Participants

Anna Heller; IR; ICR Inc.

William Toler; Chairman of the Board, Chief Executive Officer; Hydrofarm Holdings Group Inc

B. John Lindeman; Chief Financial Officer; Hydrofarm Holdings Group Inc

Peter Grom; Analyst; UBS Group AG

Andrew Carter; Analyst; Stifel Financial Corp

Jesse Redmond; Analyst; Water Tower Research LLC

Presentation

Operator

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Hydrofarm Holdings Group First Quarter 2024 earnings conference call. (Operator Instructions) Please note that this conference is being recorded today, May 14, 2024. I would now like to turn the call over to Anna Kate Heller of ICR. Please go ahead.

Anna Heller

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 first quarter 2024 earnings release and Form 8-K issued this morning as well as an investor presentation available for reference. These documents are available on the Investors section of hydrocarbons website at www.hydrofarm.com.
Before we begin our formal remarks, please note that our discussion today will include forward-looking statements and 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.

William Toler

Thank you, Anna Kate, and good morning, everyone. I am pleased to report that in our first quarter, we delivered better results in many key profitability metrics, including adjusted gross profit margin, adjusted EBITDA adjusted EBITDA margin and free cash flow. In addition, March 2024 marked the fifth consecutive month of sequential net sales growth for Hydrofarm. That's the longest string of sequential monthly growth we have seen since our IPO in 2020.
Second, we have now increased our adjusted gross profit margin on a year-over-year basis across the last five consecutive quarters. And we've achieved adjusted positive adjusted EBITDA in three of the past four quarters, demonstrating our ability to continue to operate profitably during the industry downturn. While we are far from satisfied with the $2.7 million of positive adjusted EBITDA that we have reported over the last 12 months it is clear that our cost savings and restructuring actions are making a difference and when sales begin to increase, this volume will make an even larger impact on our bottom line.
Our biggest opportunity is to continue to find new and unique ways to drive profitable growth. To accomplish that, we are innovating and expanding our brands to address growers' needs. For example, at the end of Q1, we launched a new and improved photo bio-LED light design, specifically for commercial growing applications that offers 10% more light output, 47% less weight in the fixture and increased efficacy, all at a 20% lower price than comparable models.
While we are still in the early innings of this product innovation, we did see year-on-year growth on the photo bio brand in Q1. Second, we continued to diversify our revenue stream by driving sales in our non-cannabis markets and broadening our geographic reach. In Q1, our non-cannabis and non-North American revenue sources increased to an estimated 32% of sales, representing approximately a 360 basis points increase from the prior year.
In addition to our diversification strategies, the regulatory environment is finally getting better for U.S. cannabis growers. It's improved and will help drive US sales drive sales in the industry in the future. Recently, we all read that the rig will propose the reclassification of marijuana from a Schedule one to a Schedule three drug, a significant step in the process to legalize cannabis in the US.
Separately in April, we learned that the Florida Supreme Court will allow the state's voters to decide on the November ballot, whether legalize adult use marijuana or not in the state of Florida. These are good signs for our industry while the financial metrics we just reported are central to this earnings call. I want to share a broader view where I believe the beginning the beginning of a turn in the industry.
I mentioned the five consecutive months of sequential sales growth. That's encouraging, but we're also seeing recent stabilization in our core U.S. business. Some of this is driven by innovation, like the previously mentioned photodiode LED lights and some of it's simply that supply and demand are rebalancing across the country.
Proprietary brands, including grow check Group's organic guy, Agri and photo bio grew Q 1 compared to the prior year, coupled with slight improvement in demand with our tight control on costs, including our adjusted SG&A being 24% lower in Q1 this year versus last and we are well positioned for continued improvement in profitability as volume returns.
We are reaffirming our full year guidance for net sales, adjusted EBITDA and free cash flow as we remain focused on our brands, diversification of revenue and improved mix and controlling and reducing costs.
With that, I'll turn it over to John to further discuss the details of Q1 and our outlook for 2024. John?

