Toro Co (TTC) 2020 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Toro Company Third Quarter 2020 Earnings Conference Call. (Operator Instructions) Please be advised that today's conference is being recorded. (Operator Instructions) I would now like to hand the conference over to Nicholas Rhoads, Managing Director of Investor Relations. Please go ahead.

Thank you, and good morning. Our earnings release was issued this morning by Business Wire, and a copy can be found in the Investor Information section of our corporate website, thetorocompany.com.

On our call today are Rick Olson, Chairman and Chief Executive Officer; and Renee Peterson, Vice President, Treasurer and Chief Financial Officer. We begin with our customary forward-looking statement policy.

During this call, we will make forward-looking statements regarding our business and future financial and operating results. You are all aware of the inherent difficulties, risks and uncertainties in making predictive statements. Our earnings release as well as our SEC filings detail some of the important risk factors, including those related to COVID-19 that may cause our actual results to differ materially from those in our predictions. Please note that we do not have a duty to update our forward-looking statements.

In addition, during this call, we will reference certain non-GAAP financial measures. Reconciliations of historical non-GAAP financial measures to reported GAAP financial measures can be found in our earnings release or on our website. The company believes these measures may be useful in performing meaningful comparisons of past and present operating results to understand the performance of its ongoing operations and how management views the business. Such non-GAAP financial measures should not be considered superior to, as a substitute for or as an alternative to and should be considered in conjunction with the GAAP financial measures presented in our earnings release and this call.

With that, I will now turn the call over to Rick.

Thanks, Nick, and good morning. Our third quarter was a strong and dynamic one, given the circumstances. Since COVID-19 began to spread across the globe, the macroeconomic environment went from robust growth to recession almost overnight.

Now we are seeing more positive economic and market trends, but the rates of the recovery and the status of the virus remain highly variable. In short, the environment in which we conduct business remains uncertain.

For the third quarter, we were pleased to have achieved top line growth on the strength of our residential segment as favorable weather, our new product lineup and stay-at-home trends drove robust demand in the mass and dealer channels. Incremental sales from our successful Venture Products acquisition also contributed to third quarter growth.

I am deeply grateful for the extraordinary efforts and the commitment of our team during these challenging times. The health and safety of our people remains our top priority as we support and deliver value to our customers. Our talented global team of more than 9,000 remain resilient and solution-oriented. Among other things, we modified production lines and workflow to accommodate social distancing and manufacturing; continued to work effectively while adhering to local safety guidelines; developed methods to move production and inventory to meet customer requirements; and managed the demands of home, child care and personal wellness. Our teams did all of this while delivering a solid quarter of financial results.

Turning to the demand environment during the quarter. In May, as the residential segment remained strong, we saw an improvement in our professional segment. And those trends continued throughout the quarter and into the month of August.

As customers gain more confidence, demand started to return. The market continues to be dynamic, given the variability of the economic recovery and the status of the virus around the world. We are fully prepared to respond to potential market changes. Our long-standing ability to adapt to different business environments was evident in the quarter, and our team is well positioned to continue to succeed even in challenging market conditions.

Looking at the results for the quarter. Our residential segment continued to excel with 38% year-over-year net sales growth and strong margins. The movement outdoors we've seen during the past several months contributed to record sales of zero-turn mowers, which doubled in the quarter. We also saw strong contributions from walk power mower sales.

Professional segment net sales for the quarter declined 8% year-over-year, which was better than expected. Sales included incremental revenue from the Venture Products acquisition. We're encouraged by improved demand for our professional segment products, particularly in the landscape contractor, rental, specialty construction and irrigation markets. We're seeing demand driven by greater business confidence and increased home investments. Improved retail demand within the quarter reduced field inventory, which is in good shape and lower than prior year, setting us up well for preseason shipments.

With robust performance in our residential segment and improved demand in our professional segment, we demonstrated the strength of our diverse portfolio of businesses and our ability to be agile while focusing on customer needs. This positions us to drive growth forward as our end markets normalize.

There are 2 additional highlights in the quarter that I would like to recognize. First, we launched our Sustainability Endures platform, which furthers and enhances our long-standing dedication to make a positive global impact, socially, environmentally and financially.

And second, we were named Innovative Partner of the Year by the Tractor Supply Company. This reflects our commitment to innovation as well as the effectiveness of our partnership to deliver great products during these difficult times.

