Hydrofarm Holdings Group, Inc.: Form 10-Q for the period ended Sep 30, 2023

The following discussion and analysis provides information that we believe is relevant to an assessment and understanding of our results of operations and financial condition. You should read this analysis in conjunction with our audited and unaudited consolidated financial statements and the notes contained elsewhere in this Quarterly Report on Form 10-Q and our 2022 Annual Report. 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 Quarterly Report on Form 10-Q, which could cause actual results to differ materially from those expressed in, or implied by, any forward-looking statements, including those set forth in “Risk Factors” in our 2022 Annual Report. See “Special Note Regarding Forward-Looking Statements.”

Company Overview

We are a leading independent manufacturer and distributor of branded hydroponics equipment and supplies for controlled environment agriculture ("CEA"), including grow lights, climate control solutions, growing media and nutrients, as well as a broad portfolio of innovative and proprietary branded products. We primarily serve the U.S. and Canadian markets, and believe we are one of the leading 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 have experienced adverse financial results which we believe is primarily a result of an agricultural oversupply impacting our market. The extent to which these market conditions will continue to negatively impact our business and results of operations 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 initiated a restructuring plan (the "Restructuring Plan") during the three months ended December 31, 2022. In connection with the first phase of our Restructuring Plan, we have undertaken significant actions to streamline our operations, reduce costs and improve efficiencies during the industry recession. Our major initiatives included (i) narrowing our product and brand portfolio, including removing approximately one-third of all products and one-fifth of all brands relating to our primary product portfolio, which excluded our garden center business in Canada, and (ii) relocating and consolidating certain manufacturing and distribution centers, including headcount reductions and reorganization to drive a solution based approach, focusing commercial sales on competencies and product assortment gained from our recent acquisitions.

During the three months ended September 30, 2023, we recorded a net restructuring benefit of $0.2 million for the first phase of the Restructuring Plan, primarily due to reversing an immaterial restructuring accrual. For the nine months ended September 30, 2023, we recorded net pre-tax charges of $2.0 million which were primarily costs related to the relocation and termination of certain facilities in Canada. The restructuring charges are primarily recorded within Cost of goods sold on the condensed consolidated statements of operations. Total costs incurred relating to this first phase of the Restructuring Plan since it commenced in the fourth quarter of 2022, are (i) $6.4 million relating primarily to inventory markdowns, and (ii) $3.2 million relating primarily to the relocation and termination of certain facilities in Canada.

As a result of the continued adverse market conditions, we are implementing a second phase of the Restructuring Plan, including U.S. manufacturing facility consolidations, in particular with respect to our production of certain durable equipment products. We plan to reduce facility space and consolidate our manufacturing operations to improve efficiency and reduce costs, while maintaining our high standard of customer service. During the three and nine months ended September 30, 2023, we recorded estimated pre-tax charges of $7.8 million for the second phase of restructuring relating primarily to non-cash raw material inventory write-downs as we plan to sell the assets and reduce capacity and facility space, given low customer demand for these products. We also may evaluate other alternatives or opportunities to maximize our recovery of the inventory value. These restructuring charges are recorded within Cost of goods sold on the condensed consolidated statements of operations. Further, we estimate additional charges associated with this second phase of the Restructuring Plan may exceed $3.0 million and be incurred through the next several quarters as we consolidate and exit facilities. These estimated additional charges include an estimated cash impact of approximately $1.5 million for facility consolidations and lease and other contract terminations. We anticipate the restructuring and related actions may result in cost savings of approximately $1.5 million on an annualized basis. The amounts we will ultimately realize or disburse in connection with both phases of the Restructuring Plan could differ materially from our estimates, and we may not be able to realize the full extent of our anticipated cost savings.

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 goodwill 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 United States 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 during the remainder of 2022, or the nine months ended September 30, 2023.

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 sales declines we experienced, which we believe were primarily a result of an agricultural oversupply impacting our market, and a reduction to our profitability and loss from operations. These market conditions continued to negatively impact our business and results of operations during the remainder of 2022, and the nine months ended September 30, 2023.

