Distribution Solutions Group, Inc. (NASDAQ:DSGR) Q2 2023 Earnings Call Transcript

Distribution Solutions Group, Inc. (NASDAQ:DSGR) Q2 2023 Earnings Call Transcript August 6, 2023

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

Steven Hooser: Good morning, ladies and gentlemen and welcome to the Distribution Solutions Group second quarter 2023 earnings call. In conjunction with today’s call, we have provided a Q2 earnings presentation that has been posted on the company’s IR website at investor.dstributionsolutionsgroup.com. Please note that statements made 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 described. 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 any obligation to do so.

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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 also posted on the Investor Relations section of the 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 also being webcast on the Internet via the Distribution Solutions Group Investor Relations page on the company’s website. A replay of the teleconference will be available through August 17, 2023. I will now turn the call over to Bryan King, DSG’s Chairman and Chief Executive Officer. Bryan?

Bryan King: Thanks, Steven and thank you all for joining to review our second quarter results. Joining me for today’s call is Ron Knutson, DSG’s Executive Vice President and Chief Financial Officer. Distribution Solutions Group delivered strong 2023 first half results, anchored by our industry leadership positions, our broad portfolio of products, value-added services and mission-critical solutions and the benefits we are starting to unlock with our significantly improved scale, coupled with our talented team’s relentless focus on execution. Starting on Slide 4 of the second quarter earnings presentation. We again delivered strong quarterly sales up almost 18% in the second quarter which included organic growth of 5%. Second quarter adjusted earnings per share were — was $0.52, up over 40% from the comparable prior year earnings per share.

We also generated adjusted EBITDA in excess of $40 million or a margin of 10.6% in the quarter. This quarter represents the fifth consecutive year-over-year quarterly EBITDA margin expansion. We are extremely pleased with how the teams have executed, especially in a dynamic operating environment with a lot of initiatives that are requiring investment of internal and external resources in the first half of 2023 to accelerate unlocking future value to the shareholders. Later, we will provide more commentary on important sales and cost initiatives we are currently working on, along with our discussion of the operating unit performance for the second quarter. We are excited that DSG has successfully established itself as a leader in the end markets we serve.

We are positioned well to leverage our high-touch service delivery model and deepen customer relationships with our increasing breadth of value-added products and services. We are thrilled to have closed on the Hisco acquisition on June 8 and are successfully integrating processes and the team to create a unified and streamlined single platform with test equity. We fully expect to realize expanded sales productivity and meaningful cost synergies. We continue to grow significant wallet share across DSG and are identifying key cross-selling opportunities with solid contract wins through our growing business pipeline and Hisco only expands these growth engagements. I applaud the strong collegiality and respectfulness across the collective expertise and DSG of our leadership teams we have assembled and how they have prioritized and aligned their common goals across how our verticals can best leverage the total spend and capabilities at DSG to successfully improve and expand our products and services within our intimate customer engagement model, allowing me to see quite discretely how it will continue to translate into an acceleration in building shareholder value for all of us.

In conjunction with these efforts and as a reality following many of our investments, I also expect shareholders to benefit in coming quarters and for years to come from the investments being made in process improvements underway that will accelerate free cash flow and specifically for free cash flow conversion in the back half of 2023 and 2024 to significantly improve. While we remain guarded about our current rate environment and how it could weigh on our customers, business activity remained solid through July, very consistent with our first half of the year. Our sales organizations continue to engage the marketplace using customer-centric experiences that deliver quality products and smart, efficient solutions that reinforce our value proposition to our important end markets.

We are actively monitoring the demand environment and marketplace forces in each of our channels. We are leveraging DSG’s strong customer relationships and focus on a customized customer experience to expand our engagement, especially getting traction with large strategic accounts. We are confident this is strengthening the company’s organic growth trajectory and reducing resistance to our cross-selling efforts as we reinforce our customer-centric priority and offer more value-added capabilities in each of our verticals. Moving to Slide 5. Let me briefly provide business updates on initiatives for each of our verticals. First, Lawson Products is a leader in the MRO distribution of C-Parts offering vendor-managed inventory services. During the second quarter of 2023, Lawson continued to make significant operational and financial progress.

