Mueller Water Products, Inc. Q3 FY2020 Earnings Call

Welcome, and thank you for standing by. At this time, all participants are in listen-only mode. Today's conference is being recorded. If you have any objections, you may disconnect at this time. I would now like to turn the meeting over to Whit Kincaid. You may begin.

Good morning. I hope everyone is doing well. Thank you for joining us on Mueller Water Products' Third Quarter 2020 Conference Call. We issued our press release reporting results of operations for the quarter ended June 30, 2020, yesterday afternoon. A copy of it is available on our website, muellerwaterproducts.com. Scott Hall, our President and CEO; and Martie Zakas, our CFO, will be discussing third quarter's results, market conditions, and our current outlook for the fourth quarter. This morning's call is being recorded and webcast live on the Internet. We have also posted slides on our website to accompany today's discussion, as well as to address forward-looking statements and our non-GAAP disclosure requirements. During this call, all references to a specific year or quarter, unless specified otherwise, refer to our fiscal year, which ends on September 30. A replay of this morning's call will be available for 30 days at 1-866-461-2738. The archived webcast and corresponding slides will be available for at least 90 days in the Investor Relations section of our website. I'll now turn the call over to Scott.

Thanks, Whit. Thank you for joining us today. I hope everyone in the audience is staying safe and healthy during this challenging time. Before we discuss our third quarter results for 2020, I will provide a brief update on how we are adapting to the challenges from the ongoing COVID-19 pandemic. Like everyone else, as I think back over this past year, I am amazed at how quickly the world where we live and work has shifted. Since our last earnings call, the initial shock to our employees, customers, and communities has turned into a more normalized cadence as we adapt to a new normal. We took swift action, implementing enhanced safety and hygiene processes to create safe and healthy working environments for our employees, customers, suppliers, and communities. These are now part of our standard work procedures. Additionally, our response team continues to provide leadership through this crisis as the pandemic continues to evolve. We take great pride in being an essential business, providing products and services needed to manage and maintain our nation's critical water infrastructure. During the quarter, our manufacturing plants and distribution centers continued to supply products to customers with minimal disruption as a result of the pandemic. I have been impressed by how effectively our teams have transitioned to the new health and safety protocols, which is helping us address the positive COVID-19 tests and exposures that we have experienced. We continue to proactively monitor our supply chain, and we did not experience any material supply chain issues during the quarter. I believe that our execution in this environment is a testament to our employees and their resolve. Moving on to the third quarter, we realized a 16.7% decrease in consolidated net sales during the quarter. I was pleased that our net sales were better than our expectations for a year-over-year decrease between 20% and 30% as we worked closely with our customers and channel partners to reduce the effects of the pandemic on our business. We saw a smaller-than-expected downturn in residential construction activity during the quarter. As expected, our channel partners reacted quickly to protect their balance sheets and cash flows by meeting demand with their existing inventory. The increase in construction activity after the initial shelter-in-place orders in April and May led to a significant sequential growth in sales and orders in June. Overall, we believe that our key end markets, excluding certain project-related areas, experienced a mid-single-digit decrease during the quarter. However, there was a wide range of performance depending on geography, with some markets close to flat versus the prior year. The lower volumes and additional expenses related to the pandemic resulted in a 33% decrease in adjusted EBITDA during the quarter. We anticipated elevated decremental margins given our fixed cost structure, especially for our core products, and additional expenses related to the pandemic. Due to the decrease in volumes, we immediately took actions to adjust our production capacity and SG&A expenses with a combination of temporary furloughs, salary reductions, and elimination of some discretionary spending. We benefited from positive pricing dynamics during the quarter despite the additional challenges from lower market volumes. Additionally, lower raw material costs helped offset inflation from purchased components and labor, in addition to higher tariffs. Despite the decrease in adjusted EBITDA, we generated strong free cash flow during the quarter, resulting in a $59 million increase in cash on our balance sheet. Our performance during such a challenging period positions us well to face additional uncertainty from the pandemic as markets continue to recover. Overall, I couldn't be more proud of everyone at Mueller as they continue to respond to the disruption from the pandemic and to adapt to our new environment. As we look forward, our top priorities remain focused on keeping our employees safe, protecting our communities, delivering exceptional products and support to our customers and increasing cash flow. We remain hopeful that our end markets will continue to improve in the fourth quarter. Later in the call, I will discuss the current market conditions and our outlook for the fourth quarter of this year. With that, I'll turn the call over to Martie.

