UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549FORM 10-K(Mark One)( X ) ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended September 30, 2005OR( ) TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from to Commission file number 1-13292The Scotts Miracle-Gro Company (Exact name of Registrant as Specified in Its Charter)
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leading position through the combination of strategic acquisitions and organic growth by driving category expansion and capturing increased market share with product innovation and award-winning advertising campaigns. Our portfolio of consumer brands in North America includes the following:
foods for extended feeding convenience sold as Miracle-Gro® Shake ’N Feed® Continuous Release Plant Food. Growing Media We sell a complete line of growing media products for indoor and outdoor uses under the Miracle-Gro®, Scotts®, Hyponex®, Earthgro® and Nature Scapes®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. Effective October 3, 2005, we acquired SuperSoil® and related strong West Coast brands via the acquisition of Rod McLellan Company (RMC). Controls We sell a broad line of weed control, indoor and outdoor pest control and plant disease control products 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®, Weed-B-Gon Maxtm, Bug B Gon®Maxtm, Home Defense®Maxtm, Ortho® Season-Long Grass & Weed Killer, Brush-B-Gon®, RosePride®, Ortho-Klor® and Orthene® Fire Ant Killer. In fiscal 1999, we 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, Canada, France, Germany, Belgium, Holland and the United Kingdom. Other Consumer ProductsWe manufacture and market several lines of high-quality lawn spreaders under the Scotts® brand name — EdgeGuard® Total Performance 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, a line of pottery 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. We also sell numerous varieties and blends of high-quality grass seed, many of them proprietary, designed for different conditions and geographies. These consumer grass seed products are sold under the Scotts® Pure Premium®, Scotts® Turf Builder®, Scotts® and PatchMaster® brands. Wild Bird FoodEffective November 18, 2005, the Company acquired Gutwein & Co., Inc. (“Gutwein”). Through its Morning Song®brand, Gutwein is a leader in the growing United States 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. North American ProfessionalWe sell 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 We believe we are 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® We provide residential lawn care, lawn aeration, tree and shrub care and external pest control services through our Scotts LawnService® business in the United States. These services consist primarily of fertilizer, weed control, pest control and disease control applications. As of September 30, 2005, Scotts LawnService® had 77 company-operated locations serving 38 metropolitan markets and 76 independent franchises primarily operating in secondary markets. 4
International In our International segment, we sell consumer lawn and garden products in over 25 countries outside of North America. We also sell a broad line of professional products throughout Europe to commercial nurseries, greenhouses and specialty retailers. Our 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, we 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 57 retail stores, as well as through catalog and Internet sales. For further details concerning the acquisition of this business, please refer to Note 5 of the Notes to Consolidated Financial Statements.Research and Development We believe strongly in the benefits of research and development, and we continually invest in research and development to improve existing or develop new products, manufacturing processes and packaging and delivery systems. Our spending on research and development was $30.5 million, $34.4 million and $30.4 million in fiscal 2005, fiscal 2004, and fiscal 2003, respectively. We believe that our long-standing commitment to innovation has benefited us, as evidenced by a portfolio of patents worldwide that support 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 Levington, the United Kingdom; Chazay, France; Heerlen, the Netherlands and Sydney, Australia, as well as several research field stations located throughout the United States.Biotechnology We believe that the development and commercialization of innovative products is an important key to our continued success. We have a long history of dedication to responsible research in search of more effective and easier-to-use products that are preferred by consumers and are better for the environment. In particular, we have worked for over 75 years to create better products for the establishment and maintenance of turfgrass. Plant breeding has been a part of that research and development for the past 50 years. We remain dedicated to being the technology leader in turfgrass products. Today, that dedication results in research into products that can be enhanced, not only with traditional plant breeding, but also with proven agricultural biotechnology. This research offers the long-term promise of grasses that require less maintenance, less water, and are even better for the environment. Before products 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, Animal and Plant Health Inspection Service (the “USDA”), 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 5
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 30, 2002. 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 requested additional information and data. We determined it was more expedient to withdraw the petition and submit a revised petition that addressed the USDA’s requests than to amend the current petition. On October 3, 2002, we withdrew our petition. We prepared a revised petition that we believe addresses the USDA’s requests and submitted it on April 14, 2003. 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.Trademarks, Patents and Licenses 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 Peters®, are federally and/or internationally registered and are considered material to our business. We regularly monitor our trademark registrations, which are generally effective for ten years, so we can renew those nearing expiration. As of September 30, 2005, we held 99 issued patents in the United States covering fertilizer, chemical and growing media compositions and processes; grass varieties; and applicator and sprayer devices. Many of these have similar patents which have also been issued internationally, bringing our total worldwide patent portfolio to 446. United States and International patents provide patent 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. Currently, we have 145 pending patent applications, worldwide, including 12 applications that have been allowed for issuance of patents. We also hold exclusive and non-exclusive patent licenses from various raw material suppliers, permitting the use and sale of additional patented fertilizers and pesticides. During fiscal 2005, we were granted 22 United States and 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; coated fertilizers having coatings that can be triggered to begin nutrient release at specific times; and growing media prepared from surfactants mixed with coir material to provide controlled-nutrient-release characteristics. 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 aquaculture, growing media, applicator and sprayer technologies to additional countries within our Canadian, European and Asia/ Pacific markets. Significant accomplishments are the extension of our coir/peat international patent coverage, our “Grasshopper” applicator products within the European markets, our “Pull ’N Spray” sprayer in New Zealand and additional coverage of our Ortho applicator technology in both Canada and Japan. Three United States patents expired in fiscal 2005. The first patent covered the Accu Pro 2000 Rotary Spreader and the SR 2000 Rotary Spreader. The second patent covered a combination fertilizer/growth regulator composition and process for treating turf. The third patent was an expansion of the second 6
patent and covered the treatment of all vegetation with the combination fertilizer composition. The loss of these patents is not expected to materially affect our business. We have one patent currently being opposed by a third party in Europe. In regard to this opposed patent, the European Patent Office (the “EPO”) in calendar year 2004 rendered a favorable decision. However, the opposing party has appealed that decision. A ruling on the appeal is not expected until calendar year 2006. An unfavorable ruling by the EPO in the appeal could materially affect our indoor pest control market share in Germany.Roundup® Marketing Agreement Under the terms of the marketing agreement with Monsanto, we are 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, Canada, France, Germany 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 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 exceeds specified thresholds. Regardless of these earnings, we are required to make an annual contribution payment against the overall expenses of the Roundup® business. In fiscal 2005, the contribution payment as required by the agreement was $23.8 million. For 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 Statements of Operations. For fiscal 2005 and fiscal 2004, the net amount earned under the marketing agreement was 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. We have 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 7
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.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, supply chain effectiveness, value, brand strength and advertising. 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 believe 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 we believe 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 2005 were made by our North America segment. Within the North America segment, approximately 33% of our net sales in fiscal 2005 were made to Home Depot, 17% to Wal*Mart and 14% to Lowe’s. We face strong competition for the business of these 8
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.Strategic Initiatives The Company has developed a strategic plan that refocuses 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 to significantly strengthen the Company. Over the course of the next two years, we expect to reduce purchasing and selling, general and administrative costs by reducing headcount and implementing better business processes. Savings generated by these initiatives will be shared between improving operating profits and supporting our brand with increased marketing and innovation. In addition, to our base earnings growth of 10 to 12 percent, we anticipate that fiscal 2006 annual pre-tax earnings will increase by $25 to $30 million as a result of savings associated with this initiative. An additional $25 to $30 million of savings will be re-invested in fiscal 2006 behind our brands to strengthen the relationships with our consumers and retail partners. 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 wild bird food category. This is the Company’s 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) realigning the organization 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 $42 million in fiscal 2001 to revenues of $159.8 million in fiscal 2005. This growth has come from geographic expansion, acquisitions and organic growth fueled by our highly effective direct marketing programs. We invested $6.4 million in lawn service acquisitions in fiscal 2005. We anticipate continuing to make selective acquisitions in fiscal 2006 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. 9
Seasonality and Backlog Our business is highly seasonal with approximately 73% of our net sales occurring in our combined second and third quarters of both fiscal 2005 and fiscal 2004. 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. In general, we do not enter into forward contracts or other market instruments as a means of minimizing our risk exposures on these materials but, when appropriate, we will procure a certain percentage of our needs in advance of the season to secure pre-determined prices. Occasionally, we do hedge certain commodities to ensure seasonal material supplies 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. Certain products are also produced for our professional businesses 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 either a distribution center or mixing warehouse.Employees As of September 30, 2005, we employed 4,289 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 10
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, 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.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. Regulations and environmental concerns also exist surrounding peat extraction in the United Kingdom and the European Union. In August 2000, English Nature, the nature conservation advisory body to the United Kingdom government, notified us that three of our peat harvesting sites in the United Kingdom were under consideration as possible “Special Areas of Conservation” under European Union law. In April 2002, working in conjunction with Friends of the Earth (United Kingdom), we reached agreement with English Nature to transfer our interests in the properties and for the immediate cessation of all but a limited amount of peat extraction on one of the three sites. As a result of this agreement, we have withdrawn our objection to the proposed European designations as Special Areas of Conservation and will undertake restoration work on the sites, for which we will receive additional consideration from English 11
