Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Holdings Group's Fourth Quarter and Fiscal Year 2022 Earnings Conference Call. At this time, all participants have been placed in a listen-only mode, and the lines will be open for your questions following the presentation. Please note that this conference is being recorded today, March 9, 2023. I would now like to turn the conference call over to Anna Kate Heller at ICR to begin. Please go ahead.

Thank you, and good afternoon. With me on the call today is Bill Toler, Hydrofarm's Chairman and Chief Executive Officer; and John Lindeman, the company's Chief Financial Officer. By now, everyone should have access to our fourth quarter 2022 earnings release and Form 8-K issued today after market close. These documents are available on the Investors section of Hydrofarm's website at www.hydrofarm.com. Before we begin our formal remarks, please note that our discussion today will include forward-looking statements. These forward-looking statements are not guarantees of future performance and therefore you should not put undue reliance on them. These statements are also subject to numerous risks and uncertainties that could cause actual results to differ materially from our current expectations. We refer all of you to our recent SEC filings for a more detailed discussion of the risks that can impact our future operating results and financial condition. Lastly, during today's call we will discuss non-GAAP measures, which we believe can be useful in evaluating our performance. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with GAAP, and reconciliations to comparable GAAP measures are available in our earnings release. With that, I'd like to turn the call over to Bill Toler.

Thank you, Anna Kate, and good afternoon, everyone. 2022 was a challenging year for our industry and as a result for Hydrofarm. However, I'm encouraged to report that we finished the year at the upper end of our previously provided outlook for net sales for last year. We also generated positive free cash flow in Q4, marking the third consecutive quarter of positive cash generation. While I'm encouraged by these metrics, it is really the many decisions we made and the actions we took last year that leave me the most optimistic about our future. In Q4, our team here in the US consolidated our product portfolio, eliminating more than 40 brands and 1,100 SKUs, representing about 20% of our brands and over 33% of our SKUs. We've also begun to rightsize our manufacturing and supply chain footprint by closing a nutrient manufacturing facility in Canada and we've begun subletting some space in our distribution centers. In addition, we have reduced total headcount by more than 30%, primarily as a result of integrating the companies we acquired. We've also aggressively reduced our working capital and have begun to further expand our sales efforts into non-cannabis channels, including CEA food, floral, and lawn and garden. As you see in today's earnings release, some of these actions started in Q4 and were part of a restructuring initiative, which John will elaborate on later. Collectively, these actions set us up to be a leaner, more nimble, more diverse, and importantly, more profitable business. Looking ahead, I see brighter days on many fronts. From a sales perspective, we have experienced stabilization in our average daily sales from November '22 through February '23. We're also starting to see some positive signals from several industry metrics. Although, no single data source captures a complete view of demand in the hydroponic or cannabis industry, we are encouraged to see several data points that reflect some level of stabilization. In particular, according to Headset data, US cannabis dispensary inventory in '23 is below the average inventory in '22. And US cannabis prices have been stabilizing in many markets, while US cannabis dispensary sales, measured by unit volumes, have continued to grow. We believe our recent sales trends and these positive signals give us a reason to expect a return to growth in the second half of 2023. From a profit margin standpoint, we expect to see many of the benefits of the actions we took in 2020 come to fruition. Specifically this year, we expect improved sales mix, more focused and efficient trade spend, and increased productivity across our manufacturing and distribution centers. All of which will help drive improvement in our adjusted EBITDA and our adjusted EBITDA margin. Finally, as we begin a new fiscal year, I'd like to remind all of our stakeholders of my bullish view on the long-term prospects for our category and for Hydrofarm. Our company has a long history of double-digit compound annual growth despite some brief periods of revenue softness. The fact still remains that in the US, the largest consumer economy in the world, a large portion of the population is still just beginning to experience improved access to cannabis, reduced stigma, and higher quality branded products that come from legalized medical and adult-use regulations, which should drive more reliable and trackable consumption patterns. Given this incredible industry dynamic, our team remains resilient and focused on executing our strategy to position the company for higher margins and future growth. For these reasons, I've made several open market purchases in 2022 to continue to increase my personal investment in Hydrofarm. My actions support my view that we are positioned to be a proven leader in the hydroponic industry. With that, I'll turn it over to John to let him discuss further details of our fourth-quarter financials and provide our outlook for 2023.

