Thank you for standing by, and welcome to the third quarter 2022 investor relations conference call. At this time, all participants are in a listen-only mode until the question and answer session. At that time, if you'd like to ask a question, please press star then one. 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 June 30th, 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 is 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 and our non-GAAP disclosure requirements. As a reminder, we have changed our management structure and segment reporting effective October 1st, 2021.
We filed an 8-K in January that provided the recap of historical quarterly results for 2020 and 2021. At this time, please refer to slide two. 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 three 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 two and three 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 1-800-834-5839. 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.
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 our gate valves, specialty valves, and repair and installation products. Order levels remained 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 and operational performance as we manage healthy demand and record backlogs. We expect continued benefits from improved price realization in the fourth quarter, and we'll 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 segment 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 volumes. 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, inflation, and warranty obligations. We increased our warranty accrual based on our historical warranty experience and cost, 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, P&E, trade show 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 note 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 5.6% 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 segment's product lines. 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 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 products.
Net sales of $137.3 million increased 2.8% compared with the prior year, primarily due to higher pricing across most of the segment's product lines and the addition of i2O. Repair and installation products experienced double-digit net sales growth compared to the prior year. Volumes decreased 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 million 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 was $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 five-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 receivables. 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 was -$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 30th, 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 1.4 x.
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 maturity 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 discuss our third quarter performance, end 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 inefficiencies. 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 meet production schedules while dealing with long lead times and price premiums. Challenges in the scrap steel market have caused us to shift to a more expensive mix of steel and iron in order to get timely materials.
This phenomenon is playing out in many of our purchased 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. Unfavorable manufacturing performance at our foundries was the primary reason for the lower-than-expected conversion margin in the quarter. Our Chattanooga and Auburndale foundries, which purchase energy from the Tennessee Valley Authority, were both impacted by emergency load curtailments. These actions impacted melt capacity, which lowered production volumes for hydrants and our gate valves. Machine downtimes at our brass foundry in Decatur significantly impacted melt 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 improve lead times, we have increased our use of third-party maintenance personnel and outsourcing to achieve higher production levels. Our teams also remain focused on completing our new brass foundry, which will eventually replace the existing foundry. Replacing the century-old plant with our new state-of-the-art facility that we believe will provide many lasting 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 enhance 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 the three large capital projects we have previously announced will account for a combined $30 billion annualized incremental gross profit when all are complete and at full run 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 the materials, labor, and machines to increase production and improve delivery times. To support our efforts, we have proactively invested in our hourly production team members by working with the unions 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 from 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 municipal repair and replacement end market activities remained very strong. Overall, the market continues to benefit from healthy budgets, especially at larger municipalities. As a reminder, we estimate that approximately 2/3 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 stormwater 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 from 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 bill spending. For the new residential construction end market, specifically lot and land development activity, we believe that demand continued to be at healthy levels during the quarter. However, based on the most recent monthly housing start 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 lot 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 in 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 dividends and share repurchases.
We have repurchased $35 million of common stock over the last 12 months, including the $5 million repurchased in the third quarter, and we have $110 million remaining under our share repurchase authorization. In closing, water utilities face many challenges, including accelerating aging infrastructure, climate change and unfavorable 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. With that, operator, please open this call for questions.
Thank you. As a reminder, if you'd like to ask a question, please press star then one. Remember to unmute your phone and record your name clearly when prompted. If you'd like to withdraw that question, you may press star two. The first question comes from Bryan Blair with Oppenheimer. Your line is open.
Thank you. Good morning, everyone.
Good morning.
Good morning.
Given your record backlog and order momentum, your fiscal 4Q growth seems, you know, pretty locked in barring major disruption. I assume the same goes for early 2023. Maybe offer a little more color on the puts and takes of, you know, market activity and demand drivers, as we look forward for municipal repair and replace, and resi new construction respectively.
