Earnings Call Transcript - HYFM Q1 2023

Operator, Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Holdings Group’s First 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, May 10, 2023. I would now like to turn the conference call over to Anna Kate Heller of ICR to begin.

Anna Kate Heller, IR Representative

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 first quarter 2023 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 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.

Bill Toler, CEO

Great. Thank you, Anna Kate, and good afternoon, everyone. During the first quarter, we continued to see signs of stabilization in the industry as we saw our first quarter sales increase sequentially from Q4 2022 to Q1 2023. We remain focused on controlling and cutting costs at Hydrofarm, including rightsizing our business, making operations as efficient as possible, and managing for profitability. We are seeing positive industry signals, which I’ll talk about more shortly. And we’re confident that the industry will return to growth. I am proud of the hard work done by the entire team at Hydrofarm to shape our business into a leaner and stronger organization. We appreciate the work our team has done. These actions have positioned us better than ever to take advantage of the growth opportunities that lie ahead. I’ll point to a few key accomplishments during the quarter. I’ll discuss the positive signs as well as the challenges that we are currently seeing. We continue to execute on our previously announced restructuring initiatives. We completed the consolidation of our Canadian nutrient manufacturing facility, the closing of our regional office in China, as well as the relocation of our distribution center in Western Canada. In January, we completed the sale-leaseback of our property in Eugene, Oregon, which serves as a location for manufacturing and processing for some of our grow media and nutrient brands. We received just over $8 million in net proceeds from the transaction. Turning to a recent achievement regarding innovation, one of our core brands I’m really thrilled to talk about. On April 20th, we officially launched our newest House & Garden powder product line. It is a dry nutrient lineup aimed at commercial growers that was built around our highly reputable premium brand, House & Garden, an early player in the industry and an industry leader in the nutrient category. Based on professional field trials in a controlled environment, our new House & Garden commercial powders produced more yield and higher plant quality than any of the other tested alternatives. We are excited about our team’s ability to innovate on our core brands and offer value-added solutions for our retail customers and our commercial customers. Turning to industry dynamics. In Q1, we experienced relative strength from our specialty retail customers, especially in the western states. I’d like to note that in California, historically our largest shipping state, it was up sequentially in dollar sales when you compare Q4 of last year to Q1 of this year. We’re also seeing strength in APP, our Aurora Peat brand, which has a diverse customer base and also serves non-cannabis channels. This brand grew double digits on a year-on-year basis in the first quarter. We’re excited to see the improvement in APP and our specialty retail in the west. One of the challenges we faced in the quarter was that some commercial customers delayed builds in new projects. As a result, our commercial sales in Q1 fell short of expectations. This is primarily due to ongoing legislative battles and frankly, lack of cohesive legislative support that has been slowing implementations in key states like New York, New Jersey, Connecticut, and Mississippi. As we have previously said, for us to achieve our top-line guidance for the year, we need a modest seasonal lift in the spring, and we also need to close some of those commercial opportunities in front of us. Now as we sit here in early May, we have recently seen a lift in our daily sales. This seasonal uptick needs to continue and increase through the remainder of Q2 and into the back half in order for us to achieve our top-line guidance. In summary, we are laser-focused on driving profitability and executing our strategy. As a result of our actions, we’re already seeing some benefits as evidenced by our sequential and year-over-year improvement in adjusted gross profit margin. We will continue to execute on key initiatives which include driving a more favorable sales mix by selling and focusing on high-margin products, diversifying revenue streams by further expanding our sales efforts in the non-cannabis channels, including CEA food and floral and lawn and garden, increasing productivity across all of our manufacturing and distribution centers, generating cost savings by continually reexamining the size and scope of the organization relative to the current industry demand levels, and of course, reducing our working capital. I’m encouraged by our team’s discipline and execution during the quarter. The margin improvement we saw in the first quarter is a testament to the success of the recent actions which have put us in a stronger position in 2023 and beyond. With that, let me turn it over to John to discuss the details of our first-quarter financial results and outlook for 2023.

