Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Holdings Group fourth 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, February 29, 2024. I would now like to turn the call over to Anna Heller of ICR to begin. Please go ahead.

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 fourth quarter and full year 2023 earnings release and Form 8-K issued this morning. 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 a more detailed discussion of the risks that could impact our future operating results and financial condition. Lastly, during today's call, we'll 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 again, and good morning, everyone. We achieved positive adjusted EBITDA and positive free cash flow for the full year 2023 as we had provided in our outlook, even at lower sales levels. Throughout 2023, our team worked very hard to execute our restructuring and related cost savings initiatives, which allowed us to achieve the improvement in several profitability metrics that we are reporting today, including adjusted gross profit, adjusted gross profit margin in '23 for both the fourth quarter and the full year. Our initiatives included streamlining our product portfolio to enable greater emphasis on our higher-margin proprietary brands, continued focus on inventory reduction overall working capital management, better space utilization in our distribution centers, and cost reductions in our transportation and logistics. Our cash balance, overall liquidity, and ability to generate positive free cash flow, as we have demonstrated in the last two fiscal years, gives me confidence about where we are from a balance sheet perspective. On the top line, our 2023 sales fell short of our guidance range due to several key factors. Fourth quarter sales were lower primarily due to industry softness in the US specialty retail channel. You may hear from others in the industry that retail stores and cultivation facilities have been closing as the US cannabis industry remains bogged down in regulatory challenges. These issues have led to an overall reduction in demand from retail stores and cultivation facilities. For example, regulators are enacting stronger enforcement in Oklahoma and many facilities and stores are closing down as a result. We believe these changes will ultimately be good for the long-term health of our industry as the stronger players will consolidate and create a more stable market environment. There are a number of bright spots in 2023 that we will carry into…

Thanks, Phil, and good morning, everyone. Net sales for the fourth quarter were $47.2 million, down 23.2% year over year, driven primarily by an 18.7% decrease in sales volume and a 4.5% price mix decline. While we anticipated softer sales volumes in Q4 with a standard cadence for the business, the softness was larger than we had expected. Our price mix decline in the quarter was primarily driven by promotional activity in our durable products as well as a higher mix of lower priced consumer products relative to our higher price durables. Our sales mix continues to evolve, and for the full year, consumable products represented approximately 74% of our sales compared to 65% in 2022. Our proprietary brands continued to mix higher on a year-over-year basis and approached 60% of our total net sales in the fourth quarter, our highest ever quarterly level since our IPO. Some of this mix shift was a reflection of the encouraging demand for our proprietary nutrient brands. Accompanying our favorable brand mix for the quarter was continued sales diversification. As Bill noted, our international and non-cannabis sales increased from a sales mix perspective in Q4 '23 and for the full year, and now represent approximately a quarter of our total sales. In 2024, we will look to further capitalize on what is working today, focusing on improving our mix of proprietary brands, most notably our proprietary nutrients, as well as driving further momentum in our international and non-cannabis sales. Gross profit in the fourth quarter was $8.4 million compared to a gross loss of $0.5 million in the year ago period. Adjusted gross profit was $11.5 million or 24.3% of net sales compared to $9 million or 14.7% of net sales in the year ago period. This represents a significant adjusted gross profit…

[Operator Instructions]. Our first question is from Andrew Carter with Stifel.

The first thing I want to ask is, so your guidance here implies a low-teens to high teens decline, therefore kind of $27 million to $39 million of lost revenue. But you have flat EBITDA. Could you kind of take us through -- I know that there is productivity in there at the gross margin line as well as the SG&A. Can you take us through how much is productivity/savings versus just improvements in the underlying gross margin from favorable supply chain cost assuming that we'll be hitting on lag as well as you mentioned the mix up of proprietary brands.

Thanks, Andrew.

