Advanced Drainage Systems, Inc.: Form 10-Q for the period ended Dec 31, 2023

Unless the context otherwise indicates or requires, as used in this Quarterly Report on Form 10-Q ("Form 10-Q"), the terms “we,” “our,” “us,” “ADS” and the “Company” refer to Advanced Drainage Systems, Inc. and its directly- and indirectly-owned subsidiaries as a combined entity, except where it is clear that the terms mean only Advanced Drainage Systems, Inc. exclusive of its subsidiaries. We consolidate our joint ventures for purposes of GAAP, except for our South American Joint Venture.

Our fiscal year begins on April 1 and ends on March 31. Unless otherwise noted, references to “year” pertain to our fiscal year. For example, 2024 refers to fiscal 2024, which is the period from April 1, 2023 to March 31, 2024.

The following discussion and analysis of the financial condition and results of our operations should be read in conjunction with our Condensed Consolidated Financial Statements and related footnotes included elsewhere in this Form 10-Q and with the audited Consolidated Financial Statements included in our Fiscal 2023 Form 10-K, as filed with the Securities and Exchange Commission (the “SEC”) on May 18, 2023. In addition to historical condensed consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. This discussion contains forward-looking statements that are based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. Our actual results could differ materially from those discussed in the forward-looking statements. For more information, see the section below entitled “Forward Looking Statements.”

Overview

ADS is the leading manufacturer of innovative water management solutions in the stormwater and onsite septic wastewater industries, providing superior drainage solutions for use in the construction and agriculture marketplaces. Our innovative products, for which we hold many patents, are used across a broad range of end markets and applications, including non-residential, infrastructure and agriculture applications. We have established a leading position in many of these end markets by leveraging our national sales and distribution platform, industry-acclaimed engineering support, overall product breadth and scale plus manufacturing excellence.

Executive Summary

Third Quarter Fiscal 2024 Results

• Net sales increased 1.1% to $662.4 million
• Net income increased 28.5% to $106.9 million
• Net income per diluted share increased 35.4% to $1.34
• Adjusted EBITDA, a non-GAAP measure, increased 20.3% to $204.2 million

Net sales increased $7.2 million, or 1.1%, to $662.4 million, as compared to $655.2 million in the prior year quarter. Domestic pipe sales decreased $18.8 million, or 5.2%, to $346.1 million. Domestic allied products & other sales increased $8.7 million, or 5.9%, to $156.4 million. Infiltrator sales increased $14.9 million, or 16.8%, to $103.9 million. The overall increase in domestic net sales was primarily driven by the improvement in the U.S. residential and infrastructure construction end markets. International sales increased $2.4 million, or 4.4%, to $56.0 million.

Gross profit increased $35.9 million, or 16.0%, to $259.8 million as compared to $223.9 million in the prior year. The increase in gross profit is primarily due to favorable material cost and sales mix.

Adjusted EBITDA, a non-GAAP measure, increased $34.5 million, or 20.3%, to $204.2 million, as compared to $169.7 million in the prior year. As a percentage of Net sales, Adjusted EBITDA was 30.8% as compared to 25.9% in the prior year.

Year-to-date Fiscal 2024 Results

• Net sales decreased 9.5% to $2,220.6 million
• Net income decreased 1.7% to $417.8 million
• Net income per diluted share increased 4.4% to $5.24
• Adjusted EBITDA, a non-GAAP measure, remained flat at $731.8 million
• Cash provided by operating activities increased 6.0% to $700.3 million
• Free cash flow, a non-GAAP measure, increased 5.7% to $563.9 million

Net sales decreased $232.9 million, or 9.5%, to $2,220.6 million, as compared to $2,453.6 million in the prior period. Domestic pipe sales decreased $189.7 million, or 13.8%, to $1,180.3 million. Domestic allied products & other sales decreased $22.7 million, or 4.2%, to $520.7 million. Infiltrator sales decreased $11.6 million, or 3.3%, to $343.0 million.

The decrease in domestic net sales was driven by lower demand in the U.S. construction and agriculture end markets. International sales decreased $8.8 million, or 4.7%, to $176.6 million.

Gross profit decreased $2.0 million, or 0.2%, to $894.0 million as compared to $896.0 million in the prior year. The decrease in gross profit is primarily due to the decrease in volume and unfavorable fixed cost absorption, partially offset by favorable material costs.

