Hydrofarm Holdings Group, Inc. (NASDAQ:HYFM) Q3 2024 Earnings Call Transcript

Hydrofarm Holdings Group, Inc. (NASDAQ:HYFM) Q3 2024 Earnings Call Transcript November 9, 2024

Operator: Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Third Quarter Earnings Call. [Operator Instructions] Please note that this conference is being recorded today, November 7, 2024. I would now like to turn the call over to Anna Kate Heller at ICR to begin.

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 third 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 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, and good morning, everyone. In the third quarter, we achieved solid year-on-year improvements in our gross profit margin and adjusted gross profit margin. Our continuing focus on our proprietary brands is yielding results as they have increased as a percentage of our net sales, both in the quarter and year-to-date, providing a boost for our margins. We also continue to realize significant savings on the adjusted SG&A line through our effective cost savings and restructuring actions. Our net sales were seasonally weaker for us as industry challenges remain, and we have seen several large retailers close stores. With that said, we remain on track to hit our full year outlook on our key metrics.

I’d now like to cover a number of the other bright spots in the third quarter. We saw strong performances from select proprietary consumable brands in the grow media and nutrient categories. Specifically in the quarter, we saw Aurora Peat achieved significant year-over-year growth, while several of our key proprietary nutrient brands had solid results. On the durable side, we saw good performances on our proprietary Active Aqua and our PHOTOBIO lighting brand. We will continue to strategically invest behind our key proprietary brands as we look to meet growers’ evolving needs. Last quarter, we announced the distribution relationships or new distribution relationships with several partner brands, including Quest dehumidifiers, Hurricane Fans and Mills Nutrients.

These new partner brands added to our top line in the third quarter. However, they did weigh a bit on our cash flow in the period. We remain optimistic about future performance for these partner brands, but we’ll balance the upside of more sales with the inventory investment. We also saw progress in the diversification of our revenue sources. We continue to expand our international presence outside the U.S. and Canada and continue to seek ways to drive non-cannabis sales, including CEA products sold into food, floral, lawn and garden and certain other customer channels. As a percentage of sales, our non-cannabis and non-US. Canada revenue sources increased several hundred basis points compared to Q3 last year. We are finding ways to become more diverse and less reliant on cannabis in the U.S. and Canada.

And we expect these revenue sources to be a greater percentage of sales this year than they were in 2023. Improving profitability remains a top priority, and we took more steps in the third quarter to integrate, consolidate and optimize our manufacturing footprint as we drive productivity and cost efficiencies where possible. Notably, since the beginning of 2023, we have now reduced our manufacturing footprint by nearly 60% and have reduced our total manufacturing and distribution space by almost 45%. Our actions have enhanced profitability and efficiency throughout our operations, and we have completed these initiatives while maintaining excellent customer service, on-time deliveries and a customer-centric distribution footprint. A testament to the effectiveness of our cost savings and restructuring initiatives, we have now realized six consecutive quarters of adjusted gross profit margins at or above 23% and nine consecutive quarters of meaningful year-on-year adjusted SG&A savings.

And our absolute adjusted SG&A dollar cost is below our pre-IPO level. We’ve also achieved an increase in adjusted EBITDA for the nine months year-to-date. I’d like to give a quick update on the state of the industry. We continue to operate in a challenging environment as we move into the last quarter of 2024. With that said, there are some positive indicators, including actual growth in monthly cannabis users, the amount of actual cannabis being consumed. That continues across the country, which is encouraging. And according to 2023 National survey, nearly 70% of adults consider cannabis as readily available, which is up significantly. This indicates a great runway or a massive runway for the future of our industry. One other source of encouragement continues to be the progressing regulatory environment for U.S. cannabis growers.

The DEA has scheduled a hearing on December 2 regarding the proposed reclassification of cannabis from Schedule I to Schedule III, which would loosen restrictions on cannabis and help cash flow dynamics for licensed growers across legalized states. These positive developments would inject more life in the supply side of the industry and represent a step forward towards legalization of cannabis in the U.S. We are still optimistic demand for our products will turn around and deliver growth in the future. In the meantime, we have continued to show our ability to drive additional cost savings. Looking ahead with our strategic focus on our proprietary brands, revenue source diversification and cost controls and related restructuring initiatives, we’re confident that we are positioned for growth once demand and volume return to the industry.

I am happy to reaffirm our full year 2024 guidance for net sales, adjusted EBITDA and free cash flow. With that, I’ll turn it over to John to talk about the details of the third quarter financial and further about our outlook for 2024. John?

