Item 7. 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 consolidated financial statements and the notes contained elsewhere in this Annual Report on Form 10-K. This discussion and analysis contains statements of a forward-looking nature relating to future events or our future financial performance. These statements are only predictions, and actual events or results may differ materially. In evaluating such statements, you should carefully consider the various factors identified in this Annual Report on Form 10-K, 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 this Annual Report on Form 10-K. See “Special Note Regarding Forward-Looking Statements.”
Company Overview
We are a leading independent manufacturer and distributor of CEA equipment and supplies, including a broad portfolio of our own innovative proprietary branded products. We primarily serve the U.S. and Canadian markets, and believe we are one of the leading competitors in these markets in an otherwise highly 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, CO2, 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 experienced adverse financial results during 2022 which we believe is primarily a result of an agricultural oversupply impacting our market. This has led to a reduction in our 2022 profitability, as compared to the prior year, and a loss from operations. These market conditions continued to negatively impact our business and results of operations, and the extent to which this will continue is uncertain and difficult to predict at this time.
In connection with our previously disclosed evaluation of our facility footprint and product and brand portfolio, we began a restructuring plan during the quarter ended December 31, 2022. We are undertaking significant actions to streamline our operations, reduce costs and improve efficiencies during the industry recession. Our major initiatives include (i) narrowing our product and brand portfolio and (ii) relocating and consolidating certain manufacturing and distribution centers including headcount reductions and reorganization to drive a solution based approach. We are focusing commercial sales on competencies and product assortment gained from our recent acquisitions. During the year ended December 31, 2022, we recorded pre-tax charges of $6.8 million relating to inventory markdowns of products and brands being removed from our portfolio, which is primarily non-cash, and $0.9 million relating primarily to the relocation and termination of certain facilities in Canada, which are primarily cash charges. Restructuring charges are primarily recorded within Cost of goods sold on the consolidated statement of operations for the year ended December 31, 2022.
We plan to incur approximately $1.7 million of additional charges in 2023, which are primarily cash, associated with the execution of our restructuring plan, which we expect to complete in the first half of 2023. We may also execute a second phase of our restructuring plan in 2023 and incur additional costs. Our strategic product consolidation entails removing approximately one-third of all products and one-fifth of all brands relating to our primary product portfolio, which excludes our garden center business in Canada. We expect the restructuring and related actions to result in cost savings of approximately $7.0 million on an annualized basis.
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As of June 30, 2022, primarily due to a sustained decline in the market value of our common stock and the market conditions described above, we identified a triggering event requiring a test for goodwill impairment. We completed our goodwill impairment testing and recorded an impairment charge of $189.6 million as the test determined that the carrying value of the reporting units of U.S. and Canada was in excess of the fair value. The recognized impairment reduced the goodwill balance to zero as of June 30, 2022. The impairment was primarily due to a deterioration in customer demand in the U.S. and Canada caused by macroeconomic and industry conditions. We also 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 did not identify a triggering event requiring a test for impairment of intangible assets during the remainder of 2022.
In connection with the goodwill impairment analysis performed as of June 30, 2022, we determined the fair value of the U.S. and Canada reporting units based on an income approach, using the present value of future discounted cash flows, and based on a market approach. The fair values were reconciled to the market value of our common stock to corroborate the estimates used in the interim test for impairment. The fair value determinations were a reflection of recent sales declines we have experienced, which we believe are primarily a result of an agricultural oversupply impacting our market, and a reduction to our 2022 profitability and loss from operations.
We maintain an allowance for excess and obsolete inventory that is based upon assumptions about future demand and market conditions. During the year ended December 31, 2022, our consolidated statements of operations included charges of $18.5 million, primarily relating to increases to our allowance for inventory obsolescence relating to certain lighting products, which are incremental to the restructuring costs described above. In addition, during the year ended December 31, 2022, our consolidated statements of operations included $2.9 million of accounts receivable allowances and write downs.
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 plans and incur future associated charges, and we may not be able to realize the full extent of our anticipated cost savings.
Five Acquisitions Completed in 2021
During the year ended December 31, 2021, we completed the following five acquisitions of branded manufacturers of CEA products, resulting in a significant expansion of our portfolio of proprietary branded products and manufacturing capabilities. Our proprietary brands generally provide for higher gross profit margins compared to distributed brands.
•Heavy 16, a manufacturer of plant nutrients and additives, in May 2021. Heavy 16 was a leading manufacturer and supplier of branded plant nutritional products, with nine core products featuring a full line of premium nutrients used in all stages of plant growth, helping to increase the yield and quality of crops.
•House & Garden, a manufacturer of plant nutrients and additives, in June 2021. House & Garden is located in Arcata, California, and produces and distributes premium grade plant nutrients and fertilizers, offering a strong product line to strengthen our position in the nutrient sector.
•Aurora, a manufacturer of soil, grow media, plant nutrients and additives, in July 2021. Aurora provides comprehensive plant fertility products and grow media and includes organic nutrient and premium soil brands. With the Aurora acquisition, we gained new domestic manufacturing and distribution capabilities on the east and west coasts along with a peat moss harvesting operation in Canada.
•Greenstar Plant Products, a manufacturer of plant nutrients and additives, in August 2021. Greenstar produces premium horticultural products and solutions with brands including Grotek, Gaia Green, Supergreen, and EarthSafe.
•Innovative Growers Equipment, a manufacturer of horticultural benches, racks and grow lights, in November 2021. The acquisition of Innovative Growers Equipment added to our existing lineup of high performance, proprietary branded products.
See Note 3 - Business Combinations in the notes to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
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Recent Financing Arrangements and Other Transactions
During the years ended December 31, 2022, and 2021, we entered into new financing arrangements and other significant transactions including:
◦Term Loan:On October 25, 2021, we entered into a senior secured term loan facility, in the aggregate principal amount of $125.0 million, with JPMorgan Chase Bank, N.A. as administrative agent for the lenders (the "Term Loan"). The Term Loan bears interest at a rate of either LIBOR (with a 1.0% floor) plus 5.50%, or an alternate base rate (with a 2.0% floor) plus 4.50% and matures on October 25, 2028.
◦Investor Warrant Redemption: On July 19, 2021, we completed the redemption (the “Warrant Redemption”) of certain of our outstanding warrants (the "Investor Warrants") to purchase shares of our common stock that were issued in connection with a private placement of units. Prior to the redemption date, 3,367,647 Investor Warrants were exercised, generating total gross proceeds of approximately $56.8 million. As of December 31, 2022, and 2021, respectively, there were no Investor Warrants outstanding.
◦Follow-on Public Offering: On May 3, 2021, we closed our follow-on offering, in which we issued and sold 5,526,861 shares of our common stock, including the full exercise by the underwriters of their option to purchase 720,894 additional shares of our common stock, at a public offering price of $59.00 per share, which resulted in net proceeds of approximately $309.8 million after deducting underwriting discounts and commissions and offering expenses.
◦JPMorgan Revolving Loan Facility: On March 29, 2021, we and certain of our subsidiaries entered into a Senior Secured Revolving Credit Facility (the “JPMorgan Revolving Loan Facility”) with JPMorgan Chase Bank, N.A., as administrative agent, issuing bank and swingline lender for a three-year revolving line of credit up to $50 million. Our and our subsidiaries’ obligations under the JPMorgan Revolving Loan Facility are secured by first priority liens (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 a Canadian Pledge and Security Agreement, dated March 29, 2021, and the other security documents. The JPMorgan Revolving Loan 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 JPMorgan Revolving Loan 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. The JPMorgan Revolving Loan 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 JPMorgan Revolving Loan Facility and granted liens on their assets. On December 22, 2022, we entered into a Fourth Amendment pursuant to which the maximum commitment amount under the JPMorgan Revolving Loan Facility was reduced from $100 million to $75 million, and certain other changes were made, including transitioning the LIBOR based rates to SOFR based rates.
The aforementioned financing arrangements and other transactions are more fully described in the notes to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
Effects of COVID-19 on Our Business
The World Health Organization recognized COVID-19 as a global pandemic on March 11, 2020, and COVID-19 has had significant and ongoing negative impacts on global societies, workplaces, economies and health systems. Authorities throughout the world have implemented measures to contain or mitigate the spread of the virus, including at various times physical distancing, travel bans and restrictions, closure of non-essential businesses, quarantines, work-from-home directives, mask requirements, shelter-in-place orders, and vaccination programs, but despite these efforts, COVID-19 has persisted, has mutated into new variants, and is expected to become endemic. We have implemented business continuity plans and followed safety protocols as recommended by government guidelines, and we will continue to do so as the state of COVID-19 evolves. As of the filing of this Annual Report on Form 10-K, our operations are not impacted by any COVID-19 related facility closures, lockdown measures, travel restrictions or similar limitations. However, new waves of COVID-19 or its variants could cause the reinstatement of such limitations, and such limitations may adversely impact our supply chains, the manufacturing of our own products and our ability to obtain necessary materials, all of which could adversely affect our business, results of operations and financial condition. We have historically and may continue to source select products from China. We have in the past, and may again in the future experience some extended lead times in our supply chain, as well as increased shipping costs and believe the COVID-19 pandemic is a contributing factor to those extended lead times and increased costs. Furthermore, potential suppliers or sources of materials may pass the increase in sourcing costs due to the COVID-19 pandemic to us through price increases, thereby impacting our potential future profit margins.
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The extent to which the COVID-19 pandemic will ultimately impact our business, results of operations, financial condition and cash flows depends on future developments that are highly and rapidly evolving and difficult to predict at this time. It is difficult to assess or quantify with precision the impact COVID-19 has directly had on our business since we cannot precisely quantify the impacts, if any, that the various effects have had on the overall business.
We believe COVID-19 may have provided a positive demand impact 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 due to agricultural oversupply initiated during the height of COVID-related shelter-in-place orders in 2020 and 2021. We continue to monitor the COVID-19 pandemic and will adjust our mitigation strategies as necessary to address changing health, operational or financial risks that may arise.
