HYDROFARM HOLDINGS GROUP, INC. 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis provides information that we believe is relevant to an assessment and understanding of our results of operations and financial condition. You should read this analysis in conjunction with our audited and unaudited consolidated financial statements and the notes contained elsewhere in this Quarterly Report on Form 10-Q and our 2023 Annual Report. This discussion and analysis contains statements of a forward-looking nature relating to future events or our future financial performance. Actual events or results may differ materially from forward-looking statements. In evaluating such statements, you should carefully consider the various factors identified in this Quarterly Report on Form 10-Q, which could cause actual results to differ materially from those expressed in, or implied by, any forward-looking statements, including those set forth in “Risk Factors” in our 2023 Annual Report. See “Special Note Regarding Forward-Looking Statements.” Company Overview We are a leading independent manufacturer and distributor of branded hydroponics equipment and supplies for controlled environment agriculture ("CEA"), including grow lights, climate control solutions, growing media and nutrients, as well as a broad portfolio of innovative and proprietary branded products. We primarily serve the U.S. and Canadian markets, and believe we are one of the leading companies in these markets in an otherwise fragmented industry. For over 40 years, we have helped growers make growing easier and more productive. Our mission is to empower growers, farmers and cultivators with products that enable greater quality, efficiency, consistency, and speed in their grow projects. Hydroponics is the farming of plants using soilless growing media and often artificial lighting in a controlled indoor or greenhouse environment. Hydroponics is the primary category of CEA and we use the terms CEA and hydroponics interchangeably. Our products are used to grow, farm, and cultivate cannabis, flowers, fruits, plants, vegetables, grains and herbs in controlled environment settings that allow end users to control key farming variables including temperature, humidity, CO 2 , light intensity spectrum, nutrient concentration and pH. Through CEA, growers are able to be more efficient with physical space, water and resources, while enjoying year-round and more rapid grow cycles as well as more predictable and abundant grow yields, when compared to other traditional growing methods. We reach commercial farmers and consumers through a broad and diversified network of over 2,000 wholesale customer accounts, who we connect with primarily through our proprietary online ordering platform. Our products are distributed across the United States and Canada through a diversified range of retailers of commercial and home gardening equipment and supplies. Our customers include specialty hydroponic retailers, commercial resellers and greenhouse builders, garden centers, hardware stores, and e-commerce retailers. Specialty hydroponic retailers can provide growers with specialized merchandise assortments and knowledgeable staff. Market Conditions We have experienced adverse financial results which we believe is primarily a result of an agricultural oversupply impacting our market. An agricultural oversupply has impacted our industry, driving cannabis wholesale prices down and resulting in a decrease in indoor and outdoor cultivation in the markets where we operate. The extent these market conditions will continue to negatively impact our business and results of operations is uncertain and difficult to predict at this time. We believe COVID-19 may have provided a positive demand impact for the Company in 2020 and 2021 from shelter-in-place orders in the United States, a possible negative supply chain impact from workforce disruption at international and domestic suppliers, and a possible negative growth rate impact in 2022 and 2023 due to agricultural oversupply initiated during the height of COVID-related shelter-in-place orders in 2020 and 2021. In connection with our previously disclosed evaluation of our facility footprint and product and brand portfolio, we initiated a restructuring plan (the "Restructuring Plan") during 2022. In connection with the first phase of our Restructuring Plan, our major initiatives included (i) narrowing our product and brand portfolio, including removing approximately one-third of all products and one-fifth of all brands relating to our primary product portfolio, which excluded our garden center business in Canada, and (ii) relocating and consolidating certain manufacturing and distribution centers, including headcount reductions and reorganization to drive a solution based approach, focusing commercial sales on competencies and product assortment gained from our recent acquisitions. Total costs incurred relating to this first phase of the Restructuring Plan from its commencement in 2022 to its completion in 2023, were (i) $6.4 million relating primarily to inventory markdowns, and (ii) $3.4 million relating primarily to the relocation and termination of certain facilities in Canada. As a result of the continued adverse market conditions, in the third quarter of 2023 we began a second phase of the Restructuring Plan, including U.S. manufacturing facility consolidations, in particular with respect to our production of certain 23 TABLE OF CONTENTS durable equipment products. We are reducing facility