John Lindeman, CFO

Thanks, Bill, and good afternoon, everyone. Net sales for the first quarter were $62.2 million compared to $111.4 million in the prior year period, driven primarily by a 42.5% decrease in sales volume. Note that this now marks the second consecutive quarter of reduced year-over-year organic sales declines, dating back to Q3 2022. We realized, as expected, a 1.1% price mix decline in the quarter, resulting primarily from the sell-through of discounted lighting products. Our overall brand mix improved in the quarter as proprietary brands increased as a percentage of total sales to 56% from 54% in the prior year, driven primarily by nutrient sales, partially offset by lower commercial equipment sales. We did see some other positive trends in the quarter too. First, we saw sequential strength in several key western states. For example, our total dollar sales in California, Oklahoma, Washington, and Oregon all increased sequentially for the first time since mid-2021. This strength helped our specialty retail business outperform internal expectations for the quarter, although this outperformance in our specialty retail channel was mitigated by weaker-than-expected performance in our commercial channel. Second, our international sales outside of the U.S. and Canada grew sequentially and then on a year-over-year basis. While international sales make up less than 2% of total sales, the significance was the placement of some of our house nutrient brands into markets outside the U.S., which gives us something to build on. Gross profit in the first quarter was $11.4 million compared to $16.6 million in the year-ago period. Adjusted gross profit was $14.1 million or 22.6% in net sales in the first quarter, compared to $22.3 million or 20% in net sales last year. The increase in adjusted gross profit margin is largely due to improved brand mix and improved productivity, primarily in our distribution centers, and the fact that we recorded lower inventory reserves than last year. Our Q1 adjusted gross profit margin improvement suggests that our restructuring and related cost-saving initiatives are making an impact. Against these benefits, we realized $1.4 million in pre-tax charges in Q1 related to the closure and relocation of certain facilities in Canada and China. We do expect to incur additional restructuring charges primarily in Q2 of 2023. Selling, general administrative expenses were $24.4 million in the first quarter compared to $40.2 million in the year-ago period. Adjusted SG&A expenses were $16.2 million a quarter versus $19.2 million last year; this $3 million or 15% decrease was primarily due to lower compensation costs resulting from headcount reductions, as well as reduced spending with professional and outside service providers. Finally, adjusted EBITDA decreased to a loss of $2.1 million in the first quarter from a $3.1 million profit in the prior year period. The decrease in adjusted EBITDA was driven primarily by the lower organic cost of sales volume. Notably, this is the second consecutive quarter of sequential improvement in adjusted EBITDA. We still have work to do, but the sequential improvement demonstrates the progress of our restructuring and related cost-saving initiatives. We will continue to control what we can in an effort to drive increased profitability through improved brand mix, distribution center and manufacturing productivity, and reduced SG&A. Moving on to our balance sheet and overall liquidity position. Our cash balance as of March 31, 2023, was $18.7 million. We ended the quarter with $123.4 million of term debt. As a reminder, our term debt facility has no financial maintenance covenant and does not mature until 2028. And as was also the case for the entirety of 2022, we maintained a zero balance in the Company’s revolving credit facility across the entire first quarter. I would also like to note that in March, we extended the maturity of our revolving line of credit to June 2026. As you see in today’s earnings release, our free cash flow in the first quarter improved by approximately $2 million relative to the same period last year. This improvement is something we expect to build on as we move into what are typically the more seasonally favorable cash flow periods of the year. We estimate total liquidity of approximately $57.7 million as of March 31st, comprised of our cash position plus approximately $39 million of available borrowing capacity under our revolving credit agreement. With that, let me turn to our updated full-year 2023 outlook. We continue to expect net sales in the range of $290 million to $310 million for the full year 2023. As we discussed on our last earnings call, our sales guide assumed a modest seasonal lift in early Q2, and year-over-year top-line growth resuming in the second half of 2023. As you heard from Bill, we have not yet seen enough of the seasonal lift that we previously expected. And we now have a little bit of a gap in our commercial sales that we need to close across the remainder of the year. Our current 2023 sales guidance assumes that the pickup will occur mid to late Q2, and that year-over-year top-line growth will resume in the second half of 2023. As a result, we expect the top line for the second quarter to be modestly higher than the first quarter and we expect our full-year sales to be at the lower end of our $290 million to $310 million range. As noted earlier in the call, our adjusted EBITDA and adjusted EBITDA margin have sequentially improved in each of the last two quarters, and today we are reaffirming our expectation for modestly positive adjusted EBITDA for the full year 2023. We are also reaffirming our expectation for positive free cash flow for the full year. In closing, we believe we remain on the right path to control the controllables while weathering the industry headwinds. And we remain excited about our prospect for continued improvement and near-term profitability. And with that, let me ask the operator to open the line for any questions you may have.

