Notes to Condensed Consolidated Financial Statements (Unaudited)
Note 1 – Nature of Operations and Basis of Presentation
Organization
Distribution Solutions Group, Inc. ("DSG"), a Delaware corporation, is a global specialty distribution company providing value-added distribution solutions to the maintenance, repair and operations ("MRO"), original equipment manufacturer ("OEM") and industrial technology markets. DSG has three principal operating companies: Lawson Products, Inc., an Illinois corporation ("Lawson"), TestEquity Acquisition, LLC, a Delaware limited liability company ("TestEquity"), and 301 HW Opus Holdings, Inc., a Delaware corporation conducting business as Gexpro Services ("Gexpro Services"). The complementary distribution operations of Lawson, TestEquity and Gexpro Services were combined on April 1, 2022 to create a specialty distribution company. A summary of the Mergers (as defined below), including the legal entities party to the transactions and the stock consideration, is presented below.
Unless the context requires otherwise, references in this Quarterly Report on Form 10-Q to “DSG”, the “Company”, "we", "our" or "us" refer to the holding company, Distribution Solutions Group, Inc., and all entities consolidated in the accompanying unaudited condensed consolidated financial statements.
Combination with TestEquity and Gexpro Services
On December 29, 2021, DSG entered into:
• an Agreement and Plan of Merger (the “TestEquity Merger Agreement”) by and among (i) LKCM TE Investors, LLC, a Delaware limited liability company (the “TestEquity Equityholder”), (ii) TestEquity, which was a wholly-owned subsidiary of the TestEquity Equityholder, (iii) DSG and (iv) Tide Sub, LLC, a Delaware limited liability company and a wholly-owned subsidiary of DSG (“Merger Sub 1”), pursuant to the terms and subject to the conditions of which the parties agreed, among other things, that Merger Sub 1 would merge with and into TestEquity, with TestEquity surviving the merger as a wholly-owned subsidiary of DSG (the “TestEquity Merger”); and
• an Agreement and Plan of Merger (the “Gexpro Services Merger Agreement” and, together with the TestEquity Merger Agreement, the “Merger Agreements”) by and among (i) 301 HW Opus Investors, LLC, a Delaware limited liability company (the “Gexpro Services Stockholder”), (ii) Gexpro Services, which was a wholly-owned subsidiary of the Gexpro Services Stockholder, (iii) DSG and (iv) Gulf Sub, Inc., a Delaware corporation and a wholly-owned subsidiary of DSG (“Merger Sub 2”), pursuant to the terms and subject to the conditions of which the parties agreed, among other things, that Merger Sub 2 would merge with and into Gexpro Services, with Gexpro Services surviving the merger as a wholly-owned subsidiary of DSG (the “Gexpro Services Merger” and, together with the TestEquity Merger, the “Mergers”).
At the closing of the Mergers, each outstanding share of TestEquity and Gexpro Services common stock outstanding immediately prior to the closing of the Mergers was converted into approximately 0.3618 shares and 0.7675 shares, respectively, of DSG common stock, based on the ratio of outstanding shares of each entity immediately prior to the Mergers to the number of shares of DSG common stock acquired in the Mergers.
Completion of the TestEquity Merger
On April 1, 2022 (the "Merger Date"), the TestEquity Merger was consummated pursuant to the TestEquity Merger Agreement. In accordance with the TestEquity Merger Agreement, Merger Sub 1 merged with and into TestEquity, with TestEquity surviving as a wholly-owned subsidiary of DSG.
In accordance with and under the terms of the TestEquity Merger Agreement, in connection with the closing of the TestEquity Merger on the Merger Date, DSG: (i) issued to the TestEquity Equityholder 3,300,000 shares of DSG common stock, (ii) on behalf of TestEquity, paid certain indebtedness of TestEquity and (iii) on behalf of TestEquity, paid certain transaction expenses of TestEquity.
The TestEquity Merger Agreement provided that up to an additional 700,000 shares of DSG common stock would be potentially issuable to the TestEquity Equityholder in accordance with, and subject to the terms and conditions of, the earnout provisions of the TestEquity Merger Agreement. On March 20, 2023, DSG issued 700,000 shares of DSG common stock to the TestEquity Equityholder (the "TestEquity Holdback Shares") pursuant to the terms of the earnout provisions of the TestEquity
Merger Agreement. The TestEquity Holdback Shares issued represented the maximum number of additional shares that could be issued under the TestEquity Merger Agreement, and no further shares are available for issuance, and no additional shares will be issued, in connection with the TestEquity Merger Agreement. Refer to Note 8 – Earnout Derivative Liability for information about the earnout derivative liability related to the TestEquity Holdback Shares.
Completion of the Gexpro Services Merger
On the Merger Date, the Gexpro Services Merger was consummated pursuant to the Gexpro Services Merger Agreement. In accordance with the Gexpro Services Merger Agreement, Merger Sub 2 merged with and into Gexpro Services, with Gexpro Services surviving as a wholly-owned subsidiary of DSG.
In accordance with and under the terms of the Gexpro Services Merger Agreement, in connection with the closing of the Gexpro Services Merger on the Merger Date, DSG: (i) issued to the Gexpro Services Stockholder 7,000,000 shares of DSG common stock, (ii) on behalf of Gexpro Services, paid certain indebtedness of Gexpro Services and (iii) on behalf of Gexpro Services, paid certain specified transaction expenses of Gexpro Services.
The Gexpro Services Merger Agreement provided that up to an additional 1,000,000 shares of DSG common stock would be potentially issuable to the Gexpro Services Stockholder in accordance with, and subject to the terms and conditions of, the earnout provisions of the Gexpro Services Merger Agreement. On March 20, 2023, DSG issued 1,000,000 shares of DSG common stock to the Gexpro Services Stockholder (the “Gexpro Services Holdback Shares”) pursuant to the terms of the earnout provisions of the Gexpro Services Merger Agreement. The Gexpro Services Holdback Shares issued represented the maximum number of additional shares that could be issued under the Gexpro Services Merger Agreement, and no further shares are available for issuance, and no additional shares will be issued, in connection with the Gexpro Services Merger Agreement.
As of April 1, 2022, approximately 538,000 of the Gexpro Services Holdback Shares had been expected to be issued under the first earnout opportunity in the Gexpro Services Merger Agreement based on certain earnout metrics related to the consummation of certain additional acquisitions which were completed prior to the Merger Date. Under the Gexpro Services Merger Agreement, if any Gexpro Services Holdback Shares remained after the calculation of the first earnout opportunity, there was a second earnout opportunity under the Gexpro Services Merger Agreement based on certain earnout performance metrics. On March 20, 2023, all 1,000,000 Gexpro Services Holdback Shares were issued under the earnout opportunities. The incremental 462,000 Gexpro Services Holdback Shares that were issued in excess of the 538,000 Gexpro Services Holdback Shares that were originally expected to be issued had been remeasured at fair value immediately prior to and reclassified to equity at December 31, 2022. Refer to Note 8 – Earnout Derivative Liability for information about the earnout derivative liability related to the Gexpro Services Holdback Shares.
Accounting for the Mergers
TestEquity and Gexpro Services were treated as a combined entity as the accounting acquirer for financial reporting purposes, and DSG was identified as the accounting acquiree. Accordingly, periods prior to the April 1, 2022 Merger Date reflect the results of operations and financial position of TestEquity and Gexpro Services on a consolidated basis, and the results of operations of DSG's legacy Lawson business are only included subsequent to the April 1, 2022 Merger Date.
For more information about the Mergers, refer to Note 3 – Business Acquisitions.
Nature of Operations
A summary of the nature of operations for each of DSG's operating companies is presented below. Information regarding DSG's reportable segments is presented in Note 16 – Segment Information.
Lawson is a distributor of specialty products and services to the industrial, commercial, institutional and government maintenance, repair and operations market.
TestEquity is a distributor of test and measurement equipment and solutions, electronic production supplies, and tool kits from its leading manufacturer partners supporting the technology, aerospace, defense, automotive, electronics, education, and medical industries.
Gexpro Services is a global supply chain solutions provider, specializing in developing and implementing vendor managed inventory and kitting programs to high-specification manufacturing customers.
