Atmus Filtration Technologies Q2 2023 Earnings Call Transcript

Quartr
Provided by Quartr
August 9, 2023

There are 8 speakers on the call.

Operator

Good morning.

Speaker 1

My name is David, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Atmos Filtration Technologies Second Quarter 2023 Earnings Call. Today's conference is being recorded. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session.

Speaker 1

Thank you. Todd Sciarillo, Executive Director, Investor Relations, you may begin your conference.

Speaker 2

Thank you, David. Good morning, everyone, and welcome to the Atmos Filtration Technologies' Q2 2023 earnings call. On the call today, we have Steph Disher, Chief Executive Officer and Jack Kinstler, Chief Financial Officer. Certain information presented today will be forward looking and involve risks and uncertainties that could materially affect expected results. Please refer to our slides on our website for the disclosure of the risks that could affect our results and for a reconciliation of any non GAAP measures referred to on our call.

Speaker 2

For additional information, please see our SEC filings and the Investor Relations pages available on our website at atmos.com. Now, I'll turn the call over to Steph.

Speaker 3

Thank you, Todd, and good morning. I'm excited to be here for our company's first earnings call and to provide you with an update of our Q2 2023 results. At the end of May, we completed our initial public offering, a significant milestone for our company and the culmination of multiple years of work. The launch of Atmos provides us with a unique opportunity to grow, both in our core market and through expansion into industrial filtration market. Our successful IPO would not have been possible without the tireless dedication of our global employees.

Speaker 3

Every person on our team from our quality inspector at our dedicated media production facility in Korea to our safety leader in Cookeville, Tennessee is key to our success. Our people provide premium FleetGuard products and deep industry knowledge to support the success of our customers. We have made significant progress in our Q1 as a public company and are on track with plans to separate fully from Cummins. I do want to bring to your attention that we filed an 8 ks on Tuesday, restating our Q1 2023 financial statements and revising annual prior periods for 2020 through 2022. Jack will provide more detailed information later in our call and of course we want to address any questions you have.

Speaker 3

We are committed to ensuring a strong internal control environment and to communicating transparently. I would like to now turn to a summary of our strong second quarter results. I'll start with a high level overview of our markets and the drivers of our results and then turn to our financial performance. Demand remains strong in our 1st fit markets through the Q2, and we expect this to continue through the second half with our customers reporting strong orders through the end of the year. In the aftermarket, We experienced some destocking by customers through the Q2 and we expect a softer second half connected with slower economic activity.

Speaker 3

China market continues to be challenging to predict and whilst we see some recovery from 2022 demand levels, it is a slow recovery and we expect a continued muted recovery through the end of 2023. Sales in the Q2 2023 were 414,000,000 an increase of approximately 5% from the Q2 of 2022. Increased pricing more than offset lower volume and FX headwinds. Adjusted EBITDA margin rose 220 basis points from the prior year to 19.3%. The benefits of pricing actions coupled with the moderation of commodity and freight costs drove the improvement in profitability.

Speaker 3

We are adjusting EBITDA for one time separation costs, which were $9,000,000 in the Q2 of 2023 compared to $1,000,000 a year ago. Adjusted earnings per share was $0.63 and adjusted free cash flow was 35,000,000 an increase of $11,000,000 over the same period last year. We have adjusted free cash flow for $2,000,000 of one time capital expenditures related to separation. Overall, it was a strong quarter and we are continuing to build momentum. We have strong leadership in place and we are working together to create Atmos.

Speaker 3

I would like to make some brief comments on our strategic progress in the quarter. You may recall, our strategy is focused on 4 pillars: grow share in 1st fit in our core markets, accelerate profitable growth in the aftermarket, transform our supply chain and expand into industrial filtration market. I would like to highlight 3 areas of strategic momentum during the Q2. Firstly, we are a technology leader. Our proven leadership enables us to win FirstFit business by solving our customers' complex problems.

Speaker 3

During the Q2, we launched at Wuhan, China Technical Center. This was the first of 3 transitions as we progress our technical strategy and establish full separation from Cummins. During the opening of our Wuhan facility, We introduced our next generation of media technology, Nano Net Plus for China, which further extends the performance capabilities of our existing NanoNet technology. The next generation NanoNet Plus along with our new technical center enables us to continue to develop differentiated products in fuel filtration. This further underpins our global market leading position in fuel filtration.

