Distribution Solutions Group, Inc. Q3 FY2021 Earnings Call

Good morning, ladies and gentlemen, and welcome to the Lawson Products Third Quarter 2021 Earnings Call. This call will be led by Michael DeCata, Lawson Products' President and Chief Executive Officer, along with Ron Knutson, Lawson Products' Chief Financial Officer. They will provide an update on the business and discuss relevant financial and operational information. Following their remarks, there will be a session for questions and answers. Please be aware that statements made during this call and in the press release may include forward-looking statements about goals, beliefs, expectations, strategies, plans, future operating results, and underlying assumptions, all of which are subject to risks and uncertainties that could lead to actual results differing significantly from those discussed. Additionally, the statements made during this call reflect the company's views as of today, and future developments may lead to changes in those perspectives. It's important to consider the information shared with this understanding. The company may choose to update the forward-looking statements made today, but it does not commit to doing so. This call is being audio simulcast on the Internet via the Lawson Products Investor Relations page on the company's website, lawsonproducts.com. A replay of the webcast will be available on the website until November 30, 2021. I will now hand the call over to Lawson Products' CEO, Mike DeCata.

Good morning. And thank you for joining the call. This morning I'll comment on the third quarter and share some thoughts about the state of the business. Additionally, I will update you on the final stages of the Partsmaster integration. I'll also discuss the growth initiatives that I mentioned in the second quarter earnings call. Lastly, I'll comment on the business environment, supply chain, and our competence in the future growth as our market continues to expand due to ongoing customer labor shortages. Ron Knutson, our CFO, will provide a more detailed review of our financial results followed by your questions. Before I begin my prepared remarks, I'd like to comment on our progress in evaluating the Schedule 13D amendment filed by Luther King Capital Management on May 17, 2021. While this process has taken longer than expected, the special committee of the Board is nearing the completion of their analysis. And we anticipate updating shareholders shortly. Beyond that, we will not be able to make any additional comments on the topic at this time. Overall, our consolidated business performed well, achieving significant sales growth over the third quarter of 2020. We benefited from the inclusion of Partsmaster as well as organic growth from Lawson core, including strategic accounts, Kent Automotive, and Bolt Supply. We're seeing broad-based recovery from last year's pandemic. However, ongoing supply chain disruptions and related shipping issues have slowed the overall pace of recovery. Our supply chain and sales teams are doing an extraordinary job managing in this environment. And we are confident that we will continue to improve performance while looking forward to returning to a more normal supply chain environment. However, our expectation is that these disruptions will continue at least to the first half of next year. On a consolidated basis, we achieved 16.9% sales growth as compared to the third quarter of 2020, including the Partsmaster acquisition, which closed on August 31, 2020. Excluding the Partsmaster acquisition, organic growth was 8.4% over the third quarter of 2020. Consolidated sales were $105.6 million. And Partsmaster generated sales of $13.6 million in the quarter. Partsmaster sales slowed during the quarter, primarily due to a broad slowdown in military sales combined with a 2-month slowdown in 2 of Partsmaster's large strategic accounts, one of which is tied to military. Both accounts have rebounded in September. And we are seeing good progress in the recovery. Military is also showing signs of recovery. Overall, we were very pleased with the Partsmaster integration and strategic fit with our existing business, and expect to realize significant additional benefits over the intermediate and long term. While supply chain disruption proved to be challenging, our supply chain team is making progress in managing through this. We're working to improve items in backorder, and we're adding new suppliers and using product substitution when necessary. The consolidated business achieved $9.4 million in adjusted EBITDA for an 8.9% adjusted EBITDA margin for the quarter. Our Lawson organic gross profit margin was 58.7% versus 57.2% in the second quarter of 2021, and 58.8% in the third quarter of 2020. Before the reclassification of service expenses into margin. Both the third quarter and the second quarter of 2021 were impacted by inventory reserves or write-downs of PPE items. While we were up against supply chain challenges, labor shortages, transportation and vendor cost inflation, I'm very pleased with these results. While supply chain challenges have not abated, our teams have made significant progress in managing through this environment, including passing cost increases along to customers. When we discuss supply chain challenges, it is important to include labor challenges. Lawson is not exempt from this. However, broad labor challenges are a very large driver of our service-intensive vendor-managed inventory value proposition and provides us with