Atmus Filtration Technologies Inc. Q3 FY2024 Earnings Call

Thank you for waiting. My name is Kayla, and I will be your conference operator today. I would like to welcome everyone to the Atmus Filtration Technologies Third Quarter 2024 Earnings Call. I will now turn the call over to Todd Chirillo, Executive Director of Investor Relations. You may begin.

Thank you, Kayla. Good morning, everyone, and welcome to the Atmus Filtration Technologies third quarter 2024 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 pages available on our website at atmus.com. Now I'll turn the call over to Steph.

Thank you, Todd, and good morning, everyone. Our team delivered another quarter of solid performance despite continued softness in the aftermarket and weakening first-fit markets. The dedication and hard work of our global employees consistently focused on delivering technology-leading products for our customers allows us to deliver these results even in challenging market conditions. On the call today, I will provide an update about our performance during the quarter, share an updated outlook for the year and highlight progress executing our growth strategy. Jack will then provide additional details regarding our financial performance. Let me begin with some comments on our capital allocation priorities. We are focused on growth in both our core business and expansion into industrial filtration, and we'll continue to allocate our capital to fuel this growth. Additionally, share repurchases and quarterly dividends are components of our balanced approach to capital allocation. We continue to assess opportunities for share repurchases with a minimum annualized target of offsetting dilution from long-term incentive compensation. In the third quarter, we repurchased $10 million of shares as part of the $150 million program we announced last quarter. We also paid a cash dividend of $0.05 per share. Now let's turn to third quarter financial results and our updated outlook for 2024. Sales were $404 million compared to $396 million during the same period last year, an increase of approximately 2%. Adjusted EBITDA in the third quarter was $79 million or 19.6% compared to $73 million or 18.3% in the prior period. Adjusted EBITDA for the quarter excludes $9 million of one-time stand-alone costs and $7 million for the same period last year. Adjusted earnings per share was $0.61 in the third quarter of 2024, and adjusted free cash flow was $65 million. Adjusted free cash flow excludes $10 million of one-time separation-related items. We have made substantial progress moving from transition service agreements with Cummins to operating as a fully stand-alone company. We estimate to have completed 80% of the transition and expect to be 90% complete by the end of this year. This transition is a significant milestone for our company and will enable us to focus our energy on growth. Now let me provide some insight into our global markets. Beginning with the aftermarket. We continue to see soft freight activity, a trend we have seen throughout the year. Our continued outperformance in share gains coupled with tailwinds from prior year destocking activity allowed us to more than offset market weakness. Demand in the U.S. heavy-duty first-fit market softened in line with our expectations, while U.S. medium-duty demand remains resilient. The Indian market softened and China did not show any signs of rebounding. Turning to our outlook. I will start with the aftermarket. As we have progressed through the year, we have become more confident in our opportunities to grow revenue despite challenging market conditions. We are expecting our overall global aftermarket revenue to be up approximately 2% to 4% compared to last year. As we have seen throughout the year, we are still experiencing year-over-year declines in freight activity and have not yet seen a positive inflection. We expect our global markets for the aftermarket to be down approximately 2% to 3%, reflecting soft freight activity, along with continued weakness in the off-highway, construction, mining and agriculture markets. Offsetting market conditions, our outperformance is expected to continue as we execute our growth strategy and expand our new business wins. We expect our market outperformance to contribute 2% to aftermarket revenue growth. Adding an additional 2% of revenue growth will be the benefit related to destocking year-over-year. You may recall our customers were destocking from Q2 through Q4 in 2023 as supply chains normalized. This activity is not expected to repeat. Pricing is also expected to provide an additional 1.5% year-over-year increase. Let's now turn to our first-fit markets. In the U.S., our view of the heavy-duty market remains unchanged, with an expectation of down 7% to 12% for the full year. We anticipate further softening in the fourth quarter in line with industry expectations. Our expectation of the medium-duty market remains unchanged at flat to up 5%. Demand for trucks in India is expected to continue softening, and we anticipate weak market conditions to continue in China. Overall, our continuing outperformance gives us the confidence to raise our revenue guidance to now be in a range about 1% to 3% compared to the prior year with global sales in an expected range of $1.65 billion to $1.675 billion. We have delivered strong operational performance throughout the year, and we are raising our adjusted EBITDA margin to be in an expected range of 19.25% to 19.75%. We are also raising our adjusted EPS outlook and now expect to be in a range of $2.35 to $2.50. Now I would like to discuss our plans for growth. During the third quarter, we brought our global enterprise leaders together to focus on our long-term strategic vision for unlocking both opportunities as a fully independent company. Our team has been executing on our growth strategy. As a reminder, there are four pillars to our growth strategy. Our first pillar is to grow share in first-fit. We are realigning our organization and adding resources to our account management teams to focus on first-fit growth. This has resulted in increased bid rates for new business opportunities and will allow us to further capture market share. We are leaders in fuel filtration and crankcase ventilation and continue to win with the winners as we partner with industry-leading OEMs. The reorientation of our organization for growth, coupled with technology leadership, provides us with the continued opportunity to expand with new and existing OEMs around the world. Our second pillar is focused on accelerating profitable growth in the aftermarket. Our outperformance through challenging market conditions this year demonstrates our ability to grow share in the aftermarket. We are expanding and adding aftermarket partnerships for continued growth, allowing us to deliver Fleetguard products when and where our customers need them. We have also implemented advanced digital analytic tools for our sales team to identify cross-sell and upsell opportunities and generate new customer leads. This provides a win-win for both Atmus and our dealers to increase sales of Fleetguard products. Our third pillar is focused on transforming our supply chain. We are continuing to transition our supply chain to our own dedicated network. This quarter, we opened a new warehouse facility in the United Kingdom, increasing the volume being distributed through dedicated Atmus facilities to approximately 85%. During the fourth quarter, we anticipate transitioning our remaining European facility to the Atmus network, at which point substantially all our volume will go through our own distribution network. Controlling our distribution network allows us to improve on-shelf availability and provide our customers with Fleetguard products when and where our customers need them. Our distribution network transformation is delivering results as we achieved all-time high delivery and availability metrics during the quarter. I am proud of the Atmus team delivering a significant accomplishment while simultaneously transforming our distribution network. Turning to supply chain efficiency. Our adjusted EBITDA performance continues to demonstrate the results of our supply chain transformation and the cost reduction efforts we are driving through the organization. At the midpoint of our guidance, we expect to expand adjusted EBITDA margin by 390 basis points since the end of 2022, another significant achievement by the Atmus team. Our fourth pillar is to expand into industrial filtration markets. Our strategy remains focused on growth into industrial filtration, primarily through inorganic acquisitions. As a reminder, we are broadly looking at three verticals: industrial air, industrial liquids excluding water and industrial water. We continue to take a disciplined approach as we review a robust pipeline of opportunities for inorganic expansion in these three verticals. We have also been focusing on opportunities to expand in industrial filtration organically. We recently launched multiple products to grow organically. While we are in the early stages of organic industrial product growth, this demonstrates another opportunity for continued growth for Atmus. Now, Jack will discuss our financial results in more detail.

