ScottsMiracle-Gro - 10-Q quarterly report FY

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     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

The number of Common Shares, without par value, of the registrant outstanding as of May 4, 2006 was 67,314,532.

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

NATURE OF OPERATIONS

The Scotts Miracle-Gro Company (“Scotts Miracle-Gro”) 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 and Smith & Hawken^®, a leading brand in the outdoor living and gardening lifestyle category. Effective November 18, 2005, we entered the North America wild bird food category with the acquisition of Gutwein & Co. Inc. (“Gutwein”).

Due to the nature of our lawn and garden business, the majority of our shipments to retailers occur in the second and third fiscal quarters. On a combined basis, net sales for the second and third fiscal quarters generally represent 70% to 75% of our annual net sales. As a result of the seasonal nature of our business, results for the first six months of our fiscal year are not indicative of the full year.

The Company’s condensed, consolidated financial statements are unaudited; however, in the opinion of management, these condensed, consolidated financial statements are presented in accordance with accounting principles generally accepted in the United States of America. The condensed, consolidated financial statements include the accounts of Scotts Miracle-Gro and all wholly-owned and majority-owned subsidiaries. All intercompany transactions and accounts have been 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. Interim results reflect all normal and recurring adjustments and are not necessarily indicative of results for a full year. The interim financial statements and notes are presented as specified by Regulation S-X of the Securities and Exchange Commission, and should be read in conjunction with the financial statements and accompanying notes in Scotts Miracle-Gro’s fiscal 2005 Annual Report on Form 10-K.

On November 9, 2005, the Company executed a 2-for-1 stock split to shareholders of record on November 2, 2005. All share and per share information included in these condensed, consolidated financial statements and notes thereto have been adjusted to reflect this stock split for all periods presented.

Revenue is recognized when title and risk of loss transfer, which generally occurs 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 of returns and are periodically adjusted for known changes in return levels. 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 Amended and Restated Exclusive Agency and Marketing Agreement (the “Marketing Agreement”) between the Company and Monsanto Company (“Monsanto”), the Company in its role as exclusive agent performs certain functions, such as sales support, merchandising, distribution and logistics on behalf 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 Marketing Agreement. The reimbursement of costs for which the Company is considered the primary obligor is included in net sales.

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 these programs are included in the “Accrued liabilities” line in the Condensed, Consolidated Balance Sheets.

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.

Scotts LawnService® promotes its service offerings primarily 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 period not beyond the end of the subsequent calendar year. The costs deferred at April 1, 2006, April 2, 2005 and September 30, 2005 were $5.6 million, $2.2 million and $2.4 million, respectively.

Beginning 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 Company adopted SFAS 123(R), “Share-Based Payment” effective October 1, 2005, following the modified prospective application approach. The Company was already in substantial compliance with SFAS 123(R) at the adoption date as the standard closely parallels SFAS 123. The adoption of SFAS 123(R) did not have a significant effect on the Company’s results of operations for the three or six-month periods ended April 1, 2006.

The Company grants share-based awards annually to officers, other key employees, and non-employee directors. Historically, these awards primarily included stock options with exercise prices equal to the market price of the underlying common shares on the date of grant with a term of 10 years. The Company also has issued stock appreciation rights (“SARs”) awards with a stated price determined by the closing price of the Company’s common shares on the date of the grant. Stock appreciation rights result in less dilution than option awards as the SAR holder receives a net share settlement upon exercise. In recent years, the Company also has begun to grant awards of restricted stock. These share-based awards had been 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. The Company has traditionally used newly issued shares to satisfy the exercise of stock options. Beginning in fiscal 2006, the Company has used treasury shares, as available, to satisfy the exercise of stock options.

On January 26, 2006, the shareholders of the Company approved the 2006 Long-Term Incentive Plan, providing for the availability of an additional 4.9 million common shares of the Company for grants under the terms of the plan. As of April 1, 2006, the Company had approximately 5.0 million common shares not subject to outstanding awards and available to support the grant of new share-based awards.

