Finning International Inc.

Welcome to the Finning International Inc. Fourth Quarter 2022 Investor Call and Webcast. As a reminder, all participants are in listen-only mode and the conference is being recorded. After the presentation, there will be an opportunity to ask questions. Analysts who wish to join the question queue may press star then 1 on their telephone keypad. Should you need assistance during the conference call, you may signal an operator by pressing star and zero. I would now like to turn the conference over to Greg Palaszczuk, Executive Vice President and Chief Financial Officer. Please go ahead.

Thank you, Operator. Good morning, everyone, and welcome to Finning's fourth quarter earnings call. Joining me today on today's call is Kevin Parks, our President and CEO. Following our remarks today, we'll open the line to questions. This call is being webcast on Finning.com. We've provided a set of slides that we'll reference during our prepared remarks. These slides are posted on the investor relations section of our website, and an audio file of this call will also be archived on our website. Before I turn it over to Kevin, I want to remind everyone that some of the statements provided during this call are forward-looking. Please refer to slides 10 and 11 for important disclosures about forward-looking information, as well as currency and specified financial measures. including non-GAAP financial measures. Please note that forward-looking information is subject to risks, uncertainties, and other factors as discussed in our annual information form under key business risks in our MD&A under risk factors and management and forward-looking disclaimer. Please treat this information with caution as our actual results could differ materially from current expectations. Over to you, Kevin.

Thank you, Greg, and good morning. When I started my career at Finney more than two decades ago, I knew I was joining a great company, and I'm honored to be asked to lead our amazing team of over 14,000 employees, particularly as we celebrate our 90th anniversary this year. I cannot say enough about how our employees make it a pleasure to work for our company every day. We're focused on keeping each other safe while striving to deliver high levels of service to our customers and meaningful outcomes to our partners and communities. Turning to our results, beginning on slide two. 2022 was a strong year. We did an excellent job of controlling what we could, effectively deploying all of our resources through our great teams to support growth in all of our regions. We secured significant strategic wins, drove strong product support, and continued to improve our earnings capacity. We delivered product support revenue of 4.6 billion, up 24% from 2021, and well ahead of pre-pandemic levels. We did this while reinforcing our mid-cycle cost and capital model, which allows us to control SG&A as a percentage of net revenue to 17.7%. We also reinvested to compound our earnings and delivered record EPS of $3.25. We achieved these results through relentless execution of our strategy and the fantastic hard work of our teams. My transition to CEO is going well. Succession is an advantage, and with my team, we are very focused on execution and building on accurate momentum. I've been talking to many of our stakeholders to ensure I understand their perspectives before we start to work on the refinement of our strategy. I don't anticipate any hard turns, but rather a simplification, a prioritization of the current plans. whilst ensuring all of our employees are empowered and engaged in our strategy. We'll be focusing on prioritized growth opportunities, performance through all market conditions, and reinvesting in our business. Looking ahead to 2023, please turn to slide three. Overall, we expect demand conditions in our end markets to remain constructive, supported by favorable commodity prices. Activity levels remain strong in mining, energy, and infrastructure. We do, however, expect some softness in the construction markets in the UK and Chile. We are mindful of the uncertainty in the global business economic environment, and we will continue to reinforce our mid-cycle operating cost and capital model. Our goal is to strengthen the resilience of our business through all market conditions. The team are focused on productivity and optimizing working capital levels, and we will also thoughtfully manage our capital expenditures, and we will be prioritizing further debt repayment, which Greg will provide more details on in a moment. 2023 has started well, and we expect to continue to grow in the first half of the year. Despite strong deliveries in Q4, we have maintained our record backlog We continue to execute on our product support strategy, and we expect to see growth in component remanufacturing, equipment rebuilds, and product support contracts in 2023. I am confident in our ability to continue building on our execution momentum, and I look forward to seeing many of our investors in the coming months to update you all in person. I will now hand it back to Greg to provide more color around our results.

