Mueller Water Products - Earnings Call - Q4 2019

Transcript

Speaker 0

Welcome and thank you for standing by. I'd like to inform all participants that your lines have been placed on a listen only mode until the question and answer session of today's call. Today's call is also being recorded. If anyone has any objections, you may disconnect at this time. I would now like to turn the call over to Mr.

Whit Kincaid. Thank you. You may begin.

Speaker 1

Good morning, everyone. Welcome to Mueller Water Products fourth quarter and fiscal year end twenty nineteen conference call. We issued our press release reporting results of operations for the quarter and year ended September 3039, yesterday afternoon. A copy of it is available on our website, muellerwaterproducts.com. Discussing our fourth quarter and full year results and the outlook for 2020 are Scott Hall, our President and CEO and Marty Zakas, our CFO.

This morning's call is being recorded and webcast live on the Internet. We have also posted slides on our website to help illustrate the quarter's results as well as to address forward looking statements and our non GAAP disclosure requirements. At this time, please refer to Slide two. This slide identifies non GAAP financial measures referenced in our press release, on our slides and on this call and discloses the reasons why we believe that these measures provide useful information to investors. Reconciliations between non GAAP and GAAP financial measures are included in the supplemental information within our press release and on our website.

Slide three addresses forward looking statements made on this call. This slide includes cautionary information identifying important factors that could cause actual results to differ materially from those included in forward looking statements. Please review Slides two and three in their entirety. During this call, all references to a specific year, unless specified otherwise, refer to our fiscal year, which ends September 30. A replay of this morning's call will be available for thirty days at 806038.

The archived webcast and corresponding slides will be available for at least ninety days in the Investor Relations section of our website. In addition, we will furnish a copy of our prepared remarks on Form eight ks later this morning. I'll now turn the call over to Scott.

Speaker 2

Thanks Whit. Thank you for joining us today to discuss our fourth quarter and full year results for 2019. Our teams finished the year well despite a more challenging operating environment relative to the prior year. We continued to grow the business in the fourth quarter as we increased both net sales and adjusted EBITDA. Our consolidated net sales growth of 5% in the quarter was driven by the benefit of the Krausz acquisition and higher pricing.

However, due to the slower than expected recovery in residential construction, lowered inventory levels in the channel and a decrease in Canadian sales, our organic net sales decreased slightly compared with strong sales in the prior year fourth quarter. We continue to improve our gross margin as we delivered a 50 basis point increase in the quarter, excluding the impact of the inventory step up at Krausz. Additionally, our adjusted EBITDA increased 6% in the quarter with a 20 basis point improvement in margin. I am pleased with how we responded to the challenges we faced throughout this year as we achieved annual net sales growth of 5.7%. Our growth this year was primarily driven by the benefit of the Krausz acquisition and higher pricing.

We increased organic net sales 1.6% despite the unexpected contraction in residential construction and lowered inventory levels in the channel. I was especially pleased with the sales growth achieved this year with the specialty valve portion of our business, which was directly impacted by the Aurora tragedy. Higher pricing and improved execution led to a 70 basis point improvement in our gross margin for the year, excluding the impacts of the inventory step up at Krausz and the warranty charge in the prior year. We more than covered inflation this year and made significant progress absorbing the cost pressures we have felt over the last three years. Our full year adjusted EBITDA increased 10.1% to $198,200,000 with a 20.5% adjusted EBITDA margin, representing an 80 basis point improvement.

When I look back over the past five years, I believe our performance compares very well to our peers in the water industry. We have increased net sales and adjusted EBITDA every year. Our adjusted EBITDA has increased at a 9.4% compounded annual growth rate with a four thirty basis point improvement in adjusted EBITDA margin. Throughout this period, we have demonstrated a balanced and disciplined approach to capital allocation, as we shifted priorities from deleveraging the business to reinvesting back in the business through capital investments and strategic acquisitions. In addition, we have consistently returned cash to shareholders through our quarterly dividend and share repurchases.

In fact, we have been a consistent dividend payer since we became a public company and have increased our quarterly dividend four times in the last four years. Additionally, we continue to make progress on the Walter Energy tax liability and believe we are nearing the final stages of the process. Marty will provide an update later in the call. In summary, we have made tremendous progress executing our key initiatives to become an innovative leader in the water infrastructure industry and to position ourselves for sustained long term growth. I am very excited about our future and our transformation is well underway.

Later in the call, I will address our key strategies for 2020 and beyond. With that, I'll turn the call over to Martie.

Speaker 3

Thanks, Scott, and good morning, everyone. I will start with our fourth quarter GAAP consolidated financial results and then review our segment performance. Consolidated net sales for the twenty nineteen fourth quarter increased 5% or $12,600,000 to $266,900,000 This increase was primarily driven by the acquisition of Krausz and higher pricing, partially offset by lower volumes in Infrastructure. Gross profit this quarter increased 3.9% to $88,800,000 yielding a gross profit margin of 33.3%. Our gross profit margin decreased 30 basis points compared to the prior year, primarily due to the $2,300,000 inventory step up expense at Krausz.

We delivered a 50 basis point year over year improvement in our gross margin excluding this inventory step up expense as higher pricing more than offset higher costs associated with inflation. Selling, general and administrative costs were $48,500,000 in the quarter and SG and A as a percent of net sales was 18.2%. SG and A expenses increased $5,600,000 in the quarter, primarily due to the Krausz acquisition. For the year, SG and A as a percent of net sales increased 70 basis points to 18.9%. Excluding the impact of the Krausz acquisition, SG and A as a percent of net sales increased 10 basis points in 2019.

In fiscal twenty twenty, we expect total SG and A expenses to be between 1920% of consolidated net sales. Operating income was $39,000,000 in the fourth quarter compared to $40,500,000 in the prior year. Strategic reorganization and other charges were $3,700,000 in the quarter versus $2,100,000 last year. Our fourth quarter results this year also include a $2,400,000 gain from the sale of an idle property. Turning now to our consolidated non GAAP results.

