Earnings Call Transcript - WMS Q3 2021

Operator, Operator

Good morning, ladies and gentlemen, and welcome to Advanced Drainage Systems Third Quarter Fiscal 2021 Results Conference Call. My name is Tammy and I am the operator for today’s call. At this time, all participants are in a listen-only mode. Later we will conduct the question and answer session. 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.

Mike Higgins, Vice President of Corporate Strategy and Investor Relations

Thank you, and good morning. Thanks to everyone for joining us 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 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.

Scott Barbour, President and CEO

Thanks, Mike, and good morning, everyone. Thank you for joining us on today's call. We delivered another quarter of record financial performance in the third quarter of fiscal 2021. Sales grew 24% year-over-year, driven by 17% nonresidential sales growth and 36% residential sales growth, as we continue to execute at both ADS and Infiltrator in a favorable demand environment. In fact, sales across each of our end markets increased double digits in the quarter. It was very encouraging to see the demand in our nonresidential end market increase 17% this quarter. We continue to benefit from growth in horizontal construction, such as warehouses, distribution centers, data centers, and developments that follow the residential build-out. There was continued strength in the regions we have experienced growth this year, such as the Atlantic Coast and Southeast, and we experienced a rebound in regions that have been softer this year like the Northeast and Western United States. In addition, allied product sales in the nonresidential market increased 23%, giving us confidence in the underlying market strength. We also continue to experience strength in our residential market with 36% growth in the quarter, driven by favorable dynamics in new home construction, repair/remodel, and on-site septic, accelerated by the material conversion strategies at both businesses. Our indicators are showing that homebuilders continue to acquire land for future development and that there's an overall shortage in available homes, which bodes well for both the front end, new community development stake with ADS and at the home completion stage with on-site septic at Infiltrator. The retail market, which is roughly one-fourth of our residential sales, continues to experience strong growth as well with the continued strength in remodeling and home improvement. Sales in the agriculture market increased 33% this quarter, driven by the programs we put in place around organizational changes, new product introductions, and improving execution as well as favorable weather and market dynamics. These dynamics are being driven by favorable indicators such as higher farm income and strong crop pricing, which is leading farmers to invest in land productivity through better field drainage. Improving field drainage is a low-risk, proven method of increasing per acre yield for farmers.

Scott Cottrill, CFO

Thanks, Scott. On Slide 6, we present our third quarter fiscal 2021 financial performance. I'll be brief on this slide, as Scott has already covered a lot of the details here, but I want to reiterate a few key points. The very strong 24% revenue growth we reported this quarter was driven by both volume and pricing as well as strong growth across both our ADS legacy and Infiltrator businesses as well as in each of our end markets and product applications.

Operator, Operator

Your first question comes from the line of Michael Halloran with Baird.

Michael Halloran, Analyst

So good stuff, really impressive quarter there. So at the risk of trying to front-run your fiscal '22 guidance, not what I'm trying to do here, but you want to parse out a couple of things that you said there. In the slide deck, you said demand was pretty similar to last year, but it certainly sounds like you're saying demand is growing, and the expectation is for demand growth in this calendar year. Maybe just kind of sync those two before I go into a few more relevant questions.

Scott Barbour, President and CEO

So, Mike. What I mean by that is when I look at fiscal 2021 as a whole, the first half will be quite different regionally. I think the second half will show more consistency across regions. If you combine those two, I believe the fiscal year 2022 will reflect that overall pattern. Overall, if you've managed to navigate well and performed strongly, which we believe we have over the last nine or ten months during the pandemic, looking ahead, I think you will find the future even more favorable. It should be more consistent and less affected by regional variations.

Michael Halloran, Analyst

The expectation is for growth, but there will be some variability. On the pricing side, it seems likely to remain strong based on current feedback. I would like to hear your thoughts on the market's readiness to accept price increases and if there has been any regional pushback. I know Infiltrator operates a bit differently, so insights on that would be helpful as well.

Scott Barbour, President and CEO

Yes, I believe the pricing environment for all types of construction materials is expected to remain strong for various reasons, including good demand and increasing input costs. Both companies have implemented pricing adjustments, and they are holding steady and ongoing. You may remember that we, at ADS, made some changes back in September, which had a positive outcome. Since then, Infiltrator has also made pricing adjustments. We are further refining our pricing strategies in select regions and segments. I would say Cottrill has been quite proactive with our sales teams and has a clear understanding of what we need to achieve our goals. To address your question, we have observed that these pricing adjustments are taking hold. While there may be some minor exceptions in a few areas, they are not significant or unexpected based on our past experiences.

