Hillman Solutions Corp. Q2 FY2022 Earnings Call

Good morning, and welcome to the Second Quarter 2022 Results Presentation for Hillman Solutions Corp. My name is Shannon, and I’ll be your conference call operator today. Before we begin, I would like to remind our listeners that today’s presentation is being recorded and simultaneously webcast, the company’s earnings release presentation and 10Q were issued this morning. These documents and a replay of today’s presentation can be accessed on Hillman’s investor relations website. I would now like to turn the call over to Michael Koehler with Hillman.

Thank you, Shannon. Good morning, everyone. And thank you for joining us. I am Michael Koehler, Vice President of Investor Relations and Treasury. Joining me on today’s call are Doug Cahill, our Chairman, President, and Chief Executive Officer; and Rocky Kraft, our Chief Financial Officer. We will begin today’s call with a business update and quarterly highlights from Doug, followed by a financial review of the quarter and a guidance update from Rocky. Before we begin, I would like to remind our audience that certain statements made in today’s call may be considered forward-looking and are subject to the safe harbor provisions of applicable securities laws. These forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties, assumptions, and other factors, many of which are beyond the company’s control and may cause actual results to differ materially from those projected in such statements. Some of the factors that could influence our results are contained in our periodic and annual reports, filed with the SEC. For more information regarding these risks and uncertainties, please see slide 2 in our earnings call slide presentation. In addition to today’s call, we will refer to certain Non-GAAP financial measures. Information regarding our use of, and reconciliations of these measures to our GAAP results are available in our earnings call slide presentation. With that, it is my pleasure to turn the call over to our Chairman, President, and CEO, Doug Cahill.

