Mueller Water Products, Inc. Q2 FY2022 Earnings Call

Welcome and thank you for standing by. At this time, all participants are in a listen-only mode. Today's call is being recorded and if you have any objections, you may disconnect at this time. And I'd like to turn the call over to Mr. Whit Kincaid. Good morning, everyone. Thank you for joining us on Mueller Water Products Second Quarter 2022 Conference Call. We issued our press release reporting results of operations for the quarter ended March 31, 2022, yesterday afternoon. A copy of the press release is available on our website muellerwaterproducts.com. Scott Hall, our President and CEO, and Martie Zakas, our CFO, will be discussing our second quarter results and our current outlook for 2022. 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 and to address forward-looking statements in our non-GAAP disclosure requirements. As a reminder, we have changed our management structure and segment reporting effective October 1, 2021. We filed an 8-K in January that provided the recast of historical quarterly results for 2020 and 2021. This is our second quarter reporting with our new segments, Water Flow Solutions and Water Management Solutions. 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. It discloses the reasons 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 on the 30th of September. A replay of this morning's call will be available for 30 days at 1-800-8195739. The archived webcast and corresponding slides will be available for at least 90 days on the Investor Relations section of our website. I will now turn the call over to Scott.

Thanks, Whit. Thank you for joining us on the call today. I hope everyone is safe and healthy. Before getting started, I would like to comment on the terrible humanitarian crisis in Ukraine, which is having many direct and indirect effects around the world. While we have no sales to Russia or Ukraine, we see the effects on our global supply chain. Most importantly, our thoughts and prayers are with those impacted by the conflict. With that, I will turn to a short recap of our second quarter. We achieved record second quarter net sales and delivered our fourth consecutive quarter of double-digit net sales growth. Our consolidated net sales growth of 16% in the quarter was supported by both improved price realization and continued strong demand. We are encouraged that our price realization more than offset inflation for the first time in more than a year. We experienced solid order growth in the quarter with end market activity remaining robust in both municipal repair and replacement and new residential construction. With another strong quarter of net sales growth, record backlog at the end of the quarter, and expected realization from price increases, we are again raising our expectations for annual net sales growth. Overall, I am pleased with the diligence and focus of our teams as they continue to secure materials for production, manage our record backlog, and serve the needs of our customers during this challenging operating environment. Our second quarter conversion margins were below expectations, primarily due to operational challenges which I will address later in the call. However, we anticipate delivering improved conversion margins in the second half of the year, leading to adjusted EBITDA growth for the year. While we believe the operational challenges will continue through 2022, we are confident that our teams can execute initiatives to help offset them and increase margins for the balance of the year and beyond. Before providing more details on our second quarter and updated guidance, I'll turn the call over to Martie to discuss our second quarter results.