great opportunities. Customers find it necessary to outsource inventory management, which has long been a key aspect of our business model and a driver of our growth. One other aspect of VMI warrants discussion. Many people equate VMI solely to labor and inventory put-away. As we've stated previously, our service-intensive VMI includes put-away but also anticipates and manages the customer's future needs. This forward-thinking service value that our sales reps provide greatly differentiates Lawson from many others who refer to their service as VMI. Now I'd like to take a moment to discuss the integration of Partsmaster and Partsmaster quarterly performance. The integration of Partsmaster into the Lawson system is essentially complete. The last major stage of this process is fully transitioning to our new distribution center in Dallas, which will be completed by the end of the year. As I mentioned last quarter, this distribution center will house our military business, the Torrent parts washing system, and our cryogenically treated surface hardening process. With some final steps in the months ahead, Partsmaster is now integrated and extensive new product training is underway to fully utilize our expanded product offering. As I mentioned, a moment ago, Partsmaster sales for the third quarter softened due to the slowdown in military sales. Partsmaster core sales were flat for the quarter. And with the exception of 2 strategic accounts, which have begun to recover in September, strategic accounts portfolio showed modest growth. Our Bolt Supply business continues to perform very well, achieving a 13% EBITDA for the quarter and sales growing at over 12.5% from a year ago quarter, and nearly 2% over the second quarter of 2021. We continue to make investments in several distribution centers, including the Dallas DC that I just mentioned, a new and larger Calgary DC, as well as significant technology upgrades in Suwanee, Georgia and McCook, Illinois. All of these investments will add capacity and productivity to our physical infrastructure and provide us with significant expansion capability for growth. Now turning to sales. Customers have responded very well to price increases and are working with us to anticipate their future needs. Strategic accounts achieved growth for the fifth quarter in a row at 4% versus the second quarter, and 29% versus the third quarter of 2020. Our Kent Automotive business achieved nearly 7% growth versus the second quarter, and 18% as compared to the third quarter of 2020. We added 528 new strategic account locations on the Lawson side of the business, and 338 new Kent locations. Between the third quarter and the coming year, Kent will add several hundred new locations from new and existing auto body repair customers. These customers have specifically commented on their labor issues along with our operational excellence as the primary drivers of their decision to engage Kent. We're also making good progress expanding our integrated supply customer base, and recently added another large integrated supply partner to this segment. This customer segment continues to expand with several customers achieving all-time highs in sales this quarter. We're also winning a continued stream of new strategic accounts. Most recently we added an account in highway construction and another in recreational low-speed vehicles sales and service market. Sales in our government civilian segment were down as compared to the third quarter of 2020. This is attributed to lower September sales of PPE to the K through 12 market compared to 2020. In fact, we experienced PPE headwinds in all of our businesses. Our Lawson MRO business grew at 7.6%. However, excluding the impact of PPE, sales grew at over 10%. On our last earnings call I mentioned 3 areas that we're investing in to accelerate growth: developing additional channels to market in underserved markets, state, local, and educational, and the rollout of our newly acquired Torrent parts washing line of products. We've made good progress in all 3 areas. And we are confident that in 2022 these investments will show significant growth. In fact, I recently attended the American Rental Association conference in which many of our construction equipment rental customers attended. One of the products that received significant interest and customer enthusiasm was the Torrent parts washing system. Over the coming quarters, we'll be reporting on our progress in these areas. Our 3-part growth strategy remains unchanged: add sales reps, drive sales rep productivity, and make accretive acquisitions. Sales rep productivity remains a key focus area. We realized an 8.2% improvement in sales per rep per day versus the third quarter of 2020. Looking forward, I have never been more optimistic and confident in the Lawson strategy and our ability to profitably execute that strategy. The company has never been stronger, and our value proposition has never been more critical for our customers than it is now. Next year we celebrate our 70th anniversary. Over those 70 years we've seen many challenges, but I am 100% certain that Lawson is entering an extraordinary phase of our evolution. And I am equally confident that customers, suppliers, teammates, and shareholders will benefit from Lawson's success. Thank you to all of our team members for their commitment to driving this success. I look forward to all that we will accomplish. Now I'd like to turn it over to Ron for more detailed information on our financial performance.

