Mueller Water Products, Inc. Q4 FY2021 Earnings Call

Welcome, and thank you for joining us. All participants are currently in listen-only mode until the question and answer portion of today's conference. I would like to inform everyone that this conference is being recorded. If you have any concerns, you may disconnect now. I will now hand the conference over to your host, Whit Kincaid. Thank you. You may begin.

Good morning, everyone. Thank you for joining us on Mueller Water Products fourth quarter and fiscal year-end 2021 conference call. We issued our press release reporting results of operations for the quarter ended September 30, 2021, yesterday afternoon. A copy of the press release is available on our website. www.muellerwaterproducts.com. Scott Hall, our President and CEO; and Martie Zakas, our CFO, will be discussing our fourth quarter and full year results, end markets, and expectations for fiscal 2022. This morning's call is being recorded and webcast live on the Internet. We have also posted slides on our website to go along with today's discussion and address forward-looking statements and our non-GAAP disclosure requirements. At this time, please refer to Slide 2. This slide identifies non-GAAP financial measures referenced in our press release, on our slides, and on this call and discloses why we believe that these measures provide useful information to investors. Reconciliations between non-GAAP and GAAP financial measures are included in the supplemental information within our press release and on our website. Slide 3 addresses forward-looking statements made on this call. This slide includes cautionary information identifying important factors that could cause actual results to differ materially from those included in forward-looking statements. Please review Slides 2 and 3 in their entirety. During this call, all references to a specific year or quarter, unless specified otherwise, refer to our fiscal year, which ends this 30th of September. A replay of this morning's call will be available for 30 days at 1 (800) 834-5839. 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 listening to our call continues to stay safe and healthy. The fourth quarter was a disappointing end to a strong year, which we achieved despite the ongoing pandemic and other challenges. In addition to the pandemic, we have faced many obstacles over the past year, including significant raw material and other cost inflation, supply chain disruptions, and labor availability challenges which impacted fourth quarter operations and results. I want to thank all of our team members for their perseverance and dedication throughout this past year as they continue to execute in this unprecedented operating environment. Our consolidated net sales increased 11.4% for the fourth quarter and 15.2% for the full year. Following record sales growth in the third quarter, we experienced continued strong demand in the fourth quarter driven by both new residential construction and municipal repair and replacement activity. Fourth quarter orders remained elevated compared with pre-pandemic levels and we ended the year with record backlog for our infrastructure products. While our fourth quarter adjusted EBITDA decreased primarily due to the challenging operating environment, we still achieved 6.8% growth for the year. Although we realized improved pricing in the quarter for the majority of our products, it was not enough to offset the continued higher inflation. We do expect that our current pricing actions will more than cover anticipated inflation in 2022, assuming material costs do not increase beyond current levels. Additionally, during the quarter, our specialty valve product portfolio experienced longer delivery times for parts, delaying shipments, and our ongoing plant restructuring has been impacted by the supply chain disruptions and labor challenges. I am especially pleased with our cash flow for the year, where we generated $94 million of free cash flow. We ended the year with a stronger cash position compared with the prior year after acquiring i2O Water for $19.7 million and allocating $44.8 million to shareholders. We repurchased $10 million of common stock during the fourth quarter and recently announced a dividend increase of approximately 5.5%. In summary, while we had a disappointing finish to the year from a conversion margin perspective, we delivered strong top-line growth and remain focused on overcoming the operational challenges. We believe that the record backlog across our short-cycle products, coupled with the expected realization from higher pricing, have positioned us to deliver net sales and adjusted EBITDA growth in 2022. Additionally, we are nearing the completion of our three large capital projects, which we expect to drive gross margin benefits once they are up and fully running. I am confident that we are in a great position to accelerate our strategies and improve our culture of execution as we become a world-class water technologies company, bringing solutions to critical water infrastructure. With that, I'll turn the call over to Martie to discuss our 2021 fourth quarter and full year results.

