Earnings Call Transcript - AYI Q2 2023

Operator, Operator

Good morning and welcome to the Acuity Brands Fiscal 2023 Second Quarter Earnings Call. Please be advised that today's conference is being recorded. I will now turn the conference over to Charlotte McLaughlin, Vice President of Investor Relations. Charlotte, please proceed.

Charlotte McLaughlin, Vice President of Investor Relations

Thank you, Liz. Good morning and welcome to the Acuity Brands fiscal 2023 second quarter earnings call. As a reminder, some of our comments today may be forward-looking statements based on management's beliefs, assumptions, and information currently available. These beliefs are subject to various risks and uncertainties, many of which may be beyond our control, including those detailed in our periodic SEC filings. Please note that the company's actual results may differ significantly from those anticipated, and we are not obligated to update these results. Reconciliations of certain non-GAAP financial metrics with their corresponding GAAP measures are available in our 2023 second quarter earnings release on our Investor Relations website. With me this morning is Neil Ashe, our Chairman, President, and Chief Executive Officer, who will provide an update on our strategy and fiscal second quarter highlights, and Karen Holcom, our Senior Vice President and Chief Financial Officer, who will discuss our fiscal second quarter financial performance. There will be an opportunity for Q&A at the end of this call. We are webcasting today's conference call live. Thank you for your interest in Acuity Brands. I will now turn the call over to Neil Ashe.

Neil Ashe, Chairman, President, and CEO

Thank you, Charlotte. Good morning and welcome to all of you joining us on this call. We delivered solid performance again in the second quarter of fiscal '23. We grew sales in both our lighting and spaces businesses, expanded adjusted operating profit and grew adjusted diluted earnings per share. We generated strong cash flow from operations and created permanent value for shareholders through share repurchases. Both our lighting and spaces businesses delivered solid revenue while improving adjusted operating profit. In the Acuity Brands lighting and Lighting Controls business, our strategy of increasing product vitality and service levels continues to differentiate us in the market. A few weeks ago, we hosted our annual sales conference in Atlanta, NEXT 23. It was a great event, where we brought together our network of independent sales agents and shared our strategic vision for ABL and introduced new products. I'd like to take a minute to describe our independent sales network. Stated simply, we have the best agency network in the industry. To give you an idea of their scope, we have about 80 agents in North America and they have about 50 employees per agency. In other words, we have over 4,000 local sales and sales support people working for us every day throughout North America. While our agents are independent, they are exclusive to us for key controls and do not represent the other majors. They are generally the largest in their market, and we are their most important partner. Our partnership works very well. With our product vitality and service efforts, we make products that deserve to be chosen and our independent sales agents ensure that they are chosen. Product vitality is driving success across our portfolio and during NEXT 23, we introduced several new products. I want to highlight a couple here. The first was the new nLight AIR System Input Device. This is an indoor controller that can be used in multiple spaces, including office, commercial and retail. The device converts analog outputs to wireless broadcast to control intelligent luminaires. This reduces the need for complex wiring solutions during installation and reduces the associated cost for the customer. The second was the nLight AIR rPOD Micro. This is a battery-powered wall switch that can be used as a traditional wall switch or as a remote, providing control from anywhere within a build space. This is a really exciting extension of the technology and an elegant response to our customers' need for flexibility. These and other products continue to gain market attention. This quarter, several of our architectural lighting brands, A-Light, Eureka and Luminis, won a total of eight Good Design Awards from the Chicago Athenaeum which recognizes products and industry leaders in design and manufacturing that have charted new directions for innovation. Now moving to our Intelligent Spaces Group. The spaces team continued to perform well, delivering another quarter of solid sales and operating profit growth, driven by the continued success of Distech. Distech is winning because we have the best digital control solutions in the market. Its technology is open protocol which means you can connect our controller to most new or existing systems in a build space, giving our customers significant flexibility. We are also winning because Distech goes to market through independent system integrators. We are continually curating the highest quality network of SIs in each market in which we compete. Our focus is on expanding the addressable market for Distech which we have started to do in two ways. The first is geographic, as we mentioned last quarter. Today, we sell our controls primarily in the U.S., Canada and France, and we are expanding our presence in the U.K. and in the future in Asia. As we enter new markets, we are identifying and recruiting the highest-quality SIs as our partners. Second, we believe that any control that is currently mechanical or analog will become digital over time. So we are increasing what we can control in build spaces; this will provide us a second vector for continued growth. Finally, I also joined our spaces team at the AHR Expo in Atlanta, where HVACR professionals gathered to share ideas and showcase technology. It was great to hear firsthand from the SIs there how differentiated our Distech and Atrius products are. Now looking to the rest of fiscal 2023. We've been intentional around our product vitality and service efforts and how we operate the business. We have demonstrated our ability to manage price and cost, both in our go-to-market efforts and in our operations. Today, we are in greater control of the things we can control than we have ever been. As you know, there are meaningful changes in the economic climate. During the quarter, we began to see a slowing in the order rate for our project business, while we continue to work through our extended backlog. We believe that the slower order rate is driven by the lead time compression that we discussed last quarter and now the changing C&I lending environment. At the same time, our Contractor Select business continued to be strong. We will continue our focus on end markets and identifying new ways to grow. As we deal with these changing market conditions, our focus is on generating profits and turning those profits into cash. We are continuing to manage the price/cost relationship and we'll continue to generate strong cash flow. In closing, we entered the second half of fiscal '23 with our strategy unchanged. We are in control of what we can control, and we are confident in our ability to adapt to the changing market conditions and requirements of our customers. Now I'll turn the call over to Karen, who will update you on our second quarter performance.

