Mueller Water Products, Inc. (MWA) Q3 2022 Earnings Report, Transcript and Summary

Thank you for standing by, and welcome to the Third Quarter 2022 Investor Relations Conference Call. [Operator Instructions] As a reminder, today's call is being recorded. If you have any objections, you may disconnect at this time. I would like to turn today's meeting over to your host, VP of Investor Relations, Mr. Whit Kincaid. Thank you. You may begin.

Good morning, everyone. Thank you for joining us on Mueller Water Products third quarter 2022 conference call. We issued our press release reporting results of operations for the quarter ended March 31, 2022 yesterday afternoon. A copy of the press release is available on our website muellerwaterproducts.com. Scott Hall, our President and CEO, and Martie Zakas, our CFO, will be discussing our third quarter results and our current outlook for 2022. This morning's call was being recorded and webcast live on the Internet. We have also posted slides on our website to accompany today's discussion and to address forward-looking statements in our non-GAAP disclosure requirements. As a reminder, we have changed our management structure and segment reporting effective October 1, 2021. We filed an 8-K in January that provided the recast of historical quarterly results for 2020 and 2021. At this time, please refer to Slide 2. This slide identifies non-GAAP financial measures referenced in our press release, on our slides, and on this call. It discloses the reasons why we believe that these measures provide useful information to investors. Reconciliations between non-GAAP and GAAP financial measures are included in the supplemental information within our press release and on our website. Slide 3 addresses forward-looking statements made on this call. This slide includes cautionary information identifying important factors that could cause actual results to differ materially from those included in forward-looking statements. Please review Slides 2 and 3 in their entirety. During this call, all references to a specific year or quarter, unless specified otherwise, refer to our fiscal year, which ends on the 30th of September. A replay of this morning's call will be available for 30 days at 1-800-8345839. The archived webcast and corresponding slides will be available for at least 90 days on the Investor Relations section of our website. I will now turn the call over to Scott.

Thanks, Whit. Good morning, everyone. Thank you for joining us for our third quarter earnings call. This quarter we delivered record net sales with both water management solutions and water flow solutions contributing to the growth in the quarter. We generated double digit net sales growth in iron gate valves, specialty valves and repair and installation products. Order levels were made healthy again this quarter driven by end market activity, and we ended the quarter with a record backlog. As expected the growth in the quarter came primarily from the continued improvement in price realization across most of our product lines. We are benefiting from the multiple price actions taken over the past year and we're pleased with the sequential increase in the third quarter. While the improved price realization led to a sequential improvement in our adjusted EBITDA conversion margin, our third quarter margin was below the expectations discussed on our last earnings call. We faced many of the same operational headwinds we experienced in our second quarter, including ongoing supply chain disruptions, inflationary pressures, and manufacturing performance. Our teams are focused on improving production levels of operational performance as we manage healthy demand and record backlog. We expect continued benefits from improved price realization in the fourth quarter, and will continue to execute initiatives to manage the operational headwinds, which I will discuss later in the call. I'll now turn the call over to Martie to review our third quarter financial results.

