Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Holdings Group Third Quarter 2023 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, 2023. I would now like to turn the call over to Anna Kate Heller at ICR to begin.

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 third quarter 2023 earnings release and Form 8-K issued today after market close. These documents are available on the Investors section of Hydrofarm’s website at www.hydropharm.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.

Thank you, Anna Kate and good afternoon everyone. We're pleased that in the third quarter we achieved adjusted EBITDA profitability for the second quarter in a row. The successful execution of our restructuring and related cost-saving initiatives has driven significant improvement in our adjusted gross profit, which was also driven by greater emphasis on our own proprietary brands, which typically carry a higher margin. Our quarter-end cash balance is the highest it's been since the second quarter of 2021, putting us in a much stronger position as a result of our laser focus on optimizing our business to drive profitability. We've maintained our dedication to excellent customer service and on-time deliveries, even as we reduce costs. While we've implemented operational changes, our distribution footprint remains customer-centric and we maintain our commitment to providing top-notch service. We're glad to report that even at current sales levels, we've achieved significant progress in many areas this quarter, delivering both adjusted -- positive adjusted EBITDA and strong free cash flow. Our primary focus at Hydrofarm continues to be diversifying our revenue stream and controlling costs, whether it's through right-sizing the company, improving operational efficiency or emphasizing profitability throughout everything we do. I'll start by highlighting a few positives on the top and bottom line in Q3. Our proprietary Nutrient business, which is one of our highest margin product lines, again delivered a strong performance. We saw excellent results in numerous key proprietary brands, which contributed nicely to this quarter's margin expansion. Our proprietary brand Nutrient sales grew over 20% versus third quarter of last year, in large part to our great brands, including House & Garden, Grotek and HEAVY 16. We also continue to enhance the diversity of our revenue streams with a growing proportion of sales originating from customers outside of the US…

Thanks, Bill, and good afternoon, everyone. Net sales for the third quarter were $54.2 million, down 27% year-over-year, driven primarily by a 22% decrease in sales volume. We realized a price/mix decline in the quarter, much like we have for the last several quarters and as we expect for the full year. Our 5% price/mix decline in the quarter, it's primarily due to promotional activity in both durable and consumable products. Our price/mix decline in the period was also driven by a higher mix of lower-priced consumable products relative to higher-priced durables. Despite some competitive pricing in the grow media category, we still experienced much stronger top line performance in our consumable products relative to durables. In fact, consumables represented approximately 75% of total sales in the quarter, up from 67% in Q3 last year. Much of this shift was influenced by a broader industry trend of weakness in durable products. In particular, sales of lighting and equipment commonly used in new expansion projects or newly established grow operations. This mix change is also a reflection of the demand for several of our higher-margin proprietary nutrient brands. As Bill mentioned, our proprietary nutrient brand sales grew double digits in the quarter, compared to the same period last year. In an industry environment in which growth is hard to come by, we are really pleased with our Q3 top line growth in our key proprietary nutrient brands. In connection with our strong nutrient performance, our proprietary brands as a whole in Q3 mix slightly higher on a year-over-year basis and remained above 50% of our total sales. In addition to the favorable brand mix, we recognized sales improvements in a few key geographies this quarter. Sales to customers outside of the US and Canada increased over 20% in Q3, which now…

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Peter Grom with UBS. Please proceed with your question.

Thanks, operator. Good afternoon guys. Hope you're doing well. So Bill, I wanted to ask specifically around your confidence, you mentioned the industry returning to growth. And, obviously, it's been a couple of years here. But you did touch on a lot of positive development. So is this something that you think can actually occur as we look out to 2024, over the next 12 to 18 months, or is the exit rate we're seeing in 4Q, I think the implied guidance is call it like a mid to high-teens decline. Is that a fair run rate to start the year at? Thanks.

Yeah. Hi, Peter, good question. I think it is a fair rate to start the year at, but I think there are a number of signs that are pointing toward growth in probably, let's call it, sometime in 2024, maybe the back half of 2024. Our backlog on our durables bids is starting to bid a little bit. The commercial activity is picking up some. You're seeing these states that have been woefully slow and rolling out, starting to do some things, whether that's New York or New Jersey or Connecticut, they are all starting to pick up. Maryland has been pretty good, Missouri is getting better. All those things are starting to turn a bit. I think you're going to see, and we have seen that in addition to the legislative stuff that we talked about. And those things can be a few months away. They can be a few longer than that a way. We don't really know at this point. But all that is pointing in the right direction. But as you said, it's been an elongated difficult period of time for all of us. And so we are hesitant to call anything until we see it, and we're kind of planning as if it's going to run at a certain rates it's running at now. And keep getting costs under control, keep managing the mix and keep looking at your assets to find ways to create a more profitable company.

