Advanced Drainage Systems' (WMS) CEO Scott Barbour on Q2 2018 Results - Earnings Call Transcript

Advanced Drainage Systems, Inc. (NYSE:WMS) Q2 2018 Earnings Conference Call November 2, 2017 10:00 AM ET

Executives

Mike Higgins - Director of Investor Relations and Business Strategy

Scott Barbour - President and Chief Executive Officer

Scott Cottrill - Chief Financial Officer, Executive Vice President and Treasurer

Analysts

Marshall Mentz - RBC Capital Markets

Mike Halloran - Baird

Timothy Daley - Deutsche Bank

Good morning and welcome to the Advanced Drainage Systems' Second Quarter Fiscal 2018 Results Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Mike Higgins. Please go ahead.

Mike Higgins

Thank you and 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 as defined under the Private Securities Litigation Reform Act of 1995. 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 we’ve submitted to the SEC. We will make a replay of this conference call available via webcast on the company website.

With that, I'll turn the call over to Scott Barbour.

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Scott Barbour

Thank you, Mike, and good morning, everyone. I’m excited to be here on our first earnings call with ADS. I’d like to start by congratulating our team on the excellent topline performance this quarter and taking care of our customers with good delivery performance in a volatile environment. We posted net sales growth of 11% with 40% growth in our core domestic construction markets.

We also saw a return to growth in our domestic agricultural market, where we posted an 8% increase in sales. The strong growth this quarter demonstrates our continued success in gaining market share and executing our retail conversion strategy with both high-density polyethylene and polypropylene pipe. This strong core and sales engine is a large part of what attracted me to ADS. I am pleased to say that by conviction and sense of confidence has only strengthened since coming on board 60 days ago.

Although I am still accessing the business and still gathering information, I would like to share a few observations. First, industry leadership is a core element of the ADS story. As I have got to know the business better over the past two months, it has become clear to me that ADS is highly relevant in the storm water market. We have strong partners and our customers and distributors who rely on us not for just great products and delivery but also our technical expertise and industry knowledge. We have a team of engineers that is setting technical standards in the industry and driving approvals for our products and solutions in the marketplace. We also have an impressive suite of products and services that allow us to provide a complete range of water management solutions to our customers. Partners, products and people are a powerful combination that creates a compelling value proposition, which has led to our success in gaining market share and driving above average market growth just as we saw this quarter.

Second, we are also a reliable and high-quality manufacture driven by our very capable engineers for both products and manufacturing processes and our leading manufacturing facilities. This includes the depth and breadth of our technical and engineering talent as well as the national scope of our manufacturing and distribution footprint, both of which are unmatched in our industry.

Additionally, our material science and recycling capabilities are a significant advantage that further sets us apart from our competition. While we are very proud of these competitive strengths, it is my belief that we can be much better in a number of areas and we have the capabilities to execute on these opportunities. The ADS Board of Directors, myself and the organization know that we must be a more profitable company with better returns on our capital. We were all disappointed that we did not achieve better profitability this quarter and such good sales performance. This is precisely why the superior performance program initiatives were rolled out earlier this year and already we are developing plans for the future to expand and accelerate this program. I fundamentally believe there is more we can do to improve on how we execute on daily basis. This includes opportunities to be more efficient in our supply chain and logistics to lower our costs. In particular, I am focused on accelerating our network optimization efforts, which to me stands out as one of the most important and actionable areas we can invest in to get immediate and sustained improvement in our performance. We are also analyzing product lines and activities that are not accretive to our results today so that we can take action to make them more profitable and competitive in the marketplace.

Additionally, with respect to our pricing, we'll react responsibly to the changes in the resi marketplace and make sure we capitalize on our product attributes, our growing approval base and our capability to provide water management solutions to our customers.

I also see greater potential in driving profitable growth in our international business. I have spent most of my career managing businesses, distributed across multiple geographies around the world. Leveraging my experience and working with the international team, we are currently identifying the appropriate actions we can take to drive more profitable growth in our international segment.

Regarding capital allocation, organic growth and margin expansion investments remain our top priority. We will also look for bolt-on acquisition opportunities particularly related to our Allied Products portfolio, and in consultation with our Board of Directors, we will continue to evaluate share repurchases under our authorization program.

For me, it's about executing the fundamentals of our business and delivering on our commitments to our customers and shareholders. As a management team, we're focused on execution, delivering high quality products on time and at the right cost in a safe environment for our people and developing our margin expansion plan for the future and then meeting our commitments to our stakeholders.

Before I turn the call over to Scott Cottrill, I would like to recognize the teams in Texas and Florida that were impacted by the recent hurricanes. We're fortunate that all of our employees are safe and then all of our facilities came back on line in a relatively short period of time. However, these were devastating events that affected a number of our employees and the communities where they live. I was extremely proud to see our entire team providing whatever support they could, whether that was making contributions to crowdfunding sites or the unsung heroes who assisted directly in the disaster relief and recovery efforts. It is moments like these that reveal one's true character and I cannot be more proud to be a member of the ADS team.

With that, I'll turn the call over to Scott to discuss our financial performance for the quarter in more detail.

