Hydrofarm Holdings Group, Inc. (NASDAQ:HYFM) Q2 2024 Earnings Call Transcript

Hydrofarm Holdings Group, Inc. (NASDAQ:HYFM) Q2 2024 Earnings Call Transcript August 8, 2024

Hydrofarm Holdings Group, Inc. misses on earnings expectations. Reported EPS is $-0.51002 EPS, expectations were $-0.23.

Operator: Good morning and welcome to Hydrofarm Second Quarter Earnings Call. Today’s call is being recorded. [Operator Instructions] At this time, I would like to turn the conference over to Anna Kate Heller, ICR. Please go ahead, ma’am.

Anna Kate Heller: Thank you and good morning. 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 second quarter 2024 earnings release and Form 8-K issued this morning, as well as an investor presentation available for reference. 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 a more detailed discussion of the risks that could impact our future operating results and financial condition. Lastly, during today’s call, we will discuss non-GAAP measures, which we believe can be useful in evaluating our performance. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with GAAP and reconciliations to comparable GAAP measures are available in our earnings release. With that, I would like to turn the call over to Bill Toler.

William Toler: Thank you, Anna Kate. Good morning, everyone. In the second quarter, we experienced sequential improvement in our adjusted gross profit margin over our first quarter levels, and also delivered positive adjusted EBITDA for the fourth time in the last five quarters. We realized further favorability on our adjusted SG&A line with substantial savings year on year. For the six-months year-to-date, we have delivered over $2 million of adjusted EBITDA, up from approximately 300,000 in 2023, and we had the smallest year-over-year net sales decline in the last three years. We maintained relatively consistent results across the first two quarters of 2024. Despite the second quarter of 2023 being a difficult quarter to lap.

We remain laser focused on driving profitability in the business, and we took additional steps in the second quarter to further integrate and optimize our manufacturing operations, which should produce improved efficiencies and reduce costs going forward. These include closing on the sale; the manufacturing equipment and inventory related to our IGE branded products, closing our paramount California manufacturing facility and ceasing production at our smallest grow media manufacturing facility in Goshen, New York. Our cost savings and restructuring actions have been very effective to date, and we have proven our ability to continue operating profitably at lower sales levels while delivering top-notch service to our customers. Our Q2 net sales were relatively in line with our expectations and the month of May marked our seventh consecutive month of sequential net sales growth.

That was the longest streak of sequential net sales growth for Hydrofarm since going public back in 2020. I will now highlight some of the areas of strength in the second quarter. Our proprietary brands, including Active Aqua, PHOTOBIO and Roots Organic, all performed well growing year on year. Notably, the strong PHOTOBIO brand performance is a result recent innovation in lighting. We are having success with the new generation of lighting products, including our PHOTOBIO MX2 model for commercial use and our Phantom Cultivar lighting model for in-home use, both delivering exceptional value at affordable prices. We will continue to innovate and invest behind our key proprietary brands to address growers’ needs as they evolve. In Q2, our non-cannabis and non-US and Canada revenue sources as a percentage of sales remain stable relative to Q2 last year.

We do expect growth in our sales mix for full-year 2024 as we continue diversifying our revenue sources by expanding our international presence to customers outside the U.S. and Canada and driving non-cannabis sales, including CEA products sold into food, floral, lawn and garden, and certain other customers. We entered into new distribution relationships with several vendors that have strong brand equity, including Quest, Dehumidifiers, Hurricane Fans, and Mills Nutrients. While our primary focus remains our proprietary brands, these new distributed brands complement our existing portfolio and bring us closer to customers who regularly purchase these branded products. The initial inventory investment into these brands in Q2 had a slightly negative impact on free cash flow in the quarter, but I expect them to yield very favorable returns in 2024.

We are also investing behind several of our key proprietary brands, including innovation behind PHOTOBIO lighting that I mentioned earlier. We are investing significantly in several of our proprietary consumable brands, and our team is excited to support several of our top brand offerings. We remain optimistic that the regulatory environment for US cannabis growers will improve and deliver a tailwind to the industry in the near future. In May, the DEA proposed the reclassification of cannabis from a Schedule 1 to a Schedule 3 drug, which would loosen federal restrictions on cannabis. Following the proposal, there has been a 60-day period for comments, which ended on July 22nd. Encouragingly over 90% of the comments received were in favor of rescheduling of cannabis, and the vast majority of those comments, more than 60% advocated for a complete rescheduling from the controlled substance list.