Yeah, I think you know, the net price realization expected to improve sequentially, which is you know, really the driver in growth in our Q4. We would expect some more improvement as it relates to you know, quarters in the future. The backlog at the record levels in the end of Q3, I think is a bigger function of you know, throughput at the plants that you know, we had opportunity to ship more. You know, 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 and demand. I think the biggest driver is that the muni budgets remain extremely strong.
I think that the larger municipalities, as I mentioned in my prepared remarks, Bryan, have in front of them, you know, a you know, pretty large menu of projects.
Yeah. Understood. I guess to level set a little more on, you know, the margin pressures that your team has faced in recent past, can you maybe isolate the impact of price versus material costs then, you know, parse out the headwind from unfavorable manufacturing performance in Q3? You know, compare that to the second quarter and then, you know, walk us through how your team's thinking about these variables and, you know, the timeline to more normalized conversion margins going forward.
Overall, we did continue to see, you know, strong price realization this quarter, probably slightly improved sequentially from the second quarter and, you know, 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. The main driver that we talked about was the machine downtime at our century-old brass foundry, which limited our pounds of production.
What that contributes to is we end 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. You know, I'd say looking out, we have 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, you know, 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, you know, opportunity as we look into 2023, for improving margins.
Okay. All helpful color. Thanks again.
Thank you.
Thank you. Now next question comes from Deane Dray with RBC Capital Markets. Your line is open.
Thank you. Good morning, everyone.
Good morning, Deane.
Hey, I'd like to continue that line of question. Just trying to reconcile, you know, what came up in the third quarter, what was the tipping point in terms of saying you've got a lower EBITDA guidance? 'Cause supply chain kind of didn't change. It's still, it's a big head when we get that same thing on inflation. 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 gonna make up that EBITDA shortfall to hit your guidance. Is that fair?
Yeah, I think that's fair, Deane, and I'll turn it to Martie. I want everybody on the call to understand there's basically brass product in every product we make. If you think about a gate valve, there's brass components in it. If you think about a hydrant, there's brass components in it. The brass foundry downtime, I think, was the tipping point for looking at the rest of the year and certainly, you know, we're experiencing, you know, downtime issues with auto pours and things like that, you know, as we speak. 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 of components for gate valves and for hydrants as well.
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. We're assuming in our fourth quarter that we will have some outsource supply chain issues through the fourth quarter as we work through these equipment issues in the Decatur foundry.
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 that, you know, things like our form machines and cores and things like that, they're all made on equipment that's older than both you and I. So I think that there's
That's saying a lot.
Opportunity. Yeah, there's opportunity for improvement. You know, we got to go tour the progress on the new foundry last month. You know, I think it's gonna be a step change improvement, both from a worker environment, a throughput capability, early warning detection systems, you know, the availability of machine data for running machine learning, things like that. I think they're all really positive, and I'm excited to get it open. I'm looking for ways to try and accelerate the PPAP process so that we can get there sooner. We are, you know, facing the headwinds associated with contractor labor and facing the headwinds associated with the supply chain and 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?
You know, I'd say, overall, in terms of looking at the lower guidance on CapEx, I think some of what we have seen is just some project delays. Some of that is coming from supply chain disruptions. You know, a portion of the spending for the new Decatur brass foundry, we've got a portion of that pushed into our 2023. I think additionally, some of the delayed projects are a result of the teams focusing on some of the operational challenges. I think that's certainly one of the reasons. You know, additionally, as we continue to look at the various capital project opportunities, we have elected to deprioritize some of them going forward.
Okay. Last one on the warranty charge. What triggered it? Are there particular products? I just wanna get a sense of how broadly this covers the warranty experience that you've had.
Yeah. With respect to the warranty charge, it relates to the sales of our metering products. Just as a reminder, that is part of our Water Management Solutions segment. What we do on an ongoing basis is we monitor and analyze our warranty obligations periodically and revise any accruals as necessary. We did increase our warranty accrual, 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 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?