Thanks, Michael. Good morning, everyone. Today I’m going to provide an overview of our strong second quarter results, give an update on our position moving forward, and discuss the current operating environment before I turn it to Rocky to talk numbers. Before we dive in, I’d like to give you a quick overview of Hillman and our differentiated service model, especially for those of you who are new to our story. We’re the largest provider of hardware products and solutions in our categories in North America. Our unique approach to sourcing, distribution, and service sets us apart from our competition. We win with our customers because we design, source innovative products, and execute inventory and merchandising solutions for complex categories. Not only are these must-have high-margin categories for our customers, but we help solve difficult problems with them like labor shortages and logistical challenges. We had a strong quarter driven by the hard-working team in Hillman and our differentiated service model. Our 1,100 member sales and service team is an important part of our competitive moat and I’ll discuss it in a moment. During the second quarter of 2022, we generated $62.3 million of adjusted EBITDA. Margins were healthy during the quarter. We benefited from having fully caught price at the end of March, resulting in three full months with the appropriate price-cost mix. Net sales grew to $394 million. This 4.9% increase over the second quarter of 2021 was driven by the implementation of price increases over the past year despite lighter volume. Now let’s dive into how each of our business segments performed during the quarter. Hardware Solutions is our biggest business and makes up approximately 50% of our overall revenue. For the quarter, Hardware led the way with a 12% increase in revenue compared to the second quarter of 2021. Price increases were the main driver of the top-line increase. Also contributing to the improvements were fill rates upwards of 97%, up from 90% a year ago. This is why retail partners trust Hillman. A 97% fill rate during one of the worst supply chains any of us can ever remember. Robotics and Digital Solutions or RDS makes up just shy of 20% of our overall revenue. During the quarter, lighter foot traffic coupled with a difficult comp quarter in 2021 resulted in a 2% decline in RDS revenue. Though this was on top of last year’s 57% increase in the second quarter. In particular, engraving was soft as pet adoptions declined and, unfortunately, shelter populations are growing, which means there are fewer new pet owners than there were during '21 when it seemed everyone was adopting a dog or cat. Our Canadian segment, which makes up about 10% of our overall revenue, performed very well during the quarter. Canada posted a 7% top-line increase compared to the year-ago quarter and ran their business very well, driving strong bottom-line results. Lastly, our Protective Solutions business makes up about 20% of our overall revenue. During the second quarter of 2022, Protective revenues were down about 12%, driven by retail softness including fewer promotional sales. COVID-related PPE sales contributed approximately $2 million of revenue for both periods and therefore did not have a meaningful impact on the comparison. Now on a year-to-date basis, Protective sales were down 10%, but when backing out COVID-related PPE sales, Protective is down less than 1% on a year-to-date basis. As we all know, we’ve now seen two consecutive quarters of negative GDP growth and there are a lot of factors influencing the economy right now. Many aspects of our business make us resilient and position us well as we navigate these uncertain economic times. They include, number one, our heavy repair and remodel exposure; two, our competitive moat; three, our successful pricing initiative; and four, with lead time improvements out of Asia, we can lower inventories, while protecting our industry-leading fill rates. To start, it’s important to remember our business is focused on repair, remodel, and maintenance. We’re not tied to new housing and we’ve grown our top line organically in 56 of the 57 years since our founding with an average top line organic growth of 6% annually since the year 2000. The only year that our top line didn’t grow was 2009, which was the bottom of the market during the great financial crisis. While our top line decreased by 5% in ‘09, our bottom line increased by 10%, which was the result of our costs coming down during that crisis and other past inflations. Without fail, we’ve seen commodity prices softening, which we’re starting to see now. Currently, you can’t read Wall Street without reading about the challenges companies have regarding labor, supply chain, and inventory management. In today’s environment, our competitive moat is more critical than ever and is helping solve these issues for our customers. This competitive moat consists of three components. Number one, over 80% of our 112,000 SKUs are delivered directly to the retail locations of our customers. We utilize our distribution network, which consists of 22 distribution centers to send their products to over 42 locations across North America for our customers. In general, our customers do not have to worry about managing Hillman inventory in their distribution centers, supply chain logistics, or shipping and labor costs. Number two, our sales and service team, which consists of 1,100 associates, provides world-class service at their shelf for our retail customers. This team of warriors ensures that Hillman must-have high-margin products are in-stock, organized, and optimized for our blue-chip customer base. Mick and Rick Hillman introduced this unique in-store service model over 27 years ago, which has allowed us to serve our five biggest customers on average for over 22 years each. And number three, 90% of our revenue comes from our brands that we own. This is not only important to the consumer and the pro but allows us to differentiate our offerings based on specific retailer strategies. Additionally, we can implement customer feedback to improve our products to meet the evolving needs of our pro and DIY consumers. These three pillars are the backbone of our retailer partnerships. We allow our customers to overcome complex labor, supply chain, and inventory challenges while delivering industry-leading fill rates in our categories. For example, many of our customers continue to struggle to find quality employees to stock shelves and manage aisles. Our sales and service team do this for them so our customers don’t have to. Another example is managing inventory. Today, we’re seeing many retailers working to reduce inventory as their distribution