Thank you, Mike. And good morning, everyone. I will start with some key takeaways for the quarter, and then we'll discuss some of the details. Keep in mind that we are now lapping the August 2020 acquisition of Partsmaster as we compare against the year-ago quarter. A few highlights for the quarter. First, consolidated sales improved by $15.3 million to $105.6 million, or nearly 17% over the third quarter of 2020 due to the inclusion of Partsmaster and continued recovery from the pandemic within Lawson and Bolt Supply. For the quarter, Partsmaster generated sales of $13.6 million. And excluding Partsmaster, organic average daily sales increased by 8.4% compared to a year ago. Second, our consolidated gross margin percentage improved to 53.1% versus 52.3% a year-ago quarter, and 51.3% in the second quarter despite the global supply chain issues in the marketplace. I'll talk more about this in a few minutes. Third, our reported operating income was $4.6 million for the quarter compared to $3.4 million in the second quarter of 2021, and $2 million a year ago. And our adjusted diluted EPS improved to $0.64 for the quarter. And fourth, our adjusted EBITDA was $9.4 million or 8.9% of sales, a sequential improvement over the $8.8 million or 8.3% reported for the second quarter. As we reflect on the third quarter, we have continued to drive our business forward. Sales continued to sequentially improve in the Lawson and Bolt business, as does our sales rep productivity. Within Partsmaster we did see a sequential decline in sales with the majority of that driven within weakness in the federal government business. Most product categories realized sequential increases over the second quarter. We continue to make great progress in this environment, and continue our focus on driving sales, gross margins, cost controls, and cash flows. We remain focused on supporting our customers in generating revenue in this environment while ensuring the safety of our teammates. As we near our 70th anniversary as an organization, our services, products, and expertise have become more critical to our customers, especially in light of the current and anticipated future labor shortages within many industries. As mentioned on previous calls, we are performing onsite visits to essentially all of our 70,000-plus VMI customers. Consolidated gross margins for the quarter came in at 53.1% compared to 52.3% a year ago and 51.3% last quarter. On a standalone basis before the classification of certain service-related costs within gross margin, the Lawson MRO margin was 58.7% in Q3 compared to 57.2% in Q2 and essentially flat with 58.8% a year-ago quarter. Both Q3 and Q2 MRO gross margin were burdened with additional inventory reserves associated with the write-down of PPE items, in which the current market value dropped below our cost. Excluding these reserves, our MRO gross margins for 2021 were 59.2% in Q3 and 57.8% for Q2. Let me state this a little differently. Despite all of the supply chain challenges that exist in the marketplace today and excluding the reserves for certain PPE items, our Lawson core gross margin percentage expanded by 140 basis points over Q2 of 2021 and 40 basis points over Q3 of 2020. Our gross margins are now more in line with Q1 of this year as many of the actions that we took became more concentrated in the latter half of the second quarter. In this challenging supply chain environment, we are laser-focused on growing our gross margin dollars and managing through the related inflation. Specific actions include, but are not limited to putting price increases in place where appropriate, identifying secondary sources of supply, including national-branded products, reallocating our labor resources to focus on fast-moving products to ensure we fill our customers' needs, and working closely with our suppliers to gain better insight on delivery times and cross-stocking certain products from McCook to our forward DCs when possible. While we're pleased with our overall gross margin percentages, our ability to get products has had a negative impact on our sales, customer backorders, and service level metrics. We're adjusting our actions to manage through these challenges. However, we expect that many of the broader base supply chain challenges may exist into the first half of 2022. For the quarter, total operating expenses were $51.4 million compared to $45.2 million a year ago and $51.2 million in the second quarter. This increase over a year ago was primarily due to the increase in sales, the inclusion of Partsmaster expense of $9.1 million post acquisition, reestablishment of temporary cost savings put in place a year ago during the pandemic which were partially offset by a $5.9 million reduction in the mark-to-market accounting for stock-based compensation. Expenses during this quarter also included $3.2 million related to the potential acquisitions, including the evaluation of the Luther King Capital Management proposal disclosed in a Schedule 13D amendment filed on May 17, 2021. Excluding nonrecurring items, adjusted operating expenses were up 1.9% compared to the second quarter of 2021, primarily driven by higher labor costs. Our reported operating income was $4.6 million for the quarter. On an adjusted basis, excluding nonrecurring items, non-GAAP operating income was $7.3 million for the quarter compared to $6.8 million in Q2 of 2021, and $7.7 million in the year-ago quarter. And adjusted EBITDA as a percent of sales improved to 8.9% for the quarter compared to 8.3% in the second quarter. On an adjusted basis, excluding stock-based compensation and other nonrecurring items, diluted EPS was $0.64 for the quarter versus $0.62 in the year-ago quarter and $0.60 in Q2 of 2021. Capital expenditures for the quarter were approximately $1.8 million, including work being performed to expand our Suwanee distribution capabilities. We expect total CapEx in 2021 to now be in the range of approximately $6 million to $6.5 million, including the planned upgrades to our Suwanee facility and some enhancements at McCook to allow for increased volume in the future. Additionally, we will be relocating our Calgary distribution center to a new location with expanded square footage in early 2022. As an organization, we continue to make investments in the business, in particular areas that have a direct impact on sales. While continuing to respect the uncertainties and unevenness of the pandemic recovery and the related supply chain challenges, we continue to generate sequential improvements with balancing our cost structure against our sales and margin trends. We ended the quarter in a net borrowing position of $3.2 million, inclusive of making the final $33 million payment for the Partsmaster acquisition in the second quarter, and increasing our working capital on higher sales this quarter. We ended the quarter with $87.4 million of availability under our $100 million committed credit facility, placing us in a great position to invest in the business and support future acquisitions. As Mike and I have both previously stated, we are managing through this challenging time with the expectation that we will come out of this environment in a stronger position than how we entered it. The integration of Partsmaster into the organization is largely behind us. And all sales reps are now utilizing Lawson's technology systems with the order fulfillment coming from the legacy Lawson distribution center network. Going forward, certain pieces of our government business will be fulfilled from a dedicated distribution center in Texas to comply with certain federal requirements. As with other companies, as Mike and I have both discussed, we have experienced inflationary costs due to the global supply chain disruptions. We are actively managing through these challenges as evidenced by our continued improvement in our results, including gross margins recovering to being more in line with our historical performance. Before I turn it over to the operator, let me thank the entire team. We've had significant activities taking place on many fronts, not to mention still managing through the pandemic and more recently the global supply chain challenges. The team continues to step up on every aspect of the business to make us stronger for our customers, our employees, and our shareholders. Thank you for your efforts and your never-ending commitment. I'll now turn it over to the operator for questions.

