AZZ Inc.

Good day, and welcome to the AZZ Inc. Q3 2023 Earnings Conference Call and Webcast. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, then one on a touch-tone phone. To withdraw your question, please press star, then two. Please note this event is being recorded. I would now like to turn the conference over to Sandy Martin, three-part advisors. Please go ahead.

Thank you, operator. Good morning, and thank you for joining us today to review AZZ's financial results for the third quarter of fiscal 2023, ended November 30, 2022. Joining the call today are Tom Ferguson, President and Chief Executive Officer, Philip Shlom, Chief Financial Officer, and David Nark, Senior Vice President Marketing, Communications, and Investor Relations. After the conclusion of today's prepared remarks, we will open the call for questions. Please note there is a webcast and slide presentation for today's call, which can be found on AZZ's Investor Relations page under the latest earnings presentation at azz.com. Before we begin, I would like to remind everyone that our discussion today will include forward-looking statements, that are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements by their nature are uncertain and outside of the company's control. Except for actual results, our comments containing forward-looking statements may involve risks and uncertainties, some of which are detailed from time to time in documents filed by AZZ with the Securities and Exchange Commission. including the annual report on form 10 K for the fiscal year ended February 28th, 2022. These statements are not guarantees of future performance and therefore undue reliance should not be placed upon them. Actual results could differ materially from these expectations. In addition, today's call will include a discussion of non-GAAP financial measures. Non-GAAP financial measures should be considered as a supplement to, and not a substitute for GAAP measures. We refer you to the reconciliation of non-GAAP to the nearest GAAP measure included in today's earnings release and investor presentation for further detail. The earnings press release and Q3 presentation are posted on our website and have been included in the Form 8K submitted to the SEC. I would now like to turn the call over to Tom Ferguson, CEO. Tom?

Thank you, Sandy. Welcome to AZZ's third quarter earnings call, and thank you for joining us this morning. We accomplished a lot this quarter, including completing the divestiture of 60% of our infrastructure solution segment. We also paid off over $230 million of our debt, which improved our leverage to 3.4 times EBITDA. Both of our business groups grew their sales significantly, and I will get into the specifics shortly. But let me first express how appreciative I am of our AZZ Metal Coatings and AZZ Precoat Metals leadership teams. I commend them for the professionalism they have demonstrated as they have maintained focus on their customers while dealing with continual supply chain and labor issues, as well as storms and other distractions. Working with leaders that demonstrate so much pride and passion for their teams and business is truly invigorating. As you can see here, we achieved nice flow through of adjusted EBITDA on the higher sales, generating over $71 million, or a 79% increase versus prior year. Net income on adjusted basis was $22 million, up 4%, resulting in adjusted EPS of $0.88. Philip will talk about the one-time write-down on AIS shortly. Metal coatings had another strong quarter, with sales up 17% to $158 million. The growth was a result of volume, the earlier acquisitions of Dom and Steel Creek, and adding tubing to the metal coatings, as it was not divested along with the rest of AIS. Operating income was only up slightly versus prior year due to inflationary pressures, particularly as ink cost peaked in most of our kettles. We continue to maintain our pricing discipline and focus on delivering value to our customers. Tubing is a good business, albeit relatively small and with significantly lower margins than our galvanizing business. Additionally, service technology is underperformed for the quarter. The net of these two things amounted to about 100 basis points of margin headwind for metal coatings. The metal coatings team has already taken actions to strengthen surface technologies leadership, and improved performance. EBITDA of almost $42 million was up 3% over prior year. We continue to benefit from our investment in DGS, or the Digital Galvanizing System, which is driving both productivity and customer service. We are also seeing potential in the longer term to improve performance of our kettles arising out of technology efforts in conjunction with Texas A&M. The outlook in the fourth quarter is for a typical winter season, and we'd hope to not experience any more major storms like we navigated in December. Pre-code in its second full quarter with AZZ had nice sales growth to 215 million, which generated over 34 million of EBITDA. While pre-code did grow its underlying unit volume modestly versus prior year, sales were lower than the second quarter due to normal seasonality, as we have noted previously. The lower volume sequentially has about a 100 basis point impact due to the deleveraging effect on fixed cost. Pre-code's underlying business performance was solid given the continued inflation on indirect materials, labor shortages, and extraordinarily high customer owned inventories that caused significant inefficiencies in cost. We have taken actions to improve the inventory situation and have focused initiatives to improve productivity at several plants, but are still dealing with skilled labor shortages and some logistical inefficiencies. Additionally, we have taken pricing actions to address the indirect material inflation and higher logistical costs. We have made progress on the 10 million of synergies we had noted at the time of the acquisition. And while so far the benefits have been balanced by the cost, these will be showing up in our run rates in fiscal year 2024. Year to date, our business on a consolidated basis has done well. To put it in perspective, we have generated sales approaching $1 billion in the first nine months, which used to be what we did all year. We have generated over $238 million in adjusted EBITDA, which doubles the prior year. Adjusted net income of $97 million and adjusted EPS of $3.89 are up 56% versus the prior year. For the AIS joint venture, we have recognized a little over $1 million of equity income. While it has been a tumultuous year, we are positioned well as we finish up this fiscal year and prepare for fiscal 2024. So now, I'll turn it over to Philip.

