Distribution Solutions Group, Inc. 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Partsmaster Acquisition In September 2020, we acquired Partsmaster, a leading Maintenance, Repair and Operations ("MRO") distributor from NCH Corporation. Partsmaster has over 200 sales representatives and serves approximately 16,000 customers throughout the United States and Canada. We also assumed the lease on the Partsmaster distribution center located in Greenville, Texas, and we will continue to fulfill orders from this facility as we integrate Partsmaster into our MRO segment operations. The purchase price of the acquisition was $35.3 million in cash and the assumption of certain liabilities. We paid $2.3 million at the time of the acquisition and we will pay the remaining $33.0 million in May 2021. We plan to pay the remaining portion of the purchase price with cash on hand and, as necessary, any remaining portion using our existing credit facility. The liabilities assumed include approximately $2.9 million relating to deferred employee compensation and $4.1 million of accounts payable and other accrued liabilities. Assets acquired and liabilities assumed as a result of the acquisition were accounted for at their fair value on the acquisition date. The identified assets include $5.0 million of intangible assets for customer relationships and $2.8 million for trade names with estimated useful lives of 10 years and 5 years, respectively. Goodwill of $16.0 million related to this acquisition reflects the purchase price less the fair market value of the identifiable assets. The appropriate fair values of the assets acquired and liabilities assumed are based on preliminary estimates and assumptions. These preliminary estimates and assumptions could change significantly during the purchase price measurement period as we finalize the valuations of the assets acquired and liabilities assumed. Additional information related to the Partsmaster acquisition is provided in Note 2 - Acquisition in the notes to the consolidated financial statements. COVID-19 Pandemic In March 2020, the World Health Organization declared a new strain of coronavirus (“COVID-19”) a pandemic. The COVID-19 pandemic continues to negatively impact the global economy by disrupting global supply chains and financial markets and has negatively impacted our operational and financial performance, including the ability of our sales representatives to call on customers in person and perform VMI services at customer locations. The Bolt Supply House saw a decline in sales in the second quarter and third quarter as the ability of customers to visit branch locations was restricted and certain customers temporarily closed. The continued impact of the COVID-19 pandemic on our operational and financial performance, including our ability to execute our business strategies and initiatives in the expected time frame, will depend on future developments, including the duration and spread of the pandemic and related restrictions on travel and transports, all of which remain uncertain. An extended period of global supply chain and economic disruption could materially affect our business, sales, results of operations and financial condition. Lawson continues to be defined as an essential business by the state of Illinois. A change in this status could result in the temporary closure of our business. Additionally the COVID-19 pandemic could result in a temporary closure of some or all of our distribution facilities or the Bolt branch locations, which would negatively impact our operations. Other disruptions to our supply chain such as reduced capacity or temporary shutdowns of freight carriers could also negatively impact our performance. The pandemic has negatively impacted our current operations and may negatively impact our future financial results, liquidity and overall performance. Additionally, it is possible that estimates made in support of our financial statements may be materially and adversely impacted in the near term as a result of these conditions, including delay in payment of receivables, impairment losses related to goodwill and other long-lived assets, and inability to utilize deferred tax assets. The economic climate in the third quarter has improved as many nonessential businesses have reopened in both limited capacity and full capacity. The relaxed restrictions have resulted in increased customer contact and more consistent customer visits for Lawson MRO sales representatives and customers were also allowed in Bolt branch locations. The improved economic climate and increased activity of the Lawson MRO and Bolt segments led to a sequential improvement in financial results in the third quarter of 2020 compared to the second quarter of 2020. However, restrictions related to the COVID-19 pandemic and a downturn in the oil and gas industry has led to lower sales and operating income compared to the third quarter of 2019. 