Thanks, Scott. And good morning everyone. I will start with our third quarter 2022 consolidated GAAP and non GAAP financial results. After that I will review our segments performance and discuss our cash flow and liquidity. Our third quarter consolidated net sales increased 7.3% to $333.2 million compared to the prior year, with growth in both water flow solutions and water management solutions. For both segments, higher pricing across most of our product lines was partially offset by lower overall volume. Gross profit this quarter decreased 6.7% to $98.3 million compared with the prior year. Gross margin decreased 440 basis points to 29.5% compared with the prior year as the benefits from higher pricing were more than offset by higher costs associated with unfavorable manufacturing performance, installation and warranty obligations. We increased our warranty accrual based on our historical warranty experience and costs, resulting in a $4.5 million charge. Excluding this charge, the gross margin was 30.9%, which sequentially improved 100 basis points compared with our second quarter gross margin as we improved our price realization. Selling, general and administrative expenses of $60.8 million in the quarter increased 3.4% compared with the prior year. The increase which was primarily driven by inflation and investments in personnel, D&A, tradeshow activity and professional fees was partially offset by foreign exchange gains. SG&A as a percent of net sales improved to 18.2% in the quarter, as compared to 18.9% in the prior year quarter, due to the leverage from higher sales. Operating income of $36.9 million decreased 13.6% in the quarter, compared with $42.7 million in the prior year. Operating income includes the $4.5 million warranty charge, as well as the strategic reorganization and other charges of $600,000, which primarily relate to the previously announced plant closures. Turning now to our consolidated non-GAAP results. Adjusted operating income of $42 million decreased 9.9% compared with $46.6 million in the prior year. The benefits from higher pricing were more than offset by higher costs associated with unfavorable manufacturing performance, inflation and SG&A expenses. Adjusted EBITDA of $57.8 million decreased 7.7% in the quarter, leading to an adjusted EBITDA margin of 17.3% compared with 20.2% in the prior year. Adjusted EBITDA margin improved sequentially by 100 basis points, compared with 16.3% in the second quarter. For the last 12 months, adjusted EBITDA was $201.5 million, or 16.6% of net sales. Net interest expense for the quarter declined to $4.2 million compared with $6.8 million in the prior year. The decrease in the quarter primarily resulted from lower interest expense associated with the refinancing of our 5.5% senior notes with 4% senior notes in May 2021. The effective tax rate this quarter was 21.1%, as compared with 28% during the third quarter of last year, primarily due to benefits from R&D tax credits. For the full year, we now anticipate our effective tax rate will be between 22 %and 24%. We increased adjusted net income per diluted share by 0.6% to $0.19 in the quarter, compared with $0.18 in the prior year. Moving on to segment performance starting with water flow solutions, which consists of iron gate valves, specialty valves and service brass products. Net sales of $195.9 million increased 10.7% compared with the prior year, primarily due to higher pricing across most of the segments product line. Iron gate valves and specialty valves experienced double digit net sales growth compared to the prior year. Volumes decreased compared with the prior year as sales of service brass products were impacted by manufacturing inefficiencies. Adjusted operating income of $38.1 million decreased by 5.2% as higher pricing was more than offset by higher costs associated with unfavorable manufacturing performance, inflation and SG&A expenses. Adjusted EBITDA of $45.7 million decreased 5% leading to an adjusted EBITDA margin of 23.3% compared with 27.2% last year. Adjusted EBITDA margin was flat compared with the second quarter. Turning now to water management solutions, which consists of fire hydrants, repair and installation, natural gas, metering, leak detection, pressure control and software product. Net sales of $137.3 million increased 2.8% compared with the prior year primarily due to higher pricing across most of the segments product lines and the addition of i2O. Repair and installation products experienced double digit net sales growth compared to the prior year. Volumes decrease compared with the prior year as sales of hydrants, meters and control valves were impacted by manufacturing inefficiencies and the ongoing supply chain disruptions. Adjusted operating income of $16.5 decreased 22.5% in the quarter, as higher pricing was more than offset by higher costs associated with unfavorable manufacturing performance, inflation and SG&A expenses. Adjusted EBITDA of $23.7 million decreased 16.8% in the quarter, leading to an adjusted EBITDA margin of 17.3% compared with 21.3% last year. Adjusted EBITDA margin improved sequentially by 220 basis points, compared with 15.1% in the second quarter. Moving on to cash flow. Net cash provided by operating activities for the nine month period, with $20.5 million compared with $123.3 million in the prior year. The decrease was primarily driven by higher inventory and payments for other current liabilities, including customer rebates, income taxes and employee incentives. Average net working capital using the 5-point method, as a percent of net sales increased to 26.7%, compared with 25.9% in the third quarter of last year, primarily due to the increase in inventories and receivable. Inventories of $250.9 million at the end of the third quarter were $21.7 million higher than the end of the second quarter and $66.2 million higher than the end of fiscal 2021. For the nine month period, we have invested $36.7 million in capital expenditures, compared with $46.1 million spent in the same period in the prior year. Free cash flow for the nine month period with negative $16.2 million compared with $77.2 million in the prior year primarily due to the decrease in cash provided by operating activities partially offset by lower capital expenditures. For the full year we anticipate that free cash flow will be positive. Additionally, during the quarter, we repurchased $5 million in common stock and have $110 million remaining under our share repurchase authorization. As of June 30, 2022, we had total debt outstanding of $447 million and total cash of $154.9 million. At the end of the third quarter, our net debt leverage ratio was 1.4x. We did not have any borrowings under our ABL agreement at the end of the quarter, nor did we borrow any amounts under our ABL during the quarter. Our 4% senior notes have no financial maintenance covenants and our ABL agreement is not subject to any financial maintenance covenants unless we exceed the minimum availability threshold. Based on June 30, 2022 data, we had approximately $160.7 million of excess availability under the ABL agreement, which brings our total liquidity to $315.6 million. We currently have no debt maturities before June 2029 and continue to maintain a strong flexible balance sheet with ample liquidity and capacity to support our capital allocation priorities. Scott, back to you.

