Atmus Filtration Technologies Inc. Q3 FY2023 Earnings Call

Good morning. My name is Krista, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Atmus Filtration Technologies' Third Quarter 2023 Earnings Call. All lines have been placed on mute to prevent background noise. After the speakers’ remarks, there will be a question-and-answer session. I would now like to turn the conference over to Todd Chirillo, Head of Investor Relations. Todd, you may begin.

Thank you, Krista. Good morning, everyone, and welcome to the Atmus Filtration Technologies' third quarter 2023 earnings call. On the call today, we have Steph Disher, Chief Executive Officer; and Jack Kienzler, Chief Financial Officer. Certain information presented today will be forward-looking and involve risks and uncertainties that could materially affect expected results. Please refer to our slides on our website for the disclosure of the risks that could affect our results and for a reconciliation of any non-GAAP measures referred to on our call. For additional information, please see our SEC filings, and the Investor Relations page is available on our website at atmus.com. Now I'll turn the call over to Steph.

Thank you, Todd, and good morning. It's great to be here with you today to provide an update on our third quarter financial results and business highlights for Atmus. The Atmus team achieved another quarter of superior performance by focusing on our customers and delivering technology-leading Fleetguard products. I am pleased with the progress we have made to establish Atmus as an independent company. We are a purpose-driven company, and our culture is shaped by our shared values. We have a clear strategy, which is beginning to deliver results. Let me now turn to an overview of our performance in the quarter. First, I will review our global market and provide you with a summary of our solid third quarter. We continued to see strong demand in our first-fit markets in the third quarter, and we expect this strength to continue through the end of the year. In the aftermarket, as expected, we continue to see softening conditions driven by lower freight activity and continued destocking by customers. Most of our customers have now worked through destocking and we expect this impact to now moderate through the end of the year. In the China market, there continues to be a sluggish economic recovery from last year, which is likely to persist through the remainder of the year. Now let's review our third quarter results. Sales in the third quarter 2023 were $396 million, a decrease of approximately 1% from the third quarter of 2022. Lower volumes were partially offset by higher pricing and foreign exchange tailwinds. Adjusted EBITDA margin rose 40 basis points from the prior year to 18.3%. We were able to grow margins on slightly lower sales as pricing actions, along with improved commodity and freight costs drove margin growth. EBITDA has been adjusted for onetime separation costs which were $7 million in the third quarter of 2023 compared to $2 million a year ago. Adjusted earnings per share was $0.52, and adjusted free cash flow was $50 million. We have adjusted free cash flow for $2 million of onetime capital expenditures related to separation. Our performance in the third quarter has enabled us to fully repay our revolving credit facility during the quarter. Additionally, we are also raising our full year 2023 guidance. Jack will provide additional details later in the call. As I reflect on our performance, it is clear our people provide the foundation for delivering these impressive results. During the quarter, we launched our first leadership catalyst event. This event brought together our top 75 leaders to engage them in leading the Atmus way. This enabled us to engage key leaders in our purpose, culture, and strategy. The themes for the event were empowered, learning, and customer focus. The energy and excitement I felt from my engagement with this group of extraordinary leaders fuels my passion to unleash the full potential of Atmus. As I have previously highlighted, our growth strategy is focused on four pillars: grow share in first-fit in core markets, accelerate profitable growth in the aftermarket, transform our supply chain, and expand into industrial filtration markets. Our product and technology leadership form the cornerstone for growth in our core first-fit and aftermarket segments. Our iconic Fleetguard brand is recognized in the industry as being synonymous with premium products. We have a unique multichannel path to market. Our global presence provides us a diverse customer base across truck, bus, agriculture, construction, mining, and power generation end markets. With over 80% of our business being aftermarket, we are well positioned to deliver strong results through the cycle. Our filters are available in over 45,000 independent aftermarket retail outlets. We will continue to grow the retail presence of Fleetguard products with expanded partnerships and improved availability. Our delivery metrics continue to rise, providing our customers the right product at the right time. I have been impressed by our team's ability to drive superior performance in product availability. Achieving our growth and delivery targets will be fueled by the continued transformation of our supply chain. In addition to the Brazil and Mexico distribution facilities we brought online earlier this year, we expect our Dallas facility to be operational in the fourth quarter. As we progress through 2024, we expect additional facilities to be operational across multiple locations in Europe and Asia Pacific, providing us with a greater ability to enhance customer satisfaction. We also continue to evaluate a robust pipeline of opportunities aligned with our strategy for inorganic expansion into the industrial filtration markets. While we are enthusiastic to execute on this opportunity, we intend to pursue this growth through a disciplined programmatic approach. I will continue to update you on our progress. This is an exciting time for Atmus and our customers. I am confident we have the right strategy to deliver superior results, and we have a strong energized team who are demonstrating accelerated execution of our plan. Now, I will turn the call over to Jack.

