Tennant Company (TNC) Q3 2021 Earnings Call Transcript

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Tennant Company (TNC 0.15%)
Q3 2021 Earnings Call
Nov 2, 2021, 11:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning. My name is Brent, and I will be your conference operator today. At this time, I would like to welcome everyone to Tennant Company's 2021 Third Quarter Earnings Conference Call. [Operator Instructions]

Beginning today's meeting is Mr. William Prate, Senior Director of Global Financial Planning and Analysis and Investor Relations for Tennant Company. Mr. Prate, you may begin.

William Prate -- Senior Director, Investor Relations

Thank you. Good morning, everyone, and welcome to Tennant Company's third quarter 2021 earnings conference call. I'm William Prate, Senior Director of Global Financial Planning and Analysis and Investor Relations. Joining me today are Dave Huml, Tennant's President and CEO; and Fay West, our Senior Vice President and CFO.

On today's call, we will update you regarding our third quarter performance and guidance for 2021. Dave will brief you on our operations and enterprise strategy, and Fay will cover the financials. After their remarks, we will open the call to questions. Please note, a slide presentation accompanies this conference call and is available on our Investor Relations website at investors.tennantco.com.

Before we begin, please be advised that our remarks this morning and our answers to questions may contain forward-looking statements regarding the company's expectations of future performance. Such statements are subject to risks and uncertainties and our actual results may differ materially from those contained in the statements. The risks and uncertainties are described in today's news release and the documents we filed with the Securities and Exchange Commission. We encourage you to review those, particularly our Safe Harbor statement, for a description of the risks and uncertainties that may affect our results.

Additionally, on this conference call, we will discuss non-GAAP measures that include or exclude certain items. Our 2021 third quarter earnings release includes the comparable GAAP measures and a reconciliation of these non-GAAP measures to our GAAP results. Our earnings release was issued this morning via Business Wire and is also posted on our Investor Relations website at investors.tennantco.com.

I'll now turn the call over to Dave.

Dave Huml -- President and Chief Executive Officer

Thanks, William, and thank you everyone for joining us today. Our third quarter results reflect the returns of pre-pandemic demand across the majority of our geographic markets and verticals. Our comprehensive and innovative product offerings are resonating with customers during this broad-based market recovery, and we expect this demand environment to continue for the foreseeable future.

While we are certainly encouraged by these positive trends, our financial performance continued to be impacted by the unexpected and prolonged global supply disruptions, inflation and labor constraints that have affected virtually every industry and geographic markets. The increased demand for our products combined with the effect of macro level constraints on our production capabilities contributed to a record order backlog that varies by product category or region and is now 3 to 5 times our historical averages.

In response, we've taken actions wherever possible to minimize the impact on our operations. Our plants continue to remain open and operate due to the significant efforts by our global teams to maximize output and to safeguard our customers' experience. While we expect that these macro headwinds will continue well into 2022, we remain confident in our ability to drive long-term sustainable growth and improve our operational efficiencies to generate long-term value for our shareholders. We are doing so not only through short-term mitigation actions, but also to the changes we've made and continue to make as part of our enterprise strategy.

To minimize the impact of higher freight costs and related supply disruptions, we continue to prioritize local-for-local and region-for-region manufacturing and sourcing to allow us to manufacture our products closer to our customers. As an example, we are making the necessary investments to add production of our T16 line to our China plants mid next year. The T16 is a highly maneuverable battery-operated ride-on scrubber that has proven to be very popular with our customers within the APAC region. By adding production to the local market, we can help minimize freight costs, improve lead times and better leverage our global production capacity.

We have continued to make capital investments to drive greater efficiency and capacity in all of our plants. As just one example, we have invested in the new lays in our Minneapolis plant that will improve production flow, reduce the amount of labor spent machining parts and will allow us to in-source items that we would have otherwise purchased from vendors. New tooling, specifically tooling related to our rotational molding machines, is another example of how we are investing in our business to support our local-for-local initiatives. This lets us manufacture key components at the point of assembly, meaning, we can avoid situations where we manufacture in one location before shipping to a second location for final assembly. These actions help avoid unnecessary shipping delays, freight costs, added time to manufacture and inventory carrying costs.

