangements. We were in compliance with all of our debt covenants throughout fiscal 2006.

 

The recapitalization plan announced on December 12, 2006, to return $750 million to shareholders during the second quarter of fiscal 2007 will be financed by a restructuring of the Company’s principal borrowing arrangements. Our Revolving Credit Agreement will be replaced with new senior secured $2.1 to $2.3 billion multicurrency credit facilities that will provide for revolving credit and term loans. As part of the refinancing, we intend to repurchase the $200 million of 65/8% senior subordinated notes outstanding. We believe our new facilities will continue to provide the Company with the capacity to pursue targeted, strategic acquisitions that leverage our core competencies.

 

We are party to various pending judicial and administrative proceedings arising in the ordinary course of business. These include, among others, proceedings based on accidents or product liability claims and alleged violations of environmental laws. We have reviewed our pending environmental and legal proceedings, including the probable outcomes, reasonably anticipated costs and expenses, reviewed the availability and limits of our insurance coverage and have established what we believe to be appropriate reserves. We do not believe that any liabilities that may result from these proceedings are reasonably likely to have a material adverse effect on our liquidity, financial condition or results of operations; however, there can be no assurance that future quarterly or annual operating results will not be materially affected by final resolution of these matters.

35

The following table summarizes our future cash outflows for contractual obligations as of September 30, 2006 (in millions):

 

 

Purchase obligations primarily represent outstanding purchase orders for materials used in the Company’s manufacturing processes. Purchase obligations also include commitments for warehouse services, seed, and out-sourced information services which comprise the unconditional purchase obligations disclosed in Note 15 to Consolidated Financial Statements.

 

Other includes actuarially determined retiree benefit payments and pension funding to comply with local funding requirements. Pension funding requirements beyond fiscal 2007 are not currently determinable. The above table excludes interest payments, and insurance accruals as the Company is unable to estimate the timing of the payment for these items.

 

The Company has no off-balance sheet financing arrangements.

 

In our opinion, cash flows from operations and capital resources will be sufficient to meet debt service and working capital needs during fiscal 2007, and thereafter for the foreseeable future. However, we cannot ensure that our business will generate sufficient cash flow from operations or that future borrowings will be available under our credit facilities in amounts sufficient to pay indebtedness or fund other liquidity needs. Actual results of operations will depend on numerous factors, many of which are beyond our control.

 

Environmental Matters

 

We are subject to local, state, federal and foreign environmental protection laws and regulations with respect to our business operations and believe we are operating in substantial compliance with, or taking actions aimed at ensuring compliance with, such laws and regulations. We are involved in several legal actions with various governmental agencies related to environmental matters. While it is difficult to quantify the potential financial impact of actions involving environmental matters, particularly remediation costs at waste disposal sites and future capital expenditures for environmental control equipment, in the opinion of management, the ultimate liability arising from such environmental matters, taking into account established reserves, should not have a material adverse effect on our financial position. However, there can be no assurance that the resolution of these matters will not materially affect our future quarterly or annual results of operations, financial condition or cash flows. Additional information on environmental matters affecting us is provided in “ITEM 1. BUSINESS — Environmental and Regulatory Considerations,” “ITEM 1. BUSINESS — Regulatory Actions” and “ITEM 3. LEGAL PROCEEDINGS.”

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of financial condition and results of operations is based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). Certain accounting policies are particularly significant, including those related to revenue recognition, goodwill and intangibles, certain employee benefits, and income taxes. We believe these accounting policies, and others set forth in Note 1 of the Notes to Consolidated Financial Statements, should be reviewed as they are integral to understanding our results of operations and financial position. Our critical accounting policies are reviewed periodically with the Audit Committee of The Scotts Miracle-Gro Company Board of Directors.

 

The preparation of financial statements requires management to use judgment and make estimates that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those

36

related to customer programs and incentives, product returns, bad debts, inventories, intangible assets, income taxes, restructuring, environmental matters, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Although actual results historically have not deviated significantly from those determined using our estimates, our results of operations or financial position could differ, perhaps materially, from these estimates under different assumptions or conditions.