Thanks, Martie. I'll discus our third quarter performance and markets and updated expectations for this year. After that, we'll open the call up for questions. In our third quarter, we faced a variety of the same operational challenges that impacted our conversion margins in the second quarter. These included inflationary pressures, higher costs associated with the ongoing supply chain disruption and manufacturing efficiencies. Inflationary pressures continue to be challenging, especially in relation to materials, freight, energy and labor. Obtaining raw materials and purchase parts remains a top priority for our teams as they work to beat production schedules while dealing with long lead times and price premiums. Challenges of the scrap steel market have caused us to shift to a more expensive mix of steel and iron in order to get materials. This phenomena is playing out in many of our purchase parts where we continue to see long lead times. While we believe a decrease in commodity prices will eventually lower our raw material costs, we expect the benefits will take longer than usual to impact our conversion margins. Due to the magnitude and breadth of inflation in this economic environment, we anticipate higher costs will continue into 2023. On favorable manufacturing performance at our foundries was the primary reason for the lower-than-expected conversion margin in the quarter. Our Chattanooga and Albertville foundries, which purchased energy from the Tennessee Valley Authority were both impacted by emergency load curtailments. These actions impacted melt capacity, which lowered production for and our gate valves. Machine downtime at our brass foundry in Decatur, significantly impacted mill capacity in June. This downtime decreased shipments for service brass products and led to Water Flow Solutions year-over-year decline in volumes. We did experience healthy order activity during the quarter and ended the third quarter with a record backlog for service brass products. While we would typically be able to get the machines back in service in less than a week, the supply chain disruptions continue to extend lead times for critical replacement parts. To help address the backlog and improved lead times, we have increased our use of third-party maintenance personnel and outsource it to achieve higher production levels. Our teams also are very focused on completing our new brass foundry, which will eventually replace the foundry. Replacing the plant with our new state-of-the-art facility, that we believe will provide many benefits. The new facility, which will use a new lead-free brass alloy will increase capacity for melting, machining and assembly. It will expand product development capabilities. The facility will help achieve many of our sustainability goals because it will lower energy usage per pound, reduce waste, improve the product life cycle and enhanced safety. It will also provide cost savings relative to the current facility with enhanced productivity, sourcing and product design capabilities. While we have made significant progress, the supply chain disruptions and labor availability challenges have pushed our construction completion date to the end of fiscal 2023 with the production part approval process extending into 2024. We continue to anticipate that three large capital projects we have previously announced will account for a combined $30 million annualized incremental gross profit when all are complete and at full rate. With a record backlog and healthy demand, our teams are focused on maximizing production levels at our foundries. These actions include adding shifts, upgrading equipment and investing in inventory, all to ensure that we have material labor and machines to increase production and improve delivery times. To support our efforts, we have proactively invested in our hourly production teams members by working with the prior to contract renewals. To help address the impact of inflation that workers are experiencing, we are implementing wage increases for union and non-union hourly production teams. While these labor investments will add near-term pressure to our margins, we believe our teams can deliver improvements in 2023, which will come from the continued price realization, more manageable inflation and improved operational performance. Additionally, we continue to monitor the overall inflationary environment closely and will take price actions as needed to help offset the ongoing cost pressures for materials, labor and supply chain disruptions. I will now briefly review our end markets and updated outlook for 