Karen Holcom, Senior Vice President and CFO

Thank you, Neil. We delivered a solid performance in the second quarter of 2023. Sales in both businesses grew, delivering improved adjusted operating profit and margins and adjusted diluted EPS. We generated strong cash flow from operations and continued to allocate capital effectively. In the second quarter, we generated net sales of $944 million which is 4% higher than the prior year. This was largely due to price, with both the ABL and ISG businesses contributing to the growth during the quarter. Operating profit in the second quarter was $112 million and adjusted operating profit increased $10 million to $132 million from the prior year. Adjusted operating profit margin improved 50 basis points over the prior year to 14%. The improvement in adjusted operating profit and adjusted operating profit margin was a result of the increase in gross profit performance as we successfully managed price and cost. Finally, we continued to grow adjusted diluted earnings per share. Our diluted earnings per share of $2.57 was an increase of $0.44 or 21% year-over-year while our adjusted diluted earnings per share of $3.06 increased $0.49 or 19% over the prior year. The growth in adjusted diluted earnings per share was primarily due to higher operating profit and lower shares outstanding due to the share repurchases. Moving to our segment performance review. ABL, net sales grew to $891 million, an increase of 3% compared with the prior year. This increase was primarily driven by higher year-over-year sales in our independent sales network, the direct sales network and the retail channel. As Neil mentioned, the order rate related to our project business slowed during the quarter. However, our Contractor Select business targeted at distributors and retail continued to grow. ABL's operating profit was $124 million, an increase of 6% versus the prior year with ABL adjusted operating profit at $133 million, an increase of 5% versus the prior year. The adjusted operating profit margin was 15%, which was 30 basis points better than last year. The improvement was a result of our ability to manage price and cost. Now moving to ISG. The spaces segment continued to perform well with another good quarter of net sales growth and improved adjusted operating profit. Sales in the second quarter of 2023 were $58 million, an increase of $8 million or 16% versus the prior year, primarily as a result of the growth in Distech. During the quarter, both Distech and Atrius delivered growth across new and existing customers. Operating profit in the second quarter of 2023 increased to approximately $6 million this quarter, with ISG adjusted operating profit at $11 million. Now, I want to expand on our cash flow performance. We generated $306 million of cash flow from operating activities for the first 6 months of fiscal 2023, an increase of $179 million over the prior year's first half, driven largely by improvements in working capital. Last year, we invested in inventory in order to support our growth as well as insulate our production facilities from inconsistent supply availability with the intention of working down that inventory over several quarters, which we have done. We are now down 16 inventory days from the peak in February of 2022 and we have brought inventory levels down by over $50 million sequentially from the first quarter of fiscal 2023. We also invested $36 million in capital expenditures and $124 million to repurchase approximately 700,000 shares during the first half of fiscal 2023. As we said before, our capital allocation priorities remain the same. We have invested for growth in our current businesses through R&D and CapEx. We've expanded our platform through acquisitions, as evidenced by the purchase of OPTOTRONIC in our lighting business. We've maintained our dividend and we've created a permanent shareholder value through over $1.1 billion of share repurchases since the fourth quarter of fiscal 2020, which was funded by our organic cash flow generation. Before I turn the call to the operator for questions, I want to summarize our performance. We continued to deliver solid performance in the second quarter of 2023. We grew sales in both our lighting and spaces businesses, we improved adjusted operating profit and margins and grew adjusted diluted earnings per share. We generated strong cash flow from operations and created a permanent value for shareholders through share repurchases. Our guidance provided for fiscal 2023 remains unchanged and we are continuing to focus on what we can control and position ourselves to quickly adapt to changing market conditions. Thank you for joining us today. I will now pass you over to the operator to take your questions.