We maintain an allowance for excess and obsolete inventory that is based upon assumptions about future demand and market conditions. While we believe our estimates of charges relating to our Restructuring Plan, long-lived assets, inventory obsolescence, and accounts receivable allowances are reasonable, it is possible that we may incur additional charges in the future and actual results may differ significantly from these estimates and assumptions. Depending on the length and severity of the industry and market conditions impacting our business, it is possible we may execute additional restructuring plans and incur future associated charges, and we may not be able to realize the full extent of our anticipated cost savings.

Filing Status

As of June 30, 2023, the market capitalization of outstanding shares of our common stock owned by non-affiliates decreased to below $60 million, which triggered the Company being classified as a non-accelerated filer with respect to SEC regulations and filing requirements effective December 31, 2023. As a result, our annual assessment of the effectiveness of our internal control over financial reporting does not require an audit by our external audit firm in compliance with the provisions of Section 404 of the Sarbanes-Oxley Act of 2002 for our next Annual Report on Form 10-K for the year ending December 31, 2023. The Company continues to qualify as a smaller reporting company in accordance with Rule 12b-2 under the Exchange Act and may continue to follow certain of the scaled back disclosure accommodations.

Results of Operations—Comparison of three and nine months ended September 30, 2023 and 2022

The following table sets forth our unaudited interim condensed consolidated statements of operations for the three and nine months ended September 30, 2023, and 2022, including amounts and percentages of net sales for each period and the period-to-period change in dollars and percent (amounts in thousands):

Net sales

Net sales for the three months ended September 30, 2023, were $54.2 million, a decrease of $20.0 million, or 27.0% compared to the same period in 2022. Net sales for the nine months ended September 30, 2023, were $179.4 million, a decrease of $103.6 million, or 36.6% compared to the same period in 2022.

The 27.0% decrease in net sales for the three months ended September 30, 2023, as compared to the same period in 2022, was due to a 22% decline in volume of products sold and a 5% decrease in price and mix of products sold. The decrease in volume of products sold was primarily related to the aforementioned oversupply in the cannabis industry. During the three months ended September 30, 2023, we reduced selling prices for certain brands and product segments and sold a higher mix of generally lower-priced consumables relative to higher-priced durable products.

The 36.6% decrease in net sales for the nine months ended September 30, 2023, as compared to the same period in 2022, was due to a 34% decline in volume of products sold and a 2% decrease in price and mix of products sold. The decrease in volume of products sold was primarily related to the aforementioned oversupply in the cannabis industry. During the nine months ended September 30, 2023, we sold a higher mix of generally lower-priced consumables relative to higher-priced durable products, and reduced selling prices for certain brands and product segments, including previously reserved lighting products.

Gross profit

Gross profit for the three months ended September 30, 2023, was $3.3 million, a decrease of $2.6 million, or 43.6%, compared to the same period in 2022. Gross profit for the nine months ended September 30, 2023, was $29.2 million, a decrease of $0.6 million, or 2.2%, compared to the same period in 2022.

Gross profit decreased $2.6 million for the three months ended September 30, 2023, as compared to the same period in 2022, primarily due to (i) lower net sales, (ii) $7.4 million of estimated restructuring charges recorded in the current year, primarily due to non-cash inventory markdowns, and partially offset by (iii) $4.4 million of inventory reserves and related charges recorded in the prior year period, and (iv) benefits from selling a higher proportion of proprietary brand products, lower freight costs, and improved productivity. Our Restructuring Plan and related cost-saving initiatives contributed to realizing these benefits. Due to non-cash charges in both periods, including the aforementioned inventory markdowns, reserves, and related charges, our gross profit margin percentage (gross profit as a percent of net sales) decreased to 6.1% for the three months ended September 30, 2023, from 7.9% in the same period in 2022.