The following is a recap of the share-based awards granted over the periods indicated:

Total share-based compensation and the tax benefit recognized on the compensation expense was as follows for the periods indicated:

Aggregate option and stock appreciation right award activity consists of the following (options/SARs in millions):

The fair value of each award granted has been estimated on the grant date using a binomial model using the assumptions noted in the following table. Expected volatility is based on implied volatilities from traded options on the Company’s common shares and historical volatility of the Company’s stock. Historical data, including demographic factors impacting historical exercise behavior, is used to estimate option exercise and employee termination within the valuation model. The expected life shown below is used for purposes of calculating expected volatility while the risk neutral expected life that is an output of the model of 6.26 years represents the expected option holding period. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The weighted-average assumptions for awards granted for the six-month periods ended April 1, 2006 and April 2, 2005 are as follows:

Aggregate restricted stock award activity is as follows:

As of April 1, 2006, there was $20.4 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements; that cost is expected to be recognized over a weighted-average period of 2.9 years. Unearned compensation is amortized over the vesting period for the particular grant and is recognized as a component of “Selling, general and administrative” expense within the Condensed, Consolidated Statements of Operations.

The total intrinsic value of stock options exercised was $17.6 million and the total fair value of restricted stock vested was $0.5 million during the six months ended April 1, 2006.

Cash received from option exercises under all share-based payment arrangements for the six months ended April 1, 2006 was $14.2 million. The tax benefit realized for the tax deductions from option exercises under the share-based payment arrangements totaled $6.9 million for the six months ended April 1, 2006.

Management assesses the recoverability of long-lived assets being amortized whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If it is determined that an impairment has occurred, an impairment loss is recognized for the amount by which the carrying amount of the asset exceeds its estimated fair value.

Management also assesses the recoverability of goodwill and other intangible assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Goodwill and intangible assets not being amortized are reviewed for impairment at least annually during the first fiscal quarter. If it is determined that an impairment of intangible assets has occurred, an impairment loss is recognized for the amount by which the carrying value of the asset exceeds its estimated fair value.

The Company performed its annual impairment analysis during the first quarter of fiscal 2006 and recorded a $1.0 million charge. A fiscal 2005 impairment charge of $22.0 million was for the U.K. consumer business, reflecting a reduction in the value of the business resulting primarily from the decline in the profitability of its growing media business and unfavorable category mix trends.

The following represents a reconciliation from basic earnings per share to diluted earnings per share. Options to purchase 0.1 million and 0.8 million shares of common shares were outstanding at April 1, 2006 and April 2, 2005, respectively, but were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the underlying common shares and, therefore, the impact would be antidilutive.

On October 27, 2005, we announced that Scotts Miracle-Gro’s 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. Through April 1, 2006, we have reacquired 971,200 shares of our common stock to be held in treasury at an aggregate cost of $45.9 million. A total of 266,967 shares of our common stock held in treasury have been reissued to support the exercise of employee held stock options.

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 condensed, consolidated financial statements and accompanying notes. 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.

Certain revisions and reclassifications have been made to prior years’ financial statements to conform to fiscal 2006 reclassifications.

Effective with our fiscal 2005 Form 10-K and 2005 Annual Report to Shareholders, we made changes to our Condensed, Consolidated

Statements of Operations that management believes improve the overall presentation. As such, the fiscal 2005 quarterly condensed, consolidated financial statements presented therein have been revised to reflect these changes. With respect to the Marketing Agreement with 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 were previously reported on a net basis, with no effect on gross profit or net income. See further details regarding these matters in Note 3. Furthermore, we have simplified the presentation of Selling, General and Administrative (“SG&A”) expenses presented on the face of the Condensed, Consolidated Statement of Operations.

Inventories, net of provisions for slow moving and obsolete inventory of $17.0 million, $20.4 million, and $16.3 million, respectively, consisted of:

Under the terms of the Marketing Agreement with Monsanto, the Company is Monsanto’s exclusive agent for the domestic and international marketing and distribution of consumer Roundup^® herbicide products. Under the terms of the Marketing Agreement, the Company is entitled to receive an annual commission from Monsanto in consideration for the performance of the Company’s duties as agent. The Marketing Agreement also requires the Company to make annual payments to Monsanto as a contribution against the overall expenses of the consumer Roundup^® business.

