Earnings Call Transcript - HYFM Q2 2022

Operator, Operator

Good day, ladies and gentlemen, thank you for standing by. Welcome to the Hydrofarm Holdings Group's Second Quarter 2022 Earnings Conference Call. At this time all participants have been placed in a listen only mode, and the lines will be open for your questions following the presentation. Please note that this conference is being recorded today, August 9, 2022. I want to turn the call over to Mr. Fitzhugh Taylor, Managing Director at ICR to begin.

Fitzhugh Taylor, Managing Director

Thank you, Anthony. Good afternoon. With me on the call today is Bill Toler, Hydrofarm’s Chairman and Chief Executive Officer; John Lindeman, the Company's Chief Financial Officer. By now everyone should have access to our Second Quarter 2022 Earnings Release and Form 8-K issued today after market close. 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 more detailed discussion of the risks that can impact our future operating results and financial condition. Lastly, during today's call, we will discuss non-GAAP measures, which we believe can be useful in evaluating our performance. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with GAAP and reconciliations to comparable GAAP measures are available in our earnings release. With that, I'd like to turn the call over to Bill Toler. Bill?

William Toler, CEO

Thank you, Fitzhugh, and good afternoon, everyone. As we announced in our press release last week, our second quarter results continued to feel the impact of Hydrofarm’s Industry Recession in the U.S. and Canada. Initially, in the quarter, we were encouraged by our results early in Q2, as sales trends displayed signs of stabilizing. However, these trends weakened as the quarter progressed, and our mix shifted to less profitable products, impacting our results for Q2 and our expectations for the remainder of the year. More specifically, originally our business plan for 2022 always expected a seasonal improvement in the spring and summer months, with sales volume continuing to build from there. Once we did not get the expected improvement in Q2, we have assumed the current trends will continue through the third quarter and that Q4 will have its normally lower volumes, but again off a lower base that we didn't achieve in Q2, so we took the volume out for the entire year. While the industry recession has lasted longer than expected, we remain confident in the long-term opportunities ahead of us. According to headset data, which is the best measurement of volume sold through dispensaries, units sold continue to grow, albeit at lower prices. Furthermore, with cannabis consumption growing in the U.S. and Canada, ultimately supply and demand will balance, and pricing should strengthen. This should invite many growers back to the category and give multi-state operators the expansion signals they are looking for. When that occurs, we are well-positioned for the rebound, the strength of Hydrofarm as a course in our brands and people in our unique customer relationships and in our manufacturing and distribution footprint. This has not changed. As a reminder, we drove over 50% of our sales in our own brands, and we also proudly represent many of the industry's top distributed brands. Just last month, we added Emerald Harvest, a leading nutrient, to our preferred brand lineup. This new addition will further strengthen our consumables portfolio, which is currently about 66% of our sales. We believe this provides us even more insulation against weakness in the industry. Now another important measure of Hydrofarm’s competitive position is our relative market share. Our sales declines while disappointing are less than a decline seen by other public reporting entities suggesting that we are building market share. During this difficult time, we've continued to focus our efforts on deleveraging and strengthening our core assets, while right-sizing our operations to maintain the long-term health of our business. In fact, during the second quarter through our team's net working capital management, we increased our cash position, lowered our net debt, and maintained a solid liquidity position, which John will talk about in more detail. In this effort, positive steps have been taken to lower our cost structure. As we did in the first quarter during the second quarter, we continued to take strategic price increases, further increased freight surcharges, reduced our employee base, and took steps to capture cost synergies from our 2021 acquisitions. More specifically, we enacted further expense-cutting measures, including continued headcount optimization. Since the end of last year, we've reduced headcount by about 25%. We've also reduced shifts at our plants to increase efficiency and protect inventory levels. And finally, we've cut select outside services and expenses to tighten our belts across the board. All in all, we estimate we've reduced our costs by about $14 million to $15 million on an annualized basis, and we'll continue to find efficiencies and further streamline our business as the business conditions dictate. As we look ahead, we believe we have appropriately reset the full year expectations and can successfully build back from here. Additionally, we remain confident that the industry will eventually return to historical growth rates and that the actions we're taking to refine and optimize our organization will leave us leaner and stronger, and as a result, better positioned to take advantage of future growth opportunities. With that, let me turn it over to John, who will further discuss the details of our second quarter financial results and provide comments on the updated full year 2022 outlook. John?