Components of Results of Operations
Net sales
We generate net sales from the distribution and manufacturing of hydroponic equipment and supplies to our customers. The hydroponic equipment and supplies that we sell include consumable products, such as growing media, nutrients and supplies that are subject to regular replenishment and durable products, such as lighting and hydroponic equipment. Our scale allows us to provide delivery and service capabilities to customers across the U.S. and Canada.
We periodically offer sales incentives to our customers, including early pay discounts, volume-based rebates, temporary price reductions, advertising credits and other trade activities. Net sales reflect our gross sales less sales incentives which are estimated and recorded at the time of sale plus amounts billed to customers for shipping and handling costs. We anticipate that sales incentives and/or the amount billed to customers for shipping and handling costs could impact our net sales and that changes in such promotional activities or freight recovery charges could impact period-over-period results.
Cost of goods sold
Cost of goods sold consists primarily of material costs, inbound and outbound freight costs, direct labor costs primarily for manufacturing and warehouse personnel, facility costs for manufacturing operations, depreciation, depletion and amortization of manufacturing and warehouse improvements and equipment, inventory allowances, restructuring costs, and certain acquisition and integration expenses. We expect that our cost of goods sold would increase in absolute dollars in conjunction with net sales growth if that occurs in the future. However, we expect that, over time, cost of goods sold may decrease as a percentage of net sales if we are able to scale our business as we obtain a higher proportion of net sales associated with proprietary and exclusive branded products.
Selling, general and administrative
Selling, general and administrative expenses ("SG&A") consists primarily of marketing and advertising, facility costs for distribution operations, depreciation and amortization of all other assets, certain acquisition and integration expenses and other selling, general and administrative costs, including but not limited to salaries, benefits, bonuses, stock-based compensation, professional fees, and various costs related to being a publicly-traded company.
Results of Operations Data
The results of operations data in the following table for the years ended December 31, 2022, and 2021 have been derived from the audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
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Results of Operations - Comparison of Years Ended December 31, 2022, and 2021
The results of operations data in the following table, including amounts and percentages of net sales for each year and the year-to-year change in dollars and percent, for the years ended December 31, 2022, and 2021, have been derived from the audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K (amounts in thousands):
Years ended December 31,
Operating expenses:
Net sales
Net sales for the year ended December 31, 2022, were $344.5 million, a decrease of $134.9 million, or 28.1%, compared to the same period in 2021. The 28.1% decrease was due to a 29.5% decline in volume of products sold (a 46.5% decline in organic sales and a 17.0% increase from 2021 acquired proprietary brands), a 1.7% increase in price and mix of products sold, and a 0.3% decline from unfavorable foreign exchange rates. The decrease in volume of products sold was primarily related to the aforementioned oversupply in the cannabis industry. The increase in price was primarily related to list price increases, as well as higher freight recovery as we put multiple measures in place to combat rising freight costs. The decrease in foreign exchange related to recent strength in the U.S. Dollar relative to the Canadian Dollar and to the Euro.
Gross profit
Gross profit for the year ended December 31, 2022, was $29.3 million, a decrease of $72.2 million, or 71.1%, compared to the same period in 2021. The decrease in gross profit was primarily related to the aforementioned decrease in net sales and a significant decrease in our gross profit margin percentage. Our gross profit margin percentage decreased to 8.5% for the year ended December 31, 2022, from 21.2% in the same period in 2021. The lower gross profit margin percentage is primarily due to an increase in the inventory obsolescence allowances and related charges of $18.5 million primarily related to certain lighting products, and restructuring costs of $7.5 million associated with inventory markdowns of products and brands being removed from our portfolio and the relocation and termination of certain facilities in Canada. Also negatively impacting gross profit margin were freight and labor costs which were higher as a percentage of net sales. These were partially offset by the aforementioned list price increases, as well as a higher proportion of higher-margin proprietary brand sales.
Selling, general and administrative expenses
SG&A expenses for the year ended December 31, 2022, were $118.6 million, an increase of $14.4 million, or 13.8% compared to the same period in 2021. The increase is primarily related to (i) a $23.4 million increase in depreciation, depletion and amortization expense primarily due to the acquisitions completed in 2021 which includes $5.9 million of additional amortization expense from adjustments to useful lives that were determined this year, (ii) a $2.9 million increase in accounts receivable allowances and write-offs, (iii) a $2.8 million increase in share-based compensation, (iv) a $2.1 million increase in compensation costs (primarily salaries and benefits for employees from companies acquired in 2021), of which $0.7 million was an increase in severance associated with a recent reduction-in-force, and (v) a $2.0 million increase in insurance costs. The SG&A increases compared to the prior year were partially offset by (i) a $16.8 million decrease in acquisition and integration expenses, and (ii) a $1.9 million decrease from investor warrant solicitation fees incurred last year.
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Impairments
We recorded goodwill impairment charges of $189.6 million for the year ended December 31, 2022, as we determined that the carrying value of the reporting units of U.S. and Canada were in excess of the fair value. The recognized impairment reduced the goodwill balance to zero as of December 31, 2022. The impairment was primarily due to a deterioration in customer demand in the U.S. and Canada caused by macroeconomic and industry conditions. For the year ended December 31, 2022, we also recorded an impairment of a note receivable of $2.6 million.
Interest expense
Interest expense for the year ended December 31, 2022, was $11.0 million, an increase of $8.8 million, or 412.5%, compared to the same period in the prior year. The increase was primarily due to the interest-bearing Term Loan entered into in the fourth quarter of 2021 and outstanding for the entirety of 2022, as well as interest rate increases through the year.
Loss on debt extinguishment or modification
Loss on debt extinguishment or modification for the year ended December 31, 2022, was $0.1 million, a decrease of $0.5 million, or 78.7%, compared to the same period in 2021. The Loss on debt extinguishment or modification for the year ended December 31, 2022, resulted primarily from the write-off of unamortized deferred financing costs associated with the modification of the JPMorgan Revolving Loan Facility entered into during the fourth quarter of 2022, which reduced our borrowing capacity from $100 million to $75 million, permitted a sale and leaseback transaction, and made certain other changes, including transitioning the LIBOR based rates to SOFR based rates. Loss on debt extinguishment or modification for the year ended December 31, 2021, resulted primarily from the write-off of unamortized deferred financing costs associated with the termination of the Encina Credit Facility.
Other income (expense), net
Other income for the year ended December 31, 2022, was $0.8 million compared to Other expense of $0.2 million for the year ended December 31, 2021. The increase in other income compared to the prior year periods relates primarily to foreign currency exchange rate gains in 2022.
Income tax benefit
Income tax benefit for the year ended December 31, 2022, was $6.4 million, compared to $19.1 million in the prior year. Our effective income tax rate was 2.2% for the year ended December 31, 2022, and differs from the U.S. federal statutory rate of 21% primarily due to the impairment of goodwill for certain 2021 acquisitions which was not deductible for U.S. tax purposes, increases in our valuation allowance on U.S. deferred tax assets, and the establishment of a valuation allowance for Canadian deferred tax assets. As described in Note 4 - Goodwill and Intangible Assets, Net, during the year ended December 31, 2022, we fully impaired the goodwill associated with all 2021 acquisitions. In connection with the measurement period adjustments associated with 2021 acquisitions, the Company recorded a net deferred tax liability which provided an additional source of taxable income to support the realization of the pre-existing deferred tax assets. The Company's income tax benefit was partially offset by income taxes from certain foreign subsidiaries. For the year ended December 31, 2021, income tax benefit was primarily the result of a reduction in the valuation allowance recorded against our net deferred tax assets. In connection with the acquisition of the H&G Entities, we recorded a net deferred tax liability in 2021 which provided an additional source of taxable income to support the realization of the pre-existing deferred tax assets.
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Non-GAAP Financial Measures
We report our financial results in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP” or “GAAP”). However, management believes that certain non-GAAP financial measures provide investors with additional useful information in evaluating our performance and that excluding certain items that may vary substantially in frequency and magnitude period-to-period from net (loss) income provides useful supplemental measures that assist in evaluating our ability to generate earnings and to more readily compare these metrics between past and future periods. These non-GAAP financial measures may be different than similarly titled measures used by other companies.
To supplement our audited consolidated financial statements which are prepared in accordance with GAAP, and to supplement "net (loss) income" and "net (loss) income as a percent of sales", we use “Adjusted EBITDA” and “Adjusted EBITDA as a percent of sales” which are non-GAAP financial measures. Our non-GAAP financial measures should not be considered in isolation from, or as substitutes for, financial information prepared in accordance with GAAP. There are several limitations related to the use of our non-GAAP financial measures as compared to the closest comparable GAAP measures. Some of these limitations include:
• Adjusted EBITDA does not reflect the significant interest expense, or the amounts necessary to service interest or principal payments on our indebtedness;
• Adjusted EBITDA excludes depreciation, depletion and amortization, and although these are non-cash expenses, the assets being depreciated and amortized may have to be replaced in the future;
• Adjusted EBITDA does not reflect our tax provision that adjusts cash available to us;
• Adjusted EBITDA excludes the non-cash component of stock-based compensation;
• Adjusted EBITDA excludes the amount of employer payroll taxes on stock-based compensation; and
• Adjusted EBITDA does not reflect the impact of earnings or charges resulting from matters we consider not to be reflective, on a recurring basis, of our ongoing operations. These items include restructuring, impairments, severance and other expenses, acquisition and integration expenses, distribution center exit costs, loss on debt extinguishment or modification, investor warrant solicitation fees, and other (expense) income, net.
We define Adjusted EBITDA as net (loss) income excluding interest expense, income taxes, depreciation, depletion and amortization, stock-based compensation including employer payroll taxes on stock-based compensation and other non-cash, unusual and/or infrequent costs (i.e., restructuring, impairments, severance and other expenses, acquisition and integration expenses, distribution center exit costs, loss on debt extinguishment or modification, investor warrant solicitation fees, and other income/expense, net), which we do not consider in our evaluation of ongoing operating performance.
