Valvoline Inc.

Thank you for standing by and welcome to Valvoline's third quarter 2022 earnings conference call and webcast. My name is Sam and I will be your moderator for today's call. All lines will be muted during the presentation portion of the call with an opportunity for questions and answers at the end. If you'd like to ask a question at this time, please press star one on your telephone keypad. I'll now hand the call over to Sean Cornett with Investor Relations. Sean.

Thanks, Sam. Good morning, everyone, and welcome to Valvoline's third quarter fiscal 2022 conference call and webcast. On August 3rd at approximately 5 p.m. Eastern time, Valvoline released results for the third quarter into June 30, 2022. This presentation should be viewed in conjunction with that earnings release, a copy of which is available on our investor relations website at investors.valvoline.com. Please note that these results are preliminary until we file our Form 10Q with the Securities and Exchange Commission. On this morning's call, Sam Mitchell, our CEO, and Mary Meiselsberger, our CFO. As shown on slide two, any of our remarks today that are not statements of historical fact are forward-looking statements. These forward-looking statements are based on current assumptions as of the date of this presentation and are subject to certain risks and uncertainties that may cause actual results to differ materially from such statements. Valvoline assumes no obligation to update any forward-looking statements unless required by law. In this presentation and in our remarks, we'll be discussing our results on an adjusted, non-GAAP basis, unless otherwise noted. Non-GAAP results are adjusted for key items, which are unusual, non-operational, or restructuring in nature. We believe this approach enhances the understanding of our ongoing business. A reconciliation of our adjusted non-GAAP results to amounts reported under GAAP and a discussion of management's use of non-GAAP and key business measures is included in the presentation appendix. The information provided is used by our management and may not be comparable to similar measures used by other companies. Now as we move to slide four, I'd like to turn the call over to Sam.