B. John Lindeman

Thanks, Bill, and good morning, everyone. Net sales for the first quarter were $54.2 million, down 12.9% year over year, driven primarily by a 12.6% decrease in volume mix. The decrease in volume mix was mainly related to oversupply in the cannabis industry. Additionally, pricing was relatively flat in Q1 as we lapped the price concessions made in the first quarter of 2023.
In the first quarter, consumable products represented approximately 76% of our sales compared to 72% in the first quarter of 2023. This higher mix of consumables was led by a year-over-year sales increase in grow media products, including our own proprietary reach, organics and Guy green brands. During the quarter, we maintained a strong mix of proprietary brands at approximately 57% of our total net sales, relatively consistent to the same period last year.
Gross profit in the first quarter was $10.9 million compared to $11.4 million in the year ago period. Adjusted gross profit was $12.7 million or 23.4% of net sales compared to $14.1 million or 22.6% of net sales. This 80 basis points increase is primarily the result of improved productivity inside our manufacturing plants. This marked our fifth consecutive quarter of year-over-year adjusted gross margin expansion from while we are pleased with our progress we do feel there's some opportunity to further improve upon this metric as we track across the remainder of 2024.
Now a quick update on our restructuring plan. As we previously mentioned, our second phase of restructuring was largely focused on rightsizing our manufacturing footprint, particularly with respect to durable equipment products. We announced today the signing of an agreement in which we are selling the manufacturing equipment and on-site inventory related to our IGE-branded products for approximately $8.7 million in cash.
As part of the transaction, we will no longer be responsible for carrying the heavy manufacturing, labor and overhead costs for the investment in costly steel aluminum necessary to build our high-quality IG products. Instead post transaction, our new exclusive co manufacture will produce our IG products, helping us to variabilize our cost structure and ultimately improve our profit margin profile on this product set.
We are excited about the prospects for both Hydroform and our new exclusive co manufacturer with whom we expect to enjoy a close relationship going forward. We expect the transaction to close in the second quarter.
Now let me move on to our selling, general and administrative expense, which we dramatically reduced from the prior year period. In the first quarter, our SG&A expense was $19.6 million compared to $24.4 million. Adjusted SG&A expenses were $12.3 million, nearly a 24% reduction when compared to $16.2 million in the first quarter of '23. This was primarily due to a reduction in facility expenses, professional fees, insurance costs and headcount. It is worth noting that much of this reduction is due to the cost we took out as part of our restructuring actions in the first half of 2023.
Adjusted EBITDA was $0.3 million in the first quarter compared to a loss of $2.1 million in the prior year period and the $2.4 million improvement and the 400 basis points expansion in adjusted EBITDA margin, it was driven by our improved adjusted gross profit margins and our reduced adjusted SG&A expenses.
We continue to demonstrate our ability to generate positive adjusted EBITDA, which is a testament to the effectiveness of our restructuring and cost-saving initiatives, along with our focus on proprietary brand sales mix.
Moving on to our balance sheet and overall liquidity position. Our cash balance as of March 31st, 2024 was $24.2 million. We ended the first quarter with $120.5 million of term debt and approximately $130 million of total debt, inclusive of finance lease liabilities. Our net debt at the end of the quarter was approximately $106 million. As a reminder, our term loan facility has no financial maintenance covenant and does not mature until October 2028.
We continue to maintain a zero balance on our revolving credit facility. And at this point we have not borrowed against our revolver for nine straight quarters. In the first quarter, reported cash used in operating activities of $2.3 million with capital expenditures of $1.4 million, yielding negative free cash flow of $3.7 million.
I will remind you that the first quarter is a seasonally low period for our free cash flow, and we achieved a significant nearly $7 million improvement from the prior year period, which we accomplished through positive adjusted EBITDA and disciplined reduction of inventories and working capital. We remain on track to deliver our positive free cash flow guidance for the full year.
With that, let me turn to our full year 2024 outlook. We are reaffirming our 2024 guidance, which includes net sales to decline low to high 10s on a percentage basis, adjusted EBITDA. That is positive for the full year 2024. And lastly, positive free cash flow for the full year, which includes the continued expectation of $4 million to $5 million of capital expenditures.
To wrap up, we remain on the right path and will continue to control what we can. We are operating profitably despite lower sales levels. Our restructuring plan and cost-saving initiatives have proven effective. And as Bill discussed before, there are reasons for optimism on the demand side of our industry.
As we look ahead, we are excited about the future of this business and look forward to continued improvement throughout the year. Thank you all for joining us, and we're now happy to answer your questions. Operator, please open the line.

Question and Answer Session

Operator

(Operator Instructions) Peter Grom, UBS.