Thanks, Bill, and good afternoon, everyone. Net sales for the fourth quarter were $61.5 million compared to $110.4 million in the prior year period. Our 2021 acquisitions added 3.1% to our top line in the fourth quarter of 2022 relative to the prior year period, but this M&A benefit was more than offset by a 46% decline in organic sales volume. We realized a 0.9% price mix decline in the quarter, which was driven by a strong effort from our sales team to sell through discounted lighting products. Without that factor, we estimate that our Q4 price mix impact would have been positive, similar to prior quarters. Also, as noted in prior quarters, the industry recession continued to have an impact on our sales mix. While proprietary brands increased as a percentage of total sales to over 55% in Q4, the margin contribution of our proprietary brand category was diluted by the sell-through of discounted proprietary branded lighting products. We did see some positive sales trends in the quarter. First, the level of year-over-year sales declines improved in Q4 from Q3 in several more mature states, including Oklahoma, Colorado, Oregon, Washington, Michigan, and Maine. Second, our commercial sales continue to advance on a relative basis. For the full year 2022, our commercial sales represented approximately 40% of total sales versus approximately 25% in the prior year. I will now take a minute to discuss our restructuring initiative. As we heard from Bill, we instituted a restructuring initiative that included consolidating our product portfolio, consolidating our Canadian nutrient manufacturing facility, eliminating our China office, and terminating contracts to help reduce future facility and transportation costs. As a result of these actions, we recorded pre-tax charges of approximately $7.7 million in Q4, of which approximately $6.1 million are noncash. We also expect to incur approximately $1.7 million of additional charges, primarily in the first half of 2023 as we continue to execute our restructuring plan. We believe that our restructuring and related actions will result in efficiencies and cost savings of approximately $7 million on an annualized basis. Gross loss in the fourth quarter was $0.5 million compared to gross profit of $18.7 million in the year-ago period. Adjusted gross profit was $9 million or 14.7% of net sales in the fourth quarter compared to $23.3 million or 21.1% in net sales last year. The decrease in adjusted gross profit margin is largely due to proportionately higher freight and labor costs and $0.7 million of the inventory reserve and related charges for which we did not adjust. Selling and general and administrative expense was $26.2 million in the fourth quarter of 2022 compared to $27.7 million in the year-ago period. Adjusted SG&A expense was $17.4 million in the quarter versus $18.4 million last year. The decrease was primarily due to a decline in employee compensation costs, professional and outside service costs, and facility costs, partially offset by an increase in insurance expense. I should also note that adjusted SG&A in Q4 was negatively impacted by $1.8 million in accounts receivable reserves and related charges that we took during the period. Finally, adjusted EBITDA decreased to a loss of $8.4 million in the fourth quarter from a $4.9 million profit in the prior year period. The decrease in adjusted EBITDA was driven primarily by lower net sales, lower adjusted gross profit margin, as well as $2.5 million in inventory and accounts receivable reserves and related charges, again for which we did not adjust in our EBITDA calculation. Moving on to our balance sheet and overall liquidity position. Our cash balance improved to $21.3 million as of December 31st, up nearly $5 million from the third quarter. We ended the year with an aggregate principal amount of debt outstanding of $125.8 million, the vast majority of which does not mature until 2028. And as was the case for the entirety of 2022, we have a zero draw on the company's revolving credit facility. We estimate total liquidity of approximately $61.3 million as of December 31st comprised of our cash position plus approximately $40 million of available borrowing capacity under our revolving credit agreement. We generated positive free cash flow in Q4 and accumulated approximately $14 million in total free cash flow for the full year 2022. With that, let me now turn to our full year 2023 outlook. We expect net sales in the range of $290 million to $310 million for the full year. Our estimate assumes a seasonal lift in the spring and summer months, which we expect will be modest in comparison to the lift we have seen in four of the last five years, in which we expect we’ll result in growth resuming in the second half of 2023. We are modeling that on the heels of the restructuring initiatives in which we reduced SKUs and brands, largely in our distributed and preferred product categories, we will see a further increase in the percentage of our proprietary brands sold. We expect to feel some negative pricing impact in Q1 from the continued sell-through of discounted lighting products, but then expect positive price mix will resume for the remainder of the year, primarily from the benefit of price increases put into effect across the course of 2022. We do expect to realize productivity savings in 2023, which on top of a more favorable sales mix should further energize our adjusted gross profit margins and help us to return to margins that approach 2021 levels. To get there, we need to see sales levels within the expected range, continued improvement in our sales mix, productivity improvements contributing to lower costs, and minimal increase in inventory reserves. We expect adjusted EBITDA that is modestly positive for the full year 2023. This assumes a significant improvement in adjusted gross profit margin, some reduction in adjusted SG&A, and the expectation that inventory and accounts receivable reserves are largely behind us. We expect to generate positive free cash flow for the full year of 2023. We expect that with total sales down from our 2022 levels, we will continue to reduce our working capital and generate positive free cash flow. I should note that we do not expect to generate positive free cash flow in Q1, primarily because of the seasonal nature of our cash flows. But just to be clear, we do expect positive free cash flow for the full year 2023. We have laid out a few other assumptions in today's earnings release and we encourage you to review them in conjunction with our full year outlook. In closing, I want to thank our team at Hydrofarm for all they did in 2022 to better position our business for improved profitability in 2023 and beyond. And with that, let me ask the operator to open the line for any questions you may have.