B. John Lindeman: Thanks, Bill, and good morning, everyone. Net sales for the third quarter were $44 million, down 18.8% year-over-year, driven primarily by a 13.7% decrease in volume mix and a 4.9% decline in pricing. The decrease in volume mix was mainly related to oversupply in the cannabis industry. The pricing decline was driven largely by promotional pricing activity during the period. We alluded to this last quarter and expect to see a similar pricing dynamic for the remainder of the year. Consumable products once again made up more than three quarters of our total sales, outperforming durables. Consumable products comprised approximately 79% of our total sales in Q3, an increase compared to last year. Overall, brand mix was solid during Q3 as our proprietary brands represented 56% of our total net sales compared to 54% in the prior year period.

Importantly, even with our proprietary — even within our proprietary brand bucket, we sold a greater mix of our higher-margin brands compared to last year. Gross profit in the third quarter was $8.5 million or 19.4% of net sales, compared to $3.3 million or 6.1% of net sales in the year ago period. Adjusted gross profit was $10.7 million or 24.3% of net sales, compared to $12.5 million or 23% of net sales last year. The 130 basis point increase is primarily due to a better mix of our higher-margin proprietary branded sales in the quarter and increased productivity within select manufacturing facilities. We also recorded no significant inventory write-downs during the quarter. As Bill mentioned, this was our sixth consecutive quarter with adjusted gross profit margins at or above 23%.

That said, there continues to be room for improvement if we continue to execute on our strategic priorities, including our focus on proprietary brand sales and further improving our operational productivity. A quick update here on some of our recent restructuring and cost-saving actions. As we mentioned last quarter, in June, we consolidated our grow media manufacturing by closing our smalls facility, followed by a greater than 30% reduction in our Northern California facility in July. Our manufacturing is now concentrated in two U.S. locations plus our peat moss harvesting and processing facility in Canada. During the quarter, we began to realize small but incremental efficiencies and cost savings from these consolidations. We are currently evaluating opportunities to optimize our distribution center network, including potential third-party logistic partnerships for one or more of our DCs in the U.S. and Canada.

Lastly, we successfully integrated one of our Canadian entities into our main ERP system during the quarter. Building on these achievements and our previously consolidated back-office functions, we now intend to fully integrate our U.S. and Canadian front office and operating teams over the next two quarters. We expect these actions to drive operating efficiencies and potential revenue synergies on both sides of the border. We look forward to sharing more details next quarter as we further streamline our business into one cohesive team. Moving on to our selling, general and administrative expense, where we continue to realize significant savings. In the third quarter, our SG&A expense was $17.6 million compared to $19.5 million last year. Adjusted SG&A expenses were $10.7 million, a nearly 11% reduction when compared to $12 million last year.

These savings are due to reductions across a wide range of items, including facility expenses, headcount reductions, professional fees and insurance costs. Year-to-date, we have achieved a 19% reduction on the adjusted SG&A line compared to last year. Adjusted EBITDA was slightly positive in the third quarter and year-to-date, our adjusted EBITDA of $2.1 million has more than doubled compared to 2023, demonstrating the success of our restructuring and cost-saving initiatives and our ability to operate profitably on lower sales levels. Moving on to our balance sheet and overall liquidity position. Our cash balance as of September 30 was $24.4 million, down from our balance of $30.3 million at the end of the second quarter last year. We ended the third quarter with $119.6 million of term debt and approximately $128 million of total debt, inclusive of financial lease liabilities.

Our net debt at the end of the quarter was approximately $104 million. As a reminder, our term loan facility has no financial maintenance covenant and does not mature until October 2028, and we continue to maintain a zero balance in our revolving credit facility. With our cash on hand and over $17 million of availability on our untapped revolving line of credit, we have over $41 million of total liquidity, a comfortable position for us. In the third quarter, we reported cash flow from operating activities of negative $4.5 million with capital expenditures of $0.8 million, yielding free cash flow of negative $5.3 million. Our cash flow in the quarter was impacted by our investment in new partner brands that Bill referenced earlier and temporary working capital delays from our US., Canadian ERP and related people integration.

While these impacts have put pressure on free cash flow, we are reaffirming our expectation to achieve positive free cash flow for both the fourth quarter and the full year. With that, let me turn now to our full year 2024 outlook. We are reaffirming our 2024 guidance on key metrics. Net sales are tracking towards the middle of our outlook range, which calls for a decline of low to high teens on a percentage basis. We are also reaffirming our expectation for adjusted EBITDA that is positive for the full year 2024 and positive free cash flow for the full year as well, which includes an updated expectation of $2.5 million to $3.5 million of capital expenditures. We also included a couple of updates to our full year assumptions in today’s earnings release.

