Advanced Drainage Systems, Inc. Q4 FY2022 Earnings Call

Good morning, ladies and gentlemen, and welcome to Advanced Drainage Systems' Fourth Quarter and Fiscal Year 2022 Results Conference Call. My name is Juhan, and I will be your operator for today's call. I would 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.

Thank you, and good morning, everyone. Thanks for joining us for our call today. With me, 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 on file 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 said, I'll turn the call over to Scott Barbour.

Thanks, Mike, and good morning, everyone. Thank you for joining us on today's call. Fiscal 2022 played out largely as we communicated in February with profit improvement occurring in the back half of the year due to multiple actions we took over the course of the year to improve pricing and operations. We closed out fiscal 2022 with a record $2.8 billion in revenue and $676 million in adjusted EBITDA, up 40% and 19%, respectively. Our adjusted EBITDA margin was 24.4%, coming in at the high end of our guidance range. This fiscal year, we successfully managed through a number of challenges, including significant inflationary cost pressures, labor shortages and two waves of COVID. Despite material shortages early in the year and persistent labor challenges, we were able to increase production and improve inventory levels to better service our customers, all while improving the safety within our facilities by double-digit rates. We employed $149 million in CapEx, primarily to drive organic growth more than any year in the history of the company. We also executed $292 million of share buybacks and acquired Jet Polymer, a recycling company in the Southeastern United States. I'm very proud of the performance of the entire operations team to help the company exceed our guidance ranges in this market environment. Domestic revenue increased across all end markets driven by favorable pricing as well as double-digit volume growth in the construction markets as we continued our consistent track record of converting the market to our more environmentally-friendly materials. Sales increased 45% in our priority states with notable growth in Florida, Texas, and California. In addition, the 8% growth in the agriculture market displayed on Slide 4 would have been even higher if we had more available labor to run all of our production lines and available material in the spring season. In summary, the sales team did a great job executing our plan to meet the favorable demand we continued to see in the market. We finished out the year strong with a record $678 million in fourth quarter revenue, a 53% increase compared to last year. Sales growth was driven by both favorable pricing as well as construction market volume growth at ADS and Infiltrator. Agriculture volumes were down, driven by the cool wet start to spring in the Midwest. Infiltrator sales increased 43%, primarily due to favorable pricing with strong growth in the Southeast and southern regions of the United States. The 2022 investments at Infiltrator continue to give us more capacity to work down the backlog and order rates within that business remain favorable. Housing growth in the South, Midwest, and in rural areas remain strong where we have a better penetration of on-site septic products. Additionally, international sales increased 16% this quarter, driven by growth in Mexico and the export businesses. We continue to leverage our Mexican and Canadian capacity to help service the strong domestic market demand and reduce our backlog. We have been working closely with our distribution partners to monitor market demand and we collectively remain bullish on activity through calendar 2023. We continue to work programs with homebuilders and are encouraged by continued strength in land development. Our backlog is up double digits over this time last year, and we continue to work to reduce our backlog from peak levels through the recent capacity additions, improving service levels overall. Pace of orders and project strength remain favorable, as well as our ability to capture price in the market, which gives us confidence in the fiscal 2023 sales targets we issued today. April financial results were strong on a tough comparison to last year, which sets us up well for this year, in line with the guidance ranges we communicated today. To that end, we continue to invest in expanding our capabilities with investments in production capacity coming online at both ADS and Infiltrator in fiscal 2023. We plan to spend another $150 million to $180 million on CapEx this year. These investments will allow us to continue working down the high levels of backlog, build back inventory and service the strong demand we continue to see in our end markets, particularly in key growth regions like the Southeastern United States. From a profitability perspective, our adjusted EBITDA increased 78% this quarter, we realized the full benefit from price increases implemented throughout the first half of fiscal 2022, covering inflationary cost pressure on materials, transportation, and labor. We continue to face challenges around labor shortages and elevated transportation costs, which we expect to continue. Now I want to highlight some other recent announcements. Earlier in May, we announced the acquisition of Cultec, Inc. Cultec designs and sells plastic stormwater and on-site septic chambers with a strong presence in the Eastern United States. Their products expand ADS' portfolio of Allied product solutions, enabling us to meet the growing and evolving needs of our customers. Cultec is well respected within the industry, and we are excited to welcome the Cultec team to ADS. Finally, in a press release issued earlier this morning, we announced ADS' Board Chair, Bob Kidder, intends to retire at the end of his term this July and will not seek reelection. Bob has provided tremendous leadership and in part of timely advice throughout ADS' journey as a public company. His board knowledge and management experience are unmatched, and I'm personally very grateful for his guidance and partnership since I joined ADS in 2017. It is ADS' good fortune to have had Bob Kidder serve as Board Chair over the last five years, and I wish him success in his future endeavors. The Board has elected Bob Eversole, currently serving as Chair of the Audit Committee, to serve as Board Chair starting in July. Bob has been on the ADS Board since 2008 and brings a very strong background in finance and business management. I am excited to work with Bob in his new role going forward. With that, I will turn the call over to Scott Cottrill to further discuss our financial results.

