Earnings Call Transcript - HYFM Q1 2024

Operator, Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Holdings Group First Quarter 2024 Earnings Conference Call. Please note that this conference is being recorded today, May 14, 2024. I would now like to turn the call over to Anna Kate Heller of ICR to begin. Please go ahead.

Anna Heller, Investor Relations

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 first quarter 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 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 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 Bill Toler.

William Toler, Chairman & CEO

Thank you, Anna Kate, and good morning, everyone. I am pleased to report that in our first quarter, we delivered better results in many key profitability metrics, including adjusted gross profit margin, adjusted EBITDA, adjusted EBITDA margin and free cash flow. In addition, March 2024 marked the fifth consecutive month of sequential net sales growth for Hydrofarm. That's the longest string of sequential monthly growth we have seen since our IPO in 2020. Second, we have now increased our adjusted gross profit margin on a year-over-year basis across the last five consecutive quarters, and we achieved positive adjusted EBITDA in three of the past four quarters, demonstrating our ability to continue to operate profitably during the industry downturn. While we are far from satisfied with the $2.7 million of positive adjusted EBITDA that we have reported over the last 12 months, it is clear that our cost savings and restructuring actions are making a difference. When sales begin to increase, this volume will make an even larger impact on our bottom line. Our biggest opportunity is to continue to find new and unique ways to drive profitable growth. To accomplish that, we are innovating and expanding our brands to address growers' needs. For example, at the end of Q1, we launched a new and improved PHOTOBIO LED light designed specifically for commercial growing applications that offers 10% more light output, 47% less weight in the fixture and increased efficacy, all at a 20% lower price than comparable models. While we are still in the early innings of this product innovation, we did see year-on-year growth on the PHOTOBIO brand in Q1. Second, we continue to diversify our revenue stream by driving sales in our non-cannabis markets and broadening our geographic reach. In Q1, our non-cannabis and non-North American revenue sources increased to an estimated 32% of sales, representing approximately a 360-basis-point increase from the prior year. In addition to our diversification strategies, the regulatory environment is finally getting better for U.S. cannabis growers. It's improved and will help drive sales in the industry in the future. Recently, we all read that the DEA will propose the reclassification of marijuana from a Schedule I to a Schedule III drug, a significant step in the process to legalize cannabis in the U.S. Separately, in April, we learned that the Florida Supreme Court will allow the state's voters to decide on the November ballot whether to legalize adult-use marijuana or not in the state of Florida. These are good signs for our industry. While the financial metrics we just reported are central to this earnings call, I want to share a broader view of what I believe to be the beginning of a turn in the industry. I mentioned the five consecutive months of sequential sales growth. That's encouraging, but we're also seeing a recent stabilization in our core U.S. business. Some of this is driven by innovation, like the previously mentioned PHOTOBIO LED lights, and some of it simply by the supply and demand rebalancing across the country. Proprietary brands, including Grotek, Roots Organic, Gaia Green and PHOTOBIO grew in Q1 compared to the prior year, coupled with slight improvement in demand with our tight control on costs, including our adjusted SG&A being 24% lower in Q1 this year versus last. We are well positioned for continued improvement in profitability as volume returns. We are reaffirming our full year guidance for net sales, adjusted EBITDA and free cash flow as we remain focused on our brands, diversification of revenue and improved mix in controlling and reducing costs. With that, I'll turn it over to John to further discuss the details of Q1 and our outlook for 2024. John?

