Hydrofarm Holdings Group, Inc. (NASDAQ:HYFM) Q3 2022 Results Conference Call November 9, 2022 4:30 PM ET
Company Participants
Fitzhugh Taylor – Managing Director of ICR
John Lindeman – CFO
William Toler – CEO & Chairman
Conference Call Participants
Andrew Carter – Stifel, Nicolaus & Company
Stephen Lengel – Truist Securities
Andrea Teixeira – JP Morgan
Chris Carey – Wells Fargo
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
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 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
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 own internal expectations, and though our reported adjusted EBITDA was heavily impacted by inventory and account 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. And 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 at bright spot. Our commercial effort has been led by our associates at the Integrated Growers Equipment or IGE company or part of that company, which we acquired in November of 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 %age 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 grow 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 more broadly to adapt 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 industries 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 to return 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
Thank you, Bill, and good afternoon, everyone. Net sales for the third quarter were $74.2 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 is the category that’s been hardest hit by the industry downturn.
Commercial sales as a percentage of our total have strengthened [despite] (ph) 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 that magnitude 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 or 10.5% of net sales in the third quarter compared to $33 million or 26.6% in 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 was $16.8 million or 22.7% of net sales in the quarter versus 16.9% 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. And so, while we continue to keep closed tabs on our collection efforts, we have not seen any broad based deterioration in this area.
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 $16.1 million profit 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, for 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. And that has been the case for the entirety of 2022, we have 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, helping us to generate positive operating cash flow and enabling growth oriented capital investments, namely in our more diverse peat and IGE businesses. And while we have opportunity 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 that we will finish the full year on a positive basis and we 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 whether 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 are now happy to answer your questions. Operator, please open the line for questions.
Question-and-Answer Session
Operator
Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Andrew Carter with Stifel. Please go ahead.
Andrew Carter
Hey, thanks. Good evening. I wanted to ask, so obviously the drawdown of inventory has been a good source of funds here. How much farther can this go? I mean, if I did my math right, I probably didn’t. But I have your peat’s is down 58% in the quarter, that’s behind the organic growth of 47%. Can it be like that? Or do you expect some expect some kind of a big catch up here? How much more can you — how much more is our target working capital, et cetera. I’ll stop there finally.
William Toler
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. Do you still got in terms of days of supply good bit of inventory, right? Think of it in two buckets. One is our finished goods in our DCs 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. And we can always continue to tighten on the finished goods side as well.
As a 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, of course, 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 ail, if you will, finish goods that we buy from others and on the direct materials side.
Andrew Carter
Got you. And then thinking about like usually typically kind of on 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 decision, 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
Generally, the area that involves the most kind of buying ahead is around the grow media businesses, right? There’s generally a lot of kind of pre booking of that in the fall. Well, 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 kind of hand to mouth. I mean, 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
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 like, are you actually expanding product margins on products outside of lighting just through the pricing you’re getting? Thanks.
William Toler
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. And 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
Thanks. I’ll pass it on.
William Toler
Thanks a lot.
Operator
Next question comes from Bill Chappell with Truist Securities. Please go ahead.
Stephen Lengel
Hey, good evening guys. This is Stephen Lengel on for Bill Chappell. Thank you for taking our question. You guys kind of — as a little bit of a follow-up to Andrew’s question on the lighting inventory. We kind of heard from Hawthorne that they seem to be exiting the LED lighting. Can you kind of provide more color? I know that this is an opportunity just to kind of gain some share over the long term or you kind of expecting to exit the category as well? Thank you.
William Toler
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 pot 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 and obviously we still sell LEDs very aggressively and we’ll 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
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
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. And we’ve actually been granted last year some additional acreage in bogs. So it’s becoming a very nice business for us. And importantly, it sells outside of just an ingredient going into cannabis or into grown mixes, right? So it sells into different kind of food and floral and outdoor grows and sells into mushroom farmers and a number of different places. So there’s many channels there that we can develop. It does require capital to develop those new bogs and I think we 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 place that’s unique commodity, that’s differentiated and it’s 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
Awesome. Thank you so much, guys. I’ll pass it on.
Operator
[Operator Instructions] Next question comes from Andrea Teixeira, JP Morgan. Please go ahead.
Andrea Teixeira
Thank you, operator, and good afternoon, everyone. So my question is — how are you? So, Bill or John, like just on a bit on kind of like going back to your point about getting into the EBITDA guidance, but more on the low end. So I’m assuming that implies gross margins still in the high single digits for the fourth quarter and then I’m assuming the top line, is this still — I think top line is still coming okay given that you are kind of being tactical about how you get rid of the inventory. But thinking of profitability from here, I’m assuming you did mention that you don’t see any other write downs from here. How should we be thinking as we move forward into ‘23? Do you think most of it is behind us? And then why getting the shelf registration, is that to avoid or to just being tactical about having the ability to tackle or to draw back in some of the other alternatives other than the revolver?
William Toler
Yes, Andrea. God afternoon. Now with respect to Q4 and what’s implied out of our guidance from a margin standpoint, I think you’re generally thinking about it correctly. Number of the things that we saw occurring in Q3 from our mix and sales volume perspective are what we expect to continue to emerge into Q4. Obviously, there’s some seasonality that brings the sales level down. I think that was already implicit in sort of a lot of the numbers I saw floating around out there for us for Q4 and before the call. So I think directionally that’s all right.
With respect to 2023, we’ve got some planning to do for sure over the next couple of months and I think we’ll have more to say about like formal thoughts for 2023 as we prepare to report the Q4 results here in the coming period.
With respect to the shelf registration, I think it’s just — for companies like us, I mean typically you have a shelf up there available for access if and when needed. Right now, I think as you know, we’ve got cash on the balance sheet, we’ve got a fair amount of liquidity available in the line of credit that is completely untapped at this point. Those obviously would be the first places we would go for cash. And then we — although we’ve guided it and offered an outlook that suggests generating free cash flow in the fourth quarter will be a challenge. We are cautiously optimistic, there’s some opportunities for us to continue to do in the future. And our last call suggested there’s still some opportunity — our last question rather suggested there’s still opportunity in the inventory area and we feel that way.
Andrea Teixeira
Meaning, you can continue to in a way get — I mean, I don’t know if what means in terms of like — what that means in terms of the retail inventory, right? Well, how the health of — and how much visibility you have in some of your retail partners, if they still are running high levels of inventory that may heat you? It’s true in the following quarters or you have some good visibility there?
William Toler
We don’t have — certainly, it’s not — ahead, John.
John Lindeman
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 you know 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 level. That’s part of the reason I think our sales levels are down. But 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
Okay. Thank you.
William Toler
Thanks, Andrea.
Operator
Next question comes from Chris Carey with Wells Fargo Securities. Please go ahead.
Q – Chris Carey
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
I’m sorry, was it — I think we did [indiscernible] on free cash flow, but –
Chris Carey
So in Q4, you’re saying that generating cash flow will be difficult. Is there a way to frame that?
William Toler
Yes, I think, look, I mean, obviously, Q4 from a seasonal perspective is sort of slow for us and others in the industry. And just 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. And so, those things are some of the things we’re thinking about when we sort of air on the side of caution with respect to free cash in Q4.
Chris Carey
Got it. Just on the comment around the commercial grower versus hobbyist or small grower. Are you seeing noticeable differences in 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 and you can really go after that customer and take market share and perhaps deliver a bit healthier financial results over the next 12 months even if the category remains under pressure, can you just talk to that dynamic, please?
William Toler
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. And so 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 a 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. So 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
Okay. Thank you.
William Toler
Thanks, Chris.
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
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
This conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.
Be the first to comment