Distribution Solutions Group - Q2 2023

Transcript

Operator (participant)

Please note, this conference is being recorded. I will now turn the conference over to your host, Mr. Steven Hooser. You may begin.

Steven Hooser (Managing Director)

Good morning, ladies and gentlemen, and welcome to the Distribution Solutions Group Q2 2023 Earnings Call. In conjunction with today's call, we have provided a Q2 earnings presentation that has been posted on the company's IR website at investor.distributionsolutionsgroup.com. Please note that statements made on this call and in the press release contain forward-looking statements concerning goals, beliefs, expectations, strategies, plans, future operating results, and underlying assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from those described. In addition, statements made during this call are based on the company's views as of today. The company anticipates that future developments may cause those views to change, and we may elect to update the forward-looking statements made today, but disclaim any obligation to do so.

Management will also refer to non-GAAP measures, and reconciliation to the nearest GAAP measures can be found at the end of the earnings release. The earnings press release issued earlier today was also posted on the investor relations section of the website. A copy of the release has also been included in the current report on Form 8-K filed with the SEC. This call is also being webcast on the Internet via the Distribution Solutions Group investor relations page on the company's website. A replay of the teleconference will be available through August 17, 2023. I will now turn the call over to Bryan King, DSG's Chairman and Chief Executive Officer. Bryan?

Bryan King (Chairman and CEO)

Thanks, Steven. Thank you all for joining to review our Q2 results. Joining me for today's call is Ron Knutson, DSG's Executive Vice President and Chief Financial Officer. Distribution Solutions Group delivered strong 2023 first half results, anchored by our industry leadership positions, our broad portfolio of products, value-added services and mission-critical solutions, and the benefits we are starting to unlock with our significantly improved scale, coupled with our talented teams' relentless focus on execution. Starting on Slide 4 of the Q2 earnings presentation, we again delivered strong quarterly sales, up almost 18% in the Q2, which included organic growth of 5%. Q2 adjusted earnings per share was $0.52, up over 40% from the comparable prior year earnings per share.

We also generated adjusted EBITDA in excess of $40 million, or a margin of 10.6% in the quarter. This quarter represents the fifth consecutive year-over-year quarterly EBITDA margin expansion. We are extremely pleased with how the teams have executed, especially in a dynamic operating environment with a lot of initiatives that are requiring investment of internal and external resources in the first half of 2023 to accelerate unlocking future value to the shareholders. Later, we will provide more commentary on important sales and cost initiatives we are currently working on, along with our discussion of the operating unit performance for the Q2. We are excited that DSG has successfully established itself as a leader in the end markets we serve. We are positioned well to leverage our high-touch service delivery model and deepen customer relationships with our increasing breadth of value-added products and services.

We are thrilled to have closed on the Hisco acquisition on June 8 and are successfully integrating processes and the team to create a unified and streamlined single platform with TestEquity. We fully expect to realize expanded sales, productivity, and meaningful cost synergies. We continue to grow significant wallet share across DSG and are identifying key cross-selling opportunities with solid contract wins through our growing business pipeline, and Hisco only expands these growth engagements.

I applaud the strong collegiality and respectfulness across the collective expertise in DSG of our leadership teams we have assembled, and how they have prioritized and aligned their common goals across how our verticals can best leverage the total spend and capabilities of DSG to successfully improve and expand our products and services within our intimate customer engagement model, allowing me to see quite discreetly how it will continue to translate into an acceleration in building shareholder value for all of us. In conjunction with these efforts, and as a reality following many of our investments, I also expect shareholders to benefit in coming quarters and for years to come from the investments being made and process improvements underway that will accelerate free cash flow, and specifically for free cash flow conversion in the back half of 2023 and 2024 to significantly improve.

While we remain guarded about our current rate environment and how it could weigh on our customers, business activity remains solid through July, very consistent with our first half of the year. Our sales organizations continue to engage the marketplace using customer-centric experiences that deliver quality products and smart, efficient solutions that reinforce our value proposition to our important end markets. We are actively monitoring the demand environment and marketplace forces in each of our channels. We are leveraging DSG's strong customer relationships and focus on a customized customer experience to expand our engagements, especially getting traction with large strategic accounts. We are confident this is strengthening the company's organic growth trajectory and reducing resistance to our cross-selling efforts as we reinforce our customer-centric priority and offer more value-added capabilities in each of our verticals.

Moving to Slide 5, let me briefly provide business updates on initiatives for each of our verticals. First, Lawson Products is a leader in the MRO distribution of C-parts, offering vendor-managed inventory services. During the Q2 of 2023, Lawson continued to make significant operational and financial progress. I'm pleased with how well the team managed pricing, freight recoveries, and organic growth within its customer base. During the Q2, the Lawson team successfully aligned the sales organization to better serve our customers with key strategic field and inside sales personnel shifts. We believe critical initiatives like positioning our field sales team to become more productive with our high touch, high demand customers, generates greater customer lifetime value. We are confident that this more balanced approach will drive sustained long-term growth and engagement with customers.