20 Table of Contents We continue to take action to mitigate the potential negative impacts of COVID-19. The actions taken included, but are not limited to, furloughing employees, reducing base salaries for a period of time and incentive awards, canceling travel and award trips, temporarily consolidating our Suwanee distribution center operations into the McCook facility eliminating non-critical capital expenditures and eliminating various positions throughout the Company. In the third quarter we brought back approximately 70% of the previously furloughed employees and reopened our Suwanee distribution center in a reduced capacity as overall business activity increased. We continue to monitor our balance sheet and liquidity position and take actions to protect our cash flows from operations while at the same time managing our operating expenses in relation to current sales trends. At September 30, 2020, we had $17.2 million of unrestricted cash and cash equivalents and an additional $66.0 million of borrowing capacity, net of outstanding letters of credit. Our outstanding letters of credit include a letter of credit for $33.0 million for the remaining payment of the Partsmaster acquisition. We will continue to closely monitor the overall economic and operating environment and we will take appropriate actions to protect the safety of our employees, customers and suppliers while continuing to meet our working capital needs and remain in compliance with our debt covenants. While COVID-19 has negatively impacted our sales, cost control measures and ability to effectively service our customers, we have continued to generate positive cash flow that has enabled us to maintain a strong financial position. We plan to continue to respond to pandemic developments in a prompt and disciplined manner with an emphasis on maintaining our strong financial position. Sales Drivers The MRO distribution industry is highly fragmented. We compete for business with several national distributors as well as a large number of regional and local distributors. The MRO business is significantly impacted by the overall strength of the manufacturing sector of the U.S. economy which has been significantly affected by the COVID-19 pandemic. One measure used to evaluate the strength of the industrial products market is the PMI index published by the Institute for Supply Management, which is considered by many economists to be a reliable near-term economic barometer of the manufacturing sector. A measure above 50 generally indicates expansion of the manufacturing sector while a measure below 50 generally represents contraction. The average monthly PMI was 55.2 in the third quarter of 2020 compared to 49.4 in the third quarter of 2019. The third quarter 2020 PMI of 55.2 follows a second quarter PMI of 45.7 and a first quarter PMI of 50.0. This high degree of volatility in 2020, primarily reflecting the effect of the COVID-19 pandemic on the current economic environment, makes this indicator more difficult to interpret in measuring year over year economic growth. Our sales are also affected by the number of sales representatives and their productivity. The acquisition of Partsmaster in September increased our sales f orce by approximately 200 sales representatives in September 2020 and contributed a weighted average of 67 sales representatives to the sales force head count in the third quarter 2020. Including the Partsmaster sales representatives, the average sales rep headcount for the quarter was 993 sales representatives in the third quarter of 2020 compared to 989 sales representatives during the thir d quarter of 2019. Lawson segment sales representative productivity, measured as sales per rep per day and including the Partsmaster sales reps, decreased 4.6% to $1,249 in the third quarter of 2020 from $1,309 in the third quarter of 2019. Partsmaster contributed $5.4 million in sales in the third quarter. The decrease in sales rep productivity compared to t he third quarter of 2019 was primarily driven by the negative impacts of COVID-19 and the downturn in the oil and gas industry. We anticipate the size of our sales force to increase slightly for the remainder of 2020, however, the size of our sales force will be influenced by the performance of the overall economy. We also plan to continue to concentrate our efforts on increasing the productivity of our existing and acquired sales representatives. Non-GAAP Financial Measure - Adjusted Operating Income We believe that certain non-GAAP financial measures may provide users of this financial information with additional meaningful comparisons between current results and results in prior operating periods. We believe that these non-GAAP financial measures can provide additional meaningful reflection of underlying trends of the business because they provide a comparison of historical information that excludes certain infrequently occurring, seasonal or non-operational items that impact the overall comparability. These non-GAAP financial measures should be viewed in addition to, and not as an alternative for, our reported results prepared in accordance with GAAP. Adjusted operating income is defined by us as GAAP operating income excluding stock-based compensation, severance expenses and acquisition costs in the period in which these items are incurred. 