And your first question comes from Andrew Carter from Stifel.

Mentioning the lighting kind of actions that you took, that’s negative pricing in the quarter. First up, could you tell us the impact of the product margin? I might be confusing things in what's adjusted and what’s not. Number two, you have more to go in the first quarter if I understand that. And if I look at your drawdown in the fourth quarter of inventory, it was $26 million or so benefit to cash flow. Was the majority of that the lighting products moving, and how much more kind of inventory drawdown do you think you can do and still maintain a healthy business?

I think our lighting sales in Q4 were roughly about 10% or 11% of our total sales, just to give you some perspective. And as we indicated, there definitely was some margin compression; a good chunk of our lighting that we sell is proprietary branded. And again, when you think about the discounted lighting products we're selling, our brand is predominantly the high-pressure sodium phantom lights that were sold through in Q4. We do have some more inventory of those, although our team did a very good job selling through it in Q4. We expect that we'll work through the remainder of it in Q1.

So we've taken the full amount, all the stuff we expected to sell through.

And then kind of second question is, now that you've kind of done this restructuring initiative, and if you back into your volumes this year your debt, you're 60% of where you were in '21. Any ideas, can you give us any sense of kind of where your manufacturing network is from a utilization standpoint? And if we have another step down in volume, is there more to take out or just anything you could give us on that front?

As you well know, we bought sort of four nutrient businesses; that’s the place where you have the most overlap. And when we brought it in and then the volume declined, we probably had utilizations in the 20% to 25% range. By closing the Canadian facility, that moves them up to maybe in the 30s to low 40s, and we still have room to go there. We don’t want to have to do any more of that, but we certainly have some levers to pull. We also have some options of perhaps developing a different location, maybe in the Eastern Midwest where we don’t have production today. All the facilities we have now are kind of on the West Coast. So moving that to the Midwest or East could be an option as well. But we certainly have some more levers to pull if we find that we need to get further cost out or further optimization of the footprint.

Your next question comes from Andrea Teixeira from JPMorgan.

Just wanted to go back to the commentary. A couple of things, I want to clarify. In terms of the debt capacity and liquidity, I know, John, you mentioned that you feel comfortable, but just to make sure that we are not missing anything and moving pieces there in terms of your revolver or any financial needs that you may expect, then I think you put in $40 million now. Then the other clarification is on what you mentioned in terms of the gross margin approaching 2021 levels. So just doing the math with the lower level of revenues. I think you’re just saying adjusted EBITDA that is positive, we can kind of back out and then the positive free cash flow. Just wanted to make sure that we have the moving pieces from a gross margin perspective and how we should be thinking in the dollar EBITDA and how we should be thinking of progression of the quarters? Because when I say approaching, is that towards the end of the year when we have more of the results of the restructuring, how we should be thinking of all these moving pieces from a cadence perspective?

Let me address those points in order, Andrea. Regarding liquidity, we reported approximately $60 million at the end of the year, which includes $20 million in cash on our balance sheet and $40 million available on our line of credit. We are confident in our liquidity position for various reasons. Most of our debt, around $124 million of the total $126 million mentioned, is in our term debt facility and is not due until 2028. Additionally, the principal portion amortizes at about 1% a year, which is around $1.3 million. From a liquidity perspective, we remain optimistic. We expect to continue generating positive free cash flow throughout 2023, having achieved this for three consecutive quarters from Q2 to Q4, and we are hopeful about maintaining this trend into the upcoming year. Our success in this area has been driven by a reduction in our working capital investment due to decreased demand in the short term, which has generated cash for us. Based on the guidance we've shared regarding our outlook for 2023 versus 2022, we see further opportunities to reduce our working capital. As for our EBITDA margins, our adjusted gross profit margin for 2022 was reported at 14%. Looking ahead, our projections for 2023 assume minimal additional inventory reserves. In 2022, we incurred an $18.5 million inventory reserve expense that we did not add back, which would improve our adjusted gross profit margin to about 19% if accounted for. We also anticipate improvements from a better price mix due to more effective trade spending, benefits from price adjustments made in 2022, and an increased share of proprietary brand sales. Additionally, we expect productivity gains in our manufacturing operations linked to our nutrient manufacturing consolidation as part of our restructuring efforts. We are also optimizing our activity levels in distribution centers based on the higher value of inventories after our SKU rationalization. All these factors combined could provide us with an additional 200 to 400 basis points of margin improvement.

