Fortune Brands Innovations, Inc. Q3 FY2021 Earnings Call

Good afternoon. My name is Holly, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Fortune Brands Third Quarter 2021 Earnings Conference Call. As a reminder, today's conference call is being recorded.

Good afternoon, everyone, and welcome to the Fortune Brands Home & Security Third Quarter 2021 Investor Call and Webcast. Hopefully, everyone has had a chance to review the earnings release issued earlier. The earnings release and the audio replay of the webcast can be found in the Investors section of our fbhs.com website. I want to remind everyone that the forward-looking statements made on the call today, either in our prepared remarks or in the associated question-and-answer session, are based on current expectations and 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. The company does not undertake any obligation to update or revise any forward-looking statements, except as required by law. Any references to operating profit or margin, earnings per share, or cash flow on today's call will focus on our results on a before charges and gains basis, unless otherwise specified. With me on the call today are Nick Fink, our Chief Executive Officer; and Pat Hallinan, our Chief Financial Officer. Following our prepared remarks, we have allowed time to address some questions. I will now turn the call over to Nick.

Thanks, Dave, and thank you to everyone for joining us on the call today. Our teams once again rose to the occasion to deliver an exceptional quarter, driving outperformance while facing tremendous supply chain headwinds, including challenges in labor, freight, and material availability. Demand for our products remains very strong, and we are working tirelessly to serve our customers while combating the global supply chain challenges facing most industries. The perseverance shown by our team members across our world-class brands has been nothing short of remarkable. Our third quarter results demonstrate that we can deliver even in the face of significant challenges. We remain firmly on track for a record year with exceptional growth and margin improvement to reach the long-term goals for Fortune Brands that were communicated earlier this year. For the third quarter, company sales increased 20% in total and 14% organically, with all segments driving strong growth. This past quarter marked an all-time record in quarterly sales as we neared $2 billion. Operating income increased 20%, and earnings per share increased 25%, incredible results especially given the current external environment. Demand for our products in the quarter was and remains robust, and we expect growth to persist as consumers continue to invest in housing. Our leading brands are well positioned to capitalize on these tailwinds, and our teams continue to drive share gains across the portfolio. Our mid-teens organic sales growth was complemented by LARSON, which is exceeding our expectations in terms of both performance and synergies. I am proud of our team's ability to integrate this asset and drive performance, notwithstanding the challenging supply chain environment. Headwinds from supply chain, particularly in labor availability and freight and materials inflation, increased both during the quarter and relative to previous expectations. We are addressing these challenges by leveraging our Fortune Brands Advantage capabilities and through incremental pricing. Across the company, we are diligently working to meet continued strong demand while keeping our customers served and employees safe. As global supply chains, labor, and inflationary pressures all remain dynamic, we've updated our 2021 financial guidance as highlighted in our earnings press release earlier today. Pat will provide additional details later in the call. Importantly, we remain on track to achieve exceptional growth and margin improvement in 2021, as well as towards our long-term targets communicated earlier this year. Notwithstanding these external challenges, we continue to increase investment to drive long-term growth and margin progression of the company. In the quarter, we furthered our strategic agenda and made more than $30 million of incremental investments behind our digital journey, brand innovation, and Fortune Brands' Advantage capabilities, while also delivering an operating margin on par with the prior year. These investments were made in addition to the incremental investments made throughout last year. For the full year, we expect to make operating margin progress of around 50 basis points versus a year ago while continuing to invest in our strategic priorities to drive long-term stakeholder value creation. Our strategies are delivering in this environment, and those incremental investments should only accelerate our performance when the current pace of challenges moderates. The company continues to generate high levels of free cash flow, and our balance sheet is strong. We're committed to efficient and effective capital deployment by investing in strategic capital projects, executing disciplined M&A transactions, and returning dollars to shareholders via dividends and share repurchases. Our leverage remains very healthy, and we have plenty of capacity to deploy additional capital for more value creation activity. We recently chose to accelerate capacity investments in Moen, the House of ROHL, Therma-Tru, and Fiberon brands and expect excellent returns from these initiatives. Additionally, we repurchased $114 million of shares in the third quarter, and our year-to-date share repurchase total currently stands at over $380 million. As the company celebrated its 10-year anniversary of its spin-off and public listing in early October, cumulative capital returned to shareholders through repurchases alone surpassed $2.5 billion. Importantly, throughout our 10 years, we have also worked to serve all of our stakeholders from developing sustainable, innovative products and processes, to our best-in-class safety records, to our commitments to advance diversity, equity, and inclusion; ESG has long been a part of our culture. This past quarter, we made some exciting advancements in our ESG journey and unveiled a new website with an enhanced focus on ESG. We continue to receive recognition for our best-in-class safety record, including multiple awards for the work we do, keeping our employees safe. In honor of our 10-year anniversary, we announced meaningful partnerships with two outstanding affordable housing organizations. I can't think of a better way to celebrate