Thanks, Scott. On Slide 5, we present our fourth quarter financial performance. From a top-line perspective, we generated 53% growth year-over-year, driven by favorable pricing at both ADS and Infiltrator as well as strong volume growth in the domestic construction markets. Legacy ADS Pipe products grew 61%. Allied Products sales grew 49%, and Infiltrator sales increased 43% with double-digit sales growth in both tanks and leach 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. Consolidated adjusted EBITDA increased an impressive 78% to $169 million, resulting in 350 basis points of margin expansion to 24.8% in the quarter. Consistent with our guidance, year-over-year margin expansion began in the fourth quarter, and we expect to carry this momentum forward as we progress throughout fiscal 2023. The fiscal 2023 guidance issued today shows an 18% to 21% increase in adjusted EBITDA dollars as well as over 100 basis points of margin expansion year-over-year. Moving to Slide 7. We generated $126 million of free cash flow in fiscal 2022. In addition to the growth-oriented capital investments, working capital was a significant use of cash year-to-date. We purchased raw materials and built inventory at a much higher cost compared to last year to support our strong demand. In addition, accounts receivable increased compared to last year primarily due to the significant pricing we introduced into the market throughout 2022. As Scott noted, we will spend another $150 million to $180 million on capital expenditures this fiscal year as we continue to invest at elevated levels to support the strong market demand, we continue to see and work down our significant backlog. In the fourth quarter, the remaining balance on the company's outstanding ESOP loan was repaid. And effective March 31, 2022, the remaining unallocated shares of preferred stock were allocated to participants. In April, those shares converted to 12.8 million common shares outstanding. Closing out the ESOP is another way to thank our employees for the great work they've done throughout this dynamic year. As a reminder, in fiscal 2023, we will replace the ESOP compensation expense with an employer 401(k) match program, which will cost approximately $8 million to $10 million annually. I'll direct you to the 8-K we intend to file later today after the market closes that will present our earnings per share numbers on an as-reported basis as well as on a pro forma basis. Finally, on Slide 7, we provide our fiscal 2023 guidance. Based on our order activity, backlog and current market trends, we currently expect net sales to be in the range of $3.1 billion to $3.2 billion, representing growth of 12% to 16% and adjusted EBITDA to be in the range of $800 million to $820 million, representing growth of 18% to 21%, translating to an adjusted EBITDA margin of 25.7% at the midpoint versus 24.4% this past year. With that, I'll open the call for questions.

And the first question comes from Josh Pokrzywinski from Morgan Stanley.

So just, I guess, a question first, trying to understand some of the volume comments because the EBITDA waterfall shows that as a drag that I think you mentioned up double digits in Pipe. Can you maybe just sort of kind of explain where you're seeing maybe that volume shortfall if I'm understanding the waterfall chart right? And then how much kind of deferred revenue or unexpected backlog build you had in the quarter?

This is Scott Barbour. If you refer to the fourth quarter chart, you'll notice strong double-digit volume growth in both nonresidential and residential sectors, along with improved pricing. In the agriculture segment, there has been some price growth, but volumes have been lower due to challenging comparisons from a year ago and a slow start to the selling season, which accounts for about 7% to 8% of our total sales. There are many good agriculture orders, but they haven't been shipped yet, which relates to the delayed revenue issue. Looking ahead, this year may not see a strong spring season for agriculture, but a favorable fall season could follow if the weather is good. This situation is not only seasonal but also highly cyclical; while we are experiencing a challenging period now, we are positioned well within the cycle.

