Mueller Water Products, Inc. (NYSE:MWA) Q1 2023 Earnings Call Transcript February 3, 2023
Operator: Welcome and thank you for standing by. This call is being recorded; any objections you may disconnect at this time. I’ll now turn the call over to Whit Kincaid.
Whit Kincaid: Good morning, everyone. Thank you for joining us on Mueller Water Products’ First Quarter 2023 Conference Call. We issued our press release reporting results of operations for the quarter ended December 31, 2022, yesterday afternoon. A copy of the press release is available on our website, www.muellerwaterproducts.com. Scott Hall, our President and CEO; and Martie Zakas, our CFO, will be discussing our first quarter results and outlook for 2023. This morning’s call is being recorded and webcast live on the Internet. We have also posted slides on our website to accompany today’s discussion which address our forward-looking statements and non-GAAP disclosure requirements. At this time, please refer to Slide 2. This slide identifies non-GAAP financial measures referenced in our press release, on our slides and on this call.
It 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 3 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 our forward-looking statements. Please review Slides 2 and 3 in their entirety. During this call, all references to a specific year or quarter, unless specified otherwise, refer to our fiscal year which ends on September 30. A replay of this morning’s call will be available for 30 days at 1800-876-4955.
The archived webcast and corresponding slides will be available for at least 90 days on the Investor Relations section of our website. I’ll now turn the call over to Scott.
John Hall: Thanks, Whit. Good morning, everyone. Thank you for joining us for our first quarter earnings 2023 call. I’m pleased with our solid start to this year. We again generated a double-digit increase in consolidated net sales as we benefited from past pricing actions taken to help offset inflationary pressures. The improved price realization was partially offset by a modest decrease in overall volumes in the quarter. Although our brass production levels did improve sequentially, lower production levels compared with the prior year contributed to the decrease in volumes. We believe the municipal repair and replacement market remains resilient and helped partially offset the slowdown in residential construction activity.
As our end markets evolve in this economic environment, we are working closely with our channel partners to manage inventories and order levels. We sequentially improved gross margins in the quarter as higher price realization, combined with a lower level of inflation and better manufacturing performance more than offset lower volumes. While the inflationary pressures have eased, they are still elevated compared with the prior year, leading us to implement additional price increases. Our teams remain focused on delivering the benefits from our large capital projects, particularly the ramp-up of our new brass foundry. We are seeing operational improvements at our Kimball facility as our specialty valve products delivered the strongest year-over-year growth in the quarter.
We believe we are on track to achieve the operational improvements needed to increase margins in the second half of this year. While we are pleased with our first quarter results, we also remain vigilant in this environment and are reiterating our annual guidance. After Martie discusses our financial results, I’ll provide more color on our first quarter performance, end markets and outlook for 2023. Now, I’ll turn the call over to Martie.
Martie Zakas: Thanks, Scott and good morning, everyone. I will start with our first quarter 2023 consolidated GAAP and non-GAAP financial results. After that, I will review our segment performance and discuss our cash flow and liquidity. Our consolidated net sales increased 15.6% to $314.8 million compared to the prior year, with growth in both Water Flow Solutions and Water Management Solutions. The increase was primarily due to higher pricing across most product lines in both segments and volume growth across most products and Water Management Solutions. These benefits were partially offset by a decrease in volumes at Water Flow Solutions. Gross profit of $93.2 million, increased 6.4% compared with the prior year. However, gross margin of 29.6%, decreased 260 basis points compared with the prior year as benefits from higher pricing were more than offset by increased cost associated with unfavorable manufacturing performance, inflation and lower volumes.
We sequentially improved our gross margin by 380 basis points in the quarter. The unfavorable manufacturing performance which includes the impact of outsourcing, machine downtime, supply chain disruptions and labor productivity, was primarily driven by our foundry operations. The negative impact of inflation improved sequentially. However, we continue to experience higher costs associated with raw and purchased materials, utilities, freight and labor relative to the prior year. Our total material costs increased around 8% compared with the prior year. Our price realization again improved sequentially, more than covering inflationary pressures for the fourth consecutive quarter. Selling, general and administrative expenses of $62.9 million in the quarter, increased 11.7% compared with the prior year.