our milestone anniversary and to make this commitment to help make the dreams of home more attainable for many families in our communities. While there is more work to be done, I'm proud of what our team has accomplished. Turning to the remainder of our remarks today. First, I will discuss what we're seeing in the home products market. I will then highlight key takeaways from our third quarter and provide additional color on what drove the results. Finally, Pat will provide highlights on our financial results, balance sheet strength and liquidity as well as thoughts around our updated guidance to our financial outlook for the full year. Now turning to our view on the housing market. Long-term fundamentals for housing and home products remained very favorable. The significant deficit of homes available for sale and the structural underbuilding that contributes to the current housing situation has been elongated by increasing labor, supply chain, and material availability headwinds. While these challenges have made global headlines and will take time to normalize, it will take much longer, years, in fact, to work through the significant undersupply of up-to-date homes relative to demand. We saw some moderation in the pace of home sales versus Q3 of 2020. We view this moderation as a net positive, as it allows for a more sustainable long-term expansion of housing products while still driving strong demand. Notwithstanding the moderation, demand for our products continues to persist ahead of supply. We also experienced some rebalancing of demand across channels. Between the rebalancing and the strong but moderating home purchasing market, we believe the overall marketplace is on an even healthier footing for long-term sustainable growth than it was this time last year. Within both the new construction and repair and remodel markets, we continue to see consumers focusing investment on the home. Demand for larger ticket and pro-oriented projects remains elevated, which squarely aligns with much of our product portfolio. These product categories are sold mostly through trade, wholesale, and builder channels, and we experienced strong, sustained momentum since before the pandemic. With our excellent relationships and preferred positioning in those channels, coupled with market leadership for our premium brands, we expect this momentum to continue and demand for our products to remain robust. We also saw consumers continue to spend up the price spectrum into premium offerings. We have seen this multi-quarter trend in both plumbing and cabinets and are also seeing this trend play out within our premium offerings in decking and doors. This sign of continued consumer confidence to invest in the home reflects both the health of the consumer and household balance sheets as well as consumers' growing aspirations for what the home can become. Whether it be new construction or repair and remodel markets, we believe we are optimally positioned to capture accelerated share, leveraging the best home products portfolio in the U.S. and have leadership positions in all of our brands. Driven by an advantaged set of channel positions, significant growth capital to deploy, and supported by our world-class people, we could not be more excited about the future. With that market backdrop, some thoughts on the recent quarter. We had a stellar quarter even in the face of incremental supply chain headwinds. Demand was robust through the quarter and remains strong today across the whole portfolio. Our teams are working tirelessly to offset the numerous supply chain and labor constraints, and we're taking incremental actions to deliver both near-term results and long-term growth and margin objectives. Cumulatively, labor shortages and freight constraints were our most acute pressure points across the portfolio and are more challenging than even 90 days ago. We are responding with stronger measures in human capital attraction and retention strategies. At the same time, we're also leveraging our Fortune Brands Advantage capabilities to reduce complexity and minimize dependence on labor. We're also utilizing our scale and capabilities in global sourcing and logistics to optimize freight efficiency. We're further developing and deploying our Fortune Brands Advantage capabilities and are funding strategic investments in key growth priorities, including our digital journey, brand building, product innovation, as well as capacity and distribution expansion. These investments contribute to our resiliency and as conditions normalize, we expect to continue to increase sales and margin, allowing for stronger capital deployment and investment which will drive our perpetual outperformance engine for the long term. Now let me turn to our individual businesses and how we're positioning for long-term growth, starting with Plumbing. Our Global Plumbing Group once again significantly outperformed the global and U.S. markets this past quarter, taking share in every geographic region in which we operate. The business continues to fire on all cylinders with sales growth of 26% or 23% excluding FX. Our strong Plumbing sales drove operating leverage, resulting in a 22.6% operating margin for the quarter, notwithstanding increased investment in brand, innovation, and improved customer service. Our North American wholesale and e-commerce channels delivered strong double-digit growth, and we continue to grow in retail despite very elevated comps from the prior year. We are winning share and generating incremental investment dollars to pursue further above-market growth and margin. In North America, our Plumbing business has never been stronger. We continue to be an industry leader in both innovation and key metrics on brand awareness, purchase intent, and loyalty among customers. Moen continues to lead in innovation and design and push new on-trend styles and functionality, including the recently launched Nebia by Moen's Quattro product line. This cutting-edge shower gives consumers the power to customize their experience while incorporating the Nebia by Moen's proprietary water-saving technology, delivering on our water-saving initiatives and ESG strategy. As our business grows, we are also investing in incremental capacity across the supply chain, including a new distribution center opening this quarter. In China, Moen achieved strong double-digit growth as our investments behind the Moen brand, category expansion, and innovation continued to resonate with the Chinese consumer. Given our broad product offering, diverse