Distribution Solutions Group, Inc. (NASDAQ:DSGR) Q1 2023 Earnings Call Transcript May 6, 2023

Operator: Greetings, and welcome to the Distribution Solutions Group’s First Quarter 2023 Earnings Conference Call. [Operator Instructions] Please note this conference is being recorded. I will now turn the conference over to your host, Steven Hooser, Investor Relations. You may begin.

Steven Hooser: Good morning, and welcome to the Distribution Solutions Group First Quarter 2023 Earnings Call. In conjunction with today’s call, we have provided a Q1 earnings presentation that has been posted on the company’s IR website at investor.distributionsolutionsgroup.com. Please note that statements on this call and in the press release contain forward-looking statements concerning goals, beliefs, expectations, strategies, plans, future operating results and underlying assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied. In addition, statements made during this call are based on the company’s views as of today. The company anticipates that future developments may cause those views to change and we may elect to update the forward-looking statements made today, but disclaim no obligation to do so.

Management will also refer to non-GAAP measures and reconciliations to the nearest GAAP measures can be found at the end of the earnings release. The earnings press release issued earlier today was posted on the Investor Relations section of our website. A copy of the release has also been included in the current report on Form 8-K filed with the SEC. This call is being audio webcast on the internet via the Distribution Solutions Group Investor Relations page. A replay of the teleconference will be available through May 18, 2023. I will now turn the call over to Bryan King, DSG’s Chairman and Executive Officer. Bryan?

Bryan King : Thanks, Steven and thank you all for joining to review our first quarter results. Joining me for today’s call is Ron Knutson, DSG’s Executive Vice President and Chief Financial Officer. Distribution Solutions Group delivered another record quarter of outstanding financial performance with expansion in both revenue and profitability. Steven mentioned the slide deck that we’re using in conjunction with our prepared remarks. Starting on Slide 4, we delivered strong sales of 28% on a comparable basis, which included almost 14% of organic growth. In addition, we generated first quarter adjusted EBITDA of $39 million representing our fourth consecutive quarter of expanded EBITDA margin into the double-digits. We believe that our scale and breadth of products and services continue to provide competitive advantages in the specialty industrial distribution industry.

Our DSG operational teams are working well together and we’re seeing good evidence of wallet share growth, volume increases and encouraging and validating cross-selling wins as well as continued identification of an initiative to capture cost synergies across each of our verticals. The first quarter’s results further confirm the financial and commercial logic of the combination that took place only a year ago, an improved business model we now enjoy. The strength, depth and strong collegiality across the combined expertise of our leadership team is enhancing our performance and accelerating building a best-in-class specialty distribution company with strong market leadership across several distinct but increasingly coordinated value-added verticals.

As shareholders, together we will continue to benefit as our team identifies and executes on myriad value creation opportunities. As we highlighted during our fourth quarter call, we continued strong sales momentum in the first quarter. Our business has successfully captured market share, delivered incremental margin expansion and generated additional cash flow in our first fiscal period of this new year and culminated a strong first full year, 4 season so to speak, working increasingly well together. We are actively engaging customers with a goal of providing a simple and efficient and even more value-added and customized customer experience as we remain hyper-attentive to reinforcing our value proposition to our existing in markets. We continue to monitor the overall demand environment for our products and solutions.

We believe that further leveraging our strong historic customer relationships adds to organic growth increasingly, through cross-selling our expanding value-added customer-centric capabilities in each of our channels. Moving to Slide 5, I’m pleased to comment on the previously announced plan to acquire Hisco expected to close during the second quarter of this year. Hisco is a leading distributor of specialty products serving high growth industrial technology applications, with 38 locations across North America and over $400 million in annual sales. This business most closely aligns with TestEquity, although anecdotally and curiously to me, each of several distribution investment banking friends that called to enthusiastically congratulate on the surprise announcement that we were able to get Hisco to join our vision of building out a scaled up best-in-class specialty distribution platform, each thought Hisco’s capabilities fit more closely with different of our verticals, understanding how well it fits overall and how it more tightly binds TestEquity’s capabilities to the Gexpro solutions and Lawson verticals.

