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Operator: Welcome and thank you for standing by. This call is being recorded; any objections you may disconnect at this time. I’ll now turn the call over to Whit Kincaid.

Whit Kincaid: Good morning, everyone. Thank you for joining us on Mueller Water Products’ First Quarter 2023 Conference Call. We issued our press release reporting results of operations for the quarter ended December 31, 2022, yesterday afternoon. A copy of the press release is available on our website, www.muellerwaterproducts.com. Scott Hall, our President and CEO; and Martie Zakas, our CFO, will be discussing our first quarter results and outlook for 2023. This morning’s call is being recorded and webcast live on the Internet. We have also posted slides on our website to accompany today’s discussion which address our forward-looking statements and non-GAAP disclosure requirements. 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 our 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 September 30. A replay of this morning’s call will be available for 30 days at 1800-876-4955.

The archived webcast and corresponding slides will be available for at least 90 days on the Investor Relations section of our website. I’ll now turn the call over to Scott.

John Hall: Thanks, Whit. Good morning, everyone. Thank you for joining us for our first quarter earnings 2023 call. I’m pleased with our solid start to this year. We again generated a double-digit increase in consolidated net sales as we benefited from past pricing actions taken to help offset inflationary pressures. The improved price realization was partially offset by a modest decrease in overall volumes in the quarter. Although our brass production levels did improve sequentially, lower production levels compared with the prior year contributed to the decrease in volumes. We believe the municipal repair and replacement market remains resilient and helped partially offset the slowdown in residential construction activity.

As our end markets evolve in this economic environment, we are working closely with our channel partners to manage inventories and order levels. We sequentially improved gross margins in the quarter as higher price realization, combined with a lower level of inflation and better manufacturing performance more than offset lower volumes. While the inflationary pressures have eased, they are still elevated compared with the prior year, leading us to implement additional price increases. Our teams remain focused on delivering the benefits from our large capital projects, particularly the ramp-up of our new brass foundry. We are seeing operational improvements at our Kimball facility as our specialty valve products delivered the strongest year-over-year growth in the quarter.

We believe we are on track to achieve the operational improvements needed to increase margins in the second half of this year. While we are pleased with our first quarter results, we also remain vigilant in this environment and are reiterating our annual guidance. After Martie discusses our financial results, I’ll provide more color on our first quarter performance, end markets and outlook for 2023. Now, I’ll turn the call over to Martie.

Martie Zakas: Thanks, Scott and good morning, everyone. I will start with our first quarter 2023 consolidated GAAP and non-GAAP financial results. After that, I will review our segment performance and discuss our cash flow and liquidity. Our consolidated net sales increased 15.6% to $314.8 million compared to the prior year, with growth in both Water Flow Solutions and Water Management Solutions. The increase was primarily due to higher pricing across most product lines in both segments and volume growth across most products and Water Management Solutions. These benefits were partially offset by a decrease in volumes at Water Flow Solutions. Gross profit of $93.2 million, increased 6.4% compared with the prior year. However, gross margin of 29.6%, decreased 260 basis points compared with the prior year as benefits from higher pricing were more than offset by increased cost associated with unfavorable manufacturing performance, inflation and lower volumes.

We sequentially improved our gross margin by 380 basis points in the quarter. The unfavorable manufacturing performance which includes the impact of outsourcing, machine downtime, supply chain disruptions and labor productivity, was primarily driven by our foundry operations. The negative impact of inflation improved sequentially. However, we continue to experience higher costs associated with raw and purchased materials, utilities, freight and labor relative to the prior year. Our total material costs increased around 8% compared with the prior year. Our price realization again improved sequentially, more than covering inflationary pressures for the fourth consecutive quarter. Selling, general and administrative expenses of $62.9 million in the quarter, increased 11.7% compared with the prior year.

The increase was primarily driven by personnel costs, third-party services, inflation and T&E expenses, partially offset by foreign exchange gains. SG&A as a percent of net sales decreased to 20% as compared to 20.7% in the prior year quarter. Operating income of $34 million, increased 17.6% in the quarter compared with $28.9 million in the prior year. Operating income includes a net benefit of $3.7 million from strategic reorganization and other charges in the quarter. The net benefit primarily consisted of a $4 million pretax gain on the sale of the Aurora, Illinois facility. This gain was partially offset by transaction-related expenses. Turning now to our consolidated non-GAAP results. Adjusted operating income of $30.3 million, decreased $1 million or 3.2% compared with $31.3 million in the prior year.

The benefits from higher pricing were more than offset by increased costs associated with unfavorable manufacturing performance, inflation, additional SG&A expenses and lower volumes. Adjusted EBITDA of $44.2 million, decreased 6.9% in the quarter, leading to an adjusted EBITDA margin of 14% compared with 17.4% in the prior year. As a reminder, adjusted EBITDA was also impacted by a year-over-year increase in pension expense of $1.9 million in the quarter. Net interest expense for the quarter declined to $3.7 million as compared with $4.3 million in the prior year. The decrease in the quarter primarily resulted from higher interest income. For the quarter, we generated adjusted net income per share of $0.13 which was flat compared with the prior year.

