Advanced Drainage Systems Inc (WMS) 2018 Q3 法說會逐字稿

Good morning, and welcome to the Advanced Drainage Systems Third Fiscal Quarter 2018 Conference Call. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Mike Higgins, Director of Investor Relations and Business Strategy. Please go ahead.

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 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.

Thank you, Mike, and good morning, everyone. We executed the fundamentals of our business well this quarter, which helped to drive solid top line growth and margin expansion. We posted net sales growth of 9% in both our domestic and international businesses and drove 280 basis points of margin improvement this quarter.

Our sales team worked to get ahead of resin cost increases with our price increases. Their efforts, in addition to favorable product mix, helped drive the margin improvement this quarter. We will continue to focus on the fundamentals of the business and drive execution in sales, operations and logistics. This is our path to driving sustainable improvements in our company.

I recently spent several days at regional sales meetings discussing strategies for growth and profitability improvement. There were a couple of themes I would like to share with you. First, our sales team is very excited about our HP product line, which posted double-digit gains again this quarter with strong market penetration in key states. HP Pipe is the tip of the spear for ADS in capturing market share in large-diameter applications against concrete pipe. We will continue to invest in this product and our capacity to produce it to ensure that we fully seize this opportunity.

Second, from what our team has seen in the marketplace, the activity out there is very good. When our team meets with project managers, engineers and contractors, they're excited about the level of project activity, and we are well positioned to capitalize on these market tailwinds. I left the sales meetings excited by the momentum of the business. I believe there is great focus within the organization around solid execution. I will continue to drive that mind-set with an eye on sales growth, margin expansion and free cash flow generation.

Next, I'll spend a couple minutes on capital allocation priorities, particularly in light of the recent tax reform. We plan to accelerate investment in our SPP initiatives to drive growth and improve our profitability, whether that be through network optimization, investing in margin expansion of high-growth products like HP or improving the efficiency of our logistics and transportation. We will also continue to invest in the safety of our workers and the productivity of our plants. The recent tax reform does not change our capital allocation priorities, whether -- rather, it will provide us with additional free cash flow to accelerate these important investments in our business.

We will also invest more in our sales engine, including people, tools and processes as well as supporting the growth of our higher-margin Allied Products. We have talked a lot in the past about our Storm Tech product, which continues to have a long runway for growth. We also have an opportunity to take our Nyloplast and Inserta Tee product lines to the next level of market participation, which will require capital to fully support that effort.

Beyond organic investments in the business, our second priority is bolt-on acquisitions. We need to become more active in the M&A space. And we will do that by implementing a more disciplined and strategic M&A program. We will evaluate targets through a strategic, qualitative and financial lens to identify the right opportunities at the right price. We are in a good position to capitalize on M&A. And it is important that we maintain our ability to quickly react to opportunities as they come before us.

Lastly, we will evaluate other alternatives to deploy our capital, including buybacks, dividends and paying down debt to ensure we are deploying our cash in the best way possible.

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

Thank you, Scott. Moving to Slide 5. Our domestic construction market sales grew 12% in the quarter, further strengthening our conviction in our market conversion strategy. We generated double-digit growth in each of our end markets as well as in our HP product line and Allied Products. The 9% international net sales growth in the quarter was also driven by our conversion strategy in the Canadian construction market as well as 37% growth in Allied Products.

We generated adjusted EBITDA growth of 29%, representing margin improvement of 280 basis points. The improvement was primarily driven by the key items we mentioned on our last call. Most importantly, we were able to achieve price increases ahead of our material cost increases. We also achieved volume growth both domestically and internationally with favorable product mix.

And finally, we executed on our previously announced restructuring actions, of which we realized about $3 million of benefit during the quarter. As Scott said, we are pleased with this performance but far from satisfied. We believe there's a lot of room to run with our SPP and productivity initiatives, which should drive sustainable margin improvement over time.

Moving to Slide 6. Through 9 months, we generated $104 million of free cash flow, an increase of $24 million compared to last year, primarily due to working capital improvements and strong year-to-date net sales. For the full year, we expect our free cash flow to be north of $90 million, a significant improvement from last year.