Thanks, Scott, and good morning, everyone. I hope you and your families continue to be safe and healthy. I will start with our fourth quarter 2021 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 fourth quarter, we generated consolidated net sales of $295.6 million, which increased $30.3 million or 11.4% as compared with the fourth quarter last year. The increase was primarily a result of increased shipment volumes and higher pricing at Infrastructure. We generated a 10.8% increase in consolidated net sales when compared with the fourth quarter of 2019, which preceded the pandemic, reflecting improved end market demand. Our gross profit this quarter decreased $7.6 million or 8.1% to $86.3 million compared with the fourth quarter of the prior year, yielding a gross margin of 29.2%. Gross margin decreased 620 basis points compared with the prior year. Higher pricing in infrastructure and increased shipment volumes were more than offset by continued higher inflation and unfavorable manufacturing performance, which includes the impact of labor challenges, supply chain disruptions, and our plant restructurings. Our total material costs increased 18% year-over-year in the quarter, primarily driven by higher raw materials, which increased sequentially and year-over-year. Our primary raw materials are scrap steel and brass ingot and prices of both were up over 50% year-over-year. While our price realization improved sequentially, and our price-cost relationship was negative for the third consecutive quarter. Given the acceleration of raw material pricing in the quarter, the price-cost relationship did not improve as much as anticipated due to the level of inflation. Scott will discuss the drivers of the decrease in gross margin versus expectations in more detail later in the call. Selling, general and administrative expenses of $56.6 million in the quarter increased $4.5 million compared with the prior year. The increase was primarily a result of investments, including the i2O Water acquisition, IT-related activities, and personnel-related costs, the reversal of temporary travel and entertainment savings relating to the pandemic, and general inflation. SG&A as a percent of net sales was 19.1% in the fourth quarter compared with 19.6% in the prior year. Operating income of $27.8 million decreased $12.9 million or 31.7% in the fourth quarter compared with $40.7 million in the prior year. Operating income includes strategic reorganization and other charges of $1.9 million in the quarter, which primarily relate to our previously announced plant restructuring. Turning now to our consolidated non-GAAP results. Adjusted operating income of $29.7 million decreased $12.1 million or 28.9% as compared with $41.8 million in the prior year quarter. Higher inflation, unfavorable manufacturing performance, and higher SG&A expenses more than offset higher pricing and increased volumes in infrastructure. Adjusted EBITDA of $45.6 million decreased $12 million or 20.8%, leading to an adjusted EBITDA margin of 15.4%, which is 630 basis points lower than the prior year. For the full year 2021, we generated adjusted EBITDA of $203.6 million, which grew 6.8%, yielding an adjusted EBITDA margin of 18.4%. Interest expense net for the 2021 fourth quarter declined to $4.4 million as compared with $6 million in the prior year quarter. The decrease in net interest expense in the quarter primarily resulted from lower interest expense as a result of the refinancing of our senior 5.5% notes with senior 4% notes. The effective tax rate this quarter was 24.3% as compared with 24.8% last year. For the full year, our effective tax rate was 25.8% as compared with 23.5% for the prior year. For the quarter, we generated adjusted net income per share of $0.12 compared with $0.17 in the prior year. Turning now to segment performance, starting with Infrastructure. Infrastructure net sales of $271.9 million increased $29.9 million or 12.4% as compared with the prior year primarily as a result of increased shipment volumes, particularly of hydrants, iron gate valves, service brass, and repair products, and higher pricing. Adjusted operating income of $46.2 million decreased $10.6 million or 18.7% in the quarter as higher inflation, unfavorable manufacturing performance, and higher SG&A expenses were only partially offset by higher pricing and increased volumes. Adjusted EBITDA of $59.3 million decreased $10.3 million or 14.8%, leading to an adjusted EBITDA margin of 21.8%. For the full year, adjusted EBITDA margin was 25.2%. Moving on to Technologies. Technologies net sales of $23.7 million increased 1.7% as compared with the prior year primarily as a result of our acquisition of i2O Water. Organic net sales declined slightly compared with the prior year as higher pricing was more than offset by lower volumes. Adjusted operating loss was $4.3 million as compared with adjusted operating loss of $2.3 million in the prior year. This increase was primarily due to unfavorable performance, including inventory adjustments, increased expenses associated with our acquisition of i2O Water, and higher inflation, which were partially offset by higher prices. Technologies adjusted EBITDA was a loss of $2.4 million as compared with adjusted EBITDA loss of $200,000 in the prior year. Moving on to cash flow. Net cash provided by operating activities for the year ended September 30, 2021, improved $16.4 million to $156.7 million, primarily as a result of the $22 million Walter Energy tax payment in the prior year. Our net working capital as of September 30, 2021, decreased $11.3 million to $207.1 million. Net working capital as a percent of net sales improved to 18.6% compared with 22.7%, primarily as a result of better inventory turns. We invested $16.6 million in capital expenditures during the fourth quarter, bringing the year-to-date total to $62.7 million as compared with $67.7 million in the prior year. The decrease in capital expenditures for the year, which was below our updated guidance range was primarily due to the supply chain disruptions that have slowed the pace of some planned expenditures, including spending for our large capital projects. Free cash flow for the year improved $21.4 million to $94 million and exceeded adjusted net income. At September 30, 2021, we had total debt of $446.9 million and cash and cash equivalents of $227.5 million. At the end of the fourth quarter, our net debt leverage ratio improved to 1.1 times from 1.3 times at the end of the prior year. We did not have any borrowings under our ABL agreement at year-end, nor did we borrow any amounts under our ABL during the year. As a reminder, we currently have no debt maturities before June 2029. Our senior 4% 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. Based on September 30, 2021 data, we had approximately $158.7 million of excess availability under the ABL agreement, which brings our total liquidity to $386.2 million. In summary, we continue to have a strong, flexible balance sheet with ample liquidity and capacity to support our capital allocation opportunities. Scott, back to you.