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. As the first earnings threshold is typically not achieved until our second fiscal quarter, there is no gross commission income in the first quarter.

The annual contribution payment as defined in the Marketing Agreement is $20.0 million; however, portions of the annual contribution payments for the first three years of the Marketing Agreement were deferred. 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 to be appropriate. Factors considered in this determination included the likely term of the Marketing Agreement, the Company’s ability to terminate the Marketing Agreement without paying the deferred amounts, 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 were not terminated prior to 2018, unless significant earnings targets were exceeded.

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 then recent strong performance and other economic developments surrounding the consumer Roundup^®business, the Company concluded it probable that the deferred contribution payment that totaled $45.7 million as of July 2, 2005 would be paid. Since the recognition of this contingent obligation is for previously deferred contribution payments under the Marketing Agreement, 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 was recorded as a current liability at September 30, 2005.

Under the terms of the Marketing Agreement, the Company performs certain functions, primarily manufacturing conversion, selling

and marketing support costs, on behalf of Monsanto in the conduct of the consumer Roundup^®business. The actual costs incurred for these activities are charged to and reimbursed by Monsanto, for which the Company recognizes no gross profit or net income. Prior to the fourth quarter of fiscal 2005, these costs were recognized in the consolidated statements of operations on a net basis as a recovery of incurred costs. The Company records costs incurred under the Marketing Agreement for which the Company is the primary obligor on a gross basis, recognizing such costs in “Cost of sales” and the reimbursement of these costs in “Net sales,” with no effect on gross profit or net income. As disclosed in Note 22 — “Quarterly Consolidated Financial Information (Unaudited)” to the Consolidated Financial Statements included in the Company’s fiscal 2005 Annual Report on Form 10-K, net sales and cost of sales for the quarters in fiscal 2005 were revised to reflect this change. The related net sales and cost of sales were $10.0 million and $11.0 million for the three-month periods and $18.2 million and $20.7 million for the six-month periods ended April 1, 2006 and April 2, 2005, respectively.

Net sales also have been revised to reflect the net commission associated with the Marketing Agreement. Prior to the fourth quarter of fiscal 2005, the elements of net commission were reported as separate line items in the Condensed, Consolidated Statements of Operations. The following table displays elements of the Marketing Agreement included in “Net sales.”

FISCAL 2006 CHARGES

During the three and six month periods ended April 1, 2006, the Company recorded $1.1 million and $5.8 million, respectively, of restructuring and other charges relating to our profit improvement plan, consisting primarily of severance and related costs. In addition, an impairment charge of $1.0 million was recorded during the first quarter of fiscal 2006 for a tradename no longer in use in our United Kingdom business.

During the three and six month periods ended April 2, 2005, the Company recorded $1.0 million and $1.2 million, respectively, of impairment, restructuring and other charges relating primarily to Smith & Hawken^® integration related severance. An impairment charge of $22.0 million was recorded during the first quarter of fiscal 2005 related to tradenames within the United Kingdom consumer business.

The following is the detail of impairment, restructuring and other charges reported in the Condensed, Consolidated Statements of Operations:

The following is a roll forward of the restructuring and other charges accrued:

The restructuring activities to which these costs apply are expected to be largely completed in fiscal 2006.

The components of long-term debt as of April 1, 2006, April 2, 2005 and September 30, 2005 are as follows:

The components of other comprehensive income and total comprehensive income for the three and six month periods ended April 1, 2006 and April 2, 2005, are as follows:

The following summarizes the net periodic benefit cost for the various retirement and retiree medical plans sponsored by the Company:

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.

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 April 1, 2006, $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:

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.

