Earnings Call Transcript - HYFM Q3 2022

Operator, Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Holdings Group's Third 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, November 9, 2022. I'd now like to turn the call over to Mr. Fitzhugh Taylor, Managing Director at ICR to begin. Please go ahead.

Fitzhugh Taylor, Managing Director

Thank you, Victoria, and good afternoon. With me on the call today is Bill Toller, Hydrofarm’s Chairman and Chief Executive Officer; and John Lindeman, the company's Chief Financial Officer. By now, everyone should have access to our third quarter 2022 earnings release and Form 8-K issued 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 a 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 you saw in today's press release, our Q3 results continue to reflect an industry under pressure from the oversupply dynamics and lack of consistent legislative support. Net sales for the quarter were in line with our internal expectations, and though our reported adjusted EBITDA was heavily impacted by inventory and accounts receivable reserves and related charges, our underlying profit performance was generally in line with our internal estimates. Additionally, our free cash flow performance exceeded our expectations as we generated positive free cash flow for the second straight quarter. As the industry evolves, we are adapting and moving with it. This was demonstrated during our third quarter. Even though our product sales through our specialty retail channel remain challenged in the current industry environment, particularly in the mature states, our commercial sales have been a bright spot. Our commercial effort has been led by our associates at the Integrated Growers Equipment, or IGE company, which we acquired in November 2021. Currently, our commercial sales make up 35% of our year-to-date 2022 sales through the end of the third quarter, an increase from only 19% of company sales in the same year-to-date period last year. Now I'll take a moment to talk about the impact of legislation. The improvement in our commercial sales percentage is due in part to the benefit of IGE, as I noted, but it's also a result of winning bids with growers around the country, particularly in states that have more recently adopted and implemented favorable cannabis legislation. For example, nearly half the sales of our IGE branded products were sold in states largely along the eastern seaboard. Though difficult to predict in the short term, over the long term, we expect continued growth from commercial operations in new states as legislation becomes more favorable to cannabis on a state-by-state basis. We continue to be pleased with our peat business, which serves a diverse customer base that includes both food and floral growing operations and is less reliant on North American cannabis trends. We believe the relative success in our peat business points to the benefits of our consumable portfolio and our ability to adapt more broadly during a period of supply imbalance in the cannabis sector. As we look ahead, we remain confident in the long-term opportunities of our business. In addition to some of the recent positives I just discussed, we believe we have several reasons to be confident about our long-term opportunity. First, we believe the industry's supply-demand imbalance brought on by the COVID overhang and uneven state legislative rollouts has been inching the industry closer to a rebound. Additionally, recent legislative activity at both the state and national level, including yesterday's adult use passage in Missouri and Maryland, continue to point towards greater consumer access and awareness of legal cannabis and ultimately even higher legal cannabis consumption in the years ahead. Next, our consumable-driven portfolio has provided us with a more tempered decline compared to some of our industry peers, and we believe this fact coupled with our strong financial position sets us up well to grow market share and/or engage in consolidation opportunities in the future. Finally, as we discussed previously, we've taken a number of actions this year to better position our organization for future growth. We have rightsized where necessary with an overall impact of reducing our headcount by over 25%. We continue to remain focused on mitigating costs, streamlining our manufacturing and distribution operations and further diversifying our revenue streams. In closing, we believe our actions thus far in 2022 and those yet to come put us in a healthy position heading into 2023 and beyond. Furthermore, we remain confident in the industry returning to growth and we'll be better positioned than ever to take advantage of these opportunities ahead as we have shaped our business into a leaner and stronger organization. With that, I'll turn it over to John to discuss the details of our third quarter financial results and our outlook for 2022. John?