2022. As mentioned earlier, order levels remained healthy during the quarter. We believe with this full repair and replacement end market activities remains very strong. Overall, the market continues to benefit from healthy budgets, especially at larger municipalities. As a reminder, we estimate that approximately two-third of our net sales are related to repair and replacement activities of utilities, providing resiliency for our business. The infrastructure bill with $55 billion of new funds dedicated to water, wastewater and storm water infrastructure represents the highest level of federal spending since the mid-1970s. While there appears to be a high level of interest in the infrastructure bill for municipalities, there is a process mostly driven by the states to access the money that has not been directly earmarked by the bill. We don't anticipate any benefit this year and believe benefits for next year could be limited due to ongoing supply chain constraints and labor availability challenges that could impact the timing of projects. We expect that beyond that time period, we should benefit from the infrastructure build spending. For the new residential construction end market, specifically lot land development activity, we believe that demand continued to be at healthy levels during the quarter. However, based on the most recent monthly housing data and other data points, the increase in interest rates is contributing to slower new residential construction activity. We continue to anticipate that this will lead to lower levels of and land development activity. We expect activity will slow for the rest of the year relative to strong levels during the pandemic. Low inventory, demographics and population shifts suggest that we could return to normalized activity that is above pre-pandemic levels. Due to strong municipal demand levels, we believe a lower level of new residential construction activity could help municipal repair and replacement activity, given challenges with labor availability for construction. Moving on to our updated outlook for 2022. With one quarter remaining, we are pleased to be on track to deliver our second consecutive year of double-digit consolidated net sales growth. For the full year, we are narrowing our forecasted range for consolidated net sales growth to be between 11% and 12% as compared with the prior year. This forecast takes into account the current expectations for orders, price realization and end market demand. We expect the benefit from improved price realization to continue with the fourth quarter resulting from the multiple price increases we have already announced. We also anticipate that our conversion margin in the fourth quarter will be lower than previously anticipated, primarily due to the operational challenges previously discussed. As a result, we now expect adjusted EBITDA will be comparable to the prior year. Looking beyond 2022, we anticipate delivering better conversion margins with improved operational performance and higher price realization from pricing actions we have already taken. With the ongoing economic uncertainty, we will benefit from our strong flexible balance sheet and our disciplined and balanced cash allocation strategies. We will continue to reinvest in our business as appropriate and return cash to shareholders through our quarterly dividend and share repurchases. We have repurchased $35 million of common stock over the last 12 months, including the $5 million were purchased in the third quarter, and we have $110 million remaining under our share repurchase authorization. In closing, water utilities face many challenges, including accelerating ageing infrastructure, climate change, and unfavorable work demographics - workforce demographics. We have a broad product portfolio, primarily serving the drinking water network that is well positioned to benefit from a strong municipal demand environment. Our product development, operational and commercial strategies are focused on capitalizing on key trends in water. These include the accelerating adoption of technology enabled products, and increased demand for products that qualify for the American Iron and Steel and Build America Buy America requirements. The most important priorities for our teams are to execute our operational improvements, and deliver the benefits from our ongoing capital investments. In conjunction with a favorable municipal end market and continued price realization we expect to deliver sales and adjusted EBITDA growth in 2023 and beyond. And with that operator, please open this call for questions.

