Earnings Call Transcript - WMS Q1 2022

Operator, Operator

Good morning, ladies and gentlemen, and welcome to Advanced Drainage Systems' First Quarter Fiscal Year 2022 Financial Earnings Results Conference Call. My name is Tiffany, and I am 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.

Mike Higgins, Vice President of Corporate Strategy and Investor Relations

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

Scott Barbour, President and CEO

Thanks, Mike, and good morning, everyone. Thank you for joining us on today's call. We achieved a record $669 million of sales in the first quarter, a 32% growth over last year. Growth was split fairly evenly, weighted a little bit more towards favorable pricing than volume growth. Demand remained strong at both ADS and in Infiltrator throughout our end markets and geographic footprint. In addition, international sales increased 82% this quarter with growth in our Canadian, Mexican, and exports businesses. Our backlog and pace of orders remain favorable, as well as our ability to capture price in the market, giving us confidence in the updated sales targets we issued today. We have issued several price increases since late last year to cover inflationary cost pressure, and we'll continue to use our leading market position in that respect, as well as ADS and Infiltrator's scale position in material procurement and recycling operations to procure material at the best possible cost and availability. Moving to profitability, our adjusted EBITDA increased 4% on a dollar basis, again driven by favorable pricing and strong volume growth. The price increases we issued over the last 10 months largely covered the inflationary pressure on materials and diesel. There are additional headwinds related to driver availability, an increase in the use of common carriers, and an increase in common carrier rates that we are working to offset. We remain confident in our ability to identify and execute the right mitigation programs and expand our margins over time. Material prices started to rise in October 2020, increasing more significantly as a result of the winter storms that hit the Gulf region in February 2021. In the first quarter, our material cost per pound increased significantly compared to the prior year. Additionally, in the second quarter, we will experience the largest gap between historically high material prices this year and historically low material prices of last year. The price increases we pushed into the market are largely covering material, and we continue to raise prices in line with these material increases, as well as repricing quotes over 30 days old to ensure we're recovering the sequentially higher cost. Material availability has improved since our last call. It comes at a price, but we are doing what it takes to get materials out to our facilities so we can support customer needs, including incurring additional transportation costs and shuffling production scheduling more than we have in the past. We remain committed to meeting our customers' demand and have efforts underway to ensure we continue to do so. Across the market, attracting and retaining manufacturing labor and drivers is difficult right now. We've had to increase the pay rate in many locations to help mitigate this issue, both starting pay as well as raises for current employees. In addition, last year, we delayed all manufacturing merit increases until the second quarter due to the COVID-19 pandemic, making the first quarter year-over-year comparison more pronounced than usual. Within transportation, there are three major factors driving additional costs. One, we have a shortage of available drivers for our fleet, requiring us to utilize more common carriers than normal to service our customers. Number two, common carrier rates are up over 50% year-on-year. And number three, we're moving more material throughout the network to get it into the right locations so we can meet customer demand. While three of our largest cost components - materials, labor, and transportation - have a lot of moving parts, we're responding with the following programs. To address the labor issues within manufacturing, we are focused on simplifying the manufacturing process for new employees, including focusing production and decreasing SKUs, reducing changeovers, and deploying centralized scheduling techniques. We've also consolidated inventory of some key products to fewer locations for better visibility and order management, again, simplifying the task and providing better visibility. Management time is focused on a handful of locations where we have the most issues, particularly with labor and capacity. We've created dedicated transportation lanes and are deploying route planning techniques to help with the transportation labor shortage. We've also expanded the use of 3PL partnerships for retail to an additional region which freed up ADS fleet capacity for trade deliveries. More broadly, on labor, we have added recruiting process outsourcing partnerships for our manufacturing and transportation labor hiring, which has improved both the applicant flow and the onboarding process. Where possible, we've increased pipe imports from our Mexican and Canadian operations to further supplement supply and availability in the U.S. Finally, we are making capital investments to increase capacity, with some having an impact in Q4 for Infiltrator and the ADS pipe manufacturing. We started up a pipe production line this month in the Midwest to increase capacity, and we've also made aggressive investments in the strong tech business to increase production capacity. We