Advanced Drainage Systems - Q2 2020

Transcript

Operator (participant)

Good morning, ladies and gentlemen, and welcome to Advanced Drainage Systems' second-quarter fiscal 2020 results conference call. My name is Rob, and I am your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. To ask a question during the session, you will need to press star one on your telephone. Please be advised that today's conference is being recorded. I would now like to turn the presentation over to your host for today's call, Mr. Mike Higgins, Vice President of Corporate Strategy and Investor Relations. Sir, you may begin.

Mike Higgins (VP of Corporate Strategy and Investor Relations)

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. 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 the 8-K 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.

Scott Barbour (President and CEO)

Thanks, Mike, and good morning, everyone. We're happy to have you all join us today on the call. Our second-quarter financial results were very strong, building on a solid Q1 as we continue to execute on our growth and strategic priorities. There are a couple of points I would like to hit right up front. First, the legacy ADS business continues to outpace the broader market, and we feel very good about where the business is positioned as we head into the second half of the year. The traditional ADS profitability levers of strong growth, favorable pricing and material costs, as well as disciplined execution, drove margin expansion and improved profitability during the quarter. The recently acquired Infiltrator Water Technologies business is also performing well. They were right in line, if not slightly ahead of our expectations, driven by double-digit growth of both chambers and tanks.

The integration remains on track, including the synergies we discussed on our last call. The combination of strong growth, improved profitability, execution on our working capital initiatives resulted in an increase of over $100 million in free cash flow year to date compared to the prior year period. This strong cash flow generation puts us well on our way to being back within our targeted guardrails of 2x-3x levered in the next 12 months. Additionally, due to the very strong demand, we secured financing for a new long-term capital structure at favorable rates. And finally, we are raising our fiscal 2020 net sales and Adjusted EBITDA guidance, primarily due to the strong first half performance of the legacy ADS business. Overall, this was a very good quarter, which positions us well for a strong second half of the year.

With that, I'd like to provide a little bit more color on our performance for the quarter, starting with the top line. Top line growth of 22% was driven by organic growth of 9%, plus the two-month contribution from Infiltrator Water Technologies. Because the acquisition is so new for today's call, I will primarily separate and have a discussion of the two businesses. Starting with our legacy ADS business, domestic construction market sales grew 10%, well in excess of the low single-digit growth of these end markets. Our above-market growth was driven by the continued execution of our conversion and water management solution strategies, as well as our focus on the key growth regions of the United States.

We continue to see steady strength in the domestic construction markets through fiscal 2020, supported by favorable tailwinds, including low interest rates, favorable housing and healthy consumer confidence. Our backlog and order trends reflect this. Turning to the domestic agriculture end market, sales were up 38% in the quarter due to the prevented plant acres and pent-up demand. We were able to capitalize on these favorable market dynamics and accelerate our growth through some organizational changes, new product introductions and focused execution in the quarter. Overall, organic domestic sales were up 13%, driven by the factors I've mentioned, as well as strong execution on the strategic growth initiatives. We experienced double-digit growth of key products such as our HP pipe, StormTech retention/detention chambers, and Nyloplast Catch Basins.

We also generated broad-based growth across all of our regions in the United States, with particular strength in Texas, Florida, California, Georgia, New Jersey, and Virginia. We experienced another challenging quarter in international business, however. In Canada, our sales were impacted by poor construction activity in our primary markets of Ontario and Quebec. Additionally, Mexican infrastructure spending continues to be very low due to the decrease in public funding. Our export business continues to grow nicely. Moving on to profitability. Organic Adjusted EBITDA grew 31% this quarter, and margins expanded 360 basis points. The improvement was driven by the traditional ADS legacy levers of strong top-line growth, favorable pricing in both pipe and allied products, as well as favorable resin and recycling costs.

We continue to work these familiar levers of profitability very hard. As we grow the company, it's important to build new levers for improving profitability. We have been talking about transportation and logistics initiatives for several quarters, and we're beginning to see these initiatives gain traction in better payload efficiency and logistics planning. We have also developed a partnership with a common carrier to narrow the number of providers while improving service and pricing, and this allowed us to use a common carrier to move interplant freight, which gives us better leverage on our company assets to drive revenue and customer service. Another important initiative is improving efficiency within our four-wall manufacturing network. We're developing maintenance programs to improve the performance of our equipment, and we're seeing some better performance from that.

