Apogee Enterprises, Inc. Q2 FY2023 Earnings Call

Good day and thank you for standing by. Welcome to the Apogee Enterprises Fiscal 2023 Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today’s conference call is being recorded. I would now like to turn the conference over to your speaker for today, Jeff Huebschen. Please go ahead, sir.

Thank you, Jeff, and thanks, everyone, for joining us today. This was another strong quarter for Apogee. Execution of our strategy is clearly driving improved results with both revenue and earnings per share reaching new quarterly records. I'm incredibly proud of our team execution this quarter and the progress they've delivered to date. This morning, I'll offer insights into how our strategy drove our record results this quarter, provide some commentary on our end markets and review our outlook for the rest of the year. Then I'll turn it over to Mark for more details on the quarter and our guidance. It's now been about a year since we began to execute our new enterprise strategy. As a reminder, our strategic framework is shown on Page 4 of today's presentation. Last year, we began to take actions to address each of the three pillars. We announced a restructuring to align and simplify our portfolio, bring more clarity to our go-to-market approach and improve our cost structure. These efforts were primarily focused on Framing systems and Glass, the segments with the most opportunity to improve their margin performance. We also re-launched our Lean and Continuous Improvement program. This is the foundation of our new operating model. Our initial emphasis was in the Glass segment, and we are expanding it to other parts of the business. Our focus in these early days is on the production floor with an approach of win the hour, win the shift, win the day. Our goal is to drive near-term improvements using short-cycle feedback to make course corrections and drive repeatable results. We work to build control plans to support a new baseline and then start the improvement efforts all over again. We've made tremendous progress over the past year, which is especially evident in the Glass segment's results. We also launched several important initiatives to strengthen core processes and systems. We're building center-led functional expertise in human resources, procurement, and finance. This will enable more efficient operations with more capabilities and greater scalability, which will also support future M&A work. Finally, we have added talent in key roles across the organization and brought new energy and content to our talent development programs. The results of our efforts are evident in our performance this quarter and further strengthen our foundation for future quarters. The highlights from Q2 are shown on Page 5 in the presentation. We had record revenue with 14% growth in the quarter. Adjusted operating margin increased more than 300 basis points and adjusted earnings per share doubled compared to last year, coming in at a record $1.06 per share. In addition to the progress on our strategy, our team has done a terrific job managing through cost inflation over the past several quarters, demonstrating stronger operational muscle across the Company. We've improved our discipline around cost management. We've worked with our suppliers and customers to minimize the impact of inflation and supply chain disruptions, and we've strengthened our approach to pricing. We still have work ahead of us to reach the financial goals we set at our Investor Day, but a year into our new strategy, we are proud of our progress and we're more confident than ever in the path ahead of us. We are controlling what we can control with price, productivity and cost management while setting the stage for meaningful shifts in the coming years to further support our goal of being an economic leader. Now as we've spoken with investors over the past few months, the state of our end markets is top of mind for many of you. So I would like to provide an update on what we are seeing. Of course, we're closely monitoring inflation, rising interest rates and overall economic conditions to understand how they might impact demand in our end markets. At this point, however, most indicators for non-residential construction remain favorable. The Architectural Billing Index has been positive for 18 consecutive months. New construction starts have been strong, and the federal government has passed several bills that provide significant support for infrastructure and construction spending. These indicators suggest that our industry is building a strong pipeline of new projects. Nearly every industry forecast for non-residential construction calls for continued growth through calendar 2022 and calendar 2023. This corresponds to what we are seeing in our own business. We continue to see solid quoting and bidding activity. In this quarter, we won several new projects, especially in the Services segment. Looking at all the data, we have a positive view of our markets well into next year. More importantly, our strategy is better positioning the Company to outperform regardless of the state of our end markets. We're diversifying our business mix, shifting to align with changes in the market. We've won new transportation and infrastructure-related projects, expanding our backlog in these and other non-office segments like health care and education. And we're aligning our product and service offerings to take advantage of continued demand for premium office space and more energy-efficient buildings. Across our business, we're focused on those parts of the market where we have differentiated offerings that provide the most value for customers. Over time, this will build a more resilient business model with more sustainable profitability. We have meaningful organic growth opportunities in several of our businesses. These include investments to scale and grow the services segment, capacity investments in Large-Scale Optical, which will enable more diversification of their revenues and geographic expansion opportunities in both Framing Systems and Architectural Services. In addition, we are working to strengthen our M&A capabilities. We're building a pipeline of potential acquisitions to accelerate our strategy, and we're developing a stronger approach to integration to ensure that we capture meaningful cost synergies in future deals. With this set of opportunities, we're confident that we can deliver on our goal of growing faster than the overall non-residential construction market. Let me wrap up with some comments about our outlook. Generally, we see the trends from the first half of the year continuing into the second half. This has led us to increase our earnings guidance for the full year. We expect continued top line growth, primarily from Framing Systems, and we anticipate continued year-over-year margin gains led by Framing Systems and Architectural Glass. The biggest variables will continue to be the overall impact of inflation and how we manage costs and pricing. But we have demonstrated stronger operational execution around pricing, cost management, and productivity. Stepping back and looking beyond this year, we are driving sustainable improvements in our business. Our priorities for the year have not changed and are listed on Page 6 in our presentation. Making progress in these areas will enable profitable growth in this and in future years. We're only beginning to scratch the surface of the productivity improvements from our Lean program. We are increasing our mix of differentiated products and services, which will be a driver in fiscal '24 and fiscal '25. We're investing to develop talent across the Company, and we're driving further progress on our transformation initiatives. Through this work, I'm increasingly confident that we will achieve or exceed the financial goals we have set for ourselves. With that, let me turn the call over to Mark for more details on the quarter and our guidance.