Thanks, Scott, and good morning, everyone. I will start with our second quarter 2022 consolidated GAAP and non-GAAP financial results. After that, I will review our segment performance and discuss our cashflow and liquidity. During the second quarter of this year, we generated consolidated net sales of $310.5 million, which increased $43 million or 16.1% compared with the second quarter of last year. We increased net sales in both Water Flow Solutions and Water Management Solutions, with both segments benefiting from higher pricing across most of our product lines and increased volumes. As a reminder, net sales in the prior year quarter benefited by $6 million as a result of the elimination of the one-month reporting lag for Krausz. Gross profit this quarter increased $4.4 million or 5% to $92.8 million compared with the prior year, yielding a gross margin of 29.9%. Gross margin decreased 310 basis points compared with the prior year as the benefits of higher pricing and increased volumes were more than offset by higher costs associated with inflation and unfavorable manufacturing performance. Selling, general, and administrative expenses of $58 million in the quarter increased $3.8 million or 7% compared with the prior year. The increase was primarily a result of inflation, higher T&E, trade show activity, investments, and the addition of i2O. SG&A as a percent of net sales improved to 18.7% in the quarter compared to 20.3% in the prior year quarter, due to the leverage from higher sales. Operating income of $34.2 million increased $800,000 or 2.4% in the quarter compared with $33.4 million in the prior year. Operating income includes strategic reorganization and other charges of $600,000 in the quarter, which primarily relate to the previously announced plant closures. Turning now to our consolidated non-GAAP results. Adjusted operating income of $34.8 million decreased $400,000 or 1.1% compared with $35.2 million in the prior year. Higher pricing and increased volumes were more than offset by higher costs associated with inflation, unfavorable manufacturing performance, and higher SG&A expenses. Adjusted EBITDA of $50.6 million was nearly flat to the prior year quarter. Our adjusted EBITDA margin was 16.3%, which is 310 basis points lower than the prior year. For the last 12 months, adjusted EBITDA was $206.3 million or 17.4% of net sales. Net interest expense for the quarter declined to $4.5 million compared with $6.1 million in the prior year. The decrease in the quarter primarily resulted from lower interest expense associated with the refinancing of our 5.5% senior notes with 4% senior notes. We increased adjusted net income per diluted share by 7.1% to $0.15 in the quarter compared with $0.14 in the prior year. Turning now to segment performance, starting with Water Flow Solutions, which consists of our iron gate valves, specialty valves, and Service Brass products. Net sales of $183.9 million increased $36.8 million or 25% compared with the prior year, due to increased volumes and higher pricing across most of the segment’s product line. Our gate valves and specialty valves experienced double-digit net sales growth compared to the prior year. However, brass service product shipments were impacted by manufacturing inefficiencies from increased equipment downtime and the ongoing supply chain disruptions. Adjusted operating income of $35.4 million increased $3.3 million or 10.3%, as higher pricing and increased volumes were partially offset by higher costs associated with inflation, unfavorable manufacturing performance, and higher SG&A expenses. Adjusted EBITDA of $42.9 million increased $3.3 million or 8.3%, leading to an adjusted EBITDA margin of 23.3% compared with 26.9% last year. Despite the operational challenges impacting our manufacturing costs, conversion margin was 9% in the quarter for the segment. Moving on to Water Management Solutions, which consists of fire hydrants, repair and installation, natural gas, metering, leak detection, pressure control, and software products. Net sales of $126.6 million increased $6.2 million or 5.1% compared with the prior year, primarily due to higher pricing and increased volumes across most of the segment’s product lines and the addition of i2O. Excluding the prior year one-time benefit from the one-month reporting lag, net sales for the 2022 second quarter increased 10.7%. Fire hydrants, natural gas, and repair and installation products experienced double-digit net sales growth compared to the prior year. Additionally, sales of meter and control valve products continued to be constrained by ongoing supply chain disruptions and manufacturing inefficiencies. Adjusted operating income of $11.8 million decreased $4.4 million in the quarter as higher pricing and increased volumes were more than offset by unfavorable manufacturing performance, higher costs associated with inflation, and higher SG&A expenses. Adjusted EBITDA decreased $4.3 million to $19.1 million in the quarter, leading to an adjusted EBITDA margin of 15.1% compared with 20.5% last year. Moving on to cash flow. Net cash provided by operating activities for the six months period was $800,000 compared with $63.2 million in the prior year. The decrease was primarily driven by higher inventories and payments, including customer rebates, income taxes, and employee incentives. Average net working capital using the 5-point method as a percent of net sales improved to 25.8% compared with 28.6% in the second quarter of last year. For the six months period, we have invested $26 million in capital expenditures compared with $31.1 million spent in the prior year. Free cash flow for the six months period was negative $25.2 million compared with $32.1 million in the prior year, primarily due to the cash used in operating activities in the second quarter. For the full year, we anticipate that free cash flow will be positive, and cash provided by operating activities will be positive in the second half of the year. However, we expect it to be below 2021 primarily due to higher inventories resulting from investments and inflation. As of March 31, 2022, we had total debt outstanding of $447.1 million and total cash of $164.1 million. At the end of the second quarter, our net debt leverage ratio was 1.4 times. We did not have any borrowings under our ABL agreement at the end of the quarter, nor did we borrow any amounts under our ABL during the quarter. As a reminder, we currently have no debt maturities before June 2029. Our 4% senior 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 March 31, 2022 data, we had approximately $160.1 million of excess availability under the ABL agreement, which brings our total liquidity to $324.2 million. We continue to maintain a strong, flexible balance sheet with ample liquidity and capacity to support our capital allocation priorities. Scott, back to you.