space and consolidating our manufacturing operations in the U.S. to improve efficiency and reduce costs. These restructuring charges are primarily recorded within Cost of goods sold on the consolidated statements of operations. During the three months ended March 31, 2024, we recorded pre-tax restructuring charges of $0.1 million, relating primarily to cash charges associated with the consolidation of U.S. manufacturing facilities. Further, we estimate additional charges associated with this second phase of the Restructuring Plan may exceed $2.0 million and be incurred through the next several quarters as we consolidate and exit facilities. These estimated additional charges include an estimated cash impact that may exceed $1.0 million for facility consolidations and lease and other contract terminations. We anticipate the second phase of our restructuring plan and related actions may result in cost savings of approximately $1.5 million on an annualized basis. The amounts we will ultimately realize or disburse in connection with both phases of the Restructuring Plan could differ materially from our estimates, and we may not be able to realize the full extent of our anticipated cost savings. We review intangible assets with finite lives and indefinite lives for impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. We noted a deterioration in customer demand in the United States and Canada caused by macroeconomic and industry conditions and fully impaired goodwill in 2022. However, we did not identify a triggering event requiring a test for impairment of intangible assets during the year ended December 31, 2023, or the three months ended March 31, 2024. We maintain an allowance for excess and obsolete inventory that is based upon assumptions about future demand and market conditions. While we believe our estimates of charges relating to our Restructuring Plan, long-lived assets, inventory obsolescence, and accounts receivable allowances are reasonable, it is possible that we may incur additional charges in the future and actual results may differ significantly from these estimates and assumptions. Depending on the length and severity of the industry and market conditions impacting our business, it is possible we may execute additional restructuring plan actions and incur future associated charges, and we may not be able to realize the full extent of our anticipated cost savings. Results of Operations—Comparison of three months ended March 31, 2024 and 2023 The following table sets forth our unaudited interim condensed consolidated statements of operations for the three months ended March 31, 2024, and 2023, including amounts and percentages of net sales for each period and the period-to-period change in dollars and percent (amounts in thousands): Three months ended March 31, 2024 2023 Period change Net sales $ 54,172 100.0 % $ 62,178 100.0 % $ (8,006) -12.9 % Cost of goods sold 43,247 79.8 % 50,797 81.7 % (7,550) -14.9 % Gross profit 10,925 20.2 % 11,381 18.3 % (456) -4.0 % Operating expenses: Selling, general and administrative 19,621 36.2 % 24,431 39.3 % (4,810) -19.7 % Loss from operations (8,696) -16.1 % (13,050) -21.0 % 4,354 33.4 % Interest expense (3,931) -7.3 % (3,692) -5.9 % 239 6.5 % Other income, net 215 0.4 % 40 0.1 % 175 437.5 % Loss before tax (12,412) -22.9 % (16,702) -26.9 % 4,290 25.7 % Income tax expense (196) -0.4 % (147) -0.2 % 49 33.3 % Net loss $ (12,608) -23.3 % $ (16,849) -27.1 % $ 4,241 25.2 % Net sales Net sales for the three months ended March 31, 2024, were $54.2 million, a decrease of $8.0 million, or 12.9% compared to the same period in 2023. The 12.9% decrease in net sales for the three months ended March 31, 2024, as compared to the same period in 2023, was due to a 12.6% decline in volume/mix of products sold and a 0.3% decrease in price. The decrease in volume/mix of products sold was primarily related to the aforementioned oversupply in the cannabis industry. Gross profit Gross profit for the three months ended March 31, 2024, was $10.9 million, a decrease of $0.5 million, or 4.0%, compared to the same period in 2023. The decrease was due to lower net sales. Our gross profit margin percentage increased to 24 TABLE OF CONTENTS 20.2% for the three months ended March 31, 2024 , from 18.3% in the same period in 2023, primarily as a result of our restructuring and related cost savings initiatives which drove improved productivity in manufacturing. Selling, general and administrative expenses SG&A expenses for the three months ended March 31, 2024, were $19.6 million, a decrease of $4.8 million, or 19.7% compared to the same period in 2023. The decrease was due to lower expenses in several areas, including as a result of our cost saving and restructuring initiatives: (i) $1.4 million decrease in facility costs, (ii) $1.0 million decrease in professional and outside services, (iii) $0.8 million decrease in insurance costs, and (iv) $0.8 million decrease in salaries and benefits, along with other expense reductions in multiple areas. Interest expense Interest expense for the three months ended March 31, 2024, was $3.9 million, an increase of $0.2 million compared to the same period in the prior year. The increase was primarily due to higher variable interest rates on our Term Loan. Other income, net Other income, net for the three months ended March 31, 2024, was $0.2 million, an increase of $0.2 million compared to the same period in the prior year. Other income, net for the three months ended March 31, 2024, was primarily