Thanks, Martie. I'll touch on our fourth quarter results, new management structure, end markets, and full year 2022 guidance. After that, we'll open the call up for questions. As mentioned earlier, there were a number of challenges during the quarter, which impacted our gross margins and led to the disappointing adjusted EBITDA conversion, which was below our expectations. The gross margin gap was approximately $15 million with the labor challenges making up more than one-third of the gap. Higher inflation, freight, and electricity costs, combined, also accounted for more than one-third of the gap. Of the other factors, the operational challenges for our specialty valve product portfolio had the largest impact, along with unfavorable inventory adjustments. The labor challenges have led to an increase in costs associated with overtime, benefits, and efficiencies. We provided additional performance incentives for team members at the plants, recognizing their hard work and dedication throughout this exceptionally challenging operating environment. Additionally, the pandemic continues to pose labor challenges for us even with the progress made with vaccinations. Our teams are working closely to continue to improve our relationships with our employees and enhance our efforts around hiring, training, and retention. Raw material inflation continued to be a headwind during the quarter. We experienced another sequential increase in raw material inflation, resulting in scrap steel and brass ingot prices up over 50% versus the prior year. Raw material prices didn't start to accelerate higher until the second quarter of 2021. Therefore, we anticipate that raw material inflation will be most impactful in the first half of the year if prices do not continue to increase. In the past, we have been successful in executing price increases as needed to more than cover inflationary expenses over the cycle. Our pricing actions during this past year, which include free price increases across most product lines, are helping to offset inflation as we saw a notable sequential increase on our price realization during the fourth quarter. Unfortunately, record backlogs are extending the timing for the realization of continued price benefits. So we do not expect to be in a positive price-cost position on a quarterly basis until the middle of 2022. At this time, we expect that our current pricing actions will more than cover anticipated inflation in 2022. This belief assumes that material costs do not increase beyond current levels. The strong demand we have experienced also led to some manufacturing inefficiencies, triggered by the rapid increase in volumes, particularly in the second half of our year. With the increased demand, we are having to run our foundries during peak periods leading to much higher energy costs. The supply chain disruptions have also led to higher freight costs and extended lead times for some third-party purchase parts. Our supply chain teams have been focused on obtaining needed supplies on a timely basis and working to find alternative sources where possible. While we believe our actions will put us in a better position to increase shipments to meet demand, we anticipate that supply chain disruptions and labor availability will continue to be headwinds well into next year. In the fourth quarter, the operational challenges were even greater for our specialty valve product portfolio, which accounts for approximately 15% of annual sales. These products are typically used in large projects with long lead times. Due to the longer manufacturing and delivery times, the gap between material cost inflation and pricing improvements can be more than now. Additionally, as a reminder, we announced a major plant restructuring project in the second quarter of 2021. At that time, we were anticipating a different operating environment. The strong demand, supply chain disruptions, and labor challenges have impacted shipments for these products and increased the transition cost for our plant restructuring. We remain confident that we will fully complete the transition and ramp up in 2023 with the margin benefits following accordingly. We recently announced a new management structure beginning with the first quarter of 2022. The new structure is designed to increase revenue growth, drive operational excellence, accelerate new product development, and enhance profitability. We believe that the new structure positions us for improved long-term growth and increased margins while helping to accelerate the commercialization of our technology-enabled products and the Sentryx software platform. The two newly named business units are Water Flow Solutions and Water Management Solutions. Water Flow Solutions product portfolio includes iron gate valves, specialty valves, and service brass products. Net sales of products in the Water Flow Solutions business were approximately 60% of 2021 consolidated net sales. Within