Finning International Inc.

Thank you for standing by. This is the conference operator. Welcome to the Finning International Inc third quarter 2023 investor call and webcast. As a reminder, all participants are in listen only mode and the conference is being recorded. After the presentation, there'll be an opportunity to ask questions. Analysts who wish to join the question queue may press star then one on their telephone keypad. Should you need assistance during the conference call, you may signal an operator by pressing star then 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 third quarter earnings call. Joining me 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 the Investor Relations section of Finning.com. We have also provided a set of slides that we will reference during our prepared remarks. The slides are posted on our website as well. An audio file of this call and the accompanying presentation will be archived. In addition, in September, we hosted our 2023 Investor Day in Antofagasta, Chile, which laid out our refreshed strategy and key objectives going forward. On our website, you can review our slide presentation as well as the full webcast of our Investor Day. 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 forum under key business risks, and in our MD&A under risk factors and management and forward-looking information disclaimer. Please treat this information with caution, as our actual results could differ materially from current expectations. Kevin, over to you.

Thank you, Greg, and good morning, everyone. On our recent Invest Today in Chile, we presented our refreshed strategic priorities. I'll speak to our quarter through those priorities, and as Greg mentioned, We do have the webcast and the presentation in the investor section of our website. And for those of you that haven't had a chance to see and hear the presentation, I'd encourage you to do so. Following my remarks, Greg will provide additional details around our third quarter results. Please turn to slide two. We delivered another strong quarter in Q3 through strong execution. Driving our product support business remains our primary strategic objective Product support builds customer loyalty through greater integration with our customers and the performance of their equipment. It is our biggest value driver, the largest opportunity for profitable growth, and the most resilient part of our business. We are capturing greater share of product support across the full asset lifecycle, growing customer value agreements, expanding our rebuild business, and strategically growing our equipment population in our territories. Optimizing our operating model and culture around full-cycle resilience is a new explicit strategic objective. This includes building more contracted revenue than costs, finding ways to variable our cost structure, and increasing working capital velocity. Building greater resilience into our business will provide more security and certainty for our employees, better support for our customers, and more reliable and consistent returns for our investors. Finally, we're building a sustainable growth platform In addition to driving product support, we are excited about growing our addressable market in used equipment, rental and power systems. Building our used equipment capabilities is a great way to increase the installed base in our markets, grow aftermarket opportunities while also helping build full cycle resilience. We plan to grow our rental business and increase our customer base specifically around retail customers. We're also increasing our capabilities in both prime, standby power solutions, as well as capacity power to support the growing demand for electrification. Please turn to slide three. Our regions delivered strong performance in Q3, while managing through some unique challenges. In Western Canada, wildfires impacted many of the communities in which we operate. The safety of our employees, their families, and their communities became our primary objective at times through this summer. In South America, the team is managing through a very difficult operating and economic environment in Argentina related to the presidential elections. I'm really proud of how our teams continue to demonstrate their strength and resilience while providing important support for our customers, being great colleagues and important members of their communities. We are pleased with our product support growth, strong operating margins and return on invested capital. Our revenue mix shifted due to the higher proportion of large mining equipment we delivered from our backlog to increase our install base and product support opportunity. Our product support revenue was up 13% year-over-year, growing across all regions. Since Q3 of last year, we've added 370 technicians globally to support an increased number of product support contracts and strong demand for rebuilds. As we highlighted at our investor day, We are very focused on improving our invested capital performance to drive heroic higher and build greater resilience into our business. Initiatives underway in each of our regions are in place to drive more efficiency in our operations, higher velocity in our invested capital, while most importantly increasing our customer service levels. Key focus areas include automating our warehouse operations, working closer with customers on planning component exchanges and rebuilds, and increasing velocity in our new equipment preparations. Improving supply chain is a positive for our customers, our operations, and our business performance, and we are pleased with the progress. Our adjusted return on invested capital was 20.2% in Q3, up 190 basis points from a year ago led by South America. Looking ahead, we are excited about sustainable growth at Filling. We are building capabilities and empowering our people to drive long-term customer loyalty. We expect continued momentum in our business to be supported by robust customer activity across our diverse end markets, healthy equipment backlog that stands at 2.3 billion, and a strong demand for service. From a regional standpoint, Chile is a premium business and mobilizing for growth. Our Canada business is positioned for steady growth and has the largest addressable market in each of rental used equipment and power systems. And our UK and Ireland business is resilient sharing best practices to drive innovation and efficiency across our company. I will now hand it back to Greg to provide greater level of detail on our third quarter results.

