Mueller Water Products, Inc. Q4 FY2022 Earnings Call

Welcome, and thank you for your patience. I will now hand the call over to Whit Kincaid. You may proceed. Good morning, everyone. Thank you for joining us on Mueller Water Products Fourth Quarter and Fiscal Year-end 2022 Conference Call. We issued our press release reporting results of operations for the quarter ended September 30, 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 fourth quarter and full year results and our outlook for 2023. 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, which address our 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. 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 1-800-834-5839. 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. Good morning. Thanks for joining us for our fourth quarter earnings call. We were pleased to deliver our second consecutive year of double-digit net sales growth. Our fourth quarter net sales growth exceeded our expectations, driven by continued higher price realization. We saw healthy order activity during the quarter and ended the year with record backlog. The sequential increase in orders is a testament to the resiliency of end market demand in the face of an evolving macro environment. Our fourth quarter results were disappointing as lower-than-expected shipment volumes of service brass products and manufacturing inefficiencies at our brass foundry more than offset the higher net sales. While improved price realization has helped offset the current level of inflationary pressures, it has not been enough to offset all of the headwinds. Although we continue to experience headwinds from the ongoing supply chain disruptions and inflationary pressures, our teams maintain their focus on executing our large capital projects. We have a lot more work to do, but are confident we will deliver the benefits of our key initiatives including our large domestic capital investments. Last month, we announced several corporate governance changes, including the appointment of two new Board members. Our Board also announced a process to accelerate the refreshment of our Board of Directors. Our Board believes in the importance of having best-in-class corporate governance, including a proactive Board refreshment process and ongoing shareholder engagement. Both new members bring valuable operating and supply chain management experience to our Board. We believe Mueller and its stockholders will benefit from the perspectives and insights of our new Board members and their support of the company's commitment to enhance shareholder value. Before turning it over to Martie, I want to thank Bill Cofield, our Senior Vice President of Operations, who recently announced his retirement. Bill has worked tirelessly to drive process improvement in our operations during the past five years. Most notably, he led the development and execution of our safety, excellence and leadership program, which is used to evaluate safety and environmental performance across all areas of our facilities. Bill has kindly agreed to stay on to support the transition to new leadership. Paul McAndrew just started as Mueller's new operations leader. Paul brings more than 20 years of manufacturing experience and served most recently as Vice President of Global Operations and Supply Chain for Emerson Commercial and Residential services. Now I'll turn the call over to Martie to discuss our financial results.

