Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Holdings Group's Fourth Quarter and Fiscal Year 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, March 9, 2023. I would now like to turn the conference call over to Anna Kate Heller at ICR to begin. Please go ahead.

Thank you, and good afternoon. 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 fourth quarter 2022 earnings release and Form 8-K issued today after market close. These documents are available on the Investors section of Hydrofarm's Web site 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.

Thank you, Anna Kate and good afternoon, everyone. 2022 was a challenging year for our industry and as a result for Hydroform However, I'm encouraged to report that we finished the year at the upper end of our previously provided outlook for net sales for last year. We also generated positive free cash flow in Q4, marking the third consecutive quarter of positive cash generation. While I'm encouraged by these metrics, it is really the many decisions we made and the actions we took last year that leave me the most optimistic about our future. In Q4, our team here in the US consolidated our product portfolio, eliminating more than 40 brands and 1,100 SKUs, representing about 20% of our brands and over 33% of our SKUs. We've also begun to rightsize our manufacturing and supply chain footprint by closing a nutrient manufacturing facility in Canada and we've begun subletting some space in our distribution centers. In addition, we have reduced total headcount by more than 30%, primarily as a result of integrating the companies we acquired. We've also aggressively reduced our working capital and have begun to further expand our sales efforts into non-cannabis channels, including CEA food and floral and lawn and garden. As you see in today's earnings release, some of these actions start in Q4 and were part of a restructuring initiative, which John will elaborate on later. Collectively, these actions set us up to be a leaner, more nimble, more diverse and importantly, more profitable business. And so looking ahead, I see brighter days ahead on many fronts. From a sales perspective, we have experienced stabilization in our average daily sales from November of '22 through February of '23. We're also starting to see some positive signals from several industry metrics. Although, no single data…

Thanks, Bill and good afternoon, everyone. Net sales for the fourth quarter were $61.5 million compared to $110.4 million in the prior year period. Our 2021 acquisitions added 3.1% to our top line in the fourth quarter of 2022 relative to the prior year period, but this M&A benefit was more than offset by 46% decline in organic sales volume. We realized the 0.9% price mix decline in the quarter, which was driven by a strong effort from our sales team to sell-through discounted lighting products. Without that factor, we estimate that our Q4 price mix impact would have been positive similar to prior quarters. Also, as noted in prior quarters, the industry recession continued to have an impact on our sales mix. While proprietary brands increased as a percentage of total sales to over 55% in Q4, the margin contribution of our proprietary brand category was diluted by the sell-through of discounted proprietary branded lighting products. We did see some positive sales trends in the quarter. First, the level of year-over-year sales declines improved in Q4 from Q3 in several more mature states, including Oklahoma, Colorado, Oregon, Washington, Michigan and Maine. Second, our commercial sales continue to advance on a relative basis. For the full year 2022, our commercial sales represented approximately 40% of total sales versus approximately 25% in the prior year. I will now take a minute to discuss our restructuring initiative. As we heard from Bill, we instituted restructuring initiative that included consolidating our product portfolio, consolidating our Canadian nutrient manufacturing facility, eliminating our China office and terminating contracts to help reduce future facility and transportation costs. As a result of these actions, we recorded pre-tax charges of approximately $7.7 million in Q4, of which approximately $6.1 million are noncash. We also expect to incur approximately…

[Operator Instructions] And your first question comes from Andrew Carter from Stifel.

Mentioning the lighting kind of actions that you took that's negative pricing in the quarter. First up, could you tell us the impact of the product margin? I might be confusing things in what's adjusted and what’s not. Number two, you have more to go in the first quarter if I understand that. And if I look at your draw down in the fourth quarter of inventory, it was $26 million or so benefit to cash flow. Was the majority of that the lighting products moving and how much more kind of inventory draw down you think you can do and still maintain a healthy business?

I think our lightning sales in Q4 were roughly about 10% or 11% of our total sales, to give you some perspective. And as we indicated, there definitely was some margin compression, a good chunk of our lighting that we sell is proprietary branded. And again, when you think about the discounted lighting products we're selling that our brand is predominantly the high pressure sodium phantom lights dominantly that were sold through in Q4. We do have some more inventory of those, although, our team did do a very good job selling through it in Q4. We expect that we'll work through the remainder of it in Q1.