Basis of Presentation and Consolidation
The Mergers were accounted for as a reverse merger under the acquisition method of accounting in accordance with the accounting guidance for reverse acquisitions as provided in Accounting Standards Codification ("ASC") 805, Business Combinations ("ASC 805"). Under this guidance, TestEquity and Gexpro Services were treated as a combined entity as the accounting acquirer for financial reporting purposes, and DSG was identified as the accounting acquiree. This determination was primarily made as TestEquity and Gexpro Services were under the common control of an entity that owns a majority of the voting rights of the combined entity, and therefore, only DSG experienced a change in control. Accordingly, the unaudited condensed consolidated financial statements for the three months ended March 31, 2023 and 2022 reflect the results of operations of TestEquity and Gexpro Services on a consolidated basis, and the results of operations of DSG's legacy Lawson business are included only in the unaudited condensed consolidated financial statements for the three months ended March 31, 2023 for activity subsequent to the April 1, 2022 Merger Date. The unaudited condensed consolidated financial statements as of March 31, 2023 and December 31, 2022 reflect the financial position of TestEquity, Gexpro Services and DSG's legacy Lawson business on a consolidated basis.
The Company and its consolidated subsidiaries, except for Gexpro Services, operate on a calendar year-end. Gexpro Services operates on a calendar year-end for annual reporting purposes. However, quarterly financial statements for Gexpro Services are prepared on financial close dates that may differ from that of the Company. The consolidated financial statement impact of the one day difference arising from the different period ends for the quarter ended March 31, 2023 was not material. The Company utilizes the exchange rates in effect at Gexpro Services’ reporting date and the appropriate weighted-average rate for its fiscal reporting period.
The accompanying unaudited condensed consolidated financial statements of DSG have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP") for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not contain all disclosures required by GAAP for complete consolidated financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with DSG's audited consolidated financial statements and accompanying notes included in its Annual Report on Form 10-K for the year ended December 31, 2022 filed with the U.S. Securities and Exchange Commission ("SEC") and the Lawson Products, Inc. unaudited condensed consolidated financial statements and accompanying notes included in DSG’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2022. All normal recurring adjustments have been made that are necessary to fairly state the results of operations for the interim periods. Operating results for the three month period ended March 31, 2023 are not necessarily indicative of the results that may be expected for the year ending December 31, 2023.
Note 2 – Summary of Significant Accounting Policies
There were no significant changes to the Company's accounting policies from those disclosed in DSG's Annual Report on Form 10-K for the year ended December 31, 2022. See Note 2 of the 2022 consolidated financial statements included in DGS's Annual Report on Form 10-K for the year ended December 31, 2022 for further details of the Company's significant accounting policies.
Accounting Pronouncements - Adopted
In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which revises the requirements for how an entity should measure credit losses on financial instruments. The pronouncement was effective for smaller reporting companies in fiscal years beginning after December 15, 2022, including interim periods within those fiscal years, and the new guidance will be applied on a prospective basis. The Company adopted this guidance on January 1, 2023. The adoption had no impact on the Company's financial condition, results of operations or cash flows.
In October 2021, the FASB issued ASU 2021-08, Business Combinations (Topic 805): Accounting for Contract Assets and Contract Liabilities from Contracts with Customers, which requires an entity to apply Topic 606 to recognize and measure contract assets and contract liabilities in a business combination. The pronouncement is effective in fiscal years beginning after December 15, 2022 and early adoption is permitted. The Company adopted this guidance on January 1, 2023. The adoption had no impact on the Company's financial condition, results of operations or cash flows.
Note 3 – Business Acquisitions
HIS Company, Inc. - Purchase Agreement
On March 30, 2023, DSG entered into a Stock Purchase Agreement (the “Purchase Agreement”), with various parties for the acquisition by DSG, on the terms and subject to the conditions therein, of all of the issued and outstanding capital stock of HIS Company, Inc., a Texas corporation (“Hisco”, the "Hisco Transaction"), a distributor of specialty products serving industrial technology applications. Hisco, an employee-owned company, operates in 38 locations across North America, including its Precision Converting facilities that provide value-added fabrication and its Adhesive Materials Group that provides an array of custom repackaging solutions. Hisco offers customers a broad range of products, including adhesives, chemicals and tapes, as well as specialty materials such as electrostatic discharge, thermal management materials and static shielding bags. Hisco also offers vendor-managed inventory and RFID programs with specialized warehousing for chemical management, logistics services and cold storage. DSG intends to combine the operations of TestEquity and Hisco to further expand the product and service offerings at TestEquity, as well as all of our operating businesses under DSG.
Contingent upon closing of the Hisco Transaction, DSG has agreed to pay $269.1 million at closing, with a potential additional earn-out payment of up to $12.6 million, subject to Hisco achieving certain performance targets. DSG also agreed to pay $37.5 million in cash or DSG common stock in retention bonuses to certain Hisco employees that remain employed with Hisco or its affiliates for twelve or more months after the closing of the Hisco Transaction. The completion of the Hisco Transaction is subject to regulatory and customary closing conditions.
DSG intends to finance a portion of the purchase price through a combination of (i) the incurrence of additional indebtedness pursuant to DSG's Amended and Restated Credit Agreement dated April 1, 2022 by and among DSG, certain subsidiaries of DSG as borrowers or guarantors, the lenders party thereto and JPMorgan Chase Bank, N.A., as administrative agent; and (ii) the issuance of additional shares of DSG common stock pursuant to a rights offering (the "Rights Offering") to existing holders of DSG common stock as of the record date therefor.
The Rights Offering is expected to raise an aggregate amount of approximately $100 million and will be conducted pursuant to DSG's effective registration statement on Form S-3. The subscription rights will be transferable but will not be listed for trading on any stock exchange or market. Luther King Capital Management and its affiliates currently own approximately 77% of DSG’s outstanding stock and have indicated an intention to fully subscribe for their pro rata portion in the Rights Offering, as well as for their pro rata portion of any rights remaining unsubscribed at the completion of the subscription period.
Completion of Mergers
On April 1, 2022, the Mergers were completed via all-stock merger transactions. Pursuant to the Merger Agreements, DSG issued an aggregate of 10.3 million shares of DSG common stock on April 1, 2022 to the former owners of TestEquity and Gexpro Services. On March 20, 2023, an additional 1.7 million shares of DSG common stock were issued. Refer to Note 1 – Nature of Operations and Basis of Presentation for further information regarding the Mergers.
The business combination of Lawson, TestEquity and Gexpro Services combines three value-added complementary distribution businesses. Lawson is a distributor of products and services to the industrial, commercial, institutional, and governmental MRO marketplace. TestEquity is a distributor of parts and services to the industrial, commercial, institutional and governmental electronics manufacturing and test and measurement market. Gexpro Services is a provider of supply chain solutions, specializing in developing and implementing VMI and kitting programs to high-specification manufacturing customers. Gexpro Services provides critical products and services to customers throughout the lifecycle of highly technical OEM products. Refer to Note 1 – Nature of Operations and Basis of Presentation for more information on the nature of operations for these businesses.
The Mergers were accounted for as a reverse merger under the acquisition method of accounting for business combinations, whereby TestEquity and Gexpro Services were identified as the accounting acquirers and were treated as a combined entity for financial reporting purposes, and DSG was identified as the accounting acquiree. Accordingly, under the acquisition method of accounting, the purchase price was allocated to DSG's tangible and identifiable intangible assets acquired and liabilities assumed, based on their estimated acquisition-date fair values. These estimates were determined through established and generally accepted valuation techniques.
Allocation of Consideration Exchanged
Under the acquisition method of accounting, the estimated consideration exchanged was calculated as follows:
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(in thousands, except share data) | | April 1, 2022 |
Number of DSG common shares | | 9,120,167 |
DSG common stock closing price per share on March 31, 2022 | | $ | 38.54 | |
Fair value of shares exchanged | | $ | 351,491 | |
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Other consideration(1) | | 1,910 | |
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Total consideration exchanged | | $ | 353,401 | |
(1)Fair value adjustment of stock-based compensation awards.
Due to the publicly traded nature of shares of DSG common stock, the equity issuance of shares of DSG common stock based on this value was considered to be a more reliable measurement of the fair market value of the transaction compared to the equity interests of the accounting acquirer.
The allocation of consideration exchanged to the tangible and identifiable intangible assets acquired and liabilities assumed was based on estimated fair values as of the Merger Date. The accounting for the Mergers was complete as of December 31, 2022. Goodwill generated from the Mergers is not deductible for tax purposes.
