Forterra, Inc. (FRTA) Q2 2019 Earnings Call Transcript

FRTA earnings call for the period ending June 30, 2019.

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Forterra, Inc.  (NASDAQ:FRTA)
Q2 2019 Earnings Call
Aug. 06, 2019, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning, and welcome to Forterra's Second Quarter 2019 Earnings Conference Call. As a reminder, ladies and gentlemen, this conference call is being recorded. Today's call is being hosted by Karl Watson, Jr., the Company's Chief Executive Officer; and Charlie Brown, the Company's Chief Financial Officer.

With that, I will now turn the call over to Mr. Brown.

Charlie Brown -- Executive Vice President and Chief Financial Officer

Thank you, and good morning to everyone. Welcome to Forterra's second quarter 2019 earnings conference call. I would like to point out that Forterra intends to take advantage of the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995, as noted in the earnings release we filed last night. In addition, we have posted an Investor Presentation on our website under Investor Relations.

Please remember that our comments today may include forward-looking statements, which are subject to risks and uncertainties, and actual results may differ materially from those indicated or implied by such statements. Some of the risks are described in detail in the Company's SEC filings, including our annual report on Form 10-K. The Company does not undertake any duty to update such forward-looking statements.

Additionally, we will refer to certain non-GAAP financial measures during the call, including EBITDA, EBITDA margin, adjusted EBITDA and adjusted EBITDA margin. You can find a reconciliation of these non-GAAP financial measures to the most direct comparable GAAP measure and other related information, including a discussion of why we consider these measures useful to our investors in our earnings release.

Now Karl will give an update on our business.

Karl H. Watson -- Chief Executive Officer

Thank you, Charlie. Good morning, everyone. We appreciate you being on the call, and I am pleased to join you for the first time. But before discussing the quarter, I want to thank Jeff Bradley for his many contributions to Forterra over the last four years. He leaves a talented team in place to capitalize on the many opportunities we have in front of us. I speak for all of us, and especially me personally, in wishing him the very best. I would also like to thank my teammates at Forterra, for so graciously welcoming me these first few weeks. It is clear you want to win and I am honored to have the opportunity to lead the Company.

The second quarter was another solid one for Forterra. Despite a slight decline in our top-line revenue, our adjusted EBITDA was in line with our expectations and was 8% higher than the same quarter last year, driven by higher gross profit and gross profit margins in both Drainage and Water businesses. With volumes essentially flat in Drainage and down in Water, our gross profit improvement was driven primarily by improved average selling prices in both Drainage and Water. Additionally, backlogs in both businesses grew in the second quarter compared to the first quarter of 2019 and this gives us confidence in the demand outlook for the balance of the year.

Having been here just a few weeks, I'm not really prepared to talk in depth about our strategy and how we're going to execute on it. However, after a few weeks, I am prepared to say one thing, we are going to sell on value and value alone as we manage our backlogs to maintain our industry leading positions. Neither Water or Drainage are commodity businesses. There are ample ways to differentiate ourselves and we plan to do just that to bring value to our employees, customers and shareholders

On the cost side, we're in the early stages of executing on various operational excellence projects to further improve per-unit productivity and more effectively manage total production cost. While this is not the first time we have talked about operational excellence, my experience is that it takes some time to gain traction all the way to the front line employees, where it makes a real difference. The initial results in operations where we have gone deep are yielding very, very impressive results.

In summary, while we have had some modest improvements in our results, there remains a very long runway of opportunities both commercially and operationally to improve the business, which the team and I are excited about getting after and more importantly, are confident in capturing.

With that, I'll hand it over to Charlie.

Thanks, Karl. I will take a moment to address our segment and consolidated results with the conclusion being, as you've already seen in our press release, that we are reiterating our full year guidance. Our Drainage segment performed well during the second quarter. Improved selling prices and better controlled costs resulted in higher gross profit and adjusted EBITDA year-over-year.

