“Even with our leadership position and strong business model, we know we can and must improve further. The best way to do so is to act from a position of strength – not to wait for the marketplace to force us to change.”

  
 
 
Dear Shareholder,
 

Few companies have built what I call ‘an enduring franchise,’ an enterprise that continues to win in the marketplace by clearly owning the relationship with its consumers, leveraging its core strengths and continuing to distance itself from the competition. Our goal is to be one of those companies.

 

In fiscal 2005, ScottsMiracle-Gro took another significant step in this journey. As we move toward our goal to emerge as a leader in all areas of lawn and garden, we reported record sales and earnings despite the season’s late start. We also overcame significantly higher raw material prices and legal expenses as well as higher-than-expected costs related to compliance with Sarbanes-Oxley. In the face of those challenges, we also improved our U.S. market share another two points to 54 percent.

Along the way, we began to successfully integrate Smith & Hawken® into our organization while developing an aggressive strategy to succeed in the fast growing outdoor living category. We also announced our plans to enter the growing wild bird food category with the acquisition of Morning Song®, a leading brand in this $700 million industry.

Not only did we meet each of the challenges we faced in 2005, but we also took steps to streamline our organization, reduce our cost structure and improve our business practices as part of an initiative we called Project Excellence. As part of this initiative, we reduced the size of our senior management team by nearly 20 percent – forcing us to make difficult decisions and to say goodbye to some dear and trusted friends.

Few companies would have taken on such an effort during a time of strength and prosperity. But ScottsMiracle-Gro is not like most companies.

Even with our leadership position and strong business model, we know we can and must improve further. The best way to do so is to act from a position of strength – not to wait for the marketplace to force us to change. The landscape is littered with once great companies that failed to create an enduring franchise by not embracing change while at the top of their game. Maintaining the status quo for too long is nearly always a mistake – one we must avoid.

Instead, we must further improve our understanding of lawn and garden consumers and meet their needs regardless of how they interact with us. We must further invest in and leverage our competitive advantages – industry-leading brands, a powerful infrastructure and an unrivaled sales force. And we must set the performance standard even higher in all areas of our industry.

These goals are embodied in a simple, yet aggressive, strategy that we shared in last year’s annual report and again on the opening page of this report. It is a strategy defined by just three words: Gro, Excel, Win.

The year in review
Throughout 2005, we remained focused on this strategy as well as overcoming the challenges I outlined earlier. As a result, each of our business units posted strong results, allowing us to increase company-wide sales by nearly 12 percent to a record $2.4 billion. Excluding the first-year impact from the acquisition of Smith & Hawken®, sales were still a record and improved 5 percent.

Net income also continued to climb, improving 12 percent to a record $151 million on an adjusted basis. When including the impact of restructuring and other non-recurring charges, net income was flat on a year-over-year basis.

We are especially pleased that return on invested capital (ROIC) continued to improve and free cash flow exceeded our expectations.

When ScottsMiracle-Gro first began using ROIC as part of its incentive compensation program in 2002, the return was about 7 percent. For fiscal 2005, ROIC improved for the fourth straight year and now stands at 10 percent. We believe ROIC will improve again in 2006 as we remain focused on continued improvement of this metric.

  

Cash Flow = Flexibility
Strong levels of free cash flow remain a compelling aspect of our story. In fiscal 2005, the Company generated more than $175 million of free cash flow, giving us tremendous flexibility in managing our business. During the year, we spent nearly $75 million to acquire Smith & Hawken and continued to pay down our debt.

Going forward, we will continue to use free cash flow to fund growth and strengthen our balance sheet. But we also have begun returning money to shareholders. Last summer, our Board of Directors authorized ScottsMiracle-Gro to pay its first-ever dividend, which we are paying on a quarterly basis. And early in fiscal 2006, the Board authorized a five-year $500 million share repurchase program. Even with these initiatives, we believe we continue to maintain the flexibility to manage our business for long-term growth and continued success.

In an increasingly competitive and complex marketplace, we clearly are pleased with our results. Over the past several years, Wall Street has taken notice of our efforts and currently rewards us with a price-to-earnings ratio that is higher than the market average. To maintain this premium and further improve our valuation, we cannot be satisfied with the status quo.

As we look ahead to fiscal 2006, we expect organic earnings growth of about 10-12 percent. Also, our Project Excellence initiative is expected to improve pre-tax earnings by at least another $25 million. We expect to generate a similar amount of savings from this initiative that we will reinvest in our brands, while also strengthening our relationship with both the lawn and garden consumer and our retail partners.

All of our efforts tie back to our goal of building an enduring franchise. While this goal may be a lofty one, we are confident we can succeed. Our work will start with strengthening our relationship with consumers in each of the three channels in which they interact with us.

- We must continue to build upon the strengths of our core ‘do-it-yourself’ business and the industry leading brands – Scotts®, Miracle-Gro®, Ortho® and Roundup® – which we sell in traditional channels of retail.

- We must continue to improve upon our industry-leading customer service efforts at Scotts LawnService® as we build upon our No. 2 market position in the $4 billion ‘do-it-for-me’ service category.

- We must also leverage the potential of our newly acquired Smith & Hawken brand as we improve our stores and build upon the Internet and catalog businesses that are critical in our ‘direct-to-the-consumer’ efforts in the outdoor living category.

Throughout this annual report, we describe our efforts to improve our relationship with the consumer in each of our major business units to drive growth with an eye toward continued improvement in both free cash flow and return on invested capital.

Across the board, I have never felt more confident about our business and optimistic about our future. The merger of Scotts and Miracle-Gro in 1995 set in motion a series of events that reshaped the lawn and garden industry. Since then, our Company has emerged as the clear industry leader. Now we set our sights on much more.

I believe ScottsMiracle-Gro will continue to evolve – not just as the world’s greatest lawn and garden company – but as one of the great consumer products companies in any category. And, in the end, I believe ScottsMiracle-Gro will emerge as one of the few companies that can credibly say it has built an enduring franchise.

Sincerely,

James Hagedorn
Chief Executive Officer and
Chairman of the Board
The Scotts Miracle-Gro Company
December 14, 2005