Yeah. What I would say is, you know, look, the warranty periods, I would say, generally within the industry tend to be very long. You know, 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. As we get more information and experience, we'll evaluate and update the estimates and adjust as appropriate. That was what we did this quarter.
Okay. Thank you.
Thank you. The next question comes from Joe Giordano with Cowen. Your line is open.
Hey, guys. Morning.
Good morning.
Just wanna, like, think into next year. You know, the foundry gets pushed to, you know, end of 2023, part of it will roll into 2024 now. Like, what gets better, like, just from a margin for, like, a manufacturing productivity type setup? Like, what is under your control to get better into 2023, and what offsets that by delays in the push out of the project?
Yeah. I think that, you know, certainly notwithstanding the highly uncertain economic environment, given the interest rate rises and the supply chain disruptions, we, you know, acknowledge and believe that, you know, the ongoing inflationary pressures offset by the monetary policy the Fed is taking, it could lead to a recession. I think the biggest thing that we think about is that we are gonna 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 in the resi construction market. We anticipate municipal repair replacement market continue to benefit from the healthy budgets at municipal level.
We expect to improve the Adjusted EBITDA conversion margins, 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. I also believe that we'll have improved manufacturing performance, which will contribute significantly to the year-over-year improvement. You know, certainly we're in the dog days of summer from an uptime 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.
I think, we're mindful of the headwinds from ongoing inflationary pressures relating to higher wage rates, utilities and freight. As I said in my prepared comments, I expect that we will take the actions, in a rational market that will offset those. You know, that's the basis for, I guess, our bullishness for 2023 from a margin improvement conversion margin performance perspective.
Just thinking about the housing data that's come out on, you know, single family, it's pretty, you know, it's not looking great. You've 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, you know, potentially, you know, decently worse than it is now?
Yeah. I think in Q3 new residential construction end market, specifically lot and land development, activity continued to be at healthy levels, which is also reflected in our Q3 order book. You know, I understand that the permits pulled data would indicate that. I think, you know, as I remind everybody, you really have to look at lot inventories because we use housing starts as a surrogate. 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. In June, total housing starts declined slightly to slightly less than, I believe, about 1.6 million pace, with single family starts decreasing, but interestingly, multi-family increasing.
I think you know that there's still some underlying 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. You know, if you were to compare the average annual, you know, we're still significantly above it. I think the sharp rise in borrowing costs clearly leading home builders to scale back production plans will continue this downward trajectory. 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 put in the land lot development.
I believe that a lower level of new resi construction could help municipal repair and replacement activity. You know, let me spend a minute on that. Not long, but you know, the home builders tend not to be the people to put in the curb and sewer. They tend to be contractors, and they tend to be the exact same contractors that the municipalities contract to put in to do repair and replacement work. A lot of the trenching and a lot of the repair work are the same people. You know, 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.
I think the biggest indicator is the healthy order activity we saw in the third quarter. I think July orders were in line with our expectations. I feel confident that while there will be some slowdown, the tailwinds we have from IIJA, 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 you know? 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?
Yeah, that's harder to parse out. You know, when we are looking at performance, you know, we look at, you know, what it would've cost us versus, you know, what the actual cost was. It kind of shows up in a couple of different places. Long story short, you know, manufacturing performance, you know, was the biggest reason for, you know, our cost increases experienced in Q3. Part of that is machine uptime, part of that is outsourcing, part of that, frankly, is freight. It's hard to parse it, and I'm not sure that it's something I would want to get into.
Okay.
in the longer
Oh, okay. All right. That's fine. Let me ask it this way 'cause you know it all comes down to gross margin. In the fourth quarter, you know, I'm sorry if you mentioned this already, but what gross margin should we be thinking about for the fourth quarter? Then at what, you know, how do you think the gross margin ramps as you know maybe get on stronger footing with some of these manufacturing issues?