On Slide 7, we outlined the impact from U.S. tax reform on our financials in the period. In the third quarter, we recorded a $16.8 million benefit to our income tax expense, which is composed of 3 items. The largest component is a $14.7 million onetime benefit to income taxes from the revaluation of our deferred tax liabilities. We also recorded a onetime expense of $900,000 from the deemed repatriation of foreign earnings. Finally, we recorded a $3 million benefit to income tax expense from the change in our statutory rate, which includes the year-to-date catch-up for the lower rate.

Due to our fiscal year end of March 31, we will have a blended federal statutory rate of 31.5% this year. That includes a 35% statutory rate for the first 3 quarters of the year and a 21% statutory rate for the last quarter of the year. These are provisional amounts and may be updated in the future as additional information becomes available.

Looking to the longer-term impact of tax reform. After this fiscal year, we expect our effective tax rate to be in the range of 30% to 32%. This reduction in our tax rate, together with the ability to immediately deduct 100% of qualified capital expenditures, will result in cash savings of approximately $10 million to $15 million in future years. As Scott discussed, recent tax reform does not change our capital deployment priorities. Rather, it provides us an opportunity to accelerate the investment in our Superior Performance Program. Our SPP and organic investments remain our first priority, which will drive profitable growth, margin expansion and shareholder value over the longer term.

Moving to Slide 8. As Scott said, demand trends are favorable. Domestic construction markets should continue to grow. And we expect to outpace the market through our conversion strategy. We will wait until our fourth quarter call to give guidance on fiscal '19. But we currently expect these construction market trends to continue into next year. Finally, on the international front, we expect modest growth in Canada with strength in the construction markets being slightly offset by a soft agricultural market.

Moving on to Slide 9. We are confirming our full year guidance. We are taking a conservative approach, given the seasonality in our business and the variability that weather presents during the fourth quarter. We are currently tracking to the upper end of our anticipated net sales range of $1.275 billion to $1.325 billion and to the midpoint of our expected adjusted EBITDA range of $195 million to $210 million.

With that, we'll be happy to take questions. Operator, please open the line.

(Operator Instructions) And our first question comes from Ryan Connors with Boenning and Scattergood.

Wanted to actually drill down on something you mentioned a little bit, and that is the selling expense related to the HP products. And I know that selling expense did seem to jump in the quarter. I wasn't sure if that was related to that or not. So if you could kind of just talk about that in the quarter itself and then on a go-forward basis, how structuring incentives and so forth around selling of those new products will impact that line item.

Yes, Ryan, Scott Cottrill here. So what you saw in that selling expense line item is just the result of the top line growth that we've experienced, that 9% that Scott and I both spoke to. So that's just what came through as a result of commissions and the higher sales growth in the quarter.

Okay. And are those incentive structures any different than the incentive structures or selling incentives on the more traditional HDPE products? Or are those more or less the same? In other words, as the mix shifts towards HP...

They're the same.

They're the same, okay.

Yes, we understand the question. And they're the same. This is a volume -- sales volume-driven item.

Okay. And my other question was -- and I might have missed it, I apologize if I did, I had to hop off for a brief minute. But any update on the ag market? I know there had been some talk about that being a headwind a couple quarters ago now. I'm just curious what the update is there and anything you can provide.

So I'd say the ag market is pretty stable right now. We believe we kind of hit a lower end of what has been happening, and it's kind of moving along sideways, I would say. That's particularly true in the U.S., maybe a little more challenged in Canada. But volume-wise, price-wise, it's kind of moving just sideways. I'd say the downdraft related to volume in that market, we've experienced the majority of the pain.

Okay. And then also apologize if I missed this, too, but did you mention a tax rate we should be assuming going forward?

I did, Ryan. So in that 30% to 32% range should be what you assume.

Our next question comes from Nishu Sood with Deutsche Bank.

It's actually Tim Daley on for Nishu. So solid performance on improving the margin in the face of last quarter's headwinds from the storm activity in the Gulf. Just curious if you could walk us through the moving parts behind the 70 basis point increase in gross margins, specifically quantifying kind of what was there from price increases, raw material costs and then other parts of SPP initiatives.

