Tennant Company (NYSE:TNC) Q2 2023 Earnings Call Transcript

Tennant Company (NYSE:TNC) Q2 2023 Earnings Call Transcript August 4, 2023

Tennant Company beats earnings expectations. Reported EPS is $1.67, expectations were $1.16.

Operator: Good morning. My name is Chris and I will be your conference operator today. At this time, I would like to welcome everyone to Tennant Company’s 2023 Second Quarter Earnings Conference Call. This call is being recorded. There will be time for Q&A at the end of the call. [Operator Instructions] After the Q&A, please stay on the line for closing remarks from management. If you’ve joined our call today via telephone and logged into the conference call presentation on your computer, please mute the audio on your computer to avoid potential quality issues during the call. Thank you for participating in Tennant Company’s 2023 second quarter earnings conference call. Beginning today’s meeting is Mr. Lorenzo Bassi, Vice President, Finance for Tennant Company. Mr. Bassi, you may begin.

Lorenzo Bassi: Good morning everyone and welcome to Tennant Company’s second quarter 2023 earnings conference call. I’m Lorenzo Bassi, Vice President, Finance and Investor Relations. Joining me on the call today are Dave Huml, Tennant’s President and CEO; and Fay West, Senior Vice President and CFO. Today, we will provide you with an update on our second-quarter performance. Dave will provide you with an update on our operations and enterprise strategy, and Fay will cover our financials. After our prepared remarks, we will open the call to questions. Please note the slide presentation accompanies this conference call and is available on our Investor Relations website at investors.tennantco.com. Before we begin, please be advised that our remarks this morning and our answers to questions may contain forward-looking statements regarding the Company’s expectations of future performance.

Such statements are subject to risks and uncertainties, and our actual results may differ materially from those contained in the statements. These risks and uncertainties are described in today’s news release and the documents we filed with the Securities and Exchange Commission. We encourage you to review those documents, particularly our Safe Harbor statement for a description of the risks and uncertainties that may affect our results. Additionally, on this conference call, we will discuss non-GAAP measures that include or exclude certain items. Our 2023 second-quarter earnings release and presentation include the comparable GAAP measures and a reconciliation of those non-GAAP measures to our GAAP results. Our earnings release was issued this morning by a Business Wire and is also posted on our Investor Relations website at investors.tennantco.com.

I will now turn the call over to Dave.

Dave Huml: Thank you, Lorenzo, and hello everyone. On the call today, I will be discussing highlights from the second quarter, new product innovations, our new sustainability framework Thriving People Healthy Planet, and our outlook for the remainder of 2023. Before analyzing the details of this quarter, it is important to frame our performance in relation to the prior quarters. In 2021, as the economy started to recover and reopen, we experienced a spike in demand for our products and services and we have continued to benefit from strong and resilient demand since that time. Also, beginning in early 2021, we started to experience supply chain issues, labor shortages, and high inflation, conditions that have persisted for seven straight quarters, which impacted our ability to increase production to fully meet demand.

This led to a substantial increase in our order backlog, which reached unprecedented levels. To address these circumstances, our team took significant actions and made incremental investments to mitigate these short-term disruptions and enable us to increase production. Leveraging our enterprise strategy, we also implemented structural changes, such as optimizing plant capacity and securing labor to support increased parts availability that help address the immediate production and supply chain issues as well as position us for long-term future success. These actions and investments have started to yield results as evidenced by our performance in the last two consecutive quarters. The availability of critical parts has increased and the impact of supply chain challenges and inflation has abated.

Lead times are reverting to normal in almost all of our locations and we have been able to reduce our backlog substantially. Our elevated backlog is a testament to the strength of our brands, the quality of our products and service, and our commitment to supporting our customers. And we appreciate our customers’ loyalty and patience during this extended period. We will continue to work diligently to reduce lead times and satisfy customers with our exceptional products and services. We anticipate that we will be able to reduce backlog further in the back half of the year, however, the backlog will remain elevated specifically in North America Industrial products. Now, moving on to some specifics about the quarter. In the second quarter, we achieved record net sales of $321.7 million, which was underpinned by organic growth of 15%.

