Earnings Call Transcript - DSGR Q4 2022

Operator, Operator

Greetings. Welcome to the Distribution Solutions Group Fourth Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. A questions-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference to your host, Steven Hooser. You may begin.

Steven Hooser, Host

Good morning, ladies and gentlemen, and welcome to the Distribution Solutions Group fourth quarter and full year 2022 earnings call. In conjunction with today's call, we have provided a Q4 earnings presentation that has been posted on the company's IR website at investor.distributionsolutionsgroup.com. Joining me for today's call are Bryan King, DSG's Chief Executive Officer and Chairman; and Ron Knutson, DSG's Executive Vice President and Chief Financial Officer. During the call, they will be providing an update on the business from an operational and financial perspective. Additionally, Brad Wallace, LKCM-Headwater Partner and DSG Advisor as well as operating company CEOs, Cesar Lanuza, Russ Frazee, and Bob Connors will be joining for the Q&A session. Please note that statements on this call and in the press release contain forward-looking statements concerning goals, beliefs, expectations, strategies, plans, and future operating results and underlying assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from those described. In addition, statements made during this call are based on the company's views as of today. The company anticipates that future developments may cause those views to change. And we may elect to update the forward-looking statements made today but disclaims any obligation to do so. Management will also refer to non-GAAP measures and reconciliations to the nearest GAAP measures that can be found at the end of the earnings release. The earnings press release issued earlier today is posted on the Investor Relations section of our website. A copy of the release has also been included in a current report on Form 8-K filed with the SEC. This call is being audio webcast on the Internet via a Distribution Solutions Group Investor Relations page on the company's website. A replay of this teleconference will be available through March 23, 2022. With that, I'd like to turn the call over to Bryan King. Bryan?

Bryan King, CEO

Thank you, Steven. And good morning, everyone. It is a pleasure to be with you. Today Distribution Solutions Group delivered exceptional performance in 2022, which we believe demonstrates the power of our strategic transformation from a standalone MRO business at Lawson Products to a leading multiplatform specialty distribution solutions company with the scale and leadership to drive sustainable growth. We achieved sales records in 2022, enhanced margins, and expanded profitability while reducing our net debt leverage ratio, creating more firepower for reinvestment in the business and M&A. In addition, we attained our adjusted EBITDA margin target during the second half of 2022 and most recently during the fourth quarter, we delivered strong double-digit organic sales growth that beat expectations, realizing an adjusted EBITDA margin of 10.3% on fewer selling days. In January and February, our business momentum continues. I believe our companies will continue to take market share, deliver margin expansion, and generate meaningful free cash flow to support DSG's capital allocation priorities in 2023. Although we are closely monitoring the macroeconomic environment and customer demand, we remain bullish about our business prospects for 2023. Turning to Slide 4 in the earnings presentation, I am pleased to report that full year GAAP revenue for the company totaled $1.15 billion, and we generated adjusted EBITDA of $123 million. We believe that our scale and breadth of products and services are competitive advantages in the specialty industrial distribution industry. Although the fourth quarter is traditionally impacted by seasonality and fewer sales days, our revenues grew by 42%, which included a strong comparable organic expansion of 17%. While price contributed to this increase, we also realized organic sales wins in 2022 on momentum from growing wallet share, volume increases, and cross-selling among the three businesses. Ron will discuss more on pricing in a few moments. Our teams have identified an increasing number of leads based on cross-selling and the potential for expanded relationships and wallet share expansion for many of our largest strategic customers. We believe that leveraging strong customer relationships positions us for continued strong organic growth in each of our three businesses. Additionally, we successfully completed five acquisitions in 2022. These acquisitions produced annualized 2022 revenues of about $204 million and annualized adjusted EBITDA of an incremental $21 million. These acquisitions were acquired for a collective 7.7 times EBITDA multiple, and through our internal initiatives, we have improved the contribution of these acquisitions, reducing the multiple to the low sixes based on 2022 adjusted EBITDA. Between our three dedicated corporate development professionals at the DSG level, our operating teams, and the LKCM Headwater team, we are actively pursuing acquisitions that enhance DSG as a better business and are keenly focused on successful integrations after we close. In our pursuit of strategic acquisitions, we not only seek fit within each of our operating companies but also aim to find opportunities that possess commercial logic for all three business units, bringing them closer together while enhancing each of their organic growth rates and returns on working capital investment. We remain cautiously optimistic in our 2023 outlook and continue to be confident about our ability to manage through cycles for significant value creation. 2023 has started strong as the levers we are pulling are unlocking value. We continue to build out our roadmap for initiatives to create a stronger, more enduring business without losing the advantages of three separate customer-facing efforts and operating teams that manage discrete channels to market. Our commitment to a disciplined working capital investment framework is beneficial for our vendors and our customers who want us to grow alongside them.