B. John Lindeman, CFO

Thanks, Bill, and good morning, everyone. Net sales for the first quarter were $54.2 million, down 12.9% year-over-year, driven primarily by a 12.6% decrease in volume/mix. The decrease in volume/mix was mainly related to oversupply in the cannabis industry. Additionally, pricing was relatively flat in Q1 as we lapped price concessions made in the first quarter of 2023. In the first quarter, consumable products represented approximately 76% of our sales compared to 72% in the first quarter of 2023. This higher mix of consumables was led by a year-over-year sales increase in Grow Media products including our own proprietary Roots Organics and Gaia Green brands. During the quarter, we maintained a strong mix of proprietary brands at approximately 57% of our total net sales, relatively consistent with the same period last year. Gross profit in the first quarter was $10.9 million compared to $11.4 million in the year-ago period. Adjusted gross profit was $12.7 million or 23.4% of net sales compared to $14.1 million or 22.6% of net sales. This 80-basis-point increase is primarily the result of improved productivity inside our manufacturing plants. This marked our fifth consecutive quarter of year-over-year adjusted gross margin expansion. And while we are pleased with our progress, we do feel there is some opportunity to further improve upon this metric as we track across the remainder of 2024. Now a quick update on our restructuring plan. As we previously mentioned, our second phase of restructuring was largely focused on rightsizing our manufacturing footprint, particularly with respect to durable equipment products. We announced today the signing of an agreement in which we are selling the manufacturing equipment and on-site inventory related to our IGE-branded products for approximately $8.7 million in cash. As part of the transaction, we will no longer be responsible for carrying the heavy manufacturing labor and overhead costs or the investment in costly steel and aluminum necessary to build our high-quality IGE products. Instead, post-transaction, our new exclusive co-manufacturer will produce our IGE products, helping us to variabilize our cost structure and ultimately improve our profit margin profile on this product set. We are excited about the prospects for both Hydrofarm and our new exclusive co-manufacturer with whom we expect to enjoy a close relationship going forward. We expect the transaction to close in the second quarter. Now let me move on to our selling, general and administrative expense, which we dramatically reduced from the prior year period. In the first quarter, our SG&A expense was $19.6 million compared to $24.4 million. Adjusted SG&A expenses were $12.3 million, nearly a 24% reduction when compared to $16.2 million in the first quarter of 2023. This was primarily due to a reduction in facility expenses, professional fees, insurance costs, and headcount. It is worth noting that much of this reduction is due to the costs we took out as part of our restructuring actions in the first half of 2023. Adjusted EBITDA was $0.3 million in the first quarter compared to a loss of $2.1 million in the prior year period. The $2.4 million improvement and the 400-basis-point expansion in adjusted EBITDA margin was driven by our improved adjusted gross profit margins and our reduced adjusted SG&A expenses. We continue to demonstrate our ability to generate positive adjusted EBITDA, which is a testament to the effectiveness of our restructuring and cost-saving initiatives along with our focus on proprietary brand sales mix. Moving on to our balance sheet and overall liquidity position. Our cash balance as of March 31, 2024, was $24.2 million. We ended the first quarter with $120.5 million of term debt and approximately $130 million of total debt, inclusive of finance lease liabilities. Our net debt at the end of the quarter was approximately $106 million. As a reminder, our term loan facility has no financial maintenance covenant and does not mature until October 2028. We continue to maintain a zero balance on our revolving credit facility. At this point, we have not borrowed against our revolver for nine straight quarters. In the first quarter, we reported cash used in operating activities of $2.3 million, with capital expenditures of $1.4 million, yielding negative free cash flow of $3.7 million. I will remind you that the first quarter is a seasonally low period for our free cash flow, and we achieved a significant nearly $7 million improvement from the prior year period, which we accomplished through positive adjusted EBITDA and disciplined reduction of inventories and working capital levels. We remain on track to deliver our positive free cash flow guidance for the full year. With that, let me turn to our full year 2024 outlook. We are reaffirming our 2024 guidance, which includes net sales to decline low to high teens on a percentage basis, adjusted EBITDA that is positive for the full year 2024 and, lastly, positive free cash flow for the full year, which includes the continued expectation of $4 million to $5 million of capital expenditures. To wrap up, we remain on the right path, and we'll continue to control what we can. We are operating profitably despite lower sales levels. Our restructuring plan and cost-saving initiatives have proven effective, and as Bill discussed before, there are reasons for optimism on the demand side of our industry as we look ahead. We are excited about the future of this business, and we look forward to continued improvement throughout the year. Thank you all for joining us. We're now happy to answer your questions. Operator, please open the lines.

Operator, Operator

Our first question is from the line of Peter Grom with UBS.

Peter Grom, Analyst

I have a couple of quick questions. First, regarding the revenue guidance, could you clarify the monthly improvements you mentioned? I may have misheard, but you indicated that these are some of the best improvements since the IPO. Can you reiterate that for us? Also, looking at the overall reported numbers, there has been a sequential improvement in sales trends over the last five quarters. You started the year at the higher end of your top-line guidance range. Can you provide insight on your expectations for top-line progression moving forward? Is there any reason to believe there might be a setback from the low double-digit decline we experienced, or can we anticipate continued sequential improvement? Additionally, are you maintaining this cautious range since we are still early in the year?

William Toler, Chairman & CEO

No. Thanks, Peter, and good question. So the first one for clarification. We've seen sequential improvements in revenue really from last October through March. So each month, it's stepped up just a bit. October through March, that's five consecutive months there, and that's the longest string of those since our IPO back in the end of 2020. Now, addressing your other question about guidance, we are being conservative here. It is early in the year. We think things are looking pretty good, but we also had a very large quarter last Q2. So we're lapping up against some big numbers there. We just don't want to get ahead of ourselves. We've got such an important period here in, really, May, June, July going into the core of the outdoor season and the late spring, early summer. We just really don't want to get ahead of ourselves and try to take up numbers too quickly. We want to see that traction going for a few more months, but we are encouraged by recent trends. We're not overly giddy or optimistic yet, but we do think that things are certainly firming up, as you probably heard from some others. We are seeing some overall sales trends that finished up Q1, and then we even start in Q2 that are encouraging for us as we go forward. But, much like you suggested, it is early in the year. We don't want to get ahead of ourselves.

Peter Grom, Analyst

Okay. That's helpful. And then I guess just on the asset sale announced this morning, can you remind us how big IGE is as part of your revenue mix? And when you talk about kind of the margin improvement as a result of this transaction, is there anything you can share in terms of the magnitude of improvement? Just trying to understand how much this could really move the needle here.

