Fortune Brands Innovations Inc (FBIN) 2016 Q3 法說會逐字稿

Good afternoon. My name is Suzanne, I will be your conference operator today. At this time, I would like to welcome everyone to the Fortune Brands third-quarter 2016 earnings results conference call.

(Operator Instructions)

Thank you. I would like to turn the call over to Mr. Brian Lantz, Vice President of Investor Relations and Corporate Communications. You may begin your call.

Good afternoon, everyone, and welcome to the Fortune Brands Home & Security quarterly investor conference call and webcast. We are pleased to be here today to provide an update on our progress during the third-quarter of 2016. Hopefully, everyone has had a chance to review the news release issued earlier. The new release and the audio replay of the webcast of this call can be found in the Investor section of our FBHS.com website.

I want to remind everyone that the forward-looking statements we make on the call today, either in our prepared remarks or in the associated question and answer session are based on current expectations and a market outlook, and are subject to certain risks and uncertainties that may cause actual results to differ materially from those currently anticipated. These risks are detailed in our various filings with the SEC, such as our annual report on 10-K.

The Company does not undertake to update or revise any forward-looking statements, which speak only to the time at which they are made. Any references to operating profit, earnings per share or cash flow on today's call will focus on our results on a before charges and gains basis for continuing operations, with the exception of cash flow unless otherwise specified.

With me on the call today are Chris Klein, our Chief Executive Officer; and Lee Wyatt, our Chief Financial Officer. Following our prepared remarks, we've allowed some time to address questions that you may have. I will now turn the call over to Chris.

Thank you, Brian, and thanks to everyone for joining us today. Our teams delivered profitable growth in the third quarter, in the face of challenging comps, select channel inventory reductions, and slower than anticipated repair and remodel activity. Importantly, our businesses remained focused on targeting the most attractive segments of our markets, and we delivered strong profit performance across all four segments.

Since late September and through the month of October, we've seen the pace of orders across our business strengthen, returning to levels that we would expect. So based on our solid third-quarter performance, consistent execution, and our current assumption for market growth, we are revising our full year outlook for sales growth to 9% to 10%, while confirming our previous EPS outlook.

Let me first spend some time on our view of the US home products market, followed by my thoughts on our business performance in the third quarter. Then I would like to discuss the recent creation of our Global Plumbing Group, and why we view this platform as the first step to further accelerating growth in the plumbing segment. And finally, since we've just celebrated our 5 year anniversary as an independent company, I'll provide my perspectives on the Company that we have built, and how we have positioned ourselves to maximize growth and value for the years ahead. Lee will then provide more details on our third quarter performance, and our 2016 outlook.

Starting with our view of the US home products market, in the third quarter the market for our home products grew at the lower end of the pace that we expected. We estimate that repair and remodel activity grew at around 4%, and new construction grew generally as expected. Our businesses experienced repair and remodel activity that began to slow in July, and was clearly slower throughout August, and the first half of September.

While demand was slower over this period, our channels also reported a tighter labor market, and available contractors and trades people to take on incrementally more projects over the summer months, after a fast start to the year. Notably over the past five weeks, we've seen R&R activity and order patterns improve, and more consistent with what we would expect, starting in mid-September and continuing through October. And consumers continued to drive an improving mix within our categories. New construction demand continues to grow as expected, with single-family growing faster than multi-family, and single-family entry level activity continuing to improve.

Looking at the full year 2016, our overall assumption is that the US home products market which impacts 70% of our sales, grows at a combined rate of around 6%. Within the year, we saw upside in the first quarter, driven by better weather. Second quarter was pretty much as we expected. The third quarter saw slower repair and remodel activity, partially due to labor constraints.

And with our current visibility into order patterns, the fourth quarter is shaping up to be on plan. Taken together, 2016 will be a good year. Looking forward, our basket of near-term indicators for the home products market remains pointed to strong underlying demand, some constraints in skilled labor, significant levels of single-family new construction activity, and continued market momentum as we head into 2017.

Now let me provide some perspective on our business performance. For the third quarter, our teams delivered strong performance across all operating segments. Sales increased 3%, and total Company operating margin increased to 14.8%.

Starting with our cabinet segment, continue to follow disciplined strategy focused on profitable growth. Our consistent pace of product innovation, and our high levels of reliable service to our channel partners continue to drive performance. In the third quarter, our overall cabinet sales were flat to the prior year, and operating margins driven by increasingly efficient operations and an improving mix expanded to 12.4%. Excluding last year's third quarter load-in to support a major new vanity program launch and promotional timing, our total cabinet sales increased mid-single digits in the quarter. And the dealer channel sales grew low single digits overall, however, sales grew solid mid-single digits in all of our core semi custom product lines, and we continue to see mix improve.

And our luxury lines, which make up a little more than 25% of our dealer channel volume, sales were lower. Overall dealers are seeing strong growth from our new construction products. We're benefiting from deeper relationships with existing customers, and we're beginning to see some cross-sell benefits from our Norcraft acquisition. Sales for our in-stock cabinets and vanities which are sold through home centers were down, but grew high single digits when adjusted for the comparison to last year's load-in and promotional timing in the third quarter.

