Good day, ladies and gentlemen and thank you for standing by. Welcome to the Hydrofarm Holdings Group Fourth Quarter 2021 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 1, 2022. I would now like to turn the call over to Mr. Fitzhugh Taylor, Managing Director at ICR, to begin.

Thank you, Maria and good afternoon, everyone. 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 2021 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.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 what we expect. 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'd like to turn the call over to Bill Toler. Bill?

Thank you, Fitzhugh and good afternoon, everyone. We're pleased to cap off a successful 2021, with a fourth quarter that include a revenue growth of over 26%, while our Q4 was impacted by the previously discussed short-term agricultural oversupply of cannabis. When you take a step back, there's no doubt we have made significant progress reconfiguring our portfolio during the year to further establish Hydrofarm as a leading branded manufacturer and distributor within the fast-growing controlled environment agriculture industry and we believe we've set the company up for long-term success. Let's recap some of the highlights of the full year 2021. We posted total growth of over 40% in 2021 via significant organic growth, plus acquisition-related growth. Our organic growth was over 18% for the year, very much in line with our long-term historic growth trends. I would also note that on a 2-year basis, our full year organic growth was over 72% in aggregate or about 31% on a compounded annual growth basis. This represents a period of strong expansion in the industry with growth rates a little above our long-term historic norms. Secondly, we successfully completed five acquisitions in 2021 that helped to reshape our product portfolio. As a result of these acquisitions, on a pro forma full year basis, 77% of our sales come from proprietary and preferred brands compared to just 66% last year. In addition, on a pro forma basis, the consumable portion of our portfolio is now about 68%, up from 65% last year from a product mix standpoint. And more than half of our sales now come from our own brands. And we produce, manufacture in-house about 40% of that revenue, up from only 10% a year ago prior to our acquisitions. Third, we successfully completed three financings in 2021 to enable these…

Thanks, Bill and good afternoon, everyone. Net sales for the fourth quarter increased 26.3% to $110.4 million from $87.4 million in the prior year period. The increase in net sales was related to the year-over-year impact from the five companies that we acquired between May and November. Together, these acquisitions added 40% to our top line in the fourth quarter 2021 relative to the prior year period and offset a decline in organic sales which was impacted by softness we experienced in several U.S. states, though most prominently in California and in Canada. Though we experienced organic growth softness in Q4 in several markets, we did see several other states that more recently passed adult-use legislation build some momentum. In particular, we experienced more than 100% growth rates in the quarter in New York, Missouri, Louisiana, Arizona and Virginia as well as strong growth in several less mature cannabis states. Combined, the volume impact from acquisitions and organic growth yielded an overall 22.8% increase in volume in Q4. Net sales in our fourth quarter did benefit from a 2.8% increase in pricing mix as we continue to reassess our portfolio SKUs and take price on those SKUs where we see higher costs. For the full year 2021, net sales were up 40.1% to $479.4 million from $342.2 million in 2020. This growth in our top line was led by an organic growth of approximately 18%, coupled with M&A growth of approximately 22%. Gross profit during the fourth quarter increased to $18.7 million as compared to $16 million in the year ago period. Reported gross profit margin decreased by 140 basis points to 16.9%, due primarily to $3.2 million of combined costs associated with our distribution center relocations in California and with acquisition-related expenses absorbed in the quarter. On an adjusted…

Our first question comes from Andrew Carter with Stifel. Please proceed with your question.

Hi, thanks. I guess the first question is just kind of the certainty of the environment, I mean, I know that you've basically said kind of -- first off, could you give us the magnitude of the organic sales decline expected in the first quarter? Not returning to three quarter but just anything you can give us around the months. How things are tracking on a week by week, January, February? Any incremental color there would be helpful.

Andrew, how are you?

Good.

Yes. So the -- I think John said in his numbers but the number in Q4 organic was sort of mid-teens, call it, 14%, 15%. We're seeing similar results to that year-to-date in '22. So we don't expect it to miraculously turn here in March, although we hope spring will bring a brighter day but we don't expect that to happen. So we're seeing that trend continue. And we're kind of modeling that which is one of the reasons you see kind of that organic number showing up like it is in our '22 outlook which is first half kind of looking like the second half of '21. And second half looking better as we start to lap the easier comps and hopefully get more growers back into the industry and back into the business.

