Earnings Call Transcript - WMS Q2 2021

Operator, Operator

Good morning, everyone, and welcome to the Advanced Drainage Systems Second Quarter Fiscal 2021 Results Conference Call. My name is Laura, and I will be your operator for today's call. I will now hand the presentation over to your host for today, Mr. Mike Higgins, Vice President of Corporate Strategy and Investor Relations.

Michael Higgins, Vice President of Corporate Strategy and Investor Relations

Good morning, everyone. Thank you for joining us today. With me here, 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 all of that said, I'll turn the call over to Scott Barbour.

Scott Barbour, President and CEO

Thanks, Mike. Good morning, everyone. Thank you for joining us on today's call. We had a strong second quarter of fiscal 2021, with 10% net sales growth as demand and business activity remain favorable. I want to thank the ADS and Infiltrator employees for their execution and diligence in making that happen. I also appreciate our customers for working with us in new and imaginative ways to serve the construction markets. We generated strong performance in key growth states, including Florida, the Carolinas, Tennessee, Georgia and Utah as well as more broadly across the South and Southeast regions of the United States. As a whole, we benefited from our national presence and geographic exposure as well as our increased residential exposure from Infiltrator and the focused homebuilder programs at ADS. Infiltrator once again exceeded revenue expectations with 63% sales growth in the second quarter. Infiltrator continues to see double-digit growth in tanks and leachfield products, with particular strength in Florida, the Carolinas, Georgia, Tennessee and Alabama. Recall, the Infiltrator results are for two months of the prior year quarter, given the timing of the acquisition, which closed July 31, 2019. In the residential end market, legacy ADS sales increased 15% this quarter. We see favorable dynamics in new construction, repair/remodel and on-site septic. Orders, backlog and sales remained strong through the period, with very limited impact from the slowdown in residential starts earlier this year. As a whole, we are well positioned for growth in the residential market. On the front end of the cycle, the ADS products and go-to-market strategy are positioned for the land development phase, whereas Infiltrator products come in play towards the end of the cycle when construction is nearing completion. Additionally, both Infiltrator and ADS have a repair and remodel component that is strong and growing. Its home improvement activity and existing home sales continue to rise. About one-third of the Infiltrator sales are related to repair and remodel. At ADS, the repair and remodel exposure is covered through our retail and national accounts. The company's exposure to the residential market has increased to 38% of domestic sales compared to 28% at this time last year. Sales in our nonresidential end market were up modestly, led by strong growth in HP Pipe and Storm Tech retention/detention chambers as we continue to benefit from our exposure to horizontal construction. We are tracking very closely to the segments of the nonresidential market that continue to do well such as data centers and warehouses as well as geographies that are experiencing growth like the Southeast and Atlantic Coast. Importantly, we believe ADS is well positioned to continue to grow above market due to our conversion strategy, national coverage and water management solutions package. Given what we see in the market today, we believe the second half of the year will be similar to the market conditions we experienced in the first six months. Agriculture sales were down just slightly this quarter as we called out to a tough comparison period. Still, the agriculture sales team has had a great first half of fiscal 2021, with sales up 14% year-over-year. In addition, the fall selling season is off to a great start as we continue to benefit from the programs we put in place around organizational changes, new product introductions and improving execution in the agriculture market. International sales increased 3%, driven by double-digit growth in our Canadian business. Canada is doing well across both the construction and agriculture end markets. Mexico, on the other hand, is not performing as well, having been more significantly impacted by the COVID-19 pandemic. Overall, strong demand is causing some regional- and product-level constraints. Lead time and inventory levels are stretched as we get into this part of the season. Based on this strong demand and our desire to more fully capitalize on opportunities in our core end markets, we are stepping up our capital investments, which we now expect will total between $80 million and $90 million for this fiscal year. The focus of our investments will be to improve safety, increase capacity for future growth and improve productivity. We will rebuild finished goods inventory in the second half of the year by level-loading production at our facilities in our traditionally slow months, preparing both ADS and Infiltrator for good customer service and normal lead times. This build will depend on our second-half demand, ramping up new capital and dealing with the COVID-19-related circumstances like employee retention, absenteeism and local conditions. This is consistent with the environment we've been managing since the pandemic hit. We are also making investments in talent, including the recent addition of a senior leader to accelerate new product introductions, marketing and innovation. As highlighted in a press release this morning, we created a new product management and marketing organization to accelerate the development, launch and marketing of new products to meet customer needs. I'm pleased to announce Brian King joined our organization in September to lead this effort as the Executive Vice President of Product Management and Marketing. Brian has 25 years of successful product management experience, and we're excited to have him join our team. Moving to our profitability results. We achieved another quarter of record adjusted EBITDA during the period. Adjusted EBITDA margin increased 820 basis points overall with a 640 basis point increase in the legacy ADS business. This was driven by favorable material costs, leverage from the growth in Pipe and Allied Products, execution of our operational initiatives and contributions from the proactive cost mitigation steps we took earlier this year. Infiltrator also achieved record profitability in the quarter due to strong demand, favorable material costs, contributions from our synergy programs and continued execution of their proven business model. The synergy programs are right on track to achieve the run rate targets we've previously communicated. As we look ahead to the second half of the year, we are optimistic as our order book, project tracking, book-to-bill ratio and backlog all remain positive. We expect the normal seasonal patterns to apply to the second half of our fiscal year as installation activity slows down in geographies with colder temperatures. We also have some profitability headwinds coming up in the third and fourth quarters, including inflationary costs for materials and labor. We are working to offset these headwinds through pricing actions, operational productivity initiatives and our synergy programs. In summary, we did a very good job executing this quarter. We're focused on safety, managing through the COVID-19 environment, servicing our customers and driving these new levels of profitable performance. Though uncertainty still exists regarding the broader market environment, we are well positioned to capitalize on residential development and horizontal construction while continuing to generate above-market growth through the execution of our material conversion and water management solution strategies. We remain focused on disciplined execution as we look to build off a very strong first half of our fiscal 2021. With that, I'll turn the call over to Scott Cottrill to further discuss our financial results.