Thank you, Kevin. I'll talk about our fourth quarter performance in more detail, including regional results and outlook. I'll also speak to our capital allocation priorities for 2023. Turning to slide four. Net revenue of $2.4 billion was up 34% from Q4 2021, led by mining deliveries in Canada and South America and strong product support growth rates in all regions. EBIT and EPS were up 36% year-over-year on solid revenue growth and disciplined operational executions. 89 cents of EPS was very strong, particularly considering that Q4 2022 saw 10 cents per share higher LTIP expense compared to Q4 2021 due to our share price appreciation of 39% in the quarter. Consolidated EBIT as a percentage of net revenue was 9%, led by strong profitability in South America at 11.4% and in Canada at 11%. These strong margins were achieved despite the high level of mining equipment and overall new equipment mix in Q4 and a high LTEP expense in the quarter. Due to these factors, operating leverage in Q4 was lower than prior quarters of 2022. We generated $332 million of free cash flow in the fourth quarter and finished the year with net debt to EBITDA of 1.6 times, down from 1.8 times at the end of September. Given our organic growth opportunities, we invested in working capital to support our buildup of backlog and strong product support growth rates, resulting in a use of 170 million of free cash in 2022. We are encouraged to see our service work in progress balances up 50% year over year, reflecting strong activity levels, and our inventory health is very strong and of a high quality. Our equipment backlog remains at record levels, up 35% from the end of 2021, driven primarily by mining winds and a notable increase in power systems order intake. Now please turn to slide five. New equipment sales were up 52% compared to Q4 of 2021, underpinned by strong mining deliveries. Product support revenue is up 32% year over year, reflecting continued robust market activity in all sectors and strong execution by our regional teams. Approximately half of the increase was due to price, and a half due to volume, including the acquisition of Hydroquip in the UK. We were pleased to enter 2023 with a record equipment backlog of over 2.5 billion. Mining orders comprised over 40% of the backlog today, a significant increase from a year ago. And power systems orders now represent 20% of our backlog, with strong activity and order intake in our Canadian energy segment in 2022. Turning to slide six for the details on our EBIT performance. Our gross profit was up 30% year over year on strong volume and product support and new equipment. As a percentage of net revenue, gross profit was up 80 basis points or was 80 basis points below Q4 2021 due to a higher proportion of new equipment sales in the revenue mix and lower margin mining equipment deliveries in Q4 of 2022. We are pleased with the improved annual earnings capacity we've demonstrated for pre-pandemic levels with EBIT as a percentage of net revenue up 300 basis points, Return on invested capital up 670 basis points, and EPS has nearly doubled from 2019 adjusted results. Moving to our Canadian results and outlook, which are summarized on slide 7. Net revenue increased by 28% from Q4 2021, driven by strong market conditions in Western Canada. New equipment sales were up 56%, with higher mining deliveries contributing to most of this growth. Product support revenue is up 30% on strong market demand and continued momentum in our product support growth strategy in all sectors. EBIT as a percentage of net revenue was 11%, up 90 basis points from Q4 2021, driven by improved operating leverage. SG&A as a percentage of net revenue is down 190 basis points year over year. Our outlook for the Canadian business is positive, given the strength in mining and energy sectors in Western Canada, and we expect that to continue in 2023. We expect constructive commodity prices and improved capital budgets from customers to drive investment in renewal of aging fleets and product support opportunities in mining. We're pleased to see our mining customers committing to comprehensive rebuild programs to extend the life of their assets, and we expect strong growth and rebuilds in 2023 compared to 2022. In construction, demand for equipment, rental, and product support is expected to remain healthy, supported by ongoing infrastructure projects. While we're seeing signs of slowdown in forestry and residential construction, these markets represent less than 5% of our Canadian business. Power systems, high activity levels from our energy sector customers are driving a notable increase in order intake. Our power systems backlog and activity levels in Canada are now at the highest levels since 2014. Turning to South America on slide 8. In functional currency, net revenue increased by 34% from Q4 2021, driven by strong mining activity. New equipment sales were up 54% in functional currency on high mining deliveries in Chile, including catch-up of delayed backlog deliveries from Q3 of 2022. Product support revenue is up 25% in functional currency, with strong overall demand and higher volume from new and expanded mining product support contracts. South America's EBITDA as a percentage of net revenue was 11.4%, up 130 basis points from Q4 of 2021, driven by revenue growth, improved cost structure, and service productivity, as well as the favorable impact of Chilean peso devaluation. Heroic in South America was 24.5%, the highest on record, up 420 basis points from 2021. Looking ahead, we expect a strengthening copper price to continue to support a positive mining outlook in Chile. Our recent wins and continued investments in fleet replacement across our mining customer base are expected to drive mining sales in Chile this year. We also see continued strong demand for mining product support and technology solutions. Construction activity in Chile is projected to decline in 2023, impacted by slowing economic growth and higher interest rates. We continue to monitor the process for approval and revised mining royalty proposal. We are encouraged by the latest moderation in the proposal, However, we expect the timing of investment decisions related to Greenfield and new expansion projects to remain uncertain until the new royalty proposal is finalized and approved. We are pleased with our high-quality, high-return business in Chile, and we are optimistic about growth opportunities in mining. We believe Chile will remain an attractive place to invest long-term, as electrification trends drive growing global demand for copper. Please turn to slide 9 for our results in the UK and Ireland. Net revenue was up 38% in functional currency on increased volumes across all lines of business. The fourth quarter saw high power systems project deliveries, higher HS2 deliveries, and strong product support activity across all sectors compared to Q4 of 2021. EBIT as a percentage of net revenue was 4.4%, which was slightly above Q4 21 levels. UK and Ireland delivered ROIC of 17% in 2022, up 220 basis points from the prior year. reflecting strong revenue growth and structural improvement in profitability, including the acquisition of Hydroquip. In 2023, we expect lower construction new equipment sales in the UK compared to 22. We have largely completed equipment deliveries to HS2. In addition, slower economic growth rates are expected to impact broader construction activity. However, we expect strong demand for product support to continue, driven by HS2 activity and high machine utilization. We also have a solid backlog of power system projects for delivery in 2023. We expect demand for our power systems business in the UK and Ireland, including the data center market, to remain robust. As Kevin mentioned, we're seeing continued momentum to start 2023 and expect growth in the first half of the year compared to the first half of 2022. Underpinned by our record equipment backlog, very busy workshops and growth and rebuilds driven by our strong execution of our product support growth strategy. While we expect demand conditions to remain constructive in 2023, we are mindful of the uncertain global business environment, including slowing rates of economic growth. We are reinforcing our mid-cycle operating cost and capital model and reducing our 2023 capital expenditures budget by about 25% in 2022. We expect our 2023 net capital expenditure and rental fleet additions to be between $190 million and $240 million. We will be allocating a higher proportion of capital to rental fleet and strategic investments in electric drive mining trucks for demonstration at customer sites. In 2023, we'll be placing higher priority on debt repayment and further reduction of our net debt to adjusted EBITDA ratio. In summary, we're really pleased with the record results demonstrated in 2022. We have great continuity and momentum as we start 2023. We'll continue to work to improve the resiliency of the earnings capacity for our business. Before I turn it over to the Q&A session, I'd like to invite everyone to attend our investor day and tour of our Chilean mining operations in Antofagasta during the week of September 25th. We'll be providing more details on this event in the coming months. We hope that you can join. In the meantime, Kevin will be doing additional marketing in the second quarter to share his views and plans for Finning's future. Operator, I'll now turn the call back over to you for questions.