Yeah, good morning, Andrew. I can jump in on that. A couple of things that will be driving it. I mean, you heard us mention an improvement in adjusted gross profit margin for the full year 2024 versus '23. Obviously, we ended last year roughly at 24% adjusted gross profit margins. We expect that our improved sales mix, so higher proprietary brands, we have a couple of hundred basis point opportunity to improve that in '24 versus '23. And I think, as you know, our proprietary nutrients are really inside of that number of proprietary brands more broadly and really represent one of the more profitable pieces of our overall business. We also think we have a couple of hundred basis point margin opportunity to improve in terms of percentage of sales from proprietary nutrients. On top of that, with the restructuring that we've been instituting and other related productivity and cost-saving initiatives, we do think that we'll reduce some space to reduce overhead costs and our labor pool in our manufacturing durable facility located in Chicago. We've already instituted some of that and have a little bit more work to do there. But overall, that's gone pretty well and we've reduced basically a third of our space there. We also have an opportunity to further consolidate our manufacturing facilities with respect to some of our consumable operations. And while we haven't yet quite accomplished that, that's on the bill for '24 and should extract savings similar in terms of reducing overhead costs and improving productivity in our main nutrient manufacturing facility. We also, as I think you see that through our results in 2023 we captured some freight savings last year, really in the back half of '23, we will get some lap benefit in the first half of '24 as we continue to achieve lower LTL and local freight rates that will be a favorable comparison in the first half of the year. On top of that, at the SG&A level, we still have very many benefits that are coming our way in 2024. We have expected last benefit from a savings that we achieved last year in terms of headcount reductions. We reduced headcount by almost 25% during 2023. So in the first half of 2024, we should see some benefit from that. We also expect in '24 we'll have lower professional fees, distribution facility costs related to our subleasing activities. We've been subleasing a lot of our excess distribution warehouse space. And then on top of that, we have some insurance expense savings. So I think you're gathering and there's a lot of savings opportunity, much of which we've already instituted, some of which is still on the come, which we think gives us margin opportunity at the gross profit level as well as more savings at the SG&A level.

That's helpful. I guess the second question is, and I think we just got a press release that GrowGen picked up the Quest business. They are, obviously, is the largest manufacturers less distributor out there. is focusing more on signature. And a lot of like some of the kind of third-party distributed brands out there kind of in play are some of those that we're going to direct to retail are now looking for a different solution has become economical. What is the landscape like out there in terms of the opportunities for third-party? Or should we just think about this more as just focusing on really driving proprietary?

Yeah. I think that clearly the proprietary part of it -- and Andrew, it's a good question, has been the big winner for us, right? What's happened in the distributed side of things is as the primary hydroponic distributors, primarily us and Hawthorne over the last few years weren't delivering the volumes. These third-party brands went to other lawn and garden suppliers, direct to retail, other number of things. And so they've kind of diluted themselves across the market with a number of supply points. So what we have done conversely is make sure that we continue to supply those because it makes us the industry distributor we are, but also really focus on our proprietary signature house brands, whatever -- however you call them. And in doing that, you're seeing us being able to uphold slightly positive EBITDA for last year because of the mix benefit of driving the profitable house brands. In my script, and I think in John's as well, we said that our proprietary nutrient brands actually grew year on year, but that's a very different story than what our total company did. And weakness, frankly, has been in this -- mostly in these distributor brands as they have dedicated themselves across a number of supply points across the industry. And we're talking to all those guys as well to figure out the right partners to have and we'll go forward with a good mix of distributed brands. But really, it's -- proprietary is kind of driving the bus.

Our next question is from Peter Grom with UBS.

So I just wanted to ask -- I wanted to ask on visibility. You kind of take a step back and you kind of look at the implied revenue guidance for this year, and I was just kind of going back to the model and it's even below 2018 levels. And I know the business has cyclicality, but it just feels like this downward pressures has been far more pronounced than we all would have anticipated. So when we think about the guidance for this year, low teens to high teens decline, what's your degree of confidence in that and what are kind of the underlying drivers of that? Just trying to understand when do you think we will reach a bottom here, just given kind of the performance we've seen over the last several years?

Yeah, I think we have reached the bottom. The question is when are we coming off of it, right? And so we really felt like it was important for us to plan the year at being slightly profitable at the lowest sales level we've given out, right? That's kind of our responsibility to come to you with that and then go out and try and beat those numbers, right? That's the goal here is to say, all right, let's say, it's in the high teens, which I think hopefully is the worst, worst-case scenario, then we need to be ready to be profitable at that level. And then let's get better than that and then we should have really nice business and a really good outcome. But I do think we are at a bottom. I think we've been at a bottom, frankly, for the last four or five months as an industry. And I think you're starting to see some things get a little bit better. Our visibility into kind of March, April, May with the pre-bookings around a lot of the look a good bit better than it did a year ago. But we've got this dilution among the distributor brands that has created this sort of drag and an anchor on us that's creating the total number not being where we'd like it to be. But we also really think it's important that we put a number out there, set up our cost structures, and our strategies around hitting -- making money at the lowest possible level that we're talking about and then going out there and trying to beat those numbers. And that's really what our goal is and how we structured this year's guidance.