So just to this would offer 200 to 230 basis points opportunity that you think you realized already in 2023 or that's going to be a long-term goal?

No, we think on the sales level that we call within that outlook range, we have an opportunity to get there over the course of 2023.

This suggests that the range will be around 21% to 21.3%, approximately 21%, which reflects the level from 2021. To clarify, you're indicating that this would likely occur sometime in the third or fourth quarter, especially since you mentioned that pricing will be challenging in the first quarter. Therefore, I assume you aim to reach that level, but not for the entire year. Is that correct?

That's correct.

In terms of inventory, you mentioned that most of the adjustments are complete, but there are still some pricing concessions to address in the first quarter. Regarding your guidance on volume and pricing, how should we interpret the $300 million in top line revenue? Specifically, what portion of the 10% decline should we expect to come from volume versus pricing? I anticipate that the decline in volume will exceed the total sales drop, but how much pricing or mix carryover do you still have?

So we are estimating that in Q1 we will have some negative price/mix impact, much like we did here in Q4. And again, for the same reason that we continue to sell through the remaining portion of our sort of high-risk lighting products. But we are expecting low single-digit positive pricing for the remainder of the year. So I think when you sort of look at that across the span of the full year, think of it as a very low single-digit positive pricing for the full year, and then the residual will just be the volume.

Your next question comes from John Anderson from William Blair.

I wanted to ask just about the commentary around stabilization in average daily sales. And I'm not sure, I've heard similar commentary perhaps not from you in this way but from some others in the industry. And I'm just wondering if you've seen enough of that at this point in terms of the duration coupled with other input you are getting from customers and others in the channel that kind of gauge your degree of confidence here that not only can we see stabilization and kind of the seasonal recovery in '23, but then kind of growth in the back half and what kind of level of growth kind of thinking about second half?

I believe it's fair to say that we observed a downward trend in the industry through October, but it began to level off and show slight improvements in November, December, January, and February. That's encouraging. Considering all factors and seasonal adjustments, it's reasonable to conclude that we're somewhat on the upswing, as others have described it. What boosts our confidence are the insights we're gathering, such as inventory levels observable in Headset, pricing stabilization, and the positive sentiment from customers. It seems that some people who had stepped away from the market for about a year or 18 months are now returning, which we find promising. However, it has been a challenging journey, and determining the low point has been tough. Therefore, we remain cautious in our predictions. This is why our projection for the year is $290 to $310 million, which is still below our desired target but reflective of our view on current industry performance. Additionally, in the latter half of the year, we're facing relatively weak comparisons from the second half of 2022. We are hopeful that we can achieve growth from that point, aiming for the midpoint of $300 million and potentially exceeding it.

You mentioned the product portfolio work that you're doing. I think you mentioned 40 brands, perhaps over a thousand SKUs rationalized. Where do you think you are in terms of that part of the restructuring work? Is that largely complete at this point? Is there more work to do? And where do you think, as the industry recovers, how does your business look different exiting this industry recession than it did entering? I'm thinking proprietary versus non-proprietary mix, maybe even the kind of categories that mix across the business and perhaps what that says about your kind of position in the industry?

No, I think that proprietary will continue to expand and it should be 55%; last year, it should get deeper this year, maybe 60% to 65% in two or three years from now and get to two-thirds of our business in two or three years would be proprietary. We still have some very strong branded partners we represent, and we're proud of that. But I think back to your first question, I hope that we exit this phase with a simplified business. We were carrying almost 200 brands, and the industry doesn’t need and can't support 200 brands. So there should be some natural shakeout in smaller businesses, some are going to go away naturally, some are going to go away or find someone else to represent them. But I think you're seeing from the bigger distributors who also own brands that we focus on fewer SKUs, more powerful SKUs, less brands, and less complexity, and hopefully a simpler, cleaner operation, which has helped to come out of it with a higher penetration of proprietary brands. We have to have the depth of proprietary brands to be able to support the infrastructure to distribute broadly to the industry. So that's important for everybody to have that kind of healthy proprietary penetration, if you will. So I think a simpler business, less brands, and fewer SKUs is certainly the right direction. We've been doing this portfolio rationalization every year now for three and a half years, and I think we've done the big work. But I think every year you should always prune the bottom 15% or so. And I think you'll see that as more of our work going forward. This year was a pretty good whack that we took on over 30% of the SKUs and over 40 brands is quite a big change.