Operator, Operator

Thank you. Our first question comes from Tim Wojs at Baird.

Tim Wojs, Analyst

Nice job on the quarter. Maybe just kind of starting off on the sales side. Just wondering if you can maybe add a little bit of color on kind of what you're seeing on the order rate front that you alluded to and just how those orders maybe trended through the quarter, both on a project basis and in distribution? And then how do you think we should maybe think about the back half of the year from a revenue perspective, just given some of the slowing you talked about?

Neil Ashe, Chairman, President, and CEO

Yes. So Karen, I'll begin and you can add anything afterward. To provide an overview, let’s divide the lighting business into various components. We will concentrate on the projects through Commercial and Industrial (C&I). That's where we've started to notice a decline in the order rate. We believe this is due to two factors, Tim. First, lead times have compressed significantly since we introduced changes last quarter. Currently, lead times are about 30% lower than their peak in the fourth quarter of fiscal 2022. As these lead times decrease, it's natural for some projects that would have been ordered later to be placed sooner. Second, regarding distributors, there are two perspectives to consider. One is how they manage the project business, which is related to that segment. We mentioned the stock and flow in the last quarter. The second aspect involves inventory they bought for resale, primarily from our Contractor Select portfolio, which has seen growth beyond the rest of the business. Looking ahead, we perceive mixed signals from the market. There is evident economic uncertainty, and the C&I lending rate federal loan survey indicates considerable tightening in that area, which raises concerns. However, parts of our business, like Contractor Select, which focuses on everyday products, are performing very well. Overall, we remain prepared to respond to whatever conditions the market presents. As Karen mentioned, we're optimistic about our current projections.

Tim Wojs, Analyst

Okay. I was wondering if you could break down the sequential improvement in margins for the quarter, considering that typically there’s a seasonal decline in margins from Q1 to Q2. What contributed to this increase, and as you think about the usual seasonality for the second half of the year, do you anticipate the typical margin increase in Q3 and Q4 that you've observed in the past?

Neil Ashe, Chairman, President, and CEO

The margin performance at the gross margin level was achieved by managing prices and experiencing some favorable changes in input costs. We have taken a more strategic approach to pricing, and we believe that our Contractor Select portfolio is positioned with the right product, in the right place, at the right price, and we are intentional about this strategy. On the project side, we have the flexibility to choose which projects to pursue, allowing us to strategically manage prices there as well. Additionally, we are starting to see positive trends in input costs. We are actively managing this situation, and we expect this trend to continue for the remainder of the year.

Operator, Operator

Our next question comes from Ryan Merkel with William Blair.

Ryan Merkel, Analyst

First off, can you speak to the risk of channel destocking later this year? Any view on if the channel has too much inventory out there?

Neil Ashe, Chairman, President, and CEO

Yes, we receive this question frequently. Let me break it down into parts. We're specifically discussing the electrical distributors, which have two segments in their business. The first is the project business, where they're staging and storing materials for delivery to job sites; this operates mainly as a fee-for-service model. They maintain inventory for this purpose, which is linked to ongoing projects. As we mentioned last quarter, we believe there is excess inventory in their system, but that will be resolved as the projects progress. The second segment involves the inventory purchased for resale, which is part of our Contractor Select portfolio. As noted earlier, we are witnessing strong volume in this area. This short lead time, high-turns inventory is performing well. Looking at our OEM business, the disaggregated revenue shows a decrease year-over-year. We believe this decline is due to customers reducing their inventory from previous purchases, which is known as destocking, among other factors. Overall, regarding the distributors, their Contractor Select portfolio continues to sell well, indicating that their inventories are in good shape.