saw capital spending increasing year-over-year in the first quarter, and this will continue as we invest in the long-term potential of both businesses. All that said, the momentum underpinning the core drivers of our business remains strong. Infiltrator maintained the high levels of profitability in the first quarter, despite similar challenges around materials, labor, and transportation. The international businesses also performed very well with double-digit revenue and EBITDA growth in each of those businesses. The domestic pipe business is large and complex, and while we are very proud of the sales volume and pricing power, there are work guidance, particularly with labor and transportation, which we'll have to grind through and continue to improve. While some of these work items are inflationary and potentially transitory, others are operational that need to be worked through systematically. And in the areas where we started implementing programs using these techniques, namely the agriculture business, Canada, and Florida, we've seen positive results over the years. However, throughout our larger manufacturing network is our task now. The ADS legacy and Infiltrator businesses combined to have their best sales quarter in our history. The combination of the highest demand we've seen in our history across all regions simultaneously, in an environment with labor and driver shortages and rapid inflation. This all hit us and our industry very quickly in May and June. Given this environment, we expect our profitability going forward to look different quarter-to-quarter this year, more like the seasonality in fiscal 2018 when we made the majority of our profitability dollar growth in the back half of the year. 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 first quarter fiscal 2020 financial performance. There are some key points that I want to hit on from a results perspective. Obviously, from a top-line perspective, we had significant growth year-over-year, driven by both pricing and volume. Legacy ADS pipe products grew 42%, and Allied Products sales grew 13%. Infiltrator sales increased 24% with double-digit sales growth in both tanks and leach field products. Consolidated adjusted EBITDA increased 4.5% to $167 million, resulting in an adjusted EBITDA margin of 24.9% in the quarter, down from 31.4% in the first quarter of fiscal 2021. Scott discussed in detail the actions we have taken around the largest drivers of the margin compression: materials, labor, and transportation inflation, as well as the labor availability. Material costs are at the highest levels in recent memory and have continued to increase sequentially month-to-month throughout this year. We've issued two more price increases since the end of our fiscal first quarter, one in July and another just last week. We will hit the full run rate of the announced price increases today in our fiscal third quarter. From an SG&A perspective, the first quarter results contain approximately $2 million of wages, travel, medical, and other expenses that were not incurred last year due to the COVID-19 pandemic. In addition, commission expense increased in line with the sales growth we experienced in the first quarter year-over-year. In summary, we have good line of sight to the costs impacting us and have actions in place to offset such as we move through the year. Based on the timing of these actions, we expect to see most of this improvement in the second half of our fiscal year. The long-term fundamentals of the business are still intact, and we will play out as we move past this unique period of higher inflation. Moving to Slide 7, we generated $79 million of free cash flow this quarter compared to $124 million in the prior year, primarily driven by increased capital spending and working capital. The impact from working capital was primarily due to the higher material costs moving to the balance sheet as compared to the year-ago period. We continue to make progress on our working capital initiatives, and during the quarter, working capital decreased to approximately 19% of sales, down from 21% of sales last year. Our first priority for capital deployment remains investing organically in the growth of the business, as demonstrated by the $15 million increase in capital expenditures we experienced in the first quarter. For the full year, we continue to expect between $130 million and $150 million in capital expenditures, our largest investment being to support future growth, followed by our productivity and automation initiatives. Further, as part of our disciplined capital deployment strategy, we repurchased 1.1 million shares of our common stock for a total of $115 million in the first quarter, leaving $177 million remaining under our existing authorization as of June 30. Our trailing 12-month leverage ratio was 1.2x, and we ended the quarter with $480 million of liquidity. Finally, on Slide 8, we have updated our fiscal 2022 guidance. Based on our performance to date, pricing actions taken, order activity, backlog, and current market trends, we currently expect net sales to be in the range of $2.5 billion to $2.6 billion, representing growth of 26% to 31% over the prior year. Our adjusted EBITDA guidance is unchanged at a range of $635 million to $665 million, representing growth of 12% to 17% over last year. The increase in our revenue guidance is due primarily to the pricing that we've introduced into the market to date to offset the additional inflationary cost pressures we've discussed on the call today. With that, I'll open the call for questions. Operator, please open the lines.

