HF Foods Group Inc. 10-Q

ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS AND RISK FACTOR SUMMARY This Quarterly Report on Form 10-Q for HF Foods Group Inc. (“HF Group,” “HF Foods”, the “Company,” “we,” “us,” or “our”) contains forward-looking statements. Forward-looking statements include statements about our expectations, beliefs, plans, objectives, intentions, assumptions and other statements that are not historical facts. Words or phrases such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “ongoing,” “plan,” “potential,” “predict,” “project,” “will” or similar words or phrases, or the negatives of those words or phrases, may identify forward-looking statements, but the absence of these words does not necessarily mean that a statement is not forward-looking. We derive many of our forward-looking statements from our operating budgets and forecasts, which are based on many detailed assumptions. While we believe that our assumptions are reasonable, we caution that it is very difficult to predict the impact of known factors, and it is impossible for us to anticipate all factors that could affect our actual results. All forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those that we expected. Important factors that could cause actual results to differ materially from our expectations, or cautionary statements, include without limitation: • The effects of the COVID-19 pandemic or other pandemics; • Low margins in the foodservice distribution industry and periods of significant or prolonged inflation or deflation; • Qualified labor shortages; • Unfavorable macroeconomic conditions in the United States; • Competition in the foodservice distribution industry particularly the entry of new competitors into the Chinese/Asian restaurant supply market niche; • Increases in fuel costs; • Disruption of relationships with vendors and increases in product prices; • Dependency on the timely delivery of products from vendors, particularly the prolonged diminution of global supply chains; • The steps taken by the governments where our suppliers are located, including the People’s Republic of China, to address the COVID-19 pandemic; • Disruption of relationships with or loss of customers; • Changes in consumer eating and dining out habits; • Related party transactions and possible conflicts of interests; • Related parties and variable interest entities consolidation; • Failure to protect our intellectual property rights; • Our ability to renew or replace our current warehouse leases on favorable terms, or terminations prior to expiration of stated terms; • Failure to retain our senior management and other key personnel, particularly our CEO, COO, CFO and CCO/General Counsel; • Our ability to attract, train and retain employees; • Changes in and enforcement of immigration laws; • Failure to comply with various federal, state and local rules and regulations regarding food safety, sanitation, transportation, minimum wage, overtime and other health and safety laws; • Product recalls, voluntary recalls or withdrawals if any of the products we distribute are alleged to have caused illness, been mislabeled, misbranded or adulterated or to otherwise have violated applicable government regulations; • Costs to comply with environmental laws and regulations; • Litigation; • Increases in commodity prices; • U.S. government tariffs on products imported into the United States, particularly from China; • Severe weather, natural disasters and adverse climate change; • Unfavorable geopolitical conditions; • Any cyber security incident, other technology disruption or delay in implementing our information technology systems; • Current indebtedness affecting our liquidity and ability of future financing; • Failure to acquire other distributors or wholesalers and enlarge our customer base could negatively impact our results of operations and financial condition; • Scarcity of and competition for acquisition opportunities; • Our ability to obtain acquisition financing; • The impact of non-cash charges relating to the amortization of intangible assets related to material acquisitions; • Our ability to identify acquisition candidates; • Increases in debt in order to successfully implement our acquisition strategy; 20 • Difficulties in integrating operations, personnel, and assets of acquired businesses that may disrupt our business, dilute stockholder value, and adversely affect our operating results; • Our ability to regain compliance with Nasdaq listing requirements; • The impact on the price and demand for our common stock resulting from the relative illiquidity of the market for our common stock and the as yet resolved Nasdaq delisting determination; • Significant stockholders’ ability to significantly influence the Company; and • The impact of state antitakeover laws and related provision in our governance documents. We caution you that the foregoing list may not contain all of the forward-looking statements made in this Quarterly Report on Form 10-Q. All written and oral forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by these cautionary statements as well as other cautionary statements that are made from time to time in our other filings with the Securities and Exchange Commission (the "SEC") and public communications. We caution you that the important factors referenced above may not contain all of the risks, uncertainties (some of which are beyond our control) or other assumptions that are important to you. These risks and uncertainties include, but are not limited to, those factors described under Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2022, filed with the SEC. In addition, we cannot assure you that we will realize the results or developments we expect or anticipate or, even if substantially realized, that they will result in the consequences or affect us or our operations in the way we expect. The forward-looking statements included in this Quarterly Report on Form 10-Q are made only as of the date hereof. Except as otherwise required by law, we undertake no obligation to update or revise any forward-looking statement as a result of new information, future events or otherwise. Overview We market and distribute Asian specialty food products, seafood, fresh produce, frozen and dry food, and non-food products primarily to Asian restaurants and other foodservice customers throughout the United States. HF Group was formed through a merger between two complementary market leaders, HF Foods Group Inc. and B&R Global. On April 29, 2022, HF Group acquired substantially all of the assets of Sealand Food, Inc. (the "Sealand Acquisition"), one of the largest frozen seafood suppliers servicing the Asian/Chinese restaurant market along the eastern seaboard, from Massachusetts to Florida, as well as Pennsylvania, West Virginia, Ohio, Kentucky, and Tennessee. See Note 6 - Acquisitions to the condensed consolidated financial statements in this Quarterly Report on Form 10-Q for additional information. We have grown our distribution network to 18 distribution centers nationwide with a fleet of over 400 refrigerated vehicles. Capitalizing on our deep understanding of the Chinese culture, we have become a trusted partner serving Asian and Chinese restaurants and other foodservice customers throughout the United States, providing sales and service support to customers who mainly converse in Mandarin or other Chinese dialects. We are dedicated to serving the vast array of Asian and Chinese restaurants in need of high-quality and specialized food ingredients at competitive prices. How to Assess HF Group’s Performance In assessing our performance, we consider a variety of performance and financial measures, including principal growth in net revenue, gross profit, distribution, selling and administrative expenses, as well as certain non-GAAP financial measures, including EBITDA and Adjusted EBITDA. The key measures that we use to evaluate the performance of our business are set forth below: Net Revenue Net revenue is equal to gross sales minus sales returns, sales incentives that we offer to our customers, such as rebates and discounts that are offsets to gross sales; and certain other adjustments. Our net revenue is driven by changes in number of customers and average customer order amount, product inflation that is reflected in the pricing of our products and mix of products sold. 21 Gross Profit Gross profit is equal to net revenue minus cost of revenue. Cost of revenue primarily includes inventory costs (net of supplier consideration), inbound freight, customs clearance fees and other miscellaneous expenses. Cost of revenue generally changes as we incur higher or lower costs from suppliers and as the customer and product mix changes. Distribution, Selling and Administrative Expenses Distribution, selling and administrative expenses consist primarily of salaries, stock-based compensation and benefits for employees and contract laborers, trucking and fuel expenses, utilities, maintenance and repair expenses, insurance expenses, depreciation and amortization expenses, selling and marketing expenses, professional fees and other operating expenses. EBITDA and Adjusted EBITDA Discussion of our results includes certain non-GAAP financial measures, including EBITDA and Adjusted EBITDA, that we believe provides an additional tool for investors to use in evaluating ongoing operating results and trends and in comparing our financial performance with other companies in the same industry, many of which present similar non-GAAP financial measures to investors. We present EBITDA and Adjusted EBITDA in order to provide supplemental information that we consider relevant for the readers of our condensed consolidated financial statements included elsewhere in this report, and such information is not meant to replace or supersede GAAP measures. Management uses EBITDA to measure operating performance, defined as net income before interest expense, interest income, income taxes, and depreciation and amortization. In addition, management uses Adjusted EBITDA, defined as net