Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Holdings Group fourth quarter 2023 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, February 29, 2024. I would now like to turn the call over to Anna Heller of ICR to begin. Please go ahead.

Thank you and good morning. 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 and full year 2023 earnings release and Form 8-K issued this morning. 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 could impact our future operating results and financial condition. Lastly, during today's call, we'll 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 would like to turn the call over to Bill Toler.

Thank you again, and good morning, everyone. We achieved positive adjusted EBITDA and positive free cash flow for the full year 2023 as we had provided in our outlook, even at lower sales levels. Throughout 2023, our team worked very hard to execute our restructuring and related cost savings initiatives, which allowed us to achieve the improvement in several profitability metrics that we are reporting today, including adjusted gross profit, adjusted gross profit margin in '23 for both the fourth quarter and the full year. Our initiatives included streamlining our product portfolio to enable greater emphasis on our higher-margin proprietary brands, continued focus on inventory reduction overall working capital management, better space utilization in our distribution centers, and cost reductions in our transportation and logistics. Our cash balance, overall liquidity, and ability to generate positive free cash flow, as we have demonstrated in the last two fiscal years, gives me confidence about where we are from a balance sheet perspective. On the top line, our 2023 sales fell short of our guidance range due to several key factors. Fourth quarter sales were lower primarily due to industry softness in the US specialty retail channel. You may hear from others in the industry that retail stores and cultivation facilities have been closing as the US cannabis industry remains bogged down in regulatory challenges. These issues have led to an overall reduction in demand from retail stores and cultivation facilities. For example, regulators are enacting stronger enforcement in Oklahoma and many facilities and stores are closing down as a result. We believe these changes will ultimately be good for the long-term health of our industry as the stronger players will consolidate and create a more stable market environment. There are a number of bright spots in 2023 that we will carry into 2024 and continue to build on which I'd like to highlight. Our proprietary nutrient brands continue to perform well. In fact, sales grew in the fourth quarter and for the full year of 2023, when you compare them to 2022. Because proprietary nutrient brands is one of our higher margin product lines, the increased portion of sales mix helped to support margin improvement and also helped us to achieve positive adjusted EBITDA for 2023. Another area of focus in 2023 was to diversify our revenue streams. We have made progress in this area through both geographic and product diversity. Our international sales, which are to customers outside the US and Canada and non-cannabis sales of CEA products sold into food, floral, lawn and garden, and certain other customers increased to about 25% of our total 2023 sales, up from 22% in the prior year. In 2024, we will continue to develop geographic and sales channel diversity. Hydroponic sales in the US and Canada are still our core business, but the revenue diversity will help support us as we are navigating challenging industry dynamics. Several potential catalysts are on the horizon for the cannabis industry. The first is the possibility of federal descheduling, which should inject new life into the industry by reducing taxes on legal plant-touching businesses, enabling them to reinvest. This should attract renewed investment from both institutional and retail players. And importantly, since the beginning of 2023, there are an additional seven US states that have legalized adult-use cannabis, which means now there's an estimated 54% of US adults who live in a legalized state. Momentum is beginning to swing positively internationally as well, as Germany just legalized recreational cannabis use last week. We are confident that Hydrofarm will continue to navigate our path forward, and we are well-positioned when the industry returns to growth. I'm very proud of the entire team at Hydrofarm for all their hard work this year in delivering a positive adjusted EBITDA and free cash flow in 2023. With that, I'll turn it over to John to discuss further details of the fourth quarter financial results and our outlook for 2024.