The sell-through of the new program of product upgrades that we launched last year are performing very well, and we're planning for the launch of additional new programs in 2017. Our cabinet team has been focused on partnering with our customers, to continue to deliver on consumer trends, and drive growth in our in-stock cabinet and vanity programs. The remaining 25% to 30% of our cabinets business, which includes home center special orders, semi custom, builder direct and targeted markets, and Canada, grew mid-single digits.

We're disciplined in our approach to these segments, as we focus on where we can partner with our customers to capture profitable growth. With our focused approach, we grew share in these segments, and drove strong margin improvement. We're especially pleased with our home center special order business, where our partnership approach is working well and driving growth at above market rates, with an improving mix.

In summary, I feel good about our industry-leading cabinet business. We continue to execute well and deliver strong results, even in a quarter where the market was not as strong as we planned. We're building share in the most attractive segments of the market. Our plants are increasingly more efficient, and our new product introductions and program wins are helping us drive a richer mix across a number of price points in the market.

For our plumbing segment, sales were up 7% for the quarter, with solid mix and strong operating margin. Excluding select channel inventory reductions and sales from the recent acquisitions, sales increased 6%, driven by strength in US wholesale, China and Canada. Across our markets, we continue to see consumers trade up, and our mix improve, as innovation and design, finish and function attracts consumers who trust our brand.

As we look at the remainder of the year, our growth should benefit from incremental marketing spend, a healthy new construction market, and more focus on recently launched products. Sales in Canada were up high single-digits to the prior year, where we are gaining share. Notably, we continue to see strong growth in the urban markets with our home center partners. China sales increased double-digits versus the prior year. Sales gains were broad across the China business, particular in our Moen-branded stores, where we continue to drive increased productivity.

Doors reported sales were up 4% for the quarter. Door products again saw sales growth in both wholesale and retail. [Therma-Tru continues to benefit from the rollout of a refreshed retail strategy that includes an enhanced product line, simpler, more intuitive displays, and better sales support for our customer associates. And in wholesale, we continue to benefit from strong new construction placements, and our enhanced distribution in the southern and western US.

In the security segment sales increased 6% from the prior year quarter, and were up approximately 8% excluding the negative impact of the planned exodus in less profitable SentrySafe product lines. The growth came from multiple channels and geographies, and we are beginning to see profit improvement from the integration of SentrySafe into Master Lock. We're also ramping up our Sentry sales efforts, as we continue to be excited about the opportunities we see between our Master Lock and Sentry businesses over the next few years.

So to recap the quarter, our teams are consistently leveraging our competitive advantages to deliver profitable growth. We executed well, in a US home products market that is continuing to expand, despite periodic labor constraints among installers and tradesmen, and we are gaining momentum in our security business, with the Sentry integration behind us.

Now let me turn to the newly-formed Global Plumbing Group, which is a key strategic step to enable accelerated organic and incremental long-term growth. The approach to the GPG is much like the evolution of our cabinets business into a platform that can support multiple brands, across multiple price points, sold into leading channel positions, supported by dedicated supply chains. The new GPG platform structure should allow us to accelerate growth, while leveraging our global supply chain and strong distribution. It paves the way for additional acquisitions, joint ventures, and supply agreements, and allows for seamless integration and continued growth.

While only an initial step, we recently made our first two acquisitions as part of this new platform. Riobel is a premium Canadian showroom brand which brings strong innovation and best-in-class service. We also recently purchased ROHL, which includes both the ROHL and the Perrin & Rowe brands which bring a design-centric artisianal approach to luxury products.

Under the GPG, these additions now have even greater potential for profitable growth. The new Global Plumbing Group enhances the potential for future growth, as we look to grow our plumbing sales to $2.5 billion by 2020. We are excited about the opportunity to transform our business, enter new markets, develop new products, manage our channels and customers more holistically, and accelerate both organic and incremental growth.

Finally, before I turn the call over to Lee, we're proud that we just celebrated our five year anniversary as an independent company, and we're excited about our accomplishments over a relatively short period of time. Our teams have executed extremely well, and delivered outstanding results. But I'm even more excited about the foundation that we have built to drive organic and incremental growth over the next five years. Notably in our first five years, this team has nearly doubled our sales, and more than doubled our operating margin.

We've increased our EPS almost five-fold. We've deployed capital in value-creating ways, which include making five acquisitions for $1.4 billion, repurchasing over $900 million of our shares, and initiating and consistently increasing a dividend. And we've delivered exceptional returns for our shareholders. At the same time, we've evolved and positioned our businesses for future growth, by building on our structural competitive advantages and our leading market share positions, creating stronger operating capabilities and platforms, driving new products, new programs and new distribution, investing in capacity and productivity, and by strengthening our management team and aligning incentives to focus on driving shareholder value.

