Earnings Call Transcript - SPXC Q3 2022

Paul Clegg, VP, Investor Relations and Communications

Thank you, operator, and good afternoon, everyone. Thanks for joining us. With me on the call today are Gene Lowe, our President and Chief Executive Officer; and Mike Reilly, our Chief Accounting Officer and Interim Chief Financial Officer. The press release containing our third quarter results was issued today after market close. You can find the release and our earnings slide presentation as well as a link to a live webcast of this call in the Investor Relations section of our website at spx.com. I encourage you to review our disclosure and discussion of GAAP results in the press release and to follow along with the slide presentation during our prepared remarks. A replay of the webcast will be available on our website until November 10. As a reminder, portions of our presentation and comments are forward-looking and subject to cautionary provisions. Please also note the risk factors in our most recent SEC filings. Our comments today will largely focus on adjusted financial results, and comparisons will be for the results of continued operations only. You can find detailed reconciliations of historical adjusted figures to their respective GAAP measures in the appendix of today's presentation. Our adjusted earnings per share excludes non-service pension items, changes in the fair value of certain equity investments and amortization expense, certain discrete tax items, and asbestos-related charges. In today's presentation, we have again included a slide in the appendix breaking down our revenue by end market. Finally, we will be conducting meetings with investors over the coming months, including at the Baird Industrials Conference on November 9. And with that, I'll turn the call over to Gene.

Gene Lowe, President and Chief Executive Officer

Thanks, Paul. Good afternoon, everyone, and thank you for joining us. On the call today, we'll provide you with an update on our consolidated and segment results for the third quarter. We'll also provide an update to our full year guidance. Now I'll touch on some of the highlights from the quarter. Our Q3 results exceeded our expectations with strong performances in both HVAC and Detection & Measurement. Both segments drove revenue and margin growth, and we continue to effectively manage supply chain and labor constraints. During the quarter, we made further progress on several of our key initiatives, including the completion of our previously announced corporate reorganization, which simplifies and better aligns our corporate structure with our value creation journey. Earlier this week, we also announced that SPX has divested all of its liabilities and assets associated with legacy asbestos matters. This is very significant as it eliminates all current and future risks related to asbestos. This transaction will be accretive to earnings, improving our cash generation and freeing up management and administrative time and attention. Overall, orders remained strong in Q3, up 21% organically year-on-year. Ending backlog of $563 million is up 39% organically, positioning us well for a solid close to the year. In the near term, the biggest factor driving our performance is effective operational execution. Based on our strong Q3 results and a solid Q4 outlook, we are raising our adjusted EPS guidance for the full year 2022 by $0.125 to a range of $2.85 to $2.95. Our new midpoint reflects year-on-year growth of approximately 25%. Turning to our high-level results. For the quarter, both segments helped drive strong organic growth of 19% and our recent acquisitions provided significant contributions to results. Adjusted operating income grew 76% year-on-year with 340 basis points of margin expansion. I'm very pleased with our Q3 performance and our momentum entering Q4 and 2023. Despite mixed macroeconomic data, we believe our diverse portfolio remains resilient. With significant capital availability, an attractive M&A pipeline, and several ongoing organic growth and continuous improvement initiatives, I am confident in our ability to deliver on our SPX 2025 targets. As always, I'd like to touch on progress in our value creation framework, where we have had several successes and gained momentum on key initiatives. In Q3, we continued to introduce new product offerings that position SPX to benefit from infrastructure spending, such as more advanced wind turbine lighting and high-precision cable test and location equipment. On the digital front, our Weil-McLain Hydronics business saw record levels of engagement in our contractor app, which helps identify end market sales opportunities and improve efficiency for installers. And in ESG, we published our most detailed sustainability report to date, including several new diversity and inclusion statistics. Over the last several months, we have also had our ESG scores upgraded significantly by both MSCI and Sustainalytics. As we look at our strong Q3 results and our near-term outlook, there have been notable successes in the performance of recent acquisitions. This includes a strong Q3 operational performance at Cincinnati Fan within HVAC and in our compact platform within Detection & Measurement. Context performance benefited from revenue synergies related to combining technologies from our TCI business and ECS, which we acquired in August of 2021. As noted in my opening remarks, we also recently took action to reduce our legacy liability exposure by divesting three wholly-owned subsidiaries that hold all of our asbestos liabilities and related insurance assets. As part of the transaction, we contributed approximately $139 million in cash to the divested subsidiaries, and SPX is now fully indemnified for all legacy asbestos liabilities. We believe that by eliminating this long-term liability, we have taken another important step towards strengthening and simplifying our company and positioning ourselves for continued growth. We anticipate that this transaction will result in an annualized EPS benefit of $0.08 to $0.10, starting in 2023, which will convert to cash at 100%. In addition, we have eliminated future claims settlements and have freed up considerable management time and attention. Before we go into the financial section, I'd like to introduce Mike Reilly, who is our interim CFO, while our candidate search progresses for Jamie's replacement. Mike is our Chief Accounting Officer and an excellent resource across a number of areas here at SPX. He is a seasoned veteran, having been SPX's Chief Accounting Officer for almost 18 years, including for the combined company pre-spin. We're glad to have him on the call today and appreciate him stepping in to fill this role. I'll now turn the call to Mike to review our financials.