21 Table of Contents Operating income was $2.0 million for the third quarter of 2020 compared to $6.4 million for the third quarter of 2019. Excluding stock-based compensation, severance expense and acquisition costs, adjusted non-GAAP operating income was $7.7 million in the third quarter of 2020 compared to $8.9 million in the third quarter of 2019, driven by decreased sales due to the COVID-19 pandemic, partially offset by inclusion of Partsmaster adjusted operating income of $0.4 million in the third quarter of 2020. Operating income was $21.2 million for the first nine months of 2020 compared to $13.6 million for the first nine months of 2019. Excluding stock-based compensation, severance expense and acquisition costs, adjusted non-GAAP operating income was $20.5 million in the first nine months of 2020 compared to $22.8 million in the first nine months of 2019. Reconciliation of GAAP Operating Income to Adjusted Non-GAAP Operating Income (Unaudited) Three Months Ended September 30, Nine Months Ended September 30, (Dollars in Thousands) 2020 2019 2020 2019 Operating income as reported by GAAP $ 2,001 $ 6,446 $ 21,208 $ 13,613 Stock based compensation (1) 4,746 2,374 (2,767) 7,621 Severance expense 488 30 1,520 1,542 Acquisition costs 473 — 555 — Adjusted non-GAAP operating income $ 7,708 $ 8,850 $ 20,516 $ 22,776 (1) Expense for stock-based compensation, of which a portion varies with the Company's stock price Quarter ended September 30, 2020 compared to quarter ended September 30, 2019 2020 2019 (Dollars in thousands) Amount % of Net Sales Amount % of Net Sales Revenue $ 90,277 100.0 % $ 94,779 100.0 % Cost of goods sold 43,052 47.7 % 44,205 46.6 % Gross profit 47,225 52.3 % 50,574 53.4 % Operating expenses: Selling expenses 19,155 21.2 % 21,255 22.4 % General and administrative expenses 26,069 28.9 % 22,873 24.2 % Total operating expenses 45,224 50.1 % 44,128 46.6 % Operating income 2,001 2.2 % 6,446 6.8 % Interest expense (142) (0.2) % (138) (0.1) % Other income (expenses), net 615 0.7 % (13) (0.1) % Income before income taxes 2,474 2.7 % 6,295 6.6 % Income tax expense 736 0.8 % 1,521 1.6 % Net income $ 1,738 1.9 % $ 4,774 5.0 % 22 Table of Contents Revenue and Gross Profits Three Months Ended September 30, Increase/(Decrease) (Dollars in thousands) 2020 2019 Amount % Revenue Lawson $ 79,806 $ 83,461 $ (3,655) (4.4)% Bolt Supply 10,471 11,318 (847) (7.5)% Consolidated $ 90,277 $ 94,779 $ (4,502) (4.7)% Gross profit Lawson $ 43,038 $ 46,148 $ (3,110) (6.7)% Bolt Supply 4,187 4,426 (239) (5.4)% Consolidated $ 47,225 $ 50,574 $ (3,349) (6.6)% Gross profit margin Lawson 53.9 % 55.3 % Bolt Supply 40.0 % 39.1 % Consolidated 52.3 % 53.4 % Total sales decreased 4.7% to $90.3 million in the third quarter of 2020 compared to $94.8 million in the third quarter of 2019. Sales were negatively impacted by the effect of the COVID-19 pandemic and a downturn in the oil and gas industry, partially offset by the contribution of $5.4 million of sales from Partsmaster in the third quarter 2020. Sales productivity, measured as sales per rep p er day, decreas ed 4.6% in the third quarter of 2020 compared to the same quarter of 2019, primarily driven by the COVID-19 pandemic. Bolt Supply sales were also negatively impacted by COVID-19 compared to the prior year quarter. Consolidated average daily sales increased on a sequential basis throughout the third quarter, from $1.294 million in July to $1.315 million in August and $1.629 million in September as the economy continued to improve. Partsmaster contributed $0.257 million in average daily sales in September. Average daily sales declined 4.7% to $1.411 million in the third quarter of 2020 compared to $1.481 million in the prior year quarter. Partsmaster contributed $0.085 million of average daily sales in the third quarter 2020. Both the third quarter of 2020 and 2019 had 64 selling days. Gross Profit Reported gross profit decreased $3.3 million to $47.2 million in the third quarter of 2020 compared to $50.6 million as a result of the sales decline. Partsmaster contributed $3.6 million to reported gross profit in the third quarter of 2020 before giving effect to service costs. C onsolidated gross profit as a percent of sales was 52.3% in the third quarter of 2020 compared to 53.4% in the prior year quarter. Gross profit as a percentage of sales generated by sales representative acquired from Partsmaster was 66.8% before giving affect to service related costs. The organic Lawson MRO segment gross margin as a percent of sales declined to 58.8% in the third quarter of 2020 compared to 60.9% a year ago quarter before giving effect to the service-related costs, as a result of de-leveraging of fixed distribution costs over a lower sales base, a shift to lower margin products in the quarter and higher net transportation costs. 