Under Cesar's leadership, we took the first steps this quarter. We also continue to make strategic investments by enhancing our supply chain technology to support our customers and progressing on our digital roadmap. We are working diligently on the CRM go live with enhanced mobile capabilities at Lawson. The company's investment in lead generation capabilities and CRM tools is expected to roll out in a few months. Our goal is to better enable our sales reps across all sales channels to be more productive, serve customers more efficiently, be better equipped for cross-sell opportunities, and ultimately, drive higher compensation for our high-performing, growing sales force. Secondly, Gexpro Services is a leader in the supply chain solutions of largely C-parts, specializing in VMI programs for high spec OEM customers. Gexpro Services delivered strong quarter results, both sequentially and versus the prior year quarter.

Customers continue to be interested in our renewables value proposition that combines expanded electrical, mechanical, and hardware product offerings with kitting supply chain services. We've accelerated our leadership position as a value-added channel partner for major OEMs, helping them with solutions not only on the OEM side, but across the growing demand around the retrofit and upgrade cycle for the installed base. We've seen recovery in the aerospace and defense vertical, and industrial power demand remains strong, very solid. Importantly, Gexpro Services value creation initiatives this year include getting additional synergies out of our acquisitions, expanding kitting and project services, and successfully launching our e-commerce platform with a focus initially on tech and aerospace and defense customers. We are also working through an expanded pipeline of opportunities where our customers are engaging us as partners to offer solutions around additional product and service capabilities.

Our goal is to continue to win OEM programs, where we are, where we are intensely embedded with a customer as a provider of choice. Our collaborative approach and the benefits seen through strategic combinations and bolt-on acquisitions, significantly increases our resources, footprint, and collective expertise in offerings. Thirdly, moving to TestEquity. Vendor Managed Inventory solutions continue to show sustained, strong, double-digit strength in the Q2. We've seen pressure in the technology and R&D sectors, which we believe are impacted by higher cost of capital and capital expenditure delays. Our teams are learning that projects are not being canceled. However, they are being pushed out for several months. As we mentioned last quarter, we continue to see increases in rental bookings and refurbishments as market dynamics change.

Significant progress has been made on reducing our lead times for chambers by over 50%, allowing us to work through our backlog of historic orders by the Q4. We will begin shipping many models just in time from current stock in early 2024, which should drive expanded margins. Digital sales were up 8% in the Q2, with growth primarily from the new TestEquity and TEquipment e-commerce sites. We're in the process of optimizing people, processes, and technologies as we integrate Hisco with TestEquity. In addition to acquisition-related costs, we also recorded about $2 million of restructuring expenses that Ron will cover more in a few moments. We will continue to capture cost synergies and production efficiencies, resulting in improved delivery times and lower shipping costs.

Regarding Hisco, we are accelerating our work to build a higher structural margin profile and are encouraged by early results. In addition, the Hisco team quickly embraced and is successfully engaging in the established DSG cross-selling efforts. We expect this to have a meaningful impact on the overall profitability and cash flow generation for DSG beginning this year. With that, I would like to turn the call over to Ron to walk through the financials. Ron?

Ron Knutson (EVP and CFO)

Thank you, Bryan, and good morning, everyone. Turning to Slide 7, we're excited this morning to share with you our strong Q2 results of Distribution Solutions Group. Let me summarize Q2 results. On a combined basis, we reported strong top line and bottom line results over a year ago. As Bryan mentioned, we reported total sales growth of 17.6%, with organic sales growing 4.8% through both price and volume expansion. The Q2 results reflect continued growth in margin dollars. GAAP reported income improved threefold, with Q2 adjusted EBITDA exceeding $40 million, a first since bringing DSG together over a year ago. Our positive momentum and movement in cash flows generated from operations continued with our focus on working capital improvements.

I'll now walk through some of the specific numbers on a combined basis, of which most of this is on page seven of our presentation. First, consolidated revenue for the Q2 was $378 million. Revenue increased 17.6%, or $56.7 million over the Q2 of 2022, driven by organic growth, plus approximately $43.4 million coming from acquisitions, of which $28 million was from Hisco. Second, reported GAAP operating income was $13.8 million compared to $4.1 million a year ago quarter. On an adjusted basis, excluding merger-related costs, acquisition costs, stock-based compensation, severance, and other non-recurring items, adjusted EBITDA improved by nearly 27% or $8.5 million to $40.1 million, or 10.6% of revenues.

While the percentage is down slightly from Q1, approximately 40 bps of the decline was related to including the initial 3 weeks of Hisco, which we did anticipate. Third, we reported GAAP diluted earnings per share of $0.14 for the quarter, compared to a loss of $0.23 a year ago. On an adjusted basis, diluted EPS was $0.52 for the quarter versus $0.36 for a year ago quarter. Turning to Slide 8, let me now comment briefly on each of the businesses. Starting with Lawson, sales were $119.1 million for the quarter. Please note that this does not include Bolt Supply, as they are included in the all other reporting segment. The Lawson segment average daily sales, or ADS, grew 11% organically over the Q2 of 2022.