The successes we experienced this quarter were due to the dedication of our team, our innovative product lineup, strong demand through mass and dealer channels and the contribution from our first full quarter of the Venture Products acquisition. We're enthusiastic about our future, given our balanced and flexible business model that allows us to adapt quickly to change, enduring values that focus on the success of customers, innovative new products aligned to customer trends, a strong financial position and the proven ability of our people to adapt and perform successfully in these dynamic times.

With that, I will turn the call over to Renee for a more detailed discussion of our financial results.

Thank you, Rick, and good morning, everyone. During the third quarter, we once again demonstrated the ability of our adaptable business model and resilient culture to manage near-term headwinds and position us for long-term growth.

We continue to capitalize on our strong balance sheet to invest in growth while executing well operationally. We remain flexible in order to drive financial results while keeping our people safe and delivering on our brand promise to our customers.

In this environment, we grew third quarter net sales by 0.3% to $841 million. Reported and adjusted EPS was $0.82 for the quarter compared to reported EPS of $0.56 and adjusted EPS of $0.83 last year.

For the first 9 months, net sales increased 5.6% to $2.54 billion. Diluted EPS was $2.37 compared to $2.18 in the first 9 months of fiscal 2019. Year-to-date, adjusted diluted EPS was $2.38 compared to $2.52 a year ago.

Before I review segment results, I'll cover liquidity. At the end of the third quarter, our liquidity was $992 million. This included cash and cash equivalents of $394 million and availability under our revolving credit facility of $598 million. We have no significant debt maturities until April of 2022. We are in a strong position today and in an event of an extended period of macroeconomic uncertainty.

Now to the segment results. Residential segment net sales for the third quarter were up 38.3% to $205 million mainly driven by strong retail demand for zero-turn riding and walk power mowers and our expanded mass channel. Year-to-date fiscal 2020 net sales increased 20.4% compared to the same period of fiscal 2019.

Residential segment operating earnings for the quarter were up 76.7% to $28.5 million. This reflects a 300 basis point year-over-year increase to 13.9% when expressed as a percent of net sales. This improvement was largely driven by productivity and synergy initiatives and SG&A expense reduction and leverage on higher sales volume. This was partially offset by COVID-related manufacturing inefficiencies and unfavorable product mix.

Year-to-date, residential segment operating earnings increased 70.2% to $87.2 million. On a percent of sales basis, segment operating earnings increased 400 basis points to 13.8%.

For the third quarter, professional segment net sales decreased 7.9% to $623.6 million. This was due to reduced channel demand as a result of COVID-19-related impacts. This included fewer shipments of golf and grounds equipment; reduced sales of rental, specialty and underground construction equipment; and fewer shipments of landscape contractor zero-turn riding mowers. This was partially offset by incremental Venture Product sales. For the year-to-date period, professional segment sales increased 1.3% compared to the same period of fiscal 2019.

Professional segment operating earnings for the third quarter were up 39.3% to $113.7 million and when expressed as a percentage of net sales, increased 610 basis points to 18.2%. This increase was primarily due to lower nonrecurring acquisition-related expenses versus the prior year period, favorable net price realization and decreased commodity costs. This increase was partially offset by unfavorable product mix and COVID-related manufacturing inefficiencies.

Year-to-date, professional segment operating earnings increased 0.8% compared to the same period in the prior fiscal year. When expressed as a percentage of net sales, operating earnings remained constant, 17.2% year-over-year for both fiscal periods.

Moving to our operating results. We reported gross margin for the third quarter of 35%, an increase of 330 basis points over the prior year period. Excluding acquisition-related costs, adjusted gross margin decreased 70 basis points to 35.2%. The decrease in adjusted gross margin was primarily driven by COVID-19-related manufacturing inefficiencies, unfavorable mix due to the higher sales of residential products and an increased inventory reserve in one of our professional businesses. This was partially offset by favorable net price realization in the professional segment, and productivity and synergy initiatives.

For the first 9 months, reported gross margin was 35%, up 160 basis points compared with 33.4% in the prior year period. Adjusted gross margin was 35.2% compared with 35.3% in the first 9 months of fiscal 2019.

SG&A expense as a percent of sales decreased 170 basis points to 21.2% for the quarter primarily due to lower travel and meeting expenses, acquisition-related charges and employee salaries. For the first 9 months of fiscal 2020, SG&A expense as a percent of sales was 21.9%, up 20 basis points from the prior year period.

Operating earnings as a percent of net sales increased 500 basis points to 13.8% for the third quarter. Adjusted operating earnings as a percent of net sales increased 50 basis points to 13.9%.

For the first 9 months of fiscal 2020, operating earnings as a percent of net sales were 13.1% compared with 11.7% a year ago. Adjusted operating earnings as a percent of net sales for the first 9 months were 13.4% compared with 14.2% a year ago.