Ron Knutson, CFO

Thank you, Bryan, and good morning, everyone. Turning to Slide 5. We're excited this morning to share with you the fourth quarter results of Distribution Solutions Group. Let me remind you that given the reverse merger accounting treatment, Lawson Products is only in the year-to-date GAAP numbers subsequent to the April 1, 2022 merger date. All three companies are included for the fourth quarter GAAP results. For ease of comparing the results, the slides that we're utilizing this morning are adjusted for the pre-merger activity of Lawson Products. Let me summarize Q4 results. On a combined basis, we reported strong top-line and bottom-line results across the three principal operating companies. As Bryan mentioned, we reported total sales growth of 42%, with organic sales growth of nearly 17% through both price and volume. In 2022 we closed on five acquisitions with an annualized 2022 revenue run rate of $204 million and higher EBITDA of $21 million. Broadly, the product demand remains strong. However, we are cautious given some of the macroeconomic indicators. Now, let's talk through some of the numbers on a combined basis. First, consolidated sales for Q4 were $328.9 million. This represents an increase of 155% on a GAAP basis driven by the inclusion of Lawson Products commencing on April 1, organic growth of the businesses, and acquisitions made by both Gexpro Services and TestEquity in 2021 and 2022. With the inclusion of Lawson from a comparative basis, sales increased 42%, or $97.6 million, over the fourth quarter of 2021, with approximately $60 million coming from acquisitions and organic growth of 16.7%. Second, reported GAAP operating income was $12.7 million, compared to a loss of $1.8 million a year ago quarter. On an adjusted basis, factoring in merger-related costs, stock-based compensation, severance, and other nonrecurring items, adjusted EBITDA improved by $16.3 million to $34 million, or 10.3% of sales, exceeding our previously stated goal of exiting 2022 at 10%. Third, diluted loss per share was $0.10 for the fourth quarter. However, on an adjusted basis, diluted EPS was $0.25 for the fourth quarter of 2022 versus $0.15 for the year-ago quarter. Before I comment on the individual companies on a year-to-date basis, we feel really good about how our full-year results progressed as the year developed. On an adjusted basis, including Lawson for the pre-merger activity, sales increased 35% and adjusted EBITDA grew to $123 million, an increase of $48 million or 64%.