Thanks, Bill, and good morning, everyone. Net sales for the fourth quarter were $47.2 million, down 23.2% year over year, driven primarily by an 18.7% decrease in sales volume and a 4.5% price mix decline. While we anticipated softer sales volumes in Q4 with a standard cadence for the business, the softness was larger than we had expected. Our price mix decline in the quarter was primarily driven by promotional activity in our durable products as well as a higher mix of lower-priced consumer products relative to our higher-priced durables. Our sales mix continues to evolve, and for the full year, consumable products represented approximately 74% of our sales compared to 65% in 2022. Our proprietary brands continued to mix higher on a year-over-year basis and approached 60% of our total net sales in the fourth quarter, our highest ever quarterly level since our IPO. Some of this mix shift was a reflection of the encouraging demand for our proprietary nutrient brands. Accompanying our favorable brand mix for the quarter was continued sales diversification. As Bill noted, our international and non-cannabis sales increased from a sales mix perspective in Q4 '23 and for the full year, and now represent approximately a quarter of our total sales. In 2024, we will look to further capitalize on what is working today, focusing on improving our mix of proprietary brands, most notably our proprietary nutrients, as well as driving further momentum in our international and non-cannabis sales. Gross profit in the fourth quarter was $8.4 million compared to a gross loss of $0.5 million in the year-ago period. Adjusted gross profit was $11.5 million or 24.3% of net sales compared to $9 million or 14.7% of net sales in the year-ago period. This represents a significant adjusted gross profit margin expansion when compared to the fourth quarter of 2022 and a 130 basis point expansion when compared to our vastly improved third-quarter margin. This margin expansion demonstrates continued progress on more favorable brand mix, lower freight costs, and improved productivity. As you may recall from our Q3 call, we initiated a second phase of our restructuring plan, which includes US manufacturing facility consolidations intended to improve efficiency and further right size our footprint. This second phase is primarily focused on our durable products manufacturing operations. In the fourth quarter, we recorded $1.3 million of restructuring expenses, which included non-cash inventory write-downs associated with the reduction in durable manufacturing and warehousing space. In total, when you combine our phase one and phase two restructuring initiatives, along with our sublease cost-saving activities, we expect that by the end of 2024, we hope to have reduced our company-wide manufacturing and distribution footprint a little over 25% since the start of 2023. Selling, general, and administrative expense was $19.9 million in the fourth quarter compared to $26.2 million in the year-ago period. Adjusted SG&A expenses were $12 million, a significant 31% reduction when compared to $17.4 million in the year-ago period. The decrease was primarily driven by reductions in headcount, professional fees, lower accounts receivable reserves, distribution center facility costs, and insurance costs. Our Q4 adjusted SG&A expense remained in line with our third-quarter, which was our lowest quarterly total since before going public. Adjusted EBITDA was a loss of $0.6 million in the fourth quarter compared to a loss of $8.4 million in the prior year period. The $7.8 million improvement was driven by our lower adjusted SG&A expenses and our higher adjusted gross profits. Most notably, for the full year, we achieved positive adjusted EBITDA which delivered on our expectations and demonstrates the effectiveness of our improved proprietary brand mix and our restructuring, productivity, and cost-saving initiatives. Moving onto our balance sheet and overall liquidity position. Our cash balance as of December 31, 2023, was $30.3 million, an improvement of $9 million compared to the end of 2022. We ended the year with approximately $123 million of term debt, approximately $132 million of total debt when you include finance lease liabilities, and approximately $102 million of net debt. As a continued reminder, our term loan facility has no financial maintenance covenants and our debt facility does not mature until October 2028. We continued to maintain a zero balance on our revolving credit facility throughout the fourth quarter and across the entire 2023 fiscal year. In the fourth quarter, we reported a loss from operating activities of $1.6 million with capital investment of $0.2 million, yielding negative free cash flow of $1.7 million. However, our positive adjusted EBITDA and our disciplined management of working capital throughout the year helped us generate positive free cash flow as expected for the full year of 2023. With that, let me turn to our full year 2024 outlook. We expect net sales to decline low to high teens on a percentage basis for the full year 2024. As we have seen each sequential quarter since Q4 2022, we expect the quarterly declines to decelerate over the coming year. We also expect to see an increase in adjusted gross profit margin, primarily due to improved sales mix and our restructuring and related cost-saving initiatives. We expect adjusted EBITDA that is positive for the full year 2024. This assumes improved adjusted gross profit margin and adjusted SG&A expense savings to more than offset some limited productivity investments. We also do not expect any significant charges related to non-restructuring inventory write-downs or accounts receivable for the full year. Finally, we expect to generate positive free cash flow in 2024. We will continue to reduce our working capital inventory levels. I will note that we do expect capital expenditures of approximately $4 million to $5 million in the year. In closing, we remain optimistic about the future of the industry and the future of Hydrofarm. This year, we proved we can operate profitably despite lower sales levels as we deliver positive adjusted EBITDA and positive free cash flow. And we look forward to continuing to deliver the results in 2024.