Scott Cottrill, CFO

Thanks, Scott. On Slide 6, we present our second quarter fiscal 2021 financial performance. Net sales increased 10%, with 4% growth in our legacy ADS business plus 63% growth in our Infiltrator business. Sales growth in the legacy ADS business was led by a 15% sales growth in the residential market, which remains robust. As Scott discussed, demand in our nonresidential market remains stable, with pockets of strength in horizontal construction, data centers and warehouses. Overall, sales were solid throughout the quarter, and this trend has continued through October. Sales grew in Infiltrator across their portfolio, driven especially by strength in their leachfield and tank product lines. Infiltrator continued to benefit from the underlying strength in the repair and remodel market as well as growth in single-family housing. This growth was further accelerated by their material conversion strategy. From a profitability standpoint, adjusted EBITDA increased $56 million or 47% compared to the prior year. Adjusted EBITDA for the legacy ADS business increased $33 million or 35%, with strong performance from our sales, operations, procurement and distribution teams. ADS is very well positioned to capitalize on the current stability in our end markets due to our market-leading position, national relationships, breadth of products and services as well as our geographic and end market diversity. These attributes make us the premier partner and leader in the industry and led to the margin expansion and strong financial performance in the quarter. Infiltrator's adjusted EBITDA increased $21 million or 86%, benefiting from strong demand, favorable pricing, lower input costs, productivity improvements as well as our synergy programs. Moving to Slide 7. Our free cash flow increased $112 million to $257 million as compared to $135 million in the first half of fiscal 2020. These impressive free cash flow results were driven by the strong sales growth and profitability we achieved in the first half of fiscal 2021 as well as execution on our working capital initiatives. Our working capital decreased to right around 20% of sales, down from 22% at this time last year. Further, our trailing 12-month pro forma leverage ratio is now 1.5x, slightly below our target range of 2 to 3x leverage. We ended the quarter in a very favorable liquidity position as well, with $204 million of cash and $339 million available under our revolving credit facility, bringing our total liquidity to $543 million. The favorable changes we have made to our capital structure have also resulted in no significant debt maturities until 2026. While pleased with our conversion of adjusted EBITDA to free cash flow in the first half of this year, we will need to make strategic investments in working capital and CapEx during the second half of this year to position us to take full advantage of expected growth as well as to make the necessary investments to support our productivity initiatives at both the legacy ADS and Infiltrator businesses. In addition, we continue to assess bolt-on acquisition opportunities through our disciplined acquisition process. Finally, on Slide 8, we introduced our guidance for fiscal 2021. Based on our performance to date, order activity, backlog and current market trends, we currently expect net sales to be in the range of $1,790,000,000 to $1,840,000,000, representing growth of 7% to 10% over last year; adjusted EBITDA to be in the range of $495 million to $515 million, representing growth of 37% to 42% over last year. And we expect to convert our adjusted EBITDA to free cash flow at a rate of around 60% for the full year, driven by our strong results as well as the investments we just discussed. With that, I'll open the call for questions. Operator, please open the line.