John Lindeman, CFO

Thanks, Bill. And good afternoon, everyone. Net sales for the second quarter were $97.5 million compared to $133.8 million in the prior year period. Our 2021 acquisitions added 13.5% to our top line in the second quarter of 2022 relative to the prior year period, but this M&A benefit was more than offset by a 43.4% decline in organic sales volume. We did realize a 3.1% price mix benefit in the quarter as we continued to pass through higher costs. While we saw encouraging results in March and April, sales trends in the second half of the quarter tailed off and continued into the remainder of Q2. Furthermore, these sluggish sales trends have continued into the third quarter to date period. We did experience year-over-year growth in select U.S. states, but the growing demand in these states was not yet sizable enough to offset the overall oversupply dynamic in many key U.S. markets. We also experienced a notable sales mix shift in the quarter. On a sequential basis, sales of our proprietary branded products in Q2 were outpaced by sales of distributed and preferred brands relative to Q1. We believe this was caused by the change in relative performance of select product categories, primarily the relative outperformance of grow media, which is largely composed of distributed preferred brands for us, and the relative underperformance in lighting, which includes several of our proprietary brands. I should note that on a year-over-year basis, we experienced the same sales mix benefit as our proprietary brands represented a much higher proportion of our total sales than they did in the prior year period. This positive year-over-year sales mix largely relates to the full quarter benefit we received from all of the acquired proprietary brands in Q2 ’22 relative to only a partial benefit for select brands, namely Heavy 16 and House & Garden in Q2 2021. Gross profit during the second quarter decreased to $7.3 million compared to $29.6 million in the year-ago period. Similar to last quarter, we included in the press release a calculation of adjusted gross profit, which excludes certain items largely related to our acquisitions, which impact comparability. On this basis adjusted gross profit was $9.1 million or 9.3% of net sales in the second quarter, down from $30.2 million or 22.5% of net sales last year. The decrease in adjusted gross profit is mainly due to the negative impact of the $10.2 million increase in inventory reserves that we recorded at the end of Q2. Excluding the increase in inventory reserve, the adjusted gross profit margin would have been much higher than disclosed, but lower than 22.5% last year. This margin difference was due to proportionately higher freight and labor costs, which were impacted by the lower total sales volume and the altered sales mix. Selling, General and Administrative expenses decreased to $26 million in second quarter ’22 compared to $27.3 million in the year-ago period. The decrease in SG&A was primarily due to an $8.4 million decrease in acquisition-related expenses. Adjusted SG&A expenses, which just this acquisition-related expense as well as certain other items impacting comparability were $15.9 million, or 16.3% of net sales in the quarter versus $14 million, or 10.5% last year. This was primarily driven by an increase in facility costs, compensation costs, and insurance expenses. As a reminder, these added costs primarily emanate from our distribution center expansions and the five acquisitions we completed last year, which increased our headcount and the size and scope of our operations. And while this positions us well for future growth, we remain diligent in mitigating costs in the near term and right-sizing our overall cost structure for the sales demand that we see today. Along these lines, we estimate that we've reduced our costs by approximately $14 million on an annualized basis. This reduction has come mostly in the form of headcount reductions conducted primarily over the last two quarters, during which we reduced our headcount by nearly 25%. The impact of these reductions is most visible in our adjusted SG&A expense, which has come down 17% from $19.2 million in our fiscal first quarter to approximately $15.9 million in Q2. And then we will diligently pursue additional cost savings and productivity initiatives on top of those already achieved. We are currently estimating $15 million to $16 million in adjusted SG&A for the next two quarters. As noted in our August 2nd press release, declining valuation trends within the industry and its impact on the company's market valuation triggered a full evaluation of the goodwill arising from prior acquisitions. As a result, our second quarter included an impairment of goodwill of approximately $189.6 million. Reported net loss for the quarter was heavily impacted by the impairment as well as the $10.2 million inventory write-down recorded in the quarter. As a result, reported net loss was $203.3 million or $4.53 per diluted share in the second quarter compared to net income of $2.3 million or $0.05 per diluted share last year. Adjusted net loss for the quarter was $8.4 million or $0.19 per diluted share compared to adjusted net income of $12.9 million or $0.31 per diluted share in the year-ago period. Lastly, adjusted EBITDA decreased to a loss of $6.8 million in the second quarter from a $16.2 million profit in the prior year period. The decrease in adjusted EBITDA was driven primarily by the decline in net sales and its impact on our current cost structure as well as the $10.2 million inventory reserve for which we did not adjust in our EBITDA calculation. Moving on to the balance sheet and overall liquidity position. As of June 30, '22, we had $27.4 million in cash, cash equivalents, and restricted cash, and an aggregate principal amount of debt outstanding of $126.7 million. I should note that we had $0 drawn on the company's revolving credit facility. At the end of the quarter, we also had approximately $15.3 million in contingent payments composed of an earn-out on the 2021 Aurora acquisition, which was subsequently paid out last month using cash on hand. We estimate total liquidity of approximately $97 million as of June 30, composed of the $27.4 million in cash and cash equivalents at the end of the period plus approximately $70 million of available borrowing capacity under our revolving credit agreement. We made significant progress in the second quarter managing net working capital and even more specifically, our inventory position. We sold through and thereby reduced our inventory by approximately $22 million while also making necessary capital investments in the quarter. Together through these actions, we generated significant free cash flow, which in turn helped us increase our cash position. We believe that as of the end of the second quarter, we still have strong inventory levels, which gives us the opportunity to further manage down our investment in net working capital and further aid our liquidity position. However, in the context of our current forecast, which I will highlight in a moment, we feel it prudent to suggest that driving further free cash flow in the second half of 2022 will be a challenge. I know this is a question many will ask, and so we figured it best to cover now. But let me be clear, given all that we know now regarding our 2022 outlook, we feel that we can and will maintain a strong liquidity position for the duration of the year. With that, let me highlight our updated full year 2022 outlook. We expect total company net sales of approximately $330 million to $347 million, which assumes sales levels similar to those experienced from late second quarter through July continue over the remaining months of the year with some further reduction to account for holiday-shortened months in the fourth quarter. We also expect an adjusted EBITDA loss of between $25 million to $16 million. This range includes $13.4 million of inventory reserves taken year-to-date. In closing, we believe we put in place the necessary steps to weather the current industry headwinds. And while it's prudent to lower our expectation for the full year, we remain optimistic about our long-term business fundamentals and our ability to capitalize on the growth opportunities in the CEA industry. This concludes our prepared remarks. We are now happy to answer any questions you might have. Operator, please open the lines for questions.

Operator, Operator

Our first question will come from Andrew Carter with Stifel.

Andrew Carter, Analyst

First question I want to ask is I appreciate the commentary around the liquidity for the remainder of the year, incremental cost savings. But can you remind us of the parameters of your term debt and your ability to use the incremental capacity you have left?

John Lindeman, CFO

Certainly. Thanks, Andrew. Let me start with the ABL facility. So I think, as you know, we have a $100 million credit facility with JPMorgan Chase. And as we noted in the quarter, we had availability of $70 million roughly on that facility. $0 was drawn against it at the end of the quarter and $70 million is available to us. We really only have one financial covenant of note in that particular facility, and it's a spring fixed-charge coverage ratio that only comes into play when our excess availability on the facility is less than $10 million. As I noted, $0 drawn at the end of the quarter and $70 million available, so not near that at this time. On the term debt facility, we have $125 million of term loan outstanding, a little bit less than that actually borrowed currently. It was a covenant-light structure that has no meaningful financial covenant ratio. We did actually put in the 10-Q additional details on this matter, and so you could see that there.

Andrew Carter, Analyst

That's helpful. Yes, it's good to get that out of the way. My second question is about the operating environment. You mentioned a 3% pricing increase, and I understand the release indicated that costs were higher than pricing for the quarter. If we exclude lighting, which has seen deflation, would you still be pricing above your costs? I'm looking for any indicators that suggest there remains some rationality in this category.

William Toler, CEO

Yes, you're right. Lighting is the one that's kind of going the other way, right? But the other categories, we are taking all the price that has come through to us from either raw material increases or packaging increases on our direct brand or our own brands and anything that's come through our distributor brands. We are passing all of that on. And so far, the elasticities haven't been too exaggerated, and the competition has been pretty rational. Again, lighting being the exception, which is kind of going the other way on high-pressure sodium and other things. But yes, we're taking the pricing that's coming through to us, and it's working out okay.

Operator, Operator

Our next question will come from Andrea Teixeira with JPMorgan. We will move on to the next question. Our next question will come from David Shakno with William Blair.

David Shakno, Analyst

This is David Shakno stepping in for Jon Andersen. Two questions for you. The first, I just wanted to clarify from the prepared remarks. Did you say you expect $15 million to $16 million in adjusted SG&A for the next two quarters? $15 million, $16 million each?

William Toler, CEO

Correct.

David Shakno, Analyst

Okay. Great. And then the second thing, what states do you think still require the most consolidation right now? Is it Oklahoma, Michigan, or somewhere else? And where do you feel they are in that process?

William Toler, CEO

Yes. I think Oklahoma stands out. I think if there are rough numbers, 15,000 commercial licenses in the U.S., and Oklahoma literally has half of them, which is a bit overbuilt for a 4 million population state. So that one is the one that I think we're seeing the most consolidation and kind of roll-up strategy, if you will. Michigan had some issues although it's not, over the longer term, going to be as severe as what you're seeing in Oklahoma. California, yes, it's still going through some pain. But honestly, I think California will find its normalized sea level here, hopefully in the next couple of quarters. But we hope to see it sooner than that, but we haven't yet, so we're not going to call it. But specifically to your question, Oklahoma is the one that's the most overbuilt, if you will, and needs the most work to get it back to kind of supplying demand on its consumption level.

Operator, Operator

Our next question will come from Bill Chappell with Truist Securities.

Stephen Lengel, Analyst

This is Stephen Lengel on for Bill Chappell. How are the newer markets sort of progressing through the year? And where should we expect the meaningful step-up in growth as we move through or move to or through '23?

William Toler, CEO

It's great to hear from you, Stephen. I believe 18 out of the 50 states have shown growth, particularly in the Midwest and East, as you might expect. Some smaller states, like Montana, aren't in the East, but we are seeing positive developments in Montana, Louisiana, Mississippi, and Florida. New Jersey has also experienced significant growth in dispensaries and hydroponics. It's encouraging to see some traction in states that legalized in 2020 and even earlier. Virginia has also shown some growth. The trend is moving East, but the large markets in California, Michigan, Oklahoma, Colorado, and Oregon are still quite dominant. Any declines in those markets can't be compensated for by the newer states. However, we are noticing traction and expect it to be interesting to observe as we move forward.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Bill Toler for any closing remarks.

William Toler, CEO

Great. Thank you, operator, and I appreciate your interest in following Hydrofarm today. We all look forward to speaking with you in greater detail soon. Take care. Thank you.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.