Nature. We believe we have sufficient raw material supplies available to replace the peat extracted from such sites.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 treatment capabilities at our Marysville, Ohio facility and seeking corrective action under the federal Resource Conservation and Recovery Act. The action relates to 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 are negotiating 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. At September 30, 2005, $3.3 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, 2005 are expected to be paid through fiscal 2007; however, payments could be made for a period thereafter. We believe the amounts accrued as of September 30, 2005 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: • that we have identified all of the significant sites that must be remediated; • that there are no significant conditions of potential contamination that are unknown to us; and • that with respect to the agreed judicial Consent Order in Ohio, the potentially contaminated soil can be remediated in place rather than having to be removed and only specific stream segments will require remediation as opposed to the entire stream. 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 2005, fiscal 2004, and fiscal 2003, we expensed approximately $3.7 million, $3.3 million, and $1.5 million for environmental matters. There were no material capital expenditures in fiscal 2005, fiscal 2004 or fiscal 2003 related to environmental or regulatory matters.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.ITEM 1A. RISK FACTORSCautionary 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 2005 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. 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 12
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 2005 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, more than 70% of our 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 North America segment net sales represented approximately 70% of our worldwide net sales in fiscal 2005. Our top three North American retail customers together accounted for 64% of our North America segment fiscal 2005 net sales and 80% of our outstanding accounts receivable as of September 30, 2005. Home Depot, Wal*Mart and Lowe’s represented approximately 33%, 17% and 14%, respectively, of our fiscal 2005 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. 13
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 were 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 substantial indebtedness could have important consequences. For example, it could: • make it more difficult for us to satisfy our obligations under outstanding indebtedness and otherwise; • increase our vulnerability to general adverse economic and industry conditions; • require us to dedicate a substantial portion of cash flows from operating activities to payments on our indebtedness, which would reduce the cash flows available to fund working capital, capital expenditures, advertising, research and development efforts and other general corporate requirements; • limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; • place us at a competitive disadvantage compared to our competitors that have less debt; • limit our ability to borrow additional funds; and • expose us to risks inherent in interest rate fluctuations because some of our borrowings are at variable rates of interest, which could result in higher interest expense in the event of increases in interest rates. Our ability to make payments on and to refinance our indebtedness and to fund planned capital expenditures, acquisitions, dividends and the planned five-year stock repurchase plan 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 credit facility contains 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. 14
Equity Ownership Concentration Hagedorn Partnership, L.P. beneficially owned approximately 31% of our outstanding common shares as of December 1, 2005, 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 effect 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: • that we have identified all of the significant sites that must be remediated; • that there are no significant conditions of potential contamination that are unknown to us; and • that with respect to the agreed judicial Consent Order in Ohio, the potentially contaminated soil can be remediated in place rather than having to be removed and only specific stream segments will require remediation as opposed to the entire stream. 15
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 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 2005, International net sales accounted for approximately 18% of our total net sales. Accordingly, we are subject to risks associated with operations in foreign countries, including: • fluctuations in currency exchange rates; • limitations on the remittance of dividends and other payments by foreign subsidiaries; • additional costs of compliance with local regulations; and • historically, in certain countries, higher rates of inflation than in the United States. 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 (“S,G&A”) expenses. This reorganization places significant pressure on many S,G&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 and that unanticipated difficulties may be encountered in executing the plan.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 2005. 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) and the November 2005 acquisition of Gutwein (Morning Song®). 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. 16
ITEM 1B. UNRESOLVED STAFF COMMENTS NoneITEM 2. PROPERTIES 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 24 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. Scotts LawnService® conducts its company-owned operations from 77 leased facilities, primarily office/warehouse units in industrial/office parks, across the United States serving 38 metropolitan markets. Smith & Hawken® operates 57 retail stores, 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; a German office, located in Ingelheim; an Austrian office, located in Salzburg; an Australian office, located in Baulkan Hills (New South Wales); and a Canadian office located in Toronto. 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. 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.ITEM 3. LEGAL PROCEEDINGS 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. 17
Legal proceedings resolved during fiscal 2005:AventisAgrEvo Environmental Health, Inc. v. The Scotts Company, et al. (Southern District of New York)The Scotts Company v. Aventis S.A. and Starlink Logistics, Inc. (Southern District of Ohio) A jury trial was held in New York from May 23, 2005 to June 13, 2005 in the case originally filed by AgrEvo Environmental Health, Inc. (which subsequently changed its name to Aventis Environmental Science USA LP). The jury rejected all of plaintiff’s antitrust claims and all but one of its contract claims, an undisputed, minor claim for non-payment of invoices of approximately $194,000. On September 30, 2005, sanofi-aventis Group S.A., the successor to Aventis, S.A. and Aventis Environmental Science USA LP and the parent of Starlink Logistics, Inc. (collectively, “Aventis”) paid to the Company in full and final settlement of all the outstanding claims between the Company and Aventis approximately $10 million. Of this amount, $8.9 million of the settlement is recorded in “Impairment, restructuring and other charges” within the Consolidated Statements of Operations (see Note 4 of the Notes to Consolidated Financial Statements). The payment by Aventis, and the agreement signed in connection with the settlement, terminates Aventis’ post-trial motions and appeals in New York and brings to a conclusion all litigation between the companies.Central Garden & Pet CompanyThe Scotts Company v. Central Garden (Southern District of Ohio)Central Garden v. The Scotts Company & Pharmacia (Northern District of California) In regards to this matter and related litigation against Central Garden & Pet Company (“Central Garden”), on April 12, 2005, the Sixth Circuit modified in part and affirmed the trial court’s judgment providing for a net award of approximately $15 million to the Company, which we received on July 15, 2005. The Company has recognized the satisfaction of this judgment in its financial results for the period ended July 2, 2005. Details of how the $15 million was reflected in our financial statements are presented in Note 16 of the Notes to Consolidated Financial Statements. This brings to a conclusion all pending litigation between the Company and Central Garden including the previously pending antitrust case in the Northern District of California in which the Company prevailed. 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 (“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 Sections 1 and 57 of the Sherman Antitrust Act. The Company believes that all of Geiger’s claims are without merit and intends to vigorously defend against them. If any of the above actions are 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. Any potential exposure that the Company may face cannot be reasonably estimated. Therefore, no accrual has been established related to this matter.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 18
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, its financial condition or its results of operations. 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. 19
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of the security holders of The Scotts Miracle-Gro Company during the fourth quarter of fiscal 2005.SUPPLEMENTAL ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of The Scotts Miracle-Gro Company, their positions and, as of December 9, 2005, their ages and years with the Company (and its predecessors) are set forth below.
Mr. Nagel was named Executive Vice President and Chief Financial Officer of The Scotts Miracle-Gro Company in March 2005. 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. Nagel serves as a director of the Leukemia & Lymphoma Society, Central Ohio Chapter, a charitable organization. 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. 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. 21
PART IIITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES The common shares of The Scotts Miracle-Gro Company 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 on November 9, 2005 to shareholders of record on November 2, 2005.
ITEM 6. SELECTED FINANCIAL DATAFive-Year Summary(1)(2)For the fiscal year ended September 30,(in millions, except per share amounts)
(4) Operating results includes the following items segregated by accounts effected on the Consolidated Statements of Operations included with the Consolidated Financial Statements included in this Annual Report on Form 10-K.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 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: • Executive summary • Results of operations • Liquidity and capital resources • Critical accounting policies and estimates • Management’s outlook 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. At the end of fiscal 2005, on a split-adjusted basis, The Scotts Miracle-Gro Company had approximately 68.6 million diluted common shares outstanding. 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. Effective with the fiscal 2005 Form 10-K and 2005 Annual Report to Shareholders, we have made changes to our Consolidated Statements of Operations, which management believes improves the overall presentation. With respect to the Amended and Restated Exclusive Agency and Marketing Agreement (the “Marketing Agreement”) with Monsanto Company (“Monsanto”), we have made two presentational changes. First, we have reclassified as net sales the amounts previously reported as net commission from the Marketing Agreement. Second, net sales and cost of sales have been adjusted to reflect certain reimbursements and costs associated with the Marketing Agreement on a gross basis that was previously reported on a net basis, with no effect on gross profit or net income. See further details regarding these matters in Note 3 of the Notes to Consolidated Financial Statements. Furthermore, we have simplified the presentation of selling, general and administrative expenses presented on the face of the Consolidated Statements of Operations. Details of this line item are included in the Results of Operations section of this MD&A.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 have a presence in Australia, the Far East, Latin America and South America. Also, in the United States, we operate what we believe to be the second largest residential lawn service business, Scotts LawnService®. In fiscal 2005, our operations were divided into the following reportable segments: North America, Scotts LawnService®, International, and Corporate & Other. The Corporate & Other segment consists of the recently acquired 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 the past several 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. In fiscal 2006, we expect to increase advertising spending by 18% to 20% as we reinvest a portion of our selling, general and administrative cost savings to strengthen our brands. 25
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.