Operator, Operator

And our first question comes from Mike Halloran of Baird.

Michael Halloran, Analyst

So a couple of questions here, first on the demand side. How parsed out how you're thinking about the back half of the year? The commentary around order rates, backlog, funnel, everything seems directionally positive. Guidance is kind of stable year-over-year. Is that timing mix just giving yourself a little push in case weather or COVID becomes a bigger headwind? Just help me understand kind of those puts and takes a little bit.

Scott Barbour, President and CEO

So Mike, Scott Barbour. So I would say that we were off to a really good start in October. It was a lot like September in the prior quarter, and September was particularly strong. We, I think, are a little more conservative in our fourth quarter. It tends to be the most variable quarter around weather, and we feel like we have a bit of a tough comp to last year. We had very favorable construction weather conditions last January, February, and March, and both Infiltrator and ADS benefited from that. So we've kind of looked at that and put in what we would call the average scenario for our fourth quarter. Our near term is as you described. I mean we continue to move along at a pretty good clip. And we think we've got a good handle on kind of, let's call it, our 60-, 90-day horizon. But as always, there's a lot going on out there in the world. I think we want to be prudent just a bit on the conservative side.

Scott Cottrill, CFO

And Michael, to Scott's point about the pull ahead in the fourth quarter, last year's second half saw approximately $20 million attributed to this, with about $10 million resulting from COVID uncertainty and customers wanting their orders before the end of March, along with another $10 million due to the warm weather.

Michael Halloran, Analyst

Yes. Very good context there. And then what's the latest thought process internally? I know you typically say you need to get towards Thanksgiving a little later, so you can start getting a view on what the next 12 months after that looks like. But how are you thinking about the nonres market or nonres pieces of your portfolio today? Obviously, the conversion and your marketing efforts are driving outperformance versus the end market. But any early thoughts on how you're thinking about how the next 12 to 18 months might shape up on that side and the ability to navigate what are going to be probably pretty disparate trends among the verticals within that nonres space?

Scott Barbour, President and CEO

Yes, I believe there will be varying trends, possibly influenced by geography. We still view the Southeast and Florida, as well as the Southern Atlantic Coast, as promising areas for nonresidential opportunities. Recently, we have noticed some recovery in Texas and California. There may also be a resurgence in the Northeast for nonresidential projects. Ultimately, it will depend on our new projects that are initiated and funded. However, we have a solid pipeline of quotations and are hearing positive feedback regarding the availability of funding and the willingness of people to advance projects. Overall, I would say we feel more optimistic now than we did during our last discussion.

Michael Halloran, Analyst

And then last one from me. Just puts and takes on the margin side here. How are you thinking about the pricing equation, your ability to capture price in the marketplace versus some of the inflationary pressures that you're seeing on the materials side? And how should we think about that cadence and any lag impacts over the next few quarters?

