Hydrofarm Holdings Group, Inc.

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Holdings Group third 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, November 9th, 2023. I would now like to turn the call over to Anna-Kate Heller at ICR to begin.

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 third quarter 2023 earnings release in Form 8K issued today after market close. These documents are available on the Investors section of Hydrofarm's website at hydrofarm.com. Before we begin our formal remarks, please note that our discussion today will include forward-looking statements. These forward-looking statements are not guarantees of future performance, and therefore, you should not put undue reliance on them. These statements are also subject to numerous risks and uncertainties that could cause actual results to differ materially from our current expectations. We refer all of you to our recent SEC filings for a more detailed discussion of the risks that could impact our future operating results and financial conditions. 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 Poehler.

Thank you, Anna Kate, and good afternoon, everyone. We are pleased that in the third quarter we achieved adjusted EBITDA profitability for the second quarter in a row. The successful execution of our restructuring and related cost-saving initiatives has driven significant improvement in our adjusted gross profits. which was also driven by greater emphasis on our own proprietary brands, which typically carry a higher margin. Our quarter-end cash balance is the highest it's been since the second quarter of 2021, putting us in a much stronger position as a result of our laser focus on optimizing our business to drive profitability. We've maintained our dedication to excellent customer service and on-time deliveries, even as we reduce costs. While we've implemented operational changes, Our distribution footprint remains customer-centric, and we maintain our commitment to providing top-notch service. We're glad to report that even at current sales levels, we've achieved significant progress in many areas this quarter, delivering both positive adjusted EBITDA and strong free cash flow. Our primary focus at Hydrofarm continues to be diversifying our revenue stream and controlling costs. whether it's through right-sizing the company, improving operational efficiency, or emphasizing profitability throughout everything we do. I'll start by highlighting a few positives on the top and bottom line in Q3. Our proprietary nutrient business, which is one of our highest margin product lines, again delivered a strong performance. We saw excellent results in numerous key proprietary brands, which contributed nicely to this quarter's margin expansion. Our proprietary brand nutrient sales grew over 20% versus third quarter of last year, in large part to our great brands, including House and Garden, Grotech, and Heavy 16. We also continue to enhance the diversity of our revenue streams with a growing proportion of sales originating from customers outside of the U.S. and Canada. Additionally, we observed an uptick in sales year-to-date versus last year from non-cannabis CEA applications, including food, floral, lawn and gardens, making our progress in diversifying revenue sources. I'm pleased to announce that our restructuring and related cost savings actions have been successful, as evidenced by our strong year-over-year improvement adjusted gross margin and adjusted SG&A, as well as positive adjusted EBITDA for the second quarter in a row. We still have work to do, but these improvements demonstrate significant progress. Given the current industry backdrop, we initiated a second phase of restructuring, focused primarily on our durables businesses. which John will talk about more in a moment. We will continue to control what we can by driving improved brand mix, distribution center and manufacturing productivity, and reducing SG&A. I am encouraged by our team's discipline and execution during the quarter, achieving adjusted EBITDA profitability of these lower sales rates and adjusted gross margin improvement that we saw in third quarter versus last year as a testament to the success of our recent actions, which has put us in a stronger position heading into 2024 and beyond. We are seeing positive momentum from a regulatory standpoint, and we remain confident the industry will return to growth. Several potential catalysts are on the horizon for the cannabis industry. The first is the possibility of now the Safer Banking Act and federal descheduling or rescheduling, which could inject new life into the industry by attracting renewed investment from both institutional and retail players. Another notable catalyst lies in the U.S. states where adult-use cannabis has been approved, but there's been a slow start, but now these states are starting to position themselves for significant growth. And Ohio, it's a recent addition to the list, having just legalized adult use cannabis on November the 7th, making it the 24th state to do so. We are hopeful the Ohio State Legislature will follow the will of the people and approve this measure. Being the seventh most populated state in the U.S., this is certainly significant, and it actually pushes the total U.S. adult use population to over 50% for the first time. There is increasing momentum in additional states as well, like Pennsylvania, Virginia, and Florida, where we believe we may have fully legalized adult-use cannabis on the ballot in the near future and have successfully expanded the industry's reach and present new growth opportunities. With that, I'll turn it over to John to further discuss the details of our third quarter financial results and our outlook for 2023. John?