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The following table presents a reconciliation of net (loss) income, the most comparable GAAP financial measure, to Adjusted EBITDA for the years ended December 31, 2022, and 2021 (in thousands):
Years ended December 31,
Distribution center exit costs and other1 1,412 2,641
Depreciation, depletion and amortization 41,527 14,934
Restructuring expenses3 7,687 —
Other (income) expense, net6 (841) 204
Loss on debt extinguishment or modification8 145 680
Investor warrant solicitation fees9 — 1,949
As a percent of net sales:
Net (loss) income (GAAP) (82.8) % 2.8 %
Adjusted EBITDA (Non-GAAP) (6.2) % 9.8 %
Net (loss) income (GAAP) and Adjusted EBITDA (Non-GAAP) for the year ended December 31, 2022, were negatively impacted by $21.4 million of inventory and accounts receivable reserves and related charges.
1. For the 2022 and 2021 periods presented, this relates to costs incurred to exit and relocate distribution centers in California and Pennsylvania including lease exit costs, transportation, and labor related costs.
2. The Company completed its goodwill impairment testing and recorded an impairment charge of $189.6 million during year ended December 31, 2022, due to market softness in demand in the U.S. and Canada. Additionally, during the year ended December 31, 2022, the Company recorded an impairment primarily related to a $2.6 million charge associated with a note receivable that originated in 2019 in connection with a third party independent processor serving the CBD market.
3. During the year ended December 31, 2022, the Company recorded pre-tax charges of $6.8 million relating to the inventory markdowns of products and brands being removed from our portfolio and $0.9 million relating primarily to the relocation and termination of certain facilities in Canada.
4. Severance and other primarily consists of severance costs incurred during the year ended December 31, 2022, related to workforce reductions to optimize our cost structure. Severance and other primarily consists of costs related to an aborted financing during the year ended December 31, 2021.
5. For the year ended December 31, 2022, acquisition and integration expenses include non-cash purchase accounting inventory adjustments for House and Garden, Aurora, Greenstar and Innovative Growers Equipment of $4.8 million, and acquisition and integration consulting, transaction services and legal fees incurred for the completed Heavy 16, House and Garden, Aurora, Greenstar, and Innovative Growers Equipment acquisitions and certain potential acquisitions of $4.5 million, partially offset by the change in fair value of contingent consideration for Aurora of ($1.6 million). For the prior year period, acquisition and integration expenses primarily include investment banking, consulting, transaction services and legal fees incurred for the completed Heavy 16, House & Garden, Aurora, Greenstar, and Innovative Growers Equipment acquisitions and certain potential acquisitions, including non-cash purchase accounting inventory adjustments of $4.5 million, partially offset by the change in fair value of contingent consideration for Aurora of ($2.5 million) for the year ended December 31, 2021.
6. Other (income) expense, net relates primarily to foreign currency exchange rate gains and losses and other non-operating income and expenses.
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7. Includes stock-based compensation and related employer payroll taxes on stock-based compensation for the periods presented.
8. For the year ended December 31, 2022, loss on debt extinguishment or modification resulted primarily from the write-off of unamortized deferred financing costs associated with the modification of the JPMorgan Revolving Loan Facility. For the year ended December 31, 2021, loss on debt extinguishment resulted primarily from the write-off of unamortized deferred financing costs associated with the termination of the Encina Credit Facility.
9. Reflects the elimination of investor warrant solicitation fees.
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Liquidity and Capital Resources
Cash Flow from Operating, Investing, and Financing Activities
Comparison of Years Ended December 31, 2022, and 2021
The following table summarizes our cash flows for the years ended December 31, 2022, and 2021 (amounts in thousands):
Years ended December 31,
Net cash from (used in) operating activities $ 21,989 $ (45,067)
Net cash used in investing activities (8,487) (468,184)
Net cash (used in) from financing activities (20,200) 464,707
Net decrease in cash, cash equivalents and restricted cash (7,093) (48,571)
Cash, cash equivalents and restricted cash at beginning of year 28,384 76,955
Cash, cash equivalents and restricted cash at end of year $ 21,291 $ 28,384
Operating Activities
Net cash from operating activities was $22.0 million for the year ended December 31, 2022, primarily due to a $39.6 million net cash inflow from a reduction of working capital related assets and liabilities. This included a decrease of $57.0 million in inventories and a decrease of $16.7 million in accounts receivable, net, partially offset by decreases of $13.3 million in deferred revenue and $16.5 million in accounts payable, accrued expenses and other current liabilities. The net cash inflow from a reduction of working capital is partially offset by consolidated net loss on the statement of operations. During the year ended December 31, 2022, we paid $9.6 million in cash interest, compared to $1.6 million in the prior year.
Net cash used in operating activities was $45.1 million for the year ended December 31, 2021, primarily consisting of $13.4 million in net income, $4.4 million in net non-cash expense reductions, which were largely comprised of depreciation, depletion and amortization, stock-based compensation expense, non-cash operating lease expense, deferred income tax benefit and other non-cash expenses, less a $62.9 million increase in working capital. This change in working capital primarily reflects an aggregate increase of $47.8 million in accounts receivable, inventories, prepaid expenses and other current assets, and other assets for the period as well as an aggregate net decrease of $15.1 million in accounts payable, accrued expenses and other current liabilities, deferred revenue, and a decrease in lease liabilities due to payments on lease obligations during the period.
Investing Activities
Net cash used in investing activities for the year ended December 31, 2022, was $8.5 million, due primarily to capital expenditures for property, plant and equipment, which increased over the prior year primarily due to growth investments in our manufacturing operations and the expansion and relocation of certain of our distribution centers. The 2022 cash usage primarily includes our growth-oriented investments in the peat moss harvesting operation in Canada and IGE manufacturing operations in the U.S.
Net cash used in investing activities for the year ended December 31, 2021, was $468.2 million, due primarily to five business acquisitions we completed during the period, which totaled $462.2 million in cash outflows and $6.0 million in capital expenditures for property, plant and equipment and other.
Financing Activities
Net cash used in financing activities was $20.2 million for the year ended December 31, 2022, primarily consisting of $15.5 million in payments to settle contingent consideration, primarily on our Aurora acquisition. We paid $2.5 million related to employees' withholding tax in connection with the vesting of restricted stock units. In addition, we paid $1.3 million in principal payments on the Term Loan.
Net cash provided by financing activities was $464.7 million for the year ended December 31, 2021. We received $309.8 million proceeds from our follow-on offering, $119.9 million proceeds from the Term Loan, net of discount and
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issuance costs, and received an additional $56.8 million from the exercise of warrants, including the Warrant Redemption. We also paid $20.0 million related to employees' withholding tax in connection with the vesting of certain restricted stock units.
JPMorgan Revolving Loan Facility
On March 29, 2021, we entered into the JPMorgan Revolving Loan Facility, which provided for a borrowing limit of $50 million. The JPMorgan Revolving Loan Facility replaced the Encina Credit Facility. The JPMorgan Revolving Loan Facility matures on March 29, 2024.
The JPMorgan Revolving Loan 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 JPMorgan Revolving Loan 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 JPMorgan Revolving Loan 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 JPMorgan Revolving Loan Facility and granted liens on their assets. On December 22, 2022, the Company entered into the Fourth Amendment pursuant to which the maximum commitment amount under the JPMorgan Revolving Loan Facility was reduced from $100 million to $75 million, a sale and leaseback transaction was permitted and certain other changes were made, including transitioning the LIBOR based rates to SOFR based rates.
The JPMorgan Revolving Loan 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 0.25% per annum is charged for available but unused borrowings. Our obligations under the JPMorgan 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.
The JPMorgan Revolving Loan 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 JPMorgan Revolving Loan Facility is less than an amount equal to 10% of the Aggregate Revolving Commitment (currently $75 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, the Company 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 December 31, 2022. As of December 31, 2022, approximately $40 million was available to borrow under the undrawn JPMorgan Revolving Loan Facility, before we would be required to comply with the minimum fixed charge coverage ratio of 1.1x.
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 $125.0 million senior secured term loan. The Term Loan bears interest at LIBOR (with a 1.0% floor) plus 5.50%, or an alternative base rate (with a 2.0% floor), plus 4.50%, and is subject to a call premium of 2% in year one, 1% in year two, and 0% thereafter, and matures on October 25, 2028. We received net proceeds of $119.9 million from the Term Loan after deducting discounts and deferred financing costs.
The principal amounts of the Term Loan are scheduled to be repaid in consecutive quarterly installments in amounts equal to 0.25% of the $125 million 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.
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 December 31, 2022. The Term Loan is secured by a first lien on our non-working capital assets and a second lien on our working capital assets.
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Cash and cash equivalents
The cash and cash equivalents balances of $21.3 million and $26.6 million at December 31, 2022, and December 31, 2021, respectively, included $7.3 million and $4.1 million, respectively, held by foreign subsidiaries.
Material Cash Requirements
Our material cash requirements include interest payments on our long-term debt, operating lease payments, and purchase obligations to support our operations. Refer to Part II, Item 8, Financial Statements, Note 10 - Debt, Note 7 - Leases, and Note 14 - Commitments and Contingencies, and Related Party Transactions 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.
Seasonality
Our net sales are typically seasonally stronger in our fiscal second and third quarters due to robust sales in the warmer spring and summer months in North America (the United States and Canada are our primarily markets). This seasonal trend is primarily due to the garden center portion of our customer base, and because certain of our customers may use some of our products (such as grow media and nutrients) in outdoor applications. While this seasonal pattern did not hold true during fiscal 2022, likely due to the industry recession, we expect this typical seasonal pattern to return in fiscal 2023. Also, we typically expect to utilize cash from operating activities in the first quarter to fund our working capital requirements related to the seasonal sales pattern described above.
Availability and Use of Cash
Our ability to make investments in our business, service our debt and maintain strong liquidity will depend upon our ability to generate excess operating cash flows through our operating subsidiaries. We believe that the Company will generate positive cash flows from operating activities over the next twelve months. We believe that our cash flows from operating activities, combined with current cash levels and borrowing availability under the JPMorgan 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 ensure 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 includedelsewhere in this Annual Report on Form 10-K.
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 “Sale-Leaseback Transaction”). 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. We intend to reinvest the net cash proceeds into certain permitted investments in 2023, such as capital expenditures.
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.