You are not certain how long it will take to get a ruling on the matter, but this represents another step forward in the process of legalizing cannabis in the U.S. We are seeing signs of encouragement on the macro level that give us optimism that growth will return, and we believe through the diversification of our revenue streams and our effective cost savings initiatives, that we are well positioned to achieve further improvements in profitability as demand and volume increase. To wrap up my remarks today, we are reaffirming our full-year of guidance for net sales, adjusted EBITDA, and free cash flow as we remain focused on our brands, diversification of revenue, improving our mix, and controlling and reducing costs. With that, I will turn it over to John further discuss the details of our second quarter financial results and our outlook for the balance of 2024.

John?

John Lindeman: Thanks, Bill, and good morning, everyone. Net sales for the second quarter were 54.8 million down, 13.1% year-over-year, driven primarily by a 10.3% decrease in volume mix and a 2.6% decline in pricing. The decrease in volume mix was mainly related to oversupply in the cannabis industry. The pricing decline was largely driven by promotional pricing activity and is something we expect to see for the remainder of 2024. Consumable products continue to make up more than three quarters of our total sales, representing approximately 76% of our total sales in Q2, which is roughly the same amount when compared to the second quarter of 2023. Overall, brand mix was solid in the quarter with proprietary brands increasing though approximately 58% of our net sales compared to 55% last year.

Gross profit in second quarter was 10.9 million compared to 14.5 million in a year ago period. Adjusted gross profit was 13.3 million or 24.4% of net sales compared to 17 million or 27% in net sales in the year ago period. The decrease in margin is related to a very difficult lap. Typically, we expect to see a rise in our adjusted gross profit margin when we experience a rise in our proprietary brand mix. However, in Q2 of last year, we experienced particularly strong manufacturing productivity in certain consumable manufacturing facilities, due primarily to an early harvest in our PEA facility, enabled by favorable early spring weather in Alberta, Canada. We also experience relatively higher manufacturing throughput for select consumable products last year.

With all that said, we are pleased with our overall adjusted gross profit margin trend as Q2 represents the third highest level we have recorded in any quarter since our IPO and this quarter marked the fifth consecutive quarter with adjusted gross profit margins of at least 23%. To put that into perspective, our 2021 full-year adjusted gross profit margin was 22.9% and that was on much larger sales base. With the cost saving actions, we continue to execute and consistent with our full-year 2024 outlook, we expect our full-year 2024 adjusted gross profit margin to be higher than it was last year. I will now provide an update on our most recent restructuring and cost saving actions. Our second phase of restructuring is focused primarily on right sizing our manufacturing footprint, particularly with respect durable equipment products.

In this quarter, we made great progress. On May 31st, we closed on the sale the manufacturing equipment and inventory related to our IGE branded products, and are now aligned with an exclusive contract manager to produce those same grade products. In June, we closed our Paramount California manufacturing facility and consolidated those operations into our facility in Northern California. Also in June, we ceased production in our smallest grow media manufacturing facility and intend to consolidate some or all of those operations into our remaining facilities. In July, we further right sized our Northern California manufacturing facility, reducing space approximately 31% in the building. After completing these actions, we have now consolidated all of our manufacturing activity into two U.S. locations, plus our single peat moss harvesting and processing facility up in Alberta, Canada.

We have now fully integrated the ERP system and our peat business, and we will continue to make progress on system integration in other areas. Lastly, on the restructuring front, as we continue to evaluate opportunities to consolidate and become more efficient, we are now reassessing our distribution center network. We expect these actions collectively will help us operate more efficiently and cost effectively going forward. Moving on to our selling general administrative expense, which continues to be a good story for us as we continue to take cost out of the business. In the second quarter, our SG&A expense was 18.7 million compared to 23.5 million last year. Adjusted SG&A expenses were 11.6 million, more than 20% reduction when compared to 14.6 million in the second quarter of 2023.