Moving on to the quarterly segment performance, starting with Water Flow Solutions. Net sales increased 6.9% compared with the prior year, primarily due to higher pricing across most of the segment’s product lines. We experienced lower volumes primarily for our gate valve and service brass products which were partially offset by higher volumes for specialty valve products. Adjusted operating income of $24.2 million, decreased 22.7% in the quarter. Benefits from higher pricing were more than offset by increased costs associated with unfavorable manufacturing performance, primarily at our foundry operations, lower volumes and inflation. Adjusted EBITDA of $31.9 million, decreased 17.6%, leading to an adjusted EBITDA margin of 19.3% compared with 25% last year.

Turning to Water Management Solutions. Net sales of $149.2 million, increased 27.1% as compared with the prior year. This increase was primarily due to higher pricing across most of the segment’s product lines and increased volumes, mainly in hydrant and water application products. Adjusted operating income of $19.6 million, increased 70.4% in the quarter, benefits from higher pricing and volumes more than offset increased costs associated with unfavorable manufacturing performance, primarily at our foundry operations, inflation and additional SG&A expenses. Adjusted EBITDA of $26.6 million, increased 38.5% in the quarter, leading to an adjusted EBITDA margin of 17.8% compared with 16.4% last year. Moving on to cash flow. Net cash used in operating activities for the quarter ended December 31, 2022, was $6.5 million compared with $19.8 million of net cash provided by operating activities in the prior year.

The decrease was primarily due to an increase in inventory. Average net working capital using the 5-point method as a percent of net sales increased to 28.2% compared with 25.4% in the first quarter of last year, primarily due to higher inventory levels. During the quarter, we invested $9.9 million in capital expenditures compared with $11 million in the prior year. Free cash flow for the quarter was negative $16.4 million compared with positive $8.8 million in the prior year, primarily due to the decrease in cash provided by operating activities, partially offset by lower capital expenditures. We did not repurchase any common stock. And as of December 31, we had $100 million remaining under our share repurchase authorization. At December 31, 2022, we had total debt of $447 million and cash and cash equivalents of $125.6 million.

At the end of the first quarter, our net debt leverage ratio was 1.7x. We did not have any borrowings under our ABL agreement at quarter end nor did we borrow any amounts under our ABL during the quarter. As a reminder, we currently have no debt maturities before June 2029. At December 31, 2022, we had $288 million of total liquidity, giving us ample capacity to support our strategic priorities, including acquisitions. Scott, back to you.

John Hall: Thanks, Martie. I’ll now comment on our first quarter performance, end markets and full year 2023 outlook. After that, we’ll open the call up for questions. As mentioned earlier, we are pleased with our solid start to the year. While we sequentially improved gross margins in the quarter, our margins were below the prior year. We continue to be pleased with our price realization which more than offset inflationary pressures for the fourth consecutive quarter. As expected, unfavorable manufacturing performance, primarily at our foundries, partially offset the benefits from higher pricing in the first quarter. Unfavorable manufacturing performance was impacted by lower production, primarily at our Chattanooga and Decatur foundries, leading to under-absorption of labor and overhead.

Our Chattanooga foundry which is focused on gate valve production, delivered lower volumes due to fewer production days relative to the prior year, primarily driven by increased planned maintenance over the Christmas period. Our melt production at our Decatur foundry increased sequentially. However, it was more than 30% below the prior year. Our teams made progress on the operational challenges at the foundry with improved machine uptime contributing to the sequential increase in melt production. The ramp-up of our new brass foundry is well underway. We have 2 lines working through the production parts approval process, prioritizing our highest volume parts, including parts used in our hydrants and gate valves. We are working through the new casting and machining processes and expect to begin shipping the initial parts using the new alloy later this quarter.

I am pleased to share that Mueller product utilizing components manufactured at the new foundry will continue to be certified under NSF 61 for drinking water system components through underwriters laboratories. This certification is crucial to ship products containing parts with the new alloy to customers. With elevated backlogs, our teams remain focused on improving production levels, to reduce lead times and satisfy orders, especially for our hydrants and brass products. We continue to experience higher costs year-over-year, primarily related to outsourcing materials, machining and maintenance. We expect these headwinds to carry on into the second quarter as well as the second half of the year. Increasing brass production levels from both foundries will ultimately allow us to bring some production back in-house and lower costs.

As backlog levels normalize and our new brass foundry begins shipping product, we anticipate decreasing the use of outsourcing. Additionally, we are working to add shifts at our Albertville Foundry to increase internal production for key hydrant parts. We’ve already mentioned the sale of assets associated with the closure of our Aurora facility. We are pleased that we now have completed the divestment of all the locations from which operations have transitioned to the new Kimball, Tennessee facility. Our specialty and large vial CapEx investments are continuing to ramp up this year and we expect the margin benefits to follow accordingly. During the first quarter, our specialty valve products delivered the strongest year-over-year growth of all of our product lines which resulted in a sequential and year-over-year improvement in gross margin.