Thanks, Martie. I will touch on our second quarter performance and updated outlook for 2022. After that, we'll open the call for questions. One of the highlights from our second quarter was pricing. We saw significant sequential improvements in price realization in the quarter as our teams continued working through our backlog. Given the level of inflation we continue to experience, we were pleased to see the progress we've made with our past pricing actions and remain encouraged for our team's execution and the market's acceptance level. We again took pricing actions on the majority of our steel products during the quarter to help address the ongoing inflationary pressures and supply chain headwinds. As referenced earlier, our second quarter conversion margins were below expectations. We faced a variety of operational challenges in the quarter from inflationary pressures, supply chain disruptions, and unfavorable manufacturing performance at our foundries. The indirect effects from Russia's invasion of Ukraine continue to ripple through the global supply chain, exacerbating the ongoing material availability challenges and increasing costs for energy, freight, raw materials, and purchased parts. During the quarter, we experienced a sequential increase in raw material prices, most notably scrap steel. We expect to continue to experience inflation in scrap metal, brass ingot, and other materials throughout the year. In addition to higher material costs, we continue to face challenges with material availability. As our teams remain focused on serving the needs of the customer and working to meet project timelines, we have paid premiums to access needed materials. The supply chain disruptions have also impacted our freight costs. Overall, the environment remains highly uncertain. However, we're hopeful that some of these costs will not extend beyond 2022. Manufacturing performance at our foundries was unfavorable this quarter due to high labor and energy costs as well as increased equipment downtime. The increased utilization at our foundries led to unplanned equipment failures. Our teams are counter measuring and have initiated action programs associated with driving uptime, improving supply chain logistics, and improving operational efficiencies. In the near term, we do anticipate that we will continue to experience elevated maintenance costs and increased outsourcing costs for the rest of the year. We are focused on improving production levels in the second half of the year as we manage our backlog and strong demand levels. In summary, I am pleased with the diligence and focus of our teams as they continue to secure materials for production, manage our backlog, and serve the needs of our customers during this challenging operating environment. We expect that higher price realization from our pricing actions will help offset the elevated manufacturing costs and sequentially improve margins in the second half of the year. We will continue to monitor the inflationary environment closely and we'll take additional price increases as needed to help offset cost pressures. As a reminder, over the entire inflationary cycle, our goal is to have price increases more than cover inflationary expenses and preserve margins. I will now briefly review our end markets and updated outlook for 2022. We saw healthy order activity again in the second quarter with end market activity remaining robust. The municipal repair and replacement market continues to benefit from healthy budgets, especially at larger municipalities. As a reminder, we have not included any benefits from the infrastructure bill in our assumptions for 2022 guidance. The new residential construction end market maintained momentum in the second quarter, reflected in the 10% increase in total housing starts. Our expectations for new residential construction are for activity to return to a more normalized level in the second half of the year, primarily due to higher interest rates. We are pleased to be, again, raising our annual guidance for consolidated net sales growth for the year. Taking into account our strong second quarter growth and current expectations for end markets, we now anticipate consolidated net sales will increase between 10% and 12%. Our record backlog and expected realization for price increases gives us confidence in our second half net sales forecast. We anticipate delivering improved conversion margins in the second half of the year leading to adjusted EBITDA growth for the year. We now expect adjusted EBITDA to increase between 7% and 10% compared with the prior year. Our updated conversion margin expectations assume the challenges associated with the supply chain disruptions, inflationary pressures, and unfavorable manufacturing performance continue throughout the rest of the year. In summary, I continue to be impressed with the dedication and perseverance of our team members as they navigate an unprecedented operating environment. While they continue to prioritize serving our customers, they also remain focused on executing our strategic initiatives to grow and enhance our business. We're creating a stronger foundation for future growth and have the right strategies in place to expand our presence in the market as we become a technology-enabled solutions provider to water companies. We continue to innovate, bridging the gap between infrastructure and technology, keeping sustainability and responsibility at the forefront of our engineering, design, and manufacturing processes. Our ESG goals are aligned with our business strategies and I am confident that together we will contribute to creating a safer environment in a more sustainable future. We have delivered net sales and adjusted EBITDA growth over the last 12 months, including four consecutive quarters of double-digit net sales growth. Our product portfolio is well-positioned for continued growth given accelerating impact from aging infrastructure, government stimulus focused on repairing water networks and improving operations, including benefits from our capital investments. We have a strong balance sheet, liquidity, and cash flow, which support our strategies. We continue to take a balanced and disciplined approach to our cash allocation strategies, focusing on reinvesting in our business, accelerating growth through acquisitions, and returning cash to shareholders through our quarterly dividend and share repurchases. We are confident that our growth strategies, capital investments, and operational initiatives will enable us to deliver further sales and adjusted EBITDA growth. And with that, Operator, please open this call for questions.