channel exposure, and increasingly relevant consumer brand, we see continued growth in China despite headwinds from a slowing new construction market. As we've demonstrated in the past, our sales growth is driven by our innovation and category expansion efforts and is not tightly tied to the overall market. Additionally, we've built a resilient China business with a cost structure that could flex to preserve margin delivery. While we anticipate that there may be interim slowing of that marketplace, we are well equipped to outperform as we did during the last slowdown in 2017. Finally, the House of ROHL sales grew very strong double digits in all regions. Momentum in the luxury category has remained robust, and we expect demand to continue as consumers' willingness to invest and spend into larger ticket R&R remains significant. To keep up with this demand, we recently approved an investment to modernize and add capacity to our House of ROHL manufacturing facilities. Turning to Outdoors & Security. Sales increased by 30% and operating margin was 15.6%. Organically, sales increased 6% and were impacted by the very elevated comps due to the shift of sales from Q2 to Q3 last year in doors and decking as our channels reopened following COVID shutdowns. Material and labor availability headwinds increased through the third quarter and continue to impact operations across all brands, including material shortages caused by Hurricane Ida. Our teams are hard at work to offset these challenges, which have restrained us from achieving targeted output. Doors delivered mid-single-digit sales growth in the quarter, reflecting constraints in labor and materials and very elevated comps due to the shift of sales from Q2 to Q3 last year, as our channels reopened more fully after COVID shutdowns. Adjusting for the shift, sales increased mid-teens. Production interruptions to key component suppliers caused by Hurricane Ida affected supply in the quarter, though we worked diligently across our supply chain to resolve these challenges going forward. Underlying demand remains strong across channels, and we continue to work to service our customers at a high level. Turning to Decking. Fiberon sales grew mid-single digits off of a very strong quarter last year that also included the shift of sales from Q2 to Q3 due to channel reopening. Adjusting for 2020 shipment cadence, sales increased around 20%. Our strategy of leveraging our deep customer relationships to partner with leading distributors in each region continues to pay dividends as we remain in a sold-out position. We will be bringing incremental capacity online before year-end, and we expect fourth quarter sales growth to eclipse 25%. We continue to leverage Fortune Brands' Advantage capabilities and other internal synergies to increase output and streamline costs. Our eco-friendly composite decking continues to resonate with consumers and remains in high demand as we take additional share from traditional wood decking. As I mentioned earlier, integration of LARSON continues to progress well, and the business is performing above expectations. Our teams across outdoors and security are working together to advance integration while capturing planned synergies. Finally, within Security, we experienced continued success and momentum with high single-digit sales growth in the quarter as commercial, back-to-school, and travel markets continue to rebound. Our key North American retail market for both locks and safes continues at levels stronger than prior to the start of the pandemic. The business is delivering on the Fortune Brands' Advantage investments made over the last couple of years and is now generating incremental fuel for reinvestment. Now turning to Cabinets. Our Cabinet operations again delivered strong performance in the past quarter, with sales growing over 9% and operating margin of 9.7%. In an extremely tough environment, sales grew sequentially off of the strong Q2 and margins performed at industry-leading levels. Demand was equally strong on both stock and made-to-order, with the strongest momentum continuing in our premium offerings. While labor challenges, material and freight inflation increased further, all are manageable and we continue to take price and deploy continuous improvement initiatives to offset these headwinds. The Cabinets' margin performance in such a challenging and fast-evolving environment is a testament to how well our pivot plan and Fortune Brands Advantage capabilities are delivering. As the pace of challenges moderates and our pricing actions take further hold, the business will accelerate its progress towards its long-term margin objective. Labor shortages and freight availability remain the biggest challenges impacting performance in margins in our Cabinets business. Our teams are deploying lean methodologies and complexity reduction strategies to ease these supply chain and labor limitations. Significant order backlog exists across the business and will be worked through into 2022. We remain committed to our long-term margin goals for Cabinets, and the business simplification progress that we made this year within our facilities will prove beneficial as we continue to solve our labor challenges and price realization catches up during the fourth quarter and into early 2022. In summary, we continue to see very strong demand for our products and believe this housing cycle is being further elongated by current short-term acute headwinds. We're very focused on overcoming challenges and delivering in the short term. We have built this company and its strong culture to win for the long term. Our commitment to excellence, each other and our brands, leveraged by innovation, investment, and most importantly purpose, drives everything that we do. Our products positively impact people's lives every day, and we do not take that for granted. We are committed to growing stronger together and will do so sustainably. As we near the end of 2021 and look to 2022 and beyond, the actions that we are taking now and the investments that we are making and expect to make in the future should drive above-market growth and a stronger margin profile. We have a strong balance sheet and the ability to deploy a significant amount of capital over the next few years. We're excited about the housing market and for the future of our company. We will remain steadfast in our mandate to create value, regardless of the environment. With that, I will turn the call over to Pat, who will speak to our financial results and updated guidance. Pat?

