ESAB Corp Q4 FY2022 Earnings Call

Good morning and welcome to ESAB's Fourth Quarter 2022 Earnings Conference Call. Thank you. Mark Barbalato, Vice President of Investor Relations, you may begin your conference.

Thanks, operator. Welcome to ESAB's fourth quarter 2022 earnings call. This morning, I'm joined by our President and CEO, Shyam Kambeyanda; and CFO, Kevin Johnson. Please keep in mind that some of the statements we are making are forward-looking and are subject to risks, including those set forth in our SEC filings and today's earnings release. Actual results may differ and we do not assume any obligation or intend to update these forward-looking statements, except as required by law. With respect to any non-GAAP financial measures mentioned during the call today, the accompanying reconciliation information related to those measures can be found in our earnings press release and today's slide presentation. With that, I'd like to turn the call over to our President and CEO, Shyam Kambeyanda.

Thank you, Mark. Good morning, everyone and thank you all for joining us today. 2022 was the beginning of a new era in ESAB's 118-year rich history. We had a strong finish to 2022 and are entering 2023 with positive momentum as we continue to shape ESAB for the future. Let me take a moment to highlight a few accomplishments. We successfully launched as an independent company. We are well positioned to compound value for our shareholders. We again demonstrated our innovation leadership by introducing several exciting new products, like Renegade VOLT, a battery-powered welder, and our new heavy industrial product, the Warrior Edge. We took our business system, EBX, up a notch. Our EBX process helped drive price and working capital improvements in a challenging environment. Our strengthened balance sheet and robust cash flow funded three acquisitions that moved our strategy forward. We continue our progress on ESG initiatives and I'll share more on this later. Before I highlight the fourth quarter, let me take a moment to acknowledge the hard work and commitment of our associates. They embody our purpose and values and have been relentless in their focus on our customers and key stakeholders. Moving to Slide 3 and our performance in the fourth quarter. As I said before, we had a strong finish to 2022. Organic sales increased 11%, adjusted EBITDA rose 10% and margins expanded to 17.4% as our EBX initiative drove margin and working capital improvement. We made two acquisitions in the fourth quarter that further strengthened our enterprise, shaping ESAB towards higher growth, lower cyclicality, higher margins and higher cash flow. Moving to Slide 4. We met all of our key financial metrics, reflecting strong execution despite a challenging operating environment. Full year organic revenue grew 13%, all of our regions contributed to our growth. India and the Middle East were standout performers. We achieved $417 million of EBITDA, which was $7 million higher than the midpoint of our guidance. And we delivered $4.21 of EPS, which was $0.16 higher than the midpoint of our guidance. To appreciate the team's EBITDA performance, I would like to highlight that we absorbed approximately $10 million of unfavorable currency pressure or roughly $0.12 a share compared to our original guidance. And on free cash flow, we generated $219 million of cash with a strong finish in the fourth quarter. The key takeaway on this slide is ESAB delivered on all of its commitments. And we're on a clear, continuous improvement path towards our long-term strategic goals of 20% EBITDA and 100% free cash flow conversion. Moving to Slide 5. Over the last six years, we worked hard to reshape our company. And with the recent acquisitions of Swift-Cut and Therapy Gas Equipment, we continue our journey to compound value. Therapy Gas Equipment strengthened our gas control business by broadening our product offering and extending our geographic reach. Like our Ohio Medical acquisition, Therapy Equipment is immediately accretive to our margins. Swift-Cut is a leader in light industrial automated cutting and provides us with an opportunity to extend our process leadership as well as grow our aftermarket. Additionally, there's an opportunity to accelerate growth and expand margins by plugging in Swift-Cut's innovative products and solutions into our global distribution network. Turning to Slide 6. Let me share an example of EBX at work. We're all aware of the supply chain issues at the start of 2022. We felt this was a perfect situation to use our powerful EBX tools to drive improvement. We used product line simplification, AI forecasting, enhanced standard work, improved shop floor gemba, and glass boards to systematically optimize and improve our inventory levels. As the chart indicates, we were able to reduce inventory by $60 million over the course of the second half of 2022. In 2023, expect us to raise the bar and continue to reduce our inventory days. Moving to our fourth quarter financials on Slide 7. As I mentioned before, fourth quarter sales grew 11% organically. Our markets remained resilient with particular strength in our emerging markets. Acquisitions added two points of growth and are performing as expected. Our integration and synergy plans are off to a good start. I recently had the opportunity to visit with our team at Ohio Medical for our 100-day integration plan review. This includes the implementation of our strategic vision as a global leader in gas control equipment as well as leveraging EBX across the business to drive growth, margins and cash flow. It was evident that there was great energy in the room, Ohio Medical has fit right in and the team is excited about our future opportunities together. Similarly, I'll be visiting both Swift-Cut and Therapy Equipment for their 100-day reviews in the second quarter. Continuing with the impact of EBX, we're pushing price to offset inflation and our cadence of innovative new product introductions are driving excitement within our sales team and our customers. I'm encouraged by the strength of our sales funnels and the activities that will drive both an increased share of wallet as well as bring new customers to ESAB. Strong price and cost-saving execution helped offset both inflation and currency headwinds in the quarter. As a result, EBITDA margins expanded 40 basis points year-over-year and 80 basis points sequentially. Moving to Slide 8. The Americas had a solid quarter and performed as expected. Sales rose 5% organically as the team executed on price. Volume in the Americas reflected a tough year-over-year comparison. We made strong progress on penetrating new channels, accelerating our product line rationalization and improving our operational efficiency. Acquisitions added four points of growth. As a result, adjusted EBITDA increased 9%, margins expanded by 20 basis points and 100 basis points on a sequential basis. Turning to Slide 9 and our EMEA and APAC segments, they had a strong quarter again. Our fourth quarter sales rose 15% organically, reflecting eight points of price and seven points of volume. Acquisitions added another 100 basis points. We saw particular strength in India and the Middle East. In the quarter, both regions made significant progress on equipment, digital solutions and automation sales. Adjusted EBITDA improved 10%. Margins expanded 60 basis points year-over-year, reflecting strong execution and despite being impacted by a strong U.S. dollar. With that, let me turn it over to Kevin for Slide 10.