I will now briefly review our end markets. As mentioned earlier, we believe the municipal repair and replacement market remains resilient, helping partially offset the slowdown in residential construction activity. For the municipal repair and replacement market, we remain excited about the benefits of the Infrastructure Bill starting to take effect later this year. The first wave of distributions have taken place with additional guidelines from the EPA regarding the Build America Buy America domestic sourcing requirements. This further supports the strategic rationale for all 3 of our large capital projects. As domestic sourcing requirements for iron and steel products increase, we believe we will be well positioned with our increased domestic capacity for our larger valve and service brass products.

Looking at the new residential construction market. Total housing starts were down 15.6% year-over-year during our first quarter with around 1.4 million seasonally adjusted annual rate in December. We expect construction activity to pick up in the spring relative to our first quarter which is the typical seasonality of our core products. For fiscal 2023, we continue to forecast that total housing starts will be in the 1.3 million to 1.4 million range. While we expect higher interest rates and economic uncertainty to continue to impact residential construction, we believe lot inventories remained relatively low. Moving on to our outlook for 2023. As expected, we experienced a slowdown in order activity during the first quarter. While our total backlog decreased sequentially, we continue to have an elevated backlog, especially for shorter cycle products like service for and hydrants.

With product lead times and project timelines improving, we anticipate our backlog levels could normalize over the coming quarters, depending on end market activity. We expect to get a clearer sense of sell-through channel inventory plans and order levels as we move into the upcoming spring construction season. As mentioned earlier, we are reiterating our guidance for 2023 which we provided with our fiscal 2022 fourth quarter earnings. We anticipate that our consolidated net sales will increase between 6% and 8%. Our backlog at the end of the first quarter and the expected realization from higher pricing position us to deliver net sales growth again in 2023. We expect our adjusted EBITDA will increase between 10% and 14% as compared with the prior year, primarily driven by benefits from higher price realization and operational improvements in the second half of the year.

In closing, our teams continue to focus on maintaining our strong customer relationships while executing our top priorities for the year which include achieving operational improvements, delivering benefits from our large domestic capital investments, accelerating development and commercialization of new products and generating ongoing price realization. We are on track with the ramp-up of our new brass foundry which will have significantly more capacity to deliver the best long-term manufacturing solutions and advance our sustainability initiatives with a new led-free brass alloy. We are in a transformational period for Mueller with our large capital projects in various stages of ramping up. We believe the benefits from these projects and ongoing operational improvements will greatly enhance our position in the market.

These investments are especially important as water utilities increase needed repair and replacement projects supported by the Federal Infrastructure Bill and the requirements for domestically manufactured products. Our broad portfolio of products and solutions enable us to help water utilities address growing challenges from the aging infrastructure climate change and workforce demographics. While uncertainty from the external environment has increased, we are a much more resilient organization supported by a strong balance sheet. This gives us liquidity and capacity to continue to reinvest in our business while returning cash to shareholders, primarily through our quarterly dividend. We are confident that our growth strategies, capital investments and operational initiatives will deliver both further net sales growth and a return to pre-pandemic margins in 2025.

That concludes my comments. Operator, please open this call for questions.

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Operator: The first question in the queue is from Deane Dray with RBC Capital Markets.

Deane Dray: Maybe we can start, Scott, with your perspective on the demand dynamics in the quarter with respect to some of the order slowdowns. We’re hearing lots of commentary across the industrials about destocking and we can see what’s going on in the resi side. And in particular, you had a — there’s a pipe manufacturer yesterday that was seeing some of the same dynamics and their outlook was a lot more dire than what you’re talking about today. So just kind of frame for us the order slowdown, is this destocking? And I know there’s going to be offset from the muni break and fix but just very specifically on the resi side.

John Hall: Yes. So I think that the dynamic is as much as you described. But if you recall my comments in previous quarters, there is a big piece of this theme that is DRP driven or distribution resource planning driven. And it’s this notion that as the lead times collapse that you’ll kind of get here with this double whammy. One, the sell-through may have slowed as housing goes from that 1 5, 1 6 down to the 1 3, 1 4 range but lead times are coming down as well. And so the amount of material that’s needed in the channel continues to decline. And so what’s necessary and what’s not. So I think the end market evolution work closely with the channel partners to look at sell-through and to manage inventory and order levels will be key.

And I think that everybody is kind of looking at this spring construction season and saying, is it going to be even further down? Or will there be enough resiliency? I think that there is a tendency to be overly bearish once you start to see the negatives. But I would also point to the January jobs report which would indicate that employment levels and potentially income levels could be rising for the average American which I think would be kind of the counterpoint to the housing starts where these people enter the housing market. I think that remains to be seen. But what’s most important to us in the last 6 months is watching the balance sheets of the municipalities and how flush they are with cash still 2 years later. And I believe that, that is the counterpoint along with the emergence of more interest in the drinking water stream from governments that is going to kind of offset the kind of demand profile reduction that we’ll see from the housing market.