Adjusted EBITDA, a non-GAAP measure, decreased $0.2 million to $731.8 million, as compared to $732.0 million in the prior year. The decrease is primarily due to the factors mentioned above. As a percentage of net sales, Adjusted EBITDA was 33.0% as compared to 29.8% in the prior year.

Results of Operations

Comparison of the Three Months Ended December 31, 2023 to the Three Months Ended December 31, 2022

The following table summarizes our operating results as a percentage of Net sales that have been derived from our Condensed Consolidated Financial Statements for the periods presented. We believe this presentation is useful to investors in comparing historical results.

(In thousands)

Net sales - The following table presents Net sales to external customers by reportable segment for the three months ended December 31, 2023 and 2022.

(Amounts in thousands)

Our consolidated Net sales for the three months ended December 31, 2023 increased by $7.2 million, or 1.1%, compared to the same period in fiscal 2023. The overall increase in domestic net sales was primarily driven by the improvement in the U.S. residential and infrastructure construction end markets which resulted in volume growth for Infiltrator and Allied Products & Other.

Cost of goods sold and Gross profit - The following table presents gross profit by reportable segment for the three months ended December 31, 2023 and 2022.

(Amounts in thousands)

Our consolidated Cost of goods sold for the three months ended December 31, 2023 decreased by $28.7 million, or 6.7%, and our consolidated Gross profit increased by $35.9 million, or 16.0%, compared to the same period in fiscal 2023. The increase in our gross profit was primarily due to favorable material costs and sales mix. Manufacturing costs benefited from investments in in equipment, automation and tooling.

Selling, general and administrative expenses

(Amounts in thousands)

Selling, general and administrative expenses for three months ended December 31, 2023 increased from the same period in fiscal 2023 and as a percentage of sales, increased by 0.7%. The increase in Selling, general and administrative expenses is result of the investment in our engineering and innovation initiatives as well as the impact of inflation.

Interest expense - Interest expense increased $2.3 million in the three months ended December 31, 2023 compared to the same period in the previous fiscal year. The increase was primarily due to an increase in interest rates.

Derivative gains and other income, net - Derivative gains and other income increased by $0.6 million for the three months ended December 31, 2023 compared to the same period in the previous fiscal year primarily due to increased interest income.

Income tax expense - The following table presents the effective tax rates for the periods presented:

The change in the effective tax rate for the three months ended December 31, 2023 was primarily related to the discrete income tax benefits for the amended state tax returns and the federal return to provision adjustment. See “Note 10. Income Taxes” for additional information.

Comparison of the Nine Months Ended December 31, 2023 to the Nine Months Ended December 31, 2022

The following table summarizes our operating results as a percentage of net sales that have been derived from our Condensed Consolidated Financial Statements for the periods presented. We believe this presentation is useful to investors in comparing historical results.

(In thousands)

Net sales - The following table presents Net sales to external customers by reportable segment for the nine months ended December 31, 2023 and 2022.

(Amounts in thousands)

Our consolidated Net sales for the nine months ended December 31, 2023 decreased by $232.9 million, or 9.5%, compared to the same period in fiscal 2023. The decrease in domestic net sales was driven by lower demand in the U.S. construction and agriculture end markets.

Cost of goods sold and Gross profit - The following table presents gross profit by reportable segment for the nine months ended December 31, 2023 and 2022.

(Amounts in thousands)

Our consolidated Cost of goods sold for the nine months ended December 31, 2023 decreased by $230.9 million, or 14.8%, and our consolidated Gross profit decreased by $2.0 million, or 0.2%, compared to the same period in fiscal 2023. The decrease in gross profit is primarily due to the decrease in volume and unfavorable fixed cost absorption, partially offset by favorable material costs.

Selling, general and administrative expenses

(Amounts in thousands)

Selling, general and administrative expenses for nine months ended December 31, 2023 increased $8.4 million from the same period in fiscal 2023 and as a percentage of sales, increased by 1.5%. The increase in Selling, general and administrative expenses is result of the investment in our engineering and innovation initiatives as well as the impact of inflation.

Loss (gain) on disposal of assets and costs from exit and disposal activities - The gain on disposal of assets in the current year was due to the sale of Spartan Concrete.

Interest expense - Interest expense increased $16.7 million in the nine months ended December 31, 2023 compared to the same period in the previous fiscal year. The increase was primarily due to increased average debt levels and increased interest rates.

Derivative gains and other income, net - Derivative gains and other income increased by $10.2 million for the nine months ended December 31, 2023 compared to the same period in the previous fiscal year primarily due to increased interest income.