Thanks, Shyam and good morning, everyone. ESAB had another strong quarter for free cash flow, $35 million higher than the prior year and a cash conversion greater than 100%. I'm proud of the work the ESAB team has completed during the year, particularly on inventory which we reduced by a further $30 million in the fourth quarter. We funded our new acquisitions with our strong free cash flow and ended the year with net leverage of 2.7x, 0.1x better than we expected last time we spoke. As we look forward to 2023, new technology is being implemented that will further improve our cash generation. We are confident of delivering on our long-term goal of cash conversion greater than 100% in the next few years. Turning to Slide 11. We provide our 2023 guidance. Our guidance numbers exclude our Russian business for the full year 2022 and 2023. Total sales growth is expected to be 2% to 4%, with sales seasonality similar to 2022. Organic growth of 3% to 5% includes 1 to 2 points of volume and the rest from price. We expect 2.5% from acquisitions and a 3.5% FX headwind due to a stronger U.S. dollar, impacting the first half of 2023. We expect a year-on-year increment in the mid-20s with an adjusted EBITDA guidance of $420 million to $440 million. This includes $15 million of investment we are making to drive growth for our gas control and equipment products. As we discussed last year, we successfully fixed half of our debt at a 4% interest rate and we are assuming the Fed will increase the cash rate to around 5% by the end of Q2. Our interest expense is guided to $70 million to $72 million. 2023 adjusted tax rate is expected to be 24% to 25% with a 50 basis point improvement at the midpoint versus 2022. We expect to consistently lower our adjusted tax rate over the next few years. Overall, 2023 adjusted EPS guidance is $3.80 to $4. Finally, our cash flow conversion guide is greater than 90%, as we continue to generate strong free cash flow with a similar quarterly seasonality to 2022. To assist with modeling, we have included a more detailed guidance slide in the appendix. With that, let me hand back to Shyam on Slide 12 to discuss our ESG progress.