Adjusted operating income of $42,600,000 was flat compared with prior year as higher adjusted operating income at both Infrastructure and Technologies was offset by higher corporate SG and A expenses. Adjusted EBITDA for the fourth quarter increased 6% to $56,900,000 or 21.3% of net sales. Consolidated adjusted EBITDA conversion margin was 25.4% for the quarter and 35% for the full year. Regarding the Walter Energy Accrual, in September 2019, we reached an agreement with the Internal Revenue Service, Department of Justice, and a third party whereby the liability associated with the Walter Energy tax matter and subsequent bankruptcy was resolved. As of September 3039, the Walter Energy tax liability was approximately $39,000,000 Under the terms of the agreement, a third party has agreed to contribute approximately $17,000,000 to the settlement, and we will contribute approximately $22,000,000 Accordingly, during the quarter, we reduced the Walter Energy accrual by $16,400,000 net of additional interest expense.

The settlement agreement, was filed by the IRS and DOJ on Tuesday, November 5, with the US Bankruptcy Court handling the Walter Energy bankruptcy and associated Walter Energy tax matter, must be formally approved by the bankruptcy court. We expect that the bankruptcy court will approve the settlement of the Walter tax liability by the 2019, at which point this matter will be fully resolved upon payment and execution of certain settlement documents. As you know, no assurances as to timing or outcome can be made. As we have previously discussed, this matter has been very complex and challenging. We believe that meaningful progress obligations are less than we had previously estimated.

Turning now to taxes. For the twenty nineteen fourth quarter, we reported a net income tax expense of $11,400,000 or 22.1% of income before income taxes. This rate differs from the statutory rate primarily due to the effects of state income taxes, farm rate differential, and tax effects of discrete items. For the fiscal year, income tax expense was $18,300,000 or 22.3% of income before taxes. Excluding the one time impacts from tax legislation, the effective income tax rate was 23% this year and 26.2% in the prior year, primarily due to a lower federal statutory rate in 02/2019.

In fiscal twenty twenty, we anticipate that our effective income tax rate for the full year will be between 2426%. Our adjusted net income per share was 19¢ for the quarter compared to $0.17 in the prior year. Our 2019 quarterly adjusted EPS excludes the inventory step up expense, strategic reorganization and other charges, gain from the sale of an idle property and $16,400,000 net favorable adjustment associated with the Walter Energy Accrual. Turning now to segment performance, starting with Infrastructure. Infrastructure net sales increased 5% or $11,200,000 to $234,700,000 in the quarter.

This increase was due to the sales from Krausz and higher pricing, partially offset by lower shipment volumes. Organic net sales decreased 1.3% in the quarter as compared with the prior year. The decrease in shipment volumes was primarily driven by the slower than expected recovery in residential construction, lowered inventory levels in the channel and a decrease in sales in Canada during the quarter, reflecting the softer economic conditions and a weaker residential market. Adjusted operating income for the quarter increased 2.2 or $1,100,000 to $51,200,000 excluding the inventory step up expense, strategic reorganization and other charges and the gain from the sale of an idle property. The increase was primarily due to higher pricing, improved manufacturing performance and the inclusion of Krausz, partially offset by lower shipment volumes and higher costs associated with inflation, which included higher tariffs.

Adjusted EBITDA for the fourth quarter increased 5.7% or $3,400,000 to $63,200,000 yielding an adjusted EBITDA margin of 26.9 for this segment. Adjusted EBITDA conversion margin improved to 30.4% in the quarter compared with a negative 2.1% conversion margin last year. Moving on to Technologies. Technologies net sales increased 4.5% or $1,400,000 to $32,200,000 in the quarter. The increase this quarter was primarily driven by higher volumes at Ecologics.

Adjusted operating income increased $500,000 to $800,000 in the quarter. The improvement in adjusted operating income was primarily due to lower SG and A expenses and higher volumes, partially offset by performance and higher costs associated with inflation. Adjusted EBITDA for the fourth quarter increased $800,000 to $2,800,000 yielding an adjusted EBITDA margin of 8.7% for this segment. Adjusted EBITDA for Technologies for 2019 was close to breakeven, improving $3,300,000 to a loss of $800,000 Including with liquidity, cash provided by operating activities for full year 2019 was $92,500,000 The decrease compared to the prior year was primarily driven by the timing of payments, including a $33,100,000 increase in cash taxes and cash interest. We also invested $86,600,000 in capital expenditures in the period, which is $30,900,000 more than the prior year as we prioritize investments in our manufacturing capabilities, particularly our large casting foundry expansion in Chattanooga, a new brass foundry in Decatur, and a new manufacturing facility in Kimball, Tennessee.

At September 3039, we had total debt of $446,300,000 and cash and cash equivalents of $176,700,000 At the end of the fourth quarter, our net debt leverage ratio was 1.4 times. I'll turn the call back to Scott to talk more about our results and outlook for 2020.

Speaker 2

Thanks, Marty. I'd like to comment on a few areas, discuss our full year 2020 outlook, and then open the call for questions. 2019 was a challenging year for our organization. We will forever remember the tragedy which occurred at our Henry Pratt facility on February 15. We can never replace the five members of the Mueller family we lost that day.

Our hearts and minds will always be with the victims and their loved ones, the first responders and the Aurora community. The loss has demonstrated the strength and resiliency of the Aurora community and the Mueller family. The teamwork to heal and rebuild has been an inspirational story for our entire organization as we work to live our core values and improve our culture of execution. In 2019, we faced challenges markets and increased macroeconomic uncertainty from global trade tensions. The challenges from slower residential construction activity and the severe weather earlier in the year contributed to lower volumes in our core products.