Thank you, Ty, and good morning, everyone. I'm happy to be joining you this morning. This was another strong quarter for Apogee with continued positive momentum in our business. Let me provide some details, starting with consolidated results on Page 7 of our presentation. Second quarter revenue grew 14% to a record $372 million. This was led by double-digit growth in both Framing Systems and Architectural Services. Large-Scale Optical also grew by 7%. Operating income increased to $32 million driven primarily by pricing and productivity gains that more than offset inflation. Operating margins improved to 8.6%, and this was 320 basis points higher than the adjusted margin of 5.4% last year. And notably, this was our third consecutive quarter with adjusted operating margin greater than 8%. Interest expense increased by $600,000, primarily due to a higher debt balance. Our GAAP earnings and EPS included a $13.7 million deduction on the income tax line for a worthless stock loss. Absent this deduction, our tax rate in the quarter would have been 21.6%. This was slightly lower than our long-term rate of 24.5% due to several discrete tax items. Finally, our diluted share count was 22.2 million, down from 25.1 million a year ago due to our share repurchases over the past year. Putting it all together, adjusted earnings grew to $1.06 per diluted share. This was double last year's adjusted earnings and a new record for Apogee. Let's move on to the segment results on Slide 8. Starting with Architectural Framing Systems, Framing had another exceptionally strong quarter. Revenue grew 26%. This was primarily driven by pricing actions taken to offset inflation. Operating income was $2.5 million, nearly double adjusted operating income in last year's second quarter. Last quarter, we said that Framing profits benefited from $4 million due to volatility in aluminum pricing and the timing of inventory flows. That benefit continued into this quarter, but at a much lower amount of about $1 million as our average cost of aluminum increased compared to the first quarter. Nonetheless, Second quarter margin came in at 11.9%. This is near the top end of our target margin range for Framing Systems of 9% to 12%. The improved margins were driven by pricing to offset inflation, improved mix, and the benefits from last year's restructuring. Turning to the Architectural Services segment. Revenues grew 11% to $107 million. This was driven by higher volume as we executed projects in our backlog. Operating margins came in at 5.1%. As expected, this was a nice sequential improvement from the first quarter, but below our 7.4% in last year's second quarter. The year-over-year change was primarily due to investments we're making to enable future scale and growth in services. Also, the integration of Sotawall continued to suppress overall segment margins. Over time, we expect this transition will drive operational improvements and stronger profitability for the combined operations. Looking at orders and backlog, Services had a strong quarter. Backlog increased 15% to $785 million. We had several new project awards, including notable wins in transportation and health care segments. Our sales pipeline remains healthy, quoting activity is strong, and we're optimistic about the opportunities ahead of us. As a reminder, services, orders, and backlog are typically a small number of large orders. So backlog amount can vary significantly from one quarter to the next. In Architectural Glass, the team continued to make impressive progress in its strategic shift. Like the past few quarters, revenue was down compared to the prior year. This reflects the closure of the Velocity business and our strategic shift away from some lower margin sales. Operating margin continued to trend higher, reaching 8.3%. Adjusted operating margins have now improved sequentially each quarter since we announced our new strategy. Margins benefited from pricing that more than offset inflation, productivity gains from our Lean program, and cost savings from the restructuring we completed last year. Finally, LSO continues to deliver steady performance gains. Revenue grew 7%, primarily driven by higher volume and the operating margin was 23.8%, up 50 basis points from a year ago. Let's turn to the cash flow and the balance sheet on Page 9. In the second quarter, we had positive cash flow from operations of $28 million, rebounding nicely from the first quarter. Year-to-date, our cash flow remains negative and below last year's level. This is primarily due to increased working capital to support our growth and the impact of inflation on working capital. We also had higher-than-normal tax payment in the first half. We expect cash flow will continue to improve as we move through the year. Year-to-date capital spend was $9 million; this will ramp up the rest of the year as we put capital to work on high-return projects and evaluate opportunities to further invest in our business. We now expect full year CapEx to be approximately $40 million. During the quarter, we reduced net debt by $17 million. We also refinanced our primary credit facility during the quarter. This extended the maturity out to 2027, increased our revolver capacity, and lowered our borrowing costs. Let me wrap up by discussing our outlook, which is found on Page 10. Based on our year-to-date results and increased confidence in our outlook, we are raising full year earnings guidance to a range of $3.75 to $4.05 per share. At the midpoint, that is a 57% growth over last year's adjusted EPS. For the year, we expect 8% to 10% revenue growth. This will primarily be driven by Framing Systems, and as a reminder, framing normally has lower revenue in the fourth quarter due to seasonality, and we expect that same trend to continue this year. In the other three segments, we anticipate second half revenue to be similar to that of the first half. We expect to drive continued year-over-year margin expansion primarily in Framing Systems and Glass. We will continue to benefit from the productivity and cost reductions that we've seen. We also expect continued volatility in aluminum, glass, and other commodities. This volatility does make it more challenging to forecast our business, particularly in the Framing segment. Interest expense in the third and fourth quarter should be similar to that of the second quarter, and we continue to expect long-term average tax rate of approximately 24.5%. With that, I'll turn it back over to Ty for some concluding remarks.

