Hydrofarm Holdings Group, Inc.

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Holdings Group first 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, May 10, 2022. I'd now like to turn the conference over to Mr. Fitzhugh Taylor, Managing Director at ICR, to begin.

Thank you, Claudia, and good afternoon. With me on today's call is Bill Toller, Hydrofarm's Chairman and Chief Executive Officer, and John Lindemann, the company's Chief Financial Officer. By now, everyone should have access to our first quarter 2022 earnings release, Inform 8K, 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 discussions 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 risk 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 would like to turn the call over to Bill Tuller. Bill?

Thank you, Fitzhugh, and good afternoon, everyone. Since our IPO in December of 2020, we've worked hard to strengthen our business and lay a foundation for long-term success. We've completed five acquisitions that have reshaped our product portfolio with a focus on higher margin consumables, increasing both our proprietary and preferred brands. We have also expanded our distribution and manufacturing footprint by over 70% and completed three financings to further solidify our balance sheet. We have added new skills to our management team here at Hydrofarm as well. With a long history of consistent growth, combined with the strong tailwinds of the CEA hydroponic growth, we believe our optimism is grounded. However, while optimistic about the future of our business and our long-term potential, recent volume trends across the industry have been impacted by the external environment due to the agriculture oversupply that has hampered cannabis growing activity across the U.S. and Canada. Our sales in Q1 are essentially flat compared to last year's first quarter, supported largely by our M&A volume. With that in mind, we believe it's prudent to adjust our outlook for 2022, which John will discuss in further detail in a moment. Nevertheless, beside these transient challenges, we should not lose sight of the fact that end consumption of cannabis continues to grow. The best proxy we have for this is dispensary unit volume data measured by headset, which is showing increasing volume, both sequentially and year over year. This end-use consumption is leveling out cannabis inventories, which should help the hydroponic industry return to more normalized growth. During this challenging time, we are working to control the controllables by taking additional actions to control cost, increase prices, and protect our business. These include price increases, passing on fuel surcharges, passing on higher freight costs. We have also reduced our employee base by about 11% by the end of the first quarter and continue to optimize our organization as we capture cost synergies from the acquisitions completed in 2021. The results of these actions are helping to mitigate inflationary costs and beginning to positively impact our P&L. We are using the short-term volume challenges as a time to make us a better operator and a stronger, leaner company, so when growth returns, we will be more profitable and a stronger business. In addition to these actions, the growth drivers we laid out in prior communications are actually performing relatively well. When you look at IGE and our commercial business, they both enjoyed a solid first quarter. Several of the newer legalized states are doing pretty well, and also our PEAT business, we're seeing solid performance. However, this has been offset by softness in our core retail business, including legacy markets like California, Michigan, and Oklahoma. Lastly, we continue to believe that adult use legislation will provide us with significant growth opportunities in the future. While the new states have been slow to implement, we continue to see an opportunity for growth and cultivation activity in late 2022. Ultimately, we expect an acceleration in the cannabis market growth resulting from these state legislative changes and increasing popular support. In summary, the actions we've taken combined with our growth drivers have not only helped us refine and optimize our organization, but also equipped us to move past the near-term challenges. Moreover, with strong product portfolio and a healthy balance sheet, we believe we're well positioned to capture the tremendous growth opportunities that lie ahead. With that, I'll turn it over to John to further discuss the details of our first quarter financials and provide comments on our updated full year 2022 outlook. John?