the Water Flow Solutions business unit, we will advance manufacturing and assembly efficiencies across valves and brass products while driving the expected benefits from our three large capital projects. Additionally, we will look to increase growth in existing product areas and support expansion of valves into adjacent markets. Water Management Solutions product and service portfolios include fire hydrants, repair and installation, natural gas, metering, leak detection, pressure control, and software products. Net sales of products in the Water Management Solutions business unit were approximately 40% of 2021 consolidated net sales. Within the Water Management Solutions business unit, we look to leverage our hydrants, which provide a bridge for digital communications throughout the water system with enhanced coordination among products and services. Also, we plan to reduce product development cycle times with enhanced coordination of digitally enabled products and network management. Turning to our end markets. We again experienced strong demand and order growth in our fourth quarter driven by both new residential construction and municipal repair and replacement activity. While we expect the end markets to remain healthy in 2022, we do anticipate that growth will slow down relative to the strong recovery we experienced during 2021. State and local budgets appear to be in good shape, especially at the larger municipalities. The aging water infrastructure will continue to be a driver of repair and replacement activity at water utilities. We were pleased to see that the federal infrastructure bill was passed over the weekend. It is an important step forward for the needed investment in our aging water infrastructure. We have not built any benefits from the bill into our assumptions for our 2022 guidance. While we expect residential construction activity to continue to be healthy relative to pre-pandemic levels, we expect that it will be difficult to achieve significant growth again in 2022. Residential construction activity was incredibly strong during 2021, highlighted by total housing starts increasing approximately 18% and single-family starts increasing around 23%. We believe that supply chain disruptions, which are extending overall build cycles for new residential construction could support a healthy demand environment well beyond 2022. Moving on to our expectation for 2022. The record backlog across our short-cycle products and the expected realization from higher pricing position us to deliver net sales growth in 2022, continuing the strong net sales growth achieved in 2021. We believe the operating environment will remain challenging, especially in the first half of the year, with the potential for gradual improvement during the second half of the year. We currently anticipate that our full year 2022 consolidated net sales will increase between 4% and 8%, with our adjusted EBITDA also increasing between 4% and 8% as compared with the prior year. We expect to generate solid free cash flow during the year. These expectations assume the challenges associated with higher inflation, labor availability, and supply chain disruptions and the pandemic's impact will modestly improve relative to 2021, and that material costs do not increase beyond current levels. Our focus remains on keeping our employees safe, protecting our communities, delivering exceptional products and support to our customers, and generating strong cash flow. During 2022, we will remain focused on executing our strategic initiatives and overcoming the external and internal operational challenges. We are committed to improving our culture of execution as we become a world-class water technologies company, bringing solutions to critical water infrastructure. We are excited about the progress we have made in our new product development programs and the growing market acceptance for digitally enabled product offerings such as our Super Centurion smart hydrant, Sentryx software platform, and i2O pressure management solutions. Additionally, we are making progress on our sustainability initiatives and we'll share our strategic goals and progress in our second ESG report to be published in January of 2022. With a strong balance sheet, liquidity, and cash flow, we are very well positioned to accelerate growth and efficiencies through capital investments and acquisitions. We will continue to maintain a balanced approach to capital allocation, investing in our business and returning cash to shareholders. We recently announced another increase to our quarterly dividend, marking the fifth increase since the end of 2016. Additionally, we repurchased $10 million of common stock during the fourth quarter after resuming our share repurchases earlier this year. We currently have $135 million remaining authorization on our share repurchase program. That concludes my comments. Operator, please open this call for questions.

