Fortune Brands Innovations, Inc. Q3 FY2022 Earnings Call

Good afternoon. My name is Donna, and I will be your conference operator today. I would like to welcome everyone to the Fortune Brands Third Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. I will now turn the conference over to Mr. Dave Barry, Senior Vice President of Finance and Investor Relations. Thank you, sir. Please go ahead.

Good afternoon, everyone, and welcome to the Fortune Brands Home & Security third quarter 2022 earnings call and webcast. Hopefully, everyone has had a chance to review the earnings release issued earlier. The earnings release and audio replay of the webcast of this call can be found in the Investors section of our fbhs.com website. I want to remind everyone that the forward-looking statements we make on the call today, either in our prepared remarks or in the associated question-and-answer session, are based on current expectations and 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 income 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. Joining me on the call today are Nick Fink, our Chief Executive Officer; Pat Hallinan, our Chief Financial Officer; and Dave Banyard, President of our Cabinets business. Following our prepared remarks, we have allowed time to address some questions. I will now turn the call over to Nick.

Thank you, Dave, and thank you to everyone for joining us on the call today. Our teams delivered a very strong third quarter with 20% EPS growth and improved margins across all segments in a shifting demand landscape. During the quarter, we saw a softening in U.S. single-family new construction and R&R as the Federal Reserve's continued action on interest rates started to have its intended effect on housing demand. We remain strong believers in the medium to long-term market opportunity, underpinned by attractive demographics and a significant shortage of U.S. housing. Our third-quarter results demonstrate both the strength of our portfolio and the team's ability to deliver results regardless of the environment. Despite these increasing challenges, we once again made operating margin progress in each segment versus last year. We expect second half margin expansion versus the first half of the year inclusive of our digital investment. Our strong performance demonstrates our ability to outgrow the market, increase margins, and make focused strategic investments in the challenging macro environment. We are expecting a soft start to 2023 and are focused on driving outperformance, while executing a tight set of strategic priorities. We remain strongly positioned and are well ahead of schedule in executing our planned separation into two world-class companies. Our teams are working hard towards finalizing the separation before the end of this year. I've invited Dave Banyard, who will continue to lead the Cabinets business following the separation, to join the call today. Dave will provide an update on the progress of the separation and give his perspective on his team's transformational work as well as the exciting potential for the Cabinets business as a stand-alone company. Dave, thanks for joining the call today. Turning to our third quarter performance. Our teams delivered impressive results in a shifting macro environment, including 20% EPS growth versus the prior year. Sales grew 3%, reflecting strong price realization offset by the continued normalization of channel inventory, coupled with comping against an exceptional third quarter of 2021. As the unprecedented supply chain and demand environment of the COVID years begins to dissipate on a trailing basis, our three-year organic sales and operating income CAGRs are up 10% and 17%, respectively, are proof points of the sustainable long-term value created over this period. Importantly, our consolidated operating margin was up 150 basis points over last year, with each segment making year-over-year operating margin improvement. Price and continuous improvement outpaced inflation in the quarter, and we continue to invest in key strategic priorities, such as our digital transformation. Our digital initiatives are already yielding tangible results including increased e-commerce sales, improved app ratings and accelerated procurement savings. Our results are a further testament to the strength of our brands, the hard work of our teams driving transformation and the power of our Fortune Brands Advantage capabilities. While our third quarter results were impressive, we are facing increasing headwinds from shifting consumer behavior in response to housing affordability and macroeconomic uncertainty. The Fed's tightening monetary policy is having the intended impact on capital goods, including housing. Rising interest rates are impacting single-family new construction permits and starts activity, and our wholesale and retail channel partners are destocking inventory as customer traffic slows and lead times normalize. The pace of impact is accelerating, and we are revising our full-year guidance to reflect the current environment. We have managed through similar headwinds before and are taking thoughtful yet decisive action to protect our business are prioritizing investment in a tighter set of key strategic priorities to win for the long-term. Pat will provide more detail later in the call on how we intend to manage the P&L and balance sheet through the anticipated period of softness, while protecting our long-term growth and market leadership positions. We constantly challenge ourselves to do better regardless of the macro environment. We recently announced a redesign of the new Fortune Brands organization, which will better position us to realize the many opportunities to drive growth and margin progression at an accelerated pace. At the center of this exciting evolution, we are transitioning from a decentralized structure with separate businesses to a more aligned operating model that prioritizes activities that are core to brand, innovation, and channel under Cheri Phyfer. Additionally, we have aligned all of our global supply chain resources under Ron Wilson as our Chief Supply Chain Officer, to fully leverage the scale and execution excellence of our total business. This new operational focus structure will better align the company's resources with our growth and productivity priorities following the separation. This organizational redesign increases our ability to leverage best practices across the whole organization. We will be able to further leverage the Fortune Brands Advantage to drive increased productivity and capture additional growth at higher margins. We look forward to unveiling more of this advantage strategy at our highly anticipated