No, that's very helpful. But I guess maybe a question following up on that. Just the positive adjusted EBITDA kind of following up on Andrew's question, I guess, obviously positive is anything above zero. So can you maybe provide some guardrails in terms of how we should think about our model to reach that kind of similar EBITDA profit dollars versus what we saw this year? Should we expect sequential improvement? Just trying to understand because, you know, both we and consensus have something that's more in the high single digit million dollar range, and I'm not sure if that's far too optimistic at this point given the weaker revenue outlook?

Yes, I think it is optimistic at this point because you got your head -- higher fourth quarter and a higher '24 building off that that created that consensus. And at this point, we said modestly positive last year and it was very modest, more modest than we'd like it to be. We're saying positive this year. Yeah, I think we'd like to do better than we did certainly in 2023, but we're not nearly in a position yet to start putting any kind of guardrails around how much that will be, how many millions of dollars or where. But a lot of it depends on what range we come in on the top line. In fact, all of it depends on that range because we've got our costs very much under control, but we're not ready to kind of put any finer point on that, but we expect to be and want to be and are going to work to be positive EBITDA this year.

Our next question is from Bill Chappell with Truist Securities.

Good morning. This is Davis Holcombe on for Bill Chappell. And you all had mentioned the seven new legalized adult-use states in 2023 and we're just kind of wondering what sort of demand you might be seeing out of those newly legalized states and what kind of maybe regulatory environments they may have compared to some of the existing states that you all are operating in?

Yeah. I think the newer states, whether it's the Ohio's or Missouri's, they are some of our better performing states right now. The challenges, first of all, scale wise, they're very small compared to your Colorado's or California's or Oregon and Michigan. So it takes a while to do and there's a lag between legalization and implementation. And then, of course, there's kind of the political dynamics that have slowed implementation even in places like in New York and New Jersey, but they've actually been finally picking up. It's just a matter of scale, but you've got these long legacy states that are a lot bigger than the new ones, but you're definitely seeing that shift now. California used to be by itself 50%, 60% of the total business. Now it's probably in the low 30s or less. I think that's true for everybody in the industry as it shifted the overall business to the newer states into a more balanced thing. And you also got that unique dynamic in Oklahoma where Oklahoma at one point had nearly -- just under 20,000 licenses in the US, Oklahoma had half of them at one point. But fortunately, Oklahoma's regulatory folks have gotten a little more strict and they're cutting that down. License are cut in half from what they were in Oklahoma, which is encouraging because you need a good balance of production and consumption. The newer states are seeming to learn from the mistakes of others, and they're doing a much better job of regulating the number of dispensaries tied to the number grows, tied to the actual population and ultimate demand. So people are learning, but it's just been very, very slow and a lot more interruptions than it should be. And the lack of federal guidance and federal sanity, if you will, in this has really kind of cast a huge shadow over the whole category for the last three, four years.

Our next question is from Jesse Redmond with Water Tower Research.

Good morning, guys. I had a question on the catalyst side, we're looking at the multistate operators and just the plant-touching businesses, certainly the potential for , the E removal is the biggest thing on the horizon. Can you talk a little bit about how Schedule III could be helpful to you, although you weren't a plant-touching operator? Do you see that freeing up budgets and potentially increasing CapEx? Or do you see that as not being a meaningful catalyst for your business?

No. We think that can be a very important catalyst in terms of particularly durable orders, but also just a confidence and a sentiment around the whole category that it's now time to lean in and invest again. I think you've got [Technical Difficulty] thing on the sideline. You've got MSOs staying on the sidelines, people holding capital back, interest rates have obviously been harder. So that's -- you can get that it's hard to put on these businesses. And so everybody is in a holding pattern as you're waiting for this big move from Schedule I to Schedule III. As you indicated, the biggest benefit there, of course, is that plant-touching legalize businesses don't have tax burden they currently have today. And once that frees up for them and they can retain a lot of those -- that cash flow for themselves, they'll be able to lean back in to the category. So we definitely see that as a benefit to us. Certainly, it'll take a little time from when it turns to when people are actually placing orders, but we've seen a number of projects that have been delayed, delayed, delayed over the last year or two that are kind of ramping up and starting. So we're hopeful that this catalyst is going to happen and/or people are going to get back in as supply and demand has become more imbalanced as I referenced a moment ago regarding Oklahoma. So all that steps speaks to, yeah, the rescheduling, the scheduling would be -- benefit to the whole industry. And it also would, I think, give people a lot of confidence that now we're going to get back to a more normalized category trajectory and normalized growth pattern.