We saw a contraction in our Canadian sales, particularly in the fourth quarter as Canadian GDP growth slowed and residential markets weakened. Additionally, channel inventory levels decreased year over year as customers adjusted to the slower growth. Despite these headwinds, organic sales grew nearly 2% at Infrastructure in 2019 and our teams executed well on our pricing actions and we generated strong sales growth with our specialty valve products. We continue to make progress on our strategies to strengthen and grow the business regardless of the external environment as we prioritize investment in our people and our manufacturing capabilities. Our key priorities for 2020 include accelerating new product development, developing a fully integrated technology platform for infrastructure monitoring, driving operational excellence and modernizing our manufacturing facilities.

Accelerating new product development is critical for us as we look to maintain our leadership position in the market, drive above market growth and improve our costs. We have increased investments in our product development capabilities, including expanding our engineering staff to develop and market new products and services. As a result, we launched several key products this year, including the industry's first dry barrel smart hydrant, which currently measures for pressures and leaks. We also launched a new to the market insertion valve incorporating our popular resilient wedge gate valve with a hot tapping sleeve. This product allows utilities and contractors to replace failed valve systems without doing a line stop, saving them significant time and resources.

Thanks to the Krausz acquisition, we are offering product combinations with Krausz restraint technology coupled with hydrants and valves. These innovative products are targeted towards decreasing time to install, which can save customers significant amounts of money. In addition to accelerating new product development, we are working to develop a fully integrated technology platform for infrastructure monitoring, which will leverage our growing portfolio of smart products. As our customers prioritize their spending dollars with real time data and analytics to more efficiently manage and repair their aging infrastructure, we are uniquely positioned to help solve their problems more efficiently and effectively given our installed base of assets and expertise. At the twenty nineteen WESTEC Conference, we introduced Sentrex, a software platform that provides data intelligence to help water utilities make strategic and operational decisions.

Our new technology enabled dry barrel and wet barrel hydrants serve as a communications backbone that houses data gathering sensors. This data includes leak detection, pressure monitoring, metering and water quality, which are aggregated and consolidated within the Sentrex platform, providing utilities with critical information regarding their distribution systems. We continue to make progress on our multi year effort to modernize our manufacturing facilities processes in order to improve quality, service and employee engagement and drive non price margin expansion. We remain focused on driving operational excellence to improve our culture of execution and create a strong foundation for future growth. As we continue to invest in engineering talent and bring best practices focused on lean manufacturing, we plan to deliver consistent manufacturing productivity improvements.

We are targeting at least 50 to 100 basis points of margin improvement on an annual basis, which will facilitate additional product development, productivity initiatives and margin expansion. We are prioritizing capital investments over the next two to three years to increase sales growth and drive margin expansion. We have nearly completed our large valve manufacturing expansion in Chattanooga. In addition, we expect to make significant progress on the construction of our new brass manufacturing facility in Decatur, Illinois, which we announced earlier this year. We also recently made an additional investment to further expand our capabilities in the Chattanooga area to bring added capacity and advanced manufacturing technologies.

We just announced the closure of our Hammond, Indiana facility, which will be relocated to a new facility in Kimball, Tennessee. The new facility will enable us to drive additional efficiencies by insourcing certain activities and further leveraging our large casting foundry. These investments will allow us to capitalize on the growing need for large valves in more densely populated urban areas and an increased focus by customers on products made in America. In fiscal twenty twenty, we anticipate the capital expenditures will be between 80,000,000 and $90,000,000 which is above our long term target. In fiscal twenty twenty three, we anticipate the capital expenditures as a percent of consolidated net sales will decrease to less than 4%.

As we have discussed previously, our key strategies are supported by our strong balance sheet and operating cash flow, which enable us to reinvest in our business while returning cash to shareholders. We will continue to take a balanced and disciplined approach to capital allocation, prioritizing strategic investments to strengthen and grow the business through capital investments and acquisitions. Since December 2016, we have returned $176,000,000 of cash to shareholders through a combination of dividends and share repurchases. Over the same period, we

Speaker 0

$179,000,000 towards capital expenditures and $167,000,000 towards acquisitions. Going forward, we will continue to return cash to shareholders through our quarterly dividend and our

Speaker 2

share share repurchase program. I will now review our full year 2020 expectations for consolidated results and then open the call for questions. For 2020, we anticipate increased demand in all of our end markets. This includes municipal spending and residential construction growth in the low single digit range. The municipal market fundamentals continue to be favorable, especially as it relates to large projects, which favor our specialty valve products.

We believe the conditions are favorable for residential construction to improve in calendar 2020, driven by lower land and lot inventory levels, lower interest rates, employment and income growth and demographic shifts. We expect natural gas distribution growth in the mid single digit range. I am very encouraged about the progress we have made executing strategies to drive sales and increase adjusted EBITDA, which are creating a strong foundation for future growth. For 2020, we expect to increase consolidated net sales between 35% with adjusted EBITDA growth between 48%. We believe our balanced and disciplined capital allocation supported by a strong balance sheet will continue to benefit shareholders while facilitating reinvestments in the business.

In conclusion, I want to remind everyone that we are in the early stages of our transformation to become a municipal and residential solutions company focused on helping utilities deliver important resources to their customers. As we incorporate technology into our products and accelerate the development of new solutions for our customers, we will look to leverage our market leading position and extensive installed base of infrastructure products. We believe that over time profit pools will shift to the companies who provide information and solutions to customers and the companies with more embedded technology and sales growth will achieve higher valuations. This is why we have invested in the technology portion of our business and we will continue to work to increase the number of data driven products and solutions in our business. I have confidence that our teams will deliver this vision while we navigate a more challenging operating environment.

And with that, operator, please open the call for questions.

Speaker 0

Thank you. We will now begin the question and answer session. Our first question comes from Michael Wood with Nomura Instinet. You may go ahead.

Speaker 4

Hi, good morning.

Speaker 2

Good morning, Mike.

Speaker 4

Wanted to just first ask about your profit leverage outlook for I'm calculating at the midpoint about 40 basis points of EBITDA improvement. And that's half the rate that you improved this year. And as you mentioned, you're targeting 50 basis points or more of net productivity. So curious why there would not be leverage on the sales growth that you're expecting and if you could just help me bridge that?