Operator, Operator

Our first question comes from Andrew Carter with Stifel. Please go ahead.

Andrew Carter, Analyst

Yes. Thank you. I just want to drill down a little bit on what you’re seeing through April and May. You say you’re seeing a little bit of the seasonal pickup. But to be clear, not enough for your previous guidance. But could you help us understand right now what the April trends are looking like and how much of a change you need to see by June to get to that back half, which I think is still implied kind of mid-teens growth? Thanks.

Bill Toler, CEO

Yes. Hey, Andrew. Thanks. I’ll start, and John can fill in the gaps if I leave some out. Yes. I think in simple terms, April was a little weaker than we’d hoped, and May has started to pick up a bit, which is great to see. So, we’re not quite sure if the delay was due to holiday timing, weather, or what it was in April. But we think we’ve seen now in May the beginning of, and not all the way there, but the beginning of the seasonal lift that we had mentioned. And you’re right, it’s sort of in that low-teens kind of area, which is kind of the average of what we’ve seen over the last four out of the last five years. So, we think it’s a reasonable assumption, although the industry has been through a tough time over the last six quarters. But yes, the May numbers have given us some encouragement, but we’re only a third of the way through the month. I hate to put too much credence into that, and that’s why we thought it was prudent to stay within the guide, but recognize that we’re probably on the lower end of the guide at this point.

Andrew Carter, Analyst

Could you clarify the impact of pricing? Last quarter, you mentioned there would be a negative effect due to lighting. How significant was that? Additionally, do you anticipate seeing a positive price mix in Q2? Thank you.

John Lindeman, CFO

Yes. Thanks, Andrew. I’ll jump in on that one. Yes. We did, as you point out, expect to have negative price mix in Q1. And indeed, it was due to the lighting sales, which was also what we had suggested. When we look at the math, if you exclude the discounted lighting sales that we had in Q1, we do see positive price mix beneath that. So, as we’re modeling the rest of the year, we are still modeling positive price mix for the full year, albeit we are a little more cautious than we were before just because of our callout as we noted today earlier on the commercial side of our business.

Operator, Operator

Our next question comes from Bill Chappell with Truist Securities. Please go ahead.

Bill Chappell, Analyst

I just want to follow up. It’s great that you’re experiencing a spring lift, which is encouraging. I’m trying to relate that to what Hawthorne Scotts mentioned; they hadn’t observed much change in daily order patterns since the start of the year. I'm curious if that's due to competition, product mix, geographic factors, or anything else we should consider, or are you seeing an overall lift in the category?

Bill Toler, CEO

Yes. Good question. Because really, what we’re seeing is we’re seeing the consumables lift, right? And that’s where the strength of our portfolio is. It also is where most of our business is; almost 70% is now consumables. I would say that our durables numbers are more like what you’ve seen from other people. And the reason is that right now we’re getting people back into the repeat purchase of consumables, but the delays in builds and the delays in refurbishments and the delays in all the issues and new states and stuff have cost us on the commercial side, which is more durable for us. So yes, it is more about portfolio than it is about anything else.

Bill Chappell, Analyst

Sorry. You cut off there for a second. And then, in terms of the technical difficulties reported six weeks ago, I’m not sure how much has changed in terms of the opening up front. But trying to understand if in New York, Connecticut, and stuff like that, if you’ve seen any kind of further openings, regulations starting to fall, things that are moving any faster, or is it still all in line with expectations?

Bill Toler, CEO

Yes. It’s still kind of moving slowly. In spite of Delaware saying yes, and Minnesota moving, with North Carolina being rumored to be closer, we’re in the states that kind of have these big legislative quagmires going on, and we haven’t seen much progress at all. A number of our projects that we thought would come in Q1 have been delayed and pushed to Q2, Q3, and onward. And so, that’s been part of the slowness of the commercial business, these delays. So no, we have not seen a lot of progress in those key states.