Yes, Scott here. Again, solid performance on the top line growth, Allied Products being up significantly or as part of that, HP as well. So again, starting with volume, solid growth there, and that mix of Allied to Pipe really helped out. On the pricing side of the house, you hit on it, got in front of the resin cost up, so mid-single-digit price increases there that led to -- when you look at that Slide 5 and the bridge there, those would be the biggest pieces. When you look at the period cost for manufacturing and transportation, a lot of that again is a result of the higher sales and some of those products that have to travel over a little bit greater distances than others. So diesel being up year-over-year, common carrier rates, those are some of the things you see in our period cost that led to that margin expansion year-over-year.

All right, great. And then I guess, just kind of going more on the -- thinking about the input cost versus pricing. So last quarter, you talked on a bit of weakness from temporary timing gaps between suppliers increasing cost a bit more aggressively than you guys were. You talked about responsible price increases. Just curious as to how the trends went this quarter. Have they coupled up again? Should we maybe in just be a bit of a -- maybe this quarter was a bit higher than next quarter as these trends kind of catch up and, I guess, recouple?

So I think when we spoke previously, it was -- we received resin cost increases, it takes 30 to 60 days for our pricing to catch up. And I would say in the quarter just completed, we saw that catch-up of pricing occur. I would say as we move through this quarter -- and what's going on right now is resin prices are, I would call, stubbornly sticky at -- what we experienced last quarter. So we think our pricing and our resin inputs are relatively lined up well. Now we have some elements that bounce around, and then we try to manage those. And we'll continue to do that. But in aggregate, I would say they're in that state that you've described as coupled.

And our next question is from Scott Schrier with Citi.

Just on a follow-up on that last question, I just want to confirm. So based on the timing differences you had between pushing the price ahead of the resin, you would say that you had a little bit of a positive margin impact in the quarter that could potentially moderate a little bit as we go forward and the price versus cost kind of moderate -- or couples.

I think that's an accurate description. I would say, however, that we continue to do a good job of holding on to price. There are other things we do for customers, particularly around logistics and transportation, that we need to be adequately paid for. So we -- that's a theme going through our discussions with customers and with our sales teams right now. So we're going to be very mindful, prudent, maybe even aggressive in making sure that we're paid for not only the product we produce but the services we provide in that logistics and transportation, and we will -- that should manifest itself in us being able to hang on to the pricing that we achieved. It won't be there forever. But kind of that's our game plan right now as we look forward over the next period of time here.

Got it. And then moving on to your domestic end markets, obviously you had that double-digit growth outpacing the market. I know you mentioned the mid-single-digit pricing increase. But I just want to see if you can give a little bit more color on the material conversion. Obviously infrastructure at 14%. Based on what the market is doing, it seems like whether it's quite a bit more of acceptance with some of your HP products. So I just want to see if you can give a little bit more color around the material conversion of the marketplace.

So that's a good question. And I would say that the color I would add is even if you strip out pricing effects, we're -- our conversion from concrete to our products is ahead -- or on or ahead of that kind of 2 points a year, 1.5 to 2 points a year conversion. And you see it manifesting itself in that infrastructure where we have the HP Pipe, which is our polypropylene product, firmly aimed at that market in the larger diameters. So you kind of nailed it. That's the color. That's the place for us to grow and take advantage of the tailwinds there. I'd also add in infrastructure, I know the bill is going to be announced here maybe this week or Monday or something like that. And we don't think we've fully seen the effects of that. I mean, we do -- where we are seeing those effects is where our market share model has worked and worked well, where we get the approvals with the various agencies and Departments of Transportation. We work on acceptance within the professional engineering community servicing those agencies. We have great coverage locally. And then we track these projects and win. And what you see in that infrastructure line is that happening in states that have some of these private-public partnerships already in gear and are expanding their infrastructure spending. That's what that is. That is not the effect of any type of national legislation that we might be seeing, which will take a little longer to dial out.