Mike Reilly, Chief Accounting Officer and Interim Chief Financial Officer

Thanks, Gene. We are very pleased with our performance for the quarter. Our adjusted EPS grew 84% year-over-year to $0.81. The adjustments I reviewed at the beginning of the call include mark-to-market pension adjustments, changes in the fair value of certain equity investments, asbestos-related charges, and amortization. In addition to the segment income drivers, which I will review shortly, below-the-line items had a modest impact on our earnings this year, including higher corporate expenses, lower net interest costs, and a higher effective tax rate. The lower net interest cost resulted from lower borrowings and higher interest rates on our cash balances. A review of our adjusted results reflects strong growth across our company. Revenues increased nearly 30% year-on-year, including 19.2% organic growth, with strength in both our HVAC and Detection & Measurement segments. Acquisitions contributed 12.4% of inorganic growth related to ECS, Cincinnati Fan, and ITL. Segment income grew by $22 million, or 52%, to $63.4 million, while margin increased by 250 basis points. The increases were driven by both segments, including earlier-than-expected deliveries in our CommTech platform within Detection & Measurement and within our HVAC segment. Price/cost remained a modest margin tailwind for Q3, and we expect this to continue in Q4. Partially offsetting our top-line organic and acquisition growth was a 1.9% FX headwind due to the strong dollar. As a reminder, currency fluctuations generally have little effect on our overall profitability because of significant natural hedges in our cost structure. In our HVAC segment, revenues grew 27% year-on-year, with heating and cooling both contributing to organic growth of 16.3%. This reflected higher prices in both platforms and an increase in heating volumes related to gains in plant throughput as labor and supply chain management initiatives progressed. Inorganic growth was 11.3%, reflecting the acquisition of Cincinnati Fan. The strong dollar was a modest FX headwind. HVAC's adjusted segment income increased by approximately $10 million, and margin grew by 130 basis points, reflecting higher production volumes in heating and a favorable price cost trend. We continue to experience strong demand for both heating and cooling products. Segment backlog at the end of the quarter was $288 million, up 41% year-on-year, including an organic increase of 24%. Weather is usually an important driver of Q4 results for heating and HVAC overall, and our strong backlog supports our revenue outlook for Q4. Production levels are now the key determinant of our near-term results. In Detection & Measurement, revenues grew 34% year-on-year. All four of the segment's platforms contributed organic growth of 24%, with significant contributions from contract project sales, including the early deliveries I mentioned earlier. The strong dollar resulted in a 4.3% currency headwind. Adjusted segment income increased approximately $12 million, and margin grew by 420 basis points due to higher revenue from strong project deliveries, which typically carry higher-than-average incremental margins. We continue to see solid run-rate demand and robust momentum in project bookings. Segment backlog at the end of the quarter was $275 million, an increase of 6%. Now, regarding our financial position at the end of the quarter, our balance sheet remains strong, and we have significant liquidity available to support both organic and inorganic growth initiatives. At the end of the quarter, we had $187 million in cash and no borrowings under our revolving credit facility. This is prior to the divestiture of our asbestos liabilities, which was funded with cash on hand. We expect our net leverage of 0.3x at the end of Q3 to rise to approximately 0.5x at the end of Q4, reflecting the impact of the asbestos divestiture. During the quarter, we amended our credit facility to extend the maturity to 2027 and expanded our revolver capacity by $50 million. As mentioned last quarter, we expect our cash flow profile this year to be back-end weighted, as we have invested in working capital, primarily inventory, to manage supply chain pressures and meet customer demand promptly. In addition to our inventory investments, we made a vendor prepayment associated with CommTech project orders expected to deliver in 2023. As we address our backlog, we anticipate converting our additional working capital investments into cash. At this stage, we do not expect all of these investments to convert to cash by year-end. If they do not convert in 2022, we expect significant conversion to happen in 2023. Finally, we did not repurchase any shares this quarter and still have $66 million available under our existing buyback authorization. Moving on to our guidance, we have increased our full-year 2022 guidance to reflect our strong Q3 results. As previously noted, Q3 results benefited from some deliveries anticipated for Q4. We have raised the midpoint of our adjusted EPS guidance by $0.12 to a range of $2.85 to $2.95. Our new $2.90 midpoint represents year-on-year growth of about 25%. We have also raised our full-year revenue guidance for both HVAC and Detection & Measurement, as well as our midpoint for Detection & Measurement to a margin range of 20% to 21%, an increase of 50 basis points at the midpoint. Consistent with previous years, we expect our HVAC segment to show a seasonally strong Q4, while in Detection & Measurement, we anticipate performance to be similar to Q3. You will find modeling considerations in the appendix to our presentation. I'll now turn the call back over to Gene for a review of our end markets and his closing comments.