The following table summarizes the allocation of consideration exchanged to the estimated fair values of assets acquired and liabilities assumed at the Merger Date and after applying measurement period adjustments:
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(in thousands) | | | | | | Final Purchase Price Allocation | | |
Current assets | | | | | | $ | 148,308 | | | |
Property, plant and equipment | | | | | | 57,414 | | | |
Right of use assets | | | | | | 18,258 | | | |
Other intangible assets | | | | | | 119,060 | | | |
Deferred tax liability, net of deferred tax asset | | | | | | (19,394) | | | |
Other assets | | | | | | 18,373 | | | |
Current liabilities | | | | | | (71,165) | | | |
Long-term obligations | | | | | | (25,746) | | | |
Lease and financing obligations | | | | | | (28,827) | | | |
Derivative earnout liability | | | | | | (43,900) | | | |
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Goodwill | | | | | | 181,020 | | | |
Total consideration exchanged | | | | | | $ | 353,401 | | | |
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The allocation of consideration exchanged to other intangible assets acquired was as follows:
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(in thousands) | | Fair Value | | Estimated Life (in years) |
Customer relationships | | $ | 76,050 | | | 19 |
Trade names | | 43,010 | | | 8 |
Total other intangible assets | | $ | 119,060 | | | |
The Company incurred transaction costs related to the Mergers of $1.2 million for the three months ended March 31, 2023 and $1.4 million for the three months ended March 31, 2022, which are included in Selling, general and administrative expenses in the Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss).
Unaudited Pro Forma Information
The following table presents estimated unaudited pro forma consolidated financial information for DSG as if the Mergers and other acquisitions disclosed below occurred on January 1, 2021 for the acquisitions completed during 2022. The unaudited pro forma information reflects adjustments including amortization on acquired intangible assets, interest expense, and the
related tax effects. This information is presented for informational purposes only and is not necessarily indicative of future results or the results that would have occurred had the Mergers been completed on the date indicated.
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(in thousands) | | | 2022 | | | | |
Revenue | | | $ | 308,790 | | | | | |
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Net income | | | $ | 7,270 | | | | | |
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Other Acquisitions
Through the TestEquity and Gexpro Services operating companies, the Company acquired other businesses during the year ended December 31, 2022. The consideration exchanged for the acquired businesses included various combinations of cash and sellers notes. The acquisitions were accounted for under ASC 805, the acquisition method of accounting. For each acquisition, the allocation of consideration exchanged to the assets acquired and liabilities assumed was based on estimated acquisition-date fair values. Certain estimated values for the acquisitions, including the valuation of intangibles, contingent consideration, and income taxes (including deferred taxes and associated valuation allowances), are not yet finalized, and the preliminary purchase price allocations are subject to change as the Company completes its analysis of the fair value at the date of acquisition. The final valuations will be completed within the respective one-year measurement periods following the respective acquisition dates, and any adjustments will be recorded in the period in which the adjustments are determined.
During the year ended December 31, 2022, TestEquity acquired Interworld Highway, LLC, National Test Equipment, and Instrumex, and Gexpro Services acquired Resolux ApS ("Resolux") and Frontier Technologies Brewton, LLC and Frontier Engineering and Manufacturing Technologies, Inc. ("Frontier"). The accounting for the Interworld Highway, LLC, Resolux and Frontier acquisitions was complete as of December 31, 2022. The purchase consideration for each business acquired and the allocation of the consideration exchanged to the estimated fair values of assets acquired and liabilities assumed is summarized below:
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(in thousands) | | Interworld Highway, LLC | | Resolux | | Frontier | | National Test Equipment | | Instrumex | | | | |
Acquisition date | | April 29, 2022 | | January 3, 2022 | | March 31, 2022 | | June 1, 2022 | | December 1, 2022 | | Total | | |
Current assets | | $ | 15,018 | | | $ | 10,210 | | | $ | 2,881 | | | $ | 2,187 | | | $ | 3,495 | | | $ | 33,791 | | | |
Property, plant and equipment | | 313 | | | 459 | | | 1,189 | | | 642 | | | 30 | | | 2,633 | | | |
Right of use assets | | — | | | 1,125 | | | 9,313 | | | — | | | — | | | 10,438 | | | |
Other intangible assets: | | | | | | | | | | | | | | |
Customer relationships | | 6,369 | | | 11,400 | | | 9,300 | | | 2,100 | | | 800 | | | 29,969 | | | |
Trade names | | 4,600 | | | 6,100 | | | 3,000 | | | — | | | — | | | 13,700 | | | |
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Other assets | | 10 | | | 86 | | | — | | | — | | | 14 | | | 110 | | | |
Accounts payable | | (8,856) | | | (3,058) | | | (778) | | | (196) | | | (1,305) | | | (14,193) | | | |
Current portion of long term debt | | — | | | — | | | — | | | (2,073) | | | — | | | (2,073) | | | |
Accrued expenses and other liabilities | | — | | | (4,747) | | | (1,462) | | | (1,171) | | | (153) | | | (7,533) | | | |
Lease liabilities | | — | | | (1,125) | | | (9,313) | | | — | | | — | | | (10,438) | | | |
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Goodwill | | 37,236 | | | 10,305 | | | 11,544 | | | 5,703 | | | 1,053 | | | 65,841 | | | |
Total purchase consideration exchanged, net of cash acquired | | $ | 54,690 | | | $ | 30,755 | | | $ | 25,674 | | | $ | 7,192 | | | $ | 3,934 | | | $ | 122,245 | | | |
Cash consideration | | $ | 54,690 | | | $ | 30,755 | | | $ | 25,674 | | | $ | 6,023 | | | $ | 3,934 | | | $ | 121,076 | | | |
Seller's notes | | — | | | — | | | — | | | 1,169 | | | — | | | 1,169 | | | |
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Total purchase consideration exchanged, net of cash acquired | | $ | 54,690 | | | $ | 30,755 | | | $ | 25,674 | | | $ | 7,192 | | | $ | 3,934 | | | $ | 122,245 | | | |
Following the initial fair value measurement, the Company updated the purchase price allocations as follows:
•National Test Equipment was adjusted to reflect changes in working capital, accrued expenses and other liabilities. The adjustments to these balances resulted in a $0.3 million decrease to goodwill.
The consideration for the Frontier acquisition includes a potential earn-out payment up to $3.0 million based upon the achievement of certain milestones and relative thresholds during the earn out measurement period which ends on December 31,
2024, with payments made annually beginning in 2023 and ending in 2025. During the first quarter of 2023, a $1.0 million earn-out payment was made based on the achievement of certain milestones in 2022. The fair value of the contingent consideration arrangement was classified within Level 3 and was determined using a probability-based scenario analysis approach. As of March 31, 2022 (the Frontier acquisition date), December 31, 2022 and March 31, 2023, the fair value of the earn-out was $0.9 million, $1.7 million and $0.7 million, respectively, with amounts recorded in Accrued expenses and other current liabilities and Other liabilities in the Unaudited Condensed Consolidated Balance Sheets. Changes in the fair value of the earn-out are recorded as a component of Change in fair value of earnout liability in the Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss).
The Company incurred transaction costs related to the other completed and potential acquisitions of $2.9 million for the three months ended March 31, 2023 and $0.8 million for the three months ended March 31, 2022.
As a result of acquisitions completed in 2022, the Company recorded tax deductible goodwill of $53.6 million in 2022 that may result in a tax benefit in future periods.
Other Acquisitions Pro Forma Information – The pro forma information for other acquisitions was included in the estimated unaudited pro forma consolidated financial information for DSG, which is presented above under Pro Forma Information.
Actual Results of Business Acquisitions
The following table presents actual results attributable to our business combinations that were included in the unaudited condensed consolidated financial statements for the first quarter 2022. The results of DSG's legacy Lawson business are included only subsequent to the April 1, 2022 Merger Date, and the results for other acquisitions are only included subsequent to their respective acquisition dates provided above.
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| | | Three Months Ended March 31, 2022 |
(in thousands) | | | | | | | Lawson | | Other Acquisitions | | Total |
Revenue | | | | | | | $ | — | | | $ | 7,645 | | | $ | 7,645 | |
Net Income | | | | | | | $ | — | | | $ | 1,035 | | | $ | 1,035 | |
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Note 4 – Revenue Recognition
Under the definition of a contract as defined by ASC 606, the Company considers contracts to be created at the time an order to purchase product and services is agreed upon regardless of whether there is a written contract. Revenue from customers is recognized when obligations under the terms of a contract are satisfied; this generally occurs with the delivery of products or services. Revenue from customers is measured as the amount of consideration the Company expects to receive in exchange for the delivery of goods or services. Contracts may last from one month to one year or more and may have renewal terms that extend indefinitely at the option of either party. Price is typically based on market conditions, competition, changes in the industry and product availability. Volumes fluctuate primarily as a result of customer demand and product availability. Consistent with the way the Company manages its businesses, the Company refers to sales under service agreements, which includes both goods (such as parts, equipment and equipment upgrades) and related services (such as monitoring, maintenance and repairs) as sales of “services,” which is an important part of the Company’s operations. The Company has no significant financing components in its contracts with customers. The Company records revenue net of certain taxes, such as sales taxes, that are assessed by governmental authorities on the Company’s customers.
