Core & Main, Inc. (NYSE:CNM) Q2 2023 Earnings Call Transcript

Core & Main, Inc. (NYSE:CNM) Q2 2023 Earnings Call Transcript September 6, 2023

Core & Main, Inc. beats earnings expectations. Reported EPS is $0.75, expectations were $0.65.

Operator: Hello, everyone, and welcome to the Core & Main Second Quarter 2023 Earnings Call. My name is Bruno, and I’ll be operating your call today. [Operator Instructions] I will now hand over to your host, Robyn Bradbury. Please go ahead.

Robyn Bradbury: Thank you. Good morning, everyone. This is Robyn Bradbury, Vice President of Finance and Investor Relations for Core & Main. We are thrilled to have you join us this morning for our second quarter earnings call. I am joined today by Steve LeClair, our Chief Executive Officer, and Mark Witkowski, our Chief Financial Officer. Steve will lead today’s call with a business update, followed by an overview of our recent acquisitions. Mark will then discuss our second quarter financial results and full year outlook followed by a Q&A session. We will conclude the call with Steve’s closing remarks. We issued our second quarter earnings press release this morning and posted a presentation to the Investor Relations section of our website.

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As a reminder, our press release, presentation and the statements made during this call include forward-looking statements. These statements are subject to risks and uncertainties that could cause actual results to differ from our expectations and projections. Such risks and uncertainties include the factors set forth in our earnings press release and in our filings with the Securities and Exchange Commission. We will also discuss certain non-GAAP financial measures, which we believe are useful in assessing the operating results of our business. A reconciliation of these measures can be found in our earnings press release and in the appendix of our investor presentation. Thank you for your interest in Core & Main. I will now turn the call over to Chief Executive Officer, Steve LeClair.

Steve LeClair: Thanks, Robyn. Good morning, everyone. Thank you for joining us today. If you’re following along with our second quarter investor presentation, we’ll begin on page 5 with a brief business update. Core & Main delivered another quarter of solid results as we maintain our focus on driving operational excellence across the business. Sales of $1.9 billion were equal to last year’s record high, and up 43% from the second quarter of fiscal 2021. End market demand has largely performed as expected through the first half of the year. Municipal repair and replacement demand has been resilient, supported by healthy municipal budgets, and increased water and wastewater utility rates. Residential construction has been soft compared to last year’s strong performance.

We are optimistic for the second half of the year, as there continues to be a limited supply of developed lots, and builders look to invest in lot developments for continued demand from homebuyers. The non-residential market was probably flat through the second quarter. However, we are beginning to see pockets of softness for new project starts in select markets. Despite the potential for near-term softness in non-residential starts, our broad exposure to various project types within this market generally provide stability as demand for these projects can happen on different cycles. The need for more robust water management solutions remains highly relevant due to the increasing effect of extreme weather events and water scarcity. Core & Main is well positioned to capitalize on these trends over the long term due to our size, scale, and technical expertise across the water sector.

We delivered strong adjusted EBITDA margins of 14.5% for the second quarter through our disciplined pricing and gross margin execution. Prices have sustained through the first half of the year, in part due to the non-discretionary nature of demand in our industry, coupled with the fact that most of our products are either highly specified or made specific for our sector, which provides a resilient pricing framework in our industry. Overall, we expect a slightly positive impact from pricing for the full year as we continue to anniversary the prior year price increases. Gross margins exceeded expectations yet again as we execute on our gross margin initiatives and continue to benefit from our prior inventory investments. We expect gross margins to continue normalizing in the second half of the year, as our inventory costs catch up with market prices.

We generated robust cash flow in the second quarter from our inventory optimization efforts, creating balance sheet capacity to reinvest in the business, pursue strategic M&A, and return capital to shareholders. To that end, we executed a $141 million share repurchase from our majority shareholder during the second quarter, reducing diluted share count by 5 million shares. This marks our second share repurchase transaction this year, having deployed over $470 million of capital and retiring 20 million shares. Turning to our recent acquisitions on page 6, we added two high performing businesses to our family during the quarter, generating annual net sales of approximately $100 million on a combined basis. Foster Supply is a leading producer, installer, and distributor of specialty precast concrete products, storm drainage, and other erosion control solutions, operating out of seven locations across Kentucky, Tennessee, and West Virginia.

Since 1981, The team at Foster Supply has been the partner of choice for contractors and municipalities, seeking innovative solutions for unique worksite and infrastructure challenges. Bringing that team to Core & Main will allow us to combine our collective expertise and differentiated product and service offerings to meet the needs of our shared waterworks and geosynthetics customers. Dangelo was a leading provider of fire protection and waterworks products with three locations in Southern California. Since 1987, the team at Dangelo has provided underground and fire protection contractors with an extensive product and service offering. including water, sewer, storm drainage, and other related products. The breadth of knowledge, dedication to outstanding customer service, and complimentary product offering gained through this acquisition will greatly enhance our presence and service capabilities in Southern California.