Thanks, Sean, and thank you everyone for joining us this morning. In case you missed our announcement on Monday, we are excited to have reached a definitive agreement to sell our global products business for $2.65 billion in cash. I encourage you to review our announcement presentation and press release for further details on the transaction. With the separation of global products, Valvoline is marking a pivotal step in its strategic transformation. As a pure-play auto aftermarket service company, Valvoline expects to be a faster growth, higher margin business with lower margin volatility and a long runway for reinvestment opportunity. The sharpened corporate focus, enhanced capital structure, and capital allocation policies further cement our corporate transformation into a high-growth auto aftermarket retailer. The long-term benefits of the transaction are clear. Historically, Valving has been a combination of a predominantly slower-growth cash-generated products business and a high-growth high margin services business. The separation will drive increased clarity and transparency on the performance of our fast growing retail services business, which should lead to a more appropriate public market valuation and a new shareholder base focused on high growth retail concepts. We believe Valvoline as a standalone auto aftermarket services company represents a compelling value opportunity for investors. Valving's board and management team are committed to executing our strategy and delivering best-in-class results for our shareholders. Moving to slide five, let's discuss how we plan to utilize the transaction proceeds to drive our transformation. Valving expects to receive approximately $2.25 billion in net cash proceeds. We anticipate paying down some debt, particularly the 2030 bonds, which we expect to redeem at par given the asset sale covenant provision. and other indebtedness specifically related to global products. Our enhanced capital structure is targeting 2.5 to 3.5 times rating agency adjusted net leverage ratio, which allows Valvoline to both invest in the business and return cash to shareholders via share repurchases. We believe in the long-term value of our stock and will retire a substantial percentage of the shares outstanding to right-size our capital structure and minimize earnings dilution from the separation. Let me walk you through how we expect the transaction to impact long-term EBITDA margins for our business. Slide six is consistent with what we shared on Monday, though a slightly different view to help add some clarity. We anticipate that our portfolio realignment will improve our overall corporate margins by roughly 400 basis points, while demonstrating a faster growth and high returns profile. Beginning with our guidance of 30% to 32% retail services segment margin, we must allocate approximately 50% of our legacy corporate costs to derive a comparable corporate EBITDA margin. The synergies from the transaction, mainly incremental standalone and supply agreement costs, reduce margins by roughly 300 to 400 basis points to generate our 23% to 26% margin targets. The brand use for product purposes is reflected in the transaction consideration, and so no brand licensing fees are involved going forward. Despite separation to synergies, we're confident in our long-term growth, margin profile, and cash flow generation. Regarding sales growth, we've outperformed historically, driven by same-store sales and store additions, so there's room for upside in our outlook as well. Pro forma 2022 EBITDA margins are forecasted to be slightly below our long-term expectations, primarily due to the price-cost lag from the extreme raw material inflation that we have seen this year. The improved Valvoline corporate margin profile, coupled with optimized capital structure and capital allocation, is projected to drive 20% or more of EPS growth annually. Let's review our Q3 results, starting on slide 8. Our results in Q3 show that the demand profile for Valvoline's products and services remains robust, with both businesses continuing to capture market share. While we are experiencing temporary dilutive effects on profit margins due to higher costs and price pass-through impacts, the strength of our top-line growth highlights the non-discretionary nature of our preventive maintenance business and positions us well for margin expansion when the current inflationary cycle eases. Let's turn to the next slide to look at retail services results for the quarter. Our retail services segment continues to generate strong top line growth, with Q3 sales increasing 16%. System-wide store sales also increased 16%, driven by a nearly 10% same-store sales growth and an 8% increase in units. On a two-year stack basis, our same-store sales in the quarter grew in excess of 50%, And for the year, we expect growth in excess of 30%. At the end of fiscal 22, we expect to have delivered our 16th consecutive year of same-store sales growth. We have a three-pronged approach to expanding our retail footprint, building company stores, acquisitions, and working with our franchisees on their store development. We anticipate adding 140 to 160 units this fiscal year with a strong franchise contribution as they continue to invest in growth. Turning to slide 10, let's review our recent margin performance in the context of our segment strategies, our segment targets, and by comparing year-over-year and sequential performance. In Q3 last year, EBITDA margins ran well ahead of our long-term targets, driven by high store utilization levels. We were understaffed in our stores, but seeing a significant rebound in transactions, leading to roughly 300 basis points above the midpoint of our target range. As we said during our earnings call last quarter, our segment EBITDA margins in Q2 were below our long-term targets due to product and labor inflation, as well as labor investments we made to improve staffing levels and turnover. We took pricing actions beginning in early Q3 to improve margin performance. Those actions were successful and drove a 230 basis point sequential increase in margin rates this quarter. While improved, our Q3 margin was slightly below our long-term target driven by continued inflationary pressure, as well as a dilutive impact of passing through higher product cost and sales to our franchisees, which drove 100 basis point of margin decline year-over-year. In Q4, we expect similar margin performance to Q3. However, with continued top-line growth, we expect better flow-through to profitability, leading to a solid year-over-year growth in segment EBITDA. While the macro environment remains challenging, we are monitoring potential impacts of higher inflation on consumer behavior and any differences by region. We do have levers to address any developments, including adapting our digital marketing offers, among others. We remain confident in our targeted segment margin range. Given our top line strength, we are well positioned to see both improved EBITDA dollar growth and margin expansion as inflationary pressures ease and the margin leverage of our model is demonstrated. Let's review global products results on the next slide. Volume growth in global products continues to be impressive, with a 9% increase in Q3. These results were generated despite disruptions to the business from geopolitical events and COVID, particularly the lockdowns in China. With demand strength continuing, combined with pricing actions, adjusted EBITDA grew 7%. Unit margins continued their sequential improvement progress in Q3, highlighting the business's ability to efficiently pass through earlier rounds of raw material cost increases with pricing. Nonetheless, with raw material costs continuing to increase, we expect impacts to profitability in Q4. Despite disruptions in higher costs, discretionary recast flow for the segment remains strong and steady. I will now pass it over to Mary to further discuss our financial results for the quarter.