The Company also operates as a lessor and recognizes lease revenue on a straight-line basis over the life of each lease. The Company has adopted the practical expedient not to separate the non-lease components that would be within the scope of ASC 606 from the associated lease component as the relevant criteria under ASC 842 are met.
The Company does not incur significant costs to obtain contracts. Incidental items that are immaterial in the context of the contract are recognized as expenses. Sales of products and services to customers are invoiced and settled on a monthly basis. ASC 606 requires an entity to present a contract liability in instances where the customer is entitled to a volume rebate based on purchases made during the period. The Company is not usually subject to obligations for warranties, rebates, returns or refunds except in the case of rebates for select customers if predetermined purchase thresholds are met as discussed for the TestEquity segment below. The Company does not typically receive payment in advance of satisfying its obligations under the terms of its
sales contracts with customers; therefore, liabilities related to such payment are not significant to the Company. Accounts receivable represents the Company’s unconditional right to receive consideration from its customers.
Lawson Segment
The Lawson segment has two distinct performance obligations offered to its customers: a product performance obligation and a service performance obligation, and accordingly, two separate revenue streams. Although Lawson has identified that it offers its customers both a product and a service obligation, the customer only receives one invoice per transaction with no price allocation between these obligations. Lawson does not price its offerings based on any allocation between these obligations.
Lawson generates revenue primarily from the sale of MRO products to its customers. Revenue related to product sales is recognized at the time that control of the product has been transferred to the customer; either at the time the product is shipped or the time the product has been received by the customer. Lawson does not commit to long-term contracts to sell customers a certain minimum quantity of products.
Lawson offers a VMI service proposition to its customers. A portion of these services, primarily related to stocking of product and maintenance of the MRO inventory, is provided over a short period of time after control of the purchased product has been transferred to the customer. Since certain obligations pursuant to the VMI service agreement have not been provided at the time the control of the product transfers to the customer, that portion of expected consideration is deferred until the time that those services have been provided and the related performance obligations have been satisfied.
TestEquity Segment
TestEquity’s contracts with customers generally represent a single performance obligation to sell its products. Revenue from contracts with customers reflect the transaction prices for contracts reduced by variable consideration. TestEquity provides a rebate to select customers if pre-determined purchase thresholds are met. The rebate consideration is not in exchange for a distinct good or service. Variable consideration is estimated using the expected-value method considering all reasonably available information, including TestEquity’s historical experience and current expectations, and is reflected in the transaction price when sales are recorded. Sales returns are generally accepted by TestEquity; however, sales returns are not material to the Company’s operations. TestEquity provides an assurance type warranty which is not sold separately and does not represent a separate performance obligation.
TestEquity generates revenue from contracts with customers through the sale of new and used electronic test and measurement products. Typically, TestEquity has a purchase order or master service agreement with the customer that specifies the goods and/or services to be provided. TestEquity generally invoices customers as goods are shipped. Fees are typically due and payable 30 days after the date of shipment. Generally, customers gain control of the goods upon providing the product to the carrier, or when services are completed. For the majority of transactions, TestEquity recognizes revenue at the time of shipment, when control passes to the customer. For consigned inventory, revenue is recognized when inventory is removed from TestEquity’s stock location and control passes to the customer.
Gexpro Services Segment
Gexpro Services’ contracts with customers generally represent a single performance obligation to sell its products. Revenue from sales of Gexpro Services’ products is recognized upon transfer of control to the customer, which is typically when the product has been shipped from its distribution facilities. The transaction price is the amount of consideration to which Gexpro Services expects to be entitled in exchange for transferring goods to the customer. Revenue is recorded based on the transaction price, which includes fixed consideration and an estimate of variable consideration such as, early payment/volume discounts and rebates. The amount of variable consideration included in the transaction price is constrained and is included only to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
Gexpro Services’ products are marketed and sold primarily to original equipment manufacturers globally. Sales of products are subject to economic conditions and may fluctuate based on changes in the industry, trade policies and financial markets. Payment terms on invoiced amounts range from 10 to 120 days. In instances where the timing of revenue recognition differs from the timing of the right to invoice, the Company has determined that a significant financing component does not exist.
Disaggregated consolidated revenue by geographic area (based on the location to which the product is shipped to):
| | | | | | | | | | | | | | | |
| Three Months Ended March 31, | | |
(in thousands) | 2023 | | 2022 | | | | |
United States | $ | 298,727 | | | $ | 125,256 | | | | | |
Canada | 21,845 | | | 9,797 | | | | | |
Europe | 16,916 | | | 8,082 | | | | | |
Pacific Rim | 1,937 | | | 5,039 | | | | | |
Latin America | 7,429 | | | 4,845 | | | | | |
Other | 1,416 | | | 1,066 | | | | | |
Total revenue | $ | 348,270 | | | $ | 154,085 | | | | | |
Rental Revenue
TestEquity rents new and used electronic test and measurement equipment to customers in multiple industries. These leases are classified as operating leases under ASC 842. Rental equipment is included in Rental equipment, net in the Unaudited Condensed Consolidated Balance Sheet, and rental revenue is included in Revenue in the Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss). The unearned rental revenue related to customer prepayments on equipment leases of $0.3 million at March 31, 2023 and $0.3 million at December 31, 2022 was included in Accrued expenses and other current liabilities in the Unaudited Condensed Consolidated Balance Sheet and is expected to be earned in its entirety during the next twelve months.
Lawson leases parts washer machines to customers through its Torrents leasing program. These leases are classified as operating leases under ASC 842. The leased machines are included in Rental equipment, net, in the Unaudited Condensed Consolidated Balance Sheet, and the leasing revenue is recognized on a straight-line basis. The unearned rental revenue, which was included as a component of Accrued expenses and other current liabilities in the Unaudited Condensed Consolidated Balance Sheet, was nominal at March 31, 2023 and is expected to be earned during the next twelve months.
Rental revenue from operating leases:
| | | | | | | | | | | | | | | |
| Three Months Ended March 31, | | |
(in thousands) | 2023 | | 2022 | | | | |
Revenue from operating leases | $ | 6,100 | | | $ | 3,541 | | | | | |
| | | | | | | |
Note 5 – Supplemental Financial Statement Information
Inventories, net
Inventories, net, consisting of purchased goods and manufactured electronic equipment offered for resale, were as follows:
| | | | | | | | | | | |
| |
(in thousands) | March 31, 2023 | | December 31, 2022 |
Inventories, gross | $ | 282,837 | | | $ | 275,072 | |
Reserve for obsolete and excess inventory | (12,856) | | | (10,698) | |
Inventories, net | $ | 269,981 | | | $ | 264,374 | |
Changes in the reserve for obsolete and excess inventory were as follows:
| | | | | | | | |
(in thousands) | | Amount |
Balance at December 31, 2022 | | $ | (10,698) | |
Provision charged to expense (net) | | (2,198) | |
| | |
Write-offs | | 40 | |
Balance at March 31, 2023 | | $ | (12,856) | |
Property, Plant and Equipment, net
Components of property, plant and equipment were as follows:
| | | | | | | | | | | |
| |
(in thousands) | March 31, 2023 | | December 31, 2022 |
Land | $ | 9,595 | | | $ | 9,578 | |
Buildings and improvements | 27,872 | | | 27,199 | |
Machinery and equipment | 28,853 | | | 26,948 | |
Capitalized software | 8,355 | | | 7,889 | |
Furniture and fixtures | 7,166 | | | 6,346 | |
Vehicles | 1,715 | | | 1,713 | |
Construction in progress(1) | 3,013 | | | 3,140 | |
Total | 86,569 | | | 82,813 | |
Accumulated depreciation and amortization | (22,136) | | | (18,418) | |
Property, plant and equipment, net | $ | 64,433 | | | $ | 64,395 | |
(1)Construction in progress primarily relates to upgrades to certain of the Company's distribution facilities that we expect to place in service in the next 12 months.
Depreciation expense for property, plant and equipment was $3.5 million and $0.6 million for the first quarter of 2023 and 2022, respectively. Amortization expense for capitalized software was $0.7 million and $0.2 million for the first quarter of 2023 and 2022, respectively.
