Douglas Dynamics, Inc Q2 FY2022 Earnings Call

Good morning, ladies and gentlemen and welcome to the Douglas Dynamics Second Quarter 2022 Earnings Conference Call. All participants will be in a listen-only mode. Please note this event is being recorded. I would now like to turn the conference over to Ms. Sarah Lauber, Chief Financial Officer of Douglas Dynamics. Please go ahead, Ma'am.

Thank you. Welcome, everyone, and thank you for joining us on today's call. Before we begin, I'd like to remind you that some of the comments made during this conference call, including answers to your questions, will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters described in yesterday's press release and in our filings with the SEC. Joining me on the call today is Bob McCormick, our President and Chief Executive Officer. In a moment, Bob will provide an overview of our performance, then I'll review our financial results and guidance. After that, we'll open the call for your questions. With that, I'll hand the call to Bob.

Thanks, Sarah. Good morning, everyone. As noted in the press release, we are pleased with our results for the second quarter. We see continued strength in overall demand across our businesses. Our team is using its considerable ingenuity to address and work around the various industry-wide challenges we continue to face. The Attachments segment reported strong results with record net sales and strong preseason orders. The Dilution segment continues to see strong demand, but is still facing macroeconomic headwinds from chassis supply and inflationary pressures. The strong demand outlook in both segments means we're well positioned for long-term success. The headwinds we outlined last quarter remain our biggest challenges today. First, we continue to see inflationary pressures negatively impacting margins. Second, labor market constraints, where our teams have found creative ways to attract and retain talent, and the situation is stable to slightly improved. Lastly, supply chain disruption and chassis availability. I'll speak more to chassis in just a minute. We continue to improve how we operate most effectively under these conditions. While the macroeconomic constraints are not easy, significantly, the situation is more stable and changing less rapidly today than it was last year. Despite these limitations, we remain on track to deliver our full-year guidance, which we have narrowed towards the center of our original ranges. Now let's walk through each segment. Beginning with Work Truck Attachments, where we had another strong quarter, we produced record net sales of $130.4 million, more than 25% higher than the second quarter of last year, and almost $33.6 million of adjusted EBITDA, also above last year's number. So a great start to preseason orders. We expect to see the typical 55:45 ratio between second and third quarters this year. We believe there is some preseason order pull-ahead from Q4 as dealers want to build inventory ahead of the snow season. Nonetheless, dealer inventories and dealer sentiment remain positive. Overall attachments continue to lead the industry and manage through the supply challenges effectively. Turning to our Work Truck Solutions segment, we delivered $57.2 million of net sales and $500,000 of adjusted EBITDA for the quarter. Let's talk a bit more about what we're seeing from a chassis perspective. In the Class 7-8 chassis for our municipal business, supply is now more predictable and consistent, and while this is a positive sign, lead times are still long. From a Class 3-6 perspective, which is our core chassis for Dejana, we aren't yet seeing notable across-the-board improvements in supply today. The supply of work vans for final mile is improving, which is a small but growing portion of our business. This is a positive sign, indicating that ships are starting to free up and gives us confidence that the overall supply of chassis will start to improve in the near future. The main takeaway on the chassis discussion is that while we're starting to see signs of improvement, the positive impact will not show itself until later in the year and into 2023. We maintain excellent backlogs in our Solutions segment and are well-positioned for long-term success. In summary, we're pleased with our performance overall, especially under the circumstances, and remain confident about the rest of 2022, which is why we've narrowed guidance toward the middle of our original ranges. Demand trends remain very positive, and we are managing through industry-wide headwinds as well as can be expected. New product introductions for both Attachments and Solutions are gaining traction and we expect them to positively impact revenue and earnings in 2023. In the longer term, we are confident in our ability to expand our value proposition, enhancing our industry-leading position while providing the highest level of value to our customers. Our laser focus on continuous improvement at all of our divisions will put us in a position to drive towards our long-term financial targets in 2023 and beyond. With that, I'd like to pass the call back to Sarah to discuss our financial results in more detail. Sarah?