Second question I wanted to ask, just in terms of kind of the margin, because I believe you outlined the margin profile of 14.5% to 15.5% when you were kind of looking at pro forma 2021. And it looks like it's in that range. So your initial guidance is about 300 basis points kind of degradation. You have 400. I mean when do you think get back to that mid-teens level? Is it pricing catching up? Is it just going to be a function of volume absorption given the estimates, probably like '23 we're getting back there. Just any clarity in getting back to that kind of margin profile that you got to on a pro forma basis last year.

Yes. I'll start and John can certainly build on it. And yes, that's certainly a challenge in the '22 outlook, right? I mean we're taking a lot of costs as many industries and many contemporaries of ours are on freight, on inputs, on labor, on a number of different warehousing, all the things that you know are out there. And so that really has eroded that margin. We have put in place the most aggressive pricing that we've taken on a broad basis, both reflecting through input cost increases. We've also started passing through freight impacts. We've raised our minimums. We changed that we put on for freight surcharges. Most of that is going to start coming into effect in March and April. And so that's new for us and the first time we're pushing that kind of cost return through. I think this will all shake out and normalize late this year but I don't think we're going to see the 13%, 14% kind of numbers until '23. And that's frustrating because that was a good performance by the business, kind of the first half of 2021. And these costs have frankly hit us hard and they hit us at a time when we were integrating, adding people, building SG&A, building capability, doing things you have to do as a public company, all that stuff. So it really hit us at a time then the volume dropped in the back half and it really caused us to have to absorb an awful lot of cost and pass through as many as we could. And we're now getting more fully caught up on that as we're getting through this first quarter of 2022.

Thanks. I'll pass it on.

Thanks, Andrew.

Our next question is from Chris Carey with Wells Fargo. Please proceed with your question.

Hi, everyone.

Hey, Chris.

Hi. So I want to just better understand some of the confidence around back half recovery. I hear you on the comps. It certainly sounds like year-to-date, the markets are still under pressure, specifically on the West Coast. And so as you get into the back half of the year, can you maybe just dimensionalize how big of an impact you're expecting from new states coming online, East Coast or otherwise, to get to the back half acceleration? Also, you mentioned some pretty significant pricing coming in, in March and April. How much are you pricing? I think it was 2.8% or 2.9% in this quarter. And so how is that going to be factoring into the back half? And then just perhaps on the M&A, you noted that the IGE had some pretty good backlog. And so maybe can you just comment on upside from the M&A call and maybe that shielding some of the unknowns on organic sales growth? So thanks for kind of dimensionalizing the sales outlook specifically in the back half.

Yes, I'll start and then John should give you some more on the pricing. But the four building blocks that we can see and we don't have perfect visibility into the role of Virginia versus Louisiana versus Missouri, right? That's not where we -- we're not able to do to that level of precision. But commercial momentum and that comes in commitments that we have, backlog that we've got, people that are moving business over to us, our DMI proposition which is really the scheduled deliveries. We schedule those out months and months and months in advance. So we know that's all coming. It's essentially like a backlog, if you will. So we know that commercial business is still going to continue for us. And it's a newer business for us. So we're on a different point on the curve than others might be. So we can see a good bit of the growth. And if you pulled apart our growth, you'd see that more of it is in the commercial side than in the retail side this year. Second is these peat bogs. Peat is a wonderful business, both as a stand-alone, as an ingredient in a professional mix and also as an ingredient to go, not only into cannabis and indoor and outdoor but into other market segments of agriculture. And we've got 70% more acres this year. And while you're not going to get full farming capability out of those acres in the first year, you're going to get some. And so peat gives us, again, sort of another visibility into some nice growth numbers. The new states, again, we see that coming. We know those are there. We're getting -- John quoted a handful that we had over 100% growth in. That's not going to stop. Once that gets going, that keeps building. And then IGE backlog, that is a significant -- we expect to see 30%, 40%, 50% growth out of IGE in '22 versus their full year '21. And we know that because you can see it in the backlog. They have 50% deposits down for a lot of that. They have longer lead time sales cycles. They have three, four, five months lead times we have to give to these guys. You can see that volume a little more clearly than you can kind of the retail volume that we've been sort of living on the last few years. So those are the four building blocks that give us the confidence and probably give us perhaps a little more optimism than you're hearing from other industry factors right now because we see those things happening for Hydrofarm. And others will obviously speak for themselves and that's fine. John, you want to cover and talk about the pricing dynamic?