We expanded gross margins to 43.4% and delivered adjusted EBITDA of $57.6 million or 17.9% of net sales. Additionally, we converted over 100% of net income to free cash flow. Key drivers of our second-quarter performance were a noticeable improvement in parts availability and in general, a more stable and predictable supply chain environment, which resulted in an increase in volume and a reduction in backlog, continued price realization, and moderating inflation, which drove an improvement in gross margin and a cautious approach to S&A spending, which benefited adjusted EBITDA. Regarding the supply chain, we have seen a significant improvement in parts availability and have experienced fewer line disruptions. This allowed us to operate our plants more efficiently, increased volumes, and as I just mentioned meaningfully reduced backlog.

We are pleased with the improving supply chain landscape and are cautiously optimistic that we will continue to see stability and predictability, but we do not think that we are fully recovered. Therefore, this remains an area of significant focus, continued action, and necessary agility. Strong price realization, moderating inflation, and careful cost control have benefited both gross margin and adjusted EBITDA in the quarter. Based on our first-half performance, resilient demand, and continued backlog reductions, we are pleased to increase our full-year 2023 guidance. We are cautiously optimistic that inflation will remain at moderate levels and that the global economy will continue to recover. Turning now to recent product launches and our innovative technology, we continue to see success in utilizing our global network of manufacturing design and engineering facilities.

This quarter, we broadened our portfolio of innovative products and solutions by leveraging the Italy-based IPC product platforms and launched the Tennant branded S680 and S880. These ride-on sweepers in our mid-tier range are the right fit for light to medium-duty tasks requiring high maneuverability in both indoor and outdoor environments. These products improve existing offerings of similar-sized legacy equipment but are presented at different price points. This allows us to reach a broader set of customers across the broad array of vertical markets we serve through our multi-channel distribution approach. Our acquired product platforms allow us to bring a diverse range of equipment to the market at different price points for our customers with minimal financial investment and resources from Tennant.

Turning now to our innovative technology products. The most disruptive and innovative technology with the highest potential in our industry is the Autonomous Mobile Robot or AMR. This equipment operates in complex environments without the need for direct operator control, not only does this ensure consistent cleaning operations, but also reduces the cost of ownership by helping to minimize the impact of labor expenses for cleaning in today’s tight labor markets. These products work alongside cleaning staff and allow them to focus on the difficult and variable cleaning tasks, while the more repetitive and expensive floor cleaning can be handled by our equipment. Tennant currently offers three autonomous mobile robots, including our most recent product, the T16 AMR floor scrubber.

This was the first autonomous scrubber designed for industrial applications like warehousing and manufacturing markets. Tennant has been traditionally strong in these industrial vertical markets and our customers value our high-performance equipment, reputation for quality and durability, as well as our ecosystem of support including our factory direct field service organization. The T16 AMR is a natural progression for us. Since 2022, about 30% of our T16 sales have been the AMR version of the equipment. We believe autonomous equipment and large space industrial markets have significant growth potential and the adoption rate will continue to expand. The industrial market has already adopted automation and robotics in areas outside of cleaning and employees in these settings are accustomed to working alongside robotics.

We also believe that it is easier to manage and measure the ROI of automation in the industrial space, allowing our customers to fully realize the value of our AMR products. We are excited about the T16 AMR potential and believe we are uniquely positioned to enable customer success and drive AMR adoption in these verticals. Now turning to sustainability. In April, we announced the launch of our new sustainability framework, Thriving People Healthy Planet. Along with our first set of goals and our commitment to reduce greenhouse gas emissions and achieve net zero by the year 2040, in the coming weeks, we will plan to release our 2023 sustainability report, which will detail Tennant’s progress on our goals and ESG metrics. We also plan to announce our second set of goals under the Thriving People Healthy Planet framework.