The increase over a year ago was driven by strong performance within the strategic business, up nearly 25%, Kent Automotive up 21%, the core business up nearly 2.5%, and government up 22%. During the quarter, unit volume increased approximately 2.5% versus a year ago. Lawson's growth during the quarter was achieved through increased share of wallet with existing customers and new customer relationships, in particular within strategic or large accounts in our Kent Automotive business. During the quarter, Lawson continued to build out its infrastructure to help our field sales reps become more productive. This included investments in additional account managers to help grow the strategic and government businesses, inside sales reps to assist with smaller accounts, conversion implementation individuals, technical specialists, and we are 3-4 months away from rolling out our CRM tool.

We're excited about these overdue investments to help the long-term growth of our field sales representatives as they expand their book of business. Lawson continues to realize steady improvements in its gross margin %. While we're up against some mix shift headwinds, as our largest customers have been growing faster, and we continue to see expansion given price realization, lower net freight costs, and leveraging our costs over a higher sales base. Lawson's adjusted EBITDA improved to $16.1 million, compared to adjusted EBITDA of $9.4 million a year ago quarter, primarily driven by the sales in gross margin improvements, partially offset by increased compensation on higher sales. Lawson's adjusted EBITDA as a % of sales was 13.5% of the quarter versus 8.8% a year ago quarter.

You may recall that Lawson got out of the gate with an extremely strong start in Q1, with its strongest quarter that we've seen. During the Q2, we launched our initiative to better service our customers, depending upon their needs and size, through additional channel offerings, which should improve the effectiveness and long-term efficiency of our sales force. That, combined with some of the infrastructure investments that I previously mentioned, brought down the percentage sequentially slightly. However, we are well positioned to grow the company and the long-term margin profile. In the first half of the year, Lawson nearly doubled its adjusted EBITDA, going from $17.4 million to $34.6 million, and is well positioned with these investments to grow the company on an accelerated basis. Turning to Gexpro Services on Slide 9.

Total sales were $108.3 million for the Q2 of 2023, an increase of $8.5 million over the Q2 of 2022, all from organic growth. Approximately 4.4% came from volume, with the rest from price. The increase in aggregate sales was primarily driven by new customers and the expansion of existing customer relationships. Profitability improved, although mix shift was a headwind, as softer sales to the semiconductor end market were more than offset, with nice growth in aerospace and defense and industrial power markets. Five of the six verticals delivered year-over-year sales growth. Gexpro Services continues to expand its relationships with existing customers and attract new customers through its value creation offerings, including VMI, kitting, project management services, and the ability to deliver world-class support to the OEM production cycle.

Gexpro Services works extremely close with its customer base to ensure they have the necessary product and services, and to simplify the supply chain and improve total cost of ownership for their customers. Gexpro Services adjusted EBITDA expanded to $13.1 million, or 12.1% of sales, as compared to $11.9 million, or 11.9% for the year ago quarter, and 11.6% in the Q1 of 2023. Gexpro Services continues to make incremental improvements in their margin profile in managing through varying end market cycles. Lastly, I'll turn to TestEquity on Slide 10. Sales for the quarter grew $38.2 million, or 39% to $136.1 million, primarily driven by the recent acquisitions.

During 2022, TestEquity closed on 3 acquisitions: Key Equipment and National Test Equipment in the Q2 and Instrumex in Q4. In the Q2 of 2023, we closed on Hisco. Of the $38.2 million sales increase for the quarter, $43.4 million was generated from these acquisitions, and of that, approximately $28 million came from Hisco. Organic sales were down 7% versus a year ago, with a decrease in test and measurement sales and a softening of the EPS sales, as Bryan previously commented on. The test and measurement piece of the business is more closely tied to customer capital projects. Our sense is that our performance is consistent with others in our space and that these projects are delayed and not canceled. We anticipate volumes will pick back up in late 2023 and into early 2024.

On an adjusted EBITDA basis, the Q2 ended at 7% of sales or $9.5 million, representing an increase of $900,000 over a year ago quarter. With the softening of T&M sales and with the benefit of thinking how Hisco's resources will begin to be leveraged as folded in through the integration plan later this year and next, the legacy TestEquity business had more flexibility to remove nearly $4 million of annual costs out of the company, which commenced in June. Moving on to Slide 11. During the quarter, we expanded our committed credit facility from $500 million to $805 million. We were able to accomplish this in a very difficult bank market, which validates the support of our strategy from our existing bank group, plus four additional banks that joined our credit facility.

Additionally, we also issued $100 million of additional stock to existing shareholders through a common stock rights offering. These two actions allowed us to close on the Hisco transaction, pay down our revolver, manage our overall financial leverage within the guided range, and increase our capacity for future acquisitions. From an access to capital, we have approximately $44.2 million of unrestricted cash and $189.6 million available under our existing credit facility. As part of that facility, we also have an additional $200 million accordion feature. We ended the quarter at a net debt leverage ratio of 3.1x, primarily on increased earnings and taking on debt for the Hisco acquisition.