Rental Equipment, net
Rental equipment, net consisted of the following:
| | | | | | | | | | | |
| |
(in thousands) | March 31, 2023 | | December 31, 2022 |
Rental equipment | $ | 63,546 | | | $ | 63,184 | |
Accumulated depreciation | (36,378) | | | (36,045) | |
Rental equipment, net | $ | 27,168 | | | $ | 27,139 | |
Depreciation expense included in cost of sales for rental equipment was $2.3 million and $1.7 million for the first quarter of 2023 and 2022, respectively. Refer to Note 4 – Revenue Recognition for a discussion on the Company's activities as lessor.
Other Liabilities
Other liabilities consisted of the following:
| | | | | | | | | | | |
(in thousand) | March 31, 2023 | | December 31, 2022 |
Security bonus plan | $ | 9,769 | | | $ | 9,651 | |
Deferred compensation | 10,321 | | | 9,962 | |
Other | 4,322 | | | 4,036 | |
Total other liabilities | $ | 24,412 | | | $ | 23,649 | |
Note 6 – Goodwill and Intangible Assets
Goodwill
Changes in the carrying amount of goodwill by segment were as follows:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | |
(in thousands) | | Lawson | | TestEquity | | Gexpro Services | | All Other | | Total |
Balance at December 31, 2022 | | $ | 155,773 | | | $ | 114,104 | | | $ | 55,421 | | | $ | 22,750 | | | $ | 348,048 | |
| | | | | | | | | | |
| | | | | | | | | | |
Impact of foreign exchange rates | | 11 | | | — | | | 94 | | | 59 | | | 164 | |
Balance at March 31, 2023 | | $ | 155,784 | | | $ | 114,104 | | | $ | 55,515 | | | $ | 22,809 | | | $ | 348,212 | |
| | | | | | | | | | |
Intangible Assets
The gross carrying amount and accumulated amortization for definite-lived intangible assets were as follows:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| |
| March 31, 2023 | | December 31, 2022 |
(in thousands) | Gross Carrying Amount | | Accumulated Amortization | | Net Carrying Value | | Gross Carrying Amount | | Accumulated Amortization | | Net Carrying Value |
Trade names | $ | 92,539 | | | $ | (19,822) | | | $ | 72,717 | | | $ | 92,286 | | | $ | (17,401) | | | $ | 74,885 | |
Customer relationships | 192,947 | | | (50,863) | | | 142,084 | | | 192,934 | | | (44,481) | | | 148,453 | |
Other (1) | 7,960 | | | (3,548) | | | 4,412 | | | 7,961 | | | (3,305) | | | 4,656 | |
Total | $ | 293,446 | | | $ | (74,233) | | | $ | 219,213 | | | $ | 293,181 | | | $ | (65,187) | | | $ | 227,994 | |
(1) Other primarily consists of non-compete agreements.
Amortization expense for definite-lived intangible assets was $9.2 million for the three months ended March 31, 2023 and $5.2 million for the three months ended March 31, 2022. Amortization expense related to intangible assets was recorded in Selling, general and administrative expenses.
The estimated aggregate amortization expense for the remaining year 2023 and each of the next five years are as follows:
| | | | | | | | |
(in thousands) | | Amortization |
Remaining 2023 | | $ | 26,139 | |
2024 | | 34,368 | |
2025 | | 30,999 | |
2026 | | 28,338 | |
2027 | | 23,903 | |
2028 | | 20,680 | |
Thereafter | | 54,786 | |
Total | | $ | 219,213 | |
Note 7 – Leases
Activities as Lessee
The Company leases property used for warehousing, distribution centers, office space, branch locations, equipment and vehicles. The expenses generated by leasing activity for the three months ended March 31, 2023 and 2022 were as follows (in thousands):
| | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | |
| | | | Three Months Ended March 31, | | |
Lease Type | | Classification | | 2023 | | 2022 | | | | |
| | | | | | | | | | |
Operating Lease Expense (1) | | Operating expenses | | $ | 4,882 | | | $ | 1,836 | | | | | |
Financing Lease Amortization | | Operating expenses | | 138 | | | 74 | | | | | |
Financing Lease Interest | | Interest expense | | 26 | | | 12 | | | | | |
Financing Lease Expense | | | | 164 | | | 86 | | | | | |
Net Lease Cost | | | | $ | 5,046 | | | $ | 1,922 | | | | | |
(1) Includes short term lease expense, which is immaterial.
The value of net assets and liabilities related to our operating and finance leases as of March 31, 2023 and December 31, 2022 was as follows (in thousands):
| | | | | | | | | | | | | | |
Lease Type | | March 31, 2023 | | December 31, 2022 |
| | | | |
Total ROU operating lease assets (1) | | $ | 46,403 | | | $ | 46,755 | |
Total ROU financing lease assets (2) | | 1,756 | | | 1,519 | |
Total lease assets | | $ | 48,159 | | | $ | 48,274 | |
| | | | |
Total current operating lease liabilities | | $ | 10,159 | | | $ | 9,480 | |
Total current financing lease liabilities | | 585 | | | 484 | |
Total current lease liabilities | | $ | 10,744 | | | $ | 9,964 | |
| | | | |
Total long term operating lease liabilities | | $ | 38,014 | | | $ | 38,898 | |
Total long term financing lease liabilities | | 1,047 | | | 930 | |
Total long term lease liabilities | | $ | 39,061 | | | $ | 39,828 | |
(1)Operating lease assets are recorded net of accumulated amortization of $13.6 million as of March 31, 2023 and $10.8 million as of December 31, 2022
(2)Financing lease assets are recorded net of accumulated amortization as a component of Other assets in the Unaudited Condensed Consolidated Balance Sheet of $1.0 million as of March 31, 2023 and $0.9 million as of December 31, 2022
The value of lease liabilities related to our operating and finance leases as of March 31, 2023 was as follows (in thousands):
| | | | | | | | | | | | | | | | | | | | |
Maturity Date of Lease Liabilities | | Operating Leases | | Financing Leases | | Total |
| | | | | | |
Year one | | $ | 11,172 | | | $ | 551 | | | $ | 11,723 | |
Year two | | 11,939 | | | 529 | | | 12,468 | |
Year three | | 10,464 | | | 372 | | | 10,836 | |
Year four | | 7,152 | | | 290 | | | 7,442 | |
Year five | | 5,822 | | | 79 | | | 5,901 | |
Subsequent years | | 12,125 | | | — | | | 12,125 | |
Total lease payments | | 58,674 | | | 1,821 | | | 60,495 | |
Less: Interest | | (10,501) | | | (189) | | | (10,690) | |
Present value of lease liabilities | | $ | 48,173 | | | $ | 1,632 | | | $ | 49,805 | |
The weighted average lease terms and interest rates of leases held as of March 31, 2023 were as follows:
| | | | | | | | | | | | | | |
Lease Type | | Weighted Average Term in Years | | Weighted Average Interest Rate |
| | | | |
Operating Leases | | 5.7 | | 7.2% |
Financing Leases | | 3.4 | | 6.9% |
The cash outflows of leasing activity for the three months ended March 31, 2023 were as follows (in thousands):
| | | | | | | | | | | | | | | | | | | | |
| | | | Three Months Ended March 31, |
Cash Flow Source | | Classification | | 2023 | | 2022 |
| | | | | | |
Operating cash flows from operating leases | | Operating activities | | $ | (3,524) | | | $ | (1,797) | |
Operating cash flows from financing leases | | Operating activities | | (68) | | | (12) | |
Financing cash flows from financing leases | | Financing activities | | (123) | | | (73) | |
Refer to Note 4 – Revenue Recognition for a discussion on the Company's activities as lessor.
Note 8 – Earnout Derivative Liability
On the Merger Date, the Company recorded an earnout derivative liability for the two earnout provisions within the Merger Agreements. The Company estimated the initial fair value of the earnout derivative liability based on an aggregate of 1,162,000 additional shares available to be issued under the two earnout provisions of the Merger Agreements. The aggregate of 1,162,000 shares was comprised of 700,000 shares of DSG common stock that were contingently issuable to (or forfeitable by) the TestEquity Equityholder and 462,000 shares of DSG common stock that were contingently issuable to (or forfeitable by) the Gexpro Services Stockholder, in each case as of the Merger Date. The additional 538,000 shares that were potentially issuable as of the Merger Date under the earnouts were not recorded as an earnout derivative liability as the acquisition contingency for these shares was determined to have been met at the Merger Date.