Thank you. We will now begin the question and answer session. Analysts who wish to join the question queue may press star, then 1 on their telephone keypad. You will hear a tone acknowledging your request. If you are using a speakerphone, please pick up your handset before pressing any keys. To withdraw your question, please press star, then 2. We will pause for a moment as callers join the queue. The first question comes from Jacob Bout with CIBC. Please go ahead.

Good morning. Good morning, Jacob. So you're outlining some softness in the UK and the Chilean construction markets. From a revenue perspective, would that be roughly about 10% of revenues? And then how do we think about that from a mix, new equipment versus product support? Would it be similar to the rest of your business or... a little more skewed to new equipment?

Sure. So on the construction side, I mean, it was a one-in-10, 15-year project with HS2, and the level of deliveries is about 200 million pounds over the last two years. So that piece won't repeat. There still is very solid business, particularly in quarry and aggregates and on the power side, so that can offset some of that. That would be the UK side. You know, Chile would be... somewhat similar. We're seeing declines in the market, but we'll obviously push for share where we can. So we won't give an exact number on that, but certainly on the construction side, which is a smaller part of that business, we're seeing slower growth. We do think mining is more than picking up the baton in South America. And so from a mixed perspective, I think mining will more drive the equation there. And we expect continued momentum on both new mining equipment and product support in 2023.

Okay. And maybe trying to square your comments about reduction in CapEx versus H123 being a little stronger than H122. Maybe just comment on your duration of backlog. And then, you know, is the expectation a slowdown in the back half of the year?

