Good day, ladies and gentlemen and thank you for standing by. Welcome to the Hydrofarm Holdings Group's Third Quarter 2022 Earnings Conference Call. At this time, all participants have been placed in a listen only mode, and the lines will be open for your questions following the presentation. Please note that this conference is being recorded today, November 9, 2022. I'd now like to turn the call over to Mr. Fitzhugh Taylor, Managing Director at ICR to begin. Please go ahead.

Thank you, Victoria, and good afternoon. With me on the call today is Bill Toller, Hydrofarm’s Chairman and Chief Executive Officer; and John Lindeman, the company's Chief Financial Officer. By now, everyone should have access to our third quarter 2022 earnings release and Form 8-K issued after market close. These documents are available on the Investors section of Hydrofarm’s website at www.hydrofarm.com. Before we begin our formal remarks, please note that our discussion today will include forward-looking statements. These forward-looking statements are not guarantees of future performance, and therefore you should not put undue reliance on them. These statements are also subject to numerous risks and uncertainties that could cause actual results to differ materially from our current expectations. We refer all of you to our recent SEC filings for more detailed discussion of the risks that can impact our future operating results and financial condition. Lastly, during today's call we will discuss non-GAAP measures, which we believe can be useful in evaluating our performance. The presentation of this additional information should not be considered in isolation, or as a substitute for results prepared in accordance with GAAP and reconciliations to comparable GAAP measures are available in our earnings release. With that, I'd like to turn the call over to Bill Toler. Bill?

Thank you, Fitzhugh, and good afternoon, everyone. As you saw in today's press release, our Q3 results continue to reflect an industry under pressure from the oversupply dynamics and lack of consistent legislative support. Net sales for the quarter were in line with our own internal expectations, and though our reported adjusted EBITDA was heavily impacted by inventory and account receivable reserves and related charges our underlying profit performance was generally in line with our internal estimates. Additionally, our free cash flow performance exceeded our expectations as we generated positive free cash flow for the second straight quarter. As the industry evolves, we are adapting and moving with it. And this was demonstrated during our third quarter. Even though our product sales through our specialty retail channel remain challenged in the current industry environment, particularly in the mature states, our commercial sales have been at bright spot. Our commercial effort has been led by our associates at the Integrated Growers Equipment or IGE company or part of that company, which we acquired in November of 2021. Currently, our commercial sales make up 35% of our year to date 2022 sales through the end of the third quarter, an increase from only 19% of company sales in the same year to date period last year. Now I'll take a moment to talk about the impact of legislation. The improvement in our commercial sales %age is due in part to the benefit of IGE, as I noted, but it's also a result of winning bids with growers around the country, particularly in states that have more recently adopted and implemented favorable cannabis legislation. For example, nearly half the sales of our IGE branded products were sold in states largely along the eastern seaboard. Though difficult to predict in the short term, over…

Thank you, Bill, and good afternoon, everyone. Net sales for the third quarter were $74.2 compared to $123.8 million in the prior year period. Our 2021 acquisitions added 9.5% to our topline in the third quarter of 2022 relative to the prior year period, but this M&A benefit was more than offset by a 52.1% decline in organic sales volume. We realized a 2.7% price mix benefit in the quarter as we continue to pass through higher costs, but the magnitude of our pricing benefit has been tempered in the second half by the need to reduce price in the lighting category, which is the category that's been hardest hit by the industry downturn. Commercial sales as a percentage of our total have strengthened [despite] (ph) the industry weakness in the Lighting category. Our proportional increase in commercial sales is due in part to our acquisitions, namely IGE, which continues to drive relatively strong demand in this otherwise challenged industry environment. Bill earlier noted that magnitude of IGE's business along the eastern seaboard and I would note strength in several states, particularly Massachusetts, Mississippi, Florida, Louisiana, Pennsylvania and New Jersey, all of which are among our top 10 commercial states. As we noted last quarter, the industry recession is having an impact on our sales mix. This is primarily due to the relatively strong performance of distributed brands on a sequential basis relative to our proprietary and preferred brands. While our proprietary brands continue to drive over 50% of our total sales in Q3, the current industry environment is resulting in weak volumes in our lighting product sales, which in our portfolio are dominantly proprietary branded. While conversely, we're experiencing stronger demand for grow media products, which are primarily composed of distributed and preferred brands. We expect this trend to…

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Andrew Carter with Stifel. Please go ahead.

Hey, thanks. Good evening. I wanted to ask, so obviously the drawdown of inventory has been a good source of funds here. How much farther can this go? I mean, if I did my math right, I probably didn't. But I have your peat’s is down 58% in the quarter, that's behind the organic growth of 47%. Can it be like that? Or do you expect some expect some kind of a big catch up here? How much more can you -- how much more is our target working capital, et cetera. I'll stop there finally.