So we've taken [Multiple Speakers] full amount, all the stuff we expected sell through.

And then kind of second question is now that you've kind of done this restructuring initiative and if you back into your volumes this year your debt you're 60% of where you were in '21. Any ideas, can you give us any sense of kind of where you're manufacturing that network is from a utilization standpoint? And if we have another step down in volume, is there more to take out or just anything you could give us on that front?

As you well know, we bought sort of four nutrient businesses that's the place where you have the most overlap. And when we brought it in and then the volume declined, we probably had utilizations in the 20% to 25% range by closing the Canadian facility that moves them up maybe in the 30s to low-40s and we still have room to go there. And we don't want to have to do any more of that, but we certainly have some levers to pull. We also have some options of perhaps developing a different located site, maybe in the Eastern Midwest where we don't have production today. All the facilities we have now are kind of on the West Coast. So moving that to the Midwest or East could be an option as well. But we certainly have some more levers to pull if we find that we need to get further cost out or further optimization of the footprint.

Your next question comes from Andrea Teixeira from JPMorgan.

Just wanted to go back to the commentary. A couple of things, I want to clarify. In terms of the debt capacity and liquidity, I know, John, you mentioned that you feel comfortable, but just to make sure that we are not missing anything and moving pieces there in terms of your revolver or any financial needs that you may expect, then I think you put in $40 million now. Then the other clarification is on what you mentioned in terms of the gross margin approaching 2021 levels. So just doing the math with the lower level of revenues. I think you’re just saying adjusted EBITDA that is positive, we can kind of back out and then the positive free cash flow. Just wanted to make sure that we have the moving pieces from a gross margin perspective and how we should be thinking in the dollar EBITDA and how we should be thinking of progression of the quarters? Because when I say approaching is that towards the end of the year when we have more the results of the restructuring, how we should be thinking of all these moving pieces from a cadence perspective?

Let me try to take those in order, if I can, Andrea. So liquidity, yes, I think we mentioned roughly $60 million of liquidity at the end of the year, that's $20 million plus on the balance sheet and cash plus $40 million available on the line. You know we continue to feel good about our liquidity position for a number of reasons. Again, our debt doesn't come due -- the bulk of our debt is really held in our term debt facility, roughly $124 million of the roughly $126 million that we mentioned. That doesn't come due until 2028 and the principal portion that amortizes only amortizes about 1% a year, which is roughly $1.3 million. So from a liquidity standpoint, we continue to feel good. As we noted, we expect to continue to generate positive free cash flow for the full year 2023. We've now done that three quarters in a row, Q2 through Q4, and feel good about our prospects to continue to do that into the coming year. The way in which we've been having good success doing it and we expect to continue to have success is as the demand levels have shrunk in the category in this short -- in this brief period, we've been able to reduce our investment in working capital and take down our working capital, and that's been generating cash for us. And we feel like with the call down that we've had, that we've given you in terms of our outlook for '23 versus '22, that once again, gives us that opportunity to continue to pull down our working capital. In terms of the margin call or rather sort of the modest EBITDA, let me sort of attack it this way, if you will. So our adjusted gross profit…

So just to this would offer 200 to 230 basis points opportunity that you think you realized already in 2023 or that's going to be a long term goal?

No we think on the sales level that we call within that outlook range, we have an opportunity to get there over the course of 2023.

So that would mean that 21% to 21.3%-ish, like roughly, so it's about 21%, which is the level that you had in 2021. So as -- just to make sure that that would be at some point, so let's say, third quarter, fourth quarter, or you think that obviously you called out that pricing will be tough in the first quarter. So I'm assuming you are going to ramp to that level but not for the full year, of course. Is that fair?

That's correct…

And then in terms of like the inventory, you mentioned that the inventory adjustments are mostly done but you still have some pricing concessions, I guess, in the first quarter that needs to work through. So within your guide like in terms of volume and pricing, how we should be thinking of the $300 million in top line, like what is the -- how should we be thinking in the midpoint $300 million, part of how much of that 10% decline would be coming from -- actually more than that, would be coming from volume and I guess pricing? I'm sure that the volume decline would be greater than what the total sales would be down, but how much pricing do you still have carryover or mix carryover?