Specifically, we aim to increase the percentage of women in leadership by 50% by the end of 2030. Ultimately, we believe that there are opportunities to deepen the diversity of our organization and expand the perspectives of our teams. We believe that combining this objective with providing an inclusive work environment will positively support our business success. With that, I will turn the call over to Fay for a discussion of our financials.

Fay West: Thank you, Dave, and good morning everyone. This morning, I’m going to discuss our second-quarter results, cash flow, and liquidity, as well as our full-year 2023 guidance. In the second quarter of 2023, Tennant delivered net income of $31.3 million, an increase of $14.7 million from the prior year period. Strong operating performance was fueled by higher net sales and improved gross margins. Net sales growth and gross margin improvement were driven by both volume increases and higher price realization. Selling and administrative expenses were higher in the quarter as compared to the prior year period due to higher variable costs associated with the increase in operating performance, as well as higher employee-related costs.

As a percentage of net sales, S&A expense for the second quarter of 2023 decreased by 120 basis points to 27% from 28.2% in the prior-year quarter. The decrease in the period was driven by the leverage attributable to our sales and gross margin growth as well as our cost containment initiative. Also impacting net income was higher interest expense and higher income tax expense. Net interest expense increased to $4 million in Q2, up from $1.2 million in the prior year period. The increase was due to higher debt levels coupled with rising interest rates on our variable interest rate debt. Income tax expense of $8.6 million was $4.9 million higher than the prior year. The comparisons between periods was impacted by a decrease in discrete tax benefits recognized during the quarter, partly offset by favorable changes in the mix and forecasted earnings by country.

The second quarter’s effective tax rate of 21.6% is in line with our full-year expectations. Second quarter adjusted earnings per diluted share, which excludes amortization, gains on the sale of assets, and restructuring charges, more than doubled to $1.86 per share from $0.92 per share in the prior year period. For the second quarter of 2023, Tennant reported net sales of $321.7 million, a 14.8% increase compared to the prior year period or 15% on an organic basis. Approximately 60% of the year-over-year growth was attributed to pricing and the remaining 40% was driven by volume. We ended the quarter with approximately $255 million of backlog, a reduction of $43 million from the end of the first quarter. Increased parts availability allowed us to increase our production to service outstanding backlog and fulfill customer orders.

Net sales growth of $41.5 million in the quarter was primarily due to this backlog reduction. Tennant groups its sales into three geographies, the Americas, which include North America and Latin America; EMEA, which covers Europe, the Middle East, and Africa; and Asia-Pacific, which includes Australia, China, Japan, and other Asian markets. All of the geographic regions achieved year-over-year net sales growth. Net sales in the Americas grew 21.4% to $216.6 million or 21.7% on an organic basis, while FX had a net unfavorable impact of approximately 0.3%. This significant year-over-year growth in our largest region was driven equally by price realization and volume increases, led by strong equipment and parts and consumable sales in North America.

Net sales in EMEA in the second quarter increased 3.5% over the prior year to $80 million or 2.4% on an organic basis. This was driven by price realization in both equipment and service product categories across the region, partly offset by volume declines the region also had a net favorable impact from foreign exchange of approximately 1.1%. Net sales in the Asia Pacific region increased by 2.4% over the prior year to $25.1 million or 6.3% on an organic basis. This was driven primarily by price realization in Australia and volume growth in China. However, it was partly offset by a net unfavorable impact from foreign currency exchange of approximately 3.9%. We also group our net sales into the following categories; equipment, parts and consumables, and service and other.

We experienced growth in all categories in the second quarter of 2023, as compared to the prior year period, most notably in equipment sales, which grew 18.1% year-over-year. Turning to adjusted EBITDA, adjusted EBITDA for Q2 was $57.6 million, an increase of $27.3 million versus the prior year period. Adjusted EBITDA margin was 17.9%, an increase of 710 basis points versus the prior year. Our sales growth, driven by both volume and price and expanded gross margins were the most significant drivers of adjusted EBITDA growth. Gross profit of $139.5 million was $33.4 million higher than the second quarter of last year. The gross margin of 43.4% in the second quarter of 2023 improved 550 basis points compared to the same period in the prior year.

