Advanced Drainage Systems, Inc. Q3 FY2022 Earnings Call

Good morning, everyone, and welcome to the Advanced Drainage Systems Third Quarter Fiscal 2022 Results Conference Call. My name is Katrina, and I’ll be your operator for today’s call. I’d now like to turn the presentation over to your host for today's call, Mr. Mike Higgins, Vice President of Corporate Strategy and Investor Relations. Sir, you may begin.

Good morning, everyone. I'm here today with 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, and thank you all for joining us on today's call. We achieved a record $715 million in sales in this third quarter, an increase of 47% compared to the same period last year. Sales growth was driven by both pricing and volume at ADS and Infiltrator. Construction market Pipe volume increased double digits in the third quarter, with particular strength in the nonresidential, new residential and infrastructure end markets. Agriculture sales were down just slightly, driven by the strategic decision we made earlier this year to service commercial markets in areas where we experienced material and labor shortages. This came at the expense of growth in the agriculture market, but importantly, we achieved favorable pricing in this market. The material availability issues are now behind us, and we can again begin to start the work of growing our agriculture market share as we successfully did in FY '20 and FY '21. Infiltrator sales increased 51%, primarily due to favorable pricing as well as a slight volume increase with strong growth in the Southeast and southern regions of the United States. Roy Moore and the entire team at Infiltrator are doing a great job managing record levels of demand, working through material price and availability issues, while achieving record production levels in their factories, installing new capacity and executing the Jet Polymer acquisition this past quarter. Additionally, international sales increased 23% this quarter with growth in each of the businesses, Canada, Mexico and exports. Not only were we able to execute price and volume agreements in these markets, but we also began importing large volumes of Pipe products into the Northeast from Canada and into Texas from Mexico to improve service levels to customers and reduce our backlog levels. This past year is the first time ADS has meaningfully used these international facilities at scale to supplement domestic production for U.S. customers. This is a competitive advantage for ADS and demonstrates the scale and capacity we can bring to our distribution partners and customers. I want to take this opportunity to also thank the ADS and Infiltrator employees for their outstanding work in a really challenging environment. The majority of our employees are in manufacturing, transportation and sales roles. I cannot express enough the credit due to these folks, executing at a high level in this environment of dynamic price situations, high production rates and high rates of transporting our goods while dealing with all kinds of disruptions and labor shortages. Our backlog and pace of orders remain favorable as well as our ability to capture price in the market, which gives us confidence in the updated sales targets we issued today. Overall, the demand environment remains very favorable, and our leading indicators point to continued strength for the foreseeable future. To that end, we have continued to invest in expanding our capabilities with production capacity coming online at both ADS and Infiltrator this fourth quarter. The new equipment will modestly benefit production in the fourth quarter with a larger impact that will be realized in FY '23. The Infiltrator capacity comes online will have a more significant immediate impact, and these investments will allow us to bring down the high levels of backlog, build back inventory levels and service the strong demand we see in our end markets, particularly in the key growth regions like the Southeastern United States. Moving to profitability. Our adjusted EBITDA increased 27% this quarter. We realized the full benefit from price increases implemented over the last several quarters, covering inflationary pressure costs on materials, transportation and labor. This quarter, we faced many of the same challenges around labor shortages and the elevated transportation costs. I want to note that the second half plan for increased profitability over the prior year that we shared in November is right on track with what we communicated. The price levels have caught up with the inflationary pressures, and we have line of sight on the year as we have consistently communicated and reflected in our guidance ranges. We took actions this past summer to simplify our production processes, reduce our SKUs, decrease changeovers, all to increase our production rates, and these programs are working as we anticipated. Compared to previous quarters, the availability of raw materials has normalized, though material costs remain a little elevated overall. We are beginning to see some modest relief in material pricing as resin supplier inventories rise and availability is robust. However, within the manufacturing organization, we were unable to consistently operate all our production lines as we wanted to due to open production positions and absenteeism. This trend continued in January, though we did see modest incremental improvement as we progressed through the month. So I want to turn to some other recent announcements that we've made. In January, we issued our third annual sustainability report. Sustainability is a core part of ADS. Our reason is water. We protect and manage water, the world's most precious resource to safeguard our environment and communities. And it is the second largest recycling company in North America. We are committed to advancing the quality of life and sustainable solutions to water management challenges. This year's report includes 10-year company-wide sustainability goals, including our commitment to science-based targets to reduce our greenhouse gas emissions. In this report, we furthered our commitment to reducing our environmental impact, enhancing the safety of our people, creating a diverse, inclusive and equitable workforce and improving the communities we impact. Through these new goals, we will reduce our absolute greenhouse gas emissions by over 40% from our baseline year while simultaneously increasing our use of recycled plastics by nearly 100% over the same time period. Additionally, in December, we announced the acquisition of Jet Polymers, further demonstrating our commitment to recycling and strategic mergers and acquisitions. Jet Polymers is the largest supplier of recycled polypropylene to the Infiltrator business. Through this acquisition, we will gain access to more recycled material to support the growing business in the Southeast, plus diversify and gain scale in the polypropylene materials for the company. Finally, today, we made two additional really important announcements. First, this week, our Board of Directors passed a resolution that will ultimately lead to the final allocation of the remaining ESOP shares to the participants. The company contributed $325,000 to the ESOP to enable the ESOP to repay the remainder of the loan one year ahead of the ESOP expiration date in March of 2023. Scott Cottrill will discuss some additional information on the ESOP in a moment, but to me, there are three key takeaways. Preferred shares in the ESOP will convert to approximately 12 million common shares in April. After this event, participants will be able to diversify and manage their retirement accounts more like a typical 401(k) plan; and third, this transaction does not impact our adjusted EBITDA or free cash flow and is accretive to EPS beginning next year in FY '23. Second, today, we announced that the board approved a new $1 billion open market multiyear stock repurchase program. This is the largest repurchase authorization we announced today. Recall that we executed a $292 million share repurchase in the May to August timeframe this year, and we plan to execute this program over time without hindering our ability to allocate capital to our top two strategic priorities: investing organically in the business to drive growth, productivity, safety and automation as well as to make strategic acquisitions. The strength of our balance sheet, our operational excellence initiatives and cash generation profile of both ADS and Infiltrator give us confidence in executing our capital deployment priorities. This year, we nearly doubled our capital spending to $130 million to $150 million, executed on the acquisition of Jet Polymers, increased the dividend by 22% and executed a $292 million share repurchases. So before I turn this call over to Scott, I'd also like to announce we are hosting an Investor Day on March 10 in New York. The event is available in-person and virtually. We will issue new three-year targets, conduct a deep dive of the Infiltrator business and give updates on our sustainability, sales and operations programs. If you have any questions about the event, please reach out to us through our Investor Relations team. With that, I'll turn it over to Scott to further discuss the financial results.