So we remain, let’s call it, cautiously optimistic.

Deane Dray: That’s all really helpful. And we’ve heard that whole dynamic about the slowing the pace of orders as lead times normalize. So that’s getting to be pretty familiar for us. as well. All right. So a follow-up question for Martie. Can you talk about the impact of your inventories on free cash flow because that was really well below your typical free cash flow use? Is that inventory? Is it still buffer inventory? Is this a supply chain issue? Scott just talked about how there’s less inventory in the channel, there’s destocking going on but you’re taking on more inventory. So just walk us through that, please.

Martie Zakas: Yes. So I’ll say certainly looking at the negative free cash flow that we had in the quarter, as you pointed out, was driven by the higher inventory levels. As we work through our 2023 and certainly consistent with the guidance that we have reiterated with respect to full year free cash flow being in the 40% to 60% of our adjusted net income, that improvement year — through the year, we expect to be largely driven by working capital improvements and that’s going to come from inventory turn. So I’m going to say, as we — as our production teams are focused on improving the lead times, as Scott just talked through, lowering the backlog levels, particularly with the short-cycle products that we’ve had and with the outsourcing, I think that as you — we’ve had more of that philosophy of we’re going to bring any inventory in the needed parts just in case rather than just in time, all the supply chain disruptions.

I think we’re going to — we are going to look to sort of transition to that as we begin to see some improvements in the supply chain. We’re going to look to shift that focus and certainly look to bring down these inventory levels through the year which will help with that. There will be some — as the new brass foundry is coming up, we will have some elevated inventory levels associated with that. Scott referenced in and around destocking activity and what we could see from distributors through the balance of the year. And I would say, certainly, if the destocking is greater than what our estimates are, that could impact our overall inventory levels and our free cash flow guidance.

Deane Dray: Martie, that’s real helpful. And I probably should have prefaced it with that throughout the industrial reporting season, most of the companies have underdelivered on free cash flow, I think, versus expectations. So you’re a good company here. It’s just — we’re all anxious to see that working capital come down. But I think what we’re all learning is it’s going to take longer throughout the year to see it. It’s not just a 1-quarter flush. So I appreciate the reference about the time frame for you. And just last question for me. Scott, it’s been a while since we had an opportunity about a potential guidance boost. So we saw nice results first quarter out of the year. It’s still early, I get that. But when you’re not boosting after a quarter like this, does that imply a lower outlook? Is this — are you a bit more cautious? Just help us frame the idea of reaffirming guidance and not boosting it here.

John Hall: Yes. So I think that the — there was some definite difference in how the first quarter came out external estimates to internal. So I think that our timing they have different from the market’s timing. So when we talked about on our last earnings call, where we provided the initial guidance for 2023, we talked about how the timing of the ramp-up of the new brass foundry was important to our improved margins in the second half of the year. And then, if you just were to take that improvement and say, where was your starting point for the year from earnings versus where the externals were? I can’t really speak to that. What I can say is that the start to the year was solid with the sequential improvement in margins. But I’m mindful that we’re still early in the year.

And additionally, we’re still in the ramp-up period of the new brass foundry improving those — improving those PPAP processes. And I would also say there remains a fairly high level of uncertainty in the external environment. So residential construction has slowed. Product lead times and project timelines are improving. I expect that the backlog levels could normalize over the coming quarters, depending on end market activity. So, I expect to get a clear sense of the sell-through in the channel and the channel inventory plans as we move into the spring construction season. I think that will be a critical time being as we look at what happens with the sell-through in the channel inventories. And I think that will set the pace for the balance of the year.

So I think we elected — when we look here, certainly a little better first quarter than anticipated — but we elected to kind of keep our powder dry as we look at the rest of the year, I think there’s a couple of ways this can go. And I would speak to everybody and say, the most important elements for our guidance to be met is to hit our throughput numbers at our own facilities and not hit throughput by using other people’s materials or outsourced materials. And those are going to be the keys for execution. And I think it’s just too soon to say where we are on that path.

Operator: Next question is from Bryan Blair with Oppenheimer.

Bryan Blair: Solid start to the year, good to see that price continues to outpace inflation being 4 quarters into that catch-up process. Are you now at a point where price/cost is margin accretive year-on-year? Or is that still pending?

John Hall: Well, year-on-year, I guess, you could argue that it is accretive. But as you know, Bryan, we don’t measure it that way. We go back to the trough. We know that the entire inflationary cycle is multiple years on. So when we said in our prepared comments at the end there that we expect to be back to pre-pandemic margins in ’25. We are looking at the rate of accretion. So we’re still not accretive to inflation over the entire cycle going back to 2020 but we expect that we will be back to breakeven on the dilution effect at 20 — sometime this year if the price that’s trapped in the backlog and the throughput assumptions we have in there, we’ll kind of get back the price piece sometime in 2023. We believe that we’ll be at pre-pandemic margins in 2025.