The Q&A session is now open for questions. The first question in the queue is from Jake Jernigan with Baird, your line is now open.

Hey, good morning, everyone, I'm Terry Mike Halloran today. So, first question, just on some of the implied sequential margin improvement here, looks primarily attributed to price cost, just continuing to normalize and start to turn positive. Why is that accurate, and then second, are there any notable divergences here in terms of the sequential improvement by segment?

No. I think that as I said in the prepared comments, we do anticipate that the initiatives we have around uptime, around supply chain logistics to ensure that material is out of machine when the machine is available to run and to ensure the man is at the machine when it's available, things like that. We have implied in the sequential improvement, improved it from our Q2 performance. I think whereas, as I said in my prepared comments, a little disappointed on the conversion margin, I would have liked to have had a little better manufacturing performance. Certainly, we knew there would be some challenges, but implied is the price costs, as you said, but it's also some manufacturing improvement in the second half of the year.

Got it. Thank you. And then so in terms of free cash flow here, the lower CapEx – or I mean, the higher CapEx this year was anticipated. We knew that. And then, obviously, inventories here have become a headwind. It's just thinking directionally into next year with the lower CapEx theory inventory should swing in your favor. Is the expectation right now you should return to kind of normal conversion levels or is there a chance we see maybe that swing a little more positive versus history? And then the second part of the question would be with some of these equipment downtimes and things like that and kind of materialized the potentially maybe increased visibility to some other modernization opportunities out there outside of what you already have planned. So, any color on those two would be great.

Okay. Well, I'll let Martie handle the cash flow question when we come to it, but for just to reiterate what I said about the equipment downtime and some of the operating challenges. I think that if you think about OEE and what the causes are, is the machine operable or is it broken down? Maintenance costs, things like that are there? Is demand there or is it a labor shortage issue? Those all got better in the second quarter compared to the first. Sorry, the downtime was worse than the second quarter, but the staffing levels, I think have smoothed out from things I've said in the past. And so now really, we're focused on, do we have the material there so that it can be processed? Have we got supply chain logistics issues with having material on hand? And do we have equipment with its preventative maintenance schedules in place so that it can operate when we expect it to operate? I think those are the two bigger challenges and as I said in the first question there, there is some implied improvement in our guidance in the second half. As for free cash flow, Martie.

Yeah. So, looking at our free cash flow, when you look at where we stood for the first six months of the year, we were about $57 million below the prior year. And as I said, that was largely due to the higher inventory levels that we have as well as certain payments that we made. When we look out for the full year, we do anticipate that free cash flow will be positive. We think that cash provided from operating activities will be positive in the second half of the year. However, when we think about where we will be for free cash flow for the full-year 2022, as opposed to 2021, we think we will be below the 2021 levels with some of the reasons being the higher inventory levels resulting from some of the investments that we're making in and around purchase parts, etc., as we discussed, as well as inflation. Additionally, when we look at where our current expectations are for capital expenditures for 2022, those are higher than where we came out in 2021.

Got it. Appreciate it. I'll jump back into the queue. Thank you.

Thank you.

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

Hey, everyone, good morning. Thanks for taking the questions. I might have missed this, but did you call out what you actually saw on price in the quarter? And then with respect to the future pricing actions, can you give us a bit more detail on kind of the timing and magnitude? And then also if you saw any pull-forward on demand ahead of the pricing actions, and if that impacted Q2 at all.

This is a reminder. We don't announce prospective price increases without first having published with customers. But I can retrospectively say that during Q2, we took a couple of pricing actions. One were related to brass and then two separate actions, actually related to steel as the impacts of the pig iron shortage led over into the scrap steel market pricing as a result of the Russia-Ukraine situation, and so – but none of those price actions really manifested themselves in a current quarter. Our backlog is such that the lag is anywhere from three to four months out. But I think price realization stepped up sequentially due to previous quarter announced price actions. I think realization is down in the high single-digits, about half of Q2 organic net sales growth. We continue to have order growth, which resulted in another quarter of record total backlog end of Q2, both pre and post price increase, which I think is encouraging. I think price realization will continue to improve throughout the year as we ship against older orders that are in our backlog, and we purged some of those older orders that will have an ever-increasing price realization environment. I think the teams managing the backlog have made a lot of progress in some areas and less so in a couple of others. But obviously, we continue to monitor the inflation environment closely and if we need to take additional price increases, we will help offset cost pressures. I think I want to remind everybody over the entire inflationary cycle, our goal is to have prices more than cover inflation and preserve margin, so no dilution effect. And so, we're in this climate market, we're in that lag period but I do believe that we're getting through a lot of the backlog and that's why we remain bullish on the second half of the year.

All right. That's super helpful. And then just on that point, the second half of the year, if I just – and Scott, look at your guidance. You guys basically grew the first half of the year, kind of mid-teens on the top line on a year-on-year basis, implicit in your guidance for the rest of fiscal '22, you're going to grow half of that, sort of 7% to 8% in the second half versus the second half of last year. I know the comps are a little bit different but with price reading out kind of at those levels, does it imply you're seeing volumes steady or starting to slow in the back half to try and reconcile the second half trend versus what you saw in the first half with price still being at your back, it sounds like.

I think that that's a good observation. I think that we expect the operating environment to remain challenging for the rest of the year. Plus we're going to be lapping one of our strongest Q3s that we've had. Well, frankly, when you think about our Q3 last year, I think the anticipation of shipment volumes in the second half with these uptime challenges and these more complexities in the supply chain. The second half is a little bit lower than actually units in the prior year due to strong volumes in the second half last year and these ongoing operational challenges. And so, I think in 2021, or Q3 was one of our better months because we had virtually no operational headwinds. And you'll recall that we actually had more units on the shelf. So if you were to inflation adjust inventories for these increases, you realized that we actually sold more than we actually produced in the second half of last year as a result of having bigger inventories of finished goods as we went into it. And so, while we will be lapping a challenging Q4 in 2021, I think material availability is a much bigger challenge for us this year than it will be for last year. And so basically, as you have correctly surmised, most of the volume in the second half is really price-related. And our guidance implies that we're going to continue to have some of these supply and maintenance issues in front of us and we will sequentially improve. That is not to say the team won't have any improvement, but it will be not as strong as the previous year in units.

Okay. Fair enough. That's helpful. And then maybe just the last one. In terms of seasonality, you mentioned sequential improvement, obviously from Q2 to Q3 you will see that, but should we expect normal seasonality where Q4 is a little bit softer than Q3, or because of some of the sequential improvements around uptime and what have you, we could actually see abnormal seasonality where Q4 is better than Q3? Thank you.

Well, Q4 is always not just seasonality; it's also how many people face availability we have. We have our summer shutdowns; it's just very hot in our boundaries. We looked at absenteeism, there's a whole bunch of internal reasons. But I think that the general gist of your question is the backlogs are so strong, it's really now about what we can produce and what sales focus needs for getting projects completed during the peak construction months. And so I expect you'll see the seasonality muted in the second half, but I think that Q4, as always, the quarter ending September 30th will have, from production days, the majority of our vacation time, etc., will take place in that period and we will have comparatively lower throughput.

All right. Makes sense. Thanks, guys. I'll pass it on.

Thank you.

Next question is from Deane Dray with RBC Capital Markets. Your line is now open.

Thank you. Good morning, everyone.

Good morning, Deane.

From our perspective, the positive price costs this quarter was the significant upside surprise. I know that's something you all have worked really hard on. If we could – and I was really interested in your comments about how much of this was reading through from backlog. And it sounds like – so what's the – if you give a perspective on implied margins in the current backlog. And that should be helpful for us in terms – I know you're not going to give implied price, but implied margin in backlog versus where it was, let's say, this time last year.

Yeah. I don't know that I have the exact number, but I do know that the last quarter when we had the call, Deane, we thought we would get the break even to get price inflation on the right side of the ledger for the first time in more than a year, which was good news. And the backlog margin, assuming the lapping that we have in our guidance, I believe takes us from this high single-digits into low double-digits in the second half of the year is what you would get as the implied improvement. I think that the margin improvement that's implied mathematically in the second half from our Q2 actual is partial price and then partial improvement in the manufacturing performance line, which saw the costs associated with outsourcing. It saw the costs associated with frankly scrambling to get scrap metal as a result of when Russia invaded Ukraine. I don't know if you're aware, but about 60% of the world's pig iron gets produced in those two countries. And so, it was a bit of a mad dash. We think we have secured supply now. We think – certainly, we've got those increased costs. But that manufacturing performance in price will yield all the improvements in implied margin in the second half.

How much just on the raw materials? How much of the scrap steel and brass ingot have you pre-purchased or committed to the demand you expect for the current quarter?

Yeah. So, I think we're covered for the current quarter in brass all the way home, so at least 80% of it. Scrap steel, virtually three days – we have visibility to three to five days right now. And so, every day, I think this is an interesting point not to get philosophical, but we've taken organizations that have been focused on cost, that was focused on price out in our supply chain. We have a team of very capable professionals whose whole reason for existence for many years of their career was to get the price lower tomorrow than it was today and find savings in logistics, find savings in carriers and all of that kind of thing. And now, every day the meeting is about when do we run out of steel and where do we get more steel?

I'd imagine though some of your steel is since you can't get scrap, you have to go to Virgin.

Yes. We've been using some busheling here and there now. Thankfully, the busheling utilization in Q2 was minimal. So, we have been able to get shred and plate. But as you know, fortunately, it costs as much as virgin pig. And then by the time you freight it from some of the rail yards, it could actually be a premium. So, we've got the pig iron. We think we've got a source to keep us in good shape for the virgin material for about 90 days. And for everybody's benefit, that's about 15% of the valve mix needs to be pig and hydro mix, and then the balance needs to be scrapped and high-quality plate as opposed to some of the thinner shreds that creates a lot of slag in the ladle.

All right. And then I'd like to revisit the commentary about equipment failures. And if we keep it simple, for me, inefficiencies are when you have startups and changeovers and staffing level issues. But it also sounds like you've actually had machines broken. And is its outdated equipment? Is it a maintenance problem? And maybe to differentiate, what is just manufacturing inefficiency versus actually machine failures?

Okay, so OEE was poor for the quarter at two facilities in particular. I won't name names, but one of them is the old brass foundry. Obviously, that's 100 years old. It's got some very old equipment. I think the equipment issues primarily have been due to increased utilization at all the foundries. So as more time increases as we are making time for preventative maintenance in a more constricted window, we're starting to see unplanned failures increase particularly at two plants. I think the teams have been briefing us on the countermeasures and have initiated actual programs around improving uptime. And all of that includes more structure to the preventative maintenance programs. Some outsourcing of maintenance to third parties so that we can get faster turnaround times. Workforce arrangements to ensure coverage on Sunday, and we try and do some of the more critical process maintenance so that on Monday mornings we're hopefully going to get the week from it. We anticipate, as I said in my prepared comments, continued elevated maintenance costs because some of the critical things that, Deane, normally would take like a gearbox for a machine might take eight hours to fix, we were having to increase our spares across the board because the reliability of getting spare parts in on a lot of these machines which used to be a 24-hour overnight delivery is now several weeks, and so we've gone back and examined all our critical-to-success spares and increased those inventories dramatically in the quarter. So we have a lot of different ways of thinking so that we can ensure that not only does the maintenance get done, but that when something does go down on an unplanned basis, the cycle time to get it back up and running is back near usual norms as opposed to some of the outliers we've seen as a result of the difficulties in the supply chain.

That's really helpful. Thank you.

Thank you.

Our next question is from Joe Giordano with Cowen, your line is now open.

Good morning. This is Michael in for Joe.

Morning.

Go ahead, Michael.

Thanks for taking my question. I realized you haven't included any infrastructure bill impacts in the guide. However, is there any color you could provide related to pockets of opportunity on this front?

I think in 2022, they're all very, very muted. There are some rumblings that some people are going to qualify and that the projects are being evaluated. There's the Lead Copper Rule. It looks like it's going to be the one that's easiest for municipalities. It's got the most press and visibility as to what the rules that are going to be. But I think even what we are sitting at, and are here, it is made maybe the third or fourth or whatever it is. And so, we've got seven months to have the project in, approved, allocated in for shovels to grow into the ground, for fittings and things like that to actually being used. I think it's highly unlikely that you will see much in the way of meaningful impact to demand in the current year from the infrastructure bill. I think '23 and beyond is where these things start to go. And I would remind everybody on the whole $1.2 trillion, when you take away the re-authorization dollars and you get to the real stimulus dollars, which maybe $600-700 million of the bill, remind everybody that it is backloaded in years 5, 6, and 7. So it's an eight-year program and years 5, 6, and 7 have the bulk of the funding.

Thanks. That's helpful. And just one more if I may. As we look towards the housing market link, how are you guys thinking about new construction? And are there any other KPIs on the Resi front that seem interesting to you?

I think that the RESI front in and of itself is going to be interesting for the next four or five quarters as we see what happens with inflation and what the response to interest rates will be. Remind everybody though that we're really early in the cycle, and we use RESI as a proxy. But really, our products get deployed in large numbers when lots are being developed. So, we didn't see any signs of slowing in Q2, which I think was reflected in our Q2 orders. I think the new residential construction end market maintained momentum in the second quarter as a result of the 10% increase in total housing starts. Single-family starts were 1.1 million units over the last 12 months through March. And while I think future rate increases can have play a strong role in the strong quarter we had, I believe the developed lot inventories remained relatively low in many of the key markets where consumer demand has been especially strong. And I think as I said, we're early in the cycle. So, when the lots get developed, not necessarily when the permit gets pulled, do we start to see our impact in that light lot inventory – a lot of Ls there – makes it difficult for builders to sell homes. And so, we think a lot of subdivision development is still in the future. And so, we remain relatively bullish. Our part of RESI is irrespective of what we start to see with interest rates. Although, this morning's Wall Street Journal articles and things like that were certainly aware of them are watching it very, very closely. And so, I think the residential construction activity could remain above pre-pandemic levels beyond 2022 for us. I think due to that low lot inventory and what seems to be really, really good fundamental consumer demand, even at these 6% interest rate levels.

Great. Thank you. That's very helpful.

Your next question is from John Ramirez with D.A. Davidson. Your line is now open.

Good morning. This is John Ramirez from Brent Thielman. Thank you for taking my questions.

Good morning.

Jumping into the first question, how have higher natural gas prices impacted margins? And are you hedging those costs for your facility?

Yes. None of our foundries use natural gas for power generation; they all rely on electricity and are coal-free. While natural gas has had some minor impact on our energy costs, it's a small factor in our overall operations. Most of our capacity is located in the Tennessee Valley Authority districts, such as the plants in Auburn, Alabama and Tennessee, which are quite electricity-intensive but do not generate much power from natural gas. Additionally, our Decatur facility is served by Amarin substations, and I'm not entirely sure of their primary power source, but I believe they purchase some power from Exelon, which operates nuclear plants in Illinois. Overall, we have minimal exposure to natural gas.

Thank you. And for the second question, that the inflationary environment costs utilities to look at the solutions more or are budgets more constrained and more break-fix work is being prioritized?

I think mostly municipalities are fairly flush with money and I think it really started with the CARES Act grants that put $5.5 billion into a lot of municipalities' hands. And so those larger municipalities, I think, are examining more of the solution kinds of things. Just to touch on it, I know that we'll be running some spark hydro trials in Boulder in the coming days, we have some active in McKinney, Texas. So, it's larger communities looking to see how they can make their workforce efficiency a little bit better and I think that there is more receptivity out there. But with that said, I think there's very cautious industries that we talked about many, many times. And putting their big toe in the water versus full-scale adoption, I think is the few things that we have to watch for and look for those road signs that tell us it's ready. But to your other part of your question, break-fix continues to be on track and I will go back to say, we talked about – for those on the call that have been talking about break-fix with me for the last several years, as we talked about the increasing failure rate of 70-year-old infrastructure is tracking as we anticipated three and four years ago with kind of these double-digit increases. And so, both parts of the perfect storm. RESI is good. You need to have money for operations and maintenance and break-fix is increasing. That's why you post up 16% sales growth and be double digits for four quarters in a row.

Thank you. I appreciate the time. I'll jump back in the queue.

Okay. So, thanks. Thank you. And thanks to everyone for joining today's call. I think we're very pleased with where we are through the first half of the year, given the external challenges and kudos to the team for managing through what has been some pretty unprecedented challenges both in the supply world and this post-pandemic operating environment we're in. Look, I really think the team’s ability to get price in the market will help offset any further inflation. It gives me confidence that even if there are a few more curve balls coming, that we can manage through it. I think that the processes are in place, the people are in place to make the right decisions. And I think even at the ground levels, we're starting to see good traction with good customers as it relates to getting trials in place and having meaningful business discussions around the economics of what's going on out there. I think the continuation of net sales and order growth is a testament to the health of our end markets. I believe our spec position in our products are well-positioned in the market. And we're very pleased to be raising annual sales guidance again. I think the challenges and uncertain environment are keeping us from increasing the annual adjusted EBITDA guidance in lockstep with the net sales growth this year. But I do think as we've purged backlog and getting more of the current order environment showing up in our P&L that we will then have the reversal of that. And that is that EBITDA will have the opportunity to grow a little faster than sales in some of those out-quarters and we'll get back to normality and equilibrium. I think we're focused on countermeasuring the offset, the operational challenge for the position to sequentially improve margins for the rest of the year with the support from price realization. And I believe our foundation continues to improve and remain bullish for next year. So, I'm really looking beyond this year. I'm excited about our growth potential in the water infrastructure market. I think the benefits will be seen from our large capital investments in the path we're on to become a sustainable leader in the water infrastructure that will leave us in good shape. And so, thank you for your continued interest. And Operator, I would ask that you please conclude the call.

This concludes today's call. Thank you for your participation. You may disconnect at this time.