Thank you. [Operator Instructions] First question comes from Bryan Blair with Oppenheimer. Your line is open.

Thank you. Good morning all.

Good morning.

Good morning.

Given your record backlog and order momentum, your fiscal 4Q growth seems pretty locked in barring major disruption I assume the same goes for early 2023. And maybe offer a little more color on the puts and takes of market activity and demand drivers. As we look forward for municipal repair, and replace and ready new construction respectively?

I think the - net price realization expected to improve sequentially, which is really the driver and growth in our Q4. We would expect some more improvement as it relates to, quarters in the future. The backlog at the record levels - at the end of Q3 I think it's a bigger function of throughput at the plants that we had opportunity to ship more. And so, to answer the question directly, I expect an improving environment from a volume performance. The backlog is there to support it. I believe that the mix of price will contribute to that growth in demand. And I think the biggest driver is that the muni budgets remain extremely strong. And I think that the larger municipalities, as I mentioned in my prepared remarks Bryan, have in front of them, a pretty large menu of projects.

Yes understood, I guess to level set a little more on the margin pressures that your team has faced in recent past. Can you maybe isolate the impact of price versus material costs and parse the headwind from unfavorable manufacturing performance in Q3. Compare that to the second quarter, and then walk us through how your team's thinking about these variables and the timeline to more normalized conversion margins going forward?

Yes, so overall, we did continue to see, strong price realization this quarter, probably - slightly improved sequentially from the second quarter, and up close to double-digits that did more than cover inflationary expenses that we experienced this quarter. I think the real pressure there came from the unfavorable manufacturing performance that we saw, as well as the continued supply chain disruptions. Some of the challenges during the quarter, some of our foundries where we purchased energy from the Tennessee Valley Authority, were impacted by some emergency load curtailments. And that impacted our melt capacity. But the main driver that we talked about was machine down time that, are century old brass foundry, which limited our pounds of production. And what that contributes to is, we ended up with sort of inefficient labor, as well as overhead inefficiencies, when the machines are down, or materials aren't in place, et cetera. A lot of that impacted the shipments of our service brass products, and that was one of the key drivers of the year-over-year volume decline that we experienced. I'd say looking out we've got a number of initiatives that to address the equipment failures. We have increased our use of third-party maintenance personnel, as well as we've engaged in outsourcing for certain products to help with the availability. Certainly longer term, once we get our new brass foundry coming online that we think that will help. Additionally, I would say as we as we look out into our 2023, I think, as Scott talked about with what we've got from a backlog and outlook for the municipal segment, we think we've got opportunity as we look into 2023 for improving margins.

Okay, helpful color. Thanks again.

Thank you,

Thank you. And our next question comes from Deane Dray with RBC Capital Markets. Your line is open.

Thank you, good morning everyone.

Good morning, Deane.

Hey, like to continue that line of question. Just trying to reconcile that yes - what came up in the third quarter? What was the tipping point in terms of saying you've got a lower EBITDA guidance as supply chain kind of didn't change? It's still, it's a big headwind we get that same thing on inflation. So - and Martie, just to clarify, it sounded like it was the manufacturing inefficiencies at the foundry was more of the tipping point that you were not going to make up that EBITDA shortfall to hit your guidance. Is that fair?

Yes. I think that's fair Deane and I'll turn it to Martie, but I want everybody on the call to understand there's basically brass product in every product we make. So if you think about a gate valve, there's, brass components in it. If you think about a there's brass components of it. The brass foundry downtime, I think, was the tipping point for looking at the rest of the year. And certainly, we're experiencing downside issues with our workforce [ph] and things like that as we speak. And so what does that force you to do? Once you have that supply problem, yes, the service brass, sales is part of it, but it forces outsourcing the components for gate valves and for hybrid as well. And those were the -- that was the biggest driver as we thought about providing insight for investors into what we think will happen in the fourth quarter, that really made us reevaluate and we're assuming in our fourth quarter that we will have some outsourced supply chain issues through the fourth quarter as we work through these equipment issues in the Decatur foundry.

So when you have the new foundry in place, how much of these operational manufacturing inefficiencies go away?

I would say all of them. Because the reality is, is that - things like for machines and things like that, they're all made of equipment that's older than both you and I.

That saying a lot.