Speaker 3

Secondly, we are focused on transforming our supply chain. One element of this transformation is improving the availability of products for our customers, which will drive share in the aftermarket and profitable growth. During the Q2, we progressed the implementation of our global distribution strategy through the establishment of new Atmos warehouses in Sao Paulo, Brazil and San Luis Potosi in Mexico. Our teams have done an outstanding job establishing these new facilities, embedding capabilities and ensuring improved delivery for our customers. The progress in the quarter to deliver enhanced availability for our customers, whilst maintaining disciplined inventory management was remarkable.

Speaker 3

And finally, I wanted to focus on our growth potential through expansion into industrial filtration market. At Atmos, we intend to pursue this growth opportunity through a disciplined programmatic approach to acquisitions. We have established a strategy and corporate development team. We have developed a robust pipeline of targets and are continuing to assess acquisition opportunities aligned with our strategy. My leadership team and I are focused on growing beyond our core and we'll continue to update you on our progress.

Speaker 3

It has been a big quarter, a successful IPO and launch of Atmos, progress on multiple fronts against our strategic priorities and strong financial performance. I want to thank all of the Atmos team for their significant contribution. Now, I will turn the call over to Jack.

Operator

Thank you, Steph, and good morning, everybody. Before reviewing our quarterly results and full year 2023 outlook, I want to provide you with some additional details regarding the recent 8 ks filing, which Steph referred to. We restated our March 31, 2023 financial statements and revise our annual financial statements for 2020, 2021 and 2022. As we close the books in the Q2 of 2023, we identified errors within our intercompany and related party accounting practices. These errors principally included overstatements of related party receivables and related party payables and an understatement of net parent investment.

Operator

When combined with other prior period errors originally considered to be immaterial both individually and in the aggregate, the amount of the overstatement of cash provided by operating activities totaled approximately $25,000,000 for the period. These overstatements in cash provided by operating were offset by an overstatement of cash used in investing activities of $3,000,000 and cash used in financing activities of $22,000,000 It is important to note that these errors had no impact on revenue, net income or EBITDA for the Q1 of 2023, nor did they have an impact on the amount of the company's cash balance upon closing of the initial public offering, which was 115,000,000 Now let's discuss our Q2 2023 results compared to the same period last year. As Steph mentioned at the beginning of the call, we delivered strong financial performance. Sales were $414,000,000 compared to $393,000,000 from the same period last year, an increase of approximately 5%. The increased sales were driven by $32,000,000 of pricing, which more than offset $7,000,000 of decreased volume and $4,000,000 of foreign exchange headwinds.

Operator

Gross margin for the quarter was $114,000,000 an increase of $19,000,000 compared to the Q2 of 2022. In addition to favorable pricing, we saw commodities and freight improved by $12,000,000 This was partially offset by higher variable compensation costs, the impact of lower volumes and foreign exchange headwinds. SG and A expenses were $46,000,000 an increase of $14,000,000 over the same period in the prior year. The growth in cost was driven by higher variable compensation. In addition, we experienced some cost inefficiencies as we incurred corporate costs from our parent company, while standing up our own dedicated resources.

Operator

We expect this inefficiency to continue until we are a fully standalone company. The increase in variable compensation segmentation is a result of the efforts of all of our employees as they delivered strong results through the first half of the year relative to our expectations. Equity, royalty and interest income was $8,000,000 an increase of $3,000,000 from 2022 primarily due to higher earnings from our joint ventures in China and India. This resulted in adjusted EBITDA of $80,000,000 or 19.3 percent compared to $67,000,000 or 17.1 percent in the prior period. Adjusted EBITDA for the quarter excludes $9,000,000 of one time standalone costs.

Operator

These one time costs primarily relate to the establishment of functions previously co mingled with our parent company, such as information technologies, distribution centers and Other Human Resources matters. Overall, we delivered strong profitability, driven by higher pricing and a moderating cost environment. Our effective tax rate for the Q2 was 24.5 percent, an increase of 500 basis points from the Q2 of 2022. The increase was primarily due to a change in the mix of earnings among tax jurisdictions. Adjusted earnings per share was $0.63 for the same period last year, adjusted EPS was $0.60 Adjusted free cash flow was $35,000,000 this quarter compared to $24,000,000 in the prior year.