Critical Accounting Policies and Estimates
Certain accounting policies require us to make estimates and judgments in determining the amounts reflected in the Consolidated Financial Statements. Such estimates and judgments necessarily involve varying, and possibly significant, degrees of uncertainty. Accordingly, certain amounts currently recorded in the financial statements will likely be adjusted in the future based on new available information and changes in other facts and circumstances. A discussion of our principal accounting policies that required the application of significant judgments as of December 31, 2022 follows.
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Goodwill and indefinite-lived intangible assets
Goodwill is measured as the excess of the sum of the consideration transferred, the amount of any non-controlling interests in the acquiree, and the fair value of the acquirer's previously held equity interest in the acquiree (if any) over the net acquisition-date fair value amounts of the identified assets acquired and liabilities assumed in a business combination.
Goodwill is evaluated for impairment annually in the fourth quarter, or on an interim basis when an event or change in circumstances occurs, indicating that the carrying value may not be recoverable. Primarily due to a decline in the market value of our common stock and market conditions, we identified a triggering event requiring a test for impairment as of June 30, 2022. We completed our goodwill impairment testing and recorded an impairment charge due to market softness in demand in the U.S. and Canada. We determined the fair value of the U.S. and Canada reporting units based on an income approach, using the present value of future discounted cash flows, and based on a market approach. Significant estimates used to determine fair value include the weighted average cost of capital, financial forecasts, and pricing multiples derived from publicly-traded companies that are comparable to the reporting units. The fair values were reconciled to the market value of our common stock of to corroborate the estimates used in the interim test for impairment.
Long-lived tangible and finite-lived intangible assets
Long-lived tangible assets and finite-lived intangible assets are stated at cost. Depreciation, depletion and amortization expense is primarily provided on the straight-line method and based on the estimated useful economic lives of the long-lived tangible assets. Intangible assets with finite lives are subject to amortization. Intangible assets with finite lives and indefinite lives are reviewed for impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. For the quarter ended June 30, 2022, we performed an evaluation of intangible assets for impairment in connection with the triggering event identified requiring a quantitative test for goodwill impairment. This impairment evaluation includes a comparison of the undiscounted cash flows expected to be generated by that long-lived asset or asset group to its carrying amount. If the carrying amount of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, impairment is recognized to the extent that the carrying amount exceeds its fair value. Based on our evaluation, there was no impairment of intangible assets or other long-lived assets for the quarter ended June 30, 2022. No such triggering event was identified during the remainder of 2022.
We believe that the intangible asset impairment evaluations were based on reasonable assumptions that marketplace participants would use. However, such assumptions are inherently uncertain and actual results could differ from those estimates. Changes to or a failure to achieve our projected business assumptions, including growth and profitability, could result in a valuation that would trigger an impairment in future periods.
Inventory valuation
Inventories consist of finished goods, work-in-process, and raw materials used in manufacturing products. Inventories are stated at the lower of cost or net realizable value, principally determined by the first in, first out method of accounting. We maintain an allowance for excess and obsolete inventory. The estimate for excess and obsolete inventory is based upon assumptions about current and anticipated demand, customer preferences, business strategies, and market conditions. Management reviews these assumptions periodically to determine if any adjustments are needed to the allowance for excess and obsolete inventory. The establishment of an allowance for excess and obsolete inventory establishes a new cost basis in the inventory. Such allowance is not reduced until the product is sold. If inventory is sold, any related reserves would be reversed in the period of sale. The Company estimates inventory markdowns relating to restructuring charges based upon current and anticipated demand, customer preferences, business strategies, and market conditions including management's actions with respect to inventory products and brands being removed from our portfolio. Hydrofarm's strategic product consolidation entails removing approximately one-third of all products and one-fifth of all brands relating to our primary product portfolio.
Recent accounting pronouncements
For information regarding recent accounting pronouncements, refer to Note 2 - Basis of presentation and significant accounting policies — Recently issued accounting pronouncements, to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
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Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of economic losses due to adverse changes in financial market prices and rates. Our primary market risk has been interest rate, foreign currency and inflation risk. We do not have material exposure to commodity risk.
Interest Rate Risk
We are exposed to interest rate risk through our variable rate debt. As of December 31, 2022, we had $124 million of debt under the Term Loan subject to variable interest rates that are based on LIBOR or an alternate base rate. Refer to Part I, Item 1, Financial Statements, Note 10 - Debt for details relating to the debt. If these rates were to increase by 100 basis points from the rates in effect as of December 31, 2022, our interest expense on the variable rate debt would increase by an average of $1.2 million annually. There are inherent limitations in the sensitivity analysis presented, primarily due to the assumptions that interest rate changes would be instantaneous, while LIBOR changes regularly. We do not currently hedge our interest rate risks, but may determine to do so in the future. See Risk Factors—We may be adversely impacted by the transition from the London interbank offered rate (“LIBOR”) to the Secured Overnight Funding Rate ("SOFR") as a reference rate.
Foreign Currency Risk
The functional currencies of our foreign subsidiary operations are predominantly in the Canadian dollar (“CAD”) and the Euro. For the purposes of presenting these consolidated financial statements, the assets and liabilities of subsidiaries with CAD or Euro functional currencies are translated into USD using exchange rates prevailing at the end of each reporting period. Income and expense items are translated at the average rate prevailing during the period with exchange differences impacting other comprehensive income (loss) in equity. Therefore, our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, principally the CAD. We are impacted by changes in foreign currency exchange rates when we sell product in currencies different from the currency in which costs were incurred. The functional currencies and our purchasing and sales activities primarily include USD, CAD and Euro. As these currencies fluctuate against each other, and other currencies, we are exposed to foreign currency exchange rate risk on sales, purchasing transactions, and labor. To date, we have not entered into any foreign currency exchange contracts and currently do not expect to enter into foreign currency exchange contracts for trading or speculative purposes.
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Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Consolidated Financial Statements
Page
Report of Independent Registered Public Accounting Firm (PCAOB ID No. 34) 65
Consolidated Balance Sheets 68
Consolidated Statements of Operations 69
Consolidated Statements of Comprehensive (Loss) Income 70
Consolidated Statements of Changes in Stockholders’ Equity 71
Consolidated Statements of Cash Flows 72
Notes to the Consolidated Financial Statements 74
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the stockholders and the Board of Directors of Hydrofarm Holdings Group, Inc.
Opinion of the Financial Statements
We have audited the accompanying consolidated balance sheets of Hydrofarm Holdings Group, Inc. and subsidiaries (the "Company") as of December 31, 2022 and 2021, the related consolidated statements of operations, comprehensive (loss) income, changes in stockholders' equity, and cash flows, for each of the two years in the period ended December 31, 2022, and the related notes listed in the Index to Consolidated Financial Statements (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2022 and 2021, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2022, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2022, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2023, expressed an unqualified opinion on the Company's internal control over financial reporting.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matters
The critical audit matters communicated below are matters arising from the current-period audit of the financial statements that were communicated or required to be communicated to the audit committee and that (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.
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Inventory Valuation - Refer to Note 2 to the financial statements
Critical Audit Matter Description
As of December 31, 2022 the inventory excess and obsolescence reserve was $15.7 million. The Company’s inventories are stated at the lower of cost or net realizable value, principally determined by the first in, first out method of accounting. As described in Note 2 to the consolidated financial statements, the Company maintains an allowance for excess and obsolete inventory that is based upon assumptions about future demand, customer preferences, business strategies, and market conditions. The analysis of the required inventory valuation reserves includes consideration of current inventory levels, historical sales information, forecasted customer demand and current economic conditions and business trends.
Given the quantitative and qualitative materiality of the inventory excess and obsolescence reserve balance, coupled with the judgments necessary to identify and record the inventory excess and obsolescence reserve timely, performing audit procedures to evaluate management’s estimates of the net realizable value for the inventory on-hand as of the reporting date involved a high degree of auditor judgment.
How the Critical Audit Matter Was Addressed in the Audit
Our audit procedures related to the inventory valuation included the following, among other things:
•We tested the design and operating effectiveness of internal controls over the inventory valuation process, including controls over the inputs that are used in management's valuation of the excess and obsolescence reserve analysis.
•We evaluated the appropriateness and consistency of management’s methodology and assumptions used in determining the inventory valuation of the excess and obsolescence reserve.
•We obtained the Company’s valuation of the inventory excess and obsolescence reserve calculation and tested the mathematical accuracy.
•We tested the accuracy and completeness of the underlying data used in the calculation of the Company’s valuation of the inventory excess and obsolescence reserve.
•We selected a sample of inventory items and compared the recorded unit cost against the most recent sales price to determine if inventory was recorded at lower of cost or net realizable value.
•We selected a sample of inventory items and evaluated historical sales performance relative to management’s conclusions on the ability to sell through the inventory on-hand at the forecasted levels.
/s/ Deloitte & Touche LLP
Minneapolis, Minnesota
March 9, 2023
We have served as the Company's auditor since 2020.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the stockholders and the Board of Directors of Hydrofarm Holdings Group, Inc.
Opinion on Internal Control over Financial Reporting
We have audited the internal control over financial reporting of Hydrofarm Holdings Group, Inc. and subsidiaries (the “Company”) as of December 31, 2022, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2022, based on criteria established in Internal Control — Integrated Framework (2013) issued by COSO.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated financial statements as of and for the year ended December 31, 2022, of the Company and our report dated March 9, 2023, expressed an unqualified opinion on those consolidated financial statements.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Annual report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ Deloitte & Touche LLP
Minneapolis, Minnesota
March 9, 2023
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Hydrofarm Holdings Group, Inc.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)
December 31,
Assets
Current assets:
Restricted cash — 1,777
Note receivable — 622
Prepaid expenses and other current assets 5,032 9,760
Liabilities and stockholders’ equity
Current liabilities:
Accrued expenses and other current liabilities 13,208 33,996
Current portion of lease liabilities 9,099 7,198
Current portion of long-term debt 2,011 2,263
Commitments and contingencies (Note 14)
Stockholders’ equity
Accumulated other comprehensive loss (7,235) (1,382)
Total liabilities and stockholders’ equity $ 573,559 $ 891,242
The accompanying notes are an integral part of the consolidated financial statements.