While our teams are taking every opportunity to find creative solutions to address the current supply chain environment, each day brings new challenges in terms of parts availability. Right now, the lack of availability of hydraulic pumps, chips and other electronic components, which are critical parts within our machines, are main drivers of our increased backlog and are directly affecting our ability to deliver on our full year potential. However, we will continue to control everything we can control and work diligently to capitalize on the strong demand environment.

An important component of our enterprise strategy is a long-term move toward platform design. In the current environment, our engineering teams are taking a balanced approach to this initiative as they weigh the long-term benefits of platform design with the near-term need to adjust our designs to allow for available parts and to increase our sourcing flexibility. Of course, our commitment to quality and safety and meeting the needs of our customers will not waiver.

Regarding labor shortage, specifically in manufacturing, we are staying competitive with wages and are making every effort to attract new talent by providing a safe, rewarding and fulfilling work environment. We are also supplementing and strengthening our talent acquisition teams by partnering with third-party vendors to assist with our employment outreach through targeted marketing campaigns and professionally staged hiring events. We are encouraged by these actions which are having a positive effect on our recruiting and helping to mitigate the ongoing labor challenges.

As Fay will discuss, while our revised full year guidance reflects what continues to be a challenging operating environment, our team remains committed to meeting the needs of our customers and executing against our enterprise strategy to deliver on our long-term financial commitments. In particular, we continue to innovate for profitable growth, which is the third pillar of our enterprise strategy. Over the past year, we've announced the introduction of new products to help address the evolving needs of our customers.

Earlier this year, we introduced new mid-tier products, which leverage our IPC product portfolio, to meet the needs of a broader segment of customers by offering a wider range of performance and price points. Our mid-tier products have been well received by our customers and distributors. While they leverage the same IPC platform, these Tennant-branded products benefit from the broader customer experience associated with the Tennant brand, including the full ecosystem of application expertise, technological innovations and best-in-class sales and service support.

During the past year, we've also introduced two key new products to our AMR portfolio, including the T380AMR and the T16AMR. Together with the T7AMR, these products have created a comprehensive robotic portfolio to meet all of our customers' needs. With the addition of these new products, we have been able to strategically enter new verticals outside of just retail, including manufacturing, logistics and warehousing and education, among others. Our AMR portfolio continues to be well received by an expanding number of customers, and we look forward to updating you on a number of other AMR innovations as they materialize.

The one strategic pillar I haven't yet touched on is winning where we have a competitive advantage. For example, we recently launched a value realization exercise in Australia building on our successful North American execution back in 2019 where we assessed all of our strategic accounts and distributor partners. In Australia, this allowed us to realign over 40% of our strategic account customers and 80% of our distributor partnerships, ensuring that we have an optimized channel structure in place to serve this highly competitive market.

By adjusting our customer segmentation appropriately, we can better adjust lead times, pricing and sales support across our customer base. In doing so, we are aligning the customer experience with our profitability goals. Moreover, we are relentlessly focused on providing our customers with high quality products and exceptional service as we execute on our enterprise strategy. With that goal in mind, we will continue to take decisive and appropriate actions to maintain our customer experience, while remaining focused on our business objectives.

With that, I will turn the call over to Fay for a discussion of our financials.

Fay West -- Senior Vice President and Chief Financial Officer

Thank you, Dave, and good morning, everyone. For the third quarter of 2021, Tennant reported net sales of $272 million, an increase of 3.9% over the prior year, which included a favorable foreign currency effect of 1.2% and a divestiture impact of negative 2% related to the sale of our Coatings business in the first quarter of 2021. Organic sales, which exclude the impact of these currency effects and divestitures, increased 4.7%. As Dave mentioned, our revenue results were tempered by the continued global supply chain disruptions and labor constraints, with North America being the most affected.