With favorable demographics, driven by housing demand from the longer-living baby boomers and increasingly the millennials, we see an elongated new construction cycle, and pent up R&R demand being realized. These demand drivers, coupled with the stronger business model we have created position us extremely well, not only for 2017, but for the next several years. Additionally, over the next three years, we continue to believe that we have the potential to deploy more than $2 billion, to drive incremental growth in shareholder value through strategic acquisitions, share repurchases and increasing our dividend.

To sum up, R&R demand was softer in the summer, but after accounting for inventory impacts and some market labor constraints, the core of our business continued to perform well, and we're maintaining share. So I'm quite comfortable with the top line performance, as we head into the balance of the year, as we're picking up sales in the better parts of the market which drive profitable growth. With respect to the bottom line, I am very pleased. Margins in the quarter were again strong, and we're pacing ahead of our planned long-term profit targets.

And lastly, I'm encouraged by what we've seen in terms of our orders over the last five weeks. It's a sign to me that fundamental demand is still healthy, even if there was some softness this summer. Now I'd like to turn the call over to Lee, who will review our third-quarter financial performance, and provide detail on our outlook for 2016.

Thanks, Chris. As Brian mentioned, to best reflect ongoing business performance, the majority of my comments will focus on income before charges and gains from continuing operations. Let me start with our third quarter results. Sales were $1.28 billion, up 3% from a year ago. However, simply adjusting for the major program launch and promo event in cabinets last year, Company sales would be up 5%.

Consolidated operating income for the quarter was $189 million, up 13% or $21 million compared to the same quarter last year. EPS were $0.80 for the quarter, versus $0.64 for the same quarter last year, increasing 25% or $0.16. Our earnings were strong, and ahead of expectations, driven by continued stronger operating performance, and a lower tax rate.

Now let me provide more color on the segment results. Our third-quarter cabinet sales reflect a combination of very challenging comps, and a softer R&R market. Sales were $602 million, approximately flat from the prior year, but increased mid-single digits excluding the major program launch and promotional event for in-stock vanities in the third-quarter of 2015. Dealer sales increased low single-digits from the prior year.

Core [semi-] custom sales at dealers increased mid-single digits, while luxury products were lower this quarter. Sales from in-stock cabinets and vanities decreased, due to the prior year product launch and promotional event. Excluding the prior year activity, which was $23 million of the total $38 million increase last year, in-stock cabinets and vanity sales increased around 7%.

Remaining sales for home center semi-custom, builder direct, and Canada increased 6%. Within those remaining sales, Canada declined, largely due to the areas impacted by the downturn in the energy industry. In spite of flat sales, our cabinet segment continued to increase its leading operating margin. Operating income for the cabinet segment increased $11 million or 17% over the prior year. Operating margin for the quarter increased 180 basis points to 12.4%. For the full year, we expect an operating margin of around 11%, compared to 9% in 2015.

Turning to plumbing, the GPG generated solid sales growth in the third quarter. Sales were $391 million, up $27 million or 7%. Excluding select channel inventory reductions and sales from acquisitions, sales increased 6%. Sales in Canada increased 8%, and in China sales increased 11%.

In spite of around $7 million in additional brand spending, the GPG maintained its leading operating margin. Operating income increased $3 million to $85 million, up 4% from the prior year quarter. Operating margin for the segment was 21.7%. For the full year 2016, operating margin is expected to be over 21%, including incremental brand spending of $6 million in the fourth quarter.

Door sales were $129 million, up $5 million or 4% from the prior year quarter. Operating income increased 34%, with an operating margin of 17.3%, which benefited by around 100 basis points due to expense timing. Full year operating margin for this segment is expected to be around 12.5%.

Security sales were $157 million in the third quarter, up 6% to the prior year. Segment operating income was $27 million, and the segment operating margin was 17%, which also benefited by nearly 100 basis points due to expense timing. For the full year 2016, operating margin is expected to be about 14%, with an expected fourth quarter margin of over 15%.

To sum up consolidated third quarter performance, sales increased 3%, and EPS were ahead of plan at $0.80. Our total company operating margin was 14.8%, up 130 basis points from the prior year, with an incremental margin of more than 50%. We are ahead of plan on our operating margin growth, and squarely on track to reach our goal of approaching 15% operating margin, when the housing market returns to steady-state levels.

Before turning to the balance sheet, let me comment on the impact of lower tax rate. Our effective tax rate in the quarter is down from the prior year, due to the previous adoption of the new accounting standard that requires companies to reflect the excess tax benefit from stock-based compensation transactions in their tax rate and EPS. While our previous guidance assumes some benefit in both the third and fourth quarters, our current guidance assumes all benefit was realized in the third quarter.

Let me now turn to the balance sheet. Our September 30 balance sheet remains solid, with cash of $279 million, debt of $1.59 billion, and our net debt to EBITDA leverage declined to 1.7 times. By year end, we expect leverage to decline another 10 to 20 basis points, excluding any additional capital transactions.

Turning last to the details of our outlook for 2016. Our market and sales assumption for 2016 now call for US home products market growth of 6%, down from 6% to 7%, due to softer summer repair and remodel activity that Chris discussed earlier. Accordingly, we now assume total global market growth of 5%, down from our 5% to 6% expectation earlier in the year.