So the price piece of it is one part of it but the actual throughput and getting rid of the outsource and getting rid of the other things won’t have us back to pre-pandemic margins until 2025. So I hope that answers it. We’ll be accretive year-on-year but we still got a ways to go to get back to when the inflationary cycle began in 2020 and the headwinds associated with the outsourced and the other product inefficiencies or manufacturing inefficiencies, we won’t have those out of our system until we can close that second foundry until we can hit all of our production targets internally and we anticipate everything to be back to pre-pandemic margins by 2025.

Bryan Blair: Yes. I appreciate all the color there. I guess to simplify that progression, it would be getting back to recovering margin price/cost this year, stamping out inefficiencies into next year and then allowing for the read-through of the projects once you are past completion and at that full run rate, driving the — I think it’s $30 million or so in benefits that you’ve called that would be ’24 into ’25. Is that kind of the step forward?

John Hall: Yes, yes. So if you were to look at us to be at a high level, like 2019 19%, 20%, call it 20% in the EBITDA margin and now we’re in the 14%, 15% range, we will get that 500 to 600 basis points in ’25. And it’s a combination of a lot of things. The biggest two things, as I’ve been saying repeatedly, is the brass foundry, the elimination to outsource and getting throughput levels back to — at our own foundries. Those are the 2 big movers. It really is. And that’s — we will end up with as long as the end markets hang together, we’ll be fine. I think the other thing I’d point out for everybody here is, I think the end markets are conducive to us to continue the growth but we’re probably going to have to look to the IIJA timing to carry us through what will likely be a temporary housing slump.

Bryan Blair: And that’s actually a perfect segue there, Scott. Any other color you can offer on IIJA impact to date, I assume minimal. More importantly, your confidence in there being a tangible impact looking to the latter part of ’23 into ’24, ’25. Just looking at SRF funding data and specifically the awarded funding and it’s somewhat underwhelming right now seem to do a lot of administrative issues at hand and a lot of work that remains just to coordinates the project funding before moving forward with a lot of this. Just curious your perspective on that. And then again, level of confidence or incremental confidence in this being a real catalyst going forward.

John Hall: Well, I think it will be a real catalyst going forward. I think you’re seeing whenever we have some of these government programs, you’re seeing the sausage-making process. There’s going to be all these new rule sets like give you an example like a fastener is a fastener have to be American made? Is it part of the American iron and steel? Or can we use imported fasteners? Well, how many fasteners are there being manufactured in the U.S. that meet the stainless steel, all these things. And so the EPA is working through all those rule sets to say what the exemptions are, what they’re not, what materials have to constitute the bulk of the cost with the labor content. So all those kind of sausage-making has been going on for the last 9 months.

And you saw some funds released to California, some of the bigger states. And as you said, it was a small piece of the $100-ish billion that we expected to see. And so I would say that the money is going to be set. I believe it will be a catalyst for ’24 and ’25 and beyond. But any project that got approved let’s say, today even, let’s say that today, none of those installs are going to happen in ’23 or even the early part of the ’24. By the time those jobs are engineered, those builds and materials are cut, the water system is in a position where the install could happen and the labor is available, these are multi-month projects, not to mention the size of the backlog in the specialty valve business or the large gate valve business. So I do think, yes, I’m very, very bullish as a result of the funding and we can see the need for where these dollars need to be spent in both the storm water, wastewater and drinking water investment opportunities.

Yes, we think it’s actually going to have a meaningful impact on the size of the served market for products that Mueller makes. No, I don’t see it happening in the next 3 quarters.

Operator: The next question is from Mike Halloran with Baird.

Unidentified Analyst: It’s Paz on for Mike. So another question on backlog. So how are you thinking about backlog duration at this point versus normal? Obviously, a lot of puts and takes. The backlog levels are elevated. We talked about the numerous puts and takes on the manufacturing and outsourcing side. But then also on the flip side, we talked about an opportunity to normalize backlog levels this year. And then secondarily, based on the answers to Deane’s question, I suspect I know the answer here but I’ll ask anyway. How much if any backlog normalization is assumed in the current guidance?

John Hall: Let me hit the first how I think about it. I probably think about it a little differently than the analysts on the call because I’m keenly interested in knowing where our sector competitors are in their lead times. And I think we’re advantaged in our lead time at gate valves right now. The Chattanooga plant has done a great job of plowing through the backlog there. But I believe we’re disadvantaged in hydrants right now. I think our lead times are too long compared to our competitors. When I think about our specialty valve business, I think we’re near par. But we should — with the investment and we can get the throughput, we should be advantaged, we’re domestic. And we’re not as dependent on that China supply chain as some of the competitors in the specialty valve market.