Thanks Mark. Our results this quarter continue to demonstrate how we are executing our strategy. We're improving operational execution through sustainable productivity improvements, effective cost and price management, and navigating supply chain challenges. Our team continues to do a terrific job managing through these challenges, staying focused on serving our customers and driving the execution of our strategy. Our bidding and award activity is also positioning us for a stronger mix shift in the years ahead, which we also hope to accelerate with M&A work as well. Let me close by congratulating the entire Apogee team on our record results this quarter. And I know they're already working to continue our momentum through the rest of our fiscal year. With that, we are ready to take your questions.

I'm sorry. I got cut off. So the guidance increase, is that more a function of better-than-expected Q2 or that the second half of the year is now looking better than perhaps three months ago?

Yes. Chris, this is Ty. As you look at our performance in Q2, I mean, that was a very strong performance. So looking at how that and now how the first half has performed, we factored that into our guidance for the rest of the year. And you can do the math, I think, in looking at the second half. We do still see upside opportunity in that second half. That's reflected in our range. But we also know the questions and concerns around the broader economy. And so, we're trying to factor that in as well that we could see some softness, although like I said in my opening comments, we're just not seeing that right now in our order run rate and especially in our bidding activity.

Got it. That makes sense. The 14% growth in Q2, can you provide some insight into what volume growth looked like? Was there any volume growth?

Sure, Chris. This is Mark. We did see nominal volume growth although it was mixed across our segments, and mix also played a part of it, but it was primarily driven by really nice pricing, specifically that pricing to offset the inflationary cost that we were seeing.

Yes. If you look at the areas where we experienced negative volume, it was in the segments we anticipated and aimed to see that decline. Glass continued to show negative volume with flat revenue. This was due to our decision to step away from some lower-margin offerings that were being sold, and they still had the last quarter of Velocity history. In Framing, particularly in our window and wall business unit, we recognized an opportunity to significantly improve margins. Consequently, they intentionally stopped quoting on various project types and product offerings that we assessed, and concluded that even if we achieved the best margins, it wouldn't lead to the profitability we desired. This decision resulted in some negative volume so far this year. However, looking at the rest of the business, the overall volume has been positive, albeit with low single-digit growth.

Got it. No, that's interesting. And then last one for me. Just the Framing backlog, so it's down a little bit, but I just was trying to get your thoughts here from what you just said, there are some projects that may be you're not putting that you would have. And then the other piece of that question is before Sotawall moved to services, you used to talk roughly half Framing was quick return, have longer lead time. What does that ratio look like now?