These initiatives and several others are in flight, and we expect to see more benefit from these as we move forward. On slide six, we present Infiltrator Water Technologies results for August and September. Revenue was in line to slightly ahead of our expectations. Double-digit growth over the prior year period in both leach field chambers and tank sales was driven by their successful long-term material conversion strategy, which is similar to the ADS material conversion story and one of the reasons this acquisition was such a good fit. Sales were strong in the East, South, and Midwest regions, and growth in key states such as North Carolina, Georgia, and Florida outpaced single-family housing starts over the same period. This integration is on track, and we are working on the identified synergy projects to deliver the expected synergies of $4 million-$6 million in year one.

Additionally, we have approved capital projects to support the growth of this business. We've included that spending in today's updated CapEx projection. On slide seven, we present our capital deployment priorities, which remain focused on investing in growth, productivity, and efficiency of the combined businesses, paying down the debt to get our leverage ratio back within our two to three times guardrails in the next twelve months. Today, we announced a $0.09 quarterly dividend to shareholders payable this December. Upon payment, our year-to-date total cash return to shareholders will be $96 million in fiscal 2020. This quarterly dividend demonstrates our commitment to shareholder returns, as well as our confidence in the strength of our balance sheet to be able to return this cash without impacting our ability to execute on our other capital deployment priorities.

All in all, we did a good job executing in the quarter, meeting our commitments and positioning ourselves for a strong second half of the year. We will continue to mitigate inflationary pressures and deliver continuous improvement in manufacturing and logistics to deliver improved and sustainable profitability. Finally, we will continue to execute on our strategic capital deployment plan with a focus on working capital and debt paydown. With that, I'll turn it over to Scott, who will further discuss our second quarter performance.

Scott Cottrill (EVP, CFO, and Treasurer)

Thanks, Scott. Good morning, everyone. Moving to slide 8, we present a snapshot of our second quarter fiscal 2020 financial performance. Organic net sales increased $37 million or 9% to $443 million. Infiltrator Water Technologies contributed an additional $65 million in August and September to bring our consolidated net sales to $496 million, an increase of 22% over the prior year. Organic pipe sales increased 8%, driven by strong domestic construction and agricultural market sales. Organic allied product sales increased 13%, primarily driven by strength in our domestic markets. Consolidated Adjusted EBITDA increased $47 million or 65% to $118.2 million, and our consolidated Adjusted EBITDA margin increased 620 basis points to 21.2%.

Organic Adjusted EBITDA increased $23 million, and our organic Adjusted EBITDA margin increased 360 basis points to 21.2% in the second quarter. The improvement was driven by sales growth in both pipe and allied products, favorable material cost and pricing, as well as effective cost containment. Additionally, we benefited from modestly lower transportation expense due to improved efficiency as well as favorable diesel and common carrier rates. This improvement was offset by an increase in selling, general, and administrative expenses, which reflects investments in our sales team to drive various growth initiatives, as well as higher compensation expense due to our current and expected performance for the year. Infiltrator Water Technologies contributed an additional $25.1 million to Adjusted EBITDA and delivered an additional 260 basis points of improvement to the consolidated Adjusted EBITDA margin.

Standalone, the Adjusted EBITDA margin of the Infiltrator Water Technologies business was 38.6%. Moving to slide nine, we highlight our year-to-date free cash flow performance. The business generated $146 million of free cash flow year to date, an increase of $107 million over the same period last year. Our very strong free cash flow performance was driven primarily by higher profitability and favorable working capital performance, which improved by $74 million during the quarter. This improvement in working capital was driven by better enforcement of our collection policies, greater inventory turns from reductions in our slow-moving inventory and improving the sell-through of our existing inventories, and as well, was further boosted by lower resin costs. Finally, we worked hard to negotiate and better manage payment terms on our payables, all which drove the favorable performance year-over-year.

We're very happy with our performance to date and the traction our working capital initiatives are producing, which we expect to continue throughout the balance of this year. On slide 10, we detail our new capital structure, updated since our first quarter results. We secured long-term permanent financing during the second quarter to finance the acquisition and close out our prior debt. During the quarter, we issued 10,350,000 shares of common stock at $29.75 per share, raising $294 million net of offering costs. We also issued $350 million of 5% senior notes due in 2027, and entered into a new senior secured credit facility, which includes a $700 million term loan and a $350 million revolving credit facility at LIBOR+ 2.25%.