That's helpful. Thanks. And on the state side, the two biggest markets that could flip rush this year are Florida and Pennsylvania. Can you talk a little bit about those states and if they were to move to adult use sales, how you would see federal spending increasing there?

Yes, both are incredible opportunities. Florida is one that has been kind of on the docket for a while. And then in terms of people's expectations, it looks like it is -- the governor has said it's going to be on the ballot here in November, which is fantastic. Pennsylvania, I think, is in a similar situation. Both of those population of over 20 million in Florida and around 10 million in Pennsylvania, you can see that these are very, very important catalysts for us, would drive their population number up probably closer to 60% or greater percent of category. So we do expect that to be a big part of the growth going forward.

And Jesse, both of those states have been comping better for us than the overall population has.

Our next question is from Harold Weber with Aegis Capital Corp.

Good morning, guys. How are you doing? One of my questions is in regard to the previous issues in regards to inventories, how's that, the win? Is there any more benefit to see out of that? Is that imbalance presently? Are you satisfied with that?

Yeah, I'll start there. There's really two sides of the inventory thing, both are trending in the right direction. We've reduced our total inventory in a two year period by close to $100 million. Some of that was inventory write-down, but the vast majority of that was simply getting inventories down to manageable and workable levels. And so we still think we have another bit to go. We'd like to be able to run this industry or this company on 90 days worth of inventory right now or at a higher number than that. And we think we've got probably $15 million, $20 million more we could take out of the total. So it's a terrific thing. The other piece of inventory improvement from '23 compared to '22 is we had far, far, far less write-downs in '23 compared to what we had in '22 as we are -- again, we're dealing with the supply chain whipsaw from even back to COVID days and the industry high volume days back in '20 and '21. So the inventory had gotten exaggerated in everybody's balance sheets. So we worked all that down. So we didn't have those sort of write-down issues in '23. Don't expect them again in '24, which is great. Although you still have to manage it every quarter and every month and we do very, very aggressively to try and protect our balance sheet, protect our inventory investments.

Maybe just -- math to --

Yeah. I'm sorry, go ahead.

Yes. Just to add some math to what -- to Bill's comment there a second ago, you heard him say we'd love to manage the business on basically 90 days or one quarter's worth of demand. We ended this past year 2023 with roughly $75 million worth of inventory. And over the last four quarters, we've been averaging about $56 million in sales. So clearly, you there's real opportunity for us there and that's why you hear us talking about sort of an ability to manage that further down into 2024.

Okay. And regards to your -- little bit of the cost cuts you've made and so forth, hopefully, we're going to see a turn up. Business improved 20% and you're going to be able to fulfil that without having to add back a bunch of those whatever course what you are going to, call it, layoffs, capacity, rightsizing whenever you like. I was thinking that based on where you are, you should be able to increase the business by -- what do you think before having this ad spending back again?

Well, you have some variable costs, obviously, with staffing in the DCs. But importantly, as we have come down in top line, we did not dramatically alter footprint. Still have six DCs in the US. We have two in Canada, and we have one over in Europe, and that was the footprint we had three years ago. What we've done instead is we've been subletting basic vacant space and underutilized space to allow us to provide them a service to others, if you will. And so we're able to handle the volumes that we had back in '21, '22 or '20 and '21 very, very easily. We would have some costs on the way back up as you of course have more people touching more volume. But structurally, we've got our cost structure really screwed down now to where we can make money at these low levels, but also can scale up very quickly and be able to support our customers.

So that would mean to me though that that's going to happen that our margins should expand quite a bit based on a increase in overall revenue so the -- spread the cost more, is that reasonable expectation?

Absolutely. Let's not forget that three years ago, we were roughly a 10% EBITDA business when things were growing and better. And we think that with our mix change toward the more profitable, powerful brands that are ours, that could be a very achievable number over time. We're probably not going to get there anytime in the next 6 to 12 months, but I think as industry growth returns and we're able to drive our profitable proprietary brands that we certainly have a really good position going forward.

As there are no further questions, I would now hand the conference over to Bill Toler for his closing comments. Bill?

Thank you, Ryan, and we appreciate all of you being on the call this morning and thanks for your continued support of Hydrofarm. We look forward to speaking to you soon. Take care.

Thank you. The conference of Hydrofarm Holdings Group has now concluded. Thank you for your participation. You may now disconnect your lines.