We are excited that they so strongly saw how it strengthens our DSG value proposition through 4 table stakes. First, similar to our existing verticals opportunities to expand engagement with historic customers and the inaugural successes we’ve enjoyed in this area, we see Hisco and its expansion of TestEquity’s OEM and MRO efforts around electronic production supply and expansion and extension of cross-selling and wallet share opportunities to further expand how customers are more broadly engaging in and deeply embracing our breadth of value-added and leadership around solutions. Second, Hisco brings new distinct value-added capabilities across the platform. For example, the business adds specialty materials and products that are not currently included in our DSG offerings.

In addition, Hisco offers vendor-managed inventory and RFID programs with specialized warehousing for chemical management, logistics services and cold storage. Next, we’re projecting with the addition of Hisco’s leadership, market knowledge, footprint and close collaborative customer relationships, a meaningful geographic pull-through that spans deeper into Mexico and South America that we believe will create further operating leverage for their resource investment and our platform’s distinctive capabilities, leading to sustained revenue and profitability growth and accelerated returns. And finally, we expect Hisco to accelerate our time line to a higher structural margin profile at the TestEquity Hisco vertical. Not to mention the incremental returns generated from associated cross-selling revenue growth accruing to our other verticals, which collectively has a meaningful effect on the future state of overall DSG profitability, return on investment on working capital and critically, DSG’s accelerating ability to generate and grow free cash flow.

Hisco is an exciting addition, bringing DSG closer to the total scale and connectivity we identified 2 years ago that we desired where the flywheel should accelerate value creation and durability of this leading specialty distribution platform we created. And remixing TestEquity’s total revenue to be tilted more significantly towards electronic production supplies focused on OEM and MRO solutions provides a stronger, more consistent ballast for that vertical, while offering us more embedded value-added engagements to daily reinforce our total value to the customer, including more opportunities to collaborate with them on their test and measurement needs. While we are enthusiastic about what the future will look like, the closing is still subject to certain regulatory approvals, although we are progressing as planned toward a closing in the second half of this quarter.

Before Ron covers the consolidated and operating company financial results, I would like to talk about operational progress and value drivers for each of our business units. First, Lawson Products is a leader in the MRO distribution of C-Parts offering vendor-managed inventory services. During the first quarter of 2023, Lawson exceeded our initial 2023 plan, realizing significant margin expansion that many of us who have been investors in Lawson for the last decade have been expectantly waiting. I was pleased with how well the team managed pricing, expense control and growth within its customer base. Ron will dig in a bit deeper, but a large portion of Lawson’s growth is coming from long, well-established relationships within their larger or strategic accounts and Kent automotive lines along with attracting new customers, some of which are coordinated introductions from the other verticals.

For example, within both the Lawson and Kent strategic businesses, unique ship-to locations this quarter grew approximately 9% over a year ago quarter. While experiencing good expansion in the quarter as a leadership team and sales force, we see many more opportunities with the network effect and current internal initiatives expanding and accelerating the vertical. We are focused on a balanced but more aggressive approach to driving growth and engagement with customers. We’re making strategic investments in additional sales channels to support our customers, including inside sales, strategic account managers, web enhancements as well as better positioning our field sales team to drive higher conversion with our high-touch customers that create greater long-term value.

Lawson is also investing in lead generation capabilities and CRM tools, all of which will be rolled out in the second half of the year, with the goal of helping our sales representatives across all sales channels become more productive, better equipped for cross-sell opportunities and to better serve our customers and to help make them more money. Secondly, Gexpro Services is a leader in the supply chain solutions of largely C-Parts, specializing in VMI programs for high-spec OEM customers. We delivered strong first quarter operating results, driven by growth in many of our diversified end markets such as industrial power, aerospace and defense, Europe and in our recent acquisitions. In addition, we’re starting to see strong year-over-year improvements for renewables in both the U.S. and Europe.