Ryan Merkel, Analyst

Got it. That's helpful. And then my second question, in some of the channel work that we've done, we heard about shortages of switchgear and then also a positive outlook for infrastructure work. Can you just comment on those two items, please?

Neil Ashe, Chairman, President, and CEO

Yes, I'll start on switchgear and then Karen can talk about the infrastructure. So on the switchgear, that's largely what's holding up the stage in-store orders. So the switchgear lead times continue to be far in excess of what the lighting lead times are, for example. So that's why these projects are kind of inconsistently executing. And I believe that the consensus is that, that won't improve until later in the calendar year.

Karen Holcom, Senior Vice President and CFO

And then on infrastructure, Ryan, as we've said before, we do think this is a place of opportunity for us and we are starting to see some green shoots in the infrastructure projects. But it's still pretty early. We're going to continue to position ourselves to be on project specifications which will eventually turn into bids and then orders down the road.

Operator, Operator

Our next question comes from Joe O'Dea with Wells Fargo.

Joe O'Dea, Analyst

I wanted to start on revenue mix and trying to kind of understand your views on the percent of revenue that's most exposed to credit availability and interest rates. So I think about the exposure as being roughly 50% kind of new construction, 50% renovation. I think you're roughly 20% kind of Contractor Select. And so trying to think as you're talking about some of the projects and what you're seeing in terms of maybe evidence of some slowdown in ordering. Just what part of the portfolio, what part of the revenue you think is maybe most exposed to some of these slowing trends?

Neil Ashe, Chairman, President, and CEO

Thank you, Joe. As we've consistently mentioned, we access these projects through various channels, which you can see in our detailed revenue breakdown, particularly in the C&I and direct categories, which are the most significant. The end markets do differ in their impacts. For instance, government infrastructure projects are not affected, and the educational market will also remain unaffected. However, some other areas are indeed impacted. We don't have a precise measure for you, and we can't predict exactly how this will unfold. The C&I project business will be the most significantly affected segment, and within that, it's likely that around half of the business will feel the most impact, though these are just rough estimates.

Joe O'Dea, Analyst

Got it. Okay. And then can you expand a little bit on cost coming down and the degree to which you're seeing that in component costs. How much of that is, as supply chain eases, there's just smoother operations and that enables some costs coming down? How much of that is you sort of being more proactive at the negotiating table? And then given the recent move up in steel, how you're thinking about the durability of some of those costs coming down?

Neil Ashe, Chairman, President, and CEO

We have been very intentional about managing our input costs moving forward. On the component side, the prices of electronic components are largely stable, with little change in terms. Additionally, we have been deliberate in our sourcing decisions for other inputs. We feel confident about managing these costs in the future. We have made significant improvements in our steel sourcing. Transport costs have also decreased. We are now designing our products to facilitate easier sourcing at the right levels. We believe that all these factors will provide us with durability in managing input costs going forward.

Operator, Operator

Our next question comes from the line of Chris Snyder with UBS.

Chris Snyder, Analyst

So prior communication suggested that gross margin would step up in the back half relative to the first half. Is that still the case, just given the higher first half starting point and then some of the cycle concerns called out in the back half?

Neil Ashe, Chairman, President, and CEO

Basically, it started to perform the way we expected it to perform earlier than we expected it to perform that way. So we're not surprised by these gross margin levels.

Chris Snyder, Analyst

Okay, appreciate that. And then, Neil, I think earlier, you kind of called out taking a more strategic approach to pricing. Can you just maybe provide a little bit more color on that? And does this mean essentially a trade-off of higher gross margin maybe at the expense of volumes? Is that the right takeaway?

Neil Ashe, Chairman, President, and CEO

Yes. Thank you, Chris. This is a very important topic for us. We want to approach our pricing strategically to effectively manage the balance between volume and margin. As the largest player in the industry, we are showcasing significant strategic pricing. We compete daily with our Contractor Select portfolio, which we believe is effective as it continues to grow. This growth occurs even with challenges such as decreased Asian imports, which Census data shows are down over 30%. We are still seeing growth, and our portfolio contributes to that. This differentiation is important. We are providing higher value while maintaining competitive pricing for both our customers and our margins. On the project side, we recognize the importance of the relationship between price and volume. We will be strategic in choosing where to focus on volume while continuing to achieve these margin levels.