centers are full of products. Some retailers have rented additional warehouse space to house their inventory and other categories and have been working around the clock to move products through their distribution networks. At Hillman, we ship over 80% of our products directly to the store, so our customers don’t have to worry about managing the inventory of our products. And lastly, not having products on the shelf, we all know, is the quickest way for our customers to lose revenue and market share. So in today’s economic environment, our moat has proven to be an increasingly indispensable part of our relationship with our customers who know they can rely on Hillman to get products on their shelves even during the most challenging times. Let me give an example of how our moat can also drive new business by providing some detail of a recent new customer win. As we talked about briefly last quarter on the call, we won the fastener business at one of our major retail partners. The incumbent had a difficult time keeping products on the shelves, which gave us the opportunity to get our foot in the door. After securing the new business, we shipped 150 truckloads with store-specific pallets for approximately 4,000 retail locations. This rollout has gone extremely well with fill rates of 99.7%, and we’re already receiving orders for more fasteners from this customer. Our customer is thrilled with how this rollout has gone, and we believe this has the potential to drive additional business wins. I’ve run a bunch of businesses, and I’ve never seen one like this. We have a strong team, great customers, and a bunch of hard-working folks at Hillman. They ensure we win at the shelf and help nurture the long-standing partnership we have built with our customers over many years. Now turning to pricing and cost. As we talked about on our last earnings call, most U.S. companies, including us, negotiated new contract ocean container rates that became effective on May 1, 2022. These rates were dramatically higher than last year and are expected to increase our cost by about $50 million on an annualized basis. These increases hit all companies that import products from overseas, including all of our major customers. And so we have recently initiated yet another price increase to cover these additional costs. We expect our price increase to wholly offset these increased shipping costs in our P&L for '22 and beyond. Another quarter, another price increase. Let’s recap what we’ve done from a price-cost perspective. The latest price initiative marks our fourth increase since the beginning of 2021, and we expect to have taken approximately $225 million in price since then. Again, all of these have been dollar-for-dollar price increases to cover our costs. This breaks down to approximately $90 million of commodity costs, $15 million of labor, and $120 million of transportation and shipping costs. Going into the past 24 months, our relationships with our customers were strong. And remarkably, even after these four price increases, our relationships with our customers, I think, are even stronger. We believe this is because we have shown our customers that we’re only taking price to cover costs, not increasing our profits. We truly respect and are grateful for the healthy partnership we have with our customers. We remain in a strong position with them because of the mutual respect and our long-standing relationship in our competitive moat. In short, we bring something to our customers that our competitors do not. Thankfully, we do not foresee a need for additional price increases in the near future based on what we’re seeing today. Now let me spend a minute talking about some specifics about our business. We’ve all read about retailers looking to reduce inventories while maintaining their in-stock levels, and we’ll work together with our customers to help them reach their goals. Because of our direct-to-store model, most of our customers don’t have inventory of our products in their distribution center. However, we may see some of our customers consider reducing inventories at the shelf by 2 or 3 weeks on slower-turning items during the second half of this year. I can tell you with our direct ship network and the in-store Hillman team will make sure either way, our customers’ in-stocks continue to be high. We’ll be reducing our own inventories as well as we think about lead times from Asia. We saw them peak during January of 2022 at 255 days. This means that when we place an order from our suppliers in Asia, it takes 255 days for that order to arrive in our distribution centers here in the States. Today, we’re seeing lead times around 160 days. In normal times, like 2018 or ‘19, lead times were approximately 130 days, so they’ve come down significantly since the end of January. We believe that this dynamic will allow us to reduce our inventories by $50 million before the end of the year, while protecting our fill rates, which averaged 97% in the second quarter. Rocky will get into more detail on how inventory will impact our second half expectations shortly. As we discussed earlier, the majority of our product sales are driven by repair, remodel, and maintenance projects. These are your pickup truck pros, your local contractors, and DIYers. To be clear, we believe that our business is not reliant on new home construction. For that reason, demand for our products has historically been steady through all economic cycles, considering our products are relatively inexpensive, particularly as it relates to the total cost of the project. We believe that the balance sheet of the U.S. homeowner remains healthy. While interest rates may slow new housing transactions, we believe the increase in home prices and therefore, homeowners’ equity over the past few years will be a meaningful driver of home improvement projects for years to come. We expect to see the continuing investment in the home as trends in nesting, aging in place, and outdoor living remain prominent. At the same time, we’re laser-focused on successfully navigating this environment. We are also working on our growth initiatives, which include the expansion of quick tags machines, smart fob auto, and our knife sharpening kiosk Resharp. We are also continuing to focus on new wins and share gains in categories like builders hardware, deck and drywall screws, anchors, and barn door accessories. I know you’re waiting for them. We strongly believe that we’re well situated for the second half of 2022 and into the future. I’m encouraged about the opportunities that lie ahead and the value we will continue to bring for all of our shareholders, customers, and employees. With that, let me turn it over to Rocky.