Yeah, I think gross margin's gonna be under pressure in Q4. Walt, I think that you know, the reason we took it down, if you do the implied adjustment to our fourth quarter EBITDA, you know, going from 7%-10% down to flat, that you can see that Q4 will be at or near the significant pressure that we've seen in Q3. You could, you know, might even have a couple of basis points of pressure.
I think the other thing of note in our Q4 is that we will expect to have higher SG&A just based on the seasonal way, you know, our national sales meeting takes place and some of those other things that, you know, are significant expenses in our fourth quarter. 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, you know, 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. That is job one for us, is that we are going to do the things necessary to hang on to our share. We're gonna do the things necessary in order for our customers to maintain and have a preference for Mueller Water Products. Sometimes that comes from a cost.
Certainly in the third quarter, we expect that to kind of continue in the fourth quarter before improving.
Okay, great. Thank you. That helps.
Thank you. Now next question comes from Jean Ramirez with D.A. Davidson. Your line is open.
Good morning. This is Jean speaking for Brent Thielman. How are you?
Good, thank you. How are you?
Good. Historically, MWA has had very defensive positions and market share in your core products. Have 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.
Yeah. 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, you know, a sprint, if you will, going on to make sure that the projects that are scheduled to get worked on, get worked on. I would say on hydrants, our lead time are outside our competitors. I would say on gate valves, we're inside our competitors as far as lead times. You know, the reality is that the material costs are a small piece. 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, you know, it's the same cast of characters. I think that, you know, when you think about where we've been and where we are, it's been a, you know, kind of a market that's kind of in that, I don't know, 1,200-1,300 valve a day kind of gate valve market that's, you know, significantly higher than that, you know, over 2,000 valves a day today. I don't think that anybody has flexed much more than we have flexed. I, you know, I feel good about where we are from a share shift perspective.
Got it. Just to follow up, if I could you provide more color on how much the availability issue has worsened since the last quarter? I'm sorry if you already mentioned, but what strategies are being taken to secure those raw materials, you know, for following quarters as well as going into next year? Thank you.
That's a great question. Look, I think that we've seen some softening in raw material prices, but peculiarly, we've also seen some availability challenges. Normally when you know, you can't get shred or you can't get plate, you know, there's pressure, upward pressure on the price, but we've actually seen it come down. As I've explained in some previous quarters, you know, when availability or the quality, if you have too much shred and not enough plate, you know, we lose efficiencies in what our yield per flask are. We've had to substitute things like busheling, you know, at a high cost premium into our recipe in order to keep yields up.
Those costs are certainly in our near-term view to you know 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. I think that these recent premiums that we're experiencing today, especially in the steel market, will continue. Your question then is you know 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. The reality is that you can only buy forward in those markets right now about 21-30 days.
Just a quick follow-up. You said 21-30 days. In a normal environment where you didn't have the availability issues, were these, you know, how much you were allowed to buy higher than that, or is this just the top?
No. I understand what you're asking. I think you're thinking about it incorrectly. When we have one to two days of backlog on what we call our high turn materials, you know, 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. You know, it's a daily ordering, daily shipment, kind of even flow. Now that we're months away from, you know, basically backlog, what we call short cycle materials, the need to buy forward increases obviously. You know, 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 can lock in our margins.
you know, 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 appreciate you.
I wanna make sure you understand that relates to steel, not brass. Brass is a different animal where you buy your ingot 30-90 days in advance.
All right. Thank you so much. I appreciate the additional information you provided. I'll hop back in the line. Thank you.
Okay. If there's no more questions, I'd like to thank you, operator. Thanks to everyone for joining today's call. I think 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 wanna say that we continue to be inspired by our team's dedication as they deal with an 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 increase production volumes. I think we're seeing healthy orders and 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. I'd like to thank you all for your continued interest. With that, operator, please conclude the call.
Thank you. That concludes today's conference. You may all disconnect at this time.