Speaker 2

Hang on a second here. We'll try and get the actual leverage numbers in our model. But I think the difference between forty and fifty basis points at this point is rounding. I'm not sure, Mike, but we can get back to you.

Speaker 4

Okay. And are you able to give some clarity on the inventory destock? Maybe what specific products or end markets that occurred in? And are inventory levels now normal or do you perceive them as either high or low?

Speaker 2

Well, think they're a little bit lower from our data checks with our largest customers than they have been over the last twenty four month period. So I think they're at a twenty four month low kind of number right now. Certainly down substantially from peak inventories which may have occurred at Q2 this year. And so I think that if on average we think of the distribution market as having six turns, I think the destocking could be anywhere from 50 to 150 basis points of demand that happened in the market that didn't flow through the manufacturing.

Speaker 4

Okay. Finally, can you give us some color on what you're seeing in input cost trends, your outlook for that heading into next year? Maybe just also comment as to it sounds like from your comments, you're not expecting price in your guidance. Is there a price increase planned?

Speaker 2

I think that we'll announce price increases to our customers first as opposed to on this call, and I think that's been our habit for the last several years. But with regard to our view for the inflationary pressures, I think we're kind of in limbo right now. If you were to look at our plan, our inflation expectations would be around less than 1%, let's call it. I think there's price down pressures on scrap materials and on copper in the brass markets. But then I think we have inflationary pressures on some of the components that we purchase.

And as for our ability to get price, I want to reiterate what I said in the prepared comments that we had two price increases during fiscal twenty nineteen. We finally got ahead of that whole inflationary cycle that began in the 2016 and kind of got back to par during 2019. So I don't know how much more justification for price we'll see in the market, but certainly it won't be as strong as it was in 2019.

Speaker 5

Okay. Thank you.

Speaker 2

The caveat I would put on that too, Michael, is that the depending on what happens with tariffs, we could see some impact in market pricing.

Speaker 0

Thank you. Our next question comes from Deane Dray with RBC Capital Markets.

Speaker 6

I would love to get an update on Krausz, just the integration. And then can you talk a bit about the growth rate? I mean it's come in pretty strong right out of the blocks, high single digit growth. And unfortunately, the demographics work in its favor with aging infrastructure just as would increase the demand for their emergency pipe repair. I mean that's favorable for Krausz for sure.

But just talk us through that dynamic, what kind of growth rates you're baking in for next year for Krausz?

Speaker 2

Okay. So let me start by saying Krausz acquisition added around $14,000,000 of sales to our net sales growth in Q4. And year to date sales impact of about $37,000,000 over three quarters would implies around a $50,000,000 annual sales number, which is nearly percent higher than the $43,000,000 calendar twenty seventeen sales reported when we announced the acquisition. So we haven't disclosed the impact to adjusted operating income or EBITDA, but Krausz adjusted EBITDA margin percentage is higher than our consolidated average. So I don't want to say it's going to continue at 20%, but we expect it to be well into that double digit range as we guided when we did the acquisition.

But it has been fairly healthy and really been a bright spot as the fourth quarter rolled out. Set records in two of the three months.

Speaker 6

Update there. And then how has the reception been to the software platform Centrix? It was rolled out officially at Wabtec and looked like you already had some installations. How's the reception been?

Speaker 2

We're still in the phase where we're doing our test customers or trial customers, launch customers, if you will. It's I think it's going to be very, very well accepted because I think especially in the in the mid market where they realize they can do their billing, they can look for leaks, they can you know, it's it's kind of a a single user interface for your maintenance and your billing requirements for your metering business. So I think it's going to be very well accepted. I think the early returns are there's a fair deal of excitement about it. But we want to make sure we get this right.

We want to work on the time to acquire data and make sure we can scale at a very, very large level. And our launch customers are being helpful to say the least. But as of right now, we still have no revenue in results for Sentrex, but we're very hopeful that it will become a mainstay of software as a service in the future.

Speaker 6

Great. And then just last question for me is, I know you referred to the muni markets as favorably set up for 2020, and I hope you can expand on that. There's been this bridging between expectations of low single digit to mid single digit, but it really does depend on what regions you're indexed to. I mean, if you're if you were overexposed to the Rust Belt, you'd be at the lower end of that. But if you had more exposure to growth areas like Denver, Texas and California, you'd be on the higher end.

So how do you parse out regional exposures and the regional differences versus Mueller's overall exposure?

Speaker 2

Yeah, so that's what we've tried to do. You I've had that discussion where it was really the tale of two Americas, population, depopulation in Connecticut, Illinois, Wisconsin, Michigan, those areas, and then the population migration into the American Southwest, American Southeast, and the Pacific Northwest. And certainly, think what the bridge is, make it helpful for everybody, we've kind of gone from a mid single digit to a low single digit view to municipal spending kind of based on what we saw over the last two quarters. We believe there to be a fair deal of pent up project demand and a fair deal of pent up construction demand as well. And I am not calling it labor, but we didn't have as big a recovery in Q4 in project and resi construction and contract work that we anticipated.

And the most common discussion we had with the contractor community was certainly around availability of labor and whether this economy is at full employment or not, and the labor that's coming in whether they're qualified to do the work or not. So if we're really at this 3%, is there more capacity for construction to go on? And so we've tempered our outlook, as everybody's seen in our guidance, to the low single digit municipal growth and low single digit residential growth. And I think the primary driver we should take from that is contract labor availability. I don't know if that helps or answers your question, but that's kind of what our big driver was.

Speaker 6

It does, and thanks for the color. Thank

Speaker 0

you.

Speaker 2

Thank you.

Speaker 0

And the next question comes from Brian Blair with Oppenheimer. You may go ahead.

Speaker 7

Good morning, everyone. Thanks for taking my questions.

Speaker 2

Good morning, Brian.