Investor Day expected to take place on December 6 at the New York Stock Exchange. We hope that you can all join us. As is well documented, there's a fundamental long-term need for housing in the U.S. as a deficit of millions of homes exist and the current age of homes today remain at or near multi-decade highs. We believe the importance of the home remains as strong as ever as consumers continue to invest in priority areas of the home, including the kitchen, bathroom, and the outdoors. Our portfolio is targeted at the heart of the market and is exceptionally well positioned to navigate the challenges ahead and capitalize on consumers' continued desire to upgrade their homes. Our brand power, innovation and best-in-class service provide a unique value proposition that greatly resonates with the consumer and our channel partners. These attractive attributes, coupled with market leadership positions and advantaged channel exposure will provide stability and opportunity as we proactively manage the business through the near-term macro environment. Now I will turn to each of our segments to provide some color on what we are seeing. Beginning with Water Innovations, sales were down 14% in the quarter as channel inventory reductions and a soft China market more than offset mid single-digit POS growth in the U.S. Upgraded Moen and House of ROHL showroom displays are driving double-digit POS lift and our investments in brand and innovation continue to resonate with consumers and customers. In our core U.S. market, channel destocking accelerated ahead of our expectations during the quarter and is continuing into the fourth quarter. In addition to continued destocking at our major customers, down channel inventory held by production plumbers, builders, and smaller wholesalers grew as lead times extended. As our service levels recovered and construction and consumer activity slowed, this additional inventory has started to work its way out of the channels at an accelerated pace. In China, economic and pandemic headwinds continue with new construction activity down almost 40% year-to-date. Our team is doing an outstanding job rightsizing our cost structure relative to the demand environment in China, and we remain positive on the opportunities for further innovation and long-term growth in this market. It is important to note that while the Water Innovations top-line has been impacted by inventory destocking in China over the last two quarters, U.S. POS has maintained mid single-digit growth throughout the period. Additionally, the segment has delivered a three-year organic sales CAGR in the high single digits, while expanding year-to-date operating margins by nearly 300 basis points over 2019. We expect the destocking dynamic to normalize in early 2023, and our sell-in should approximately equal our sellout. Notwithstanding the top-line challenges, our water innovations team took action in the quarter to preserve operating margin and delivered 10% decremental margins, resulting in third quarter operating margins of nearly 25%. We continue to prioritize strategic investments, including the purchase of Aqualisa and its leading smart water in valve technology. The business remains well positioned to outperform over the long-term through strong brands, innovation, and industry-leading service. Turning to the Outdoors & Security business. Sales grew 6% driven by our POWERHOUSE Therma-Tru brand, which grew at strong double-digits. As one of the most recognized builder brands in housing, Therma-Tru continues to convert homeowners to advanced material fiberglass door systems from traditional wood and steel alternatives. LARSON sales grew mid-single digits as we continue to capture synergies as we integrate LARSON offerings with the rest of our outdoor portfolio. Security sales were down mid-single digits, driven by retail inventory reductions, partially offset by commercial sales growth. Decking sales were down low double-digits as destocking continues in the wholesale channel, while retail POS remained positive during the quarter. We continue to believe the value proposition of material conversion will drive long-term secular growth in composite decking. The Outdoors and Security operating margin was 16.1% and improved 70 basis points sequentially and 50 basis points versus the prior year as price and cost actions continue to more than offset inflation. Finally, our Cabinets business delivered another exceptional quarter with sales growth of 20% as our transformational efforts continue to deliver and pricing actions become more fully realized in the P&L. Our service levels and product offerings have enabled continued share gains across the channels. The business will continue to work down excess backlogs through the fourth quarter and expect to end the year at normal levels. Cabinet's operating margin was up over 400 basis points versus the prior year. Price and cost actions more than offset inflation and our team is strategically positioning the business to enter 2023 as a stand-alone public company with a cost structure that reflects the macro environment. The transformational work continues as Master Brand drives its lean culture through its operational and supply chain strategy. Cabinet's tremendous results this year are the product of several years' work to re-platform the business into a world-class performer. The transformation is remarkable and yet we believe there are still plenty of opportunities to pursue further value creation following the separation. Our stakeholders should be excited about the increased agility, resilience, growth and profit potential of this market leader in its future journey ahead. To summarize, it's been a strong quarter. and our value creation algorithm remains fully intact. In 2022, we expect to deliver another year of above-market growth and margin progression even in the face of multiple headwinds. We are already taking action in anticipation of softening demand and are laser-focused on maintaining our margin journey and driving cash generation. We will proactively manage through the short term and are actively positioning both new Fortune Brands and Master brand to win for the long-term with above-market growth and higher margins over time. We are well prepared to face any future challenges and we'll work to deliver on our commitments to all of our stakeholders. Before Pat addresses our quarterly financial performance and financial guidance update in greater detail, I would first like to turn it over to Dave Banyard to give his perspective on Cabinet's progress towards the separation and provide some insight into the transformational journey he has led over the past three years. Dave?

