Distribution Solutions Group, Inc. (DSGR) FY 2021 MD&A

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

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Overview

We are a distributor of products and services to the industrial, commercial, institutional, and governmental maintenance, repair and operations ("MRO") marketplace. We operate in two reportable segments: Lawson and Bolt. The Lawson operating segment primarily distributes MRO products to its customers through a network of sales representatives throughout the U.S. and Canada. The Bolt operating segment primarily distributes its MRO products through a network of 14 branches located in Alberta, Saskatchewan, Manitoba and British Columbia, Canada.

Sales Drivers

The North American MRO market is highly fragmented. We compete for business with several national distributors as well as a large number of regional and local distributors. The MRO business is influenced by the overall strength of the manufacturing sector of the U.S. economy which has been significantly affected by the COVID-19 pandemic. One measure used to evaluate the strength of the industrial products market is the Purchasing Managers Index (PMI) published by the Institute for Supply Management. The PMI is a composite index of economic activity in the United States manufacturing sector and is available at https://www.instituteforsupplymanagement.org. A measure of that index above 50 generally indicates expansion of the manufacturing sector while a measure below 50 generally represents contraction. The average monthly PMI was 60.7 for the year ended December 31, 2021 compared to 52.5 for the year ended December 31, 2020.

Our sales are also influenced by the number of sales representatives and their productivity. One metric we use to measure sales rep productivity is Average Daily Sales ("ADS") in which we calculate our total sales divided by the number of selling days, which exclude weekends and holidays. Our sales are affected by the number and effectiveness of sales representatives and the amount of sales each representative can generate from providing products and services to our customers, which we measure as average sales per day per sales representative. We had an average of 1,072 sales representatives working for us in 2021 compared to an average of 1,012 in 2020, an increase of 5.9%. This was primarily driven by the inclusion of Partsmaster sales reps for the full year of 2021 compared to the four-month post-acquisition period in 2020.

Lawson segment ADS, including Partsmaster, increased 19.8% to $1,471 million in the full year 2021 compared to $1,228 million in the prior year. Partsmaster contributed $57.8 million of revenue and operating income of $1.6 million in the full year 2021, compared to $22.6 million of revenue and $0.8 million of operating income in the four-month post-acquisition period of 2020. Excluding the impact of Partsmaster, Lawson segment ADS increased 9.1% in 2021 compared to the prior year, primarily driven by improved business conditions and fewer COVID-19 related restrictions compared to the full year of 2020. We plan to continue concentrating our efforts on increasing the productivity and size of our sales team.

Supply Chain Disruptions

Along with the broader economy, we are experiencing additional pressure in our supply chain, labor shortages and inflation. This results in challenges in acquiring and receiving inventory in a timely fashion and fulfilling customer orders, which has offset some of the sales gains we recorded in 2021 compared to 2020. The supply chain disruptions have also led to increased product costs which have contributed to lower gross margins as a percentage of sales compared to the prior year. We have instituted various price increases during 2021 in response to rising supplier costs, as well as increased transportation and labor costs. Further discussion in included within the financial discussion of the Management's Discussion and Analysis of Financial Condition and Results of Operations.

Partsmaster Acquisition

In August 2020, we acquired Partsmaster, a leading Maintenance, Repair and Operations ("MRO") distributor from NCH Corporation, with approximately 200 sales representatives and approximately 16,000 customers throughout the United States and Canada. The purchase price of the acquisition was $35.3 million in cash and the assumption of certain liabilities. We paid $2.3 million at the time of the acquisition and paid the remaining $33.0 million in May 2021. We also subleased the Partsmaster distribution center located in Greenville, TX from NCH and we currently fulfill orders from the facility. We will move out of the Greenville, TX facility and into a new distribution facility in Dallas, TX in the first quarter of 2022. The integration of Partsmaster into Lawson was substantially completed in July 2021.

Additional information related to the Partsmaster acquisition is provided in Note 3 - Acquisition in the notes to the consolidated financial statements.

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COVID-19 Pandemic

Various events related to COVID-19 may impact revenue, product sourcing, sales functions, and customers' ability to pay timely.

The onset of the COVID-19 pandemic occurred in March 2020. This resulted in widespread closures of businesses, decreased travel and other substantial restrictions on economic activity beginning in the first quarter of 2020. The most severe restrictions were effective in the second quarter of 2020, particularly the month of April. These restrictions began to be relaxed subsequent to April 2020, which led to an improved business climate and increased economic activity throughout the remainder of the year. The relaxed restrictions continued during 2021, which led to increased business activity and contributed to improved operating results compared to the prior year 2020.