Scott Barbour, President and CEO

We anticipated this question. We implemented a price increase in October, and it has been effective. We are prepared to tackle rising costs, especially in resin, using four strategies: pricing adjustments we have already introduced; level-loading to rebuild our inventories while also maximizing our factory output, which will help reduce off-season conversion costs—this will reflect on our balance sheet and affect our profits and losses early next year; productivity programs that are gaining momentum; and investments in fixed assets and automation that should yield benefits. While these initiatives might not have immediate impact, we are beginning to see progress in some areas. It's not happening as quickly as I would prefer, but we are making headway. These are the four strategies we will employ to combat the inflationary pressures we are facing, and we are committed to addressing inflation every day.

Operator, Operator

Our next question is from Matthew Bouley of Barclays.

Matthew Bouley, Analyst

I wanted to ask about your comments regarding the need for capital expenditures in the second half and the inventory build you're planning, which seems to depend on both demand and ramping capacity. Are you encountering any capacity constraints at this time? Additionally, could you provide more details on the investments you intend to make?

Scott Barbour, President and CEO

Yes, that's a great question and one we spend a lot of time working on. The answer to your question is, yes, we are running up against capacity constraints. Both businesses are build-to-stock. We have extreme seasonality, so we've got to kind of build ahead of that and drain down and build back. But even doing that at both companies, we've run very hard since basically May. As we look into next year, we're going to have to make additional fixed asset capacities to give us more seasonal capacity, to give us more overall capacity. And if you think about it in terms of like Infiltrator, a couple of more presses earlier than we had anticipated. Roy and his team were right on top of that, and we were able to kind of get that in the pipeline. On the ADS side, it's getting some assets into key areas, the growth areas we have. That is a combination of new assets and maybe moving some assets and some different production planning and inventory strategies, which we, by the way, have been successfully executing and are now building upon those ideas. My goal, Matt, is to give us better peaking, both better absolute capacity and better peaking capacity in, call it, that June through October time frame. In that way, we can meet surges in demand and better availability and service to our customers. I think that's one of our strongest growth programs is getting those things in place.

Matthew Bouley, Analyst

Got it, that's very helpful. For my second question, I wanted to inquire about some regional dynamics. Scott, you mentioned significant progress, particularly in the Southeast. Could you elaborate on that a bit? I'm interested in the markets you've identified as medium-term opportunities, like Texas and California, where you believe there's less penetration compared to other areas. What is the current status of those markets? Are there any additional markets where you're aiming to improve penetration and progress?

Scott Barbour, President and CEO

Yes. Our plans for penetration in the Southeast and Florida are key to our strategy. I think that's progressing well. Texas has faced a challenging year due to the economy, COVID-19, falling oil prices, hurricanes, and general uncertainty. However, in the last two months, we've started to see an acceleration and a return to year-over-year growth. Our penetration is probably slightly up or stable. We're performing strongly in Houston, which faced the most significant impacts, and it's rebounding well. In Dallas, San Antonio, and Austin, our penetration is improving daily. We are still working towards obtaining the full suite of approvals we need, but we're making progress with our team collaborating effectively with local influencers to achieve that. In California, like the Northeast, it was difficult to engage with customers due to shutdowns, and we experienced a flat or slight decline. However, in the last two months, we've begun to recover. We've secured a significant distribution center contract with a well-known e-commerce company, and we're currently fulfilling that order. There are additional opportunities we are pursuing, so while we may not be where we want to be, we're actively engaged and working hard.

Operator, Operator

Our next question is from John Lovallo of Bank of America.

John Lovallo, Analyst

The first one on the price mix and materials bucket. I mean, obviously, that was a big contributor year-to-date around, I think, $43 million on a year-over-year basis in EBITDA. It sounds like the back half gets a little bit more challenging. But is it fair to assume that, that bucket is still going to be a good guy in the EBITDA walk in the back half?

Scott Cottrill, CFO

Yes. John, those walks are, as you know, year-over-year, so that will still be a good contributor. As we walk through the second half, it will get a little bit more constrained as we go, but that will be a good contributor in the second half. And equally important, as we look at the second half versus the first half, we're holding on to kind of that spread, as we call it, which is what we aim to do as we move forward.