Thank you, Kevin. Let me highlight some of the exciting things we've been doing with ESG. At ESAB, we've established five work streams that are aligned to our purpose of shaping the world we imagine. We've reduced our footprint by 30%, and as a result, reduced our energy, waste and water usage by the same proportion. We've improved our safety performance and our performance is in the 90th percentile amongst industrials. Every voice is valued at ESAB and diversity is a big part of it. As part of our design process, all of our new products meet eco-standard designs. We use over 20% recycled steel in our consumables business and are making great progress on sustainable packaging for our products. Lastly, the communities we're part of, ESAB believes in participating and growing the communities we live in. As a result, our associates have volunteered and ESAB has funded several initiatives globally to ensure shared success. We are using ESG to make ESAB a better business for our customers, our associates and our communities. Turning to Slide 13, and to wrap up. I'm very proud of our team. ESAB delivered a strong year of performance in a challenging environment. There is more to come from EBX as we drive growth, expand margins and generate cash. We have a healthy funnel of bolt-on acquisitions as we continue our compounded journey. We have made strong progress on our ESG initiatives and we'll be doing much more in this field. ESAB has had a solid start to the year. And as I've said in the past, our best is yet to come. Thank you again for joining us. Operator, please open the line for questions.

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

So my first question is, it seems like volume in the Americas was down in the quarter, about 3%. Could you expand on that a little bit? What drove that? And what are you seeing now quarter-to-date?

Tami, thank you for the question. So the first aspect to answer your question is we actually performed as we expected in the Americas. We felt that we had a really strong performance in the quarter from a margin perspective. We made great progress with some of the initiatives that I spoke about which was around creating new channels, driving better equipment sales, and continuing to win our share of wallet with our existing customers going forward. We did have year-over-year comparable issues. If you remember from my call last year, the Americas business actually grew 31% in Q4 of last year. And we're also running the playbook around our product line rationalization which is really the 80/20 strategy. And so for us, what we find in North America and South America is that we're right where we want to be, we're positioning the business to be less cyclical, better margin and a better profile for long-term growth. I'm really thrilled about the work the team is doing to set ourselves up to sell more equipment, and better process automation in the market. And we're off to a good start in Q1 and so looking forward to how the business performs in the year.

Got it. And one more from me. Can you remind us which of your key end markets you still see sort of volumes below pre-COVID levels and enhance you expect some sort of recovery in the next couple of years?

We are very encouraged by the performance in emerging markets. I noted that we are pleased with our business in India, which is performing well as a public company, and the Middle East business also did well. We observed a broad-based recovery in the emerging markets, with activity levels exceeding those of pre-COVID times. The auto market in Europe is recovering, which provided some positive momentum as we concluded Q4 and began Q1 on a positive note. In North America, strong performance in agriculture and general industry continues, while we have noted some weakness in the retail sector. However, since we are new to that area, every sale contributes positively to our growth. We are excited about the opportunities this creates for ESAB in 2023.

Your next question comes from the line of Nathan Jones from Stifel.

I'd just like to pick up on part of your answer to one of those questions, Shyam. You talked about product rationalization through the use of 80/20. Maybe you could give us a bit more color around what's going on there? I know 80/20 is somewhat of a new initiative for ESAB. What kind of impact that could have on the sales number and what kind of impact that could have on the margins over the next few years?

Yes. So a couple of aspects. And I sort of ended my call by stating that we are exactly where we wanted to be positioned to invest in the things that we believe creates long-term value for all of our stakeholders. So 80/20 as an initiative, as you know, takes a bit of time to gain traction. Nathan, you've been around this a while, but I'm really thrilled about what the North America team was able to do as we finished out the year. The biggest portion of that exercise is that it's not just a pruning exercise. It's also a growth exercise as to where you want to see your business grow, where do you want to add value to your customers and where you see yourself creating a significant amount of efficiency within your shop floor and your facilities. So what I'd say to you is that we're in the early innings on that particular front. I expect us to be in the mid-innings as we go through 2023 and really drive significant value as we get into 2024. So as we sit here today, we're very confident about the goals that we set of creating a 20-plus EBITDA percentage business at ESAB. We think 80/20 is a big part of it, along with the mix change that we talked about, to gas control and equipment as we go through the next couple of years. We know exactly what we need to do. We've been talking to a few people that have done this in the past. We have a roadmap to get there. And so for us, it's about reaching the task of 20 and then taking it up a notch from there.

Great. My follow-up question is going to be on price/cost. Can you talk about where you ended the year on price/cost from a dollar basis and I assume price cost was probably dilutive to margins. So if you could give us the impact for that. And then the outlook for '23 where you expect to be on price/cost as we go forward here.