Thanks, Scott. On Slide 5, we present our second quarter fiscal 2022 financial performance. From a top-line perspective, we generated 47% growth year-over-year driven by price and volume at both ADS and Infiltrator. Legacy ADS pipe products grew 53%, Allied Product sales grew 33%, and Infiltrator sales increased 51% 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. In addition, our Pipe segment experienced double-digit volume growth in the construction markets this quarter. Our consolidated adjusted EBITDA increased 27% to $176 million, resulting in an adjusted EBITDA margin of 24.6% in the quarter. Importantly, we hit the full run rate of our previously announced pricing actions in the third quarter and not only covered resin increases year-over-year, but also covered incremental labor, manufacturing and transportation costs as noted on Slide 5 of our Q3 earnings presentation. It is important to note that our manufacturing and transportation costs remain at elevated levels. But I want to reiterate Scott's comments. Our employees continue to work hard and do a great job despite the day-to-day labor shortages we are facing. Moving to Slide 6. We generated $94 million of free cash flow year-to-date. In addition to the growth-oriented capital investments we're making, 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. While we spend a lot of time discussing investments in CapEx to support growth, productivity and drive improved service levels, it is important to highlight that we view our investments in working capital this year the same way. From a capital deployment perspective, we are committed to efficient and disciplined capital allocation to drive shareholder value. Our first priority for capital deployment remains investing organically in the growth of our business, as we view this as the highest return and lowest risk use of our available capital. 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. We are pleased with the recent acquisition of Jet Polymers, a recycling company located in the Southeastern United States. We will remain focused on staying close to our core, including regional pipe capacity, Allied Products that fit our solutions package and recycling capacity to support the growth of the business. Beyond our first two priorities, the share repurchase authorization announced today demonstrates our commitment to a balanced capital allocation strategy and an efficient use of our balance sheet. Finally, today's ESOP announcement is another way to show appreciation to our employees for the great work they have done. This will allow our employees to have full control over their shares one year ahead of our original plan. This transaction will result in a noncash charge of approximately $30 million to $35 million in the fourth quarter of this year to reflect the additional grant of ESOP shares to our employees. There is no impact to adjusted EBITDA or free cash flow in fiscal year 2022. Beginning in fiscal 2023, next year, we will replace the current ESOP compensation expense with an employer 401(k) match program. The 401(k) match program will result in approximately $8 million to $10 million of annual compensation expense. It is important to point out that despite the conversion of the ESOP preferred shares to common shares, this transaction will actually be accretive to our earnings per share calculation. We plan to issue pro forma financial statements illustrating such later today after we file our Form 10-Q. 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 $2.675 billion to $2.725 billion, representing growth of 35% to 37% 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. With that, I'll open the call for questions. Operator, please open the line.