Last one for me. You did mention that you've seen some, I guess, better sequential trends in some of the markets, Colorado, Oregon, Washington, I think you mentioned, even Oklahoma. How about in maybe some of the newer states that have been, I guess, somewhat delayed in terms of going live or ramping up? I'm thinking of some in the Northeast Corridor. Any commentary around what you're seeing there and whether that could be maybe a positive tailwind as you move forward?

Yes, it should be. I mean, Virginia has been frustrating; they keep fooling around with it a bit. New Jersey and New York have been kind of hot and cold. The ones that have stood out recently, Missouri has been a really good state for the industry; I think we're seeing a lot of quick sales there. You've seen Louisiana doing pretty well. There are other places that are popping up now. But yes, the Northeast really hasn't been that huge wave that we all thought was going to happen, and I think that's been something that's caught us all by surprise, and we hope they'll get it sorted out. But it hasn't really been the windfall or the tailwind that we'd hoped for.

Your next question comes from Chris Carey from Wells Fargo Securities.

Can you just address the health of your core consumer right now and whether you have any concerns there as far as stabilization of the industry? I'm really referring to as the growers and whether you just have any read on, on that one way or the other?

You have done considerable research in this field and possess valuable insights. As you are aware, we primarily sell through the retail channel. We collaborate with growers but do not sell directly to them. We maintain close relationships with the growers, and I anticipate some consolidation in the industry. In certain markets like Oklahoma, there has been excessive capacity development. Canada is still experiencing adjustments, and California also has a significant amount of capacity. Therefore, I expect to see a reduction in capacity and stabilization as some of these key markets, which overheated back in early '21, undergo corrections. The demand during that time was artificially inflated and not backed by the actual population served, likely due to substantial transshipments. As more states legalize, I believe that will create balance, and each state will develop its own infrastructure based on their operational preferences. However, I do foresee some rationalization as the overbuilt areas consolidate.

I know you've been discounting on lighting, and you mentioned that in the press release. What's your near and medium-term view between consumables and durables? And apologies if I missed this. But as we're coming out of this, do durables have a place in this recovery, or are you even more focused on just creating a more consumable portfolio going forward? So just any comments on the near term but all the strategic portfolio.

For our portfolio, it’s still sort of two-thirds, one-third consumable versus durable. We had some of our oldest brands on the durable side, ironically, Phantom and Active Air and Active Aqua. I think the biggest change in lighting that caused everybody to get a little off kilter was how quickly we all got ahead in inventory and then the speed of which high-pressure sodium shifted to LED. Some industry elements have completely exited high-pressure sodium lights, we haven't. We're staying in them with a very limited range and actually they're doing okay. So that part is good. But we think that branded representation in each of the key categories is still very important to us as a strategy, as a manufacturer and a distributor. We want to compete and operate in the lighting business; we think they've got very good products in the lighting business. But our bigger part of our portfolio is going to be consumables; it's going to be nutrients and grow media. We like that recurring revenue stream, but we also want to be represented across all segments.

And then one just last follow-up on the lighting side. You know, as pricing got to the point where you can clear inventory, the prices need to still come down. What's your sense of lighting inventory in general? Is this going to be an ongoing process given a year, or are you getting close?

No, we do think we're getting close. And to your pricing question, with all of the hard work or decisions we made last year with taking pretty aggressive and significant amounts of reserves across the span of the year; really the bulk of that was in lighting. And so through that, we put ourselves in a position to be able to discount the levels that we can actually sell through. And I think I mentioned earlier, 10% of our sales in the quarter were roughly in the lighting category that may not sound like a lot because back when we IPO, it was probably about 20% of our business. But it's actually up from Q3. Our team did a really good job; we mentioned sort of strong effort. They did a really good job of selling our way through this challenged inventory. We do think we have a little bit more to do and we have kind of focused on trying to get it done in Q1 and then hopefully have some prospects in Q2 through Q4 for a little bit sort of cleaner selling initiative without the discount in lighting.

And just to give you some perspective on that, the lighting’s after reserves now, the value of the lighting is about equal to the percent of sales that it represents as a category for us. When you look at total inventories, we are much more in line than we were a year or so ago in that. So that's a very important dynamic as you get inventory relative to your sales penetration by segment.

There are no further questions at this time. I'll turn it back to Bill for closing remarks.

Thanks, Colin, and thank you all for this important interest in Hydrofarm. We look forward to speaking with you all soon. Take care.

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating, and ask that you please disconnect your lines.