Income tax expense - The following table presents the effective tax rates for the nine months ended December 31, 2023 and 2022.

The change in the effective tax rate for the nine months ended December 31, 2023 was primarily related to the decrease of the discrete income tax benefit related to the stock-based compensation windfall. See “Note 10. Income Taxes” for additional information.

Adjusted EBITDA and Adjusted EBITDA Margin - Adjusted EBITDA and Adjusted EBITDA Margin, which are non-GAAP financial measures, have been presented in this Form 10-Q as supplemental measures of financial performance that are not required by, or presented in accordance with GAAP and should not be considered as alternatives to net income as measures of financial performance or cash flows from operations or any other performance measure derived in accordance with GAAP. We calculate Adjusted EBITDA as net income before interest, income taxes, depreciation and amortization, stock-based compensation expense, non-cash charges and certain other expenses. We calculate Adjusted EBITDA Margin as Adjusted EBITDA divided by net sales.

Adjusted EBITDA and Adjusted EBITDA Margin are included in this Form 10-Q because they are key metrics used by management and our board of directors to assess our consolidated financial performance. These non-GAAP financial measures are frequently used by analysts, investors and other interested parties to evaluate companies in our industry. In addition to covenant compliance and executive performance evaluations, we use these non-GAAP financial measures to supplement GAAP measures of performance to evaluate the effectiveness of our consolidated business strategies, to make budgeting decisions and to compare our performance against that of other peer companies using similar measures. We use Adjusted EBITDA Margin to evaluate our ability to generate profitable sales.

Adjusted EBITDA and Adjusted EBITDA Margin contain certain other limitations, including the failure to reflect our cash expenditures, cash requirements for working capital needs, cash expenditures to replace assets being depreciated and amortized and interest expense, or the cash requirements necessary to service interest on principal payments on our indebtedness. In evaluating Adjusted EBITDA and Adjusted EBITDA Margin, you should be aware that in the future we will incur expenses that are the same as or similar to some of the adjustments in this presentation, such as stock-based compensation expense, derivative fair value adjustments, and foreign currency transaction losses. Management compensates for these limitations by relying on our GAAP results and using non-GAAP measures on a supplemental basis.

The following table presents a reconciliation of Adjusted EBITDA to Net income, the most comparable GAAP measure, for each of the periods presented.

(In thousands)

(a) Represents expenses recorded related to legal, accounting and other professional fees incurred in connection with business or asset acquisitions and dispositions.

(b) Includes derivative fair value adjustments, foreign currency transaction (gains) losses, the proportionate share of interest, income taxes, depreciation and amortization related to the South American Joint Venture, which is accounted for under the equity method of accounting and executive retirement expense.

Liquidity and Capital Resources

Historically we have funded our operations through internally generated cash flow supplemented by debt financings, equity issuance and finance and operating leases. These sources have been sufficient historically to fund our primary liquidity requirements, including working capital, capital expenditures, debt service and dividend payments for our common stock. From time to time, we may explore additional financing methods and other means to raise capital. There can be no assurance that any additional financing will be available to us on acceptable terms or at all.

Free Cash Flow - Free cash flow is a non-GAAP financial measure that comprises cash flow from operations less capital expenditures and is used by management and our Board of Directors to assess our ability to generate cash. Accordingly, free cash flow has been presented as a supplemental measure of liquidity that is not required by, or presented in accordance with GAAP, because management believes that free cash flow provides useful information to investors and others in understanding and evaluating our ability to generate cash flow from operations after capital expenditures. Free cash flow is not a GAAP measure of our liquidity and should not be considered as an alternative to cash flow from operating activities as a measure of liquidity or any other liquidity measure derived in accordance with GAAP. Our measure of free cash flow is not necessarily comparable to other similarly titled captions of other companies due to different methods of calculation.

The following table presents a reconciliation of free cash flow to cash provided by operating activities, the most comparable GAAP measure, for each of the periods presented:

(Amounts in thousands)

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The following table presents key liquidity metrics utilized by management including the leverage ratio which is calculated as net debt divided by the trailing twelve months Adjusted EBITDA:

(Amounts in thousands)

The following table summarizes our available liquidity for the period presented:

(Amounts in thousands)

In addition to the available liquidity above, we have the ability to borrow up to $1.3 billion under our Senior Secured Credit Facility, subject to leverage ratio restrictions.