 

Revenue Recognition

 

Most of our revenue is derived from the sale of inventory, and we recognize revenue when title and risk of loss transfer, generally when products are received by the customer. Provisions for payment discounts, product returns and allowances are recorded as a reduction of sales at the time revenue is recognized based on historical trends and adjusted periodically as circumstances warrant. Similarly, reserves for uncollectible receivables due from customers are established based on management’s judgment as to the ultimate collectibility of these balances. We offer sales incentives through various programs, consisting principally of volume rebates, cooperative advertising, consumer coupons and other trade programs. The cost of these programs is recorded as a reduction of sales. The recognition of revenues, receivables and trade programs requires the use of estimates. While we believe these estimates to be reasonable based on the then current facts and circumstances, there can be no assurance that actual amounts realized will not differ materially from estimated amounts recorded.

 

Goodwill, Indefinite-lived Intangibles and Long-lived Assets

 

We have significant investments in property and equipment, intangible assets and goodwill. Whenever changing conditions warrant, we review the realizability of the assets that may be affected. At least annually, we review goodwill and indefinite-lived intangible assets for impairment. The review for impairment of long-lived assets, intangibles and goodwill is primarily based on our estimates of future cash flows, which are based upon budgets and longer-range strategic plans. These budgets and plans are used for internal purposes and are also the basis for communication with outside parties about future business trends. While we believe the assumptions we use to estimate future cash flows are reasonable, there can be no assurance that the expected future cash flows will be realized. As a result, impairment charges that possibly should have been recognized in earlier periods may not be recognized until later periods if actual results deviate unfavorably from earlier estimates.

 

Inventories

 

Inventories are stated at the lower of cost or market, the majority of which are based on the first-in, first-out method of accounting. Reserves for excess and obsolete inventory are based on a variety of factors, including product changes and improvements, changes in active ingredient availability and regulatory acceptance, new product introductions and estimated future demand. The adequacy of our reserves could be materially affected by changes in the demand for our products or regulatory actions.

 

Contingencies

 

As described more fully in Note 16 of the Notes to Consolidated Financial Statements, we are involved in significant environmental and legal matters, which have a high degree of uncertainty associated with them. We continually assess the likely outcomes of these matters and the adequacy of amounts, if any, provided for their resolution. There can be no assurance that the ultimate outcomes will not differ materially from our assessment of them. There can also be no assurance that all matters that may be brought against us are known at any point in time.

 

Income Taxes

 

Our annual effective tax rate is established based on our income, statutory tax rates and the tax impacts of items treated differently for tax purposes than for financial reporting purposes. We record income tax liabilities utilizing known obligations and estimates of potential obligations. A deferred tax asset or liability is recognized whenever there are future tax effects from existing temporary differences and operating loss and tax credit carryforwards. Valuation allowances are used to reduce deferred tax assets to the balance that is more likely than not to be realized. We must make estimates and judgments on future taxable income, considering feasible tax planning strategies and taking into account existing facts and circumstances, to determine the proper valuation allowance. When we determine that

37

deferred tax assets could be realized in greater or lesser amounts than recorded, the asset balance and consolidated statement of operations reflect the change in the period such determination is made. Due to changes in facts and circumstances and the estimates and judgments that are involved in determining the proper valuation allowance, differences between actual future events and prior estimates and judgments could result in adjustments to this valuation allowance. We use an estimate of our annual effective tax rate at each interim period based on the facts and circumstances available at that time, while the actual effective tax rate is calculated at year-end.

 

Associate Benefits

 

We sponsor various post-employment benefit plans. These include pension plans, both defined contribution plans and defined benefit plans, and other post-employment benefit (OPEB) plans, consisting primarily of health care for retirees. For accounting purposes, the defined benefit pension and OPEB plans are dependent on a variety of assumptions to estimate the projected and accumulated benefit obligations determined by actuarial valuations. These assumptions include the following: discount rate; expected salary increases; certain employee-related factors, such as turnover, retirement age and mortality; expected return on plan assets; and health care cost trend rates. These and other assumptions affect the annual expense recognized for these plans.

 

Assumptions are reviewed annually for appropriateness and updated as necessary. We base the discount rate assumption on investment yields available at year-end on corporate long-term bonds rated AA or the equivalent. The salary growth assumption reflects our long-term actual experience, the near-term outlook and assumed inflation. The expected return on plan assets assumption reflects asset allocation, investment strategy and the views of investment managers regarding the market. Retirement and mortality rates are based primarily on actual and expected plan experience. The effects of actual results differing from our assumptions are accumulated and amortized over future periods.