Gutwein is a leader in the growing U.S. 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. Prior to fiscal 2005, we had not paid dividends on our common shares. Based on the levels of cash flow generated by our business in recent years and our improving financial condition, on June 22, 2005, we announced that The Scotts Miracle-Gro Company’s Board of Directors approved an annual dividend of 50-cents per share, to be paid in 12.5-cent quarterly increments beginning in the fourth quarter of fiscal 2005. Our first and second quarterly dividends were paid on September 1, 2005 and December 1, 2005, respectively. In addition to the 2-for-1 stock split noted earlier, on October 27, 2005, The Scotts Miracle-Gro Company announced that its Board of Directors approved a $500 million share repurchase program. This repurchase program is authorized for five years and we currently anticipate allocating approximately $100 million per year to the program.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, 2005:
gross margin by approximately 90 basis points. Smith & Hawken® has gross margins below the Company’s average, accounting 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. Gross margins include the net commission from the Roundup® marketing agreement, which in fiscal 2005 was a net expense of $5.3 million. In the third quarter of fiscal 2005, the Company recorded a charge of $45.7 million to reflect a liability for the outstanding balance of the deferred contribution amounts payable to Monsanto under the Roundup® marketing agreement. Previously, we had not recognized the contribution amounts deferred under the Roundup® marketing agreement until such deferred amounts were paid, based on management’s evaluation of the surrounding facts and circumstances. We now believe it is appropriate to record the liability based on numerous factors, including the recent strong financial performance of the Roundup® business. In October 2005, the then outstanding balance of deferred contribution amount was paid to Monsanto, providing savings to us because this liability carried 8.0% interest compared to our interest rate on incremental borrowings of approximately 5.0%. Excluding this charge, the commission would have been $40.4 million for fiscal 2005, compared with $28.5 million a year earlier. The increase in the pre-charge net Roundup® commission was primarily attributable to the strong sales profitability of this brand in fiscal 2005. Gross profit margins for fiscal 2004 increased 150 basis points versus fiscal 2003. Gross profit margins were higher in all three segments, as favorable product mix and operating efficiencies more than offset cost pressures primarily from higher fuel and commodity costs, including urea. Lastly, restructuring and other expense in fiscal 2003 costs of sales, primarily related to International supply initiatives, contributed approximately 50 basis points to the fiscal 2004 gross profit margin improvement.Selling, General and Administrative Expenses (in millions)
We began expensing stock options commencing with grants issued in fiscal 2003. The majority of stock options vest over a three-year period subsequent to the grant date, so the expense associated with an option grant is generally recognized ratably over three years. As such, 2005 is the first year that includes a full charge for three years of option grants. Forfeitures reduced the fiscal 2005 expense by approximately $2.2 million. Amortization of intangibles increased in fiscal 2005, primarily as a result of a comprehensive review of intangibles and corrections to the accumulated amortization of certain intangible assets. Recent acquisitions, primarily Smith & Hawken® and Scotts LawnService® locations, also contributed to this increase.Impairment, Restructuring and Other Charges, net (in millions)
Income from Operations Income from operations in fiscal 2005 was $200.9 million, compared to $252.8 million in fiscal 2004. As noted above, income from operations in fiscal 2005 includes 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. The remainder of 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. Income from operations in fiscal 2004 increased $21.2 million from fiscal 2003, which was partially attributable to a $7.4 million reduction in restructuring and other charges, in Cost of Sales and S,G&A combined. Fiscal 2004 included $9.8 million in restructuring activities, primarily related to restructuring of the International management team and outsourcing of certain technology functions. The remainder of 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 investments in media advertising and higher S,G&A expenses.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 $48.8 million in fiscal 2004 to $41.5 million in fiscal 2005. The decrease in interest expense was primarily attributable to a $113.9 million reduction in average borrowings, coupled with nine basis point reduction in our weighted average interest rate to 5.83%. In fiscal 2004, interest expense decreased $20.4 million compared to fiscal 2003. The decrease in interest expense was due to a $107.0 million reduction in average borrowings coupled with a reduction in our weighted average interest rate (from 7.42% in fiscal 2003 to 5.92% in fiscal 2004) resulting from more favorable borrowing arrangement terms as secured by the debt refinancings and a favorable interest rate environment.Income Taxes The effective tax rate for fiscal 2005 was 36.5% compared to 36.7% in fiscal 2004 and 36.5% in fiscal 2003. 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 rates and increased utilization of foreign tax credits. The effective tax rate in fiscal 2003 was favorably impacted by an adjustment of state deferred income taxes resulting from a detailed review of state effective tax rates, and increased utilization of foreign tax credits. We anticipate the effective tax rate will be 37.0% to 37.5% going forward. 30
Net Income and Earnings per Share We reported income from continuing operations of $100.4 million in fiscal 2005, compared to $100.5 million in fiscal 2004. 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, 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 significant Roundup®, 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. In fiscal 2004, we reported income from continuing operations of $100.5 million, compared to $103.2 million in fiscal 2003. Reported net income, including income from discontinued operations, decreased from $103.8 million or $1.62 per share in fiscal 2003 to $100.9 million or $1.52 per share in fiscal 2004. The increase in income from operations in 2004 compared to 2003 as described above and a significant reduction in interest expense were offset by costs associated with debt refinancings in 2004. Average diluted shares outstanding increased from 64.3 million in fiscal 2003 to 66.6 million in fiscal 2004, due to option exercises and the impact on common stock equivalents of a higher average share price. Segment Results In fiscal 2005, our operations were divided into the following reportable segments: North America, Scotts LawnService®, International, and Corporate & Other. The Corporate & Other segment consists of the recently acquired Smith & Hawken® business 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)
Operating Profit by Segment (in millions)
Scotts LawnService® segment net sales increased $24.6 million or 18.2% in fiscal 2005. In fiscal 2004, Scotts LawnService® net sales increased 22.5% or $24.8 million. The growth in net sales for both years has been from increased customer retention, higher new customer sales during the peak spring selling season, geographic expansion and the full year impact of recent acquisitions. The impact of acquisitions contributed approximately 3.6% and 5.4% of revenue growth in 2005 and 2004, respectively. Operating income for the Scotts LawnService®segment increased $3.7 million or 39.4% in fiscal 2005 and $3.4 million or 56.7% in fiscal 2004. These increases are the result of revenue growth and improving operating margins where we are balancing capturing scale economies as we grow with making the appropriate infrastructure investments to support future growth and service levels.International 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. Net sales for the International segment in fiscal 2004 grew 8.6% or $32.1 million compared to fiscal 2003. Excluding the effects of currency fluctuations and the impact of discontinuing the sale of certain low margin professional growing media products, net sales were essentially unchanged in fiscal 2004 versus the prior year. Sales increases in the United Kingdom and the International professional business were offset by lower sales in Central Europe and the Benelux countries, principally due to cold and wet spring weather conditions. International segment 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 S,G&A spending, partially offset by lower gross margins. In fiscal 2004, International operating income decreased $0.1 million, as favorable foreign currency impacts and a higher Roundup® commission were offset by increases in media and S,G & A spending.Corporate & Other The loss in Corporate & Other increased by $23.5 million in fiscal 2005. As discussed earlier, this was largely driven by increased legal and Sarbanes-Oxley compliance costs.Management’s Outlook We are very pleased with our performance in fiscal 2005. Despite upward pressure on commodity raw material costs and poor early season weather conditions in North America and Europe, we delivered record net sales and strong earnings for the year. Our sales results were driven by strong point of sales growth in our North America business, particularly gardening and control products, and continued expansion of our Scotts LawnService® business. Our strong results in fiscal 2005 have set the stage for another successful year in 2006. We are committed to executing the strategic initiatives outlined in “ITEM 1. BUSINESS — Strategic Initiatives”, all of which will increase operating profits, secure future growth opportunities an 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 dividends and stock repurchase program 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 $226.7 million for fiscal 2005, compared to $214.2 million for fiscal 2004. This strong cash flow performance was fueled by increased profitability 33
(excluding the non-cash costs related to the $22.0 million impairment charge for certain U.K. intangible assets) and reduced working capital associated with higher payroll and miscellaneous accrued liabilities. 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. Investing activities over the past three years have been directed towards a number of acquisitions to support the growth and expansion of our Scotts LawnService®business. In addition, on October 2, 2004, we acquired all outstanding shares of Smith & Hawken®for a total cost of $73.6 million (net of cash acquired). Capital spending on property, plant and equipment has declined since fiscal 2003 when major capital investments were made in the information systems area (principally supply chain related). The investment and redemption of available-for-sale securities represents the impact of investing in adjustable rate notes (“Notes”) during fiscal 2004. These investments were made in lieu of investing excess cash in overnight funds as the Notes offered an improved yield with comparable risk. The Notes were redeemed and converted into cash on October 1, 2004, to partially fund the acquisition of Smith & Hawken®. Financing activities used cash of $195.2 million and $133.0 million in fiscal 2005 and fiscal 2004, respectively. We have aggressively managed our credit agreements and borrowings to maximize the benefit of our improving capital structure and debt facilities. To this end, approximately $211 million of debt was retired in fiscal 2005 in addition to the approximately $144 million retired in fiscal 2004. We also paid our first ever common share dividend in the fourth quarter of fiscal 2005 in the amount of $8.6 million. Continuation of this dividend will require an ongoing annual cash cost of approximately $35 million. Offsetting these financing cash uses was $32.2 million in proceeds from the exercise of employee stock options in fiscal 2005 in addition to proceeds of $23.5 million in fiscal 2004. Our primary sources of liquidity are cash generated by operations and borrowings under our credit agreements. On July 21, 2005, we entered into a Revolving Credit Agreement (the “New Credit Agreement”), which consists of an aggregate $1.0 billion multi-currency commitment, that extends through July 21, 2010. We may also request an additional $150 million in revolving credit commitments, subject to approval from our lenders. The New Credit Agreement provides for tighter borrowing spreads and greater flexibility to repay debt compared to our previous borrowing arrangement. As of September 30, 2005, there was $818.7 million of availability under the New Credit Agreement. As of September 30, 2005, we also had $200.0 million of 65/8% Senior Subordinated Notes outstanding. Note 9 of the Notes to Consolidated Financial Statements provides additional information pertaining to our current borrowings and debt refinancing activity during the past two fiscal years. We were in compliance with all of our debt covenants throughout fiscal 2005. We have not paid dividends on common shares in the past. Based on levels of cash flow generated by the business in recent years and our improving financial condition, on June 22, 2005, we announced that The Scotts Miracle-Gro Company’s Board of Directors approved an annual dividend of 50-cents per share to be paid at 12.5-cents each quarter beginning in the fourth quarter of fiscal 2005. Our first and second quarterly dividends were paid on September 1, 2005 and December 1, 2005. In addition to the 2-for-1 stock split noted earlier, on October 27, 2005, The Scotts Miracle-Gro Company announced that its Board of Directors had approved a $500.0 million share repurchase program. This repurchase program is authorized for five years and we currently anticipate allocating approximately $100.0 million per year on the program. We did not repurchase any common shares in fiscal 2005 or fiscal 2004. The unfunded status of our pension plans deteriorated during fiscal 2005 after showing an improvement at the end of fiscal 2004. The unfunded status of our curtailed defined benefit plans in the United States increased from $22.5 million to $23.6 million at September 30, 2004 and 2005, respectively. The funded status was negatively impacted by the $2.3 million curtailment loss resulting from early retirements and severance in conjunction with our strategic improvement plan. In addition, plan contributions of $0.1 million and $9.7 million were made in fiscal 2005 and fiscal 2004, respectively. Our International plans’ deficit increased from $50.9 million to $61.8 million at September 30, 2004 and 2005, 34
