Earnings Call Transcript - HYFM Q4 2024

Operator, Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Holdings Group Fourth Quarter and Fiscal Year 2024 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 5, 2025. I would now like to turn the call over to Anna Kate Heller at ICR to begin. Please go ahead.

Anna Kate Heller, IR Officer

Thank you, and good morning. With me on the call today is John Lindeman, Hydrofarm's Chief Executive Officer; and Kevin O'Brien, the company's Chief Financial Officer. Bill Toler, Executive Chairman of the Board, is also on the call. By now, everyone should have access to our fourth quarter and full year 2024 earnings release and Form 8-K issued this morning, as well as an investor presentation available for reference. These documents are available on the Investor 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 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 would like to turn the call over to John Lindeman.

John Lindeman, CEO

Thank you, Anna Kate. Good morning, everyone. I'm pleased to be speaking with you on my first call in the capacity of CEO, the transition that occurred on January 1st of this year. And before I begin, I want to thank Bill for his leadership over the past five years and his continued support in his role as Executive Chairman. Now, let me begin by stating that we made some notable improvements across the business in 2024. Though the benefits from some of these improvements were masked by a challenging second half, particularly in the fourth quarter, industry conditions weakened in the second half of 2024, marked by persistent oversupply challenges and further retail store closings across the sector. This has resulted in lower sales across the supply chain, a trend we are seeing echoed across our industry peers. That said, I'm pleased to report that we finished the year with sales comfortably within our full year outlook and successfully completed reductions in adjusted SG&A through our effective cost-saving and restructuring actions. Having said that, our 2024 adjusted EBITDA and free cash flow fell short of guidance due primarily to our fourth quarter performance. While it is seasonally our smallest quarter, fourth quarter sales came in softer than expected due to industry conditions. For quite some time, we have been clear that our strategic priority is driving the sales of our higher margin proprietary brands. This strategy has yielded positive results as we have improved our proprietary brand sales mix from approximately 35% in 2020 to 56% in 2024. This strategy has allowed us to operate profitably for the majority of quarters over the past two years, even as industry sales levels have compressed. In October and November, we saw our proprietary sales mix slip, which significantly pressured our profitability for the quarter and impacted our full year results. As we detailed on previous calls, we invested in multiple new distributed brands, primarily in the spring of 2024, in an effort to position our product portfolio for growth. While our investment in these distributed brand partnerships helped our top line, they did weigh on our adjusted gross profit margin and free cash flow for the full year. We've since taken a number of actions to reemphasize our proprietary brand focus across the Hydrofarm platform and are now expecting an improvement in proprietary brand mix for the full year 2025. There were a number of positive developments in 2024 that we intend to further build upon this year. For example, in 2024, we saw strong performances from select proprietary consumable brands in the grow media and nutrient categories. Specifically, full year results for our Aurora Peat brand remain steady, improved again to be one of our most consistent brands. In addition, several of our other key proprietary consumable brands also had relatively strong year-on-year results. On the durable side, we saw outperformance from our proprietary Active Aqua brand. As I have mentioned, we are deeply focused on our proprietary offerings and will continue to strategically invest behind our key brands as we look to meet growers' evolving needs. We also will continue to innovate and evolve our portfolio, and have a number of exciting new proprietary products on the docket for 2025. We also were encouraged by our e-commerce business in 2024, as U.S. sales for this channel increased over 25%. E-commerce has become a strong channel for home-growing solutions, and we are committed to expand our presence and our capabilities in this space. Another area of focus has been to increase overall revenue diversity to help balance industry fluctuations. And in 2024, we achieved a nearly 200 basis point increase in our sales to non-cannabis and non-U.S. Canadian customers. In 2025, we are planning to introduce several new products outside of the U.S. and Canada. As a result of this action and others, we expect to further increase our non-cannabis and non-U.S. Canadian sales mix again this year. Improving profitability by improving the efficiency of our manufacturing and distribution operations and by reducing our adjusted SG&A expense continues to be a top priority. While our profitability took a step back in the fourth quarter, we should not discount the significant progress we have made over the past couple of years in several key areas. Since the beginning of 2023, we reduced our manufacturing footprint by nearly 60% and invested in productivity-enhancing capital equipment in our manufacturing operations. We also delivered ten consecutive quarters of meaningful year-on-year adjusted SG&A savings and are now operating below our pre-IPO dollar cost. Looking ahead to 2025, we have a clear strategic roadmap focused on driving diverse, high-quality revenue streams, improving our profit margins, managing our financial position, and continuing to improve our overall capabilities. This starts with reinvigorating our proprietary brand sales mix through targeted marketing investments, enhanced salesforce capabilities, refined incentive structures, and additional sales support infrastructure. To enhance our profit margins, we will further optimize our distribution network to align with current sales volume and pursue contract manufacturing opportunities to maximize our production capacity. To further support margin enhancement, we will also reduce our SG&A expenses in several areas, including professional and outside services, facility costs, and insurance. Managing free cash flow and our overall financial position will remain a priority. We believe there is room for improvement in this area with tighter working capital management since ERP integrations are now complete, and AP software automation is near complete. While we cannot be certain on the timing of an overall industry recovery, we are certain that we will manage these initiatives. Lastly, before I turn it over to Kevin, I should reiterate that we also will focus on strategic alternatives that could enhance shareholder value. We continue to monitor the market for opportunities that serve to conform to our strategic priorities, complement our portfolio, and strengthen our business. This could be achieved either through a strategic combination or in the context of a potential acquisition or divestiture. With that, I will hand it over to Kevin to further discuss the details of our fourth quarter financial results and our full year 2025 outlook.