Gross profit decreased $0.6 million for the nine months ended September 30, 2023, as compared to the same period in 2022, primarily due to (i) lower net sales, (ii) $9.4 million of estimated restructuring charges recorded in the current year, primarily due to non-cash inventory markdowns, and partially offset by (iii) $17.8 million of inventory reserves and related charges recorded in the prior year period, (iv) $4.5 million decrease in acquisition and integration expenses, and (v) benefits from selling a higher proportion of proprietary brand products, lower freight costs, and improved productivity. Our Restructuring Plan and related cost-saving initiatives contributed to realizing these benefits. Our gross profit margin percentage increased to 16.3% for the nine months ended September 30, 2023, from 10.5% in the same period in 2022.

Selling, general and administrative expenses

Selling, general and administrative ("SG&A") expenses for the three months ended September 30, 2023, were $19.5 million, a decrease of $6.6 million, or 25.4% compared to the same period in 2022. SG&A expenses for the nine months ended September 30, 2023, were $67.4 million, a decrease of $25.0 million compared to the same period in 2022.

SG&A expenses decreased $6.6 million for the three months ended September 30, 2023, as compared to the same period in 2022. SG&A expenses decreased in several areas, including as a result of our cost saving and restructuring initiatives: (i) $1.8 million decrease in accounts receivable reserves and related charges, (ii) $1.5 million decrease in salaries and benefits, (iii) $0.9 million decrease in professional and outside services, (iv) $0.7 million decrease in acquisition and integration expenses, (v) $0.6 million decrease in stock-based compensation expense, (vi) $0.4 million decrease in amortization and depreciation expenses, and (vii) $0.3 million decrease in insurance expenses, along with other expense reductions in multiples areas.

The $25.0 million decrease in SG&A expenses for the nine months ended September 30, 2023, as compared to the same period in 2022, was primarily related to a $9.3 million decline in amortization and depreciation expenses, as the prior year period included additional amortization expense due to adjustments to the useful lives of intangible assets, as described in Note 2 – Basis of Presentation and Significant Accounting Policies. Additionally, SG&A expenses decreased by $15.7 million in the nine months ended September 30, 2023, due to lower expenses in several areas, including as a result of our cost saving and restructuring initiatives: (i) $4.1 million decrease in salaries and benefits, (ii) $2.8 million decrease in stock-based compensation, (iii) $2.6 million decrease in acquisition and integration expenses, (iv) $1.8 million decrease in professional and outside services, (v) $1.8 million decrease in accounts receivable reserves and related charges, (vi) $1.4 million decrease in costs associated with the relocation of certain of our distribution centers incurred last year, and (vii) $0.7 million decrease in marketing expenses, along with other expense reductions in multiples areas.

Impairments

The Company did not record any impairment charges for the three and nine months ended September 30, 2023. The Company recorded a goodwill impairment charge of zero and $189.6 million for the three and nine months ended September 30, 2022, as we determined that the carrying value of the goodwill reporting units of the 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 United States and Canada caused by macroeconomic and industry conditions. For the nine months ended September 30, 2022, the Company also recorded, in the fiscal first quarter, an impairment of a note receivable of $2.6 million. Refer to Note 2 – Basis of Presentation and Significant Accounting Policies and Note 14 – Fair Value Measurements for further description regarding the note receivable impairment.

Interest expense

Interest expense for the three months ended September 30, 2023, was $4.0 million, an increase of $0.9 million compared to the same period in the prior year. Interest expense for the nine months ended September 30, 2023, was $11.4 million, an increase of $3.6 million compared to the same period in the prior year. The increase was primarily due to higher variable interest rates on our Term Loan.

Other income, net

Other income, net for the three months ended September 30, 2023, was $0.4 million, a decrease of $0.2 million compared to the same period in the prior year. Other income, net for the nine months ended September 30, 2023, was less than $0.1 million, a decrease of $0.9 million compared to the same period in the prior year. Other income, net for the three and nine months ended September 30, 2023, was primarily driven by foreign currency exchange rate gains and interest income, partially offset by legal fees associated with the amendment of the Term Loan. Refer to Note 9 – Debt for a further description of the Term Loan amendment.