These savings resulted from reductions across a wide range of items, including head count facility expenses, professional fees, and insurance costs. Adjusted EBITDA was 1.7 million in the second quarter compared to 2.5 million in the prior year period. The decrease was in large part due to the dynamics discussed earlier regarding our adjusted gross profit, partially offset by our reduced adjusted SG&A expenses. This quarter marks the fourth time in the last five quarters that we have realized positive adjusted EBITDA, further illustrating the success of our restructuring and cost saving initiatives and our ability to drive profitability against lower sales levels. Moving onto our balance sheet and overall liquidity position, our cash balance as of June 30th, 2024 was 30.3 million up significantly compared to our balance of 24.2 million at the end of the first quarter.

The increase was primarily related to the net proceeds from the sale of the IGE assets of about 6.3 million. We ended the second quarter with 120.2 million of term debt and approximately 129 million of total debt inclusive of financial lease liabilities. Our net debt at the end of the quarter decreased to approximately 99 million from approximately 107 million last year. As a reminder, our term loan facility has no financial maintenance covenant does not mature until October, 2028, and we continue to maintain a zero balance on our revolving credit facility. Our cash balance at the end of the quarter of approximately 30 million, plus the availability on our revolving line of credit of approximately 20 million results in total liquidity of 50 million.

Lastly, on this point, we continue to make progress towards monetizing non-operating excess land that we own in upstate New York, which could further reduce net debt and or add to our liquidity when we complete the associated real estate sales. For all these reasons, we continue to feel good about our liquidity position. In the second quarter, we reported cash flow from operating activities of 3.8 million with capital expenditures of 0.4 million, yielding free cash flow of 3.4 million. Our free cash flow would have been about breakeven for the quarter without the impact of the IGE asset sale as a portion of the net proceeds were required to be accounted for in operating activities. We achieved this cash flow position for the second quarter despite investing in inventory for new distribution relationships and innovative lighting products, which Bill mentioned earlier.

With that, let me turn to our full-year 2024 outlook. We are reaffirming the key metrics to our 2024 guidance, which includes net sales to decline low to high teens on a percentage basis adjusted EBITDA that is positive for the full-year 2024 and positive free cash flow for the full-year. We also reaffirmed all other assumption in today’s earnings release with the exception of capital expenditures, which is now 3.5 million to 4.5 million for the full-year 2024 down slightly from four to five million previously. Before turning it over for questions, I would like to echo what Bill mentioned earlier, that we continue to control what we can and have set up our business to operate profitability with even lower sales. As we look ahead, we are excited about the future and when demand hopefully picks back up, we are in a great position to capitalize on it profitably.

Thank you all for joining us this morning and we are now happy to answer your questions. Operator, please open the line.

Q&A Session

Operator: [Operator Instructions] We will take our first question from Andrew Carter from Stifle.

Andrew Carter: Wanted to ask about, you mentioned the demand trends in the quarter. I think, or you may, sorry, the entrance, I mean the revenue in the quarter. You mentioned May was the seventh highest month of sequential growth. I think that there is usually a seasonal build during the quarter. Could you talk about what underlying revenue did as you progress through the quarter and do you think the industry helped steady or deteriorated during 2Q? Thanks.

William Toler: Thanks Andrew. Appreciate the question. Specifically, what I had said is that May was the seventh consecutive month of sequential growth going back to October. That did not continue in June, or I probably would have said June. So May was sort of the peak of that seven month trend. I think, that we saw some encouraging signs on in the fact that some of our durable products, you heard me mention active aqua, therefore healing and you heard me mention photo bio, which of course is lighting showed year-over-year growth. So the mix has changed a little bit and I think it is an encouraging sign for the industry when durable products are starting to do a little bit better than what it says is people are either replenishing or rebuilding or building new.

So I think that is an overall positive. We were lapping some really strong international shipments on our consumable brands in June as we opened up pipeline into new countries last year. So a year-on-year on consumables didn’t look quite as good, as we had hoped. But I think overall the demand signs are stable, let’s call them with a little bit of a mix change toward durables, which is encouraging. And then we think that onward from here we are maintaining the ability to make a little bit of money in some lower demand levels and then waiting for things to improve as rescheduling happens and as new states begin to open up.

Andrew Carter: Then the second question I would ask is like, kind of thinking about where your mix is today from a geographical perspective, mature states, licensed cannabis sales, still under pressure, cannabis pricing metrics still under pressure, but how about kind of the new states as a percentage of your mix. New York, obviously Ohio just opened Missouri. Are those big, do those, have those kind of achieved any kind of critical mask that could be kind of growth next year or is it still your sales base is still dominated by the mature markets?