Based on that market assumption, we now expect our full year 2016 sales to increase 9% to 10%, compared to 2015. We have narrowed the range on our outlook for 2016 EPS to $2.72 to $2.76. The midpoint of our full year EPS outlook remains unchanged at $2.74, based on our continuing strong operating margin performance and the lower annual tax rate. The midpoint reflects a 32% increase over prior year EPS of $2.07.

The guidance reflects a fourth quarter EPS range which is unchanged, of $0.67 to $0.71 to achieve the annual EPS outlook of $2.72 to $2.76. Note that our year-to-date EPS through the third quarter are $2.05, which includes the benefit of a lower tax rate due to the adoption of the new accounting standard. Although we adopted this new standard in this year's second quarter, our year-to-date EPS of $2.05 also reflects the benefit of $0.04 attributable to the first quarter. This first quarter benefit will begin to be reflected in quarterly comparisons in 2017.

We expect 2016 free cash flow to be around $400 million, with our conversion rate of over 90%. The annual EPS outlook includes the following assumptions: interest expense of around $50 million, a full-year tax rate of approximately 29.5% with no benefit in the fourth quarter from the previously mentioned new accounting standard, average fully diluted shares of approximately 158 million.

In summary, we're pleased with our performance so far this year, and are set up for a strong 2017. The R&R market growth was softer than expected in the third quarter, but recent trends and long-term fundamentals continued to point to solid demand and an elongated cycle. Our disciplined focus on profitable growth is working well, as we are ahead of plan and on track to hit our long-term operating margin goal of 15%, as the housing market reaches its long-term average. We remain focused on using our balance sheet and cash flow to drive incremental shareholder value through acquisitions and share repurchases. I will now pass the call back to Brian.

Thanks, Lee. That concludes our prepared remarks on the third-quarter of 2016. We will now begin taking questions. Since there may be a number of you who would like to ask a question, I'll ask that you limit your initial questions to two, and then reenter the queue to ask additional questions. I will turn the call over to the operator to begin the question and answer session. Operator?

(Operator Instructions)

Bob Wetenhall, RBC Capital Markets.

Hey, good afternoon, and congratulations on the five-year milestone.

Thank you, Bob.

Chris, I think you referenced a soft patch in demand, and I think Lee provided some context about Canada being weak in cabinets specifically. I was hoping you could spend a little bit more time talking about kind of the length of the soft patch, and the duration of it? And it sounds like, it was a transitory phenomena, and you've seen demand pick up. So I was just trying to tie that in, as we move towards year end, what's giving you the confidence in the new guidance range, based on the trends you've seen since the end of the quarter?

Sure. We entered the third quarter, July is always a quiet month. And so, it was quiet, but in the past we've had quiet Julys, and things have picked up in August and September. This year, as we kind of moved through August, it continued to be pretty flat. I'd say there was activity in pockets, but there were other places where it was kind of quiet. Finally, as we kind of got into second, third week of September, things started picking up.

So in many ways, the order patterns picked up, and it was kind of too late to really drive third quarter. But since mid September and through October, we're right back on our plans for where we thought the market would be, really across all of our businesses. And so, you kind of look at it, and you say, from what might have been, kind of looking back, in mid-June through early part of September, we had a quiet R&R market.

New constructions during this whole period kept rolling through. As we look at the data, I think builders put a lot of attention into completing houses that were under construction. We come in, in the later stages of those homes. So to the extent we're delivering product into those homes, cabinet business, direct-to-builder, faucet business going in, doors business going in, that kept at a good pace. It was just this R&R market was quiet.

And I'll give you a little color, just in the channel feedback that we got, even for those who were out looking, they were getting feedback that this starter project now, there really wasn't the installation labor, carpenters, plumbers, available, until later in the fall. And so, I don't know how much that end up having to do with underlying activity. I'm sure some of it was the more basic drivers, consumer confidence, et cetera. But there was this feedback loop inside of our distribution, that was kind of telling folks that the activity, that most of the contractors were booked up from the strong spring, and so installers weren't really available. That's freed up a bit.

I'd still say there is still some labor constraints out in the market, but it's freed up a bit. And so, I think that that's passing through in some of the order activity that we see. I'd say that pretty consistent activity now, through late September, October across all of the businesses. So that gives us the confidence to say, we're going to come in, where we thought we would in the fourth quarter.

I've been calling this the Goldilocks year. First quarter, a little bit hot, little bit too hot. Second quarter was kind of just right. Third quarter was a little bit cool, and looks like fourth quarter is going to be like second quarter, which is basically back on plan.

So altogether a good year. It's just kind of cycling up and down; not unusual. This is my eighth year running this business, our fifth year of being public. And this whole recovery has had these kind of surges, flat spots, dips, and then kind of back up.

So as a Company, we're used to this. We staff accordingly. We kind of take the rolling view of it all. And so, that gives us a pretty good confidence coming into the end of the year, and frankly, setting up 2017.

That makes a lot of sense, and it's very encouraging, looking into 2017. Just to Lee's comments about generating $400 million in free cash flow with the clean balance sheet, how do you make the decision internally between share buy-backs and M&A? And what are you seeing on the M&A front in the current market place?