Thanks, Nick. And as a reminder, the majority of my comments will focus on income before charges and gains in order to best reflect ongoing business performance. Additionally, all comparisons will be made against the same quarter last year unless otherwise noted. Let me start with our third quarter results. Sales were $1.99 billion, up 20%. Organic sales excluding the LARSON acquisition, were up 14%. Consolidated operating income for the quarter was $293 million, up 20% or $49 million, and total company operating margin was 14.8%, in line with the prior year period. EPS were $1.49 for the quarter, up 25%. These results reflect our team's tremendous performance in a highly disruptive environment, a testament to our culture of safety and outperformance across the organization. Now let me provide more color on our segment results, beginning with Plumbing. Sales for the third quarter were $741 million, up $151 million or 26% or up 23% adjusting for FX. Our Plumbing business continues to gain share and drive growth across all major brands, channels, and geographies. Plumbing operating income increased 36% to $168 million. Operating margin for the quarter was 22.6% despite significant investment during the quarter in our brands, strategic priorities, and to serve our customers. Turning to Outdoors & Security. Sales for the third quarter were $528 million, up $122 million or 30%, driven by the addition of LARSON and mid-single-digit organic growth. On an organic basis, sales were up 6% against an elevated comp from the shift of sales from the second quarter to the third quarter last year as our wholesale channels reopened following the COVID shutdowns these channels experienced. Door sales were up mid-single digits in the third quarter, driven by wholesale and would have been up mid-teens adjusting for the shift of sales from the second quarter to the third quarter in 2020. Reported results would have been even stronger within the quarter were it not for labor and material constraints, the latter the result of Hurricane Ida. Decking sales were up mid-single digits in the quarter as Fiberon continued to sell out. Sales were up around 20% adjusting for the shift in sales from Q2 to Q3 last year. We expect incremental capacity to come online in the fourth quarter and are also increasing throughput by deploying process improvement. We expect fourth quarter decking sales growth to exceed 25%. Security sales continue to trend nicely with high single-digit growth in the quarter, driven by returning strength in commercial, back-to-school, and travel markets. Outdoors & Security operating income was $82 million during the quarter, up 24%, driven by the addition of LARSON and operating improvements in decking and security. Segment operating margin decreased 80 basis points to 15.6%, primarily driven by inefficiencies caused by labor and material constraints in the quarter impacting doors and decking. Turning to Cabinets. Sales for the third quarter were $717 million, an increase of over 9% over the same quarter in 2020. We, again, saw strong demand across all price points during the quarter. Backlogs and lead times have extended during the quarter, and demand for contractor-led projects such as cabinets remains very healthy. Operating income in the third quarter was $69 million, down 13% or $11 million. Operating margin for the quarter was 9.7%, down 250 basis points versus the same period a year ago as price increase realization trailed inflation and labor and material availability resulted in inefficiencies. We expect this relationship to improve significantly during the fourth quarter. By the first quarter of 2022, we expect continuous improvement and pricing actions to offset inflation fully and our rate of margin enhancement in cabinets to reaccelerate to our targeted objective. We remain well positioned to win in North America versus domestic competitors and imports. We expect to win increasing share and achieve our long-term margin objectives. Before turning to the balance sheet and updated financial guidance, some thoughts on demand, supply, and the current environment. Demand continues to be strong across the portfolio. Increasing headwinds from labor, freight availability, and certain supply-constrained materials are being addressed. We are and expect to stay nimble as the situation warrants. We have made significant investments to serve continued strong demand and to increase service levels. We are also making further progress in the deployment of our Fortune Brands Advantage capabilities to leverage synergies across the portfolio in sourcing and other improvement initiatives. We are keenly focused on the current dynamic environment, contributing towards rising COGS and freight inflation. The decisive actions we are taking will allow us to offset fully these headwinds, maintain our long-term margin trajectory, and will put us in an advantaged position for 2022. Through a combination of continuous improvement and thoughtful pricing actions, we plan to offset all inflationary headwinds during the first quarter of 2022 and to continue to target around 75-plus basis points of margin improvement during 2022. Turning to the balance sheet. Our balance sheet remains strong, with cash of $461 million, net debt of $2.2 billion, and our net debt-to-EBITDA leverage is now 1.7x. We ended the third quarter with approximately $410 million of available capacity on our revolver. We are advantageously positioned to deploy capital to the highest returning opportunities. Year-to-date, we have repurchased over $380 million of shares and have repurchased over $2.5 billion in common stock in 10 years as a public company. Our investment-grade balance sheet and strong free cash flow provide fuel for continued investment into our businesses, propelling the flywheel of outperformance on the top line and accelerating common capability building and deployment across our portfolio to achieve higher margins. I would now like to address our updated market and financial outlook. Demand for our products remains strong in a sound housing market. However, increasing headwinds from labor shortages, supply chain challenges, and inflation have adjusted our expectations for the full year 2021, based on the expectation that the global market for our products will now grow 11% to 12%, with the U.S. housing market growing 12% to 13%. Within this forecast, we now expect U.S. new construction growth of 11% to 12% and U.S. R&R growth of 13% to 14%. Based on these assumptions, our revised 2021 full year sales growth outlook is expected to be 24.5% to 25.5% or 17.5% to 18.5% on an organic basis. We continue to target meaningful margin progress and expect to deliver around 50 basis points of margin improvement during 2021, despite inflation that is almost 3x what we expected at the beginning of this year. We are tracking to our longer-term margin objectives, demonstrating our ability to accelerate value creation regardless of the environment. We now expect full year EPS within the range of $5.63 to $5.73 on a before charges and gains basis, of which the implied midpoint equates to earnings growth of 36% over our record year in 2020. Specifically, our outlook for each business as it relates to our updating guidance includes Plumbing net sales growth of 24.5% to 25.5% with operating margins at or above 22.5%. Outdoors & Security net sales growth of 43% to 45% or 14% to 16%, excluding LARSON, with segment operating margins of 14.5% to 15% or approximately 100 basis points higher adjusting for purchase accounting. Cabinets net sales growth of 14% to 15%, with operating margins between 10% and 11%. We expect 2021 free cash flow of approximately $625 million to $675 million, which includes additional investments in working capital to improve service levels and capacity to accelerate growth. We anticipate a cash conversion rate of 80% to 85%. The revised full year EPS outlook includes the following assumptions: corporate expenses of about $108 million to $110 million; interest expense of approximately $83 million to $86 million; a tax rate of approximately 23% and average fully diluted shares of approximately 139 million to 140 million. While short-term market challenges persist, we have the talent and capabilities to manage and offset these headwinds, and we'll continue to adjust quickly to the dynamic environment as merited. We delivered a record year in a challenging 2020 and we'll deliver a record year again in 2021. We are doing the hard work and making the critical investments necessary to outperform the market and to achieve our margin objectives. You can count on us to capture value and effectively manage the business regardless of the speed bumps along the way. I will now pass the call back to Dave to conclude our prepared remarks.