Thanks, Nick. It's great to be joining you here on today's call. I appreciate the chance to provide you all with an update on the separation and highlight some of the exceptional work that the Cabinets business has accomplished. I trust you'll see why I'm proud of our current performance, but I'm equally as excited about Master Brand's future. As Nick said, we're progressing well ahead of schedule on the separation. The team has diligently worked to develop the infrastructure required to be an independent publicly traded company, which includes building on our current leadership team and adding key roles. Our search for the best talent extends to Master Brand's future Board as we're finalizing a world-class independent and diverse Board of Directors. As we prepare for the separation, we continue to make progress on our strategic transformation, which began three years ago. Master Brand has a great history as a market leader, but there is an opportunity to improve. Our culture of continuous improvement is part of what we call the Master Brand Way, focuses on efficiency and the best use of our scale, which has allowed us to both increase manufacturing flexibility and improve margins. We continue to better align around customers and channels with products specifically tailored to the needs of each part of the market. This realignment has improved service levels, increased customer satisfaction, and delivered stronger financial performance. These improvements were made during times of immense disruption to global supply chains and labor markets. This demonstrated performance in challenging times gives us confidence in our ability to deliver as market conditions change. Because of our strategic transformation, we've aligned the Cabinets manufacturing network in anticipation of the future demand environment, and we have flexibility to adjust further as market conditions change. This flexibility will help preserve financial performance and allow us to continue to invest in our strategic initiatives, including in areas such as digital and e-commerce, which will help drive incremental future growth. I look forward to showcasing more operational success stories from our strategic transformation and details of our strategy at our upcoming Investor Day. I speak for the entire team when I say how excited we are knowing the best days of Master Brand are ahead of us. I'll now turn the call over to Pat.

Thank you for joining the call today. I will primarily discuss income before charges and gains to accurately represent ongoing segment performance. All comparisons will be made against the same period last year, unless noted otherwise. Let's start with our third quarter results. Sales were $2.1 billion, a 3% increase, and consolidated operating income was $335 million, up 14%. Total company operating margin increased by 150 basis points to 16.3%. EPS was $1.79, representing a 20% growth. Each segment's operating margins improved in the quarter as pricing and cost actions more than offset inflation. Our third quarter sales growth faced tough comparisons from a year ago, unexpected channel destocking, softness in China, and slowing U.S. new construction and R&R activity. Our teams did a remarkable job managing expenses in a challenging demand environment, resulting in strong margins across all segments and exceptional EPS growth. Looking ahead, we are committed to ensuring a strong long-term future for both companies. We recognize the short-term impact of rising interest rates on consumers. We are acting promptly to maintain our strong margin focus and convert inventory into cash as the excess pandemic inventory is no longer necessary. We have navigated slowdowns successfully before and are confident in delivering results regardless of market conditions. Now, let's discuss our segment results, starting with Water Innovations. Sales were $635 million, down $106 million or 14%, also down 14% when excluding foreign exchange impacts and our Aqualisa acquisition. Sales were affected by destocking across North American channels, ongoing market weakness in China, and changes in U.S. new construction and R&R activity during the quarter. Notably, U.S. POS increased by 5% in the quarter. Operating income was $157 million, a decrease of $11 million or 6%. Operating margin was 24.7%, supported by better pricing and proactive expense management in both North America and China. The team effectively managed to achieve an impressive 10% decremental operating margin. Our POS performance indicates that consumers continue to choose Moen as the leader in water solutions for the home, while the House of ROHL delights consumers with its Artisan Brands collection. Our recent acquisition of Aqualisa underscores our commitment to investing in leading innovations for sustained above-market growth. Moving on to Outdoors & Security, sales were $560 million, an increase of $32 million or 6%, 5% when adjusting for foreign exchange and acquisitions. Therma-Tru experienced strong double-digit sales growth due to higher prices and sustained material conversion benefits. LARSON's sales rose in mid-single digits, driven by pricing. LARSON is collaborating with Therma-Tru to achieve synergies as both companies innovate together across channels. Decking sales saw a decline in low double digits due to ongoing destocking in the wholesale channel, which has persisted into the fourth quarter. Our teams are collaborating with channel partners to optimize wholesale