So I want to see improvement there on what that backlog reduced in terms of days of production because I think it’s an opportunity to take share. So I know you’re asking me and I’m kind of evading the financial answer to your question. But that is how I think about the backlog and I want to be honest with you about that. I don’t think about it in the context of how much price is trapped there, although there’s a considerable amount or what an optimal number is. What I do think normalization looks like though is that what we call the short-cycle business, the smaller gate valves, let’s call them 4 6 8s and the 5.25% Super Centurion or the couple of the wet barrel size hydrants, those have to get inside 2 weeks because that has to be the rapid turn for the channel.

Those are probably the most competitive markets for the channel and therefore, they need to turn that inventory rapidly. They don’t want to be sitting on months of gate valves or sitting on months of hydrants. And so with our channel partners, we have to get that supply chain balanced out which is — continues to be out of balance today. So ideally, we would see that continue to shrink and get back inside of a 30-day backlog by the end of the year for the short-cycle business. The project business, I expect that those lead times will continue to grow. But as IIJA money puts more of these bigger projects out there that we and our competitors will start having more and more, a, engineered valves and b, longer and longer lead times on those engineered valves.

If anybody remembers back when we did the large casting foundry, we put in a 20-foot x 20-foot bed for a 3D printer for tools, so we can make large tools for Build America Buy American products. We expect that our cycle time to engineer will be better than the competition but that our throughput times will be on par. And so we hope to be advantaged there. So, I know that’s a long-winded answer to say expect backlogs to continue to fall and it’s more important, I think, in the market for us to be competitive or advantaged even than to worry too much about where we are in context of days.

Unidentified Analyst: No, absolutely. That’s incredibly helpful, Scott and a much better answer than it was question. So thank you. I’ll switch gears a little bit. The balance sheet is in good shape. You called out ample capacity to pursue the strategic priorities. Can you maybe just provide a little color on what the M&A landscape looks like? Is there anything out there that has you excited right now?

John Hall: I mean, there’s always properties that we’re constantly evaluating our pipeline and, I would say, our pipeline is fulsome right now. I think that the opportunities that you see where the investment dollars are going probably over the next 6 to 8 years offers some adjacencies for the Mueller line valves or bolt-ons that perhaps we don’t offer today that we think will gain money. I would say that if you look at the conversation in the country around what water retention looks like especially on the West Coast, you see the water crisis around Lake Mead, around these declining I think there’s going to be massive amounts of investment needed to move water from where we have plentiful water to the areas where we seem to be moving and getting population concentrations.

So all of those things, I think, drive and feed our acquisition pipeline. And we continue to be fairly bullish on our ability to get some of that done. But nothing is in the next quarter, that’s for sure.

Operator: The next question in the queue is from Brian Lee with Goldman Sachs.

Miguel De Jesus: This is Miguel on for Brian. We just had one question. I wanted to touch on the channel inventory dynamic again. Could you go into more detail possibly on the — on that dynamic that you’re seeing. Is there a way that you’ve been able to estimate how much is out there for the key products that you’re monitoring, maybe in terms of number of weeks or months and to what level the channel is trying to get down to?

John Hall: Yes, it’s a hard question to answer because I think if you were to ask the channel, they would say a lot of the inventory is committed inventory. And so if you look at what’s happened with price, so you take your baseline going in and you add — I’m making this up, don’t take this by 30% to 40% of the increase in inventory that you’ve seen in the channel is just price driven. So units are constant. And the balance is the increase as a result of the inflationary pressures that we see in price increases taken in the water space. So you say that’s 30% to 40% inflation. Then the balance of, let’s call it, ballpark, 100% increase is units. That 60% or 65% of increase that’s in units, there’s a huge portion of that, that is committed.

But waiting on pipe or waiting on labor or waiting on — and — but the — when the distributor took the order for that contractor, for that municipality, it was earmarked. And so there’s a fairly high backlog now measured in weeks of what’s just logistics backlog. So the speculative inventory would be the balance, right? Let’s call it 15%, 20% of channel inventories are on the speculative basis. I would expect that that’s the piece that would get targeted quickly. And so I think that that’s the at-risk. The other part for the channel to add value, they have to serve those contractors and those municipality jobs. Those are almost always delivered a job site. They’re not going from the distributors’ warehouse to some municipality work center and then being loaded on the truck again.

Some of that — a lot of that inventory and a lot of that backlog for the distributor is when we have the crew there, we want you to deliver this and this simultaneously for install here, here and here. And that piece of it, I think, has left because it’s been — the lease times between pipe valves and other fittings have become so disparate between one and other that we end up with a much larger inventory needed to support the logistics piece. And I think that, that — as that shrinks, then you’ll start to see that inventory shrink as well. And so if you use the 30% price kind of, let’s call it, 30% logistics, 30% speculative, as you see the lead times trash, you’ll be able to use one. As you see the prices increase, that will be an upward pressure.