Thanks, Doug. This morning, I’m going to provide a quick summary of our second quarter results and then turn to our outlook and guidance for the remainder of 2022. Net sales in the second quarter of 2022 increased 4.9% to $394.1 million versus the prior year quarter. Hardware Solutions was the main contributor to the increase, which was up 12% to $225.4 million. Overall, the improvement was driven by a 16% price realization, partially offset by a 4% decline in volume. As our retail partners have discussed publicly, April was a very light month in terms of foot traffic and volume. We saw May and June return towards the norm, but not enough to make up for April. Further, we saw softer volumes in July, which I will talk about in a few minutes. RDS sales decreased by 2% to $64.8 million. Lighter foot traffic, less activity in pet engraving, and a difficult comparable quarter were the main drivers of the decline. Our Canadian business had terrific performance in the quarter. Sales were up 7% compared to the prior year, and we significantly improved profitability for the second quarter in a row. Price, product mix, and exiting unprofitable businesses have driven nice profit improvement in Canada. And while we don’t anticipate maintaining 17% EBITDA margins for the remainder of 2022 in Canada, we are well on our way to our minimum expected adjusted EBITDA goal of 10% across this business. Protective Solutions sales were down 12% or $7.5 million, resulting from lighter volume and fewer promotional sales. Looking at our year-to-date numbers for Protective, we are down only 1%, excluding COVID-related PPE sales. COVID-related sales for the quarter were $2.1 million compared to $1.6 million during Q2 of '21. However, for the third and fourth quarters of 2021, COVID-related PPE sales were $15.1 million and $19.2 million, respectively, as we liquidated our COVID inventory. As a reminder, we worked with our retail partners to sell and donate these products in the second half of '21 at 0 or very little profit. We do not anticipate meaningful COVID sales for the remainder of 2022. On a GAAP basis, net income for the second quarter of 2022 totaled $8.8 million or $0.04 per diluted share compared to a net loss of $3.4 million or $0.04 loss per diluted share in the prior year quarter. Adjusted earnings per diluted share for the second quarter of 2022 was $0.14 per share compared to $0.24 per diluted share in the prior year quarter. On an adjusted basis, second quarter gross profit margin improved by 50 basis points to 44.1% versus the prior year quarter. Sequentially, margins improved by 290 basis points. The improvements in both periods were the result of catching price costs in March fully benefiting the second quarter of 2022. For the quarter, GAAP SG&A totaled $118.2 million compared to $111.7 million for the prior year quarter, driven by higher selling and warehouse and delivery expenses. Adjusted SG&A was $111.3 million compared to $100.2 million in the prior year quarter. This analysis backs out stock compensation, acquisition and integration expenses, certain legal fees, and restructuring costs, which we feel give us a better analysis of our base expenses. Adjusted SG&A as a percentage of sales increased to 28.2% from 26.7%, driven by the higher SG&A. While our business has variable costs, the softness in quarterly sales resulted in adjusted SG&A as a percentage of sales coming in a bit on the higher side. Subsequent to quarter-end, we have implemented several cost-saving actions, including some reductions in headcount to better position the business for financial flexibility in the second half of the year. Adjusted EBITDA in the second quarter was $62.3 million compared to $64.5 million in the year-ago quarter. Our results were driven by having caught price cost before the start of the quarter and a lift from strong earnings from Protective and our Canadian businesses. The decrease in EBITDA from the comparable quarter was anticipated and baked into our guidance and expectations. Now turning to our cash flow and balance sheet. For the year-to-date in 2022, operating activities generated $14.7 million of cash as compared to operating activities using $59.8 million in the prior year quarter. The main driver for the improvement was that last year during the period of global supply chain shortages, we made the strategic decision to meaningfully invest in our inventory. This investment has allowed us to maintain our healthy fill rates, which we believe has helped us win new business. Capital expenditures were $28.9 million compared to $22.7 million in the prior year quarter. We continued to invest in our RDS kiosks and merchandising racks, which are important parts of our high-return CapEx initiatives. Chip shortages continue to hinder our ability to produce robotic kiosks to meet demand, particularly our Resharp knife sharpening machines, which has kept our CapEx lower than we would like. Maintenance CapEx remained near 1% of sales as expected. We ended the second quarter of 2022 with $949 million of total net debt outstanding, up from $931 million at the end of 2021. At the end of the second quarter, we had