Peter Grom

Thanks, operator. Good morning, everyone. Hope you're doing well. Maybe just some a couple of quick ones from me. Just first on the guidance from the revenue perspective, maybe first, Bill, can you maybe just remind us I might have misheard you, but you talked about some monthly improvements, some of the best you've seen since the IPO.
So maybe just can you just repeat that for us and then on taking a bigger picture and looking at kind of the reported numbers here, you've had some sequential improvement in sales trends over the last five quarters or so. You started the year kind of at the better end of your top-line guidance range. Can you maybe just help us understand what you're seeing from a top line progression and what you expect from a top line progression from here.
Is there a reason that it can potentially step back from kind of this low double digit decline we saw in Q4? Or should we expect sequential continued improvement? And I guess within that, are you simply just kind of keeping this range to kind of be cautious given we're still very early in the year?

William Toler

No. Thanks, Peter, and good question. So the first one for clarification. We've seen sequential improvements in revenue really from last October through March of each month had stepped up just a bit October through March. That's five consecutive months there. And that's the longest string of those since our IPO back in the end of 2020, which, of course, you remember some so on that.
Now the other question is around kind of guidance, and we've sort of are at the better end of the range. Now why not move it up there? And what can we expect to see, I think is where you're headed with that when the that we are we are being conservative here.
It is early in the year on we think things are looking pretty good. But we also had a very large quarter last Q2. So we were lapping up against some big numbers there. And we just don't want to get ahead of ourselves against such an important period here and really May, June, July going through that kind of the core of the of the outdoor season in late spring, early summer stuff. We just really don't want to get ahead of ourselves and train take-up numbers too quickly. We want to see that traction going on for a few more months.
Other things but we are encouraged by recent trends were not overly giddy or optimistic yet, but we do think that things are certainly firming up. As you probably heard for some others and we're seeing some overall sales trends that finished up Q1 and have even starting Q2 that are encouraging for us as we go forward. But much like you suggested, it is early in the year, and we don't want to get ahead of ourselves.

Peter Grom

Okay. That's helpful. And then I guess just on the asset sale announced this morning. Can you maybe just remind us how big IG is as part of your kind of revenue mix? And when you talk about kind of the margin improvement as a result of this transaction, is there anything you can kind of share in terms of the magnitude of improvement? I'm just trying to understand and get out of how much you can really move the needle here. Thanks.

B. John Lindeman

Yes, sure if you guys, I can jump in on that one. I mean, just in terms of magnitude today, as it sits, our IG products are less than 10% of our total sales somewhere closer to even almost a 5%. And then the intent. So the magnitude is not that dramatic, but we did this because we do think it's a step that can continue to improve the profit margin on those particular products.
As you'll recall, in the second half of last year, we did reduce and restructure that facility. The manufacturing facility outside Chicago. We took it down from like roughly 300,000 square feet to 200,000 square feet. We right-sized the staff and made some other improvements in the business but even in spite of those changes, we're still not getting at the kind of volumes we have today.
We're still not getting the profitability we think we should on that business so this step, the step really rectifies that the benefit should show through in the back half of this year.

Peter Grom

Great. Thanks so much and best of luck. I'll pass it on.

William Toler

Thanks, Peter.

Operator

Andrew Carter, Stifel.

Andrew Carter

Thank you. Good morning. I guess the first thing I wanted to ask is kind of within the sale of IG, I know that last quarter there was kind of a message either shrink to profitability or grow. I guess heavy picked a firm path as IGE. signal that exactly and has kind of the landscaping or you're thinking about the world changed following Hawthorne's announcement to partner with BFG?

William Toler

No, not really. I think IG is a step that, as John mentioned, kind of assures more better profitability from that smaller business positions us really more cleanly now as a manufacturer brands in the consumable space and really gets us out of that durable piece. IG was the only durable piece we had that's not an area where we spend a lot of time or have a lot of synergy on.
So we don't we didn't think being there was a good, good fit and also the previous owner who we sold the assets back to and it's important to recognize we didn't sell that business back to him. We still own the brand. We still have the business should have little or no effect on our revenue through IG and will improve our profit margin.
So back to your larger question, this does not sort of and cast our direction in terms of either getting smaller, getting bigger. This is really just kind of a tactical step to clean up the portfolio and make us more focused on the consumables where we're now doing 75% of our business in total or so.
We still are looking for options to expand our footprint and to get Canada, where I would call that, that Hydrofarm two data, which were not there yet. So ideas out there include different kinds of combinations, different kinds of ideas. So we're still working on that and know that that is an important step for us to be ready for the industry, which does feel like it's starting to strengthen a bit.