Are you going on offense? What kind of opportunities are out there for GPG? Thanks and good luck.

Thanks. Yes, we remain focused on acquisitions. We are active, and looking at a number of things. Obviously, we completed a couple of acquisitions on the luxury side of the plumbing market, and we're excited about that fitting into the GPG. We continue to be busy looking at a number of other things in plumbing, some things in security, and then our other segments, and even looking at additional segments.

To the extent, that market is soft overall, we've shown that we've been opportunistic in buying back shares. Summer of 2014, some weakness, and so we took advantage of that: bought back $440 million of shares. This year, late January, February, some weakness in the market, we bought back $350 million or so shares.

So to the extent, there's soft spots, we'll take advantage of that. But I still see some good opportunities in acquisitions, so that'll -- we'll balance those two between. We've said from the start, for the last five years, that we're going to be efficient with our cash flow.

We're not stockpiling cash. We're trying to be efficient for our shareholders to create value. And so, that is kind of our mindset as we lean into this whole thing.

Dennis McGill, Zelman & Associates.

Thank you, guys. Chris, just to push a little further on this, because it is pretty relevant to help people, who are thinking about the cycle, and I think you put some good context about it. But if I back out the acquisition benefit, it looks like the guidance in the fourth quarter is basically sales growth of call it, 4% to 7% versus 3% in the third quarter.

So can we interpret your comments to say that the quarter to date is essentially in the midpoint of that 4% to 7% range?

Yes, that's good math. (laughter)

Okay, perfect. And then, the other thing that's kind of out there, and just I don't think you touched on it, but sorry if I missed it, but promotions that retail on the cabinet side, what are you seeing, and how are you guys behaving both at the home center channel and the dealer channel?

Yes, so we've been more disciplined than the other larger guys who are in the retail channel. It's a smaller part of our business. It's only 14% of our cabinet business. And so, we have been measured. I think we're third most aggressive of the three. So we have seen elevated promotions, but we kind of picked our spots.

I'd say that we were careful, because we've got such a big dealer business, our in-stock business in vanities and in-stock kitchens, those aren't promotional driven. So we don't really have to use promotions to drive volume. Maybe some others are more reliant upon it. And to the extent that you're more active on the promotion side, it's going to deteriorate margins. So that's how we balance that.

We're targeted, but as you can see from our margin improvements, we're not going that far into it, because we're driving that margin improvement across cabinets. And we're getting good utilization across our business from another dealer and coming out of in-stock, so. And direct-to-builder, where that business we've obviously readjusted that over time here, but that's really attractive business.

So the context for it is, we're participating, but we're participating to a lesser extent. I guess, if the other guys want to go knock themselves out, they can. And for us, there is some business there that we like, and that we're partnering with the home centers around, but we have a certain point that we're not comfortable going past.

And then, on the dealer side, are you seeing elevated promotions versus the year ago there?

Much less so. That tends to be more targeted. I mean, really it gets down to almost the individual dealer, and going after a single project. So it's not programmatic, as much as in the home centers, you kind of go net nationally. You have to. But within the dealer market, you can go very local, and to the extent, you see some attractive business, chase it. So no, that's not the same environment that we would see in the home center side.

Okay. Appreciate it, Chris. Thanks, guys.

John Lovallo, Bank of America.

Hey, guys, thanks for taking the call. First question is last quarter you had outlined your expectation for relatively benign commodity costs year-over-year in the second half of 2016. Any update on how you're thinking about the fourth quarter, and perhaps into 2017?

Yes, it's happening much as we outlined on the first call. We had said the first half would be more of a benefit, when you net commodity deflation or inflation against FX. So in the third quarter, we probably net, picked up about a penny from commodity less FX impact. And in the fourth quarter, probably a penny or less. So much less of an impact in the second half, a little more impact in the first half.

2017, if you look at commodities right now, it, they have not started to spike up. There are certain pockets, steel is a little higher. Glass has actually been higher all year. Wood has been kind of break-even right now, at this point. So not sure of the pace right now. Don't anticipate huge spikes right now, but we would assume it would move up, commodities, inflation would move up during the year.

Okay. That's helpful. And in terms of the $2.5 billion plumbing target for 2020, we're curious, are you thinking that -- are you targeting getting there organically, or is there any way to dimension what percentage of that, you'd think would be attributable to acquisitions? And would the acquisitions, to the best of your view right now, include getting into other parts of the value chain, or other products in plumbing?

Yes, it's a combination, and it really strikes to the core why we formed the Global Plumbing Group is, we think it's a combination of both organic and acquisitions. And there's a little loop in there, where acquisitions feed into faster organic growth.

So our real strategy within plumbing is to become multi-branded, multi-product, a wider spectrum of price points. We've got really strong channel strength in our geographies across North America and China, and we can put more through those channels, more brands, more volume. And we're looking at other geographies.

So I'd say, in terms of dimensioning it, you could say half of it through acquisition, half of it through organic. But that's -- I'd say that's rough estimate. Certainly, it's not anticipated to be all organic. And there could be even more upside, if we're more aggressive on the acquisition side.