Scott Cottrill, CFO

And I'd say, Michael, the only thing I'd add, a couple of years ago, especially Scott changed the paradigm around pricing here. It's input costs and resin first, absolutely. But then we also look at what's going on with diesel, common carrier, transportation, logistics, and labor. So it's a holistic look at that cost scenario and making sure that we stay in front of it. So that's embedded in the pricing dynamic or paradigm that we now have.

Michael Halloran, Analyst

Absolutely. On the commercial side, there was a 17% increase, and on the non-residential side, we've seen a remarkable continuity in the environment. Could you discuss the factors by region, the verticals you serve, and your thoughts on sustainability?

Scott Barbour, President and CEO

I believe there are two very positive aspects regarding the nonresidential numbers, which had raised some concerns. First, the Northeast has returned to solid demand levels. Second, we saw an increase in sales in the Western U.S., particularly in California, focusing on target segments such as distribution, data centers, residential build-outs, and land development. These areas have shown notable growth, especially in the Western U.S. Additionally, our allied products, which are closely tied to nonresidential markets, had shown low single-digit growth in the first half of the year, which was unusual for us. However, they have rebounded well, and our order book is strong. This gives us confidence in our nonresidential efforts and the importance of ensuring our supply chains are functioning effectively.

Mike Higgins, Vice President of Corporate Strategy and Investor Relations

Mike, this is Mike Higgins. I want to add to Scott's comment about nonresidential demand. He mentioned the rebound in the Northeast and the West, but I want to emphasize that the South and Southeast, which were already doing well, continue to show strength, if not an acceleration in growth.

Michael Halloran, Analyst

Yes. Great. And then last one, high-quality problem here. It's kind of amazing how quickly your leverage got down towards one. What's the plan on the free cash from here? Obviously, internal investments, but how does the M&A side look? And how are you thinking about usage of that cash?

Scott Barbour, President and CEO

We have increased our capital spending, particularly for Infiltrator and ADS. We discussed this extensively in our recent Board meeting, and they are encouraging us to expedite our organic growth efforts. We are currently working on a few initiatives, though they are not at the level of Infiltrator. While we are making progress, I wouldn't describe anything as highly imminent or actionable at this point.

Scott Cottrill, CFO

The only thing I'd add to that is that we're going to make some additional investments on our side on the capabilities side to help accelerate and move that. But it's going to be a disciplined process. So it's been very active, but it's got to be the right thing, close to our core. We've talked about bolt-ons. It's got to be at the right multiple. It's got to hit the strategic lens. So all of those things. We're not going to let kind of this leverage kind of burn a hole in our pocket, if you will. We're going to make sure we do the right thing and do the right acquisitions as we move forward. So very active is the way I would characterize it. We know we've got a great opportunity in front of us. And we're going to make some investments on that side to help accelerate that moving forward.

Operator, Operator

Our next question comes from the line of Matthew Bouley with Barclays.

Matthew Bouley, Analyst

Congrats on the results. I guess I'll start out with a question on Infiltrator. 37% growth, kind of similar as the nonres question you just had. But we know residential is in a strong place right now in general, but I'm curious if you have any sense of how that Infiltrator growth may have compared versus sort of the underlying market opportunity, if it's just higher penetration. I don't know if you rolled out some of that portfolio to new products or just customer wins. Just kind of bridge us from the market, so that's 37% growth there.

Scott Barbour, President and CEO

Yes, that's a good question. Firstly, Matthew, we're very pleased with Infiltrator's performance across the board. Roy and his team are doing an excellent job, and we are continuing to make significant investments in them. While I can't provide a precise breakdown, their performance is certainly better than the market, possibly even double the market rate, particularly benefiting from ongoing trends in the Southeast and the mid-South, as well as a higher usage of on-site septic systems in those regions. Roy would likely agree, and we discussed this recently. When land development happens quickly, it can be challenging to get municipal sewer systems established in those areas, leading to an increased reliance on on-site septic systems to facilitate quicker home sales. There has been a noticeable rise in the use of on-site septics in recent years, which Roy believes has increased due to the migration towards suburban and rural areas. Additionally, they have excellent national distribution for their products, ensuring they are well-positioned wherever market growth occurs. Their primary product, The Chamber, offers advantages such as faster installation, a smaller footprint, and a familiarity among contractors. Given the labor constraints many are facing while trying to accelerate their work, this is a significant advantage. We've observed that their team has developed a strong operational momentum and knows how to leverage it to gain market share. I also want to highlight our satisfaction with the residential segment of ADS; our high-touch sales model is proving effective.