Customers are interested in our renewables value proposition to combine expanded electrical, mechanical and hardware product offerings with kitting supply chain services and domestic manufacturing capabilities. We have won some recent mandates that should accelerate our leadership as a value-added channel partner for the leading OEMs in that marketplace, helping them with solutions not only on the OEM side, but across accelerating demand around the retrofit and upgrade cycle for the installed base. Specifically, regarding what we are currently seeing in our end markets, aerospace and defense has sustained double-digit growth and we expect this to continue. Additionally, in industrial power, demand remained strong, primarily due to changing dynamics in oil and gas.

Gexpro services value creation initiatives this year are leveraging the synergies of our acquisitions securing cross-sell wins with both Lawson and TestEquity, expanding kitting and project services as well as launching the e-commerce platform. Additionally, the 5 acquisitions we closed over the last 2 years have cross-selling opportunities within the Gexpro Services vertical, like the increased capabilities I alluded to that secured the expansive retrofit opportunity in the renewable space. We are also working through an expanded pipeline of opportunities where our customers are engaging us as partners to offer solutions around additional product and service capabilities in a thoughtful and customer-centric way. Winning initial OEM programs where you’re embedded with a customer can be a tediously long lead time affair.

However, with our expanded — and expanding number of customers we now work with, we have found a surprising number of them have celebrated embracing our collaborative approach and the benefits gained through the last year’s verticals, combinations and strategic tuck-in acquisitions that have increased our set of resources, geographies and collective expertise. Third, moving to TestEquity. January started strong with pent-up demand that landed in early 2023. We also saw growth in the VMI sector, somewhat offset by meaningful declines in tech sector capital spend. First quarter chamber production hit new record highs and continues to grow as supply chains begin to stabilize and we expect profitability to significantly improve after a period of working off backlog priced in a different market.

Overall, digital sales were up 10% in the first quarter, with growth primarily from the new TestEquity and TEquipment e-commerce sites. We continue to capture cost synergies and production efficiencies by moving our products into distribution centers that are closer to our customers, resulting in what will be improved delivery times and lower shipping costs. Higher cost of capital are impacting some of our customers’ behavior as we have seen a delay or reduction in their 2023 capital spend on new Test and Measurement Equipment, not helped by some of the lead time and supply chain challenges with continued overhang in some of our key channel partners. We are seeing this influence more of our customers in the current cloudy economic environment and with some lead time challenges around new product, renewing their focus on refurbishing rental equipment, which we expect to be a growth area for us and where it offers us the opportunity for higher margins.

And finally, as we discussed earlier in the Hisco transaction, we expect to accelerate our time line to a higher structural margin profile of TestEquity and expanded engagement around cross-selling initiatives with the other verticals, which will have a meaningful effect on overall profitability and cash flow generation for DSG. As you can likely tell, our team is very encouraged by our prospects and internal initiatives to improve and expand all 3 operating verticals for 2023 and beyond. Now I’d like to turn the call over to Ron to walk through the financials. Ron?

Ron Knutson : Thank you, Bryan, and good morning, everyone. Turning to Slide 7. We’re excited this morning to share with you the first quarter results of Distribution Solutions Group. Let me remind you that given the reverse merger accounting treatment, Lawson Products was not in the prior year first quarter results in 2022. However, all 3 of the businesses are included for the first quarter of the 2023 GAAP results. For ease of comparing the results, the slides that we’re utilizing this morning adjust and include first quarter Lawson’s financial results for 2022. But let me summarize the first quarter results. On a combined basis, we reported strong top line and bottom line results. As Bryan mentioned, we reported total sales growth of 28%, with organic sales growing 13.7% through both price and volume expansion.

The first quarter results reflect 4 quarters of sequential margin improvement with Q1 finishing above 11% of revenue. I’ll now walk through some of the specific numbers on a combined basis and most of this is on Page 7 of our presentation. First, consolidated revenue for Q1 was $348.3 million, with the inclusion of Lawson on a comparative basis, revenue increased 28% or $76.3 million over the first quarter of 2022, driven by organic growth plus approximately $39 million coming from acquisitions. Second, reported GAAP operating income was $16.7 million compared to $3 million a year ago quarter. On an adjusted basis, excluding merger-related costs, acquisition costs, stock-based compensation, severance and other nonrecurring items, adjusted EBITDA improved by $16.7 million to $39.4 million or 11.3% of revenue.