Income taxes

We recorded income tax expense of $0.1 million for the three months ended September 30, 2023, representing an effective tax rate of (0.4)%. We recorded an income tax benefit of $0.1 million for the nine months ended September 30, 2023, representing an effective income tax rate of 0.2%. Our effective tax rate for the nine months ended September 30, 2023, differs from the federal statutory rate of 21% primarily due to maintaining a full valuation allowance against our net deferred tax assets in the United States and most foreign jurisdictions. The income tax expense and benefit for the three and nine months ended September 30, 2023, respectively, was primarily due to minor foreign tax items in certain jurisdictions.

We recorded income tax expense of $0.8 million for the three months ended September 30, 2022, representing an effective tax rate of (3.3)%. We recorded an income tax benefit of $11.7 million for the nine months ended September 30, 2022, representing an effective income tax rate of 4.5%. Our effective tax rate for the nine months ended September 30, 2022, differs from the federal statutory rate 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.

Liquidity and Capital Resources

Cash Flow from Operating, Investing, and Financing Activities

Comparison of the nine months ended September 30, 2023, and September 30, 2022

The following table summarizes our cash flows for the nine months ended September 30, 2023, and 2022 (amounts in thousands):

Operating Activities

Net cash from operating activities was $8.6 million for the nine months ended September 30, 2023, driven by positive cash from operating activities in the second and third quarters. The net cash from operating activities was primarily due to a $11.7 million net cash inflow from a reduction in working capital, partially offset by a reported net loss of $49.6 million less non-cash items of $46.6 million. The net reduction in working capital was primarily driven by decreases of inventories of $22.6 million and prepaid expenses and other current assets of $1.2 million, partially offset by decreases of $7.0 million of lease liabilities and $4.4 million of accrued expenses and other current liabilities.

Net cash from operating activities was $15.5 million for the nine months ended September 30, 2022, primarily due to $22.7 million net cash inflow from a reduction of working capital. This included a decrease of $37.1 million in inventories and a decrease of $13.1 million in accounts receivable, net, partially offset by decreases of $11.0 million in deferred revenue and $11.0 million in accounts payable, accrued expenses and other current liabilities.

Investing Activities

Net cash used in investing activities was $4.1 million and $7.4 million for the nine months ended September 30, 2023, and September 30, 2022, respectively, primarily due to capital expenditures of property, plant and equipment.

Financing Activities

Net cash from financing activities was $6.6 million for the nine months ended September 30, 2023, primarily driven by $8.6 million of proceeds from the Sale-Leaseback Transaction. In addition, we paid $0.9 million on the Term Loan relating to required quarterly payments of principal.

Net cash used in financing activities was $19.5 million for the nine months ended September 30, 2022, primarily consisting of $15.6 million in payments to settle contingent consideration. We paid $2.4 million related to employees' withholding tax in connection with the vesting of restricted stock units. In addition, we paid $0.9 million on the Term Loan.

Availability and Use of Cash

Our ability to make investments in our business, service our debt and maintain liquidity will depend upon our ability to generate excess operating cash flows through our operating subsidiaries. We believe that our cash flows from operating activities, combined with current cash levels and borrowing availability under the Revolving Credit Facility, will be adequate to support our ongoing operations, to fund debt service requirements, capital expenditures, lease obligations and working capital needs through the next twelve months of operations. However, we cannot guarantee that our business will generate sufficient cash flow from operating activities or that future borrowings will be available under our borrowing agreements in amounts sufficient to pay indebtedness or fund other working capital needs. Actual results of operations will depend on numerous factors, many of which are beyond our control as further discussed in Item 1A. Risk Factors included in this Form 10-Q and in our 2022 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 new lease has a term of 15 years with annual rent starting at approximately $0.7 million and increases to the final year when annual rent is approximately $1.0 million. The Eugene Property serves as the manufacturing and processing site for certain of our grow media and nutrient brands. Refer to further discussion below relating to Term Loan reinvestment provisions regarding the net cash proceeds of the Sale Leaseback Transaction.