Thanks, Sam. Our Q3 results are summarized on slide 13. Strong top-line growth was broad-based across segments and channels, highlighting ongoing robust demand. Overall sales growth of 21% in the quarter was driven by 15 points of pricing, including pass-through of raw material inflation, and nearly six points from favorable volume mix. The growth in adjusted EBITDA was primarily driven by volume mixed benefits, partially offset by a modest increase in SG&A due to wage inflation and normalizing levels of travel and advertising. Let's take a closer look at segment results on the next slide. Retail services sales growth of 16% includes same store sales of nearly 10%, reflecting the continued strong performance in the business with ticket growth outpacing transaction growth in the quarter. EBITDA margin in retail services was down 450 basis points year over year, highlighting the difficult comparison and dilutive impacts from inflation that Sam mentioned earlier. Margins improved 230 basis points sequentially with the pricing actions we took. While we do not expect significant improvement in Q4 due to ongoing price pass-through effects, we remain confident in the long-term outlook for margin enhancement. Sales growth in global products continued to run well ahead of strong volume increases in Q3. Unit margins also saw a noticeable sequential improvement. Both of these highlight our ability to pass through inflationary costs with pricing. Let's review our updated guidance on the next slide. We are updating our guidance range for adjusted EBITDA and now expect $670 to $680 million on a consolidated basis. Going into the year, we didn't expect the level of inflation that we've experienced. The reduction in guidance for retail services is primarily related to the unfavorable price cost lag from higher raw material costs. Our updated outlook represents a low double digit growth in earnings year over year at the midpoint for retail services, a meaningful increase in a challenging environment. On adjusted EPS, we now anticipate $2.07 to $2.15 a share. We're reducing our guidance for free cash flow to 140 to 160 million. Continuing raw material inflation is driving a higher working capital investment in the global products business. As inventory values increase and price pass through leads to higher levels of accounts receivable. Now, as we turn to slide 16, I'll turn things back over to Sam to wrap up.

Thanks, Mary. As we turn our focus to preparing for the new fiscal year, we are expecting strong profit growth as we move past the impacts of product inflation. While we've guided to a mid-teens EBITDA growth on average, given the challenges that we'll be lapping, we expect a stronger EBITDA growth rate next year. We also will be focused on minimizing corporate dis-synergies and optimizing SG&A. We look forward to sharing more on our fiscal 23 outlook for the new Valvoline at our year-end earnings. We are bullish on our capabilities and opportunities in automotive aftermarket services. On a roadmap to drive shareholder value, we remain committed to our successful growth strategy of making vehicle care easy and accessible for our customers. We will optimize our capital structure and capital allocation policies to supplement the growth in our core business, where we expect to continue to grow market share and non-oil change revenue. With a footprint of nearly 1,700 stores that currently reaches less than 15% of households, we have significant opportunities for unit expansion. and we will be increasing our emphasis on franchisee growth. Finally, with a clear corporate focus, we will increase and leverage our scale to prepare for and capture new customer and service opportunities. We are very excited about the future of retail services, and we are pleased that we have found the right strategic partner for global products. Finally, I'd like to again recognize our teams across Baveling. I'm proud of the results generated growing the business and delivering outstanding customer service while working through a rigorous separation process. This gives me great confidence that we're ready for the next step in our transformation. With that, I'll hand things back to Sean to open the line for Q&A.

Thanks, Sam.

Before we open the line for Q&A, I'd just like to remind everyone to limit your questions to one and maybe a couple of follow-ups so that we can get everyone on the line. With that, Sam, please open the line.

Thank you, Sean. We will now begin the Q&A session. If you'd like to ask a question, please press star 1 on your telephone keypad. If for any reason you'd like to remove that question, please press star 2. As a reminder, if you're using a speakerphone, please remember to pick up your handset before asking your question. Our first question comes from the line of Simeon Gutman with Morgan Stanley. Simeon, your line is open.

Hey, guys. This is Michael Kessler on for Simeon. Thanks for taking our questions. First, I wanted to ask about the retail services EBITDA margins still a little bit below the longer-term targets that you've previously outlined and on a pro forma basis have outlined to us. Is the gap, is it just primarily due to the raw material cost inflation and the lag passing to franchisees? I guess, is there anything else that would explain the gap? And then if we're thinking about next year, if we get a more stabilized pricing backdrop, should we expect that the margin should come back into, like on a pro forma basis, the 23 to 26% range?

Yeah, so first of all, you're correct in that our margins going into Q3 and going into Q4 they're impacted by those higher prices that we're passing through to franchisees, so impacting our percent margins. We did note earlier in the year in Q2 where we had a margin decline that we took appropriate pricing actions, both in our oil change services and our additional services, and those helped us recover margin in Q3. So when we look at Our current pricing in the stores, we think we're where we need to be in terms of our margins for both oil changes and services. And so now we're talking about that percent margin being somewhat depressed by that pricing impact to our franchisees primarily.