Working Capital and Cash Flows

As of December 31, 2023, we had $1,149.6 million in liquidity, including $560.7 million of cash, $588.9 million in borrowings available under our Revolving Credit Agreement, net of outstanding letters of credit. We believe that our cash on hand, together with the availability of borrowings under our Credit Agreement and other financing arrangements and cash generated from operations, will be sufficient to meet our working capital requirements, anticipated capital expenditures, and scheduled principal and interest payments on our indebtedness for at least the next twelve months.

Working Capital - Working capital increased to $829.3 million as of December 31, 2023, from $638.7 million as of March 31, 2023. The increase in working capital is primarily due to an increase in cash partially offset by a decrease in accounts receivable and inventory due to seasonality and an increase in accrued liabilities and accrued taxes due to the timing of payments.

(Amounts in thousands)

Operating Cash Flows – Cash flows from operating activities increased $39.8 million during the nine months ended December 31, 2023 primarily driven by changes in net working capital.

Investing Cash Flows - Cash flows used in investing activities during the nine months ended December 31, 2023 decreased by $58.9 million compared to the same period in fiscal 2023. The decrease in cash used in investing activities was primarily due to the acquisition of Cultec, Inc. in fiscal 2023.

Capital expenditures totaled $136.4 million and $126.9 million for the nine months ended December 31, 2023 and 2022, respectively. Our capital expenditures for the nine months ended December 31, 2023 were used primarily to support facility expansions, equipment replacements and technology improvement initiatives.

We currently anticipate that we will make capital expenditures of approximately $200 million in fiscal year 2024, including approximately $125 million of open orders as of December 31, 2023. Such capital expenditures are expected to be financed using funds generated by operations.

Financing Cash Flows - During the nine months ended December 31, 2023, cash used in financing activities included the repurchase of common stock of $178.2 million, $33.1 million of dividend payments, and $8.9 million for shares withheld for tax purposes.

During the nine months ended December 31, 2022, cash provided by financing activities included the issuance of $500.0 million of 2030 Notes and proceeds of $123.2 million on our revolving credit facilities. Cash used in financing activities during the nine months ended December 31, 2022 included repurchase of common stock of $375.0 million, payments of $237.5 million on our revolving credit facilities, $30.1 million of dividend payments, and $28.7 million for shares withheld for tax purposes.

Cash held by Foreign Subsidiaries - As of December 31, 2023, we had $39.7 million in cash that was held by our foreign subsidiaries, including $24.5 million held by our Canadian subsidiaries. We continue to evaluate our strategy regarding foreign cash, but our earnings in foreign subsidiaries still remain indefinitely reinvested, except for Canada. We plan to repatriate earnings from Canada and believe that there will be no additional tax costs associated with the repatriation of such earnings other than any potential non-U.S. withholding taxes.

Financing Transactions - There have been no changes in our debt disclosures from those disclosed in “Liquidity and Capital Resources” in our Fiscal 2023 Form 10-K. We are in compliance with our debt covenants as of December 31, 2023.

Off-Balance Sheet Arrangements

Excluding the guarantees of 50% of certain debt of our unconsolidated South American Joint Venture as further discussed in “Note 7. Related Party Transactions” to the Condensed Consolidated Financial Statements, we do not have any other off-balance sheet arrangements. As of December 31, 2023, our South American Joint Venture had approximately no outstanding debt subject to our guarantees. We do not believe that this guarantee will have a current or future effect on our financial condition, results of operations, liquidity or capital resources.

Critical Accounting Policies and Estimates

There have been no changes in critical accounting policies from those disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Fiscal 2023 Form 10-K, except as disclosed in "Note 1. Background and Summary of Significant Accounting Policies.”

Forward-Looking Statements

This Form 10-Q includes forward-looking statements. Some of the forward-looking statements can be identified by the use of terms such as “believes,” “expects,” “may,” “will,” “would,” “should,” “could,” “seeks,” “predict,” “potential,” “continue,” “intends,” “plans,” “projects,” “estimates,” “anticipates” or other comparable terms. These forward-looking statements include all matters that are not related to present facts or current conditions or that are not historical facts. They appear in a number of places throughout this Form 10-Q and include statements regarding our intentions, beliefs or current expectations concerning, among other things, our consolidated results of operations, financial condition, liquidity, prospects, growth strategies, and the industries in which we operate and include, without limitation, statements relating to our future performance.