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Hydrofarm Holdings Group, Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share and per share amounts)
Years ended December 31,
Operating expenses:
Loss on debt extinguishment or modification (145) (680)
Other income (expense), net 841 (204)
Net (loss) income per share:
Weighted-average shares of common stock outstanding:
The accompanying notes are an integral part of the consolidated financial statements.
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Hydrofarm Holdings Group, Inc.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME
(In thousands)
Years ended December 31,
Other comprehensive loss:
Foreign currency translation loss (5,853) (1,981)
The accompanying notes are an integral part of the consolidated financial statements.
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Hydrofarm Holdings Group, Inc.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(In thousands, except for share amounts)
Shares Amount
Issuance of common stock for vesting of restricted stock units 851,741 — — — — —
Issuance of common stock under cashless warrant exercise 418,633 — — — — —
Stock-based compensation expense — — 5,006 — — 5,006
Foreign currency translation loss — — — (1,981) — (1,981)
Common stock issued upon exercise of options 8,283 — 75 — — 75
Issuance of common stock for vesting of restricted stock units 818,489 1 — — — 1
Issuance of common stock under cashless warrant exercise 99 — — — — —
Stock-based compensation expense — — 8,354 — — 8,354
Foreign currency translation loss — — — (5,853) — (5,853)
The accompanying notes are an integral part of the consolidated financial statements.
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Hydrofarm Holdings Group, Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Years ended December 31,
Depreciation, depletion and amortization 41,527 14,934
Provision for (benefit from) doubtful accounts 2,998 (110)
Provision for inventory obsolescence 16,449 1,201
Restructuring expenses 6,091 —
Stock-based compensation expense 8,354 5,006
Non-cash operating lease expense 9,751 5,660
Change in fair value of contingent consideration (1,560) (2,610)
Changes in assets and liabilities:
Prepaid expenses and other current assets 3,663 2,761
Accrued expenses and other current liabilities (4,532) (3,238)
Other long-term liabilities (370) —
Net cash provided by (used in) operating activities 21,989 (45,067)
Investing activities
Business combinations, net of cash and cash equivalents 190 (462,172)
Capital expenditures of property, plant and equipment (8,229) (5,402)
Net cash used in investing activities (8,487) (468,184)
Continued
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Years ended December 31,
Financing activities
Proceeds from exercises of investor warrants — 56,778
Payment of withholding tax related to restricted stock units (2,470) (20,025)
Borrowings under revolving credit facilities 853 142,628
Repayments of revolving credit facilities (1,102) (143,003)
Repayments of Term Loan (1,250) —
Payments to settle contingent consideration (15,474) —
Net cash (used in) provided by financing activities (20,200) 464,707
Net decrease in cash, cash equivalents and restricted cash (7,093) (48,571)
Cash, cash equivalents and restricted cash at beginning of year 28,384 76,955
Cash, cash equivalents and restricted cash at end of year $ 21,291 $ 28,384
Non-cash investing and financing activities
Right-of-use assets acquired under operating lease obligation 28,972 22,873
Supplemental information
Concluded
The accompanying notes are an integral part of the consolidated financial statements.
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Hydrofarm Holdings Group, Inc.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts)
1. DESCRIPTION OF THE BUSINESS
Description of the business
Hydrofarm Holdings Group, Inc. (collectively with its subsidiaries, the “Company”) was formed in May 2017 under the laws of the state of Delaware to acquire and continue the business originally founded in 1977. The Company is a leading independent manufacturer and distributor of controlled environment agriculture ("CEA", principally hydroponics) equipment and supplies, including a broad portfolio of proprietary branded products. Products offered include agricultural lighting devices, indoor climate control equipment, nutrients, and plant additives 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, CO2, light intensity and color, nutrient concentration and pH.
Initial public offering and follow-on public offering
On December 14, 2020, the Company closed its initial public offering (“IPO”) under a registration statement effective December 9, 2020, in which it issued and sold 9,966,667 shares of its common stock, including the full exercise by the underwriters of their option to purchase 1,300,000 additional shares of common stock. The public offering price was $20.00 per share. The Company received net proceeds of $182,271 from the IPO after deducting underwriting discounts and commissions and offering expenses, of which $148 of offering expenses were paid in 2021.
On May 3, 2021, the Company closed its follow-on public offering ("follow-on offering") under a registration statement effective April 28, 2021, in which it issued and sold 5,526,861 shares of its common stock, including the full exercise by the underwriters of their option to purchase 720,894 additional shares of common stock. The public offering price was $59.00 per share. The Company received net proceeds of $309,782 from the follow-on offering after deducting underwriting discounts and commissions and offering expenses.
2. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
Basis of consolidation and presentation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries and have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and the requirements of the U.S. Securities and Exchange Commission (“SEC”) for year end financial reporting. All intercompany balances and transactions have been eliminated in consolidation. The Company reclassified the balance within "Impairment, restructuring and other" on the consolidated statements of operations for the prior period into "Selling, general and administrative expenses" ("SG&A") to conform to the current period presentation. The Company reclassified the balance of customer deposits, totaling $18,273 as of December 31, 2021, previously reported in "Accounts payable" into "Deferred revenue" in the consolidated balance sheet as of December 31, 2021, to conform to the current period presentation. Consistent with the reclassifications on the consolidated balance sheet, the Company made corresponding reclassifications to conform with the current period presentation in the consolidated statement of cash flows.
Use of estimates
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Significant estimates include provisions for sales returns, rebates and claims from customers, realization of accounts receivable and inventories, fair value of assets acquired and liabilities assumed for business combinations, valuation of intangible assets and goodwill, estimated useful lives of long-lived assets, incremental borrowing rate applied in lease accounting, valuation of stock-based compensation, recognition of deferred income taxes, recognition of liabilities related to commitments and contingencies and valuation allowances. Actual results may differ from these estimates. On an ongoing basis, the Company reviews its estimates to ensure that these estimates appropriately reflect changes in its business or new information available.
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Hydrofarm Holdings Group, Inc.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts)
Business combinations
Acquisitions of businesses are accounted for using the acquisition method. The consideration transferred in a business combination is measured at fair value, which is calculated as the sum of the acquisition date fair values of the assets transferred, liabilities incurred to the former owners of the acquiree, and the equity interests issued in exchange for control of the acquiree. Acquisition related costs are recognized in net (loss) income as incurred.
When the consideration transferred in a business combination includes assets or liabilities resulting from a contingent consideration arrangement, the contingent consideration is measured at its acquisition date fair value and included as part of the consideration transferred in a business combination. Contingent consideration is established for business acquisitions where the Company has the obligation to transfer additional assets or equity interests to the former owners if specified future events occur or conditions are met. Contingent consideration is classified as a liability when the obligation requires settlement in cash or other assets and is classified as equity when the obligation requires settlement in the Company's own equity instruments. Changes in the fair value of the contingent consideration that qualify as measurement period adjustments are adjusted retrospectively, with a corresponding adjustment to goodwill. Measurement period adjustments are adjustments that arise from additional information obtained during the measurement period (which cannot exceed one year from the acquisition date) about facts and circumstances that existed at the acquisition date. All other subsequent changes in the fair value of contingent consideration classified as a liability are included in net (loss) income in the period. Changes in the fair value of contingent consideration classified as equity are not recognized.
For a given acquisition, the Company may identify certain pre-acquisition contingencies as of the acquisition date and may extend its review and evaluation of these pre-acquisition contingencies throughout the measurement period to obtain sufficient information to assess these contingencies as part of acquisition accounting, as applicable.
Goodwill is measured as the excess of the sum of the consideration transferred, the amount of any non‐controlling interests in the acquiree, and the fair value of the acquirer’s previously held equity interest in the acquiree (if any) over the net of the acquisition‐date fair value amounts of the identifiable assets acquired, and the liabilities assumed.
If the initial accounting for a business combination is incomplete by the end of the reporting period in which the combination occurs, the Company reports provisional amounts for the items for which the accounting is incomplete. Those provisional amounts are adjusted during the measurement period, or additional assets or liabilities are recognized, to reflect new information obtained about facts and circumstances that existed at the acquisition date that, if known, would have affected the amounts recognized at that time. Upon conclusion of the measurement period or final determination of the values of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to net (loss) income.
Restructuring
The Company began a restructuring plan during the quarter ended December 31, 2022, and is undertaking significant actions to streamline operations, reduce costs and improve efficiencies. The major initiatives of the restructuring plan include (i) narrowing the Company's product and brand portfolio and (ii) the relocation and consolidation of certain manufacturing and distribution centers, including headcount reductions and reorganization to drive a solution based approach.
During the year ended December 31, 2022, the Company recorded pre-tax charges of $6,790 relating to the inventory markdowns of products and brands being removed from our portfolio, which is primarily non-cash, and $897 relating primarily to the relocation and termination of certain facilities in Canada, which are primarily cash charges. The Company's strategic product consolidation entails removing approximately one-third of all products and one-fifth of all brands relating to our primary product portfolio, which excludes our garden center business in Canada. The Company expects the restructuring and related actions to result in cost savings of approximately $7,000 on an annualized basis. The amounts the Company will ultimately realize or disburse could differ from these estimates.
The Company recorded $7,466 of restructuring related charges within Cost of goods sold and $221 within Selling, general and administrative expenses on the consolidated statement of operations for the year ended December 31, 2022. The Company's accrued liability for restructuring costs as of December 31, 2022, was $696. The Company estimates it will incur additional restructuring charges of approximately $1.7 million during the first half of 2023.
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(In thousands, except share and per share amounts)
Segment and entity-wide information
Segment information
The Company's chief operating decision maker is the chief executive officer ("CEO") who reviews financial information for the purposes of making operating decisions, assessing financial performance and allocating resources. The business is organized as two operating segments, the U.S. and Canada, which meet the criteria for aggregation, and the Company has elected to present them as one reportable segment, which is the distribution and manufacture of CEA equipment and supplies. Aggregation is based on similarities which include the nature of its products, production or acquisition of inventory, customer base, fulfillment and distribution and economic characteristics.
Since the Company operates as one reportable segment, all required segment financial information is found in the consolidated financial statements and footnotes with entity-wide disclosures presented below.