Scott Cottrill

Thank you, Scott. As Scott said, second quarter net sales grew 11%, driven by strong demand in our domestic business, where net sales grew 13% year-over-year. Our domestic construction market sales grew by 14% and our agriculture end-market sales grew by 8% in the period. Broadly speaking, we saw growth across all of our domestic geographies this quarter. With that said, a portion of our domestic sales increase was a result of pull-forward sales due to the pricing actions we took during the quarter as well as market uncertainty related to the availability of resin due to the hurricane this quarter. As a result, we estimate approximately $10 million to $15 million of our 2Q revenue was pulled ahead from the remainder of fiscal 2018.

From an international standpoint, low single-digit growth in Canada was offset by softness in Mexico. In Mexico, while we have seen volumes improve, we continue to experience a difficult pricing environment, which is negatively impacting our profitability

Moving to adjusted EBITDA, our second quarter margin was 16.7%, down from 18.2% last year. The lower margin performance was a result of higher raw material, manufacturing and transportation cost year-over-year. The higher raw material cost was primarily driven by polypropylene purchased during the early part of this calendar year.

In addition, we have seen an increase in resin costs due to the recent hurricanes and we have taken pricing actions to offset this, which will impact second half of our fiscal year. The increase in manufacturing cost was primarily the result of higher labor and overhead cost year-over-year. To this end, we are in a process of shutting down underutilized facilities and reducing our headcount. In the last 12 months, we have announced a closure of six facilities in an effort to optimize our plant network. We expect the benefit of these closures to materialize in the second half of this year. It is worth noting, however, that due to the strong demand we experienced in the second quarter, we had to post the shutdown of one of these facilities until our fiscal third quarter, when we will be able to move the manufacturing the lines to other facilities.

Finally, transportation costs were higher during the quarter because of an increase in common carrier rates and usage, the latter of which was related to strong demand we experienced in the second quarter. In addition, the cost of diesel is up double digits year-over-year.

As Scott mentioned, we are now content with our margin performance. As a result, we will continue to prioritize our SPP initiatives and evaluate every aspect of the business to better align our cost structure.

Moving to Slide 6. Year-to-date, we have generated $28 million in cash from operations. This is down from $46 million last year. The difference was primarily due to lower earnings year-over-year and increased working capital, which is primarily attributable to an increase in our accounts receivable balance due to the strong sales we experienced in the quarter. Additionally, as we look toward capital expenditures for the full year, we now expect to spend $50 million to $55 million, down $5 million from our previous range.

Turn to Slide 7, our market outlook remains unchanged. We expect the domestic construction markets to grow low to mid-single digits. We continued to expect our conversion strategy to drive sales performance that outpaces the market. Additionally, though our agricultural market sales were strong in the quarter, we still anticipate a mid-single digit market decline for the full year, given how contingent our second half ag sales are on weather.

Moving to Slide 8. Our expectation for net sales in fiscal year 2018 remains unchanged in the range of $1.275 billion to $1.325 billion supported by our strong second quarter sales, order backlog and our performance to-date. With regard to adjusted EBITDA, we are updating our guidance for fiscal 2018, which we now expect to be in the range of $195 million to $210 million as compared to our previous range of $200 million to $220 million.

Our updated guidance reflects the following key assumptions. First, pricing that outpaces increases in our material costs; second, savings from our previously communicated restructuring actions to realign our cost structure; third, continued top line growth in our domestic construction end markets in both our pipe and allied products; and finally, favorable performance from our international businesses. We have and will continue to prioritize and accelerate initiatives that not only result in profitable growth but margin expansion and free cash flow generation. This is how we will drive shareholder value.

Now we'll be happy to take your questions. Operator, please open the line.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Bob Wetenhall with RBC Capital Markets. Please go ahead.

Marshall Mentz

Good morning. This is actually Marshall on for Bob. Congrats on the quarter. I think really strong performance in light of the storms and also the leadership change, and welcome, Scott.

Scott Barbour

Thank you very much. It’s good to be hear.

Marshall Mentz

On resin costs in the past, you've used a statistic that a 1% increase in the price of resin would translate to roughly a $4 million change in cost of goods. Is that still an appropriate way to analyze the cost in light of what's happened on the back of these storms? And then along that same line, at current prices, where -- how much of your cost of goods is resin?

Scott Cottrill

Yes, I think, Marshall, the best way to look at that is use our resin cost -- about 40% of cost of sales is the right metric to use there.

Marshall Mentz

And then just on demand trends, obviously really strong improvement across the board and I think obviously some pull-forward that you’ve also highlighted. Can you talk about any trends in October that may have shifted in any of your end markets? And also maybe it sounds like potentially a slight pullback given pull-forward that you highlighted?

Scott Barbour

This is Scott Barbour, and I would say that what we saw in September is kind of moving forward into October and that would be across all of our markets that we talked about today, the construction markets, and the agricultural markets, where we feel good, very good about kind of the sales guidance. Scott went over there and we see that some kind of real stability in those markets and pace right now.

Marshall Mentz

Great, thank you.

Operator

Next question comes from Mike Halloran with Baird. Please go ahead.