Thank you, Steph, and good morning, everyone. We delivered another quarter of solid financial performance. Sales were $404 million compared to $396 million during the same period last year, an increase of approximately 2%. The increase in sales was primarily driven by higher volumes of 2% and pricing of approximately 1%, partially offset by foreign exchange of 1%. We continue to outperform in many of our global markets. Gross margin for the third quarter was $111 million, an increase of $8 million compared to the third quarter of 2023. In addition to volumes and pricing, we also benefited from lower commodity costs, partially offset by foreign exchange, one-time separation costs and higher manufacturing costs. Selling, administrative and research expenses for the third quarter were $56 million, an increase of $4 million over the same period in the prior year. The increase was primarily driven by higher people-related and consulting costs as we continue to stand up our own team and separate our functions from Cummins, partially offset by lower variable compensation costs. Joint venture income was $8 million in the third quarter, flat to our 2023 performance. This resulted in adjusted EBITDA in the third quarter of $79 million, or 19.6%, compared to $73 million, or 18.3%, in the prior period. Adjusted EBITDA for the quarter excludes $9 million of one-time stand-alone costs compared to $7 million for the same period last year. One-time costs are higher than originally anticipated. We incurred additional costs as we completed the separation of our Mexican production facilities and incurred additional information technology costs due to unanticipated delays as we stand up independent systems. We now believe these costs will be in the range of $20 million to $25 million in 2024 and be substantially complete by the end of this year. Adjusted earnings per share were $0.61 in the third quarter of 2024 compared to $0.52 last year. Adjusted free cash flow was $65 million this quarter compared to $50 million in the prior year. Free cash flow has been adjusted by $5 million for capital expenditures related to our separation from Cummins compared to $2 million in the previous year. We expect one-time capital expenditures to be in the range of $13 million to $18 million in 2024 and be substantially complete by the end of this year. We are also adjusting free cash flow for the working capital inefficiencies associated with the move from intercompany settlement terms with Cummins to stand-alone practices. In the third quarter, the adjustment was $5 million. We expect these inefficiencies to be complete this year and total approximately $35 million, unchanged from our previous outlook. The effective tax rate for the third quarter of 2024 was 18.4% compared to 23.1% in 2023. The decrease was driven by a change in the mix of earnings between U.S. and foreign operations and favorable discrete items, which occurred during the quarter. Now let's turn to our balance sheet and the operational flexibility it provides us to execute our growth and capital allocation strategy. We ended the quarter with $197 million of cash on hand, combined with the full availability of our $400 million revolving credit facility, giving us $597 million of available liquidity. Our cash position and continuing strong performance during the third quarter of 2024 has resulted in a net debt to adjusted EBITDA ratio of 1.2x for the trailing 12 months ended September 30. In closing, I want to thank our global team for continuing to execute on our growth strategy and deliver value to our customers. Now we will take your questions.