Even with multiple acquisitions over the past 15 months, we've been able to deleverage the company and improve our scale and offering to accelerate further deleveraging and support additional inorganic growth. For reference, at the time of the April 1, 2022, merger date, our net debt leverage was 3.6 times. This progress is consistent with our intention to prudently manage our debt levels and our leverage in the 3-4 times range. Our positive movement in cash flows generated from operations continued during the quarter, with our focus on working capital improvements.

Net capital expenditures, inclusive of rental equipment, was $5.7 million for the quarter, and we expect full year CapEx to be in the range of $16 million-$22 million, most of which is a discretionary investment to grow rental assets, which also supports used T&M equipment sales. Before I turn the call back to Bryan, I wanted to reiterate how pleased we are with the company's strong financial performance for the quarter. We generated over $40 million in adjusted EBITDA for the quarter, a significant increase over a year ago, and also up over a very tough Q1 comparison. We're also very excited that in conjunction with the Hisco closing during the quarter, we expanded our credit facility, providing us more firepower to continue on our growth strategy. All of the businesses continue to execute on their planned initiatives for 2023.

We will continue to prudently manage our balance sheet and financial position as we monitor current market trends. Thank you to the operating teams at Lawson Products, Gexpro Services, and TestEquity for their continued focus and commitment to deliver these great results, and welcome to the entire Hisco team. I'll now turn the call back over to Bryan.

Bryan King (Chairman and CEO)

Thank you, Ron. Let's turn to Slide 12. We believe it is important, especially as U.S. and global markets evolve and change quickly, to discuss with investors our approach to capital deployment. DSG's allocation of capital is focused on a disciplined balance between investing in growth, both in our core businesses as well as in strategic acquisitions that fit our model, with a prudent approach to working capital intensity, leverage, and occasionally through opportunistic share buybacks. Our goal is to continue to scale the DSG platform into an even more enduring, well-positioned, specialty distributor, with key differentiators that uniquely benefit from utilizing our high touch, value-added distribution solutions, services, and customizable capabilities that customers clearly recognize and celebrate.

Since we have built this business as an asset-light structure, we have planned for organic and inorganic growth through deliberate working capital investments, as well as strategic acquisitions that are aligned with our commitment to accelerating shareholder value. Our targeted leverage will continue to be in the 3-4 range, and at the end of the Q2, just 3 weeks post-closing of Hisco, our leverage is 3.1 times. At the end of the quarter, we had approximately $476 million of net working capital with accelerating cash flow. Our investment in working capital over the last year facilitated our focus to drive organic growth that drives accelerating profitability for our shareholders. Finally, we continue to seek the highest return on invested capital opportunities with an obsessive commitment to build incremental shareholder value for the benefit of all of us.

We understand and appreciate why there continues to be interest in DSG from investors. It is easy to see the long-term compounding effects of owning a leading specialty distribution company with the scale and breadth of our products and solutions. Turning to Slide 13. Our principal goal at DSG remains focused on improving our overall return profile by building and maintaining profitable scale as a specialty distribution business. Q2 results accomplished our profitability objectives while balancing significant investments in the business. We know that adding Hisco will accelerate advancing many of our current initiatives and longer-term goals. We continue to be selective with our robust acquisition pipeline as we carefully analyze opportunities that fit our focused value accelerating criteria. I'd like to thank all our DSG associates who are working to optimize and streamline operations, better serve our customers, and position the company to maximize its full potential.

We believe that decisions and actions today from our teams generates accelerated shareholder value. Before I open it up for questions, I would like to let you know that we are hosting an Investor Day on September 28 in Fort Worth. We plan to share key operational initiatives and will include a showcase or show and tell, featuring Lawson Products, Gexpro Services, and TestEquity, so that investors can better understand each of the unique products and solutions. We will audio webcast elements of the Investor Day, but believe you may get the most benefit by attending the event live and get to know the many DSG and LKCM Headwater team members that are working and engaging daily across countless work streams to build shareholder value. If you've not registered yet, please reach out to our IR team for more details. Thank you for your time today.

Now, operator, we would like to take questions from analysts and investors.

Operator (participant)

Thank you very much. At this time, we are opening the floor for questions. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate that your line is in the queue. You may press star two if you would like to remove your question from the queue. For any participants using speaker equipment, it may be necessary to pick up your handset before you press the star keys. Please pause a moment while we poll for questions. Thank you. Your first question is coming from Kevin Steinke of Bain Research. Kevin, your line is live.

Kevin Steinke (VP and Senior Research Analyst)

Good morning.

Ron Knutson (EVP and CFO)

Good morning, Kevin.