Entity-wide information
Sales to external customers and property, plant and equipment, and operating lease right-of-use assets, net in the United States and Canada, determined by the location of the subsidiaries, are shown below. Other foreign locations, which are immaterial, individually and in the aggregate, are included in the U.S. below.
Years ended December 31,
Intersegment eliminations (4,116) (7,610)
December 31,
All of the products sold by the Company are similar and classified as CEA equipment and supplies.
Concentrations of business and credit risk
The Company maintains cash balances at certain financial institutions that can, at times, exceed amounts insured by the Federal Deposit Insurance Corporation (“FDIC”). The Company has not experienced any losses in these accounts and believes it is not exposed to any significant credit risk in this area.
Accounts receivable expose the Company to credit risks such as collectability and business risks such as customer concentrations. Exposure to losses on receivables is dependent on each customer’s financial condition. Receivables arising from sales are not collateralized; however, credit risk is somewhat mitigated as a result of the large diverse customer base. No customer accounted for more than 10% of revenues in 2022, or 2021. No customer accounted for more than 10% of accounts receivable as of December 31, 2022, or December 31, 2021. One supplier accounted for more than 10% of purchases in 2022 and 2021.
Fair value measurements
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company has applied the framework for measuring fair value which
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(In thousands, except share and per share amounts)
requires a fair value hierarchy to be applied to all fair value measurements. All financial instruments recognized at fair value are classified into one of three levels in the fair value hierarchy as follows:
Level 1 — Valuation based on quoted prices (unadjusted) observed in active markets for identical assets or liabilities.
Level 2 — Valuation techniques based on inputs that are quoted prices of similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not in active markets; inputs other than quoted prices used in a valuation model that are observable for that instrument; and inputs that are derived from or, corroborated by, observable market data by correlation or other means.
Level 3 — Valuation techniques with significant unobservable market inputs.
The Company measures certain non-financial assets and liabilities, including long-lived assets, intangible assets and goodwill, at fair value on a nonrecurring basis. The fair value of contingent consideration is classified within level 3 of the fair value hierarchy (See discussion of contingent consideration in Note 3 - Business Combinations and Note 15 - Fair Value Measurements).
Foreign currency matters
The Company reports its financial results in United States dollars, which is the currency of the primary economic environment in which it operates. The functional currency for each of the Company’s foreign subsidiaries is generally its local currency. Monetary assets and liabilities, and transactions denominated in currencies other than the functional currency are remeasured to the functional currency at the exchange rate in effect at the end of each period. Foreign currency transaction gains and losses are included in the determination of net (loss) income and classified as other income (expense), net in the consolidated statements of operations. Assets and liabilities of foreign subsidiaries are translated at the exchange rates in effect at the end of each period. Revenues, expenses, gains and losses are translated at the average rates of exchange prevailing during the period. Accumulated deficit and other equity accounts are translated at historical rates. Translation gains and losses are included in accumulated other comprehensive loss within stockholders’ equity.
The effect of currency translation adjustments on cash, cash equivalents and restricted cash is presented separately in the consolidated statements of cash flows.
Cash, cash equivalents and restricted cash
Cash includes funds deposited in banks. Cash equivalents include highly liquid investments such as term deposits and money market instruments with original maturities of three months or less. As of December 31, 2021, amounts included in restricted cash represent those funds required to be set aside as security for letters of credits, and other various contractual arrangements. As of December 31, 2022, there were no amounts classified as restricted cash, as all previous restrictions lapsed during the year.
Accounts receivable, net
Trade accounts receivable represents amounts due from customers. Other receivables represent other current non-trade receivables. Allowance for doubtful accounts reflects the Company’s estimate of amounts in its existing accounts receivable that may not be collected due to customer claims or customer inability or unwillingness to pay. The allowance is determined based on a combination of factors, including, but not limited to the age of the account, the credit worthiness of the customer, payment terms, the customer’s historical payment history and general economic conditions. Management reviews these factors quarterly to determine if any adjustments are needed to the allowance for doubtful accounts. Accounts receivable are written off when the receivables are deemed uncollectible.
Inventories
Inventories consist of finished goods, work-in-process, and raw materials used in manufacturing products. Inventories are stated at the lower of cost or net realizable value, principally determined by the first in, first out method of accounting. The Company maintains an allowance for excess and obsolete inventory. The estimate for excess and obsolete inventory is based upon assumptions about current and anticipated demand, customer preferences, business strategies, and market conditions.
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(In thousands, except share and per share amounts)
Management reviews these assumptions periodically to determine if any adjustments are needed to the allowance for excess and obsolete inventory. The establishment of an allowance for excess and obsolete inventory establishes a new cost basis in the inventory. Such allowance is not reduced until the product is sold. If inventory is sold, any related reserves would be reversed in the period of sale. The Company estimates inventory markdowns relating to restructuring charges based upon current and anticipated demand, customer preferences, business strategies, and market conditions including management's actions with respect to inventory products and brands being removed from our portfolio. Hydrofarm's strategic product consolidation entails removing approximately one-third of all products and one-fifth of all brands relating to our primary product portfolio.
Leases
Leases are accounted for under Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 842, Leases. At inception of a contract, the Company determines whether that contract is or contains a lease. A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. Leases are then classified as either finance or operating, with classification affecting the location of expense recognition in the consolidated statements of operations.
Right-of-use assets ("ROU") represent the right to use an underlying asset for the lease term while lease liabilities represent the obligation to make lease payments arising from a lease, measured on a discount basis. All leases greater than 12 months result in the recognition of a ROU and a lease liability at the lease commencement date based on the present value of the lease payments over the lease term. The present value of the lease payments is calculated using the applicable weighted-average discount rate. The weighted-average discount rate is based on the discount rate implicit in the lease, or if the implicit rate is not readily determinable from the lease, the applicable incremental borrowing rate is estimated. The incremental borrowing rate is estimated using the currency denomination of the lease and the contractual lease term. To determine the incremental borrowing rate, reference is made to interest rates that would be available to finance assets similar to the assets under lease in their related geographical location.
The Company accounts for lease components separately from non-lease components, other than for office equipment. The Company has certain leases that include one or more options to renew with renewal terms that can extend the lease term. The exercise of the lease renewal options is at the Company’s discretion. A lease renewal option is included in the determination of the ROU asset and lease liability when the option is reasonably certain of being exercised.
Property, plant and equipment
Property, plant and equipment ("PP&E") is recorded at cost less accumulated depreciation, depletion and amortization. PP&E assets are reviewed for impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable.
Property, plant and equipment, excluding peat bogs and related development, are depreciated using the straight-line method. The following table summarizes the estimated useful lives as follows:
Buildings and improvements 10 - 40 years
Machinery and equipment 5 - 15 years
Leasehold improvements Lesser of useful life or term of the lease
Computer equipment 3 - 4 years
Furniture and fixtures 5 years
Peat bogs and related development costs are depleted using the units of production method over the total expected volume of the peat bogs.
Intangible assets and goodwill
Definite-lived intangible assets are amortized using the straight-line method over their estimated useful lives. The Company has one trade name that is considered to have an indefinite useful life. Intangible assets are also tested for impairment at least annually and when events or changes in circumstances indicate that, more-likely-than-not, the carrying
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts)
amount may not be recoverable. Significant judgment is required in estimating fair values and performing goodwill and intangible asset impairment tests.
Goodwill represents the excess of the acquisition price of an acquired business over the fair value of the identifiable assets acquired and liabilities assumed in a business combination less any subsequent write-downs for impairment. Goodwill is tested for impairment on an annual basis in the fourth quarter and more frequently if indicators of potential impairment exist. Impairment testing is conducted at the reporting unit level, which is generally defined as an operating segment or one level below an operating segment (also known as a component), for which discrete financial information is available and segment management regularly reviews the operating results. The Company has determined that its reporting units for the purpose of goodwill impairment testing are the U.S. and Canada.
Goodwill impairment reviews include performing either an initial qualitative or quantitative evaluation for each of the reporting units. Several methods may be used to estimate a reporting unit’s fair value, including market quotations, asset and liability fair values and other valuation techniques. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then the excess is charged to earnings as an impairment loss.
Note Receivable
In 2019, the Company executed a note receivable secured by equipment to a third-party, the terms of which were amended and restated during the first quarter of 2021. The note receivable provided for interest and installment payments to the Company, and full maturity of the note in 2024. During the first quarter of 2022 the third-party defaulted on interest payments, and the Company measured an impairment on the note receivable based on the estimated fair value of the collateral. The Company recorded an impairment loss of $2,636 during the year ended December 31, 2022, respectively, in “Impairments” on the consolidated statements of operations. There were no impairment losses recorded in the year ended December 31, 2021. As of December 31, 2022, the note receivable carrying value was $475 and is classified in Other assets on the consolidated balance sheet.
Revenue recognition
ASC 606, Revenue from Contracts with Customers, requires that revenue recognized from contracts with customers be disaggregated into categories that depict how the nature, amount, timing and uncertainty of revenue and cash flows are affected by economic factors. The Company has determined that revenue is generated from one category, which is the distribution and manufacture of controlled environment agriculture equipment and supplies.
Revenue is recognized as control of promised goods is transferred to customers, which generally occurs upon receipt at customers’ locations determined by the specific terms of the contract. Arrangements generally have a single performance obligation and revenue is reported net of variable consideration which includes applicable volume rebates, cash discounts and sales returns and allowances. Variable consideration is estimated and recorded at the time of sale.
The amount billed to customers for shipping and handling costs included in net sales was $13,180, and $8,050 in 2022, and 2021, respectively. Shipping and handling costs that occur before the customer obtains control of the goods are deemed to be fulfillment activities and are accounted for as fulfillment costs included in cost of goods sold. The Company does not receive noncash consideration for the sale of goods. Contract consideration received from a customer prior to revenue recognition is recorded as a contract liability and is recognized as revenue when the Company satisfies the related performance obligation under the terms of the contract. The Company's contract liabilities, which consist primarily of customer deposits are reported within deferred revenue in the consolidated balance sheets, totaled $3,654 and $18,273 as of December 31, 2022, and 2021, respectively. There are no significant financing components. Excluded from revenue are any taxes assessed by governmental authorities, including value-added and other sales-related taxes that are imposed on and concurrent with revenue-generating activities.