Forward-looking statements are subject to known and unknown risks and uncertainties, many of which are beyond our control. We caution you that forward-looking statements are not guarantees of future performance and that our actual consolidated results of operations, financial condition, liquidity and industry development may differ materially from those made in or suggested by the forward-looking statements contained in this Form 10-Q. In addition, even if our actual consolidated results of operations, financial condition, liquidity and industry development are consistent with the forward-looking statements contained in this Form 10-Q, those results or developments may not be indicative of results or developments in subsequent periods. A number of important factors could cause actual results to differ materially from those contained in or implied by the forward-looking statements, including those reflected in forward-looking statements relating to our operations and business, the risks and uncertainties discussed in this Form 10-Q (including under the headings “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”), and those described from time to time in our other filings with the SEC. Factors that could cause actual results to differ from those reflected in forward-looking statements relating to our operations and business include:

• fluctuations in the price and availability of resins and other raw materials and our ability to pass any increased costs of raw materials on to our customers in a timely manner;
• disruption or volatility in general business and economic conditions in the markets in which we operate;
• cyclicality and seasonality of the non-residential and residential construction markets and infrastructure spending;
• the risks of increasing competition in our existing and future markets;
• uncertainties surrounding the integration and realization of anticipated benefits of acquisitions;
• the effect of any claims, litigation, investigations or proceedings, including those described under “Item 1. Legal Proceedings” of this Form 10-Q;
• the effect of weather or seasonality;
• the loss of any of our significant customers;
• the risks of doing business internationally;
• the risks of conducting a portion of our operations through joint ventures;
• our ability to expand into new geographic or product markets;
• the risk associated with manufacturing processes;
• the effect of global climate change;
• cybersecurity risks;
• our ability to manage our supply purchasing and customer credit policies;
• our ability to control labor costs and to attract, train and retain highly qualified employees and key personnel;
• our ability to protect our intellectual property rights;
• changes in laws and regulations, including environmental laws and regulations;
• the risks associated with our current levels of indebtedness, including borrowings under our existing credit agreement and outstanding indebtedness under our existing senior notes; and
• other risks and uncertainties, including those listed under “Item 1A. Risk Factors” in the Fiscal 2023 Form 10-K.

All forward-looking statements are made only as of the date of this report and we do not undertake any obligation, other than as may be required by law, to update or revise any forward-looking statements to reflect future events or developments. Comparisons of results for current and any prior periods are not intended to express any future trends, or indications of future performance, unless expressed as such, and should only be viewed as historical data.

We are subject to various market risks, primarily related to changes in interest rates, credit, raw material supply prices and, to a lesser extent, foreign currency exchange rates. Our financial position, results of operations or cash flows may be negatively impacted in the event of adverse movements in the respective market rates or prices in each of these risk categories. Our exposure in each category is limited to those risks that arise in the normal course of business, as we do not engage in speculative, non-operating transactions. Our exposure to market risk has not materially changed from what we previously disclosed in Part II. Item 7A. “Quantitative and Qualitative Disclosures about Market Risk” of our Fiscal 2023 Form 10-K except as disclosed below.

Interest Rate Risk - We are subject to interest rate risk associated with our bank debt. A 1.0% increase in interest rates on our variable-rate debt would increase our annual forecasted interest expense by approximately $4.2 million based on our borrowings as of December 31, 2023. Assuming the Revolving Credit Facility is fully drawn, each 1.0% increase or decrease in the applicable interest rate would change our interest expense by approximately $10.2 million, for the twelve months ended December 31, 2023.

Evaluation of Disclosure Controls and Procedures - The Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”) are responsible for evaluating the effectiveness of our disclosure controls and procedures as defined in the Securities Exchange Act of 1934, as amended (the “Exchange Act”), rules 13a-15(e) and 15d-15(e). The Company’s disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed in the Company’s reports under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including the Company’s CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives, and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Based on the evaluation of our disclosure controls and procedures, our CEO and CFO concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.

Changes in Internal Control over Financial Reporting - There were no changes in the Company’s internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act that occurred during the three months ended December 31, 2023 that has materially affected, or is reasonably likely to materially affect, internal control over financial reporting.

Important risk factors that could affect our operations and financial performance, or that could cause results or events to differ from current expectations, are described in “Part I, Item 1A — Risk Factors” of our Fiscal 2023 Form 10-K. These factors are further supplemented by those discussed in “Part II, Item 7A — Quantitative and Qualitative Disclosures about Market Risk” of our Fiscal 2023 Form 10-K and in “Part I, Item 3 — Quantitative and Qualitative Disclosures about Market Risk” and “Part II, Item 1 — Legal Proceedings” of this Form 10-Q.