Advanced Drainage Systems, Inc. Q2 FY2022 Earnings Call

Good morning, everyone, and welcome to Advanced Drainage Systems Second Quarter Fiscal 2022 Results Conference Call. My name is May, and I will be your operator for today's call. I would now like to hand the presentation over to Mr. Mike Higgins, Vice President of Corporate Strategy and Investor Relations.

Thank you, and good morning, everyone. With me today, I have Scott Barbour, our President and CEO; and Scott Cottrill, our CFO. I would also like to remind you that we will discuss forward-looking statements. Actual results may differ materially from those forward-looking statements because of various factors, including those discussed in our press release and the risk factors identified in our Form 10-K filed with the SEC. While we may update forward-looking statements in the future, we disclaim any obligation to do so. You should not place undue reliance on these forward-looking statements, all of which speak only as of today. Lastly, the press release we issued earlier this morning is posted on the Investor Relations section of our website. A copy of the release has also been included in an 8-K submitted to the SEC. We will make a replay of this conference call available via webcast on the company website. With that, I'll turn the call over to Scott Barbour.

Thank you, Mike, and good morning. Thank you all for joining us on today's call. We achieved a record $706 million in sales in the second quarter, reflecting a 30% increase compared to the same period last year. The growth was mainly driven by pricing at both ADS and Infiltrator across our markets. Our volume was slightly down in the second quarter, primarily due to the challenges in the retail business within the ADS residential market, which faced a tough comparison to last year when we saw record shipping levels during the peak of the COVID-19 pandemic. Excluding retail, the ADS construction market sales volume experienced a slight uptick, despite some constraints in our manufacturing and transportation operations. Infiltrator sales rose by 38%, largely due to favorable pricing and a slight increase in volume, particularly in the Southeast and Southern regions of the United States. Our international sales also grew by 29% this quarter, with double-digit increases in our Canadian and Mexican businesses. Our backlog and order pace remain strong, along with our ability to capture market prices, which gives us confidence in our updated sales targets issued today. The price increases we implemented in the second quarter will reach their full effect in the fiscal third quarter, and we have achieved additional pricing on certain products to address ongoing inflationary cost pressures. Overall, the demand environment is favorable, and our leading indicators suggest continued strength as we work through the high levels of backlog. We must continue to address the backlogs in both ADS and Infiltrator, manage the seasonal impacts expected in the second half of the fiscal year, and leverage the self-help programs that are creating additional production capacity. Additionally, we are focused on installing and increasing the output of new equipment coming online, which will enhance our production capability in the latter part of the year and add capacity as we enter fiscal 2023 in April. Regarding profitability, our adjusted EBITDA decreased by 5% this quarter. The favorable pricing we've implemented over the past year helped mitigate inflationary cost pressures, but labor shortages in both manufacturing and transportation negatively impacted our profitability. This was particularly evident in our transportation sector, where we had to rely more on third-party logistics services, which comes at a higher cost compared to using our own fleet. Furthermore, year-over-year costs for third-party logistics have risen significantly. In manufacturing, we struggled to consistently operate all desired production lines due to labor shortages. Nonetheless, the initiatives we discussed in our last call, such as SKU reduction, process simplification, inventory consolidation, and sourcing from Mexico, are proving effective, resulting in improved daily production rates as we moved through the second fiscal quarter and into October. Availability of raw materials was more challenging in the early part of the quarter but improved over time. Material costs remain high, and as anticipated, the second quarter highlighted a significant gap between this year's elevated material prices and last year's historically low prices. Importantly, we maintained the level of adjusted EBITDA generated from the Infiltrator business in the second quarter. Infiltrator products are primarily produced at a single manufacturing site and are less sensitive to transportation issues compared to ADS products. While Infiltrator faced similar labor and transportation challenges, their impact on profitability was not as severe. Overall, the first half of this fiscal year has unfolded largely as we expected. As noted on our first quarter call, we anticipate seeing year-over-year improvements in adjusted EBITDA during the latter half of the fiscal year. We expect to realize the full effect of price increases in the third quarter and see benefits from our self-help initiatives. Although this year has posed challenges, we remain confident in our ability to identify and implement the right programs to enhance our margins over time. Finally, our year-to-date capital spending more than doubled in the first half of this fiscal year. We are investing to increase capacity, some of which will impact the fourth quarter for both Infiltrator and ADS pipe manufacturing. We started a production line in the Midwest at the end of the first quarter to help boost capacity and made investments in the Storm Tech business to enhance production capabilities for Infiltrator. New injection molding presses are being launched now with additional units expected in the fourth quarter to support the growing on-site septic business. These investments also include automation initiatives to help mitigate the effects of labor shortages. Once our improved capital investments are fully operational, we anticipate a double-digit increase in capacity at both ADS and Infiltrator, enabling us to meet the strong demand for the rest of this fiscal year and beyond. All in all, the core drivers of our business remain robust. We will continue to systematically pursue our self-help programs, particularly in addressing labor and transportation issues to improve both production efficiency and customer service levels. As we navigate this unique period marked by record demand and significant labor challenges, we are confident that our ongoing initiatives will benefit our business in the long term. With that, I'll turn it over to Scott Cottrill to discuss the financial results in more detail.