This is Ashley Kim on for Matt today. So just first with the capacity plans that you have coming on, how do you plan to maximize utilization on that new capacity, just given, one, the shortages in manufacturing labor? And then two, if you can get the product made, getting the transportation capacity to deliver it?

This is Scott Barbour. That's a great question. First and foremost, staffing is the top priority. You are correct that, as we increase our capacity, we need personnel to operate it. We have been hiring in advance of this new equipment. The most rapid progress is being seen at Infiltrator, where our recent investments are already operational with staff in place. In some instances, we may transfer employees from older, less efficient machines to newer, more efficient ones. Overall, we are indeed increasing our workforce there. Similar efforts are ongoing at a few of the ADS pipe plants. We are somewhat lucky that the initial two machines we are introducing in Florida have more readily available labor compared to other regions. However, once that phase is complete, the challenge shifts to transportation. I believe that transportation issues will eventually resolve themselves. On any given day, we could likely ship more if we had access to additional trucks, but it tends to balance out, though it does come with increased costs, which is a significant concern.

Great. And then just for my follow-up, on your longer-term view with your plans to grow recycling, just appreciating that target for 1 billion pounds of recycled material that you kind of put out there in that ESG report. But could you just help us bridge the gap to getting there? What would it take between scaling up material sourcing or any kind of regulatory hurdles? And then maybe just some color around the eventual margin impact that you could see there?

So we'll talk a lot about this at the Investor Day, but it's really going to come from three different things in our program that we think about. One is you got to get the supply of the raw materials and expanding relationships, expanding the way the material you'll go after to bring into that input stream. The Jet Polymer acquisition is a great example of an acquisition that was driven by a company that had a solid supply of material that we knew we could grow. Roy and the team at Infiltrator knew they could grow that source of supply. We've sent our people out more aggressively looking for that supply. That's number one. Number two is you got to add capacity. That capacity will come through acquisitions like Jet Polymer or probably new facilities that we'll need to develop. Similar to what we do in Pennsylvania and Iowa, we have smaller operations in Ohio and Georgia that process this material for us and then feed into the pipe plants. Number three is in the existing places where we do recycle Pennsylvania, Iowa, Ohio and Georgia, we'll add-on capacity and debottleneck those operations to try to incrementally increase their capacity. So you add that all up, and that's how you get to the extra 500 million pounds. That's the logic that we're using.

Hopping on for Mike this morning. So first question here, I guess, just I'll give you the opportunity to expand a little bit on the forward-looking comments specifically on underlying demand. Just an update on what you're seeing on the ground, are new projects continuing to come in, are conversations getting a little more tense around inflation and price points and things like that? Any incremental color there would be helpful.

I would say that when we look at the commercial and nonresidential sectors, the pace of quotes and orders is consistent, if not slightly improved compared to the last six months. This area is proving to be quite strong. The new residential market for both pipe and Infiltrator is also performing well, and we are working through a significant backlog. While our shipment rates are healthy, incoming orders continue to be strong. On the Pipe side, we are at the beginning of land development, whereas we are seeing home completions lag behind due to labor shortages. What used to take six to nine months is now taking about nine to sixteen months. Overall, the demand remains solid as we address our backlog. However, we face challenges with staffing and absenteeism due to the impact of the COVID variant, and transportation can occasionally be a bottleneck, although we usually manage to navigate through it. Demand trends appear to be good, possibly even slightly better than before. The agriculture sector has been affected by poor weather and cold conditions, which has temporarily hindered progress. Last year, we opted not to expand that business as quickly as before, but we believe we now have the materials and capacity to revitalize it this year. Our Infiltrator team is eager to pursue new territories and sales strategies, especially with their active onsite septic products like the Presby product line. Overall, we are optimistic about our prospects.