So we are estimating that in Q1 we will have some negative price/mix impact much like we did here in Q4. And again, for the same reason that we continue to sell through the remaining portion of our sort of high risk lighting products. But we are expecting low single digit positive pricing for the remainder of the year. And so I think when you sort of look at that across the span of the full year, think of it as a very low single digit positive pricing for the full year, and then the residual will just be the volume.

Your next question comes from John Anderson from William Blair.

I wanted to ask just about the commentary around stabilization in average daily sales. And I'm not sure, I've heard similar commentary, perhaps not from you in this way but from some others in the industry. And I'm just wondering if you've seen enough of that at this point in terms of the duration coupled with other input you are getting from customers and others in the channel that kind of gauge your degree of confidence here that not only can we see stabilization and kind of the seasonal recovery in '23, but then kind of growth in the back half and what kind of level of growth kind of thinking about second half?

I think it's fair to say that, we were trending, the industry was trending down all the way through October, and then it did begin to really flatten and sequentially show a little improvement, November, December, January, February. So that's good. And we think that's when you take in all the factors, seasonally adjust and all that, you can say, right, we really are sort of -- others have said bouncing along the bottom, and I think that's probably a reasonable way to think about it. But the other thing that gives us more confidence is kind of the things people are saying, the inventory levels we are seeing in Headset, the pricing, the stabilization, the kind of, let's say, mood and tone we are getting from customers, is speaking to there being people coming back into the business that it probably took a year, 18 months off. And we think that, that is encouraging. But it's been a ride, you've been with us the whole time, John, and it's been difficult to find the bottom here. So we're very cautious about how much we call and how much we're predicting. That's why our projection for the years that 2.90 to 3.10, which is still not anywhere close to where we'd like to be, but we think it's reflective of how we believe the industry to be performing right now. And part of that back half is, of course, you're up against pretty soft comps from the back half of '22. So hopefully, you're able to show growth off of that and get to that midpoint 300 for the year and hopefully go past.

You mentioned the product portfolio work that you're doing. I think you mentioned 40 brands, perhaps over a thousand SKUs rationalized. Where are you do you think in terms of that part of the restructuring work, is that largely complete at this point, is there more work to do? And where do you think -- as the industry does recover, how does your business look different exiting this industry recession than it did entering and I'm thinking, proprietary versus non-proprietary mix, maybe even the kind of the categories that mix across the business and perhaps what that says about your kind of position in the industry?

No, I think that proprietary will should continue to expand and it should be 55, last year, it should get deeper this year, maybe 60, 65 in two or three years from now and get to two thirds of our business in two or three years would be proprietary. We still have some very strong branded partners we represent and we're proud of that. But I think back to your first question, I hope that we exit this phase with a simplified business, right? I mean, we were carrying almost 200 brands and representing and the industry doesn't need and can't support 200 brands. So there should be some natural shakeout in smaller businesses, and some are going to go away naturally, some are going to go away [Technical Difficulty] representing them, some will find other people to represent them. But I think you're seeing from the bigger distributors who also own brands that we were focused on fewer SKUs, more powerful SKUs, less brands, less complexity, and hopefully a simpler, cleaner operation, which has helped to come out of it on with a higher penetration of proprietary. We have to have the depth of proprietary brands to be able to support the infrastructure to distribute broadly to the industry the way we do. So that's important for everybody to have that kind of healthy proprietary penetration, if you will. So I think simpler business, less brands, less SKUs is certainly there. We've been doing this portfolio rationalization every year now for three and a half years, and I think we've done the big work. But I think every year you should always do the pruning of the bottom 15% or so. And I think you'll see that as more of the [price] of our work going forward. This year was a pretty good whack that we took on over 30% of the SKUs and 40 some brands is quite a big change.

Last one for me. You did mention that you've seen some, I guess, better sequential trends in some of the markets, Colorado, Oregon, Washington, I think you mentioned, even Oklahoma. How about in maybe some of the newer states that have been, I guess, somewhat delayed in terms of going live or ramping up, I'm thinking of some in the Northeast Corridor. Any commentary around what you're seeing there and whether that could be maybe positive tailwind as you move forward?