Our first question comes from Jerry Revich with Goldman Sachs.

Steph, Jack, I am wondering if you could just talk about the puts and takes around expectations for the fourth quarter. You had really excellent margin performance in the third quarter. The revision looks like generally by the extent of the beat, and it looks like you folks continued to outperform your operating efficiency targets. So are there any discrete items impacting the outlook for the fourth quarter, or just given the choppy environment, we want to make sure we have room to execute?

Thank you, Jerry, for your question. I'll begin by discussing the market impact and our expectations for revenue in the fourth quarter, and then I'll have Jack explain the sequential margin bridge. From a market standpoint, we anticipate revenue to remain relatively stable from Q3 to Q4. I want to highlight two key factors that may exert continued downward pressure: fewer working days, which significantly affect us since 80% of our business comes from aftermarket sales, and a expected decline in heavy-duty trucks that will impact our first-fit business. This will likely result in lower volume, which will in turn affect margins. Now, I’ll let Jack address some of the impacts we experienced in the third quarter and how they relate to margins in the fourth quarter.

Thanks, Steph. And thanks, Jerry, for the question. So the first piece, I would say, Jerry, as we think about the sequential walk from kind of Q3 levels into our Q4 outlook, it is the impact from the volumes that Steph just talked about with lower volumes, top line, but also lower production hours. We will see a bit of a drag from a profitability standpoint from that. The second piece is from a variable compensation standpoint, based on our outperformance over the first half of the year, we had been accruing at a higher rate. And as the markets have softened here and we haven't seen that recovery in the aftermarket, our outlook has come down a little bit. Therefore, we had a $4 million benefit in Q3 associated with variable compensation truing that up. And so obviously, we would not expect that to repeat into the fourth quarter, and I think that helps bridge a little bit of sequential margins.