Speaker 7

A quick follow-up on Centrix. It's good to hear that reception has been favorable so far. I was just wondering whether you believe the platform could drive accelerated adoption of Smartwater technologies during fiscal twenty twenty-twenty twenty one time frame or if that's a longer term consideration?

Speaker 2

Well, think it's I think it will help drive the adoption of Smartwater, absolutely. But I think the pace of adoption is something that that everybody in the industry is is rightfully skeptical of. And so we're not we're not hanging our '21 or '22 results on that. But what we do believe and believe strongly in is that regardless of its early adoption, it should help us with valves, hydrants, brass, and our core products as customers need smart ready equipment to be installed. And whether it's existing Centurion that you can convert later to a smart hydrant, we believe it will help both our spec position and allow us to grow our share in our core products.

So to the extent that it's an enabler of improving, let's call it our number one market position, I think is of paramount importance. In addition, it's an easy gateway for anybody who's already using our meter system to go into leak detection and pressure monitoring. Or conversely, if you're using our pressure monitoring and leak detection, you could easily transition to more flow metering technologies because you don't need an incremental software investment. And we believe we're the only ones now with a single user interface that can look after all of the layered needs. And we anticipate that it will drive growth for us, certainly beyond 'twenty one and 'twenty two as more smart water gets adopted.

Speaker 7

Got it. It's very helpful color. And you quickly mentioned leak detection there. What was Ecologics' performance in the quarter? The growth in

Speaker 2

Ecologics had, as we said in the prepared comments, had the largest quarter of the year and it represented almost half their sales for the year. That was primarily due to shipping the Equishore DXs. As I had said on an earlier call, Brian, jog everybody's memory, we had gotten a large follow on order to the original order for San Jose. And those nodes all shipped in the fourth quarter. And so that was what really drove them to profitability and drove them to having such a large quarter.

They were the bulk of the Technologies growth in the quarter.

Speaker 7

Got it. Okay. And then a quick one on capital deployment. Obviously, organic investment is a top priority, but any updates on your deal funnel? And how are you thinking about M versus share buybacks in the current environment?

Speaker 2

Well, as I said many times, we have I think we've demonstrated we've been very balanced in our capital allocation process and that share buybacks and dividends represented about a third of our cash utilization in the three categories and acquisitions was about a third and CapEx was about a third. And so I think that you can expect that to come from us in the future. As for deal funnel, you know, it's a it's a like, let's call it a fulsome funnel with add ons that would expand our influence with existing channel partners and expand our product presence with existing customers. And then there's the ones that will enable us geographic expansion and the ones that will enable technology adoption or sensors and things like that that could be deployed more rapidly. So those are the three main areas.

We have fulsome deal and we still feel we have a lot of capacity, but as always, we're going to be very disciplined about how we do it.

Speaker 7

Okay. Thanks again.

Speaker 8

Thank you.

Speaker 0

Thank you. The next question comes from Ryan Connors with Boenning and Scattergood. You may go ahead.

Speaker 9

Great. Thank you. I wanted to go back to this topic of technology. You mentioned, Scott, the Ecologics shipping a lot of orders in the fourth quarter. It's the second straight year where we've had this pattern where Technologies loses money in the first three quarters and then breaks even or better in the fourth quarter.

Is that kind of a pattern and we should see that revert in the coming fiscal year where technologies would kind of lapse back down and then ship a lot late in the year? Or is this or do you feel like we're at a point where maybe we can take the momentum in the fourth quarter here and build in and start to see some more consistent profitability there?

Speaker 2

Thanks for that. It's something I was toyed with getting involved with in the prepared comments, so thanks for the question, Ryan. But yes, I think that we've had the phenomena of when you think about July, August, September being the heaviest construction season, it's when the North can accept meter installs along with the South. And so it's peak for the meter business, peak demand season. And so that's we've seen that for the last three years actually where Q4 is the biggest quarter.

But what I'm more proud of and wanted to talk more about is, the business lost $7 ish million two years ago, lost $3 ish million It's going to lose $800,000 I think is the adjusted EBITDA full year. I expect that business to get better every year. Expect continuous improvement to mean just that. I think asked when I first got here, will it be fixed overnight?

We went, we looked at operations, we looked at contracts, we looked at our product offering and we got to work on the hard work of making that business better, not just in the short term by removing all the engineering costs or something like that, but by structurally changing how we make things, relaying out plans, being more disciplined about what contracts we would take, being more disciplined around price. And I think we've we've been rewarded with, you know, near breakeven this year. And so I expect that business to continue to get better from an operating point of view, from a price discipline point of view, and from a growth point of view. And so, you know, I'm not ready to call success yet, but I do think you will continue to see that July, August, September quarter be the largest quarter when the weather is conducive to doing a lot of meter install. And I do think you should expect as investors for that business to have continuous improvement in its operating results given modest growth expectations.

Speaker 9

Got it. Okay. Now just to be clear, the SentriX product, I know you mentioned the side benefit of helping you to market your core products as well. But to the extent you realize actual sales for the SentriX, that does go into technologies, correct?

Speaker 2

It will go into Technologies, yes. Will be in the Technologies. It will be a replacement for the MiHost revenues, yes.

Speaker 9

Got it. Okay. And then my only other question was bigger picture in nature, but just wanted to get your thoughts with the macro uncertainty, just get your thoughts on the cyclicality of the business in general. I know in the last recession, the business was hit very hard, but it's a much different business today. For one thing, we don't have U.

S. Pipe, which was a big challenge in the last recession, other things like technology. So can you just give us your thoughts about how you think the portfolio business will behave in hypothetical scenario of a recession and maybe a fairly severe recession? I mean, where do you think the puts and takes are in terms of the beta of the business, so to speak?

Speaker 2

Yeah. I think without getting too heavy into the speculatory nature of that, I think that we can look back to the 2008 timeframe and point out that when it went down the last time, it was it was a very different kind of recession. It was really in Mueller's power alley and that housing was 2,100,000 housing starts. It basically fell to zero. You know, I think it got down to 400,000, but as for any new curb and sewer going in which would use our products, it it was, you know, effectively zero.

