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Forterra, Inc. (NASDAQ:FRTA)
Q3 2019 Earnings Call
Nov 5, 2019, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning, and welcome to Forterra's Third Quarter 2019 Earnings Conference Call. Today's call is 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 Third Quarter 2019 Earnings Conference Call. I'd 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 that includes price and volume information for both of our segments. 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 these 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 directly comparable GAAP measure and other related information including a discussion of why we consider these measures useful to investors in our earnings release.

Now, Karl will give an update on our business.

Karl H. Watson, Jr. -- Chief Executive Officer

Good morning, everyone. We appreciate you being on the call with us today. Our third quarter results reflect the continued improvement in the operating performance of our Company. The solid quarter saw a year-over-year increase in revenue of 7% and gross profit of 32% primarily driven by; one, higher volume associated with favorable weather conditions pending our drainage operations; two, higher average selling prices in both of our businesses; three, lower raw material costs in the Water business; and fourth, the beginnings of productivity improvements across both businesses. As a result, adjusted EBITDA was 30% higher than the same quarter last year.

I'd like to spend a few moments to summarize our current quarter performance in terms of volume, price and cost. Finished shipment volume increased 9% year-over-year. The growth in volume reflects fewer rainy days in many of our key markets, especially Texas.

Our backlogs for Pipe & Precast products at the end of the third quarter were up year-over-year, giving us confidence in our near-term volume outlook. Water shipment volume decreased by 9% over the same quarter in the prior year. Our customers indicated that they built inventory in the third quarter of last year, an action they did not repeat this year.

Regarding future demand, while our backlog at the end of the third quarter was less than at the same time last year, we have seen an increase in recent booking volumes. We anticipate volumes in Water business to return to our historic averages. In regard to pricing, Drainage pricing increased by 5% per ton and Water pricing increased by 6% per ton year-over-year.

We have kicked off Forterra Commercial Excellence, which is a multi-layered approach as to how we market our products and price them to earn a fair return on our investments. We expect continued improvement in pricing in the coming quarters, most notably in the Water business. Our cost performance is affected by major raw material inputs and our productivity in converting those inputs into products. In the Drainage business, input costs were up slightly year-over-year, primarily driven by a shift in product mix to products which require more steel.

In Water, we have been the beneficiary of reduced ferrous scrap pricing which has decreased over 20% compared to the same quarter last year. Our conversion costs in both businesses have improved modestly and we anticipate more notable improvements in the future as we advance in our Forterra Operational Excellence journey.

Our margin expansion has benefited both pricing and cost initiatives. Continuing to expand our unit margins provides a balance objective for our teams as we drive change. We are in the early stages of both our commercial and operational excellence journeys and see many opportunities for continued improvement.

After a little over four months with Forterra, I'm pleased with the progress we have made so far and I've been more excited about the future ahead of us.

With that, I'll turn the call over to Charlie, who will give you an update on our third quarter financial results.

Charlie Brown -- Executive Vice President and Chief Financial Officer

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're revising our full year guidance.

Our Drainage segment performed well during the third quarter. Shipment volumes were up 9% and average selling prices were up 5%, contributing to a 29% increase in gross profit and a 25% increase in adjusted EBITDA year-over-year.

On the cost side, as Karl mentioned earlier, we have seen small increases in our raw material costs, labor, as well as freight costs this year. However, we offset these cost increases with operational efficiency savings. As a result, our cost in the quarter remained relatively flat year-over-year.

Switching over to Water segment; again, we don't believe the 9% year-over-year decline in shipment volume is an indication of future trends. Historically, backlog at the end of the third quarter is lower than the second quarter level due to seasonal nature of our business. That being said, our backlog at the end of this quarter actually grew compared to the second quarter supported by the strength of recent bookings.

The operational issues we had last year are now behind us and our ductile iron pipe business is more than capable to service our customer's needs. Our average sales prices have improved 6% and our input costs are lower than prior year. As a result, our gross margin in the Water segment expanded by more than 450 basis points year-over-year.

Our corporate adjusted EBITDA was in line with our internal plans for the quarter but reflected an increase year-over-year due to our favorable adjustments last year and current year investments in our systems. On a consolidated basis, we reported adjusted EBITDA of $80 million compared to $61.6 million in the third quarter last year.

The improvement in our adjusted EBITDA is primarily driven by higher sales price, as well as higher volumes in Drainage, partially offset by lower volumes in Water as well as an increase in SG&A expense.

On the liquidity side, we generated $93 million of cash flow from operations compared to $18 million in the third quarter of last year. We paid down $39 million in borrowings under our revolving credit facility, voluntarily repurchased over $16 million in our term loan, and still ended the quarter with $44 million of cash.