Kevin Steinke (VP and Senior Research Analyst)

I wanted to start off by asking about the organic growth and, you know, the breakdown of price versus volume. Is kind of roughly half and price and half volume, the way to think about that, 5% organic growth in the Q2? Or if not, can you give me the breakdown there?

Ron Knutson (EVP and CFO)

Yeah, Kevin, this is Ron. I can, I can jump in on that one. It varied a little bit by each of the three individual companies. If you look at Lawson's organic growth of 11%, about 2.5 points of that was volume, and the rest being price. Gexpro Services of the 8.5% organic growth, kind of split 50/50. A little bit north of 4% on price, and it's same on volume. On the TestEquity side, organic, you know, we mentioned that they were down about 7%. About 2% of that was price and down, you know, the offset to that was lower volume.

All, all in, if you, if you kind of take the weighted average between the three operating companies, you know, kind of flattish, maybe up just slightly in volume, and then, with, with price, you know, being the remainder of that. Hopefully that breakdown by company is, is more specific than maybe what you asked, but, hopefully that answers your question.

Kevin Steinke (VP and Senior Research Analyst)

Well, that's great. Yeah, no, that's perfect. I... and I know you touched on that in some of the segment discussion as well. Okay, great. I think you mentioned in your prepared comments that business activity had remained solid in July. Should we think about similar type volume trends on the organic side continuing to July? Have we, you know, largely lapped the benefit of the price increases that, that you've been implementing?

Ron Knutson (EVP and CFO)

Yeah, I'll, I'll, I'll jump in on that one as well. I would say that, that, we'll start lapping, some of the, some of the increases that we put in place, more so in the, in the second half of the year, in particular on the, on the Lawson business. You know, more of that, of those changes took place in the second half, of 2022. We're on the early stages of, of starting to lap some of those. And, you know, I think the, the pricing, piece for Test and Gexpro was probably a little bit more dynamic, throughout 2022. I think that's probably a little bit more consistent.

On the Lawson side, we're, we're probably lapping some tougher numbers in the second half of the year. You know, and, you know, as we think about, you know, just overall, what we've seen so far here in the month of July, you know, flattish to, you know, kind, to kind of where we were, you know, in the Q2, flattish to down just a little bit. We continue to see, you know, a little bit of softening yet within some of the end markets. It again, it kind of varies a little bit by, by operating company as to, as to where we're seeing that. There's. You, you end up with some, kind of, some strange dynamics based upon, you know, how the, how the calendars fall.

That, that, you know, impacts our average daily sales, especially, Gexpro Services, which has a, has basically a, you know, a 5-week July. Typically, we see a little bit of compression in the, in the average daily sales number. You know, kind of flattish as I, as I think about, you know, where we're, where we're at today versus, you know, the reported numbers in, in Q2 on a consolidated basis.

Bryan King (Chairman and CEO)

Ron, I just, I, I'd love to give him a little more detail on. The, the lapping, Lawson, Ron, would, why don't you give him more specifics on where we did. On Lawson, we had specific spots where we did take pricing actions last year, and they weren't in July last year, so it was later in the year. To specifically answer your question, July did have both, as it related to Lawson, had both the benefit of some volumes and had some benefit of pricing. We're gonna see, I think it was September, was it late August or September that we had a specific price action initiative in Lawson?

Ron Knutson (EVP and CFO)

It was. Yep.

Bryan King (Chairman and CEO)

That, that way you've got specifically some, some support from us in terms of actually kind of where those skating spots were. We had a lot less ability last year to on the longer cycle pieces of Gexpro Services to be able to take price action on those contracts until later. There, you know, to kind of give context around Gexpro's Gexpro Services, we were, it was, it was later in the course of the year, and in some cases, it was really rolling through those contracts as they reset through the inflationary pressures that we had last year, that we started to get the benefit of some pricing actions there.

As we moved into this year, it became a little bit more dynamic on price action. It was less of, on a single day, a point of, of a price action taken. It started to kind of become more dynamically blended into what we were seeing in those particular SKUs on the sourcing side. It becomes less clean, if you will, to be able to kind of point to specific points in time, as we move back into 2023. That's, I'm hopeful that gives you some context.

On the, the, the sales side, the softening that we saw on TestEquity, you know, I think that the context there that I would offer is, first of all, we're really glad that we've bought Hisco, because Hisco offers what longer term we want out of that business unit, which is to have a lot more MRO and OEM kind of repeat activities. As opposed to TestEquity itself, the legacy business that we've enjoyed for the last number of years did have, you know, two-thirds of its revenue, of the legacy business, was tied towards, you know, test and measurement equipment or bench sales, and really, what I would, you know, characterize as more of a capital spend from the customers.

On that piece of it, we've got active dialogues going with the customers, and there is, you know, we've seen some sliding in their interest to kind of either replace or expand their equipment needs. We think that we're gonna see a renewed level of order flow there. That's the area that we've had the most softness across all of our DSG platform, which is in those, you know, that kind of two-thirds of the historic TestEquity piece, that was tied as more capital spend.