Thanks, Bob. We're pleased with our results for the quarter as we produced strong year-over-year top-line growth and demand signals remain strong in both segments today. We also continued to navigate the ongoing impact of supply chain constraints and inflationary pressures and delivered earnings that met our expectations for the quarter. From a consolidated perspective, we generated record second-quarter net sales of $187.6 million and gross profit of $51.2 million compared to net sales of $157.5 million and gross profit of $48.8 million during the second quarter of last year. Sales and gross profit both increased year-over-year as a result of strong preseason orders at Work Truck Attachments and our implemented pricing increases over the past 12 months. SG&A expenses, including amortization expense, were $25.7 million, compared to $24.7 million during the second quarter of 2021. The increase is primarily due to inflationary pressures on salaries and benefits and increased discretionary spending as business conditions returned more towards normal. For the second quarter, we generated consolidated adjusted EBITDA of $34.1 million, relatively flat compared to $33.5 million in the same period of the prior year. Our performance benefited year-over-year from ongoing strong demand and a more predictable operating environment. While inflation continues to be an issue, the rate of cost increases has slowed. Interest expense was $2.5 million for the quarter, lower than the $4.4 million incurred in the same period last year. The $1.9 million decrease was primarily due to lower interest paid on the term loan owing to the decrease in principal balance from the June 2021 refinancing. Offsetting the favorable interest expense was the effective tax rate of 23.2%, compared to 5.5% in the prior year. The rate was higher in the current quarter due to a discrete tax benefit of $2.7 million stemming from a successful outcome in a state income tax audit during the second quarter of 2021. We recorded GAAP net income of $17.7 million or $0.75 per diluted share, higher than the GAAP net income of $14.1 million or $0.60 per diluted share in 2021. On an adjusted basis, we generated net income of $20.1 million or $0.85 per diluted share, compared to adjusted net income of $21.3 million or $0.91 per diluted share in the prior year. Now let's turn to the earnings information for the two segments. For the second quarter, our Work Truck Attachments segment generated record net sales of $130.4 million, significantly higher than the $104.6 million last year, and adjusted EBITDA of $33.6 million, a slight increase when compared to adjusted EBITDA of $32.2 million recorded in the prior year. The sales increase is driven by significant pricing actions taken over the last year to offset inflation on input costs. Sales and adjusted EBITDA also benefited from an increase in preseason shipments, demonstrating the ability of the attachments team to deliver despite supply chain challenges. The timing of preseason shipments in 2022 continues to shift back towards traditional pre-pandemic levels. We now anticipate an approximately 55-45 ratio between second and third quarter preseason shipments. While difficult to quantify, we are considering that some of the strength in orders so far in preseason could partly relate to dealers pulling forward orders from the fourth quarter, based on concerns about being able to get products and parts reordered at our usual market-leading speed during the snow season. This pull-forward of orders could impact our fourth-quarter attachments revenue, and we continue to monitor that situation. That brings us to Work Truck Solutions where we reported net sales of $57.2 million and adjusted EBITDA of $513,000 compared to net sales of $52.9 million and adjusted EBITDA of $1.3 million in the same period last year. The increase in net sales compared to the prior year is primarily due to pricing increases implemented as we had anticipated inflationary pressures continued to negatively impact adjusted EBITDA due to increased material, labor, and freight costs. Demand, ordering trends, and backlog remain strong. We hope to see chassis supply start to show itself in the coming quarters. Turning to the balance sheet and liquidity figures. Net cash used by operating activities during the first six months of 2022 was $58.2 million, compared to $13.1 million cash provided for the same period last year. Free cash flow for the first six months of 2022 was negative $63.8 million compared to positive $8.6 million during the same period in 2021. These cash flow declines were a result of increased accounts receivable due to the increase in sales, as well as higher material costs and the pull-forward of supply leading to elevated inventories to protect against potential supply chain issues. Both sales and inventory are also largely impacted by inflated costs and higher pricing due to inflation. Inventory increased to $131.5 million compared to $93.9 million at the end of the second quarter of 2021. Accounts receivable were $127.9 million compared to $92.1 million at the end of the second quarter of 2021, which is in line with the increased sales year-over-year. At the end of the quarter, we had a net debt leverage ratio of 3.2x, higher than the 2.1x at the same point last year. We maintain total liquidity of approximately $47.1 million at the end of the second quarter, comprising $6 million in cash and cash equivalents and borrowing availability of $41.1 million under our revolver. This compares to $114.3 million at the end of the second quarter of 2021. Moving on to capital allocation, capital expenditures for the first half of the year totaled $5.6 million, compared to $4.6 million in the first half of 2021, which is in line with our expectations. We continue to invest in the business to fund our long-term growth initiatives. As our vertical integration strategy continues, we are lining up projects that, when combined, will help drive long-term organic growth. At our recent investor events, we outlined our plans for growth beyond our historical markets, and utilizing the tremendous innovative talents of our team and attachments to develop new products. Our commitment to our dividends remains strong, and we paid a $0.29 per share dividend as planned following an increase earlier this year. We continue to execute our share buyback program, which we initiated earlier this year, purchasing 89,000 shares at a cost of approximately $3 million. Finally, we continue to actively monitor the competitive landscape for potential M&A opportunities. Before opening the call for questions, as you probably saw in our release, we are narrowing our quantitative guidance ranges as we often do at this point in the year. Based on the ongoing positive demand dynamics we are seeing, plus the stable to slightly improving outlook for chassis and component supply, we feel comfortable narrowing towards the center of the ranges as follows: Net sales are expected to be between $590 million and $630 million. Adjusted EBITDA is predicted to range from $75 million to $95 million. Adjusted earnings per share are expected to be in the range of $1.40 to $2 per share. Our effective tax rate is expected to be approximately 25% to 26% for the year. Our outlook assumes economic and pandemic conditions remain relatively stable and that we experience average snowfall levels in our core markets in the fourth quarter of this year. Results and attachments remain strong heading into the third quarter. We believe our solution segment is in a stable position and we expect to start seeing improvement as we exit the year. We are confident that the changes implemented over the past two years will start to pay dividends and improve earnings power as the macroeconomic headwinds subside. With that, we'd like to open up the call for questions.