Thank you, Kevin. I'll talk about our third quarter performance in more detail, including our regional results. I'm turning to slide four. Q3 was another strong quarter. Net revenue was $2.4 billion, up 16% from Q3 2022. We saw strong new equipment deliveries and product support volumes in Q3 led by mining. We're also pleased with the momentum in our power systems business across all regions underpinned by strong demand and effective project execution. EPS of $1.07 was up 9% from Q3 2022. Operating margins were solid and SG&A as a percentage of net revenue was below 17% in the quarter. The proportion of large lower margin mining deliveries in the revenue mix and higher financing costs were the main reasons for EPS to grow at a slower rate than revenue compared to Q3 2022. But Q3 2022 was also a very strong quarter and we're pleased with the steady growth in earnings year over year. Q3 free cash flow was at breakeven and our net debt to adjusted EBITDA was at 1.8 times at the end of September. On slide five, you can see changes in our net revenue by line of business compared to Q3 2022. and the comparison of our backlog by market sector. New equipment sales were up 28%, led by mining deliveries in Canada and Chile, as well as higher power system sales in all regions. Product support revenue was strong in all regions, up 13% on a consolidated basis. Our equipment backlog of 2.3 billion is down slightly from the end of June. Equipment backlog in South America grew, driven by significant mining orders, and was offset by lower equipment backlog in Canada due to strong deliveries. and lower equipment backlog in the UK and Ireland. Our quoting activity remains robust in mining and power systems, with customers continuing to increase capital expenditures and operating budgets to support fleet investment and production increases. Our mining and power systems equipment backlog continues to grow as a proportion, representing roughly 45% and 25%, respectively, of total equipment backlog as of September 30th. We see supply chain improvements as a positive, and our Canadian and Chilean construction businesses we are seeing core market share improve as a result. Turning to slide six, which shows our EBIT performance. Gross profit was up 14% on strong new equipment and product support volumes. As a percentage of net revenue, gross profit was down 30 basis points, primarily due to a higher proportion of large mining deliveries in the revenue mix. In the third quarter, we delivered 26 ultra-class trucks, which has highlighted our investor day as great for long-term product support growth. SG&A as a percentage of net revenue was 16.9%, up 20 basis points from Q3 2022. EBIT was up 12%, EBIT as a percentage of net revenue was a solid 10.3%. Now, moving to our Canadian results and outlook, which are summarized on slide 7. New equipment sales were up 57%, led by mining deliveries to oil sands customers. Product support revenue increased by 10%, led by mining, including higher rebuild activity. We're also driving strong growth in power systems business in Canada, with power systems equipment backlog up significantly from Q3 2022. EBIT was up 10%, and EBIT as a percentage of net revenue is 10.8%, below Q3 2022, again due to a higher proportion of large mining equipment sales in the revenue mix. Canada's adjusted ROIC increased 170 basis points from Q3 2020, driven by improved invested capital turnover and strong operating margins. Western Canada is well-positioned for steady growth going forward. Our mining and energy customers are financially healthy, increasing investments into their fleet and production. Can the oil sands demand for product support is expected to remain strong, and we are in active discussions with customers planning for major rebuilds. Turning to South America on slide eight. In functional currency, new equipment sales were up 37%, driven by deliveries of large mining equipment in Chile. Product support sales were up 12%, also led by strong mining activity. EBIT was up 20%, and EBIT as a percentage of net revenue is 12.3%, which was comparable to Q3 of 2022. South America generated ROEC of 27.6, up 490 basis points from Q3 2022, our highest ROEC to date, reflecting both improved profitability and invested capital turns. As reviewed in detail in Antofagasta in September, our business in Chile is mobilizing for growth. a strong outlook for mining supported by growing demand for copper, and improved political clarity. We're encouraged by recent government approvals of large-scale brownfield expansions and increasing customer confidence to invest in new projects. We continue to see demand for large contractors supporting mining operations in Chile, while infrastructure construction activity is expected to remain stable. Additionally, power systems activity is growing in industrial and data center markets. In Argentina, we're operating in an environment of high inflation, significant currency restrictions, and import regulations that are impacting our business. While we're actively managing and mitigating these risks, the significant and prolonged import and currency restrictions put in place during the current election process has increased the risk and likelihood of losses and negative tax impacts in the fourth quarter. Please turn to slide nine for our results in the U.K. and Ireland. In functional currency, net revenue decreased by 17% from Q3 2022 due to lower equipment sales and construction, which is partially offset by higher power systems revenues. Product support revenue was up 6%, driven by strong customer activity and equipment utilization in power systems. EBIT as a percentage of net revenue was a solid 5.9%, reflecting our continuous focus on growing the product support business. Product support activity in the UK and Ireland is expected to be resilient, the steady machine utilization and growing contribution from Hydroquip. As HS2 deliveries are now complete, we continue to expect lower new equipment sales in the UK compared to the record levels of 2022. In power systems, we continue to expect strong demand for both primary and backup power generation in the data center and utility applications. In summary, we're pleased with the Q3 results and continued momentum. Our focus is squarely on executing the refresh strategy as outlined at Investor Day to drive product support full cycle resilience, and sustainable growth for the long term. Operator, I'll now turn the call back to you for questions.