So it's all -- in terms of putting that number out there, we're just trying to create an understanding of how we're looking at it. And frankly, how significant it could be, just based on some of the things we're looking at, and the power we see of bringing more through the channel strength that we've got, and leveraging the brands that we've got.

Moen is obviously a huge brand. We think we can do more with it. We acquired some additional brands, we think we're going to acquire some other brands. And so, it's just to create the expectation. And internally, it's the way we're talking about what the opportunity could be.

Thanks a lot, guys.

Tim Wojs, Baird.

Yes, hey guys. Good afternoon, nice job on the margins.

Thank you.

In the cabinets business, I think that at least relative to our expectations, that the margins there have been a lot better this year, versus maybe what we thought initially. Could you talk about -- I mean, is -- just as we kind of think forward, I mean, is there -- how do you feel about just capacity, and the ability to kind of continue to expand margins, to that kind of the 25% to 30% incremental margin clip that you've talked about historically?

Yes, it's -- thank you for that, and the credit goes to our team. We have an outstanding operational team in our cabinets business. It is an incredibly complicated business. You think of our spectrum of product we're making from in-stock vanities through semi custom, up to our more custom business, and these guys are really on the ball.

So if I break it down, we've got better operating efficiency going through the plants. We still have capacity. We made our big capacity investments a couple of years ago. They're just getting better at running it, and we frankly, got more volume coming through. So that's part of it.

Part of it is, we are getting synergy benefit from Norcraft. You're seeing that come through. They've been aggressive in driving that, and improving the operations of the acquired Norcraft businesses. And then, some of it is just mix.

As we've said, we've targeted profitable growth in the market. We're not chasing every dollar of sales out there. And within the relationships that we've got, we're driving a stronger mix. And that's coming through finishes, that's coming through more complicated projects.

And we spent a lot of time out in the field with the designers, helping them really design the product into the -- what the consumer is looking for, and that yields a higher mix for us. So you take all those three things together, and that team has really been driving things together to improve that margin.

We're headed toward mid-teens. That's what we've said that business is capable of doing, and we're well on track with that, and the team is focused on it. And you'll continue to see improvement in 2017, 2018, as we're moving up to that.

Okay. No, that's great. That is real helpful. I appreciate that.

And then, just thinking about mix. I mean, has there been -- mix has been pretty strong over the last couple of years. Is there -- have you seen any change in how the kind of breakdown of mix within your different businesses has, has it changed at all, or has it been pretty steady?

It keeps improving. I'd say it's -- I would call it back to the consumer. I think the consumer is really driving a lot of this. She's going for more painted looks, opaques, more complicated designs. And so, as we're fulfilling that need, it drives the mix up.

I'd say it's that fundamental, as long as we're on point, with bringing out the products that she wants, then these -- we're going continue to see that mix drive through. And it's within price tier. So if you go to vanities, the mix is improving in vanities, so in-stock vanities. Which you'd say, oh that's not a huge price point. Well, within that price point, the mix is improving up.

In-stock kitchens, the mix is improving up. Value semi custom, stronger mix in there. In our core semi custom lines, stronger mix in there. So it's kind of throughout the price points and parts of the business. I think we're just trying to understand what the consumer is looking for, and if we can bring that into the market, work with the designers, to say here's what we've got. This is what your customer is looking for, and you can execute on that.

You can continue to drive that mix. And that's -- it's getting into a bit of the detail, but that's really what's going on inside of the channels, and what's driving our mix improvement.

That's great. I appreciate the color, and good luck through the rest of the year here.

Thank you.

Philip Ng, Jefferies.

Quite strong from a top line perspective, the last few quarters. What's driving the strength, and is this a business you're looking to put more capital to work?

You cut out in the first part of the question. If you could restate the question?

Sure. The security business has been pretty strong from a top line perspective, the last few quarters. What's driving the strength, is this a business you're looking to put more capital to work?

Yes, they've been growing, the last couple of quarters, they had a particularly good quarter across the board. So they were strong in retail, had a very good back-to-school season, so within padlock, and that's our big season for the year, they were good there.

Strong commercial performance, kind of across the line, strong safe performance, we integrated the safe operation into both our Milwaukee operation, as well as down in Nogales, Mexico. We completed that over the summer. So it's kind of freed up some management capacity.

So, yes, good consistent growth there, and we are looking at other opportunities to bring other products in. We've got very strong distribution on the retail and commercial side. We think our brands are strong, both the Master Lock and Sentry brands. And so, it's an area of focus, we're working through that.

Frankly, I didn't want to -- we had to get the SentrySafe integration done operationally before -- I think we wanted to move too aggressively into other acquisitions, that then had to be integrated. But we got through that milestone this summer. So I think we freed up some management capacity, and we'd be excited to bring some more product in there. And so, when we talk about our acquisition pipeline, that's very much a part of that pipeline.

Okay. Sounds great. On margins, I mean, margins were strong across all your segments, but doors as well. That was pretty strong. What new initiatives are you putting in place to drive that improvement, and is that type of margin sustainable? Thanks.