And one more, I just want to ask a little bit about the comments about kind of turning up your M&A spend and how you're looking at that into next year. Just curious if you could talk about, is there a sweet spot for size range? Is this more Allied Products-related? And based on your conversations, how are you getting a sense for seller expectations or potential multiples that you might be facing in the coming years?

So I think it's fair to say that Allied Products would be a very fruitful area for us to look more expansively. We're going to stay in the stormwater kind of section of our market pretty much. That will be the focus of that kind of program. Through the strategic and qualitative and financial lens, I would expect that sellers would have increased expectations, somewhat driven by the tax reform and lower tax rates and all that kind of stuff and a market that, I think, has some tailwinds from a -- we're showing it here to you today, we're doing pretty well, better than the market. But it's clearly a market that is healthy right now. So we'll be very mindful of what those multiples would be and very much in lockstep with our Board of Directors and their kind of guidance on that.

(Operator Instructions) Our next question is from Mike Halloran with Baird.

So could you just provide an update on how you're thinking about some of the strategic internal initiatives as we sit here today, whether on the network optimization, the logistics side or maybe even a higher-level view on -- since you've come onboard as CEO, how the allocation of priorities has changed or not changed and if there's any new focal points for us that you can share?

So we have, I think, really upped our skills and tools to manage our network of plants and our production planning and sales and operations planning processes. And we've seen some really positive ways that's manifested itself in just the operation of our business and what I would call the velocity of our inventory and our ability to do very detailed production planning, which is really important for us to do and helps us optimize our kind of transportation cost and things like that. So that -- we've got a full-court press on that. And we'll continue to invest in people and tools and processes to strengthen our execution in that area. That has also highlighted opportunities for us to put in capacity in certain areas of the country for HP Pipe, in particular, that would further strengthen our customer service and our footprint to serve some really important local markets where HP has gotten a good foothold in particular. Third, I would say, as we've been through that, we've also seen opportunities in what I'd call our logistics and transportation activities, which are high customer service activities, and we do a lot of great things for our customers there. But we can do it better. We can be more efficient. We can put in new metrics that I think will drive better performance internally around that service. And maybe, most importantly, I want to make sure that we are adequately compensated for that performance -- for performing that service. So Mike, you kind of ask, what have you really latched on to and kind of driven in different directions over the past 5 months, 6 months. I would say those 3 things. You probably heard me say this. We're highly relevant in the market. And that's a great place to be. I think the way we were able to get out and get this pricing done was very effective. And we saw that real early. We jumped on that. It's obviously paying some benefits for us now. And we're building upon that with these other 3 areas as far as kind of, what I would call, really immediate attention and impact that we're trying to have.

That's useful. And then just on the demand side, sequentially through the quarter, it sounds like things were pretty stable through -- pretty healthy or pretty consistent. If that's true on one hand, then on the other hand, you commented on weather potentially being a swing factor in the first -- in the fourth quarter here. Is that different than normal, though? Or is that just your way of saying, "Hey, look, we just know weather can swing things around a little bit, but for now we're pretty comfortable with what we're seeing"?

So to answer your second question is I called it with our Board of Directors. Local lore or legend in the company is that March is a really big swing month. And that makes sense. March weather in the Midwest and Northeast, which is we're really strong, it can be highly, highly variable and swing stuff around. That said, we're doing pretty well in the Sun Belt in the Southeast and out West. And we talk and work very hard to make sure we're maximizing what's going in those areas that don't have that weather variability. Now not to go against local legend, so March is highly variable and we've got to pay attention to that. Your first part was sequentially how things were going, we feel pretty good. Our backlog is up year-over-year, double -- kind of nice double digits. We have a good book-to-bill ratio in December, which is very unusual, but good in January, really good through the first couple of days of February. So I'd say market pace is really kind of on the right side of the line versus decent if you will.

Our next question is from Mike Dahl with Barclays.

Just wanted to go back to the discussion around the SPP initiatives. And you mentioned in the opening remarks a desire to accelerate some of the investments using in part the benefits from what you'll see in terms of lower taxes. I just wanted to get a little more color of the details you just kind of went through on what you've been working on. Which specifically are things that you think you can lean into more aggressively in the near term in terms of pulling that forward?