Thanks, Scott, and good morning, everyone. I will start with our fourth quarter 2022 consolidated GAAP and non-GAAP financial results. After that, I will review our segment performance and discuss our cash flow and liquidity. Our consolidated net sales increased 12.1% to $331.4 million compared to the prior year with growth in both water flow solutions and water management solutions. The increase was primarily due to higher pricing across most of our product lines, which was partially offset by a decrease in volumes, mainly in our service brass products. For 2022, our consolidated net sales increased 12.3% due to both higher pricing and increased volumes. Gross profit of $85.6 million decreased 0.8% compared with the prior year. Gross margin of 25.8% decreased 340 basis points compared with the prior year as benefits from higher pricing were more than offset by higher costs associated with inflation, unfavorable manufacturing performance and lower volumes. The unfavorable manufacturing performance, which includes the impact of outsourcing, machine downtime, supply chain disruptions and labor challenges was primarily driven by our brass foundry and specialty valve operations. Inflation increased sequentially as we experienced higher costs associated with raw and purchased materials, tariffs, utilities, freight and labor. The supply chain disruptions continued to impact our total material cost, which increased around 14% compared with the prior year. However, our price realization again improved sequentially, more than covering inflationary pressures. Selling, general and administrative expenses of $63.6 million in the quarter increased 12.4% compared with the prior year. The increase was primarily driven by inflation, investments in personnel, travel and entertainment, trade show activity and professional fees. SG&A as a percent of net sales was 19.2% as compared to 19.1% in the prior year quarter. Operating income of $11.6 million decreased 58.3% in the quarter compared with $27.8 million in the prior year. Operating income includes strategic reorganization and other charges of $3.6 million in the quarter, which primarily relate to transaction expenses and previously announced plant restructurings. Additionally, we wrote off the goodwill relating to our specialty valve product line, which was a noncash expense of $6.8 million. Turning now to our consolidated non-GAAP results. Adjusted operating income of $22 million decreased 25.9% compared with $29.7 million in the prior year. The benefits from higher pricing were more than offset by higher costs associated with inflation, unfavorable manufacturing performance, SG&A expenses and lower volumes. Adjusted EBITDA of $38.6 million decreased 15.4% in the quarter, leading to an adjusted EBITDA margin of 11.6% compared with 15.4% in the prior year. For 2022, adjusted EBITDA of $194.5 million declined $9.1 million or 4.5%, yielding an adjusted EBITDA margin of 15.6%. Net interest expense for the quarter declined to $3.9 million as compared with $4.4 million in the prior year. The decrease in the quarter primarily resulted from higher interest income. For the full year, our effective tax rate was 22.3% as compared with 25.8% in the prior year, primarily due to benefits from R&D tax credits and lower foreign tax rates. For the quarter, we generated adjusted net income per share of $0.10 compared with $0.12 in the prior year. For the full year, our adjusted net income per share increased 3.6% to $0.58 per share compared with $0.56 per share in the prior year. Moving on to the quarterly segment performance, starting with Water Flow Solutions. Net sales increased 8.8% compared with the prior year, primarily due to higher pricing across most of the segment's product lines. Double-digit sales growth in iron gate valves and specialty valves more than offset lower volumes of service brass products resulting from manufacturing inefficiencies. Adjusted operating income of $20.5 million decreased 26.5% as the benefits from higher pricing were more than offset by higher costs associated with unfavorable manufacturing performance, primarily at our brass foundry and specialty valve operations, inflation and lower volumes. Adjusted EBITDA of $28 million decreased 21.3%, leading to an adjusted EBITDA margin of 15.6% compared to 21.6% last year. For the full year, adjusted EBITDA margin was 21.7%. Turning now to Water Management Solutions. Net sales of $152 million increased 16.3% as compared with the prior year, primarily due to higher pricing across this segment's product lines. Hydrants, gas and repair and installation products experienced double-digit net sales growth compared to the prior year, driven by higher pricing and increased volumes. Adjusted operating income of $13.8 million decreased 1.4% in the quarter as benefits from higher pricing and increased volumes were more than offset by higher costs associated with inflation, SG&A expenses and unfavorable manufacturing performance. Adjusted EBITDA of $21.9 million increased 2.8% in the quarter, leading to an adjusted EBITDA margin of 14.4% compared with 16.3% last year. For the full year, adjusted EBITDA margin was 15.7%. Moving on to cash flow. Net cash provided by operating activities for the year ended September 30, 2022 was $53.9 million compared with $159.8 million in the prior year. The decrease was primarily due to an increase in inventories primarily driven by higher volumes and the supply chain disruptions as well as inflation. Average net working capital using the 5-point method as a percent of net sales increased to 27.5% compared with 25.7% in the fourth quarter of last year, primarily due to higher inventories. During the year, we invested $54.7 million in capital expenditures compared with $62.7 million in the prior year. Free cash flow for the year was negative $0.8 million compared with $97.1 million in the prior year, primarily due to the decrease in cash provided by operating activities, partially offset by lower capital expenditures. Additionally, during the quarter, we repurchased $10 million in common stock, bringing our full year total to $35 million. As of September 30, we had $100 million remaining under our share repurchase authorization. At September 30, 2022, we had total debt of $446.9 million and cash and cash equivalents of $146.5 million. At the end of the fourth quarter, our net debt leverage ratio was 1.5x. 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. With $307.2 million of total liquidity at the end of the year, we continue to have ample liquidity and capacity to support our strategic priorities, including acquisitions. Scott, back to you.