It does. I appreciate the color and strong performance even when adjusting for that. And as we think about the puts and takes around 2025 margin profile, can you just help us through where you have visibility so far, touch on, if you can, the expectations for pricing, opportunity for material cost reductions and any other moving pieces. Obviously, the end markets are going to do what they're going to do and we'll firm up those views in three months. But I'm wondering, based on developments and visibility that you have now, what are some of the puts and takes around margin profile '25 versus '24?

Yes. So thanks for the question, Jerry. Now I want to try to give you some color on how we feel we're going to end 2024 and our confidence in being able to sustain that. I guess without straying into forward guidance on 2025, which I'm not in a position to give at this stage. But a couple of things. Let me just talk broadly about the market, about how we see that playing out as that may impact some pieces of our margin profile. And then I'll talk about how confident I feel in the sustainability of the expansion of margins that we've been able to achieve here in this year and also prior to that. And so starting with the outlook of the market as we head into the fourth quarter and wrap up 2024, we will be in the unusual situation of being at the bottom of the cycle for both our first-fit and aftermarket markets. It's not that common that both of them are at the bottom of the cycle at the same time. As you know, we've been in a longer-term period down in the cycle on the aftermarket side. So as we look to 2025, industry view and views from our customers, we do expect first-fit to continue to be at lower levels through the first half with some discussion around possible prebuy at the back of 2025 driving some improvement in first-fit in the second half. The aftermarket, we've been waiting and waiting for a point of inflection. I think we originally thought it might be July, and that seems to be dragging out. We certainly do expect some turn of positive market conditions in the aftermarket, but it's very difficult to call at this stage. Obviously, greater performance in the end markets of aftermarket really drives better margin upside for us. So that's something to be mindful of as we turn to 2025. Those are just some broad comments about the market. I think as I turn to just our margin story, we've done a really terrific job as a team of expanding margins throughout 2024 and also 2023. I feel confident that this will be sustainable as we head into 2025 and we'll be able to give a further update on our specific guidance for 2025 in a future call.

And your next question comes from the line of Rob Mason with Baird.

Maybe I'll follow up there, Steph, just on '25. You somewhat framed it, but it sounds like typically, the first quarter is one of your stronger seasonal growth quarters moving from the fourth to the first. However, we are observing this first-fit downturn in real time. I'm just curious if you have enough visibility at this point to have a sense of how that might look sequentially, or how we should generally consider seasonality in this first quarter compared to historical trends?

Okay. Rob, good to talk to you. Look, I don't know that I can give a lot more color than what I just said. I think we would expect to see the same seasonal impacts that you've seen throughout the quarter this year. We did see some differences obviously, where in this back half, we've seen positive tailwinds from the prior year destocking, which will no longer take place. Broadly, I'd expect you to still see the seasonal implications, but this downward pressure on the first-fit market will be something that impacts our first half, no doubt. So I wouldn't give much more than that color, I would say. The only other thing probably to point out in terms of what drives that sort of seasonal activity heavily for us, I think I just referenced it as it relates to our Q4 expectations for 2024, is just selling days. It really drives a lot of the quarterly movement for us given our high exposure to aftermarket.

Yes, very good. As a follow-up, the one-time costs you mentioned came in higher. Do you have a breakdown of how those are divided between cost of goods sold and SG&A?

Absolutely. I'll ask Jack to respond to that one, Rob.