Interest expense decreased $700,000 for the third quarter compared to a year ago due to lower interest rates. Interest expense increased $4.7 million for the year-to-date period compared to a year ago. This was due to increased borrowings as a result of our professional segment acquisitions. For the full year, we continue to expect interest expense of about $33 million.

The effective tax rate was 19.8% for the third quarter, and the adjusted effective tax rate was 20.9%. For the first 9 months of fiscal 2020, the effective tax rate was 19.2%, and the adjusted effective tax rate was 20.6%. For the full year, we continue to expect an adjusted effective tax rate of about 20.5%.

Turning to the balance sheet and cash flow. Accounts receivable totaled $294.7 million, down 5.6% from a year ago. Inventory was up 5.7% to $656.2 million, and accounts payable decreased 11.8% to $268.7 million. Year-to-date, free cash flow was $259.3 million with a net income conversion of 100.7%. This positive performance was due to the increase in net earnings, favorable net working capital change and reduced capital expenditures.

Our disciplined capital allocation strategy includes investing in organic and M&A growth opportunities, maintaining an effective capital structure and returning cash to shareholders. Our sharp focus on near-term liquidity has reaffirmed our capital allocation priorities for the year. These include prioritizing debt repayment to maintain our leverage targets, curtailing share repurchases and considering strategically compelling acquisitions.

We increased our cash dividend for the third quarter of fiscal 2020 by 11.1% to $0.25 per share as compared to the prior year period. Based on our current outlook and strong financial position, we expect to maintain our dividend.

As Rick discussed, there remains uncertainty as a result of COVID-19-related factors. We withdrew our guidance in March, and we will not be providing specific full year guidance on this call. Similar to past practice, we will provide full year fiscal 2021 guidance on our fourth quarter call if we have sufficient visibility and confidence to do so.

However, based on current visibility and with an understanding of the uncertain nature of the economic environment, we would like to provide you with our current thinking about the fourth quarter. We anticipate continued year-over-year growth in the residential market. Professional markets should benefit from the gradual return to more normal buying patterns as customers' confidence in the economy increases. These positive trends will likely be somewhat offset by remaining COVID-19 headwinds such as budget constraints, the effect of social distancing restrictions and regional variations in economic recovery.

As you know, precision is difficult in this environment. But if these assumptions hold true, we anticipate that fiscal 2020 fourth quarter net sales will be higher than that of the prior year quarter, and adjusted EPS will be similar to that of the fiscal 2019 fourth quarter. We expect net other income to be lower in the fourth quarter of fiscal 2020 than in the prior year period as a result of a favorable pension and post-retirement plan benefit in fiscal 2019 that will not be repeated.

We continue to expect total net other income for fiscal 2020 to be about $13 million. We continue to expect depreciation and amortization for fiscal 2020 of about $95 million and capital expenditures of about $80 million.

We anticipate that fiscal 2020 free cash flow conversion rate to be similar to fiscal 2019. We plan to build inventory in the fourth quarter to mitigate any potential supply chain and manufacturing constraints due to social distancing restrictions.

In summary, we executed well in the third fiscal quarter in a challenging environment as our team demonstrated their resiliency, commitment and determination. We are in a strong financial position and continue to invest in technology and innovation to drive long-term growth. As a result, we are confident in our ability to navigate through any near-term challenges and capitalize on growth opportunities.

I will now turn the call back to Rick.

Thanks, Renee. We're optimistic about our future. Our diverse portfolio of businesses and strong customer relationships position us to drive growth as our end markets normalize.

Our productivity initiatives continue to enable operational improvements. And our focus on innovative products and our recent acquisitions are aligned with changing global market dynamics.

We had several new products introduced during the year that demonstrate our ability to innovate and satisfy our customers' evolving needs. For example, the new chainsaw and power shovel that are part of the Toro 60-volt lithium-ion Flex-Force platform, the e-Dingo compact utility loader, electric and hybrid greens mowers, the Ditch Witch JT-24 horizontal directional drill and SK-3000 Stand-On Skid Steer and Aqua-Traxx Azul drip tape.

Our recent acquisitions also continued to deliver, with both Charles Machine Works and Venture Products aligned with key market trends such as 5G and broadband build out, infrastructure improvements and product versatility for our professional and homeowners with acreage customers. We are encouraged by the continued strong residential demand and the improvement in our professional markets.

As we look forward, we'll be watching a number of macro trends such as the trajectory and duration of COVID-related impacts, including social distancing restrictions and global supply chain disruptions; global economic recovery factors driving general consumer and business confidence and commodity trends; and weather patterns for the fall and winter seasons.