We, you know, now there were some pieces of that that's been interesting, that have been more favorable to, you know, or kind of, I guess, equally. One has been kind of pressure on gross margins, other has been to the benefit of. We have seen a shift as people have deferred or delayed their purchases on equipment. They have asked for more rental equipment access, and that obviously is, has historically come with a higher gross margin associated with it. It does influence how we have to think about investing dollars into our rental fleet.

Then, you know, one of the things that I spoke to, specifically on test and measurement, that's been a real drag for, on the TestEquity side, on the capital spend side, that's been a drag to us, but, you know, has actually had a little bit more support in the top line. It's been a drag to margins and to revenue over the last several years, has been our chamber side. We will lap some orders that we got over a year ago, where we were in a different, cost of goods sold environment, that we had locked into pricing. We finally get out from that burden here in the Q4, having worked through the backlog.

We have, it expanded our contract manufacturing capabilities, that for those that, support us on our, on the chamber side. It allows us to start accelerating the revenue, out of our chambers again, because we've had a large backlog there, and it allows us to get back to a, a much, healthier margin.

Kevin Steinke (VP and Senior Research Analyst)

Okay, great. That's a helpful color. I was just wondering how we should think about adjusted EBITDA margins as we look to the second half and beyond. I think you mentioned, Ron, that 40 basis points sequentially of the, you know, margin versus the Q1, you know, the 40 basis point headwind just from inclusion of Hisco. And you also talked about plans to improve Hisco margins. I mean, you know, we start to run into some tougher comps, I guess, in the second half year-over-year. Should we think about just, you know, layering in Hisco being largely offset by organic margin expansion? Or, you know, how quickly can you start to improve the Hisco margins? Just any color on margin direction and would be helpful.

Ron Knutson (EVP and CFO)

Yeah.

Bryan King (Chairman and CEO)

You want me to...

Ron Knutson (EVP and CFO)

Yeah, I can start. Yeah, sure, Bryan. Yeah, I'll start with that. Yes, you're Kevin, you're spot on on the on the Hisco impact on the on the sequential margins from Q1 to Q2. We did anticipate that. You know, when we announced the Hisco transaction, we knew that it would, you know, bring down the overall margin on a shorter term basis. Clearly, you know, our expectation is that, you know, when we, you know, work through the integration process, which we're well underway as we even as we sit today, that those margins will... That they'll, you know, really come up to the margin profile of overall DSG.

Bryan King (Chairman and CEO)

You know, I, you know, the interesting part in the Q2 was they were only in for 3 weeks, right? We have to think about, you know, bringing them in for the, for the full quarter here, in, in Q3 and Q4. You know, whether or not it's going to be entirely offset by, by margin expansion from the other, from the other entities.

Ron Knutson (EVP and CFO)

You know, is, is a bit of a tough question to, to answer without giving, you know, specific guidance here over the last six months of the year. What I would say is, is that we have very specific objectives around and action items around the integration of Hisco. We did comment on some of the cost actions that TestEquity has already taken around that to help, you know, that that'll, that'll help right away here starting in, in the Q3. You know, and, and Gexpro Services just continues to deliver. You know, when we start thinking about, you know, even their end market cycling a bit, they, they have a, a great ability to be able to focus on those end markets where they can pick up growth.

We saw, and we continue to see, you know, incremental margin expansion there on the organic basis, as well as on the Lawson side. You know, it... Hopefully, that helps without giving you, without giving you a specific percentage that we're going after here in Q3 and Q4, but that might give you a little bit of context just in terms of some of the actions we're taking.

Bryan King (Chairman and CEO)

Yeah. Ron, let me I'm gonna dovetail onto that and just kind of as it relates to Hisco. Their, one thing I wanna flag is that we've got an earn-out element to the Hisco transaction that's at the end of this quarter, or I think it's October, I guess, Ron, is that right?

Ron Knutson (EVP and CFO)

Yes, October. Yep.

Bryan King (Chairman and CEO)

October. There, there are elements to making sure that they are able to have clean numbers for that opportunity, which really was set around some real growth and profitability as well as their targets. Right now, you know, we would expect that, that that'll be a tough reach for them to hit, but, we don't, and we've got a great relationship with that management team. We wanna make sure that, we give them every opportunity to kind of get through October with their stewardship of, of, of kind of, the margin profile there.

It's easier for us to take those actions that we took in the month of June, looking forward to how the businesses are getting integrated on the TestEquity side itself. That's why when we call out the $4 million of actions that we took on the TestEquity side, and we didn't call out actions that we've played, that, that the management team of Hisco is, is, has looked at, as the two businesses come together, you know, we wanted to make sure that, that we wanted them to have every opportunity, and we would love for them to hit the earn-out.