Well, so let me answer the first question in terms of that backlog in Framing. So where we saw a drop in backlog and Framing that was primarily driven by our storefront and finishing solutions. And that is a shorter cycle business, and frankly, with some of the demand that they have seen as well as managing through some of the continued supply chain and labor conditions. They actually were building a backlog and pushing out some of their lead times, which is something that they do not want to see. So we actually saw that as good news. The drop in Framing was driven by storefront and finishing, and that was reflective of them starting to catch up on some of those orders that we're starting to push out a number of their lead times.

To provide some context, Chris, storefront still accounts for around 60% of our overall AFS business, while windows and walls make up the remaining 40%. Therefore, the business with shorter lead times would be more significantly affected by the lack of backlog.

Ty and Mark, it's Aaron Spychalla on for Eric. First, maybe on Services, nice job on the backlog growth there. Can you just talk about how the margins are on that new backlog? And any update on how you're thinking about the right split between growth for that business while trying to maintain the profitability targets?

Yes, that's a great question, Aaron. To remind you, we transitioned Sotawall from Framing to Services. This was a previously underperforming business. Both the Harmon branded project backlog and the Sotawall backlog are currently executing work that was primarily secured during the low-demand period at the bottom of the pandemic. At that time, there was intense competition with pressure on margins. They are currently addressing the situation in this fiscal year, with some challenges expected to continue into the next fiscal year. We also identified an opportunity to enhance operational execution within Sotawall by implementing the Architectural Services operating system, which is currently being integrated into that business. We've seen a sequential improvement in margins, and we anticipate ongoing margin improvement as they tackle the challenges from the former Sotawall business. Looking ahead, we are observing strong demand and increased bidding activity, contributing to our backlog. While it is too early to provide guidance, we believe that as our backlog grows, we will see margin improvements from the current levels. We expect that as we move into fiscal '24 and '25, this will benefit us, especially in '25 and '26 when the project work is fully executed.

All right. And then maybe second for me, on the M&A. I know actively managing the portfolio is part of the three pillars that you're focusing on, and you talked about the pipeline building there. Can you just maybe give an update there on the process and the opportunity, valuations, any areas that you're kind of looking to fill in?

Yes. I'll give you just kind of at a high level, Aaron. So, we've invested in that year-to-date. We've added resources in terms of building our internal capabilities and working with third parties to support that work. Our goal is to be strategic here. So, we're strategically looking for the right fit in terms of product or services that complements what we have today in our portfolio and maybe moves us out maybe one adjacency from the market segments and applications that we're serving today. So that work right now is really focused on building that pipeline, identifying those targets. That's not to say we will be opportunistic as things come to market that we think makes sense. We will definitely jump in and look at those. But I would say there's a bigger emphasis on being strategic, which may mean we see this process still play out for another year or so. When we look at the types of targets, we are looking for businesses that fit strategically that are accretive to our long-term financial goals and that fit also should allow us to drive meaningful cost synergies in that first year. And the fact that we're going to take an aggressive integration approach on those new acquisitions will help drive those cost synergies, and that's a big shift from how we manage acquisitions in the past.

Just on Framing, Ty, I mean, it looks like aluminum price as some of the other input cost components of the business has pulled back at least some. Are you seeing that reset in terms of quoted prices in the market now? Or are things still pretty strong?

Well, I think there's two things to remember there. So one, if you look at our Q1, we did note that Framing saw a benefit on cost flow that helped boost those margins. So, there was about roughly a $4 million benefit on lower cost aluminum that was working its way through our system, while we had already moved to adjust price to reflect the higher aluminum costs. There was still a slight benefit in Q2, but it was approximately maybe a $1 million. So, we saw that as good news, right, that they worked through that, and we expected margins to come down, but they still performed double-digit margin for the quarter. In terms of market pricing, as you know, it's a competitive market. So we need to stay on top of that. We want to grow our business, and particularly on storefront and finishing solutions business. So where we need to, we will make pricing adjustments. We do anticipate some of that will start to show maybe in our Q4. And that's why as we looked at our guidance and looking at how we performed in the second half, while they're working through that, they're going to be focused on working to maintain margins in that long-term goal of 9% to 12%, and I think they're on track. They're probably going to be in the middle of that as they close out the year. But while we've seen some adjustments on pricing, we haven't seen a wholesale drop across the market with respect to pricing. But that can change, and we're staying on top of it.