Thanks, Martie. I'll touch on fourth quarter performance, end markets and our full year 2023 outlook. After that, we'll open the call up for questions. Similar to last quarter, manufacturing challenges were the primary reason for our disappointing gross margin and adjusted EBITDA conversion compared with the expectations provided on our last earnings call. The adjusted EBITDA gap was around $10 million, primarily due to a gross margin gap of around 400 basis points, partially offset by lower SG&A. The primary driver of the gap versus our expectations was the manufacturing performance at our brass foundry. The machine downtime challenges did not improve as we anticipated for August and September. Due to the downtime in our brass foundry, our melt production was more than 20% below our forecast. The foundry production was down about 35% sequentially and more than 50% below the prior year. While machine uptime has had periods of improvements, we have been unable to get foundry production up to 2021 levels. Lower foundry production impacted our service brass shipments in the quarter and led to a significant amount of under-absorbed labor and overhead costs. Additionally, as this foundry supplies brass parts to our other facilities, we incurred higher outsourcing costs to meet our needs for brass purchase parts. While we expect the challenges to continue into 2023, we believe we can get the foundry production back to 2021 levels in the second half of the year. The new brass foundry start-up and progression to full run rate are critical for us as it is the best long-term solution for the manufacturing inefficiencies. We are on track to begin the initial start-up phase later this quarter. In the new year, we expect the production part approval process to begin. We will prioritize developing tools for the highest volume brass parts first. The new foundry will have more than 2 production lines to provide capacity for maintenance and contingency planning. We also will have significantly more capacity at the new foundry. The manufacturing inefficiencies have added pressure to other plants since the foundry has historically made some of the brass parts used in iron gate valves and hydrants. This needed outsourcing has unfavorably impacted our product costs compared with the prior year. With record backlog for service brass, iron gate valves and hydrants, we anticipate material outsourcing to continue until the new foundry is able to take over the production for these parts. We took additional price actions during the quarter due to these higher costs and ongoing inflationary pressures. I will now briefly review our end markets and updated outlook for 2023. As mentioned earlier, we saw healthy order activity again during the quarter. We believe this was primarily due to strong municipal repair and replacement activity, offsetting slower new residential construction. We expect municipal repair and replacement activity to remain healthy in 2023 as utilities try to proactively address the aging water infrastructure while they also deal with unplanned maintenance issues like water main breaks. As a reminder, we estimate that approximately two-thirds of our net sales are related to repair and replacement activities of utilities, which provides resiliency for our business. We believe the initial phase of the new funding from the infrastructure bill could flow into projects later in 2023. While improvements in the ongoing supply chain and labor availability challenges could improve the timing of projects, we don't expect to see meaningful benefit until 2024. For the new residential construction end market, specifically lot and land development activity, we continue to anticipate that the higher interest rates will lead to lower levels of lot and land development activity as the housing market adjusts to lower demand. As a result, we expect to see a slowdown in residential construction activity in 2023. However, we do expect new residential construction activity to normalize at a level above pre-pandemic levels due to relatively low inventories, demographics and population shifts. Moving on to our updated outlook for 2023. The record backlog at the end of 2022 across our short-cycle products and the expected realization from higher pricing position us to deliver net sales growth in 2023. We currently anticipate that our consolidated net sales will increase between 6% and 8%. We did see a slowdown in order activity in October. However, this isn't surprising given the timing of our most recent price increases in August in the evolving macro environment. As a result of our sales growth forecast and improved operations execution, we expect adjusted EBITDA will increase between 10% and 14% as compared with the prior year. Note that this outlook includes a headwind from higher pension expense, primarily due to the stock market performance. We estimate the expense will be approximately $3.8 million or a swing of negative $7.7 million versus the prior year. Our adjusted operating income, which excludes the impact of pension expense, is expected to increase more than 20% compared with the prior year. As a result of improved cash flow from operations, we anticipate free cash flow to increase as compared with 2022. This forecast includes higher capital expenditures from both carryover spending and the completion of the new brass foundry in addition to other capital investments. Taking this increase into account, we expect free cash flow as a percentage of adjusted net income to be between 40% and 60%. These expectations assume the challenges associated with higher inflation, labor availability and supply chain disruptions will continue in 2023. With our broad portfolio of water infrastructure products and solutions, we are well positioned to help water utilities address challenges from aging infrastructure, climate change and workforce demographics. Our top priorities for 2023 include executing operational improvements, delivering benefits from our large domestic capital investments, accelerating development and commercialization of new products and generating ongoing price realization. Our strategies are focused on capitalizing on the key trends in water, which include the increased demand for water infrastructure products that qualify for the federal domestic production requirements. Key trends are also driving the growing need for technology-enabled products and solutions to help customers address challenges with the aging water infrastructure. With our strong balance sheet, liquidity and cash flow, we will continue to reinvest in our business while returning cash to shareholders through our quarterly dividend and share repurchases. We recently announced another increase to our quarterly dividend. During this past year, we repurchased $35 million of common stock. With $100 million remaining in our share repurchase authorization, we will continue to balance our cash allocation to support our key strategies to grow the business. That concludes my comments. Operator, please open this call for questions.