income before interest expense, interest income, income taxes, and depreciation and amortization, further adjusted to exclude certain unusual, non-cash, or non-recurring expenses. Management believes that Adjusted EBITDA is less susceptible to variances in actual performance resulting from non-recurring expenses, and other non-cash charges and is more reflective of other factors that affect our operating performance. The definition of EBITDA and Adjusted EBITDA may not be the same as similarly titled measures used by other companies in the industry. EBITDA and Adjusted EBITDA are not defined under GAAP and are subject to important limitations as analytical tools and should not be considered in isolation or as substitutes for analysis of HF Group’s results as reported under GAAP. For example, Adjusted EBITDA: • excludes certain tax payments that may represent a reduction in cash available; • does not reflect any cash capital expenditure requirements for the assets being depreciated and amortized that may have to be replaced in the future; • does not reflect changes in, or cash requirements for, our working capital needs; and • does not reflect the significant interest expense, or the cash requirements, necessary to service our debt. For additional information on EBITDA and Adjusted EBITDA, see the section entitled “EBITDA and Adjusted EBITDA” below. 22 Results of Operations The following table sets forth a summary of our consolidated results of operations for the three months ended March 31, 2023 and 2022 . The historical results presented below are not necessarily indicative of the results that may be expected for any future period. Three Months Ended March 31, Change (In thousands) 2023 2022 Amount % Net revenue $ 293,855 $ 278,215 $ 15,640 5.6% Cost of revenue 243,683 227,488 16,195 7.1% Gross profit 50,172 50,727 (555) (1.1)% Distribution, selling and administrative expenses 52,929 40,408 12,521 31.0% (Loss) income from operations (2,757) 10,319 (13,076) (126.7)% Interest expense 2,868 1,278 1,590 124.4% Other income (228) (776) 548 (70.6)% Change in fair value of interest rate swap contracts 2,746 (358) 3,104 (867.0)% Lease guarantee expense (120) 5,931 (6,051) (102.0)% (Loss) income before income tax provision (8,023) 4,244 (12,267) (289.0)% Income (benefit) tax provision (2,226) 1,104 (3,330) (301.6)% Net (loss) income and comprehensive (loss) income (5,797) 3,140 (8,937) (284.6)% Less: net income attributable to noncontrolling interests 136 26 110 423.1% Net (loss) income and comprehensive (loss) income attributable to HF Foods Group Inc. $ (5,933) $ 3,114 $ (9,047) (290.5)% The following table sets forth the components of our consolidated results of operations expressed as a percentage of net revenue for the periods indicated: Three Months Ended March 31, 2023 2022 Net revenue 100.0 % 100.0 % Cost of revenue 82.9 % 81.8 % Gross profit 17.1 % 18.2 % Distribution, selling and administrative expenses 18.0 % 14.5 % Income (loss) from operations (0.9) % 3.7 % Interest expense 1.0 % 0.5 % Other income, net (0.1) % (0.3) % Change in fair value of interest rate swap contracts 0.9 % (0.1) % Lease guarantee expense — % 2.1 % (Loss) income before income tax provision (2.7) % 1.5 % Income tax (benefit) provision (0.8) % 0.4 % Net (loss) income and comprehensive (loss) income (1.9) % 1.1 % Less: net income attributable to noncontrolling interests 0.1 % — % Net (loss) income and comprehensive (loss) income attributable to HF Foods Group Inc. (2.0) % 1.1 % Net Revenue Net revenue for the three months ended March 31, 2023 increased by $15.6 million or 6% compared to the same period in 2022. This increase was attributable to the additional Seafood revenue generated due to the Sealand Acquisition and product cost inflation, partially offset by a decrease in Meat and Poultry revenue compared to the same period in 2022. 23 Gross Profit Gross profit was $50.2 million for three months ended March 31, 2023 compared to $50.7 million in the same period in 2022 , a decrease of $0.6 million, or 1% . The decrease was primarily attributable to a decrease in Meat and Poultry revenue, partially offset by the additional Seafood revenue generated due to the Sealand Acquisition. Gross profit margin for three months ended March 31, 2023 decreased from 18.2% in 2022 to 17.1% for the same period in 2023. The decrease was primarily attributable to the shift in product mix to higher Seafood sales, timing of inventory purchases, increases in key commodity pricing and a higher than normal gross profit margin in the prior year due to our sales recovery to above pre-COVID-19 pandemic levels during the three months ended March 31, 2022. Distribution, Selling and Administrative Expenses Distribution, selling and administrative expenses increased by $12.5 million, or 31%, primarily due to an increase of $2.8 million in payroll and related labor costs, inclusive of the additional costs due to the Sealand Acquisition, increased professional fees of $4.2 million, from $2.9 million for the three months ended March 