Both of these businesses offer an expansion into new geographies, enhance our product lines, connect key talent, while aligning with our strategy of advancing reliable infrastructure. We are committed to driving sustainable growth through M&A. And we look forward to adding more high-quality businesses like these to the Core & Main family moving forward. Turning to page 7. I’ll now discuss how we are well positioned to win in our industry. We play a critical role to supply chain by connecting a large and diverse set of suppliers with a highly fragmented customer base. Our customers benefit from our technical expertise, customer service, purchasing capabilities, product [prep], and availability, and the convenience of our branch locations which allows us to provide consistent and timely delivery.

Combined, these capabilities provide advantages relative to smaller local competitors, and allow us to attract business from large multi-regional contractors and municipalities with more complex projects. Our suppliers recognize our value proposition to customers, and we believe they increasingly view us as an integral partner given our ability to extend their sales and geographic reach with deep technical knowledge of local specifications. This enables us to benefit from favorable supplier agreements and product availability as well as opportunities for product line exclusivity and restrictive distribution arrangements. These exclusive and restrictive distribution rights limit new entrants into our industry and provide a significant and sustainable competitive advantage.

At the local level, our branches carry a range of product lines, brands, and inventory levels tailored to local specification to effectively respond to our customer’s project needs. Our associates are specifically trained in project scoping and planning, often performing digital takeoffs by curating a product list and custom solution, leveraging our regional and national network of product specialists to develop a solution tailored to our customer’s needs. We complement this knowledge and sales expertise with our proprietary technology platforms that incorporate decades worth of experience and insights into customer’s planning and sourcing needs. Our proprietary bidding platform and online customer portals build customer loyalty by facilitating a more seamless bidding, planning, materials management, and delivery experience.

We also prioritize investments in the development and well-being of our people. Our award-winning training programs enable us to accelerate development of our top talent to drive profitable growth while maintaining a supportive and mission-driven culture. Our dedication to developing industry leaders allows us to track and retain the most qualified and motivated individuals in our industry. In addition, we provide attractive career growth opportunities to our associates while utilizing their knowledge and local expertise. The role of the specialized distributor within the value chain is becoming increasingly important as our fragmented customer base demands higher levels of availability across a broad set of products, which are procured from a large number of suppliers.

As our industry becomes more complex with new regulations and product specifications, our scalable competitive advantages position us to win over our smaller local competitors. Before I turn the call over to Mark, I’d also like to announce that we’re hosting our inaugural Investor Day in New York City on October 4th. The event will be hosted both in-person and virtually, and we plan to present our business strategy, growth drivers, and financial objectives. If you have any questions about the event, please reach out to us through our Investor Relations team. With that, I will now turn it over to Mark to discuss our financial results and full year outlook. Go ahead, Mark.

Mark Witkowski: Thanks, Steve. I’ll begin on page 9 with highlights of our second quarter results. We reported net sales of roughly $1.9 billion for the quarter which was in line with the prior year period and consistent with our expectations. This follows very strong comparative performance in the prior year, when net sales grew 43% compared with the first quarter of fiscal 2021. In aggregate, price contributed low single-digit sales growth, while organic volumes were down mid-single digits. Acquisitions are performing well and contributed approximately 3% to net sales on a year-over-year basis. Gross margin of 26.9% was consistent with the prior year period and our performance reflects the execution of our margin enhancement initiatives and the benefit of accretive acquisitions, offset by selling higher cost inventory compared with the prior year.

As we have discussed in prior quarters, we expect gross margin to normalize in 2023 as our inventory costs catch up with market prices, and we have already seen a sequential gross margin reduction from last quarter. Selling, general and administrative expenses increased 4% to $238 million for the second quarter. The increase in SG&A reflects the impact of cost inflation and acquisitions. SG&A as a percentage of net sales increased 40 basis points 12.8%. Interest expense was $22 million for the second quarter compared with $17 million in the prior year period. The increase was due to higher variable interest rates on the unhedged portion of our senior term loan. We recorded income tax expense of $40 million for the second quarter compared with $38 million in the prior year period, reflecting effective tax rates of 19.6% and 17.3% respectively.

The increase in the effective tax rate was due to a decrease in partnership interests of Core & Main holdings held by non-controlling interest holders. We recorded $164 million of net income in the second quarter compared with $182 million in the prior year period. The decrease was due to SG&A, higher interest expense and higher income taxes. Diluted earnings per share in the second quarter was $0.66, down 2% compared with the prior year period. The decrease in earnings per share was due to lower net income, partially offset by lower share counts following the repurchase of 20 million shares. Adjusted EBITDA decreased 3% to $270 million and adjusted EBITDA margin decreased 40 basis points to 14.5%. The decrease in adjusted EBITDA margin was due to an increase in SG&A.