Thanks, Pat. That concludes our prepared remarks on the third quarter. We will now begin taking a limited number of questions. I will now turn the call back over to the operator to begin the question-and-answer session.

Our first question will come from Stephen Kim with Evercore ISI.

Thank you for the updates and positive results. I was especially interested in your mention of a 75 basis points improvement in operating margin for fiscal '22, starting in the first quarter. Can you help clarify how you achieved that? Specifically, how much of that improvement is due to a better cost mix, and how much comes from increased volume and other factors?

Steve, it's Pat. Our reference to that was the full year objective. We remain on track for our longer-term objectives in what has been a challenging year and a particularly challenging back half. We wanted to be very clear on that. And we have, as a team, already been working on cost improvement and pricing actions to address some of the back half inflation. And when we looked to the first quarter of '21, we could see with the actions we have already put in place or are being put in place right now, and we expect very much to be in place in the early part of this quarter, that we're fully covering inflation in the first quarter with cost improvement and pricing actions in the first quarter. And I would say, as we look to not just '22 but beyond, I would tell you, we continue to drive that formula margin improvement pretty equally across 3 levers, whether that's innovation and brand building, structural cost change in addition to the marginal cost improvement we do with Fortune Brands' capabilities; we still have structural levers we plan to pull across a number of our businesses and also leverage from volume. It is not purely a leverage from volume formula nor is it purely a pricing formula.

Okay. Pat, just to clarify, though, the 75 basis points you were referring to was that just from price mix improvements? Or is that sort of including these other 3 levers as well?

Including those other 3 levers. And it's full year '21 to full year '22.

I'm sorry, to evolve of the longer-term margin journey, and so we sort of laid out this roadmap of Fortune Brands Advantage capability helping drive the combination of margin accretion and fuel for reinvestment, a lot of which we've deployed this year. We've significantly upped investment in our strategic priorities. And so it builds on 50 basis points of improvement this year, targeting 75 basis points of improvement next year and then staying on track, consistent with the long-term goals that we laid out earlier.