 

Changes in the discount rate and investment returns can have a significant effect on the funded status of our pension plans and shareholders’ equity. We cannot predict these discount rates or investment returns with certainty and, therefore, cannot determine whether adjustments to our shareholders’ equity for minimum pension liability in subsequent years will be significant.

 

We also award stock options to directors and certain associates. Beginning in fiscal 2003, we began expensing prospective grants of employee stock-based compensation awards in accordance with Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation”. The fair value of future awards is being expensed ratably over the vesting period, which has historically been three years, except for grants to directors, which have shorter vesting periods. Stock options granted prior to fiscal 2003 are accounted for under the intrinsic value recognition and measurement provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. As those stock options were issued with exercise prices equal to the market value of the underlying common shares on the grant date, no compensation expense was recognized.

 

 

As part of our ongoing business, we are exposed to certain market risks, including fluctuations in interest rates, foreign currency exchange rates and commodity prices. Financial derivative and other instruments are used to manage these risks. These instruments are not used for speculative purposes.

 

Interest Rate Risk

 

The Company had variable rate debt instruments outstanding at September 30, 2006 and 2005 that are impacted by changes in interest rates. As a means of managing our interest rate risk on these debt instruments, the Company enters into interest rate swap agreements to effectively convert certain variable-rate debt obligations to fixed rates.

 

At September 30, 2006, the Company had outstanding interest rate swaps with major financial institutions that effectively converted a portion of our British pound (GBP) and Euro dollar denominated variable-rate debt to a fixed rate. The swaps agreements have a total U.S. dollar equivalent notional amount of $108.2 million with three-year terms expiring November 2008. Under the terms of these swaps, we paid fixed rates of 2.98% on Euro denominated swaps and 4.76% on GBP denominated swaps. At September 30, 2005, we had no outstanding interest rate swaps.

38

The following table summarizes information about our derivative financial instruments and debt instruments that are sensitive to changes in interest rates as of September 30, 2006 and 2005. For debt instruments, the table presents principal cash flows and related weighted-average interest rates by expected maturity dates. For interest rate swaps, the table presents expected cash flows based on notional amounts and weighted-average interest rates by contractual maturity dates. Weighted-average variable rates are based on implied forward rates in the yield curve at September 30, 2006 and 2005. A change in our variable interest rate of 1% would have a $1.5 million impact on interest expense assuming the $145.8 million of our variable-rate debt that had not been hedged via an interest rate swap at September 30, 2006 was outstanding for the entire fiscal year. The information is presented in U.S. dollars (in millions):

 

 

 

Excluded from the information provided above are $27.4 million and $27.3 million at September 30, 2006 and 2005, respectively, of miscellaneous debt instruments.

 

The recapitalization plan announced on December 12, 2006, to return $750 million to shareholders during the second quarter of fiscal 2007 will be financed by a restructuring of the Company’s principal borrowing arrangements. Our Revolving Credit Agreement will be replaced with new senior secured $2.1 to $2.3 billion multicurrency credit facilities that will provide for revolving credit and term loans. As part of the refinancing, we intend to repurchase the $200 million principal amount of 65/8% senior subordinated notes outstanding.

 

Other Market Risks

 

Our market risk associated with foreign currency rates is not considered to be material. Through fiscal 2006, we had only minor amounts of transactions that were denominated in currencies other than the currency of the country of origin. We are subject to market risk from fluctuating market prices of certain raw materials, including urea and other chemicals and paper and plastic products. Our objectives surrounding the procurement of these materials are to ensure continuous supply and to minimize costs. We seek to achieve these objectives through negotiation of contracts with favorable terms directly with vendors. We have entered into arrangements to partially mitigate the effect of fluctuating fuel costs on our Scotts LawnService^® business and hedged a portion of our urea needs for fiscal 2007.

 

 

The financial statements and other information required by this Item are contained in the consolidated financial statements, notes thereto and schedule listed in the “Index to Consolidated Financial Statements and Financial Statement Schedule” on page 51 herein.

39

 

As previously reported in the Current Report on Form 8-K/A filed by The Scotts Company, the public company predecessor to The Scotts Miracle-Gro Company, on December 17, 2004, at a meeting held on December 2, 2004, the Audit Committee of the Board of Directors of The Scotts Company dismissed PricewaterhouseCoopers LLP as the Company’s independent registered public accounting firm and approved the engagement of Deloitte & Touche LLP as the Company’s independent registered public accounting firm. Deloitte & Touche LLP accepted the engagement as the Company’s independent registered public accounting firm effective as of December 17, 2004.