So yes, Nathan, as we've talked about before, we've built some very strong processes around the management of price and showing that we've got good visibility of what's happening on the inflation side. So we've continued to play that playbook during 2022. As we exited the year 2022, we are price/cost neutral. As we stepped into 2023, we are continuing to see inflation across the world. We are in certain pockets, continuing to go after price to cover that inflation. And our assumptions in the 2023 guidance are that we will be price inflation neutral.

Yes, Nathan, over the past three years, we've demonstrated our execution capabilities related to inflation and foreign exchange. This proficiency is a solid part of our business's core competencies and our strong EBX process. Looking ahead, we always aim to be price/cost neutral. While some initiatives might offer positive results, I am very confident about how we have structured the business.

And Kevin, when you say price/cost neutral, you're talking on a dollar basis, correct?

That's correct, yes.

Your next question comes from the line of Mig Dobre from Baird.

I want to follow up on this price discussion. One of the things that we're consistently hearing is that lower steel costs are starting to impact many of our corporate company P&L. So I guess I'm curious how you see that dynamic playing through to the consumable portion of your business? If there's any difference between the first half and second half of '23 and the way you kind of framed your pricing outlook? And if you are able to hold price positive, what gives you that ability in an environment in which steel prices that retrench?

Yes. Mig, great to hear from you. So let me start by saying, we have seen steel prices abate a bit, but they are, for the most part, stable. In some regions, there's still some amount of volatility and inflation on steel prices. So it's not a broad-based retreat on steel prices across the globe. And to answer the second part of your question which was, hey, in the past, what we've had is the ability to be able to hold on to price as commodities have abated. And that is, again, our intention this year. So far, the market continues to be rational. And obviously, our intention is to hold on to as much of that price on the way down as we possibly can. On the point around whether we see the second half, let me hand it over to Kevin and he can sort of talk to you how we've sort of planned our pricing, at least in the guidance for the second half.

Yes. I mean in terms of comps in the first quarter in the first half of the year, you'll expect higher price year-over-year. The second half of the year, we are expecting to go for some price, but there will be less price in the second half of the year. I think the thing that we've proven out over the last few years is no matter what happens on the inflation side, we'll respond to that with price. We have extremely strong processes today within the business. And regardless if we do see more inflation, we'll go for more price. If we do see inflation abate, we'll try to hold on to as much price as we can on the way down.

To address your question about its impact on our consumer business, we see various inflation factors at play, including energy-related costs and other indirect influences. This situation enables us to maintain some pricing even as steel and raw material costs decrease. We have consistently favored this position and discussed it previously. Therefore, we perceive an ongoing opportunity to retain and potentially increase our prices in response to any inflation-related activities in the market.

Okay. Understood. If I may follow up then with a question on volume in your EMEA and APAC segment, 7% and frankly, this was a lot better than what I was guessing. Can we get a little more detail on the strong performance in the Middle East and India and what those regions contributed to this number? Additionally, can we discuss how Europe has progressed?

Yes. And as I mentioned earlier, our playbook on all of this is actually quite simple. We have a really strong process around our sales growth plan. We create really strong territory plans. We create regional plans off of it and then growth bridges within our business. And what we've seen over the last couple of years is our sales teams really incarnate that into the DNA and drive that as we move forward. So when you look at our EMEA and APAC business, we did see a lot of strength in India. The same things that we've spoken about in the past, Mig, we've seen investment in infrastructure. We've seen investment in agriculture. We've seen investment in renewables. And then also investment in LNG and oil and gas. And so what you're seeing is that India is sort of benefiting in general for the general industry rising, especially agriculture and infrastructure; the Middle East on LNG, oil and gas, and investments. And what I call in the Middle East, more slightly so that gives us a lot of confidence is the fact that it's a steady investment. It's not been the sort of massive investment upfront. It's been a steady state of investment within the Middle East region across all geographies there that's driving for capacity improvement, especially as it relates to LNG and processing of crude oil. So we really like those two spaces. Europe, I mentioned it briefly in my commentary earlier, we're seeing the auto market rebound. And then just the market being resilient and that's probably the best word that I could use for Europe. It continues to be resilient with some automotive business coming back, a strong focus into renewables. The other piece that I'm really proud of our team on is that we had a chance to visit with a couple of customers this past week and we're looking at building partnerships where we're providing digital, consumable and equipment solutions to our customers, creating a full workflow solution set that has gained traction, giving us confidence about the mix change that we've talked about creating within ESAB where today, we're at about 70-30 and we'd like to continue to improve that over the next 3 to 5 years to get closer to 60-40. And so we're really pleased about our initial onset, how our sales teams have approached it, and more importantly, how the customers have engaged with us in that sales process.