John Lindeman, CFO

Thank you, Bill, and good afternoon, everyone. Net sales for the third quarter were $74.2 million compared to $123.8 million in the prior year period. Our 2021 acquisitions added 9.5% to our topline in the third quarter of 2022 relative to the prior year period, but this M&A benefit was more than offset by a 52.1% decline in organic sales volume. We realized a 2.7% price mix benefit in the quarter as we continue to pass through higher costs, but the magnitude of our pricing benefit has been tempered in the second half by the need to reduce price in the lighting category, which has been the category hardest hit by the industry downturn. Commercial sales as a percentage of our total have strengthened despite the industry weakness in the lighting category. Our proportional increase in commercial sales is due in part to our acquisitions, namely IGE, which continues to drive relatively strong demand in this otherwise challenged industry environment. Bill earlier noted the strength of IGE's business along the eastern seaboard, and I would note strength in several states, particularly Massachusetts, Mississippi, Florida, Louisiana, Pennsylvania, and New Jersey, all of which are among our top 10 commercial states. As we noted last quarter, the industry recession is having an impact on our sales mix. This is primarily due to the relatively strong performance of distributed brands on a sequential basis relative to our proprietary and preferred brands. While our proprietary brands continue to drive over 50% of our total sales in Q3, the current industry environment is resulting in weak volumes in our lighting product sales, which in our portfolio are dominantly proprietary branded. While conversely, we're experiencing stronger demand for grow media products, which are primarily composed of distributed and preferred brands. We expect this trend to continue into our fiscal fourth quarter. Gross profit in the third quarter decreased to $5.9 million compared to $30 million in the year-ago period. Excluding certain items largely related to our acquisitions, adjusted gross profit was $7.8 million or 10.5% of net sales in the third quarter compared to $33 million or 26.6% of net sales last year. The decrease in adjusted gross profit margin is largely due to the negative impact of the $4.4 million increase in inventory reserves and related charges that we recorded at the end of Q3. Excluding these inventory charges, adjusted gross profit margin would have been much higher than disclosed, albeit still lower than last year. This margin difference was due to the lower total sales volume, the altered sales mix, as well as proportionally higher freight and labor costs. Selling, general, and administrative expense decreased to $26.2 million in the third quarter of 2022 compared to $33.4 million in the year-ago period. The decrease in SG&A was primarily due to an 8.2% reduction in acquisition-related expense as compared to last year's third quarter. Adjusted SG&A expenses, which adjust for these acquisition-related expenses, as well as certain other items impacting comparability, were $16.8 million or 22.7% of net sales in the quarter versus $16.9 million or 13.6% last year. This was primarily driven by decreases in marketing and employee compensation costs, partially offset by an increase in insurance expenses. I would like to note two items inside of adjusted SG&A in the period. First, our Q3 compensation expense was lower on a year-over-year basis for the first time since we began acquiring businesses in 2021. We believe this is a positive sign pointing to our successful M&A integration efforts, as well as our aggressive cost reduction plans instituted across the year. Second, I wanted to point out that adjusted SG&A was negatively impacted by $1.1 million in higher than anticipated accounts receivable reserves. This largely relates to a single international customer. While we continue to keep close tabs on our collection efforts, we have not seen any broad-based deterioration in this area. Our reported net loss for the quarter was $23.5 million or $0.52 per diluted share compared to net income of $17.3 million or $0.37 per diluted share last year. Adjusted net loss for the quarter was approximately $15 million or $0.33 per diluted share compared to adjusted net income of $31.8 million or $0.69 per diluted share in the year-ago period. Finally, adjusted EBITDA decreased to a loss of $9 million in the third quarter from a profit of $16.1 million in the prior year period. The decrease in adjusted EBITDA was driven primarily by lower net sales, lower adjusted gross profit margin, as well as the $5.5 million in the inventory and accounts receivable reserves and related charges, which we did not adjust in our EBITDA calculation. Moving on to our balance sheet and overall liquidity position. As of September 30, 2022, we had $16.5 million in cash and cash equivalents and an aggregate principal amount of debt outstanding of $126.3 million. For the entirety of 2022, we have had zero drawn on the company's revolving credit facility. We estimate total liquidity of approximately $78 million as of September 30, composed of the $16.5 million in cash and cash equivalents, plus approximately $62 million of available borrowing capacity under our revolving credit agreement. As Bill noted earlier, we generated positive free cash flow for the second quarter in a row, and now have generated over $8 million in total free cash flow in the year-to-date period. We continue to aggressively convert our working capital into cash, which helps us to generate positive operating cash flow and enables growth-oriented capital investments, namely in our more diverse peat and IGE businesses. While we have opportunities to further reduce our investment in working capital, we feel that generating positive free cash flow in the fourth quarter will be a challenge. However, we do expect that with the level of free cash flow already generated in the year-to-date period, we will finish the full year on a positive basis and expect to maintain a strong liquidity position. Finally, you will see us file a Shelf S-3 registration statement later today. The filing is a universal shelf, which covers a range of capital market securities both on the debt and equity side. We view this as proper corporate housekeeping that will provide maximum flexibility and allow us to access the markets if and when appropriate. I will note that we have no immediate plan to raise debt or equity. With that, let me turn to our full year 2022 outlook. We are reaffirming expectations of net sales in the range of $330 million to $347 million. I would add that given fourth quarter year-to-date sales trends, it is likely that net sales come in at the lower end of our range. Similarly, we expect to finish on the lower end of our previously estimated range of an adjusted EBITDA loss of $25 million to $60 million. This range now includes the negative impact of approximately $19 million of inventory and accounts receivable reserves and related charges realized to date and assumes no further material increase to these amounts. Naturally, we will go through a reassessment of our reserves at year-end and we'll update you accordingly. In closing, we believe we've put in place the necessary steps to weather the current industry headwinds, remain optimistic about our long-term business fundamentals and our ability to capitalize on the growth opportunities ahead. This concludes our prepared remarks and we are now happy to answer your questions. Operator, please open the line for questions.