Yes. So as I think about the $9 million for the third quarter, $5 million is up in cost of sales and $4 million is in SG&A. And maybe I’ll just expand a little bit. So as a reminder, the one-time costs are primarily related to IT costs associated with separation projects from Cummins as well as supply chain costs as we separate facilities from Cummins. The overage relative to our original expectations is primarily driven by two things. The first is delays in IT system cutovers. You can imagine it’s quite complex to navigate these system cutovers. We are ensuring that we strike the right balance between the desire to move quickly, coupled with risk mitigation. We’ve seen a few delays on that front. The second and really the primary driver behind this specific quarter increase is really the separation of our Mexican production facility from a legal perspective from Cummins. We originally thought that, that would happen inside of Q1, and that flipped into Q3 here. It was completed in August. So about a six-month slip there, which related in higher costs from a transition service standpoint from Cummins. And just to clarify, that’s now completed. You should see a step-down here in Q4, and as I noted, we do expect to be substantially complete with those inside of 2024.

And your next question comes from the line of Bobby Brooks with Northland Capital Markets.

I first was just curious to hear some more discussion just on your international business. I know in the prepared remarks, you mentioned India, the market softened a little, and there's no signs of rebound in China. But maybe just a little bit curious to maybe break that down even more, maybe talk about Europe and APAC more broadly. And if you could compare and contrast where maybe you're seeing strength internationally versus what markets might be a little cooler. And any specific markets that's a big focus for you in 2025?

Thank you for your question. Building on my earlier comments, we are currently observing declines across all markets, and it has become difficult to identify any positive trends. In the last quarter, I would have pointed to India as a bright spot, and while it still might be our strongest global market, we've also seen a softening in that region, with a less optimistic outlook compared to our last update. Jack and I will be traveling there soon, which should give us a clearer understanding of the market. We have a joint venture in India and maintain a strong market position, so I still anticipate significant benefits from this market internationally. In contrast, we continue to face challenges in China, which have persisted throughout this year and are expected to continue into 2025. We are focused on how to maintain our competitive edge in China through our partnerships and product innovations. Regarding Europe, we intentionally do not emphasize it much in our discussions, as it is less significant to us compared to other markets, but we are experiencing a similar downturn there. We did see some improvement with a decline moderating from an anticipated 18% to around 10%, yet it still indicates a year-over-year decrease without any significant recovery in sight. Overall, it's a tough international landscape, including here in the U.S., and our goal is to continue outperforming the market despite these challenging conditions.

Got it. That's great color. And it's great to hear how well you guys are winning despite a tough backdrop. And next question is just on margins. So there continue to be a really strong point for Atmus, that's for sure, benefited by some of the improvement initiatives we've taken across our manufacturing footprint. So what I'm most curious on specifically is that green cartridge line in France, that was your first fully automated line. Has that been a large enough success where the team is now contemplating executing a fully automated line elsewhere? Obviously, lower cost labor regions maybe don't make as much sense. But just trying to get a sense of where and what is the next round of margin expansion initiatives?

Thanks for that question. Let me talk about broadly our supply chain transformation and just cover the areas where we’ve seen the most benefit delivered. Certainly, you highlighted one of them, which is the automation of our manufacturing operations. That is firmly part of our ongoing strategy, and a great example of that is the green cartridge line. I'm really pleased with how we’re learning fast as an organization as we implement that automated line. We really build capability in this area to continue to do that on a much larger scale across our operations. I see automation as a continued part of us unlocking value into the future. We have had some wonderful benefits that we’ve been able to achieve through a focus on purchasing, working with our suppliers to improve our input costs, and I’ve been really pleased with the work of our purchasing team and how they’re thinking about that. Certainly, I see further opportunity to be able to do that, but that’s been another big part of the delivery of the benefits in our supply chain expansion.

And your next question comes from the line of Tami Zakaria with JPMorgan.

I wanted to clarify, so do you expect volumes to remain positive in the fourth quarter? What are you seeing quarter-to-date in terms of volume?

Yes. I believe our volume forecast for the fourth quarter indicates that we expect to keep gaining market share, although market conditions are exerting some downward pressure on that. This situation is quite similar to what we observed in the third quarter. Additionally, I previously mentioned that two other factors related to the market will affect us: the selling days in the fourth quarter and anticipated further declines in heavy-duty first-fit.

Got it. Okay. That's helpful. And my second question is, as you start planning for next year, what magnitude of pricing are you thinking about when you implement in January?