Operator

Now I would like to discuss our approach to capital allocation, which is focused on delivering long term shareholder value. We maintain strong liquidity to protect against volatility and uncertainty. We ended the Q2 with $140,000,000 of cash, combined with $350,000,000 of availability under our revolving credit facility, our total liquidity was 490,000,000 for approximately 30% of the last 12 months sales. We paid down $20,000,000 of our outstanding revolving credit facility following the quarter end. This reflects our strong performance and confidence in our ability to generate cash.

Operator

We plan to allocate capital for the sustainable growth opportunities, which Seth addressed earlier. These include growth in our traditional business and inorganic expansion into industrial filtration market. Finally, we will continue to assess returning cash to shareholders. Next, I will turn to our guidance for the full year of 2023. We expect sales to be in a range of $1,580,000,000 to $1,630,000,000 We expect adjusted EBITDA margin in the range of 17.25% to 18.25%.

Operator

This excludes an expected $30,000,000 to $35,000,000 of one time separation costs for the full year of 2023. Moving to adjusted earnings per share, our outlook for 2023 is in the range of $2.05 to $2.25 as we look towards the second half of the year, we expect to incur interest expense of approximately $25,000,000 to $30,000,000 as we service debt incurred at the IPO. Our effective cash tax rate will be in the range of 23% to 25% for the full year 2023. This range is consistent with our year to date average tax rate. Overall, our team did a fantastic job delivering strong results during the Q2 and we look forward to a strong full year of 2023.

Operator

Now, I'll turn it back over to the operator and we will take your questions.

Speaker 4

Thank

Speaker 1

you. We'll take our first question from Tami Zakaria with JPMorgan Chase. Your line is now open.

Speaker 3

Hi, good morning, Steph and Jack. Hope you're doing well. So my first question is, Seems like volume growth was flattish in the first half. So can you help us understand what's the volume decline outlook is embedded in for the back half as you think about the full year guide. Meaning, can you quantify what kind of volume you're expecting for the back half and whether 3Q should be worse than 4Q because I think compares step down in the 4th quarter.

Speaker 3

So any color on volume execution would be very helpful. Okay. Good morning, Tammy, and thank you for your question. I think as we provided in my overview comments and I'll let Jack to talk to the specifics of how it plays out into the 3rd and 4th quarters in our guidance. Overall, I would say we're seeing a softening in the second half relative to the first.

Speaker 3

We've seen strong performance in the Q1 particularly, we saw that soften somewhat in the Q2, particularly in the U. S. Markets as we see some destocking through the channel. We expect our customers are doing that at different rates. Some had progressed that through the Q2.

Speaker 3

We would expect more of that in the Q3 and through the 4th. We do see softened economic activity impacting largely the Q4, I would say, and that's strongly connected to economic activity, which is a primary driver of our aftermarket obviously. So I'll let Jack add any other specific.

Operator

Sure. Thanks Tammy. So generally speaking, It can vary year by year, but over the long period of time, we generally see the second half from a seasonality perspective being softer than the first, somewhere in the range of 5% or less. Our outlook implies a little bit more of a softening than that in the second half of this year driven by the factors that just described. Usually we've seen the Q3 be that Decline be more pronounced in the Q3 with a little bit of recovery in the Q4, but it's hard to say precisely in this period.

Speaker 3

Got it. Thank you so much. And if I can ask a follow-up question. Since you want to enter into industrial filtration market, Can you tell us whether your current product portfolio has any products in there that can be fitted or leveraged to enter some industrial end markets relatively quickly. We are certainly assessing our opportunities to grow into industrial filtration markets.

Speaker 3

We see this as a significant growth opportunity. So these markets They're growing at twice the rate of our existing core market and we see the market size opportunity Being 3 times the size of our current market opportunity. We are primarily focused on assessing that growth opportunity through inorganic expansion, and we discussed that in our remarks. We do see some possibilities of Spring through organic and we are exploring those. It really would be leveraging off our media capability.