It looks like our first question comes from Brian Lee with Goldman Sachs.

This is Miguel on for Brian. I appreciate all the guidance around 2023. Maybe if I could just start there. On the adjusted EBITDA guidance for 2023, it's looking like it's implying a fairly steep ramp in adjusted EBITDA margin coming off of maybe a more challenging fourth quarter. How should we think about the cadence on margins through the year? And should we sort of be thinking about the fourth quarter as the bottom of adjusted EBITDA margins and things picking up from there?

Yes. As you consider the expected trends, you are correct that we anticipate an increase in the latter half of the year compared to the first half. The implied conversion margin is projected to fall within the 20% to 35% range, with 27% being the midpoint. There are some fluctuations due to operational issues, and we expect some of the outsourcing to be temporary. As the year moves forward, we will decrease outsourcing and produce more of the brass in-house with the new foundry. Additionally, we have agreements with our unions and foundry plants that will enable regular weekend shifts, which will help reduce the need for outsourcing as staffing improves. We also expect outsourcing costs to lessen during the second half of the year. However, increasing pension expenses, around $7.9 million to $8 million year-over-year, will impact EBITDA, changing from a benefit in the baseline year 2022 to an expense in 2023. I believe the turning point will be in mid-2023 as we face challenges related to outsourcing, staffing for weekend shifts, and equipment uptime in our brass facility, which is currently operating below capacity. The main issues this year primarily stem from outsourcing concerns, particularly related to brass performance and the foundry’s challenges, some of which were anticipated and others unexpected. The key takeaway is that most manufacturing performance issues related to outsourcing and material shortages from the brass foundry should be temporary. As we ramp up the new foundry and it operates at full capacity, we are making progress, albeit at a slower pace, with facilities in Aurora, Hammond, Surrey, and the Western plant now closed.

Thank you for the detailed information. My second question is about the infrastructure bill, which was not included in last year's guidance. You mentioned that we might start to see some effects from it in the latter part of this year. What are your expectations for 2023 regarding the availability of funds? Additionally, how much of this is anticipated to contribute to the revenue growth you are projecting for 2023?

Yes, we remain enthusiastic about the Infrastructure Investment and Jobs Act. However, it will take time for the funds to be allocated to new projects. We are seeing money and tasks being processed through the EPA and state agencies. We experienced a timing lag back in 2009 with the American Recovery and Reinvestment Act, which resulted in delays as utilities navigated the requirements for stimulus funding. The initial phase of yearly appropriations seems to have been approved for many states, particularly larger ones like California, which have started approving projects. Nevertheless, we do not expect to see significant benefits until later this year and believe the advantages for next year will be limited due to ongoing supply chain issues and labor availability challenges facing utilities. Beyond that period, we expect to see benefits from the infrastructure bill spending. Additionally, the slowdown in residential construction may provide more labor for infrastructure projects. In summary, we anticipate starting to feel the benefits in the second half of 2023, with an increase through the 2028-2029 period as indicated by the funding profile for the bill.

Our next question comes from Deane Dray with RBC Capital Markets.

I'd like to start with the plans for the new plant ramp because this comes with its own set of operational challenges. You've got duplicate labor going on. You've got higher working capital needs that will come into play. I'd like to know, with a little bit more color, what's baked into your guidance, especially regarding contingencies? Ramping new plants like a foundry like this just raises prospects for more things not going exactly right or in the timing that you expect it to be. So just what's baked into your guidance for these kinds of contingencies as well as the higher working capital impact on cash flow?