Yeah, so from backlog perspective, it's quite evenly distributed. As we discussed last call, a lot of the backlog additions in the back half of this year, for the back half of next year, that would include BHP and others. And so, you know, it's a great way to start the year when you've got your LTM sales in backlog, and it's pretty distributed throughout the year, so we feel solid about that. Okay.

Thank you. It's my turn. Thanks, Jacob. Thanks, Jacob.

The next question comes from Yuri Link with Canaccord Genuity. Please go ahead.

Hey, good morning, guys.

Good morning, Yuri.

Just wanted to follow up on that line of questioning. So the backlog evenly distributed throughout 23, so the bulk of it gets recognized this year, and the follow-on to that would be you know, when you were putting your outlook together, I mean, why not comment on the back half of the year? Is it just that you don't have the visibility that far out?

Yeah, so you're right, Kevin. So we expect around 90% of the backlog to deliver this year, but, you know, we are seeing some orders, you know, moving to 2024 now. I think that maintaining the backlog after the strong equipment deliveries is a really encouraging sign. But I've been around long enough to know that January is a reset month, particularly given there are macro uncertainties out there. So we've been very thoughtful about how we think about the second half of the year. But I would say that our strategic focus around the initiatives is around winning strategically important business, growing market share. And if you think about, you know, what Tad have said this week about, you know, supply chain is improving as we move through the course of this year, that gives us some optimism as we move through the year. And so I would say that we come back to work this year encouraged, but thoughtful about... about the second half of the year. But as every week goes past, we get more encouraged.

Okay. And can you just comment on the outlook for product support for this year and whether you're expecting growth for the full year in 23 versus 22? And that'll be my two. Thanks.

Yeah, sure. So absolutely. We expect growth in 2020. we expect growth because we have market share opportunity we expect growth because it's a key pillar of our strategy along with that of Caterpillar and we've got the might of both organisations focused on executing there and I think our track record over the last two years you know reinforces our execution capabilities in that regard so we remain relentlessly focused on that It's a critical value driver in this company, and we expect a strong year this year.

Thanks, guys.

Thanks, Eric.

The next question comes from Sharif Al-Shabasi with Bank of America. Please go ahead.

Hi, good morning, and congrats on another strong quarter. I guess just one thing is just given your positive outlook, how do you feel about your inventory levels? They're a bit elevated, but do you think you will need to build inventory through the year to meet ongoing demand if it materializes continuously?

Yeah, we're certainly pleased to have been able to get our hands on inventory in a tight environment. A really big driver of that is our ability to build an effective backlog. So when you've got $2.5 billion of backlog, which we just highlighted, 90% dedicated for this year and we're still selling, that's a good spot to be. And so it's a highly committed set of inventory. So we feel really good about that. The high quality aging profile is excellent. And so we feel good about that dynamic. And we feel like we've got sufficient to support that backlog. So we feel like we're in pretty good shape here.

Yeah, just to reinforce that, you know, the quality of the inventory is a very high standard, and the proportion of convicted inventories is high, too. So, for sure, we have some safety inventory around us to be able to support our customers, and we're confident, you know, we're going to be able to continue to support our customers. And, you know, as a supply chain provider, dynamics continue to improve, you'll see some normalization there for sure.

Understood. And then just with regards to the CapEx and rental fleet additions decline, you mentioned adding a higher proportion going towards rental fleet additions. Is the overall level going into rental fleets declining or do you still see a strong demand there?

Yeah, so it would be, you know, it's a little more than half of our allocation this year, which is a bit of a shift in percentages from history. And so it would be up year over year at about, you know, half of the CapEx allocation.

Understood. Thank you very much. Thank you.

Once again, any analyst who has a question may press star, then one on their telephone keypad. The next question comes from Brian Fast with Raymond James. Please go ahead.

Yeah, good morning.

Hey, Brian. How are you, Brian?

I know you touched on it, but maybe can we just get an update on supply chains? It seems like things are improving. Is this widespread across all products, or are there still pockets that are challenged?