driven by interest income and foreign currency exchange rate gains. Income taxes We recorded income tax expense of $0.2 million for the three months ended March 31, 2024, representing an effective tax rate of (1.6)%. Our effective tax rate for the three months ended March 31, 2024, differs from the federal statutory rate of 21% primarily due to maintaining a full valuation allowance against our net deferred tax assets in the United States and most foreign jurisdictions. The income tax expense for the three months ended March 31, 2024, was primarily due to U.S. state taxes and foreign taxes in certain jurisdictions. We recorded an income tax expense of $0.1 million for the three months ended March 31, 2023, representing an effective income tax rate of (0.9)%. Our effective tax rate for the three months ended March 31, 2023, differs from the federal statutory rate of 21% primarily due to the Company maintaining a full valuation allowance against its net deferred tax assets in the U.S. and most foreign jurisdictions. The income tax expense for the three months ended March 31, 2023, was primarily due to foreign taxes in certain jurisdictions. Liquidity and Capital Resources Cash Flow from Operating, Investing, and Financing Activities Comparison of the three months ended March 31, 2024, and March 31, 2023 The following table summarizes our cash flows for the three months ended March 31, 2024, and 2023 (amounts in thousands): Three months ended March 31, 2024 2023 Net cash used in operating activities $ (2,297) $ (8,950) Net cash used in investing activities (1,408) (1,602) Net cash (used in) from financing activities (2,358) 7,959 Effect of exchange rate changes on cash and cash equivalents (97) 5 Net decrease in cash and cash equivalents (6,160) (2,588) Cash and cash equivalents at beginning of period 30,312 21,291 Cash and cash equivalents at end of period $ 24,152 $ 18,703 Operating Activities Net cash used in operating activities was $2.3 million for the three months ended March 31, 2024. Consistent with historical seasonal trends, we utilized cash from operating activities in the first quarter to fund our working capital. The $1.3 25 TABLE OF CONTENTS million net reduction in working capital was primarily driven by a $5.7 million increase of accounts receivable and a $2.0 million decrease of lease liabilities, partially offset by a $4.2 million increase of accounts payable and accrued expenses and other current liabilities and a $2.2 million decrease of inventory. Net cash used in operating activities was $9.0 million for the three months ended March 31, 2023, primarily due to a net loss of $16.8 million, partially offset by net non-cash items. Additionally, we had a $5.5 million net cash usage for working capital. This was primarily due to an increase of $5.1 million in accounts receivable, net, and decreases of $3.1 million of accrued expenses and other current liabilities, $2.2 million of lease liabilities, and $1.1 million in deferred revenue, partially offset by a decrease of $7.3 million in inventories. Investing Activities Net cash used in investing activities was $1.4 million and $1.6 million for the three months ended March 31, 2024, and March 31, 2023, respectively, primarily due to capital expenditures of property, plant and equipment. Financing Activities Net cash used in financing activities was $2.4 million for the three months ended March 31, 2024, primarily driven by $2.0 million of Term Loan repayments relating to required quarterly payments of principal and prepayments made in conjunction with the Sale-Leaseback Transaction. Net cash from financing activities was $8.0 million for the three months ended March 31, 2023, primarily driven by $8.6 million of proceeds from the Sale-Leaseback Transaction. Availability and Use of Cash Our ability to make investments in our business, service our debt and maintain liquidity will depend upon our ability to generate excess operating cash flows through our operating subsidiaries. We believe that our cash flows from operating activities, combined with current cash levels and borrowing availability under the Revolving Credit Facility, will be adequate to support our ongoing operations, to fund debt service requirements, capital expenditures, lease obligations and working capital needs through the next twelve months of operations. However, we cannot guarantee that our business will generate sufficient cash flow from operating activities or that future borrowings will be available under our borrowing agreements in amounts sufficient to pay indebtedness or fund other working capital needs. Actual results of operations will depend on numerous factors, many of which are beyond our control as further discussed in Item 1A. Risk Factors included in this Quarterly Report on Form 10-Q and in our 2023 Annual Report. If necessary, we believe that we could supplement our cash position through additional sale-leasebacks, asset sales and equity financing. We believe it is prudent to be prepared if required and, accordingly, continue to be engaged in the process of evaluating and preparing to implement one or more of the aforementioned activities. Any potential such event may be subject to provisions referenced in our Term Loan and Revolving Credit Facility, such as subjecting the Company to making mandatory prepayments . In January 2023, Gotham Properties LLC, an Oregon limited liability company and our subsidiary ("Seller"), consummated a Purchase and Sale Agreement with J & D Property, LLC, a Nevada limited