Bryan King, CEO

Thank you, Ron. Turning now to Slide 13. Our business combination was built to outperform, and we are pleased with our strong performance in 2022 in what remains a complex operating environment. Our fourth quarter efforts resulted in organic and inorganic growth of 42% compared to last year's quarter, and our margin-enhancing efforts have resulted in combined adjusted EBITDA margins of over 10%. All three operating companies performed at or above our expectations last year. Our combined platform has proven scalable, and our high-performing collaborative teams are capitalizing on our unique and diverse channels to market, products, and solutions. Since the transaction last year, we have fully aligned senior management compensation with shareholders through pay-for-performance plans in 2023. These compensation plans link our sales teams to ambitious cross-selling goals for strategic or large accounts. Key professionals at LKCM Headwater continue to support each operating company and major initiative with additional resources without management fees, pulling in trusted operating partner relationships and service provider resources that we have used consistently over the last two decades to assist us in other industrial distribution efforts. This analytical and operational support in collaboration with the talented operating teams is fully aligned with investors to capture market share, improve financial and operational performance, generate cash, and create long-term shareholder value. In 2023, we are prudently executing against our capital allocation strategy by analyzing the best long-term methods to drive shareholder returns with our collective resources by assessing investment opportunities in our core businesses, paying down debt with free cash flow, selectively buying back our stock, and investing in highly strategic and accretive acquisitions that add economic value, commercial durability, and accelerated organic growth to our platform. We will continue to be disciplined with our capital investments, prioritizing the highest growth opportunities that strengthen our businesses and deliver exceptional returns for our shareholders. Lastly, DSG is a leading multi-platform specialty distribution solutions company, providing high-touch value-added distribution solutions for the MRO, OEM, and industrial technologies markets. With a combined addressable market of $57 billion dollars, these asset-light businesses offer customers replenishable industrial parts and products as well as specialized products. In addition, we also offer managed solutions for companies that have decided to outsource labor and supplies with secure supply chain management. We believe that our unique, solution-oriented approaches are competitively advantageous, and resiliently compelling to customers, colleagues, and manufacturers alike. Thank you for your time today. And now we would like to open up the line for investor questions.

Operator, Operator

Certainly. Your first question for today is coming from Ken Newman at KeyBanc.

Ken Newman, Analyst

Hey, good morning, guys.

Bryan King, CEO

Good morning, Ken.

Ron Knutson, CFO

Good morning, Ken.

Ken Newman, Analyst

For my first question, sorry if I missed this Ron, but did you quantify how demand has trended in January and February, just both on a consolidated basis and across the segments?

Ron Knutson, CFO

No, Ken, we did not give specific numbers other than just indicating that it's outperforming our internal plans. I would just say that the growth that we saw in Q4 really continued into January and February, but we've not identified specifically a percentage in terms of the increase over the prior year in the first couple of months. But I will say, I think across all three companies, we feel really good about the start that we've had here in the first eight weeks of the year, and we're excited to jump off to a really strong start here for the year.

Ken Newman, Analyst

Got it. I guess the next question kind of piggybacks off of that, is maybe just a little bit of color on what customer conversations are like across the three businesses. I'm curious, are customers coming to you with higher inventory needs or are they destocking within the Lawson business where are you seeing customer backlogs growing across the other two businesses? Any color there would be helpful.

Ron Knutson, CFO

Yes. Sure, I can — Bryan, you can start on that.

Bryan King, CEO

Ron, you can start, and we may pull Russ and Bob and Cesar into commenting as well. So from an overall customer perspective, I would say generally speaking, across the three companies, we've not necessarily seen a destocking taking place. I would say that within all three businesses, again, we feel good about the start of the year. I would say that from a pricing perspective, we're probably feeling a little bit of pushback on some of our larger customers. But generally, I would say overall, from a DSG perspective, those conversations are still going very well. All three companies are seeing some vendor cost increases continue to come through, and we've been, I would say, very successful in being able to manage through that both in 2022 and here early in 2023. So I don't know if Russ or Bob or Cesar want to jump in relative to any customer feedback around stocking levels, but I'll open it up to them.

Cesar Lanuza, CEO

Sure, Bryan. Hi, Ken, this is Cesar speaking. When we go across the different segments that we serve, and as you know, we manage about a little over 80,000 customers, different sizes, different market segments. We continue to see the need to fill up the beans and the cabinets and their inventories to keep their lights and parts moving around. Like Bryan said, this is a short-cycle business and we're not so far within the first eight weeks of the year. We continue to see the same momentum that we saw from the fourth quarter. We continue to be cautiously optimistic about the investments that we're doing and growing the business both within our current customer base and also capturing new customers. So, like I said, we continue to see within the short cycle of customers requiring our products. And as you know, this through our vendor-managed inventory, which makes up a big chunk of our revenue, we basically become an extension of our customers in this tight labor market. We're there for them every day.