So the first topic to address is working capital. Our balance sheet shows we've increased inventory by about $98 million year-over-year. A significant portion of this increase, roughly one-third, can be attributed to inflation, while the rest is due to the actual number of units we have on hand. This increase in units is partly a result of third-party inventory and materials in transit associated with outsourcing. Although we anticipate some additional challenges related to working capital from an inventory standpoint, most of the impact is already reflected in our baseline. Regarding your second question, while I can't provide specific figures due to competitive reasons, we estimate a contingency of about 20% between our expectations for machine performance and what we have forecasted. Martie's comments highlighted that the foundry was operating 20% below our expectations, 35% lower sequentially, and 50% year-over-year in Q4, indicating we're likely at the lower end of our estimate. There is a risk if we fall short of the anticipated output. Our hot commissioning starts next week, and we'll begin melting metal and pouring it into forms, followed by the production part approval process. Getting the first 200 parts through is crucial, as achieving this will help alleviate the absorption issues we discussed. Initially, production in the new foundry won't absorb labor or overhead costs, but once we start earning from that, we will see operational leverage. Therefore, we are anticipating some duplicate costs during the first quarter, and I hope this provides enough insight without diving into specific numbers.

No, it really does help, especially in framing the contingencies. I also appreciate the competitive dynamics. You're not going to provide exact figures, but the roadmap here is useful. So, for the second question, shifting gears, can you set expectations for the potential scale of change now that there is an activist and new board members coming in? Also, can you provide some context about the capital allocation and operating committee that you co-chair? How is this all going to work? Is there an expectation for significant changes in the portfolio? Is a major restructuring on the horizon? We noticed some impairment; was that already planned before the activist involvement? There are many elements to consider, but if you could walk us through that, please.

I believe there are a few important points to address in relation to your question. First, the key takeaway is that following the settlement, we had several discussions, primarily collaborative ones with Ancora, to understand their perspectives and share ours regarding the significant investments we've made. While I won't go into specifics about their views on the pace of progress, I can say that the Board was pleased to reach an agreement, which also accelerates our ongoing Board refreshment process. I believe that Brian and Nicholas will add valuable operating and supply chain management experience to our already diverse Board, benefiting our stockholders. However, I don't foresee any major restructurings or portfolio rebalancing at this time. The goodwill issue you mentioned is simply a consequence of the changing macro environment, and I'll allow Martie to discuss our standing on goodwill. As for the Ancora agreement, I think we are in a vulnerable period having made significant investments, with about nine months of investments remaining with the three major projects ramping up. Progress in the large casting foundry and Kimball is in line with our expectations, though they are currently dilutive during this overlapping period. As we move past this phase, I expect to see the anticipated outsourcing and the flexibility from the new labor contracts, which I mentioned earlier, become more manageable. I believe both Ancora and our other shareholders will benefit from this, and their focus is on ensuring we execute effectively. Now, Martie will cover the goodwill details.

Yes. Let me go ahead, Deane, and just talk specifically about the goodwill impairment we took this quarter. It was a noncash expense of $6.8 million. It relates back primarily to an acquisition we had in 2014 with Lined Valve Company. So this is part of our specialty valve product line. On an annual basis, we test our reporting units for any potential impairment and largely as an increase that we have with respect to the discount rates that we needed to use. That was the primary reason as to why we determined that we needed to write-off this goodwill of $6.8 million in the quarter.

Our next question comes from Joe Giordano with Cowen.

Can you just comment on what price contribution was in the quarter? And how much is carrying over in that 6% to 8% revenue growth guide?

Yes, I think the price exceeded our expectations for the quarter, effectively offsetting inflation and dilution effects. We are still monitoring the inflation cycle that started in late 2017 and early 2018, and we remain dilutive. We still need to achieve some additional price increases overall. In the fourth quarter, total material cost inflation, including purchased parts, stayed high, increasing in the mid-teens. The better price realization more than compensated for that in the third quarter, but we are still down cumulatively, and I expect that price and inflation will persist into 2023. Regarding your second question about implied volume, the guidance suggests we will see slightly fewer units year-over-year in this environment, as challenges in the residential market are balanced out by the benefits from the Infrastructure Investment and Jobs Act and the municipal repair and replacement market.

Yes. But being very clear, when we look at the short-cycle backlog and the series of price increases that we took, we go into 2023, knowing that we'll experience higher price realization as we continue to work through the backlog that we have with a series of price increases that were taken.