Mike Halloran

Good morning, guys.

Scott Barbour

Good morning.

Mike Halloran

So let’s start on the margin side. The domestic margins, given some of the resin pressures, didn’t really surprise me, but the international was pretty weak. Maybe talk about what’s going on there. Obviously Mexico in on the pricing pressure, but more importantly, what’s the path to improvement? When we look at previous quarters, there is always a lot of choppiness in that margin profile quarter-to-quarter and so wondering if some of its just quarter-to-quarter mass nations or is there something broader?

Scott Cottrill

No, I think one thing you got is the fact that we had some timing issues related to things like transfer pricing, so non–operational. There is about $2.5 million in the quarter between international and domestic. So if you kind of normalize for that, our 17.7% domestic margin -- EBITDA margin would have been about 17.3% and our international margins would have been about 12.5% on an EBITDA basis. That being said, in Canada and Mexico, it’s both on pricing. We’ll see some favorability come in as we get into the back half, especially when you look at some of the manufacturing costs that we’ve had in Canada. But it’s mostly volume as well in Canada, which is coming back nicely as we went through the quarter. But we got to get our pricing up in Mexico and that’s one of the key drivers we’re doing that.

Mike Halloran

So high level, lots of puts and takes on the margin line moving forward. Resin has moved higher than what we would have talked about in the original guidance range. You’ve got some ongoing transportation and other inflationary pressures. But you also have execution in in your SP plan, which is going to have some benefits, you also laded some pricing as you work to the back half of the year. So help us understand the cadence of these margins as we move forward from a year-over-year perspective and what we should expect these upcoming quarters is how that plays out.

Scott Cottrill

Yeah, at the midpoint of our EBITDA guidance, we have to have significant margin improvement year-over-year. To your point, something north of 300 basis points performance. And again, as we’ve talked about that, that’s going to come into play via volume and pricing outpacing our resin cost increases. That in itself is going to about 70% of that benefit, 65 to 70% of that benefit, and then the other 30 to 35 is going to be the savings from our restructuring actions. The key point I’ll say our restructuring actions and savings there off is those will offset the headwinds, if you will, from the increased manufacturing and transportation cost we’ve been saying year-over-year. So that’s kind of the deliver and goal that we want to get to in a more normalized go-forward basis. But we’ll see that during the second half through the cost reduction actions we’ve taken.

Operator

The next question comes from [ Nishu ] with Deutsche Bank. Please go ahead.

Timothy Daley

This is actually Tim Daley on for Nishu. So my first question is sorry to be, but the resin prices, so the spikes in the hurricanes to be temporary. You talked about falling prices in the back half of the year, so just the curious as to how does that effect your ability to take pricing?

A – Scott Barbour

This s Scott Barbour, and we as I think kind of said, we’ll will responsibly look at any cost increase we have in resins and cash that on into the marketplace, and we have kind of a long history of doing that, and that's what we've executed successfully over the last 60 days. And as the resin market changes, we'll hold on to that as long as we can. That will be dictated by competitive forces in the market. That will be dictated by what goals we might be trying to achieve on particular product lines or jobs that we're trying to win, but in general we'll try to hold on to that as we march through the second half of this year.

Timothy Daley

And then I guess thinking about some of the initiatives that are going on right now, so the supply chain could be a bit long dated there, but the network optimization, you used the terms immediate improvements. I'm just curious as to how quickly we continued see some uptick in profitability to these particularly the network optimization and on magnitude?

A – Scott Barbour

So, I would answer that question in two parts. One is you'll see the first tranche of that in the second half of this year which are the actions that we're taking around the six facilities that we closed and moved in the first half of this year. The second tranche of that is -- and very immediate for us is to how we go and do our production planning, our inventory planning, where we build products, in what region for consumption in that region, and we have hired some very talented people over the last year and many of the programs that we're working on to what I would call optimize that production, inventory, logistics plan, I think are the most immediate and sustainable actions, and that was, in slice, when I arrived 60 days ago and we're stepping up quite significantly the progress that we want to make on that program right now. As we go further on and I get more familiar with the business, and we are already starting this, we'll continue to look at other ways to optimize our network as we go forward and the capital that will be required to support those investments.

Operator

[Operator Instructions] At this time, there are no more questions in the queue, so this conclude our question-and-answer session. I'd like to turn the conference back over to Scott Barbour for any closing remarks.

Scott Barbour

All right, thank you very much. In closing, we're pleased with our top line performance this quarter. It reflects the strength of our underlying markets and our continued success in executing our conversion strategy. While we're disciplinary with the continued pressure on our margins, I'm confident we have the capability, expertise and resources to drive sustainable improvements in our profitability going forward. It is my belief that we need to focus on the fundamentals and drive better execution across all aspects of our operations as we progress through the remainder of fiscal year 2018 and beyond. As I move through my first 100 days, the strategies and actions we must take to be successful into the future will take shape and turn into exciting and executionable plans. I look forward to sharing these plans with you in the future.

Thank you all again for joining us today. We’ll look forward to speaking with many of you. Operator, that concludes our call.

Operator

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.