23 Table of Contents Selling, General and Administrative Expenses Three Months Ended September 30, Increase (Decrease) (Dollars in thousands) 2020 2019 Amount % Selling expenses Lawson $ 18,373 $ 20,402 $ (2,029) (9.9)% Bolt Supply 782 853 (71) (8.3)% Consolidated $ 19,155 $ 21,255 $ (2,100) (9.9)% General and administrative expenses Lawson $ 23,553 $ 20,369 $ 3,184 15.6% Bolt Supply 2,516 2,504 12 0.5% Consolidated $ 26,069 $ 22,873 $ 3,196 14.0% Selling expenses consist of compensation and support for our sales representatives. Selling expenses were $19.2 million in the third quarter of 2020 compared to $21.3 million in the prior year quarter and, as a percent of sales, decreased to 21.2% from 22.4% in the third quarter of 2019. Th e decrease in selling expense is primarily related to reduced sales compensation driven by lower sales and lower travel related expenses. Partsmaster contributed $1.6 million to selling expense in the third quarter 2020. General and administrative expenses consist of expenses to operate our distribution network and overhead expenses to manage the business. General and administrative expenses increased to $26.1 million in the third quarter of 2020 from $22.9 million in the prior year quar ter. The increased General and administrative expense was driven by an increase in stock-based compensation expense of $2.4 million, inclusion of Partsmaster expenses of $1.5 million, increased severance of $0.5 million, and acquisition costs of $0.5 million. These items were partially offset by lower compensation costs. Interest Expense Interest expense was $0.1 million in the third quarter of 2020, which was flat compared to the third quarter of 2019. Other Income, Net Other income, net increased $0.6 million in the third quarter of 2020 over the prior year quarter primarily due to Canadian currency exchange rate effect. Income Tax Expense Income tax expense was $0.7 million, resulting in a 29.7% effective tax rate for the three months ended September 30, 2020 compared to an income tax expense of $1.5 million and an effective tax rate of 24.2% for the three months ended September 30, 2019. 24 Table of Contents Nine months ended September 30, 2020 compared to September 30, 2019 2020 2019 (Dollars in thousands) Amount % of Net Sales Amount % of Net Sales Revenue $ 253,458 100.0 % $ 282,219 100.0 % Cost of goods sold 118,999 47.0 % 131,679 46.7 % Gross profit 134,459 53.0 % 150,540 53.3 % Operating expenses: Selling expenses 55,445 21.9 % 64,864 23.0 % General and administrative expenses 57,806 22.8 % 72,063 25.5 % Total operating expenses 113,251 44.6 % 136,927 48.5 % Operating income 21,208 8.4 % 13,613 4.8 % Interest expense (329) (0.1) % (481) (0.2) % Other income (expense), net 15 (0.1) % 798 0.3 % Income before income taxes 20,894 8.2 % 13,930 4.9 % Income tax expense 6,004 2.3 % 3,703 1.3 % Net income $ 14,890 5.9 % $ 10,227 3.6 % Revenue and Gross Profit Nine Months Ended September 30, Increase/(Decrease) (Dollars in thousands) 2020 2019 Amount % Revenue Lawson $ 224,511 $ 250,895 $ (26,384) (10.5)% Bolt Supply 28,947 31,324 (2,377) (7.6)% Consolidated $ 253,458 $ 282,219 $ (28,761) (10.2)% Gross profit Lawson $ 123,031 $ 138,524 $ (15,493) (11.2)% Bolt Supply 11,428 12,016 (588) (4.9)% Consolidated $ 134,459 $ 150,540 $ (16,081) (10.7)% Gross profit margin Lawson 54.8 % 55.2 % Bolt Supply 39.5 % 38.4 % Consolidated 53.0 % 53.3 % Revenue Revenue for the nine months ended September 30, 2020 decreased 10.2% to $253.5 million from $282.2 million for the nine months ended September 30, 2019. All customer sales categories have been negatively impacted by the effect of the COVID-19 pandemic which began in March 2020. The decrease in sales compared to the prior year was partially offset by $5.4 million of sales from the inclusion of Partsmaster in the third quarter 2020. Average daily sales decreased 10.7% to $1.320 million in the first nine months of 2020 compared to $1.478 million in the prior year period with one more selling day in the current year to date period compared to the corresponding prior year period. 25 Table of Contents Gross Profit Gross profit decreased to $134.5 million in the first nine months of 2020 compared to $150.5 million in the first nine months of 2019, primarily driven by decreased sales, partially offset by lower service costs classified as cost of goods sold and the inclusion of the Partsmaster acquisition. Consolidated gross profit as a percent of sales was 53.0% compared to 53.3% a year ago. The organic Lawson MRO segment gross margin as a percent of sales was 59.8% in the first nine months of 2020 compared to 60.7% a year ago. Selling, General and Administrative Expenses Nine Months Ended September 30, Decrease (Dollars in thousands) 2020 2019 Amount % Selling expenses Lawson $ 53,222 $ 62,334 $ (9,112) (14.6)% Bolt Supply 2,223 2,530 (307) (12.1)% Consolidated $ 55,445 $ 64,864 $ (9,419) (14.5)% General and administrative expenses Lawson $ 50,816 $ 64,700 $ (13,884) (21.5)% Bolt Supply 6,990 7,363 (373) (5.1)% Consolidated $ 57,806 $ 72,063 $ (14,257) (19.8)% Selling expenses decreased to $55.4 million for the first nine months of 2020 from $64.9 million in the first nine months of 2019 and, as a percent of sales, decreased to 21.9% in th e first nine months of 2020 from 23.0% a year ago. The decrease in selling expense is primarily related to reduced sales compensation driven by lower sales and a reduction in travel related expenses in the third quarter. These declines were partially offset by the inclusion of $1.7 million of selling expenses from the Partsmaster acquisition. General and administrative expenses decreased to $57.8 million in the first nine months of 2020 from $72.1 million in the prior year period primarily due to a decrease in stock-based compensation expense of $10.4 million, a portion of which varies with the Company stock price. Lower employee compensation, travel expenses and other cost control measures put in place as a result of COVID-19 also contributed to the decline. These declines were partially offset by the inclusion of $1.5 million of general and administrative expenses from the Partsmaster acquisition. Interest Expense Interest expenses decreased $0.2 million in the first nine months of 2020, due primarily to decreased average outstanding borrowings compared to the prior year. Other Income (Expense), Net Other income (expense), net decreased $0.8 million in the first nine months of 2020, primarily due to Canadian currency exchange rate effect. Income Tax Expense Income tax expenses were $6.0 million resulting in a 28.7% effective tax rate for the first nine months of 2020 compared to income tax expense of $3.7 million and a 26.6% effective tax rate for the first nine months of 2019. 26 Table of Contents Liquidity and Capital Resources Available cash and cash equivalents were $17.2 million on September 30, 2020 compared to $5.5 million on December 31, 2019. Net cash generated from operations for the nine months ended September 30, 2020 was $20.0 million, primarily due to operating earnings and the Company managing working capital. Net cash generated from operations for the nine months ended September 30, 2019 was $8.0 million, primarily due to operating earnings offset by an increase in working capital to support higher sales. In the third quarter of 2020, the Company paid $2.3 million in cash related to the Partsmaster acquisition. Capital expenditures w ere $1.3 million and $1.4 million for the nine month periods ended September 30, 2020 and 2019, respectively, primarily for improvements to our distribution centers and information technology. We used $4.6 million of cash in financing activities in the first nine months of 2020, primarily to repurchase shares of common stock and to pay down the revolving line of credit. No dividends were paid to shareholders in the nine months ended September 30, 2020 and 2019. In 2019, o ur Board of Directors authorized a program in which we may repurchase up to $7.5 million of our common stock from time to time in open market transactions, privately negotiated transactions or by other methods. In the first quarter of 2020 we purchased 47,504 shares of our common stock at an average purchase price of $36.93, under the repurchase program. No shares were repurchased under this program in the second and third quarters. In the third quarter of 2020, we repurchased 12,077 shares of our common stock at an average price of $36.07, for the purpose of satisfying tax withholding obligations of certain employees upon the vesting of their Company issued restricted stock units. Loan Agreement On September 30, 2020, we had $66.0 million of borrowing availability remaining, net of outstanding letters of credit, under our Credit Agreement. Our outstanding letters of credit include a $33.0 million letter of credit to secure the remaining payment for the Partsmaster acquisition. We had no outstanding borrowing under our Credit Agreement as of September 30, 2020. Along with certain standard terms and conditions of our Credit Agreement, we are able to borrow up to 3.25 times its EBITDA, as defined, and a minimum fixed charge ratio, as defined, of 1.15. As of September 30, 2020, we were in compliance with all covenants. While we were in compliance with our financial covenants included in our Credit Agreement for the quarter ended September 30, 2020, failure to meet the covenant requirements of the Credit Agreement in future quarters could lead to higher financing costs, increased restrictions, or reduce or eliminate our ability to borrow funds and could have a material adverse effect on our business, financial condition and results of operations. We believe cash provided by operations and funds available under our Credit Agreement are sufficient to fund our operating requirements, strategic initiatives and capital improvements, including the potential impact of COVID-19 over the next twelve months although we cannot provide assurance that events beyond our control will not have a material adverse impact on our liquidity. Partsmaster Acquisition Liability As a part of the Partsmaster acquisition, payment of $33.0 million is due to the sellers in May 2021. The p ayment has been guaranteed under the Purchase Agreement, which includes the issuance of a $33.0 million irrevocable standby letter of credit. P ayment will be made with cash on hand and, as necessary, any remaining portion using our existing credit facility. The $33.0 million obligation has been discounted to present value and is recognized as a current liability of $32.5 million in our condensed consolidated balance sheet as of September 30, 2020. . 27 Table of Contents ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ITEM 3 of Part I is inapplicable and has been omitted from this report.