Operator, Operator

Thank you. We will now be conducting a question-and-answer session. Our first question comes from Andrew Carter with Stifel. Please go ahead.

Andrew Carter, Analyst

Thank you. Good evening. I wanted to ask about the reduction in inventory, as it has been a significant source of funds. How much further can this go? If my calculations are correct, your inventory is down 58% for the quarter, which is behind the organic growth of 47%. Is that accurate? Or do you anticipate a significant recovery? How much more are we targeting for working capital? I'll stop there.

William Toler, CEO

Yes, we've got I think roughly $145 million, $150 million of total inventory now on a business doing $330 million to $340 million in sales. We still have, in terms of days of supply, a good bit of inventory, right? Think of it in two buckets. One is our finished goods in our distribution centers that we buy from others. And the other is, of course, our own direct materials that we produce our own brands with. I would say right now because of the seesaw that we're all familiar with, Andrew, on the volume, we've got more inventory on the direct material brands that we own side and that can continue to come down. We can always continue to tighten on the finished goods side as well. As part of one of the things we're doing to strengthen the company, we're going through aggressive SKU and brand rationalization processes as well, so taking out more SKUs, taking out brands, cutting down on that inventory. That's going to give us even more room to take more inventory out. So while I'm not going to give you a specific number of how much we can take down, we think we've got a good amount of room to keep working inventories down on both sides of the aisle, if you will, finished goods that we buy from others and on the direct materials side.

Andrew Carter, Analyst

Got you. And then thinking about, like usually typically kind of on the same topic. 1Q is your kind of big purchase for the season. I guess as you've gone through this cycle and you go into year, I mean, how confident are you you can plan for next year, make the right decisions? Maybe that's something you have to use the credit facility for about knowing the season and knowing how much you do have to purchase when you actually have to do that going into next year. I mean, we're thinking like 1Q early year, but just how are you approaching that potential next kind of big decision for the company?

William Toler, CEO

Generally, the area that involves the most kind of buying ahead is around the grow media businesses, right? There's generally a lot of pre-booking of that in the fall. I would say, as an industry there's been a lot less of that this year and people are not really making these big early buys to get ahead on inventory. I think it's going to be more hand-to-mouth. There's going to be a lot of pure packer. You need to pack that grow media up because you can't catch up if the volume takes off in Q2. But on our side of things, I think many other distributors and other industry players are not really leaning into these big buys. So I don't think it's going to be the same draw that it has been in prior years. And we're going to be cautious. We're not going to lean into it and like you suggest, to tap the credit facility simply for inventory. We want to be careful not to do that and to manage it as tightly as we can. Well, it doesn't mean we won't touch the credit facility, but it certainly means that we're going to be very cautious in how we buy in.