On November 5, 2004, U.S. Horticultural Supply, Inc. (“Geiger”) filed suit against the Company in the U.S. District Court for the Eastern District of Pennsylvania. This complaint alleges that the Company conspired with another distributor, Griffin Greenhouse Supplies, Inc., to restrain trade in the horticultural products market, in violation of Sections 1 and 57 of the Sherman Antitrust Act. Geiger has not specified the amount of monetary damages it is seeking. A motion to dismiss the complaint has been filed and is pending.

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

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 consolidated financial statements. There can be no assurance that these cases, whether as a result of adverse outcomes or as a result of significant defense costs, will not have a material adverse effect on the Company’s financial condition or its results of operations.

The Company has pursued and continues to pursue insurance coverage for 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. We recovered a substantial portion of our past defense costs from one carrier during the second quarter of fiscal 2006 and that carrier has agreed to cover most of our defense costs in the future, subject to policy limits. Approximately $9.1 million has been recorded during the second quarter of fiscal 2006 and has been included in the “Selling, general and administrative” line of the Condensed, Consolidated Statement of Operations. The carrier also agreed to cover a portion of our future costs. We continue to pursue coverage from other carriers, although there can be no assurance as to the results of these efforts.

The Company is involved in other lawsuits and claims which arise in the normal course of business. These claims individually and in the aggregate are not expected to result in a material adverse effect on the Company’s results of operations, financial position or cash flows.

Effective October 3, 2005, the Company acquired all the outstanding shares of Rod McLellan Company for approximately $21.0 million in cash. Rod McLellan Company, a provider of soil and landscape products in the western U.S., operates three soil-manufacturing facilities in California and Oregon with approximately 100 employees. This business will be strategically integrated into our existing growing media business.

Effective November 18, 2005, the Company acquired all the outstanding shares of Gutwein, for approximately $77.0 million in cash. Gutwein’s annual revenues approximate $85.0 million in the growing wild bird food category. Gutwein’s Morning Song^® products are sold at leading mass retailers, grocery, pet and general merchandise stores. Gutwein has 140 employees and operates five production facilities. This is the Company’s first acquisition in this category, offering the opportunity to expand our share of the outdoor living market.

Preliminary purchase accounting allocations have been recorded for both Rod McLellan Company and Gutwein, including the allocation of the purchase price to assets acquired and liabilities assumed, based on their estimated fair values at the date of acquisitions. The Company expects to finalize purchase accounting for the acquisitions prior to the end of fiscal 2006.

On a pro forma basis, net sales for the three and six months ended April 2, 2005 would have been $841.9 million and $1,107.5 million, respectively (an increase of $28.5 million and $47.6 million, respectively) had the acquisitions of Rod McLellan Company and Gutwein occurred as of October 1, 2004. The pro forma reported net income would have increased by $2.2 million or 3 cents per diluted common share for both the three and six months ended April 2, 2005.

The Company is divided into the following segments — North America, Scotts LawnService^®, International, and Corporate & Other. This division of reportable segments is consistent with how the segments report to and are managed by senior management of the Company. The following table 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). Prior year amounts have been reclassified to conform with certain modifications to the Company’s reporting structure in fiscal 2006.

Segment operating income or loss represents earnings before amortization of intangible assets, interest and taxes, since this is the measure of profitability used by management. Accordingly, the Corporate & Other operating loss for the three and six month periods ended April 1, 2006 and April 2, 2005 includes unallocated corporate general and administrative expenses, and certain other income/expense items not allocated to the business segments.

Total assets reported for the Company’s operating segments include the intangible assets for the acquired businesses within those segments. Corporate & Other assets primarily include deferred financing and debt issuance costs, corporate intangible assets, deferred tax assets and Smith & Hawken^® assets.

The 6 5/8% Senior Subordinated Notes are general obligations of Scotts Miracle-Gro 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 Scotts Miracle-Gro. 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 unaudited information presents condensed, consolidating statements of operations and statements of cash flows for the three and six month periods ended April 1, 2006 and April 2, 2005 and condensed, consolidating balance sheets as of April 1, 2006, April 2, 2005, and September 30, 2005.