And third, we reported GAAP diluted earnings per share of $0.28 for the first quarter compared to a loss of $0.25 a year ago quarter. On an adjusted basis, diluted EPS was $0.52 for the quarter versus 0 a year ago quarter. Now moving on to Slide 8. Slide 8 includes the full run rate of all closed acquisitions as of March 31, 2023, as if they were owned for each quarter presented. For clarity, since we have not yet closed on Hisco, it is not reflected on this page. As you can see from these charts, our full run rate inclusive of acquisitions has seen nice sequential margin expansion from quarter-to-quarter, reflecting strong performance of each of the 3 operating companies. You’ll notice Q4 is historically our slowest quarter given fewer selling days than the other quarters.

Turning to Slide 9. Let me now comment briefly on each of the businesses. Starting with Lawson, recall that since Lawson is the accounting acquiree, it is not in the GAAP reported numbers for Q1 2022. However, for purposes of these slides, we’ve included the premerger results. Sales were $125.3 million for the quarter. Please note that this does not include Bolt Supply as they are now included in the — all other reporting segment. The Lawson segment average daily sales or ADS grew 19.4% organically over the first quarter of 2022 on an adjusted basis, and ADS grew 8.7% sequentially over the fourth quarter of 2022. The increase over a year ago was driven by strong performance within the strategic business, up nearly 25%; Kent Automotive up 28%, the core business up nearly 14% and government up 40%.

During the quarter, unit volume was essentially flat versus a year ago, however, increased approximately 3% sequentially over the fourth quarter of 2022. Lawson’s growth during the quarter was achieved through an increased share of wallet with existing customers and new customer relationships, in particular, within strategic or large accounts in our Kent Automotive businesses. In both of those pieces of our business, we shipped to approximately 9% more unique locations this quarter than a year ago. Lawson continues to realize steady improvement in its gross margin percentage. While growth within our larger strategic customers is putting pressure on the overall gross margin percentage, we continue to see margin expansion given price realization, lower net freight costs and leveraging our costs over a higher sales base.

Lawson’s adjusted EBITDA improved to $18.5 million compared to adjusted EBITDA of $8 million a year ago quarter, primarily driven by the sales and gross margin improvements, partially offset by increased compensation on higher sales. Lawson’s adjusted EBITDA as a percent of sales was 14.7% in the quarter versus 7.7% a year ago quarter. Turning to Gexpro Services on Slide 10. Total sales for Gexpro Services were $101 million for the first quarter of 2023, an increase of $19.3 million over Q1 2022, of which $4 million was driven by acquisitions and $15.3 million from organic growth. In 2022, Gexpro Services acquired Resolux early in the year and Frontier at the end of Q1 of 2022. Excluding the impact of these acquisitions on the first quarter, organic sales grew by 18.7%, of which approximately 4% came from price.

The increase in aggregate sales was primarily driven by new customers and the expansion of existing customer relationships. Gexpro Services adjusted EBITDA expanded to $11.7 million or 11.6% of sales as compared to $8 million or 9.8% for the year ago quarter. And lastly, I’ll turn to TestEquity on Slide 11. Sales for the quarter grew $35 million or over 48% to $107.4 million, primarily driven by recent acquisitions. During 2022, TestEquity closed on 3 acquisitions, TEquipment and National Test Equipment in Q2 and Instrumex in Q4. Of the $35 million sales increase for the quarter, approximately $34.9 million was generated from the 2022 acquisitions. Organic sales were essentially flat versus a year ago with a decrease in Test and Measurement sales, offset by an increase in the electronic production supply sales.