Bryan King, CEO

So, said another way, we're seeing and feeling still volume, some volume growth there not saying destocking at all in the short cycle. Bob, why don't you give the longest of the long cycle? Russ is in between the two on the OEM front. Bob can we hear you?

Bob Connors, CEO

Sorry guys. Yes. Ron can I go back to — Bryan? I'm in Admiral's Club. I would say that in 2022, we saw five or six verticals growing double digits with renewables lagging and then five of five acquisitions growing double digits. So we still have tailwinds coming over into 2023. I would say that we're starting to see a pickup in backlog with renewables. We're seeing more and more customers are looking for supply rationalizations, and they're looking for us to expand the product line and capabilities to better support the growth, for instance, in renewables. AMD has been very strong and it's continuing to build and grow. Our largest verticals, industrial power and renewables, are starting to show some promising tailwinds, and we'll navigate through any headwinds that come with a slowdown in transportation and CNI technology, as Bryan communicated earlier.

Russ Frazee, CEO

I can comment briefly. This is Russ with TestEquity. Our short-cycle business continues to perform as it did last year. We still see growth in our VMI business. The longer cycle capital expenditures are still there. Those budgets from our customers, the cycle is a little bit longer getting those approved this year, but we still see that business there.

Ken Newman, Analyst

Perfect. That's a really good color across everybody. I appreciate that. Maybe one more before I pass it on. Bryan, you talked about prudent capital allocation and disciplined M&A in the heightened macro uncertainty. That said, you're still at the bottom of your targeted net leverage range. I just want to clarify, should we take those comments to mean that M&A is still the highest priority for capital allocation? And if so, just maybe provide some color on how active the pipeline is today in terms of deal sizes and multiples and whether you see higher rates materially impacting your ability to close deals this year?

Bryan King, CEO

Yes, I appreciate that question, and I know it's probably on everybody's mind. We are at the lower end of our target range. The team that we've got working on opportunities. I'd say that when we allocate and I frame up the capital allocation objectives that we've got and how we're looking at it, there's no doubt about it; we view investing in our organic growth opportunities as our top priority. It's got the highest incremental returns on invested capital. It's got the most amplified impact on shareholder value creation. But having said that, when we look at our M&A opportunities, we're being very selective. We do have a very strong robust pipeline right now that we're working through; some things that we thought we might be able to pull to the table within the end of last year. We didn't get done by the end of the year, and we're still working through trying to ensure that they're the right fits. They must not only have significant financial accretion to compete with the financial accretion we would expect on the organic side or other capital allocation opportunities like buying back shares or paying down debt, but they also need to demonstrate strong commercial logic. That's a core framework we push hard on with both our M&A team and our three management team leads across each of the verticals. If they're bringing something to the table, we want to see it being super accretive to Bob's Gexpro Services business, for instance. We want to ensure there is an opportunity to drive his organic growth rate higher. But we also want to maintain a constructive lens on what this will do for Cesar and Russ. What we have found is that the areas we are most focused on right now are largely ones that are going to significantly enhance the long-term organic growth rate and the ability to accelerate shareholder value creation for the platforms. There are ongoing discussions that we expect will result in some real accretive moves for the platform, and we are excited. The teams are demonstrating that the value of the platform and the initiatives we have to unlock value is real, providing further confidence in our ability to selectively add to that narrative with the targeted opportunities we previously identified. Interestingly, several items we are working on were objectives we sought out several years ago, which we can now pursue thanks to the consummation of the DSG platform, and we're close to getting those secured.

Ken Newman, Analyst

That's solid color. I appreciate that help.

Kevin Steinke, Analyst

Good morning, everyone.