Gene Lowe, President and Chief Executive Officer

Thanks, Mike. Overall, market conditions remain supportive of further growth. Across our HVAC businesses, demand remains robust, and we continue to effectively manage supply chain and labor constraints. We continue to see favorable demand drivers for our HVAC cooling products in North America and the APAC region. In our heating business, orders remained solid, driven by commercial and industrial demand and residential replacements. In Detection & Measurement, our run rate demand is solid overall with some areas of flattening in Europe, while project orders continue to strengthen. In summary, I'm very pleased with our Q3 performance and our progress simplifying our corporate structure and reducing our legacy exposures. We're on pace to achieve our increased full year guidance and to begin 2023 in a strong position. As we look ahead, I'm excited about our growth momentum as we execute towards our SPX 2025 targets, which include adjusted EPS of $5 a share. With a solid demand backdrop, a strong balance sheet, and a highly capable experienced team, I'm confident in our ability to continue executing on our value creation roadmap for years to come. And with that, I'll turn the call back to Paul.

Paul Clegg, VP, Investor Relations and Communications

Thanks, Gene. Operator, we are ready to go to questions.

Operator, Operator

Our first question comes from Damian Karas with UBS.

Damian Karas, Analyst

Congrats on the results. And Mike, great to have you on the call.

Mike Reilly, Chief Accounting Officer and Interim Chief Financial Officer

Thank you.

Damian Karas, Analyst

Yes. So maybe just we could talk about HVAC first. You mentioned maybe having some shipments come in sooner than expected into the third quarter. But you did up the sales guidance by a little bit. I'm just wondering what's driving that, whether on the organic or inorganic side, and I mean just given the really strong margin execution there in the third quarter, it seems like the unchanged 14% guidance on the margin front for the year seems potentially a little low. Maybe you could just explain why you'd expect more flattish margins for HVAC in the fourth quarter, that is?

Paul Clegg, VP, Investor Relations and Communications

So yes, Damian, we did have some very favorable experience with respect to productivity. During the quarter, we would expect some of that to continue to move through Q4. As you know, we have also acquired Cincinnati Fan. We've mentioned that Cincinnati Fan did fairly well during the third quarter as well. With respect to the fourth quarter, yes, we still feel pretty good about our outlook. We're looking at a fourth quarter here that's pretty solid in terms of demand. But we still do face some constraints in some of our businesses with respect to labor and supply chain productivity, and we want to make sure that we reflect that in the guidance.