The first thing I want to ask is your guidance implies a low-teens to high-teens decline, resulting in approximately $27 million to $39 million in lost revenue. However, your EBITDA remains flat. Can you explain how much of this is due to productivity or savings compared to improvements in the underlying gross margin from favorable supply chain costs, considering the lag and the mix of proprietary brands?

Thanks, Andrew.

Yeah, good morning, Andrew. I can jump in on that. A couple of things that will be driving it. I mean, you heard us mention an improvement in adjusted gross profit margin for the full year 2024 versus '23. Obviously, we ended last year roughly at 24% adjusted gross profit margins. We expect that our improved sales mix, so higher proprietary brands, we have a couple of hundred basis point opportunity to improve that in '24 versus '23. And I think, as you know, our proprietary nutrients are really inside of that number of proprietary brands more broadly and represent one of the more profitable pieces of our overall business. We also think we have a couple of hundred basis point margin opportunity to improve in terms of percentage of sales from proprietary nutrients. On top of that, with the restructuring that we've been instituting and other related productivity and cost-saving initiatives, we do think that we'll reduce some space to reduce overhead costs and our labor pool in our manufacturing durable facility located in Chicago. We've already instituted some of that and have a little bit more work to do there. But overall, that's gone pretty well and we've reduced basically a third of our space there. We also have an opportunity to further consolidate our manufacturing facilities with respect to some of our consumable operations. And while we haven't yet quite accomplished that, that's on the bill for '24 and should extract savings similar in terms of reducing overhead costs and improving productivity in our main nutrient manufacturing facility. We also, as I think you see that through our results in 2023, we captured some freight savings last year, really in the back half of '23, we will get some lag benefit in the first half of '24 as we continue to achieve lower less-than-truckload and local freight rates that will be a favorable comparison in the first half of the year. On top of that, at the SG&A level, we still have very many benefits that are coming our way in 2024. We have expected lag benefit from a savings that we achieved last year in terms of headcount reductions. We reduced headcount by almost 25% during 2023. So in the first half of 2024, we should see some benefit from that. We also expect in '24 we'll have lower professional fees, distribution facility costs related to our subleasing activities. We've been subleasing a lot of our excess distribution warehouse space. And then on top of that, we have some insurance expense savings. So I think you're gathering and there's a lot of savings opportunity, much of which we've already instituted, some of which is still on the come, which we think gives us margin opportunity at the gross profit level as well as more savings at the SG&A level.

That's helpful. I guess the second question is, and I think we just got a press release that GrowGen picked up the Quest business. They are, obviously, the largest manufacturers less distributor out there. is focusing more on signature. And a lot of like some of the kind of third-party distributed brands out there kind of in play are some of those that we're going to direct to retail are now looking for a different solution has become economical. What is the landscape like out there in terms of the opportunities for third-party? Or should we just think about this more as just focusing on really driving proprietary?

I believe that the proprietary aspect has been our main success. Over the past few years, as we and Hawthorne struggled to meet demand as primary hydroponic distributors, many third-party brands shifted towards other lawn and garden suppliers, direct retail, and various channels, which has led to their dilution in the market. In response, we have ensured consistent supplies to maintain our position as industry distributors while emphasizing our proprietary signature house brands. This approach has allowed us to achieve slightly positive EBITDA for last year, thanks to the beneficial mix of our profitable house brands. Although our proprietary nutrient brands have shown year-over-year growth, it's a different narrative from our total company performance. The weakness we're experiencing is largely due to the distributor brands spreading too thin across numerous supply points in the industry. We're in discussions with those parties to identify the right partnerships moving forward, but our focus remains firmly on driving our proprietary brands.

I wanted to ask about visibility. When we look at the implied revenue guidance for this year, it seems to be below the levels from 2018. I understand the business has cyclicality, but the downward pressure appears to be more significant than expected. Considering the guidance indicates a decline in the low to high teens, how confident are you in that projection and what are the main factors contributing to it? I'm trying to understand when we might hit a bottom, given the performance trends we've seen over the past few years.