We ended the quarter with no balance on our cash flow revolver, and due to our strong cash position, we paid down an additional $50 million on our term loan at the end of October. Importantly, there was strong demand for each of these financing transactions, and we were able to secure more favorable pricing than we had initially expected. Our weighted average maturities now extend to seven years from under four years previously, and our weighted average cost of debt has increased to approximately 4.5%. We ended the quarter with a leverage ratio of 3.8x.

On a trailing 12-month pro forma basis for both companies, our leverage ratio was 2.9x, which is well ahead of our original expectations, primarily due to the strong free cash flow performance, as well as the strong demand we experienced for our September equity offering. On slide 11, we present our updated financial guidance for the combined companies in fiscal 2020, which includes eight months of Infiltrator Water Technologies results. Based on our order activity, backlog, and current market trends, we have increased the midpoint of our net sales guidance by $25 million. We now expect consolidated revenue to be in the range of $1.06 billion-$1.065 billion, representing year-over-year growth of between 16% and 19%.

We also raised the midpoint of our Adjusted EBITDA guidance by $15 million due to our strong year-to-date performance, our updated sales guidance, as well as favorable input costs. We now expect Adjusted EBITDA to be in the range of $325 million-$345 million, representing growth of 40%-49%. These ranges represent an Adjusted EBITDA margin of 20.3%-20.9%, or margin expansion of 360 basis points-420 basis points. Today's increase in guidance is due to the strong performance in the legacy ADS business during the first half of the fiscal 2020, and our projected performance throughout the remaining remainder of the year, which is reflected in the legacy ADS guidance, also presented on this slide. Slide 12.

Finally, on slide 12, we present our updated market outlook for the remainder of 2020 that supports our guidance. Overall, our outlook for the domestic construction market remains unchanged, though the domestic residential market is stronger than anticipated, supported by consumer confidence, low interest rates, and improving housing trends. Going into the year, we were cautious about the agricultural end market. However, due to the prevented plant acres, pent-up demand, and investments in drainage, we expect this market to grow double digits in fiscal 2020. Finally, the international market is weaker than we initially expected, due to a softer construction market in Canada and very weak infrastructure spending in Mexico. Exports continue to grow and perform in line with our expectations. With that, I'll open the call for questions. Operator, please open the line.

Operator (participant)

Thank you. As a reminder, to ask a question, you will need to press star one on your telephone. To withdraw your question, press the pound or hash key. Please stand by while we compile the Q&A roster. And your first question comes from the line of Mike Halloran from Baird. Your line is open.

Morning, everyone. This is, Pez on for Mike this morning.

Scott Cottrill (EVP, CFO, and Treasurer)

Morning.

If we could start with Infiltrator, the sales contribution and EBITDA margin was impressive. Can you speak to the sustainability of that margin going forward? And then secondarily, now that you're two months into having the Infiltrator contribution, can you maybe talk about what you're seeing as you've gotten a closer look under the hood? I know that you guys have a deep relationship with these guys going back about 15 years, but maybe, if you could talk about what you're seeing under the hood as well.

Scott Barbour (President and CEO)

I think I'm gonna take the second question first about under the hood, because I think it speaks a bit to the sustainability of the profitability of the business. You're right. We know these guys well, organizationally and individually, and they are everything that we thought they were and more. The Infiltrator team, Roy Moore and his team, are very solid operators, very execution-focused, and just total pros in every respect. And given that, you know, they've built a business over a long period of time, and many of these guys have been there quite a long period of time, they've built a business that has a lot of sustainable features in it, and I'll just mention a couple of them.

One, to replicate the technology in both injection molding and in design of product, really hard to replicate. Lot of expertise, lot of intellectual property, lot of capital, just raw capital dollars in that, that would be-

... hard to just do a knockout blow on them. You know, you could hit them around the edges, but hard to be a knockout blow on them. They back that up with tremendous engineering skills, not only in the product design, in the machinery and automation piece, but in the material science piece. And I think when you add those kinds of things together, it shows you that they have a very sustainable profit margin. Because they use a lot of recycled material, not as volatile as the virgin. You know, they have very good execution, so their kind of conversion is very steady. It's basically kind of in one big campus or a set of facilities in Kentucky, so they can really kind of keep their eye on it.