Thank you, Steph, and good morning, everybody. I will be discussing our third quarter 2023 results compared to the same period last year and provide an update to our 2023 outlook. As Steph mentioned at the beginning of the call, we delivered another quarter of solid financial performance. Sales were $396 million compared to $401 million from the same period last year, a decrease of approximately 1%. The decrease in sales was driven by lower volumes of $25 million, partially offset by $17 million of pricing benefit and $3 million of foreign exchange tailwinds. Gross margin for the quarter was $103 million, an increase of $3 million compared to the third quarter of 2022. In addition to favorable pricing, we saw commodities and freight improve by $16 million. This was partially offset primarily by lower volumes and unfavorable manufacturing costs. Selling, administrative, and research expenses were $52 million, an increase of $10 million over the same period in the prior year. The increase was primarily driven by administrative costs related to our separation and variable compensation. Variable compensation is higher this year as our team continues to deliver impressive results in 2023. Equity, royalty, and interest income were $8 million, an increase of $1 million from 2022. This resulted in adjusted EBITDA of $73 million or 18.3% compared to $72 million or 17.9% in the prior period. Adjusted EBITDA for the quarter excludes $7 million of onetime stand-alone costs. These onetime costs primarily relate to the establishment of functions previously associated with Cummins, such as information technologies, distribution centers, and human resources functions. Our effective tax rate for the third quarter was 23.1%, an increase of 110 basis points from the third quarter of 2022. The increase was primarily due to a change in the mix of earnings among tax jurisdictions, partially offset by a decrease in unfavorable discrete tax items. Adjusted earnings per share was $0.52. For the same period last year, adjusted EPS was $0.62. The decrease was primarily due to interest expense incurred as a result of the debt issued at our IPO. Adjusted free cash flow was $50 million this quarter compared to $42 million in the prior year. The improvement was a result of strong working capital management, partially offset by an increase in interest expense. Now let's discuss our strong cash generation and liquidity position. Our ability to generate cash during the third quarter provided us with the opportunity to fully repay the $50 million borrowed on our revolving credit facility at the close of our IPO in late May. We now have full availability of $400 million under our credit facility. Combined with $139 million of cash, our liquidity at the end of the third quarter was $539 million. This liquidity provides us with the flexibility to deploy capital for both our organic and inorganic strategic growth initiatives. Now I will provide an update to our guidance for the full year 2023. With the combination of delivering another solid quarter and the increased visibility we have for the remainder of the year, we are raising our guidance as follows: we now expect sales to be in a range of $1.6 billion to $1.625 billion. We expect adjusted EBITDA margin in a range of 18% to 18.5%. This excludes an expected $30 million to $35 million of onetime separation costs for the full year of 2023. Moving to adjusted earnings per share. Our outlook for 2023 is now in the range of $2.20 and $2.30. With the full repayment of our revolving credit facility resulting in lower debt levels, we now expect interest expense to be approximately $25 million. Our effective cash tax rate will be in the range of 23% to 25% for the full year 2023. This range is consistent with our year-to-date average tax rate. Overall, our team continued to deliver solid results during the third quarter, and we look forward to achieving a strong full year 2023. Now we will take your questions.

Your first question comes from the line of Tami Zakaria from JPMorgan.

Great quarter. So my first question is, could you provide a little more color on the destocking headwinds you saw in on versus off-highway markets in the quarter and how you're thinking about those two for the remainder of the year?

Yes. Thanks, Tami. Let me just talk to the third quarter first and how we saw that playing out. And really, we saw this in freight indices as well. We look significantly at the cash freight index. September month was down 6%. And I think year-on-year, and I think the quarter was down 9%. So from a demand perspective, we certainly saw a softer third quarter on the on-highway sector. And then we had the added factors of continued destocking with customers. As we've said throughout the year, we've seen our customers destocking at different rates. And some of that happened in the second quarter, some in the first quarter and then more significant than we saw some in this third quarter. We think we're most of the way through that now, I would say. We see that moderating here into the fourth quarter. We still see headwinds from a demand perspective in our on-highway aftermarket. And so we'll see that come through in the fourth quarter. But from a destocking perspective, we think we're largely through it in the on-highway side. It hasn't been as significant an impact on our results, I would say, in the off-highway side again, I would describe it as very similar. We think we're most of the way through the destocking and expect that to be a much more muted impact as we head into the final quarter of the year here.

Got it. That's very helpful. And my second question is, I remember you took some pricing in July this year. Any incremental pricing actions since then or expected in the rest of the year?