More specifically, we're tracking certain key factors for individual markets as we end the year and look ahead to fiscal 2021. For the residential segment and certain professional segment businesses, continued customer interest in home investments driven by stay at home trends. For golf, continued strength in rounds played, coupled with improved food and beverage revenue. For grounds equipment, the health of municipal and other tax-supported budgets constrained by COVID-related factors. For landscape contractors, business confidence and favorable mowing conditions. For underground, 5G and broadband build-out, critical need infrastructure rehab and replacement and increased oil and gas projects. For rental and specialty construction, homeowner-related projects and the resumption of construction activity. And for snow and ice management, the timing of the winter season and continued demand within our new product categories.

In closing, we are enthusiastic about our future, given our new product pipeline and the proven ability of our people to drive growth and productivity in these dynamic times. I'd like to, again, recognize the dedication and resilience of our employees and channel partners and offer my sincere thanks to our customers and shareholders for your continued support.

With that, Renee and I will take your questions.

(Operator Instructions) Our first question comes from the line of Mike Shlisky with Colliers Securities.

So I want to start off maybe asking a question or 2 about Tractor Supply. Can you give us an update on your level of satisfaction on that new initiative this year? It sounds like they're certainly satisfied with you given the awards you've won. But I'm curious how things went according to your expectations now that we're past the spring and summer and whether you have any major additions or improvements for next year plan at this point.

It was a great first year with Tractor Supply. It was a little scary as we started the spring season given the lockdowns and so forth, but it turned out to be a fantastic year with Tractor Supply. And to your point, we're always with all of our partners exploring opportunities to further those partnerships and look for opportunities for both parties going forward.

I think the good news is residential, it's been a broad-based growth factor this year. So it's not only mass, it's not only a new channel partner, but we've seen growth in our dealer channel. We've seen significant growth in our long-standing mass partners as well. So it's been good across the board.

Tractor Supply has been fantastic. It's a great fit in so many ways and complementary to our other channels. And it's been very positive. So we feel great about it.

Great. I also wanted to ask about your dealerships in the professional world. Could you get a sense -- any of them were under any kind of financial strain during the quarter? And do you think that most of them are going to kind of make it through this COVID okay if they've gotten through it okay so far?

I didn't hear the first part of the question, which -- the dealers in what area?

I was curious if kind of broadly speaking across professional, whether you're seeing any dealers who have had some volume challenges, if they've faced any financial strain recently? And do you think most of them will get through it, given that some of the demand environment is improving so far?

Yes. Obviously, with the professional businesses being down, they certainly felt that. But they acted as businesses have, in any place, any part of our businesses, so they took actions early. Many of them were able to take advantage of the CARES Act to help bridge the gap.

And I think they're grateful to see the business customers coming back and coming back into buying cycles. So we did not see any kind of widespread overall business threatening kind of financial situations with that channel.

Okay. And perhaps lastly for me. It looks like one of the major engine suppliers out there is facing some financial difficulties and has filed for Chapter 11. Can you tell us if there's been any issues in your supply chain on engines? And whether your -- you might see any engines get changed or stopped going forward if this company changes its own product offerings?

Yes. Briggs & Stratton, assuming that's who you're referring to.

Yes.

Is and has been a good supplier to us. They are also a competitor, which historically makes that an interesting dynamic.

The sale process is continuing. I think there are some procedural pieces in place, but it's likely that it will go to the stocking horse at this point. And from our perspective, we are always adjusting our engine strategies, and we have multiple engine suppliers. And that's certainly a factor that we have seen coming for some time.

So because of the long lead times of engines, we have to have those strategies in place well in advance of the season. And we have our plan that we're already executing against for '21. So that's already set.

Our next question comes from the line of David MacGregor with Longbow Research.

Pretty solid quarter under the circumstances. So congratulations on that. I guess I'd just start off with Tractor Supply just because it's been discussed so far. Is there any way to kind of parse out sort of the growth in residential from Tractor Supply versus that core growth, that core underlying growth and give us some sense of proportion?

Yes. We wouldn't break it down real precisely, but we can talk about the internal factors that we were driving along with our partners -- the external factors. So I think we've talked about in previous quarters, we've really done a reboot in our residential business. So new fresh product line with lots of innovation that people are interested in, increased marketing, change in marketing and brand messaging, that's been very well received. And that cuts across all of our channels. They all benefit from that.

Obviously, adding a significant new mass partner has been a positive as well. But those are the drivers that we're driving, and we would expect those to continue on.