Thanks, Scott. On Slide 5, we present our second quarter fiscal 2022 financial performance. From a top-line perspective, we generated significant growth year-over-year, driven by both ADS and Infiltrator. Legacy ADS pipe products grew 31%, Allied Products sales grew 19% and Infiltrator sales increased 38%, with double-digit sales growth in both tanks and lease field products. We continue to demonstrate our pricing power with significant year-to-date price increases across each of our segments. As Scott mentioned, during the second quarter, strength in our construction market sales partially were offset by constraints within manufacturing and transportation as well as weakness in our retail end market, which was impacted by tough comparisons year-over-year. Consolidated adjusted EBITDA decreased 5% to $165 million, resulting in an adjusted EBITDA margin of 23.3% in the quarter. We knew this quarter would be our most challenging from a year-over-year comp perspective, given the low input cost and high demand environment we experienced last year. Importantly, we have good line of sight into the cost impacting our business and have taken actions to mitigate them in the back half of this year. These efforts have already contributed to margin improvement on a sequential basis throughout the second quarter. The long-term fundamentals of our business remain intact, and we are on track to hit the double-digit growth in our adjusted EBITDA guidance for the fiscal year. Moving to Slide 6. We generated $31 million of free cash flow year-to-date. In addition to the growth-oriented capital investments Scott outlined, working capital was a significant use of cash year-to-date as we purchased raw materials and built inventory at a much higher cost compared to last year in order to support the demand we are experiencing. We continue to make progress on our working capital initiatives, most recently working to extend our payment terms with some of our largest suppliers. As a percent of sales, working capital was 22% as compared to 20% in the same period last year. From a capital deployment perspective, we remain committed to efficient and disciplined capital allocation to drive shareholder value. Our first priority for capital deployment remains investing organically in the growth of the business, as we view this as the highest return and lowest risk use of our available capital. To that end, we have spent more than 2 times the amount as last year at this time, primarily on these types of growth initiatives. For the full year, we continue to expect between $130 million and $150 million in capital expenditures with the largest investments focused on future growth, followed by our productivity and automation initiatives. In addition, we continue to work an active M&A pipeline, focus on staying close to the core, including regional pipe capacity, Allied Products that fit our solutions package and recycling capacity to support the future growth of the business. We are committed to a strong balance sheet, financial flexibility and returning excess cash to our shareholders, as demonstrated by the $312 million returned to shareholders year-to-date through share buybacks and dividends. We completed our share repurchase program in the second quarter, purchasing a total of 2.6 million shares year-to-date. Finally, our trailing 12-month leverage ratio was 1.7x, remaining below our targeted leverage of 2 to 3x that we've previously communicated. Finally, on Slide 7, we have updated our fiscal 2022 guidance. Based on our performance and pricing actions taken to date, order activity, backlog, and current market trends, we currently expect net sales to be in the range of $2.55 billion to $2.65 billion, representing growth of 29% to 34% over the prior year. Our adjusted EBITDA guidance is unchanged at a range of $635 million to $665 million, representing growth of 12% to 17% over last year. The increase in our revenue guidance today is due primarily to the continued strength in orders in our backlog as well as the impact of favorable pricing that we've introduced to the market to date. With that, I'll open the call for questions. Operator, please open the line.