Got it. That's helpful. And then just on '23 guidance. Obviously, a lot of volatility over the past, call it, 1.5 years with inputs, especially on the resin side. Is there sort of an explicit price cost benefit that you guys are thinking about in guidance? I know that the long-term targets weighed out at the Analyst Day didn't really have anything, but just given that like you kind of see the whites of their eyes now, anything that you're built into the year.

Yes, Josh, Scott Cottrill here. So yes, absolutely, there is. When you look at the yield or pricing side of the house, really good momentum. We saw that in Q4, all year really as we kind of ratcheted that up, and we talked about run rate in Q3, Q4. We'll continue to take pricing actions as we deem appropriate and necessary. On the other side of that coin, though, we're very much keeping focus not only in resin, but what's happening with labor, transportation, diesel all of those costs. So we've got those in our guidance with kind of assuming that those continue to be up well over what they were for the full year of '22. So we've kind of taken a realistic, we think, approach on what those costs are going to mean to us.

Our next question comes from the line of Michael Halloran from Baird.

So on the guidance, maybe just some thoughts on how you guys are thinking about the underlying demand patterns for the year by your end markets. If you're assuming that backlog normalizes as you work through the year? And any thoughts as you see it on sustainability of some of those end markets? Because obviously, there's a lot of commentary on softening in some of the residential pieces. Even some of the nonres pieces like, say, the distribution center side. So any kind of help on the assumptions that you're embedding in the guidance would be really helpful.

Scott Barbour here, Michael. There's a lot to discuss regarding that. Let me summarize a few key points. In the first half of the year, we observed continued growth in orders, driven by our quoting activity. We are monitoring several projects that are continuing to expand. The market sentiment is positive, and I've been in communication with our teams for the past 30 to 45 days, and they are feeling very optimistic about the ongoing projects and demand, which is reflecting in our performance. We are addressing some backlog as our capacity ramps up, especially with Infiltrator, where the added capacity from last year is performing well. This has allowed us to reduce lead times on some products to more typical levels, and we are actively working on this. Looking ahead to the second half, we have modeled it as a standard year, without any significant downturn or drop-off. We expect a typical distribution of profits between the first and second halves, based on what we consider average volume levels in the latter part of the year. We are committed to maintaining our pricing, even as inflation impacts us, and we feel confident in our current position. It took us six months to stabilize, but we are pleased with our achievements and performance anticipated in the fourth quarter.

And on the free cash flow side, obviously, you took on extra inventory this year to make sure you could get in front of some of the environmental challenges or the challenges in the environment, I should say. Maybe some help on how you think that plays out as we work through the year. Is this a year where you're going to see some normalization on the working capital side? Or do you think you're going to have to keep some elevated inventory on hand to manage through the challenges?

Yes, Michael, the way we think about working capital is it will start to normalize. We'll hit and target kind of a 20% working capital as a percent of sales. We ended up last year. This current year, we just closed fiscal '22 at 21.8%. A little bit higher than obviously, we like to be for all the reasons that we indicated with all the pricing that we got into the market as well as that inflationary resin cost plus building some of that inventory in that Q4 winter period, which we normally do. So as we look forward, we have not forecasted any of those costs or pricing come off. So those rates kind of stay at those elevated levels. So it's much more of just kind of a pounds and sales volume gain. And so again, we think that will be right at that 20% of working capital as a percent of sales target as we move forward.

Our next question comes from the line of Garik Shmois from Loop Capital.

I was just wondering if you could expand a little bit more on what you're seeing on the cost side, whether it's on raw materials and polypropylene or on the transportation side. You had a nice deceleration sequentially at least on the transportation and manufacturing cost bucket. So just kind of curious if you could expand on that a little bit.