approximately $118 million of liquidity, which consists of $100 million of available borrowings under our revolving credit facility and $18 million of cash and cash equivalents. Subsequent to the quarter-end, we expanded our revolving credit facility by $125 million to $375 million and extended the maturity by a year. This provides us with financial flexibility on attractive terms. We don’t have an immediate need for the increased line and, importantly, we still expect to fully pay down our revolving credit facility by year-end. Our net debt to trailing 12-month adjusted EBITDA ratio at the end of the quarter was 4.7x, up from 4.5x at the end of 2021 and equal to where we were last quarter. Our leverage at quarter-end was expected given the normal operating cycle of our business. Our long-term target for net debt to adjusted EBITDA ratio remains unchanged at below 3x. And by the end of 2022, we believe we can reduce our leverage to just below 4x. Let me spend a few minutes talking about our short-term outlook. As Doug said, we were successful in securing our fourth price increase to cover the increase in contracted ocean container rates. The price increase offsets an increase in cost on a dollar-for-dollar basis just like the previous three. The price increase will be implemented throughout the third quarter. As we look forward to the back half of the year, we will be fully caught up on price costs as we were in Q2. Additionally, we typically see an increase in sales and EBITDA during the second and third quarters, as we talked about last quarter. Warmer weather during the spring and summer typically results in more trips to the hardware store driven by an increase in home repair, remodel, and maintenance projects. As we think about our guidance for the remainder of the year, there are two important aspects to consider. Number one is the consumer. As we all know, there is some uncertainty in the economy right now and the consumer is being impacted by inflation. After gas and groceries, homeowners may be waiting to start that home improvement project they were previously planning to do. Number two is inventory. As Doug mentioned, we will likely see some of our customers reducing their inventory levels, which translates into less order volume than we would see typically. As lead times have come down and commodity costs are starting to soften, we believe we can reduce our own inventory by approximately $50 million between now and the end of the year. With that, it will be important to balance the long-term relationships we have with our suppliers to ensure they remain viable partners into the future. That said, so long as sales at our customers are generally healthy and the consumer isn’t greatly impacted by a potential economic slowdown, we believe our full year ‘22 results will fall within our original guidance range given back in March. While we have benefited from taking price, sales volumes were soft during April and have again been soft in July. With this visibility, we are providing the following updates. We now anticipate our full year 2022 net sales will come in towards the low end of our original guidance, which was $1.5 billion to $1.6 billion. This implies that our second half net sales will see a percentage increase in the mid-single-digit range versus the second half of 2021. We also anticipate our full year 2022 adjusted EBITDA will come in at the low end of our original guidance, which was $207 million to $227 million. This implies that our second half adjusted EBITDA will see a percentage increase in the high single-digit range versus the second half of '21. Our guide also implies that adjusted gross margins during the second half will remain fairly consistent with what we saw during the second quarter of '22. Lastly, we still feel comfortable that our original free cash flow guidance range of $120 million to $130 million is intact. As we look a bit further out, our long-term growth algorithm of 6% organic net sales and 10% organic adjusted EBITDA growth remains intact. On the other side of the current macroeconomic environment, we have a high level of confidence that our business will see adjusted EBITDA growth in excess of our algorithm. We believe this as we are beginning to see commodities, containers, freight, and other costs begin to moderate in the second half of 2022, which should benefit us in '23 and beyond. While our approach to implement dollar-for-dollar price increases has resulted in some margin rate degradation, we have not given price back dollar for dollar when inflation moderates historically. This gives us potential margin expansion over time, which we believe we will begin to see flow through our P&L in '23. Our business continues to have several structural tailwinds that Doug discussed earlier. We expect these trends will continue and position Hillman to capitalize on sustained growth in the home repair, remodel, and maintenance market. As we look forward, we continue to believe that our competitive moat will allow us to win new business, drive sales, and allow us to perform at or above our stated growth algorithm over the long term. With that, Doug, back to you.