Kevin O'Brien, CFO

Thanks, John. And good morning, everyone. I am excited to be here on my first earnings call as CFO at Hydrofarm. Net sales for the fourth quarter were $37.3 million, down 20.9% year-over-year, driven primarily by a 16.8% decrease in volume mix and a 3.9% decline in pricing. The decrease in volume mix was mainly related to an oversupply in the cannabis industry. As we had indicated last quarter, the pricing decline was driven largely by promotional activity in the period. As John discussed before, overall brand mix slipped during Q4. Our proprietary brands represented approximately 52% of our total net sales, a decrease compared to the prior year period. We started Q4 2024 with weaker proprietary brand mix performance compared to our expectations. As John noted, we began implementing several corrective actions and have achieved some recovery in proprietary brand mix over the past few months. The negative impact on profitability made clear our strategic priorities for 2025. We are focused on driving performance of our higher margin proprietary brands, and we'll be investing in them to improve this mix in 2025. For the fourth quarter and full year 2024, consumable products continued to account for approximately three quarters of our total sales, which was similar to 2023. Gross profit in the fourth quarter was $1.8 million or 4.9% of net sales compared to $8.4 million or 17.9% of net sales in the year-ago period. Adjusted gross profit was $3.6 million or 9.6% of net sales, compared to $11.5 million or 24.3% of net sales last year. The decrease was due to lower overall sales and a decreased mix of our higher margin proprietary branded sales in the quarter. We also incurred approximately $1.4 million of inventory-related charges that were not associated with our restructuring plans. During the fourth quarter, we substantially completed the second phase of our restructuring plan, which included significant reductions to our manufacturing and distribution center footprint. Our manufacturing operations are now concentrated in two U.S. locations, plus our Canadian peat moss harvesting and processing facility. We successfully integrated our Canadian entities into our main ERP system and reorganized business activities and reporting into a single operating segment, effective in the fourth quarter. These integrations were important to reduce costs and are expected to improve operating efficiencies and drive synergies. Given the ongoing challenges in the industry, we will continue to evaluate opportunities to drive further efficiencies and cost reductions. Moving on to our selling, general and administrative expense. In the fourth quarter, our SG&A expense was $17 million compared to $19.9 million last year. Adjusted SG&A expenses were $10.8 million, a 10% reduction compared to $12 million last year. For the full year, we achieved a 17% reduction in adjusted SG&A due to lower expenses in several areas, including facility expenses, headcount reductions, professional fees, and insurance costs. This marks 10 consecutive quarters of significant year-on-year adjusted SG&A savings, and we have line of sight into further cost savings in 2025, net of our plans to invest in proprietary brand marketing. As previously stated, in connection with our restructuring and related cost-saving initiatives, we significantly reduced our distribution center facility footprint through sublease and third-party logistics agreements for several of our U.S. and Canadian locations. In 2025, we will continue to review opportunities to reduce facility space and our overall inventory levels in connection with distribution center consolidations. Adjusted EBITDA was a loss of $7.3 million in the fourth quarter. The loss was due to lower sales and adjusted gross profit, partially offset by adjusted SG&A savings. Moving on to our balance sheet and overall liquidity position. Our cash balance as of December 31, 2024, was $26.1 million, up from $24.4 million at the end of the third quarter. We ended the year with $119.3 million of term debt, and approximately $128 million of total debt, inclusive of financial lease liabilities. Our net debt at the end of the year was approximately $102 million. As a reminder, our term loan facility has no financial maintenance covenants and does not mature until October 2028, and we continue to maintain a zero balance on our revolving credit facility. With our cash on hand and approximately $13 million of availability on our untapped revolving line of credit, we have $39 million of total liquidity, a comfortable position for us. In the fourth quarter, we generated cash flow from operating activities of $2.7 million and capital expenditures of $0.3 million, yielding free cash flow of $2.4 million. With that, let me turn to our full year 2025 outlook. The outlook we are providing today is based on our current industry view for 2025. We expect net sales to decline between 10% and 20% compared to 2024 levels. We also expect an increase in adjusted gross profit margin primarily due to improved proprietary brand mix and our restructuring and related cost-saving initiatives. We expect adjusted EBITDA to be negative but an improvement compared to full year 2024. To accomplish improved adjusted EBITDA on lower sales, we are assuming improvements in our proprietary brand mix and operational efficiencies, leading to higher adjusted gross profit margin. We also anticipate further reducing our adjusted SG&A in 2025. As John noted, we plan to make some targeted investments to drive sales. We are also assuming no significant charges related to non-restructuring inventory write-downs or accounts receivable for the full year. Lastly, we believe we can continue to drive inventory reductions through our facility consolidations and improved execution on working capital management, generating an improvement in free cash flow compared to our 2024 level. To close, we remain optimistic about the long-term prospects for our industry and the future of Hydrofarm. In 2025, we will continue to invest behind our key higher-margin proprietary brands and further diversify our revenue streams and better position ourselves for an eventual demand turnaround in the industry. Thank you all for joining us, and we are now happy to answer any questions.