The Company's earnout derivative liability was classified as a Level 3 instrument and was measured at fair value on a recurring basis. The fair value of the earnout derivative liability was measured using the Monte Carlo simulation valuation model using a distribution of potential outcomes on a monthly basis for the year ended December 31, 2022. Inputs to that model included the expected time to liquidity, the risk-free interest rate over the term, expected volatility based on representative peer companies and the estimated fair value of the underlying class of common stock. The significant unobservable inputs used in the fair value measurement of the earnout derivative liability were the fair value of the underlying stock at the valuation date and the estimated term of the earnout arrangement periods. Generally, increases (decreases) in the fair value of the underlying stock and estimated term would result in a directionally similar impact to the fair value measurement.
The estimated aggregate fair value of the earnout derivative liability recorded on the April 1, 2022 Merger Date was $43.9 million, with an offsetting entry to additional paid-in capital. As of April 29, 2022 and December 31, 2022, 700,000 and 462,000 of the 1,162,000 shares, respectively, were reclassified to equity, as the contingencies had been determined to have been met. Immediately prior to the reclassifications, the respective shares were remeasured to fair value. For the year ended December 31, 2022, the Company recorded income of $0.3 million as a component of Change in fair value of earnout liability in the Unaudited Consolidated Statements of Operations and Comprehensive Income (Loss) due to changes in the fair value of the earnout derivative liability.
The change in the fair value of the earnout derivative liability for the year ended December 31, 2022 was as follows:
| | | | | | | | |
(in thousands) | | Amount |
Balance at December 31, 2021 | | $ | — | |
Initial recognition on Merger Date | | 43,900 | |
Change in fair value | | (276) | |
Reclassifications to equity at fair value | | (43,624) | |
Balance at December 31, 2022 | | $ | — | |
On March 20, 2023, all of the 1.7 million shares of DSG common stock stock available to be issued under the earnout provisions within the Merger Agreements were issued in accordance with the two earnout provisions within the Merger Agreements. As the remaining additional shares had been reclassified to equity as of December 31, 2022, there was no change in fair value for the first quarter of 2023.
Note 9 – Debt
The Company's outstanding long-term debt was comprised of the following:
| | | | | | | | | | | | |
| | |
(in thousands) | March 31, 2023 | | December 31, 2022 | |
Senior secured revolving credit facility | $ | 128,600 | | | $ | 122,000 | | |
Senior secured term loan | 237,500 | | | 243,750 | | |
Senior secured delayed draw term loan | 48,750 | | | 50,000 | | |
Other revolving line of credit | 1,094 | | | 1,352 | | |
| | | | |
| | | | |
Total debt | 415,944 | | | 417,102 | | |
Less current portion of long-term debt | (16,094) | | | (16,352) | | |
Less deferred financing costs | (4,635) | | | (4,925) | | |
Total long-term debt | $ | 395,215 | | | $ | 395,825 | | |
Amended and Restated Credit Agreement
On April 1, 2022 (the "Closing Date"), DSG and certain of its subsidiaries entered into an Amended and Restated Credit Agreement (the “Amended and Restated Credit Agreement”) by and among DSG, certain subsidiaries of DSG as borrowers or guarantors, the lenders party thereto and JPMorgan Chase Bank, N.A., as administrative agent. Pursuant to the Amended and Restated Credit Agreement, the Company's previous credit agreement was amended and restated in its entirety.
The Amended and Restated Credit Agreement provides for (i) a $200 million senior secured revolving credit facility, with a $25 million letter of credit sub-facility and a $10 million swingline loan sub-facility, (ii) a $250 million senior secured initial term loan facility and (iii) a $50 million senior secured delayed draw term loan facility. In addition, the Amended and Restated Credit Agreement permits the Company to increase the commitments under the Amended and Restated Credit Agreement from time to time by up to $200 million in the aggregate, subject to, among other things, the receipt of additional commitments from existing and/or new lenders and pro forma compliance with the financial covenants in the Amended and Restated Credit Agreement. Each of the loans under the Amended and Restated Credit Agreement mature on April 1, 2027.
Net of outstanding letters of credit, there was $69.8 million of borrowing availability under the revolving credit facility as of March 31, 2023. The weighted average interest rate from January 1, 2023 through March 31, 2023 was 7.1%.
The loans under the Amended and Restated Credit Agreement bear interest, at the Company’s option, at a rate equal to (i) the Alternate Base Rate or the Canadian Prime Rate (each as defined in the Amended and Restated Credit Agreement), plus, in each case, an additional margin ranging from 0.0% to 1.75% per annum, depending on the total net leverage ratio of the Company and its restricted subsidiaries as of the most recent determination date under the Amended and Restated Credit Agreement or (ii) the Adjusted Term SOFR Rate or the CDOR Rate (each as defined in the Amended and Restated Credit Agreement), plus, in each case, an additional margin ranging from 1.0% to 2.75% per annum, depending on the total net leverage ratio of the Company and its restricted subsidiaries as of the most recent determination date under the Amended and Restated Credit Agreement.
In connection with the Amended and Restated Credit Agreement, deferred financing costs of $4.0 million were incurred. Deferred financing costs are amortized over the life of the debt instrument and reported as interest expense. As of March 31, 2023, deferred financing costs net of accumulated amortization were $7.5 million of which $4.6 million are included in Long-term debt, less current portion, net (related to the senior secured term loan and senior secured delayed draw term loan) and $2.9 million are included in Other assets (related to the senior secured revolving credit facility) in the Unaudited Condensed Consolidated Balance Sheets.
The Amended and Restated Credit Agreement contains various covenants, including financial maintenance covenants requiring the Company to maintain compliance with a consolidated minimum interest coverage ratio and a maximum total net leverage ratio, each determined in accordance with the terms of the Amended and Restated Credit Agreement.
The Company was in compliance with all financial covenants set forth in the Amended and Restated Credit Agreement as of March 31, 2023.
Note 10 – Stock-Based Compensation
The Company recorded stock-based compensation expense of $2.2 million and $0.0 million for the three months ended March 31, 2023 and March 31, 2022, respectively. A portion of the Company's stock-based awards are liability-classified. Accordingly, changes in the market value of the Company's common stock may result in stock-based compensation expense or benefit in certain periods. A stock-based compensation liability of $4.5 million as of March 31, 2023 and $3.3 million as of December 31, 2022 was included in Accrued expenses and other current liabilities in the Unaudited Condensed Consolidated Balance Sheets.
Restricted Stock Awards
For the three months ended March 31, 2023, the Company issued 10,000 Restricted stock awards ("RSAs") that vest over five years from the grant date with a grant date fair value of $0.4 million. Upon vesting, the vested RSAs are exchanged for an equal number of shares of the Company’s common stock. The participants have no voting or dividend rights with the RSAs. The RSAs are valued at the closing price of the Company common stock on the date of grant and the expense is recorded ratably over the vesting period.
Stock Options
For the three months ended March 31, 2023, the Company issued approximately 606,000 stock options to key employees that vest over five years from the grant date. The fair value was determined using a Black-Scholes valuation model with a grant date fair value of $8.3 million. Each stock option can be exchanged for one share of Company common stock at the stated exercise price. Upon vesting, stock options are recognized as a component of equity. Unrecognized compensation related to stock options as of March 31, 2023 was $9.8 million, which is expected to be recognized over a weighted-average period of 2.5 years.
Activity related to the Company’s stock options during the three months ended March 31, 2023 was as follows:
| | | | | | | | | | | |
| Number of Stock Options | | Weighted Average Exercise Price |
Outstanding on December 31, 2022 | 288,000 | | | $ | 77.59 | |
| | | |
Granted | 605,821 | | | 72.74 | |
| | | |
| | | |
Outstanding on March 31, 2023 | 893,821 | | | 74.30 | |
| | | |
Exercisable on March 31, 2023 | 40,000 | | | 27.01 | |
The weighted average fair value assumptions used in the Black-Scholes model for the stock options issued during the three months ended March 31, 2023 were as follows:
| | | | | |
Expected volatility | 45.23% |
Risk-free rate of return | 3.6% |
Expected term (in years) | 6.2 years |
Expected annual dividend | $0 |
The expected volatility was based on the historic volatility of the Company's stock price commensurate with the expected life of the stock options. The risk-free rate of return reflects the interest rate offered for zero coupon treasury bonds over the expected life of the stock options. The expected life represents the period of time that options granted are expected to be outstanding and was calculated using the simplified method allowed by the SEC, which approximates our historical experience. The estimated annual dividend was based on the recent dividend payout trend.