As previously communicated, sales in the Test and Measurement business were lumpy throughout 2022 and as expected, slowed in the first quarter of 2023 as customers have delayed expansion projects and we continue to face supply chain challenges. On an adjusted EBITDA basis, the first quarter ended at 7.1% of sales or $7.7 million, representing an increase of $2.2 million over a year ago quarter, of which approximately $2.4 million came from the 2022 acquisitions previously mentioned. Moving on to Slide 12. From an access to capital, we have approximately $31.1 million of available cash and $70 million available under our existing credit facility. As part of our credit facility, we have also an additional $200 million accordion feature. We ended the quarter at a net debt leverage ratio of 2.7x, primarily on increased earnings.

Our deleveraging that started in 2022 continued into the first quarter of 2023. For reference, at the time of the April 1, 2022, merger of the 3 businesses, our net debt leverage was 3.6x. This progress is consistent with our intention to prudently manage our debt levels and our leverage in the 3 to 4x range. Net capital expenditures, inclusive of rental equipment was $5.1 million for the quarter. Before I turn the call back to Bryan for some closing remarks, I wanted to reiterate how pleased we are with the company’s financial performance. We said that we are going to exit 2022 with margins exceeding 10%, which we did. We have maintained double-digit adjusted EBITDA margins into 2023, and we have substantially delevered the company within the first 12 months.

As Bryan mentioned, we continue to be pleased with our long-term outlook. However, we are up against tougher sales comps going into the second half of 2023. All of the businesses continue to execute on their planned initiatives for 2023, which will make us a stronger company going forward. We will continue to prudently manage our balance sheet and financial position. Thank you to the operating teams at Lawson Products, Gexpro Services and TestEquity for their commitment and drive to deliver these great results in the first quarter. I’ll now turn the call back over to Bryan.

Bryan King : Thank you, Ron. Let’s turn to Slide 13 for a few additional comments before we get into the Q&A. Our approach to capital deployment and working capital investments are not unique. Our underlying philosophy is anchored in a discipline to allocate capital to the highest return projects while building the best positioned long-term specialty distributor with the deepest and widest smoke possible around our value-added focus areas of leadership for our customers. Since we are an asset-light business, our organic growth primarily comes in the form of investment in trade working capital and great people as well as inorganic investments through M&A. We’ve invested significantly in all 3 over the last year. The returns on our incremental investments in working capital made to support organic growth or without a doubt, the highest returns on a pretax basis.

They often approximate 80% to 100% or significantly higher, consistent with what we’ve observed over a long cycle have been and continue to be the returns of our peers of best-in-class specialty distributors. Our second best return on investment at this point is identifying and buying the most strategically enhancing but accretive acquisitions that make our specialty verticals, both individually and holistically more competitive. These acquisitions should enhance our ability to organically grow at a faster, more profitable rate. In turn, sustaining and driving higher returns on working capital, all of which will significantly cheapen back the purchase price. We certainly believe that Hisco like others we have done over the last years and others we are currently dialoguing with, will do that.

While we are committed to this approach, we are not in any hurry to buy something that is only accretive. Along those lines, our debt leverage is an important focus, especially given the rising rate environment. And currently, our leverage remains below 3x ahead of the closing of the Hisco acquisition, which we expect to take us to somewhere between 3 and 3.5x. After the close, we will have approximately $450 million of net working capital pro forma alongside our accelerating cash flow to comfortably support and pay down that debt. We also have a Board-approved share repurchase program to take advantage of opportunistic buybacks should our stock weaken unexpectedly inconsistent with our current trajectory to unlock earnings and accelerate shareholder value creation.

We are constantly informed about the private value of our business and that a scarcity exists for exceptional specialty distributors with our size and line of sight around growth of revenue and earnings by strategic suitors as well as large private equity firms. It is not surprising the interest in DSG by those with the benefit of time as leading specialty distributors continue to be tremendous long-term compounding engines, which is why I have loved the space as much as I have for the last 30 years. And so much so that I don’t want to sell this business prematurely that we have such tremendous line of sight on how to compound. If the marketplace offers an unnatural price with us generating strong cash earnings, the Board and I believe we should have the flexibility to buy back stock and think about ways to improve the value for the shareholders that want to continue to be partners with us on this journey.