Your first question comes from the line of Mike Halloran of Baird.

So let's talk through the moving pieces as we go to the back half of the fiscal year for you. Obviously, the guidance implies above normal seasonal ramp and the EBITDA levels as you move to the back half of the year. I'm hoping we can just talk about the components behind that because it seems like it's a combination of capacity coming online, being able to loosen some of the labor shortages and the impacts and then also price cost and price timing. So maybe we could start on the capacity piece first. And just to understand what levers you guys have pulled and what this could mean for demand as we move to the back half or at least the ability to service the demand in the back half. And if that question needs to have the labor piece embedded in it, certainly understand.

I see it in three parts for the latter half of our plan, and we have a clear perspective on it. The components are pricing, capacity, and volume in terms of order release. We've made significant efforts on pricing in the first half, and that’s progressing well. Capacity has improved over the months, although there are labor challenges that we're addressing. While not fully resolved, if conditions remain stable, we're confident in overcoming these challenges. The machinery we've planned for is starting to come online, positively affecting both companies, particularly Infiltrator, which is quite profitable. Our distribution has been maintaining a good shipping pace, and the capital investments we've made will yield positive results in the second half, potentially leading to double-digit increases in capacity moving forward, which we've not previously emphasized. Regarding volume, while orders and backlog are solid, actual shipments depend on coordinating with contractors, and there could be delays due to seasonality or labor issues that are outside our control. We're focused on ensuring maximum shipments as we navigate these complexities. That summarizes our position.

Well, it was a long question, too...

Your typical multi-tiered question.

Well, to get as much as possible, I guess. So the price cost piece then, Scott mentioned that your margin levels got better through the quarter. As we get to the back half here, do you think you're above the curve in the third quarter or the fourth which one when it comes to not just mitigating the diesel and the resin or commodity inflation like you did this quarter, but also maybe getting on top of the transportation piece and major pieces? Or does that take a little bit more time?

It takes a little bit more time. But I think that sequential improvement we saw intra-quarter is something that we plan on. Obviously, you've got some seasonality impacts and leverage impacts as we go. But that pricing piece of this and getting to that run rate later in as we go through this third quarter, I think it becomes extremely leveraging. And when we get into that fourth quarter, you see kind of that nice margin improvement on a year-over-year basis as well. So I would say it continues to get better as we march through the back half with kind of that inflection point on a year-over-year basis by Q4.

So the gross price is good?

Yes. The leverage on the SG&A piece, we're going to continue to get. It's just some of the gross profit piece subscribing it.

So in other words, sequential improvement in the margins through the back half of the year despite what are the kind of the normal seasonal factors given all those things you mentioned. Is that fair?

Directionally, yes.

Your next question comes from the line of Josh Pokrzywinski of Morgan Stanley.

I'm going to ask a multipart question. Regarding your volume and pricing situation, we can see how variable prices have been this year. Scott, you mentioned some increases as well. If we consider past inflation trends as a reference for what happens when resin prices change, which seems to be starting, how much do you anticipate being able to keep? The company's margins have improved significantly over the past four to five years by using inflation as a pricing strategy and retaining some of that when costs stabilize. Can you clarify how much of that you think you will retain? We understand that freight costs may remain high for an extended period and labor costs might be permanently elevated, but there are certain factors that could be more temporary.

We completely agree with you on that. Looking ahead, we expect to maintain our previous performance in price retention. However, we won’t keep every bit of it, as some markets are more competitive than others, depending on the segment or region. We will continue to focus on our conversion efforts and market share growth, and I believe we can retain a significant portion of this pricing. Everyone running industrial companies is pondering how much of this they can keep moving forward. We are exploring various elements of our value proposition to achieve this. As I’ve mentioned before, it’s not solely about the product; it also encompasses the services and transportation we offer. We aim to assist our clients in designing projects and similar tasks. Therefore, we will evaluate our entire value proposition and diligently work on the price retention aspect.

Got it. That's helpful. And then maybe just sort of a follow-up to that. Obviously, you guys are providing more of a premium product on, say, like the pipe side. There's labor avoidance. There's other reasons why that's like a more desirable outcome. What is sort of the price differential you had to guess, kind of across your markets versus reinforced concrete? Is it still a discount? Or are you starting to come in to lock that there?