Operator, Operator

We'll take our first question from Dmitry Silversteyn from Water Tower Research.

Dmitry Silversteyn, Analyst

My question, I should say. You mentioned that a lot of your fourth quarter performance was driven by what's going on generally in the market and the industry. Can you talk a little bit more about what the dynamics look like for the broader environment in your categories as you look forward to 2025 and maybe provide some granularity on when you think oversupply in the channel will be worked off?

John Lindeman, CEO

Thank you for joining us. To start, we should reflect on early last year, 2024, when there was significant optimism about rescheduling and the passage of the Safer Banking Act in Florida. This optimism led to some sequential improvements in spending from late 2023 into spring 2024. However, as it became evident that there would be a change in the presidential administration and that Florida wouldn't pass the legislation, expectations and timelines shifted or got extended. We anticipate a potential return to growth in the second half of the year. There's a chance that increased U.S. border security could positively influence cannabis pricing in the U.S., benefiting growers. Currently, prices are somewhat unpredictable, especially concerning supplies from China, Canada, and possibly Europe. According to our internal models, we project double-digit sales declines early in the year, which we expect to moderate as the year progresses. Nonetheless, we will concentrate on our key initiatives, such as enhancing our proprietary brand mix, diversifying revenue streams outside the U.S. and Canada, and improving our profit margins. We see opportunities to further optimize our distribution network for savings and manage our SG&A expenses, both of which could benefit our free cash flow. Additionally, we believe we can effectively manage down our inventory levels given the current demand environment while overseeing our working capital and free cash flow. As mentioned by Kevin, we completed several ERP integrations this past year, which provides better visibility into our working capital and potential opportunities. I hope this gives you more insight into our perspective.

Dmitry Silversteyn, Analyst

It does. I want to follow up, if I may, on your cost-cutting initiatives. You talked about rationalizing your manufacturing infrastructure and your warehouse and distribution. The cost savings that you're getting out of the SG&A, thanks to the ERP going live. What can we look forward to in 2025 in terms of incremental benefits of the actions that you've taken? How much more can you improve your operations and improve your efficiencies as you move through 2025?