B. John Lindeman, CFO

Yes, sure, Peter. I can jump in on that one. In terms of magnitude, today, our IGE products are less than 10% of our total sales, somewhere closer to even almost a 5% than 10%. The magnitude is not that dramatic, but we did this because we believe it's a step that can continue to improve the profit margin on those particular products. As you will recall, in the second half of last year, we did reduce and restructure that manufacturing facility outside of Chicago. We took it down from roughly 300,000 square feet to 200,000 square feet. We rightsized the staff and made some other improvements in the business. But even with those changes, we're still not getting the profitability we think we should on that business. So this step really rectifies that. The benefit should show through in the back half of this year.

Operator, Operator

Our next question is from the line of Andrew Carter with Stifel.

W. Andrew Carter, Analyst

I guess the first thing I wanted to ask is kind of within the sale of IGE. I know that last quarter, there was kind of a message, either shrink to profitability or grow. Have you picked a firm path? Does IGE signal that exactly? And has the landscaping or your thinking about the world changed following Hawthorne's announcement to partner with BFG?

William Toler, Chairman & CEO

No, not really. I think IGE is a step that, as John mentioned, assures better profitability from that smaller business and positions us more cleanly now as a manufacturer of brands in the consumable space and really gets us out of that durable piece. IGE was the only durable piece we had. It's not an area where we spend a lot of time or have a lot of synergy. We didn't think being there was a good fit. Also, the previous owner to whom we sold the assets back is someone we still own the brand and the business. This should have little to no effect on our revenue through IGE, and it will improve our profit margin. So back to your larger question, this does not sort of cast our direction in terms of either getting smaller or getting bigger. This is really just a tactical step to clean up the portfolio and focus on consumables, where we're doing around 75% of our total business. We still look for options to expand our footprint and to what I would call that Hydrofarm 2.0, which we're not there yet. Ideas out there include different kinds of combinations, so we're still working on that. It's an important step for us to be ready for the industry, which does feel like it's starting to strengthen a bit.

W. Andrew Carter, Analyst

Got it. And then I guess the second question is the pricing looked pretty decent compared to what Hawthorne reported and what GrowGen implied. In terms of promotional activity, where would you say that is right now? Are you foregoing business? Within that minus 12.6% volume/mix decline, was any portion of that purposeful trading out of more profitable volume versus lower? I know that there was proprietary outperform, but I'll just stop there.

B. John Lindeman, CFO

No, I don't think the 12.6% was intentional. I think it's more continued conditions that we see in the industry. The good news is those declines have been improving over the last 18 months. And the pricing being relatively flat relates to concessions we made in the first quarter last year and a little bit into the second quarter last year on some of our older technology lighting products, which we were pushing the sell-through during that time. So hopefully, that fits for you.

Operator, Operator

Our next question is from the line of Jesse Redmond with Water Tower Research.

Jesse Redmond, Analyst

Congratulations on the quarter. I had a question about the improving macro environment that you referenced. One of the big things going on is the potential political progress. Although you're not explicitly impacted by 2(ee) removal, can you talk about how Schedule III may benefit your business? And do you expect to see the purse strings loosening at some of the bigger MSOs as they start to get more cash flow?

William Toler, Chairman & CEO

Yes. I think that there are numbers out there to say there could be up to a couple of billion dollars that used to be paid in taxes that can now be reinvested back into the industry. That's good news for everybody. We can fight for our share of that. But the reality is this is still a long process. It's still going to take time with hearings and assessments. It's important to recognize that we're focused on operating today and finding the right solution for our company today. All those things will happen down the road, but we're not sitting around waiting for the government. We're making sure we operate profitably and figuring out the right long-term solution for Hydrofarm as these things get implemented over the next, let's say, 6, 12, 18, or even 24 months.

Jesse Redmond, Analyst

And my second question is at the state level. We have good opportunities ahead of us with potentially Florida and maybe Pennsylvania. But this summer, we have Ohio rolling out, which should be a pretty good market for most operators. Can you talk about Ohio and what that market potentially represents for you?

William Toler, Chairman & CEO

Yes. Ohio has started to show some vibrance, and we're growing very nicely on a small base there, just as we are in Florida and some other rollout states like Missouri. We're seeing that start to pick into the industry, which is encouraging. Additionally, regarding developments in Germany with 90 million people being cannabis-friendly, our brands are well-positioned over there. We have a business in Spain that's been positioned in Europe for years. We are moving resources into Germany to leverage that market. It's a favorable home market and offers growth for at-home growers, which is great for companies like ours and the brands people can use at home. While states are popping in the U.S. with vibrance, Germany presents an opportunity for an additional 100 million consumers who are cannabis-friendly, and a culture that's right for us to grow in.

Operator, Operator

Ladies and gentlemen, as there are no further questions, I now hand the conference over to Bill Toler for his closing comments. Bill?

William Toler, Chairman & CEO

Thank you, Ryan, and thank you, everyone, for supporting and following Hydrofarm. We look forward to further updates through the summer and hope everyone is doing well. Thanks so much.

Operator, Operator

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