Thanks, Tom. As Tom noted, we closed on the divestiture of our controlling interest in the AZZ infrastructure solution segment to Fernois Group at the end of September 2022, after just completing the second quarter. As a result, we were required to report the results of operation as continuing and discontinued ops from the second quarter onward. My commentary will focus primarily on the results from continuing operations. I will also walk through the consolidated adjusted EBITDA and adjusted EPS and bridge results to our 2023 full year guidance ranges. For comparability, I may refer to pre-code or AI sales so investors can track quarterly sales inputs or exclusions. Our adjusted numbers primarily exclude impacts from additional non-cash loss recorded on the finalization of the divestiture of AIS and excludes the depreciation and amortization related to the purchase accounting effects of the pre-code acquisition on both the quarter and year-to-date results. AZZ generated third quarter sales of $373 million, $158 million from metal coatings, and $215 million from pre-code. One month of sales from the infrastructure segment for September prior to the divestiture of 42.3 million were included in the results from discontinued operations. Third quarter sales reflected continued stable demand with metal coatings up 17.2% and pre-coat metals up 14.8% on a comparable prior year same quarter basis. Gross profits from continuing operations for the third quarter totaled 73.1 million or 19.6% of sales. While aggregate profits are higher from a dollar perspective, the gross margin reflects increased cost of zinc flowing through our kettles within the metal coatings, as well as transitional operational expenses and warehousing costs for pre-coat. As Tom mentioned, we have taken steps to address these issues. Operating margins from continuing operations were 12.2% of sales for the third quarter, as compared to 15.8% in the prior year. Excluding the impact of the pre-coat purchase accounting related amortization and depreciation of $8 million, operating margins for the quarter would have increased to 14.3% of sales. Third quarter calculated EBITDA was 26.2 million compared to 39.8 million in the prior year same quarter. When adjusted, the EBITDA for the quarter was 71.2 million or 19.1% of sales, up 78.8% compared to the prior year. Earnings per share from consolidated operations was a loss of 97 cents, which included a $45 million loss associated primarily with a non-cash write-off and discontinued operations of the AZZ infrastructure segment related to historical currency translation adjustments. Excluding the loss and including the DNA from pre-code purchase accounting, third quarter EPS was $0.88, an increase of 3.5% versus $0.85 in the prior year quarter. Year-to-date sales from continuing operations were $987.1 million generating reported EBITDA of 63.3 million and adjusted EBITDA of 238.5 million. Year-to-date reported EPS was a loss of $2.35 as a result of the finalization of the AIS divestiture. Year-to-date adjusted EPS was 389. Year-to-date diluted EPS from continuing operations was $2.17, an increase of 39% compared to the $1.55 diluted EPS from continuing operations through the third quarter of last year. Cash flows from continuing operations for the nine months were $68.6 million compared with $45.9 million in the prior year. Our year-to-date capital expenditures from continuing operations were $35.1 million compared with $15.8 million in the prior year. The year-over-year capital increase was planned and contemplated in our strategic rationale associated with the precode acquisition. In terms of capital allocation, the company's balance sheet is strong and we continue to maintain a prudent capital allocation strategy. Utilizing proceeds received from the divestiture of AIS, in addition to cash from operations, we reduced outstanding debt by $230 million. We invested $18.3 million during the quarter in capital expenditures. We expect to invest roughly $45 million in capital expenditures for the full fiscal year as we shuffle capital spending around due to continued supply chain disruptions. Shareholder returns to common shareholders included Q3 dividend payments of $4.2 million, which represents an estimated annual dividend yield of 1.6% based on Friday's closing price. We have an active pipeline of acquisition targets, however, do not plan any actionable transactions in the near-term horizon. As we focus on reducing debt, we do not anticipate any share repurchases. As described above, we reduced our Term Loan B by 230 million and improved our leverage to 3.4 times, a good step towards our 2024 target of getting back to or under three times leverage. As discussed last quarter, we have roughly 50% of our existing term loan B debt covered by a swap agreement to reduce further interest rate exposure. Lastly, other than our current three and a quarter million mandatory quarterly principal payments on our term loan, we do not have any maturities until 2027. I'll now turn it back to Tom for his closing comments.

Thanks, Philip. Market activity generally for metal coatings is normal given we are in the seasonally slower winter months. Fabrication activity remains solid. Zinc costs have peaked in most of our plants and will begin to normalize with current market levels. Pre-code is more reliant on the construction sector, so they are typically more impacted by the winter season and major storms like we had over Christmas. We are beginning to see customer inventories normalize as supply chain disruptions are easing somewhat. and due to some of the actions we have already taken. Our pricing actions are also catching up to some of the inflationary labor, energy, and non-paint materials costs. Naturally, we are continuing to focus on debt reduction, monitoring customer credit carefully, and ensuring effective CapEx deployment. We are maintaining our sales guidance of $1.275 to $1.325 billion, and also our adjusted EBITDA guidance of $285 to $305 million. We are raising our adjusted EPS guidance by 25 cents from the $3.80 to $4 range to $4.05, from $4.05 to $4.25. This is based on the strong third quarter and the outlook for the businesses that we have previously discussed. This guidance does not include any potential equity income that we might receive in the fourth quarter from our 40% share of avail. I will also note that the fourth quarter EPS will be impacted by a more normalized tax rate than we experienced in the third quarter. Dividends in preferred equity or dividends on preferred equity and seasonally slower volumes. Our guidance reflects these impacts. As a reminder, we will be getting back into our normal cadence on annual guidance and we'll be issuing fiscal 2024 guidance in a few weeks. AZZ is the leading independent hot tip galvanizing and coil coating company with an irreplaceable footprint serving a broad and diverse set of markets. As a high-value ad-totaling business, we are not directly exposed to metal commodities, have the ability to shed variable costs quickly, and thus are able to protect our margins pretty well during downturns. We generate great margins, returns, and free cash flow by focusing on providing outstanding value to our customers, emphasizing operational excellence, and continuing to innovate and develop our technology. With that, we'll open it up for questions.

We will now begin the question and answer session. To ask a question, you may press star, then 1 on your touch-tone phone. If you are using a speaker phone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star, then 2. At this time, we will pause momentarily to assemble our roster. The first question comes from John Franz Reeb with Sedati and Company. Please go ahead.

Good morning, guys, and thanks for taking the questions. I'd like to start with the metals coatings business and incurring the high zinc costs. Can you talk a little bit about where you stand as far as those costs coming down and what's the margin profile look like in the current quarter versus Q3?

On the margin profile, I think our zinc has peaked in December, and so we'll start to see some decrease as we move forward into the fourth quarter and into fiscal year 2024.

Okay. And what was the impact in Q3 of the highest zinc on the segment in Q3?

We really don't disclose that. But, you know, I'd say typically we're, well, because of keeping in mind that our, you know, we try to price in line with those ink costs. So while we've kept our pricing discipline, I think the overall impact, we'd probably, I'd say we're looking at maybe 100 basis points overall, just kind of that headwind. You know, we have about six months of zinc in our kettles and it depended on, you know, but there's a range of costs in each cattle across the fleet.

Okay. And on the pre-code side of the business, you talked about productivity issues at several plants is what I thought you said, Tom. And you also talked about lower volume hurting the op margin profile by about 100 basis points. I guess two questions here. Is the balance of the volume sequentially, is that the productivity issue? Is there anything else going on? And can you just remind us what the productivity issues are and when do you expect them to be resolved?

Yeah, we've got a couple of different things going on. I think we've mentioned the very extremely high levels of customer inventory, which if you go into one of most of Preco's plans, that tends to get in the way of being efficient logistically and moving materials, which we're a material handling business. So that's in the majority of plants, that high inventory issue. As we noted, that's coming down, and I think we're probably within a couple, three months of being to more normalized levels in the majority of the plants. We do have three or four plants that, have struggled with, I'll call it the mix of their business. So taking some of the lower margin type activity to maintain absorption levels and keep flow. That's something that's going to take us probably a couple of quarters to work out. We've made some adjustments. We have several initiatives. a really good team within Precote of operating support and focus on quality. But that's going to take a couple quarters. We're going to be into next year before we see that move significantly. In terms of We talked about the fixed cost leverage. You know, that deleveraging effect, as we had talked about, kind of just mostly because of how our fiscal quarters fall for pre-code, tends to hit the worst five months of the year in the third and fourth quarters. So fourth quarter is basically all winter, which construction activity is less, and a lot of the metals building customers are kind of managing their inventories and managing their business. So, you know, that part of the fixed cost deleveraging will continue through the fourth quarter. And then we hope for an early spring in March and, you know, bounce back to the really strong first and second quarters.

Okay. Thanks for taking my questions. I'll actually get back into queue. All right. Thanks, John.

Our next question comes from Noel Diltz with Stifel. Please go ahead with your question.

Hi. Thanks for taking my questions. First, I was wondering if you could expand on the underperformance that you mentioned in surface technologies, and if you could quantify that impact, that would be great, and maybe how quickly you think that you'll start to make some of those improvements that you referenced.

Yeah, it's not a huge impact overall, but it's enough to move the needle. So you're looking at a business of, what, maybe $6, $7 million a quarter, but really low margins, lower than we've experienced. So the leadership changes were made. several months ago. And so I think, you know, that takes a little bit of time to gain traction. We like the initiatives that the team has going there. But I think we're going to be, you know, into the first quarter, probably well through spring before we start to see any significant improvement there. Part of it is just making sure we're going after the right kinds of business. We find, you know, Powder Coney to be better than the plating side. So these are all adjustments in how we're targeting the customers, how we're approaching the business, and then driving the normal focus on efficiencies, productivity at the six plants.

Okay, great. And then I recognize you said you're giving guidance in a few weeks, but maybe could you give us some early thoughts on how you're thinking about the outlook particularly for pre-code as we look into the next fiscal year, if you could just walk us through some of the, you know, puts and takes in terms of growth. I know obviously you're, you know, continuing to gain share or see increased penetration of pre-coded metals, but I would think some of the more, you know, residential or consumer facing parts of pieces of the business might, might see a little bit more of a headwind. So could you just give us a sense of sort of how you're thinking directionally about, about growth? Thanks.

Yeah, I think when it comes to, you know, residential construction isn't a huge piece. I'm going to let David talk to the markets a little bit here in just a second. But so for pre-code, you know, the focus is, you know, obviously it was disruptive to the pre-code leadership team going through this whole process and then coming on board with AZZ. And it's been a great I'll call it a great onboarding process. So we've tried to make it as minimally impactful on them as possible, but it's still disruptive to come into a new organization, new processes of a public company. So I'd say we're through the vast majority of that. We don't anticipate any major systems, integrations, or activities that can be disruptive as we go through at least the first part of next year. So I anticipate, well, I don't anticipate, I know, The focus is going to be on continuing to drive value with the customers. I do think there's opportunities to more quickly drive productivity and efficiency improvements. The team's really focused on that, and as some of these customer inventories are coming down, which they are, that's starting to open up the ability to drive their traditional productivity and efficiencies in their plants. The plants that are underperforming, There's a plan there, and the team is very, very focused on that. It just takes a while. These are highly automated plants, so it takes a little time to gain traction on that. But these are things that we've been focused on since they've been in full. So I think what, but those market headwinds you mentioned, that is going to have, that is, those are true headwinds. I think we'll focus on continuing to grow share. and then we'll see how the economy goes. So our focus is going to be more on let's improve our profitability on the volumes that we have and drive the efficiencies, make sure that we maintain that stability. We do think there's some synergies on the sales side, and so we have really good effort going on there, but that'll take you know, that takes two or three quarters to gain traction on. So as we get through the first quarter and into the second, I think we'll start to see the benefits of those things. The hard synergies, we've generated some of those, but the cost have offset it. So I'm pretty enthusiastic about both of our businesses, but both of them are going to be focused more on protecting their profitability, driving improvements, And then we'll see where the volumes go. And David, if you want to talk about where you see construction and things.

Sure. Thanks, Tom. Yeah, a couple of things, Noel. You know, non-residential construction still remains pretty good, particularly on the pre-code side with metal-intensive sectors like warehousing and manufacturing faring pretty well. We do have a specification of pre-painted insulated metal panels in things like data centers and cold storage construction. which continues to be a positive trend for them. When you take a look at the residential construction, as you know, single-family housing starts have struggled in the broader market, but multifamily remains quite strong. We do have the use of prepainted metal roofing continuing to gain traction in multiple markets within residential, so we think that's going to be a positive for us going forward. Appliance and HVAC shipments have eased quite a bit from the solid pace experienced earlier in the year. And again, that related to general market and economic slowdown in the U.S. But the container market, which we've talked about on previous calls, particularly the beverage can shipments, have benefited from favorable secular growth trends and the switch to aluminum for recyclability and consumer packaging preferences. So those are some of the highlights on the pre-code side specific to your question.

Okay, great. That's really helpful. And then, you know, I know you're not including the, you know, JV income in the fourth quarter. Would you anticipate that you would start to include that in guidance as you look at next year, or is that still sort of a TBD item? Thanks.

We did have our first board meeting yesterday, and we like the leadership team. So they're very disciplined and focused. They're getting through the usual purchase price accounting things to go from being part of AZZ to being a private company. I think I'd like to give them a little bit of time, call it a quarter. So I don't think we're going to be able to give guidance on what that equity income is going to look like as we issue our guidance. I do think as we get into next year, I think we're going to be able to start providing some general guidance on what that equity income is going to look like for the balance of next year. But I think we've got to let them get through at least another quarter of their operations and and how they're managing the business and what their focus is. So my intent is not to have it in this guidance that we give towards the end of January, but that hopefully we can start to provide better context as we, hopefully by the time we do our full year earnings call.

Okay. Very good. Thank you.

Our next question comes from John Brates with Kansas City Capital. Please go ahead.

Good morning, everyone. Good morning. Tom, going back to the pre-code, you mentioned that a couple of facilities took on some, I guess, lower margin business. And I guess as you look forward, how do you balance that against maybe some weakness, you know, in general market activity? How do you balance maybe taking maybe additional lower margin business versus, you know, saying no and risking maybe a little bit more deleveraging of the cost side of the equation?

Yeah, I think that's, you know, we're spending a lot of time with the pre-code team, which was actually really enjoyable because it's so similar to our galvanizing business. But yeah, we're focused on profitable growth. They've got great indicators in terms of how they're running their paint efficiencies, productivity, line feet per hour, per day, all that kind of thing, per minute. So there's a balancing act, but I think we want to defend our market share. We are focused on, you know, what things are more profitable than others. We have made some leadership team, some leadership changes in a couple of those plants already. And we anticipate that that's going to start to drive better performance, better consistency, because right now it's hard to say for sure that certain business isn't all that profitable when you've got some underperforming operational issues. So dealing with that, and the team's been dealing with that, so it's not like they've been sitting there. But those plants are also in markets where labor is even more constrained. And while I'm not gonna give any specifics on which plants those are, they are in more labor-constrained markets. So we're having to pay more to get the folks we need, which we're willing to do because labor is still a relatively small piece of our overall cost structure in pre-code. But yeah, we wanna defend share overall, take care of our customers, and then carefully balance the fixed cost absorption in those plants as well as against the overalls. So that's a mouthful that I just gave you, but I can tell you it's a daily, weekly review that the Preco team does on this. So they're looking at this every single day. Okay. And moving business between plants if they're finding they're not serving their customers. So sometimes it's It's where we've been taking some expense to move it to the right places where we can serve as the customer the best.

