Advanced Drainage Systems Inc

NYSE:WMS

Earnings Call Transcript 2020-Q2

[Operator]

Good morning, ladies and gentlemen, and welcome to Advanced Drainage Systems Second Quarter of 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. [Operator Instructions] 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.

[Michael Higgins, executive]

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's website.

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

[D. Barbour, executive]

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 in strategic priorities. There are a couple of points. I would like to hit right upfront. 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 cost 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 and free cash flow year-to-date compared to the prior year period. This strong cash flow generation puts us well on our way to be back within our targeted guardrails of 2 to 3 times 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 physical 2020 net sales and adjusted EBITDA guidance primarily due to the strong first half performance of the legacy ADS business. Over all, 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 at 22% was driven by organic growth of 9% plus the 2-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 2 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 physical 2020 supported by favorable tailwinds including low interest rates, favorable housing, and healthy consumer confidence. Our backlog in 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're 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 and 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 in margins and 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 cost. We continue to work these familiar levers of profitability very hard. As we grow the company is important to build new leverage for improving profitability. We have been talking about transportation and logistics initiatives for several quarters and we are beginning to see these initiatives gain traction and better payload efficiency and logistics planning. We have also developed a partnership with a common carrier to narrow 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 4-wall manufacturing network. We are developing maintenance programs to improve the performance of our equipment, and are 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 6, we present Infiltrator Water Technology's 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 the 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 to $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 7, we present our capital deployment priorities, which remain focused on and investing in growth productivity and efficiency of the combined businesses, paying down the debt to get our leverage ratio back within our 2 to 3 times guardrails in the next 12 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 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 pay down.

With that, I'll turn it over to Scott, who will further discuss our second quarter performance.

[Scott Cottrill, executive]

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 in 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 high -- 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 9, 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 were further boosted by lower resin cost.

Finally, we worked hard to negotiate and better manage payment terms on our payables. All of 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 plus 225. 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 7 years from under 4 years previously, and our weighted average cost of debt has increased to approximately 4.5%.

We ended the quarter with a leverage ratio of 3.8 times on a trailing 12 month pro forma basis for both companies, our leverage ratio was 2.9 times, 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 September equity offering.

On Slide 11, we present our updated financial guidance for the combined companies in fiscal 2020, which includes 8 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 $1.6 billion to $1.650 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 the $345 million, representing growth of 40%to 49%.

These ranges represent an adjusted EBITDA margin of 20.3% to 20.9% or margin expansion of 360 basis points to 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 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]

Thank you. [Operator Instructions]. And your first question comes from the line of Mike Halloran from Baird.

[Unknown Analyst]

This is [indiscernible] on for Mike this 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 2 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?

[D. Barbour, executive]

I think I'm going to 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. They're very -- the Infiltrator team, Roy Moore and his team are very solid operators, very execution focused. And I just -- total pros in every respect. And given that, 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. To -- I'll just mention a couple of them. One, to replicate the technology in both injection molding and in design a product, really hard to replicate, lot of expertise, lot of intellectual property, lot of capital, just raw capital dollars in that. There would be hard to just do a knockout blow on them. 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, in the 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. They have very good execution, though their kind of conversion is very steady. It's basically kind of in one big campus or set of facilities in Kentucky, so they can really kind of keep their eye on it. And because of their scale across the country and onsite septic, you're not going to replicate taking all those distributors away from them at one time or for that matter, systematically. You're not going to sneak up on them.

And there is not, there's not an obvious thing technology replacement for what they do. Now that leads to some of the real benefits under the hood that we're seeing, which is, as we expected, a lot of opportunities, for ADS is a big recycler, and Infiltrator is a big recycler using different materials, but some common materials to work together to gain better scale in materials recycling and material sciences. And frankly, that's what we spend probably 80 plus percent of our time together on as working those programs and that will be what fuels these synergy programs going forward, and many are already in motion, in production, or in very good engineering stages.