Operator, Operator

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

Michael Halloran, Analyst

So let's start on the demand side. Maybe just talk about sequentials through the quarter, what that visibility looks like moving forward across the various industries you serve? And what your client base is saying? And any kind of thoughts on visibility/sustainability on the demand side? It certainly feels like you're very confident. I'd just like to hear a little more detail on it.

Scott Barbour, President and CEO

Mike, this is Scott Barbour. And all of our segments are up. The retail is a little weaker, but our order rate in the core nonresidential, residential, Infiltrator agriculture businesses on a pound volume basis remains double-digit. And I don't hear our customers, either at the distribution or contractor level, talk about demand disruption. What they talk about is the availability of product. So we're pretty confident in that kind of rolling forward and being able to execute on this backlog.

Michael Halloran, Analyst

And then let's talk on the flip side of the coin. Obviously, the leverage was a challenge in the quarter. Could you try to bucket out for us how much of this was just the price cost lag that's materializing given the rapid inflation? How much is all the network repositioning that you need to do to make sure you're meeting customer demand? How much is the transportation piece? Could you just give us some directional sense for where the pressure points lined out?

Scott Barbour, President and CEO

Well, maybe, probably Scott, see how well you can take this one, but the one that really came on hard and fast was the transportation. It was really complicated to unwind as we got into May and June. Number one, we're having to run more on common carrier fleet than our fleet than we've traditionally done, and that's because of the driver shortage versus our plan. And that shortage was driven by retirements, difficulty in hiring. I mean all things that we got to go work on. And then the rate at which it costs us to get a common carrier. We have pretty good relationships and contractual type of things with these folks. But it was just a significant challenge.

Scott Cottrill, CFO

Yes, I think for the quarter, Mike, it's basically one of those items that we stayed in front of it. But again, from an incremental margin perspective on that, it was obviously dilutive from a margin perspective. But again, from a dollar perspective, we stayed in front of it. We've been, again, in the market with two price increases since the end of the quarter, as we mentioned. So yes, we've got the labor issue on both the manufacturing and transportation side of the house. We've got the common carrier usage and common carrier rates. That's all still coming at us as we go through the next couple of quarters at least. And that's why we're getting the pricing into the market.

Scott Barbour, President and CEO

Which has a lag effect.

Scott Cottrill, CFO

Yes. So our line of sight as we look forward through the year, that's why we're confident in getting that revenue guidance up to the level we're talking to and staying in front of not just material costs, which again sequentially month over month continues to go up, but as well as the labor inefficiencies and the transportation costs, and a lot of that we'll see coming in the second half.

Michael Halloran, Analyst

So to be clear here, then the price increases that you're putting through in the marketplace are designed to cover all of these inflationary pressures you just suggested. And that's why, when you hit the third quarter - fiscal third quarter, plus or minus, you should start seeing a lot more favorability in terms of the cumulative price cost metrics and what those margin metrics might look like just as the catch-up starts materializing based on what we know right now. Obviously, inflation can continue, and that can make it more challenging to push that out. But is that a fair way to think about it?

Scott Barbour, President and CEO

You got it spot on. That is the right way to think about it.

Michael Halloran, Analyst

And that's why, when I think about a typical cadence to the year-end margins, fiscal 1Q, 2Q, your peak quarters revenue tends to fade a little bit. That's why we might see a different relative margin cadence through the year than we might normally see?

Scott Barbour, President and CEO

Absolutely. Correct.

Matthew Bouley, Analyst

Following up on the last one because it sounds like the price expectation is there in terms of covering these cost issues. But Scott B, at the top, you mentioned a few operational changes you're making beyond price. I'm curious if you could maybe expand on that a little bit? And kind of what you see as - I don't know if you can quantify anything, but anything around the ability for some of these operational changes you're making to offset the cost issues as well and kind of what might be the lasting impact of some of those changes as we think about '22?

Scott Barbour, President and CEO

So I did go through kind of our focus list of operational things that we're working on. A lot of those are designed to simplify, reduce SKUs, reduce changeovers even more than we already have, to increase throughput, and make it easier as we go through a pretty significant hiring and some turnover that the new hires do tend to turn over faster. All of this is designed to get throughput up, which will give us better productivity per labor hour. And that's an important thing, mainly that additional capacity. I'd also add to that, that we've done this, and we've exercised many of these techniques in three parts of our business, one in Canada in the agriculture region, and they work very well. Getting those replicated in our network is what we're really working on, particularly in a couple of places where we've got to get focused. Those are lasting initiatives, Matthew, I mean those things will be there forever as well as many of the other procurement activities that we do in nonresidential and churning underneath. A lot of the transportation things, the move to another region where we've done a 3PL partnership for retail delivery and freed up fleet capacity for trade deliveries, we're now doing that in two regions very successfully, again, lasting impact, replicating that in other regions as we go through.