Thanks, Scott, and good morning, everyone. I hope you continue to be healthy and safe. I'll begin with our third quarter consolidated GAAP and non-GAAP financial results then review our segment performance and finish with a discussion of our cash flow and liquidity. During the third quarter, we generated consolidated net sales of $228.5 million, which decreased 16.7% or $45.8 million as compared with third quarter last year. The decrease was primarily due to reduced shipment volumes related to the pandemic seen across most of our product lines and was partially offset by higher pricing. Our gross profit this quarter decreased 22.1% or $21.5 million to $75.7 million with a gross margin of 33.1%. Gross margin decreased 230 basis points versus the prior year, primarily due to the decrease in shipment volumes and $5.2 million of expenses related to the pandemic, including certain unfavorable volume variances, voluntary emergency paid leave for employees and additional sanitation and cleaning fees. Selling, general, and administrative expenses of $47.1 million in the quarter decreased $400,000 versus the prior year. The decrease was primarily due to lower expenses relating to the pandemic, including reduced travel, trade shows, events, temporary furloughs and pay reductions for employees. The benefits from these actions were partially offset by an increase in personnel-related costs, professional fees, and IT-related activities. Operating income of $20 million decreased 57.6% in the third quarter, compared to $47.2 million in the prior year. Adjusted operating income of $28.6 million decreased 45% or $23.4 million in the quarter. The decrease is primarily due to lower volumes and higher expenses related to the pandemic. Adjusted EBITDA of $43.8 million decreased 33% or $21.6 million, leading to an adjusted EBITDA margin of 19.2% and decremental margin of 47%. For the last 12 months, adjusted EBITDA was $189.9 million or 19.7% of net sales. We invested $13.9 million in capital expenditures during the third quarter, bringing the year-to-date total to $51.2 million. Free cash flow for the year-to-date period improved $61.7 million to $26.6 million. At June 30, 2020, we had total debt of $447.6 million and cash and cash equivalents of $170.7 million. Our 5.5% notes have no financial maintenance covenants, and our ABL agreement is not subject to any financial maintenance covenants unless we exceed the minimum availability thresholds. On July 30, 2020, we renewed and extended our ABL agreement, which was set to expire in 2021. The new agreement has similar terms and terminates on July 29, 2025. With a strong balance sheet and ample liquidity, we believe that we are well positioned to face the future challenges from the COVID-19 pandemic. I'll turn the call back to Scott to talk more about market conditions.

Thanks, Martie. I will provide some additional comments on market conditions and our outlook for the fourth quarter. The impact of the pandemic was felt across all of our products. However, sales of specialty valves and Krausz repair products performed relatively well during the quarter. The performance of our Krausz repair products confirms the strategic rationale for the acquisition as the demand for these products will continue to gain momentum with the aging pipe infrastructure. Sales of our specialty valve products primarily used in large capital projects with long lead times benefited from the backlog built over the last 12 months. We believe that the municipal end market held up relatively well during the third quarter as utilities focused on maintaining essential services and completing existing projects where possible. Since Technologies has a higher portion of project-related business, sales in that segment decreased at a higher rate than in our Infrastructure segment. We do anticipate that the project-related portion of the municipal water market will remain challenging as state and local governments update their budgets and adjust to lower tax receipts and utilities feel the effects from lower water revenues. As a result, new projects could be pushed out further. We were pleased to see the residential construction end market rebound during the third quarter after a sharp decrease in activity in many regions in the first half of the quarter as shelter-in-place restrictions were lifted across the country. With mortgage rates at historic lows, relatively low lot inventories, pent-up demand and supportive demographic trends, we believe that residential and construction activity could continue to improve. However, the pace of the recovery will continue to vary greatly and is highly dependent on the pandemic. As a reminder, we estimate that 60% to 65% of our core products are critical to utilities to maintain their networks. This base of business gives us a strong foundation with additional sales coming from residential construction and project-related municipal work. We were pleased to see strong bookings across our entire Infrastructure segment, especially for our shorter-cycle products, which include gate valves, hydrants, and brass products. In addition, the backlog of our specialty valve products increased 9% versus the prior year to $98 million. Although this gives us momentum going into our fourth quarter, we remain cautious due to the highly uncertain environment and unknown impact of the pandemic. Moving on to our fourth quarter guidance. We currently anticipate that our consolidated net sales for the fourth quarter will be between flat and 5% lower compared with the prior year quarter. We do expect that our adjusted EBITDA conversion margin will improve relative to the third quarter. As a result, adjusted EBITDA is anticipated to be between flat and 10% lower as compared with the prior year quarter. Additionally, we expect to generate positive free cash flow during the fourth quarter and increase the cash on our balance sheet at the end of September 2020. Given the continued uncertainty for our end markets and the economy, we are executing initiatives to reduce operating expenses. We recently announced the closure of our Woodland, Washington knife gate valve manufacturing operations, which will be relocated to our new facility in Kimball, Tennessee. Moving the manufacturing and assembly of our knife gate valve product line will enable us to drive additional efficiencies by insourcing certain activities and further leveraging our capabilities at our Chattanooga and Albertville facilities. Going forward, we will continue to maintain tight cost controls. Additionally, we will continue to evaluate opportunities to streamline our manufacturing operations and SG&A expenses. However, we will remain focused on balancing our actions to reduce costs with the pace and timing of the recovery in our end markets and customer demand. In summary, although the COVID-19 pandemic continues to create significant challenges for our team members, our customers and our communities, I am confident that Mueller Water Products has taken the right steps to adapt and execute in this new environment. The improvements that we have made over the past few years to our processes, systems and personnel will help us address the additional challenges from the pandemic. With our flexible balance sheet and strong cash flow, we are well situated to strengthen our position in water infrastructure products and services. As a result, I remain excited about the opportunities ahead of us to further incorporate technology into our infrastructure products while also modernizing our manufacturing facilities and operations. And with that, operator, please open up the call for questions.