Our first question today comes from Bryan Blair. Your line is now open.

So you covered the headwinds you faced at a high level. I was just hoping you could quantify the impact of price costs, supply chain delays, labor-specific challenges in the quarter, and how you're thinking about each of those factors looking to the early part of your fiscal '22 and the impact on incremental progression?

Okay. Just as a reminder, the updated annual guidance suggests lower adjusted EBITDA conversions compared to the previous guidance range we provided for Q4. I'll break down the changes to that guidance. Net sales growth is a bit higher, slightly above the midpoint of our implied Q4 guidance. The 23% decline in adjusted EBITDA relative to the midpoint of our implied Q4 guidance was mainly due to a decrease in gross margin. The challenges that affected our gross margin are approximately $15 million. Labor issues and their ripple effects, including the extra costs for overtime and attendance incentives, accounted for just over 33% of that $15 million. Additionally, we faced surcharges on freight and utilities and higher inflation than anticipated, which contributed to just over one-third as well. Those were the primary factors. There were various other minor issues, but the most significant was the difficulties we encountered at Kimball with hiring and ramping up a new plant to meet increased demand. I’ve always been straightforward about these challenges, and I won't change that now. One major consideration is whether we would have expedited the closures of Surrey and Aurora in this demand landscape. The answer is no, we would not have. We were operating under different assumptions about the specialty valve business and expected a contraction in project work. This miscalculation is a key factor in the $5 million headwind we faced. The decisions we made regarding layoffs, furloughs, and accelerating closures were based on an anticipated demand environment that turned out to be incorrect. We take full responsibility for that.

I appreciate all that detail. And you mentioned accelerating price realization in the quarter. What was that figure for your fiscal 4Q? And given carryover price from back half increases and assume fiscal '22 increases, you'd have to assume both will still be above average level. What price is contemplated in your plus 4% to 8% sales guide?

Okay. I'm sorry. Yes, first me, Martie, then you. The three price increases we announced are progressing. The first price increase has fully impacted our results, the second one accounts for about 30% of our results, and the third increase will start appearing in our results this month and onwards. When considering our backlog, the timing of the price increases, and our shipping rates, the third price increase we announced in August is completely reflected in our backlog. As long as we maintain a stable cost environment, we should start to see a positive price-cost impact in our fiscal third quarter. So we expect negative results in the first quarter, breakeven in the second quarter, and positive results moving forward. Martie?

Yes. So when we're taking what Scott said, when we look at expectations for full year 2022, and that assumes that raw material and other costs don't increase from where we are we expect to be positive on price-cost for 2022, but we wouldn't were, as we always say, over the full cycle, our expectations are to more than cover cost and preserve margin. Don't expect at this point to be at that position in 2022.

Correct.

You mentioned that the infrastructure bill has passed, which is a positive development, but it has not been included in your fiscal '22 outlook. Looking ahead, how should we consider the impact on demand and possible catalysts for formula? I believe that for smaller municipalities, the increased rate of technology adoption could significantly change the game with this additional funding as we approach your fiscal '23 and '24. I am just curious if you can provide any updates on this.

Yes, this is definitely positive news in response to your question, and you should consider it a tailwind for our forecast. I do have some concerns that due to the actions of the federal government, the availability of funds in 2022 could be quite aggressive. The key aspects of the bill include $12 billion each for drinking water and clean water state revolving funds, $15 billion for replacing lead-contaminated drinking water infrastructure, and approximately $10 billion for addressing emerging contaminants like PFOS. Furthermore, there's another $50 billion allocated for enhancing the resilience of the infrastructure system, including protection against ground flags and cyberattacks, although that amount is shared with the electric grid. Overall, I believe this bill will address many of our needs. What I particularly appreciate is that the incentives in this bill may not just shift demand but could actually create new demand. It will provide funds to communities that may not be able to afford the necessary investments. For those areas with declining populations and incomes, particularly in the upper Midwest and parts of the Northeast, they will be able to access these funds more quickly than other communities with growing populations and incomes. Those declining communities will have an opportunity for infrastructure renewal that they might not have been able to afford otherwise. The investment cycle spans eight years, and while I expect a slower start, the investments should ramp up in the later years.

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

I appreciate all the specifics in being able to size the headwinds on the inflation supply chain and so forth. Can you give some color about how the monthly cadence of this progressed in the quarter? Because it really does seem like it got away from you, more so than other companies that we cover. I appreciate how, frank, you've given the specifics, but maybe just how much did this kind of catch you by surprise? Was it a last-month-in-the-quarter event? Maybe some color there, please.

Certainly. Nearly half of our total inflation occurred in the fourth quarter, with about 49% of the year’s inflation happening during that time. As we moved into the last two months of the quarter, our labor challenges became more pronounced. We should have anticipated the increase in absenteeism, especially given the high levels of overtime we were operating under during the summer months of June and July. Unfortunately, we expected attendance to remain steady. As a result, most of the inflationary pressures were focused in the latter half of the year, especially the fourth quarter. Our manufacturing performance took a significant hit during the last two months, leaving us at breakeven overall. While we made some gains through material savings and various projects, we struggled against increased costs and inefficiencies stemming from the pandemic in the earlier part of the year. Ultimately, labor shortages and peak utility periods in the fourth quarter contributed to our negative manufacturing performance for the year.