Even when you talk about channel fill, there certainly were elements of that, that wouldn't repeat, but we're also looking at ways that we can expand the partnership. And most channel -- most mass partners would not look to carry inventory anyway. So there should be continued opportunities, and all of our channels grew on the residential side.

On the external side, the couple of biggest factors would be it's been a very favorable growing season throughout. And interestingly, that was the case back in the [2008-2009] (corrected by the company after the call) Recession as well. So that helped to drive residential business when other parts of the business were challenged at that time. That continues to be the case here.

And then the one that has had a lot of press is the stay-at-home initiatives, which we know has driven interest in investing in your yards, your home, upgrading your equipment because you're spending more time there. That portion will obviously taper off as restrictions are lifted and people can do other things. But we believe we have strong underlying growth drivers that will help to continue to drive growth with residential. It's not going to be at the level that we're reporting this quarter, it will be back towards a more modest level, but certainly growth and many opportunities to continue to grow.

Right. Rick, if we could just build off that last point you were making, I guess one thing that most investors are struggling with, not just with Toro, but with pretty much all the companies that we're dealing with in this space, it's just the degree of pull-forward that may be occurring here. And clearly, there's some pull-forward. The question is just how much.

I'm guessing you guys maintain models to help you better understand that. Is there anything you can say to help us better understand kind of the extent of pull-forward demand that is just augmented growth here versus what would be perceived as maybe a more sustainable level of growth?

Yes. I think you've seen the catch-up happen in this quarter, and there will continue to be maybe a little bit of that. But we see the patterns returning back towards more normal buying cycle patterns even as we look forward into our fourth quarter here as we've gotten started with it.

So it was clearly a factor in this quarter that you can see, but that's not a dominant factor as we go forward. But it's more professional customers are returning to their normal buying patterns.

As we've said in the past, though, with turf-related products, those products are used as the grass is growing. So they continue to be consumed. And they do have to get back on their buying cycle, their normal buying cycle.

The good news is field inventory is in great shape. It's, as I reviewed that this morning, across the board, lower than last year. In fact, in some cases, we would like to see it be a little bit higher. And we're going to work to make sure we can get that in the right place here going forward. But it's a good setup as as we're in the fourth quarter and as we go into '21, we're in a great, great condition from an inventory standpoint and should be able to take advantage of the continued growth.

That's good to hear. But just one more question on that pull-forward is given the strength we're seeing right now, and you're talking about the expectation that we return back to a more normalized pace of growth, I guess the bigger question is the extent to which you perceive risk of us falling below that normalized growth and potentially into a negative growth period just because of the volume that's been pulled forward. How would you assess that risk to your business?

Yes. I would say most of the factor I was actually talking about was a catch-up. So these were purchases that were delayed -- especially on the business professional side. All the businesses responded in the same way. They pause, they watched their expenses, they held capital purchases. And then as they started to figure out what the trajectory looked like for economy, for the virus and their customers came back. Then they came back and bought those products that they probably would have bought earlier in the year.

If you're talking about the residential side with potential pull-forward, that's a very, very large base, and most of the sales are replacement. So it's driven by things like homeownership, new homeownership, other factors. Certainly, the weather is a very positive one. So if it's a good growing season, there's a percentage of people that are going to replace their equipment every year. And we see -- go ahead.

Do you think it -- I was just going to say, do you think in the residential business, it was catch-up as well as opposed to pull-forward?

Yes. It was catch-up. I think in your definition, there would be a little bit of pull up in there. But as we look forward, we continue to see growth based on our modeling. Yes. It's a very large base. So there's a lot of opportunity for people to replace their equipment.

Our next question comes from the line of Joe Mondillo with Sidoti & Company.

So in the press release and your prepared commentary, you mentioned a potential offset to some of the growth dynamics in 4Q being budget constraints. I'm just wondering what part of your business would be most affected to that? And are you actually starting to see effects of that? Or is that just something you're sort of cautious of?

There are probably several factors in there, but the one that we're probably specifically referring to was on the municipal side. So a portion of our business is tied to tax-supported entities. And I think it has yet to play out exactly what municipal budgets look like in the next budget cycle and to what extent maintaining parks and municipal golf courses becomes a priority.

I mean, you can make a case that it will continue to be a priority. We just don't know how it's going to play out.

And then other budget constraints. Golf, there's been tremendously positive news about golf. In fact, I think rounds played in July were up a record, almost 20%, 19-something percent. That's never been seen before.