31, 2022 to $7.1 million for the three months ended March 31, 2023, primarily driven by legal costs and increased compliance costs as a result of the SEC and Special Investigation Committee investigations, as well as a $0.8 million increase in sales-related costs driven primarily by the Sealand Acquisition. Distribution, selling and administrative expenses as a percentage of net revenue increased to 18.0% for the three months ended March 31, 2023 from 14.5% in the same period in 2022 primarily due to higher professional fees and increased headcount. Interest Expense Interest expense for the three months ended March 31, 2023 increased by $1.6 million or 124% , compared to the three months ended March 31, 2022, primarily due to the increase of $46.0 million to our JPMorgan Chase mortgage-secured term loan on March 31, 2022 coupled with a sharply higher interest-rate environment. Our average daily line of credit balance decreased by $19.4 million, or 31% , to $42.6 million for the three months ended March 31, 2023 from $62.0 million for the three months ended March 31, 2022, and our average daily JPMorgan Chase mortgage-secured term loan balance increased by $41.2 million, or 59% , to $110.5 million for the three months ended March 31, 2023 from $69.3 million for the three months ended March 31, 2022. Average floating interest rates for the three months ended March 31, 2023 increased by approximately 4.41% on the line of credit and 4.41% on the JPMorgan Chase mortgage-secured term loan, compared to the same period in 2022, which further contributed to higher interest expense. Income Tax (Benefit) Provision Income tax (benefit) provision was an income tax benefit of $2.2 million for the three months ended March 31, 2023 , compared to income tax provision of $1.1 million for the three months ended March 31, 2022, primarily due to decreased income before taxes. Net (Loss) Income Attributable to HF Foods Group Inc. Net (loss) income attributable to HF Foods Group Inc. was a net loss of $5.9 million for the three months ended March 31, 2023 , compared to net income of $3.1 million for the three months ended March 31, 2022. The decrease of $9.0 million, or 291% , is primarily due to the increased distribution, selling, and administrative costs and interest expense described above as well as the year-over-year change in fair value of interest rate swap contracts of $3.1 million. 24 EBITDA and Adjusted EBITDA The following table reconciles EBITDA and Adjusted EBITDA to the most directly comparable GAAP measure: Three Months Ended March 31, Change (In thousands) 2023 2022 Amount % Net (loss) income $ (5,797) $ 3,140 $ (8,937) (284.6)% Interest expense 2,868 1,278 1,590 124.4% Income tax (benefit) provision (2,226) 1,104 (3,330) (301.6)% Depreciation and amortization 6,689 5,779 910 15.7% EBITDA 1,534 11,301 (9,767) (86.4)% Lease guarantee expense (120) 5,931 (6,051) (102.0)% Change in fair value of interest rate swap contracts 2,746 (358) 3,104 NM Stock-based compensation expense 1,096 290 806 277.9% Acquisition and integration costs — 749 (749) NM Adjusted EBITDA $ 5,256 $ 17,913 $ (12,657) (70.7)% Adjusted EBITDA was $5.3 million for the three months ended March 31, 2023, a decrease of $12.7 million or 71% , compared to $17.9 million for the three months ended March 31, 2022. The decrease in Adjusted EBITDA was attributable to the lower gross profit and higher distribution, selling and administrative costs as described above. Liquidity and Capital Resources As of March 31, 2023, we had cash of approximately $17.5 million, checks issued not presented for payment of $14.1 million and access to approximately $55.5 million in additional funds through our $100.0 million line of credit, subject to a borrowing base calculation. We have funded working capital and other capital requirements primarily by cash flow from operations and bank loans. Cash is required to pay purchase costs for inventory, salaries, fuel and trucking expenses, selling expenses, rental expenses, income taxes, other operating expenses and to service debts. We believe that our cash flow generated from operations is sufficient to meet our normal working capital needs for at least the next twelve months. However, our ability to repay our current obligations will depend on the future realization of our current assets. Management has considered the historical experience, the economy, the trends in the foodservice distribution industry to determine the expected collectability of accounts receivable and the realization of inventories as of March 31, 2023. On March 15, 2023, we entered into an amortizing IRS contract with J.P. Morgan Chase Bank for an initial notional amount of $120.0 million, effective from March 1, 2023 and expiring on March 2028, as a means to partially hedge its existing floating rate loans exposure. Pursuant to the agreement, we will pay the swap counterparty a fixed rate of 4.11% in exchange for floating payments based on CME Term SOFR. Subsequent to March 31, 2023, effective as of April 20, 2023, we and