That's really helpful and gives us context about what was happening in real time. It's clear that every time you’ve spoken during the COVID era, you’ve been upfront about your actions for your employees and the incentives in place. We truly appreciate the efforts you've made. Regarding the hedging of materials, those figures for steel and brass are significant. Can you remind us how you're managing this? I'm not referring to financial hedges but rather if you are doing any prebuying. How much is secured for the current quarter? This information would be helpful.

Yes. We purchase our ingot based on our backlog. For instance, if we have 3 million pounds in backlog, we aim to have that quantity in our purchases, though it's typically less because we have adjusted our chips. Unfortunately, the availability of materials, especially in the scrap market, has made it challenging to secure that amount. Currently, we have a quarter's worth of brass contracted, but we still face challenges with scrap steel since there is not enough available for us to acquire. The shredders and cutters are not taking new orders beyond their current capacity due to uncertainty regarding their inbound supply.

And just last one since you brought up backlog. You don't typically see a bigger backlog build in your shorter cycle businesses. Do you have the ability to reprice on the backlog? And is there any kind of past due backlog number you could share?

We don't really have the ability to adjust prices on the short cycle product backlog, which is why the price increases are announced. Our customers have their forward buy window and have utilized it. Philosophically, I would prefer a situation where, while the backlog remains above a certain threshold, any announced price increase would take effect at the time of shipment, without a prebuy period. Currently, that hasn't happened, and we're discussing it with our channel partners. Announcing another price increase in the coming months, only to have prebuys delay everything again, seems unnecessary. We're exploring options to adapt in this situation. Generally, there's not much flexibility on the brass, gate valve, and hydrant side due to fixed price agreements and the 30-day window for adjusting their systems. It's important to note that the prebuy window serves not only to shift demand but also to help customers with multiple branches update their systems for coordinated purchasing, which can be a challenging task when prices increase suddenly.

Yes. We absolutely appreciate the complexities of the timing on price increases and the obligations you have to your channel partner. So I appreciate that additional color. And just last one, it's not a question, just a comment. We really do like the new resegmentation, makes all kinds of sense. So congrats on making that move. Hopefully, Martie has lots of restatement quarterlies for us because that's a big help.

Our next question comes from Brian Lee with Goldman Sachs.

This is Miguel on for Brian. On adjusted EBITDA margins, they were down this quarter, and then the midpoint of your guidance suggests flat adjusted EBITDA year-over-year. So just a couple of questions to start on supply chain and inflation and labor and also just the timing on price realizations each quarter. Can you talk through how you expect each of these to evolve over next year? And then based on the visibility you have, was this quarter sort of the bottom? Or how should we think about when we start to see some of these things get better and then you start to see a rebound in margins? And then I have a quick follow-up.

Yes. As we look ahead to 2022, it largely relates to the discussions about the price-cost relationship. We have noted the price increases for raw materials and other costs. Our expectation is that 2022 will present a challenging comparison, particularly in the first half, as the significant price increases began around the second quarter of 2021. We believe these comparisons will be the toughest during this period, but we expect to improve the price-cost balance over the quarters, provided that material costs do not rise beyond current levels. With the pricing actions we've taken so far, we anticipate being able to manage the anticipated material cost inflation in 2022.

And then just one more, if I could squeeze it in, and I'll pass it on. To what extent, if any, have you seen maybe any demand being pulled forward ahead of price increases? And if so, should we expect maybe a stronger early part of fiscal 2022 versus typical seasonality?

Yes. I think there is some expectation that our first quarter will be slow due to the tapering of the construction season, with January likely being the slowest. Following that, some production may return to the channel, potentially changing the seasonality of the business. However, the current inventory situation in the channel is quite unstable. Many companies are reporting increased inventories, but much of this is due to logistics issues. For example, pipe may have much longer lead times than valves and hydrants. Companies often have contracts for jobs but are waiting for certain products to arrive before they can proceed with installations. They are not going to install pipe without the corresponding valves and vice versa. This kind of scenario is common in the channel at the moment. Overall, while inventories are up, I believe demand is strong enough that once these logistics challenges are resolved, there will still be a need for additional inventory to meet their existing contract obligations.

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

So we kind of asked this in a bunch of different ways, but if I look at your revenue guidance for next year, how much of that do you think you hit from just price capture loans? I guess I'm trying to understand what's the implied volume growth next year on that like, 48%?