Matthew Bouley, Analyst

Yes, very much. That's exactly what I was looking for. And certainly understood around what you're saying there about common carriers and trucking and all that. So if I think back a few years when, for example, after the hurricanes in Texas, you saw a big spike in materials in the subsequent months, and you guys were able to largely offset that with price. If you can kind of educate us on some of the history? In this scenario, if we ever get to the other side of all this, and again, I hear you saying around common carriers that may take a little longer. But if we ever get the materials at least flattening out or deflating, how you think about price in that scenario? You've taken multiple price increases and you got more to come. To what degree are you able to kind of hold on to margin in a scenario where you eventually get deflation?

Scott Cottrill, CFO

So look - I think FY '18 and the fall of 2017, hurricane hits, we get pricing up, very impactful in our second half, and we had a very good second half, making the year. I think it's a little different. I didn't have my transportation and my labor moving on that same time out. It was kind of fighting one front war in that one. And we held on to that, and we largely built upon that over the last couple of years, last three years, I'd say very successfully. We're doing some models on the impact of if we can hold on to 90%, 80%, or 70% of that. I don't think we're going to be able to hold on to all of it as successfully as we did in the past. But I like our chances of holding on to the vast majority of it as we go forward. Now, we'll have to balance that against our share gain activities, plus balance that against some other things. But certainly, that's our go-to.

Scott Barbour, President and CEO

Yes. I would say it's not a question of holding on to margins, Matt, as you verbalized it, it's more of the magnitude of the ability to expand margins in that scenario.

Scott Cottrill, CFO

Yes, we'll continue to do that.

Joshua Pokrzywinski, Analyst

So just on the markets themselves because I think we could probably talk about inflation all day, and it feels like from maybe some of your peers out there, pretty much all we do all earnings season. But, Scott, if I go back to last year, you guys held up a lot better than kind of the rest of the non-residential-facing market with the share gains, the kind of bias to the crescent more horizontal construction. I think we're seeing the broader market kind of bounce back a little bit more. Is that something you guys are seeing? Is there any kind of lapping effect of maybe some of those areas of strength from last year, like warehouse and data center, that are moderating the volume growth? Can you just sort of contextualize how your markets are sort of bouncing back relative to the census data?

Scott Barbour, President and CEO

Yes. So that is all intact. I mean the crescent remains very strong. In addition, New England, the Northeast, the Northwest, which are really good territories for us, bounced back quite strong. So I think we're up in every region. The agriculture business also remains very strong. The only place that weakened was the sales to the do-it-yourself kind of channel, which is understandable given how much it was up last year and we were glad to have it last year. So we remain very bullish on that warehouse. You guys see the data just like we do, tremendous construction pulled forward to build these warehouses. We remain very bullish on residential. We had our Board of Directors at Infiltrator for the last two days, two and a half days. And that is going great guns as well as the pipe business, the services, the residential at ADS, that horizontal construction that follows that residential remains strong. And we're in a position now across our product lines where we build and ship.

Scott Cottrill, CFO

It goes on a truck.

Joshua Pokrzywinski, Analyst

Got it. And then I guess just sort of related to that point, given that you guys are pretty busy little bottlenecks, presumably with kind of the more concrete-based alternatives out there, I would imagine that capacity is sort of a little bit more fungible or maybe flexible. Is there anything in terms of kind of that share gain or selling in the story to the right folks that has gotten delayed at all as a function of, 'Hey, we're just - we're too busy as the contractors,' or 'Hey, you guys have longer than normal lead times' that has sort of thrown that off a little bit here in the short term?

Scott Barbour, President and CEO

I think the lead time issue is definitely there. It's not pervasive in every territory or every contract or something like that. But definitely, there are times it lengthens more than we'd like. There's no doubt that that gives us a chance for a concrete alternative in that. I don't think it's going to damage our share gain story long term. But you're correct, I mean it's under a little stress right now. But that said, we've got to service our customers in the ones that have been loyal to us and that they're kind of that core customer base. So I think every one of our regional managers has been talking to us about, 'I have an account that I've been trying to gain for several years, this is the opportunity to do it?' In some cases, we've had to prioritize the past, and that hurts no doubt. But fundamentally, I don't believe it's going to damage our story.

Scott Cottrill, CFO

When you look at the strength of the order book and the order activity that we've seen as well, the quoting, the coming through our digital design tools. To Scott's point, the lead times are going out. So we're still seeing really, really strong demand. And yes, on the fringe, you see that. But really good activity.