 

As of the date of PricewaterhouseCoopers LLP’s dismissal as the Company’s independent registered public accounting firm, PricewaterhouseCoopers LLP and the Company had an open consultation regarding the appropriate accounting treatment for an approximately $3.0 million liability resulting from a bonus pool related to an acquisition made during the first quarter of the Company’s 2005 fiscal year. At the time of their dismissal, PricewaterhouseCoopers LLP did not have sufficient information to reach a conclusion on the appropriate accounting for this matter. Since this matter was not resolved prior to PricewaterhouseCoopers LLP’s dismissal, this matter was considered a reportable event under Item 304(a)(1)(v)(D) of SEC Regulation S-K.

 

Based on a thorough review of the facts and circumstances, and relevant accounting literature regarding this matter, the Company determined that this liability should be recorded on the opening balance sheet of Smith & Hawken^®. This liability was based on an incentive agreement between the prior owners of Smith & Hawken^® and their employees, whereby a portion of the purchase price was to be paid to the employees upon the sale of the business. No post-sale service was required in order for the employees to earn this bonus; therefore, this was considered a liability assumed by the Company as of the purchase date and not an expense related to post-acquisition service.

 

 

Evaluation of Disclosure Controls and Procedures

 

With the participation of the principal executive officer and the principal financial officer of The Scotts Miracle-Gro Company (the “Registrant”), the Registrant’s management has evaluated the effectiveness of the Registrant’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of the end of the fiscal year covered by this Annual Report on Form 10-K. Based upon that evaluation, the Registrant’s principal executive officer and principal financial officer have concluded that:

 

 

Management’s Annual Report on Internal Control Over Financial Reporting

 

The “Annual Report of Management on Internal Control Over Financial Reporting” required by Item 308(a) of SEC Regulation S-K is included on page 52 of this Annual Report on Form 10-K.

40

Attestation Report of Independent Registered Public Accounting Firm

 

The “Report of Independent Registered Public Accounting Firm” required by Item 308(b) of SEC Regulation S-K is included on page 53 of this Annual Report on Form 10-K.

 

Changes in Internal Control Over Financial Reporting

 

There were no changes in the Registrant’s internal control over financial reporting (as defined in Rule 13a-15(f) and Rule 15d-15(f) under the Exchange Act) that occurred during the Registrant’s fiscal quarter ended September 30, 2006, that have materially affected, or are reasonably likely to materially affect, the Registrant’s internal control over financial reporting.

 

 

On December 12, 2006, The Scotts Miracle-Gro Company (the “Registrant”) issued a press release (the “December 12, 2006 Press Release”) announcing that it intended to implement a recapitalization plan (the “Recapitalization Plan”) that would return $750 million to the Registrant’s shareholders. A copy of the December 12, 2006 Press Release was included as Exhibit 99.1 to the Registrant’s Schedule TO filed with the Securities and Exchange Commission on December 12, 2006. Pursuant to this Recapitalization Plan, which has been approved in concept by the Registrant’s Board of Directors, the Registrant intends to launch a “Dutch auction” tender offer in January 2007 to repurchase up to $250 million of the Registrant’s common shares. Following the consummation of the tender offer and subject to final Board approval, the Registrant intends to declare a special one-time cash dividend during the second quarter of fiscal 2007, currently anticipated to be $500 million in the aggregate but subject to revision based on spending for tendered common shares.

 

In connection with the Recapitalization Plan, the Registrant received a commitment letter from JPMorgan Chase, Bank of America and Citigroup, subject to the terms and conditions set forth therein, to provide the Registrant and certain of its subsidiaries the following loan facilities totaling in the aggregate up to $2.1 billion: (a) a senior secured five-year term loan in the principal amount of $550 million and (b) a senior secured five-year revolving loan facility in the aggregate principal amount of up to $1.55 billion. The Registrant will have the ability to increase the aggregate amount of the revolving and term loan facilities by $200 million allocated on a pro rata basis, subject to demand in the syndication process. The new $2.1 billion senior secured credit facilities would replace the Registrant’s existing $1.05 billion senior credit facility. In connection with the Recapitalization Plan, the Registrant also intends to use proceeds from the new credit facilities to repurchase the Registrant’s 65/8% senior subordinated notes due 2013 in an aggregate principal amount of $200 million.