We have successfully returned to pre-pandemic gross margin rates based on strong price realization, which offset the multiyear impact of inflation on materials and labor. S&A expense of $87 million was up $7.9 million compared to the prior year’s quarter due to higher variable costs associated with increased operating performance, such as warranty costs and employee compensation costs. As a percentage of net sales, adjusted S&A expense for the second quarter decreased 140 basis points to 26.7% from 28.1% in Q2 of the last year, driven by both the leverage attributable to our top line and gross margin growth as well as our cost containment initiatives. Turning now to capital deployment. Net cash provided by operating activities was approximately $39.1 million in the second quarter, compared to net cash used in operating activities of $13.5 million in the year-ago period.

The increase was the result of improved operating performance coupled with a significant reduction in strategic inventory spend. In previous quarters, we increased our inventory with targeted investments in safety stock as well as Tier 2 components, which we procured on behalf of our suppliers. Those direct actions are now reading through in our results as we have been able to increase our output and fulfill orders without further increasing our inventory position. Capital expenditures of approximately $5 million were in line with our expectations and we are on pace to meet our full-year guidance. In alignment with our capital allocation priorities, we returned capital to our shareholders with dividend payments of $4.9 million and repurchased approximately 70,000 shares of our common stock for $5 million.

Tennant’s liquidity remained strong with a cash balance of $95.8 million at the end of the second quarter and $261.9 million of unused borrowing capacity on the Company’s revolving credit facility. At the midpoint of our full-year guidance range, our net leverage was 1x adjusted EBITDA, lower than our stated goal of 1.5x to 2.5x. We have remained focused on maintaining a strong balance sheet and given the current interest rate environment, we have directed cash to reduce debt by $21.1 million in the second quarter. Moving to guidance, we are pleased with our second quarter results, and based on the strength of the first half of the year, we are raising our full-year guidance. Our year-to-date results have benefited greatly from a significant increase in the availability of parts and we believe we will continue to see overall improvement in our supply chain.

The improvement in parts availability allowed us to increase our production to fulfill open orders and meaningfully reduce backlog. While many of our locations are approaching normal backlog levels and lead times, our backlog remains elevated and heavily concentrated in North America, particularly in our industrial products. We anticipate that we will be able to further reduce backlog in the back half of the year, but not at the same rate that we experienced in the first six months of 2023. Overall, demand has been resilient and we are monitoring global order rates very closely. We expect that the third quarter will experience the same level of seasonality, as it has historically, especially in our EMEA region and net sales will be slightly lower in the third quarter as compared to the second quarter.

We believe our pricing actions will continue to read out in the second half of the year. Further, we anticipate that gross margins will remain strong in the second half of the year as cost-out actions coupled with improved productivity and strong price realization will continue to materialize. Based on the timing of spends, we expect R&D expenses will be slightly higher in the back half of the year. As we’ve discussed on prior calls, we have been very cautious on all discretionary spending specifically S&A as evidenced by our low S&A percentage. We will remain cautious and prudent in our spending but anticipate that S&A will be higher in the back half of the year as we invest in employees, strategic initiatives and revert back to normal travel, which will put some pressure on adjusted EBITDA.

Given these factors and the strong profitable growth in the first half of the year, we are raising our outlook for the full year of 2023. Specifically, we now expect net sales to be in the range of $1.2 billion to $1.25 billion, reflecting organic sales growth of 10% to 14% and adjusted EBITDA to be in the range of $175 million to $190 million. With that, I will turn the call back to Dave.