And as I said in my prepared comments, we increased prices last quarter again. And then, as you see the other part, though, it’s — it too will drive down channel inventories. And I think you have to look at all 3 elements and then make the timing piece what you can of that mix of their inventory, what’s driven it?

Operator: The next question is from Joe Giordano with Cowen.

Joe Giordano: Can you talk about price realization in the quarter and what’s embedded for the full year? I assume that like — how much of the full year expectations like baked based on actions you’ve already taken? I assume it’s probably a little bit harder to like incrementally do this, given inflation is like moderating sequentially, right?

John Hall: Yes. Look, I think the sequential increases in price realization in Q1 was something we were very pleased with. We’re benefiting from the multiple price actions taken over the past year with price realization in the mid-teens for Q1. I think that improved price realization. As I said earlier, more than overcame the inflation and it was not dilutive but it’s necessary in order to get us back to that kind of pre-2020 dilution that we’ve seen from inflation. I think in the first quarter, total material cost inflation, keep me right here, Martie but — it included purchase price remains elevated and was somewhere around 8% year-over-year versus approximately 14% a year ago, while negative impact of inflation improved sequentially.

We continue to experience higher costs associated with raw and purchase materials. So to answer your question, I’m not trying to — there’s a lot of pieces moving there to say will it be dilutive or — and it really depends on how quickly we can ship the backlog, how much of the price that’s trapped in the backlog. Obviously, shipping sooner is better as evidenced by our Q1 having kind of that mid-teens price in it. So I — it’s hard to say. I can tell you what’s in our guidance is that we get back to kind of flat level with 2020 in terms of price to inflation. So it’s no longer dilutive this year but that will not offset all of the inefficiencies and costs associated with outsourcing and the other problems that we talked about. So we won’t be back to pre-pandemic margins contributed by price and then the efficiencies until 2025.

Joe Giordano: But within that, like full year revenue growth guide, is it fair to say that the price contribution is higher than the overall growth guide? So I can in contemplate price?

John Hall: Perhaps you missed it. Yes. No, That — when we did the guidance, we were explicit. The actual unit volume, we expect to be slightly down in all of our growth, all of the 6% to 8% growth that we talk about is being driven from price.

Joe Giordano: Yes, that’s okay. With respect to the new — the ramp-up of Decatur and things like that, like — what do you need to see to kind of know that you’re on the right track? Like how far into the year or like what kind of trigger points along the way kind of give you comfort that, okay, like this is progressing, how we need to see like this is going to work?

John Hall: Yes. I mean we meet every week, how many parts are PPAP, where is that on our PPAP schedule? Of those parts that are PPAP, what’s the machining trials going like? If you look at our 4K process, you start out kind of with a dimensional answer and Gate 2, you get into whether it’s form fit function porosity, all of those things in machining and then your date free as a game around that some significant volumes and then Gate 4 is machining and significant volumes and looking at tooling wear or things like that. So we know where we need to be to get those top 170-ish parts that I talked about in our last quarterly call through by the end of March. In my prepared comments, I said we’re on track for that. But there’s a thousand things that can go right and wrong in these next 90 days.

But at the end of the day, our exit rate at 2023 of pounds produced pass to approach somewhere between 50,000 and 70,000 tons a day. And we get into that 60 range at the new foundry and we can afford to then shut the existing founder and satisfy all of our customer demands and all our internal demand. So I don’t know how to really answer your question other than to say, one thing gone right, another thing will go wrong. At the end of the day, you would react and adapt, react and adapt, react and adapt to ensure that you get to the capital project targets And that’s what we’re focused on. And so yes, there’s a huge part of our margin improvement. It comes from avoiding the outsourced premiums we’re paying because of our inability to produce brass.

And that’s job 1 in this project execution.

Joe Giordano: Can you maybe speak to like what the cost differential is between these outsourced products that you have to bring into what at scale the cost would be internally?

John Hall: Absolutely not. And it’s not because I wouldn’t it’s that, obviously, you have multiple partners and I don’t want people trying to infer you’re paying this premium here and that premium there. They obviously know what we’re paying. So no, I’m not going to get into the spreads of premiums. I’m sorry.

Joe Giordano: And last for me. You mentioned your expectation for housing starts for the year. Can you kind of maybe compare that to what you think lot development will look like this year?

John Hall: Yes. As I said in my comments, look, we still believe that a lot of inventories and even options on loss. I know a lot of the builders are talking about in their prepared comments now what their option portfolio looks like. It’s still, I think, if you think about a 1.4 million housing start year and then you try and back into that which we try to do but it’s more art than science, unfortunately, because people don’t publish the numbers. We still think a lot of inventories are relatively low and that there’s not a huge backlog of developed lots for the builders to sell either spec or custom order or homes into. And so I guess the way I would describe it is after living through the 2007 overhang as a business, I wasn’t here but certainly, lots of people work and how long to work off that overhang, this one looks like it will be measured in days or even weeks but it’s not going to be measured in years.