Thanks, Rocky. Our competitive moat has more than proven itself in today’s environment and now serves as an even more appealing solution for our customers. The Hillman model with our 1,100 field sales and service folks combined with our direct-to-store delivery brings solutions to our customers’ complex needs, especially in today’s challenging environment. The value we bring our customers is reflected by our customers’ willingness to accept our pricing actions, grant additional shelf space, and award us new business, all three of which we’ve seen in the first half of this year. While the current environment is uncertain, we’ll stay focused on controlling the controllables and taking great care of our customers. As we look forward, we remain confident in our moat, and we believe we can drive long-term growth and build meaningful value for all of our shareholders. With that, we’ll begin the Q&A portion of the call. Shannon, can you open the call up for questions?

Our first question comes from Reuben Garner with Benchmark.

So Doug, I missed the $50 million, which I believe is the amount related to incremental inflation. Can you discuss what that entails and the timing and amount of the price increase you plan to implement to address it?

Yes. Reuben, it’s Rocky. So that $50 million was all related to contracted container rates. And so we spent a lot of time talking about that on our first quarter call. Basically, the world renegotiates contracted container rates on May 1 of each year. And so beginning on May 1, we saw our contracted container rates go up dramatically, as did the entire industry. And that will end up flowing through our P&L starting in late Q3, but hits us more in the fourth quarter. And then as we just said, the price increase to offset that is going in place kind of as we speak and will come in throughout the third quarter. So the timing of when we begin filling the cost and when we begin filling the price benefit are at about the same time. And again, that $50 million, just to be clear, is an annualized full year number, not what the impact in ‘22 will be.

Okay, understood. This is the update from May, and it's not additional information since then. Since May, it's been evident that spot rates for container freights have been decreasing. I believe that material cost pressures should also be easing. Could you provide an update on our current position and what benefits we might expect in 2023 at these levels? I'm trying to assess how much further freight rates and steel prices need to decline for you to completely recover from the price-cost challenges faced over the past year and a half.

Yes, Reuben, we've observed fluctuations in material costs. For instance, lumber prices peaked at 1,400 last year before falling to 500. This year, they reached a peak of $1,200 per 1,000 board feet and are now at 527. We noted a decline in China steel prices, which have shown a slight uptick recently but remain lower overall. While we haven't seen a drop in Taiwan steel prices, they are still in demand and typically follow China steel prices over time. Regarding ocean container rates, there was a significant surprise when rates nearly doubled for contracts starting May 1. Previously, spot prices for a 40-foot equivalent container were around $15,000 to $17,000, while contract prices approached $9,000. We mainly deal with 20-foot containers, but recently spot prices have decreased, exerting pressure on contract prices. If we can increase our inventory by $150 million due to changing lead times, retailers must also adapt similarly by managing their imports. We're witnessing a reduction in the commodity bubble. As you know, it takes about five months for these trends to impact our inventory, and currently, it takes around 160 days to receive it. We're optimistic about these trends, but we'll need to see how they unfold. So far, everything looks positive, and both our customers and we are relieved after 15 months of volatility.

Could you provide clarification regarding inventory? You've mentioned needing to adjust to the low end of the EBITDA range, but it seems the free cash flow remains unchanged. Is the $50 million reduction larger than you expected in your previous guidance? Additionally, Doug, if there is $150 million in excess, does that suggest there might be another $100 million available in 2023 if the supply chain normalizes further?