Tennant groups its sales into three geographies. The Americas, which include all of North America and Latin America. EMEA, which covers Europe, the Middle East and Africa. And Asia Pacific, which includes China, Japan, Australia and other Asian market. In the third quarter, sales in the Americas decreased 0.6% year-over-year, which included a negative divestiture impact of 3.1%, organic growth of 2% and a favorable foreign exchange effect of 0.5%. Strong customer demand in Brazil and Mexico drove a year-over-year increase in sales in Latin America. North America delivered modest organic growth as compared to the prior year, due to the previously mentioned supply chain and labor challenges as well as the lapping of the significant AMR order in the prior year. Additionally, the current year period benefited from an increase in our service, parts and consumables businesses.

Sales in EMEA increased 16.1% or 14% organically, including a favorable foreign exchange effect of 2.1%. The results which were impacted by global supply chain challenges reflected growth across all countries and product categories in the region as demand returned to pre-pandemic levels. Sales in APAC decreased 0.4% or 2.9% on an organic basis and included a positive foreign exchange effect of 2.7% and a negative revenue impact of 0.2% related to the sale of the Coatings business. The sales decline was partially attributed to pandemic-related lockdowns in some regional markets during the third quarter of 2021.

Supply chain disruptions and labor constraints impacting North America plants that supply APAC also limited our ability to meet orders across the region with the largest impact experienced in China and Japan. Even so, the region experienced strong results for parts and consumables and service with strength in the Australian market across all product categories.

Turning to margins. Reported and adjusted gross margin in the third quarter were both 40.1% compared to a reported gross margin of 39.6% and adjusted gross margin of 39.8% in this year ago period. Although the comparison to the prior year was favorable, the year ago period was unfavorably impacted by certain strategic investments and pandemic-related productivity challenges. As we highlighted during our last conference call, our third quarter adjusted gross margin was lower than the adjusted gross margin in the first half of 2021. This decrease was primarily due to increased material and freight costs and productivity challenges caused by parts availability.

As for expenses, during the third quarter, our adjusted S&A expenses were 28.3% of net sales compared to 29.3% in the year ago period. The year-over-year improvement in leverage was a direct result of the cost saving actions as well as the adjustment of management incentives in Q3 of 2021 to better reflect current expectations. Net income in the third quarter was $21.5 million or $1.14 per diluted share compared to $11.7 million or $0.63 per diluted share in the year ago period. Adjusted diluted EPS, which exclude non-operational items and amortization expense was $1.33 per share compared to $0.90 per share in the year ago period. The increase year-over-year was primarily driven by lower interest expense and increased business performance.

Adjusted EBITDA in the third quarter increased to $36 million or 13.2% of sales compared to $32.6 million or 12.4% of sales in Q3 of last year. The year-over-year improvement was driven primarily by increased revenues based on strong demand as we continue to lap the pandemic-related slowdown of 2020 as well as improved gross margins and an adjustment of management incentives previously mentioned.

As for our tax rate, in the third quarter, Tennant had an adjusted effective tax rate excluding non-recurring expenses of 3.8% compared to 11.3% for the third quarter of 2020. The decrease in the effective tax rate was driven primarily by a tax benefit resulting from an election to step-up the tax basis of certain assets in Italy.

Turning to cash flow and balance sheet items. Our long-term capital allocation strategy is to first fund operations and investment in growth, appropriately managed leverage, pursue strategic and accretive M&A and then to return excess free cash flow over time to shareholders through dividends and share repurchases. We ended the quarter with $140.6 million in cash and cash equivalents and our net leverage of 0.93 times adjusted EBITDA is lower than our stated goal of 1.5 to 2.5 times. Cash flow from operations was strong with $25.1 million generated in the third quarter and $62.9 million generated on a year-to-date basis. Additionally, capex is approximately $12 million for the first nine months of the year.