Matthew Bouley, Analyst

Great. Great. Well, that's helpful. And yes, that business just continues to surprise to the upside. Second one, on the margin, since it sounds like you're willing to at least give a little bit of flavor around how you're thinking about calendar '21. So you're guiding to 29%, almost the midpoint for fiscal '21. So as we think about the next leg, are there areas where you can still take cost out of the system? You had a lot of targets you outlined way back at the Investor Day there, presumably, mix can still be a driver as Infiltrator is strong here. But just what are the puts and takes as we think about margins beyond this 29% here?

Scott Cottrill, CFO

Let me answer.

Scott Barbour, President and CEO

Cottrill is eager to contribute to this discussion. Reflecting on Investor Day, the initiatives we highlighted regarding four-wall manufacturing, logistics, and transportation are either on track or slightly ahead of schedule, especially in four-wall manufacturing, which has gained momentum since then. Addressing your question about what remains to be done, we indicated on that day that we would pursue these opportunities. Our confidence in this direction has strengthened, and we see various avenues of potential, including successful non-residential procurement work, improved productivity, fixed capital investments, and automation efforts we've implemented. We believe we're just at the beginning of this journey.

Scott Cottrill, CFO

The only thing I would add is that we are going to maintain our pricing strategy and take an aggressive stance, keeping a close watch on any significant cost inflation we encounter, including input costs and transportation logistics. Scott mentioned operational excellence, and I believe the key takeaway is that we are only in the early stages in nearly all of these areas. We're experiencing solid progress and are reinforcing that with our balance sheet, deploying capital accordingly. Growth has been noteworthy, particularly in Infiltrator, with strong gross and EBITDA margins, as well as in our allied products. This growth mix is very promising as we consider margins moving forward. On the SG&A side, while we have seen some temporary savings this year, those factors are included in our pricing strategy and focus on operational excellence. Therefore, we do not foresee any significant challenges as we head into next year. We are optimistic about the sustainability and expansion of our margins.

Operator, Operator

Your next question comes from the line of John Lovallo with Bank of America.

John Lovallo, Analyst

Maybe dovetailing off of Scott, one of your answers to Matt's question. Are you seeing any project delays from builders on the single-family construction side as builders are kind of scrambling to get land and get labor as activity has been so hot?

Scott Barbour, President and CEO

We are definitely looking into that. To answer your question, no. However, we recognize that the land inventory is diminishing, and this will create challenges. We have been monitoring the commentary this quarter and all the related publications. I wouldn't say this has slowed us down, John. If we do encounter issues, it may be on the ADS side and later in the year. That said, we have opportunities and relationships to develop with national homebuilders. We've also made sure our team is aware that we should consider not just the large developers building 250-lot communities, but also smaller builders working on 50 or 40 homes. This could impact us in the future, although it hasn't affected us yet. It's a valid concern; it could happen. However, I believe we might have a chance to offset any potential impacts since we are not collaborating with every homebuilder across the U.S.

John Lovallo, Analyst

That makes sense. Okay. And then you called out international business, I think, being up 18%, and you mentioned that Canada was up double digits. How did Mexico perform in the quarter?

Scott Barbour, President and CEO

Mexico showed positive growth, and we exported some pipe from Mexico to the Southern United States to help increase our inventory levels. Without that, the growth would have only been around one or two percent. I believe we have reached a low point there. Our new leadership is implementing programs focused on distribution relationships and segment targeting, which aligns with our established strategies. It's a work in progress. They've done a commendable job in Mexico producing and supplying the product to the United States, and we anticipate increasing that activity through the winter months. Tom Waun and I are putting in a lot of effort, and we are excited about the progress in Canada as well. I want to acknowledge our Canadian team for their excellent performance this year.

John Lovallo, Analyst

Got you. Okay. And then finally, with more and more chatter around potential infrastructure build at some point. Any updates on your lobbying efforts in Texas and the ability to penetrate that 30- to 60-inch diameter market?

Scott Barbour, President and CEO

Yes. I will be visiting next week to meet with our advocate and others. We are making progress according to the timeline provided by the Texas DOT and their installation plans. While we would prefer a quicker pace, we are on track with our commitments regarding those installations. Currently, we've observed additional pickups in Texas, not directly tied to the Texas DOT, but I believe we've improved our approach there over the past few years, leading to positive growth. Although Houston has faced challenges, it has recovered. I am looking forward to my trip next week to see how everything is progressing.