During the last quarter of the year, we anticipate that pricing will continue to trend upward, demand will be solid and cost will be managed efficiently. Therefore, we are revising our 2019 outlook forecasting adjusted EBITDA to $180 million to $200 million. And as previously communicated, we expect to continue our voluntary repurchase of the term loan in the fourth quarter with a total amount of the year to be between $30 million and $85 million.

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

Questions and Answers:

Operator

[Operator Instructions] Our first question comes from the line of Jerry Revich from Goldman Sachs.

Benjamin Burud -- Goldman Sachs -- Analyst

Hi, good morning everyone. This is Ben Burud on for Jerry.

Karl H. Watson, Jr. -- Chief Executive Officer

Good morning, Ben.

Benjamin Burud -- Goldman Sachs -- Analyst

Morning, so your revised guidance is implying 4Q EBITDA in the $20 million to $40 million range. For context, normal 4Q seasonality that we've observed would imply 4Q EBITDA of about $42 million. Or thinking about it another way, the low end of the implied guide would suggest that 4Q EBITDA is about 11% of the full year, which is well below your historical average of 19% and even the prior low that we've seen of 16%.

So all that being said, can you step us through how you're thinking about 4Q based on the guidance that you've given us today. And is there a deterioration in demand that we need to calibrate it for that we're not currently modeling? Is it adverse timing, mix shift, conservatism, etc.?

Charlie Brown -- Executive Vice President and Chief Financial Officer

Okay, so Ben. You're curious about the fourth quarter, is that what I'm hearing?

Benjamin Burud -- Goldman Sachs -- Analyst

Exactly, yeah.

Charlie Brown -- Executive Vice President and Chief Financial Officer

Okay. No, I appreciate that. I guess first off, it's the fourth quarter, which is very -- highly subjected to weather. And we had a spectacular third quarter in most of our markets and so being who we are and anticipating the outdoor impact, we took a conservative view, assumed that there would be earlier winter as a result of that. So take it as a conservative perspective.

As far as demand Ben; no, as we said -- both Karl and I stated, demand actually looks pretty solid. We've got decent backlogs. Demand has been very good and we see pricing momentum continuing. So we feel that again having a conservative perspective on the fourth quarter knowing that we are totally exposed to weather and the fact that it's raining today in Dallas would keep us conservative.

Benjamin Burud -- Goldman Sachs -- Analyst

Got it, understood, any inventory [Speech Overlap]

Karl H. Watson, Jr. -- Chief Executive Officer

And just to [Indecipherable] a little bit because you asked, is there anything that we see about the underlying demand being soft? We don't. Our backlogs are up in Drainage. Our bookings are up in Water. There is nothing on the horizon that we see that would suggest anything is soft about the demand for our products.

Benjamin Burud -- Goldman Sachs -- Analyst

Got it. Perfectly, understood. And in Drainage, volume growth was obviously very strong at up 9% in the quarter, is that a sustainable rate of work in your view? Were there any project timing tailwinds we should keep in mind when thinking about sequential growth into 4Q and how that would impact 2020 comps?

Karl H. Watson, Jr. -- Chief Executive Officer

I don't know how long that is sustainable, but in the short term, I believe that it is. Because if you look at our backlogs, those percentages increase -- those percentages are reflected in our backlogs as well as our shipments.

Charlie Brown -- Executive Vice President and Chief Financial Officer

The only comment is, obviously we are subjected to weather and so when you have spectacular weather like we did really have; it was very dry and very warm, so we didn't have any problems with putting pipe in the ground for the whole third quarter.

So that's -- we've talked about this over and over again and hopefully you noticed we try to keep weather out of our release because only news we have about weather in the third quarter was it was good.

Benjamin Burud -- Goldman Sachs -- Analyst

Exactly. And just to be clear, there is weather -- just like you play catch-up or satisfy near-term demand there is not, you're not really pulling any work forward from 4Q into 3Q?

Karl H. Watson, Jr. -- Chief Executive Officer

Yeah, the backlogs don't suggest that at all.

Charlie Brown -- Executive Vice President and Chief Financial Officer

That is correct, Ben. And I think that the key point that Karl is making is, we can supply and it really comes down to the amount that the contractors can take during any period.

Karl H. Watson, Jr. -- Chief Executive Officer

I think in almost all construction material markets, there is not enough labor to pull stuff forward. If it rains, it just pushes stuff back. There is not the labor supply to actually have a large catch up in any one period of time, especially the third quarter.

Benjamin Burud -- Goldman Sachs -- Analyst

Got it. Great, thank you very much.

Karl H. Watson, Jr. -- Chief Executive Officer

Thank you.

Operator

Our next question comes from the line of Rohit Seth from SunTrust.

Rohit Seth -- SunTrust Robinson Humphrey -- Analyst

Hey, thanks for taking my question. This question is for Karl. You've got some time now to kick the tires at Forterra and you've talked about some commercial excellence initiatives, operational initiatives, curious if you can just elaborate on what those are and maybe if you have some longer-term targets for the business?

Karl H. Watson, Jr. -- Chief Executive Officer

Well, I think from a commercial excellence standpoint, I said it was multi-layered, really a sort of seven layer; segmentation, value proposition, hiring the right salespeople, training the right salespeople, managing those and then market and profit -- market analysis and product and customer -- product and customer profitability analysis.

I mean, so it's a multi-layered approach that we're taking. Let's say just starting you can't do all things at once. We're probably traveling pretty fast on two of those fronts. But I see this as, over the next three to five years of continuous journey to actually getting better and better at what we do on a commercial side.

As excited as I am about that, I am equally excited about the production side or the productivity side. I would say that my kicking the tires shows that we have franchise positions in both businesses. We have very good market structures in most of our markets. I would say that from a production standpoint though, we have a long way to go to be a world-class organization, when it comes to converting our raw material inputs into products and through a very focused effort on, for lack of a better term, all things lean, there is a lot of waste that we can take out of the system and a lot of productivity improvements that we can input into the system to actually believe that we can hold our cost on a per unit basis outside of material costs because ags [Phonetic] is going to go up, cement is going to go up, steel is going to fluctuate. We can keep our conversion costs relatively flat and fight back inflation over the long term.

Over the long term, there will be short-term differences in that and we'll have a big production month lower production month, but over the long term, we think we can hold our conversion cost flat on a per unit basis. The combination of those two, I think provides an earnings runway that we feel pretty excited about internally over the coming years. It's too early to talk about it, but we'll talk about that at our fourth quarter call, and what we think is in store for 2020 but I would say, internally, we're pretty optimistic.

Rohit Seth -- SunTrust Robinson Humphrey -- Analyst

Okay. Is there -- are there any, do you have any -- your thoughts on the footprint -- are you going to stay in the businesses that you have, are there any opportunities to maybe swap some assets or sell something off and reinvest in some areas that are growing faster or anything of that sort?

Karl H. Watson, Jr. -- Chief Executive Officer

If I look at the Water business, I'm very satisfied with our footprint, our market position and where our assets are. In the Drainage business, I'd say we're 90% satisfied with what we have, with where we are and the market positions. So it's really at the edges that we may be doing something; nothing substantial, nothing material and certainly nothing transformative.

So things -- three things that we're working on right now are just improving our unit margins by both the commercial and operational sides, being very effective with our working capital to increase our free cash flow, to then focus that on paying down debt. And that's what you'll see us doing for the next foreseeable future.

Charlie Brown -- Executive Vice President and Chief Financial Officer

Yeah. I mean, we've talked about that in the past, I mean that's just portfolio management, we will sell some assets. We have some -- with recent efforts on our part with the sale leaseback, we do have some properties that we will continue to sell, will use as trade and we will reinvest that business -- that money in our business most likely, but those are all going to be very small things, you won't see a major change in our footprint in the foreseeable future until, as Karl said, we have our -- focused all our debt -- focused on our debt and brought that into a more manageable level.

Rohit Seth -- SunTrust Robinson Humphrey -- Analyst

Understood. And then just last question, on the Water margins, I think got to 14% or so last couple of quarters. I mean, is this a run rate we can model going forward at least for the next few quarters? I know scrap steel prices will come off, and looks like it's trending down, but I don't know if it's going to stabilize here or -- just I'm curious on your thoughts?

Karl H. Watson, Jr. -- Chief Executive Officer

Yes, I do believe -- the simple answer to your question is yes, I do believe that you can model that. Our -- what we're trying to do in our Water business is price our product so that we create value when scrap prices are at an average price. And so that we're not -- we may create no value when they're at high prices, but we won't go backwards. If scrap prices come down like they are now, we will advance a little bit faster.

Having said that though, our prices in Water aren't anywhere close to where they need to be today that we're selling in order to create value at the average scrap prices. So we have some runway to go still on where we're trying to take the business in Water commercially.

Rohit Seth -- SunTrust Robinson Humphrey -- Analyst

Okay. Has your competitors announced any price increases that you can talk about?

Karl H. Watson, Jr. -- Chief Executive Officer

We announced one for October 1st. And so far, it's feeling very positive. It's early days, only been one month but it's playing pretty positive. I really can't comment on what our competitors are doing.

Rohit Seth -- SunTrust Robinson Humphrey -- Analyst

Okay. Fair, thanks, that's all I got. Thank you.

Operator

[Operator Instructions] Our next question comes from the line of Matthew Bouley from Barclays.

Matthew Bouley -- Barclays -- Analyst

Hey, good morning guys, and congrats on the results. On the Water business, I think you made the comment that bookings are beginning to pick up and then backlog is still -- it's up sequentially, but still down year-over-year and correct me if I misheard that. I guess what are you seeing with customer inventories at this point? Are we getting to a point in Water where there is visibility to positive volume growth or is that more of a 2020 event? Thank you.

Karl H. Watson, Jr. -- Chief Executive Officer

No, I don't think it is a 2020 event. I think we're seeing our bookings -- let me say it differently. Our bookings today are in the last three months, are stronger than our bookings have historically been at this point in time last three months. Typically, our bookings are higher in the first half of the year compared to shipments. And then they fall off in the last half of the year compared to shipments. We're sort of reversing that trend at the moment, which gives us growing confidence. I said growing, not absolute confidence that our volumes are going to return to more historical levels versus the trough we've been in this year.

Charlie Brown -- Executive Vice President and Chief Financial Officer

Yeah. I mean I think the key point is we created a little bit of this problem for ourselves last year. Operationally, we had some challenges and that put us behind on our deliveries in the second half of last year, which caused customers to bring forward a lot of bookings at the end of 2018.

We talked about -- we delivered a lot of that last year this time. We talked about being at operational capacity. Just trying to meet all of that demand. We pushed that all out into the system. it ended up in their inventory, that cause for delays in the second -- in the first half of the year where we were not able to -- they did -- they had excess inventory, we were improving our relationships with the customer. Looking back now with hindsight we see what has happened and it caused for less demand in the first half as they went through that inventory.

Third quarter impact was, they were last year buying for building that inventory. We now believe that we're in kind of an equilibrium. And as we've talked about before, the demand we feel is very steady in this business. The actual sales however get very lumpy. So we're feeling pretty good about what we have. I think the backlog and bookings review certainly gives us the confidence going forward.

Matthew Bouley -- Barclays -- Analyst

Okay, perfect. Thank you for all that detail. And then secondly, I think you mentioned in the release, and I think in your opening remarks, just around some of the improving plant efficiencies as well and some of the cost management progress you're going to be making into the fourth quarter. Just kind of -- any elaboration on what you've got going on there inside the walls and what's kind of the runway you see to improve the cost structure? Thank you.

Karl H. Watson, Jr. -- Chief Executive Officer

Well we -- let's just take Water first. In our Water business, we've just hired a new Vice President of Operations. We had been without one for a quite a period of time, especially since Rich has come over to run the Drainage business. And in our Drainage business, we're actually in the middle of -- actually just completed a reorganization of that business in order to bring in somebody who will be looking after operations as a Vice President of Operations to actually coordinate the activities across the Group as well as -- so having a national focus as well is the way we're structured with our division General Managers where they own the P&L.

What I think the opportunities are? As far as the numerical outcomes is, I'd want to reiterate, I believe that we can hold our conversion costs flat on a per ton basis, even with rising labor rates. There is probably 2.5% to 3% real productivity increases out there that we believe that we can get in the coming years to where all of our commercial initiatives flow to the bottom line and are not eaten up by cost increases on the conversion side.

As far as material costs, scrap will fluctuate, steel will fluctuate. On aggregate, it seems to always go up and cement will fluctuate and will do -- we have a very solid procurement organization, which I think procures very well and very competitively. So we'll do the best to hold those down. But what we're really focused on is the productivity and the reduction of waste around turning those raw material inputs into products.

The other thing I want to talk about a bit is our focus on working capital. We've been talking about that for quite some time since we went public, but you're going to see a meaningful reduction in working capital this year, especially on the inventory side, but we could also do a better job of managing it through other levers in that. So we'll be -- we're very focused on cash generation at the unit margin level, but also on the working capital level.

Matthew Bouley -- Barclays -- Analyst

Great, thank you for all the details.

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.

Charlie Brown -- Executive Vice President and Chief Financial Officer

We'll I do want to thank you for joining us on the call and we look forward to talking to you next year. Appreciate it.

Karl H. Watson, Jr. -- Chief Executive Officer

Thank you all.

Operator

[Operator Closing Remarks]

Duration: 25 minutes

Call participants:

Charlie Brown -- Executive Vice President and Chief Financial Officer

Karl H. Watson, Jr. -- Chief Executive Officer

Benjamin Burud -- Goldman Sachs -- Analyst

Rohit Seth -- SunTrust Robinson Humphrey -- Analyst

Matthew Bouley -- Barclays -- Analyst

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