[Unknown Analyst]

Great. That color is really helpful. Thank you. Now kind of looking back at some of the commentary around construction trend, 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 maybe a little bit more color of how those trends are -- the trajectory of those trends, into 2020?

[D. Barbour, executive]

So we see, we continue to see good construction activity in what we call the crescent state, starting in the Mid-Atlantic coming down the coast across Florida, the Southeast Texas, and on up Southwest into California, 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 are affirming today and continue to see those into next year. And I kind of think of it this way. Low interest rates, good consumer confidence, probably government actions are not going to do anything to upset the economy before the election. I mean, there is still that runway there that we're going to work hard in view as favorable as we go through 2020 -- in the calendar year 2020.

[Unknown Analyst]

Great, that's really helpful. Yes. Thank you. That's exactly what I was referring to. And then moving to ag obviously a pretty dramatic shift in expectations from flat to low single-digits to double digits. And some of the trends that you're experiencing -- and some of the trends that you're 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, in the calendar 2020?

[D. Barbour, executive]

Well, we wrote it hard down, so we're kind of enjoying writing it up right now. I have to be very honest with you, but I think there is 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. I think if you didn't plant by June 15 or June 8, you could go into a program and get some assistance on acreage you chose not to plant. The epicenter of those prevent plant acres are in northwest Iowa -- 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 probably 80% of it, 20% of it is, 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 it is over -- is going to be over a $1 million this year and was just hundreds of thousands, last year. So we have done some things too. I want to -- our team to take some credit for really good hard work. Now we got a bit fortunate with this, but we'll take it because I think we got some misfortune at various times.

Now I think you also spun in there looking forward. As I look into next year, it's going to be hard to re-create that same environment that we got from the prevent plant acres and all that kind of stuff. But what I'll do is, I'll kind of take out 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 bucks in that segment, 5%, 6%, 7%. And that's what our challenge our team to do, as we go and 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 the transportation and logistics we do of these products to that -- to fields and tiling contractors.

[Unknown Analyst]

Great. That's really helpful. Thanks, thanks for that. And then, I guess last question for me and just a couple of 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 what were you trying to -- were you trying to maybe strip it out to just emphasize legacy versus Infiltrator performance in the quarter? And then I'll follow up with the second one after that.

[Scott Cottrill, executive]

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

[Unknown Analyst]

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

[D. Barbour, executive]

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 is 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 the historical guess number of 70 to 75, so about 130 to 135 all in.

[Operator]

Your next question comes from the line of Matthew Bouley from Barclays.

[Christina Chiu, analyst]

This is actually Christina Chiu on for Matt. My first question is on the raised guidance of about $15 million. Was the guidance rate just reflective of a stronger second quarter or do you have a stronger outlook for the second half?

[D. Barbour, executive]

It's everything, Christina. When you look at it 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 cost, 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 in 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 rates that we went out with.

[Christina Chiu, analyst]

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

[D. Barbour, executive]

So let me let me tackle Mexico, first. You know you correctly said it that there is a big, 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 going to return in this administration and it's going to be very difficult to make that happen -- that will 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 first third of the game there, and that's going to be a 2 year. To reposition, your sales and distribution from the public to the private is going to 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 will, -- I think that will 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. It's a much better environment than it was 2 years ago. Just in the market, competitively.

And so I think that will be steady and okay. So I think that's a matter of executing our market share model, executing our factories to our plans and paid attention to our Ps and Qs. Now interestingly, our export business a little, not quite as big, as the other 2 is growing like a weed, and we are probably going to be -- we will be putting some more resources on that to kind of stimulate that growth a bit. So that -- between those 3 things, that's -- those are our work items in our international business right now.

[Operator]

[Operator Instructions]. And we have no further questions. I will turn the call back to Scott Barbour for closing remarks.

[D. Barbour, executive]

All right, thanks. We appreciate all of you joining us today. We appreciate the questions. We're off to a great start to the first half of fiscal 2020 and we expect to continue the momentum we have, as we move forward. We are focused on our strategic initiatives and the continued integration of Infiltrator. We remain committed to the execution of our 3-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]

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