Scott Cottrill, CFO

Yes, John, I would say in Texas, a couple of things. We've seen good growth in the residential market. And then while we're working very hard on this Texas DOT initiative, we have made progress in some, call it, more metro area, metro suburban approvals for public infrastructure, and we're starting to see some of those things pay off as well.

Operator, Operator

Your next question comes from the line of Garik Shmois with Loop.

Garik Shmois, Analyst

Congratulations on a great quarter. Just the first question is just curious how sales progressed during the quarter. I don't know if you could give it by month or just more broadly, just given consensus is looking for mid-single-digit growth, and you are so far ahead. And just wondering if the strength was evident right off the bat? Or did it build and accelerate as the quarter progressed?

Scott Barbour, President and CEO

So it's a good question. And I would say September, October and until Thanksgiving, we were going pretty darn hard, mainly driven by yes, the recoveries in the West and the East, but we were going real hard in the agriculture business. I mean, things were flying out of here in October and November. December seasonally came down as it normally does, but year-over-year was still a good December. So we like the pace throughout the quarter to tell you the truth, particularly with a nice December. December and January, in our business, historically can be pretty tough months. It is for everyone. But we did a nice job in December, and January is good too.

Garik Shmois, Analyst

Great. Second question is just around the fourth quarter. Are you expecting any abnormal pull forward of sales? I think a year ago, you did have some pull forward of sales. It's more due to COVID and people trying to buy ahead of the uncertainty, but I was just wondering if you're anticipating anything abnormal this summer interval?

Scott Barbour, President and CEO

Yes, you're right. We reported that there was $20 million in the fourth quarter, with $10 million attributed to a pull ahead due to COVID uncertainty and $10 million resulting from favorable weather patterns that helped the agriculture sector. As it stands now, I don’t think that will pose a significant challenge for us. There could be severe weather like what occurred in the Northeast that briefly affected our shipments, but they rebounded quickly. We are monitoring the situation closely. Therefore, I don't expect any issues from that, although I remain open to the possibility of unexpected severe weather. Additionally, our implied guidance for Q4, as reflected in our range, does not factor in any pull aheads as we approach the end of March. We are actively working to maintain progress and avoid any slowdowns.

Garik Shmois, Analyst

Great. And just a last question, just a follow-up just around the discussion on organic growth. How that's a main priority of the free cash flow? How should we think about the balance between new investments around new products versus just the need potentially to build out incremental capacity just given the surge in demand, both on the residential and nonresidential side? And how should we think about labor inflation in that context moving forward?

Scott Barbour, President and CEO

I believe that less than one-fourth of the $100 million is likely allocated to purely new product development. The majority of it seems to be aimed at enhancing capacity, safety, and productivity. There are also IT-related expenses included. While we have introduced new products that we need to tool for at both Infiltrator and ADS, these do not dominate our current capital expenditures. That being said, when we invest in tooling, such as for pipes, we examine the design and profiles to make incremental improvements in the product with new tools, but I wouldn't categorize that as introducing a new product; it’s more of an incremental enhancement. A key focus for us is ensuring that any investment in tooling or machinery results in better performance compared to previous designs or iterations of that machine.

Operator, Operator

And there are no audio questions. I will now turn the call back to Scott Barbour for closing remarks.

Scott Barbour, President and CEO

Thank you, Tammy, and thanks to everyone for joining us today. We appreciate the questions; they give us a chance to explain what’s happening. We’re pleased with our performance this quarter and the momentum we have moving forward. Our focus will continue to be on health and safety, as well as providing essential storm water management and on-site septic solutions to our customers and the communities we serve. As sales increase this year, we will implement level loading and build our inventory in preparation for seasonal demands, while also enhancing productivity and investing in new fixed capital. These elements will be critical for executing our strategy as we transition into FY 2022. There's been a lot of conversation today about addressing inflation, and as Scott emphasized, we seek fair compensation for our services, products, and logistics. Our team is doing an excellent job in this regard and will maintain a strong focus on it. Finally, I want to thank our employees for their outstanding efforts under challenging circumstances. Their dedication is evident when you see them in action, and we appreciate their support for us and our customers. Thank you all, and we look forward to speaking with you soon.

Operator, Operator

Ladies and gentlemen, that concludes today's conference call. Thank you for participating. You may now disconnect.