Yes. Thanks for that, Nick. It is impressive that you achieved what you did despite these investments, particularly in Plumbing. I was curious if you could provide some insights into which categories you see having the most sustained demand momentum. What are the fundamental drivers behind the relative outperformance you anticipate for some of these categories?

Sure. Let me break that down into two parts: where we're seeing it and what's driving that performance. Overall, the demand has been solid across all categories, price points, and channels. It's likely some of the most consistent demand we've observed, and it's still supported by long-term favorable trends we've mentioned before. Demographics continue to funnel people into housing, with baby boomers staying in their homes longer. The market is notably underbuilt, and we have an aging housing stock. Consequently, people are taking record amounts of home equity and reinvesting it, which remains true. During the quarter, it was particularly interesting due to significant comparisons from last year when channels began to reopen. We never saw the growth stop; it briefly moderated as we worked through those comparisons and then picked up again. This demand continues to hold sustainably across the board, indicating strong consumer confidence and the fundamental need for either new or updated housing. We are also seeing heightened demand for professional-oriented projects and premium offerings, which we've discussed previously. This reflects consumers' confidence in their homes. As for what is driving our sustained momentum, it's a combination of factors. We mentioned earlier the focus on reinvestment. We have outlined several strategic priorities, such as brand development, innovation, and the Fortune Brands Advantage. Year-to-date, we have invested around $80 million, which is significant and aimed at boosting the top line. The results in Plumbing have been remarkable, showing strong organic performance, and this has been building for some time. Additionally, we've faced challenges across the supply chain. Despite that, the fact that we continue to perform at these high levels and gain market share suggests we are likely outperforming in this area as well. When you combine our strong performance at this pricing level with our efforts in brand innovation and category management, the results you see now are a direct outcome of these strategies.

Our next question will come from the line of Michael Rehaut with JPMorgan.

First question, I wanted to gain a clearer understanding regarding pricing, costs, and timing. As you mentioned earlier, despite significant investment, your margins are strong, but you pointed out that there is an opportunity to better counteract inflation in the fourth quarter and into the first. I would like to clarify that when you said in Cabinets you would fully offset by the first quarter, does that imply flat? I'm not sure if that was your intention. Additionally, for the full year of '22, on a consolidated basis, would the 75 basis points result in something stronger in the upcoming quarters? I want to ensure I'm thinking about it correctly and whether that could create further momentum into '23.

Mike, it's Pat. I want to clarify that for our enterprise and Cabinets, we expect improvements that will more than offset earlier challenges. In the first quarter, we won't remain flat as we will be catching up, and we experienced some inflation this year that we will be recovering from. Year-over-year, we anticipate that cost improvements and pricing strategies will exceed the inflation we expect in the first quarter of next year. This trend is expected to hold true for the full year. However, this is not the only factor contributing to the 75 basis points of growth we project for next year. We will also implement additional cost improvements and structural initiatives, and we anticipate growth that exceeds mid-single digits. While I am not providing specific guidance for 2022, we will achieve some volume leverage. I don't expect a consistent 75 basis points of margin improvement each quarter; that’s not the message I want to convey. Instead, I estimate we will finish this year with approximately 50 basis points of margin improvement and then achieve about 75 basis points of margin improvement next year. You can anticipate a notable performance next year, with expected margins between 14% and 15% in the first half, likely leaning towards the higher end of that range. That summarizes my perspective.

And then absolutely, to your point about it carrying into 2023, we are making long-term structural improvements to the business consistently, and that is very much part of the strategy that we've laid out starting in '20 with the Fortune Brands Advantage. And so those things are sustaining and then continue to deliver for us. And really set up to accelerate because as they drive incremental margin, they also drive incremental dollars from the investment back into similar programs. So my sense is we're just getting going on some of those opportunities. We need to stay prioritized and focused in order to be able to deliver consistently, but it absolutely carries through and there's room for us to continue to accelerate.

Great. Secondly, I wanted to revisit some of your comments on positive mix. Clearly, it is encouraging and will likely drive both sales and margins when that happens, especially given some of the demand trends you continue to observe. I was wondering if you could provide a rough estimate of how much this might have benefitted you in the third quarter, whether from a sales or margin perspective. Additionally, which segments have shown this improvement? You mentioned several product areas, but I'm interested in knowing if certain segments or product categories have experienced it more than others.