Thanks, Bill, and good afternoon, everyone. Net sales for the third quarter were $54.2 million, down 27% year over year, driven primarily by a 22% decrease in sales volume. We realized a price-mix decline in the quarter, much like we have for the last several quarters and as we expect for the full year. Our 5% price-mix decline in the quarter is primarily due to promotional activity in both durable and consumable products. Our price mix decline in the period was also driven by a higher mix of lower-priced consumable products relative to higher-priced durables. Despite some competitive pricing in the Grow Media category, we still experienced much stronger top-line performance in our consumable products relative to durables. In fact, consumables represented approximately 75% of total sales in the quarter, up from 67% in Q3 last year. Much of this shift was influenced by a broader industry trend of weakness in durable products. In particular, sales of lighting and equipment commonly used in new expansion projects or newly established grow operations. This mixed change is also a reflection of the demand for several of our higher margin proprietary nutrient brands. As Bill mentioned, our proprietary nutrient brand sales grew double digits in the quarter compared to the same period last year. In an industry environment in which growth is hard to come by, we were really pleased with our Q3 top-line growth in our key proprietary nutrient brands. In connection with our strong nutrient performance, our proprietary brands as a whole in Q3 mixed slightly higher on a year-over-year basis and remained above 50% of our total sales. In addition to the favorable brand mix, we recognized sales improvements in a few key geographies this quarter. Sales to customers outside of the U.S. and Canada increased over 20% in Q3, which now marks the third consecutive quarter of year-over-year growth. In addition, during the quarter, we experienced good year-over-year momentum in hydroponic sales to our Canadian customers. And in the U.S., we experienced some pullback in the quarter in several key western states, namely California, but this was partially offset by relative strength in several states in the Midwest and in the Northeast. Gross profit in the third quarter was $3.3 million compared to $5.9 million in the year-ago period. Adjusted gross profit was $12.5 million or 23% in net sales in the third quarter compared to $7.8 million or 10.5% in net sales in the year-ago period. This strong over 1,200 basis point improvement in adjusted gross margin is a result of continued reduction in inventory charges, improved brand mix, reduced freight costs, and improved productivity. And while we are relatively pleased with this improvement, I should note that adjusted gross margin would have been another 200 basis points higher if not for an approximate 1.2 million non-restructuring inventory charge we took in the quarter. Though we assess inventory values each quarter, we do believe the inventory charge we took in Q3 is a relatively isolated charge. And as you read in the outlook section of our earnings release this afternoon, we still expect minimal additional non-restructuring inventory charges for the remainder of the year. Given the considerable progress we've made thus far in improving adjusted gross profit margin, we have initiated a second phase of restructuring. Phase two is centered on right-sizing elements of our business associated with durable products, and so this has emerged as the most challenged segment during the industry slowdown. In the third quarter, we recorded $7.8 million of restructuring expenses associated with reducing our durable manufacturing footprint and writing down the value of raw material inventory in connection with vacating storage space. And I should note that while we are reducing our manufacturing footprint, we are not eliminating any key manufacturing capabilities. We expect the second phase of the restructuring to result in annual cost savings of approximately $1.5 million, the bulk of which we will begin to realize in fiscal 2024. Our team is working hard to improve the structure of our business. We are optimistic by the progress from phase one, and look forward to continuing to execute on Phase 2 to realize further cost savings in 2024. I look forward to providing another update on our restructuring efforts on our year-end call in the new year. Selling general administrative expense was $19.5 million in the third quarter compared to $26.2 million in the year-ago period. Adjusted SG&A expenses were $12 million down from $16.8 million last year in our lowest quarterly total since before going public in late 2020. The $4.9 million reduction, or 29% decrease, was primarily due to reductions in headcount, professional fees, and lower accounts receivable reserves, primarily a result of the restructuring plan and related cost-saving initiatives. Adjusted EBITDA was $0.5 million in the third quarter compared to a loss of $9 million in the prior year period, representing positive EBITDA for the second quarter in a row. The $9.5 million increase was driven primarily by our lower adjusted SG&A expenses and higher adjusted gross profit. We are also now adjusted EBITDA positive for the nine months year-to-date through September 30th. Our ability to generate positive EBITDA at lower sales levels is encouraging and is a testament to the effectiveness of the restructuring and cost-saving initiatives. Moving on to our balance sheet and overall liquidity position, Our cash balance as of September 30, 2023, increased by $5.8 million during the quarter to $32.5 million. And while we ended the quarter with approximately $123 million of term debt and approximately $133 million of total debt, inclusive of finance lease liabilities, the considerable increase in our cash balance over the last two quarters now has helped to drive our net debt down to approximately $100 million. As a continued reminder, our term loan facility has no financial maintenance covenant. Principal amortizes at only 1% annually, and our debt facility does not mature for another five years in October 2028. We continue to maintain a zero balance in our revolving credit facility throughout the third quarter. We had positive free cash flow again this quarter, as we generated net cash from operating activities of $7.7 million, with capital investments of $0.8 million. yielding positive free cash flow of $6.9 million. We continue to aggressively convert our working capital into cash, helping us to generate positive free cash flow in the full nine-month year-to-date period. With that, let me turn to our full year 2023 outlook. We are reaffirming expectations of net sales in the range of $230 million to $240 million, and now expect our top-line results to be around the lower end of that range. With the strength of our cost-saving efforts and the performance of our proprietary nutrient brands, we are reaffirming modestly positive adjusted EBITDA for the full year. We also still expect to generate positive free cash flow for the full year. I should note that we did lower our expectation for capital expenditures to $4.5 to $5.5 million for the full year, down from $7 to $9 million previously, as we slowed our spend in Q3 while we were finalizing our plans for the Phase 2 restructuring initiative. With our phase two plan now established at the end of Q3, we do expect our CapEx spending to pick up in Q4 and into early next year. In closing, we are encouraged by the improvements in profitability that we achieved through the execution of our cost saving initiatives. We remain optimistic about the future of the industry and the growth opportunities for Hydrofarm in 2024 and beyond. We look forward to providing further updates next quarter. This concludes our prepared remarks and are now happy to answer your questions. Operator, please open the line for questions.

Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate that your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For 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. Our first question comes from Peter Grohm with UBS. Please proceed with your question.

Thanks, operator. Good afternoon, guys. Hope you're doing well. So, you know, Bill, I wanted to ask specifically around your confidence. You know, you mentioned the industry returning to growth. And, you know, obviously it's been a couple of years here, but you did touch on a lot of positive developments. So is this something that you think can actually occur as we look out to 2024 or, you know, over the next 12 to 18 months? Or is kind of the exit rate we're seeing in 4Q, I think the implied guidance is called like a mid to high teens decline. Is that a fair run rate to kind of start the year at? Thanks.

Yeah, I think it's – hey, Peter, good question. I think it is a fair rate to start the year at, but I think there are a number of signs that are pointing toward growth in probably, let's call it sometime in 24, maybe the back half of 24%. um you know they're our backlog on our durables bids is starting to bid a little bit the commercial activity is picking up some you're seeing these states that have been woefully slow and rolling out uh starting to do some things whether that's you know new york or new jersey or you know connecticut they're all starting to pick up maryland's been pretty good missouri's getting better all those things are starting to to turn a bit you know um I think you're going to see, and we have seen that in addition to the legislative stuff that we talked about. And, you know, those things can be a few months away. They can be a few longer than that away. We don't really know at this point, but all that is pointing in the right direction. But as you said, it's been, you know, an elongated difficult period of time for all of us. And so we were hesitant to call anything until we see it. And we're kind of planning as if it's going to run at the certain rates it's running at now and keep getting costs under control, keep managing the mix and keep looking at your, assets to find ways to create a more profitable company.

That's super helpful, Bill. And then I guess I just maybe a follow-up from a margin perspective and maybe more of like a long-term question, right? It's obviously very encouraging to see two straight quarters of positive EBITDA on a lower sales base, but can you maybe frame in the context of the restructuring you've done, you know, it's a second restructuring today, you know, other cost things, like what really is achievable today? from a margin perspective, particularly if we start to get some stabilization or growth in the back half of next year. Obviously, several years ago, you had some more ambitious goals from a profit standpoint. But just, you know, in the world we are in today, you know, I think it would be helpful to kind of frame, like, what's really possible, you know, and how long you actually think it can take to get there.