Okay, that's helpful. Maybe one follow-up on that and just one other separate question. on the longer-term range, 23% to 26%. Can you talk about, I guess, the drivers? We can kind of see that there's a little bit of probably uncertainty around the nature of corporate costs in a separation, what the exact impact of the supply agreement looks like, etc. But the gap between 23% and 26%, can you talk about just puts and takes, why you might end up at the lower end versus the higher end? And when we say long-term or when you guys say long-term, is 26, you know, kind of a good upper bound to think about? Or if we're thinking out several years, there could be room for further expansion.

Yeah, let's, the, yeah, we're thinking about like the, say, 23 to 26 period when we talk that, that both near term and long term. And so I would expect us to be probably closer to the 23% range as we begin this next period. We do have some more work to do as we prepare for fiscal 23 and on the dis-energies and the corporate cost and making sure that we've got our cost structure optimized. And so we'll shed some more light on that when we do our Q4 earnings call and guidance for 23. But our model has significant leverage in it. And so we've proven this over time. And as we grow same-store sales and continue to grow at a healthier rate, it's going to improve our margins over time. And so we would expect margin improvement from 23 through 26 each year as we continue to drive performance. And we remain very confident in our ability to continue to capture market share while improving performance in the stores with ticket, not all change revenue.

Great. Okay, thank you. And sorry, maybe one last follow-up for me, and then I'll close. Just on the same-store sales, I'll go for retail services. I know the total, total growth came down a little bit versus your prior, um, your prior guide. So if you can just talk a little bit about, about that, and then just thinking about the same store sales build in the out years and just kind of on a, on a normalized basis, is there any, any changes we should be thinking about and just the build their ticket versus traffic, um, anything, you know, I guess new to note, given that you've had three years of, I would say pretty strong, you know, compounded growth. Thank you.

Yeah, no doubt the last few years have been incredibly strong with same-store sales performance. And I don't know that, you know, we'll continue in the double-digit range, but we'll always be striving for that. We still have plenty of opportunity. But we'll work on our guidance, you know, for fiscal 23, and I believe it's going to continue to be strong because we're seeing – you know, good solid opportunities in both growing market share, winning new customers, retaining those customers and selling them the additional services, providing those services that they're needed, and in seeing ticket performance too. So the algorithm doesn't change. We would expect that transactions will be a healthy component of our same-store sales growth moving forward, but we also see the ticket performance driven by premiumization of oil changes, pricing leverage, and selling and providing those additional services for preventive maintenance being key. When we look at our performance in this past quarter, both transaction and ticket contributed to that same store sales growth of roughly 10%. About a third of it was driven by transactions, two-thirds by ticket performance. But, you know, I think it will be relatively balanced moving forward with, you know, steady transaction growth in the, you know, contributing, you know, close to anywhere from a third to a half of the overall same-store sales performance and the balance being ticket.

And, Sam, if I could just add on to that a little bit. I do think if you think about our long-term range for same-store sales growth of 6% to 8% and unit growth of 6% to 8% over time, there certainly is some upside opportunity. But we're guiding at the lower end to make certain that we're able to certainly provide a reasonable level of guidance on both of those going forward. In addition to that, Michael, you mentioned on the 23 margin rates, I do think we're going to still see some dilution effect of the price cost through to franchisees. We have seen additional raw material cost increases here in the last several weeks, and that price pass-through is continuing to the franchisees. So I think some of that dilution is going to continue, and you might see the 23 numbers still be a little bit light relative to the low end of the guidance when we come out with our final guidance for fiscal 23, primarily driven by the dilution of that product cost pass-through.

Thank you for your question, Mr. Kessler. The next question comes from the line of Mike Harrison with Seaport Research. Mike, your line is open.

Hi, good morning. Morning, Mike. I was hoping that you could give a little bit more color on what's going on with the free cash flow guidance. I think what we're trying to understand is if this is a structural issue or if this is mostly related to timing, and a lot of that working capital should unwind as we start to look at fiscal 2013.