Our strong free cash flow generation allowed us to return capital to shareholders through the following actions. First, and as previously announced, Tennant's Board of Directors has authorized a 9% increase in the company's quarterly cash dividend to $0.25 per share. The increased dividend is payable on December 15, 2021 to shareholders of record at the close of business on November 30, 2021, marking the 50th consecutive year that the company has increased its annual cash dividend.

Secondly, during the third quarter, Tennant repurchased approximately 102,000 shares of its common stock for $7.5 million under its existing share repurchase program. The increase in the dividend and our share repurchase activities are aligned with our long-term capital allocation priorities and display continued confidence in our ongoing business performance and future cash flow generation.

Lastly, turning to guidance. As included in today's earnings announcement, Tennant adjust its full year guidance for 2021 as follows. Net sales of $1.09 billion to $1.1 billion, reflecting organic sales growth of 9% to 10%. Full year reported GAAP earnings in the range of $3.50 to $3.70 per diluted share. Adjusted EPS of $4.20 to $4.40 per diluted share. Adjusted EBITDA of $137 million to $142 million. Capital expenditures of approximately $20 million. And an adjusted effective tax rate of approximately 15%.

With that, I'll turn it back over to Dave.

Dave Huml -- President and Chief Executive Officer

Thanks, Fay. The challenges we're facing with global supply chain and labor shortages are not unique to Tennant and are likely to remain for the foreseeable future. These challenges did have a direct impact on our Q3 results and our ability to meet our full potential in 2021. However, we are encouraged by the strong response to our innovative suite of products and the market recovery that is now at pre-pandemic levels of demand. Our continued execution of our enterprise strategy has enabled us to better navigate to continued macro challenges facing the overall economy. But more importantly, the strategic actions we've taken over the past couple of years will ultimately drive long-term growth and profitability and enhance shareholder value.

We will now open the call to questions. Operator, please go ahead.

Questions and Answers:

Operator

[Operator Instructions] Your first question comes from the line of Chris Moore with CJS Securities. Your line is open.

Christopher Moore -- CJS Securities, Inc. -- Analyst

Hey, good morning, guys. Thanks for taking a few questions.

Fay West -- Senior Vice President and Chief Financial Officer

Good morning.

Dave Huml -- President and Chief Executive Officer

Good morning, Chris.

Christopher Moore -- CJS Securities, Inc. -- Analyst

Good morning. Record backlog, a lot of that relates to the parts availability. Beyond that, are you seeing much pre-buying, accelerated buying by customers as they factor in supply chain challenges?

Dave Huml -- President and Chief Executive Officer

Yeah. Thanks for the question, Chris. We mentioned our backlog is about 3 to 5 times normal rates. That was at about 2 to 3 time rate coming out of the prior quarter, driven entirely by our supply chain challenges. Our demand has largely returned to pre-pandemic levels and we're really encouraged by that. We're booking orders at a rate similar to 2019. And the constraints on our plant output are driven by our -- driven primarily by our supply chain challenges.

The customer orders are seem to be driven primarily by demand in the period. We have a few instances of customers buying ahead to get in the queue, because they recognize that our long lead times are real and they want to get their spot in line for production, but those are the exception rather than rule. We've had a few instances of customers and/or distributors buying ahead of the price increase as well. But on whole, order demands are driven by demand in the period for the period not customers buying ahead. So we're really encouraged by that as we look forward to Q4 and 2022.

Christopher Moore -- CJS Securities, Inc. -- Analyst

Got it. That's helpful. Obviously, supply chain, labor, freight not unique to Tennant, almost all the industries we cover are in that boat. But you operate in a market with a few dominant players. And kind of the unique part here is, Tennant is really the only U.S. player out of that group of bigger competitor. So just trying to understand how that impacts your competitive positioning, both in U.S. and Europe? I mean, for example, supply chain challenges in North America, are they impacting you more or less than say Nilfisk in North America? Just kind of trying to see how that big picture looks given the fact that you're the kind of the lone U.S. player.