So I think that opportunity - yes, there's opportunity for improvement. We got to go tour the progress on the new foundry. Last month I think it's going to be a step change improvement both from a worker environment, a throughput capability, an early warning detection systems, the availability of machine data or running machine learning and things like that, I think they're all really, really positive. And I'm excited to get it open. I'm looking for ways to try to accelerate the PPAP process so that we can get there sooner, but we are facing the headwinds associated with contractor labor and facing the headwinds associated with the supply chain of getting all of the parts for the new foundry in.

All right that part is really helpful and thanks for that additional color. Just to clarify on the cut in CapEx, what projects or initiatives are getting pushed?

I'd say, overall, in terms of looking at the lower guidance on CapEx, I think some of what we have had seen is just some - project delays. Some of that is coming from supply chain disruption, a portion of the spending for the new Decatur brass foundry we've got a portion of that pushed into our 2023. And I think additionally, some of the delayed projects are a result of the teams focusing on some of the operational challenges. So I think that's certainly one of the reasons. Additionally, as we continue to look at the various capital project opportunities, we have elected to deprioritize some of them going forward.

Okay. And then last one on the warranty charge. So what triggered it? Are there particular products and is - I just want to get a sense of how broadly this covers the warranty experience that you've had?

Yes, so with respect to the warranty charge, it relates to the sales of our metering products. And just as a reminder, that is part of our Water Management Solutions segment. And what we do on an ongoing basis as we monitor and analyze our warranty obligations periodically and revise any accruals as necessary. We did our warranty accruals, and that was primarily due to the historical warranty experience on certain products as well as some higher product replacement costs.

Has there been any noticeable claims experience? Is there - is this the first of many or is this more routine just based upon whatever time period your accountants say that you're supposed to change that reserve?

Yes, so what I would say is, look, the warranty periods, I would say, generally within the industry tends to be very long. We do review them regularly. And it's an estimate that we have based on the judgment with the best information we have available at the time. So as we get more information experience, we'll evaluate and update the estimates and adjust as appropriate, and that was what we did this quarter.

Okay, thank you.

Thank you. And our next question comes from Joe Giordano with Cowen. Your line is open.

Hey guys good morning.

Good morning.

So just want to like thinking into next year, the foundry gets pushed to end of 2023, approval into 2024 now like what gets better like from a - just from a margin for like a manufacturing productivity type setup. Like what gets - what is under your control to get better into 2023? And what offsets that by delays in the push out of the project?

Yes. I think that certainly, notwithstanding the highly uncertain economic environment given the interest rate rises and the supply chain disruptions, we acknowledge and believe that the growing inflationary pressure is offset by the monetary policy the Fed has taken it could lead to a recession. But I think the biggest thing that we think about is that we are going to benefit from significant carryover price that's already locked in the backlog for actions we've already taken. We expect to end 2022 with very high backlog levels, especially for our short-cycle products, which will help offset expected decreases in demand relating to the slowdown - relating to construction market [ph]. So we anticipate municipal repair replacement market continue to benefit from the healthy budgets at municipal level. We expect to improve the adjusted EBITDA conversion margin as commodity prices remain below peak levels since we didn't implement any of the surcharges as part of our pricing actions, we would not expect to have any raw material adjustments for the items that have already been ordered. And I also believe that we'll have improved manufacturing performance, which will contribute significantly to the year-over-year improvement. Certainly, we're in the dark days of summer from an upside [ph] perspective, but I do believe that these will improve as a result of the initiatives, which Martie and I and the ELT review pretty much on a weekly basis to see what we're doing to make sure our throughputs get back to levels that they were at prior to the summer. We're mindful of the headwinds for ongoing inflationary pressures relating to higher wage rates, utilities and freight. But as I said in my prepared comments, I expect that we will take the actions in a rational market that will offset those. And so that's the basis for, I guess, our bullishness for 43 if I may a margin improvement conversion margin performance perspective.

And then just thinking about the housing data that's come out on single-family, pretty - it's not looking great. You referenced that. What kind of like actions or like plans are you drawing up internally to kind of adjust your business to a world where housing is potentially decently worse than it is now?