Can you provide an update on all the capital projects? I know there has been a lot happening recently, including the start-up of the brass foundry with commissioning beginning in about a week. You're planning to invest $70 million to $80 million in fiscal '23. Where do we stand at the end of that? What still needs to be done? Will all your major projects be completed by then? We would appreciate an updated timeline on everything and our current status.

Yes. So I think the Decatur foundry is nearing completion. It's the last of the three major capital projects at ballpark-ish $150 million of multiyear spend that was associated with, remind everybody, large casting foundry in Chattanooga. The facility consolidation play to move Woodland, Surrey, Hammond, Aurora and some Mexico maquiladora into the Kimball facility, and then last but not least, Decatur. So I think, especially in the large valve investments, the first two are in the process of ramping up now, with the vast majority of the CapEx investment completed. We're completing the transition of the Aurora facility to manufacturing in Kimball. Aurora is closed and nobody is there as of September. We remain confident that we will ramp up in 2023 with the margin benefits following accordingly in the kind of second half of the year run at rate for Kimball. The brass foundry, which will now pour the new lead-free brass, which will be an advancement in sustainability for customers and end users, it will allow us to be completely lead-free by 2030 and achieve 100% lead-free manufacturing processes by 2030. I think it's the one with some execution risks today around it as some of the unknowns. We've turned the power on. We got the lights on. We've done some cold commissioning that is moving molds, punching patterns, doing things like that. I think, combined, to answer your question specifically, all three projects are accounting for about 85% of their spending is through. So if you were to say there's $22 million, $23 million of the $85 million, 15%, the $22.5 million of the $150 million is in the new capital budget, and then you'd see what kind of we see as the maintenance budget. If you took the guidance and subtracted that. And I think if you look at every year since 2018 and subtract the large CapEx projects, we've been kind of in that maintenance range of that 3% to 4% range of sales since then with these valve. Yes, next question you had was, are we done? I believe we are done. Certainly, I'm not in a position to say that the Board has approved anything of a scale and scope as to the three large capital projects that we conceived four years ago when we set off on this path. But with that said, of course, there's always things around innovation and things of that nature that could one day come in. But I think that in the end, this next year should be mostly the end of the CapEx associated with the large capital projects.

That's great color. And if I could just sneak in one. Just strategically, as we didn't mention it once today, like is metering being somewhat deprioritized internally?

No, I would not say that metering is internally deprioritized. I think that we still have significant investments in product development in that space. We continue to have a lot of focus in the market with it. I think if anybody was at WesTech recently, our booths and our main uptake was around Sentryx, around metering, around leak detection, around the introduction of the pressure solutions and integrated the I2o equipment with the pressure control valves from Singer. And so I think that we have the most compelling economic solution for pressure zones and pressure management on an integrated remote control basis using our user interface. And so not deprioritized, but certainly become less of a discussion with investors as the noise we have had with these manufacturing problems these last two quarters has become a bigger focus. But when we start getting back to execution like clockwork, I would expect that we'll spend a lot of time discussing the progress made with the field trials that we've done. Anybody that recalls, we have a pressure management zone going on up in Canada right now at the City of Halifax. We have a couple of other trials going for pressure zone management and a couple more pending that we think will start to give traction to that particular solution.

Our next question comes from Bryan Blair with Oppenheimer.

Circling back to top line trends and outlook, what were your growth rates in municipal repair and replacement and residential new construction in fiscal '22? How did order trends diverge between those exposures in October? And what's contemplated in your fiscal '23 outlook?

So in fiscal '22, the easiest to answer, what we see is in the break/fix world, double-digit growth, right at that double-digit number. Maintenance and repair order spending kind of in the mid-single digits. Those two are going to be offset by what we anticipate for residential construction marketing. I think Martie has the actual numbers. But my recollection is it goes from 1.6-ish number back to 1.5 million-and-change, could be as low as 1.4. So that's going to have a negative impact on that MRO spend. They probably offset, which is why the implied guidance is for units to remain down slightly to flat and that we will have our lift come from the pricing power that's in the backlog. And so that's how you should think about the market in the go forward. In the current segment, it's really hard to differentiate what is associated with new construction versus what is associated with MRO. The distribution channel itself is extremely healthy, but it's also become extremely choppy. And the choppiness is a result of if pipe is the long pole in the tent, which I believe it still is, then hydrants on hand that could be said for MRO purposes, that were originally earmarked for new subdivision construction, that visibility, that flexibility in the channel is happening more and more as our chief channel partners managing their inventory investments and manage their opportunistic model. So it's becoming more difficult, Bryan, to say, which is which what's showing up in the new subdivision, new home construction and what's going to MRO because as the order was placed, it may have been intended for X, but it's being redeployed as Y as they wait on other materials. But the break/fix continues to be a very healthy part of the business for us.