Yes. So look, we’re still working through what 2025 looks like. In broad strokes, I think you can count on our growth algorithm that we’ve talked about. I’ll leave the market part of that out for the moment because obviously, this year has been downside to our market expectations. Generally, we expect through the middle of the cycle, about 2% market growth for the core markets that we’re exposed to, about 2% on share growth, and about 1% to 2% on price.

And your next question comes from the line of Joe O'Dea with Wells Fargo.

Question is on manufacturing footprint and the prospect of tariffs. I would just like to understand reliance on manufacturing outside of the U.S., for revenue in the U.S.? What kind of redundancies might exist? And then also just from the competitive playing field, to what degree is Mexico an important center of manufacturing for U.S. filtration demand?

Thank you, Joe. It's a relevant question. I want to explain our approach to our global supply chain. As a global company, we advocate for free trade globally, and the introduction of tariffs presents challenges. Nevertheless, we have thoroughly examined this issue and continue to keep an eye on developments. Overall, our manufacturing facilities are organized regionally to cater to local markets. Using China as an example, most of our production there is intended for the local market, with a few exceptions. One is our facility in Mexico, which produces for the U.S. market, and another is our media production in South Korea. We are monitoring any potential impacts from these regions, but currently, we are confident in our supply chain strategy, which focuses on producing to effectively support regional markets.

Got it. And do you find that the filtration competitive landscape is such that Mexico is a common area of supply source?

Mexico is our largest manufacturing facility globally, and it has proven to be very successful, providing us with a competitive advantage. We view this as a major benefit.

And your next question comes from the line of Andrew Obin with Bank of America.

Could you just expand a little bit more on the organic expansion into industrial filtration?

Yes. Thanks for that question, David. The first thing I would say, I mentioned it in my opening remarks, not because it's immediately significant and material revenue. The reason I thought it was really important to mention is because I see this as the spark of our innovation flywheel in our team. We’ve now launched products to be able to distribute into the industrial filtration market. We will do that through our existing distribution channels that are already established through our core, and we're starting reasonably small, I would say. I still see our growth in industrial filtration primarily through acquisitions. I'm very pleased with the progress the team has made in innovating and developing products to take into the industrial filtration market. You won't see big revenues from this in the short term, but I do expect it to build our flywheel of innovation.

Got it. Just to clarify, in 2024, there are two advantages from lapping destocking. If there is no market improvement in 2025 and everything else remains the same, the revenue would be two points lower. Is that correct?

Yes. I think the big unknown in this is what the market is doing, is what I would say, David. We’ve been in very challenged market conditions this year. But yes, we have certainly had 2% of destocking benefits this year. I would also say we’ve had pretty strong headwinds on market downside.

Our next question comes from Bobby Brooks with Northland Capital Markets.

Just wanted to jump in real quick again. A follow-up on just the M&A. You guys mentioned how the pipeline remains robust, but no deals have crossed the line yet, right? I was just curious, could you maybe discuss what have been the main factors that have been holding up deals from getting across that line? Is it more so sellers having an unreasonable valuation on our company, or is it maybe some legal stuff? Just curious on that.

Yes. Thanks, Bobby. I was wondering whether I would get through this call without an M&A question. You’re absolutely fine. The way I would describe it is we’ve developed a clear strategy. I talked about the three verticals that we are prioritizing in the industrial filtration market: industrial water, industrial liquids excluding water, and industrial air. There are numerous factors that we’re looking at. Obviously, there are a number of strategic considerations that we filter deals based on, and then as a set of financial considerations. With our disciplined filtering process, we ensure that we’re balancing profitable growth with returns on our investment. It’s not always an easy dance to do. I feel really good about the pipeline and what’s coming in, and I want to make sure we build confidence in how we’re going to do this for the long term. It does take time, but we’re confident about where we are.

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

And this concludes today's conference call. You may now disconnect.