Speaker 3

It would need some product development still though, Tammy, to have finished goods that would service those markets. So, that's how I would characterize it with you, but we are certainly exploring the full round of possibilities there as to how we would fast could fast track organic development into those markets as well. Great. Thank you so much.

Speaker 1

Thank you, Tammy. Thank you. Next, we'll go to Jerry Revich with Goldman Sachs. Your line is now open.

Speaker 5

Yes. Hi, good morning, everyone.

Speaker 4

Good morning, Jerry.

Speaker 3

Good morning, Jerry.

Speaker 5

Really impressed by the margin performance. You're now running at 19% year to date. I'm wondering if you could just update us on how you're thinking about long term margin targets and obviously you're reducing production sequentially in the guide, but It feels like the margin step down is significant. I'm wondering is that just a function of First couple of quarters out of the gate, wanting to make sure expectations are manageable versus something that's meaningfully different back half versus first half. Thank you.

Speaker 3

Thanks for the question, Jerry. Obviously, our guidance puts full year adjusted EBITDA And it's 17.25 percent to 18.25 percent. You're right. The 1st 2 quarters of the year have been very strong in terms of margin performance. There's a number of factors that I think have fed into that.

Speaker 3

We're very pleased with it. However, it's certainly not at a level I would say is sustainable at this point. So we're getting the benefits in the first half, both the first and second quarter of significant pricing actions, which were catch up actions. And at the same time, we have seen some moderation of costs in those quarters, plus we've had a strong volume environment with back orders and so forth that we have caught up on largely at this point. So it was kind of a lovely mix of strong margin for that first and second quarter.

Speaker 3

As we've spoken about previously, we certainly see margin expansion in our business and we started to realize some of that related to the short term actions of pricing and cost factors moderating. We are focused on expanding our margins into the future. The volume moderation in the second half Certainly puts downward pressure as you discussed and we've got a number of inefficiencies still factored into our EBITDA margins overall as we become a standalone company.

Speaker 5

That's clear. And Steph, can I ask to And on the M and A opportunity set, can you characterize for us the size of the M and A pipeline that you folks are pursuing and Just talk about your process in building that pipeline just to give us a sense for what the opportunities that could look like From a transaction standpoint over the next 6 to 18 months?

Speaker 3

Yes. And I don't have a specific I get to talk to you about, I hope in some of these future calls, I will be able to be very, very specific about the opportunity that we're going to proceed forward with. The rigor and the process we're putting in place, I'm very pleased with our progress. As I referenced, we have established a strategy team, corporate development team. They've built a pipeline of targets.

Speaker 3

We've filtered that pipeline of targets down to those that meet our strategic criteria and our financial criteria. We're evaluating regularly every month. It's multiple targets. And as you know, we have to fish for many before we actually are going to be able to find the right opportunity for us to take that first step. We've described our acquisition strategy as a disciplined programmatic acquisition strategy, Jerry.

Speaker 3

So I see these are smaller acquisitions that we will look to build out the synergy opportunity over time. So I'd love to be able to give you more color than that. Hopefully, that gives you a sense of the discipline and the robust establishment of team and capability we're building to really be able to set us up for a programmatic acquisition approach to industrial filtration market.

Speaker 5

Appreciate it, Seth. Thank you and congratulations on the strong start here. Thanks.

Speaker 3

Thank you, Jerry. Okay.

Speaker 1

Next, we'll go to Joe O'Dea with Wells Fargo. Your line is now open.

Speaker 6

Hi, good morning. Thanks for taking my questions. I wanted to circle back on aftermarket and if you could kind of parse it by what you're seeing on the destock side and then what you're anticipating on the slower economic activity side. And so just any color on And so just any color on what you've seen from a cadence perspective on the destock, whether kind of the right thinking is that You saw it in 2Q, maybe it's a little bit steeper headwind in 3Q and then that is in 4Q. And then regarding the software economic activity, The degree to what you're actually hearing and seeing from customers, as opposed to sort of what you're anticipating just based on what you see on the macro?