Yeah, Mike, to be clear, it's really an issue related to the global products business. You know, the average day's sales outstanding on the receivable side for the global products business, you know, is consistent with the industry. The DIY business generally has longer terms. And as we've passed through this significant inflation to our DIY customers, those receivables have grown substantially year over year. You can see that in our balance sheets. Um, at, um, September, excuse me, at June 30th, that was published with our earnings. Um, so, and you can see it also reflected in inventory, although the inventory impact is moderated because the pay of the payables growth as well. Um, you know, those businesses are, are being sold. Those receivables will be sold with the global products business. Um, I think it's, um, a one time issue associated with this raw material cost inflation. that will eventually moderate as the inflation reduces. But that is all, as I said, related to the global products business. As you think about the retail business, the retail business is almost completely a cash business. We have about 10% of our sales that are related to B2B accounts where we're selling to fleets and other types of commercial providers on terms that are pretty reasonable. And then moving forward, the supply agreement that will be between the retail services business and the global products business will provide terms to the retail business that will also allow for a reduction in working capital for the retail business. So I think what you're seeing overall is kind of a one-time move from a global products perspective. that would eventually moderate as we see the raw material costs moderate, but is not an issue within the retail business.

All right. Thank you. That's very helpful. And then you had talked in the retail services business, talked about pricing. You were watching for some potential impacts of higher pricing on volume products. I was just wondering if you can give some color on whether you're seeing customers declining higher-priced services. Are they moving away from some of the premiumization trends that you had been seeing? Just thinking about how you're striking a balance between higher prices and a potential volume tradeoff, either on oil changes or non-oil change services.

That's a great question, and we're watching the consumer dynamics really closely these days as other companies have shared pressure from inflation on consumer behavior. Our customer has been holding up really well. Our demand and transactions have held up really well, even through this period of $5 gas. And so that's been good to see. Our ticket performance has been roughly where we'd expect it to be, too. And so the higher oil change price, we haven't seen have that negative impact. I think that's one of the real strengths of our model is that people, even in challenging times, they continue to take care of their vehicle and get that preventive maintenance done. But I would add we're looking at results and just digging into it on a regional basis, too, and looking for price sensitivity issues. You know, we could be seeing some signs of price sensitivity in certain regions on the additional services. And so that's something that we have to be really sharp on and make sure that we adjust our marketing programs appropriately so that we don't lose traction there because those additional services are really important to our model. And we think they're important to, you know, customers caring for their vehicles, too. So we'll continue to report on what we're learning and what we think it means for our model. But long term, as we move through challenging periods, customers are incredibly resilient when it comes to taking care of their vehicles. And a lot of that has to do with the value that we're delivering in the stores too. And that's what really is the most important thing for investors to consider when they look at the value model. is that we've built up considerable competitive advantages in how we service the customers, providing incredible convenience, I think better than anybody else, with both the speed of service and the quality of service, too, where it's all about building trust with customers. There's never any pressure sell with our customers. And we look at some of these broader market dynamics. And in particular, the fact that we're We're only doing, even in the DIFM market, 5% of all the oil changes out there. And we talked about the opportunity to increase our store count. That's one aspect. But the other aspect is the fact that there's a real shortage of mechanics at dealerships tire and repair, and that creates a real problem for them to even be able to do preventive maintenance as they focus on repair. And so I think the opportunity to see more preventive maintenance come our way is really substantial. And so big picture is that despite any macro environment challenges, the opportunity for Valvoline to leverage our model for consistent and long-term growth is really substantial. We look forward to sharing more about that in the future.

All right, sounds good. Thanks very much for the color. Sure.

Thank you, Mr. Harrison. As a reminder, to ask a question, it is star 1 on your telephone keypad. Again, that is star, then the number 1. Our next question comes from the line of Jason English with Goldman Sachs. Jason?

Hey, good morning, folks. Thanks for slotting me in. Good morning. A couple quick questions. Sam, you mentioned the... the leverage that exists in the model to help drive margins up over time. We haven't historically seen that play out in your P&L. And I think the reason is because post your separation from Ashland, you were putting a lot of these stores in the ground and they were mixing down margins over time. A, is that understanding correct? And B, at what point will we get to this inflection where the number of new stores you put in the ground is negated by the number of old stores hitting their sweet spot? And we can actually start to see the leverage you're talking about flow through to the aggregate P&L.