Yes. Understood. And then, Ty, on the Glass business, it looks like some of the margin improvement also comes from that high Velocity business shutdown. Can you help us understand where sort of the core business stands in terms of the initiatives you put in place to drive better profitability?

Brent, this is Mark. Sure. I can give a little bit of color as it relates to what we're doing in our core business. We are really trying to drive as our strategic plan had highlighted, we're trying to drive to higher priced, higher complex type products, not projects and it's really core to the overall Glass business. They have products that are a little bit more proprietary in that space and there are plenty of opportunities for us to explore in that area. So that's the primary emphasis as it relates to that. I also want to point out the margin improvement in the quarter was also highly contributed or I should say, productivity contributed highly to the quarterly results. So not only are we moving from a mix perspective, but we've also taken cost out of the business, and that includes the costs associated with the Velocity business.

Yes. I'll just reinforce what Brent said. Lean has been a big driver on the margin expansion. Obviously, we've captured the restructuring benefits, that's showing up but then productivity on the production floor is showing up in Lean. And as Mark alluded to, that mix shift, we're seeing that showing up in the bid and award activity and I think that's a tailwind for that business as we go into fiscal '24 because a lot of that isn't going to flow through the plant and revenue rec until the very end of this year, and it's more of a '24-story that gives additional tailwinds for that business.

Okay. Regarding the Services business, you mentioned expecting sequential margin improvements throughout the fiscal year, which is typical seasonally. As some of the costs for growth initiatives take effect, should we anticipate year-on-year margin improvement as we enter the second half?

As we look at that, we have set a goal for the Investor Day to be in the seven to nine range. In Q4, if we consider Q4 on its own, we expect them to reach the lower end of that range. However, for the full year, it appears they will be outside of that range. This is due to the integration costs associated with Sotawall and the execution challenges on large projects that Sotawall is currently managing from its backlog. Additionally, we are investing a few million dollars to support the scaling and growth of that business, and this investment will continue throughout the rest of the year and likely into early next year as well.

Could you just talk about the award mix you're seeing? I believe you called out you've won some new transportation and infrastructure-related projects, if you could give any additional detail on those projects won during the quarter? And maybe how much runway do you have there to further diversify the business?

Yes, Julio, we have been focused on this effort. Many have questions about the future of office space, and I want to emphasize that we still see strong demand for premium office space, which remains a key driver in our backlog. However, when we looked at our backlog growth this quarter, a significant portion came from non-office projects. While we did secure some office projects, the biggest increases were in the transportation sector, including airport terminals and new construction, as well as additional wins in health care and education. Overall, non-office projects comprised most of our backlog, reducing the percentage of office space included. We view this as a positive development, as it's encouraging to see a diversification in our project mix. We expect favorable conditions in transportation, government, health care, and education due to recent federal funding. Additionally, the funding and tax incentives for energy efficiency look promising for our Glass and Services businesses, as they involve more complex and higher-value products related to curtain wall systems. These factors contribute positively to the backlog we are building.

Got it. I appreciate the commentary there. And I guess on the Framing segment, specifically on the storefront and finishing side. You mentioned it's a shorter lead time business and the lead time shortening and that kind of drove the framing backlog number. I guess to clarify, the lead times is normalizing, you view as kind of a good sign and more of a normalization off a high base and not necessarily as an indicator of any slowing activity there?

Correct. We still see very solid order volume on that. Again, across all the businesses, the trend line is up. It is choppy month-to-month, but the trend line continues to be up. They were seeing early demand in Q1 and as we went into Q2 and then just working through some supply chain issues, and this was happening across that market in that space, lead times started to push out again. And so, they've been working to get those lead times back under control, and that drove a reduction in their backlog. And I think we expect that they're going to continue to improve on those lead times this quarter as well, because that short lead time, the service component is a very strong part of their value proposition in the marketplace. So they're very focused on driving improvements there. Well, thank you again for everyone joining us today. And I just want to reiterate and thank our team again for really strong execution in this quarter. But more importantly, as we alluded to earlier in the call and through this Q&A, we see really strong momentum in driving our long-term strategy of really building a strong business, being the economic leader in driving those margin improvements and setting ourselves up to outperform the market regardless of that outlook, both from a revenue and an income basis as we go forward. So thanks, everyone, for joining us today, and we'll talk to you again in a few months.

Thank you, everyone, for joining. Have a good rest of your day. Everyone may disconnect.