Operator

Yes, maybe I'll take a go and Steph obviously can weigh in here too. So Joe, I think It's a little difficult in the aftermarket as you're aware to parse out the specific driver. I think All of our broader customers have approached this year from an inventory management standpoint a little bit differently. And so you're seeing destocking occur at different times with different customers. And so we did see some of that in Q2 as Seth alluded to and expect some more of that here over the back half as everyone rightsizes their inventory relative to their expectations.

Operator

In terms of the overall economic activity, I would say we are seeing some slowdowns there. You can look at a number of different inputs whether it's freight indices or truck tonnage to point to slowdown in activity. Perhaps it isn't as pronounced as we all thought a quarter ago. And so we're keeping a close eye on how that unfolds and we'll continue to monitor what happens in the aftermarket.

Speaker 6

Got it. And then, question on R and D, I think that was up 20% sequentially and year over year. Not sure how much of that is tied to standalone or how much is tied to maybe some initiatives underway. But if you could touch on anything that contributed to that by sort of specific programs or any organic efforts toward industrial.

Operator

Yes, absolutely. So generally speaking, we think about R and D as a percent of sales and right in that 2.5 percent call it in the 2% to 3% of sales range and that's kind of where we've been pretty consistently. We do have some lumpiness if you will in terms of prototype recoveries in particular as we work with our customers to develop new products. The timing of reimbursements for that can be can cause some differences quarter on quarter. But overall, we continue to invest from an R and D perspective and are excited about what the team can do, not only in our core markets as they bring new solutions forward for our customers, but also through the evaluation of these industrial markets and what capabilities can we leverage into those new markets.

Speaker 4

Got it. Thank you. Thanks, John.

Speaker 1

Okay. Next, we'll go to Rob Mason with Baird. Your line is open.

Speaker 7

Yes. Good morning, all. Good morning. I had it's good to see the benefits of your pricing initiatives flow through that's pretty visible. I was curious what your outlook for the full year includes with respect to price, as we go forward.

Speaker 7

And just also around your pricing initiatives, the stickiness of that price that you've put through, as you think about the balance of the year and if some of these costs do continue to come down like freight, input costs, etcetera.

Speaker 3

Yes. Thanks, Rob. Good to talk to you. So let me just give an overview on where I see we are in the sort of price cost story. So largely through now The Q2, we've caught up on price cost, I would say, as you've reflected in terms of our margin performance.

Speaker 3

We obviously had the lag through previous periods of performance. So I'd say largely we're caught up now And we are seeing inflationary pressures and commodity prices moderate. So I do expect pricing in our outlook and what's contained in our guidance to return much more to historical trends is where I would guide you to. Of course, if we do see costs escalate further, we will adjust for that. You will see the lag that we have experienced in the past, But we would adjust for those.

Speaker 3

I'm not expecting any issues with stickiness. We really have been able to successfully pass price into the market as you've seen and demonstrated and so I wouldn't flag any issues there at this

Speaker 7

Group. Thanks for that, Steph. Just as a follow-up, it looks like your kind of one time separation costs, the outlook for the year suggests those could increase sequentially as we go through the second half of the year. Could Just update us on where you think you are in terms of your ability to move off from some of the TSAs. And you also mentioned some inclusion of inefficiencies in the outlook as well.

Speaker 7

Just is there any way to frame up what those inefficiencies amount to quantitatively right now?

Speaker 3

Yes. So let me give an overview of how we're tracking overall. It's a significant separation from Cummins and I'll give Some more color to that to give you a sense of it. And then I'll ask Jack to add anything that he thinks I'm missing. But just overall, there are certain elements, certain functions that we are heavily entangled with Cummins, We've called those out a few times, but I would describe those predominantly as warehousing and transportation, HR and IT.

Speaker 3

And we are tracking very well in terms of Our separation plans and the individual projects, I would just broadly describe those as being on track. I to a couple of those features. In my highlights, we've established 2 of our warehouses and distribution centers. So we are very much On track with where we expected to be at the end of the second quarter. I think the challenge in terms of just Where those inefficiencies might lie that we're just guarding against is just unanticipated Elements of IT perhaps that we need to keep on longer, for example.