Okay. This is Scott Barbour. Let me take a moment to address the situation. When I think about raw materials, they surged quickly, reaching their peak around November and December, but they've since decreased slightly and have remained relatively stable. Different materials, including polypropylene, virgin high-density polyethylene, and recycled options, contribute to this mix. Overall, we are seeing flat trends month over month. Looking ahead, that's how we have structured our expectations. If there are any shifts in prices, we will respond accordingly. Regarding labor, our costs increased significantly last year, and we are seeing some lasting impacts from that, in addition to making adjustments to our labor rates moving forward. While we are currently managing those costs, they have been elevated. On the transportation front, while there has been a general decline in the broader market, our flatbed segment, which we focus on, has remained stable. We are not experiencing a decrease in our contracts for trucking services. However, we are facing a driver shortage, which has led us to rely more on external fleets than we would prefer. We are using contract drivers to operate our equipment, which is more costly than employing our drivers, primarily for capacity management reasons. Therefore, transportation costs continue to be high. We have incorporated these costs into our pricing models as part of the services we offer. I believe we effectively managed this aspect in the fourth quarter, and we started addressing it in the third quarter, while we fell short in the first and second quarters.

Got it. I would like to follow up on the EBITDA margin guidance you shared during the Investor Day, which indicated an expansion of 400 to 500 basis points through fiscal '25. Given the ever-changing environment, I'm curious about your thoughts on this long-term guidance. It’s only been two months, but has there been any change in your perspective on that guidance?

We are quite busy. I hadn’t considered that, but let me address it. Yes, let me address that because we received this question recently, so it’s a good one. We provided guidance of 400 to 500 basis points, and we indicated that this would be front-end loaded in our three-year plan. We believe the guidance we've given aligns with that promise from the Investor Day, and we see a clear path to achieve it. We are committed to following through on what we stated during the Investor Day. That's our perspective. Regarding the upcoming years, I still believe that is our objective. We are not going to alter our three-year goal based on the recent months, even though they have been quite chaotic with the war and other events; we're not going to waver from that.

Garik, the point I would add to Scott's comment there is what gives us that confidence in that three-year plan. In addition, is that conversion story, right? You can look at the end markets and you're entitled to your view of what's going to happen there, but we always talk about 100 to 200 basis points above our end markets is what ADS historically has done. It's been much greater than that over the last couple of years. So we see that conversion story accelerating. We've talked about the strength in April. We talked about how we've ended fiscal '22, our pricing power. We've got a lot of levers. And we've got a lot of diversification that adds to the strength of this company and what we can do. So we are still very bullish on the future, and there would be nothing that we see right now to be changing those guardrails.

The next question comes from Matthew Bouley from Barclays.

So the first question is just given all the price you've taken and sort of the broader challenges with inflation, are you expecting to see any pushback from customers on price or elasticity on volume? Just any larger customers or channels where that risk keeps you up at night?

Scott Barbour here, Matt. I always worry about that. The agriculture market is the most price elastic market we have. We work hard to maintain discipline within our sales team and leadership regarding pricing, and we are committed to that discipline. I don't anticipate us backing off from this approach. In the current environment, we are concerned about competition from other materials, which are also facing significant inflationary pressures. As we have noted before, we have experienced localized issues compared to reinforced concrete pipes. Therefore, we have localized pricing strategies to address those challenges. However, I don't believe there is a significant channel, geography, or segment that will undermine our efforts. Does that clarify things a bit?

It sure does. And then I wanted to zoom in on the residential end market. I know there's a question about broader markets earlier. I think you said at the top that you're still seeing strength on the front-end land development side, which is, I guess, not that surprising. But what are you hearing from customers on the front-end and as well on the back-end septic side on new construction, just given all the concerns out there, it would be helpful if you can kind of talk through some of the things you're seeing?

Let's discuss on-site septic, which is closely tied to the housing completion stage. Currently, the duration from start to completion is longer than it has been historically. It used to be around 6 to 9 months, but now it ranges from 9 to 12 or even 15 months. This extended timeline contributes to our backlog. We’re also observing solid order rates, especially from regions like the Southeast, Midwest, rural areas, and custom home markets. After attending their sales and management meeting last week, I'm optimistic about their situation. They have strong market penetration, excellent distribution, and promising new products. The demand for on-site septic systems appears to be robust, and I believe we are well-positioned in this area. On the land development side, we continue to expand our market share by developing stronger relationships with homebuilders, getting involved earlier in their planning phases as they prepare to start their communities. This is especially important due to supply chain issues impacting their ability to access other products, such as concrete. Our availability allows us to support them effectively, alongside helping with local regulatory matters. This remains a significant advantage for us. Mike and I just discussed the strong performance we're witnessing, including solid double-digit growth in both the fourth quarter and our backlog. We'll be meeting with two homebuilders next week, along with senior leaders from the organizations we collaborate with. Overall, I feel positive about our prospects in both areas. While interest rates are a factor, our positioning and the programs we are developing align with the guidance we provided in our three-year outlook a couple of months ago.