Secondly, on the galvanizing metal coating operation, you talked about zinc costs being relatively high, but natural gas costs have come down sharply here in the last 90 days. How much of an impact might that have on the margins of the business?

You know, it's, well, it's actually a significant spend. It's fairly de minimis in terms of the overall margin impact. And also because of the way our commitments flow with the utilities, you know, we won't be seeing some of that until we get into next year anyways. Okay. Okay.

All right. All right. Thank you very much.

All right. Thanks. Our next question comes from John Smith. Fran Sreeb with Sadati and Company.

Please go ahead. Hi, guys. Thanks for taking the follow-up. Just a little bit of questions about the guidance here. FACSET has the nine-month number at 352, and I believe on page, was it seven? You have it at 389, and your guidance is 405 to 425. I just wanted to know if we can kind of reconciliate what the number is we should be using as a baseline number in relationship to your guidance, because if we're using that 389 number, it seems like a really sizable drop in the fourth quarter. Can you just help us there?

Yeah, I think, John, that's a good question. And fourth quarter will be seasonally lower than the first nine months of the year. We've been working with, we've had a lot of changes in the operations with the acquisition of pre-code metals and the divestiture of the controlling interests and AVAIL or AIS infrastructure. And so some of those outlets don't have fully updated numbers. So David's been working with those outlets on getting better historical numbers. But 389 is where we're bridging from for the guidance.

So that suggests a number between 16 and 36 cents for the fourth quarter. Am I understanding that properly, Phil?

Yeah, that's the way it'll flow. Obviously, it's significantly lower volumes on the seasonality, as we've talked about, particularly for pre-coat. On the metal coating side, I think we will kind of see the tailing off of these high zinc costs, and we are doing everything we can to hold price and So yeah, this is probably our ugliest quarter. And then Q1, we get into the spring and build up into what I think going forward will traditionally be our strongest two quarters in the first half of the year.

And I guess just a nagging question, what kind of share count are you using on that 389? And what are you thinking about for the full year? It's kind of bounced around based on profitability, I guess.

It's based on the dilutive and undilutive features. We're using about 25 million shares in the calculation, John. In the fourth quarter, to finish out on Tom's question, what's putting pressure is we seasonally have lower sales and we do have the fixed cost of our interest on the debt and then the preferred dividends on our Blackstone corporate equity. So that's what's pushing a little pressure in that seasonally low fourth quarter.

Well, we also had the unusually low tax rate in the third quarter. And so that starts to normalize or go back towards normal in Q4.

Yeah, we'd expect taxes to normalize in the 24% range for fiscal 24.

You took my question. Thank you very much, Phil. Appreciate it. Thanks, John.

This concludes our question and answer session. I would like to turn the conference over to Tom Ferguson for any closing remarks.

Yeah, we really are excited about the addition of pre-code metals, and particularly as we see how well the culture and leadership teams fit with our metal coatings team. Both teams live by the same values, have almost identical operating cultures, so we look forward to sharing next year's outlook and guidance within the next few weeks. As we get back into the normal corporate operating mode, I also look for us to be able to provide a lot better clarity and transparency on what's in our margins and how to look at those going forward. I know everybody would prefer that. So we'll get out of the big adjustment mode and into a stable operating mode that drives where we're demonstrating the great margins that both of these businesses can have, and talking about our business from the normal markets, operational things that drive it and how we're getting back to growing share and driving profitability. So thank you for joining us today.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.