respectively. This $10.9 million increase was fueled by reductions in the discount rates used to measure the projected benefit obligation, unfavorable foreign currency translation, and updated mortality assumptions, which more than offset better than expected investment returns and an increase in employer contributions. Our off-balance sheet financing arrangements are in the form of operating leases that are disclosed in Note 14 of the Notes to Consolidated Financial Statements. 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. The following table summarizes our future cash outflows for contractual obligations as of September 30, 2005 (in millions):
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 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. Actual results may differ 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.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 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 36
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 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.ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 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. We use derivative financial and other instruments, where appropriate, to manage these risks. We do not enter into transactions for trading or speculative purposes.Interest Rate Risk We had various debt instruments outstanding at September 30, 2005 and 2004 that are impacted by changes in interest rates. As a means of managing our interest rate risk on these debt instruments, we 37
enter into interest rate swap agreements to effectively convert certain variable-rate debt obligations to fixed rates. At September 30, 2005, we had no outstanding interest rate swaps. At September 30, 2004, we had nine outstanding interest rate swaps with major financial institutions that effectively converted a portion of our variable-rate debt to a fixed rate. The swaps had notional amounts between $10 million and $50 million ($175 million in total) with three- to seven-year terms commencing in October 2001. Under the terms of these swaps, we paid fixed rates ranging from 2.76% to 3.77% and received three-month LIBOR. 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, 2005 and 2004. 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, 2005 and 2004. A change in our variable interest rate of 1% would have a $1.7 million impact on interest expense for the $166.2 million of our variable-rate debt that had not been hedged via an interest rate swap at September 30, 2005. The information is presented in U.S. dollars (in millions):
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE As previously reported in the Current Report on Form 8-K/A filed by The Scotts Company, the public company predecessor to the Registrant, 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.ITEM 9A.CONTROLS AND PROCEDURES 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: • information required to be disclosed by the Registrant in this Annual Report on Form 10-K and the other reports that the Registrant files or submits under the Exchange Act would be accumulated and communicated to the Registrant’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure; • information required to be disclosed by the Registrant in this Annual Report on Form 10-K and the other reports that the Registrant files or submits under the Exchange Act would be recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms; and • the Registrant’s disclosure controls and procedures are effective as of the end of the fiscal year covered by this Annual Report on Form 10-K to ensure that material information relating to the Registrant and its consolidated subsidiaries is made known to them, particularly during the period in which the Registrant’s periodic reports, including this Annual Report on Form 10-K, are being prepared. 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 49 of this Annual Report on Form 10-K. 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 52 of this Annual Report on Form 10-K. 39
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) under the Exchange Act) that occurred during the Registrant’s fiscal quarter ended September 30, 2005, that have materially affected, or are reasonably likely to materially affect, the Registrant’s internal control over financial reporting.ITEM 9B. OTHER INFORMATION None.PART IIIITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 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 2006 Annual Meeting of Shareholders to be held on January 26, 2006 (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.” 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 information which will be included under the caption “PROPOSAL NUMBER 1 — ELECTION OF DIRECTORS — Committees and Meetings 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 information which will be included under the captions “PROPOSAL NUMBER 1 — ELECTION OF DIRECTORS — Committees and Meetings 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 Registrant’s Board of Directors members and associates, 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://www.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 items 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://www.investor.scotts.com. Interested persons may also obtain copies of each of these documents 40
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 is incorporated by reference in Exhibit 14 to this Annual Report on Form 10-K.ITEM 11. EXECUTIVE COMPENSATION In accordance with General Instruction G(3) of Form 10-K, the information contained under the captions “EXECUTIVE COMPENSATION — Summary of Cash and Other Compensation, — Option Grants in 2005 Fiscal Year, — Option Exercises in 2005 Fiscal Year and 2005 Fiscal Year-End Option/SAR Values, — 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,” “PROPOSAL NUMBER 2 — APPROVAL OF AMENDMENT AND RESTATEMENT OF THE SCOTTS MIRACLE-GRO COMPANY DISCOUNTED STOCK PURCHASE PLAN” [description of manner in which The Scotts Miracle-Gro Company Discounted Stock Purchase Plan operates] and “EXECUTIVE COMPENSATION — Report of the Compensation and Organization Committee on Executive Compensation for the 2005 Fiscal Year — Executive Incentive Plan” in the Registrant’s Proxy Statement is incorporated herein by reference.ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS In accordance with General Instruction G(3) of Form 10-K, the information 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.ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In accordance with General Instruction G(3) of Form 10-K, the information 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.ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES In accordance with General Instruction G(3) of Form 10-K, the information 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 IVITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (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 48 herein. 3. Exhibits: Exhibits filed with this Annual Report on Form 10-K are attached hereto or incorporated herein by reference. For a list of such exhibits, see “Index to Exhibits” beginning at page 104. The following table provides certain information concerning executive compensation plans and arrangements required to be filed as exhibits to this Annual Report on Form 10-K. 41
EXECUTIVE COMPENSATORY PLANS AND ARRANGEMENTS
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.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTSAND FINANCIAL STATEMENT SCHEDULE
ANNUAL REPORT OF MANAGEMENT ON INTERNALCONTROL OVER FINANCIAL REPORTING Management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of The Scotts Miracle-Gro Company and our consolidated subsidiaries; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of The Scotts Miracle-Gro Company and our consolidated subsidiaries are being made only in accordance with authorizations of management and directors of The Scotts Miracle-Gro Company and our consolidated subsidiaries, as appropriate; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the assets of The Scotts Miracle-Gro Company and our consolidated subsidiaries that could have a material effect on the consolidated financial statements. Management, with the participation of our principal executive officer and principal financial officer, assessed the effectiveness of our internal control over financial reporting as of September 30, 2005, the end of our fiscal year. Management based its assessment on criteria established inInternal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Management’s assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies and our overall control environment. This assessment is supported by testing and monitoring performed under the direction of management. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluations of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Accordingly, even an effective system of internal control over financial reporting will provide only reasonable assurance with respect to financial statement preparation. Based on our assessment, management has concluded that our internal control over financial reporting was effective as of September 30, 2005, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States of America. We reviewed the results of management’s assessment with the Audit Committee of The Scotts Miracle-Gro Company. Our independent registered public accounting firm, Deloitte & Touche LLP, audited management’s assessment and independently assessed the effectiveness of our internal control over financial reporting. Deloitte & Touche LLP has issued an attestation report concurring with management’s assessment, as stated in their report which appears herein.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Shareholders ofThe Scotts Miracle-Gro CompanyMarysville, Ohio We have audited the accompanying consolidated balance sheet of The Scotts Miracle-Gro Company and Subsidiaries (the “Company”) as of September 30, 2005, and the related consolidated statements of operations, shareholders’ equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company at September 30, 2005, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of September 30, 2005, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated December 14, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting./s/ Deloitte & Touche LLPColumbus, OhioDecember 14, 2005 50
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Shareholders ofThe Scotts Miracle-Gro Company: In our opinion, the consolidated balance sheets and the related consolidated statements of operations, shareholders’ equity and cash flows present fairly, in all material respects, the financial position of The Scotts Miracle-Gro Company at September 30, 2004 and the results of its operations and its cash flows for the years ended September 30, 2004 and 2003 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 6 to the financial statements, effective October 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”. Also, as discussed in Note 1 to the financial statements, effective October 1, 2002, the Company adopted the prospective method of recognizing the fair value of stock-based compensation in accordance with Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation”./s/ PricewaterhouseCoopers LLPColumbus, OHNovember 22, 2004 51
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Shareholders ofThe Scotts Miracle-Gro CompanyMarysville, Ohio We have audited management’s assessment, included in the accompanying Annual Report of Management on Internal Control Over Financial Reporting, that The Scotts Miracle-Gro Company and Subsidiaries (the “Company”) maintained effective internal control over financial reporting as of September 30, 2005, based on criteria established inInternal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of September 30, 2005 is fairly stated, in all material respects, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of September 30, 2005, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. 52
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended September 30, 2005 of the Company and our report dated December 14, 2005 expressed an unqualified opinion on those financial statements./s/ Deloitte & Touche LLPColumbus, OhioDecember 14, 2005 53
The Scotts Miracle-Gro CompanyConsolidated Statements of Operationsfor the fiscal years ended September 30, 2005, 2004 and 2003(in millions, except per share data)
The Scotts Miracle-Gro CompanyConsolidated Statements of Cash Flowsfor the fiscal years ended September 30, 2005, 2004 and 2003(in millions)
The Scotts Miracle-Gro CompanyConsolidated Balance SheetsSeptember 30, 2005 and 2004(in millions except per share data)
The Scotts Miracle-Gro CompanyConsolidated Statements of Shareholders’ Equityfor the fiscal years ended September 30, 2005, 2004 and 2003(in millions)