There are gross margin initiatives that are across that total vertical now that we will see during the third and Q4. Some, as it relates to the TestEquity side, and more opportunity going forward, as it relates to the Hisco side. There are, you know, when we think about longer term structural margin opportunities for the whole business, and when we speak about how Hisco allows the whole business to have a structurally higher margin, there's two real levers there. One is the fact that Hisco, with TestEquity, allows TestEquity and Hisco together to get to a higher structural margin than where TestEquity would've been by itself, and it gets there faster, like this action that allowed us to take on the TestEquity side.

We had targeted to get TestEquity to double-digit EBITDA margin at the end of the year or right before the end of the year. That's without Hisco as part of it. That's been the operating objective that that team has been moving towards for the last 18 months. We continue to feel confident that they are marching us that direction. There's also the stabilization, if you will, in the kind of the repeat volumes that you get out of OEM and MRO that are now two-thirds plus of the revenue, especially with the revenue being softer in tested measurement and the kind of benches and some of the capital spend on the TestEquity side.

That's really where we've seen, just like we called out the 8% growth in the digital side of TestEquity, during the last quarter. That part's been growing, the consumables have been growing, but the softness has been on the, on the capital spending side. Now that whole division has, is much more levered to that, and, and that ought to allow us to optimize both the cost structure and the way that we approach margins to pull that up. The, the value-added capabilities that Hisco has are allowing some opportunities to look back at Gexpro Services and at Lawson, where we have, you know, Lawson's got the highest structural margin profile because of the contribution margin that it enjoys.

There's, there's opportunities that we are seeing on pulling some of the capabilities of Hisco back across the Gexpro Services and the TestEquity, or the Lawson side. There are some capabilities that Gexpro Services has on the value-added side that are allowing us to look across the TestEquity, Hisco platform. Those are, are on the margin side. Additionally, we have seen very good traction with the Hisco team out of the gate. They've been great team, team players, and they've seen and assigned real opportunity to being able to cross-sell some of the specifically the capabilities that Gexpro Services and...

A loss in half into their customers on the where they're more deeply embedded, and also the geographic expansion that we've been able to grow with the Hisco transaction south of the border.

Kevin Steinke (VP and Senior Research Analyst)

All right, thanks for all the insight. Appreciate it. I'll turn it over. Thanks.

Bryan King (Chairman and CEO)

Thank you.

Operator (participant)

Thank you very much. Your next question is coming from Ken Newman of KeyBanc Capital Markets. Ken, your line is live.

Ken Newman (Director)

Hi, good morning, guys.

Bryan King (Chairman and CEO)

Morning, Ken.

Kevin Steinke (VP and Senior Research Analyst)

Morning, Ken.

Ken Newman (Director)

Morning. Bryan, you, you gave some pretty good answers, very, very, very detailed answers here for a lot of my questions I was gonna ask. Maybe I'll just ask one here on-

Bryan King (Chairman and CEO)

It's Ken, it's 30 years of being, asking the questions that you're asking.

Ken Newman (Director)

Yep. Yep.

Bryan King (Chairman and CEO)

Given that I've been on the other side of these calls for so many years, it's hard for me to resist not trying to offer some color that I probably get in trouble with, with my team afterwards.

Ken Newman (Director)

Yeah, no worries. Well, for my question, you know, we are hearing more this earning season about customers revising orders as lead times are improving, especially in some of these electrical components that maybe you guys touch a bit with TestEquity and Gexpro. Curious if you're, if you're seeing that today, and how do you view that impacting demand, if at all, in coming quarters?

Bryan King (Chairman and CEO)

If Ron, yeah, well, there's two ways to answer that question. One is to specifically talk about how lead times have influenced our own purchases, and then also, you know, some of the actions that we took a year ago were, and 18 months ago, or I guess, 15 months ago, when we were concerned about lead times. So over the last two years, we've certainly increased the working capital intensity in, in our businesses, or across the business, across our verticals.

We've got the benefit today of being able to take a more, you know, take a posture on our working capital investment that is, should allow us, in specifically, in the opportunities that we've identified, to lean up our working capital investment over the next 3 to 6 months, maybe 9 months, to kind of get through it or so. That's where I called out free cash flow. We had good free cash flow conversion in this last quarter. I think that we'll have better, at some point in time, over the next 6 to 9 months.

We've got initiatives to really go back and look at where we took some actions on inventory stocking levels, because we were worried about strong inflationary pressure, as well as lead times and freight costs. There's a lot of money that we've tied up in working capital that we think we might be able to release over the next six to nine months. That's one part of it. That also, as it related to Gexpro Services specifically, had an impact. You know, it's kind of the old game of telephone or the, you know, kind of where one person tells you and, and the story kind of gets amplified, and it gets to the next person, or maybe it's, kind of fishing stories, if you will.

The challenge has been that our customers have, have relayed with a lot of anxiety, production levels that then got narrated back to and through purchasing. Now that there's less of a concern from their end, we're getting to the heart of exactly what their production levels are, and it's allowing us to be more exacting in our, 'cause there's less anxiety on their end that we're gonna not have adequate inventory to support their OEM needs. Specifically, the risk associated with a bunch of our customers, of us being out of it for a out of stock, out of stock on a small piece good, that would slow down a major manufacturing line.