Bryan King, CEO

Good morning, Kevin.

Ron Knutson, CFO

Good morning, Kevin.

Kevin Steinke, Analyst

I want to start off by asking about the sequential strength in adjusted EBITDA margin that you saw, particularly in the Lawson and TestEquity businesses. You had nice sequential increases in margin despite fewer selling days in those businesses as you called out. Any thoughts on what enabled those businesses or the company overall to achieve that nice sequential margin expansion? Was there anything kind of one-time in there, or what would you maybe kind of attribute that to?

Ron Knutson, CFO

Yes, Kevin, this is Ron. So I'll jump in on that. I would say no real one-time items. I think it really was just a continuation of the growth that we saw throughout 2022, and all three companies are certainly managing operating expenses closely. We're seeing certainly some lifts from the acquisitions that were made earlier in the year as well as in 2021 and then also a keen focus on margin percentage; commercial margin, and product margin. So, no, I really wouldn't say I mean we were very pleased with the 10.3% that we posted for the fourth quarter, but there weren't any major one-time items in there that were a benefit.

Kevin Steinke, Analyst

Okay, great. It just sounds like really solid operating performance then. Okay. I also wanted to ask about your organic growth drivers for the long term. You mentioned continued increases in wallet share and increasing cross-sell leads. Maybe just give us a little bit more color or any metrics around where you see the cross-selling coming from or wallet share expansion coming from or initiatives that you're working on to really ramp up those growth drivers?

Bryan King, CEO

Kevin, let me just touch on it first and then we will pass it off to the rest of the team. But when we were on a quarterly call, I think the last quarterly call maybe we alluded to the fact that we'd had kind of a consolidated initiatives forum in Chicago in August where we got a number of the sales leadership of each of the businesses and our operations kind of team that was working through synergies and both commercial synergies as well as cost savings. All that's continuing to unfold and accelerate as we've continued to expand engagement between the businesses, which is enhancing our sales momentum. Our sales engagement is notably energizing, and we've doubled the number of specific leads we have compared to last quarter. We discussed earlier about 80 or 100 leads; that's expanded significantly. We expect that momentum to continue. The longer lead time or longer selling cycles are real, but they bring larger dollars. For instance, with Gexpro Services and their relationships where they're embedded in customer accounts. Those customers eagerly seek capabilities from Lawson or TestEquity, but the lead time for larger customers often takes longer. We're achieving greater SKU congruence throughout our digital efforts, driving organic growth that we are enjoying and exploring initiatives to consolidate our operational strengths without distracting from the individual business momentum. Anyone else want to add color to that?

Bob Connors, CEO

Yes, Bryan. What I would say is a couple of things. First, the collaboration in terms of the cross-selling between Gexpro Services, Lawson, and TestEquity is really starting to gain momentum. We track the business development pipeline that’s evolving and expanding on a weekly basis to see where we need to add resources and support to help close opportunities. The receptiveness of customers has been the most impressive. Gexpro Services does very well at supply chain management solutions, but we hear customers want us to expand into MRO, and they are eager for us to further broaden the TNM product line. It's more efficient to plug and play rather than assign resources individually. The positive feedback from customers has been tremendous. Notably, we have recently won a significant renewable project with an OEM; the diverse strengths of having four businesses together enabled us to secure that initiative due to our domestic manufacturing capabilities along with a diversified supply chain.

Kevin Steinke, Analyst

All right, great. Well, that’s all very helpful color. I appreciate that. I did want to ask Ron if you called out the percentage contribution to the organic growth in the quarter from price on a consolidated basis?

Ron Knutson, CFO

Yes. From an all-in basis, Kevin, our organic growth increased 16.7% for the quarter. If you look across the three companies: price, Lawson was about 4%, Gexpro Services about 5%, and TestEquity close to the 7%. So about five of the total organic growth was price related, with the remaining percentage coming from volume and mix.