Note 11 – Stock Repurchase Program
Under an existing stock repurchase program authorized by the Board of Directors, the Company may repurchase its common stock from time to time in open market transactions, privately negotiated transactions or by other methods. No shares were repurchased during the three months ended March 31, 2023 or 2022 under the Company's stock repurchase plan. The remaining availability for stock repurchases under the program was $7.6 million at March 31, 2023.
Note 12 – Earnings Per Share
As a result of the Mergers discussed in Note 1 – Nature of Operations and Basis of Presentation, all historical per share data and number of shares and numbers of equity awards were retroactively adjusted. The following table provides the computation of basic and diluted earnings per share:
| | | | | | | | | | | | | | | |
| Three Months Ended March 31, | | |
(in thousands, except share and per share data) | 2023 | | 2022 | | | | |
| | | | | | | |
Basic income per share: | | | | | | | |
Net income (loss) | $ | 5,907 | | | $ | (2,537) | | | | | |
Basic weighted average shares outstanding | 21,120,770 | | | 10,300,866 | | | | | |
Basic income (loss) per share of common stock | $ | 0.28 | | | $ | (0.25) | | | | | |
| | | | | | | |
Diluted income per share: | | | | | | | |
Net income (loss) | $ | 5,907 | | | $ | (2,537) | | | | | |
Basic weighted average shares outstanding | 21,120,770 | | | 10,300,866 | | | | | |
Effect of dilutive securities | 183,434 | | | — | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
| | | | | | | |
Diluted weighted average shares outstanding | 21,304,204 | | | 10,300,866 | | | | | |
Diluted income (loss) per share of common stock | $ | 0.28 | | | $ | (0.25) | | | | | |
Anti-dilutive securities excluded from the calculation of diluted income per share | — | | | 266,984 | | | | | |
Note 13 – Income Taxes
The Company recorded income tax expense of $2.1 million, a 26.3% effective tax rate for the three months ended March 31, 2023. Income tax expense of $1.0 million, a 27.4% effective tax rate was recorded for the three months ended March 31, 2022. The effective tax rate for the three months ended March 31, 2023 was higher than the U.S. statutory rate primarily due to state taxes, foreign operations, and other permanent items. The effective tax rate for the three months ended March 31, 2022 was higher than the U.S. statutory rate primarily due to state taxes, transaction costs, and other permanent items.
Relative to the U.S. statutory rate, the effective tax rate for the three months ended March 31, 2023 was impacted by state taxes, foreign operations, and other permanent items.
The Company and its subsidiaries are subject to U.S. federal income tax, as well as income tax of multiple state and foreign jurisdictions. As of March 31, 2023, the Company is subject to U.S. federal income tax examinations for the years 2019 through 2021 and income tax examinations from various other jurisdictions for the years 2015 through 2021.
Earnings from the Company’s foreign subsidiaries are considered to be indefinitely reinvested. A distribution of these non-U.S. earnings in the form of dividends or otherwise may subject the Company to foreign withholding taxes and U.S. federal and state taxes.
Note 14 – Commitments and Contingencies
Merger Litigation
In February 2022, three purported DSG stockholders made demands pursuant to Section 220 of the Delaware General Corporation Law to inspect certain books and records of DSG (collectively, the “Books and Records Demands”). One stated purpose of the Books and Records Demands was to investigate questions of director disinterestedness and independence and the alleged possibility of wrongdoing, mismanagement and/or material non-disclosure related to the Special Committee’s and the DSG board of directors’ approval of the Mergers. On March 16, 2022, one of the purported DSG stockholders who previously made a Books and Records Demand filed a lawsuit entitled Robert Garfield v. Lawson Products, Inc., Case No. 2022-0252, in the Court of Chancery of the State of Delaware against DSG (the “Garfield Action”). On March 22, 2022, another of the purported DSG stockholders who previously made a Books and Records Demand filed a lawsuit entitled Jeffrey Edelman v. Lawson Products, Inc., Case No. 2022-0270, in the Court of Chancery of the State of Delaware against DSG (the “Edelman Action”). The Garfield Action and the Edelman Action, which were consolidated and re-captioned as Lawson Products, Inc.
Section 220 Litigation, Case No. 2022-0270, are collectively referred to as the “Books and Records Actions.” The Books and Records Actions sought to compel inspection of certain books and records of DSG to investigate questions of director disinterestedness and independence and the alleged possibility of wrongdoing, mismanagement and/or material non-disclosure related to the Special Committee’s and the DSG board of directors’ approval of the Mergers. Following briefing, the Delaware Court of Chancery held a trial on July 14, 2022 to adjudicate the Books and Records Actions. At the conclusion of the trial, the Court ruled orally that the stockholders’ demands would be granted only in one respect (production of documents sufficient to show the identities of any guarantors of debt of the acquired companies) and the Court denied the remainder of the stockholders’ requests. The Court’s ruling was memorialized in an order issued on July 20, 2022. Thereafter, DSG produced excerpts of certain documents as required by the Court's ruling and subsequent order.
On October 3, 2022, the plaintiffs in the Books and Records Actions filed a shareholder derivative action (the “Derivative Action”) entitled Jeffrey Edelman and Robert Garfield v. John Bryan King et al., Case No. 2022-0886, in the Court of Chancery of the State of Delaware (the "Delaware Chancery Court"). The Derivative Action names as defendants J. Bryan King, Lee S. Hillman, Bianca A. Rhodes, Mark F. Moon, Andrew B. Albert, I. Steven Edelson and Ronald J. Knutson (collectively, “Director and Officer Defendants”), and LKCM Headwater Investments II, L.P., LKCM Headwater II Sidecar Partnership, L.P., Headwater Lawson Investors, LLC, PDLP Lawson, LLC, LKCM Investment Partnership, L.P., LKCM Micro-Cap Partnership, L.P., LKCM Core Discipline, L.P. and Luther King Capital Management Corporation (collectively, the “LKCM Defendants”). Purporting to act on behalf of DSG, in the Derivative Action the plaintiffs allege, among other things, various claims of alleged breach of fiduciary duty against the Director and Officer Defendants and the LKCM Defendants in connection with the Mergers. The Derivative Action seeks, among other things, money damages, equitable relief and the costs of the Derivative Action, including reasonable attorneys’, accountants’ and experts’ fees. On October 24, 2022, the plaintiffs voluntarily dismissed PDLP Lawson, LLC and LKCM Investment Partnership, L.P. from the Derivative Action without prejudice.
The defendants filed motions to dismiss the Derivative Action, along with related supporting briefing materials, with the Delaware Chancery Court, and the plaintiffs filed briefing materials opposing those motions to dismiss. The Delaware Chancery Court has scheduled a hearing to be held on September 13, 2023, regarding the defendants’ motions to dismiss.
DSG disagrees with and intends to vigorously defend against the Derivative Action. The Derivative Action could result in additional costs to DSG, including costs associated with the indemnification of directors and officers. At this time, DSG is unable to predict the ultimate outcome of the Derivative Action or, if the outcome is adverse, to reasonably estimate an amount or range of reasonably possible loss, if any, associated with the Derivative Action. Accordingly, no amounts have been recorded in the unaudited condensed consolidated financial statements for these matters. No assurance can be given that additional lawsuits will not be filed against DSG and/or its directors and officers and/or other persons or entities in connection with the Mergers.
Cyber Incident Litigation
On February 10, 2022, DSG disclosed that its computer network was the subject of a cyber incident potentially involving unauthorized access to certain confidential information (the “Cyber Incident”). On April 4, 2023, a putative class action lawsuit (the “Cyber Incident Suit”) was filed against DSG entitled Lardone Davis, on behalf of himself and all others similarly situated v. Lawson Products, Inc., Case No. 1:23-cv-02118, in the United States District Court for the Northern District of Illinois, Eastern Division. The plaintiff in this case, who purports to represent the class of individuals harmed by alleged actions and/or omissions by DSG in connection with the Cyber Incident, asserts a variety of common law and statutory claims seeking monetary damages, injunctive relief and other related relief related to the potential unauthorized access by third parties to personal identifiable information and protected health information.