Gene Lowe, President and Chief Executive Officer

I want to mention that we entered this quarter and will go into the fourth quarter with a considerable amount of backlog, some of which was priced in earlier periods. This will likely lead to some moderation in our margins as we move into Q4.

Damian Karas, Analyst

Okay. Appreciate the color. And then just switching over to D&M and your commentary on CommTech. I mean earlier than anticipated deliveries, I mean, that's pretty unusual to hear these days. So could you just elaborate on that? Was it some of the supply chain issues that you anticipated maybe eased a little bit sooner? Or what was kind of going on there? What's kind of going on in the CommTech business?

Gene Lowe, President and Chief Executive Officer

I would say more than anything, it's orders. We've gotten some pretty significant orders over the last 6 months with some of those orders delivering here in Q3 and you'll see those continue into Q4 and even into 2023. They've had their share of supply chain issues here or there, but they've been able to knock them all down. So that hasn't necessarily been an impediment in any way.

Operator, Operator

Our next question comes from Bryan Blair with Oppenheimer.

Bryan Blair, Analyst

Great quarter, guys. This is encouraging to see the broad-based growth across your business. And maybe offer a little more color on run rate order trends? And is there any meaningful shifts relative to the Q3 trends in shorter-cycle businesses? And then on the project side of D&M, maybe speak to the visibility afforded by the backlog that you now have and how project frontlog is progressing as we move toward 2023?

Gene Lowe, President and Chief Executive Officer

Yes, Bryan. What I would say is, overall, we're just very pleased with where D&M is. The run rate business, as a reminder, if you look at our Detection & Measurement portfolio, approximately 2/3 of the revenue, we'd characterize as more run rate, about 1/3 is more project-oriented. Run rate revenue in both orders and revenue has held very solid. I'd say the only place a little bit of pockets of slowness or flatness would be in Continental Europe. France, Germany, but that's a relatively very small portion of our overall revenue. So run rate has been very solid and holding up very strong. And then as you shift to our projects, we've had a really good year on projects and we've talked about this for a while. We had a lot of stuff in the frontlog. We're working, and that has started to fall through, and that's impacted us for Q2, Q3. We see it in Q4. And as you look as we head into '23, we have a very strong backlog. And as a reminder, the two businesses that have the highest percentage relatively speaking, of project orders would be CommTech first and, to a lesser degree, transportation. So we feel very good about where we're positioned both for Q4 but also as we look ahead to 2023 and our project-oriented businesses.

Mike Reilly, Chief Accounting Officer and Interim Chief Financial Officer

Gene, the only thing I'd add is across our project-related businesses where we're seeing this growth. It's the contact, fare collection, and the obstruction lighting. We're seeing growth.

Bryan Blair, Analyst

Understood. Very encouraging. Just out of curiosity, would you be willing to share what the Q3 contribution was or what the run rate order generation is from the combined TCI and ECS technology?

Paul Clegg, VP, Investor Relations and Communications

It was a significant factor in the increase in the backlog, Brian. We can inform you that it was an important contributor, as Mike mentioned regarding the backlog during the call, as well as the order trends both sequentially and year-on-year.

Gene Lowe, President and Chief Executive Officer

Had a big contributor to Q3.

Bryan Blair, Analyst

Understood. Okay. The commentary on Cincinnati Fan has also been very positive. You're nearly a year into owning the asset, so could you provide an update on the integration process and mention if there are any major steps left? It would also be helpful if you could discuss the run rate margin and where we might expect that to go in 2023 or beyond.

Gene Lowe, President and Chief Executive Officer

Yes, Bryan. We are very pleased with Cincinnati Fan. We have a new general manager there who is doing an excellent job, and his involvement has had a very positive impact. There are no demand issues. We are optimistic about engineered air quality and see significant growth potential in this area. Cincinnati Fan and Strobic hold strong market positions, and demand is high, with a substantial backlog. However, like many businesses, we face challenges in getting products out the door, but we are seeing positive momentum. We are confident about the margins, which are higher than those in our HVAC segment, or at least slightly above it. I see a lot of opportunities ahead for us. We feel good about this business and its direction. Mike or Paul, do you have anything to add?