William Toler: They have started to achieve some level of critical mass. It is not enough to move the needle. We are still; I think the whole industry is kind of held back by the size and scale of California, Oklahoma, Michigan, a little bit of Colorado, Oregon, and Washington. But it has been very encouraging to seeing what places like Minnesota and Missouri and New York, the ones you mentioned, Virginia’s doing pretty well. The Ohio has stepped up, so they are starting to shift that kind of balance of consumption and balance of volume towards the Midwest and the East. But we still got California that is under a lot of pressure until that one at least stops declining. We are going to not be able to get over the growth hump, but we are seeing that mixed shift we are seeing that come toward the Midwest and the Mid-Atlantic and so on.

Of course, the other big one is what is going to happen in Florida. A lot of people are waiting to watch to see how the voting turns out in November. We think that one could have a huge impact on everybody’s opportunity to grow.

Operator: And we will take our next question from Peter Grom, UBS.

Peter Grom: I wanted to follow-up on Mr. Carter’s question a little bit just on the top line progression. I guess just in the context of the guidance it is still a decently wide range for the balance of the year, but you are kind of trending at the better half of that year-to-date. So can you maybe just talk through how we should be thinking about the puts and takes as to what will put you towards the better end versus maybe towards the lower end of that guidance range. And maybe any thoughts in terms of how you would be thinking about the phasing of that 3Q versus 4Q?

William Toler: And with our first half, it is sort of right at 13 and you got just above 13 and Q2 and right under 13 and Q1, obviously we are trending at the better end of our range. We talked about tightening it but honestly we felt like that with the uncertainties of things that go on in our industry in Q3 and Q4, we didn’t want to get out ahead of ourselves, so we thought about, look, we are at the better end right now. We hope to stay there. But it is been a hard nut to call and a hard nut to find. And so we are encouraged by overall macro things that I mentioned in an answering Andrew’s call, but we still want to see further stabilization before we tighten anymore or call the range any better. But we are glad to be at the better side of that range right now

Peter Grom: And then I guess if I were to just like thinking about it and just kind of getting back to stabilization, just going back to that point on the monthly sales trends, obviously June maybe wasn’t that as you mentioned, but like, not to call about not to talk about 2025 now, but because it is been you are still having a harder time figuring out where to be within the range of the back half of this year. But I guess just like, would you anticipate like just, I don’t know – like do you think we could see better stabilization and just in terms of top line growth and so set another way the stabilization and top line growth? Will that allow some of the cost savings and restructuring that you are doing to kind of allow some of the better profitability to flow through? So just trying to think about a bigger picture, how you think about maybe the puts and takes of 2025 at this point in time.

William Toler: It is something we have begun to talk about, but we are certainly not ready to call anything in 2025. But I think that the momentum is such that the shifting to the middle of the country states and the Northeast states plus the potential for rescheduling all those things should lead us to a growth year in 2025. Not really ready to put a number on that yet, but I think that we have certainly paid our dues longer than we thought only paid our dues longer than we thought we had to across the entire industry with a couple of years here of declines. So we should be ready to go. And I think now that our cost structure is as tight as it is, we will start seeing those much higher profitability numbers popping through with the control and cost, the restructuring done, the shutting of facilities, the selling of assets, all of that puts us in a great spot that when a little bit of growth does return, it is going to much more of its going to stick to the bottom line as it flows through.

Peter Grom: Great and then maybe just one quick follow-up for John, gross margin expansion still expected for the year. Just any thoughts on phasing for gross margin, as well as kind of adjusted EBITDA just as we think about calibrating our models for 3Q and kind of 4Q.

William Toler: Yes. Typically, we see as Peter, a little bit stronger profitability in Q3 than we do in Q4. Just because we typically see with the seasonality trends that exist in our business particularly up in Canada and elsewhere, that sort of top line in Q4 is typically a wee bit lower than it is in Q3. And sort of that effect has a little bit of implication on our margin. But overall, as we said, we are expecting stronger margin the second half. And hopefully that gives you a little bit of insight on sort of the Q3, Q4 aspects of it.

Operator: We will take our next question from Jesse Redmond, Water Tower Research.