Okay. And if you'll allow me one final one, maybe this one is for Kevin. How are you thinking about working capital in 2023? You hinted at additional room to work down inventory. And as you're thinking about free cash flow, how would you frame your leverage and the way you're kind of looking at deploying capital, if at all, for 2022?

So firstly, I think Shyam already mentioned it as part of today's presentation. We do still see opportunity on inventory. When we look at the DSI, we have certain parts of our business where we believe we are in really good shape, but we have other parts of the business where we believe we have opportunity to improve. So certainly, as part of our implant for this year, we have targeted to make further strides in further reducing our inventory levels. So you'll see more to come on that part. In terms of capital deployment, we're going to continue to be disciplined in our capital deployment. You've seen the acquisitions that we did in 2022. We funded that out of the free cash flow that we generated. We'll continue to manage our leverage within the 2x to 3x range and we'll be focused on bolt-on M&A to smaller acquisitions that will immediately be accretive and don't require a great deal of cash to fund.

Yes. And I think the way to think about that one, Mig, is that what we have done today is created an optimal inventory state for each of the regions and more importantly, for each of our facilities. And through our EBX process and what I talked about is strong visual board, strong daily management, just to manage our plans to achieve or create a glide back to achieve that optimal inventory level. And so Kevin and I, something that Kevin has done incredibly well since he took over as our CFO has managed our cash and I'm very confident between our EBX process and the processes that Kevin has put in place in terms of his weekly and daily management on cash that we are in a strong position to continue to deliver on our commitments on that front.

And your next question comes from the line of Chris Dankert from Loop Capital.

I guess looking at the 2023 organic sales guidance here, can you give us any detail Americas versus international? And maybe just kind of how you're looking about Europe specifically in terms of growth in '23 here?

We haven't provided those details yet, Chris. Let me think that through a bit more and get back to you. However, it's still early in the year, and it's probably best to assume that both regions will perform at similar levels as we enter the second quarter. We'll have more information to share on that soon. For now, it seems prudent to expect both businesses to be performing comparably as we move forward. As I mentioned, we're off to a good start in Q1, and in about eight weeks, we'll discuss the first quarter results in more detail.

Understood. Sounds good there. And then forgive me if I missed it but kind of circling back to Swift and Therapy Gas here. Is the sales contribution similar for each of those businesses? And then on an EBITDA margin basis, how do those kind of look versus company average here?

Yes. I think we sort of mentioned already, we haven't given individual sales numbers but I know it's in the back and you could sort of pull those numbers out. But $20 million is the total impact of those two businesses for the full year, with Therapy Equipment being accretive immediately. And I'm very confident that Swift-Cut has a really strong game plan where the gross margins are accretive today and we expect EBITDA to get accretive as we finish out the year.

Got it. And if I could sneak in one more. Maybe this is more for Kevin as well. Again, given some of the more uneven macro headlines and you highlighted the 2x to 3x debt leverage being a comfortable range. I guess, heading into a little bit of a cloudier year macro, does that change where you feel comfortable in that range? Or just any thoughts as we think about leveraging cash deployment going forward?

Yes. So the one thing, Chris, that ESAB's proven its strong ability to generate strong free cash flow. As we step back to during COVID, we actually generated over 130% cash conversion over that period, given we're short cycle. We generally cycle down our inventory pretty quick when things turn. So that gives us a lot of confidence in terms of our abilities, strength of our balance sheet to go through any type of debt that at this point, we don't see happening.

Got you. Understood.

Yes. Maybe to highlight that, I think the view for us is that we want to stay within that 2.5 to 3 range and stay disciplined. The great thing about the acquisition strategy that we have and the funnel that we have, nothing sort of is out there that pushes us to move those targets. And so we're very confident that we can create, be a compounder, create a really strong global leader in gas control, strengthen our FABTECH business and stay well within that range of 2.5 to 3 in the foreseeable future.

Great. And then best of luck in '23 here.

Thank you.

Thank you.

And there are no further questions at this time. Mr. Mark Barbalato, I'd like to turn the call back over to you for some final closing remarks.

Thank you for joining us today, and we look forward to speaking to you on our next call.

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