Yes, we've got I think roughly $145 million, $150 million of total inventory now on a business doing $330 million to $340 million in sales. Do you still got in terms of days of supply good bit of inventory, right? Think of it in two buckets. One is our finished goods in our DCs that we buy from others. And the other is, of course, our own direct materials that we produce our own brands with. I would say right now because of the seesaw that we're all familiar with Andrew on the volume, we've got more inventory on the direct material brands that we own side and that can continue to come down. And we can always continue to tighten on the finished goods side as well. As a part of one of the things we're doing to strengthen the company, we're going through aggressive SKU and brand rationalization processes as well, so taking out more SKUs, taking out brands, cutting down on that inventory, of course, that's going to give us even more room to take more inventory out. So while I'm not going to give you a specific number of how much we can take down, we think we've got a good amount of room to keep working inventories down on both sides of the ail, if you will, finish goods that we buy from others and on the direct materials side.

Got you. And then thinking about like usually typically kind of on same topic. 1Q is your kind of big purchase for the season. I guess as you've gone through this cycle and you go into year, I mean, how confident are you you can plan for next year, make the right decision, maybe that's something you have to use the credit facility for about knowing the season and knowing how much you do have to purchase when you actually have to do that going into next year. I mean, we're thinking like 1Q early year, but just how are you approaching that potential next kind of big decision for the company?

Generally, the area that involves the most kind of buying ahead is around the grow media businesses, right? There's generally a lot of kind of pre booking of that in the fall. Well, I would say, as an industry there's been a lot less of that this year and people are not really making these big early buys to get ahead on inventory. I think it's going to be more kind of hand to mouth. I mean, there's going to be a lot of pure packer. You need to pack that grow media up, because you can't catch up if the volume takes off in Q2. But on our side of things, I think many other distributors and other industry players are not really leaning into these big buys. So I don't think it's going to be the same draw that it has been in prior years. And we're going to be cautious. We're not going to lean into it and like you suggest, to tap the credit facility simply for inventory. We want to be careful not to do that and to manage it as tightly as we can. Well, it doesn't mean we won't touch the credit facility, but it certainly means that we're going to be very cautious in how we buy in.

And I'll just ask kind of one final question just kind of on the pricing. I know you mentioned the lighting is in deflation. Can you give anything on what the pricing ex lighting would be? And then kind of separately like, are you actually expanding product margins on products outside of lighting just through the pricing you're getting? Thanks.

Yes. You're right. Lighting is the one that's under the most pressure. There's a pretty aggressive promotion scheme out there, although our overall trade spending is pretty much in line with what we expected. There's a promotional environment out there right now, not anything ridiculous. And on the product margins, I would say, other than grow media we've been doing fairly well, but grow media has been tough on us this year. And of course, lighting has been the one that's under the most pressure.

Thanks. I'll pass it on.

Thanks a lot.

Next question comes from Bill Chappell with Truist Securities. Please go ahead.

Hey, good evening guys. This is Stephen Lengel on for Bill Chappell. Thank you for taking our question. You guys kind of -- as a little bit of a follow-up to Andrew's question on the lighting inventory. We kind of heard from Hawthorne that they seem to be exiting the LED lighting. Can you kind of provide more color? I know that this is an opportunity just to kind of gain some share over the long term or you kind of expecting to exit the category as well? Thank you.

Yes, we're not exiting it. We are taking out, I think, 85% or 80% plus of our SKUs in the pot pressure sodium double ended lights and also obviously for us since long past now. We're going to stay in that business. I think some other industry folks are well. Hawthorne is getting out of it. That's fine. That's their choice. So we're going to offer that to folks. We feel like that pot pressure sodium is a tried and true and long proven technology that's still run by an awful lot of growers and so we want to offer that to our customer base and obviously we still sell LEDs very aggressively and we'll continue to do that and compete on that front. But now we're going to stay in it, but it will be with a limited number of SKUs.

Thank you. And you guys kind of mentioned that you were performing well in the peat business. What kind of color can you provide on some of the progress you've made in the category and where do you see some maybe further opportunity as we look ahead to ‘23?

Yes, we've got a unique peat business in Edmonton or North of Edmonton, Canada. It came as a part of the Aurora Innovations acquisition, it’s called APP, Aurora Peat Products. And we've actually been granted last year some additional acreage in bogs. So it's becoming a very nice business for us. And importantly, it sells outside of just an ingredient going into cannabis or into grown mixes, right? So it sells into different kind of food and floral and outdoor grows and sells into mushroom farmers and a number of different places. So there's many channels there that we can develop. It does require capital to develop those new bogs and I think we spent over half our capital between IGE and Aurora Peat this year, which is appropriate, those are probably our two best performing businesses on the topline side. But Peat, we think is a place that's unique commodity, that's differentiated and it's sourcing, it's very tightly controlled by that Canadian government and gives us an angle that we like as a provider of ingredients and products to other grow mix providers and sellers. We think it's a good business for us.

Awesome. Thank you so much, guys. I'll pass it on.

[Operator Instructions] Next question comes from Andrea Teixeira, JP Morgan. Please go ahead.

Thank you, operator, and good afternoon, everyone. So my question is -- how are you? So, Bill or John, like just on a bit on kind of like going back to your point about getting into the EBITDA guidance, but more on the low end. So I'm assuming that implies gross margins still in the high single digits for the fourth quarter and then I'm assuming the top line, is this still -- I think top line is still coming okay given that you are kind of being tactical about how you get rid of the inventory. But thinking of profitability from here, I’m assuming you did mention that you don't see any other write downs from here. How should we be thinking as we move forward into ‘23? Do you think most of it is behind us? And then why getting the shelf registration, is that to avoid or to just being tactical about having the ability to tackle or to draw back in some of the other alternatives other than the revolver?

Yes, Andrea. God afternoon. Now with respect to Q4 and what's implied out of our guidance from a margin standpoint, I think you're generally thinking about it correctly. Number of the things that we saw occurring in Q3 from our mix and sales volume perspective are what we expect to continue to emerge into Q4. Obviously, there's some seasonality that brings the sales level down. I think that was already implicit in sort of a lot of the numbers I saw floating around out there for us for Q4 and before the call. So I think directionally that's all right. With respect to 2023, we've got some planning to do for sure over the next couple of months and I think we'll have more to say about like formal thoughts for 2023 as we prepare to report the Q4 results here in the coming period. With respect to the shelf registration, I think it's just -- for companies like us, I mean typically you have a shelf up there available for access if and when needed. Right now, I think as you know, we've got cash on the balance sheet, we've got a fair amount of liquidity available in the line of credit that is completely untapped at this point. Those obviously would be the first places we would go for cash. And then we -- although we've guided it and offered an outlook that suggests generating free cash flow in the fourth quarter will be a challenge. We are cautiously optimistic, there's some opportunities for us to continue to do in the future. And our last call suggested there's still some opportunity -- our last question rather suggested there's still opportunity in the inventory area and we feel that way.

Meaning, you can continue to in a way get -- I mean, I don't know if what means in terms of like -- what that means in terms of the retail inventory, right? Well, how the health of -- and how much visibility you have in some of your retail partners, if they still are running high levels of inventory that may heat you? It's true in the following quarters or you have some good visibility there?

We don't have -- certainly, it's not -- ahead, John.

No, I was just going to make the same comment. I mean, visibility in the specialty retailers that we sell into is not perfect, because you know it's a very fragmented customer base for us. But I think it's safe to say that in many cases probably we still have pretty robust inventory level. That's part of the reason I think our sales levels are down. But having said that, commercial as I think we pointed out in our earlier comments is a growing part of our business from a mix standpoint. I mean, it's 35% of our sales on a year to date basis up from 19% last year. So the commercial part of our business is something we've been leaning into.

Okay. Thank you.

Thanks, Andrea.

Next question comes from Chris Carey with Wells Fargo Securities. Please go ahead. Q - Chris Carey Hi. Good evening or afternoon, wherever you are. Just on the Q4 cash flow assumptions, can you be a bit more specific perhaps about what the drain is going to look like? I may have missed that number if you had given that.

I'm sorry, was it -- I think we did [indiscernible] on free cash flow, but –

So in Q4, you're saying that generating cash flow will be difficult. Is there a way to frame that?

Yes, I think, look, I mean, obviously, Q4 from a seasonal perspective is sort of slow for us and others in the industry. And just as a result, quite naturally the sell through will be a little bit less dramatic maybe than what we've seen in the last couple of quarters. At the same time, there is a little bit of inventory build seasonally that happens, particularly with respect to our lawn and garden business up in Canada. And so, those things are some of the things we're thinking about when we sort of air on the side of caution with respect to free cash in Q4.

Got it. Just on the comment around the commercial grower versus hobbyist or small grower. Are you seeing noticeable differences in health of these types of customers? I appreciate one has a balance sheet that maybe some cash reserves and the other is kind of living day to day, right, from a cash perspective. But is this something where there's actually a maybe unappreciated part of this channel, which is a lot healthier, which maybe is taking share even despite the macro headwinds of the category and you can really go after that customer and take market share and perhaps deliver a bit healthier financial results over the next 12 months even if the category remains under pressure, can you just talk to that dynamic, please?

Yes, that's exactly how we look at it, which is, the commercial multi state operator or commercial operators are generally better funded and have either a new bill going in or large scale grow and they are obviously able to support that. And so we've been successful there building our percent of total in commercial up to the 35% that we quoted a few moments ago. A lot of that's been driven by the team that we acquired as a part of the IGE business. We have several of our own folks who are focused on commercial. We integrated that with the IGE team and now we have a very strong presence in that space. So that is an area we expect to continue to grow and certainly think that we can gain market share and expand our footprint in that area.

Okay. Thank you.

Thanks, Chris.

There are no further questions at this time. I would like to turn the floor back over to Bill Toler, the CEO for closing comments. Please go ahead.

Great. Thank you, operator, and we want to thank everyone for joining us today to hear our Q3 results and we appreciate your support and following of Hydrofarm. Thank you very much. Have a good day.

This conference has now concluded. Thank you for attending today's presentation. You may now disconnect.