Hydrofarm Stock: Caution Saves The Day (NASDAQ:HYFM)

About a year ago I concluded that Hydrofarm Holdings (NASDAQ:HYFM) was acquiring value, making relative cheap acquisitions to average down from a high valuation. The company is a listed supplier for vertical farming in the cannabis industry which because of this positioning attracted great interest from investors.

The company has been awarded very steep valuations as a result and was averaging down by using its expensive stock/as a currency to average down.

Some Background

Hydrofarm has actually been around for some four decades already, originally being a supplier to the cottage industry, as it has focused on cannabis and controlled environment agriculture as well in more recent times, promising less need for water, less land, fewer chemicals, less carbon emissions and improved crop yields.

The company went public at $20 per share late in 2020, only to rise to $47 per share on the first day of trading, pushing up the valuation to $1.5 billion. This valuation was based on a business which reported a 10% increase in sales to $235 million in 2019, as operating losses came in at $27 million, in part being the result of restructuring charges. Even if we exclude these, the 11% gross margins of the business indicate the inherent limited margins of the business.

Revenues rose by an impressive 40% in the first nine months of 2020 as the company managed to post operating profits of $10 million that year. Moreover, momentum was accelerating with third quarter sales up 60% to $97 million as operating profits of $5.5 million indicated a $22 million run rate. With established peer Scotts Miracle-Gro (SMG) growing sales at a more spectacular number, being vastly profitable, it actually traded at a lower sales multiple.

Hydrofarm quickly became a momentum name and hit the $100 mark early in 2021, yet by August of last year, shares fell back to $50. This came amidst many moving factors as the company called for 20% organic growth in 2021, the timing of which coincided with the peak in the share price.

Fourth quarter revenues grew 62% to $87 million and while the company raised the guidance, now seeing 20-25% organic growth outlook for 2021, EBITDA was only seen at $28-31 million, comparing to a $21 million number posted in 2020. In April, the company reached a $78 million deal to acquire Heavy 16 at relative compelling multiples, as Hydrofarm sold nearly 5 million shares at $59 per share in April to fund this deal and future acquisitions. First quarter sales rose 66% to $111 million, with the organic growth guidance hiked to 30-40% and with the EBITDA guidance hiked to $39 million.

The funds raised in April were quickly used as the company acquired a $125 million deal for House & Garden and $187 million deal for Aurora Innovations early in the summer. These three deals cost $400 million, added $140 million in sales and $50 million in EBITDA.

Trading at $50 in August, the 45 million shares valued the business at $2.2 billion. These deals should create a more than $500 million business with EBITDA seen around 100 million. Factoring in assumed D&A charges, I pegged realistic operating earnings around $50 million, which created a roadmap for earnings of a dollar per share. That was far from a certainty with many factors still having to play out in the short term, amidst many moving parts (related to the many acquisitions). With earnings power (potentially) around a dollar, and shares trading at $50, the valuation was far too rich to create a compelling situation.

All Downhill

Shares of Hydrofarm ended 2021 around the $25 mark. Since my take last year, the company kept on pursuing acquisitions, which includes an $83 million deal for Greenstar Plant Products in August, as the company updated the pro forma sales outlook to $565-$590 million, yet adjusted EBITDA of $80-$90 million, a bit softer than I anticipated.

In October, the company reached a $58 million deal to acquire Innovative Growers Equipment, updating the pro forma outlook bit to account for recent dealmaking. Shares fell to the teens when the company posted its full year results in March of this year. The 2021 results were hard to read into as the company announced many deals during the year and hence the outlook is much more informative.

The company guided for 2022 sales between $575 and $615 million, yet adjusted EBITDA is seen at just $63-$74 million, far below the pro forma EBITDA numbers communicated in 2021 and my $100 million estimate based on the dealmaking spree in 2020, indicating the many deals have not lived up to expectations.

That was still manageable as net debt only stood around a hundred million, still a manageable amount. With D&A charges trending at $25 million and factoring in a $10 million run-rate in terms of stock-based compensation, adjusted EBIT runs around $30-$40 million. This still resulted in potential earnings power of around half a dollar per share, yet momentum was clearly on the soft side.

The problem is that momentum quickly went downhill as the company cut the sales guidance to a midpoint of just $500 million following the first quarter results, with EBITDA seen at a midpoint of $50 million. This is dismal as a soft first quarter made that the company posted real economic losses, resulting in a modest build up in debt as the degree of the revenue shortfall (about $95 million in just three months time) is utterly shocking as shares fell to the mid single digits in response to the results.

In August, the company announced preliminary second quarter results with revenues seen around $97 million, indicating that the updated full year sales outlook is too optimistic. This triggered huge goodwill charges in organic losses in the process, as the company only sees full year sales at $330-$347 million, indicating that the second half of the year is only set to worsen. Alongside the second quarter results the company guided for negative EBITDA between $16 and $25 million this year, a huge concern given a more than a hundred million debt load and the fact that EBITDA massively understates realistic losses.

What Now?

Amidst what the company calls a huge recession in this industry, we have seen the full year pro forma revenue base collapse by 40%, having a detrimental impact on the bottom line. With 45 million shares now trading at just $3 and change, this results in a $150 million equity valuation, or a quarter of a billion valuation if we factor in net debt. Based on the revised sales outlook, the company trades at just 0.7 times sales, as the issue is of course debt and current losses with no green shoots in sight.

To put this number into perspective, the current $250 million valuation corresponds to a $400 million dealmaking spree last year which added $140 million in sales at the time as the 3 times sales multiple looks high now but was far lower at the time. Right now, shares are just a gamble as now is not the time to become pessimistic. Current low valuations represent a huge opportunity, yet few green shoots are in place as an overhyped M&A run in recent years provides no easy solution here given leverage and earnings power being non-existing.

On the other hand, the long term trends are intact, albeit severely hurt by a recession in hydrofarming and cannabis now, as perhaps some kind of speculative M&A action might come into play at some point.