Sure. Yes, I'll touch on that. And Chris, just before I do, because I know you asked about it. I mean, as Bill talked about the IGE business that we recently acquired, while we get a good early look from the backlog in that business, the other thing we're seeing is that in a lot of cases, the new business we're winning with IGE tends to be in the eastern half of the U.S. So just another interesting element for us as we look to the back half of next year. On the pricing side, Bill is exactly right. I mean we've taken more frequent pricing actions than we historically have. We've tended to take maybe one action per quarter, historically, over the last several quarters. And generally, when we do that, we're not doing that on every SKU. Of course, we're really the only doing on the SKUs where we're seeing the additional pricing action as being necessary. But in our Q1 here, we actually took two separate actions inside of Q1. And we've got another action that we're looking at into Q2. The other thing I would tell you about pricing is historically, when we've taken pricing, we've really kind of focused on the input cost side and really put pricing in place to cover the incremental input costs we saw coming really in an effort to maintain margin. With the recent increase in freight costs and labor costs that we've seen, we're taking a little bit broader view on pricing now. And in addition to product pricing, we're actually looking at some freight initiatives, include freight surcharges and raising freight minimums, all things that we think help in a material way. Historically, for us, over the past several quarters, pricing has been a low single-digit kind of effect, obviously, on a pretty good base but a low single-digit kind of effect. As we look across the full 2022 year, we're looking more towards a mid-single digit to even a little bit better than mid-single-digit pricing for the full year effect. And again, that's an attempt to help mitigate these incremental costs we're seeing.

If I could squeeze in one just because it's related. Do you have any view on your product mix for this year? How important will all consumables for durables be specifically if you're going east and clearly, there will be some durables business there. But obviously, that's recovering a little bit slower in your base markets.

IGE and commercial new markets will be a little more durable oriented probably. I don't know that it will move the total because the total is kind of have a lot of momentum behind on a large scale, the law of large numbers saying. But yes, there will be a little more durables from those two growth drivers for a good bit of the year.

Okay, thank you.

Thanks, Chris.

Our next question comes from Bill Chappell with Truist. Please proceed with your question.

Hey, good afternoon, guys. This is Stephen Lengel on for Bill Chappell.

Hey, Stephen.

How are you guys? Just a quick question on kind of what you guys are seeing in terms of the impact from SMG's recent acquisition of Luxx Lighting on the California lighting business in that region thus far?

Yes. Luxx has had a long history in California as has Gavita and Hawthorne. So they have a deep penetration there. I think that is one of the weaker areas in the industry right now, kind of that West Coast lighting, a lot of that happened in Q4 of 2020 and Q1 of '21. So I think on a year-on-year basis, that area is probably not lapping as well. We don't have as much exposure in that market, meaning we don't have as much business in that market as they do. So it hasn't been a big impact yet for sure. We have a lot of respect for Luxx and a lot of respect for Hawthorne and Scotts. But right now, we're pretty pleased with our portfolio. We have some ideas on how to compete more effectively in lighting and we think that's going to hopefully come through here pretty soon.

Awesome. Thank you very much, guys. I appreciate it.

Sure. Thanks.

Our next question comes from Peter Grom with UBS. Please proceed with your question.

Hey, good afternoon guys. So I guess just around the organic sales outlook for modest growth. I mean -- I guess, can you maybe help us define or quantify what you mean by that? It seems to be flattish, I guess, based on the comment that M&A growth of at least 20%. So just could you maybe quantify that a bit? And I guess what I'm just really trying to understand is like what really changed versus early January? I know the category hasn't been great but it doesn't really sound like Q1 is all that much worse versus Q4. So I just would love to kind of get your sense around what's really changed versus seven weeks back.

Yes. Yes. So just to clarify on modest, I think we're thinking low single-digit growth as being modest. And I think that Bill kind of said this earlier, I mean, look, we've gotten off to a start here in the first quarter that is in line with our guidance. But we're -- the industry is certainly not yet on a tear. We've seen some of our competitors and other players in the space struggle a little bit with growth as well. So I think those things sort of err to the side of caution from our perspective. And I think, Peter, you know well this, the industry can be very dynamic and move quickly. This past year is a great example. We do think we could see the flip opposite of that this year but we're certainly not quite there yet, right? So for those reasons, we remain fairly cautious here.

Got it. I mean, I guess, that kind of leads into my next question which is kind of the confidence and the outlook as we stand today. So it sounds like -- maybe I'm wrong but it sounds like the cautious outlook is just simply being conservative -- some conservatism given what we've seen of late. Is that fair? Or is it just or more realistic or prudent based on where things stand today?

Yes. I think it's realistic, prudent and cautious, right, altogether. And let's not forget, everybody overlooks it. But 71% 2-year stack, we're lapping some monsters here. And we really -- that's not to be overlooked as we're coming off the COVID bump from a year, 1.5 years ago; so that's important. And so we are being conservative and cautious because until it turns, it hasn't turned and we don't want to get out ahead of ourselves. We don't want to put a number out there that we can't see our way towards and so we decided to put out there sort of a range that we thought was very much down the middle of the fairway. We've got the momentum drivers I talked about with commercial impedance, new states and IGE but retail specialty is probably going to struggle a bit and that's been a big part of our core but Luxx already have new things in offsetting mitigating. The other thing, Peter, that I'm sure you're tracking, likely all are, is the headset data is starting to show some pricing moving up in some key states -- that's a big deal. And that will bring people back into this category faster than anything. It's not a demand issue. It's simply a grower's willingness and interest to be in the category at various price points. So I think the headset data is showing modest tick ups in pricing. That's going to be good for everybody. And so those are the things we're watching but we really haven't seen the turn yet that we would want to, to get more bullish on the core organic number.

Thanks so much. I'll pass it on.

Thanks, Peter.

Our next question comes from Andrea Teixeira with JPMorgan. Please proceed with your question.

Thank you. Good afternoon. So I wanted to just go back to the kind of the price commentary you just gave to Peter. Perhaps, can you update also what are the inventory levels you've been seeing? So that -- is that something you're concerned at your customer level that may instruct you to become -- to be conservative on this organic growth? And a question to John. I mean, you mentioned that there was an increase in SG&A, I mean, obviously, because of the distribution centers you added, I think, like 70% more capacity. And also on salaries, despite what you've taken down 11%, I think, in your employee base so far because of the synergy. So can you try to bridge that gap, I believe, the 300 to 400 basis points that your IPO margin, if you're not suffering from your cost pressure? So if you can provide us with the cost pressure bridge that could potentially -- you could potentially lap in -- not in 2022 but perhaps in 2023? And then lastly, just a housekeeping. You mentioned commercial tripled from last year. But how much are you embedding it to be this year just as a fine point there?

Yes. I can start off, Bill, with the SG&A piece and then maybe you can backfill with some of the other points. But on SG&A on a year-over-year basis in the quarter was up significantly as we called out in the press release. When we think of SG&A, we tend to point to adjusted SG&A to take out some of the other factors that are not encapsulated in our adjusted EBITDA calc. So when we look at the adjusted SG&A, we're looking at roughly $18.5 million versus $11.2 million last year. The biggest really sort of element of that bridge which goes across these various buckets that we talked about in the earnings release, marketing expenses, salaries and benefits is the fact that in the fourth quarter of this year, we owned five businesses that we didn't own in the fourth quarter last year, right? And so the acquisition companies do come with some SG&A. And when we pull those in, we're seeing some increase. On top of that, our marketing spend in Q4 was definitely a little bit more than it was this time last year. We went to the MJBiz conference and actually spent it for a bit of a coming out party at that conference this year. Hadn't done it the year before. We've got a full quarter of D&O insurance which we didn't have last year. The facility costs which we talked about. And really, professional fees for us were a little bit more in this quarter on a year-over-year basis as we tried to knock out and did knockouts for the full first year of SOX and other things that came with getting five acquisition codes embedded in our first 10-K as an accelerated filer which by the way, should be out and issued here later this evening. So those are the elements in the bridge. We did -- as Bill referenced in his prepared comments, we did do some reductions in force that will help to mitigate some of these cost challenges. But with the five -- with the full year of five businesses that we didn't own before, I don't think we're going to see our SG&A costs go down from a dollar perspective. But as we start to see our top line pick back up, I think we can recoup some of that compression that we felt here in Q4 and as we've kind of signaled that we're looking towards in Q1.