And because of their scale across the country, in on-site septic, you're not gonna replicate taking, you know, all those distributors away from them at one time or for that matter, systematically. You're not gonna sneak up on them. And there's not an obvious thing, technology replacement for what they do. Now, that leads to, you know, some of the real benefits under the hood that we're seeing, which is, as we expected, a lot of opportunities for ADS as a big recycler and Infiltrator as a big recycler, using, you know, different materials, but some common materials, to work together to gain better scale in materials recycling and materials sciences.

And frankly, that's what we spend probably 80+% of our time together on, is working those programs, and that'll be what fuels these synergy programs going forward. And many are already, you know, in motion, in production or in very good engineering stages.

Great. That, that color is really helpful. Thank you. Now, kind of looking back at some of the commentary around construction trends, can you maybe discuss a little bit more and provide perhaps a little bit more color on what you're seeing in some of those underlying trends across markets? And then, you know, maybe a little bit more color on the trajectory of those trends into 2020.

Mm-hmm. So we see we continue to see good construction activity in what we call the Crescent states. You know, starting in the Mid-Atlantic, coming down the coast across Florida, the Southeast Texas, and on up southwest into California. You know, we're highly focused on those states, other key pockets like Denver, Columbus, Minneapolis, and we continue to see good quoting and order activity in those areas. Now, this is the part of the year where seasonally things slow down, and we're seeing seasonal, but the underlying trends in the market, we're affirming today and continue to see those into next year.

I kind of think of it this way, you know, low interest rates, good consumer confidence, you know, probably government actions that aren't going to do anything to upset the economy before the election. I mean, there's still that runway there that we're gonna work hard and view as favorable as we go through 2020, into calendar year 2020.

Great. That's really helpful. Yeah, thank you. That's, that's exactly what I was referring to. And then moving to ag, obviously a pretty dramatic shift in expectations from, you know, flat to low single digits to double digits. And some of the trends that you are experiencing are certainly better than what some of the other companies that play in ag markets are discussing. Can you maybe talk about and give a little bit more color on the outperformance and how we should think about that kind of going forward as well into calendar 2020?

We've rode it hard down, so we're kind of enjoying riding it up right now. I have to be very honest with you. I think there's a couple of things going on in the agriculture segment business line for us right now. The biggest, and I would say this is 80% of the improvement, is these prevented plant acres. Remember there was a wet spring, you know. I think if you didn't plant by June 15th or June 8th, you could go into a program and get some assistance on acres you chose not to plant.

Right.

That, though, the epicenter of those prevent plant acres are in Northwest Iowa, Southwest Minnesota, Northwest Ohio, where we have factories and good ag participation, good ag visibility. So we were clearly a benefit from that program. Where acres were not planted, they chose to do a fair amount of drainage work and tiling. So that's-

Okay

... that's probably 80% of it. 20% of it is, you know, we reorganized. You know, we've got different organizational leadership working several different programs with us in some focused areas and with focused accounts. We have a new product that we've done very well with this year, and is gonna be over $1 million this year, and was just hundreds of thousands last year. So we have done some things, too. I want our team to take some credit for really good, hard work. Now, we got a bit fortunate with this, and but we'll take it, 'cause I think we got some misfortune at various times. Now, I think you also spun in there looking forward. You know, as I look into next year, it's gonna be hard to recreate-...

that same environment that we got from the prevented plant acres and all that kind of stuff. But what I'll do is I'll kind of, you know, take out, you know, some reasonable amount of that, and then I have an expectation that kind of on a normalized basis, we ought to be going up $5 million-8 million in that segment, you know, 5%, 6%, 7%. And that's what I'll challenge our team to do as we go and put our, put in our plan for next year. Because I do think that there are growth areas in that market, regionally, new products and new service opportunities for us. Because a big part of what we do there is service-related. It's this transportation and logistics we do of these products to the fields and tiling contractors.

Great. That, that's really helpful. Thanks, thanks for that. And then, I guess, I guess last question from me, and just a couple quick modeling ones. Now if we're thinking about segmentation, do you plan on reporting Infiltrator as a separate segment on a go-forward basis? Or were we trying to, were you trying to maybe strip it out just to emphasize legacy versus Infiltrator performance in the quarter? And then, I'll follow up with a second one after that.

Yeah, the current plan right now is to keep Infiltrator as a separate segment.

Great, okay. And then secondarily, should we be thinking about depreciation, D&A this quarter, as the correct quarterly run rate going forward?

No. The way to think about run rate, once we get done with our purchase accounting adjustments and so forth, Infiltrator will probably be somewhere around a $60 million clip. A lot of that's amortization of the identifiable intangibles. About $475 million will go on the balance sheet for those. So you got about $60 million of D&A for Infiltrator on a run rate basis, and then you've got-

Okay.

The historical guess number of $70 million-$75 million, so about $130 million-$135 million all in.

Great. Thank you so much. Thanks for the help this morning, guys, and I'll pass it on.

Okay, thanks.

Operator (participant)

Thank you. Your next question comes from the line of Matthew Bouley from Barclays. Your line is open.

Christina Xu (Investment Banking Associate)

Hi, this is actually Christina Xu on for Matt. My first question's on the raised guidance of about $15 million. Was the guidance raise just reflective of a, you know, stronger second quarter, or do you have a stronger outlook for the second half?

Scott Barbour (President and CEO)

It's everything, Christina. When you looked at, again, our performance and the drivers thereof, we see continued strength all the way from the top line and outgrowing kind of our performance last year, our performance in the markets, all the way from our pipe to our allied products. You look at what's going on with how we've been doing in our pricing and our resin costs, you know, we kind of talk to those together as our net spread. Again, we continue to see favorability as we look at the back half on a year-over-year basis. Our transportation efficiencies are starting to come through, so those are factored in, and our manufacturing guys have a lot of initiatives that are in flight, and we're just starting to see some of those come through.

So I'd tell you right now, it's every one of those items factored into our updated guidance, as well as the fact that we're investing in our sales group and our organization to support some of our strategic growth initiatives. So you got to bundle them all together, but and that's what we did, and that's how we looked at it to come up with the guidance raise that we went out with.

Christina Xu (Investment Banking Associate)

Okay, great. And could you also provide just an update on what you're seeing in your international markets, seeing as those sales are still pretty soft? And particularly in Mexico, have you made any progress on making up for performance slowdowns with, you know, losses from losses of those publicly funded projects? And in Canada, is there any sign of a recovery in sight?

Scott Barbour (President and CEO)

Let me tackle Mexico first.

Christina Xu (Investment Banking Associate)

Yes.

Scott Barbour (President and CEO)

You correctly said it, that there's a big downdraft in public spending in our area, in infrastructure. The new government has swung their spending priorities into other places. I don't think that's gonna return in this administration, and it's gonna be very difficult to make that happen. That won't happen over the next couple of years. So we need to pivot to private construction. We need to pivot to different areas of the country, where you will see some investment. And that's a matter of kind of redeploying sales, redeploying distribution, and we are in the you know, the first third of the game there. And that's gonna be a two-year...

To reposition your sales and distribution from the public to the private is gonna be not an easy hill to climb. So I think that one is a little bit longer, you know, longer term. Canada, the construction market is pretty soft in Ontario and Quebec. That's half of our sales. It's where we've been putting a lot of our focus on growth. That'll I think that'll kind of smooth out. We're gaining some participation there with our allied products. The agriculture has been good in Ontario, poor in Quebec. I think overall, our agriculture business in Canada, again, about half of our sales up there, is a much better environment than it was two years ago, just in the market competitively. And so I think that will be steady and okay.

I think that's a matter of, you know, executing our market share model, executing in our factories to our plans, and paying attention to our P's and Q's. Now interestingly, our export business, a little, you know, not quite as big as the other two, is growing like a weed, and we will be, you know, putting some more resources on that to kind of stimulate that growth a bit. So that between those three things, those are our work items in our international business right now.

Christina Xu (Investment Banking Associate)

Okay, thanks for taking the questions. I'll pass it on.

Scott Barbour (President and CEO)

Okay.

Operator (participant)

As a reminder, that's star one if you would like to ask a question. We have no further questions. I will turn the call back to Scott Barbour for closing remarks.

Scott Barbour (President and CEO)

All right. Thanks. We appreciate all of you joining us today. We appreciate the questions. We're off to a great start through the first half of fiscal 2020, and we expect to continue the momentum we have as we move forward. We're focused on our strategic initiatives and the continued integration of Infiltrator. We remain committed to the execution of our three-year plan, as we continue providing best-in-class water management solutions to our customers and maximizing shareholder value. Thanks again to our employees for all their hard work. It's been great to get to know the broader Infiltrator team, and together, we look forward to another strong quarter and a good year. And we certainly do, again, appreciate the participation in the call today. Operator, that concludes our call. Thanks.

Operator (participant)

Thank you. Ladies and gentlemen, thank you for your participation. This concludes today's conference call, and you may now disconnect.