Great. That was very helpful, Scott. Secondly, and maybe just to level set us a little bit. Obviously, now we're realizing kind of the full rate of price increases that came in, it sounds like the expectation is for incremental capacity to start coming online at the start of your fiscal 2023. So in theory, does that mean we see some added seasonality relative to the normal just because these things are going to lay in, and you're going to start to catch up on your backlog a little bit? Am I thinking about that the right way?

Q4 is a little bit difficult, right, to kind of make that assumption, but directionally, you're thinking about it the right way. I would say more as we round the corner into the construction season and kind of that March, April turning into Q1 of next year, you'll kind of see that bullishness come in, and we'll talk a little bit more about that at Investor Day as well. But you're thinking about it the right way as we progress.

The way we're thinking about it, this is Scott B. That was Scott C. The way we're thinking about it is, we have a lot of variability in the fourth quarter for us. We're really pleased with the third quarter, and we expect to see improvement. We can lose the game in January and February, but we can't win it. We need to win it in March, but we believe this will take off as we get into late March and April based on all the activity we've been seeing. Our normal seasonal shipping and profitability details are a little wacky now. We believe they will return to normal next year, perhaps. We just had to deal with the circumstances we were presented this year while getting that pricing up in the first six months, experiencing inflation, and figuring out programs to combat it. We got on top of it in the third quarter and will be on top of it in the fourth.

Nice results. Maybe just starting on the first question from a prior analyst. When you guys are building out your revenue assumptions for next year and fully appreciating that you haven't given that out yet, but I guess I would expect probably somewhere in the mid- to high single-digit range, but I don't want to take those words out of your mouth. But I guess, what percentage of topline growth for next year would you expect to be from pricing versus volume? And how does that compare to 'normal' time for you? And if raw materials come down as we hope they do, do you expect to hold on to most of your pricing?

So I'll address the last part first. Yes, it's more than just resin input costs; it's the entire value that we provide. When you consider labor, manufacturing, and transportation, we do not expect these inflationary cost pressures to go away. We will continue to offer exceptional service to our customers and achieve solid returns. There will be some benefit from the price increases we've implemented this year that will carry into next year. Additionally, there will be some volume increases next year due to capacity and demand backlog. We'll provide more details as we progress and discuss how everything is shaping up for next year. You're absolutely right, and we will provide more guidance at the Investor Day and when we share our outlook for next year. But you're correct in your assessment.

Okay. That makes sense. And maybe for my follow-up question, EBITDA margins were obviously pretty challenged this year despite inflation and supply chain disruptions and so on. And also 2021 was a remarkable year for you guys. I guess the question is, how are you thinking about the path to getting back to those high 20% EBITDA margins? And would you expect to see the largest improvement in margins next year? What's the glide path there?

This year, our focus has been on financial performance. As we indicated in Q3, our pricing has responded to increases in resin, labor, manufacturing, and transportation costs, and we are very pleased with that. Looking ahead to our guidance for Q4, reaching the midpoint of our ranges also indicates a story of margin improvement on a year-over-year basis, as we've previously mentioned. There is a possibility for greater margin expansion beyond the usual 100 basis points we typically refer to. I'm uncertain if that will happen next year or the following year, and I prefer not to limit it to a specific timeline. However, due to the hard work of our employees, the effective strategies we've implemented, and many positive factors aligning, we anticipate a good year ahead. There may come a time when we see significant margin expansion.

That concludes the Q&A session. I would now like to turn it back to Mr. Scott Barbour.

All right. Thank you. We appreciate everyone participating today and the questions. It's probably not great weather where many folks are today. I know we're kind of watching our phones and such. We have a couple of plants that won't be shipping well today due to the weather and a couple of distribution yards. But we'll find our way through that. We do appreciate your participation. Many of you, we look forward to talking to over the next couple of hours. We are now preparing for our Investor Day in March. Again, we are very excited about doing this again. We thought the last one we held in late 2018 was beneficial for us as a company and our investor base. There's a lot we've built on since then, and much of what we'll discuss will be relatively new for the company. We've had considerable work over the past couple of days with our board to not only report good results and confidence in our year, but also to conclude the ESOP and the $1 billion share buyback, which I'm surprised no one asked us about, but we'll carry that out over several years. We appreciate it, and we look forward to talking to you in the future. Stay well.

Thank you, presenters. This concludes today's conference call. Thank you again for participating, and have a wonderful day. You may all disconnect.