Chris Snyder, Analyst

I appreciate that. If I could maybe just squeeze one last one in. There's some communication earlier around potential inventory destock. Because when I look at the quarters, it seems like volumes were roughly flat year-on-year, whereas non-res activity has continued to grow quite nicely. Any way to just quantify maybe the level of destock that impacted the quarter? And then kind of maybe where are we in that destock cycle?

Neil Ashe, Chairman, President, and CEO

Yes, I think we've consistently addressed this question whenever it's been raised. It's important for everyone to understand that we view lead time compression as a component of the destocking narrative. We don’t believe there is a significant amount of held-for-sale inventory within the distributors or retailers; otherwise, our Contractor Select portfolio wouldn't be performing as well as it currently is. These projects are either in the market or with the distributors. We believe the primary impact we’re experiencing is due to lead time compression, which affects the order rate and is an ongoing trend. We anticipate this will continue at least through the third quarter.

Operator, Operator

Our next question comes from Jeffrey Sprague with Vertical Research Partners.

Jeffrey Sprague, Analyst

It's Jeff Sprague. There was some interruption when she was introducing me. I hope you can hear me now. I want to revisit the lending environment, Neil. In your opening remarks, it seemed like you indicated that the changes in lending were already having a negative effect in the quarter, but it appears you might just be highlighting it as a concern. The softening in orders seems more related to a reduction in lead times. Could you clarify this? Are you actually noticing concrete signs of a credit crunch in your markets?

Neil Ashe, Chairman, President, and CEO

Thank you for your question, Jeff, and for the chance to clarify this topic. The Fed's Commercial and Industrial loan survey began to show negative trends around last fall, and we are emphasizing this as a new influencing factor because our data indicates it is now affecting the market and will continue to do so. Whether it remains consistent is uncertain, as we don't have a definitive forecast. However, the Fed's loan survey is our primary data source, and it will obviously influence the non-governmental sector. While it won't impact the educational sector immediately, it will have some repercussions moving forward due to tightening conditions. Additionally, we have consistently noted that if discount rates increase, we will see fewer projects. This combination is evident in the industry currently, and its future impact will depend on the Fed's actions.

Jeffrey Sprague, Analyst

Yes. Considering your guidance, what circumstances would lead us to the lower end of the range? Analyzing historical patterns of the first and second halves, it appears that unless there is a sudden change in the economic landscape, you're positioned in the upper third of that range by historical measures. I'm curious if you agree and what you think would need to happen for you to reach the bottom of that range, especially with half a year remaining.

Neil Ashe, Chairman, President, and CEO

Yes. Our intention is not to adjust the range during the year. Based on our performance in the first half, it suggests that achieving sales targets for the remainder of the year may be challenging, but we are showing that profits are attainable. That's a summary of how we anticipate the rest of the year will unfold.

Jeffrey Sprague, Analyst

Great. Just a quick last question about inventories. Your inventory performance has been impressive, as you've significantly reduced it. It seems like you're close to historical averages in terms of days inventory. Is there still a significant opportunity to unlock cash through additional inventory liquidations, or have we reached a normalized level?

Karen Holcom, Senior Vice President and CFO

I think, Jeff, for the most part, we are at a more normalized level. We're still a little bit heavy on component inventory for electronics but it's modest compared to the decreases that we've made so far.

Neil Ashe, Chairman, President, and CEO

And then I'd add to that, we have multiple efforts ongoing to continue to reduce that. So I think we are at historically normal levels. And I also believe that we can improve those over time.

Operator, Operator

Thank you. And I'm showing no further questions in the queue at this time. I'd like to turn the call back to Neil Ashe for any closing remarks.

Neil Ashe, Chairman, President, and CEO

Thank you. We really appreciate you joining us this morning. We're pleased with our performance so far this year. We are in control of what we can control and we're confident about our ability to deliver no matter the market conditions on our customer requirements. So thank you for spending some time with us this quarter and we look forward to talking to you again next quarter.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect.