Diversey Holdings, Ltd.

Greetings and welcome to Diversity Holdings second quarter 2022 earnings conference call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. I would now like to turn this conference over to your host, Mr. Grant Graver, Investor Relations. Thank you, sir. You may begin your presentation.

Thank you. Hello, everyone, and welcome to Diversi's second quarter 2022 earnings call. With me today are Phil Wieland, our chief executive officer, and Todd Herndon, our chief financial officer. As a reminder, during this call, we will make forward-looking statements. Some risk factors that may impact these statements and could cause actual future results to differ materially from our projected results are described in this morning's press release and in the reports we file with the SEC. The company does not undertake any duty to update such forward-looking statements. On today's call, the company will discuss certain non-GAAP measures and make reference to supplemental data which we believe can be useful in evaluating our performance. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with GAAP. A reconciliation of these non-GAAP measures and reference to supplemental data can be found on our website at ir.diversity.com and in our most recent annual report. I'll now turn the call over to Phil.

Good morning, everyone. I want to start with the headlines of our Q2 results, about which I'm very proud, and explain why they make me continue to feel so positive about the long term. Firstly, revenue improved by 10% as compared to the prior year and over 20% on a constant currency basis, reflecting strong organic growth in both pricing and new customer wins. Secondly, growth was strong across both our institutional and food and beverage businesses, which increased by 7% and 18% respectively, or 17% and 29% on a constant currency basis. And thirdly, adjusted EBITDA margins improved sequentially by 330 basis points to 12.4%. As we stated last time we spoke, we expect our consolidated margins to improve quarter on quarter throughout the year as our pricing and cost initiatives are implemented. Our second quarter results reflect our commitment to driving revenue growth while improving margins in our $46 billion market where we are one of only two global players. Now, moving to the Matco environment. We're clearly operating in challenging times with COVID, rising inflation, supply chain bottlenecks, and other operating factors, including currency exchange rates. I've been extremely pleased with the resiliency of our business model and our management team's agility in the short term, while maintaining focus on our long-term growth goals. Let me give you a couple of highlights of our current initiative. Firstly, we've been focused on pricing to cover inflation. While input costs have continued to rise, we're implementing price increases across our various geographies and products. In the second quarter, we realized more than 10% revenue growth from pricing, and I expect this level of pricing to increase further as we move through the year. To date, our price increases have been well accepted, as evidenced by our more than 20% constant currency revenue growth in Q2. We expect the majority of these increases to remain intact, reflecting the value diversity provides to its customers. Secondly, we've continued to focus on controlling our fixed costs and leveraging our variable costs. Our second quarter adjusted EBITDA margin, which improved by 330 basis points versus the prior quarter, 12.4%, is still reflective of the nearer-term inflationary environment in which we operate. As our pricing actions continue to be implemented, including additional pricing as needed, we'd expect our margins to continue to improve significantly between now and the fourth quarter of the year. We're also continuing to invest in opportunities to expand margins further next year and beyond, like our plant investment in Kentucky, which remains on track to be completed by the end of this year and is expected to improve total company margins by roughly 100 basis points starting in 2023, as we work to deliver our targeted long-term EBITDA star margin of 20% in the coming years. So in summary, we're pleased with our pricing and cost containment actions. We will maintain pricing and cost discipline so we can drive revenue growth and capture margin expansion opportunities as the year progresses. Now, just as important, I've seen strong progress on our strategic growth drivers. We continue to enhance our value proposition with digital innovation and a focus on service, which is leading to high retention levels and acceleration of net new customer wins and a robust pipeline of additional opportunities. As an example of our innovation, we recently entered into a multi-year global partnership agreement with Gorsium, to collectively disrupt the machines market with robotics technology. The focus of this partnership is to unlock the full potential of cleaning robotics with greater operational efficiency and intelligence for our customers around the world. This is part of our TASKI machines business, which is almost 10% of our institutional business and has grown by over 28% on a constant currency basis in the first half. It's this type of innovation coupled with our strategic focus in U.S. food service, global accounts, and water treatment that leads us to expect strong growth going forward. With that, let me now pass it over to Todd to give you some additional details for the quarter and to also cover our outlook for the remainder of the year.

Thanks, Phil. In summary, there are a few things I would like you to take away from today's discussion. First, Our confidence in the resiliency of this business is strong. Second, we posted solid Q2 results in the current environment. And third, we are updating our full year EBITDA guidance to reflect the current exchange environment. As you all know, we're living in an interesting environment and we continue to be very encouraged with the resiliency of the business and our ability to gain share in a fragmented market. while at the same time implementing aggressive pricing actions, reflective of the inflationary environment we are tackling. We remain on track with our daily execution and growing our business organically with significant net new business, and we continue to invest in both our product innovation and distribution channels to expand market share and margins. Our delivery in the first half of the year has been consistent with our initial outlook. That being said, the macro background continues to be broad, ranging, and underpredictable. As a point of reference, our core execution in the quarter drove revenue growth of more than 20% on a currency-adjusted basis. However, the volatility in global exchange rates is diminishing our strong execution. As we look to the remainder of the year, I want to update our outlook to reflect the current exchange rate environment. While we have a number of exchange rate hedges in place, we're not in the business of predicting foreign currency swings and when they may revert. Accordingly, I believe it's prudent to assume that such headwinds continue to occur for the remainder of the year. We are reducing both the lower end and higher end of our previous guidance range by $30 million to reflect the current exchange rate environment. To be clear, We're not changing our guidance with respect to any other matters. Our core execution of what we control is strong and on track. Now let me talk about our quarterly results. Net sales for the quarter were $715 million, an increase of $65 million, or 10%, as compared to Q2 prior year, and 20.6% on a constant currency basis. reflecting strong top-line growth across both of our business segments. I'm happy to report our institutional business, which is roughly 70% of our revenue, reported $510 million for a 7% increase over Q2 prior year. On a constant currency basis, our institutional business revenues increased by 17.4%, driven by a combination of new customer wins, pricing actions, and expansion with existing customers as we continue to progress towards a return to pre-pandemic levels. We're more than 90% recovered versus pre-COVID volume in our institutional business. Our F&B business, which is roughly 30% of our revenue, also continued positive momentum, supporting our long-term growth goals. We continue to experience high customer win rates for new business, and recently introduced water treatment to further expand our organic growth initiatives. Our Q2 revenue of $206 million is 18.4% above prior year as reported and 29.3% above in constant currency. As Phil mentioned, we're especially pleased with our Q2 adjusted EBITDA delivery in light of the numerous inflationary pressures we've had to overcome throughout the first half of the year. Consolidated adjusted EBITDA for Q2 was $88.4 million, a 12.7% decrease compared to prior year as reported, but nearly flat in constant currency. Our institutional and F&B beverage segments delivered adjusted EBITDA of $74.5 million and $23.5 million, respectively, representing declines of 4.6% and 33% as reported. Both segments were impacted by currency and high input cost inflation, particularly in Europe due to the war in Ukraine, and we're taking aggressive pricing actions to address the price-cost timing gap. While costs continue to increase, I'm committed to ongoing pricing and cost containment to assure we hit our long-term 20% adjusted EBITDA margin target. To offset and get ahead of costs as we progress towards 2023, I said in May that we expected our full year pricing for 2022 to be greater than 8%. Now, we're expecting more than 10% for the full year. As of May, we've been offsetting monthly direct material cost inflation in dollars. And as inflationary pressures moderate, combined with our steady productivity gains, I believe we will capture margin improvement over time. Now let's quickly touch on what a strong position our balance sheet is in. First, with respect to operating cash flow, we had a negative outflow of roughly $9 million for the first six months of 2022, as compared to minus $109 million in the same period last year. We continue to expect positive free cash flow in the back half of the year, consistent with historical cash flow seasonality. Our expectations for full-year free cash flow are the same as when I spoke in May, after adjusting for currency and rising interest rates. The good news on the last topic is that we've hit our interest rate caps, meaning we only have $350 million of debt exposed to further interest rate rises. This means each 1% increase in rates represents approximately $3.5 million in annualized incremental interest expense. which puts us in a positive position considering our strong liquidity. At quarter end, we had cash and cash equivalents of $248 million and available liquidity of 690 million, which I view as a position of strength. Our net debt leverage ended the quarter at 4.8 times. As we expect to generate increased positive cash flow for the full year of 22, We also expect to see net debt leverage improve by year end. So we continue to be encouraged with the execution by the team and the resilience of the business in this challenging environment. While we are not isolated from the macro headwinds impacting global markets, we do believe our solid second quarter results reflect our geographic sector and product diversification, as well as strong value proposition we offer to our customers. Accordingly, we're reaffirming high single-digit percentage revenue growth for the full year, but lowering the adjusted EBITDA range to reflect the current exchange environment. Our current outlook for full-year adjusted EBITDA is $350 to $390 million. If the inflation or foreign exchange environment changes, we would expect to update our outlook as the year progresses. Now, one last item before I turn back over to Phil. We recognize that this is a unique environment. While we generally do not provide quarterly earnings guidance, our estimate for Q3 revenue is in the range of $680 to $720 million, and adjusted EBITDA is in the range of $85 to $95 million. The third quarter outlook reflects volume growth and price increases that are expected to build throughout the year, offset by the historical seasonality of diversity's business, and the impact of opening our new Kentucky warehouse, which could have some timing impact between Q3 and Q4, along with incremental one-time costs. The expected increase in earnings from Q3 to Q4 reflects getting the warehouse up and running, pricing, growth, and cost containment action. In summary, I'm pleased with our performance to date. We are updating our guidance to reflect the current exchange rate environment, And our confidence in the resiliency of our long-term growth strategy and earnings power remains on track. With that, I'll hand it back over to Phil for a quick wrap-up.

Yeah, I wanted to take a step back and share a few headlines about where we are in our transformation. Firstly, we're executing well against a very clear plan for growth, including U.S. food service, water treatment, global accounts, and commercial excellence. We've also made some significant investments in our talent to deliver that plan. And we're seeing our employee engagement and customer net promoter scores are significantly up. So despite all of the crises of COVID and inflation and supply chain, our first half revenues were 16% up and our adjusted EBITDA was 23% up versus the pre-crisis period of 2019. So as these crises subside, we're extremely well positioned to take advantage of all the opportunities that exist in our $46 billion marketplace. So finally then, before opening up the Q&A, just summarizing the quarter, we saw 20% constant currency revenue growth, including 10% of price increases. And we saw 330 basis points of sequential margin improvement to 12.4%. Now, operator, it would be great if you could open the line for questions.

At this time, we will be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation cell will indicate your line is in the question queue. You may press star 2 to remove your question from the queue. For participants using speaker equipment, it may be necessary for you to pick up your handset before pressing the star keys. One moment while we poll for questions. Our first question comes from the line of Vincent Andrews with Morgan Stanley. You may proceed with your question.

Hi, this is Steve for Vincent. Thanks for taking my question. I just wanted to ask a question on the updated guidance. Can you, maybe just on the top line, the high single-digit sales growth, can you kind of bucket out how much you're expecting from volume, price, like what's the FX headwinds assumed in there? And then when we think about the fourth quarter versus the third quarter, can you kind of just provide like an EBITDA bridge on some of the items that you called out that would just help us size them relative to one another? Thank you.

Yeah, Steve, I can certainly do that for you. So yeah, looking at the FOIA, You know, I think we said over 10% pricing we're going to get. I think we could certainly assume 6% to 7% on volume. You'll remember against that we had a normalization of infection prevention that's worth about 3%. That was all in Q1, but 3% would be the full year equivalent. I think there's probably about 3%. coming from M&A. They're the transactions that we did in December and January of this year. And then the currency could be in the 8% to 9% range. So hopefully that gives you a reasonable sense of how we're looking at the full year on top line. If we then think about, I think the second part of your question was on Q3 to Q4. The biggest two impacts are pricing and the warehouse opening. But on pricing, maybe it's helpful just to explain the chronology of what we've done this year. So we had some significant price increases in Q1. We then had some further increases once we knew about the war that came in relatively early in the second quarter. Our next significant price rise is we expect to be at the start of the fourth quarter. And therefore, the pricing increase from Q2 to Q3 will be relatively modest. The price increase from Q3 to Q4, I think, will be much bigger. And then the other point worth talking about is the warehouse opening. We're getting into that at the moment. It's obviously a huge project. It's very significant in terms of the number of people and the volumes involved. It's also enormously important in terms of the businesses' performance and margin improvement going forward. We think there could be 20 to 30 million of potential revenue that moves from Q3 into Q4 as a result of that. It could be a lower number, okay? But I just want to make sure that people are aware that that's happening and that that is a potential impact so no one's surprised

if that impact's being seen when we report our Q3 numbers. I hope that helps. Yeah, thank you.

Our next question comes from the line of Andy Whitman with Baird. You may proceed with your question.

Yeah, thanks, guys. Excuse me. Todd, it looks like there was a comment here that you unwound a swap in the quarter. Was that in this quarter's free cash flow? Or is that a contributor to the reason why the second half cash flow is supposed to be more positive?

It would be a part of cash flow. It's not actually technically part of free cash flow. So depending on the definitions we're talking about, just to be clear, we did unwind the swap in the second quarter. It had the effect of more than $60 million in the quarter of a benefit to cash. in the second quarter. And of course, we'll contribute for the year to cash flow in general.

Got it. Okay, that's helpful. And then just on the F&B segment, I was wondering if you could just address, I mean, obviously the raw material impacts are different between the segments, but it looks like it was a lot more significant in F&B. Maybe you could, I want you guys to talk a little bit about You know, why that's the case and help us understand the magnitude of the difference between the two segments and what's happening with raw materials.

Yeah, look, I can certainly do that. I mean, overall, our Q2 raw material inflation was about 34%. But that breaks out quite differently across the two divisions. It's more like 25% in institutional and it's north of 50% for food and beverage. Um, the reason for that is just the different constitution of the materials used in the, in the business. So food and beverage is very heavy on caustic, which you'll know, um, you know, is, is, is trading up multiples, um, of the, of the cost that it was doing. If you go back 12 or 18 months. So, um, you know, whilst we're seeing, you know, ethylene and propylene actually starting to move. back a little bit, cost it continues to increase. So that's really the biggest driver of why the margin profile in food and beverage looks tougher than the one in institutional.

And maybe you could just build on that by commenting on how the price discussions are going by segment, recognizing that many of your institutional customers can be smaller, and while your typical F&B customers are larger. customer may be considered more sophisticated from that. Is it harder to push price, in other words, in F&B than it is in institutional? Maybe you could talk about that.

Yeah, sure. Actually, I would say we've had really good success in both. You're right. There's maybe a slightly different mix of small versus large in the two businesses, but The food and beverage team has done a fantastic job of pricing. And, you know, just as the, you know, currently what you see with inflation is different. I think by the time we get to the end of the year, you know, we'll see that the pricing in the food and beverage business is significantly ahead of the institutional business. In general, you know, customers are understanding and accepting the current landscape. In fact, I can only think of one customer right across the business where we've really struggled on the pricing side. So in general, I think we're making really good progress, and I wouldn't draw any distinction between the two businesses.

Thank you. Thanks, Andy.

Our next question comes from the line of John Roberts with Credit Suisse. You may proceed with your question.

John, you may proceed with your question. Are you on mute?

Our next question comes from the line of Joshua Spector with UBS. You may proceed with your question.

Good morning. This is Lucas Beaumont. I'm for Josh. So I just want to get back to pricing. So in the quarter, you're basically running now at a 12% two-year stack. And based on your second half guide, I think you're going to get to probably like a 16% to 17% exit rate in the fourth quarter on a two-year basis. So how much of that on a two-year stack should sort of flow into 2023? And could you just sort of split that 16% to 17% for us between what's base pricing versus the surcharge so we can think about how much of that is sustainable?

Yeah, sure. So look, I think your numbers on the two-year stack are about in line. About 20% of the increase that we've taken this year, so I guess that makes it probably more like about 15% of the two-year stack, is in respect of surcharges. um the balance would be um you know the more uh the more structural pricing so look as we um as we go into next year obviously we're going to get a full year effect of the pricing that we've taken you know part way you know part way through the year so if our um you know if we had six percent um went through in q1 this year and that's going to be in the low teens um you know, as we get into Q4, you obviously, you can calculate the full year effect of that as we go into 23.

Great, thanks. And then just sort of going back to the performance in F&B for the quarter. So that was probably a fair bit better versus expectations in terms of the volumes. So if we're just sort of assuming similar to like group pricing, your volumes seem like they're probably up about 12%. So could you just kind of discuss the drivers there and sort of what you're thinking in terms of volumes in the second half, first place?

Yeah, sure. So look, I think we've been talking for a while about the performance of food and beverage and the fact that on volume, they've been doing really well. If you go back to, you know, 20 and 21, you know, it was the traditional cleaning and hygiene business that was doing really well. We were taking really good share. We've seen some more of that this year, albeit I think it's fair to say that with the massive focus on pricing, maybe at a slightly lower level. What we have had, though, coming to the party this year is the water treatment more significantly. We're running a kind of double-digit millions growth in water treatment for this year, which is helpful, a bit ahead of plan, but that's ramping up nicely, sir. I think as you go into the second quarter, I'm really hoping to see that water treatment growth continue to add. I also think, as I referenced just a minute ago, I think probably the pricing in the second half of the year will be slightly more skewed towards food and beverage versus institution.

Great, thank you.

Our next question comes from the line of Edlaine Rodriguez with Credit Suisse. You may proceed with your question.

Thank you. Good morning, guys. For a quick question on pricing and surcharges, like how successful are you in implementing the surcharges? And when you think about pricing for the year, what does the composition look like in terms of fundamental price versus surcharges?

Yeah, so I think on the surcharges, we've been pretty successful. We've applied surcharges versus structural price, depending on the particular dynamics of the market. So let me give you an example. In emerging markets where there is traditionally volatile inflation and our teams and just as importantly, our customers are used to that environment. we've continued to take structural price. If you take somewhere like Europe, where traditionally inflation is much lower and very steady, and the current inflation because of the war is particularly acute, there we have taken some structural price, but also some surcharge. And that allows us to ensure that if costs go up again, we can react to that. but also customers to understand they'll have some real transparency over the drivers of the cost increase. So I think it's been a successful strategy. It's something that we've put together this year, but it seems to work well. And customers, I think, have appreciated the transparency that it's given. In terms of the overall mix, about 20% of this year's pricing relates to surcharges, with the rest being the more traditional structural price.

Okay, makes sense. And one last one on the EBITDA margin. So you've got it for this year about like 13% to 14%, but I think you've talked about the 20% target you have out there. When do you think you can get there? Do you get there by 2024, 2025? When do you get there and under what conditions?

Yeah, so I don't think it's going to be 2024. I think we're going to see two phases to this, okay? One phase is going to be the correction of the price-cost gap that results from the current issues, or maybe you might call it sectional inflation on raw materials, labor, and freight. I think we're going to see that correcting. As we did in Q2, that's going to continue to correct in the balance of this year and also through next year. The second section is going to be those things that we were doing and working on way before the current crisis. And those things are ongoing, and they're gonna continue. And we've said before that those things will account for 50 to 100 basis points of margin appreciation per annum. So you should think of it as the next several quarters, we need to get back to where we were. We reported 15.7% margins back last year. And then we need to get back onto the 50 to 100 basis points train as we go back to focusing on our supply chain initiatives, our procurement, more pricing, and the SG&O savings. The other point, just to mention, in the realm of supply chain, of course, we've got the new Kentucky factory. That's going to add 100 basis points, and that's going to start next year.

Okay. Thank you very much.

Our next question comes from the line of Christopher Parkinson with Mizuho. You may proceed with your question.

Good morning. This is Kieran on for Chris. I was just wondering if you can just briefly touch on the M&A pipeline and how you're seeing those potential for deals, I guess, at this point, with multiples having come down a little bit and the current environment. Are you seeing more More of these deals potentially come to fruition and more opportunity on that front. I'm just curious to hear your thoughts on that portion of the business. Thank you.

I'll take that one. Thanks for the question. I would say that our view to M&A has not changed in the past 12 months. We are currently in an active funnel. We have active discussions with 8 to 10 players, most of which are bilateral. The reason why that's a good thing is that we can actually control to some degree the timing at which we would choose to execute some of that M&A. We're cognizant of our current leverage ratio. While we have, I think, exceptional liquidity at close to $700 million, we're also conscious that we want to get our leverage down. So we'll manage the timing and also because of a full funnel allows us to prioritize the best of what's in our funnel as well. And so we're excited about it, but we're also managing that in the context of how we want to also deliver the business in the short to midterm. Great. That's very helpful.

Thank you so much.

Ladies and gentlemen, we have reached the end of today's question and answer session. I would like to turn this call back over to Mr. Grant Graber for closing remarks.

Thank you. That wraps up our second quarter conference call. A replay of this call and related slides will be available on our IR website. Thank you for your time and participation, and I hope everyone has a great rest of the day.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation. Enjoy the rest of your day.