The Scotts Miracle-Gro CompanyNOTES TO CONSOLIDATED FINANCIAL STATEMENTSNOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESNature of Operations The Scotts Miracle-Gro Company and its subsidiaries (collectively the “Company”) are engaged in the manufacture, marketing and sale of lawn and garden care products. The Company’s 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. The Company’s products are sold primarily in North America and the European Union. We also operate the Scotts LawnService®business which provides lawn and tree and shrub fertilization, insect control and other related services in the United States. Effective October 2, 2004, the Company acquired Smith & Hawken®, a leading brand in the outdoor living and gardening lifestyle category. Smith & Hawken® products are sold in the United States through its 57 retail stores as well as through catalog and internet sales.Restructuring Merger On March 18, 2005, The Scotts Company consummated the restructuring of its corporate structure into a holding company structure by merging The Scotts Company into a newly-created, wholly-owned, second-tier Ohio limited liability company subsidiary, The Scotts Company LLC, pursuant to the Agreement and Plan of Merger, dated as of December 13, 2004, by and among The Scotts Company, The Scotts Company LLC and Scotts Miracle-Gro (the “Restructuring Merger”). As a result of the Restructuring Merger, each of The Scotts Company’s common shares, without par value, issued and outstanding immediately prior to the consummation of the Restructuring Merger was automatically converted into one fully paid and nonassessable common share, without par value, of The Scotts Miracle-Gro Company. The Scotts Miracle-Gro Company is the public company successor to The Scotts Company. Following the consummation of the Restructuring Merger, The Scotts Company LLC is the successor to The Scotts Company and is a direct, wholly-owned subsidiary of The Scotts Miracle-Gro Company, the new parent holding company.Organization Basis of Presentation and Reclassifications The Company’s consolidated financial statements are presented in accordance with accounting principles generally accepted in the United States of America. The consolidated financial statements include the accounts of The Scotts Miracle-Gro Company and all wholly-owned and majority-owned subsidiaries. All intercompany transactions and accounts are eliminated in consolidation. The Company’s criteria for consolidating entities is based on majority ownership (as evidenced by a majority voting interest in the entity) and an objective evaluation and determination of effective management control. Certain revisions and reclassifications have been made to prior years’ financial statements to conform to fiscal 2005 classifications. With respect to the Amended and Restated Exclusive Agency and Marketing Agreement (the “Marketing Agreement”) with Monsanto Company (“Monsanto”), the Company has made two presentational changes. First, the Company has reclassified as net sales the amounts previously reported as net commission from the Marketing Agreement. Second, net sales and cost of sales have been adjusted to reflect certain reimbursements and costs associated with the Marketing Agreement on a gross basis that was previously reported on a net basis, with no effect on gross profit or net income. See further details regarding these matters in Note 3 of the Notes to Consolidated Financial Statements. Furthermore, the Company has simplified the presentation of Selling, General and Administrative expenses presented on the face of the Consolidated Statements of Operations.Subsequent Event — Stock Split On November 9, 2005, the Company executed a 2-for-1 stock split for shareholders of record on November 2, 2005. All share and per share information included in these consolidated financial statements and notes thereto have been adjusted to reflect this stock split for all periods presented. 58
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSRevenue Recognition Revenue is recognized when title and risk of loss transfer, generally when products are received by the customer. Provisions for estimated returns and allowances are recorded at the time revenue is recognized based on historical rates and are periodically adjusted for known changes. Shipping and handling costs are included in cost of sales. Scotts LawnService® revenues are recognized at the time service is provided to the customer. Under the terms of the marketing agreement between The Scotts Company and Monsanto, the Company in its role as exclusive agent performs certain functions, such as sales support, merchandising, distribution and logistics of Monsanto, and incurs certain costs in support of the consumer Roundup® business. The actual costs incurred by the Company on behalf of Roundup® are recovered from Monsanto through the terms of the agency agreement. The reimbursement of costs for which the Company is considered the primary obligator is included in net sales.Promotional Allowances The Company promotes its branded products through cooperative advertising programs with retailers. Retailers also are offered in-store promotional allowances and rebates based on sales volumes. Certain products are promoted with direct consumer rebate programs and special purchasing incentives. Promotion costs (including allowances and rebates) incurred during the year are expensed to interim periods in relation to revenues and are recorded as a reduction of net sales. Accruals for expected payouts under the programs are included in the “Accrued liabilities” line in the Consolidated Balance Sheets.Advertising The Company advertises its branded products through national and regional media. Advertising costs incurred during the year are expensed to interim periods in relation to revenues. All advertising costs, except for external production costs, are expensed within the fiscal year in which such costs are incurred. External production costs for advertising programs are deferred until the period in which the advertising is first aired. Advertising expenses were $122.5 million in fiscal 2005, $105.0 million in fiscal 2004 and $97.7 million in fiscal 2003. Scotts LawnService® promotes its service offerings through direct response mail campaigns. External costs associated with these campaigns that qualify as direct response advertising costs are deferred and recognized as advertising expense in proportion to revenues over a future period not beyond the end of the subsequent calendar year. The costs deferred at September 30, 2005 and 2004 were $2.4 million and $1.6 million, respectively.Research and Development All costs associated with research and development are charged to expense as incurred. Expense for fiscal 2005, 2004 and 2003 was $30.5 million, $34.4 million and $30.4 million, respectively.Environmental Costs The Company recognizes environmental liabilities when conditions requiring remediation are probable and the amounts can be reasonably estimated. Expenditures which extend the life of the related property or mitigate or prevent future environmental contamination are capitalized. Environmental liabilities are not discounted or reduced for possible recoveries from insurance carriers.Stock-Based Compensation Awards In fiscal 2003, the Company began expensing prospective grants of employee stock-based compensation awards in accordance with Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation”. The fair value of awards is expensed ratably over the vesting period, generally three years, except for grants to members of the Board of Directors that have a shorter vesting period. 59
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In December 2004, the Financial Accounting Standards Board replaced SFAS 123 with SFAS 123(R), “Share-Based Payment,” that the Company is required to adopt effective October 1, 2005. The Company is already in substantial compliance with SFAS 123(R) as the standard closely parallels SFAS 123. The adoption of SFAS 123(R) is not expected to have a significant effect on the Company’s results of operations. The Company changed its fair value option pricing model from the Black-Scholes model to a binomial model for all options granted on or after October 1, 2004. The fair value of options granted prior to October 1, 2004, was determined using the Black-Scholes model. The Company believes the binomial model considers characteristics of fair value option pricing that are not available under the Black-Scholes model. Both the Black-Scholes model and the binomial model take into account a number of variables such as volatility, risk-free interest rate, contractual term of the option, the probability that the option will be exercised prior to the end of its contractual life, and the probability of termination or retirement of the option holder in computing the value of the option. However, the binomial model uses a more refined approach in applying those variables thereby improving the quality of the estimate of fair value.Earnings per Common Share Basic earnings per common share is computed based on the weighted-average number of common shares outstanding each period. Diluted earnings per common share is computed based on the weighted-average number of common shares and dilutive potential common shares (stock options, restricted stock and stock appreciation rights) outstanding each period.Cash and Cash Equivalents The Company considers all highly liquid financial instruments with original maturities of three months or less to be cash equivalents. The Company maintains cash deposits in banks which from time to time exceed the amount of deposit insurance available. Management periodically assesses the financial condition of the institutions and believes that any potential credit loss is minimal.Investments Investments at September 30, 2004, consisted of adjustable rate notes issued by a variety of borrowers (the “Notes”). The Notes have been accounted for as “available for sale securities” in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Cost is equivalent to fair value at the balance sheet date as the Notes can be put back to a remarketing agent at any time at 100% of par value. The Notes were secured by an irrevocable, direct pay letter of credit. The Notes held at September 30, 2004, in the amount of $57.2 million, were redeemed on October 1, 2004.Accounts Receivable and Allowances Trade accounts receivable are recorded at the invoiced amount and do not bear interest. Allowances reflect our best estimate of amounts in our existing accounts receivable that may not be collected due to customer claims, the return of goods, or customer inability or unwillingness to pay. We determine the allowance based on customer risk assessment and historical experience. We review our allowances monthly. Past due balances over 90 days and in excess of a specified amount are reviewed individually for collectibility. All other balances are reviewed on a pooled basis by type of receivable. Account balances are charged off against the allowance when we feel it is probable the receivable will not be recovered. We do not have any off-balance-sheet credit exposure related to our customers.Inventories Inventories are stated at the lower of cost or market, principally determined by the FIFO method. Certain growing media inventories are accounted for by the LIFO method. At September 30, 2005 and 2004, approximately 6% of inventories, are valued at the lower of LIFO cost or market. Inventories include the cost of raw materials, labor and manufacturing overhead. The Company makes provisions for obsolete 60
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSor slow-moving inventories as necessary to properly reflect inventory at the lower of cost or market value. Reserves for excess and obsolete inventories were $16.3 million and $21.3 million at September 30, 2005 and 2004, respectively. The Company will be required to adopt the provisions of SFAS No. 151, “Inventory Costs,” in the first quarter of fiscal 2006. SFAS No. 151 amends ARB 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The Company has completed its evaluation of the provisions of SFAS No. 151, and does not expect its adoption to have a material impact on its financial position or results of operations.Long-lived Assets Property, plant and equipment, are stated at cost. Expenditures for maintenance and repairs are charged to expense as incurred. When properties are retired or otherwise disposed of, the cost of the asset and the related accumulated depreciation are removed from the accounts with the resulting gain or loss being reflected in income from operations. Depreciation of property, plant and equipment is provided on the straight-line method and is based on the estimated useful economic lives of the assets as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSfirm commitment hedges are deferred and included in the basis of the transactions underlying the commitments. All assets and liabilities in the balance sheets of foreign subsidiaries are translated into U.S. dollar equivalents at fiscal year-end exchange rates, as their functional currency is the local currency. Translation gains and losses are accumulated as a separate component of other comprehensive income and included in shareholders’ equity. Income and expense items are translated at the twelve month average of the month end exchange rates. Foreign currency transaction gains and losses are included in the determination of net income.Derivative Instruments In the normal course of business, the Company is exposed to fluctuations in interest rates and the value of foreign currencies. The Company has established policies and procedures that govern the management of these exposures through the use of a variety of financial instruments. The Company employs various financial instruments, including forward exchange contracts and swap agreements, to manage certain of the exposures when