But there's portions of the golf revenue streams that have not come back yet, which are food and beverage is not fully back yet and the events revenue is not back yet. So to the degree to which restrictions can be lifted and those activities can resume, the budgets will come back into a more healthy position. But they're still a little constrained at this point.

And then just the element of golf, it has to do with resorts. It's a relatively small portion of the overall market. But destination type of golf that's tied to travel, where you fly to a city that's oriented around resorts or golf, that continues to be constrained. So that puts a pressure on their budget. So those are the budget references, I think, we're referring to.

Okay. And just, I guess, broadly, looking at the 2 segments, you commented a little bit about channel inventories, but parsing with the both -- parsing through the 2 segments, would you describe inventories as below normal at this point?

They are -- field inventories are below last year at this point. And we actually would call that a success, given the pullback in a number of our businesses. So our operations team responded with making the right products at the right time and shifting production as necessary to where the opportunities go.

And there are a few areas where we would like to see a little bit more inventory as we go into the next season. That's especially true because our rate of output has been affected in some cases because of COVID-related restrictions that we've put in place. So we need to make sure that we've got inventory in place at the start of the season because we don't have the same level of output per plant, if you will.

So we've had to work some extra hours, add some shifts. And that just means there's a little bit more as we need to adjust the schedule going forward.

Yes. And in my prepared remarks, I mentioned that we would be building some inventory in fourth quarter to help to address those. So we want to make sure that we can mitigate any supply chain challenges that may occur as well as be ready for the season and be ready to deliver to meet our customers' needs.

Okay. And just to follow-up as far as field inventories, is that sort of below average? Is that across the board? Or I mean, certain areas, maybe like in golf, are you seeing flat to maybe a little above inventory? Or sort of broadly speaking, are you seeing just field inventory's pretty low?

It's broadly based across all of our businesses. And just to provide some insight into that, we sell our products through another party. They're all businesses that are looking to preserve liquidity and so forth. They've been more conservative about inventory, and we see that as we look at the overall numbers. But as they gain confidence and they see the opportunities going forward, just as our residential dealers did in the spring, they've got to have products. So they will come back into the buying cycle there as well.

All right. And then last question. Just as far as CapEx, just curious what you're investing in for CapEx? Anything interesting that's going to maybe help profitability going forward, anything that you could highlight?

Yes. I would say our CapEx is really a combination of investing in productivity and cost-reduction efforts. We're always looking for those opportunities. New products are another key area for us. And there's an element of maintenance capital as well. So we try to balance it across those 3.

And I think in particular, some of the new products are really exciting. And we'll see those come out in the next number of years.

I think especially if you go back to our technology priorities, a lot of our investments in new products is going very much on target with those priorities, alternative energy, smart connected products, longer-term robotics.

Our next question comes from the line of Tim Wojs with Robert W. Baird.

Nice job on the results.

Thank you.

Maybe just -- I guess, maybe on the supply chain. How do you feel just about your internal capabilities to make sure that there aren't any constraints on the component side? And did you have any supply chain challenges in the quarter? Or did the industry have any supply chain issues in the quarter that you're aware of?

We did not have significant disruptions during this entire period. Our ops team did an incredible job. So when I make that summary statement, it in no way describes the process that we've gone through, starting with the supply chain.

I was looking at my notes from the first quarter, and it was about our concerns about the supply chain as the virus developed elsewhere in the world. We have not had the significant stoppages from a shortage of supplies. Our plants have adapted incredibly well in a very short period of time to continue operation and continue to support our customers.

The effect is just, for example, if you have 100-foot assembly lines and 50 people on the assembly line, when we implement social distancing, they need to spread out. So it either means extend the line if you can or if you can't, then you need to reduce the number of people on the assembly line. And that just means that you then probably need an additional shift or additional production time to be able to accomplish the production.

So that's the kind of thing that our operations team has been working on and done extremely effectively. And we think that's helped us take share in a number of places, especially on the residential side as availability became a problem in the marketplace.

Okay. Okay. That's good to hear. And then it does sound, just based on the comments you've made, that pro should kind of get back to maybe more of a normalized growth kind of situation in the fourth quarter. I just -- I guess, I wanted to verify that. And I guess, which product end markets do you expect to contribute most to that?

We do expect pro to grow. I think we've talked about a couple of areas that are more constrained, the portion of our business, particularly with Charles Machine Works that are kind of tied to oil and gas, the rate at which some of those golf factors come back into play. So municipal budgets being related to that as well.

But on the driver side, the grounds business continues to be very positive for us, our landscape contractor business, the construction and underground business, the snow business continues to grow, professional and residential. And rental has been very positive.