We are confident in the long-term potential of this business. We continue to successfully execute on our cost-saving initiatives and have proven the ability to operate profitably at lower sales levels. We remain committed to our strategic priorities, including diversifying our revenue streams and further improving our sales mix via our proprietary brands. We are also optimistic about an eventual industry turnaround and believe we are well positioned to capture any incremental demand profitably. I will now turn the call back over to Bill.

William Toler: Thanks, John. And before we take questions, as we announced last month, I am retiring from the CEO role and transitioning to Executive Chairman effective on January 1, 2025, when John will take over as the CEO. Having turned 65 earlier this year, this is the right time for me to make the change. That said, I’m not really going anywhere. I’m just as committed now to the success of the company and will be closely involved as Executive Chairman and as one of the company’s largest shareholders, I strongly believe in the long-term fundamentals and the growth opportunity for Hydrofarm. This is a very natural progression. John is a proven leader who’s been an integral part of this business for the last five years. helping drive us through numerous complex industry environments.

The transition to John and the team will be seamless and provide the necessary continuity of leadership. The Board and I could not be more confident in John and the deep leadership team we already have in place around him. And I’ll support them as necessary as we seek to realize the potential for Hydrofarm. Thank you all for joining us this morning. We’re now happy to answer your questions. Operator, please open the line.

Q&A Session

Operator: Thank you, sir. [Operator Instructions] And we’ll take our first question from Andrew Carter from Stifel. Please go ahead.

W. Andrew Carter: Hey. Thank you. Good morning. First question I wanted to ask is around the kind of distributed brands. You signed up some new partners, which you mentioned. It does weigh on cash flow. Could you kind of quantify what the outlook is for partners out there? Obviously, Hawthorne is no longer distributing third party, but they’ve kind of helped cement BFG’s position. Is there a lot out there that’s profitable? Or are the demands out there of anyone looking to distribute a lot of times not worth it either on a profit basis or just the incremental working capital demands? Thanks.

William Toler: Yes. The partner brands work for us, and they work for us particularly well when we have scale, right? Obviously, with recent demand trends, scale has been a challenge for us and for the whole entire industry. So, there are a handful of the partner ones that are — that have come our way that we think have really, really got a good long-term potential. The ones I just mentioned are at the top of that list, right? The Quest and Mills and Hurricane are certainly really good brands for that. There’s also been some further consolidation of some very large lawn and garden brands on the grow media and nutrient side who have consolidated down to taken certain distributors out of the mix, and they’ve kind of come to us in an interesting way.

So that’s actually provided us some opportunity really that won’t be realized until 2025. But we’re clearly lining up to where we are a big part of the distribution industry today, and we think that’s a viable business for us, especially once the industry comes back. That being said, we are also making sure that we have the right distribution footprint that we have the right SKU count and the right viable levels of service to our customers. So, distribution can be a good business at scale. We’ve all struggled to get to that scale in the last few years, but we think that hopefully, we’re close to that coming back to being a positive force.

W. Andrew Carter: Got it. And then a second question. I know you mentioned that the independent retail closures are out there. You’ve got two kind of customer sets. You have independent retail and then you have a commercial business. We understand on the independent retail. Are you seeing stability on your kind of — on your commercial customers? Or are you seeing churn from either just exiting the industry? Or just anything on kind of the underlying trends there? Thanks.

William Toler: Yes. The — you’re right. The retailer — the brick-and-mortar retailers have been consolidated. I think that’s largely over now. But what happens is you have a two-step dynamic, right? They close the stores, and that means those stores stop buying, but then they also have to sort of eat their own inventory and consolidate that inventory back into their other stores. So, there’s really kind of a delayed effect on us, because as they’re consolidating inventory from one store to another and really consuming their own pipe, if you will, it takes longer for it to come back to us. So we certainly felt that in Q3. We’ve kind of felt that all year, right? On the other side of things, commercial has been okay, but certainly way below the levels it was a few years ago.

There was a lot of people that have been kind of waiting for these regulatory changes to come through. Obviously, we all saw that Florida did not pass. The majority of people of Florida wanted to have it pass, but it didn’t get to the 60% threshold. It’s not really that surprising. It usually takes one or two times for these things to pass, and hopefully, it will soon. And we’ve got the big DEA meeting coming up in early December. I think that will be the catalyst that gets commercial going again. Another channel that’s been very viable for us in the last — this year and certainly over the last couple of years is e-commerce. So, e-commerce now is a bigger part of the business than it had been over the last few years as people are more comfortable in ordering from e-commerce and getting products delivered that way.