Yes, Mike, there are a few points to address. We've consistently stated that driving attractive margins across various price points is a crucial part of our long-term growth strategy. We aim to keep our margin percentages consistent throughout our business. While premium products yield higher dollar margins, our plumbing business is performing well this year, expected to grow in the low 20 percent range, with significant contributions from the House of ROHL. We're also witnessing consistent growth in made-to-order cabinets, reflecting consumer confidence in their home's value and their willingness to invest. This investment extends to contractor products, influencing our overall margin progress. In the last quarter, plumbing, in particular, showed strong performance throughout the year and is expected to continue this trend into the fourth quarter. The robust performance of the plumbing segment positively impacted our quarterly margin profile. At the end of the second quarter, we predicted a decline of 30 to 60 basis points in the third quarter, but this was largely compensated by exceptional sales and margin performance in plumbing. This illustrates the strength of our plumbing services, including high-end premium brands. However, I don’t foresee our journey towards achieving a margin percentage of 16% to 17% by 2023 being solely reliant on a mix of premium brands. We're focused on product mix as a reflection of consumer confidence and their commitment to investing in their homes.

And I'll just add to that. I think you can take from that, that the portfolio is positioned at the heart of the market, right? As we talked the last couple of years how we've really positioned the portfolio very well to capture the entry of the homebuyers. Saw that first sort of wave of millennials coming in and had that there. And then over time, we've built out the House of ROHL. We've maintained our premium offerings in Cabinets. We've rolled out more as we move decking from entry price point up now to much more in a special order oriented products. Some of the stuff at LARSON and Outdoor & Security has launched as well, just positions the portfolio really well to meet the consumer where they are. As Pat said, we work very hard to make sure that the margins are exceptionally strong across all of those price points.

And our next question is going to come from the line of Mike Dahl with RBC Capital Markets.

I wanted to follow up about the cost dynamics as we look towards next year. It's clear that the environment is quite dynamic, and you've experienced challenges in the second half. So, when you discuss offsetting or exceeding inflation next year, what is your baseline assumption for additional inflation in 2022? Additionally, could you clarify how much the labor and freight issues impacted Cabinets in the third quarter and your guidance for the fourth quarter?

I'll address both of your questions at a broader level. Starting with this year, I want to clarify that we are not here to provide guidance for 2022, particularly not at the detailed level you’re inquiring about. What I mentioned earlier was related to the first part of 2022 and our expectations there, giving everyone a sense of our current run rate. Looking at fiscal 2021, we're likely seeing about 7% inflation based on last year's cost of goods sold, which approaches nearly $300 million, quite significant. Previously, during our last call, we estimated around 6%, indicating a noticeable increase since the second quarter. The figures I’m discussing pertain solely to materials, freight, and tariffs, excluding labor costs, which we mainly manage through continuous improvement efforts. A significant portion of the inflation in the latter half of the year can be attributed to freight costs, especially ground freight, compounded by the need to utilize spot rate containers and select metals, particularly aluminum, copper, and zinc. Additionally, hardwood and various resins were impacted due to conditions in the Gulf region, leading to surges that exceeded our expectations. This has resulted in about $40 million in inflation impact since our second quarter guidance. All our businesses have felt this impact, although sectors like Cabinets and Therma-Tru are more susceptible to immediate inflation effects due to their lower inventory levels, causing visible pressure reflected in our updated guidance for Cabinets and the Outdoors & Security categories. In Plumbing, while inflation exists with materials like copper, it’s absorbed into the balance sheet. We were optimistic in the second quarter about offsetting these costs within the year; however, due to the surge in the latter half, it will carry into the second quarter of next year. We are confident we can manage it in the early part of next year, and we'll provide revised inflation and offset guidance as part of our 2022 plans. Regarding 2022 inflation, I will refrain from detailing specific levels, but we do anticipate inflation in 2022 and not deflation. We are preparing for an inflationary environment, which we believe will be more moderate than what we experienced during the peak period this year when significant government funds were introduced into the economy, accelerating demand against a constrained supply chain and an already stressed global freight situation. Even if additional government stimulus occurs, it is likely to be phased over multiple years. During the spring and summer, government spending fueled consumer demand, significantly driving inflation, a trend we do not foresee repeating next year. We feel equipped to manage it. The margin challenges for Cabinets and the Outdoors & Security categories in the latter half stem from inflation but also from labor issues, exacerbated by the Delta variant and a tight labor market that has led to increased employee turnover and the challenges associated with onboarding and training new staff, adding inefficiencies to our operations. This is also part of our outlook.

Inflation presents a significant challenge, and I don't want to downplay that. However, the real issue has been the rapid pace of inflation in the latter half of the year, as it takes time to implement sales and pricing strategies. We are committed to managing our price increases without negatively impacting our customers. While they may not always agree with our pricing decisions, we strive to approach this respectfully. There is a necessary pace to executing this correctly, which is crucial for sustainability and for maintaining our market share. The intensity of inflation in the latter half of this year was anticipated, and the timing might allow for a better resolution between when inflation occurs and when we implement sales initiatives.

That's really helpful. And then, Nick, my second question, you made some interesting comments about China. And obviously, that's been top of mind for a lot of people given some of the headlines around housing both on the new construction side and on some of the mortgage side impacting just overall home sales there. Can you just go into a little bit more detail about what's giving you kind of conviction in your outlook for continued growth in that market? And maybe talk about whether it's an existing project backlog or some more detail around kind of the expansion that you've got there?