We will continue to closely monitor the overall economic and operating environment and we will take appropriate actions to protect the safety of our employees, customers and suppliers. While we believe that COVID-19 and supply chain disruptions continue to negatively impact our sales and cost control measures, our ability to effectively service our customers has continued to generate positive cash flow that has enabled us to maintain a strong financial position. We plan to continue to respond to pandemic developments in a prompt and disciplined manner with an emphasis on maintaining our strong financial position.

Proposed Combination with TestEquity and Gexpro Services

On December 29, 2021, Lawson entered into the Merger Agreements for the combination of Lawson, TestEquity and Gexpro Services. See “Proposed Combination with TestEquity and Gexpro Services” included in Part I. Item 1. Business, which section is incorporated herein by reference. In addition, upon closing of the Mergers, Lawson anticipates entering into a new credit arrangement consisting of a $200 million revolving credit facility, a $250 term loan facility, and a $50 million delayed draw term loan facility, as contemplated by the debt financing commitment letter described in “Debt Financing Commitment Letter” included in Part I. Item 1. Business, which section is incorporated herein by reference.

Lawson expects to complete the Mergers in the second quarter of 2022.

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RESULTS OF OPERATIONS FOR 2021 AS COMPARED TO 2020

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Non-GAAP Financial Measure - Adjusted Operating Income

The Company's management believes that certain non-GAAP financial measures may provide users of this financial information with additional meaningful comparisons between current results and results in prior operating periods. Management believes that these non-GAAP financial measures can provide additional meaningful reflection of underlying trends of the business because they provide a comparison of historical information that excludes certain infrequently occurring, seasonal or non-operational items that impact the overall comparability. These non-GAAP financial measures should be viewed in addition to, and not as an alternative for, the Company's reported results prepared in accordance with GAAP.

Adjusted operating income is defined by us as GAAP operating income excluding stock-based compensation, severance expense, and other non-recurring items in the period in which these items are incurred. Operating income was $12.0 million for 2021 inclusive of $4.8 million of stock-based compensation compared to $20.6 million in 2020 which included $2.0 million of stock-based compensation. Excluding stock-based compensation, severance and other non-recurring items, adjusted operating income was $27.5 million in 2021 compared to the prior year of $27.4 million, driven by higher sales volume offset by lower gross margins and higher selling expenses and incentive compensation.

(1) Expense for stock-based compensation, of which a portion varies with the Company's stock price.

(2) Includes severance expense from actions taken in 2021 and 2020 along with 2020 severance and retention costs related to the Partsmaster acquisition.

(3) Includes expense for Partsmaster inventory rationalization plan and write-down of personal protective equipment inventory to net realizable value.

(4) Primarily costs related to the negotiation, review and execution of the merger agreements relating to Lawson’s proposed business combination with TestEquity and Gexpro Services.

(5) Primarily signing bonus costs pertaining to the acquisition of Partsmaster.

(6) Represents the goodwill impairment related to the 2018 acquisition of Screw Products, Inc. as the carrying value of the reporting unit exceeded its estimated fair value.

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Sales and Gross Profits

Sales and gross profit results by operating segment for the years ended December 31, 2021 and 2020 were as follows:

Consolidated revenue in 2021 increased 18.8% to $417.7 million from $351.6 million in 2020. Average daily sales increased to $1.664 million in 2021 compared to $1.390 million in 2020 with two less selling days in 2021. The increased sales is partially driven by the inclusion of Partsmaster sales of $57.8 million for the full year of 2021 compared to $22.6 million of sales for the 2020 four-month post-acquisition period. Excluding Partsmaster, consolidated sales improved by 9.4% on a year over year basis. Additionally, sales in 2020 were negatively impacted by the onset of the COVID-19 pandemic, which led to widespread shutdowns of businesses and restrictions on other business activity throughout the year, particularly in the second quarter of 2020. The improved business environment in 2021 led to increased sales to strategic, core and Kent customers in the Lawson segment, as well as increased Bolt segment sales compared to the prior year. This was partially offset by supply chain disruptions which led to challenges of receiving inventory in a timely fashion and fulfilling customer orders, as well as lower sales among Government customers. Excluding a foreign currency effect of $5.2 million, consolidated revenue increased by 17.3% for the year.

Gross profit increased to $219.2 million in 2021 from $186.5 million in 2020. The increased gross profit is driven by the inclusion of Partsmaster gross profit of $36.4 million for the full year 2021 compared to $13.2 million of gross profit from the fourth month post-acquisition period of 2020. Gross profit as a percent of sales decreased to 52.5% from 53.1% a year ago, driven primarily by increased freight and supplier costs due to supply chain disruptions. The organic Lawson MRO (excluding Bolt, Screw Products and Partsmaster) gross margin as a percent of sales decreased to 58.3% compared to the prior year organic gross margin percent of 59.8% prior to the effect of the reclassification of service costs associated with service revenue. This is primarily a result of additional inventory reserves of $1.4 million primarily related to the integration of Partsmaster and the impact of the supply chain disruptions previously mentioned.