No, no incremental pricing actions. We did take them in July, as you indicated. And as Jack described in our bridge of the quarter, we saw some pricing impacts offset the volume downturn.

Your next question comes from the line of Joe O'Dea from Wells Fargo.

I guess on the last topic and just in terms of some visibility to less destock headwinds is encouraging, not sure about mix of price and volume in the fourth quarter, but it looks like based on revenue midpoint, still looking at maybe something like mid-single-digit volume declines. And if that's the case, just kind of the handoff from destock maybe to more macro and you can talk about does the freight environment get a little bit more challenging or anything else just sequentially from 3Q to 4Q?

Yes. Thank you for the question, Joe. Where I would describe the key market drivers for us, and we've talked about this a fair bit but 80% of our business is aftermarket, 20% first-fit. So I might just try and talk about those two cycles generically. So if I just start with aftermarket, we certainly saw a sequential increase in September over August in terms of freight activity. So whilst we see we're kind of at the bottom of the cycle in aftermarket, we still see continued declines year-on-year, probably through sort of mid next year is how I would describe the aftermarket dynamics as we're seeing it. So still softer market conditions, demand driven in the fourth quarter. And so that's where we see we are in the cycle on the aftermarket side and it's mid-single digits, as you described, decline. As we look at the first-fit, we're in a very strong position still in first-year, certainly see that continuing through the end of the year. And we're more to the top of that cycle, I would say. And we see the two flipping throughout 2024 as I alluded to with aftermarket.

You framed that answer a lot better than I framed the question. That's all helpful. And then in terms of kind of strategic planning and as you're thinking about '24, any color on sort of where you're focusing top priorities, and in particular, around innovation spend and thinking about the verticals or the applications that you are particularly focused on as you plan out next year?

Yes. Thank you. So as I talk about our strategy, I go right back to the four pillars of our strategy and how I'm driving that focus throughout our entire company. And so I'll talk to each of those in turn, perhaps and reinforce the innovation component of your question. Firstly, we see ourselves in our first-fit market in our core business as leaders in fuel filtration technology and crankcase ventilation. We want to further enhance and grow our market share leadership in those sectors and we are investing specifically in programs and product development and innovating with our customers to secure a greater share of those markets is the first piece I would talk about as a priority investment for us. That's driving, I would say, continued R&D investment in the range of 2% to 3%, and we've got targeted capital expenditure that underpins and supports those programs for growth. So that would be the first in the core first-fit markets. If I talk more broadly, the other components of our strategy, accelerating profitable growth in the aftermarket, transforming in our supply chain, and expanding into industrial filtration markets, I think your comments on innovation relate more to the fourth element or the fourth pillar of the strategy around expanding into industrial filtration market. We already have a very strong position in terms of our media technology capability, and we want to leverage that technology capability across multiple horizontal end markets, and we are investing both capital and research and development investment to expand that innovative technology capability. So this is the largest one that I would point to there as a point of focus for us. I might build just one step further on the industrial expansion strategy. We are very, very focused on how we're going to create value by aligning or acquiring companies that we can stitch together with our core capabilities. Our technology and innovation will be fundamental to that creation of value.

Your next question comes from the line of Rob Mason from Baird.

I wanted to ask about your gross margin. It actually again exceeded my expectations. You mentioned some of the contributing factors, and I'm curious if you believe that this is a more sustainable level around 26% compared to last year's challenges at around 24%. How does sustainability look from this point forward?

It's a great question. It's one we've been talking about a lot internally here. Obviously, there's some big moving factors year-on-year as I think about gross margin price, of course, being the biggest mover year-on-year for us, which was offset by volumes. We also had some positive tailwinds from a commodities and freight perspective. We are, I would say, quite focused on improving our efficiencies and taking costs out from a gross margin perspective, and we will continue to focus on that moving forward. I think the biggest swing factor is we do expect the price to moderate certainly going forward off of what's been a quite volatile, call it, 18-month span here. But I think a big factor will be what would input costs do moving forward. We've seen those costs moderate, which has been quite helpful and we'll keep a close eye on those, all while continuing to drive efficiencies into next year in our manufacturing base.

There was one point raised in the discussion regarding your gross margin, Jack, related to unfavorable manufacturing. Was that different from the volume in the quarter?

Yes. So if I think about our normal targeted decrementals, there was a bit more inefficiency than that. As we think about the cyclical aspects that Steph was highlighting, we're trying to make sure that we don't take out too much fixed costs and not position ourselves to serve our customers in the aftermarket. And so there was some inefficiencies. Obviously, there's a lot of work going on in our supply chain as we decouple that from Cummins that highlighted a few of the warehouses that have been decoupled inside of Q3, and we're continuing down that journey. As you can imagine, that causes a lot of challenges just operationally for our team that we're continuing to progress through and again, try to focus on improvement moving forward. But that was a bit of a factor, I would say, in our gross margin performance.