So what we'll do is lean into making sure that we have the right capacity in the right regions particularly to support the HP product. And we'll -- what Scott and I are talking about, some investments have kind of moved to the left on the chart. And we're particularly aggressive in getting those kind of investments done. And that is part and parcel with optimizing our network and reducing our kind of intra-network transportation cost and taking up our customer service by really kind of having the right product built in the right plant for the right customer that is within that geographic zone. And again, we've invested in some really nice tools to do that. We're integrating them into our sales and operations plan very aggressively. And we think that we will continue to get better and better and better at that. And that helps us expand our margins, at the end of the day, expand our margins and take care of our customers better.

Got it. And can you help us just size up both from an operating expense and a CapEx standpoint kind of what we should be thinking in terms of cost associated with these? And then any thoughts on framing up the benefits in terms of magnitude on that top line and margin side that you'll ultimately see from these initiatives?

Yes. So I think on that side of the house, again a lot what we're talking about here is tied to that CapEx investment with a little bit of OpEx investment. But like we said in the script, Mike, there will be a lot more of that coming up as we go through our '19 guidance on our year-end call. But that's what where framing up now. And we'll give you a lot more flavor for that coming up.

Okay, fair enough. Last one on my side, just the tax rate, 30% to 32%. Can you just give us a bridge on it's a bit more elevated than we would've thought, just a bridge on kind of why it's not coming down more? I know there's some ESOP stuff. But just help us understand that little bit.

No, no, no problem. So our effective tax rate usually runs in the low 40s, so somewhere between 40% and 42%. So the rate, as we're looking at here provisionally, would come down by about 10 basis points, if you will, 10 points from that. That would be the 14% reduction in the statutory rate from 35% to 21%. And then the manufacturing credit, domestic manufacturing credit, goes away. And that's about 3 points that goes the other way. So that's kind of how you bridge at a top level the 40% to 42% we have today to the 30% to 32% range we provided.

And our next question is a follow-up from Nishu Sood with Deutsche Bank.

Just a quick one. So the homebuilders have been accelerating land development investments over the last 2 quarters. I'm just curious, how has that translated into that portion of the business? And what was the annual year-over-year growth for the quarter there?

So while Mr. Higgins kind of looks up where that number is, let me give you the color around that, is when you do see those land developments around a city, where people are developing big neighborhoods and stuff like that, there's 2 elements of that. There's the kind of the public ways or roads that enter there, call that outside the development. And then there's the inside of the development, stormwater stuff that needs to be done. And we can participate in both of those. We usually participate higher in the ones kind of within the neighborhood. At one of these sales meetings, we were talking about the other day, I mean, this particular salesman in the Midwest has been very successful around the suburbs or small cities around the metropolitan area there. So that's a good place for us to hunt. The tertiary or derivative is you have strip shopping centers and McDonald's and all those things that go in, which use Pipe and a lot of Allied Products, particularly our Storm Tech product. So that's a good cycle for us, a good cycle, where we get kind of 3 bites at the apple, the public, the private pipe inside the development and then the development or strip shopping centers or accessories or services that are needed around those developments. So what's the number?

Yes, it's high double digits. Tim, I think if you look at what Scott was talk about, new residential construction subdivision development, for the quarter, we were up high double digits. And for the 9 months, we're up mid-double digits. And really, if you're going to look at it geographically, seen pretty good growth across most of the country obviously with strong growth areas in the South and West, which you would expect with the demographics that are occurring there.

(Operator Instructions)

All right.

Sorry, go ahead, sir.

So are we ready to close up? I think so. In closing, we're pleased with our performance this quarter. The top line reflects the strength of our underlying markets and our continued success in executing our conversion strategy through the growth of our Pipe products as well as our solutions strategy through the growth of our Allied Products. We demonstrated our commitment to expanding our margins, and we'll continue to focus on the fundamentals of our business and driving execution across all aspects of our operations as we progress through the remainder of fiscal year 2018 and beyond. Thank you again for joining us today, and we look forward to speaking with many of you very soon. Operator, that concludes our call.

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