And so the inventory is I think at a much, much lower level than it was in 2007 by a factor of 2 or 3.

Operator: The next question is from Walt Liptak with Seaport Research.

Walt Liptak: I wanted to go back to Deane’s question about the — where you commented about the forecasting and you said you had the internal forecast versus the sell-side forecast and that we were just — they were wrong. So the question is, I thought that the first half was going to be weaker and then the second half was going to be stronger. And so I guess the question is — so that this is helpful to everybody is, how are we doing on the second quarter like, seasonally, you typically have a pickup going into that spring selling season, are you expecting that? Are we going to see sort of a sequentially flat quarter? What are you thinking about?

John Hall: Okay. Well, it’s hard to get it. Gross margin expectations around Q2 is kind of how I — and I don’t want to get into giving quarterly guidance but I will say this in general. Look, I think our annual guidance implies year-over-year improvement in adjusted EBITDA margins of around, I don’t know, 70 basis points at the midpoint. I think it was driven by improvements in gross margins which are approximately 190 basis points with headwinds, I think, from the pension expense and higher total SG&A. And so you know that, let’s call it, 70 improvement. I think the inflation pressures and manufacturing performance headwinds will have to continue in Q2. We certainly are going to be dependent on the outsource. And I think we’re going to be dependent on third-party maintenance services indicator for all — certainly all of the quarter.

So, I think the timing issue with our capitalized variance and the inventory write-up associated with the inflation that took place believes that says that gross margins ought to be kind of flattish in Q2 with Q1. And then, you won’t start to see the step-up of improvement that will generate the leverage on the volume growth until you’re actually able to start impacting those 2 things. Does that help your model, Walt?

Walt Liptak: Yes, that does. And on the revenue piece for the quarter, the second quarter, I think what you’re saying is that you’ve got to — if you get that regular seasonal uptick, you’ve got to wait and see because you don’t know how the channel inventory is going to be. Is that fair?

John Hall: Yes. I think we have a big enough backlog that we should be able to hit our sales number. I’m not as concerned about that. It’s more concerned about the margin flow-through and getting the throughput up sequentially. So as I said in my comments, we had fewer days in gate valves in our Q1 because we took down the facility for an extended period of time versus the previous year so that we could do some and some other maintenance that needed to be done. And so we had fewer days in Q1. We expect that we’ll be able to get gate valve volumes back up in Q2. We expect improvement in throughput in Albertville for hydrants in Q2. We expect the continued improvement in throughput from Kimball and they’ve been quarter-on-quarter-on-quarter improving since we’ve opened them.

So pleased with that. So I think that’s really where you think about that implied improvement in adjusted EBITDA. We’re only going to get clawing back some of the inefficiency we had in manufacturing in Q2 but we still got the bulk of the heavy lifting to do in the second half which will only come when we remove be outsourced and we start producing meaningful pounds at the new foundry.

Walt Liptak: Okay. All right, great. I guess another one for me is last quarter, I think one of the big takeaways was that activist that you guys are working with. You didn’t comment on them at all. Are you still thinking about it the same way? Has anything changed?

John Hall: Yes. I mean we’re still thinking about it the same way. I think that the committee is off and running with the 2 new Board members but I don’t want anybody to be misled in. We don’t speak to the activist. I mean, they got independents that were associated with the company. Part of our agreement with them was that we would have new Board members. And I think that the integration has gone well but we’re not in contact with Ancora any more than we are with any other shareholder. And certainly, we don’t comment about our discussions with shareholders. So I think the committee, though, is we’ve had our inaugural meetings and we’ve had our discussions about capital allocations, about operational improvements. And I think we have alignment in what the priorities for the business are.

And those priorities are, as I’ve been talked about them from the large CapEx projects. So I feel good about it. Well, I think we’re at the top of the hour, operator. And I just want to thank everybody to staying with us and sitting through the call and joining us this morning. Look, final thing, though, I want to remain focused on our customers while delivering and the benefits from our capital investments, we will continue to outsource not to preserve our to preserve our customers and keep our place with them because I think share is terribly important in these times of uncertainty. I’d like to thank our teams for their continued dedication, especially as they deal with the ongoing uncertainty in the external markets. I think the transformation that Mueller is going through and the water industry is going through at this time is going to be a remarkable and exciting time to be at Mueller and to be invest in Mueller.

I think we are well positioned to continue to grow net sales and get those margins back to pre-pandemic margins in 2025. And I expect this improvement to be driven by the ability to get priced more than the — in the inflation cycle, our increased volumes, primarily from growth in mini repair and replacement, improved manufacturing performance and the realization of the benefits from the large capital projects. And so I don’t want to be pollyannish and rosy that it’s nothing but blue skies from here because there’s certainly a lot of work left to be done. But I want to thank you for your interest and I want to thank you for your continued support here at you. With that, operator, we’ll end the call.

Operator: This concludes today’s call. Thank you for your participation. You may disconnect at this time.