I'd say it's more in line step today than perhaps where we were historically, Josh. And we look at this very closely in particular markets where we want to protect our market share or gain market share. There's other markets where we probably given a bit back on our conversion story, intentionally because we didn't have the capacity in that region to service it when it came up. As you know, and we've discussed, it's really been in an availability game here. I mean, in the industry for the last six to eight months. But I would tell you that, that advantage has probably collapsed some because of our escalation in price. But I think we also know very cleverly where that is and how to make in-game adjustments if necessary.

Your next question comes from Garik Shmois of Loop Capital.

I wanted to ask just around the sales guidance increase and recognizing the balance of that is coming from pricing. But I'm just wondering if you may be able to provide a little bit more color as to where that's coming from? It seems like it's pretty broad-based. But any more color by segment as to where you're getting the incremental price more successfully.

Got it. This is Scott Barbour. A couple of things to note: the pricing is widespread, affecting all Infiltrator and ADS products, with no segment left out. It has been somewhat more aggressive for products we keep in stock compared to those tied to specific projects. Typically, we face daily competition on project-based items, so we need to remain competitive. Products in stock, which are distributed, tend to have different competitive dynamics; they need to be aligned but don't face the same everyday pressures. That's how we've characterized this environment. Additionally, agriculture tends to be more competitive than our commercial businesses.

Yes. I agree with Scott, Garik. This is Mike Higgins. When we look at our end markets, the pricing increase on a year-over-year basis is really pretty consistent. And that's a bit by design. It's how we price. As Scott said before, it's pretty consistent across the products, and that translates to pretty consistent pricing in the end markets.

There's no one place that stands out. Approximately 80% of the price seems to be the right approach.

And geographically, we're seeing the incremental pricing gains that we would want to see as well. So it's not like one part of the country carrying it versus another.

Great. That is what I was looking for. I wanted to follow up with the issue of capacity and your capacity that's coming online. Is that requiring incremental labor? And maybe more broadly, you touched a little bit on looking to ramp up labor, just given the headwinds in manufacturing on the transportation side. Can you expand a little bit more on that? Where are you in the hiring process?

That's a very good question and one we focus on a lot. Let's break it down. As the Infiltrator capacity comes online, it utilizes pretty automated manufacturing cells, resulting in minimal labor requirements—around 6 to 10 people to scale up capacity. Additionally, at the Kentucky site, various automation projects are in place that relieve labor needs, leading to no significant increases in headcount even as we add sizable increments of capacity. In the pipe-making business, we aim to achieve similar results. The projects Scott and I have been reviewing and that our Board has approved are designed to require fewer personnel than previous investments. We are striving to replicate the efficiencies seen in the Infiltrator division, with each new capacity addition needing fewer new employees. The need for additional personnel will likely be in the range of tens to twenties, which poses challenges in recruitment. However, we are significantly improving our operations on the pipe side through various activities that help reduce headcount requirements. While we are concerned about this issue, we've allocated extra capital for automation and enhanced material handling to limit the necessity for additional hires, especially given the current labor market conditions that are expected to persist.

There are no further audio questions at this time. Please continue.

Good questions, and we appreciate it today. When we spoke 90 days ago, we anticipated this would be our toughest quarter. A lot has been happening in that time, and we've made significant progress. Scott and I believe we finished the quarter slightly better than we expected, thanks to several initiatives, particularly in operations and logistics. Our team is working extremely hard to serve customers and increase capacity to capitalize on the favorable market conditions. We recognize the importance of wisely managing our capital expenditures. We have conducted buybacks and distributed a considerable amount of cash last quarter, all part of our planned activities, including rebuilding our balance sheet with inventory. Although there are many moving parts, things are unfolding as we expected. We had a productive meeting with our Board recently, and they expressed strong support for the programs we are running at Infiltrator and ADS. We feel aligned within the company and are excited about the tasks ahead for the remainder of this year and the next couple of years. Thank you for your participation today, and we look forward to connecting with all of you in the coming weeks.

This concludes today's conference call. Thank you for participating. You may now disconnect.