Thank you. We'll now begin the question and answer session. Analysts who wish to join the question queue may press star then one 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 two. The first question comes from Yuri Link with Canaccord Genuity. Please go ahead.

Good morning, guys.

Good morning, Yuri.

Good morning, guys. Greg, can you ring sense for us the potential loss in Argentina that you alluded to?

Yeah, sure. So as we've talked about in previous discussions, so Argentina is a business that's fairly small, you know, we keep it in a box. We've typically focused more on product support. What we've seen is pretty unique circumstance, really, through the election process, as they've kept the peg at about 350 peso. You know, in the past, historically, if you had kind of two weeks without access to US dollars, that would be unusual. And we're now more at the two month point. So We just have a higher exposure through that period. So we'll manage through that as effectively as we can. The election's on the 19th. And so, you know, there could be an impact from that. We'll have to see how it plays out. But ultimately, you know, we'll put Argentina back in the box after that process, probably a tighter box than ever. And so, you know, while it might be notable in the quarter in the grand scheme of things, you know, not a huge impact.

Yeah, Yuri, I would just add as well, you know, that one of the best ways for Argentina to work through this is to develop the resources in-country, which are gathering more and more momentum. And obviously we are well-placed to support that resource development, which we believe long-term will help us through this situation in the short to medium term, but long-term is still an exciting opportunity.

And what about the tax impact? What would your effective tax rate be in the fourth quarter?

Yeah, I mean, it'll depend on the level of devaluation that occurs post-election. So our tax pools would be in pesos, and so it would be directly correlated with whatever level of devaluation occurs post-election.

Okay. Just last quick one for me on SG&A. I think it was down quite nicely as a percent of revenue in South America, but not so much in Canada. Can you just speak to the nature of the expenses that you incurred there, particularly around the fixed variable split between them?

Yeah, sure. So, I mean, I think, you know, SG&A was down slightly quarter over quarter, but on a bit lower revenue. You know, we're always pleased to keep that below 17% and continue to have that as a key goal. You know, you'd have within the quarter in Canada, you'd have a little bit of non-recoverable time due to some of the disruption and a couple branch closures for part of the quarter. And then otherwise, you know, just due to the strong performance, you've got some higher, you know, short-term incentive comp numbers within Canada. I guess those would be the two to call out.

Okay, I'll turn it over. Thanks, guys. Thank you.

The next question is from Steve Hansen with Raymond James. Please go ahead.

Oh, yeah. Good morning, guys. Thanks for the time. Just a question on product support. The consolidated number was up quite nicely in the period, as you highlighted. The Canadian operations did dip sequentially, though, quarter over quarter. Just curious what's going on in that specific instance and how would you think about the ramps going forward, given the large set of deliveries you've been doing? Just help us through maybe some of the forward cadence on that.

Yeah, sure, Steve. So, I mean, the first thing is, when you talk about the dip in, I mean, it's on really strong comps on the back of, you know, quite a favorable pricing environment as well. You know, we're very optimistic about product support growth, as we mentioned in our Invest Today. In fact, you know, since our Invest Today, I would say that, you know, our outlook, over the next period of time or 12 months is probably at the top end of that range. But we did talk about product support growth, growth levels moderating as we move forward. And that's what you're seeing right now. The levels that we were growing at will moderate over time. And obviously just think about the pricing impacts in the last 12 months.