I think you could think of it as kind of about half units, and then the balance economics, whether it's price or price inflation.

That's fair. What we observed in the last quarter highlights the advantages of being vertically integrated as a company since it prevents reliance on external component parts. This aspect contributed to the surprising results. I acknowledge that some restructuring actions have contributed to this situation. However, could you elaborate on what gives you confidence in the inherent leverage of your production base, considering the high demand and associated costs like electricity? If demand decreases slightly, please discuss the leverage within your system.

I believe we will be able to respond more effectively. Even with the 11.4% growth, our position should be stronger than those who are not vertically integrated, as they are facing significant supply chain delays, similar to what our specialty business is currently dealing with. Looking back, I acknowledge that a substantial portion of the $15 million headwinds we faced in Q4 stemmed from decisions made at the pandemic's onset, such as layoffs, furloughs, tightening plant expenditure, and reducing inventories to safeguard liquidity. It is important for our management team to reflect on what we did right and wrong. In hindsight, I regret those decisions; if we had anticipated the demand levels we are now experiencing, I would not have laid off anyone, as many of those employees found new jobs and now we're struggling to find skilled labor, which has caused some challenges. As we onboard temporary staff and get them up to speed, I believe our volume leverage will improve. We will still incur freight and utility surcharges, but I anticipate that many of the temporary expenses contributing to that $15 million in Q4 will eventually dissipate. Even if just 40% of those costs go away quickly, we will see a lift together with the higher-than-normal Q1 volumes due to a strong backlog. Thus, I am confident we will have a better position compared to others relying on third-party suppliers for castings and assembly. This confidence is why we provided guidance that we believe is achievable.

Do you worry at all that there's structural labor issues? And I know you have some of your facilities in fairly remote areas. Are there just structural problems with the labor supply for like an extended period? Is there any worry about that?

Yes, I believe so. I am concerned, but I think we have solid jobs and union representation. Labor challenges have resulted in increased costs related to overtime benefits and efficiencies. The pandemic continues to create labor issues for us, despite progress with vaccines. Regulations around ocean shipping and other factors do not help clarify the current labor pool situation. There are individuals on both sides considering whether to return to the workforce. With current high demand, absenteeism remains a challenge because we're overworking our staff and not hiring quickly enough. I am indeed worried about this. However, I want to point out that labor constitutes a relatively small portion of our cost of goods sold. Therefore, even with a potential 10% or 20% increase in costs at current levels, I still believe it's economically beneficial to ensure we have enough staff to produce our products, as the returns are significantly higher. The greater risks to our financials from material costs come from potential shocks to the global economy that could lead to increased inflation. I am concerned about spending $1.2 trillion over eight years, as we currently have substantial money circulating in the system, which might lead to some lingering inflation effects. I think that poses a larger risk than labor challenges, which I view as more of a short-term issue.

Our next question comes from Walt Liptak with Seaport. Your line is now open.

I wanted to ask about the buyback you mentioned a couple of times during the presentation and the authorization details. Is there a balance you're considering between share repurchase and M&A? Should we take something away from that, or are you just highlighting it?

Just pointing it out. I think we've been really consistent with our capital allocation philosophy. I think that we've said for years now, we want a balanced approach between returning cash to shareholders, between our CapEx programs, and between acquisitions. It's an old line of business, but getting into technology, starting the digital transformation in the business, I think there was lots of opportunity to invest back in the business. I think we've shown that we are doing that. With the increases in dividends and the share buybacks, I simply want to remind everybody that we continue to return cash to shareholders. So not a signaling comment at all, just simply reminding you all that our philosophy around a balanced approach to capital allocation has changed.

All of our companies are getting hit by this inflation, labor issues, supply chain. So it's nothing new to us, especially this late in the quarter. And there seems to be a stabilization going on. So my question is, when you were looking at the guidance, it looks a little bit on the conservative side to us. I mean what could go well in your view that might make the 2022 a little bit better than expected?

I wouldn't label it as conservative. Instead, I would say we're being cautious due to the current environment, which still carries significant uncertainty. However, there are certainly some positive factors at play. Much depends on the speed at which infrastructure spending is implemented and the fact that many communities still have funds from municipal budgets due to previous allocations, such as the $50 billion designated to municipalities two years ago from the CARES Act. This could help prioritize drinking water initiatives and lead to more infrastructure changes. We also see potential upside in the break-fix segment of the business, depending on future failure rates and whether they continue to rise. So, there are some encouraging signs, but I would describe the guidance as cautious rather than conservative.