I’m pleased with how well the team managed pricing, freight recoveries and organic growth within its customer base. Also during the second quarter, the Lawson team successfully aligned the sales organization to better serve our customers with key strategic field and inside sales personnel shifts. We believe critical initiatives like positioning our field sales team to become more productive with our high-touch, high demand customers generates greater customer lifetime value. We are confident that this more balanced approach will drive sustained long-term growth and engagement with customers. Under Cesar’s leadership, we took the first steps this quarter. We also continue to make strategic investments by enhancing our supply chain technology to support our customers and progressing on our digital road map.

We are working diligently on the CRM go-live with enhanced mobile capabilities at Lawson. The company’s investment in lead generation capabilities and CRM tools is expected to roll out in a few months. Our goal is to better enable our sales reps across all sales channels to be more productive, serve customers more efficiently, be better equipped for cross-sell opportunities and ultimately drive higher compensation for our high-performing growing sales force. Secondly, Gexpro Services is a leader in the supply chain solutions of largely C-Parts, specializing in VMI programs for high-spec OEM customers. Gexpro Services delivered strong quarter results, both sequentially and versus the prior year quarter. Customers continue to be interested in our renewables value proposition that combines expanded electrical, mechanical and hardware product offerings with kitting supply chain services.

We’ve accelerated our leadership position as a value-added channel partner for major OEMs, helping them with solutions, not only on the OEM side but across the growing demand around the retrofit and upgrade cycle for the installed base. We’ve seen recovery in the aerospace and defense vertical and industrial power demand remains very solid. Importantly, Gexpro services value creation initiatives this year include getting additional synergies out of our acquisitions, expanded kitting and project services and successfully launching our e-commerce platform with a focus initially on tech and aerospace and defense customers. 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.

Our goal is to continue to win OEM programs where we are intensely embedded with a customer as the provider of choice. Our collaborative approach and the benefits seen through strategic combinations and bolt-on acquisitions significantly increases our resources, footprint and collective expertise and offerings. Thirdly, moving to test equity. Vendor managed inventory solutions continue to show sustained strong double-digit strength in the second quarter. We’ve seen pressure in the technology and R&D sectors which we believe are impacted by higher cost of capital and capital expenditure delays. Our teams are learning that projects are not being cancelled. However, they are being pushed out for several months. As we mentioned last quarter, we continue to see increases in rental bookings and refurbishment as market dynamics change.

Significant progress has been made on reducing our lead times for chambers by over 50%, allowing us to work through our backlog of historic orders by the fourth quarter. We will begin shipping many models just in time from current stock in early 2024 which should drive expanded margins. Digital sales were up 8% in the second quarter, with growth primarily from the new test equity and tea equipment e-commerce sites. We’re in the process of optimizing people, processes and technologies as we integrate Hisco with test equity. So in addition to acquisition-related costs, we also recorded about $2 million of restructuring expenses that Ron will cover more in a few moments. We will continue to capture cost synergies and production efficiencies, resulting in improved delivery times and lower shipping costs.

Regarding Hisco, we are accelerating our work to build a higher structural margin profile and are encouraged by early results. In addition, the Hisco team quickly embraced and is successfully engaging in established DSG cross-selling efforts. We expect this to have a meaningful impact on the overall profitability and cash flow generation for DSG beginning this year. With that, I would 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 our strong second quarter results of Distribution Solutions Group. Let me summarize Q2 results. On a combined basis, we reported strong top line and bottom-line results over a year ago. As Bryan mentioned, we reported total sales growth of 17.6% with organic sales growing 4.8% through both price and volume expansion. The second quarter results reflect continued growth in margin dollars. GAAP reported income improved threefold with Q2 adjusted EBITDA exceeding $40 million, a first since bringing DSG together over a year ago. Our positive momentum and movement in cash flows generated from operations continued with our focus on working capital improvements.

I’ll now walk through some of the specific numbers on a combined basis, of which most of this is on Page 7 of our presentation. First, consolidated revenue for the second quarter was $378 million, revenue increased 17.6% or $56.7 million over the second quarter of 2022, driven by organic growth plus approximately $43.4 million coming from acquisitions, of which $28 million was from Hisco. Second, reported GAAP operating income was $13.8 million compared to $4.1 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 nearly 27% or $8.5 million to $40.1 million or 10.6% of revenues. While the percentage is down slightly from Q1, approximately 40 bps of the decline was related to including the initial 3 weeks of Hisco which we did anticipate.