If necessary, we believe that we could supplement our cash position through additional sale-leasebacks, asset sales and equity financing. We believe it is prudent to be prepared if required and, accordingly, continue to be engaged in the process of evaluating and preparing to implement one or more of the aforementioned activities. Any potential such event may be subject to provisions referenced in our Term Loan and Revolving Credit Facility, such as subjecting the Company to making mandatory prepayments.

Term Loan

On October 25, 2021, we and certain of our direct and indirect subsidiaries entered into the Term Loan with JPMorgan Chase Bank, N.A., as administrative agent for the lenders, pursuant to which we borrowed a $125 million senior secured term loan. The Term Loan was amended by Amendment No. 1 effective as of June 27, 2023, to replace the LIBOR referenced rates with SOFR referenced rates. Pursuant to Amendment No. 1, any Term Loan that constitutes a Eurodollar Rate Loan that is outstanding as of the Amendment No. 1 closing date shall continue until the end of the applicable interest period for such Eurodollar Rate Loan and the provisions of the Term Loan applicable thereto shall continue and remain in effect (notwithstanding the occurrence of the Amendment No. 1 closing date) until the end of the applicable interest period for such Eurodollar Rate Loan, after which such provisions shall have no further force or effect. Such Eurodollar Rate Loan shall subsequently either be an ABR Loan or a Term Benchmark Loan. The ABR Loans shall bear interest at the Alternate Base Rate (with a 2.0% floor) plus 4.50%, and Term Benchmark Loans shall bear interest at the Adjusted Term SOFR Rate (with a 1.0% floor) plus 5.50%. The ABR Loan and Term Benchmark Loan credit spreads of 4.50% and 5.50%, respectively, within the

Amendment No. 1 have not changed from the credit spreads in the original Term Loan. The Term Loan matures on October 25, 2028.

The principal amounts of the Term Loan are scheduled to be repaid in consecutive quarterly installments in amounts equal to 0.25% of the original principal amount of the Term Loan on the last day of each fiscal quarter commencing March 31, 2022, with the balance of the Term Loan payable on the Maturity Date of October 25, 2028.

We intend to reinvest the net cash proceeds received in January 2023 from the Sale-Leaseback Transaction into certain permitted investments, such as capital expenditures. This provision of the Term Loan includes cash investments made within a one-year period from the Sale Leaseback Transaction, and includes investments which are contractually committed within one-year, and paid within 180 days after entering into such contractual commitment. If applicable, the amount of any net cash proceeds which are not reinvested would require us to make an offer to prepay the corresponding amount on the Term Loan in 2024. The foregoing description of the reinvestment provision does not purport to be complete and is qualified in its entirety by reference to the provisions of the Term Loan.

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 September 30, 2023. The Term Loan is secured by a first lien on our non-working capital assets and a second lien on our working capital assets.

Revolving Credit Facility

On March 29, 2021, we entered into the Revolving Credit Facility, which provided for a borrowing limit of $50 million. The Revolving Credit Facility was amended by the First Amendment dated August 31, 2021, which increased the revolving line of credit by an additional $50 million for an aggregate borrowing limit of $100 million. The Revolving Credit Facility was further amended by the Second Amendment dated October 25, 2021 which, among other things, permitted the incurrence of the Term Loan and made certain other changes including subordinating its liens on non-working capital assets to the obligations under the Term Loan. The Revolving Credit Facility was further amended by the Third Amendment and Joinder dated August 23, 2022, pursuant to which several previously acquired subsidiaries became parties to the Revolving Credit Facility and granted liens on their assets. On December 22, 2022, the Company entered into the Fourth Amendment pursuant to which a sale-leaseback transaction was permitted, and certain other changes were made, including a reduction of the maximum commitment amount under the Revolving Credit Facility from $100 million to $75 million and transitioning the LIBOR based rates to SOFR based rates. On March 31, 2023, the Company and certain of its subsidiaries entered into the Fifth Amendment, pursuant to which the maturity date was extended to June 30, 2026, the maximum commitment amount under the Revolving Credit Facility was reduced to $55 million, and the interest rate on borrowings was revised to various spreads, based on the Company's fixed charge coverage ratio.