And so I don't think, unless we have another housing crisis leading us in, I don't think it will be anywhere near that severe. And in fact, I've done some research that would indicate that municipalities increase spending during periods of economic downturn. And so I would expect the municipal part of the business to remain healthy. I I don't know how you feel, but it's hard for me to imagine interest rates getting much lower if we were to go into a recession. So I don't know what levers are left to stimulate the economy if we were to go into a recession.

So I think that, you know, short answer to your question is I think we will continue to be cash generative even through a downturn. I think there's enough room in inventories. I think if you had contracting sales, you could go to shorter work weeks, that kind of thing that while we may not be at a 22% or 23% EBITDA margin, we would see our conversions improve because we would take steps to remove some of the variable portions of our our our costs, not just labor, but, you know, inventories, building, utilities, some of the step fixed that are implied in our overheads too. So I would expect us to be cash generative, and I would expect us to be positive within that kind of first 10% earnings positive within that first 10% of volume decrease.

Speaker 9

Got it. Okay. That's very helpful. Thanks for your time.

Speaker 8

Thank you.

Speaker 0

Thank you. The next question comes from Andrew Buscaglia with Berenberg. You may go ahead.

Speaker 8

Hey, guys. Just wanted to touch on the SG and A guidance, you know, 19% to 20% of sales. Just trying to figure out why, you know, why exactly wouldn't that start to decline in infrastructure as you anniversary crowds, especially with, you know, you've you've invested in a lot of things over the last couple years, you would think that that that you start to see some of the benefits of that flow through at least towards the back half of this year.

Speaker 3

When we look at our SG and A, I think a couple of things. First of all, we called out Krausz, just with their split, does have a bit higher SG and A that we've seen, which is certainly a factor. But I think additionally, as we look out to 2020, a component of it is certainly gonna be some of the inflation expectations that we have around that. We also talked about, the addition, of engineering talent, etcetera, as we go forward. And I think that will be one of the other reasons that you see some higher higher slightly higher expectations around SG and A as a percent of net sales.

Speaker 8

Okay. Okay. And then, Joey, as the quarter went on, we saw some better headlines on housing. Did your sales pick up or did you see improvement as you exited the quarter?

Speaker 2

Yeah. I think the no. The answer to that is no. I think that we saw most of the destocking and certainly the collapse of the Canadian demand profile happened late in the quarter. When we I think at the end of the third quarter, I said we would be at the low end of seven to nine and I think everybody can do the math, so I'll just get straight to it.

It was about $13,000,000 of demand that we anticipated that would come from a more rapid recovery in resi construction than we saw. So yes, the quarter will show resi construction up, but after being down the previous two quarters, we expected the recovery to be a bit stronger than it was. And then on top of that, we saw

Speaker 8

meaningful

Speaker 2

demand decay in in Canada. So those were the two reasons we did not get the recovery we expected when we when we said, you know, lower July '9 at, you know, dollars 13,000,000. So no, we didn't see it pick up enough. We expected if you recall the last quarter, we expected resi to pick up in Q4. So it wasn't a surprise to us that it actually grew, but it didn't grow anywhere near as much as we thought.

I'll remind everybody, if you think about how we started the year, we started talking about 1.2 to 1,300,000 housing starts. And we're going to be substantially below that when this is all said and done.

Speaker 8

Right. Yes. And Scott, you sounded positive or a little more positive around this technologies business and what the customers are saying about Echologics. Can you talk a little bit about, first off, are you contemplating any sort of growth there in your guidance? And any expectations for, you know, if we start to see adoption, how fast that can pick up or, you know, it's and and I'm just trying to get I'm trying to gauge, you know, what sort of upside we have here to the the the sales guide that you provide?

Speaker 2

I think our long term view for technologies is that it will grow much faster than infrastructures over the long haul. And our shorter term view is, you know, we're cautiously optimistic. But we could absolutely scale we could absolutely scale the technologies business more than and quicker than I think a lot of people think. Have the ability to cast all of the DXs. We are now going to be live in in Cleveland, North Carolina with the assembly of all DXs.

We we will be able to do all our own assembly potting, testing, shipping, and and we have lots of capacity there. We are trying to build, you know, with American Water, with East Bay Mug, with San Jose, with our core customers a, you know, a testimonial, if you will, to how the technology is helping them decrease their operating budgets and go, you know, utility by utility so they can understand how they too can adopt the locating technology and have it turn into tangible operating results for them. People buying into that message, delivering that message, the selling proposition, I think it's gonna take more time than just the next twelve months. But in the long run, we expect that to far outstrip the growth in our infrastructure business, which will be kinda, as I've said many times, GDP ish plus, you know, 100, 150 basis points. That's what the infrastructure reinvestment profile is gonna look like.

Technology, on the other hand, is gonna grow double digits in the long run.

Speaker 8

All right. Thanks guys. Thank

Speaker 0

Thank you. The next question comes from Brent Thielman with D. A. Davidson. You may go ahead.

Speaker 10

Great, thanks. Good morning.

Speaker 8

Good morning. The muni spending

Speaker 10

outlook for next year, I mean, seems like a safe bet to me. I guess I'm curious if there's any areas within that market that could be more influenced or you've seen more influence in an election year? I guess I'm thinking more of your specialty valves attached to larger CapEx projects or something like that.

Speaker 2

Yeah, absolutely. Look, think that the fundamentals are that I think people have talked in terms of mid single digits for that market. And I understand there are people out there that are saying, no, no, he's wrong. It should be still mid single digits. And I understand that.

All we're saying is, I don't know what the capacity certainly the demand is there. Certainly the need is there, the fundamentals, the cost of money, all of those things are there. But they were there in the fourth quarter and the third quarter as well, and we didn't see as much growth as we anticipated. And I, think that labor is playing a part. I don't wanna lay it all at that, but certainly the capacity exists and if the money and labor capacity existed, then we would see better than low single digit growth in Muni.