If you go back to the underground business, the telecommunications is very strong right now, as we expected. The 5G major players have come back into their buying cycles. And they paused as well, but they can't really afford to pause too long because they're in a race to build out the 5G network.

And then just one other comment about telecommunications. Fiber for improved broadband, especially for home, has been a factor that's especially come into light and the whole concept of the digital divide of some parts of our population that don't have adequate broadband in order to do the things they're expected, to learn from home, work from home. So that's a good driver for our business and appropriate emphasis.

Okay. Okay. And then just on -- there are some tariffs kind of coming into the market on imported engines from China. And I just wanted to ask what the potential -- if there's a way to frame the potential impact of that to Toro and just your ability to offset that if you're looking into next year.

Yes. As you can imagine, that is something that we're watching very closely, along with 75 others in our marketplace because it really affects the entire market.

As we talked about earlier, by the nature of engines, they have a long lead time. So we have -- we're constantly working on our engine strategy and revising that based on the latest factors.

But the plan for '21 was established some time ago, and we're more in the execution phase of that. So we feel very solid about our plan for '21, and we don't see a material impact in '21 based on everything we know at this point.

The process itself is still early in the process. There are a lot of moving parts. And as I said, we work on our long-term strategies. So we've taken our best thinking of what's happening with various of our dozen or so engine suppliers and form up our best opportunity to provide the best value to our customers with those engines.

So obviously, very much watching what happens there. Historically, there's a lot of ups and downs in these cases, and they may turn out completely different in the end. So -- and oftentimes, more favorable than some of the extremes look as we go through the process.

Our next question comes from the line of Sam Darkatsh with Raymond James.

I just wanted, if I could, unpack that prior question a little bit more around the Chinese-sourced engines. I'm guessing -- I'm trying to figure out how much you imagine is going to get passed through to the consumer on the residential side next year, either with Toro product or industry-wide. Knowing that there tends to be some elasticity of demand, how much do you think is going to get pushed through? And how much do you think it's absorbed with channel partners?

Yes. I think as you understand, the pressures on the residential side from a price standpoint are significant because of those standard price points that are out there. What's interesting in this case is that it is an industry-wide issue. So if it turns out that there is a longer-term effect or some sort of bridge period until the supply chain adjusts, that's something, unfortunately, that's going to affect our customers. And it will just fundamentally change market pricing at some point. There will be no choice but to pass it through.

But as we've said, Sam, for '21, we've got our plan in place and we don't see a significant issue for '21 for us.

And remind us, in fiscal '20, what your exposure was to those Chinese-sourced engines that are now subjected to the tariffs?

I don't have a specific number in front of me. They would be certainly in our top several engine suppliers.

Limited to the residential one.

Yes, that's a good point. It's all limited to the residential segment.

Okay. And then if I could -- I'd ask a few directional questions around 2021. Obviously, everyone here respects that giving granular guidance is almost laughable based on how many variables are still an unknown.

But just trying to get a sense. First, the incremental margins. Normal incremental, you've talked about in the past, Rick, around 25% or so. I know that was implied with the vision 2020 look also. You got some good guys and bad guys. You would imagine the pro mix is going to be better next year than it was this year, although I'm guessing some of the discretionary spending is going to return to. Any sense as to why we wouldn't think that a "normal-ish" incremental margin might be in the cards for next year?

Yes, Sam, this is Renee if I may answer that question. I think we would say planning a normal-ish type of incremental margin would be reasonable.

To your point, we do recognize there'll be some cost actions that we took this year that will come back into the equation as we go into F '21. There's also some costs that we're incurring this year that, at some point in time, we think, will go away. Some of that, still impacts of social distancing and some of those inefficiencies that we talked about will also go away.

And keep in mind, we always focus on productivity and synergy to reduce our cost structure. So that remains the same. So I would think kind of a normal level would be reasonable.

And then my last question, same sort of topic around free cash flow conversion next year. I think you're talking about roughly a 90% conversion rate this year like last year as you build inventory. I'm guessing CapEx is going to be more normalized next year. Should -- how do we -- how do you imagine cash flow conversion looks like next year versus the 90% range you've had the last few years or so?

Yes. I would say we're building the inventory for a specific reason. At this point in time, it's to mitigate some of the concerns around supply chain, which, again, the team has done a great job doing today and then making sure that we're available to meet customer needs.

Assuming that social distancing impacts go away, we would then intend to normalize our inventory levels throughout the year. So we'd expect to be in a normal level or a little bit better.

So normal, better than the 90%, so maybe closer to 100% that you originally were targeting for this year sort of thing?