Speaker 3

That's what I would characterize it as. And a good example, I feel like we've adequately integrate But as we stand up our own cybersecurity capability, we do need to keep coverage of Cummins cybersecurity for the whole period, while ever we're using any of Cummins applications, right? So we can't really turn that piece off right until we get to the end of our 2 year journey, if you like, at the end of 2024. But we're on track right now. We've been managing it very well and we'll wind down the TSAs as we turn off the activities and the services.

Operator

Yes. And just to add a little bit here, Rob. So I think as you think about the cadence of the one time cost as you alluded to, we are expecting Tremendous to remain at this level, it's not a touch elevated as we move through the back half of the year. As a reminder, we had about $4,000,000 of these one time costs in our Q1 of 2023 and the $9,000,000 here in the Q2. Our guidance is $30,000,000 to $35,000,000 for the full year.

Operator

And so we do expect to continue to incur these costs as we separate facilities from Cummins, systems from Cummins, so on and so forth. And just for color, roughly a third of those that $30,000,000 to 35,000,000 should be incurred in our cost of sales, with the balance down in SG and A primarily.

Speaker 4

That's helpful. Thank you. Thank you, Rob.

Speaker 1

Okay. Next we'll go to Andrew Obin with Bank of America. Your line is open.

Speaker 4

Yes, just a follow-up on The destock commentary, I think there are a lot of dynamics here. I think one of your competitors would really have to do with specifically what one of their customers was doing. But are you seeing destock at the distributor level or are you seeing destock at your OEM customer level? Where is the destock that you're talking about?

Speaker 3

Yes. And so Andrew, I'll focus largely on the North America market with my comments. It is the majority of our Aftermarket just to give you a sense. Can you still hear me, Andrew?

Speaker 4

Yes.

Speaker 3

Yes, good. And so I'll just focus on North America. Look, what I would say, it is varying by OE actually. That's the color I would give you. Some of our customers are OE, it will really all the way through the dealer and distributor channel and it's moderated back to normal levels of inventory through the chain and we think we're most of the way through the destocking.

Speaker 3

In others, we're kind of still in the distributor or dealer level. And then in others again, it's up at the OE level. So it is varying actually. We're seeing some moving through that faster Than others. We expect it to play out almost that variation is helping us as this moderates through is how I would describe it.

Speaker 3

We're expecting that destocking to play out over the remainder of quarter 3 and 4.

Speaker 4

Got you. And just a follow-up question on inflation. I think industry is starting to talk about disinflation or maybe some talking about deflation. I think you guys are talking about better price from your supply chain. But I think historically, the industry would give back pricing in a deflationary environment.

Speaker 4

Have you adjusted the contract? Just remind us, if you have adjusted your contract structure going forward to sort of to mitigate that or should we look at sort of legacy patterns where inputs go down first and then You guys have to give back some price. Can you just talk about structurally what do contracts look like? Thank you.

Speaker 3

Yes. So I'll talk at a high level just to the differences between our First Fit business and Aftermarket as it relates to pricing. So it's roughly eightytwenty, so 80% aftermarket, 20% first fit. Our first big contracts are very much based on a contractual arrangement. Many of those have rise and fall clauses integrated into them.

Speaker 3

And you've seen that flow through in our previous period results. In terms of the aftermarket, we passed price increases to the Market and roughly on a twice a year basis, but it varies by region. At the moment, we're not seeing deflationary pressures, I would say. Certainly, we're seeing a lower inflationary environment. We have only really caught up, I would say, in those markets to the previous rising and escalating cost environment.

Speaker 3

So I certainly don't I'm not looking at a deflationary pace in our forward pricing outlook.

Speaker 4

But generally in aftermarket, the point is that pricing should be a lot more stable than in the OE channel. Exactly. Thanks so much. Congratulations on a great quarter.

Speaker 3

Thank you.

Speaker 1

And there are no further questions at this time. Todd Schiller, I'll turn the call back over to you for any additional or closing remarks.

Speaker 2

Great. Thank you. That concludes our teleconference for the day. Thank you for participating and your continued interest. As always, the Investor Relations team will be available for questions after the call.

Speaker 1

This concludes today's conference call. You may now

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Atmus Filtration Technologies Q2 2023
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