Scott Barbour, President and CEO

We question whether there are enough contractors out there to install everything on order in the industry.

Scott Cottrill, CFO

Exactly.

Garik Shmois, Analyst

First off, just on the costs that you're adding with respect to labor and capacity, I guess, just to be clear, are these costs contemplated in your guidance? And how should they end up pacing as the year progresses? Is this kind of isolated to Q2, or are you anticipating to add the labor capacity cost for the balance of the year?

Scott Barbour, President and CEO

Yes. Garik, Scott here. I would say, basically, our guidance assumes that the level of labor inefficiencies, transportation costs, and headwinds stay with us. So we've kind of assumed that that higher cost base is with us for a while. And hence, the need, desire, and actions we took related to pricing, both at the end of our fiscal Q1, as well as the two subsequent pricing increases afterward. So again, when we look at pricing, absolutely, material costs are one of the first things we look at, but it's the value proposition, it's what's coming at us on labor, transportation, etc., and making sure that we can go get that value in that return. So it's all in as we look at it further for all the remaining year in that line.

Garik Shmois, Analyst

Okay. Got it. And then just wanted to drill down by segment a little bit more. Obviously, it looks like the margin pressure in the quarter was the most pronounced in pipe. Some of the other businesses actually held in reasonably well compared to last year. So I think you cited a couple of factors that may be specific to pipe. I just wanted to be clear on that with respect to the rationalization, some of the transportation inflation. I just want to be clear that those headwinds are more specific to pipe, or should we anticipate that maybe some of the margin headwinds that hit pipe are just coming for some of the other divisions? It's just a timing issue?

Scott Barbour, President and CEO

I don't think there are timing issues. That's a good question, so it's Scott B. The pipe part of our business is the most transportation-intensive of all those product lines. If you think about it, you ship a lot of air. There's less dollars per load than on an Infiltrator product or an allied product. So that kind of makes sense. Those products saw rises in transportation costs, but they were easier to see and offset with the pricing. The pipe network is also spread out for that reason. The production tends to be a little bit more localized. So you run into those localized wage rate issues, difficulty getting labor, all these kinds of things. But I don't think this is a case where we saw first in pipe and it spreads to the others; that's not what's happening. What you're seeing in there is just the transportation intensity of that pipe manufacturing in that pipe network.

Operator, Operator

And your next question comes from the line of Michael Halloran with Baird.

Michael Halloran, Analyst

So I bought some stock back on the quarter. Obviously, the internal investment side is priority one and ramping CapEx, trying to manage the network appropriately. And I certainly understand that. But how are you guys thinking about balancing the external usage of capital at this point, buyback versus M&A? And then, also on the M&A side, just some thoughts on what the actionability in the pipeline looks like?

Scott Barbour, President and CEO

So we've got a lot of capital to raise, and that remains our number one priority and - because obviously, we need that. We have a couple of actionable things we're working on right now in the M&A pipeline that will develop as they develop, but we like them both. Once we get through this tranche, we'll go back and have another discussion on the share buyback with our Board of Directors, and we'll make an assessment on the organic M&A, what does the market look like at that point? How do we feel about going forward? Are we doing everything we said we were going to get done? And then we'll make another decision on that one. But we felt that the buyback was a good use of cash because it was building up on our balance sheet. We had plenty of liquidity to do anything we saw in a reasonable timeframe, and we remain very confident in the cash-generating capabilities of the company. So that's how we talked about it internally with the Board, Mike.

Scott Cottrill, CFO

And I think that point that Scott hit on during the opening comments. We're still making a lot of investments from a capital expenditure, organic investment, if you will, perspective, to stay in front of that great growth in that order book and backlog that we have there. But as well as those productivity and automation initiatives that we have. So a lot of that investment remains our number one, followed by M&A. And then, to Scott's point, we'll decide on the kind of distribution side of that part as to what our opportunities look like and what our forecast looks like as we move forward.

Operator, Operator

There are no further questions in queue at this time. Presenters, are there any closing remarks?

Scott Barbour, President and CEO

Thank you all very much for joining us today. We appreciate the quality of your questions and insights that you all have in the company. We are clearly thrilled with the sales and the volume and the progress side of it. We're operating very well in several parts. There are some other things we had to go work on, but that's what we do. And we'll continue to kind of work through those a little bit differently than cadence and profitability this year versus last year, but I think we're still building on the right place. So we appreciate it and look forward to speaking with you all again soon.

Operator, Operator

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