I want to emphasize Scott's point regarding our relationships with the builders; our visibility has never been better in that area. Based on what you hear from them, it's clear that the issue isn't a lack of demand or selling problems; rather, it's about building capacity. They remain optimistic about acquiring land, starting new communities, and constructing homes to satisfy the demand for single-family builds.

And our distributors say the same thing. That's what's so encouraging is when we're with the senior leaders from our distribution, they're watching this just as close as we are, and they remain very confident about demand levels in the residential segment.

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

Just wanted to follow up on the warehouse and like e-commerce fulfillment market. I know it's not the biggest piece of what you guys do, but it's gotten a lot of airplay over the last couple of years. I think you have heard from the integrator from the likes of Amazon that they're kind of tapping the brakes there. I guess the world is sort of bigger than one player, but like are you guys seeing any change there or any kind of new project mix or anything that would sort of be worth pointing out as maybe an inflection point one way or the other?

So that's a good question. Yes, it has got a lot of airplay. We've grown nicely in that market and a big focus for us. And so here's what we're hearing. And again, our team is going to be out there here in the next couple of weeks to meet with some of the largest developers in that segment. Nothing has stopped. There are some things that have moved out by a year. And what I'm told is kind of the last mile or subregional type of facilities that they were planning that they continue to be bullish on the bigger facilities. Now this is what I'm told, we haven't seen any degradation in our order book or anything like that or the projects.

Got it. That's helpful. And then just one more follow-up on residential. Obviously, if there are municipal services and wastewater like that, there isn't as much of a content opportunity for you guys. Do you have any insight into what homebuilders are focusing on regarding land activity? Is it more the rural areas where you might gain some higher content on things like septic, or are they building on land a bit closer to town? I would think the choice of land location is significant for Advanced Drainage.

For on-site septic, you're absolutely correct that it matters a lot. And here's my sense is that those top 10 homebuilders are the on-site septic participation in there is probably less than the 33% of the overall market. We tend to do well, like you said, in the rapidly, rapidly growing areas. Areas of 10 or 20 home development, not 200. Now I'm sure the Infiltrator guys will listen to this and give me 10 examples where I'm wrong. But I do believe there is a different mix with those big guys. And these smaller builders doing 10 homes, 15 miles outside the city. I mean, that's our bread and butter. The South, the Midwest, call this semi-rural areas, which are growing very rapidly. You look at those counties that are growing very rapidly. That's where we have very superior participation.

The only thing I was to say with think of their business being with more regional, local custom-type homebuilders versus the much larger builders for the most part. And I think just the other point to remember, too, is roughly 30% of their business is repair and replace. So that's very steady. It's on existing homes, the system is old. So it's an old pipe and stone system that gets replaced with plastic chambers or hey, there's more activity going on in the home. You have more people living there, you've expanded it, you need a bigger leach field, a new septic tank, et cetera.

We currently have no further questions, so I will hand back over to Scott Barbour for any final remarks.

All right. Thank you very much, and we really appreciate the questions and the participation today from you all. Just a couple of comments to wrap up. I mean, I think we issued pretty strong guidance for next year. We're very confident in it. We have line of sight on that. We have the right programs and execution to do this plan. I think really importantly, we had this right velocity out of the fourth quarter into FY '23. We feel very good about that and what we achieved in FY '22. We have programs to find. We have an execution orientation. We've got management processes in place to achieve this year and those long-term goals. I thought that was a good question by Garik, how does this fit into the long term. And I think we've got that well dialed in. We can always do better, and we strive to do that, but we feel very confident about where we are. And then last, I want to thank our employees before we got on today, Mike said, it feels like it was 2 years ago that we were having the kickoff for FY '22. It's been a long year. There's been lots of twists and turns, but our employees and operations, sales, our SG&A employees, our transportation, the network, the guys working in the yards, our truck drivers. I mean, this was very different from the year before, but still a lot of hard work, and I'm very appreciative of all that they put in, in the support that our Board gave us through a lot of twists and turns. So we look forward to the subsequent conversations and thank you all for joining.

This concludes today's call. Thank you so much for joining. You may now disconnect your lines.