Yes, I'll pick that up. On the couple of things you asked there, Andrea. On inventory, as we talk to our customers, most of the retailers will tell us that they're pretty backed up on light. They've got a lot of inventory on lighting. And so that's an area where we're seeing retailers slow down a bit. I think the whole category, as I mentioned, based on the California remarks has slowed down a good bit there and you've seen that in other folks' results as well. But beyond that, I think it's just normalized less demand. I don't think it's really a backup in inventory. On the commercial side, yes, we tripled the volume '20 to '21 and we've got strong double-digit growth, much more than 10%. I think it's a good bit more than 20% in there. It's not doubling or 80% up or anything like that. It's considered in the low 20s kind of percent growth on the commercial side for this year, plus we got growth built into IGE which is closely tied to commercial but we don't look at it quite the same way. So those are the kind of numbers we're expecting in those segments of the business for 2022.

And that commercial would be how much in total for the total company, commercial representing a smaller percentage? But just want to find on that one.

On commercial and IGE, it's going to be in the kind of 20 -- mid-20s percentage of the company.

Of the totals. Okay. Sorry, I thought we were saying about growth. Okay. Perfect.

Now I just gave you a percentage of sales versus the growth numbers that happen to be very similar numbers but a different number.

Okay, wonderful . Thank you. I'll pass it on.

Our next question is from Nicole DeBlase with Deutsche Bank. Please proceed with your question.

Yes, thanks. Good afternoon, guys.

Hi, Nicole.

Maybe we could just focus on pricing -- one more question on that. How is the competitive pricing dynamic looking? Like are you seeing your competitors take similar actions to what you're doing? And I guess, how sticky is pricing in this industry? So if we do move into an environment where costs start to come down, will you then be in a position where you're going to be reducing price? Or do you think you can kind of keep the price that you've taken so far?

Yes, we have had mostly kind of straight up inflation here for a couple of years. So we haven't gotten into that sort of how much do you have to give back issue yet; so we don't know yet. Pricing has been very sticky and the category has been very rational as people have passed on cost increases and dealt with supply chain delays. And so it's also an incredibly complicated business. We sell 6,000 SKUs, so to track pricing and percentage changes in all those SKUs, all the time from 400 suppliers around the world. It definitely gets through and gets through pretty cleanly. And retailers are happy to take price. People are willing to cost up as they have to. We're trying to make sure we reflect through the things that are affecting our P&L. And we're not trying to expand gross margin. We're simply trying to expand the -- or pass through the pricing that we're seeing affect us.

Okay, got it. And just as a follow-up, it was helpful that you guys kind of provided quarterly cadence of organic growth that's built into the outlook. What about anything that we should know about the quarterly cadence of adjusted EBITDA margins? Is that also similar to organic growth starting off at the low point of the year and then improving sequentially from there?

I can chime in on that. Yes. No. For sure, you picked up on the call out that we expect Q1 margin to be something similar to what we witnessed in Q4 2021. So that should be our low point from a margin standpoint across the quarters and the year. The other thing, I guess, I would say is that typically, we tend to see Q2 and Q3 somewhat seasonally have slightly higher margin profile than Q1 and Q4 . That has a little bit to do with sort of the top line and economies of scale as well as mix of products during those periods. And I think we would expect that to hold true to here in 2022 based on what we're seeing now.

Thanks. I'll pass it on.

Thank you.

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back over to Mr. Toler for closing remarks.

Great. Thank you very much, Maria. We appreciate your interest in Hydrofarm this afternoon. And thanks for joining us on the call. Everyone, have a great day. Take care.

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