 

In fiscal 2006, the Registrant’s Board of Directors launched a five-year $500 million share repurchase program, pursuant to which the Registrant has repurchased approximately 2.0 million common shares for approximately $87.9 million as of the date of this Annual Report on Form 10-K. In connection with the Recapitalization Plan, the remaining portion of the Registrant’s $500 million share repurchase program will be terminated.

 

IMPORTANT NOTICE:  Each of the December 12, 2006 Press Release and the disclosure in this Item 9B and elsewhere in this Annual Report on Form 10-K in respect of the Registrant’s intention to implement the Recapitalization Plan and launch a “Dutch auction” tender offer is for informational purposes only and is not an offer to buy or the solicitation of an offer to sell any of the Registrant’s common shares. The Registrant has not yet commenced the tender offer described therein. On the commencement date of the tender offer, an offer to purchase, a letter of transmittal and related documents will be filed with the Securities and Exchange Commission, will be mailed to shareholders of record and will also be made available for distribution to beneficial owners of the Registrant’s common shares. The solicitation of offers to buy the Registrant’s common shares will only be made pursuant to the offer to purchase, the letter of transmittal and related documents. When they are available, shareholders should read those materials carefully because they will contain important information, including the various terms of, and conditions to, the tender offer. When they are available, shareholders will be able to obtain the offer to purchase, the letter of transmittal and related documents without charge from the Securities and Exchange Commission’s website at www.sec.gov or from the information agent that is selected by the Registrant. Shareholders are urged to read carefully those materials when they become available prior to making any decisions with respect to the tender offer.

41

PART III

 

 

In accordance with General Instruction G(3) of Form 10-K, the information regarding directors required by Item 401 of SEC Regulation S-K is incorporated herein by reference from the material which will be included under the caption “PROPOSAL NUMBER 1 — ELECTION OF DIRECTORS” in the Registrant’s definitive Proxy Statement for the 2007 Annual Meeting of Shareholders to be held on January 25, 2007 (the “Proxy Statement”). The information regarding executive officers of the Registrant required by Item 401 of SEC Regulation S-K is included in “SUPPLEMENTAL ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT” of Part I of this Annual Report on Form 10-K.

 

The information required by Item 405 of SEC Regulation S-K is incorporated herein by reference from the material which will be included under the caption “BENEFICIAL OWNERSHIP OF SECURITIES OF THE COMPANY — Section 16(a) Beneficial Ownership Reporting Compliance” in the Registrant’s Proxy Statement.

 

Information concerning the Registrant’s Audit Committee and the determination by the Registrant’s Board of Directors that at least one member of the Audit Committee qualifies as an “audit committee financial expert” is incorporated herein by reference from the material which will be included under the caption “PROPOSAL NUMBER 1 — ELECTION OF DIRECTORS — Committees of the Board — Audit Committee” in the Registrant’s Proxy Statement. Information concerning the nomination process for director candidates is incorporated herein by reference from the material which will be included under the captions “PROPOSAL NUMBER 1 — ELECTION OF DIRECTORS — Committees of the Board — Governance and Nominating Committee” and “PROPOSAL NUMBER 1 — ELECTION OF DIRECTORS — Nomination of Directors.”

 

The Board of Directors of the Registrant has adopted charters for each of the Audit Committee, the Governance and Nominating Committee, the Compensation and Organization Committee and the Innovation & Technology Committee.

 

In accordance with the requirements of Section 303A.10 of the New York Stock Exchange’s Listed Company Manual, the Board of Directors of the Registrant has adopted a Code of Business Conduct and Ethics covering the members of the Registrant’s Board of Directors and associates (employees) of the Registrant and its subsidiaries, including, without limitation, the Registrant’s principal executive officer, principal financial officer and principal accounting officer. The Registrant intends to disclose the following on its Internet website located at http://investor.scotts.com within four business days following their occurrence: (A) the date and nature of any amendment to a provision of its Code of Business Conduct and Ethics that (i) applies to the Registrant’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, (ii) relates to any element of the code of ethics definition enumerated in Item 406(b) of SEC Regulation S-K, and (iii) is not a technical, administrative or other non-substantive amendment; and (B) a description (including the nature of the waiver, the name of the person to whom the waiver was granted and the date of the waiver) of any waiver, including an implicit waiver, from a provision of the Code of Business Conduct and Ethics to the Registrant’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, that relates to one or more of the elements of the code of ethics definition set forth in Item 406(b) of SEC Regulation S-K.