Yeah, I describe the supply chain as dynamic. and it's different by product and it's a little different by geography as well because of the specification of certain products and obviously there are additional challenges to our shipping times to our Chilean business. So it's a very dynamic environment and we've got everybody focused on using all of the resources available to maximize the opportunities and support our customers. So we have resources and capabilities and our role is to manage the dynamics of the supply chain and support our customers. I think, ultimately, it will get better as we go through the course of the year, but I think you can see from our revenues and our earnings, Brian, that we're not complaining about supply chain. We're using the might of the organization to push through it.

Thanks. That's helpful. And then, What's the appetite like for external growth opportunities similar to Hydroquip and 4Refuel, or do you see opportunity to expand those platforms?

Yeah, I think for sure with Hydroquip, we've added to that business since we bought it, as we have with 4Refuel. So they're two excellent platforms. As I mentioned previously, I'm still in listening mode really with our stakeholders, and we're about to embark on a prioritization of the strategy. which we'll communicate later this year, which will give some indication as to how we see the growth levers in the company, whether they're organic or inorganic. But we really like those two platforms. There's growth in those platforms, both organically in the regions they operate, but also internationally as we expand them out. And we will always consider the right acquisitions to continue to build our addressable market and the penetration of that addressable market. So I don't want you to take away that the business is on pause. It absolutely isn't. We're fully focused on execution around our core business and the acquisitions that we've made. And we're going to embark on this pretty quickly. review and enhancement of the strategy that's working today. And I would be very surprised if there wasn't more inorganic opportunities coming out of that work.

Great. Thanks for the call. That's it for me. Thanks, Brian.

The next question comes from Sabahat Khan with RBC Capital Markets. Please go ahead.

Great. Thanks, and good morning. We've been getting a lot of questions on this space and the future evolution of product support and what a recession maybe does. Does the mix increase? Does it decrease given some of the trends we've seen in that business recently? Is there any commentary based on your current visibility on how you expect the mix of product support to evolve as maybe the backdrop evolves somewhat?

Sure. Well, as you can tell, it's been a bit of a unique relative to history mix situation where product support's growing faster than new and pretty healthy upcycle conditions. So that's been a bit unique. So I do think it depends on how supply chains normalize through any potential down cycle. But, you know, The common denominator is that the product support business is an excellent business. As you can see, we're seeding a lot of equipment in the field, which is great. And these are high-intensity product support applications. And so we feel like we're doing a good job of increasing the population. And when that equipment goes to work at mines or infrastructure projects, it generates product support full cycle. So we're pleased with that dynamic. So it would be kind of dependent on how the supply chain is normalized, but we'd expect product support to continue to play a very significant role even through a challenging market.

I guess to add to that, I mean, product support just is more resilient than new equipment. And so, you know, that's hence one of the reasons why we've been focused on growth in that area. But that said, you know, we are pleased as well with the refresh and somewhat additional population that we're seeing going into the, particularly into the mining business, but also into the energy sector as well.

Okay, great. And then just my second one, obviously the weakness on the construction side in Chile, you know, it's been called out by you guys and the OEMs as well. I guess if we just think over the next 12 to 24 months, we've seen a lot of the issues that have caused that slowdown. Those make sense. But if the commodity markets stay strong, Is there potential for that construction site in South America to potentially pick up? Is it a pause, or do you think it's maybe just a bigger cycle that's slowing down on the construction site there?

Yeah, I mean, I think it's just been a bit of a slowdown here when your interest rates go as high as they have down there, and the cost of new equipment has increased and the peso has devalued. It's a challenging decision to make new. So we've seen high utilization hours on existing fleets. We've also seen the current government delay some decisions, which doesn't catalyze a lot of extra new equipment. So we think with some clarity that we think is coming across mining, but also broader infrastructure and maybe some normalization of rates here, I think that can see a bit of a pickup. So it's not a sharp slowdown, but it's not a growth area. But you can see a line of sight to that improving over the next 18 months.

Yeah, and I think the only thing tied to that is that in the UK, you know, When we're suggesting slowdown in the UK, you have to remember that we're coming off a huge high of delivering a massive infrastructure project as well. When I spend time talking to the teams in the UK, it doesn't feel like they're working in a slowdown environment right now, but it's moderated on last year for reasons of the huge project we delivered.

Great. Thanks very much for the call.

This concludes the question-answer session. I would like to turn the conference back over to Greg Palaszczuk for any closing remarks.

Great. Thank you, Charisse. Thank you, everyone, for participating in the call today, and have a safe day.

This concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.