As I just alluded to, at the end of the first quarter, we had $352 million invested in our working capital with another $100 million or so coming with Hisco. Our investment in working capital over the last year reflected our expectation around many ways to continue to drive organic growth and how that drive is accelerating profitability for our shareholders. We invested more aggressively last year, especially with the business combination and with opportunities to add working capital that some of the follow-on acquisitions provided and with supply chain and inflationary pressures, it made sense. This year, we indicated that we expect to optimize our investment more than dramatically increase it. Our operating team understands my intent belief that prudently managing working capital is one of the best ways to drive meaningful return on invested capital and should be that — and should the economic headwinds get tested, it is also the best way to free up the most liquidity along with timely but prudent cost leveraging opportunities to protect flexibility for growth in calmer environment.

As I mentioned last quarter, our operating teams have a heavy focus on managing our working capital intensity for 2023. I want to continue to maintain a strong balance sheet and prudent financial position by providing ample liquidity to execute on our long-term growth strategies that maximize value for all shareholders. Our principal goal at DSG is to improve our overall return profile and continue to build profitable scale as a specialty distribution business with significant free cash generation. We have now cycled our merger transaction completed in April 2022 and are seeing the benefit of our working capital investments, our acquisitions and our collaboration across the 3 business units. We are finding more ways to leverage spend and to drive cross-selling through our embedded alignment with many of our closest customers.

Hisco will significantly enhance both primary objectives. Aside from our work on Hisco, we continue to evaluate an active acquisition pipeline, analyzing opportunities that fit our strategic lens, acquisition criteria and hurdle rates. In summary, we are pleased with our first quarter results and appreciate the collaborative efforts across our leadership teams to deliver 4 sequential quarters of sales growth and margin improvements. And although we are excited to report adjusted EBITDA margins of 11.3% and commit to our partners that we have action plans over the coming years to take each of our verticals profitability and internal return metrics significantly higher from current levels. We also want to manage expectations that while the very discrete operating initiatives we are working on will yield meaningful financial improvements to performance metrics that we are all focused on, the results will not be linear, and we absolutely are not planning for the slope to track the last 4 quarters.

We all can appreciate what some of the leadership teams are now facing with having delivered exceptionally in the last few quarters and me trying to move the goalpost forward on them at a faster clip. We will get to the next margin milestone threshold soon, but I want to temper all our expectations, mine included, that it likely will not be as linear or as steep as we just enjoyed and we will be comping tougher quarters later this year. DSG is a specialty distribution solutions company, supporting a leadership position in several key vertical channels where customers rely on us to provide high-touch, value-added distribution solutions for their MRO, OEM and industrial technology needs with a combined addressable market of $57 billion. Our vertical channels to the marketplace offer customers replenishable industrial parts and products as well as specialized products.

In addition, we offer managed solutions for companies that rely on outsourced expertise, labor, specialty capabilities and supplies with secure supply chain management. It is daily reaffirmed that our unique competitive advantages are compelling to customers and are important to manufacturers, OEMs and businesses that use specialized products in their industrial and commercial industries. And expanding our distinct products and solutions makes the Hisco acquisition a compelling investment for us. Thank you for your time today. And now we would like to open up the line for investor questions. Operator?

Q&A Session

Operator: [Operator Instructions] Our first question today is coming from Kevin Steinke from Barrington Research.

Operator: And the next question is coming from Brad Hathaway from Far View.

Operator: And the next question is coming from Katie Fleischer from KeyBanc Capital.

Operator: I would now like to turn the call back to Bryan King for closing remarks.

Bryan King : Thank you, operator, and thank you for those that joined us today for the call. And absolutely, thank you to all those folks that work for DSG for allowing us to have a great quarter and continuing to operate so well together as we look prospectively at what we’re building. So thank you for your interest in DSG. We’re excited about being your partner and we are optimistic about the business that we will continue to be together with you on. Thank you.

Ron Knutson : We look forward to talking to you next quarter. Have a great day.

Operator: This does conclude today’s conference. You may disconnect your lines at this time, and have a wonderful day. Thank you for your participation.