liability company ("Purchaser") pursuant to which certain real property located in the City of Eugene, County of Lane, State of Oregon (the “Eugene Property”) was sold to Purchaser for $8.6 million and then leased back by Seller. The new lease has a term of 15 years with annual rent starting at approximately $0.7 million and increases to the final year when annual rent is approximately $1.0 million. The Eugene Property serves as the manufacturing and processing site for certain of our grow media and nutrient brands. Refer to further discussion below relating to Term Loan reinvestment provisions regarding the net cash proceeds of the Sale Leaseback Transaction. Term Loan On October 25, 2021, we and certain of our direct and indirect subsidiaries entered into the Term Loan with JPMorgan Chase Bank, N.A., as administrative agent for the lenders, pursuant to which we borrowed a $125 million senior secured term loan (the "Term Loan"). The Term Loan was amended by Amendment No. 1 effective as of June 27, 2023, to replace the LIBOR referenced rates with SOFR referenced rates. Pursuant to Amendment No. 1, any Term Loan that constitutes a Eurodollar Rate Loan that is outstanding as of the Amendment No. 1 closing date shall continue until the end of the applicable interest period for such Eurodollar Rate Loan and the provisions of the Term Loan applicable thereto shall continue and remain in effect (notwithstanding the occurrence of the Amendment No. 1 closing date) until the end of the applicable interest period for such Eurodollar Rate Loan, after which such provisions shall have had no further force or effect. Such Eurodollar Rate Loan 26 TABLE OF CONTENTS shall subsequently either be an ABR Loan or a Term Benchmark Loan. The ABR Loans shall bear interest at the Alternate Base Rate (with a 2.0% floor) plus 4.50%, and Term Benchmark Loans shall bear interest at the Adjusted Term SOFR Rate (with a 1.0% floor) plus 5.50%. As of the date of filling this Quarterly Report on Form 10-Q, the ABR Loan and Term Benchmark Loan credit spreads of 4.50% and 5.50%, respectively, within the Amendment No. 1 have not changed from the credit spreads in the original Term Loan. The Term Loan matures on October 25, 2028. The principal amounts of the Term Loan are scheduled to be repaid in consecutive quarterly installments in amounts equal to 0.25% of the original principal amount of the Term Loan on the last day of each fiscal quarter commencing March 31, 2022, with the balance of the Term Loan payable on the Maturity Date of October 25, 2028. We are also required to make mandatory prepayments in the event of (i) achieving certain excess cash flow criteria, including the achievement and maintenance of a specific leverage ratio, (ii) certain asset sales that are collateral, or (iii) upon the issuance, offering, or placement of new debt obligations. As described in Note 6 – Leases , we received net cash proceeds in January 2023 from the Sale-Leaseback Transaction and are subject to a provision whereby such net cash proceeds can be reinvested into certain investments, such as capital expenditures. This provision of the Term Loan includes (i) cash investments made within a one-year period from the Sale Leaseback Transaction, and (ii) investments which are contractually committed within one-year of the Sale Leaseback Transaction, and paid within 180 days after entering into such contractual commitment. The amount of any net cash proceeds which are not reinvested would require us to make an offer to prepay the corresponding amount on the Term Loan in 2024. In accordance with this provision, we classified $1.7 million as current debt on our consolidated balance sheet as of December 31, 2023, and prepaid the Term Loan in this amount during the three months ended March 31, 2024. In addition, we had $2.2 million of contractual commitments pursuant to this provision as of December 31, 2023. Should any of the $2.2 million of contractual commitments not be paid within 180 days of their contractual commitment dates, we will be required to make an additional offer to prepay the corresponding amount in 2024. The foregoing description of the reinvestment provision does not purport to be complete and is qualified in its entirety by reference to the provisions of the Term Loan. As of March 31, 2024, and December 31, 2023, the outstanding principal balance on the Term Loan was $120.5 million and $122.5 million, respectively. The Term Loan requires us to maintain certain reporting requirements, affirmative covenants, and negative covenants. We were in compliance with all debt covenants as of March 31, 2024. The Term Loan is secured by a first lien on our non-working capital assets and a second lien on our working capital assets. Revolving Credit Facility On March 29, 2021, we and certain of our subsidiaries entered into the Revolving Credit Facility (the "Revolving Credit Facility") with JPMorgan Chase Bank, N.A., as administrative agent, issuing bank and swingline lender for a revolving line of credit up to $50 million. The Revolving Credit Facility was amended by the First Amendment dated August 31, 2021, which increased the revolving line of credit by an additional $50 million for an aggregate borrowing limit of $100 million. The Revolving Credit Facility was further amended by the Second Amendment dated October 25, 2021 which, among other things, permitted the incurrence of the Term Loan and made certain other changes including subordinating its liens on non-working capital assets to the