Okay, helpful. And then just on the use equipment side, I understand the initiatives are relatively new, but maybe just help us understand sort of how we should think about that growth as well, because we did see some fairly sizable year-over-year dips, certainly in the Canadian business, but also in the UK as well. Canada in particular would be my focal point. How should we think about the growth on the use side there?

Yeah, we're happy with the progress we're making in use equipment. We're super excited about some of the initiatives excuse me, that we spoke about at the Investor Day and that'll come to life in Q4. Specifically around Canada, there was an extremely strong quarter in Q3, some pretty unrepeatable used equipment deliveries in Q3 last year related to the ability to get new product. And so we were very creative to get product in the hands of our customers in Q3 last year. So that's the biggest comparison. There's no doubt that the used equipment market is softening. So that would be an additional factor. But the biggest issue in Canada was the comparisons. And the softness issue would be the same narrative for the UK.

Okay. Well, thank you. Appreciate that.

The next question is from Jacob Belt with CIBC. Please go ahead.

Good morning. I had a question on backlog, looking for a bit more granularity. Maybe we'll just start specifically with Canada. Obviously, strong deliveries in the quarter, but do you expect a reload going into the fourth quarter in 2024? And are you seeing any weakness at all in Canada? I know some of your competitors are calling out construction markets.

Yes. So the first thing to say, I don't think that backlog is the best measure of forward-looking activity. I know some of the people spoke to this over the past few weeks, but obviously there are things in backlog over the last two years that wouldn't typically go into backlog under a normal free supply or a better supply environment. And so there's definitely an impact in construction, because construction is where the... you know, the supply has improved more so than in the larger engines and larger mining equipment. And so, you know, we're very optimistic about, you know, the order intake levels and the activity levels we'll see. You know, it's hard to say whether the backlog will continue to build because, obviously, I just described, you know, the improving supply chain, you know, provides more fluidity in the sales outlook. But we're happy with the growth, the outlook in Canada as it relates to construction. And we're really happy with the market share gains that we're seeing there. So, you know, I would not describe our construction equipment market in Canada as softening.

Okay. And then how about the UK and Ireland?

Yeah, so the UK and Ireland is softer. The market is reducing there for sure, and that's on the back of, you know, the comparisons with the HS2 deliveries last year. So that is more challenging. Again, we've seen good, more recently good, order intake levels as some of the larger rental companies, you know, look forward into next year and start their reload process. Reloading their fleets or putting orders in to reload their fleets. I've been pretty encouraged by recently about the order intake levels, but there's no doubt that there is a a little softening in the UK as it relates to construction equipment. That is compounded as well by the supply chain is improving faster in the UK as well because of the mix of products they sell there. One of the most improved supply chains is around excavators, which would be a much greater mix of the UK sales compared to Canada or South America. I think the combination of the slowing market and improved supply means that we're carrying A little too much stock there, but it's healthy, it's young, and the team are working through it and we're optimistic with the recent performance.

And then how much pressure on pricing is there as a result of the improving supply chain?

We have to be competitive. Our margins, as you can see in Q3, remain strong. And we're very focused on being competitive in our marketplace. We've been selling acceptable premiums for forever, and we continue to do that. And so, you know, we're a growing share in Canada and Chile. And so I think the team are well-versed and they have strong capabilities and they'll be able to sell the premiums and the value proposition that we have. we don't see that pressure.

Thank you.

Our next question is from Sherilyn Radborn with TD Cohen. Please go ahead.

Thanks very much and good morning. We've seen a couple of strong equity income pickups in Canada from pipeline machinery. I was hoping you could give us a bit of color on how that business is performing and what kind of forward visibility it has.

Sure. Yeah, no, we've seen a nice pickup, and there were certainly some difficult years in there where a lot of their activity from the U.S. actually shifted up to Canada. But as you can see, the activity in the U.S. has picked up quite strongly, and you've seen some M&A activity start to happen and some more activity levels. Some of that gear will shift down to the U.S., but that business has really picked up, and we expect that to continue into next year.

In terms of the CapEx increase that was telegraphed in the press release, can you help us understand how much of that is related to the rental fleet and strategic mining truck investments, and how much just relates to the timing of planned facility disposals?

Sure. Yeah. So, I mean, obviously through the year, the growth that we've seen has been healthy as the years progressed, but also as we highlighted in Vestor Day, some strategic areas of focus, including rental. So some of it would have been higher rental investment, but also fewer disposals than we planned at the beginning of the year. And we've got some good value assets in that fleet that we'd like to keep running for longer, as well as some deferred, one deferred real estate sale it'll move into next year. as well as some investments in mining truck fleet, some to support some product support contracts we've won, but also some to just demonstrate the new capabilities with potential conquest customers. So I'd say that's roughly about a third, a third, a third.