Okay. Fair enough. And then the last one for me. On the residential outlook, I wasn't sure if I understood 2022. Are you expecting volume growth in your residential products in 2022?

Yes. We expect some modest growth in the residential market due to lot developments. However, I don't believe there is enough capacity in the system to surpass the growth we experienced last year. Last year, housing starts were up 18%, and single-family homes were up 23%. I don't think we can achieve those kinds of numbers again. Looking ahead, we are cautious about expecting additional growth in the residential sector beyond 2021 levels, with around 1.1 million single-family starts being where we anticipate our model will land.

Our next question comes from Zane Karimi with D.A. Davidson. Your line is open.

So first off, a little bit around the Technology Solutions business. Are you seeing any challenges around getting chips or anything like that? And if so, are there any signs of those not alleviating?

Yes, that's a good question. We are experiencing challenges, particularly with the comp side of the business, including both cell chips and radio chips in our My Node line. So far, we've managed to meet demand through aftermarket sourcing and exploring various distribution options, although it comes at a premium. Our supply teams have done an excellent job finding alternative suppliers. Currently, we are concentrating on these alternative sources, which as we discussed earlier, have contributed to some of the inflation we are seeing. I anticipate that the supply chain disruptions will continue to pose challenges in 2022. However, I believe we can still enhance sales of technology-enabled products and services compared to our 2019 figures. While we will face many sourcing challenges, I don't think these will hinder our ability to meet our targets for 2022. I do not expect conditions to improve anytime soon. Additionally, I have concerns about the current tensions between the U.S. and China, given that China houses a substantial amount of chipset manufacturing. Therefore, we will keep focusing on sourcing from Taiwan, Vietnam, and other locations as we move forward.

Okay. And then I know we've talked a bit about pricing today, but from an industry perspective, are you seeing similar price increases from your competitors? I feel like historically, there hasn't really been any product substitution. Any reason to see that change will be different in the coming year?

Well, I don't comment on what our competitors are doing, nor am I really aware of anything. But I do think we have well-developed markets for inputs. So we are dealing with the same inflation challenges as the competitive base. And so I believe we operate in a rational market and expect everyone to adjust prices as they experience significant increases in material costs. And so I think that's been a hallmark of this industry and it's something I've been saying for five years. I do believe we operate in the rational environment. As to what their specifics are, I'm not really aware but I do think the switching costs are such that a 200 or 300 basis point difference in price is not going to turn a municipality one way or the other unless they have their own design and we all have their tools.

Okay. And last one for me. How do the i2O contributions look compared to what you were expecting or hoping for this quarter?

We are very excited about the integration so far. I recently saw a demo of Sentryx using the pressure controller, and we currently have a beta in place. I’m encouraged by the progress the team is making in integrating software platforms for the North American market. There are numerous synergy opportunities we can still explore, including using pressure loggers to enrich the data provided by the Echologics product, connecting that to Sentryx, and gaining better insights into whether an issue is a real leak or even the nature of the leak. I believe there is significant potential in using AI to analyze pressure and acoustic data to identify leaks more accurately. The team is diligently working on this. We have several pilots in motion, including the pressure controller that can adjust pressure zones and pressure loggers that should generate complementary data with Echologics. We are actively working on the application interface between Sentryx and iNet, and I anticipate that 2022 will be a pivotal year for i2O's acceptance in the North American market. Overall, I would say we are making good progress. Regarding their contribution, it remains quite small; it is currently a minor, slightly loss-making business, but that’s not the reason we acquired it. Our goal was to enter the fields of pressure controlling and monitoring, along with acoustic monitoring.

We have no further questions in queue.

Thank you, operator. Before I conclude, I want to highlight our discussions around inflation. I understand the concerns people have expressed. However, on a positive note, achieving 11.4% sales growth and ensuring we meet contracts and customer demands while maintaining our service-oriented approach is crucial. While I wish we could have avoided the $15 million headwinds we faced this quarter, I wouldn't have chosen to delay shipments to do so. Our standing in the market, particularly as the leading provider of fire hydrants and gate valves, has been strengthened by our team's dedication to operations and fulfilling customer needs. Given our strong sales performance, I believe we had a solid quarter, focusing on growth while needing to improve on cost management. Overall, it has been a challenging but rewarding quarter. Thanks to everyone for joining us this morning, and operator, you can wrap it up now.

Thank you all for participating. That ends today's conference. You may disconnect at this time.