Andrew Carter, Analyst

And I'll just ask kind of one final question just kind of on the pricing. I know you mentioned the lighting is in deflation. Can you give anything on what the pricing ex-lighting would be? And then kind of separately, are you actually expanding product margins on products outside of lighting just through the pricing you're getting? Thanks.

William Toler, CEO

Yes. You're right. Lighting is the one that's under the most pressure. There's a pretty aggressive promotion scheme out there, although our overall trade spending is pretty much in line with what we expected. There's a promotional environment out there right now; not anything ridiculous. On the product margins, I would say, other than grow media, we've been doing fairly well, but grow media has been tough on us this year. And of course, lighting has been the one that's under the most pressure.

Andrew Carter, Analyst

Thanks. I'll pass it on.

Operator, Operator

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

Stephen Lengel, Analyst

Good evening everyone. This is Stephen Lengel standing in for Bill Chappell. Thank you for taking our question. Following up on Andrew's inquiry about the lighting inventory, we heard from Hawthorne that they seem to be moving away from LED lighting. Can you provide more insight on that? Is this seen as an opportunity for long-term share growth, or are you also planning to exit this category? Thank you.

William Toler, CEO

Yes, we're not exiting it. We are taking out, I think, 85% or 80% plus of our SKUs in the pot pressure sodium double-ended lights and also obviously for us since long past now. We're going to stay in that business. I think some other industry folks are well. Hawthorne is getting out of it. That's fine; that's their choice. So we're going to offer that to folks. We feel like that pressure sodium is a tried-and-true and long-proven technology that's still run by an awful lot of growers, and so we want to offer that to our customer base. We also still sell LEDs very aggressively and will continue to do that and compete on that front. But now we're going to stay in it, but it will be with a limited number of SKUs.

Stephen Lengel, Analyst

Thank you. And you guys kind of mentioned that you were performing well in the peat business. What kind of color can you provide on some of the progress you've made in the category and where do you see some maybe further opportunity as we look ahead to '23?

William Toler, CEO

Yes, we've got a unique peat business in Edmonton or north of Edmonton, Canada. It came as a part of the Aurora Innovations acquisition, it’s called APP, Aurora Peat Products. We've actually been granted last year some additional acreage in bogs. So it's becoming a very nice business for us. Importantly, it sells outside of just an ingredient going into cannabis or into grown mixes, right? So it sells into different kinds of food and floral and outdoor grows and sells into mushroom farmers and a number of different places. So there are many channels there that we can develop. It does require capital to develop those new bogs and I think we've spent over half our capital between IGE and Aurora Peat this year, which is appropriate; those are probably our two best-performing businesses on the topline side. But Peat, we think is a unique commodity that’s differentiated in sourcing, it’s very tightly controlled by that Canadian government and gives us an angle that we like as a provider of ingredients and products to other grow mix providers and sellers. We think it’s a good business for us.

Stephen Lengel, Analyst

Awesome. Thank you so much, guys. I'll pass it on.

Operator, Operator

Next question comes from Andrea Teixeira, JP Morgan. Please go ahead.

Andrea Teixeira, Analyst

Thank you, operator, and good afternoon, everyone. I have a question regarding your EBITDA guidance, particularly on the lower end. I assume this indicates that gross margins will remain in the high single digits for the fourth quarter. I also think that the top line will be stable, given your strategic approach to reducing inventory. Regarding profitability moving forward, you mentioned that you don't anticipate any further write-downs. What are your thoughts as we progress into 2023? Do you believe we have largely overcome the challenges? Additionally, could you explain the decision behind the shelf registration? Is it meant to provide flexibility for exploring alternatives aside from the revolver?

William Toler, CEO

Yes, Andrea. Good afternoon. Regarding Q4 and the guidance on margins, I believe you're on the right track. Several factors we observed in Q3 relating to our sales mix and volume are expected to carry into Q4. There is some seasonality that will likely decrease sales levels, which I think was already reflected in the numbers circulating for Q4 before this call. As for 2023, we have some planning ahead and will provide more formal insights as we prepare to report our Q4 results soon. Concerning the shelf registration, it's typically available for companies like us in case we need it. Currently, we have cash on hand and a significant amount of untapped liquidity from our line of credit, which we would consider first for any cash needs. While we have indicated that generating free cash flow in the fourth quarter may be challenging, we remain cautiously optimistic about future opportunities. Our previous discussion suggested there are still potential gains in managing inventory, and we continue to hold that perspective.

Andrea Teixeira, Analyst

You can continue to question what this means for retail inventory and the health and visibility with your retail partners. Are they still holding high inventory levels that could affect you? Will this trend continue in the upcoming quarters, or do you have good visibility on the situation?

William Toler, CEO

We certainly don't have any visibility on that ahead, John.

John Lindeman, CFO

No, I was just going to make the same comment. I mean, visibility in the specialty retailers that we sell into is not perfect because it's a very fragmented customer base for us. But I think it's safe to say that in many cases probably we still have pretty robust inventory levels. That's part of the reason I think our sales levels are down. Having said that, commercial, as I think we pointed out in our earlier comments, is a growing part of our business from a mix standpoint. I mean, it's 35% of our sales on a year-to-date basis, up from 19% last year. So the commercial part of our business is something we've been leaning into.

Andrea Teixeira, Analyst

Okay. Thank you.

William Toler, CEO

Thanks, Andrea.

Operator, Operator

Next question comes from Chris Carey with Wells Fargo Securities. Please go ahead.

Chris Carey, Analyst

Hi. Good evening or afternoon, wherever you are. Just on the Q4 cash flow assumptions, can you be a bit more specific perhaps about what the drain is going to look like? I may have missed that number if you had given that.

William Toler, CEO

I'm sorry, I think we did mention free cash flow.

Chris Carey, Analyst

So in Q4, you're saying that generating cash flow will be difficult. Is there a way to frame that?

William Toler, CEO

Yes, I think, look, from a seasonal perspective, Q4 is slow for us and others in the industry. As a result, quite naturally, the sell-through will be a little bit less dramatic maybe than what we've seen in the last couple of quarters. At the same time, there is a little bit of inventory build seasonally that happens, particularly with respect to our lawn and garden business up in Canada. So those are some of the things we're thinking about when we air on the side of caution with respect to free cash in Q4.

Chris Carey, Analyst

Got it. Just on the comment around the commercial grower versus hobbyist or small grower. Are you seeing noticeable differences in the health of these types of customers? I appreciate one has a balance sheet that maybe some cash reserves and the other is kind of living day-to-day, right, from a cash perspective. But is this something where there's actually a maybe unappreciated part of this channel, which is a lot healthier, which maybe is taking share even despite the macro headwinds of the category? Can you just talk to that dynamic, please?

William Toler, CEO

Yes, that's exactly how we look at it, which is, the commercial multi-state operator or commercial operators are generally better funded and have either a new bill going in or large-scale grow and they are obviously able to support that. We've been successful there, building our percent of total in commercial up to the 35% that we quoted a few moments ago. A lot of that's been driven by the team that we acquired as part of the IGE business. We have several of our own folks who are focused on commercial. We integrated that with the IGE team, and now we have a very strong presence in that space. That is an area we expect to continue to grow and certainly think that we can gain market share and expand our footprint in that area.

Chris Carey, Analyst

Okay. Thank you.

William Toler, CEO

Thanks, Chris.

Operator, Operator

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

William Toler, CEO

Great. Thank you, operator, and we want to thank everyone for joining us today to hear our Q3 results, and we appreciate your support and following of Hydrofarm. Thank you very much. Have a good day.

Operator, Operator

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