Absolutely. By normal, more historical.

Our next question comes from the line of Tom Mahoney with Cleveland Research.

I wanted to ask about the normal cadence around price increases. I guess they're specifically focused on the pro. As you look into the next 3 to 6 months and into fiscal '21, what are the things you'd evaluate as to whether you could move forward with those annual increases in the pro segment like you typically do?

Yes. We always talk about that we price to market. So the first thing we do is look at what's the value of the product offering that we have relative to the value that the customer sees. And we historically say that we get 1% to 2% of realized price, and we're looking to provide the value -- the package of values that would continue to command that. And we do that through innovation, which is desirable features on the residential side for homeowners, also on the business side to have products that have return on investments. So that if there is a price increase, it's coming out of another portion of their budget, whether it is fuel or labor or chemicals, those types of things that they can justify an increase in equipment.

Understood. And then in terms of the inventory build in the fourth quarter, any specifics around the -- which segments those -- that incremental build is focused on?

We would look at it more generally. Certainly, we don't expect to see the same type of growth, as Rick mentioned, in residential. But we know there's some probably variability in that marketplace, and we do expect professional continue through the recovery. So I think it would be overall, not specific to one particular segment.

We do have a follow-up question from the line of David MacGregor with Longbow Research.

I guess just to follow-up on Sam's question. Renee, you said eventually the social distancing cost and the impact on the business will go away. You talked for a couple of quarters now about COVID-19-related manufacturing inefficiencies. And I'm just interested in your thoughts. And just how much longer do they last?

And I'm not necessarily asking you how much longer COVID-19 is an issue, but we do seem to be on some kind of a recovery trajectory here. And assuming that, for the purpose of this question, that trajectory continues, how much longer? Is this something that dissipates and goes away by the sort of the first calendar quarter and second calendar quarter next year? Or how should we think about this?

Yes. With social distancing, I mean our plan is not to build more capacity, but really, reuse the capacity that we have in the best way possible. And that's why we're talking about building some inventory to be able to better manage those costs. So we look at that being as long as we have to have social distancing in place, there's going to be some impact to the way that our factories will be able to execute.

Keep in mind, we always focus on synergy and productivity, and no one is more focused on that than our operations team. So they're always looking at ways they can offset those costs. But we do expect, for whatever period of time that social distancing restrictions are in place, but we'll comply with those, and they'll still have some impact just on the way we run our plants.

We do think, at some point in time, I don't know when, I think we all wish we knew when, that will change and then that cost would go away. We would reconfigure the plants back to a way that we can operate a little more efficiently.

And in the meantime, these are just higher costs. They're kind of structural and you just need volume to leverage them? Is that the idea?

Yes, it is.

Okay. And the second question is just you talked in the pro segment about favorable price cost. You did well on the pricing, you talked about better costs. Is there any way to quantify that? And then how well does that sustain through 4Q? And just how far forward should be thinking -- should we be thinking about that favorable price cost?

Yes. I think that relationship would certainly hold, all things being equal, through the remainder of the year. As we look into next year, I think it goes to the pricing that Rick just talked about. We always price to market, not to cost, so we'll see. We have to remain competitive.

We do think from a cost standpoint, continue our focus on productivity. As the economy improves, there'll probably be some headwinds related to some material input costs. So we have to see as that unfolds. If we're able to hold that or some of the dynamics change, then it will be driven more by the macroeconomics than anything we're doing.

We do have a follow-up question from the line of Joe Mondillo with Sidoti & Company.

Just one follow-up question. At the residential segment, obviously, very strong demand this year, and you're probably benefiting, I would assume from some temporary cost reductions. Just wondering how sustainable you think the 13% to 14% margins are if we sort of return to a normalized environment?

Yes. We really do feel like residential delivered big time, and we feel good about their performance. As we look forward, we feel the factors that we can control, we'll do everything we can to manage new products, productivity.

The larger scale that we have now with a broader distribution, we think, allows for cost leverage. So all of that is certainly beneficial. As I just mentioned, I think some of the challenges we may face, well, time will tell. It's just if the overall market improves, there could be more pressure on commodities.

And you never know with weather. I mean depending on what kind of the weather year, it does influence, as we've said before, the residential segment more than the professional segment. So that would be certainly a factor that would impact margins.

This concludes today's question-and-answer session. I would now like to turn the call back to Nicholas Rhoads for closing remarks.

Great. Thanks for your questions and interest in The Toro Company. We look forward to talking again in December to discuss our fourth quarter and full year results. Thanks, everybody.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.