practical. By policy, the Company does not enter into such contracts for the purpose of speculation or use leveraged financial instruments. The Company’s derivative activities are managed by the Chief Financial Officer and other senior management of the Company in consultation with the Finance Committee of the Board of Directors. These activities include the establishment of a risk-management philosophy and objectives, providing guidelines for derivative-instrument usage and establishing procedures for control and valuation, counterparty credit approval and the monitoring and reporting of derivative activity. The Company’s objective in managing its exposure to fluctuations in interest rates and foreign currency exchange rates is to decrease the volatility of earnings and cash flows associated with changes in the applicable rates and prices. To achieve this objective, the Company primarily enters into forward exchange contracts and swap agreements whose values change in the opposite direction of the anticipated cash flows. Derivative instruments related to forecasted transactions are considered to hedge future cash flows, and the effective portion of any gains or losses is included in other comprehensive income until earnings are affected by the variability of cash flows. Any remaining gain or loss is recognized currently in earnings. The cash flows of the derivative instruments are expected to be highly effective in achieving offsetting cash flows attributable to fluctuations in the cash flows of the hedged risk. If it becomes probable that a forecasted transaction will no longer occur, the derivative will continue to be carried on the balance sheet at fair value, and gains and losses that were accumulated in other comprehensive income will be recognized immediately in earnings. To manage certain of its cash flow exposures, the Company has entered into forward exchange contracts and interest rate swap agreements. The forward exchange contracts are designated as hedges of the Company’s foreign currency exposure associated with future cash flows. The change in the value of the amounts payable or receivable under forward exchange contracts are recorded as adjustments to other income or expense. The interest rate swap agreements are designated as hedges of the Company’s interest rate risk associated with certain variable rate debt. The change in the value of the amounts payable or receivable under the swap agreements are recorded as adjustments to interest expense. Unrealized gains or losses resulting from valuing these swaps at fair value are recorded in other comprehensive income. There have been no significant gains or losses recognized in earnings for hedge ineffectiveness or due to excluding a portion of the value from measuring effectiveness.Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying disclosures. Although these estimates are based on management’s best knowledge of current events and actions the Company may undertake in the future, actual results ultimately may differ from the estimates. 62
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSNOTE 2. DETAIL OF CERTAIN FINANCIAL STATEMENT ACCOUNTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The annual gross commission under the Marketing Agreement is calculated as a percentage of the actual earnings before interest and income taxes (EBIT), as defined in the Marketing Agreement, of the consumer Roundup business. Each year’s percentage varies in accordance with the terms of the Marketing Agreement based on the achievement of two earnings thresholds and on commission rates that vary by threshold and program year. The annual contribution payment is defined in the Marketing Agreement as $20 million. However, portions of the annual payments for the first three years of the Marketing Agreement were deferred. No payment was required for the first year (fiscal 1999), a payment of $5 million was required for the second year and a payment of $15 million was required for the third year so that a total of $40 million of the contribution payments was deferred. Beginning in fiscal 2003, the fifth year of the Marketing Agreement, the annual payments to Monsanto increased to at least $25 million, which included per annum interest charges at 8%. The annual payments were increased above $25 million if certain significant earnings targets were exceeded. Through July 2, 2005, the Company recognized a periodic charge associated with the annual contribution payments equal to the required payment for that period. The Company had not recognized a charge for the portions of the contribution payments that were deferred until the time those deferred amounts were due under the terms of the Marketing Agreement. Based on the then available facts and circumstances, the Company considered this method of accounting for the contribution payments to be appropriate after consideration of the likely term of the Marketing Agreement, the Company’s ability to terminate the Marketing Agreement without paying the deferred amounts (as supported by legal opinion from The Bayard Firm, P.A.), the Company’s assessment that the Marketing Agreement could have been terminated at any balance sheet date without incurring significant economic consequences as a result of such action and the fact that a significant portion of the deferred amount could never have been paid, even if the Marketing Agreement is not terminated prior to 2018, unless significant earnings targets were exceeded. The Bayard Firm, P.A. was special Delaware counsel retained during fiscal 2000 solely for the limited purpose of providing legal opinion in support of the contingent liability treatment of the deferred contribution amounts under the Marketing Agreement previously adopted by the Company and has neither generally represented or advised the Company nor participated in the preparation or review of the Company’s financial statements of any SEC filings. The terms of such opinion specifically limit the parties who are entitled to rely on it. During the quarter ended July 2, 2005, the Company updated its assessment of the amounts deferred and previously considered a contingent obligation under the Marketing Agreement. Based on the recent strong performance of the consumer Roundup business and other economic developments surrounding the business, the Company now believes that the deferred contribution amounts outstanding will be paid in full between 2010 and 2012 under the terms of the Marketing Agreement. In management’s judgment, it is now probable that the deferred contribution payment that totaled $45.7 million as of July 2, 2005 will be paid. As such, the Company recorded this liability with a charge to net sales in the quarter ended July 2, 2005. This amount bore interest at 8% until it was paid in October 2005. The deferred contribution balance is recorded as a current liability at September 30, 2005. 64
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The elements of the net commission earned under the Marketing Agreement included in “Net sales” for the three years ended September 30, 2005 were as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSbusiness prior to September 30, 2008, we will be entitled to a termination fee in excess of $100 million. If we terminate the Marketing 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 $100 million to a minimum of $16 million for terminations between September 30, 2008 and September 30, 2018.NOTE 4. IMPAIRMENT, RESTRUCTURING AND OTHER CHARGES2005 Charges During fiscal 2005, the Company recorded $9.5 million of restructuring and other charges. The Company recognized restructuring costs relating primarily to the Company’s strategic improvement plan designed to significantly improve long-term earnings through a sustained effort to reduce general and administrative costs. Primarily in relation to the plan, the Company recognized $26.3 million of severance and related costs, including curtailment charges relating to a pension plan and the retiree medical plan. The Company anticipates that restructuring activities under the strategic improvement plan will continue through fiscal 2007 and that total costs under the plan will be in the range of $33 million to $35 million. Offsetting these charges was a reserve reversal to restructuring income of $7.9 million related to the collection of outstanding accounts receivable due from Central Garden & Pet Company (Central Garden), and a net settlement gain of $8.9 million was recorded relating to the lawsuit against Aventis.2004 Charges During fiscal 2004, the Company recorded $9.7 million of restructuring and other charges. Charges related to our North America distribution restructuring were classified as cost of sales in the amount of $0.6 million. Severance costs related to our International Profit Improvement Plan and the restructuring of our International team amounted to $6.1 million. The restructuring of our Global Business Information Services group amounted to $3.0 million and related primarily to severance and outside service costs. The severance costs incurred in fiscal 2004 are related to the reduction of 75 administrative and production employees.2003 Charges During fiscal 2003, the Company recorded $17.1 million of restructuring and other charges. Costs of $5.3 million for warehouse lease buyouts and relocation of inventory associated with exiting certain warehouses in North America, and $3.8 million related to a plan to optimize our International supply chain were included in cost of sales. Severance and consulting costs of $5.3 million for the continued European integration efforts that began in the fourth quarter of fiscal 2002, and $2.7 million of administrative facility exit costs in North America were charged to impairment, restructuring and other charges. The severance costs incurred in fiscal 2003 are related to the reduction of 78 administrative and production employees. 66
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following is the detail of impairment, restructuring, and other charges and a rollforward of the cash portion of the restructuring and other charges accrued in fiscal 2005 and 2004 (in millions).
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSOctober 1, 2003. Reported net income on a pro forma basis would have decreased by approximately $1.6 million, or $0.02 per common share, for the year ended September 30, 2004.Scotts LawnService® From fiscal 2003 through 2005, the Company’s Scotts LawnService® segment acquired 29 individual lawn service entities for a total cost of approximately $41.0 million. The following table summarizes the details of these transactions by fiscal year (dollar amounts in millions):
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Effective October 1, 2001, Scotts adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”. In accordance with this standard, goodwill and certain other intangible assets, primarily tradenames, have been classified as indefinite-lived assets no longer subject to amortization. Indefinite-lived assets are subject to impairment testing upon adoption of SFAS No. 142 and at least annually thereafter. The initial impairment analysis was completed in the second quarter of fiscal 2002, taking into account additional guidance provided by EITF 02-07, “Unit of Measure for Testing Impairment of Indefinite-Lived Intangible Assets”. The value of all indefinite-lived tradenames as of October 1, 2001 was determined using a “royalty savings” methodology that was employed when the businesses associated with these tradenames were acquired but using updated estimates of sales, cash flow and profitability. As a result, a pre-tax impairment loss of $29.8 million was recorded for the writedown of the value of the tradenames in our International Consumer businesses in Germany, France and the United Kingdom. This transitional impairment charge was recorded as a cumulative effect of accounting change, net of tax, as of October 1, 2001. After completing this initial valuation and impairment of tradenames, an initial assessment for goodwill impairment was performed. It was determined that a goodwill impairment charge was not required. Intangible assets with finite lives, and therefore subject to amortization, include technology (e.g., patents), customer accounts, and certain tradenames. These intangible assets are being amortized on the straight-line method over periods ranging from 3 to 39 years. In addition to the annual impairment analysis required for goodwill and indefinite-lived intangible assets, management will assess the recoverability of any intangible asset whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. In the first quarter of fiscal 2005, the Company completed its annual impairment analysis of goodwill and indefinite-lived intangible assets and determined that tradenames associated with the consumer business in the United Kingdom were impaired. The fair value of the tradenames was determined by estimating the royalties saved because of the Company’s ownership of the tradenames. The approach uses an estimated royalty rate applied to projected revenues to develop after-tax cost savings. The implied savings are then discounted to a present value amount which is used as the approximation of fair value. The reduction in the value of the tradenames has resulted primarily from a decline in the profitability of the U.K. growing media business and unfavorable category mix trends. Although management is developing strategies to significantly improve the profitability of the U.K. business, we believe an impairment charge against the book value of the indefinite-lived tradenames is appropriate. Accordingly, an impairment charge of $22 million was recorded and classified as “Impairment, restructuring, and other charges” in the Consolidated Statement of Operations for fiscal 2005. The following table presents goodwill and intangible assets as of September 30, 2005 and 2004 (dollars in millions).