certain parties to the Delaware Action reached an agreement to settle the Delaware Action on the terms and conditions set forth in a binding term sheet (the “Binding Term Sheet”), which was incorporated into a long-form settlement agreement on May 5, 2023 and filed with the Court of Chancery on May 8, 2023. The Binding Term Sheet provided for, among other things, the dismissal of the Delaware Action with prejudice in exchange for Zhou Min Ni, a former Chairman and Chief Executive Officer of the Company, and Chan Sin Wong, a former President and Chief Operating Officer of the Company, making a payment to the Company in the sum of $9.25 million. The full terms of the settlement of the Delaware Action were incorporated into the long-form settlement agreement, which is subject to approval of the Court of Chancery. Please refer to Note 14 - Commitments and Contingencies to the condensed consolidated financial statements in this Quarterly Report on Form 10-Q for additional information. Management believes we have sufficient funds to meet our working capital requirements and debt obligations in the next twelve months. However, there are a number of factors that could potentially arise which might result in shortfalls in anticipated cash flow, such as the demand for our products, economic conditions, competitive pricing in the foodservice distribution industry, and our bank and suppliers being able to provide continued support. If the future cash flow from operations and other capital resources is insufficient to fund our liquidity needs, we may have to resort to reducing or delaying our expected acquisition plans, liquidating assets, obtaining additional debt or equity capital, or refinancing all or a portion of our debt. 25 As of March 31, 2023, we have no off balance sheet arrangements that currently have or are reasonably likely to have a material effect on our consolidated financial position, changes in financial condition, results of operations, liquidity, capital expenditures or capital resources. The following table summarizes cash flow data for the years ended March 31, 2023 and 2022: Three Months Ended March 31, Change (In thousands) 2023 2022 Amount % Net cash provided by operating activities $ 12,570 $ 10,113 $ 2,457 24.3% Net cash used in investing activities (629) (19,932) 19,303 (96.8)% Net cash (used in) provided by financing activities (18,753) 11,453 (30,206) (263.7)% Net (decrease) increase in cash and cash equivalents $ (6,812) $ 1,634 $ (8,446) NM ____________________ NM - Not meaningful Operating Activities Net cash provided by operating activities consists primarily of net income adjusted for non-cash items, including depreciation and amortization, changes in deferred income taxes and others, and includes the effect of working capital changes. Net cash provided by operating activities increased by $2.5 million, or 24% , primarily due to lower working capital requirements for the three months ended March 31, 2023 compared to increased working capital investment as a direct result of increasing sales volume and the need for normal inventory level build up post-COVID-19 for the same period in 2022. Investing Activities Net cash used in investing activities decreased by $19.3 million, or 97% , primarily due to the inventory acquired related to the Great Wall Acquisition in the three months ended March 31, 2022. Financing Activities Net cash used in financing activities increased by $30.2 million, or 264% , primarily due to the net impact of our line of credit from net proceeds of $13.3 million for the three months ended March 31, 2022 to a net repayment of $8.6 million for the three months ended March 31, 2023, as well as the net impact of $7.6 million on our checks issued not presented for payment from net proceeds of $0.7 million for the three months ended March 31, 2022 to net repayments of $7.6 million for the three months ended March 31, 2023. Critical Accounting Policies and Estimates We have prepared the financial information in this Quarterly Report in accordance with GAAP. Preparing our condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during these reporting periods. We base our estimates and judgments on historical experience and other factors we believe are reasonable under the circumstances. These assumptions form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Part II, Item 7 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of the 2022 Annual Report on Form 10-K includes a summary of the critical accounting policies we believe are the most important to aid in understanding our financial results. There have been no changes to those critical accounting policies that have had a material impact on our reported amounts of assets, liabilities, revenue, or expenses during the three months ended March 31, 2023. Recent Accounting Pronouncements For a discussion of recent accounting pronouncements, see Note 2 - Summary of Significant Accounting Policies to the condensed consolidated financial statements in this Quarterly Report on Form 10-Q. 26