DSG disagrees with and intends to vigorously defend against the Cyber Incident Suit. The Cyber Incident Suit could result in additional costs and losses to DSG, although, at this time, DSG is unable to reasonably estimate the amount or range of reasonably possible loss, if any, that might result from adverse judgments, settlements, fines, penalties or other resolution of these proceedings based on the early stage of this proceeding, the absence of specific allegations as to alleged damages, the uncertainty as to the certification of a class or classes and the size of any certified class, if applicable, and the lack of resolution of significant factual and legal issues. Accordingly, no amounts have been recorded in the unaudited condensed consolidated financial statements for the Cyber Incident Suit. No assurance can be given that additional lawsuits will not be filed against DSG and/or its directors and officers and/or other persons or entities in connection with the Cyber Incident.
Environmental Matter
In 2012, it was determined that a Company owned site in Decatur, Alabama, contained hazardous substances in the soil and groundwater as a result of historical operations prior to the Company's ownership. The Company retained an environmental consulting firm to further investigate the contamination, prepare a remediation plan, and enroll the site in the Alabama Department of Environmental Management (“ADEM”) voluntary cleanup program.
A remediation plan was approved by ADEM in 2018. The plan consists of chemical injections throughout the affected area, as well as subsequent monitoring of the area. The injection process was completed in the first quarter of 2019 and the environmental consulting firm is monitoring the affected area. At March 31, 2023 the Company had less than $0.1 million accrued for potential monitoring costs included in Accrued expenses and other current liabilities in the Unaudited Condensed Consolidated Balance Sheets. The costs for future monitoring are not significant and have been fully accrued. The Company does not expect to capitalize any amounts related to the remediation plan.
Purchase commitments
The Company enters into inventory purchase commitments with third parties in the ordinary course of business. As of March 31, 2023, we had contractual commitments to purchase approximately $174 million of product from our suppliers and contractors which is expected to be paid in the next twelve months.
Note 15 – Related Party Transactions
Management Services Agreements
Prior to the Mergers, a subsidiary of TestEquity was party to a management agreement with Luther King Capital Management Corporation (“LKCM”) for certain advisory and consulting services (the “TestEquity Management Agreement”), and a subsidiary of Gexpro Services was party to a management agreement with LKCM for certain advisory and consulting services (the “Gexpro Services Management Agreement”). In connection with the closing of the Mergers on April 1, 2022, (i) all of the TestEquity subsidiary’s rights, liabilities and obligations under the TestEquity Management Agreement were novated to, transferred to and assumed by the TestEquity Equityholder, and LKCM released the TestEquity subsidiary from all obligations and claims under the TestEquity Management Agreement, and (ii) all of the Gexpro Services subsidiary’s rights, liabilities and obligations under the Gexpro Services Management Agreement were novated to, transferred to and assumed by the Gexpro Services Stockholder, and LKCM released the Gexpro Services subsidiary from all obligations and claims under the Gexpro Services Management Agreement (collectively, the “Novations”). During the first three months of 2022, expense of $0.5 million was recorded within Selling, general and administrative expenses within the Unaudited Condensed Consolidated Statements of Income and Comprehensive Income (Loss), reflecting expenses accrued under these management agreements from January 1, 2022 through the April 1, 2022 Merger Date. As of April 1, 2022, the prior obligation of $5.3 million was effectively settled and considered to be a deemed equity contribution by LKCM recorded to additional paid in capital. As a result of the Novations, no additional expense under these management agreements has been incurred subsequent to the Mergers.
Consulting Services
Subsequent to the Mergers, individuals employed by LKCM Headwater Operations, LLC, a related party of Luther King Capital Management Corporation (“LKCM”), have provided the Company with certain consulting services in order to identify cost savings, revenue enhancements and operational synergies of the combined companies. As of March 31, 2023 expense of $0.1 million was recorded within Selling, general and administrative expenses within the Unaudited Condensed Consolidated Statements of Income and Comprehensive Income (Loss), reflecting expenses accrued for these consulting services.
TestEquity and Gexpro Services Mergers
Immediately prior to the Mergers, entities affiliated with Luther King Capital Management Corporation (“LKCM”) and J. Bryan King (the Chairman of the DSG board of directors), including private investment partnerships for which LKCM serves as investment manager, owned a majority of the ownership interests in the TestEquity Equityholder (which in turn owned all of the outstanding equity interests of TestEquity as of immediately prior to the completion of the TestEquity Merger). As of the Merger Date, Mr. King was a director of the TestEquity Equityholder. In addition, as of the Merger Date, Mark F. Moon (a
member of the DSG board of directors) was a director of, and held a direct or indirect equity interest in, the TestEquity Equityholder.
Immediately prior to the Mergers, entities affiliated with LKCM and Mr. King, including private investment partnerships for which LKCM serves as investment manager, owned a majority of the ownership interests in the Gexpro Services Stockholder (which in turn owned all of the then outstanding stock of Gexpro Services).
Immediately prior to the Mergers, entities affiliated with LKCM and Mr. King owned approximately 48% of the shares of DSG common stock then outstanding.
As a result of and after the consummation of the Mergers, the issuance of 10.3 million shares at the closing on the Merger Date and the issuance of the additional 1.7 million shares in accordance with the earnout provisions of the TestEquity Merger Agreement and the Gexpro Services Merger Agreement on March 20, 2023, entities affiliated with LKCM and J. Bryan King (the Chairman of the DSG board of directors) owned in the aggregate approximately 16.3 million shares of DSG common stock representing approximately 77.4% of the outstanding shares of DSG common stock as of March 31, 2023.
Note 16 – Segment Information
Based on operational, reporting and management structures, the Company has identified three reportable segments based on the nature of the products and services and type of customer for those products and services. A description of our reportable segments is as follows:
•Lawson is a distributor of specialty products and services to the industrial, commercial, institutional and government maintenance, repair and operations market.
•TestEquity is a distributor of test and measurement equipment and solutions, electronic production supplies, and tool kits from its leading manufacturer partners supporting the technology, aerospace, defense, automotive, electronics, education, and medical industries.
•Gexpro Services is a global supply chain solutions provider, specializing in developing and implementing vendor managed inventory and kitting programs to high-specification manufacturing customers.
The Company also has an “All Other” category which includes unallocated DSG holding company costs that are not directly attributable to the ongoing operating activities of our reportable segments and includes the results of the Bolt Supply House ("Bolt") non-reportable segment. Revenue within the All Other category represents the results of Bolt. Bolt generates revenue primarily from the sale of MRO products to its walk-up customers and service to its customers through its 14 branch locations. Bolt does not provide VMI services for its customers or provide services in addition to product sales to customers. Revenue is recognized at the time that control of the product has been transferred to the customer which is either upon delivery or shipment depending on the terms of the contract.
Financial information for the Company's reportable segments is presented below. Asset information by operating segment is not presented below since the chief operating decision maker does not review this information by segment.
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| Three Months Ended March 31, | | |
(in thousands) | 2023 | | 2022 | | | | |
Revenue | | | | | | | |
Lawson(1) | $ | 125,280 | | | $ | — | | | | | |
TestEquity | 107,359 | | | 72,402 | | | | | |
Gexpro Services | 101,016 | | | 81,683 | | | | | |
All Other(2) | 14,615 | | | — | | | | | |
Total revenue | $ | 348,270 | | | $ | 154,085 | | | | | |
| | | | | | | |
Operating income (loss) | | | | | | | |
Lawson(1) | $ | 8,245 | | | $ | — | | | | | |
TestEquity | 26 | | | (604) | | | | | |
Gexpro Services | 7,374 | | | 3,592 | | | | | |
All Other(2) | 1,076 | | | — | | | | | |
Total operating income (loss) | $ | 16,721 | | | $ | 2,988 | | | | | |
(1)Includes the operating results of Lawson only subsequent to the Merger Date of April 1, 2022 and not Lawson operating results prior to the Mergers.
(2) Includes the operating results of All Other only subsequent to the Merger Date of April 1, 2022 and not All Other operating results prior to the Mergers.
Note 17 – Subsequent Event
On May 8, 2023, the Company filed a Current Report on Form 8-K, providing (i) audited consolidated financial statements of Hisco for the year ended October 31, 2022 and (ii) unaudited pro forma condensed combined financial information to give effect to the Mergers and the Hisco Transaction as of the periods shown in the financial information and subject to the assumptions and adjustments described in the accompanying notes.
On May 9, 2023, the Company commenced a Rights Offering of transferable subscription rights (“Subscription Rights”) to holders of DSG common stock as of the close of business on May 1, 2023, for an aggregate Rights Offering value of up to $100 million. The Rights Offering is being conducted pursuant to a prospectus supplement dated on May 9, 2023. The Rights Offering will expire at 5:00pm Eastern Time on May 30, 2023 (the “Expiration Date”), unless extended at the Company’s sole discretion.