Sure, absolutely. Regarding Evergrande, we have been monitoring the situation closely, and any potential exposure we have to Evergrande is minimal, so it has not raised any concerns for us. We have thoroughly examined the entire market and have a fantastic local team in China that has been with us for a long time. We understand the market cycles well, having navigated cycles in 2015 and 2017. When you look at those past cycles, you can see that new home sales dropped significantly, but our business continued to thrive. The key factors are our market presence and focus. We concentrate on Tier 1 and Tier 2 cities and have avoided excessive exposure to the speculative construction found in Tier 3 and Tier 4 cities, where you encounter ghost towns and vacant skyscrapers. In Tier 1 and Tier 2 cities, there's a mix of established developments and renovation and repair activities. For instance, in Shanghai, where we hold a significant market share, there is an aging housing stock, leading to many renovation opportunities in addition to new construction. We also started our core loan business over 30 years ago, which has allowed us to create substantial category adjacencies; we hold the number one sink brand in China, and our sanitary ware business has seen great success, albeit with room for growth as our market penetration is still in the single digits. Our shift from developing to e-commerce channels has strengthened our showroom strategy. We have focused on improving showroom quality rather than just expanding the number of showrooms in recent years, which has contributed positively. Finally, we have a strong team operating a profitable business that has enhanced its pricing and competitive intelligence capabilities over the past two to three years, allowing it to adapt the profit and loss to reinvest while also knowing when to manage margins effectively. Considering these aspects—our market presence, adjacent opportunities, and strong capabilities—we are confident that, even as the market slows and transitions to more stable but slower growth, our exposure is solid, and we'll continue to grow within it.

And we have time for one final question. Our last question will come from the line of Truman Patterson with Wolfe Research.

Just wanted to follow up on the Evergrande situation in China. Nick, I believe in your prepared remarks, you mentioned a platform in China where you could flex the costs up and down to relatively maintain margin. I was just hoping you could elaborate on that a little bit?

Yes, I'll provide some insight, and Pat may have additional comments. Our business in China has experienced phenomenal growth, thanks to a strong team and culture. We work closely with them and have learned from past mistakes. A few years ago, we encouraged them to operate with greater discipline, focusing on continuous margin improvement to fuel their own growth. As a result, we brought in new capabilities and improved our revenue growth management and supply chain processes. The team successfully increased their contribution and operating income margins, allowing for more reinvestment in the Moen brand, driving brand pull, and providing more flexibility in managing our P&L. While we may adjust our investment in brand building if the market slows, we still have options. The progress in brand building is evident from our strategic project spending, and it allows us to pursue continuous improvement and manage cost inflation effectively. It's critical to maintain strong discipline in the business to ensure long-term sustainability.

Okay. Okay. And then you all had some pretty nice growth in the quarter, despite facing the supply chain issues that everybody is facing right now. Nick, as well, you mentioned some of the internal actions that you all took during the third quarter. Hoping you can discuss those a little bit more in depth, whether it be getting more suppliers approved, finding alternative materials, improving to an extent labor availability. Just hoping you could dig into that a little bit more.

Sure. It's been a combination of various efforts on our part to achieve this level of performance. First and foremost, our focus on safety has led us to make significant investments in our facilities, which has helped us navigate the pandemic and remain appealing to current and potential employees. Our dedication has not gone unnoticed. Recently, we dealt with Hurricane Ida, requiring us to quickly qualify several suppliers for specialized products. Our team has shown remarkable adaptability, managing to accomplish tasks in a matter of weeks. When we refer to the Fortune Brands Advantage, it encompasses three key pillars: complexity reduction, global supply chain management, and category management. The first two pillars, complexity reduction and global supply chain management, have been pivotal. We've implemented tools such as lean 80/20, design-to-value, and standard work to minimize our need for additional staffing. By doing so, we’ve been able to eliminate open positions we would have needed to fill otherwise, allowing us to simplify our operations and achieve our performance targets. This structural shift will have lasting, positive impacts on the business, and we are committed to pursuing these initiatives vigorously to reduce waste. Furthermore, our global supply chain management has allowed us to leverage resources across Fortune Brands effectively. This includes collaborating with suppliers across various categories and optimizing freight logistics, whether by ocean or domestically, to take advantage of our enterprise scale. I want to commend our supply chain team, which has been exceptional this year in utilizing all available resources, as well as our HR team and others involved. Ultimately, it all begins with our people and safety, but it’s further supported by the Fortune Brands Advantage we’ve been emphasizing.

And with that, that will conclude today's conference call. Thank you for joining. We do appreciate your participation. You may now disconnect.