Okay, very helpful. Thanks for the time.

Our next question is from Devin Dodge with BMO Capital Markets. Please go ahead.

All right, thanks. Good morning. So a lot of my questions have been answered, but just one for me, probably for Greg, but there was a pretty sizable increase in working capital in the quarter. How should we be thinking about working capital in Q4 and that outlook for a full year of free cash flow?

Sure, yeah. So throughout the business, and we've got quite a bit of growth across the complex, we've got a lot of backlog bets. getting closer to delivery here through the end of the year and into the start of next year. And so you've got that, which is at an elevated level. Also service work in progress, very healthy, healthy accounts receivable also up. So you've got the working capital use there. But normal seasonality, we would expect strong free cash flow in the fourth quarter. And then as we highlighted at Investor Day, we recognize that there's work to do to increase investment capital turns and velocity. And we've got plans in place in each of the regions. And those teams are working away and mobilizing to make that a big priority in 2024 and 2025, as discussed at Investor Day.

Okay. Just a quick follow-up. When we think about 2024, Do you think, is it reasonable to assume that you guys could get to that 50% free cash flow conversion you've talked about previously?

I think it'll depend on the growth trajectory. Of course, in a more steady growth environment, that would be the target. We'll see how it ultimately plays out in terms of end markets. As we've highlighted in Investor Day, we see mobilization in Chile, steady growth in Canada, and resilience in the U.K., So that's overall a pretty steady market, and those are the sorts of markets where that conversion makes good sense, but we'll have to ultimately see how that plays out.

Okay, thanks. I'll turn it over.

Thanks, Devin. Thanks.

Once again, if you have a question, please press star, then 1. The next question is from Michael Dumais with Scotiabank. Please go ahead. Hi.

Good morning, guys. The first question, I guess, just, you know, following up on some of the discussion with Jacob and Devin, just on inventories, you know, you've invested about $1.2 billion in inventory since the beginning of 2022. And I understand that unit costs have risen and demand is also strong. But just trying to get a sense, given, you know, supply chains are easing, how far you are from, you know, where you think inventory should be to support this level of sales?

Yeah, so, I mean, as we discussed at the Invest Today, Michael, we put a pretty explicit invested capital target out there, of which, you know, a good proportion of that will come from inventory optimisation. And, you know, we improved our invested capital turns in the quarter, but, you know, the growth, we're still growing at a healthier rate than we've described in the long-term outlook in our Invest Today. So, There's no doubt that we would see inventory levels optimizing. We see that already happening in construction equipment. But our power systems business is up 50% year over year. It's another key part of our strategic plan. There's some long lead time and large engines in that, and of course the mining The mining equipment is very lumpy in terms of how it comes to us and how we get it out to customers. It's not as fluid as we would have experienced in the past and certainly not as fluid as we aim to be in the future. I think it's a big part of our strategic objective and you can expect us to focus a lot on that as we move forward and improve the velocity that we're seeing in there. We're more concerned with the velocity. than we are with the absolute level because the absolute level supports the growth that we're seeing in the company.

That's helpful. Thanks, Kevin. With the exception of Argentina, I read your commentary on the regional outlook as largely unchanged. I'm just curious, given how interest rates have moved up in the last few months, whether your visibility into 2024 is better or worse than your visibility into 2023 at this point of last year? Just trying to get a sense for that, please.

Yeah, I would say it is definitely, Michael. I would say our visibility into next year right now in all regions, and I would say if you think about the main sector that's impacted by the higher interest rates would be construction equipment, and I feel better about construction equipment than I did even in the summer. You know, it's normalizing, it's competitive. But as I said, we delivered more large construction equipment in September in South America than we ever had by some considerable distance, I might add. And so the teams are absolutely focused on winning market share regardless of the condition. You know, our market share levels offer us an opportunity regardless of, you know, the market conditions. And so I would say we're optimistic, and as we think about the Invest Today commentary, particularly in Canada, our expectations or outlook would be at the top end of that range for 2024.

Perfect. Thank you.

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

Great. Thank you, Operator. This concludes our question and answer session. I'd like to – well, and thank you, everybody, for participating, and I hope you have a safe day.

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