Thank you. Our first question is from Bryan Blair with Oppenheimer. Your line is open.

Thanks. Good morning everyone. I was hoping you could parse out the monthly sales rate for your residential products. I assume that April into May was completely frozen, and it seems like it's a decent rebound since.

Yes. So, we're not going to give monthly guidance per se, but the initial shelter-in-place impacted business, I think, in April and May the most, but to varying degrees, depending on the region. I think if you think about the Northeast, where the seven governors got together, really locked down, we saw the biggest impact there. And then kind of in the Southeast, where it was a little more lax, the least amount there. So, I think that as construction activity increased, sales and orders improved. And I think you could kind of time that with really the last half of the quarter. So, I think the good news is many contractors maintained their labor forces during April and May, took advantage of the federal incentives to keep people employed and then were able to react quickly, and that return to work quickly as possible kind of helped things dramatically, too. So, I think that the biggest wait-and-see to see here is going to be around the project-related, Bryan, I think that's where it is. If you think about what the prepared comments were, we think we're mid – or 0 to mid-single digits down as a market, but we were down almost 17%. I think the difference is the destock.

Got it. That makes sense. Appreciate the color. And if we think about the fourth quarter sales guide by end market, what are you assuming across municipal, residential and natural gas distribution? Just trying to frame what drives the low versus high end of the range.

Yes. I think it's more of the same. I think there's a lot of uncertainty around how long construction will remain as strong as it has been for – certainly for the last 6 to 8 weeks. So, I think that that will be a big piece of it. I think the other piece that's going to really impact it is where we see municipalities, if they keep their spending at these current OpEx levels. I expect the actual Infrastructure business to be pretty steady. I think it's the other pieces around it that have the variability in it.

Got it. And then last one on capital allocation priorities. Balance sheet is in good shape. Still sound a little cautious on that front. Would you be comfortable getting back to M&A or repurchase activity for the coming quarters?

Absolutely. I think we're not – we've said all along that during the difficult times, we think that's when opportunity presents itself. That's why I've had the team and the organization focused on generating cash to make sure we do have that flexibility. We would do M&A in this environment if – and there are assets out there we covet that we would like to have if they get reasonably priced. But right now, we're focused on running the business, as well as we can. We want to have – keep our powder dry and build a little more powder. And so capital allocation is just what we've always said. We're going to remain balanced between our priorities around CapEx, M&A and then returning cash to shareholders, primarily right now in the form of the quarterly dividend, which I think is a pretty good yield.

Understood. Thanks again.

Our next question is from Deane Dray with RBC Capital Markets. Your line is open.

Thank you. Good morning, everyone. Scott, you've given some terrific color here on what's going on in the municipal world. How does the whole COVID fallout make this recession different from what might be a more normal economic recession?