And third, we reported GAAP diluted earnings per share of $0.14 for the quarter compared to a loss of $0.23 a year ago. On an adjusted basis, diluted EPS was $0.52 for the quarter versus $0.36 for a year ago quarter. Turning to Slide 8, let me now comment briefly on each of the businesses. Starting with Lawson, sales were $119.1 million for the quarter. Please note that this does not include Bolt Supply as they are included in all other reporting segment. The Lawson segment average daily sales, or ADS grew 11% organically over the second quarter of 2022. The increase over a year ago was driven by strong performance within the strategic business, up nearly 25%; Kent Automotive up 21%, the core business up nearly 2.5% and government up 22%. During the quarter, unit volume increased approximately 2.5% versus a year ago.

Lawson’s growth during the quarter was achieved through increased share of wallet with existing customers and new customer relationships, in particular, within strategic or large accounts in our Kent Automotive business. During the quarter, Lawson continued to build out its infrastructure to help our field sales reps become more productive. This included investments in additional account managers to help grow the strategic and government businesses inside sales reps to assist with smaller accounts, conversions, implementation individuals, technical specialists and we are 3 to 4 months away from rolling out our CRM tool. We’re excited about these overdue investments to help the long-term growth of our field sales representatives as they expand their book of business.

Lawson continues to realize steady improvements in its gross margin percentage. While we’re up against some mix shift headwinds as our largest customers have been growing faster and we continue to see expansion given price realization, lower net freight costs and leveraging our costs over a higher sales base. Lawson’s adjusted EBITDA improved to $16.1 million compared to adjusted EBITDA of $9.4 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 13.5% in the quarter versus 8.8% a year ago quarter. You may recall that Lawson got out of the gate with an extremely strong start in Q1 with its strongest quarter that we’ve seen.

During the second quarter, we launched our initiative to better service our customers, depending upon their needs and size through additional channel offerings which should improve the effectiveness and long-term efficiency of our sales force. That, combined with some of the infrastructure investments that I previously mentioned brought down the percentage sequentially slightly. However, we are well positioned to grow the company and a long-term margin profile. In the first half of the year, Lawson nearly doubled its adjusted EBITDA going from $17.4 million to $34.6 million and is well positioned with these investments to grow the company on an accelerated basis. Turning to Gexpro Services on Slide 9. Total sales were $108.3 million for the second quarter of 2023, an increase of $8.5 million over the second quarter of 2022, all from organic growth.

Approximately 4.4% came from volume with the rest from price. The increase in aggregate sales was primarily driven by new customers and the expansion of existing customer relationships. Profitability improved, although mix shift was a headwind as softer sales to the semiconductor end market were more than offset with nice growth in aerospace and defense and industrial power markets. 5 of the 6 verticals delivered year-over-year sales growth. Gexpro Services continues to expand its relationships with existing customers and attract new customers through its value creation offerings, including VMI, kitting, project management services and the ability to deliver world-class support to the OEM production cycle. Gexpro Services works extremely close with its customer base to ensure they have the necessary product and services and to simplify the supply chain and improve total cost of ownership for their customers.

Gexpro Services adjusted EBITDA expanded to $13.1 million or 12.1% of sales as compared to $11.9 million or 11.9% for the year ago quarter and 11.6% in the first quarter of 2023. Gexpro Services continues to make incremental improvements in their margin profile in managing through varying end market cycles. Lastly, I’ll turn to test equity on Slide 10. Sales for the quarter grew $38.2 million or 39% to $136.1 million, primarily driven by the recent acquisitions. During 2022, test equity closed on 3 acquisitions, key equipment and national test equipment in the second quarter and Instrumex in Q4. And in the second quarter of 2023, we closed on Hisco. Of the $38.2 million sales increase for the quarter, $43.4 million was generated from these acquisitions and of that, approximately $28 million came from Hisco.

Organic sales were down 7% versus a year ago with a decrease in test and measurement sales and a softening of the EPS sales, as Bryan previously commented on. The test and measurement piece of the business is more closely tied to customer capital projects. Our sense is that our performance is consistent with others in our space and that these projects are delayed and not cancelled. We anticipate volumes will pick back up in late 2023 and into early 2024. On an adjusted EBITDA basis, the second quarter ended at 7% of sales or $9.5 million, representing an increase of $900,000 over a year ago quarter with the softening of T&M sales and with the benefit of thinking how Hisco’s resources will begin to be leveraged as folded in through the integration plan later this year and next, the legacy test equity business had more flexibility to remove nearly $4 million of annual costs out of the company which commenced in June.