Yes, it should be. I mean, Virginia has been frustrating they keep fooling around with it a bit. New Jersey, New York had been kind of hot and cold. The ones that have kind of stood out recently, Missouri has been a really good state for the industry, I think, seeing a lot of quick sales there. You've seen Louisiana is doing pretty well. There are other places that are popping up now. But yes, the Northeast really hasn't been that huge wave that we all thought was going to happen and I think that's been something that's caught us all by surprise, and we hope they'll get it sorted out. But it hasn't really been the windfall or the tailwind that we'd hoped for.

Your next question comes from Chris Carey from Wells Fargo Securities.

Can you just to address the health of your core consumer right now and whether you have any concerns there as far as stabilization of the industry? I'm really referring to as the growers and whether you just have any read on, on that one way or the other?

You do a lot of research in this area and you've got a lot of insight as well. As you know, we still sell primarily through the retail channel. I mean, work with growers, but obviously don't sell directly to them. We're close to the growers. And I think you're going to see a good bit of consolidation. I think there's still, in certain markets like in Oklahoma, far too much capacity been built. I think Canada's still shaken out a bit on that front. California has got an awful lot as well. So I think you're going to see some shakeout in capacity and some stabilization by elimination in some of these key markets that got overheated, if you will, back in 2021, in early part '21, they got overheated and they had kind of an artificial level of volume that really wasn't supported by the population that they serve, probably had a lot of trans shipments moving around. And I think that as other states are now legalizing, that's going to balance out and each state will have its own infrastructure to operate the way they choose to operate. But I do think you're going to see some rationalization as these things -- the overbuild areas get consolidated back down.

I know you've been discounting on lighting and you mentioned that in the press release. What's your near and medium term view between consumables and durables? And apologies if I missed this. But as we're coming out of this, the durables have a place in this recovery or are even more focused on just creating a more consumable portfolio going forward? So just any comments on the near term but all the strategic [Multiple Speakers] portfolio…

For our portfolio, it’s still sort of two thirds, one third consumable versus durable. We had some of our oldest brands are on the durable side ironically Phantom and Active Air and Active Aqua and other ones are there. I think the biggest change in lighting that caused everybody to get a little off kilter was the back we all got way ahead in inventory and then the speed of which high pressure sodium shifted to LED, right? Some industry elements have gone completely out of high pressure sodium lights, we haven't, we're staying in them with a very limited range and actually they're doing okay. So that part is good. But we think that branded representation in each of the key categories is still very important to us as a strategy, as a manufacturer and a distributor. We want to compete and operate in the lighting business, we think they've got very good products from the lighting business. But our bigger part of our portfolio is going to be the consumables, it's going to be the nutrients and grow media. We like that recurring revenue more rapid stream, but we also want to be represented across all the segments.

And then one just last follow-up on the lighting side. You know as pricing got to the point where you can clear inventory, the prices need to still come down and then just your sense of lighting inventory in general. Is this going to be an ongoing process given a year or are you getting close?

No, we do think we're getting close. And to your pricing point or question rather, with all of the sort of hard work or decisions we had last year with taking pretty aggressive and pretty significant amount of reserves across the span of the year, really the bulk of that was in lighting. And so through that, we put ourselves in a place to be able to kind of discount the levels that we can actually sell through. And I think I mentioned earlier 10% of our sales in the quarter were roughly in the lighting category that may not sound like a lot, because back when we IPO, it was probably about 20% of our business but it's actually up from Q3. And so I mentioned that because our team did a really good job. I think we mentioned sort of strong effort. They did a really good job of sort of working our way through this challenged inventory. We do think we have got a little bit more to do. We have kind of focused on trying to get it done in Q1 and then hopefully have some prospects in Q2 through Q4 for a little bit sort of cleaner selling initiative without the discount in lighting.

And just to give you some perspective on that, the lighting’s after reserves now the value of the lighting is about equal to the percent of sales that it represents as a category for us and when you look at total inventories. So we are much more in line than we would been a year or so ago in that. So that's a very important dynamic as that you get inventory relative to your sales penetration by segment.

There are no further questions at this time. I'll turn it back to Bill for closing remarks.

Thanks, Colin, and thank you all for this important interest in Hydrofarm. We look forward to speaking with you all soon. Take care.

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating, and ask that you please disconnect your lines.