Yes, everything you said is correct, Reuben. Our original guidance anticipated a working capital benefit of approximately $20 million to $30 million. We believe we will exceed that and will be able to counterbalance the pressures within the guidance regarding EBITDA plus. Additionally, we will pay about $7 million more in cash interest this year than we initially expected due to rising rates.

Just, I guess, starting with just foot traffic at retail. Can you talk to the foot traffic trends that you saw during the quarter at your retail partners and how that translated into volumes, particularly in fastening and hardware in Q2? And then maybe talk to how that follow-through in July and the first few days of August?

Yes, Lee. April was a really challenging month for everyone; it was the coldest and wettest we’ve seen in 20 years. This situation startled our retail partners, especially since they rely on seasonal business, and losing a month when they have only four to sell creates significant pressure. We also felt the impact on foot traffic, as people drop by to browse and make purchases. As we reported, April was tough. May and June performed as we expected, and retailers managed to recover some of the seasonal losses. However, July mirrored the challenges of April with reduced foot traffic. It's worth noting that in the last month of our retail partners' second quarter, which is July, they have to focus on their inventory levels, and retailers are striving to manage their stock effectively. You may have seen this reflected in their reports. So that was the situation. Looking ahead, we could see August and September follow a pattern similar to May and June. We’re uncertain about it, and while we don’t expect any drastic changes, we do notice the effects of slower foot traffic.

First, I would like to discuss the headwind on EBITDA from the second quarter of 2021, which is approximately 140 basis points. Can you provide some insight into the factors that contributed to this? Clearly, inflation was a significant factor, but could you elaborate on how other items affected that 140 basis points of headwind?

Yes, I think the two main challenges we faced were in hardware and RDS. As we discussed regarding RDS, comparisons were particularly difficult coming out of COVID, especially with the surge in pet adoptions, while our engraving business performed well but did not meet expectations this year in terms of units sold. As Doug mentioned in his prepared remarks, the kennels and shelters are now at capacity, which unfortunately impacts our engraving business, a highly profitable segment for us. Regarding hardware, even though we managed to align price and cost, the unexpected softness during the period hindered our ability to adapt quickly, as it takes time to make significant changes in that business. We have implemented some measures for the second half of the year, as I noted earlier. However, we performed slightly better than expected in terms of gross margin in HS, although higher SG&A costs offset much of that improvement because we anticipated shipping more product.

That's helpful. Considering the situation, the prices and costs are balancing each other as we head into 2023. What is the headwind stemming from the price increases and costs you've observed as we move through 2023? Is it possible to quantify that zero margin headwind on margins?

Yes. So Brian, we’ve said publicly that we believe that it would be about a 300 basis point headwind. We would tell you, in the second quarter, we actually did a little better than that in the hardware business, probably closer to 200 basis points of headwind from the dollar-for-dollar pass-through. That’s one of the reasons that, as we’ve said, we expect margin rate to kind of remain constant through the rest of the year is we performed a little better than we expected in the second quarter from a rate perspective in hardware, and we think we’ll hold on to that as we hold on to price cost for the rest of the year. Yes. The simplest way to understand it is that we typically use working capital in the first half of the year. In the second half, due to reduced lead times, working capital will not only be beneficial seasonally, but those shorter lead times will also help us. The main factor driving this is the change in working capital along with the profitability we expect in the latter half of the year.

Yes, we have enough to reach 1,000 machines by the end of the year. We've received 200 more chips recently. One of the surprising issues, Brian, is with the Molex connectors, which are basic wiring connectors used in all our machines. They're in short supply because automotive manufacturers have purchased every single one available. It’s an odd situation that seems like it wouldn’t cause a problem in the long run. I expect that after the first quarter of '23, we won't face any chip issues. Until then, we're managing our resources carefully. The Molex connector is just a standard wiring part, yet suddenly, automotive companies have acquired all of them, including those listed on eBay and what was in stock. It's not expensive, just a fundamental component, but our situation is still tight. We're in a slightly better position, but not fully liberated. However, I'm not overly worried about it in '23.