Yeah, I'll jump in on that one. Thanks, Peter. Great question. Yeah, I mean, I think if you look at the past three quarters, you know, our adjusted gross profit margin has been running around 24%. I mean, we've had sort of two quarters where it was 23%, one quarter was 27%. Frankly, the quarter we just finished, as you saw me call out in our prepared remarks, I think we put up a 23% adjusted gross profit margin, but, you know, really sort of 200 basis points higher when you take into consideration the charge that we incurred during the period. So I think, you know, if we were to get just a little bit of cooperation from the industry and a little bit of growth, you know, I think we could look at something in the, you know, 23 to 25, maybe a little bit better than that sort of adjusted gross profit margin. And when we talk about adjusted SG&A, you know, we're kind of running right now around, you know, this $12 to $13 million kind of range in an adjusted level, you know, which is downward. nearly three and a half four million dollars from where we began the year so as we go into 2024 we're going to get some lap benefit from that just quite simply from the savings that we've already instituted and already received some benefit from you also heard from the restructuring effort phase two that we're putting in place we're expecting 1.5 million dollars of additional savings there so you know i i definitely feel like we've got some more opportunity in front of us with respect to you know uh growing the margin

at the EBITDA level from here. Super helpful. Thank you so much. I'll pass it on. Thanks, Peter.

Our next question comes from Jesse Redman with Water Tower Research. Please proceed with your question.

Hi, guys. I had a question on the product side. As we've chatted before, I always enjoy using your products and personally like your Roots Organic line for the things that I do in my backyard every season. But I know you've also been working on some proprietary nutrient brands, and I'm just wondering if you had an update there and if you could talk a little bit about how those are performing.

Yeah, thanks, Jesse. And, you know, probably the strength of our portfolio and embedded in all this adjusted gross profit progress has really been the proprietary nutrient brands. I mean, whether it's House and Garden, which honestly over the last three years has been our most consistent business, whether it's heavy 16, which it had a tough year last year, but it's come back gangbusters or finally grow tech, which was a business that we bought out of Canada. It's always been distributed by us in both Canada and the U S has a great presence in Europe as well. Grow tech has always done well in the Asian community. And we've really been able to tap back into that market this year. And we've had, you know, kind of two quarters in a row of just outstanding growth on, on that brand as well. But, The proprietary nutrients are really kind of the core of where we're making our money, if you will. And I admit we're not making a ton of money yet, but it really is driving the higher adjusted gross profit results that we're seeing. And it's been an important part of kind of how this year has held together for us on a positive adjusted EBITDA and also creating free cash flows. So good progress on the nutrients. They're really the centerpiece of our entire proprietary branded offering.

Do you see any trends in terms of, I could see this a couple of ways when I'm talking to operators, there's people that are interested in growing great flour and want to spend more money to get higher THC numbers and more terpenes and maybe more in the premium part of the markets and looking to spend more on that side to create better products. But also we recognize there's a lot of margin pressure. And one thing I've been hearing in some of the MSO calls is people, consumers are shifting down and going more towards value lines, which makes me think that providing affordable solutions maybe of more interest. Curious where you're seeing the push and pull on that side, if you're seeing people that are looking for more value conscious solutions, or if you're also seeing people that are looking for whatever is going to push the plant to its maximum potential.

Yeah, I think you're right. There's a wide spectrum of demand curve out there, right? And the margin pressure and the overall kind of glut of product over the last couple of years has caused pricing to drop way down. And so people then The corresponding reaction to that is they want to get cheaper inputs and cheaper cost of goods for growing. We've seen some of that. We've launched a house and garden dry product, which is a real value orientation instead of having the liquids, which, of course, you ship the water and you ship the dilution factor there. The dry product really gives people a value-oriented way, yet it still has the high-quality house and garden brand name on it. That's one of the things we're doing. We also offer a range of both in our proprietary line and in our distributed line, whether it's the Guy Green products, whether it's the Moab, the mother of all Bloom products, or all those that really are part of our portfolio that enable us to give people value, enable us to give people quality, and it does allow for the folks to get that wide range of the things you outline, which is some Ultimax terpene, some Ultimax THC, some just want a consistent product of what they've had before, and others play in that price market as well. We began doing some work on sourcing kind of all the way back to the core raw materials to work with our growers on so that we're able to work with them and it gives them the access to the product. They perhaps even want to mix their own. So we're really adjusting our approach to the market to reflect what each of our growers need. And there's a wide range of them out there, as you suggested, Jesse.

Great. Thank you, guys. That's really helpful. Appreciate it. Appreciate the question.

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

Great. Thank you all for your interest in Hydrofarm. We appreciate you being on the call. Look forward to updating you soon on other activity in the business. Thank you.

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