So really, you’ve got weakness in brick-and-mortar. You’ve got kind of commercial that’s been a bit on hold, but I think it is going to pick back up, especially if there’s a rescheduling event. And you’ve got e-commerce that’s probably emerging as a strong ongoing channel for us and for the industry. Thanks Andrew.

W. Andrew Carter: Thanks. Passed on.

Operator: Thank you. And next, we’ll go to Jesse Redmond with Water Tower Research. Please go ahead.

Jesse Redmond : Good morning, John. Good morning, Bill. How are you guys? I was curious, Bill, if you could talk a little bit more about Florida. That’s a couple of billion-dollar medical market that we were hoping would more than double over time. I know you’re not specifically super leveraged to that market, but curious if you could talk about what specific implications that not passing would have for Hydrofarm?

William Toler: Yes, it certainly was a setback for the progression that we know is ultimately going to take place here. The fact that almost 57% voted yes, say that people want it and they’ll eventually get it. These things generally take more than one time before they do pass. Florida is setting the bar at 60. The fact that the very popular governor was not for this is probably the reason that it didn’t get through. I am encouraged that Trump came out and said he’s in favor of it. So that kind of leads me to believe that good things can and should happen going forward. But you’re right, we don’t have a huge footprint in Florida. We don’t have any distribution centers. really the closest distribution center we have here is Pennsylvania.

So we don’t have a lot of infrastructure in the state. We obviously don’t operate any brick-and-mortar. So, our opportunity here was for the consumption growth and for the growth in infrastructure and the growth in consumables and things, but we don’t really have the sort of the cost leverage or the cost challenges down here like some other people might. So, we think that while a setback, it is headed our direction, and we are going to have other macro things, hopefully, the rescheduling that far outweighs the benefit of what might have happened down here in Florida.

Jesse Redmond : And with your strong balance sheet and cash position, you’re operating from a position of relative strength. Can you talk a little bit more about opportunities you’re seeing on the M&A front to perhaps do some consolidation?

William Toler: Yes. I think that the M&A front really has a couple of different things. We’ve been continuing to have dialogue admittedly with our preservation of cash for all the right reasons and with our current equity price, we’re not going to go out and do a lot of M&A. But there’s a couple of things that are going on. If not M&A, then perhaps people are looking at outsourcing their volume to us, meaning a smaller player can no longer afford to keep his own plant operating. So, with that kind of consolidation, perhaps we pick up volume that way. Those kind of opportunities, while they haven’t come to us fully yet, have also been discussed with a number of different people. So we may pick up some volume that way as we’re looking to help other people get through this downturn.

On that same front, we still remain having multiple dialogues with people about potential combinations and different strategic approaches that make sense for us and for the industry. And we do have kind of a lot of good brands to leverage. We have a lot of good distributor partners to leverage. We have a lot of good things that can ultimately lead to the right solution. But we have been prudent in not rushing into anything that wasn’t the right situation for us or what didn’t create long-term value for our shareholders because we know that, like you say, our balance sheet is in good shape, and we’ve got an undrawn revolver. We’ve got debt that’s still not due for four more years. We’ve got all kinds of things that protect where we are. We’ve been making money in five out of the last six quarters.

And so we get where we stand. We want to change that position over time, but we also know we’ve got to do it in a disciplined and prudent way.

Jesse Redmond : That’s helpful, thanks. And finally, congratulations on the continued cost controls. Can you talk a little bit about how we might be thinking about SG&A moving forward in ’25? How much more room you have to cut there?

B. John Lindeman: Yes. Thanks, Jesse. I’ll jump in on that one. Yes, there is a little bit more room. I mean, look, we’ve, I think, proven over time now that we find ways to nip and tuck where we can to continue to bring that down. I mean we are at pre-IPO levels, as Bill mentioned in our comments earlier. So, it does get a little bit tougher, but there’s some more opportunity there for us in ’25.

Jesse Redmond : Great. That’s all for me. Thank you.

Operator: Thank you. I’d like to turn the call back over to Bill Toler for any final or closing remarks.

William Toler: Great. Thanks, Marjorie, and thanks, everyone, on the call for the support and continued interest in Hydrofarm, and we look forward to speaking to you soon. Take care.

Operator: Thank you. And ladies and gentlemen, that does conclude today’s conference. We thank you for your participation. You may now disconnect.