Distribution Solutions Group, Inc. — Q3 2023 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2023. Financial amounts below are in millions unless noted. DSG is a specialty distributor serving MRO, OEM and industrial technology markets through Lawson, TestEquity and Gexpro Services. Hisco was acquired June 8, 2023 and its results are included in TestEquity.
Financial performance
| Metric | Q3 2023 | Q3 2022 | Nine months 2023 | Nine months 2022 |
|---|---|---|---|---|
| Revenue | $438.9 | $347.2 | $1,165.2 | $822.6 |
| Gross profit / margin | $145.3 / 33.1% | $119.2 / 34.3% | $414.2 / 35.5% | $274.6 / 33.4% |
| Operating income / margin | $12.8 / 2.9% | $22.0 / 6.3% | $43.3 / 3.7% | $29.1 / 3.5% |
| Net income (loss) | $(1.6) | $16.5 | $7.4 | $9.3 |
| Diluted EPS | $(0.03) | $0.42 | $0.17 | $0.27 |
| Adjusted EBITDA (non-GAAP) | $43.7 | $34.7 | $123.2 | $79.9 |
Q3 revenue rose 26.4%, largely reflecting acquisitions and organic growth, while operating income and net income declined. Higher interest expense and SG&A—including acquisition-related retention compensation—were significant pressures; the prior-year quarter also benefited from a larger earnout fair-value gain. Nine-month revenue comparisons are not directly comparable: under reverse-acquisition accounting, 2022 results included Lawson only after April 1, whereas 2023 includes the combined businesses for the full period. DSG’s supplemental, non-GAAP comparable Lawson results show nine-month revenue up 11.6% and Adjusted EBITDA up 88.9%.
Segment highlights: Q3 Lawson revenue was $114.5 million, up 4.6%, and operating income improved to $10.6 million; gross margin rose to 57.7%. TestEquity revenue increased 77.9% to $207.7 million, largely from acquisitions, but operating loss was $5.0 million; legacy revenue was pressured by weaker test-and-measurement demand and tighter customer capital budgets. Gexpro Services revenue was $103.2 million, down 0.5%, and operating income was $7.3 million, down 8.3%.
Cash flow, debt and liquidity
- Nine-month operating cash flow was $74.1 million, versus cash use of $19.3 million in 2022. Investing cash use was $266.7 million, principally reflecting the Hisco acquisition; financing provided $269.3 million.
- At September 30, cash and cash equivalents were $80.5 million, with a further $20.7 million restricted. Total debt was $589.6 million; the balance sheet reports $550.5 million of long-term debt net of current portion and financing costs.
- Revolver availability, net of letters of credit, was $198.3 million. The weighted-average borrowing rate for the first nine months was 7.4%. Debt matures April 2027; required principal payments are approximately $7.6 million quarterly, or $30.3 million over the next twelve months. DSG reported compliance with its credit covenants at quarter-end.
- DSG said cash, available borrowing capacity and operating cash flow should meet liquidity needs for the next twelve months. It had approximately $200 million of supplier and contractor purchase commitments payable over that period.
Material developments, outlook and risks
- DSG acquired Hisco for consideration of $268.5 million net of acquired cash, funded principally with a $305 million incremental term loan and a rights offering that raised approximately $100 million. The Hisco purchase-price allocation remains preliminary. Up to $37.5 million of employee retention bonuses are conditional on continued employment; $12.4 million was expensed in the first nine months.
- Management described organic growth and complementary acquisitions as strategic priorities. It expects the semiconductor-chip supply constraint affecting TestEquity’s electronic production supplies business to recover in the first half of 2024. No consolidated financial guidance was provided in the filing.
- Management reported continuing inflation-related supplier, transportation and labor costs, with price increases implemented in 2022 and 2023. The U.S. manufacturing PMI averaged 47.2 in the first nine months of 2023, below the 50 level generally associated with expansion. TestEquity also faced customer capital-budget tightening; Gexpro Services cited market softness and project timing.
- Disclosure controls were deemed ineffective at September 30, 2023 because of a previously reported material weakness involving accounting expertise and controls, particularly in TestEquity and complex transactions, revenue recognition, reconciliations and segregation of duties. Remediation is ongoing; Hisco is to be excluded from the company’s 2023 internal-control assessment.
- A merger-related derivative complaint was dismissed with prejudice, but plaintiffs filed an appeal on October 16, 2023 against certain defendants. A putative class action related to the 2022 cyber incident is pending; DSG could not estimate potential losses and recorded no liability for either matter. A separate environmental monitoring accrual was approximately $0.1 million.
- LKCM-affiliated entities and CEO J. Bryan King beneficially owned approximately 77.6% of shares at September 30, giving them significant voting influence. The filing also identifies acquisition integration, indebtedness, covenant compliance, cyber incidents, inventory obsolescence and economic downturns among key risks.
Important facts for investors to verify
- How much of revenue and Adjusted EBITDA growth reflects sustainable organic performance versus acquisitions, and how comparable periods are constructed.
- Whether TestEquity’s legacy demand and margins stabilize, and whether the expected semiconductor supply recovery occurs in the first half of 2024.
- Debt service, interest-rate exposure, covenant headroom and liquidity after acquisition spending and required principal repayments.
- Progress in remediating the material weakness and the effect of acquisition integration and retention costs on GAAP earnings.
- Developments in the cyber and merger litigation, the final Hisco purchase accounting and earnout, and the implications of concentrated LKCM ownership.