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Selling, General and Administrative Expenses

Selling expenses increased to $96.6 million in 2021 from $76.8 million in 2020 and, as a percent of sales increased to 23.1% in 2021 from 21.8% in 2020. The increased selling expense was driven by increased sales compared to the prior year, as well as the inclusion of selling expense of $21.4 million for Partsmaster for the full year 2021 compared to selling expense of $6.5 million for the 2020 four-month post-acquisition period. As a percent of sales, the increase was driven by the inclusion of Partsmaster with a higher sales cost and the return to more normalized sales activities in 2021.

General and administrative expenses increased to $110.6 million in 2021 compared to $89.2 million in 2020 primarily due to the inclusion of Partsmaster general and administrative expense of $13.9 million for the full year 2021 compared to $7.4 million in the 2020 post-acquisition period, as well as $8.3 million of expense related to the negotiation, review and execution of the merger agreements relating to Lawson’s proposed combination with TestEquity and Gexpro Services and a $2.8 million increase in stock-based compensation expense, a portion of which varies with the Company stock price. The remaining increase was driven to support higher sales and temporary cost reductions put in place in 2020 that were re-established in 2021.

Goodwill Impairment

The Company performed a quantitative goodwill impairment analysis as of December 1, 2020 for the Screw Products reporting unit. The Company engaged a third-party valuation firm to determine the value of the Screw Products reporting unit and determined that the carrying value of the net assets exceeded the fair value of the reporting unit and accordingly recognized an impairment charge of $1.9 million in 2020. The impairment charge is included in General and administrative expense. No impairment charges were recorded in 2021.

Interest Expense

Interest expenses increased $0.2 million in 2021 over the prior year, due primarily to higher average outstanding balances under our credit agreement.

Other Income, Net

Other income, net was $0.8 million in 2021 compared to other income, net of $0.9 million in 2020. Other income, net in both years was driven by fluctuations in the Canadian currency exchange rate.

Income Tax Expense

Income tax expense was $2.5 million resulting in a 21.1% effective tax rate for 2021 compared to income tax expense of $5.7 million and a 27.3% effective tax rate for 2020. The lower effective tax rate in 2021 is due primarily to the release of a Canadian deferred taxes valuation allowance of $1.2 million and higher stock compensation benefits.

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LIQUIDITY AND CAPITAL RESOURCES

Available cash and cash equivalents were $4.2 million on December 31, 2021 compared to $28.4 million on December 31, 2020. The decrease in available cash is primarily due to the payment of the acquisition liability related to the purchase of Partsmaster for $33.0 million in May 2021.

Net cash provided by operating activities for the year ended December 31, 2021 was $5.4 million, primarily driven by reported operating earnings offset by increased working capital from increases in inventory and accounts receivable balances due to higher sales compared to the prior year.

Capital expenditures were $8.2 million for the full year 2021 compared to $1.7 million in 2020, primarily for improvements to our distribution centers and information technology.

Cash provided by financing activities was $10.7 million for the full year 2021, primarily due to the net proceeds of $11.9 million from our Revolving Credit Facility primarily driven by the final Partsmaster payment.

In 2019, our Board of Directors authorized a program in which we may repurchase up to $7.5 million of our common stock from time to time in open market transactions, privately negotiated transactions or by other methods. We did not repurchase any shares of stock in 2021 under this plan.

The Company anticipates that outstanding stock performance rights with a value of $10.7 million at December 31, 2021 will be paid out within the next twelve months prior to expiration.

Revolving Credit Facility

On December 31, 2021 we had $11.9 million in outstanding borrowings and $87.1 million of borrowing availability remaining, net of outstanding letters of credit, under our Revolving Credit Facility.

Along with certain standard terms and conditions, the Credit Agreement requires the Company to comply with certain financial covenants including an EBITDA to Fixed Charges Coverage Ratio and a Total Net Leverage Ratio. As of December 31, 2021, we were in compliance with all financial covenants. See Note 13 - Credit Agreement for further information on the Company Credit Agreement.

While we were in compliance with the financial covenants included in our Credit Agreement for the quarter ended December 31, 2021, failure to meet the covenant requirements of the Credit Agreement in future periods could lead to higher financing costs, increased restrictions, or reduce or eliminate our ability to borrow funds and could have a material adverse effect on our business, financial condition and results of operations.

We believe cash provided by operations and funds available under our Credit Agreement are sufficient to fund our operating requirements, strategic initiatives and capital improvements, although we cannot provide assurance that events beyond our control will not have a material adverse impact on our liquidity.