I want to start off just by asking about the supply chain issues and the hit to sales related to just a lack of product availability. If you've been able to dive in at all and kind of figure out how much of a headwind that actually is, where, you know, maybe the demand is there, but you just can't fulfill it. I don't know if that can be quantified or at least can you talk about it a little bit more qualitatively?

Yes. I'm sure we're going to both want to jump into this in various aspects. So what we're seeing is broad-based supply chain challenges that range from availability of product to slowdown because of labor, trucking, and so forth. What we've done to counter that is we worked with a broader set of suppliers to find alternate products that fulfill the customers' needs. In some cases, what we've done is product substitution. And again, working closely in partnership with the customer so that we fulfill the customers' needs, though it may not have been our or their first choice for a product, but it keeps them running. So there are several actions we've taken. And one of the challenges we see is normally for us, because of the nature of our value proposition, if there's a backorder the customer never experiences it because within the one week or technically ten-day calling cycle across all 90,000 customers, generally the backorder comes in such a short period of time that the customer never experiences the backorder. In this environment, backorders are longer and a larger number. So it is our belief that when backorders extend in length and become numerous, eventually it slows down demand. Supply can eventually work its way up to a demand problem. Now, the other challenge that we're all facing, I think everybody in the industry is facing is that while we're doing a very good job in servicing our customers, customers themselves are having labor challenges, raw material challenges unrelated to our vendor-managed inventory or MRO. So there are multiple dimensions that we're all dealing with on the supply chain and the customer's side. Our customers are experiencing the same thing. Now, one of the things that does help us with is our service-intensive vendor-managed inventory value proposition has always been about driving and maximizing productivity of our customers. And as you know, there's been an acute labor shortage of maintenance mechanics, diesel mechanics, truck drivers, and so forth for many years unrelated to the pandemic. So that's been the cornerstone of our value proposition. It's been incredibly intensified recently. And in fact, customers, in fact very large customers were picking up lots and lots of locations where customers call us and even noncustomers reach out and basically say help. And because of our core value proposition, we've been added so long, all of these challenges, well, they are real challenges, are ultimately helping us to cement our value proposition and cement our relationship with the existing customers. But we are certain now because we've seen enough evidence now that we're also drawing new customers into us that for whatever reason were insourcing, they're now turning to us to outsource because of the same challenges. Ron, did you want to?