Warrants issued in connection with financings
The Company generally accounts for warrants issued in connection with debt and equity financings as a component of equity unless the warrants include a conditional obligation to issue a variable number of shares among other conditions or it is possible that the Company may need to settle the warrants in cash.
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(In thousands, except share and per share amounts)
Stock-based compensation
The Company accounts for stock-based compensation expense in accordance with the fair value recognition and measurement provisions of U.S. GAAP, which requires compensation cost for the grant-date fair value of stock-based awards to be recognized over the requisite service period. The Company accounts for forfeitures when they occur and any compensation expense previously recognized on unvested shares will be reversed when forfeited.
Service-based awards
The Company records stock-based compensation expense for restricted stock units (“RSUs”) and service-based stock options on a straight-line basis over the requisite service period.
The fair value of grants of restricted stock is based on the fair value of the common stock underlying the award. The fair value of the underlying common stock for RSUs prior to the Company’s IPO in December 2020, was determined by considering a number of objective, subjective, and highly complex factors including independent third-party valuations of the Company’s common stock, operating and financial performance, the lack of liquidity of capital stock and general and industry specific economic outlook among other factors. For awards granted after the Company's IPO, the fair value of the underlying common stock for RSUs is the closing date price of the Company's common stock at the grant-date.
The fair value of option-based awards is estimated using the Black-Scholes valuation model. The Black-Scholes model requires the use of highly subjective and complex assumptions. For inputs into the Black-Scholes model, the expected volatility is based on historical implied volatility from recent stock option transactions at the time of grant. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury implied yield at the date of grant. The Company has elected to use the “simplified method” to determine the expected term which is the midpoint between the vesting date and the end of the contractual term because it has insufficient history upon which to base an assumption about the term. The expected dividend yield is 0.0% as the Company has not paid and does not anticipate paying dividends on its common stock.
Performance-based awards
The Company has granted performance stock unit ("PSU") awards that vest upon the satisfaction of both service-based and performance-based conditions. The service-based condition for these awards generally is satisfied over one year. The performance-based conditions generally are satisfied upon achieving specified performance targets. The Company records stock-based compensation expense for performance-based equity awards on a straight-line basis over the requisite service period and only if performance-based conditions are considered probable to be satisfied.
Market-based awards
The Company has granted RSUs that vest only upon the satisfaction of both performance-based and market-based conditions. The performance-based conditions are satisfied upon achieving specified performance targets, such as the occurrence of a qualifying event, as described above for performance-based awards. The market-based condition is satisfied upon the Company’s achievement of a qualifying traded share price within the specified time frame. The Company records stock-based compensation expense once the performance condition is satisfied regardless of whether the market condition is eventually met. For one award granted in 2020, the market condition was factored into its fair value and the Company used a "Monte Carlo Simulation Method" ("MCSM") to estimate the fair value of the award. The MCSM assessed the likelihood of vesting of the RSU grants based on the probability of both a triggering event and qualifying traded share price within the specified time frame. For the years ended December 31, 2022, and 2021, there were no performance awards with market-based conditions granted.
Income taxes
The asset and liability method of accounting for income taxes is followed whereby deferred income tax assets are recognized for deductible temporary differences and operating loss carryforwards, and deferred income tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the amounts of assets and liabilities recorded for income tax and financial reporting purposes.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts)
Deferred income tax assets are recognized only to the extent that management determines that it is more-likely-than-not that the deferred income tax assets will be realized. Deferred income tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. The income tax expense or benefit is the income tax payable or recoverable for the year plus or minus the change in deferred income tax assets and liabilities during the year.
The Company has deferred tax assets and liabilities and maintains valuation allowances where it is more likely than not that all or a portion of deferred tax assets will not be realized. Significant judgment is required in determining any valuation allowance recorded against deferred tax assets. The determination of the amount of valuation allowance to be provided on recorded deferred tax assets involves consideration of estimates regarding the timing and amount of the reversal of taxable temporary differences, expected future taxable income by jurisdiction, and the impact of tax planning strategies. Changes in the relevant facts can impact the judgment or need for valuation allowances. In the event we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made.
The Company will establish a liability for tax return positions when there is uncertainty as to whether the position will ultimately be sustained. Amounts for uncertain tax positions will be adjusted when new information becomes available or when positions are effectively settled. The Company will recognize interest expense and penalties related to these unrecognized tax benefits within income tax expense. U.S. GAAP provides that a tax benefit from an uncertain tax position may be recognized when it is more-likely-than-not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits of the position. The amount recognized is measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with the related tax authority.
Recently issued accounting pronouncements
The Company reviewed recently issued accounting pronouncements and noted no new pronouncements relevant to the Company.
3. BUSINESS COMBINATIONS
During 2021, the Company completed five acquisitions of branded manufacturers of CEA products, resulting in a significant expansion of its portfolio of proprietary branded products and specialized manufacturing capabilities. The Company finalized the determination of its allocation of the purchase price relating to these acquisitions during 2022, and obtained third-party valuation reports of certain tangible and identifiable intangible assets to support its evaluation.
Goodwill arose on the acquisitions because the consideration paid effectively included amounts in relation to the benefit of expected synergies, revenue growth, future market development and the assembled workforce. These benefits are not recognized separately from goodwill and they do not meet the recognition criteria for identifiable intangible assets.
During 2022, the Company evaluated and adjusted the useful lives of certain intangible assets associated with entities that were acquired during 2021. In addition, the Company determined that the preliminary allocation of assets acquired related to indefinite lived trade names have a finite useful life because the expected usefulness of the trade names is limited. As a result of these adjustments to the provisional amounts, the Company recorded $5,894 of additional amortization expense during 2022, which related to amortization expense that would have been recorded in the previous reporting period from the acquisition date through December 31, 2021. The intangible assets were assigned estimated useful lives as follows: (i) customer relationships: 7 to 12 years, (ii) technology, formulations and recipes: 8 to 12 years, (iii) computer software: 3 years, and (iv) trade names and trademarks: 15 to 20 years.
The financial results of Heavy 16, the H&G Entities, Aurora and the IGE Entities (each as defined below) are included in the U.S. operating segment since the acquisition date. The financial results of Greenstar are included in the Canada operating segment since the acquisition date.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts)
Heavy 16 Acquisition
On May 3, 2021, the Company acquired 100% of the issued and outstanding membership interests of Field 16, LLC ("Heavy 16"), a manufacturer and supplier of branded plant nutritional products. As a result of the acquisition, the Company broadened its proprietary branded offering into the plant nutrients category complementing other product offerings. The acquisition fair value of the consideration transferred for Heavy 16 was $77,367, consisting of $60,287 in cash, $16,736 of the Company's common stock and $344 contingent consideration. The fair value of the common stock issued was determined based on the closing market price of the Company's common stock on the acquisition date.
Pursuant to the purchase agreement, the Company was required to pay up to an additional $2,500 of contingent consideration based on $200 for each $1,000 above a $21,000 threshold for net sales in calendar year 2021. As a result, the Company recorded a liability for contingent consideration at its estimated fair value of $344 as of the acquisition date in the consolidated balance sheets. The contingent consideration was estimated using a Black-Scholes valuation model, which utilized Level 3 inputs as defined in ASC 820 - Fair Value Measurements. The key assumptions in applying the valuation model were as follows: a 10% required revenue metric risk premiumand 0.33% discount periods. The contingent consideration was divided into thirteen standalone option calculations and utilized the same expected value of revenue which was calculated by discounting forecasted sales, by the revenue return metric, and adding year-to-date net sales. The contingent consideration was remeasured to fair value at each reporting date until the contingency was resolved with changes in fair value being recognized within "Selling, general and administrative expenses" ("SG&A") in the consolidated statements of operations. As of December 31, 2021, contingent consideration of $200 was calculated utilizing actual net sales for the full year ended December 31, 2021. The change in the fair value of the contingent consideration of $144 during the year ended December 31, 2021, was recognized as a benefit in SG&A on the consolidated statement of operations during the period. There were no changes to the fair value of contingent consideration in 2022, and the balance was paid in April 2022. The amount of goodwill is fully deductible for tax purposes.
House & Garden Acquisition
On June 1, 2021, the Company acquired 100% of the issued and outstanding shares of capital stock of House & Garden, Inc. (“HG”), Humboldt Wholesale, Inc. (“HW”), Allied Imports & Logistics, Inc. (“Allied”), South Coast Horticultural Supply, Inc. (“SC” and, together with HG, HW and Allied, the “H&G Entities”), a manufacturer and distributor of plant nutrients and fertilizers to domestic and various international markets. As a result of the acquisition, the Company is further broadening its proprietary branded offering into the plant nutrients category complementing other product offerings. The acquisition date fair value of the consideration transferred for the H&G Entities was $133,483 in cash. The amount of goodwill is not deductible for tax purposes. As part of the share acquisition of the H&G Entities, the Company allocated a significant value of the acquisition to identified intangible assets that are not deductible for U.S. tax purposes. Therefore, a deferred tax liability arose providing an additional source of taxable income to support the realization of pre-existing deferred tax assets.
Aurora Acquisition
On July 1, 2021, the Company acquired 100% of the issued and outstanding membership interests of Gotham Properties LLC (“Gotham Properties”), Aurora Innovations LLC (“Aurora Innovations”), Aurora International LLC (“Aurora International” and, together with Gotham Properties and Aurora Innovations, “Aurora”), a manufacturer of plant fertility product lines. As a result of the acquisition, the Company broadened its proprietary branded offering into the plant nutrients and grow media category complementing other product offerings. The preliminary acquisition fair value of the consideration transferred for Aurora was $178,871, consisting of $133,962 in cash, $25,824 of the Company's common stock, $19,300 contingent consideration and $215 forgiveness of accounts payable. The fair value of the common stock issued was determined based on the closing market price of the Company's common stock on the acquisition date. The forgiveness of accounts payable represents an effective settlement of a preexisting relationship between the parties. The amount of goodwill is fully deductible for tax purposes.