Jesse Redmond: Had a question on Ohio. I know we saw a pretty strong production ramp heading into launching sales, just a few days ago. Can you talk about how you may have benefited from that production ramp and how much of that you expect to persist, which I guess maybe speaks to a little bit about the consumables versus durables.

William Toler: Yes, thanks, Jesse. Ohio has been trending well as you get kind of these bursts of opportunities with new things happening. It has been a strong state for us for a while. We got good people on the ground there and good relationships with the key customers in that area. So that has been a good one. But there have been others. I mean, Missouri’s been strong as well. Some of the stuff finally, Virginia has come around after a couple of years to get it fully implemented. A number of these states that have been slow to implement and slow to start, they have happened. About 75% to 78% of our business now in consumables, generally a new state’s going to benefit the durable side a little bit first. And in consumables, of course, you got to build the facility before you can run it.

Part of that is why that our durable business has done a bit better driven by the innovation photo bio, the innovation phantom, and of course these new states are rolling out. The challenge for all of us has been that the size and scale of the California, Michigan, and Oklahoma, until the country kind of adjusts to absorb the new business in each of the newer states, which by definition are smaller until they scale up, until that shift happens. We are not going to see an Ohio or any state really big enough to drive growth. But it is good to see that shift. It is good to see it spreading out a little bit and not being nearly as concentrate concentrated as it was a couple of years ago.

Jesse Redmond: That is helpful, thank you. And also, was wondering if you had any, we talk a lot about what is going on in the cannabis space, obviously, because that drives most of the revenue and there is a lot of exciting catalysts on the state and Federal level, but also curious what is going on in the non-cannabis world. And if you had any insights to kind of the foods, forests, lawn and garden area of the business.

William Toler: Yes. That industry, while we have got a pretty good business in the lawn and garden side up in Canada, we have spent a good bit of time in the U.S. developing lawn and garden relationships. That business, I would call it, while cannabis has been declining, that is usually a pretty stable and flattish business, lawn and garden can grow a couple of percentage points a year and, and it has shown those kind of trends here over the last few quarters. So we are getting deeper into that. We are seeing that to be a much slower business to adopt change. And we have been working now for a better part of year or more in getting into any – into new stores and new areas. One of the things we have done is to, we are selling kind of integrated planograms into some of these lawn and garden retailers and that is had some nice traction working with good partners in some of the lawn and garden distributors that are working with us to help get volume out into these stores.

And so those partnerships are developing, but it is a slower burn and it takes a while to develop significant volume there, but we think that will continue to help us a little more in, into ‘24 and on into 2025. Just to add on to that too, Jesse our peep business, which tends to skew much more food and floral than it does, cannabis has generally been very steady business force and we expect that to continue. And then as I think we have noted on prior calls from an international standpoint, which we sort of consider outside of the US and Canada, we had very strong growth last year. Numbers are still small in absolute dollar terms, but very strong growth percentage terms last year. A little sort of flattish in the first half of this year but with orders we can see and expectations with new distributions and geographies we are expecting growth in the back half and that side of the business as well.

So all these things are sort of combining to help us diversify.

Jesse Redmond: And I could just get one more quick one, and maybe for you, John, it looks like you are making continued progress on the cost cut cutting side. Any comments on where you are in that cycle and how much room there might be able to squeeze more out of SG&A or other areas?

John Lindeman: I was looking at it this morning, if you look on a trailing 12-month basis as we ended this Q2 and compare that to a trailing 12-month basis Q2 one year ago; our adjusted gross profit margin is up 4, 540 basis points year-over-year. So, substantial improvement and we have taken $17.1 million out of adjusted SG&A expense. So really big movements in connection with the restructuring and cost saving actions we have taken. I think as we said before and was kind of alluded to in the response we gave to Peter’s question. If we get any energy on the top line across the category and continue to make progress on our own initiative to continue to drive more proprietary brands, in particular in some of our consumable products that are fairly profitable for us and higher margin.

We have the opportunity to see our adjusted gross profit margin expand into sort of couple hundred basis points higher than where we have been here the last couple of quarters. And, uh we are excited to see that prospect come to fruition.

Operator: And with no further questions in the queue, I will turn the program back over to your presenters for any additional or closing remarks.

William Toler: Thank you operator and everyone, we appreciate your support of Hydrofarm and look forward to speaking with you soon. Take care.

Operator: And this concludes today’s program. You may disconnect at this time.