See “Debt Financing Commitment Letter”, included in Part I. Item 1. Business, for a description of the potential new financing arrangement that will be executed in connection with the closing of the Transactions, which is incorporated herein by reference.

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OFF-BALANCE SHEET ARRANGEMENTS

Also, as of December 31, 2021, we had contractual commitments to purchase approximately $40.4 million of product from our suppliers and contractors. The contractual commitments have increased compared to prior years primarily due to supply chain disruptions.

CRITICAL ACCOUNTING ESTIMATES

We have disclosed our significant accounting policies in Note 2 to the consolidated financial statements. The following provides information on the accounts requiring more significant estimates.

Allowance for Doubtful Accounts — We evaluate the collectability of accounts receivable based on a combination of factors. In circumstances where we are aware of a specific customer’s inability to meet its financial obligations (e.g., bankruptcy filings, substantial down-grading of credit ratings), a specific reserve for bad debts is recorded against amounts due to reduce the receivable to the amount we believe will be collected. For all other customers, we recognize reserves for bad debts based on our historical experience of bad debt write-offs as a percent of accounts receivable outstanding. If circumstances change (e.g., higher than expected defaults or an unexpected material adverse change in a major customer’s ability to meet its financial obligations), the estimates of the recoverability of amounts due to us could be revised. At December 31, 2021, our reserve was 1.7% of our gross accounts receivable outstanding. A hypothetical change of one percent to our reserve as a percent of our gross accounts receivable would have affected our annual doubtful accounts expense by approximately $0.5 million.

Inventory Reserves — Inventories consist principally of finished goods and are stated at the lower of cost (determined using the first-in-first-out method for the Lawson segment and weighted average for Partsmaster and the Bolt segment) or net realizable value. Most of our products are not exposed to the risk of obsolescence due to technology changes. However, some of our products do have a limited shelf life, and from time to time we add and remove items from our catalogs, brochures or website for marketing and other purposes.

To reduce our inventory to a lower of cost or market value, we record a reserve for slow-moving and obsolete inventory based on historical experience and monitoring of our current inventory activity. We use estimates to determine the necessity of recording these reserves based on periodic detailed analysis, using both qualitative and quantitative factors. As part of this analysis, we consider several factors including the inventories’ length of time on hand, historical sales, product shelf life, product life cycle, product category and product obsolescence. In general, depending on the product category, we reserve inventory with low turnover at higher rates than inventory with higher turnover.

At December 31, 2021, our inventory reserve was $7.7 million, equal to approximately 9.5% of our gross inventory. A hypothetical change of one percent to our reserve as a percent of total inventory would have affected our cost of goods sold by $0.8 million.

Income Taxes — Deferred tax assets or liabilities reflect temporary differences between amounts of assets and liabilities for financial and tax reporting. Such amounts are adjusted, as appropriate, to reflect changes in enacted tax rates expected to be in effect when the temporary differences reverse. Significant judgment is required in determining income tax provisions as well as deferred tax asset and liability balances, including the estimation of valuation allowances and the evaluation of uncertain tax positions.

Goodwill Impairment – Goodwill represents the cost of business acquisitions in excess of the fair value of identifiable net tangible and intangible assets acquired. Goodwill is allocated to the appropriate reporting unit as reviewed by the Company's segment managers. The Company reviews goodwill for potential impairment annually on December 1st, or when an event or other circumstances change that would more likely than not reduce the fair value of the asset below its carrying value. The first step in the multi-step process to determine if goodwill has been impaired and to what degree, is to review the relevant qualitative factors that could cause the fair value of the reporting unit to decrease below the carrying value of the reporting unit. The Company considers factors such as macroeconomic, industry and market conditions, cost factors, overall financial performance and other relevant factors that would affect the individual reporting units. If we determine that it is more likely than not that the fair value of the reporting unit is greater than the carrying value of the reporting unit, then no further impairment testing is needed. If we determine that it is more likely than not that the carrying value of the reporting unit is greater than the fair value of the reporting unit, the Company will move to the next step in the process. The Company

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will estimate the fair value of the reporting unit and compare it to the reporting unit's carrying value. If the carrying value of the reporting unit exceeds its fair value, the Company will record an impairment of goodwill equal to the amount the carrying value of the reporting unit exceeds its fair value, up to the total amount of goodwill previously recognized.

Revenue Recognition - For reporting purposes, the Company has two separate performance obligations including products and vendor managed inventory services. The allocation of product and service revenue as well as the estimation of service costs requires judgments and assumptions including the standalone selling prices, the period of time that it takes for the service obligation to be fulfilled and the amount of time spent on vendor managed inventory services during the sales process. Changes in various assumptions could increase or decrease the allocation of service revenue and related costs; however, would not materially impact total reported revenues or reported operating income.

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