Right. You know, we have tried to share in the past, and we have shared in the past what that leverage looks like in our mature stores, and so taking out the new store impact, and so As we've shared the mature store margin leverage, we've seen it grow roughly 500 to 600 basis points in the last five-year period. And so I think we need to continue to get that in front of investors so they appreciate the leverage in the model. Now, it has been impacted by the accelerated new store growth. And so that's muted the leverage that you see at the bottom line. in addition to the factors that we've called out from the volatility of this past year. I mean, that's been the number one impact in offsetting leverage in the model has been the rapid inflation of this past year. So I think, again, we will start to see improvement next year, but as we forecast out that 23 through 26 period, I think we'll see a steady progression of improving leverage, even at this higher level of store growth that we're seeing, that we'll have equilibrium there and we'll see then the progression of the model flowing through with leverage to the bottom line. We also talked about store growth and wanting, we see a big opportunity for accelerated store growth and we've come a long way over the last five years to ramp up to this 140 40 to 160 range for this year and what we delivered last year too. I think we could do even better than that in the future, but leaning even more heavily on our franchise system. We've got some strong franchisees. We are interested in strengthening our franchise partners for continued growth and even faster growth than what they're doing this year. It's a nice step up in performance this year from previous years, but I think we can do even better. And then that also helps our leverage in the model.

Yep, understood. And coming back on this cost price lag, geez, and we've had lots of conversations in the past, and you've always characterized the retail services biz as reasonably insulated from this because you can always see the cost coming, right? You see the base oil and additive prices going into global products. you know what the cost is going to be to you reasonably well in advance. And you've got what was historically described as almost an immediate pass through escalator clause with your franchisees and the ability for you given line of sight to rapidly change at store. So there would be no lag yet. Here we are this year and there's a substantial lag. That's not just impacting ratios and I get numerator denominator impact. It's, it's impacting unit economics and penny profit. So what's, What was wrong about the prior description? Why is it broken down and why is this business proving to be more inflation sensitive than we all expected?

Well, I'm not about making excuses and I won't go back on the description of this business being quite insulated from price cost lag effects that we see on the global product side. Nonetheless, like the level of increases that we've had in product costs have created a bit of a negative impact And on the labor side, too, we admitted our Q2 performance was being a little bit behind where we needed to be in adjusting prices. And we corrected for that in Q3. So a little bit of a challenge there where I think we underperformed where we could be. What we're talking about now is more on the, like when we look at the EBITDA margin percentage being negatively impacted by the price pass-through. It's not a profit impact as we pass through prices to our franchisees because we adjust prices on a quarterly basis. That profit impact is not that significant. If anything, we could get a 45-day lag. But on a percent basis, it has been a factor for our margins. So don't misinterpret what we're saying about the model and the strength of the model And certainly, you know, as we project forward and our ability to manage, I would say, more typical inflationary impacts, this model is, again, quite resilient. I don't know, Mary, do you have anything else to add to that?

No, I mean, I think you said it well, Sam. I think, Jason, the biggest challenge we've had has been the speed and size of the types of increases that we've seen in the underlying product cost in the face of, you know, initially the post-COVID impact on refining capacity and more recently the Russian-Ukrainian conflict that has caused, you know, base oil cost to be at really all-time highs. So the impact on the unit margins and penny profit relative to what we had planned for the year, We're higher, and we have taken pricing action, and over time, we expect that to moderate. In fact, we really think that we'll benefit over time as we see those costs moderate and potentially provide structural long-term improvements to our margins. The business continues to have pricing power, but we do operate in a competitive environment. I actually feel good about the long-term opportunity for the business when we get past this rather unusual inflationary environment.

Understood. Thanks for your time. All right.

Thank you, Mr. English. That concludes our Q&A session for today. So I'd like to hand the call back to Sam Mitchell for any final remarks.

Well, that's it for today. We obviously are focused on now the transformation of the company and completing the execution of the sale of global products and preparing retail services for fiscal 23. We have managed to do some significant challenges this year, and the business is in excellent shape, and we look forward to an exciting future as a pure play automotive aftermarket services business. Thank you.

That concludes Valvoline's third quarter 2022 earnings conference call and webcast. Thank you all for your participation. You may now disconnect your lines.