Dave Huml -- President and Chief Executive Officer

Yeah. Let me try and dimensionalize that for you, Chris. So less important as to where we're headquartered, what's a bigger determinant on a competitor or our ability to react to the supply chain challenges, a couple other facets of our business. And one would be, how well platformed our product is, two would be how local-for-local our supply chain is. And so when you look at us and our competitors, those are bigger determinants of our ability to respond and react within this environment than kind of where we're headquartered or where our predominant end market is from a sales perspective.

Having said that, these supply chain challenges are really global in nature and macro in nature as well as across all facets of supply chain from parts availability all the way through freight and labor. The impact of these challenges does vary by region. And so some of these are what I would call more notable in North America when you think about some of the dynamics in our labor force, for example.

What we've seen in our infrastructure and our system and we have plants in every one of our regions which we are expanding capabilities in our local-for-local strategy, what we've seen is a variance in ability to react based on again on the platform of the product, the local-for-local supply chain and then some of the regional differences relative to the supply chain challenges. So I think it's difficult to draw conclusions at this point about the extent to which the global supply chain challenges would affect a U.S. based competitor versus a European-based competitor.

I will tell you what we're hearing from customers as we're out booking orders at a very robust rate. They're telling us that we are right in line from a lead time perspective with our competitors. And that's not to say that on a given product line and a given situation one competitor or us may have an advantage. But largely speaking, we believe based on what our customers are telling us is that we are on par with competition. So time will tell as this wears on and as recovery comes. I think our success will largely be marked by how quickly we can respond as the macro market recovers.

Christopher Moore -- CJS Securities, Inc. -- Analyst

Got it. Extremely helpful. I will jump back in line. I appreciate it, guys.

Dave Huml -- President and Chief Executive Officer

Thanks, Chris.

Operator

[Operator Instructions] Your next question comes from the line of Steve Ferazani with Sidoti. Your line is open.

Steve Ferazani -- Sidoti & Co., LLC -- Analyst

Good morning, Dave. Good morning, Fay.

Fay West -- Senior Vice President and Chief Financial Officer

Good morning.

Dave Huml -- President and Chief Executive Officer

Hey, Steve.

Steve Ferazani -- Sidoti & Co., LLC -- Analyst

Wanted to ask on your change to EBITDA guidance. Is that entirely supply chain-related? Given the quarter was good, have you seen it get significantly worse? And what you're thinking is timing on improvements?

Dave Huml -- President and Chief Executive Officer

Yeah. It's a great question. One that we've obviously wrestled with as we moved through the quarter. And really our decision to lower guidance and tighten the range reflects where we're at in the year and the trending we've seen in the business, the signals we're getting from the supply chain over the last five months.

When we spoke after Q2 results, if you recall, we really only had a couple of months, about 60 days of kind of impact, the impact on our business from supply chain challenges. We've now entered kind of five and six months impact as we move through the third quarter. We have seen the situation deteriorate from a macro perspective, and we are working hard to overcome those challenges. But we felt it was appropriate given that the trend we saw from quarter-to-quarter to reflect that in our full year guidance.

I think it's worth noting though, if you think back to the original guidance we issued, we were at $130 million to $140 million in EBITDA. We raised to $140 million to $150 million on the strength of our Q1 results. And now we've revised to $137 million to $142 million, it kind of splits the difference between the original and raised guidance. And when you look at the guidance that we've given across the P&L, we're really within striking year -- within striking distance of delivering a fantastic year for Tennant. And so despite the supply chain challenges that we're facing and all of the teams' efforts to attempt to mitigate those impacts and us revising guidance, we're still very proud of the results we're communicating and we'll deliver for the year.

Steve Ferazani -- Sidoti & Co., LLC -- Analyst

And then in terms of -- I guess, your EPS was stronger too. I think our estimates on SG&A in terms of not sort of year-over-year, but what changed sequentially with SG&A and how you're thinking about that four quarter. Has the shift been entirely on incentive?