Moving on to Slide 11. During the quarter, we expanded our committed credit facility from $500 million to $805 million. We were able to accomplish this in a very difficult bank market which validates the support of our strategy from our existing bank group, plus 4 additional banks that joined our credit facility. Additionally, we also issued $100 million of additional stock to existing shareholders through a common stock rights offering. These 2 actions allowed us to close on the Hisco transaction, pay down our revolver, manage our overall financial leverage within the guided range and increase our capacity for future acquisitions. From an access to capital, we have approximately $44.2 million of unrestricted cash and $189.6 million available under our existing credit facility.

As part of that facility, we also have an additional $200 million accordion feature. We ended the quarter at a net debt leverage ratio of 3.1x, primarily on increased earnings and taking on debt for the Hisco acquisition. So even with multiple acquisitions over the past 15 months, we’ve been able to deleverage the company and improve our scale and offering to accelerate further deleveraging and support additional inorganic growth. For reference, at the time of the April 1, 2022 merger date, 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. Our positive movement in cash flows generated from operations continued during the quarter with our focus on working capital improvements.

Net capital expenditures, inclusive of rental equipment, was $5.7 million for the quarter and we expect full year CapEx to be in the range of $16 million to $22 million, most of which is a discretionary investment to grow rental assets which also supports used T&M equipment sales. Before I turn the call back to Bryan, I wanted to reiterate how pleased we are with the company’s strong financial performance for the quarter. We generated over $40 million in adjusted EBITDA for the quarter, a significant increase over a year ago and also up over a very tough first quarter comparison. We’re also very excited that in conjunction with the Hisco closing during the quarter, we expanded our credit facility, providing us more fire power to continue on our growth strategy.

All of the businesses continue to execute on their planned initiatives for 2023. We will continue to prudently manage our balance sheet and financial position as we monitor current market trends. Thank you to the operating teams at Lawson Products, Gexpro Services and test equity for their continued focus and commitment to deliver these great results and welcome to the entire Hisco team. I’ll now turn the call back over to Bryan.

Bryan King: Thank you, Ron. Let’s turn to Slide 12. We believe it is important, especially as U.S. and global markets evolve and change quickly to discuss with investors our approach to capital deployment. DSG’s allocation of capital is focused on a disciplined balance between investing in growth, both in our core businesses as well as in strategic acquisitions that fit our model with a prudent approach to working capital intensity, leverage and occasionally through opportunistic share buybacks. Our goal is to continue to scale the DSG platform into an even more enduring well-positioned specialty distributor with key differentiators that uniquely benefit from utilizing our high-touch, value-added distribution solutions, services and customizable capabilities that customers clearly recognize and celebrate.

Since we have built this business as an asset-light structure, we have planned for organic and inorganic growth through deliberate working capital investments as well as strategic acquisitions that are aligned with our commitment to accelerating shareholder value. Our targeted leverage will continue to be in the 3% to 4% range. And at the end of the second quarter, just 3 weeks post-closing of Hisco our leverage is 3.1x. At the end of the quarter, we had approximately $476 million of net working capital with accelerating cash flow. Our investment in working capital over the last year facilitated our focus to drive organic growth that drives accelerating profitability for our shareholders. Finally, we continue to seek the highest return on invested capital opportunities with an obsessive commitment to build incremental shareholder value for the benefit of all of us.

We understand and appreciate why there continues to be interest in DSG from investors. It is easy to see the long-term compounding effects of owning a leading specialty distribution company with the scale and breadth of our products and solutions. Turning to Slide 13. Our principal goal at DSG remains focused on improving our overall return profile by building and maintaining profitable scale as a specialty distribution business. Second quarter results accomplished our profitability objectives while balancing significant investments in the business. We know that adding Hisco will accelerate advancing many of our current initiatives and longer-term goals. We continue to be selective with our robust acquisition pipeline as we carefully analyze opportunities that fit our focused value accelerating criteria.

I’d like to thank all our DSG associates who are working to optimize and streamline operations, better serve our customers and position the company to maximize its full potential. We believe that decisions and actions today from our team generates accelerated shareholder value. Before I open it up for questions, I would like to let you know that we are hosting an Investor Day on September 28 in Fort Worth. We plan to share key operational initiatives and will include a showcase our show and tell featuring Watson products, Gexpro services and test equity so that investors can better understand each of the unique products and solutions. We will audio webcast elements at Investor Day but believe you may get the most benefit by attending the event live and get to know the mini DSG and LKCM-Headwater team members that are working and engaging daily across countless works streams to build shareholder value.