I'd say that, in the third quarter, the margin was 17%. We probably have 100 basis points on that, which was just some timing of expenses, which gets you down to 16%. I think the thing you're seeing in that margin growth, and it's been that way throughout the year, is these structural advantages we have, with the strength in wholesale that we established two to three years ago, especially on the West Coast. You also see the, in the last 18 months a real thrust towards the retail, in driving the retail side of the business, and that's driving those margins up.

We get a good leverage in that business. It's a lot like cabinets. It's -- you can really leverage those manufacturing assets well. That's what's happening. We would expect it to continue.

When you think about, they finished the year last year with about a 10% operating margin, we think they'll be 12.5% this year, very much like cabinets, heading back to mid-teens margins at steady state. So them and cabinets very similar in their margin growth, and the same kind of potential to get there.

Nick Coppola, Thompson Research Group.

Hi, good afternoon. I wanted to kind of similarly ask a macro question, but more specifically to your business in Canada. I think I heard that cabinets were down, but plumbing was up, which I thought was interesting. So would there be any more color around what you're seeing in Canada?

Yes, so it's -- that's a good question. Our plumbing business is pretty well spread across the country. We've got real strength in the urban markets in Toronto, out in Vancouver, and so, you're seeing continued strong activity in those markets. And we're picking up share to begin in those markets. So our plumbing business performed quite well.

On the cabinet business, we have real strength across the plains. We're in the urban markets. We also have strength across the plains, and they're down. Calgary, the oil industry has been hit, and so you're seeing some weakness there. So that hit our cabinet business more so, and I think they'll continue to track to the market. We're certainly performing well, relative to market, but to the extent that, that impacts overall Canada, our cabinet business will be hit by that.

Okay. That's helpful.

And then, hopping back over to security here, more particularly on the margin performance, I think you called out 100 basis points of benefit from expense timing. But even excluding that, margin performance was quite strong there. And so, just want to see if you can help us think about the impact of the integration there, whether that is kind of running at full force at this point now? And then if there were any other mix kind of considerations, or the like?

So, yes, it is running well. The integration is -- start to see the benefits of it, and Lee will give you some of the detail. But we're really excited about the fact that that's behind us, and now you're starting to see it flow through the numbers.

So you're getting sales leverage, clearly on the 6% sales growth. Chris talked about product mix improvement. I think that's a big part of it. All those duplicate costs over -- from the last two quarters, when we were integrating the SentrySafe into our Nogales, those are pretty much gone now.

So I think you're now seeing that leverage. A year ago, we said we were going to integrate the manufacturing, we set a target of a 15% operating margin in the fourth quarter of 2016. We said that will be the test, that we've done a good job, and we've got that integration done. And so, we're at the point now, where we can say we'll have 15% in the fourth quarter. We'll have a 14% for the full year as the margins build throughout the year. But we'll exit at 15%, and that is a good starting point for next year.

Got you. Thanks for taking my questions.

Mike Bruno, JPMorgan.

Hi, thanks. It's -- thanks for taking my questions, it's Mike Rehart.

Hi, Mike.

Hi, how are you, guys?

Good.

First question, just on -- kind of revisiting the demand slow down, and obviously great to see the pick back up since mid-September. In terms of the slow down, I think you alluded to the fact that it hit across most of your product categories.

But were there certain end market, or channel segments that you felt it more than others? I think you kind of referred to, maybe some inventory adjustments, but and as well as across any particular price point, as you mentioned that the luxury line in our cabinets was down a little bit?

Yes, so I'd say it was soft in general. So I would say that was kind of consistent across. Having said that, I think northeast was a little softer, South Florida was a little bit softer.

Our luxury lines had run pretty hard, the past two or three years in the cabinets, in those markets, northeast, south Florida, so those were a little softer. I'd say, we kind of felt it, really across all of the businesses.

I don't know that I can -- beyond that, I don't know that it was that much different. And then, you kind of saw it accelerate, similarly kind of across the business. So it's hard to pinpoint it any more than that. It felt like a general market.

It, there's a -- I don't know how to attribute it to -- underlying consumer demand, which I think was part it, but also, it felt like the whole system was a little backed up. The ability for R&R activity to get started anew, when you've got a lot of project work coming in, and we're fulfilling a lot of the activity coming out of the spring, that the channels felt backed up. And I don't -- and again, I can't be precise to say, well, how much was related to consumer, how much was related to the channel backed up. But it felt like it was a combination of both those things, that's why I called them both out.

Right. No, that is helpful. I guess, just going back to mix for a moment as well. You kind of were very granular in saying that just, in effect, every product segment or product line, let's say within your cabinet business, in-stock, dealer, et cetera, et cetera, et cetera, mix was positive.

At the same time, you did point out that your luxury lines were down, which would have everything else equal, a negative impact on mix. So just trying to get a sense from the top down, if you just -- I don't know if you look at it this way, but average sales price per cabinet, was that still a net positive despite --

Yes, across the board, it was a net positive. So in saying that the luxury end of the market was a little softer, it's relative to last year. But inside of that segment, we're still driving mix. So it's kind of like saying, in proportion, as you say across all these price points if, at the very high end, is a smaller proportion, doesn't that hurt that mix? Well, within inside of those, you're continue to drive mix, which is continuing to drive margin.