Yes, in terms of the impact on sales, there are two components. Mike briefly mentioned one aspect. Firstly, we have observed an increase in our backorders. If we look at our backorders from the end of June to the end of September, we know their value is approximately a 1% headwind on our sales. However, this figure does not account for what Mike mentioned regarding backordered items; customers may choose not to reorder. Therefore, we've likely lost some of the recurring orders that would typically happen with those backorders. While we can measure at least a 1% increase due to actual backorders, the impact on missed replenishments is likely greater than that.

Okay. That's all very helpful commentary. Yes, I thought you did a nice job improving the gross margin sequentially in the Lawson MRO business. Can we attribute that mostly a price increase? And do you feel like you're going to have to implement more price increases in the coming quarters here given that the supply chain challenges you mentioned continuing at least through the first half of next year?

Yes, Kevin, this is Ron. So we did see a lift that helped us from a pricing perspective given some of those actions taking place later in the second quarter. So we got the third quarter kind of full benefit of that. But I think it's a combination also, right? It's also what we're doing in the distribution centers to manage our labor. It's getting better insight into when products are coming into our McCook facility. It is trying to cross-stock more items to get those products out to the forward DC. So certainly pricing helped. But we've also seen improvements in just logistically what we're doing given some of the actions that we've taken within the DCs. In terms of price increases in the future, tough question to answer specifically. What I would say is that we are going to continue to monitor the inflationary environment. And if we see cost increases continue to come through, whether or not that's in transportation or within our landed cost from our suppliers, then we'll take the necessary actions to protect our margins. So we're monitoring it very, very closely, as you could see from some of the improvements that took place here in the third quarter.

Kevin, just to add an additional data point. During the third quarter, there was a point where in our largest distribution center we had 27 job openings. And the effect of that was struggling all week to catch up and get the orders out, which also meant working on weekends, paying overtime, and the inefficiencies of transportation. At this point we have fewer than 5 openings in that same distribution center. So you would expect fewer overtime hours and lower labor costs because of the efficiency of the labor we have. So a lot has happened in our ability to navigate and manage through a difficult challenge. So we feel like we're getting ahead of it, both on the cost of goods sold and our ability to successfully pass those cost increases along. And as well our ability to manage our own internal costs because of labor pressures that we feel like we're getting ahead of in the DCs.

That's encouraging to hear. This might be a challenging question to address, but considering the steps you've taken to enhance gross margin recently, do you believe you can maintain the current gross margin moving forward, or will you be able to implement additional strategies in the future to sustain it as we progress?

Yes, Kevin, you're correct that this situation is very fluid. We've consistently stated that our price increases are linked to cost increases. We believe that our value proposition is appreciated by our customers, who are willing to pay for it. For many years, we have maintained a stable gross margin. Predicting how this will evolve in the coming quarters and next year is challenging. Supply chain issues could become more difficult, or we might finally see some relief with containers and trucking. We believe we have a solid strategy in place to sustain our margin. As we continue to grow our strategic accounts, margin percentage becomes important, but it's ultimately about the dollar amounts we take to the grocery store rather than just the percentages. Therefore, we tend to prioritize increasing margin dollars over only focusing on margin percentages. This approach is especially significant as our strategic account business and large Kent business expand. We've achieved remarkable success this quarter with Kent, attracting several high-profile accounts that are increasing their new locations, both in new accounts and in deeper penetration of existing accounts. The same is true for our strategic accounts, as we are gaining new integrated supply customers. Partnering with these integrated supply companies not only strengthens our relationships but also introduces us to numerous large factories. This partnership has a significant amplifying effect, and we are currently collaborating with a large number of integrated suppliers. In conclusion, margin dollars hold equal importance to margin percentage.