There's just not that level of flexibility on our side, and so we understand why they puffed some of their forecasting to us.

Ken Newman (Director)

Bryan, I guess just to clarify my question here. I, you know, I'm more concerned about your demand that you're seeing, are customers pulling back on orders because it used to take, you know, call it 3 months for product widget X, and now it takes back to normal 3 weeks, and so they don't have to order out as far. Are you seeing that today across the businesses?

Bryan King (Chairman and CEO)

Yeah, that's been a something that we've talked about over the last 6 months, and I think I even alluded to it on the last call, which whether or not we were gonna see some destocking at our customer level, that would have some influence on our own order levels that we were seeing. I think that some of that's going, is absolutely taking place. It's, if it was happening, we were seeing it happen some in the last quarter, because we're not seeing right now an acceleration in it.

I, I had said this, and I think, certainly I've said it to some of the investors, but I think I said it in the last, you know, last quarter's earnings call, that I had, you know, been calling out for 3-6 months for our team to be anticipating that we were gonna see some destocking at the customer level because their concerns about lead times and availability were so peaked a year ago, that they stocked deeper themselves. We're seeing on the public side, we're seeing some of our customers look like they're working inventory levels down on working capital.

We think some of that's been playing out as kind of a, you know, a bit of a, you know, kind of a bit of a dampener on our own performance over the last three months or maybe even longer. We aren't seeing a steepening of that yet this quarter 'cause we didn't see any more of that happening, we don't think, during the month of July.

Ken Newman (Director)

That's helpful.

Bryan King (Chairman and CEO)

Any more than what we saw in the Q2. I, yeah, we, we have had a lot of internal conversations about how much of that was taking place, so I think it's a, a, a very fair call-out on your part. Ron, is any more color on that? You may have some more specific areas where we're seeing it or where we might have seen it.

Ron Knutson (EVP and CFO)

Yeah, the only, the only piece I would add to that, Bryan, is on, you know, on the Lawson side, Ken, we're a, you know, we're a short-cycled business, so it's, it's a, it's a little difficult for our customers to build up. They, they really don't have to have a buildup of stock. So, you know, we just... I mean, we turn quickly with our customers. So probably a less impact of that, you know, on the Lawson side of the business. You know, generally, you know, for Gexpro Services, you know, long-term agreements that we have, with customers on the Gexpro Services side. So, you know, I agree with Bryan.

You know, there's, there's certainly, you know, not any, you know, further pullback than, than probably what we just see as part of the normal process. Gexpro Services is so well connected to the production cycle, that we probably, you know, saw a little bit of a, of a bump probably last year. Again, it's not, it's not, it's not huge movement, I would call it, you know, dramatically impacting our results from quarter to quarter.

Bryan King (Chairman and CEO)

Yeah. Ron, I would even, just kind of thinking about what I said and reflecting on it, and hearing you say it, it's sometimes so helpful. Gexpro Services has got those long-term contracts. We are required to hold that inventory. If anything, that inventory's been on our balance sheet, now what's happening is, you know, because they're pulling it as they need it. They aren't carrying any real buffer at, on their end. We're carrying the buffer on our end, and that's where I'm talking about us being able to work our own inventory levels and down, that we've been carrying for our customers as their anxiousness has kind of buffered a little bit. That should actually translate back into cash for us.

On, on TestEquity, you know, there are some shelf life elements there and on some of their products that they order from us. We have not seen it specifically in our conversations on TestEquity be something that we've been concerned about. You know, I continue to be concerned about it. It's a question I'm asking us consistently, but the answer I've gotten back on the test side has been that we have not been seeing that. Those are those two, and then the short cycle side of Lawson, I think Ron answered very well. I wouldn't offer any more color there.

Ken Newman (Director)

Perfect. Thanks for the color.

Bryan King (Chairman and CEO)

Thank you for the question.

Operator (participant)

Okay, we appear to have no further questions in the queue. I'm now gonna hand back over to Bryan for any closing remarks.

Bryan King (Chairman and CEO)

Thank you. Appreciate it, operator. We appreciate everybody participating today and your support on what we're doing with test or with across DSG. The businesses are coming together very nicely, as we alluded to earlier, and I think it's important to process. We've got a lot of moving parts. We've made some decisions that we wanted to invest in the business, and we called out some of those investments during the Q2, and we're very pleased with how those are impacting where we think we're headed with the business from a structural margin and from a long-term value for the shareholders going forward.

We look forward to talking in a lot more detail, and having a more of a forum discussion, this, at the end of September on our Investor Day. We would encourage any investors or any analysts that are interested in DSG to come to Fort Worth and participate with us in that day. Thank you very much, and we appreciate your time. Have a good balance of your summer.

Operator (participant)

Thank you, everybody. This does conclude today's conference. You may disconnect your lines at this time and have a wonderful day. Thank you for your participation.