Fay West -- Senior Vice President and Chief Financial Officer

So it's two part. But I think a big driver here is a change in guidance and the change in management incentives. And so we had accumulative adjustment here that benefited the quarter. But it's also reflective of all cost savings initiatives as well.

Steve Ferazani -- Sidoti & Co., LLC -- Analyst

Can you give a sense of how you're thinking about SG&A in Q4?

Fay West -- Senior Vice President and Chief Financial Officer

I think that we are not going to see that same kind of benefit come through that we saw in Q3. And when I look at Q4, I think it will probably be more in line with kind of our normal run rate of about $85 million a quarter.

Steve Ferazani -- Sidoti & Co., LLC -- Analyst

Okay, great. That's helpful.

Dave Huml -- President and Chief Executive Officer

And if we think about what's happening in the business, Steve, we're returning to work, returning to the office, business travel is picking back up. And so from an S&A perspective, we expect to continue to support our customers and drive the demand we're seeing and set ourselves up for 2022 that we'll be spending on S&A. I think it's also worth noting that we're not cutting our way through S&A to deliver these full year results. These results are a direct reflection of the organization's ability to execute against our GPS strategy and drive the structural changes in our business that provide referring benefit in outyears.

Steve Ferazani -- Sidoti & Co., LLC -- Analyst

If I could get one more in, in terms of -- balance sheet continues to improve. You raised the dividend actually more than we were expecting, small buyback. When you're thinking about the balance sheet and debt repayments versus potential additional buyback given that you typically raised once a year, how you're thinking about those three pockets?

Fay West -- Senior Vice President and Chief Financial Officer

So our capital allocation priorities really have not changed. Our first goal is always to invest in a business where we think the largest return exits and also has least amount of risk and to manage our leverage, and our leverage is in really below our targeted range, right now 1.5 to 2.5 times. So we're -- I think the balance sheet, as you think, is very well positioned. We had generated approximately $50 million of free cash flow through the first nine months of the year, which is very, very strong. So on the basis of the strong balance sheet and strong free cash flows, it really did allow us to increase our dividends and to execute against share repurchases in an effort to return excess cash to our shareholders without compromising growth.

Steve Ferazani -- Sidoti & Co., LLC -- Analyst

And how would you think about that over the next three or four quarters?

Fay West -- Senior Vice President and Chief Financial Officer

As far as share repurchases?

Steve Ferazani -- Sidoti & Co., LLC -- Analyst

Yeah.

Fay West -- Senior Vice President and Chief Financial Officer

Yeah. It's going to be an integrated component of our capital allocation priorities. And it is at the discretion of management, but it will be part of a systematic capital deployment strategy.

Steve Ferazani -- Sidoti & Co., LLC -- Analyst

All right. Thanks so much, Dave. Thanks, Fay.

Dave Huml -- President and Chief Executive Officer

Thanks, Steve.

Operator

There are no further questions at this time. I would like to turn the call over to management for their closing remarks.

Dave Huml -- President and Chief Executive Officer

Thank you. And before we close, please note that we will soon be posting on our IR website the first in a series of videos to offer a deeper look into our business and growth strategy. You can be notified of each video by signing up for email alerts at investors.tennantco.com.

I also want to take this moment to thank our global Tennant teams for all their hard work and dedication. From our sales and service teams who are supporting our customers directly to our operations and supply team who continue to find creative solutions in today's challenging environment and to our engineers, back office and every one else across our enterprise help and support our customers and our business, a sincere thank you. This concludes our earnings call. Have a good day.

Operator

[Operator Closing Remarks]

Duration: 32 minutes

Call participants:

William Prate -- Senior Director, Investor Relations

Dave Huml -- President and Chief Executive Officer

Fay West -- Senior Vice President and Chief Financial Officer

Christopher Moore -- CJS Securities, Inc. -- Analyst

Steve Ferazani -- Sidoti & Co., LLC -- Analyst

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