I believe we have hit the lowest point. The key question now is when we will start to improve. We thought it was essential to plan for the year with the expectation of being slightly profitable at our lowest projected sales level. It is our responsibility to present that to you and then strive to exceed those expectations. The aim is to prepare for a scenario in the high teens, which we hope is the worst-case scenario, and be ready to achieve profitability at that level. From there, we can aim for better performance, resulting in a strong business and favorable outcomes. I genuinely believe we are at a low point, and have been for the past four to five months across the industry. Signs of improvement are beginning to emerge. Our insights regarding March, April, and May show stronger pre-bookings compared to last year. However, we are experiencing some setbacks from the dilution among distributor brands, which has negatively impacted our numbers. It is crucial for us to establish a target, align our cost structures and strategies to achieve profitability at the lowest levels we predict, and then work to exceed those targets. That is our primary objective and how we've formulated our guidance for this year.

No, that's very helpful. But I guess maybe a question following up on that. Just the positive adjusted EBITDA, kind of following up on Andrew's question, I guess, obviously positive is anything above zero. So can you maybe provide some guardrails in terms of how we should think about our model to reach that kind of similar EBITDA profit dollars versus what we saw this year? Should we expect sequential improvement? Just trying to understand because, you know, both we and consensus have something that's more in the high single digit million dollar range, and I'm not sure if that's far too optimistic at this point given the weaker revenue outlook?

Yes, I think it is optimistic at this point because we are anticipating a stronger fourth quarter and a better 2024, which has contributed to that consensus. Last year, we described our outlook as modestly positive, and it was indeed more modest than we would have preferred. This year, we are saying positive. We certainly aim to perform better than we did in 2023, but we are not yet in a position to specify how much that will be in terms of millions of dollars. Much depends on the range we achieve on the top line, as everything hinges on that. Our costs are under control, but we aren't ready to provide any specifics. However, we do expect, want, and are committed to achieving positive EBITDA this year.

Good morning. This is Davis Holcombe on for Bill Chappell. And you all had mentioned the seven new legalized adult-use states in 2023 and we're just kind of wondering what sort of demand you might be seeing out of those newly legalized states and what kind of maybe regulatory environments they may have compared to some of the existing states that you all are operating in?

I believe the newer states, like Ohio and Missouri, are currently among our best performers. However, they are quite small compared to larger markets like Colorado, California, Oregon, and Michigan, resulting in a slower scale-up and a lag between legalization and implementation. Additionally, political dynamics have hindered progress even in states such as New York and New Jersey, although those areas are beginning to improve. The larger, established states have historically dominated the market, with California accounting for a significant portion of the business, but that is changing. Now, California represents only about 30% or less of the total market. This trend is evident across the industry as the focus shifts to newer states, creating a more balanced distribution. Oklahoma's unique situation saw it once hold nearly 20,000 licenses, accounting for half of the total in the U.S., but regulatory measures have tightened, cutting the number of licenses in half, which is a positive development. The new states seem to be learning from the oversights of their predecessors and are better regulating the number of dispensaries in relation to grow operations, population, and demand. While progress is being made, it remains slow and is often interrupted. The absence of clear federal guidance has significantly affected the entire sector over the past few years.

Good morning, guys. I had a question on the catalyst side, we're looking at the multistate operators and just the plant-touching businesses. Certainly, the potential for rescheduling is the biggest thing on the horizon. Can you talk a little bit about how Schedule III could be helpful to you, although you weren't a plant-touching operator? Do you see that freeing up budgets and potentially increasing CapEx? Or do you see that as not being a meaningful catalyst for your business?

No. We believe that this could be a significant catalyst, especially for durable orders, and it could also boost confidence and sentiment across the entire category, encouraging investment once again. Many people are currently on the sidelines, including multi-state operators who are holding back capital due to higher interest rates. It's clear that it's challenging to invest in these businesses right now, leading to a holding pattern as everyone awaits the transition from Schedule I to Schedule III. As you mentioned, the primary advantage of this change is that legal plant-touching businesses would no longer face their current tax burden. Once this burden is lifted, they will be able to retain more cash flow, enabling them to invest back into the category. We definitely view this as a positive development for us. While it may take time for orders to start flowing in after the change, we have seen several projects that have been delayed for the past year or two now beginning to ramp up. We are optimistic that this catalyst will materialize, especially as supply and demand become increasingly imbalanced, as I noted earlier in relation to Oklahoma. Overall, rescheduling would benefit the entire industry and would likely restore people's confidence, allowing for a return to a more normalized growth trajectory.