 

The text of the Code of Business Conduct and Ethics, the Registrant’s Corporate Governance Guidelines, the Audit Committee charter, the Governance and Nominating Committee charter, the Compensation and Organization Committee charter and the Innovation & Technology Committee charter are posted under the “governance” link on the Registrant’s Internet website located at http://investor.scotts.com. Interested persons may also obtain copies of each of these documents without charge by writing to The Scotts Miracle-Gro Company, Attention: Corporate Secretary, 14111 Scottslawn Road, Marysville, Ohio 43041. In addition, a copy of the Code of Business Conduct and Ethics, as amended on November 2, 2006, is incorporated by reference in Exhibit 14 to this Annual Report on Form 10-K.

 

 

In accordance with General Instruction G(3) of Form 10-K, the material contained under the captions “EXECUTIVE COMPENSATION — Summary of Cash and Other Compensation, — Option Grants in 2006

42

Fiscal Year, — Option Exercises in 2006 Fiscal Year and 2006 Fiscal Year-End Option/SAR Values, — Performance Shares, — Executive Retirement Plan, — Pension Plans, — The Scotts Miracle-Gro Company Discounted Stock Purchase Plan and — Employment Agreements and Termination of Employment and Change-in-Control Arrangements,” “PROPOSAL NUMBER 1 — ELECTION OF DIRECTORS — Compensation of Directors and — Compensation and Organization Committee Interlocks and Insider Participation” and “EXECUTIVE COMPENSATION — Report of the Compensation and Organization Committee on Executive Compensation for the 2006 Fiscal Year — Executive Incentive Plan” in the Registrant’s Proxy Statement is incorporated herein by reference.

 

 

In accordance with General Instruction G(3) of Form 10-K, the material contained under the captions “BENEFICIAL OWNERSHIP OF SECURITIES OF THE COMPANY” and “EXECUTIVE COMPENSATION — Equity Compensation Plan Information” in the Registrant’s Proxy Statement is incorporated herein by reference.

 

 

In accordance with General Instruction G(3) of Form 10-K, the material contained under the captions “BENEFICIAL OWNERSHIP OF SECURITIES OF THE COMPANY”, “PROPOSAL NUMBER 1 — ELECTION OF DIRECTORS” and “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS” in the Registrant’s Proxy Statement is incorporated herein by reference.

 

 

In accordance with General Instruction G(3) of Form 10-K, the material contained under the captions “AUDIT COMMITTEE MATTERS — Fees of the Independent Registered Public Accounting Firm and — THE SCOTTS MIRACLE-GRO COMPANY THE AUDIT COMMITTEE POLICIES AND PROCEDURES REGARDING APPROVAL OF SERVICES PROVIDED BY THE INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM” in the Registrant’s Proxy Statement is incorporated herein by reference.

 

PART IV

 

 

(a) LIST OF DOCUMENTS FILED AS PART OF THIS REPORT

 

1 and 2. Financial Statements and Financial Statement Schedule:

 

The response to this portion of Item 15 is submitted as a separate section of this Annual Report on Form 10-K. Reference is made to the “Index to Consolidated Financial Statements and Financial Statement Schedule” on page 51 herein.

 

3.  Exhibits:

 

The exhibits listed on the “Index to Exhibits” beginning on page 108 of this Annual Report on Form 10-K are filed with this Annual Report on Form 10-K or incorporated herein by reference as noted in the “Index to Exhibits.” The following table provides certain information concerning each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K.

43

MANAGEMENT CONTRACTS AND COMPENSATORY PLANS AND ARRANGEMENTS

 

44

45

46

47

48

 

* Filed herewith.

 

(b) EXHIBITS

 

The exhibits listed on the “Index to Exhibits” beginning on page 108 of this Annual Report on Form 10-K are filed with this Annual Report on Form 10-K or incorporated herein by reference.

 

(c) FINANCIAL STATEMENT SCHEDULE

 

The financial statement schedule filed with this Annual Report on Form 10-K is submitted in a separate section hereof. For a description of such financial statement schedule, see “Index to Consolidated Financial Statements and Financial Statement Schedule” on page 51 herein.

49

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.