Kevin Steinke, Analyst

All right, that’s great. I mean, that contribution from price is, I think, down a bit from the last couple of quarters, implying maybe some increase in volume growth. It sounded like you may have implemented some more price increases early in 2023, but I assume maybe not at the same level as we saw in 2022.

Ron Knutson, CFO

Yes, I think that's a fair comment. Certainly, '23 also benefits a little from carryover from actions taken in '22. The specifics vary among the three organizations, but we're still seeing some lift based on the actions in ’22. Specifically, Lawson did have an action at the beginning of the year as well.

Bryan King, CEO

Yes, I wouldn’t say there's any specific time period where we face a hard lapse of pricier comparisons. The actions taken throughout 2022 were consistent and spread across the entire year, so we haven't set a definitive date that indicates tougher comparisons. I believe all three companies were proactive throughout 2022 in managing their overall margins. Thus, we aren't seeing a concern of a significant tough comparison hanging over us heading into 2023.

Bob Connors, CEO

Yes. Moreover, we are continuing to focus on real pricing discipline efforts beyond just inflation. We are assessing our standing in relation to peer pricing in the market and adjusting accordingly to remain competitive while considering our supply chain and cost structures. This will add to our margin consistency over time, and I believe we're doing a commendable job managing these efforts despite the complexities that arise around contract and dynamic pricing discussions with large savvy customers.

Kevin Steinke, Analyst

Okay, that’s great to hear. That’s all I had. I’ll turn it back over. Thanks for taking the questions.

Bryan King, CEO

Thanks, Kevin.

Operator, Operator

Your next question for today is a follow-up question coming from Ken Newman. Ken, your line is live.

Ken Newman, Analyst

Hey, thanks for squeezing me in for just one quick follow-up. Bryan, a year ago we talked about getting above that 10% EBITDA margin run rate, which obviously you did here at the end of 2022. But I think we also talked about targeting 20% to 25% EBITDA flow through for the combined businesses. That's obviously been a bit lower this year, just given the moving pieces on the macro. Curious, I mean do you think you can get back to that operating leverage target this year? Or is it still too tough just given all the volatility in the operating environment?

Bryan King, CEO

Well, it's a great question, and I thought where you were going was not only the operating leverage or flow-through but ultimately where do we think we're heading on EBITDA margin. I know that's where we're all headed. And I would say that it's different for each of the businesses. As we can see right now, we're still working through many different value-unlocking initiatives. We have numerous opportunities, and several of those will require ongoing investments in the business today. While I presently have a lot of confidence that our investments will yield favorable operating leverage, they may cause fluctuations in terms of contribution margin, generating some variability in performance. Lawson, for instance, is currently facing this. First of all, Lawson is where we're investing a lot. It has been the major contributor to the operating leverage in our platform. Therefore, most analytical perspectives we have on our discussions focus on Lawson's contributions to operational efficiency. We know Lawson is a gem, and we are actively working to drive organic growth and improve performance. However, we also know that a significant part of our initiatives require investments that may take some time to yield results, consequently creating additional noise in terms of our expected margin contributions this year.

Ron Knutson, CFO

Yes, Bryan, I would just add that, Ken, when we look at the growth of the adjusted EBITDA, our organic growth last quarter contributed about 23% of the growth, while about $8.6 million of that growth was organic. We felt we were squarely in the middle of our guidance for that operating leverage on a consolidated basis.

Bryan King, CEO

Thank you for the questions today. We appreciate your interest in DSG. I would like to express gratitude to the leadership of our management team and all of our colleagues out in the field. We've enjoyed a great first eleven months together, and our momentum continues to inspire confidence and enthusiasm regarding our business integration. This strengthens our collaborative position and provides a robust platform for growth and increased shareholder value. Thank you very much, and we look forward to any follow-up discussions or calls. Please don’t hesitate to reach out; we are eager to engage.

Operator, Operator

This concludes today's conference call, and you may disconnect your lines at this time. Thank you for your participation.