Pursuant to the purchase agreement, the Company was required to pay a maximum contingent consideration equal to $70,997. To the extent 2021 EBITDA of Aurora exceeded $15,556, the excess was multiplied by eleven to determine contingent consideration. As a result, the Company recorded a liability for contingent consideration at its estimated fair value of $19,300 as of the acquisition date in the consolidated balance sheets. The contingent consideration was estimated using the discounted cash flow method, which estimated the incremental EBITDA based on the Company's forecasted 2021 EBITDA of
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(In thousands, except share and per share amounts)
Aurora as of the acquisition date, discounted to a present value as of the acquisition date using a discount rate of 15%. That measure was based on significant inputs that are not observable in the market, which utilized Level 3 inputs as defined in ASC 820 - Fair Value Measurements. The contingent consideration was remeasured to fair value at each reporting date until resolution with changes in fair value recognized within SG&A in the consolidated statements of operations. As of December 31, 2021, the contingent consideration of $16,834 was calculated utilizing actual 2021 EBITDA for the full year ended December 31, 2021. The change in the fair value of the contingent consideration of $2,466 during the year ended December 31, 2021, was recognized as a benefit in SG&A on the consolidated statement of operations during the period. During 2022, the Company recognized an additional $1,560 benefit to SG&A as the contingent consideration was revalued to $15,274, and paid in July 2022 using available cash on hand.
Greenstar/Grotek Acquisition
On August 3, 2021, the Company acquired 100% of the issued and outstanding shares of Greenstar Plant Products Inc., (“Greenstar”), a manufacturer of horticultural products and solutions for global, domestic and commercial use. As a result of the acquisition, the Company broadened its proprietary branded offering into the plant nutrients and grow media category complementing other product offerings. The preliminary acquisition fair value of the consideration transferred for Greenstar was $83,520, consisting of $85,121 in cash, less $1,601 forgiveness of accounts payable, net, and obligations due under a distribution agreement. The forgiveness of accounts payable, net, and obligations due under a distribution agreement represent an effective settlement of a preexisting relationship between the parties. The amount of goodwill is not deductible for U.S. tax purposes, but it is partially deductible for Canadian tax purposes.
Innovative Growers Equipment, Inc. Acquisition
On November 1, 2021, the Company acquired 100% of the issued and outstanding shares of Innovative Growers Equipment, Inc., an Illinois corporation (“IGE”), Innovative AG Installation, Inc., an Illinois corporation (“IAG”), Innovative Racking Systems, Inc., an Illinois corporation (“IRS”), and Innovative Shipping Solutions, Inc., an Illinois corporation (“ISS” and, together with IGE, IAG, IRS, and their respective subsidiaries, the “IGE Entities”), a manufacturer of horticulture benches, racking and LED lighting systems which complement the Company’s existing lineup of high performance, proprietary branded products. The preliminary acquisition fair value of the consideration transferred for the IGE Entities was $60,902, consisting of $49,129 in cash, $11,051 of the Company's common stock, and $722 forgiveness of a contract asset. The fair value of the common stock issued was determined based on the closing market price of the Company's common stock on the acquisition date. The forgiveness of contract asset represents an effective settlement of a preexisting relationship between the parties. The amount of goodwill is not deductible for U.S. tax purposes.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts)
The following table sets forth the components and allocation of the purchase price for the Company's acquisition of Heavy 16, the H&G Entities, Aurora, Greenstar and the IGE Entities:
Heavy 16 H&G Entities Aurora Greenstar IGE Entities
Component of Purchase Price: Amount Amount Amount Amount Amount
Contingent consideration 344 — 19,300 — —
Forgiveness of assets and liabilities — — (215) (1,601) 722
Allocation of Purchase Price:
Identifiable assets (liabilities)
Current portion of lease liabilities (274) (447) — (624) (815)
Current portion of long-term debt — — — — (482)
Long-term deferred tax liabilities — (25,589) — — (6,769)
Long-term debt — — — — (1,434)
Other long-term liabilities — — (3,840) — —
Identifiable intangible assets
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(In thousands, except share and per share amounts)
Supplemental Disclosure of Financial Results
The following represents estimated unaudited consolidated net sales and net income amounts for year ended December 31, 2021, as if the five acquisitions had been included in the consolidated results of the Company for the entire period. The estimated net income presented below also includes the impact of the aforementioned allocation adjustments to the useful lives of certain intangible assets, resulting in additional expense attributed to the year ended December 31, 2021. Management considers these estimates to represent an approximate measure of the performance of the combined Company:
Year ended
Estimated ($ in millions)
Net income $ 66
4. GOODWILL AND INTANGIBLE ASSETS, NET
Goodwill
Primarily due to a sustained decline in the Company's market value of common stock and market conditions, the Company identified a triggering event requiring a test for impairment as of June 30, 2022. The Company completed its goodwill impairment testing and recorded an impairment charge of $189,572 as the test determined that the carrying value of the reporting units of U.S. and Canada was in excess of the fair value. The recognized impairment reduced the goodwill balance to zero as of June 30, 2022. The impairment was primarily due to a deterioration in customer demand in the U.S. and Canada caused by macroeconomic and industry conditions.
The Company determined the fair value of the U.S. and Canada reporting units based on an income approach, using the present value of future discounted cash flows, and based on a market approach. The fair values were reconciled to the market value of common stock of Hydrofarm to corroborate the estimates used in the interim test for impairment. Significant estimates used to determine fair value include the weighted average cost of capital, financial forecasts, and pricing multiples derived from publicly-traded companies that are comparable to the reporting units. Refer to Note 15 - Fair Value Measurements, for further discussion of valuation inputs. There was no goodwill impairment recognized during the year ended December 31, 2021. The changes in goodwill are as follows:
Goodwill
Balance at December 31, 2020 $ —
Acquisition - H&G Entities 49,707
Acquisition - Aurora 46,433
Acquisition - Greenstar 43,009
Acquisition - IGE Entities 48,687
Foreign currency translation adjustments, net (1,172)
Acquisition - IGE Entities - measurement period adjustments (21,304)
Acquisition - Greenstar - measurement period adjustments 7,000
Balance at December 31, 2022 $ —
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Hydrofarm Holdings Group, Inc.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts)
Intangible Assets, net
Intangible assets, net comprised the following:
Finite-lived intangible assets:
Indefinite-lived intangible assets:
Amortization expense related to intangible assets was $33,308 and $10,354 for the years ended December 31, 2022, and 2021, respectively. Amortization expense includes the impact from intangible assets recorded in connection with five acquisitions completed during the year ended December 31, 2021. The following are the estimated useful lives and the weighted-average amortization period as of December 31, 2022, for the major classes of finite-lived intangible assets:
Useful lives Weighted-average amortization period
Computer software 5 years 3 years
Customer relationships 7 to 18 years 11 years
Technology, formulations and recipes 8 to 12 years 10 years
Trade names and trademarks 15 to 20 years 18 years
The estimated aggregate future amortization expense for intangible assets subject to amortization as December 31, 2022, is summarized below:
Estimated Future Amortization Expense
Year ending December 31,
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Hydrofarm Holdings Group, Inc.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts)
5. EARNINGS (LOSS) PER COMMON SHARE (“EPS”)
Basic EPS is computed using net (loss) income divided by the weighted-average number of common shares outstanding during each period, excluding unvested restricted stock units (“RSUs”).
Diluted EPS represents net (loss) income divided by the weighted-average number of common shares outstanding during the period, including common stock equivalents. Common stock equivalents consist of shares subject to warrants and share-based awards with exercise prices less than the average market price of the Company’s common stock for the period, to the extent their inclusion would be dilutive. Regarding RSUs subject to a market condition, before the end of the contingency period, the number of contingently issuable shares (i.e., RSUs) to be included in diluted EPS would be based on the number of shares of common stock issuable under the terms of the arrangement if the end of the reporting period was the end of the contingency period, assuming the result would be dilutive. Those contingently issuable shares would be included in the denominator of diluted EPS as of the beginning of the period, or as of the grant date of the share-based payment, if later.
The following table presents information necessary to calculate basic and diluted EPS for the years ended December 31, 2022, and 2021:
Years ended December 31,
Dilutive effect of warrants using the treasury stock method — 1,395,393
Dilutive effect of stock options using the treasury stock method — 533,009
The computation of the weighted-average shares of common stock outstanding for diluted EPS includes the following potential shares of common stock using the treasury stock method for the weighted-average period during which the shares were outstanding:
Years ended December 31,
Shares subject to warrants outstanding — 1,899,435
Shares subject to stock options outstanding — 831,517
The computation of the weighted-average shares of common stock outstanding for diluted EPS excludes the following potential shares of common stock as their inclusion would have an anti-dilutive effect on diluted EPS:
Years ended December 31,
Shares subject to warrants outstanding 17,669 17,817
Shares subject to stock options outstanding 670,026 10,641
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Hydrofarm Holdings Group, Inc.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts)
6. ACCOUNTS RECEIVABLE, NET AND INVENTORIES
Accounts receivable, net comprised the following:
December 31,
Allowance for doubtful accounts (1,556) (1,156)
Inventories comprised the following:
December 31,
Allowance for inventory obsolescence (15,697) (3,530)
The allowance for inventory obsolescence increased during the year ended December 31, 2022, primarily a result of a reserve for certain lighting products. Inventories are stated at the lower of cost or net realizable value, and the Company maintains an allowance for excess and obsolete inventory that is based upon assumptions about future demand and market conditions. The allowance for excess and obsolete inventory is subject to change from period to period based on a number of factors including sales of products, changes in estimates, and disposals.
7. LEASES
The Company leases its distribution centers and manufacturing facilities from third parties under various non-cancelable lease agreements expiring at various dates through 2033. Also, the Company leases some equipment under finance leases. Certain leases contain escalation provisions and/or renewal options, giving the Company the right to extend the leases by up to 10 years. However, these options are generally not reflected in the calculation of the right-of-use assets and lease liabilities due to uncertainty surrounding the likelihood of renewal. The Company recognizes operating lease costs over the respective lease periods, including short-term and month-to-month leases. The Company has operating subleases which have been accounted for by reference to the underlying asset subject to the lease, primarily as an offset to rent expense within SG&A.
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Hydrofarm Holdings Group, Inc.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS