Distribution Solutions Group, Inc. 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Sales Drivers The North American MRO market 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 Purchasing Managers Index (PMI) published by the Institute for Supply Management. The PMI is a composite index of economic activity in the United States manufacturing sector. A measure of that index above 50 generally indicates expansion of the manufacturing sector while a measure below 50 generally represents contraction. The average monthly PMI was 57.8 in the first quarter of 2022 compared to 61.4 in the first quarter of 2021. Our sales are also influenced by the number of sales representatives and their productivity. Our average sales rep headcount for the first quarter of 2022 was 1,026 sales representatives. This is compared to the average sales representative headcount of 1,083 sales representatives in the first quarter of 2021. Lawson segment sales representative productivity, measured as sales per rep per business day, increased 16.4% to $1.583 thousand in the first quarter of 2022 compared to $1.360 thousand in the prior year quarter. The increase in sales rep productivity was primarily driven by the realization of price increases instituted throughout 2021 and in the first quarter of 2022 and increased sales with fewer sales reps. These price increases were enacted to primarily offset rising supplier costs caused by inflation and increased transportation and labor costs. We plan to continue concentrating our efforts on increasing the productivity and size of our sales team. Supply Chain Disruptions Along with the broader economy, we continue to be affected by rising supplier costs caused by inflation and increased transportation and labor costs . This results in challenges in acquiring and receiving inventory in a timely fashion and fulfilling customer orders, which has offset some of the sales gains we recorded in 2022 compared to 2021. The supply chain disruptions have also led to higher product costs which have contributed to lower gross margins as a percentage of sales compared to the prior year. We have instituted various price increases during 2021 and 2022 in response to rising supplier costs, as well as increased transportation and labor costs. Further discussion in included within the financial discussion of the Management's Discussion and Analysis of Financial Condition and Results of Operations . TestEquity and Gexpro Services Mergers Refer to the section entitled "Recent Events" in Note 1 - Summary of Significant Accounting Policies and Other Information included in Part I. Item 1. Financial Statements, which section is incorporated herein by reference, for a description of the TestEquity Merger and Gexpro Services Merger consummated on April 1, 2022. Cyber Security Incident In February 2022, Lawson became aware that its computer network was the subject of a cyber incident potentially involving unauthorized access. It is possible that certain confidential business information and personnel records may have been compromised in the past. Lawson has engaged a cybersecurity forensics firm to assist in the investigation of the incident and to assist in securing its computer network. Depending on the nature of any information that may have been compromised, Lawson may be required to notify the parties whose information was compromised of the incident as well as various governmental agencies and may be required to take other actions in the future, such as offering credit monitoring services. Lawson is continuing to investigate the incident as well as potential corrective and remedial actions to take in respect of the incident. The Company has not incurred material costs and at this time, is unable to estimate the total cost of any remediation that may be required . COVID-19 Pandemic 24 Table of Contents Various events related to COVID-19 may impact revenue, product sourcing, sales functions, and customers' ability to pay timely. 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 we believe that COVID-19 and supply chain disruptions continue to negatively impact our sales and cost control measures, our ability to effectively service our customers has 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. Critical Accounting Policies and Use of Estimates The condensed consolidated financial statements were prepared in accordance with GAAP. A discussion of our critical accounting policies and estimates is contained in our 2021 annual report on Form 10-K within Part II, Item 7 and Item 8, Note 2. Please refer to these disclosures for further information regarding our critical accounting polices and use of estimates. There have been no significant changes to our previously disclosed critical accounting polices and use of estimates. Non-GAAP Financial Measure - Adjusted Operating Income The Company's management believes 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. Management believes 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, the Company's reported results prepared in accordance with GAAP. Adjusted operating income is defined by us as GAAP operating income excluding stock-based compensation, severance expense, and other non-recurring items in the period in which these items are incurred. Operating income was $12.1 million for the first quarter of 2022 compared to $4.8 million for the first quarter of 2021. Excluding stock-based compensation, severance expense, acquisition costs and other non-recurring items, adjusted non-GAAP operating income was $7.1 million in the first quarter of 2022 compared to $7.2 million in the first quarter of 2021. The decrease in non-GAAP adjusted operating income in the first quarter 2022 compared to the prior year quarter was driven by increased supplier costs, higher selling expenses due to higher sales, and higher health insurance costs compared to the prior quarter. These items were partially offset by higher sales driven primarily by the realization of price increases instituted throughout 2021 and in the first quarter of 2022 to offset rising costs. Reconciliation of GAAP Operating Income to Non-GAAP Adjusted Operating Income (Unaudited) Three Months Ended March 31, (Dollars in thousands) 2022 2021 Operating income as reported per GAAP $ 12,076 $ 4,810 Stock-based compensation (benefit) expense (1) (8,595) 1,000 Severance expense (2) 626 404 Costs related to merger agreements (3) 2,974 — Employee acquisition costs (4) — 172 Inventory reserves (5) — 825 Non-GAAP adjusted operating income $ 7,081 $ 7,211 (1) Expense for stock-based compensation, of which a portion varies with the Company's stock price. (2) Includes severance expense from actions taken in 2022 and 2021. (3) Primarily costs related to the negotiation, review and execution of the merger agreements relating to Lawson’s business combination with TestEquity and Gexpro Services consummated on April 1, 2022. (4) Includes retention costs for actions taken in 2021 related to the Partsmaster acquisition. (5) Includes expense for 2021 Partsmaster inventory rationalization plan and write-down of personal protective equipment inventory to net realizable value. 25 Table of Contents Three months ended March 31, 2022 compared to three months ended March 31, 2021 2022 2021 (Dollars in thousands) Amount % of Net Sales Amount % of Net Sales Revenue $ 117,877 100.0 % $ 103,556 100.0 % Cost of goods sold 57,379 48.7 % 48,996 47.3 % Gross profit 60,498 51.3 % 54,560 52.7 % Operating expenses: Selling expenses 26,310 22.3 % 23,802 23.0 % General and administrative expenses 22,112 18.8 % 25,948 25.0 % Operating expenses 48,422 41.1 % 49,750 48.0 % Operating income 12,076 10.2 % 4,810 4.6 % Interest expense (95) (0.1) % (323) (0.3) % Other income, net 204 0.2 % 372 0.4 % Income before income taxes 12,185 10.3 % 4,859 4.7 % Income tax expense 3,199 2.7 % 1,263 1.2 % Net income $ 8,986 7.6 % $ 3,596 3.5 % Revenue and Gross Profits Three Months Ended March 31, Increase (Dollars in thousands) 2022 2021 Amount % Revenue Lawson $ 104,902 $ 93,330 $ 11,572 12.4% Bolt Supply 12,975 10,226 2,749 26.9% Consolidated $ 117,877 $ 103,556 $ 14,321 13.8% Gross profit Lawson $ 55,531 $ 50,408 $ 5,123 10.2% Bolt Supply 4,967 4,152 815 19.6% Consolidated $ 60,498 $ 54,560 $ 5,938 10.9% Gross profit margin Lawson 52.9 % 54.0 % Bolt Supply 38.3 % 40.6 % Consolidated 51.3 % 52.7 % Revenue Total sales increased 13.8% to $117.9 million in the first quarter of 2022 compared to $103.6 million in the first quarter of 2021. The increase in sales compared to the prior year quarter was primarily driven by the realization of price increases enacted throughout 2021 and in the first quarter of 2022 to offset rising supplier costs and one additional selling day in 2022. Bolt Supply sales improved 26.9% compared to the prior year quarter driven by realization of prior period price increases enacted to offset rising supplier costs, continued strength in branch location sales and a recovery of direct sales to oil and gas customers. The first quarter 2022 had one more selling day than the prior year quarter. 26 Table of Contents Gross Profit Reported gross profit increased $5.9 million to $60.5 million in the first quarter of 2022 compared to $54.6 million in the prior year quarter primarily as a result of increased sales. Consolidated gross profit as a percent of sales was 51.3% in the first quarter of 2022 compared to 52.7% in the prior year quarter. Gross margin percentage for the first quarter 2022 was impacted by increased supplier costs from inflation, supply chain disruptions and a sales shift toward lower margin customers. Price increases enacted throughout 2021 and the first quarter of 2022 have partially offset the negative impacts of these higher costs. The Lawson segment gross margin, defined as margin generated by Lawson MRO as a percent of sales was 52.9% in the first quarter 2022 compared to 54.0% a year ago quarter. The realization of customer price increases, along with product sourcing and labor allocation, partially offset increased supplier costs in the current year quarter. The decrease in Bolt Supply gross margin as a percent of sales compared to the prior year quarter was also driven by increased sales to lower margin customers in the oil and gas industry. Selling, General and Administrative Expenses Three Months Ended March 31, Increase (Dollars in thousands) 2022 2021 Amount % Selling expenses Lawson $ 25,370 $ 22,891 $ 2,479 10.8% Bolt Supply 940 911 29 3.2% Consolidated $ 26,310 $ 23,802 $ 2,508 10.5% General and administrative expenses Lawson $ 19,065 $ 23,261 $ (4,196) (18.0)% Bolt Supply 3,047 2,687 360 13.4% Consolidated $ 22,112 $ 25,948 $ (3,836) (14.8)% Selling expenses consist of compensation and support for our sales representatives. Selling expenses increased to $26.3 million in the first quarter of 2022 compared to $23.8 million in the prior year quarter. Higher selling expense in the first quarter 2022 compared to the prior year quarter was primarily driven by costs incurred to support the increased sales and increased health insurance costs. As a percent of sales, selling expenses decreased to 22.3% from 23.0% in the first quarter of 2021 driven by expenses allocated over a larger sales base. General and administrative expenses consist of expenses to operate our distribution network and overhead expenses to manage the business. General and administrative expenses decreased to $22.1 million in the first quarter of 2022 from $25.9 million in the prior year quarter. The decrease in general and administrative expenses was driven by a stock-based compensation benefit of $8.6 million in the first quarter 2022 compared to expense of $1.0 million in the prior year quarter. A portion of our stock based compensation fluctuates with our stock price. This benefit was partially offset by costs of $3.0 million incurred in the first quarter of 2022 related to the Mergers with TestEquity and Gexpro Services, which were consummated on April 1, 2022. Excluding stock-based compensation, severance and acquisition related costs, general and administrative expense increased by $2.7 million compared to the prior year quarter. This increase was driven primarily by higher employee related costs including additional health insurance claims of approximately $1.5 million. Interest Expense Interest expense was $0.1 million in the first quarter of 2022 compared to $0.3 million of interest expense in the prior year quarter. Other Income, Net Other income, net decreased $0.2 million in the first quarter of 2022 over the prior year quarter primarily due to Canadian currency exchange rate effect. 27 Table of Contents Income Tax Expense Income tax expense was $3.2 million, resulting in a 26.3% effective tax rate for the three months ended March 31, 2022 compared to income tax expense of $1.3 million and an effective tax rate of 26.0% for the three months ended March 31, 2021. The effective tax rate in both periods is higher than the U.S. statutory rate primarily due to state taxes and other permanent items. 28 Table of Contents Liquidity and Capital Resources Available cash and cash equivalents were $5.5 million on March 31, 2022 compared to $4.2 million on December 31, 2021. Net cash used by operations for the three months ended March 31, 2022 was $0.2 million, primarily due to increased accounts receivables driven by higher sales and increased inventories due to increased supplier costs driven by inflation and global supply chain disruptions. The increased operating cash outflows were partially offset by operating cash inflows generated by realization of pricing actions taken to offset increased supplier costs. Capital expenditures were $2.1 million and $0.8 million for the three month period ended March 31, 2022 and 2021, respectively, primarily for improvements to our distribution centers and information technology. Cash provided by financing activities was $3.6 million for the first three months of 2022, primarily due to a net drawdown of $3.7 million on our Old Revolving Credit Facility due to increased working capital requirements and costs associated with the TestEquity Merger and Gexpro Services Merger. 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. We did not repurchase any shares of stock in the first three months of 2022 under this plan. The Company anticipates that outstanding stock performance rights with a value of $4.2 million at March 31, 2022 will be paid out within the next twelve months prior to expiration. Old Revolving Credit Facility On March 31, 2022, we had $15.6 million in outstanding borrowings and $83.4 million of borrowing availability remaining, net of outstanding letters of credit, under our Old Revolving Credit Facility. Along with certain standard terms and conditions of our 2019 Credit Agreement governing our Old Revolving Credit Facility, we were able to borrow up to 3.25 times our EBITDA, as defined, and required to maintain a minimum fixed charge ratio, as defined, of 1.15. As of March 31, 2022, we were in compliance with all financial covenants. While we were in compliance with our financial covenants included in our 2019 Credit Agreement for the quarter ended March 31, 2022, failure to meet the covenant requirements of the Amended and Restated 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 Amended and Restated Credit Agreement are sufficient to fund our operating requirements, strategic initiatives and capital improvements, although we cannot provide assurance that events beyond our control will not have a material adverse impact on our liquidity. Amended and Restated Credit Agreement Subsequent to quarter end, on April 1, 2022, in connection with the TestEquity Merger and Gexpro Services Merger, Lawson entered into an Amended and Restated Credit Agreement. Refer to Note 9 - Credit Agreement which is incorporated herein by reference, for a description of the agreement. 29 Table of Contents ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ITEM 3 of Part I has been omitted from this report.