John Lindeman, CEO

Yes. Great question. Yes, I mean, look, there's an opportunity for sure to continue to extract some additional savings, and we have a series of actions lined up. I would say, certainly, I mentioned it earlier, but optimizing our DC network further is something we could do, and we could do it a couple of different ways. We can expand our sublease 3PL relationships or add new ones to effectively reduce our already actively operated space, and reduce our net facility costs. We may have an opportunity to completely consolidate one or more of our DCs into other DCs. We've done that once before. We actually saw really good inventory level savings by affecting that trade. And so we're looking at both of these options right now. And there's an opportunity in front of us, perhaps in the Western U.S. There's also an opportunity to further reduce our SG&A costs. I mean, we've taken a lot out already to be fair, but we do have line of sight currently on over $2 million to $3 million in savings, and we think there's opportunity for more. Lastly, maybe on this point is within our working manufacturing centers, we also have an opportunity to get some lab benefit productivity initiatives that went into place last year. Now remember, we consolidated 2 manufacturing facilities, actually 3, into the remaining 2 here in the U.S. around midyear last year and then we still have our facility up in Canada. Now some of those benefits may be masked depending on how much demand pull-through we ultimately get this year. But our models do suggest that if we hit sort of the mid-favorable end of our range, we should see some manufacturing benefit this year, too. So, and also in light of the things I mentioned on working capital, consolidating DCs just to underscore that really does have a positive impact on our inventory reductions. And so good opportunity from a working capital standpoint there. I think those are the main points, I think.

Dmitry Silversteyn, Analyst

That's helpful. If I can ask maybe kind of a 30,000 foot view question. Investors in many industries are concerned or at least talking about the potential impact of tariffs, whether already announced or potentially announced. We also have, obviously, you mentioned the new administration, new HHS Secretary, this focus on cutting regulations and perhaps doing something with the classification of cannabis. If you look at sort of these things that are beyond your control, but do you have a view on how this may impact you either positively or negatively, whether the industry overall or you specifically?

John Lindeman, CEO

Yes, there's a lot going on with tariffs right now, and I understand it's a key concern for investors and us as well. At Hydrofarm, we have several measures in place to address this situation. It's crucial to recognize our historical trade balance with Canada. We do export some products to Canada while importing others, making us a net importer from Canada. Back in 2024, about 5% of our total sales came from Canada, particularly impacting our peat business in Edmonton. We have observed that competitors are passing the additional tariff costs onto customers, and we plan to do the same. The situation is fluid, and there are still customers who believe the tariffs could be temporary if there are favorable actions from the Canadian administration. Currently, we intend to follow the market trends and transfer these additional costs to our customers. While we don't anticipate a significant impact on volume, customer decision-making regarding tariffs might lead to fluctuations in product allocation from one quarter to the next. This could also affect our internal pricing models, which are already being influenced by the changes we're implementing. A shift in sales from quarter to quarter is possible. Regarding sourcing from China, there have been tariffs since the previous administration, and they are increasing. When we went public, we sourced a larger percentage of our products from China, but we've since reduced that to the low to mid-teens percentage of our total sales. These products usually have longer lead times, meaning we need to maintain higher inventory levels, which we've tried to minimize. Nevertheless, we still carry more inventory than in other product areas. The upside is that we have a significant amount of inventory already landed, typically measured in several months, though it varies by product. We'll continue to monitor the situation closely and be ready to adapt as needed. Overall, I hope this gives you some context on the matter.

Dmitry Silversteyn, Analyst

John, thank you for that level of detail. I appreciate it. And then one final question, if I may. You mentioned that you may become a little bit more active, if you will, or have some thoughts on the M&A side of the business, whether partnering or perhaps an acquisition. Can you talk a little bit more about specifically what is it that you're looking for? What are you going to look out for? And what are some of the things that you may be considering when it comes to strategic moves for the company?

John Lindeman, CEO

Yes, I need to be careful and specific here. However, it's clear that this is a concern for all our stakeholders and for us as well, so I'm glad you brought it up. Across the industry, all key players have been facing similar challenges. Revenue and demand declines have been widespread for over two years now, and the recovery is taking longer than we anticipated. Typically, such circumstances lead to consolidation in an industry, but in our sector, particularly among the significant players in the supply chain, consolidation has not occurred. We want to emphasize that we will focus on what we can control. Bill and I have consistently stated that we are actively monitoring opportunities that could enhance shareholder value. This could involve small acquisitions that help us diversify geographically or even explore opportunities outside the cannabis sector. We also recognize that there are valuable assets within our company that may attract interest from others, and we are considering those as well. Additionally, we see potential for strategic combinations that could benefit the industry and our shareholders, given the right conditions. Bill, I, and our team continue to pursue these avenues, along with some partners. We'll see how it unfolds.

Dmitry Silversteyn, Analyst

Understood. I appreciate that, and I understand you can be more specific, but I appreciate the granularity on that. Well, I'm going to get back into the queue and just wish you luck in 2025. It sounds like we're going to start the year a little bit slower, but hopefully, the momentum will build as the year unfolds.

Operator, Operator

And at this time, we have no further questions. That will end today's presentation. We thank you for your participation. You may disconnect.