Operator, Operator

Our next question comes from Andrea Teixeira with JPMorgan. Please go ahead.

Andrea Teixeira, Analyst

I just want to kind of go back a bit with what’s happening to the end consumer, if you’re seeing down-trading. And I know you don’t touch the plants, but perhaps talk about what’s happening in the most recent legalized state. I mean, it sounds recent, but it was not recent, but just says, as we see the last mature states, if like the whole dynamic between black markets and legalized or dispensaries have changed, if there’s any down-trade helping the non-commercial producers? And in that vein, if you think that there are inventory buildups to work through outside of lighting, or in lighting, you are seeing also that kind of like being worked out already? Hopefully.

Bill Toler, CEO

I’ll start, and then John can address inventory, which is similar to what you mentioned about lighting. In the short term, I believe we’re seeing a trend where many large multi-state operators and others reporting their results are either shutting down or reducing their capacities. During this period, we are witnessing a resurgence of hobbyist and craft growers, as well as the gray market, particularly evident in retail stores. Our business remains focused on retail, and we're starting to see some growth in that area. Meanwhile, the commercial side of MSOs is experiencing slower construction and renovations. This indicates a shift back to the earlier days, with more craft growers and hobbyists re-emerging, while the larger MSOs are entangled in various legal issues. I believe this current situation is temporary and will be resolved in the coming months. This trend contributes to the relative strength in retail we've discussed, especially in California and the Western region that John mentioned, which is reverting to its historical performance for us. This reflects an increase in volume through retail outlets, supporting craft growers, smaller producers, and the home grower market, including the gray market. John, would you like to discuss the inventory aspect related to Andrea’s question?

John Lindeman, CFO

Yes. I mean, for sure, we’ve continued to just overall talk about inventory overall, we’ve continued to work down our inventory levels. I think you see that in this quarter; once again, from where we stood at the end of last year, we’re down another $7 million to $8 million in inventory. And that number should continue to come down as we work our way through the rest of the year if we’re doing our jobs right here. With respect to lighting specifically, I do think that for sure, us internally here at Hydrofarm feel like we’ve worked through a very good portion of the lower technology, a little bit more old-generation lighting products, which tend to carry the highest amount of discounting associated with them. And I think across the industry, we’re starting to feel a little bit like that stuff is working its way through the system. So, as we work our way through the rest of the year, we’re obviously paying attention to the lighting category. But overall, we’re starting to feel like we’re getting a lot of the higher-risk lighting products behind us, which is good.

Andrea Teixeira, Analyst

One of the things to consider is how much visibility you have into the commercial delay due to legislation and other factors, particularly since this is common across consumer packaged goods and especially relevant in your industry with many layers to the final consumer. It might be anecdotal, but we don’t know how much inventory of media or nutrients people have stored. How do you assess your inventory levels? Additionally, if the weather affects the exit rate that you experienced in April, and if trends continue in that manner, you should be on track to meet the lower end of your guidance. However, what needs to occur for you not to reach that lower end? It seems that not much needs to happen for that scenario to materialize.

Bill Toler, CEO

Yes, we need that lift to continue and to increase slightly. We also need to finalize some of the commercial opportunities that have been deferred. If we achieve these goals, we will be back to the guidance and numbers we started the year with. While we are still within that range, we want to be transparent and indicate that we currently expect to trend towards the lower end of that guidance. We anticipate that profitability and free cash flow will be satisfactory. Regarding visibility, it's clearer with new builds; when someone states they will start a project on May 1st and then delays, that becomes evident. It's more challenging to link it directly to inventories, as many of these are often new builds in new states. In these cases, it presents new growth opportunities for an MSO or craft grower. The commercial side is somewhat clearer; the pipeline and backlog have been in progress for an extended period. The situation isn't necessarily linked to inventory levels as much as it relates to obtaining legislative approvals and ensuring all requirements are met so that the grower can commence construction and cultivation.

Operator, Operator

There are no further questions at this time. I would like to turn the floor back over to Bill Toler, CEO, for closing comments.

Bill Toler, CEO

Thank you, operator, and thank you all for your time and interest in Hydrofarm. We look forward to speaking with you and working with you going forward. Thanks so much.

Operator, Operator

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.