Mike Reilly, Chief Accounting Officer and Interim Chief Financial Officer

Yes. The only thing I would mention is that we inherited some backlog that had already been priced, and we have now addressed that. Some of our pricing processes are also now in effect. Therefore, if you examine the margins for Q3 and Q4, as well as the margins heading into 2023 for Cincinnati Fan, you will notice the favorable effects of the price increases and the improvements in productivity.

Operator, Operator

Next question comes from Steve Ferazani with Sidoti.

Steve Ferazani, Analyst

I appreciate all the commentary on the call. Obviously, coming out of a strong quarter, just checking on a year ago, running into some supply chain constraints, some component shortages. We hear from some companies those challenges remain. It seems like you've fully addressed them. Do you want to just comment on, I guess, supply chain and price cost match?

Gene Lowe, President and Chief Executive Officer

Yes, Steve, overall, we're feeling more optimistic. Starting with labor, we've made significant progress on the challenges we've faced. There are still some areas we're working on, but in general, the impact of labor issues has been reduced considerably. Regarding the supply chain, while the market remains somewhat unpredictable, it is trending positively. Part of this improvement is due to market conditions, but we are also managing our operations more effectively. The tools we've implemented for data and analytics to project material needs for the next three months, along with our strategic inventory investments and supply chain diversification, have enhanced our strength and resilience. So, while challenges persist, we're managing them effectively. We're also pleased to be targeting a 25% earnings growth despite these headwinds. As these challenges ease heading into next year, we expect to see a net positive impact.

Steve Ferazani, Analyst

And regarding price costs, it seems there is a little backlog in HVAC that might carry over into the fourth quarter. However, generally speaking, with inflationary pressures appearing to ease, do you feel that you are managing this situation effectively now?

Mike Reilly, Chief Accounting Officer and Interim Chief Financial Officer

Yes, I don't know if we specifically mentioned it, but we did benefit in Q3 from price cost, which comes from our price increases and the moderation of some input costs. We expect this trend to continue into Q4. One reason for this is that we already have a significant portion of our revenue in backlog, so we know what the prices are. Additionally, we have a lot of materials in our inventory that we will use in Q4, meaning the costs are already determined. Therefore, we feel quite positive about the next three to five months regarding price cost.

Steve Ferazani, Analyst

Great. Great. And just one more for me in terms of how your things are starting. I know it's early, but how things are starting to shape up for '23. It sounds like you have significant project-based backlog that will help obviously with substantial aftermarket. But based on your commentary, it sounded like maybe European location inspection is starting to slow, probably expect that in the U.S. next year. Can you sort of give a higher level of how you think SPX is positioned going into what's probably going to be some sort of a recessionary environment globally?

Gene Lowe, President and Chief Executive Officer

Sure, Steve. I'll start with our end markets. I think in general, if I start with the HVAC segment, I would say these end markets look healthy to us. And if you look ahead to '23, as you know, a lot of these projects take a while to get rolling. You look at the Dodge projections for '23 we feel that's solid. Again, the Dodge had good growth this year. We saw that across a lot of the end market verticals, and that's also looking like it's going to be there for '23. So on the HVAC side, we feel good. Our Hydronics, our channels are not overstocked. As normal, we'll watch weather and pull-through demand in Q4, Q1. I don't really see this being any sort of issue in Q4. But if there were to be a very, very warm winter that suppressed demand a little bit, we'd have to take a look at that for '23, the more normalized cadence. And then if you look at Detection and Measurement, as we talked about, the run rate is solid. Continental Europe is not really material enough to really have a meaningful net impact on us and projects are very healthy right now. As you know, the way that we typically think about our business is top line growth of 4% to 5% and then we push that down to the bottom line about double. So organically, we always look for 8% to 10% out of our businesses in a normal year and then we augment that with capital allocation. And so I would say that's just as a general how we typically think about every year as we look ahead. And then on the capital allocation side, we actually feel very good about the opportunities we have in front of us. So that's a little color. And Mike or Paul, anything you'd like to add? I know it's early, but any other comments you'd like to make as we look ahead to '23.