It's really kind of fundamental. It's cabinets. It's also inside of faucets, it's inside of doors. When we talk about growing a little faster than the rest of the market by driving innovation, what we're really driving at is, bringing new product in that's going to drive that mix up. And then, working with the channels to allow them, or to help them sell that mix through.

And that -- you can see it, as I kind of go through average ASP by price point in cabinets, it's coming through all those. If I look at the plumbing division, and look at Moen in our wholesale segment going into new construction, we're driving it from spec to first upgrade, first upgrade to second upgrade. We continue to see that move up.

In doors, we're getting better attachment rates on glass, decorative glass, side lights. And so, we're driving that, by bringing out new styles. So we're driving that mix up. And so, when I talk generally about mix, it's inside of those price points, and inside of those categories. That's where all of our innovation work is going to drive that up.

No, that's great. Thanks. And just one little quick one on the tax rate. Lee, fourth quarter, you expect it to go back to -- what was it 33% or so? And any thoughts around next year?

Yes, nothing on next year yet, we'll give you that, when we finish the annual plan. Yes, but about 33.5% in the fourth quarter. Just to kind of clarify, when we gave guidance the last quarter, the $2.74 midpoint, we'd assumed tax benefits in the second half of about $0.04 or so. And we kind of spread it by quarter, $0.02 in the fourth, and $0.02 in the third. What we saw this year, with just the way the price of our stock has worked, being strong in the early part of the third quarter, we picked up $0.04 to $0.05 in the quarter.

We'll pick up nothing, we think in the fourth quarter. So we got the same kind of tax benefit that we would have thought. We just got it in the third quarter, versus the fourth, so pretty much as we had expected.

Next year, we'll talk to you about -- our base rate is 33% or so, 33.5% so. But that's a starting point, but we'll have planning ideas for next year, and we'll give you a rate then.

Thank you.

[Garrett Schwa], Longbow Research.

Hi, thanks. I just want to dig in a little bit, just on channel inventories in plumbing. I think coming out of the second quarter, if I remember correctly, inventories were pretty lean. And it sounds like, and of course, you provide a lot of commentary about how the system just got backed up in the third quarter. But if you could provide a little bit more color, specifically what happened in plumbing? And also, just the cadence, as we look into the fourth quarter if selling this to match sell-through?

Yes, I'd say, if I were looking at the third quarter, inventories in the channel continued to be lean. I think, you can see on the retail side, we actually called out there was some further destocking. So in that channel, on the retail side, I'd say you're running leaner than POS. So at some point, we typically catch back up to that.

On the wholesale side, didn't really see any improvement, so you're still running at POS there. And so, to the extent that the channel is pretty lean, as you see some surge in demand, typically we have to ship back into that.

So on the one hand, it's healthy, on the other hand, it doesn't give us any help. It's a bit of a headwind in the existing quarter, but you know that's further demand that will come about, as the market calls for it. We've gotten good at servicing this business.

So to a certain extent, they're leaning on us, and that's fine. That's part of our service proposition, is we're just going to work hard to fulfill the orders when they come. But to the extent, they can run a little leaner on inventory, they may take advantage of that so. Lee, I don't know if you want to add anything else?

Yes, I think what we're seeing across the retail end wholesale customers in plumbing is, they're all working to be leaner on inventory, whether it is systems implementations, other approaches, methods, that they can use. We've seen that all year, and which is a good thing for them, and it's a good thing for us. It can be a little erratic quarter to quarter, but net-net, the demand we think is out there, and that's going to drive -- they'll drive the POS over time.

Okay, thanks. And then, just a quick one on China. It seemed like it bounced back this quarter after some choppiness in 2Q. Just wondering if you can provide a little bit more explanation as to what helped with the improvement?

Yes, China continues to perform well this year. I think they've seen their real estate market perform well. Beginning of the year, the government put in place some things, to try to help that market, and those things are working.

For us, we really saw it across the board. So importantly, our showroom business, kind of that traditional retail business, up strong double-digits. And that's a good sign, because that's both R&R, as well as going into new construction, so that was up strong. Direct-to-builder continues to be okay, but it's really kind of across the board, just healthy growth.

A lot of it, Tier 1, Tier 2. So and I'd say, looking back versus three years ago, where it was more spread across Tier 1, 2, 3, 4. A lot of the activity we're seeing now is more concentrated in those stronger, better developed markets. Which is again, good, because we typically see a better mix coming through there, better price points coming through those Tier 1, Tier 2 markets. So for us, China right now is a healthy market. We like that market.

This concludes today's question and answer session. I now turn the call back over to Mr. Brian Lantz.

Thank you, Suzanne. We like to thank everyone for attending our quarterly call today, and certainly look forward to speaking with all of you again very soon. Thank you again.

And this concludes today's conference call. You may now disconnect.