obligations under the Term Loan. The Revolving Credit Facility was further amended by the Third Amendment and Joinder dated August 23, 2022, pursuant to which several previously acquired subsidiaries became parties to the Revolving Credit Facility and granted liens on their assets. On December 22, 2022, we entered into the Fourth Amendment pursuant to which a sale-leaseback transaction was permitted, and certain other changes were made, including a reduction of the maximum commitment amount under the Revolving Credit Facility from $100 million to $75 million and transitioning the LIBOR based rates to SOFR based rates. On March 31, 2023, we and certain of our subsidiaries entered into the Fifth Amendment, pursuant to which the maturity date was extended to June 30, 2026, the maximum commitment amount under the Revolving Credit Facility was reduced to $55 million, and the interest rate on borrowings was revised to various spreads, based on our fixed charge coverage ratio. The Revolving Credit Facility provides for various interest rate options including the Adjusted Term SOFR Rate, the Adjusted REVSOFR30 Rate, the CB Floating Rate, the Adjusted Daily Simple SOFR, the CBFR, the Canadian Prime Rate, or the CDOR Rate. The rates that use SOFR as the reference rate (Adjusted Term SOFR Rate, the Adjusted REVSOFR30 Rate, the Adjusted Daily Simple SOFR and the CBFR rate) use the Term SOFR Rate plus 1.95%. Each rate has a 0.0% floor. A fee of 0.40% per annum is charged for available but unused borrowings. Our obligations under the Revolving Credit Facility are secured by a first priority lien (subject to certain permitted liens) in substantially all of our and our subsidiaries' respective personal property assets pursuant to the terms of a U.S. and Canadian Pledge and Security Agreement dated March 29, 2021 and other security documents, as amended to include additional subsidiaries. 27 TABLE OF CONTENTS The Revolving Credit Facility maintains certain reporting requirements, affirmative covenants, negative covenants and financial covenants. A certain financial covenant becomes applicable in the event that our excess availability under the Revolving Credit Facility is less than an amount equal to 10% of the Aggregate Revolving Commitment (currently $55 million) and would require us to maintain a minimum fixed charge coverage ratio of 1.1x on a rolling twelve-month basis. In order to consummate permitted acquisitions or to make restricted payments, we would be required to comply with a higher fixed charge coverage ratio of 1.15x, but no such acquisitions or payments are currently contemplated. We were in compliance with all debt covenants as of March 31, 2024. As of March 31, 2024, approximately $25 million was available to borrow under the Revolving Credit Facility, before we would be required to comply with the minimum fixed charge coverage ratio of 1.1x. As of March 31, 2024, and December 31, 2023, we had zero borrowed under the Revolving Credit Facility. The aforementioned financing arrangements and other transactions are more fully described in the notes to the condensed financial statements included elsewhere in this Quarterly Report on Form 10-Q. Cash and Cash Equivalents The cash and cash equivalents balances of $24.2 million and $30.3 million at March 31, 2024, and December 31, 2023, respectively, included $7.1 million and $8.5 million, respectively, held by foreign subsidiaries. Material Cash Requirements Our material cash requirements include (i) principal repayments and anticipated interest payments on our long-term debt, (ii) finance lease payments, (iii) operating lease payments, and (iv) balances subject to the Term Loan reinvestment provision, as well as other purchase obligations to support our operations. Variable rates on our Term Loan are subject to change as further described in Item 3. Quantitative and Qualitative Disclosures About Market Risk . Refer to Item 1. Financial Statements , Note 9 – Debt , Note 6 – Leases , and Note 13 – Commitments and Contingencies for details relating to our material cash requirements for debt, our leasing arrangements, including future maturities of our operating lease liabilities, and purchase obligations, respectively. From time to time in the normal course of business, we will enter into agreements with suppliers which provide favorable pricing in return for a commitment to purchase minimum amounts of inventory over a defined time period. Critical Accounting Policies and Estimates The preceding discussion and analysis of our consolidated results of operations and financial condition should be read in conjunction with our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. Our critical accounting policies and estimates are identified in Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of the 2023 Annual Report and include the discussion of estimates used in indefinite lived intangible assets, long-lived tangible and finite-lived intangible assets, and inventory valuation. Such accounting policies and estimates require significant judgments and assumptions to be used in the preparation of the Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q, and actual results could differ materially from the amounts reported. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, refer to Note 2 – Basis of Presentation and Significant Accounting Policies — Recent accounting pronouncements , to our Condensed Consolidated Financial Statements included elsewhere in this Quarterly Report on Form 10-Q. 28 TABLE OF CONTENTS