We will now begin the question-and-answer session. The first question will come from Mike Shlisky with D.A. Davidson. Please go ahead.

Thank you. Bob, can I ask first how you would characterize this year's early order season in the attachment business? Would you say maybe in your tenure at the company, it's among the top three of all-time or top five best ever? What are your thoughts on where this year stands?

Sure. First off, coming off of another slightly below-average snowfall year, we had fairly modest expectations going into the preseason. As I noted, the preseason orders were stronger than we anticipated. I don't know that I would call it a top 10, because we've obviously had some snowfall-driven record order periods over the years. However, I suggest that part of the reason for the strength in orders being stronger than we anticipated is that when we talk to our dealers, and this is how everybody is responding in these supply challenge times. Everybody is ramping up order books a little bit just because they're nervous about the ability to meet demand. Now, you know that we do that better than most, and they know that what we promise, we will deliver. In our discussions with many of our top dealers, they're probably moving a bit of Q4 orders into this preseason order book just to prepare for the retail selling season.

Thank you for that. Specifically regarding Solutions, how far out do you think the backlog extends at this time? I appreciate any details on how far out you have actually booked.

We've said over the last several quarters that we have a record backlog in our solution segment. I don't know that we've provided any quantitative data there, but it certainly is between one and two years' worth of revenue, which is robust. I will tell you that we haven't seen order pace or interest slowing at this point. There's talk about an economic slowdown, but a significant portion of our end-user base is still operating with some good budgets. They still have money to spend. Even as we look into 2023 and beyond, the vast majority of those end-user customers are eager to get their hands on that product. Demand is still robust, and while I'm sure we will see some order cancellations down the road, we are not expecting that to be of a material nature at all. It gives us confidence in our Solutions Group getting back to the levels of profit that Sarah wants from them, simply because it's a high fixed-cost business model. You need to move velocity through those upfit centers to drive the incremental profit.

Got it. I wanted to also follow up on your comment about improvements in the supply for final mile chassis. I know it's a small part of the business today but can you give us some insights on how you're addressing that market? It appears to have some double-digit growth potential even during a recession. I wonder if you're making any extra efforts there to increase penetration in the next couple of quarters?