The increase was primarily driven by personnel costs, third-party services, inflation and T&E expenses, partially offset by foreign exchange gains. SG&A as a percent of net sales decreased to 20% as compared to 20.7% in the prior year quarter. Operating income of $34 million, increased 17.6% in the quarter compared with $28.9 million in the prior year. Operating income includes a net benefit of $3.7 million from strategic reorganization and other charges in the quarter. The net benefit primarily consisted of a $4 million pretax gain on the sale of the Aurora, Illinois facility. This gain was partially offset by transaction-related expenses. Turning now to our consolidated non-GAAP results. Adjusted operating income of $30.3 million, decreased $1 million or 3.2% compared with $31.3 million in the prior year.
The benefits from higher pricing were more than offset by increased costs associated with unfavorable manufacturing performance, inflation, additional SG&A expenses and lower volumes. Adjusted EBITDA of $44.2 million, decreased 6.9% in the quarter, leading to an adjusted EBITDA margin of 14% compared with 17.4% in the prior year. As a reminder, adjusted EBITDA was also impacted by a year-over-year increase in pension expense of $1.9 million in the quarter. Net interest expense for the quarter declined to $3.7 million as compared with $4.3 million in the prior year. The decrease in the quarter primarily resulted from higher interest income. For the quarter, we generated adjusted net income per share of $0.13 which was flat compared with the prior year.
Moving on to the quarterly segment performance, starting with Water Flow Solutions. Net sales increased 6.9% compared with the prior year, primarily due to higher pricing across most of the segment’s product lines. We experienced lower volumes primarily for our gate valve and service brass products which were partially offset by higher volumes for specialty valve products. Adjusted operating income of $24.2 million, decreased 22.7% in the quarter. Benefits from higher pricing were more than offset by increased costs associated with unfavorable manufacturing performance, primarily at our foundry operations, lower volumes and inflation. Adjusted EBITDA of $31.9 million, decreased 17.6%, leading to an adjusted EBITDA margin of 19.3% compared with 25% last year.
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Turning to Water Management Solutions. Net sales of $149.2 million, increased 27.1% as compared with the prior year. This increase was primarily due to higher pricing across most of the segment’s product lines and increased volumes, mainly in hydrant and water application products. Adjusted operating income of $19.6 million, increased 70.4% in the quarter, benefits from higher pricing and volumes more than offset increased costs associated with unfavorable manufacturing performance, primarily at our foundry operations, inflation and additional SG&A expenses. Adjusted EBITDA of $26.6 million, increased 38.5% in the quarter, leading to an adjusted EBITDA margin of 17.8% compared with 16.4% last year. Moving on to cash flow. Net cash used in operating activities for the quarter ended December 31, 2022, was $6.5 million compared with $19.8 million of net cash provided by operating activities in the prior year.
The decrease was primarily due to an increase in inventory. Average net working capital using the 5-point method as a percent of net sales increased to 28.2% compared with 25.4% in the first quarter of last year, primarily due to higher inventory levels. During the quarter, we invested $9.9 million in capital expenditures compared with $11 million in the prior year. Free cash flow for the quarter was negative $16.4 million compared with positive $8.8 million in the prior year, primarily due to the decrease in cash provided by operating activities, partially offset by lower capital expenditures. We did not repurchase any common stock. And as of December 31, we had $100 million remaining under our share repurchase authorization. At December 31, 2022, we had total debt of $447 million and cash and cash equivalents of $125.6 million.
At the end of the first quarter, our net debt leverage ratio was 1.7x. We did not have any borrowings under our ABL agreement at quarter end nor did we borrow any amounts under our ABL during the quarter. As a reminder, we currently have no debt maturities before June 2029. At December 31, 2022, we had $288 million of total liquidity, giving us ample capacity to support our strategic priorities, including acquisitions. Scott, back to you.
John Hall: Thanks, Martie. I’ll now comment on our first quarter performance, end markets and full year 2023 outlook. After that, we’ll open the call up for questions. As mentioned earlier, we are pleased with our solid start to the year. While we sequentially improved gross margins in the quarter, our margins were below the prior year. We continue to be pleased with our price realization which more than offset inflationary pressures for the fourth consecutive quarter. As expected, unfavorable manufacturing performance, primarily at our foundries, partially offset the benefits from higher pricing in the first quarter. Unfavorable manufacturing performance was impacted by lower production, primarily at our Chattanooga and Decatur foundries, leading to under-absorption of labor and overhead.
Our Chattanooga foundry which is focused on gate valve production, delivered lower volumes due to fewer production days relative to the prior year, primarily driven by increased planned maintenance over the Christmas period. Our melt production at our Decatur foundry increased sequentially. However, it was more than 30% below the prior year. Our teams made progress on the operational challenges at the foundry with improved machine uptime contributing to the sequential increase in melt production. The ramp-up of our new brass foundry is well underway. We have 2 lines working through the production parts approval process, prioritizing our highest volume parts, including parts used in our hydrants and gate valves. We are working through the new casting and machining processes and expect to begin shipping the initial parts using the new alloy later this quarter.
I am pleased to share that Mueller product utilizing components manufactured at the new foundry will continue to be certified under NSF 61 for drinking water system components through underwriters laboratories. This certification is crucial to ship products containing parts with the new alloy to customers. With elevated backlogs, our teams remain focused on improving production levels, to reduce lead times and satisfy orders, especially for our hydrants and brass products. We continue to experience higher costs year-over-year, primarily related to outsourcing materials, machining and maintenance. We expect these headwinds to carry on into the second quarter as well as the second half of the year. Increasing brass production levels from both foundries will ultimately allow us to bring some production back in-house and lower costs.
As backlog levels normalize and our new brass foundry begins shipping product, we anticipate decreasing the use of outsourcing. Additionally, we are working to add shifts at our Albertville Foundry to increase internal production for key hydrant parts. We’ve already mentioned the sale of assets associated with the closure of our Aurora facility. We are pleased that we now have completed the divestment of all the locations from which operations have transitioned to the new Kimball, Tennessee facility. Our specialty and large vial CapEx investments are continuing to ramp up this year and we expect the margin benefits to follow accordingly. During the first quarter, our specialty valve products delivered the strongest year-over-year growth of all of our product lines which resulted in a sequential and year-over-year improvement in gross margin.
I will now briefly review our end markets. As mentioned earlier, we believe the municipal repair and replacement market remains resilient, helping partially offset the slowdown in residential construction activity. For the municipal repair and replacement market, we remain excited about the benefits of the Infrastructure Bill starting to take effect later this year. The first wave of distributions have taken place with additional guidelines from the EPA regarding the Build America Buy America domestic sourcing requirements. This further supports the strategic rationale for all 3 of our large capital projects. As domestic sourcing requirements for iron and steel products increase, we believe we will be well positioned with our increased domestic capacity for our larger valve and service brass products.
Looking at the new residential construction market. Total housing starts were down 15.6% year-over-year during our first quarter with around 1.4 million seasonally adjusted annual rate in December. We expect construction activity to pick up in the spring relative to our first quarter which is the typical seasonality of our core products. For fiscal 2023, we continue to forecast that total housing starts will be in the 1.3 million to 1.4 million range. While we expect higher interest rates and economic uncertainty to continue to impact residential construction, we believe lot inventories remained relatively low. Moving on to our outlook for 2023. As expected, we experienced a slowdown in order activity during the first quarter. While our total backlog decreased sequentially, we continue to have an elevated backlog, especially for shorter cycle products like service for and hydrants.
With product lead times and project timelines improving, we anticipate our backlog levels could normalize over the coming quarters, depending on end market activity. We expect to get a clearer sense of sell-through channel inventory plans and order levels as we move into the upcoming spring construction season. As mentioned earlier, we are reiterating our guidance for 2023 which we provided with our fiscal 2022 fourth quarter earnings. We anticipate that our consolidated net sales will increase between 6% and 8%. Our backlog at the end of the first quarter and the expected realization from higher pricing position us to deliver net sales growth again in 2023. We expect our adjusted EBITDA will increase between 10% and 14% as compared with the prior year, primarily driven by benefits from higher price realization and operational improvements in the second half of the year.
In closing, our teams continue to focus on maintaining our strong customer relationships while executing our top priorities for the year which include achieving operational improvements, delivering benefits from our large domestic capital investments, accelerating development and commercialization of new products and generating ongoing price realization. We are on track with the ramp-up of our new brass foundry which will have significantly more capacity to deliver the best long-term manufacturing solutions and advance our sustainability initiatives with a new led-free brass alloy. We are in a transformational period for Mueller with our large capital projects in various stages of ramping up. We believe the benefits from these projects and ongoing operational improvements will greatly enhance our position in the market.
These investments are especially important as water utilities increase needed repair and replacement projects supported by the Federal Infrastructure Bill and the requirements for domestically manufactured products. Our broad portfolio of products and solutions enable us to help water utilities address growing challenges from the aging infrastructure climate change and workforce demographics. While uncertainty from the external environment has increased, we are a much more resilient organization supported by a strong balance sheet. This gives us liquidity and capacity to continue to reinvest in our business while returning cash to shareholders, primarily through our quarterly dividend. We are confident that our growth strategies, capital investments and operational initiatives will deliver both further net sales growth and a return to pre-pandemic margins in 2025.
That concludes my comments. Operator, please open this call for questions.
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Q&A Session
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Operator: The first question in the queue is from Deane Dray with RBC Capital Markets.
Deane Dray: Maybe we can start, Scott, with your perspective on the demand dynamics in the quarter with respect to some of the order slowdowns. We’re hearing lots of commentary across the industrials about destocking and we can see what’s going on in the resi side. And in particular, you had a — there’s a pipe manufacturer yesterday that was seeing some of the same dynamics and their outlook was a lot more dire than what you’re talking about today. So just kind of frame for us the order slowdown, is this destocking? And I know there’s going to be offset from the muni break and fix but just very specifically on the resi side.
John Hall: Yes. So I think that the dynamic is as much as you described. But if you recall my comments in previous quarters, there is a big piece of this theme that is DRP driven or distribution resource planning driven. And it’s this notion that as the lead times collapse that you’ll kind of get here with this double whammy. One, the sell-through may have slowed as housing goes from that 1 5, 1 6 down to the 1 3, 1 4 range but lead times are coming down as well. And so the amount of material that’s needed in the channel continues to decline. And so what’s necessary and what’s not. So I think the end market evolution work closely with the channel partners to look at sell-through and to manage inventory and order levels will be key.
And I think that everybody is kind of looking at this spring construction season and saying, is it going to be even further down? Or will there be enough resiliency? I think that there is a tendency to be overly bearish once you start to see the negatives. But I would also point to the January jobs report which would indicate that employment levels and potentially income levels could be rising for the average American which I think would be kind of the counterpoint to the housing starts where these people enter the housing market. I think that remains to be seen. But what’s most important to us in the last 6 months is watching the balance sheets of the municipalities and how flush they are with cash still 2 years later. And I believe that, that is the counterpoint along with the emergence of more interest in the drinking water stream from governments that is going to kind of offset the kind of demand profile reduction that we’ll see from the housing market.
So we remain, let’s call it, cautiously optimistic.
Deane Dray: That’s all really helpful. And we’ve heard that whole dynamic about the slowing the pace of orders as lead times normalize. So that’s getting to be pretty familiar for us. as well. All right. So a follow-up question for Martie. Can you talk about the impact of your inventories on free cash flow because that was really well below your typical free cash flow use? Is that inventory? Is it still buffer inventory? Is this a supply chain issue? Scott just talked about how there’s less inventory in the channel, there’s destocking going on but you’re taking on more inventory. So just walk us through that, please.