My first question is on the EBITDA outlook for the second half. Can you just clarify what changed? Is it just the retail foot traffic and the destock? Or is there something else?

Ryan, it’s all volume.

I think that's a good question, Ryan. When we saw those retailers in Arkansas announce their early release, it was clear that inventory would be an issue. Target was one of the first indicators of this problem. They import a significant amount of goods from Asia and had to rent additional distribution centers to manage their inventory due to long lead times. Now that those lead times are decreasing, an interesting observation is that we've witnessed retailers needing to reduce their inventories due to business pressures. However, we haven't seen a situation where inventories are cut while lead times shrink from about 250 days to 160 in such a brief timeframe. Our approach is to balance this carefully, ensuring our long-term supplier partners remain stable, as some suppliers in different categories may experience significant disruptions. We have established relationships spanning over 20 years. I believe this situation will likely unfold in the latter half of the year. We saw some of this occurring in July, and we’re fortunate not to have excessive products sitting in distribution centers that our retailers can easily take when they go direct to stores. Therefore, I would estimate that most of this will be noticeable in the third quarter.

Okay. That makes sense. And then a longer-term question here. As we think about 2023, what is the potential range of benefit to EBITDA with container rates down and raw down? I know it’s a moving target, but is there anything you can provide?

There really isn’t. I mean, we’re playing with the numbers, too. Think about this. It’s really directionally, things are coming down. But if you just think about the math, if we don’t buy $50 million and we take inventories down, that’s a good thing. But by the time we do buy more and float it and get it through our inventory, you’re really talking about midyear ‘23, and it doesn’t mean that we won’t have benefit before that because there should be. But for the most part, if you just think about the math, when you take your inventories down and it takes, call it, 150, 60 days to get it and takes 4 or 5 months to get through your inventory, it should be pretty interesting in the second half of ‘23. We’ll feel things get a little better here and there until then, but that’s the kind of timing of it.

Yes, I hear you. So I said, well, I’ll put it in my words, 43% plus gross margin is still in the car, you probably start to see more of that second half ‘23, the impact starting to help you?

That’s right. That’s a good way to think about it.

Yes. I think the only thing that’s changed there, Ryan, I’ve gone back and spent some time with Nick and Rick Hillman who were running it at the time. We had a little bit higher percent local hardware business as a percent of our total then, as we do now, even though it’s a big part of our business, and they do extremely well in that kind of environment have historically. So I would say the 5 that Mick and Rick saw, maybe 8, 9, something like that because the mix is a little different. But directionally, I think it’s pretty similar and then commodities are bigger now than they certainly were in ‘09 as far as the run-up. So it should be better on that side as well. So it’s probably a little more on the sales side, but I think under $10 and then likely better on the EBITDA side, if you think about the math.

You have Elizabeth on for Matt today. I was just wondering, you’ve been able to successfully implement various price increases in the past, and we’ve seen that benefit in your margin this quarter. But as the macro unfolds, do you expect that there will be any risk to implementation of that price increase into Q3? And do you think people will push back on that at all?

So right now, we feel very good about the fact, Elizabeth that we have it done. Let’s be honest, retailers are very smart people. They’re looking at cost as well. They know that we’re going to be fair with them. And will there be pushback over time? Absolutely, there should be because that’s them doing their job. But as we’ve said, we’ve only gone dollar for dollar, and we’ve hurt our margin percentage, and we’ll get that back. And then we’ll see some benefits on the other side. But we’ll work with our retail partners to make sure. I mean, it’s our job when you have the share we have to make sure they’re competitive. We’re going to do that, and we’re going to be fair, and I know they will as well. So this fourth increase, we’ve been successful. We’re just getting everything implemented now. And then our retail partners have been great, but they’re not happy with all this inflation nor are we, and we’ll work together on the other side, but that will be a good side to be on. Thank you, everyone, for joining us. We look forward to updating you as we move through the second half of this year. And again, I appreciate you joining us today. Thank you.