And yes, an election year could spur even more spending and that could be a larger growth number. I am saying this for everybody on the call because basically we were flummoxed at why the growth was what it was in Q4 even with the destocking.

Speaker 10

Yes. No, I appreciate that, Scott. And I guess another question with the channel inventory reductions in the September, would you anticipate seeing the same sort of seasonal or typical seasonal sequential reduction in sales that you typically see in the December? Do you think that may be less pronounced than what you see historically?

Speaker 2

I think it's going to be less pronounced because we have it from on good authority our top customers that they finished September at 24, and in some cases, even more than twenty four month inventory lows. So they were kind of getting their inventory for a slower growth environment is how it was put. And so I think that, yes, you normally see a dip, but September inventories were lower than they were at December. And so I don't think we'll see the normal dip. I think we've taken most of the inventory punishment in the fourth quarter, our fiscal fourth quarter.

Speaker 10

Okay. And then a couple of quick I guess. One, what percentage is Canada now as a percentage of business? And then I guess, Marty, thanks for the CapEx expectation for next year. Just wondering if there's anything unusual to think about in terms of working capital or anything like that as we think about free cash for fiscal twenty twenty?

Speaker 3

Yes. Certainly, first of all, Canada overall, think one of the points that we talked about is we've seen Canada down throughout the year, but I think the certainly the magnitude of the decline in the fourth quarter was greater than what we've seen earlier. I mean, I think historically, we've seen Canada run like sort of 8% to 9% of our sales. And, so we would expect it to, you know, probably decline a little bit, from that perspective. Sorry.

Brett, your second question was in and around free cash flow or

Speaker 10

Anything unusual to think beyond the CapEx numbers you gave, anything unusual you'd expect to see that we don't typically see working Yes.

Speaker 3

Probably just a couple of things. Let me call out with respect to what we did see in free cash flow in 2019, I'll and give you just a reminder as we look out to 2020. First of all, I think certainly one of the probably the two things that impacted most the free cash flow in 2019 was the higher level of capital expenditures that you'd you know, we were about 31,000,000 higher in our CapEx spending in 2019 versus 2018. Additionally, when we look at our cash flow from operations, there was a difference in timing of payments. And the two that I would particularly call out were the cash interest payments that we had in 2019 versus 2018 as well as the cash interest.

And those were certainly higher in 2019 than 2018, which impacted our cash flow from operations. Additionally, I will just remind you as we look out to 2020, going back to the update that we provided on the Walter Energy Tax accrual, if we get the acceptance and final resolution from the bankruptcy court, we would expect to make our cash payment for, Walter tax in our fiscal twenty twenty.

Speaker 10

Is it too early to say what quarter you'd see that?

Speaker 3

You know, again, it's I I would, you know, with with no no promises in and around outcome, certainly, or timing, you know, our expectation is that we could get this resolved by the end of calendar 02/2019, and that's certainly going to be dependent at this point upon the approval from the bankruptcy court.

Speaker 10

Okay. And then just my last quick question that notwithstanding water is in the name, you hear a lot about reinvestment by utilities into natural gas infrastructure systems, safety, reliability upgrades, things like that. I know it's not a huge business, relatively speaking, but is it an area that you'd look to invest and grow in?

Speaker 2

Yes, absolutely. I mean, natural gas business has been a great little business for a couple of years now and it continues to grow and it continues to expand margins and it continues to be very reliable. And I think the huge difference between the two spaces is that if a gas utility says they're gonna do this line modernization or they're going to do these fitting upgrades because they've reached their end of life, it happens. Because I think the consequence of poor maintenance of a natural gas line is obviously much more catastrophic than the poor maintenance of a water line where people will get wet. And so, yeah, I think it's an area where we can continue to grow our influence, continue to do the new product things we talk about and continue to take share in the space, we would look at expanding the line and look at doing other investments there.

Speaker 8

Thank you. Thank

Speaker 0

you. The next question comes from Joe Giordano with Cowen. You may go ahead.

Speaker 5

Hey guys, good morning.

Speaker 3

Good morning, Joe. Good morning.

Speaker 10

I wanted to start with cash.

Speaker 8

You touched on it a little

Speaker 5

bit there. Just quick clarification. This pretty big D and A step up in 2020 versus like the run rate we've been on. Is that just from the CapEx spend being elevated?

Speaker 3

Exactly. If you look back on our 2019 versus 2018, depreciation and amortization was up probably about $9,000,000 or so. And certainly, as we look out to 2020 with a higher level of capital expenditures that we had in 2019. I'll additionally remind you that we had the acquisition of Krausz, which has added probably very little bit from a depreciation perspective, but also the amortization that we have associated with Krausz expectations when you put the higher level of CapEx and coming from Krausz, we would we do expect our depreciation and amortization to increase again in that 60 to $63,000,000 range for 02/2020.

Speaker 5

Okay. So then we talked about going down to fiscal twenty three below 4% of sales. I mean, midpoint of guide is, like, nine right now for 2020. How linear is that step down, and how should we think about free cash flow conversion in '20 and then through over the next couple of years? Are we looking at, like, meaningfully below, adjusted EPS for a couple of years just given the CapEx dynamic?

Speaker 3

You know, I I think overall, you know, we we've got the expectation for capital expenditures in and around 2020. And I think certainly given the guidance that expectations for an elevated level with some of the projects that we specifically called out, the large casting foundry, is close to completion at this point. Certainly the Kimball, Tennessee facility that will be ramping up and then the new Brass foundry that has just begun in Decatur, Illinois. So those are sort of the three big ones that we've addressed as well we have a system upgrade going on. Don't have an exact, schedule for you in terms of sort of percentage between 2023 other than to say as we sort of look out at what we see with some of the the modernization of our facilities, as well as probably a little bit of of lower spending levels, you know, historically through the recession that, we feel comfortable we we'll be back below that 4% level by 2023.