Paul Clegg, VP, Investor Relations and Communications

Yes. We talk frequently about our portfolio having kind of this asynchronous profile where not all the businesses move together at the same rate at the same time. That's still the case, obviously, to the extent we do have businesses that are more susceptible to following the macro trends, if you were to see a hit to aggregate demand GDP. We have some trends that we believe are in our favor for next year. We've talked about some of the project setup that I would argue is less oriented towards what's going on in the broader macro economy, maybe it has to do more in some cases with the geopolitical situation. And there is money that we are starting to see the benefits of related to infrastructure spending.

Gene Lowe, President and Chief Executive Officer

All that being said, I agree with Steve that 2023 is not going to be a big growth year, probably a recession or a smaller recession. We're going to be very careful on how we manage our costs, and we're going to be very careful going into 2023. But we like what we see and we think we're starting with a very strong position as we go into 2023.

Operator, Operator

Our next question comes from Walter Liptak with Seaport Research.

Walter Liptak, Analyst

Great quarter. I have a couple of follow-up questions. First, it seems that in the CommTech business, the orders were strong again. Is this becoming a trend? We had a good second quarter and now a solid third quarter, or should we view this as some variability in that business? I'm curious if you expect to receive more orders in the fourth quarter and into 2023. Is there a sales pipeline for that?

Gene Lowe, President and Chief Executive Officer

Our CommTech business is the most project-oriented aspect of our operations. Currently, we are in a very positive position. We don't anticipate a decline in Q2 or Q3. As mentioned before, we acquired a company called ECS and combined our technologies, which has led to significant commercial success. Overall, we had a solid exit in Q2 and Q3, and we feel confident entering Q4. Additionally, we believe we are well-positioned for 2023, given our backlog and upcoming bidding opportunities. We are optimistic about our current standing.

Operator, Operator

Okay. That sounds great. And then the new credit facility that you talked about, the $50 million increase. Are there other terms that changed? Obviously, we've got a date that goes out to 2027. I wonder if you could talk about any kind of covenants or in it?

Mike Reilly, Chief Accounting Officer and Interim Chief Financial Officer

The covenant is the same at 3.75x is the max net debt to EBITDA. So that hasn't changed. And obviously, we're very, very far away from that. As you remember, Walt, we do have a swap in place that hedges us on our term loan for the moment. So the borrowing rate there is quite low. And then we have a margin over the new LIBOR, so for our borrowings under the revolver. And currently, that's at about, let's call it, 1.3%, 1.4% above that rate.

Gene Lowe, President and Chief Executive Officer

Basically all the terms are similar.

Mike Reilly, Chief Accounting Officer and Interim Chief Financial Officer

Yes. Just gives us a little more flexibility on the revolver.

Paul Clegg, VP, Investor Relations and Communications

And this will be all explained in detail during the Q&A.

Walter Liptak, Analyst

Okay. I'll do that before I go to that. M&A, how is the funnel looking and considering that you're being a little bit cautious about what could happen in 2023. How are you thinking about negotiating and trying to close deals now?

Gene Lowe, President and Chief Executive Officer

Yes. What I would add to Walt is I'd say, on the SPX technology perspective, I'd say we're positive. There's a good level of activity. I would say that you are seeing just at the macroeconomic activities going on. I would say some PE companies are pulling back. And what we find is when we are in bidding situations, oftentimes we believe we're the only company that has our specific strategy; there's people who have similar strategies in different end markets. But oftentimes, we find ourselves if we are competing, it's against private equity. I think it's very challenging for private equity to borrow a lot of turns these days. So that may be bringing down a little bit of activity on the private equity side. Having said that, what I would say are our proprietary deals are very strong. We actually have a good pipeline of activity, in particular, in HVAC location and inspection and contact. So going into '23, I would expect a positive year on the inorganic growth side.

Operator, Operator

I'm not showing any further questions at this time. I'd like to turn the call back over to Paul Clegg for any closing remarks.

Paul Clegg, VP, Investor Relations and Communications

Thank you all for dialling in, and thanks for your support, and we look forward to updating you again on the road here soon and during our next quarterly call in February.

Operator, Operator

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.