Matthew Bouley, Analyst

Okay, that's encouraging. And then the residential exposure at around 38% now. Where do you think this could trend over the next year or two? And is there a mix that you believe is optimal for your business?

Scott Barbour, President and CEO

That's a great question. My answer is that since residential for ADS is growing faster than the company overall, it will increase as a percentage of sales. Infiltrator, being entirely residential in a strong growth market, is expanding more quickly than nonresidential ADS, which will affect our mix. While I can't specify an exact number for the future, I anticipate a positive trend over the coming months and years. Infiltrator is a well-managed and profitable operation, which benefits us in many ways. The residential side of ADS is performing well through HP, and we have improved our cost and pricing positions. Therefore, we are equally pleased if it grows rapidly as we are with nonresidential growth, or perhaps even a bit more so.

Matthew Bouley, Analyst

Okay. And then maybe one more from my end, if I may. You recently hired a new head of your international segment. Any early reads on kind of how he's looking at the business in terms of opportunities and challenges?

Scott Barbour, President and CEO

The main challenge for Tom currently is navigating the market dynamics in Mexico, especially considering the severe impact of COVID-19 on the economy, which is compounded by significant changes in government spending. We are collaborating with an external firm to conduct a market study there. Similar to what we did in agriculture about a year ago, I anticipate gaining new insights into this market and identifying the best strategies for engagement. Tom excels at this type of analysis, and it has been a significant focus for him in recent months.

Operator, Operator

Our next question is from Garik Shmois of Loop Capital.

Jeffrey Stevenson, Analyst

This is Jeff Stevenson on for Garik. My first question is on inventories. And I'm just wondering what the extended lead times from capacity constraints? Are they matching in distributor sell-through right now?

Scott Barbour, President and CEO

I really don't know the answer to that. A lot of our stuff is delivered right to the job site. It's not really stocked by the distribution, as you would classically think. So I don't know that, that match up, I have super-great visibility on that. What we do send to stock at certain distributor stores appears to be on a fairly normal pace right now. So I wouldn't say they're greatly mismatched.

Michael Higgins, Vice President of Corporate Strategy and Investor Relations

And just to fill, this is Mike Higgins. Just to kind of put some more context around what Scott said, about 80% of what we do goes directly to a job site. So the kind of distributor stocking dynamic doesn't have a huge impact.

Scott Cottrill, CFO

Yes, it's different for us versus the other building material companies or construction product companies that rely on the distributors to kind of pull through and sell through and deliver to the market.

Jeffrey Stevenson, Analyst

Got it, got it. And then given that you rapidly got your leverage targets down after the Infiltrator deal, I'm just wondering if you could talk more about your kind of capital allocation priorities moving forward and where you see things next year.

Scott Cottrill, CFO

This is Scott. Yes, we're extremely excited about that execution and where our leverage is. We're equally excited about the opportunities that are in front of us organically. So between the Infiltrator business, the demand, the productivity, the synergy initiatives, there are just so many things. I call it a target-rich environment, that we are accelerating not only that CapEx but then as well the organizational structure behind that, the foundational build-out, if you will, to support that CapEx as well as the OpEx. If you look at that Brian King announcement for product management, innovation, again, we're going to make investments there to accelerate growth and productivity initiatives. So extremely excited. So that's the bulk of it. The acquisition side of it, we've talked about our disciplined process. We've talked about how we're bringing resources to bear to invest in that vertical, if you will, as well. We're excited about how that funnel is building back out. It will be a very disciplined process. We'll make sure that we deploy that capital effectively when we're ready to. But we are very active in that space as well as we build it out. So those, by far, are the two pieces of our capital deployment and allocation strategy that we are solely focused on right now.

Operator, Operator

Our next question is from Josh Pokrzywinski of Morgan Stanley.