Okay. That's all fair. I appreciate the detail. And to help us level set a little bit more on what took place in fiscal '22 and then thinking about the progression in your '23/'24 profitability that should be there, can you give us a dollar impact of production downtime, outsourcing headwinds, et cetera for the full year? It sounds like it's around $10 million for 4Q. Just trying to gauge what took place here and if it is, in fact, transitory, what should roll off during '23 provide further tailwind into '24 and then you have the assumed benefit of getting to a run rate on your major projects going into the out year.

Yes, I would like everyone to consider our situation in 2024. I previously mentioned to our investors that we could see our EBITDA margins expand by 50 basis points annually from approximately a 19.5% margin up to around 24% or 25%. I haven't forgotten this, and I believe I've been straightforward with all of you. Although it may seem distant now, I believe there is a route back to the baseline we established at 19.5% to 20% EBITDA margins over the next couple of years. This will come from improved performance, effective price management, and importantly, reducing outsourcing this year. As we undertake these capital projects, I still hold firm to the beliefs I shared four years ago. It remains crucial for us to organize our manufacturing processes to foster a productivity-oriented culture, implement lean tools, and adopt Six Sigma principles. I am confident that this is still achievable. While we faced some temporary setbacks, especially last quarter, we have demonstrated our ability to adapt. I am proud of our team's response during challenges in meeting production demands; they managed to satisfy customer needs despite those difficulties. We were able to bring in outsourcing and ensured we retained our customers and market share, exceeding our sales targets. We fulfilled our commitments, and looking back at where we were four years ago compared to today, I believe we are well-positioned for EBITDA margin growth. When considering outsourcing, keep in mind that if we look at our overall performance for the year, around 40% of the performance issues arose during a quarter that accounted for only 25% of the year, specifically the fourth quarter.

Our next question comes from Brent Thielman with D.A. Davidson.

Scott, are you seeing any unusual inventory rebalancing into year-end among the distributor customers just given some of the sort of growing caution around the housing market?

Yes. There will certainly be factors affecting the current channel inventory level. We closely collaborate with our distributors to grasp their sell-through rates, manage delivery times, and fulfill orders, even bundling products as necessary to ensure contractors meet their commitment dates and avoid penalties. This dynamic is a daily occurrence. Many distributors are maintaining higher inventory levels due to anticipated inflation and ongoing supply chain disruptions. Lead times for projects are generally much longer than they were before the pandemic, so distributors must account for this in their inventory management. They adjust product availability to align with installation schedules that are extended due to labor shortages. If there are significant delays in receiving essential items, it won't benefit a contractor to have all the valves and hydrants if they lack the necessary pipes to connect them. Similarly, they won't run service lines from newly constructed homes to areas lacking existing lines. As various lead times fluctuate, we see increased complexity in channel inventory. Additionally, depending on our distribution partners' expectations regarding slowing customer demand in the housing market, we may face added pressure on inventory levels as the channel works to destock. However, some of our backlog is tied to these lead times. Therefore, the timing differences in specific quarters lead us to prefer a macro-level view for guidance over years, which is also why I avoid discussing quarterly fluctuations amidst the noise in the channel. Operator, well, I'd like to thank everybody for joining us. I think that I'm looking forward to getting the fourth quarter and getting our activities and our actions in place to continue. I'm excited about the new foundry. I'm excited about the progress we're making in Kimball. Very excited about some of the pound achievements, setting records in our third quarter in the large casting foundry. But acknowledge too and I'm sober about the fact of where we are, what we have to do in order to meet our numbers and to continue to grow the business. So I'd like to thank everybody for spending time with us this morning, and I look forward to talking to you all again next quarter. Thank you, operator.

Thank you. And this does conclude today's conference. We thank you for your participation. At this time, you may disconnect your lines.