Your next question comes from the line of Jerry Revich from Goldman Sachs.

I'm wondering if you could just talk about the implied fourth quarter margin guidance. You obviously performed really well year-to-date. You're guiding to roughly 50 to 100 basis points of lower margin 4Q versus 3Q. And I think the seasonality is more balanced than that, but maybe you can correct me if I'm wrong and just touch on the moving pieces, 4Q versus 3Q. Is that just make sure we're on track to updated numbers? Or are there underlying headwinds that we should be thinking about sequentially beyond seasonality?

Yes. Thanks for the question, Jerry. So I think it's really all down to volume to be perfectly frank. Normally, we have seen a bit of seasonality. But as Steph alluded to, it's more of a market dynamic that we're looking at in Q4. We do expect some softness to continue, particularly in the aftermarket as we move into that quarter. And so that in terms of our normal decrementals coupled with some of the inefficiencies I was just commenting on to Rob is really the driver in that margin degradation that we're guiding to Q3 to Q4. Nothing really significant outside of that dynamic from a volume perspective.

Thank you, Jack. As we evaluate this year's performance, with margins increasing despite declining volumes, how should we approach operating leverage in this situation? Will we still achieve mid-20s incremental margins as volumes recover? In other words, will we maintain the price cost gap we established this year?

Yes, I can start there. We expect to maintain the price cost gap. Historically, we haven't given back pricing in the aftermarket. We will continue to monitor our cost base and take actions to recover costs if they rise, although the situation may change based on our current position. Overall, we are focused on achieving incremental margins around 20%. Looking ahead to next year, volume will be a key factor, and we anticipate a couple of tailwinds. Variable compensation, as I mentioned, will be one of those tailwinds. Additionally, we hope to see some recovery in our markets in the aftermarket, which should create a favorable environment as we approach next year.

Yes. And Jerry, the only thing I would add on the back of that, I've talked a lot about the supply chain transformation, our focus on becoming more efficient, delivering cost benefits in that area. We have kicked off that program. We've started to see some small benefits, not enough to even sort of make it to the commentary of our earnings right now. But we're going to build momentum around that continue to underpin our focus on margin expansion. So that's the only other piece I would reinforce.

Your next question comes from the line of Andrew Obin from Bank of America.

This is David Ridley-Lane for Andrew Obin. A question on the sort of commodities and freight trend. What's embedded in your full year EBITDA margin guidance for that in the fourth quarter?

Yes. So sequentially versus Q3, we've seen some ups and downs as we move through the year. Obviously, overall, it's been a favorable freight and commodity backdrop for us year-on-year. We did see some sequential elevation of that as we entered into Q3. But all signs point to that, I would say, moderating. So essentially, as I alluded to, it's really a volume story as we move into Q4, not expecting any significant swings from a freight and commodity standpoint.

Got it. So it would be kind of neutral year-on-year?

Q4 to Q4 of last year, correct.

Okay. And then sort of the change in the separation CapEx. It looks like about $10 million of projects kind of pushed out to next year. Is that the right way to think about it?

Yes. So CapEx, it's really driven by timing of projects, frankly. Most of those are IT programs that we're continuing to decouple from Cummins, which all coincide with different locations coming online. And so we have seen a little bit of a delay in some of that all for good reasons, but just a little bit of pushing those projects out into 2024. The overall amounts are still in line with what we've commented on. It's just a shift as we think about 2023 versus 2024.

Got it. And should we expect any unusual inventory build as you stand up these distribution centers? I'm just thinking on kind of do you need to fill them up before you start winding the others down?

Yes, thank you, David, for the question. We are mostly through with our large inventory site in our distribution separation. Our distribution center in Kentucky holds about 50% of our inventory, and we have already completed that transition at the beginning of this year. We have also moved our operations in Mexico and Brazil. The remaining sites have a lower impact in terms of inventory. I do not anticipate any significant impact to discuss. We will ensure the transition is managed effectively so that our customers are not affected. I expect this to be handled within a quarter, and I don’t foresee it being a topic for these calls.

We have no further questions in our queue at this time. I will turn the call back over to Todd for closing remarks.

Thank you. That concludes our teleconference for today. Thank you all for participating and for your continued interest. As always, the Investor Relations team will be available for your questions after the call. Have a great day.

This concludes today's conference call. Thank you for your participation, and you may now disconnect.