Yes, excellent question. Over the past 12 to 18 months, we have focused on repositioning our final mile product offering. We introduced a new set of van shelving design in the fourth quarter of last year, which has been very well received. We have other product launches slated for the fourth quarter of this year that are kept confidential at this stage. However, these will also enhance our final mile product offering. Therefore, we believe that as Sarah quoted some of the solution long-term growth rates, our participation in the final mile growth sector is certainly a significant component of that.

Great, if I could squeeze one last question in here quickly. Sarah, can you review your interest costs and cash needs for interest going forward? What percentage is fixed at this point? Do you think changes in interest costs will impact earnings or cash flow over the next couple of quarters?

Absolutely, Mike. We are seeing improved interest year-over-year, as you know from the refinancing. We are utilizing our revolver more this year than we historically had, largely due to inflationary costs and inventory pricing in accounts receivable. Out of our debt, approximately 80% to 85% is fixed rate, while our revolver is not. For interest guidance, a reasonable proxy would be our Q2 interest being relatively flat for Q3 and Q4. It remains a key focus area for us as we finish the year and aim to lower our inventory levels.

Okay, that makes sense. I'll pass it along. Thanks so much, guys.

The next question will come from Tim Wojs with Baird. Please go ahead.

Hey, everybody. Good morning. Maybe just to start on price costs. Could you review a little bit how that impacted the second quarter and then the expected magnitude of improvement in the back half of the year and into '23?

Yes, absolutely. When we think about the price-cost relationship, I would say inflation, as you've seen among all companies, is still ongoing. The increases have somewhat slowed. We expect many moving variables between now and the end of the year. We've seen some costs declining but are still seeing higher natural gas and fuel costs coming in at elevated rates. From my perspective, the price-cost relationship for Douglas is playing out as we had expected. It varies by business, but generally, through the second quarter, Douglas has covered inflation dollar for dollar. However, solutions have been impacted more due to some of our long-term contracts. I expect that situation to persist through the end of the year. Low single-digit EBITDA for solutions is largely due to price-cost issues alongside the necessity of moving higher volumes.

Okay, good. Regarding the solutions business, you have reduced costs and improved throughput and efficiencies. As we start to see more material volume growth in that business, how should we expect the incrementals?

Yes, fair question. When thinking about the improvements we expect for solutions to return to 2019 levels, it's highly dependent on chassis supply and when we begin attaining pre-pandemic levels. From a cost reduction standpoint, we have undertaken many positive projects, which are highly dependent on the volume throughput. That will be a crucial part of achieving the low teens EBITDA levels.

Okay. Lastly, regarding the labor side of things, particularly in solutions, how are you positioned in case demand or chassis supply surprises to the upside?

Yes, excellent point. In the upfit solutions business, much of the shop floor labor is skilled labor because you're assembling custom vehicles, and every unit can vary. Consequently, that labor pool is somewhat more fixed than variable since you can’t afford to lose those skilled workers. In a downturn, you carry higher costs, but when chassis flow increases, we have a stable group of labor who can manage that initial load. We anticipate gradual improvements, not sudden spikes, so we are well-positioned to handle the increase effectively.

Got it. How would you estimate free cash flow for '22 ends up?

When I think about free cash flow, I was just discussing with Mike about inventory, that's probably the largest variable that could differ from last year. Our working capital might be $5 to $10 million higher than where we concluded last year. Everything else is relatively stable: cash interest is expected to be similar to last year, around $10 million to $11 million. Our tax rate is projected to be 25% to 26%, and our CapEx at 3% of sales as in recent years. That leads us to the lower 40s range for free cash flow, which is slightly lower than last year, but remains highly dependent on working capital in the last six months.

Is the $5 million to $10 million increase in working capital entirely due to inflation?

Yes, when you think about the percentage of inflation we've observed, I would say yes.

Okay, good. Thanks for your time and good luck for the rest of the year.

Thanks, Tim.

This concludes our question-and-answer session. I would like to turn the conference back over to Bob McCormick for any closing remarks. Please go ahead, sir.

Thanks. As always, thanks for your interest in Douglas Dynamics. We look forward to seeing many of you at upcoming conferences this fall. Have a terrific day and stay safe.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.