I think if I could – that's – this is a huge question. Thanks, Deane. There's a lot of uncertainty on how it plays out, first and foremost, because I think it is very different. What I like about – shouldn't say like, but what's very different and more encouraging is that the liquidity in the market and the willingness of the Fed, let's call it, the economic pressures are much, much less in this recession. I don't think we have the strain on the banking system that we saw in 2008 or the strain in the financial system that we saw when the dot-com bubble burst. And so what we have now is a lot more uncertainty, and as a result, a lot more volatility around demand. So, I think the biggest differences are also why I'm a little bit more bullish on coming out of that. Also, the money availability is there because the infrastructure is in fact, 12 years older than it was kind of the last go around. The break/fix is increasing at a fairly significant rate. And thirdly, the housing market really has been underinvested for a long period of time. And so I feel like with low interest rates, good demographic, good family formation numbers, low inventories that 30% of the business is going to be fairly healthy in the next, let's call it, 4 to 8 quarters.

That's real helpful. And restoring guidance for your fiscal fourth quarter, I liked how you framed the 0% to 5% having to do with the swing factor in projects. How does this framework change how you're thinking about 2021?

Yes. One of the things we want to be careful about in 2021 is that we actually had a decent Q3 from a bookings point of view. So, we're really challenged in getting into homes, getting into manholes, confined workspaces, working with water utilities due to social distancing. But in the longer-term, we know that Technologies has actually had a fairly decent first three quarters of the year from a bookings point of view, and so as we think about 2021, we are trying to balance where will we be from an allowed-to-work perspective and how those protocols are going to work. It's not being driven by a difference in economics but based on the health and well-being of our employees.

That is just so helpful, Scott. I appreciate all the elements of your answer there.

Hey, good morning. Congrats on the quarter. And I hope everyone is safe and well right now.

Thank you, Zane. Same to you.

Thank you. So first off, have your views changed regarding OpEx versus CapEx spending by municipalities and utilities since the last quarter?

Yes. I think what's happened is we saw scheduled work that normally would have taken place, especially in April and May, in different geographies where shelter-in-place orders were enforced. In those states where discretionary work was basically banned for at least eight weeks is where you saw the drawdown.

Got you. And then during the quarter, you guys also shut down the Woodland facility for opportunity, reducing the operating costs and in prep for further COVID uncertainty. At this juncture, how do you guys balance facility shutdowns with new capital projects aimed at those operational efficiencies?

Well, I think that, as I said in my prepared comments, we expect the Kimball facility to have multi capabilities. We see this opportunity to consolidate and insource more and more of it so that we're in a better supply chain situation, improving quality and having a higher number of products in the market. So, if it makes economic sense, we will continue to do it.

As we look with the closure of that, the benefits that we expect from it are built into what we see as the benefits from our three large capital projects as we talked about what we expect to be the improvement in incremental gross profit.

Thank you. And last one for me. On a modeling perspective, how should we be thinking about that as a percentage of sales? And is there going to be that particular cadence different from historical norms through this next year?

Yes. We certainly saw SG&A down slightly Q3 on a year-over-year basis. As we look back at that, we benefited from some of the temporary actions that we took, which was primarily furloughing some of the salaried employees and reduced travel. So certainly, going forward, as economic activity picks up, we would see some uptick from our third quarter. We expect fourth quarter to be higher from an SG&A perspective.

Thank you for all the color here today.

Our next question is from Brian Lee with Goldman Sachs. Your line is open.

Hi, everyone. This is Alex on for Brian. Can you bifurcate between the delays you've seen on ongoing projects in comparison to approvals for new projects?

Yes. Basically, what we've seen is a push out of the scheduled install dates, and they remain in flux. I think there's some uncertainty about when we'll gain access back to consumers' homes and when we'll gain access back to confined workspaces. But I think the fundamentals for the adoption of the technology continue to give me encouragement.

Great. Thanks for the additional color.

Our next question is from Joe Giordano with Cowen. Your line is open.

Hi, good morning. This is Robert in for Joe. Thanks for taking my question. I just have a quick one just on the 4Q sales guide. Can you parse it out between segments, just even directionally?

No. This is a really tough comp for tech because you'll recall that the bulk of the San Jose leak detection shipments happened in our Q4 last year. I don’t expect that to happen again this year. I expect the overall sales will be more negatively impacted in Technologies than I do in Infrastructure, with Technologies challenged due to ongoing restrictions.

That’s great. Thank you very much for that. I appreciate it.

Okay. Well, thanks, everyone. It was a very challenging quarter. I'm really proud of our team, especially our plant employees. I mean we have had really good participation, throughput, and great flexibility. The social distancing, the wearing of face masks, sanitizing the workspace, sanitizing common areas, I think everybody has just been really super. So, the quarter could have been worse, but it was good, and I'm encouraged by what I see both from an economic activity point of view and where we are with our water utility customers.

Thank you.

This now concludes today's conference. All lines may disconnect at this time.