Thanks, Bill, and good afternoon, everyone. Net sales for the first quarter held steady at $111.4 million compared to the prior year period. Our 2021 acquisitions added 34.6% to our top line in the first quarter of 2022 relative to the prior year period. But this M&A growth was offset by a 34.6% decline in organic sales due to softness we experienced in several U.S. states and in Canada. In the U.S., California remained challenged, but we also experienced softness during the quarter in several of the historically larger state markets. Though not yet sizable enough to offset these historically larger states, we experienced year-over-year organic growth in Q1 in several other states and regions. For example, in the southeastern U.S., states such as Mississippi, Louisiana, and Florida each experienced double-digit or more year-over-year organic growth in Q1. Similarly, several other states, most notably Virginia and New Jersey, experienced significant growth in the quarter. In Q1, we also realized a 2.2% price mixed benefit, which is consistent with our intention to pass through higher costs and consistent with our own internal expectations for the quarter. Gross profit during the fourth quarter decreased to $16.6 million, as compared to $23.2 million in the year-ago period. During the first quarter, we incurred $3.9 million in acquisition-related expenses. We also experienced a significant year-over-year increase in depreciation and amortization expense, largely due to purchase accounting and the stepped-up asset values that resulted from our 2021 acquisitions. And so, for comparability purposes, we included in the press release a calculation of adjusted gross profit, which excludes these items. On this basis, adjusted gross profit was $22.3 million, or 20% of net sales in the first quarter, down slightly from 23.4 million or 21% in net sales last year. And though we did not adjust for it, adjusted gross profit was negatively impacted by a 3.2 million increase in inventory reserves, primarily consisting of a write-down of certain lighting products during the quarter. Excluding the increase in inventory reserve, adjusted gross profit margin would have been higher in the first quarter of 2022 than in the prior year period. I should also note that while freight and labor costs were higher in the quarter on a year-over-year basis, our pricing actions, freight initiatives, and favorable sales mix largely offset these items. Selling, general, and administrative expense increased to $43 million in the first quarter of 2022 compared to $16.8 million in the year-ago period. The increase in SG&A was primarily due to $13.5 million increase in amortization expense again due to stepped-up asset values from the acquisitions, distribution center relocation costs, acquisition and integration-related costs, and certain other non-cash expenses detailed in the back of today's earnings release. Adjusted SG&A expense, which adjusts for these items, was 19.2 million, or 17.2% of net sales in the quarter, versus 13.5 million, or 12.1% last year, primarily driven by an increase in compensation costs, facility costs, and insurance expenses. As a reminder, these added costs primarily emanate from the five acquisitions we did last year and the overall increase in the size and scope of our operations today, all of which helps prepare us for future growth. Reported net loss was 23.3 million, or 52 cents, per diluted share in the first quarter. compared to income of 4.9 million or 13 cents per diluted share last year. Weighted average diluted shares outstanding were approximately 44.7 million for the first quarter of 2022. Adjusted net loss for the quarter was approximately 7.8 million or 17 cents per dilute share compared to an adjusted net income of 7.2 million or 18 cents per diluted share in the year ago period. Lastly, adjusted EBITDA decreased to $3.1 million in the first quarter from $9.9 million in the prior year period. Adjusted EBITDA margin decreased to 2.8% from 8.9% in the prior year period, driven primarily by higher SG&A expenses relative to net sales in the period comparisons, as well as the $3.2 million inventory reserve I mentioned earlier. It is worth noting that if not for the inventory write-down, our Q1 adjusted EBITDA would have been in line with our commentary back in March, even on lower than expected net sales. This suggests that the initiatives we put in place in Q1 are indeed having a positive impact on the P&L in spite of the continued revenue softness. Moving on to our balance sheet and overall liquidity position, as of March 31, 2022, we had over $111 million in total liquidity between 12.2 million unrestricted cash and approximately 100 million available on our undrawn ADL revolving credit facility. We also maintained approximately 125 million in debt outstanding under our term line. Based on our Q1 results in recent sales trends, we are updating our full year 2022 outlook and providing you with some color around our current assumptions. We now expect total company net sales growth of 0% to 8%, which translates to approximately $480 million to $520 million in net sales. We expect a decline in full-year organic sales offset by M&A growth. While we expect total sales growth to resume in Q3 versus reported results a year ago, we now expect quarterly organic growth to resume in Q4. Though difficult to make this call, only four full months into our 2022 fiscal year, based on the soft early spring sales, we felt updating our guidance was the prudent thing to do. Our pricing and cost saving actions are yielding positive early results and are helping to counterbalance the margin impact of a softer than expected top line. And while we expect this relationship to continue, our adjusted EBITDA estimates imply a margin profile that is impacted somewhat by the reduction in full year net sales. Lastly, and as Bill pointed out earlier, we've made many investments over the past year to prepare us for the CEA growth expected in our future. We expanded our distribution footprint, invested in inventory positions, increased the size and scope of our proprietary brand offering and manufacturing capabilities, and added key leadership roles. Against this backdrop, we feel justified in reducing our capital expenditure plans slightly to $8 million to $10 million and inserting controls to reduce over time our network and capital investments and further boost internally generated cash flow. In closing, we believe we put in place the necessary steps to weather the current industry headwinds. While it's prudent to lower our expectations for the full year, we remain optimistic about our business fundamentals and our ability to capitalize on the growth opportunities in the CEA industry. This concludes our prepared remarks, and we're now happy to answer any questions you might have. Operator, please open the lines for questions.

Thank you, sir. We will now be conducting a question and answer session. If you would like to ask a question, please press star and 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star and 2 if you would like to remove yourself from the question queue. For the participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. One moment, please, while we poll for questions. The first question comes from Andrew Carter from Skyfall. Please proceed with your question, Andrew.

Thanks. Good afternoon. First question I wanted to ask, you've taken the inventory pyramid about $3 million. First part of that is you review kind of the categories. How much more could there be, i.e., like how much of your inventory right now is in deflation? I would assume lighting is. And then a separate part of that question is I think your purchases, I did my math here quickly, were still up. Do you think you'll be able to generate free cash flow this year kind of working through inventory? Thanks.

Yeah, thanks, Andrew. For sure, our inventory levels remain pretty strong. You know, the $3.2 million inventory reserve primarily relates to select lighting SKUs, particularly in the high-pressure sodium area. I would note we did not write those down to zero, but rather to a level we think allowed us to move those products efficiently. You know, we'll continue to keep a watchful eye, but at this point we think what we did is what's warranted. And with respect to, I think, your question on free cash flow, yes. I think with, you know, our CapEx assumptions, working capital assumptions, and assuming we continue to progress towards the guidance we just outlined, we do expect to generate free cash flow this year.

Thanks. And then the second question is, you mentioned the pricing, and it was 2%. It's hard to kind of read on mix. Are you getting incremental pricing through? And I'm not sure in this environment, when volume's down 30, you can tell or not. Do you get any pushback or see any risk? In particular, I'm kind of asking about the promotional environment that you're seeing out there. Thanks.

Yeah, the pricing is primarily on a list price basis. Promotional activity hasn't materially changed across the categories, as you suggested, with volumes down and retail traffic down, the effectiveness of promotion as it would be if you were getting more people into stores and more people buying. So you haven't really seen a whole lot more investment on that side of it. I think individual distributors and brand owners may have certain categories they're promoting. John mentioned earlier that we're working to move through the HPS category. double-ended lighting that we're working against under our Phantom brand. But we haven't seen it go over the top on promotion. The pricing is primarily on list pricing. We've also put in place fuel surcharge and also increased freight requirements for our customers to buy, again, helping solidify the cost that we're seeing. Thanks. I'll pass it on. Thanks, Andrew.

Thank you. The next question comes from Peter Grum from UBS. Please go ahead with your question, Peter.

Hey, good afternoon, everyone. So just a couple questions. Maybe first, and I don't mean to be too forward here, but I guess I'm just trying to understand what happened this quarter. I mean, you reported in early March in the commentary that sales were going to be down a little bit worse than 1Q. on an organic basis and essentially more than doubled that decline. And I totally understand the category's been challenged, but you more than kind of doubled the decline that you were kind of expecting, even though you had two months in the rear view here. So I'm just trying to understand the visibility you have in your business when we think about your guidance, particularly as we look out to the balance of the year.

I think it's fair to say that visibility in the category has been difficult for everybody. We're certainly in that group that struggles to see where the demand is coming and when it's coming forward. We did have some open thought that as we got into the spring months, March, I think it's 40% of the first quarter, that March would sort of be that turn back to the positive, and actually it went the other way. It was a weaker time than we had hoped. So, yes, it was a disappointing outline. We didn't give a specific number when we gave that sort of call out in March. We just said it was going to be worse than it was in Q4, and it turned out to be a good bit worse as we are reporting now. So the visibility is clearly a challenge. We're all working through that. We're all trying to get better looks and views into it, but there's not a lot of magic, not a lot of third-party data that gets us there. We're just trying to plan out and see what business we can and work through it to, you know, get the best outcomes we can. But I certainly understand your question, Peter.

No, okay. That's helpful. And then, you know, you mentioned, you know, recent sales trends was part of the reason as to why you lowered guidance as much as you did. So maybe could you speak to what you're seeing kind of, you know, through April and May and how we should think about, you know, sales on an organic basis? And then maybe just layering on that, I guess you look at some of your peers, right? I mean, I totally understand the visibility has been a challenge for everybody, but the level of negative revision from a revenue perspective is far greater at this point. And so are you simply being conservative? Are you prudent? Do you feel like this is what we should expect to achieve? Just trying to understand you know, kind of the underlying assumptions here and your kind of comfort in hitting this, you know, revised target?

Yeah, back to your first part of that question. We have not seen much, we haven't seen any improvement in April. May is too early to tell. Obviously, April did not show us a whole lot, and that certainly influenced how we called down the whole year because we haven't seen kind of that spring return that we had hoped for. And so that's where we are. That's the part of it. You see other people. I think our largest competitor hasn't really provided their revised look. GrowGen just came out a few minutes ago. I glanced at it quickly, and that was a pretty significant call down. Their same-store sales decline is similar to what our organic number was in Q1. So we kind of track along with that. And that's where we see it. But we haven't seen it turn. That's why we went ahead and called it down. And obviously, we give you the numbers the best we can that we think we can achieve. We're not trying to be heroes or a sandbag or to, you know, call them down multiple times, but we give you the numbers that we can forecast, and that's what we see.

Okay, so just if we, you know, if we were to kind of hold the current rate that you're seeing, you know, through the balance of the year, would that kind of get you to what you're outlining in terms of, you know, revenue and EBITDA, or is it, you know, do you think that You know, I'm just trying to understand because last quarter you were kind of saying and March you were hoping.

No, that's fair.

I mean, the category.

I'm sorry. Go ahead, Peter.

No, that's it. I just want to make sure that's what I was trying to understand is that, you know, assuming that the kind of current state of the category holds and that just as the comparisons get easier in the back half of the year, that that's kind of when you would get to organic growth or does it embed that the category shows some sort of signs of life here in the coming months?

Yes, we are expecting it to show some strength in Q4 versus perhaps earlier we had thought maybe late Q2, early Q3. And there is seasonality in the business, as you well know. The last six months have been the roughest from a seasonality standpoint. Q2 and Q3 should be the stronger ones. We'll see how that plays through as we go through the year, and yes, the easier comps in the back half do give us more confidence that we should be able to track with better outcomes.

Okay, great. Well, best of luck, and I'll pass it on.

Thanks, Peter.

Thank you. Ladies and gentlemen, just another reminder, if you'd like to ask a question, please press star, then 1. If you'd like to ask a question, please press star, then 1. The next question comes from Andrea Teixeira from JP Morgan. Please proceed with your question.

Thank you. Good afternoon. So if we can just think about what is embedded in your guide going forward in terms of pricing, or it's just the pricing that you've put through so far? I mean, you parsed out some of the impacts, right? I mean, fuel, surcharge, and some of the minimum costs. freight costs and all of that. But I was thinking of also the mixed impact from having less lighting and all of these puts and takes. And then when you think about all that's happening to the industry, and I think you just discussed your cash flow not still being able to generate cash. But I was wondering if you were seeing you having to be more selective with your customers as well, maybe potentially some account receivable issues ahead, given that it's taking longer than anticipated to see demand coming back, or you're clear there in terms of that part of the equation. And just to get a little bit of what's happening, given that everybody else in the industry has been impacted, how you're seeing pricing and rationality in the marketplace.

Yeah, thanks, Andrea. A lot of good questions there. So let's just start at the top on the pricing question. So we had 2.2% pricing mixed benefit in the quarter. I think we had mentioned last time, but it's good to revisit here. that we took several pricing actions in the first quarter. First quarter did not reflect a full quarter of those pricing actions. We didn't get full benefit in the quarter. We also put in place at the very end of the first quarter some new freight initiatives, which include fuel surcharges, or rather freight surcharges, and some changes to freight minimums. all of which are beneficial and helpful to our pricing mechanism or rather net price realization overall. We are expecting to take additional actions in Q2 on pricing. And as we plan and model across the course of the year, we do expect our pricing realization to build over the course of the year as we begin to gather the full year benefit of the pricing actions we've taken both in Q1 and expect to take in Q2 The other thing that will happen for us that will have an impact on price realization is just as the acquisitions we did in 2021 work their way into the 13th month and then begin to fall into our organic sales, we did take pricing actions on some of the M&A companies or companies we acquired as well. And right now that is not showing through on our net price realization as we report it. because they're all in the M&A growth bucket, if you will. So that will benefit the pricing bill for us. From a cash flow perspective, you know, we – go ahead.

No, I was just trying to round up your commentary on the pricing. So when you think about all-in from the 2%, would you get into like a mid-single, or is that aspirational? Yeah.

No, we still think that we wind up across the course of the year at a mid-single.

I call it like end of the second quarter, I'm assuming.

I don't know that we've called it by the end of the second quarter. If you mean for the first six months of the year, I'm not sure that that would entirely because it's expected to be a little bit more weighting to the back half. as these pricing initiatives begin to gather steam and stack on top of each other. And again, a lot of the acquisitions we did were really in the last seven, eight months of last year, and we pick up the pricing action benefits inside of those companies as they roll into organic. So again, it weights a little bit more to the back half.

Okay. And then on the cash flow side and accounts receivable, anything we should be aware of?

You know, we haven't really seen a lot of pressure there yet. I mean, look, we're obviously have our antenna up and, you know, remain cautious. But so far, so good on that front, really.

Okay. Thank you, Professor.

Thank you.

Thank you. The next question comes from Bo Chappell from Tourist Securities. Please proceed with your question, Bo.

Thanks. Good afternoon. Hey, Bill. Hey, just trying to understand, I guess, the composition or if I think about it, is it more durables or lighting or is it kind of industry-wide? And the reason I ask that is it seems like there's partially a problem in terms of the glut of cannabis, but now with your competitor kind of building throughout and you maybe building throughout the past six, nine months, there's a glut of lighting or lighting. kind of hard goods or durables. And I'm trying to understand if that's something that is now factored into your outlook with this glut. There's going to be some pricing pressure as people try to move these, and it takes quite a while. And so I'm trying to understand if that's the bigger issue or if it's still more just the cannabis agricultural side.

Yeah, it's clearly still more on the cannabis agricultural side. but durables are down a few hundred basis points more than consumables for us. I can't speak to anybody else, but I know for us, if you break it apart, durables are down more. And that one is primarily targeted around the high pressure sodium double-ended lights, the phantom lights, which have been the historical way we go to market and the way the industry has gone to market. That's now shifting very quickly to LEDs. We compete effectively in LEDs, but the high pressure sodium segment is dropping faster than than LEDs are picking up, at least for us. And so we have some pressure on inventory there. That's why we took the write down that we did in Q1 to get that down to a promotional level that we think will move the products through. But overall, I still think the umbrella here is the agricultural supply. And you see that in, you know, you see that in other retailers numbers and you see that in a lot of different places that, you know, retail traffic is down, growing overall is down. But we all can't forget that if you use, headset dispensary data, then people are still buying more cannabis through the dispensaries than they were last quarter and they were a year ago, which suggests that consumption is still growing and eventually that's going to balance out inventory and get demand and inventory and growing and back in balance and you'll see growth return to the category. Okay.

And in terms of just The new states that you talked about, some positive reads in New Jersey, Virginia, are those still on kind of the same path, maybe more meaningful in the second half of this year and early the next year? Is there any pull forward or any delay that you see out of those states and kind of contribution to the industry?

Yeah, all of them have been slower than we had hoped, right? I remember many of these passed in the 16 and 18 elections and some are not even implemented yet. And, you know, you look at a New York, which is still kind of getting its sea legs. And New Jersey just opened up last week. And Virginia is still, I think they moved from 24 to 23. But, you know, a lot of them have been slower than we hoped. What we're seeing broadly in the MSO world and our commercial world is nobody is canceling, but we are seeing delays. And I think you see that from a lot of people on the durable side, that they're getting delayed orders or people are pushing off projects and waiting for the industry to normalize a little bit. And I think that's kind of cast an overall shadow on everything that's going on.

Got it. Thanks for the color.

Thank you, Bill.

Thank you. At this time, there are no further questions. I'd like to turn the call back to Mr. Bill Taller for closing comments. Thank you, sir.

Thanks, folks. We appreciate your interest and support of Hydrofarm and look forward to updating you about the business down the road. Thank you so much.

This concludes today's conference. You may now disconnect your lines at this time. Thank you very much for your participation.