Dave Huml: Thank you, Fay. It was a record first half for Tennant and I couldn’t be more proud of the team who have worked diligently for years executing our enterprise strategy, managing the supply chain crisis and working tirelessly on behalf of Tennant globally. With that, we’ll open the call to questions. Operator, please go ahead.

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Q&A Session

Operator: [Operator Instructions] The first question is from Chris Moore with CJS Securities. Your line is open.

Chris Moore: Hi, good morning guys, amazing quarter. Thanks for taking a couple of questions. So backlog $255 million, down $71 million year-to-date, it’s going to come down a little bit further in the second half. Can you just remind me kind of what the – is there an optimal backlog range that you look at, at this point?

Dave Huml: Thanks, Chris. Thanks for the question and I’ll accept your kudos on the amazing quarter. It’s really a testament to the entire Tennant team that delivered these results. Yes, backlog, we exited with the $255 million backlog, normal backlog is in the $50 million range, obviously with the price we put through – the significant amount of pricing we put through in the past several years, we’re going to readjust what our normal levels of backlog are, but I would use $50 million as a normal backlog range. So with these comments in mind, we exited Q2 with $255 million of backlog and given the – implied in our guidance, second half that will reduce down to around the $200 million range as we exit as 2023.

Chris Moore: Okay, got it. That’s helpful. I’m not sure if Fay is here or not, but orders in Q2 year-over-year, what did they look like?

Dave Huml: Yes. Orders are surprisingly resilient, that is the word I would choose. Sequentially orders flat. And so we’ve, if you look at how that – we didn’t plan it that way and so we are closely monitoring orders as an indication of underlying demand as we work diligently to reduce backlog. We’re kind of flat to plan our orders year-to-date, we – as Fay mentioned, we’re expecting kind of normal seasonality as we outlook into Q3. Q3 is historically our lowest quarter. And then we’ll need to generate the orders to fulfill our Q4 and deliver on the full year.

Chris Moore: Got it. Very helpful. And just from a – it sounds like it was 60-40 pricing versus volume. Is there still much pricing kind of catch-up coming in Q3 and Q4?

Dave Huml: I think you are referencing our pricing as trapped in backlog?

Chris Moore: Yes.

Dave Huml: Yes, so we’ve got – as the backlog reduces, there’ll be less catch-up in pricing as a result of products and orders that are trapped in backlog. If you just look at that component, I think it’s important to note our future results were 60-40 price versus volume. So we are getting underlying volume growth in our results. Backlog reduction in the first half was about $70 million and implied in our guidance is about $50 million reduction in the second half. So you would expect a similar sort of impact, slightly lower in the second half, but similar kind of impact on the revenue line. And as we get – as we work the backlog down, there will be building orders that were placed more – at more recent pricing and so less pick-up in price.

Chris Moore: Got it. I will leave it there. I appreciate it.

Dave Huml: Thanks, Chris.

Operator: The next question is from Steve Ferazani with Sidoti and Company. Your line is open.

Steve Ferazani: Good morning, Dave. Good morning, Fay. Obviously, huge record revenue quarter, I’m trying to understand, and I think, Fay, you tried to address this a little bit in your comments in terms of guidance. Guidance implies second-half revenue was lower than first half and obviously EPS lower, and I’m just trying to get – I’m just trying to understand, are there some capacity constraints at this point, given how healthy the backlog and orders remain either on the labor or just plant size?

Dave Huml: Yes. Thanks. Thanks, Steve. Let me take that and just comment on the assumptions underpinning our second half and implied in the full-year guidance. It’s not necessarily capacity constraints as Fay mentioned, most of our assembly lines around the world have returned to a normal level of output in response to the demand signals they’re getting and a normalized level of backlog. And I think we’ve mentioned in earlier calls, our backlog is overweighted in industrial products and in our North America region. And so as we’ve reduced backlog, our backlog becomes more consolidated and concentrated in fewer and fewer lines – production lines. Those are industrial products and primarily in North America and the reason that’s important is, it is more challenging to effect change because our backlog is so concentrated in fewer and fewer products.