If you’ve not registered yet, please reach out to our IR team for more details. Thank you for your time today. And now, operator, we would like to take questions from analysts and investors.

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Q&A Session

Operator: [Operator Instructions] Your first question is coming from Kevin Steinke of Barrington Research.

Kevin Steinke: I wanted to start off by asking about the organic growth and the breakdown of price versus volume is kind of roughly half and price and half volume the way to think about that 5% organic growth in the second quarter? Or if not, can you give me the breakdown there?

Ron Knutson: Yes, Kevin, this is Ron. I can jump in on that one. So it varied a little bit by each of the 3 individual companies. If you look at Lawson’s organic growth of 11%, about 2.5 points of that was volume and the rest being price, Gexpro services of the 8.5% organic growth kind of split 50-50, a little bit north of 4% on price and it’s same on volume. And then on the test equity side, organic, we mentioned that they were down about 7%. About 2% of that was price and down the offset to that was lower volume. So all in, if you kind of take the weighted average between the 3 operating companies, kind of flattish, maybe up just slightly in volume and then with price being the remainder of that. So hopefully, that breakdown by company is more specific than maybe what you asked but hopefully, that answers your question.

Kevin Steinke: Well, that’s great. Yes. No, that’s perfect. And I know you touched on that in some of the segment discussion as well. But okay, great. So I think you mentioned in your prepared comments that business activity has remained solid in July. Should we think about similar type volume trends on the organic side continue into July? And have we largely lapped the benefit of the price increases that you’ve been implementing?

Ron Knutson: Yes. I’ll jump in on that one as well. So I would say that we’ll start lapping some of the increases that we put in place more so in the second half of the year, in particular on the Lawson business, more of that — of those changes took place in the second half of 2022. So we’re — I would say we’re in the early stages of starting to lap some of those. And I think the pricing piece for test and Gexpro was probably a little bit more dynamic throughout 2022. So I think that’s probably a little bit more consistent. But on the Lawson side, we’re probably lapping some tougher numbers in the second half of the year. And as we think about just overall what we’ve seen so far here in the month of July, flattish to kind of where we were in the second quarter, flattish to down just a little bit.

We continue to see a little bit of softening yet within some of the end markets. But again, it kind of varies a little bit by operating company as to where we’re seeing that. And there’s — you end up with some kind of some strange dynamics based upon how the calendars fall. So that impacts our average daily sales, especially Gexpro services which has basically a 5-week July. Typically, we see a little bit of compression in the average daily sales number. So but kind of flattish as I think about where we’re at today versus the reported numbers in Q2 on a consolidated basis.

Bryan King: Ron, I just — I’d love to give him a little more detail on — so the lapping, Lawson, Ron, why don’t you give him more specifics on where we did on loss and we had specific spots where we did take pricing actions last year. And they weren’t in July last year. So it was later in the year. So to specifically answer your question, July did have both as it related to loss and had both the benefit of some volumes and had some benefit of pricing. We’re going to see — I think it was September. Was it late August or September that we had a specific price action initiative in Lawson.

Ron Knutson: It was just.

Bryan King: So that way you’ve got specifically some support from us in terms of actually kind of where those skating spots were. We had a lot less ability last year to on the longer cycle pieces of Gexpro services to be able to take price action on those contracts until later. So to kind of give context around Gexpro services, we were — it was later in the course of the year. And in some cases, it was really rolling through those contracts as they reset through the inflationary pressures that we had last year that we started to get the benefit of some pricing actions there. And then as we moved into this year, it became a little bit more dynamic on price action. So it was less of on a single day, a point of price action taken.

I started to kind of become more dynamically blended into what we were seeing in those particular SKUs on the sourcing side. And so what it becomes less clean, if you will, to be able to kind of point to specific points in time as we move back into 2023. And so that’s — I’m hopeful that, that gives you some context. On the sales side, the softening that we saw on test equity, I think that the context there that I would offer is, first of all, we’re really glad that we’ve bought Hisco because Hisco offers what longer term we want out of that business unit which is to have a lot more MRO and OEM kind of repeat activities as opposed to test equity itself, the legacy business that we’ve enjoyed for the last number of years did have 2/3 of its revenue of the legacy business was tied towards test and measurement equipment or bench sales and really what I would characterize as more of a capital spend from the customers.