Turning to page 10. We delivered robust operating cash flow in the second quarter of $282 million, reflecting over 100% conversion from adjusted EBITDA. We continue to benefit from the inventory optimization we started in the middle of last year, generating $150 million of cash from inventory this quarter. On a year-over-year basis, net inventory was down about 23% for the quarter, even with higher product costs, inventory acquired through acquisitions and new inventory to support our greenfields. We have generated over $700 million of operating cash flow over the last four quarters and we continue strong cash generation in the second half of the year as we continue to optimize inventory levels and experience normal seasonality. Net debt leverage at the end of the quarter was 1.7 times and our available liquidity stands at more than $1.1 billion following the capital allocation actions we took during the quarter.

The $141,000,000 share repurchase we executed in June was done concurrently with a public secondary offering of 14 million shares by our majority shareholder. As a result of these transactions, we reduced our diluted share count by 5 million shares while increasing our public float. We maintain ample liquidity and capacity to continue investing in the business, and we expect to be a consistent participant in share repurchases from our majority shareholder as opportunities arise. Before we head to Q&A, I’d like to update you on the outlook for the remainder of fiscal 2023 on page 11. Our results through the second quarter played out as expected with resilient demand and stable pricing. In terms of volume growth, municipal repair and replacement demand is expected to remain steady through the end of the year.

Residential demand is expected to be stronger in the second half than the first half as builder sentiment continues to improve and we face easier year-over-year comparisons. As Steve mentioned earlier, we are now beginning to see pockets of softness for new non-residential project starts in select markets. Based on our backlog, bidding activity and order pace, we expect the non-residential market to be down low single-digits for the year. Pricing in the second quarter was stable sequentially from the first quarter and we expect it to remain resilient in the second half of the year, resulting in a price contribution and net sales that is slightly positive for the full year. Our margin initiatives and synergies from M&A continue to drive structural gains for our gross margins.

However, we expect gross margins to continue normalizing in the third and fourth quarters as we have sold through most of our low-cost inventory. Taken all together, we are narrowing our annual outlook based on results to date. We expect net sales to be in the range of $6.6 billion to $6.8 billion and we are narrowing our expectation for adjusted EBITDA to be in the range of $850 million to $880 million due to our strong gross margin performance in the second quarter. We’re also raising our expectation for operating cash flow conversion to be in the range of 90% to 110% of adjusted EBITDA due to our accelerated inventory optimization efforts. As always, our focus will be on areas within our control, including customer service, technical expertise, productivity, and pricing execution.

We will continue to deploy capital on initiatives that we expect will result in accelerated growth, including executing on our M&A pipeline and delivering on our organic growth initiatives. We are well positioned to outperform the market in this complex demand environment, creating value for our stakeholders. We look forward to helping our customers build more reliable infrastructure as we enter a key part of the construction season. At this time, I’d like to open it up for questions.

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Q&A Session

Operator: [Operator Instructions] Our first question comes from Matthew Bouley from Barclays. Matthew, your line is now open. Please go ahead.

Matthew Bouley: Hey, good morning, everyone. Thanks for taking the questions. Maybe just one on non-resi since you called it out a few times seeing some pockets of softness. Just curious if you can elaborate on that a little bit. What exactly are you seeing across different verticals and regions? I think a decline of low single-digits for the year is perhaps a little more sanguine than we might be seeing in other areas. So just kind of curious what are some of the puts and takes around that decline of low single-digit expectations there in non-resi. Thank you.

Steve LeClair: Yeah. Thanks for the question, Matthew. Yes, as we mentioned in the comments, we really saw — it was pretty much flat and broad across the entire second quarter, but we started to see some pockets of softness. Geographically, it’s been in different pockets around the country. So we’ve certainly seen it out west, seen in pockets in the Northeast as well for non-res. And it’s possible that some of these projects are softening due to tightening lending standards. And just keep in mind that we’re really on the front edge of a lot of these things. So what we’ll be watching closely is how this shapes up with our bidding activities as we get into the back half of the year. But overall, what I would say that we’ve got pretty broad exposure to various project types, everything from commercial construction to horizontal construction with roads and bridges.

And so it generally provides stability for us, and we’ll see how these demand for these projects can happen sometimes in different cycles.

Matthew Bouley: Got it. Okay. Thank you for that. And then secondly, kind of zooming into the gross margin expectation. Just curious, you’re calling out the expectation for normalization going forward. Any color on sort of the cadence of that, Q3 versus Q4? Are we already kind of fully normalized by Q3? And then maybe if you could just kind of step back and sort of talk through some of the success you’ve been having with your structural gross margin initiatives. Thank you.

Mark Witkowski: Yeah. Thanks, Matthew, for the question. In terms of the cadence of gross margins, we’ve been pretty consistent with indicating we’re looking at about 100 basis points to 150 basis points of gross margin normalization and that was off the full year ’22 number. So you did see in the second quarter sequentially, we were down about 100 basis points off of a really strong Q1 that we had. So we’re really now based on what we’re seeing as we finished Q2, more confident that we’re going to see some of that normalization really start to happen in Q3 into Q4, probably kind of the trough at that point, maybe lingering a little bit into Q1 at ’24 and then building back off of that base as we progress through ’24. So that’s kind of how we’re thinking about it right now based on what we’re seeing and continued really good progress on a lot of our initiatives, in particular, private label continues to accelerate.

We did see continued benefit in this quarter and expect that to continue through the balance of the year and into 2024 based on the products that we expect to continue to have available there for that particular initiative. I’d say still pretty early innings on a lot of our pricing initiatives. I do expect we’ll start seeing some benefits from those later this year and into ’24. That’s — those are really the key items at this point.

Matthew Bouley: Great. Thanks, Mark. Thanks, Steve. Good luck, guys.

Steve LeClair: Thanks, Matthew.

Operator: Our next question comes from David Manthey from Baird. David, your line is now open. Please proceed.

David Manthey: Thank you. Good morning, everyone. First off, to clarify, Mark, I believe you just said that you’re expecting 100 to 150 basis points of gross margin retrenchment up to 27% annual level last year, the level closer to 28% in the first quarter here, notwithstanding. So you’re implying that gross margin on a quarterly basis should trough hopefully, by the fourth quarter of this year in that 25.5% to 26% range and then build from there. Is that your expectation?

Mark Witkowski: Yeah, Dave, that’s fair. That’s how to think about it and do expect that to really kick in, in Q3 into Q4. And depending on the progress we make on more of these initiatives, hopefully building off that base as we get into early 2024.

David Manthey: Okay. And then second, if you could talk about the status of the [IIJ] (ph) dollars moving into state revolving funds. Are the most nimble of your municipalities already accessing those dollars? And — how should we think about fiscal year end with the federal in September, certain municipalities are June or December, I mean, could you talk about how those dollars are flowing, how you expect them to build up from here?

Steve LeClair: Yes, Dave, this is Steve. So we really haven’t seen much through second quarter. We started to see some signs in the first quarter of a couple of projects, treatment plant projects and some lead service line replacements, a handful of them, and really didn’t see much at all evolve from there in the second quarter. So we do think this is going to be a tailwind. It’s hard to tell how this stuff is going to fall into a lot of these bigger municipalities. What I would tell you is that we’re certainly seeing that the current administration is really trying to build some urgency on this to get these dollars out to projects and see that start flowing. So we’ll see kind of how it plays out. But as of right now, it just — it has been slow to come, and we just haven’t seen it trickle through the way we would have anticipated for the back half of the year.

David Manthey: Thank you very much.

Steve LeClair: Thanks, Dave.

Operator: Our next question comes from Kathryn Thompson from Thompson Research. Kathryn, your line is now open. Please proceed.

Brian Biros: Hey, good morning. This is actually Brian Biros on for Kathryn. Thank you for taking my questions. On the non-res outlook, can you just touch more on the type of projects that you’re seeing softness in, if it’s light versus heavy non-res or if it’s office or something else? Just any additional color on the types of projects would be helpful.

Steve LeClair: Yeah, Brian. What we’re seeing is certainly the multifamily projects, which we categorize into the non-res has been where we’ve seen a lot of softening happen. Manufacturing continues to move forward. We’re seeing some early signs right now of large data centers that are being scoped out. So we do think that there’s certainly some things on the horizon that are coming. But obviously, the multifamily piece has been an area that’s really softened in this last quarter.

Brian Biros: Okay. Makes sense. And I guess touching on the other ones you mentioned, the manufacturing, data centers, kind of maybe fits into the mega project category that seems to be a trend going forward for a long time. Where can Core & Main kind of grow in that mega project trend when there’s more than just the non-res, but there’s also just kind of all the stuff going around the project, if it’s infrastructure, even residential built out for that. How does Core & Main see growing in the mega project trend going forward? Thank you.

Steve LeClair: Yeah. There’s a number of pockets where we participate in. Certainly, the most obvious is when we get into these mega projects and the fire protection systems, the commercial construction that goes up, the underground work that goes in there. And then also, there is an immense amount of storm drainage activity that goes into preparing a lot of these commercial lots and facilities. So a lot of the regulatory changes that have come in place about retaining and detaining storm water from preventing it from a quick release into the systems, that product category has been really big for us and the ability to provide that product and train a lot of our contractors on how to install that has been instrumental. So we definitely participate in a lot of those areas in addition to the project and the surrounding areas as well.