Joshua Pokrzywinski, Analyst

So a bit of a layered question here, so feel free to take it in pieces. So always appreciate the color and the profit waterfall, it's very helpful. If I look at kind of the last couple of years here, you're roughly double your average contribution on price/materials mix. And then the volume piece or the volume leverage of that is maybe a bit lower than where you've been in the last couple of years. Just kind of putting together some of the commentary from the earlier questions, I guess, first, how do we think about that price cost or mix contribution relative to the past couple of years? It sounds like there's some headwinds building, but it's still a good guy. I guess, is that your way of saying, we're going to mean revert? And then how do we think about that volume portion of the profit walk, given that there's some capacity investments and some of your comments about that disparate market and geographic growth?

Scott Barbour, President and CEO

Okay. So that is a multilayered question, Josh, and there's a lot to unpack.

Joshua Pokrzywinski, Analyst

Admittedly, I warned you.

Scott Barbour, President and CEO

Yes, I understand. I'll give it a try, and I think Cottrill will likely add to this. It's important to recognize that the size of those bars will fluctuate as business conditions change. Before COVID, our nonresidential segment was performing really well, and our conversion strategies were also effective. Allied Products were growing significantly faster, making volume a key contributor back then. At the same time, we experienced record-low resin and input materials during the summer, which we successfully managed. So, while the size of those bars has changed, I’m not too concerned. As long as we’re seeing a 100 basis point increase each year, we’ve had a very strong growth year, and we’re on track with the three-year plan we laid out during our Investor Day. I recognize that the size of the bars will fluctuate, and we’re now effectively offsetting inflation in manufacturing and transportation. Though we may give back a little, there are many dynamics at play, and we’re pleased with the conversion cost trend we’re following. Moving forward, I expect the size of those bars to change slightly, but our team’s goal is to ensure that while the bars may shift, the overall trajectory remains consistent. As we face challenges with resin pricing, we've initiated changes we believe will help us cover our needs. We’re also focused on recycling and managing input costs through procurement, which we’re proficient at. Additionally, we need to adapt by converting effectively in the off-season and investing in productivity and capacity, which we plan to enhance within our existing facilities. There’s a strategy behind our actions, which will reveal itself in the coming quarters. That’s my perspective, and that’s how both Scott and I are guiding the team and operations.

Joshua Pokrzywinski, Analyst

Got it. And that's helpful. So just as a follow-up to that on the volume side, with those capacity investments that you talked about, should we expect that, that incremental margin just on volume to get better, get worse? Obviously, the play there besides capacity investment.

Scott Barbour, President and CEO

It should get better.

Joshua Pokrzywinski, Analyst

Okay, got it.

Scott Cottrill, CFO

Yes. A lot of our improvements come through kind of that contribution margin side of the house. So that should play out there as well.

Scott Barbour, President and CEO

You're right, we should be leveraging that. We're starting up a piece of equipment this week. We have big expectations for that piece of equipment as we move into next quarter and the next year. I can tell you, at 5:30 Eastern Time, 4:30, that plant manager's time, he was already on the email, us going back and forth, ramping up that piece of equipment. The challenges you face in that and how we're kind of doing it, but this guy is right on top of it. I'm really proud of how they're tackling that. We're going to go through more of those over the next year at both Infiltrator and at ADS as we ramp that stuff up. That will give us that better surging capacity. It will leverage those facilities very nicely, as you said. Then we get to really walk up that curve of productivity with those new assets.

Operator, Operator

And we have no further questions at this time. Gentlemen, do you have any closing remarks?

Scott Barbour, President and CEO

I would like to make some closing remarks. We greatly appreciate everyone joining the call and the thoughtful questions. We value the opportunity to provide additional insights. Our priority will remain the health and safety of our employees, especially as we enter the Thanksgiving and Christmas season. We are committed to delivering essential stormwater management and on-site septic wastewater solutions for our customers and communities. We believe this will continue to be crucial. As highlighted in our discussions, we are focused on safeguarding our profitability, balance sheet, and cash flow. We anticipate some uncertainty in the coming months, but we have been navigating through this effectively. It’s challenging, but our factories in Florida are operating at full capacity. I want to express my appreciation for all our employees working in factories, logistics, and sales. This new way of working has been difficult, but we're managing to adapt and are enjoying it. It’s an exciting time for us. With that, I will conclude the call and thank everyone for their participation.

Operator, Operator

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