Our Water segment experienced a shortfall in revenue year-over-year, which was driven by a decline in shipment volumes. We believe shipment volumes reflect the volatility of construction project completion as well as some inventory destocking by our distributors. Thus, a timing issue, not a structural change in demand. While this has lowered our full year volume expectations, our backlog and recent bookings are encouraging.

Even more encouraging is that our higher selling prices and lower input costs more than offset the impact of lower volume and the associated cost absorption, allowing our Water segment to deliver improvements in gross profit and adjusted EBITDA. Our corporate adjusted EBITDA was in line with our internal plan for the quarter, but reflected an increase year-over-year due to favorable adjustments last year, and current year investment in the systems we use.

On a consolidated basis, we reported adjusted EBITDA of $62.5 million compared to $58.1 million in the second quarter of last year. The improvement in adjusted EBITDA is primarily driven by higher sales price and gross profit, partially offset by lower volume in Water as well as an increase in SG&A expense. While half the SG&A increase for the quarter was associated with onetime items that were removed in our presentation of adjusted EBITDA, there was a $4 million increase in SG&A associated with three items: reserves for disputes and claims, cost associated with rightsizing our business and the previously mentioned investment in systems.

Although our adjusted EBITDA improved, net income for the second quarter decreased to $3 million from $7 million in the prior quarter. This is primarily due to the recording of certain severance costs in our SG&A expenses during the current quarter. In addition we had some gains from disposition of certain idle assets in 2018, which didn't reoccur this year. You can find more discussion about our year-over-year net income changes in the Form 10-Q we filed earlier this morning.

Looking at the rest of the year, we anticipate the strength in public infrastructure spending and our positive pricing trends will continue benefiting us. The weakened shipment volume in the Water business will be offset by improvements in selling prices due to our enhanced strategic and tactical commercial processes across both businesses. Our costs will remain in line with our internal plan. Therefore, we are reaffirming our 2019 outlook forecasting adjusted EBITDA of $170 million to $200 million and voluntary prepayment of our term loan in the range of $30 million to $85 million.

That concludes our prepared remarks. Operator, will you please open the line for questions.

Questions and Answers:

Operator

Thank you. [Operator instructions] And our first question comes from Mike Dahl from RBC Capital Markets. Your line is now open.

Mike Dahl -- RBC Capital Markets -- Analyst

Hi, thanks for taking my questions. Maybe just to start out Carl just given your appointment here. I was hoping you could give us a little more detail on, I know it's early on. But as you've gotten into the role a kind of what attracted you to this opportunity. What do you see in terms of things that are being done well and what do you think needs to be done differently?

Karl H. Watson -- Chief Executive Officer

What attracted me to the role was a couple of things. One, I was with a great company, I think Tom Hill and Summit Materials are -- it's just a fantastic operation, and it was very difficult to leave. But from a personal standpoint, it was to get closer to home, and that was a large driver of it, that's the personal part. The professional part was -- what you're probably really asking is the opportunities that I see before us. I think they are largely in four broad buckets: I stress one non-financial upfront because we have a long way to go on safety and creating a culture of safety, we're already protecting our employees and their families and there is a lot of stuff we need to do around that.

The second one is, and I hate to use this word, excellence, all the time, but commercial excellence and operational excellence. Commercially, I do, for a lack of a scientific term, smell a lot of opportunities for us both strategically and tactically to sell on value and not other ways of selling. So I think there is a big opportunity there. And what we've shown is, with some -- appointment of some very solid operational guys, just how much operational improvement there potentially is.

I'd like to call out just two examples where we've already gone -- have gone deep. I said in the prepared remarks where we have gone deep, we've seen some pretty impressive results. We've spent a lot of time with one of our largest pipelines up in Stacy, Minnesota. And there is two really positive examples on two different parts of that operation. In one part of the operation, in the month of June, after spending a few months there and really getting the frontline guys involved in the lean processes, we actually produced 47 more pieces with 12% less hours on one machine. In another machine, we produced 16 more pieces with 16% less hours.