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSactuarial computations using the Projected Unit Credit method. The second frozen plan is a non-qualified supplemental pension plan. This plan provides for incremental pension payments so that total pension payments equal amounts that would have been payable from the Company’s pension plan if it were not for limitations imposed by the income tax regulations. The Company sponsors defined benefit pension plans associated with its International businesses in the United Kingdom, Netherlands, Germany, France, and Austria. These plans generally cover all associates of the respective businesses with retirement benefits primarily based on years of service and compensation levels. During fiscal 2004, the U.K. plans were closed to new participants, but existing participants continue to accrue benefits. All newly hired associates of Scotts U.K. now participate in a new defined contribution plan in lieu of the defined benefit plans. The following tables present information about benefit obligations, plan assets, annual expense, assumptions and other information about the Company’s defined benefit pension plans (in millions):
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSInvestment Strategy: The Company maintains target allocation percentages among various asset classes based on an individual investment policy established for each of the various pension plans which are designed to achieve long term objectives of return, while mitigating against downside risk and considering expected cash requirements to fund benefit payments. Our investment policies are reviewed from time to time to ensure consistency with our long-term objectives.Basis for Long-Term Rate of Return on Assets Assumption: The Company’s expected long-term rate of return on assets assumptions are derived from studies conducted by third parties. The studies include a review of anticipated future long-term performance of individual asset classes and consideration of the appropriate asset allocation strategy given the anticipated requirements of the plan to determine the average rate of earnings expected on the funds invested to provide for benefits under the various pension plans. While the studies give appropriate consideration to recent fund performance and historical returns, the assumptions primarily represent expectations about future rates of return over the long term.NOTE 8. ASSOCIATE MEDICAL BENEFITS The Company provides comprehensive major medical benefits to certain of its retired associates and their dependents. Substantially all of the Company’s domestic associates who were hired before January 1, 1998 become eligible for these benefits if they retire at age 55 or older with more than ten years of service. The plan requires certain minimum contributions from retired associates and includes provisions to limit the overall cost increases the Company is required to cover. The Company funds its portion of retiree medical benefits on a pay-as-you-go basis. 73
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following table sets forth the information about the retiree medical plan for domestic associates (in millions):
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(the “FSP”). The FSP provides guidance on accounting for the effects of the Act, which the Company adopted at the beginning of its fourth quarter of fiscal 2004. The APBO at September 30, 2005, has been reduced by a deferred actuarial gain in the amount of $5.9 million to reflect the effect of the subsidy related to benefits attributed to past service. The amortization of the actuarial gain and reduction of service and interest costs served to reduce net periodic post retirement benefit cost for fiscal 2005 and 2004 by $0.2 and $0.1 million, respectively. For measurement as of September 30, 2005, management has assumed that health care costs will increase at an annual rate of 8.5% in fiscal 2006 (period from October 1, 2005, to September 30, 2006), decreasing 0.50% per year to an ultimate trend of 5.00% in 2013. A 1% increase in health cost trend rate assumptions would increase the APBO as of September 30, 2005 and 2004 by $0.2 million and $0.9 million, respectively. A 1% decrease in health cost trend rate assumptions would decrease the APBO as of September 30, 2005 and 2004 by $0.2 million and $1.0 million, respectively. A 1% increase or decrease in the same rate would not have a material effect on service or interest costs.Estimated Future Benefit Payments The following benefit payments under the plan are expected to be paid by the Company and the retirees for the fiscal years indicated (in millions):
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Maturities of short- and long-term debt for the next five fiscal years and thereafter are as follows (in millions):
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSby The Scotts Miracle-Gro Company and its domestic subsidiaries of the capital stock of substantially all of such domestic subsidiaries and a majority of the capital stock of certain foreign subsidiaries that are first-tier subsidiaries of such domestic subsidiaries. The security interest in the Company’s and its domestic subsidiaries’ personal, real and intellectual property assets, which had existed under the prior credit agreement, was not required under the New Credit Agreement and has been terminated (except as to certain subsidiary capital stock as described above). The Company and its subsidiaries also pledged a majority of the capital stock in foreign subsidiaries that borrow under the New Credit Agreement and a majority of the capital stock of substantially all of the first-tier subsidiaries of such foreign subsidiary borrowers. Revolving credit borrowings under the New Credit Agreement in the aggregate amount of $195.7 million were combined with cash on hand in the amount of $200.3 million to repay in full the outstanding Tranche A Term Loans ($248 million) and Tranche B Term Loans ($148 million) under the prior credit agreement (which was then terminated). Certain fees in connection with entering into the New Credit Agreement were also paid from cash on hand. In addition, letters of credit in the aggregate amount of $15.6 million were assigned to the New Credit Agreement. Total fees of approximately $3.6 million have been capitalized and are being amortized on the straight-line method over the five year term of the New Credit Agreement. A loss on the refinancing in the amount of $1.3 million, representing the write-off of deferred financing costs incurred related to the Term Loans that were repaid, was recognized in the fourth quarter of fiscal 2005. In addition, interest rate swap agreements in the notional amount of $125 million, that effectively converted a portion of the variable rate Term Loans to a fixed rate, were unwound, resulting in a gain of $2.9 million that will be amortized against future interest expense under the New Credit Agreement.NOTE 10. SHAREHOLDERS’ EQUITY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSbeen made under plans approved by the shareholders in 1992, 1996, and 2003. Generally, in respect of grants to employees, a three-year cliff vesting schedule is used for all share-based awards unless decided otherwise by the Compensation and Organization Committee of the Board of Directors. Grants to non-employee directors typically vest in one year or less. A maximum of 18 million common shares may be delivered for issuance under these plans. At September 30, 2005, approximately 1.1 million common shares are not subject to outstanding awards and are available to underlie the grant of new share-based awards. Subsequent to September 30, 2005, the Company granted a total of 917,300 share-based awards to key employees. These awards have an estimated fair value of $17.0 million as of the date of grant. The following is a recap of the share-based awards granted over the last three years:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSStock Options/SARs Aggregate option and stock appreciation right award activity consists of the following (options/ SARs in millions):
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSRestricted Stock Aggregate restricted stock award activity is as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSNOTE 11. EARNINGS PER COMMON SHARE The following table (in millions, except per share data) presents information necessary to calculate basic and diluted earnings per common share. Basic earnings per common share are computed by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per common share are computed by dividing net income by the weighted average number of common shares outstanding plus all potentially dilutive securities. Options to purchase 0.04 million, 0.2 million and 0.2 million common shares for the years ended September 30, 2005, 2004 and 2003, respectively, were not included in the computation of diluted earnings per common share. These options were excluded from the calculation because the exercise price of these options was greater than the average market price of the common shares in the respective periods, and therefore, they were anti-dilutive.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The domestic and foreign components of income before taxes are as follows (in millions):
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The components of the net deferred tax asset are as follows (in millions):
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSmanagement’s best estimate of the ultimate resolution of the tax matter. Based on currently available information, we believe that the ultimate outcomes of any challenges to our tax positions will not have a material adverse effect on our financial position, results of operations or cash flows. Our tax provision includes the impact of recording reserves and changes thereto.NOTE 13. FINANCIAL INSTRUMENTS A description of the Company’s financial instruments and the methods and assumptions used to estimate their fair values is as follows:Long-Term Debt The fair value of the Company’s 65/8% Senior Subordinated Notes was estimated based on recent trading information. The carrying amounts of variable rate debt, including borrowings under the Credit Agreement and foreign bank borrowings and term loans, are considered to approximate their fair values.Foreign Currency Swap Agreements From time to time, the Company enters into foreign currency swap contracts to manage the exchange rate risk associated with intercompany loans made to foreign affiliates that are denominated in dollars. At September 30, 2005, the notional amount of such foreign currency swap contracts outstanding was $174.5 million with a fair value of $2.4 million. The unrealized gain on the swap contracts approximates the unrealized loss recognized by our foreign affiliates.Interest Rate Swap Agreements At September 30, 2005, the Company did not have any interest rate swaps outstanding. At September 30, 2004, the Company had nine interest rate swaps outstanding with a total notional amount of $175.0 million with major financial institutions that effectively converted a portion of its variable-rate debt to a fixed rate. The swaps outstanding at September 30, 2004, had notional amounts between $10 million and $50 million with three to seven-year terms commencing in October 2001. Under the terms of these swaps, the Company paid swap rates ranging from 2.76% to 3.77% and received three-month LIBOR in return. In November 2005, the Company entered into four interest rate swaps with a total notional amount of $100.0 million, each swap having a notional amount of $25.0 million and a term of three years. The Company enters into interest rate swap agreements as a means to hedge its variable interest rate exposure on debt instruments. Since the interest rate swaps have been designated as hedging instruments, their fair values are reflected in the Company’s Consolidated Balance Sheets. Net amounts to be received or paid under the swap agreements are reflected as adjustments to interest expense. Unrealized gains or losses resulting from valuing these swaps at fair value are recorded as elements of “Accumulated other comprehensive loss” within the Consolidated Balance Sheets. The fair value of the swap agreements was determined based on the present value of the estimated future net cash flows using implied rates in the applicable yield curve as of the valuation date.Estimated Fair Values The estimated fair values of the Company’s financial instruments are as follows for the fiscal years ended September 30 (in millions):
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Excluded from the fair value table above are the following items that are included in the Company’s total debt balances at September 30, 2005 and 2004 (in millions):