Speaker 5

Got it. Oh, okay. And then, Scott, if if we talk about the guide in terms of the resi construction, so the the the miss in 4Q versus, like, your full year revenue and EBITDA, you talked about the the lower slow recovery in resi construction. If I just look at the the raw data here, like, September construction was kind of at the level of the full year average so far. Pricing looks weak or is deteriorating.

So, like, if it didn't recover in here, why do we you know, what gives you confidence that it's going to start to accelerate as we move forward?

Speaker 2

So I'm not sure I agree with your first I think the September data would indicate that there was a little bit of growth in Q4, I think somewhere around 2%. Whereas in single family last twelve months has shrunk 3.1%, so about a 500 basis point swing is kind of where we are. I think that weather played a part of that in Q2, so that May spring construction season, and it was particularly bad in the areas where we've seen population migration, especially in Nashville, Texas, Arizona, those corridors where there's been a lot of the housing starts coming from. And so I think that when you kind of peel back the onion on the data, family formations, low interest rates, housing inventory, lot inventories, all give me confidence that, you know, notwithstanding some economic discontinuity, that there is pent up demand there. And we saw that in the fourth quarter, actually the September, recovering a little bit and getting back to growth after being in a contraction environment.

So I think that this cautious optimism of going from the mid single digit or in some cases as high as 9%, I think Zelman's up there really high. We have opted to be kind of in a low single digit kind of view, and that's how we based our guidance. We entered 2019 with more lots that needed to be worked. So I think we'll we'll enter 2020. We have better fundamentals to start than we did at the beginning of 2019.

But with that said, Joe, I'm not gonna sit here and argue with you on, you know, what about this labor capacity thing? Maybe it can't even grow again. Where where are we with the employment thing? And, you know, I'm sure you listen to all of the homebuilders as well, and, you know, that's that's a concern of theirs is their capacity.

Speaker 5

So Yeah. No. That's that's fair. Maybe last for me. I think and we kinda talked about this a little bit earlier, but can you kinda take me through your pitch on the smart smart infrastructure monitoring versus some of, like, the bigger players in the space that maybe had more comprehensive wastewater and, like, metering offerings than you guys have currently?

So, like, what if you're competing against them, what do you what is what do you bring to the people that they that they can how are you pitching that?

Speaker 2

Yeah. I think what everybody's doing is that they have great information for the water utilities at the treatment station, at the pumping station, at the fixed asset building brick and mortar. Whether they're using SCADA or pump diametrics, we are the only people that are actually forward deployed that can look at the chemistry and look at the physical nature of the infrastructure to the home. And we can test the quality of the drinking water, what's its turbidity, what's its alkalinity, what's its chlorinity. We can look at the pressures, we can tell if you're leaking, we can basically give you eyes on your distribution network.

And it's becoming more and more important because unlike anybody else, everybody can tell you at the source at the pumping station what the water looks like. But as we know in Flint and as we know in Mount Pleasant, Michigan and as we're learning in Montreal as we're learning in Connecticut, the quality of the water that leaves the pumping station isn't necessarily what's getting delivered to the consumer. And these periodic checks in the network where the contaminants are being picked up is going to be of paramount importance. And right now, we are the only people that have both the infrastructure through the hydrant network, the ability to retrofit, and the ability to sense all of those different things and do something about it. We kind of joked about the I'm only here to monitor, but we can actually flush, we can actually reroute water, we can actually actuate.

So I think that we have a series of solutions available to utilities that no one else can replicate.

Speaker 8

Great. Thanks guys. Thank you.

Speaker 0

Thank you. Our next question comes from Jose Garza with Gabelli Asset Management. You may go ahead.

Speaker 2

And operator, I think this will be our final question. Thank you. Go ahead, Jose. Good to talk.

Speaker 11

Yeah. Thanks for fitting me in. Scott, just how how are you you know, looking a year forward, how are you gonna measure some of the some of the newer prod products that you talked about and and, I guess, measure the success of those over the next coming year? Then maybe looking out and how how should we measure that same success?

Speaker 2

Yeah. I think that's a I think that's a fair question as far as, you know, the obvious ones are, you know, how many dollars of sales do they generate. But we'd also want to look at field trials conducted. We'll want to look at specifications it's been accepted in. We'll want to look at number of breadth of its entrance.

If we knock down a city of New York and then we don't have acceptance anywhere else, that won't be as good as getting broad based acceptance across many, many customers. We know from our experience in hydrants and gate valves that broad acceptance is what drives more spec position, which is what drives a much more dependable demand profile. So that's how we think about it. We understand that the purchasing cycle for a lot of these new products many times involves a twelve or even eighteen month field trial period. And so we know that we're making investments in products that may only start to actually pay for themselves in year two and three beyond.

And so it's not the only thing we will look at, but it will be the thing that we point to over time.

Speaker 11

Okay. Fair enough. And then just one last one. I guess just on all of the capital projects you've got going on, just kind of remind us timing wise what that kind of looks like and I guess using Chattanooga as the most one, I guess, near completion?

Speaker 2

Yep. So Chattanooga, as as Marty told you, is is very near completion. We expect to be kind of run at rate in '20, you know, near the end of it. We're in our pre production testing modes right now. We're qualifying molds, pouring test metal.

So we're very near ready to go there. Decatur, because it is a greenfield and going to be a new facility, is going be a much longer investment cycle. We don't expect really to be run rate there until 2022 late or early twenty twenty three. And this Kimball facility we just purchased, we expect the Hammond facility to be completely shuttered by November 2020. We expect to be making gates and assembling large large body castings in the 2020 calendar.

So those are kind of the big three, the large casting foundry, the plant opening and the Decatur facility. So they have various kind of go lives.

Speaker 8

Okay, perfect. Thanks, Rob. Thank you.

Speaker 2

Operator, I think that we're well past the hour and I would like to thank everybody for joining us and look forward to talking to you soon.

Speaker 0

Thank you. And that does conclude today's conference. Thank you all for participating. You may now disconnect.