Now I don't know if that is linearly scalable to the whole organization, but it's just to show an example of what was, we thought, a well-run plant with great people, just how much improvement can actually come out of these operations if we focus. And the fourth thing is the cash generation. We have the ability to use less cash in this business, to produce the same amount of output through managing our cash cycle a little bit tighter than what we have. So those are the four big things.

Mike Dahl -- RBC Capital Markets -- Analyst

Okay, thanks. And then second question, just back on the results and the guide and maybe, Charlie, you can answer this one. But just thinking through some of the puts and takes around margins. Nice results here. How much did the quarter benefit from favorable price cost and what should we think about as far as guidance for the balance of the year, specifically with respect to how the underlying cost environment relative to pricing, how that plays out?

Charlie Brown -- Executive Vice President and Chief Financial Officer

Sure. I think, in Karl's comments, really the benefit in both sides of the business was on price. There were cost benefits. In Water, we could talk about raw material benefit. But that was somewhat offset by the absorption that as a lower volume month -- quarter, we're not able to pass all that through. So I think that cost is an area of opportunity for us, there will be, obviously, pressures from various raw materials. But from our side, I think those are pretty manageable. And to Karl's point, there is lots of operational opportunities here.

Labor, as you know, is an important component for us, being efficient with that labor and the comments that Karl just pointed out on where we've seen lean improvements, those type of improvements are incredibly important for a business like ours. So I think cost opportunities are significant. So that's the long runway ahead of us, one of the big opportunities on the operations side. On price, we delivered I think very efficiently for the quarter, definitely looking forward to continuing that trend. And from my position, I'm very encouraged by seeing these type of backlogs and bookings coming through with good pricing initiatives in place.

Mike Dahl -- RBC Capital Markets -- Analyst

Okay, great. Thank you.

Charlie Brown -- Executive Vice President and Chief Financial Officer

Thank you.

Karl H. Watson -- Chief Executive Officer

Thanks, Mike.

Operator

And our next question comes from Matthew Bouley from Barclays. Your line is now open.

Matthew Bouley -- Barclays Capital Inc. -- Analyst

Good morning, and thank you for taking my questions. I wanted to extend my welcome to Karl as well. So just on the Water side, on the volume disclosure there. It looked like you guys mentioned that there was some specific destocking related to ordering on an as-needed basis, I think it's the quote you used. And Charlie, you just made a comment that it's not structural, but I'm kind of reading that as something that might at least persist for a little bit. So, I guess one, is that the case that it would persist? And two, accordingly, should it kind of remain a headwind to year-over-year volumes, sort of, until that anniversaries next year? Thank you.

Charlie Brown -- Executive Vice President and Chief Financial Officer

I'll start off and, Karl, if you have insight, you've been on the road quite a bit with these guys, maybe you can add to that. But I would say the destocking certainly was a factor. There's a lot of things that can change the demand in any one quarter. Certainly, how projects roll-out, that is -- causes lumpy demand for our products here and as well as what is a word that I'm trying not to mention, but weather can impact us, but I'm not suggesting that was an impact to the quarter.

But finally, the impact from the -- how the distributors choose to build and reduce their inventory, that is outside of our control. What I can say is we're seeing good orders, as we've indicated on the shippings. I do think that there could be some opportunities for -- it may not be as robust as we had originally thought at the beginning of the year, but I do think that there is certainly an improvement opportunity as we go into Q3, as demand and inventories normalize. Karl?

Karl H. Watson -- Chief Executive Officer

In the last year, we did notice -- the second half of last year, we did notice our distributors stocking up. And in the first -- in the second quarter of this year, if you looked at our distribution network, it's -- our sales channel, it's about 18% to 20% direct, and 80% through the distribution. And we saw tale of two worlds there.

Our direct was actually up a little bit, and our distribution was down double digits. What we have seen though is -- just if you look at the last three weeks of July, after we came out of the break, the momentum in our shipments and our bookings is up double digits. So it's -- it gives us a lot of confidence that the second half is going to be stronger than the first half. I don't believe we're going to catch up, the hole is pretty big, but certainly that hole won't be getting any deeper.

Matthew Bouley -- Barclays Capital Inc. -- Analyst

Okay. That's perfect. I appreciate all that detail. And then for my follow-up, just on the pricing side, obviously, a pretty strong number there in Drainage specifically. It looked like it even accelerated perhaps a bit, so did you actually put any additional price increases in Drainage during the quarter? Or was that simply flow through from kind of previous price increases? Just really looking for any color on the sustainability of that type of price improvement. Thank you.

Karl H. Watson -- Chief Executive Officer

It was largely flow through. We do have some pricing initiatives in the second half in Drainage, especially in our largest market, Texas. But the second quarter was flow through from actions taken earlier.

Charlie Brown -- Executive Vice President and Chief Financial Officer

As well as we have mix obviously. As you know we have got a variety of products in a variety of regions. So that certainly was somewhat of a benefit to us as well.

Matthew Bouley -- Barclays Capital Inc. -- Analyst

Got it. All right. Thanks again, for the detail.

Operator

Thank you. And our next question comes from Jerry Revich from Goldman Sachs. Your line is now open.

Jerry Revich -- Goldman sachs -- Analyst

Yes. Hi good morning everyone. And Karl congratulations.

Charlie Brown -- Executive Vice President and Chief Financial Officer

Thank you.

Karl H. Watson -- Chief Executive Officer

Thanks, Jerry.

Jerry Revich -- Goldman sachs -- Analyst

Karl, I wonder if you could just expand on the opportunities that you see across the business to the extent that you're comfortable at this point. You mentioned commercial excellence and execution opportunities, can you just expand on each of those points and your assessment now what that opportunity could look like?

And I appreciate that it's early, so I would imagine it's going to be a qualitative discussion then followed by a quantitative discussion, a quarter or two out, I would guess.

Karl H. Watson -- Chief Executive Officer

I guess when I said in my opening comments about value and value alone, I've been in the construction materials industry now for 30-plus years and it's been a fight my entire career to run away from the dreaded word, commodity. And I guess in the first couple of weeks, I just get a sort of a sense that the definition of that word within Forterra is different than the way I define it.

And I do think we are a complete business system. And so I do believe there are commercial opportunities if we concentrate on value and the value our products provide for our customers. And approach it in that manner. And it is a bit early for me to give you specific details, unlike what I gave you specific details about operation because it is more qualitative than quantitative. But that's sort of what I get a sense of in the first three weeks, four weeks.

Jerry Revich -- Goldman sachs -- Analyst

And really nice to see strong pricing actions in both Drainage and Water segments. Can you talk about where the incoming bids are coming in compared to the price that you realized in the second quarter, and just talk about that competitive market as you see it in both businesses, please?

Karl H. Watson -- Chief Executive Officer

Jerry, could you repeat that please?

Jerry Revich -- Goldman sachs -- Analyst

Sure. Can you talk about on the incoming bids today in Drainage and Water, how does the pricing compared to what you shipped in the second quarter and how would you characterize the broader pricing environment in each business?

Karl H. Watson -- Chief Executive Officer

I would say in each business, directionally, it is up, with Water probably having a more bold arrow than Drainage on the up arrow. We have a really leading position in Water, and we're very encouraged by -- directionally, by what's happening with prices.

Jerry Revich -- Goldman sachs -- Analyst

And lastly, on the volume outlook in Water, can you just expand on the inventory destocking point? Do you know how many months of inventory your dealers are carrying? I guess, the concern is potentially the distributors are framing this as a destock move when the residential environment, at least from a start standpoint hasn't been great year-to-date. So the question is, is there a retail piece that's driving weakness for them that would be the underlying concern, if you could address that?

Karl H. Watson -- Chief Executive Officer

We believe, and I say, we believe, it's -- we have to do more work on this. The discussions with our customers, there was a real destocking that is largely over. What's going on in the second half is -- would be much more indicative of the overall environment and our commercial capabilities to capture that. But from our discussions with customers, they are not concerned about their backlogs. We were just with one of our very, very large customers this past week and they were saying that their backlogs are quite strong.

I mean, very robust. There has been some delays in getting after it, but it's not affecting their backlogs and they're very positive about the second half of the year. Now that's very qualitative, it's not quantitative, but we feel the combination of those two things, their strong backlogs and then end of the destocking, are why we're starting to see, just in the first few weeks of the second half, our shipments and bookings be up quite considerably.

Charlie Brown -- Executive Vice President and Chief Financial Officer

And I think it's important to note, I mean we've done a lot of work over the past six to nine months working on our inventory, making sure we have the right inventory on hand for our customers and that's for both businesses. I think we, in the past, have been a little bit more lackadaisical in making sure that we -- in having too much inventory that may have slow returns.

So, we're very focused on those products that need to go out immediately, and making sure that we have those, so that our customers, our distributors, do not feel the need to maintain significant stores. It gives us more direct access to our customers, I think it gives us a better value for our customers, and we're certainly focused on doing that for both their benefit and our working capital benefit as well.

Jerry Revich -- Goldman sachs -- Analyst

Okay. Thank you.

Karl H. Watson -- Chief Executive Officer

All right. Thanks, Jerry.

Operator

Thank you. And our next question comes from Rohit Seth from SunTrust. Your line is now open.

Rohit Seth -- SunTrust Robinson Humphrey, Inc. -- Analyst

Hey, thanks for taking my question. Just on your geo footprint, can you maybe just talk about some of the areas of strengths and weaknesses during the quarter?

Charlie Brown -- Executive Vice President and Chief Financial Officer

Of course, Rohit. I think, as always, Karl has been on the road visiting with a lot of our facilities. So I'll let him talk about the specifics. You know that we've got great exposure in some of the big growing markets. On the Drainage side, Texas is obviously a very good market for us and has been very strong, certainly. It'd be hard for me, Karl, to think of any place in our universe that isn't doing well on the Drainage side.

Karl H. Watson -- Chief Executive Officer

Only California.

Charlie Brown -- Executive Vice President and Chief Financial Officer

Yes.

Karl H. Watson -- Chief Executive Officer

Only California has been weak in the first half, and it's the dreaded W word, but that's been a bit weak in the -- on the Drainage side. Outside of that though, all markets are really quite robust for us on Drainage.

For Water, I would say that the Northeast has been a bit slower for us. It's not a backlog thing, it is the timing of our projects. But outside of that, the destocking has been pretty much a national phenomenon with, again, California being a bit more on the Water side also because of the well-documented weather effects in the first half of the year for California.

Rohit Seth -- SunTrust Robinson Humphrey, Inc. -- Analyst

And just building on the last question, I mean, are you -- do you have any visibility to the end markets driving the destock on resi or non-resi infrastructure?

Karl H. Watson -- Chief Executive Officer

No. Not as far as the destock goes. The destock was more -- they just -- they did stock up on a lot of inventory last year, our customers did. And they carried much more inventory than they had previously into this year. So it was then destocking to get down to more normalized inventory levels that they were used to carrying.

Rohit Seth -- SunTrust Robinson Humphrey, Inc. -- Analyst

All right. Okay.

Karl H. Watson -- Chief Executive Officer

So, I don't believe it was end-market thing that was driving them. It was more of a inventory -- their own inventory cash management thing that was driving it.

Charlie Brown -- Executive Vice President and Chief Financial Officer

Yeah. I believe the underlying demand for our product is still very steady. And like I said before, the drivers for volatility on what we actually ship are going to vary. But over time, the demand is solid. And we feel very good about our position in the markets with Water.

Rohit Seth -- SunTrust Robinson Humphrey, Inc. -- Analyst

Okay. And then in the first half, scraps really come off quite a bit. Can you just remind me what the time it takes to flow through the P&L?

Charlie Brown -- Executive Vice President and Chief Financial Officer

Sure. So it's at least a quarter plus. So between when we purchase -- when we contract a purchase, get it into inventory, put it through our processing and then get it into our finished goods inventory and out the door, that's at least 90 days, probably 90 -- three to four, five months before that all flows through.

Rohit Seth -- SunTrust Robinson Humphrey, Inc. -- Analyst

Okay. And based on what you said earlier, you're not really seeing the benefit of that in the first -- in this quarter, nor -- is that right?

Charlie Brown -- Executive Vice President and Chief Financial Officer

We do see some benefit in the quarter. And that -- from my accounting perspective, if I can give you that one, Rohit, it is eaten up by absorption, the lower volume that comes through.

Rohit Seth -- SunTrust Robinson Humphrey, Inc. -- Analyst

Okay. That's interesting. All right. That's all I got. Thank you very much.

Charlie Brown -- Executive Vice President and Chief Financial Officer

Thank you.

Operator

Thank you. And our next question comes from Sam McGovern from Credit Suisse. Your line is now open.

Sam McGovern -- Credit Suisse -- Analyst

Hey guys, good morning. Just wanted to ask on the balance sheet in terms of leverage, is there a target that you guys are aiming to get to, and can you remind us how quickly you will get there?

And then just as a follow-up, with regard to the prepayments on the term loan that you guys have reiterated, I just want to confirm, I think in the past you've discussed your potentially entering the market to buy back those bonds to capture the dollar discount that exists. And so just wanted to get your updated thoughts on that and the timing?

Charlie Brown -- Executive Vice President and Chief Financial Officer

Sure, Sam, this is Charlie. I would just -- as far as the target leverage, we have not disclosed anything specific. I think our goal as Forterra is very simply, we need to -- we recognize the need to address this, we're very focused on it. I think getting it down to four is a minimum, is where we really view, OK, we have to get there, and then we can make the decision as to where we go from there.

So that is, we've talked about our focus and our commitment to the prepayments of the debt, and that is something I don't want to say it's a once and done. It is something we're going to have to look at for the long term because you don't want to address a problem like this without having a long-term strategy.

And I think over the next several calls, I'll leave Karl to extend our view on that to the group. But just for our discussions, yes, we do intend to enter the market in the fourth quarter. We do plan on purchasing those in the open market. I think you and I have talked about that in the past and it certainly is something that remains our intent.

Sam McGovern -- Credit Suisse -- Analyst

Perfect. Thanks so much. I'll pass the line.

Operator

Thank you. And our next question comes from Clark Orsky from Alcentra. Your line is now open.

Clark Orsky -- Alcentra NY, LLC -- Analyst

Yeah, thanks. In light of your comments about Water, do you think you can hang on to the margins you realized in 2Q as you go into the back half?

Karl H. Watson -- Chief Executive Officer

We do. Yes.

Clark Orsky -- Alcentra NY, LLC -- Analyst

Okay, thank you.

Operator

Thank you. I'm showing no additional questions in the queue. At this time, I would like to turn the conference back over to management for any closing remarks.

Karl H. Watson -- Chief Executive Officer

Well, thank you very much for joining us on the call. And we look forward to speaking with you all in three months time. Thanks again.

Operator

[Operator Closing Remarks]

Duration: 29 minutes

Call participants:

Charlie Brown -- Executive Vice President and Chief Financial Officer

Karl H. Watson -- Chief Executive Officer

Mike Dahl -- RBC Capital Markets -- Analyst

Matthew Bouley -- Barclays Capital Inc. -- Analyst

Jerry Revich -- Goldman sachs -- Analyst

Rohit Seth -- SunTrust Robinson Humphrey, Inc. -- Analyst

Sam McGovern -- Credit Suisse -- Analyst

Clark Orsky -- Alcentra NY, LLC -- Analyst

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