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSNOTE 16. CONTINGENCIES Management continually evaluates the Company’s contingencies, including various lawsuits and claims which arise in the normal course of business, product and general liabilities, worker’s compensation, property losses and other fiduciary liabilities for which the Company is self-insured or retains a high exposure limit. Self-insurance reserves are established based on actuarial estimates. Legal costs incurred in connection with the resolution of claims, lawsuits and other contingencies generally are expensed as incurred. In the opinion of management, its assessment of contingencies is reasonable and related reserves, in the aggregate, are adequate; however, there can be no assurance that future quarterly or annual operating results will not be materially affected by final resolution of these matters. The following matters are the more significant of the Company’s identified contingencies.Environmental Matters In 1997, the Ohio EPA initiated an enforcement action against the Company with respect to alleged surface water violations and inadequate treatment capabilities at the Marysville, Ohio facility 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. Pursuant to a Consent Order entered by the Union County Common Pleas Court in 2002, the Company is actively engaged in restoring the site to eliminate exposure to waste materials from the discontinued on-site disposal areas. At September 30, 2005, $3.3 million was accrued for environmental and regulatory matters, primarily related to the Marysville facility. Most of the accrued costs are expected to be paid in fiscal 2006 and 2007; however, payments could be made for a period thereafter. While the amounts accrued are believed to be adequate to cover known environmental exposures based on current facts and estimates of likely outcome, the adequacy of these accruals is based on several significant assumptions: • that all significant sites that must be remediated have been identified; • that there are no significant conditions of contamination that are unknown to us; and • that with respect to the agreed judicial Consent Order in Ohio, potentially contaminated soil can be remediated in place rather than having to be removed and only specific stream segments will require remediation as opposed to the entire stream.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 2005, fiscal 2004, and fiscal 2003, we have expensed approximately $3.7 million, $3.3 million, and $1.5 million, respectively, for environmental matters.AgrEvo Environmental Health, Inc. v. The Scotts Company (Southern District of New York) The Scotts Company v. Aventis S.A. and Starlink Logistics, Inc. (Southern District of Ohio) On September 30, 2005, all litigation among the aforementioned companies has been concluded with the Company receiving a payment of approximately $10 million, of this amount $8.9 million is recorded in “Impairment, restructuring and other charges” within the Consolidated Statements of Operations (see Note 4).Central Garden & Pet Company The Scotts Company v. Central Garden, Southern District of Ohio Central Garden v. Scotts & Pharmacia, Northern District of California All litigation with the Central Garden & Pet Company (“Central Garden”) has been concluded. On July 15, 2005, the Company received approximately $15 million in satisfaction of the judgment against 86
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSCentral Garden. The Company has recognized the satisfaction of this judgment in its financial results for fiscal 2005 as follows (in millions):
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS At September 30, 2005, 76% of the Company’s accounts receivable were due from customers geographically located in North America. Approximately 83% of these receivables were generated from the consumer business with the remaining 17% due from customers of Scotts LawnService®, the professional businesses (primarily distributors), and Smith & Hawken®. Our top 3 customers within the consumer business accounted for 80% of total consumer accounts receivable. At September 30, 2004, 71% of the Company’s accounts receivable were due from customers geographically located in North America. Approximately 84% of these receivable were generated from the Company’s consumer business with the remaining 16% generated from customers of Scotts LawnService® and the professional businesses (primarily distributors). Our top 3 customers within the consumer business accounted for 68% of total consumer accounts receivable. The remainder of the Company’s accounts receivable at September 30, 2005 and 2004, were generated from customers located outside of North America, primarily retailers, distributors, nurseries and growers in Europe. No concentrations of customers or individual customers within this group account for more than 10% of the Company’s accounts receivable at either balance sheet date. The Company’s two largest customers accounted for the following percentage of net sales in each respective period:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSreported as discontinued operations in the accompanying consolidated Statements of Operations. The detail comprising the discontinued operations is as follows (in millions):
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSreport to and are managed by senior management of the Company. Prior year amounts have been reclassified to conform with certain modifications to the Company’s reporting structure in fiscal 2005. The North America segment manufactures, markets and sells dry, granular slow-release lawn fertilizers, combination lawn fertilizer and control products, grass seed, spreaders, water-soluble, liquid and continuous-release garden and indoor plant foods, plant care products, potting, garden and lawn soils, pottery, mulches and other growing media products, pesticide products and a full line of horticulture products. Products are marketed to mass merchandisers, home improvement centers, large hardware chains, warehouse clubs, distributors, nurseries, gardens centers and specialty crop growers in the United States, Canada, Latin America, South America, Australia, and Asia Pacific. The Scotts LawnService® segment provides lawn fertilization, disease and insect control and other related services such as core aeration, tree and shrub fertilization and interior barrier pest control service primarily to residential consumers through company-owned branches and franchises. In most company-operated locations, Scotts LawnService®also offers tree and shrub fertilization, disease and insect control treatments and, in our larger branches, an exterior barrier pest control service. The International segment provides products similar to those described above for the North America segment to consumers primarily in Europe. The Other/ Corporate segment consists of the recently-acquired Smith & Hawken®business and corporate general and administrative expenses. The following table (dollars in millions) presents segment financial information in accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”. Pursuant to SFAS No. 131, the presentation of the segment financial information is consistent with the basis used by management (i.e., certain costs not allocated to business segments for internal management reporting purposes are not allocated for purposes of this presentation).
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSNOTE 22. QUARTERLY CONSOLIDATED FINANCIAL INFORMATION (UNAUDITED) The following is a summary of the unaudited quarterly results of operations for fiscal 2005 and fiscal 2004 (in millions, except per share data).
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Common stock equivalents, such as stock awards, are excluded from the diluted loss per share calculation in periods where there is a net loss because their effect is anti-dilutive. The Company’s business is highly seasonal with over 70% of net sales occurring in the second and third fiscal quarters combined. Unusual charges during fiscal 2005 consisted of the charge to record the deferred contribution amounts under the Roundup® agreement, impairment charges and restructuring and other costs. These charges are reflected in the quarterly financial information as follows: first quarter restructuring and other charges of $0.2 million and impairment of intangible assets of $22.0 million; second quarter restructuring and other charges of $0.1 million; third quarter deferred contribution charge under the Roundup® marketing agreement of $45.7 million; and fourth quarter restructuring and other charges of $8.3 million and impairment of intangible assets of $1.4 million. Also included in the fourth quarter is $3.6 million relating to an immaterial correction of prior periods amortization expense. Unusual charges during fiscal 2004 consisted of restructuring and other costs as follows: first quarter $1.0 million; second quarter $0.4 million; third quarter $2.6 million; and fourth quarter $5.8 million. Net sales for the quarters ended January 1, 2005, April 2, 2005 and July 2, 2005, have been revised from the amounts previously reported by $9.6 million, $11.0 million and $12.0 million, respectively, to reflect certain activity associated with the Roundup® marketing agreement with Monsanto on a gross basis that was previously reported on a net basis. Cost of sales was restated by an equal amount, with no effect on gross profit or net income. The Company also has revised the presentation of the fiscal 2004 quarterly amounts to conform to the current year presentation ($8.7 million, $10.5 million, $10.9 million and $10.0 million, respectively). Net sales for the quarters ended January 1, 2005, April 2, 2005, and July 2, 2005, have been revised from the amounts previously reported by $(7.1) million, $15.1 million and $(21.6) million, respectively, to reflect the net commission (expense) associated with the Roundup® marketing agreement with Monsanto. The Company also has revised the presentation of the fiscal 2004 quarterly amounts to conform to the current year presentation ($(7.1) million, $8.2 million, $23.4 million and $4.0 million, respectively).NOTE 23. FINANCIAL INFORMATION FOR SUBSIDIARY GUARANTORS AND NON-GUARANTORS The 65/8% Senior Subordinated Notes are general obligations of The Scotts Miracle-Gro Company and are guaranteed by all of the existing wholly-owned, domestic subsidiaries and all future wholly-owned, significant (as defined in Regulation S-X of the Securities and Exchange Commission) domestic subsidiaries of The Scotts Miracle-Gro Company. These subsidiary guarantors jointly and severally guarantee the obligations of the Company under the Notes. The guarantees represent full and unconditional general obligations of each subsidiary that are subordinated in right of payment to all existing and future senior debt of that subsidiary but are senior in right of payment to any future junior subordinated debt of that subsidiary. The following information presents consolidating Statements of Operations and Statements of Cash Flows for the three years ended September 30, 2005, and Balance Sheets as of September 30, 2005 and 2004. 93
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSThe Scotts Miracle-Gro CompanyConsolidating Statement of Operationsfor the fiscal year ended September 30, 2005(in millions)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSThe Scotts Miracle-Gro CompanyConsolidating Statement of Cash Flowsfor the fiscal year ended September 30, 2005(in millions)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSThe Scotts Miracle-Gro CompanyConsolidating Balance SheetAs of September 30, 2005(in millions)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSThe Scotts Miracle-Gro CompanyConsolidating Statement of Operationsfor the fiscal year ended September 30, 2004(in millions)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSThe Scotts Miracle-Gro CompanyConsolidating Statement of Cash Flowsfor the fiscal year ended September 30, 2004(in millions)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSThe Scotts Miracle-Gro CompanyConsolidating Balance SheetAs of September 30, 2004(in millions)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSThe Scotts Miracle-Gro CompanyConsolidating Statement of Operationsfor the fiscal year ended September 30, 2003(in millions)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSThe Scotts Miracle-Gro CompanyConsolidating Statement of Cash Flowsfor the fiscal year ended September 30, 2003(in millions)
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Shareholders of The Scotts Miracle-Gro CompanyMarysville, OH We have audited the consolidated financial statements of The Scotts Miracle-Gro Company and Subsidiaries (the “Company”) as of September 30, 2005, and for the year then ended, management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of September 30, 2005, and the effectiveness of the Company’s internal control over financial reporting as of September 30, 2005; and have issued our reports thereon dated December 14, 2005; such consolidated financial statements and reports are included elsewhere in this Form 10-K. Our audit also included the consolidated financial statement schedule of the Company for the year ended September 30, 2005 listed in the Index to Consolidated Financial Statements and Financial Statement Schedule. This consolidated financial statement schedule is the responsibility of the Company’s management. Our responsibility is to express an opinion based on our audit. In our opinion, such consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein./s/ Deloitte & Touche LLPColumbus, OhioDecember 14, 2005REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMTo the Board of Directors and Shareholders of The Scotts Company Our audits of the consolidated financial statements referred to in our report dated November 22, 2004 appearing in Item 15(a)(1) of this Annual Report on Form 10-K, also included an audit of the financial statement schedule listed in Item 15(a)(2) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements./s/ PricewaterhouseCoopers LLPColumbus, OhioNovember 22, 2004 102
The Scotts Miracle-Gro CompanySchedule II — Valuation and Qualifying Accountsfor the fiscal year ended September 30, 2005(in millions)
The Scotts Miracle-Gro CompanyIndex to Exhibits