The Revolving Credit Facility provides for various interest rate options including the Adjusted Term SOFR Rate, the Adjusted REVSOFR30 Rate, the CB Floating Rate, the Adjusted Daily Simple SOFR, the CBFR, the Canadian Prime Rate, or the CDOR Rate. The rates that use SOFR as the reference rate (Adjusted Term SOFR Rate, the Adjusted REVSOFR30 Rate, the Adjusted Daily Simple SOFR and the CBFR rate) use the Term SOFR Rate plus 1.95%. Each rate has a 0.0% floor. A fee of 0.40% per annum is charged for available but unused borrowings. Our obligations under the Revolving Credit Facility are secured by a first priority lien (subject to certain permitted liens) in substantially all of our and our subsidiaries' respective personal property assets pursuant to the terms of a U.S. and Canadian Pledge and Security Agreement dated March 29, 2021 and other security documents, as amended to include additional subsidiaries.

The Revolving Credit Facility maintains certain reporting requirements, affirmative covenants, negative covenants and financial covenants. A certain financial covenant becomes applicable in the event that our excess availability under the Revolving Credit Facility is less than an amount equal to 10% of the Aggregate Revolving Commitment (currently $55 million) and would require us to maintain a minimum fixed charge coverage ratio of 1.1x on a rolling twelve-month basis.

In order to consummate permitted acquisitions or to make restricted payments, 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 September 30, 2023. As of September 30, 2023, approximately $28 million was available to borrow under the Revolving Credit Facility, before the Company would be required to comply with the minimum fixed charge coverage ratio of 1.1x.

As of September 30, 2023, and December 31, 2022, the Company had zero borrowed under the Revolving Credit Facility.

Cash and cash equivalents

The cash and cash equivalents balances of $32.5 million and $21.3 million at September 30, 2023, and December 31, 2022, respectively, included $11.7 million and $7.3 million, respectively, held by foreign subsidiaries.

Material Cash Requirements

Our material cash requirements include interest and principal payments on our long-term debt and finance leases, operating lease payments, and purchase obligations to support our operations. Refer to Part I, Item 1, Financial Statements, Note 9 – Debt, Note 6 – Leases, and Note 13 – Commitments and Contingencies for details relating to our material cash requirements for debt, our leasing arrangements, including future maturities of our operating lease liabilities, and purchase obligations, respectively.

From time to time in the normal course of business, we will enter into agreements with suppliers which provide favorable pricing in return for a commitment to purchase minimum amounts of inventory over a defined time period.

Critical Accounting Policies and Estimates

The preceding discussion and analysis of our consolidated results of operations and financial condition should be read in conjunction with our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. Our critical accounting policies and estimates are identified in Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of our most recently filed Form 10-K and include the discussion of estimates used in goodwill and indefinite lived intangible assets, long-lived assets, and inventory valuation. Such accounting policies and estimates require significant judgments and assumptions to be used in the preparation of the Condensed Consolidated Financial Statements included in this Form 10-Q, and actual results could differ materially from the amounts reported.

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 September 30, 2023, we had $122.8 million of Term Loan debt that is subject to variable interest rates that are based on Secured Overnight Financing Rate (“SOFR”) or an alternate base rate. Refer to Part I, Item 1, Financial Statements, Note 9 – Debt for details relating to the debt. If the rates were to increase by 100 basis points from the rates in effect as of September 30, 2023, our interest expense on the variable-rate debt would increase by an average of $1.1 million annually. There are inherent limitations in the sensitivity analysis presented, primarily due to the assumptions that interest rate changes would be instantaneous, while SOFR changes regularly. We do not currently hedge our interest rate risks, but may determine to do so in the future.

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.

Impact of Inflation

Our results of operations and financial condition are presented based on historical costs. We cannot provide assurances that our results of operations and financial condition will not be materially impacted by inflation in the future.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation and supervision of our Chief Executive Officer and our Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based upon that evaluation, the Company's management, including the Chief Executive Officer and the Chief Financial Officer, concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report on Form 10-Q.

Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and management necessarily applies its judgment in evaluating the cost benefit relationship of possible controls and procedures.

Changes in Internal Controls over Financial Reporting

There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) that occurred during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

For a discussion of risk factors, please read Item 1A, "Risk Factors" in our 2022 Annual Report. Such risk factors continue to be relevant to an understanding of our business, financial condition and operating results. As of the date of this Quarterly Report on Form 10-Q, there have been the following material changes with respect to such risk factors.

Failures at financial institutions at which we maintain or deposit funds, or at which parties with whom we conduct business maintain funds, could adversely affect us.

We deposit funds in financial institutions and may, from time to time, maintain cash balances at such financial institutions in excess of the Federal Deposit Insurance Corporation ("FDIC") Limit of $250,000. Recently there has been significant volatility and instability among banks and financial institutions. For example, on March 10, 2023, Silicon Valley Bank, or SVB, was closed by the California Department of Financial Protection and Innovation, which appointed the FDIC as receiver, and for a period of time, customers of the bank did not have access to their funds and there was uncertainty as to when, if at all, customers would have access to funds in excess of the FDIC insured amounts. Should a financial institution at which deposits are maintained fail, there is no guarantee as to the extent that we would recover the funds deposited, whether through FDIC coverage or otherwise, or the timing of any recovery. In addition, if any parties with whom we conduct business are unable to access funds pursuant to arrangements with their financial institution, such parties' ability to pay their obligations to us or to enter into new commercial arrangements requiring additional payments to us could be adversely affected.

Our restructuring activities may increase our expenses and cash expenditures, and may not have the intended effects.

In connection with the Restructuring Plan, we have implemented and may continue to implement a number of restructuring initiatives designed to streamline our operations, reduce costs, and improve efficiencies during the industry recession. See “Item 2. Management’s Discussion And Analysis Of Financial Condition And Results of Operations – Market Conditions” above for more information regarding the Restructuring Plan. Restructuring initiatives such as the Restructuring Plan typically result in charges and cash expenditures that may adversely affect financial results for one or more periods, and efforts to minimize or eliminate such expenditures may not be successful. Moreover, restructuring actions can create unanticipated consequences, such as instability or distraction among our workforce or among management.

We cannot assure you that the Restructuring Plan or any other cost-saving initiatives we may undertake will be successful. A variety of factors, many of which are beyond our control, could cause us not to realize expected cost savings, including but not limited to unexpected costs incurred in connection with consolidating and/or closing certain operations or asset write-downs, delays or difficulty terminating leases, unexpected integration challenges, unintended attrition and temporary instability. Any of these factors could hamper our ability to grow and meet customer demand in future periods. If we are unable to structure our operations in the light of evolving market conditions, this could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

We are currently operating in a period of economic uncertainty and capital markets disruption, which has been significantly impacted by geopolitical instability due to the military conflict between Russia and Ukraine and armed conflicts between Israel and Hamas. Our business, financial condition and results of operations may be materially and adversely affected by any negative impact on the global economy and capital markets resulting from the conflicts in Ukraine, the Gaza Strip or any other geopolitical tensions.

U.S. and global markets have experienced volatility and disruption following the escalation of geopolitical tensions, including the military conflict between Russia and Ukraine and armed conflicts between Israel and Hamas. Although the length and impact of the ongoing conflicts is highly unpredictable, such conflicts could lead to market disruptions, including significant volatility in commodity prices, credit and capital markets, as well as supply chain interruptions. We are continuing to monitor the situations in Ukraine, the Gaza Strip and globally and assessing their potential impacts on our business. In addition, sanctions on Russia and hostilities involving Israel could adversely affect the global economy and financial markets and lead to instability and lack of liquidity in capital markets, potentially making it more difficult for us to obtain additional funds.

Any of the above mentioned factors could affect our business, prospects, financial condition, and operating results. The extent and duration of the military actions, sanctions and resulting market disruptions are impossible to predict, but could be substantial. Any such disruptions may also magnify the impact of other risks described in our 2022 Annual Report.