That's super helpful, Bill. And then I guess just maybe a follow-up from a margin perspective and maybe more of like a long-term question, right? It's obviously very encouraging to see two straight quarters of positive EBITDA on a lower sales base. But can you maybe frame in the context of the restructuring you've done, you announced the second restructuring today, other cost saves like what really is achievable from a margin perspective, particularly if we start to get some stabilization or growth in the back half of next year, obviously, several years ago, you had some more ambitious goals from a profit standpoint. But just in the world we are in today, I think it would be helpful to kind of frame like what's really possible. And how long you actually think it can take to get there?

I'll jump in on that one. Thanks, Peter. Great question. Yes, I mean, I think if you look at the past three quarters, our adjusted gross profit margin has been running around 24%. I mean we've had sort of two quarters where it was 23%. One quarter, it was 27%. Frankly, the quarter we just finished, as you saw me call out in our prepared remarks, I think we put up a 23% adjusted gross profit margin. But really sort of 200 basis points higher when you take into consideration the charge will be incurred during the period. So I think if we were to get just a little bit of cooperation from the industry and a little bit of growth, I think we could look at something in the 23% to 25%, maybe a little bit better than that sort of adjusted gross profit margin. And when we talk about adjusted SG&A, we're kind of running right now around this $12 million to $13 million kind of range on an adjusted level, which is down nearly $3.5 million, $4 million from where we began the year. So as we go into 2024, we're going to get some last benefit from that, just quite simply from the savings that we've already instituted and already received some benefit from. You also heard from the restructuring effort Phase 2 that we're putting in place, we're expecting $1.5 million of additional savings there. So I definitely feel like we've got some more opportunity in front of us with respect to growing the margin at the EBITDA level from here.

That's super helpful. Thank you so much. I’ll pass it on.

Thanks, Peter.

Our next question comes from Jesse Redmond with Water Tower Research. Please proceed with your question.

Hi, guys. I had a question on the product side, as we've chatted before, I always enjoy using your products and personally like your roots organic line or the things that I do in my backyard every season, but I know you've also been working on some proprietary nutrient brands. And I'm just wondering if you had an update there or you could talk a little bit about how those are performing.

Yes. Thanks, Jesse. And probably the strength of our portfolio and embedded in all this adjusted gross profit progress has really been the proprietary nutrient brands. I mean whether it's House & Garden, which honestly, over the last three years has been our most consistent business, whether it's HEAVY 16, which had had a tough year last year, but it's come back Gangbusters, or finally Grotek, which was a business that we bought out of Canada. It's always been distributed by us in both Canada and the US, has a great presence in Europe as well. Grotek has always done well in the Asian community and we've really been able to tap back into that market this year and we've had kind of two quarters in a row of just outstanding growth on that brand as well. But the proprietary Nutrients are really kind of the core of where we're making our money if you will. And I know we're not making a ton of money yet, but it really is driving the higher adjusted gross profit results that we're seeing and it's been an important part of kind of how this year has held together for us on a positive adjusted EBITDAI and also creating free cash flows. So good progress on the Nutrients. They're really the centerpiece of our entire proprietary branded offering.

Do you see any trends in terms of, I could see this a couple of ways when I'm talking to operators, there's people that are interested in growing great flower and want to spend more money to get higher THC numbers and more terpenes and maybe more in the premium part of the market. So we're looking to spend more on that side to create better products. But also we recognize there's a lot of margin pressure. And one thing I've been hearing in some of the MSO calls is people -- consumers are shifting down and going more towards value lines, which makes me think that providing affordable solutions may be of more interest. Curious where you're seeing the push and pull on that side if you're seeing people that are looking for more value conscious solutions, or if you're also seeing people that are looking for whatever is going to push the plant to its maximum potential?

Yeah. I think you're right. There's a wide spectrum of demand curve out there, right? And the margin pressure and the overall kind of glut of product over the last couple of years has caused pricing to drop way down. And so people then -- the corresponding reaction to that is they want to get cheaper inputs and cheaper cost of goods for growing. And so we've seen some of that. So what we've launched -- we've launched a house and garden dry product, which is a real value orientation instead of having the liquids, which of course you ship the water and you ship the dilution factor there. So the dry product really gives people a value-oriented way, yet it still has the high quality House & Garden branding on it. That's one of the things we're doing. We also offer a range of products both in our proprietary line and in our distributed line, whether it's the Guy Green products, whether it's the Moab, the mother of all Bloom products, all those that really are part of our portfolio that enable us to give people value, enable us to give people quality and it does allow for the folks to get that wide range of the things you outline which is some multimax terpenes, some multimax THC, some just want a consistent product of what they've had before and others play in that price market as well. We begin doing some work on sourcing kind of all the way back to the core raw materials to work with our growers on so that we're able to work with them and it gives them the access to the product that they perhaps even want to mix their own. So we're really adjusting our approach to the market to reflect what each of our growers need and there's a wide range of them out there as you suggested Jesse.

Great. Thank you guys. That's really helpful.

Appreciate it. Appreciate the question.

There are no further questions at this time. I would now like to turn the floor back over to Bill Toler for closing comments.

Great. Thank you all for your interest in Hydrofarm. We appreciate you being on the call. We look forward to updating you soon on other activity in the business. Thank you.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.