That's helpful. Thanks. And on the state side, the two biggest markets that could flip rush this year are Florida and Pennsylvania. Can you talk a little bit about those states and if they were to move to adult-use sales, how you would see federal spending increasing there?

Yes, both states present significant opportunities. Florida has been on our radar for some time. The governor has announced that it will be on the ballot this November, which is excellent news. Pennsylvania seems to be in a similar position. Both states have large populations, over 20 million in Florida and around 10 million in Pennsylvania, making them crucial catalysts for us. If these markets develop, they could likely account for closer to 60% or more of the category's total population. We anticipate that this will play a significant role in our growth moving forward.

And Jesse, both of those states have been comping better for us than the overall population has.

Good morning, guys. How are you doing? One of my questions is in regard to the previous issues in regards to inventories, how's that, the win? Is there any more benefit to see out of that? Is that imbalance presently? Are you satisfied with that?

Yeah, I'll start there. There's really two sides of the inventory thing, both are trending in the right direction. We've reduced our total inventory in a two-year period by close to $100 million. Some of that was inventory write-down, but the vast majority of that was simply getting inventories down to manageable and workable levels. And so we still think we have another bit to go. We'd like to be able to run this industry or this company on 90 days worth of inventory right now or at a higher number than that. And we think we've got probably $15 million, $20 million more we could take out of the total. So it's a terrific thing. The other piece of inventory improvement from '23 compared to '22 is we had far, far, far less write-downs in '23 compared to what we had in '22 as we are dealing with the supply chain fluctuations from even back to COVID days and the industry's high volume days back in '20 and '21. So the inventory had gotten exaggerated in everybody's balance sheets. So we worked all that down. So we didn't have those sort of write-down issues in '23. We don't expect them again in '24, which is great. Although you still have to manage it every quarter and every month and we do very, very aggressively to try and protect our balance sheet, protect our inventory investments.

Yes. Just to add some math to what Bill's comment there a second ago, you heard him say we'd love to manage the business on basically 90 days or one quarter's worth of demand. We ended this past year 2023 with roughly $75 million worth of inventory. And over the last four quarters, we've been averaging about $56 million in sales. So clearly, you there's real opportunity for us there and that's why you hear us talking about sort of an ability to manage that further down into 2024.

Okay. Regarding the cost cuts you've implemented, hopefully, we're going to see a turnaround. Business improved by 20%, and you're set to achieve that without needing to rehire a significant number of employees or adjust capacity drastically. I was considering that given your current position, you should be able to grow the business. How much do you think you can increase it before reinstating the advertising spending?

Well, you have some variable costs, obviously, with staffing in the distribution centers. But importantly, as we have come down in top line, we did not dramatically alter our footprint. We still have six distribution centers in the US, we have two in Canada, and we have one in Europe, and that was the footprint we had three years ago. What we've done instead is we've been subletting vacant and underutilized space to allow us to provide service to others. If you will, and so we're able to handle the volumes that we had back in '21, '22 or '20 and '21 very, very easily. We would have some costs on the way back up as you have more people touching more volume. But structurally, we've got our cost structure really tightened down now to where we can make money at these low levels, but also can scale up very quickly and be able to support our customers.

So that would mean to me that our margins should expand significantly due to an increase in overall revenue, so it seems reasonable to expect that the costs will be spread more effectively.

Absolutely. Let's not forget that three years ago, we were roughly a 10% EBITDA business when things were growing and better. And we think that with our mix change toward the more profitable, powerful brands that are ours, that could be a very achievable number over time. We're probably not going to get there anytime in the next 6 to 12 months, but I think as industry growth returns and we're able to drive our profitable proprietary brands that we certainly have a really good position going forward.

As there are no further questions, I would now hand the conference over to Bill Toler for his closing comments.

Thank you, everyone, for being on the call this morning and thanks for your continued support of Hydrofarm. We look forward to speaking to you soon. Take care.

Thank you. The conference of Hydrofarm Holdings Group has now concluded. Thank you for your participation. You may now disconnect your lines.