Andrew Carter

Got it. And then I guess a second question is the pricing looked pretty decent at least compared to what Hawthorne reported and then kind of GrowGen implied in terms of kind of the promotional activity out there. Would you say where would you say that is right now are you foregoing in the business?
And I guess when that and within that minus 12 six volume mix decline, was there any portion of that that was purposeful trading out more profitable volume versus lower? I know that there was proprietary outperform, but I'll just stop there.

B. John Lindeman

No, I don't think of the 12.6%. A lot of it was intentional. I mean, I think it's just sort of continue conditions that we see in the industry. The good news there is obviously those declines have been improving as we've been marching across the calendar year, the last 18 months. So So good news there.
And then the pricing being relatively flat, Andrew, which you called out really relates to price concessions. We made in the first quarter last year and a little bit in the second quarter last year as well on some of our older technology lighting products, which we were really pushing ourselves through during that period of time. So hopefully that all fits Florida.

Andrew Carter

Thanks. I'll pass it on.

William Toler

Thanks, Andrew.

Operator

Jesse Redman, Water Tower Research.

Jesse Redmond

Good morning, guys. Congratulations on the quarter. I had a question if you'd like improving macro. I had a question about the improving macro environment that you referenced, one of the big things going on as potentially finally seeing some political progress, although you're not explicitly impacted by two easy removal.
Can you talk about how Schedule three may benefit your business and do you expect to see the purse strings loosening that's imminent at some of the bigger MSOs as they start to get more cash flow?

William Toler

Yes, I think that there are numbers out there that say they're there could be up to couple of billion dollars that used to be paid in taxes that now can be reinvested back in the industry. And obviously, that's kind of good news for everybody, right? And we ultimately go out and fight for our share of that. So that's the impact that we expect, which is terrific.
But the reality is this is still a long process, right? It's still now been recommended and there's going to be hearings and there's going to be this is going to be that all this stuff is going to take time.
And I think that it's important and to recognize that we're focused on operating today and finding the right solution for our company today. And all those things will happen down the road, we believe, but we're not sitting around waiting for the government to solve our problems or the government to fix our business. We're making sure that we're operating profitably and figuring out the right long-term solution for Hydrofarm as these things get implemented over the next, let's call it 6, 12, 18, 24 months.

Jesse Redmond

And my second question is at the state level. We obviously have some good opportunities ahead of us with potentially Florida and maybe Pennsylvania, but this summer we have Ohio rolling out, which is happening more quickly and in a manner that looks like it should be a pretty a pretty good market for most operators.
Can you talk a little bit about Ohio and what that market potentially represents for you?

William Toler

Yes, Ohio has started to show some vibrancy in our and we're growing very nicely on a small base in Ohio just as we are in Florida and some of the other rollouts, states like Missouri and other places. So we are we are seeing that start to pick into the industry, which is really encouraging.
The other thing we are seeing across the pond, if you will, is with Germany passing 90 million people that are I'm very cannabis friendly and it's a highly consumed product in Germany. We are well positioned over there with all of our brands. We've rolled out. We had a business in Spain that's positioned across all of Europe for a number of years.
So we are moving resources and people and assets into Germany to be ready to take advantage of that. And importantly, the way that Germany laws work, it's going to be a very favorable home market. It's not going to be driven by LPs or MSOs are large entities can be driven much more by the at-home grower, which is a terrific thing for a company like ours and brands that people can use at home and know and trust.
And so we think that while there's some states that are popping here in the US are showing some nice vibrance. We also think that the Germany opportunity really opens us up to a, call it another 100 million consumers if you will, of people that are very cannabis friendly and a culture that we think is going to be right for us to growing.

Jesse Redmond

Great, I appreciate the comment.

William Toler

Thank you, Jesse.

Operator

Thank you. Ladies and gentlemen, as there are no further questions, I now hand the conference over to Bill Toler for his closing comments. Bill?

William Toler

Thank you, Ryan, and thank you everyone for supporting and following Hydrofarm. We look forward to further updates through the summer and hope everyone's doing well. Thanks so much.

Operator

Thank you. The confidence of Hydrofarm Holdings Group has now concluded. Thank you for your part and you may now disconnect your line.