Right. No, understood. That makes sense. Can you just also, following up on that, just maybe talk a little bit more on what's contributing to that momentum in adding new strategic account locations and new strategic account customers?

We've been in this industry for 70 years. Our extensive supply chain and the sales representatives we have allow us to serve almost anywhere in the U.S. and Canada, which is very appealing to our integrated supply strategic accounts. Interestingly, three or four long-term Kent customers approached us from a region where we previously had no presence. They identified that they were not receiving adequate service from a competitor and invited us to join them, bringing us into several hundred locations. In addition, we had opportunities with several companies that were not previous customers. In each instance, they highlighted our operational excellence and our strong reputation, even among those new to our services. They mentioned challenges with their internal labor demographics. Recently, at the American Rental Association conference in Las Vegas, a potential customer approached us and expressed a need for assistance, saying they were struggling to keep their operations running. That kind of feedback is very encouraging. I believe our market is growing. Although it's a large and fragmented market, a significant number of people purchase through customer-managed inventory. However, this trend is shifting rapidly toward outsourcing, which I believe will allow us to capture a larger share of new business due to our operational excellence and coverage. We're already starting to see this, and I look forward to providing more detailed information for our investors in future calls.

Okay. Great. I have a couple more quick questions about the numbers. Ron, can you share the trend in monthly consolidated average daily sales as we progressed through the third quarter and what you've observed in October?

Sure. So I can give those to you, Kevin. So on a consolidated basis, I'll give it to you in ADS: $1.611 million in July, $1.623 million in August, and $1.716 million in the month of September. So all in for the quarter we ended at $1.650 million. What I would say relative to what we've seen here for the first couple of weeks of October is kind of up slightly, I would say up slightly versus that $1.650 million for the third quarter. Pieces of our business are continuing to move right along. So again, no major changes, I would say, from what we saw in the third quarter.

All right. Lastly, will we experience fewer challenges from the PPE sector in the fourth quarter or as we transition into 2022?

Yes, we are experiencing some challenges. Mike pointed this out, and it's worth reiterating that in the third quarter, we faced headwinds regarding PPE items. If we focus solely on the Lawson legacy business, as Mike mentioned, we saw a 7.6% increase. When excluding PPE, the growth was over 10%. This reflects significant challenges compared to the same quarter last year. Looking ahead to the fourth quarter, we will still encounter some headwinds, but not to the same extent. In fact, fourth-quarter PPE sales averaged about $1.2 million per month, and our current trend is around that figure. So, it's clear that the impact is not as pronounced as we experienced in the third quarter.

We have no questions in queue. This concludes our question-and-answer session. I would like to turn the conference back over to Mike DeCata for any closing remarks.

Thank you. Thank you. And thank you for joining the call today. Labor and productivity pressures are intensifying on our customers and the market in general. Lawson's long-standing and well-established service-intensive vendor-managed inventory model anticipates customers' future needs and enables customers to maximize their machine time utilization. I believe the market is taking notice, and we have potential customers reaching out to us more than ever before. Our operational excellence, geographic coverage, expanded product offering, and nearly 70 years of experience are being brought to bear on this challenging environment. And we're experiencing strong market demand for our products and our services. Our investment in people, processes, and our analytical orientation are enabling us to navigate through difficult waters and further differentiate ourselves from our competition. I believe that this environment, we'll succeed in converting customers and as well showing that Lawson is a resilient, innovative and committed practitioner of service-intensive vendor-managed inventory and a trusted partner to 90,000 customers. Thank you to our extraordinary teammates, customers, and suppliers, your actions and commitment are critical, a critical component in restoring our economy to the growth we all expect. Thank you, and I look forward to speaking with you on the next call. Have a wonderful day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.