Yes I think in Q3, new residential construction market, specifically lot and land development activity continue to be at healthy levels, which is also reflected in our Q3 order book. So I understand that the permits pulled data would indicate that. But I think as I remind everybody, you really have to look at a lot of inventories because we use housing starts as a surrogate. But certainly, it will follow in the future that we could have lower levels. As expected, I think the increase in interest rates is leading to slower new residential construction activity. And in total housing starts slightly - to slightly less than, I believe, about 1.6 million pace with single-family starts decreasing, but interestingly, multi-families increasing. And so, I think that there's still some underling housing demand single-family starts now running at a lower pace, but it's still higher than the pace in the decade before the pandemic. So if you were to compare the average annual, we're still significantly above it. And I think the sharp rise in borrowing costs, clearly leading homebuilders to scale back production plans, we'll continue this downward trajectory. And so I anticipate that we'll see a lag for us just as we were slow to get in once housing started. There will still be a lot of curb and sewer [ph] report in, in the land lot development. And I believe that a lower level of new resi construction could help municipal repair and replacement activity. And let me spend a minute on that, not long, but the homebuilders tend not to be the people to put in the curb and sewer. So they tend to be contractors, and they tend to be the exact same contractors at the municipalities contract to put in to do repair and replacement work. So a lot of the trenching and a lot of the repair work are the same people. And so given the squeeze on labor, we expect that those healthy muni budgets will pick up some of that slack, and we remain bullish about that. And I think the biggest indicator is the healthy order activity we saw in the third quarter. In July, orders were in line with our expectations. So I feel confident that while there will be some slowdown, the tailwinds we have from IIJA [ph] the tailwinds we have from muni budgets will more than offset.

Thanks for all the color.

Thank you.

Thank you. Our next question comes from Walt Liptak with Seaport. Your line is open,

Hi thanks good morning guys. I wanted to ask about the outsourcing and some of the temporary workers. Are those - can you give us an idea of the incremental cost from that and maybe the expectation for how long those costs will be in place?

Yes, that's harder to parse out. When we were looking at performance, we look at what it would have cost us versus what the actual cost will kind of shows up in a couple of different places. But long story short, manufacturing performance was the biggest reason for our cost increases experienced in Q3. Part of that is machine part of that is outsourcing. Part of that, frankly, is freight. And so it's hard to parse it. I'm not sure that it's something I would want to get into longer.

Okay all right. That's fine. Let me ask it this way because it all comes down to gross margin. In the fourth quarter, what - and I'm sorry if you mentioned this already, but what gross margin should we be thinking about for the fourth quarter? And then what - and then how do you think the gross margin ramps as you maybe get on a stronger footing with some of these manufacturing issues?

Yes. I think gross margin is going to be under pressure in Q4. Well, I think that the reason we took it down, if you do the implied adjustment to our fourth quarter EBITDA, going from 7% to 10% down to flat. You can see that Q4 will be at or near the significant pressure that we've seen in Q3. And so might even have a little - a couple of basis points of pressure. I think the other thing that I'll note in our Q4 is that we will expect to have higher SG&A just based on the seasonal way our national sales meeting takes place and some of those other things that are significant expenses in our fourth quarter. And so I think if you were to take a little bit higher SG&A and then infer what would have to happen in the fourth quarter to be flat from an EBITDA perspective. You would determine that there's little or no improvement in gross margin in our Q4. I think the turning point comes in the first half of next year as we get more of these things put behind us as far as throughput, reliance on outsourcing, some of these freight premiums we're paying today in order to get materials expedited. I would like to remind everybody that at the end of the day, we're in the business of satisfying customers and satisfying build schedules for municipalities. And that is job one for us is that we are going to do the things necessary to hang on to our share. We're going to do the things necessary in order for our customers to and have a preference for newer water products. And that comes from the cost certainly in the third quarter, and we expect that to kind of continue in the fourth quarter before improving.

Okay great, thank you that's helps.

Thank you. Our next question comes from John Ramirez with D.A. Davidson. Your line is open.

Good morning. This is John speaking for Brent Tillman. How are you?

Good, how are you?

So historically, MWA has had very different decisions and market share in your core products. How some of the product challenges impacted that at all? Presumably, your competitors are facing the same issues, but I'm wondering if some share shift is still occurring as a result?

Yes. I don't think there's a lot of share shift going on, either us being losing share or us gaining share. I think that there's a sprint, if you will, going on to make sure that the projects that are scheduled to get work on -- get worked out. I would say on hybrids, our lead time are outside our competitors, I would say, on gate valves, we're inside our competitors as far as lead times. And so the reality is that the material costs are a small piece. And so I don't think there's a huge share shift going on. I think that when you look at the municipalities that we are supplying under supply agreements and those in the spot market, it's the same of characters. I think that when you think about where we've been and where we are, it's been a kind of a market that's kind of in that. I don't know, 1,200, 1,300 a day kind of gate valve market that's significantly higher than that, over 2,000 a day today. And so I don't think that anybody has flexed much more than we have flexed. And so I feel good about where we are from a share shift perspective.

Got it. And just a follow-up, if I could. Could you provide more color on how much the availability issue has worsened since the last quarter? And I'm sorry if you already mentioned, but what strategies are we talking to secure those raw materials for following as well as going into next year.

That's a great question. So look, I think that we've seen some softening in raw material prices. But peculiarly, we've also seen some availability challenges. So normally, you can't get shred or you take a there's pressure -- upward pressure on the price, but we've actually seen it come down. As I've explained in the previous quarters, when availability or the quality, we have too much not enough on plate, we lose efficiencies in what our yield for. And so we've had to substitute things like busheling at a high-cost premium into our recipe in order to keep yields up. And those costs are certainly in our near-term view to what Q4 looks like as we will continue to ensure that we get what we can get into the market from a finished goods perspective. And so I think that these recipe premiums that we're experiencing today, especially in the steel market will continue. So your question then is how forward are you buying? We're basically buying as much as we are allowed to under the agreements we have with our supply base. People like Progress Rail and others. And the reality is, is that you can only buy forward in those markets right now about 21 to 30 days.

And just a quick follow-up so you said 21 to 30 days in a normal environment where you don't have the availability issues, where these - how much you're allowed to buy higher than that or is this just the top though?

No. I think that - I understand what you're asking. I think you're thinking about it incorrectly. What we have 1 to 2 days of backlog on what we call our high-turn materials. There's a just-in-time mentality around the supply chain. As we take orders, we look at what the pounds required are and then we go ahead and order those materials. And it's a daily ordering, daily shipment kind of even flow. But now that we're bumped away from basically backlog, what we call short-cycle materials, the need to buy forward increases, obviously. And so we're in an unusual time, and that's why we're trying to match our forward buy with the pounds we have in backlog so that we could lock in our margins. And when we get back to, let's call it, a more normal state, we would expect the supply chain to get back into ordering today for what we sold yesterday. I want to say that relates to steel, not brass. Brass is a different animal, where you buy a rig at 30 to 90 days in advance.

Thank you so much, I appreciate the additional information you provided. I'll hop back I think. Thank you.

Okay, there's, no more questions. I'd like to thank you, operator. Thanks to everyone for joining today's call while we're pleased with our net sales growth and price realization at this point in the year, we are disappointed with the lack of progress this quarter in addressing internal and external challenges, most importantly, the machine downtime issue we've discussed. I really want to say that we continue to be inspired by our team's dedication as they deal with unprecedented external environment, while also executing initiatives to transform our manufacturing capabilities and service our customers. We are well positioned to improve margins in 2023 as we continue to get price in the market, address operational challenges, execute our capital projects and increased production volumes. If we're seeing healthy orders that have a record backlog for our shorter-cycle products. Finally, we're excited about the tailwinds for the water infrastructure end markets and our ability to help municipalities address their accelerating challenges. So I'd like to thank you all for your continued interest. And with that, operator, please conclude the call.

Thank you. And that concludes today's conference. You may all disconnect at this time.