inventories, anticipating that adjustments will be complete by early 2023. Retail POS remained strongly positive in the quarter. We are optimistic about the long-term conversion opportunity from traditional wood products, having seen a similar transition at Therma-Tru over the decades. Security sales decreased in mid-single digits during this period, with strong commercial and connected product sales partially offsetting retail destocking and declining demand for safes. Master Lock continues to be a high-visibility brand through which we can drive long-term growth in safety and connected security products. The operating income for the Outdoors & Security segment was $90 million, a 9% increase or an $8 million rise, while the segment's operating margin was 16.1%, up 50 basis points. Turning to Cabinets, sales were $858 million, an increase of $142 million or 20%, driven by pricing. Stock cabinets outperformed the segment, while make-to-order sales grew in the mid-teens. During the second and third quarters, cabinets benefited from a robust backlog and a strong influx of orders. In the fourth quarter, we expect to address the excess backlog, with typical seasonality and market conditions expected to drive revenue by year-end. The Cabinets team has been proactive in preparing the business for 2023. Operating income reached $119 million, up 71% or $49 million, with an operating margin of 13.8%—a 410 basis point improvement from last year. This margin performance reflects the team's transformation efforts, and we anticipate a similar year-over-year margin outcome in the fourth quarter. The Cabinets team has made remarkable strides in enhancing the business's competitiveness and margin production. As a standalone public company, this team is positioned to unlock even greater potential. Regarding the balance sheet, it remains robust, with cash of $345 million, net debt of $3 billion, and a net debt-to-EBITDA ratio of 2.2x. We finished the quarter with total liquidity of $537 million available through our revolver. Since the end of the second quarter, we have repurchased approximately $75 million in common stock, which includes $36 million in the third quarter. To date, we have repurchased about $580 million in common stock and remain committed to managing our cash and balance sheet efficiently. Our top priorities for 2023 include maintaining margin strength and converting working capital investments into cash. The Federal Reserve's interest rate actions are producing a near-term slowdown in consumer demand for capital goods, including home products. While we had a strong third quarter and executed well despite various challenges, we are observing a softening in U.S. new construction and R&R demand alongside ongoing channel destocking. With these market conditions in mind, I will now update our 2022 guidance. We are revising our full-year 2022 global and U.S. market outlook downward based on these factors. Our global market outlook now reflects growth of 2% to 4%, with U.S. growth expected at 3% to 5%. Within the U.S., we anticipate single-family new construction growth between a decline of 1% and an increase of 1%, while R&R growth is projected at 4% to 5%. Given the shifts in our market outlook, we have adjusted our full-year net sales growth guidance to 4.5% to 5.5% to align with our strong year-to-date results, tempered by a softening market environment. We remain focused on achieving OI margin expansion this year and beyond, targeting around 50 basis points of margin improvement and aiming for an operating margin of approximately 15% for 2022. We are updating our 2022 EPS guidance to a range of $6.20 to $6.30 per share, considering the market softening and continued inventory destocking. On a segment basis for 2022, we now expect Water Innovations net sales to decline by 5% to 6%, with operating margins around 24%. Outdoors and Security sales growth is projected at 5.5% to 6.5%, with operating margins between 14.5% and 15%. Cabinets are expected to see a net sales increase of 14% to 15%, with operating margins around 11.5% to 12%. This updated EPS outlook for 2022 includes assumptions of corporate expenses around $130 million, including approximately $20 million for digital transformation investments and up to $15 million in separation costs, with interest expenses ranging from $122 million to $124 million, a tax rate of about 24.5% to 25%, and approximately 131 million average fully diluted shares. Our sales forecast reductions have occurred within shortened supplier lead and transit times, resulting in higher inventory levels than previously targeted. Consequently, we anticipate 2022 free cash flow of about $400 million to $450 million, factoring in capital expenditures between $250 million and $275 million as we adjust our investment pace to align with current market conditions while continuing to enable future growth. As we prepare for 2023, we recognize how housing affordability and macroeconomic uncertainty are impacting consumers. It is not wise to provide 2023 guidance at this time, but we can share that we are preparing for a global market decline of low to mid-single digits, with the first half likely more challenging than the second half. Our teams are strategically focused on driving industry-leading margin performance, including managing decremental margins should a global market decline occur. We are also emphasizing rapid inventory-to-cash conversion without sacrificing supply chain resilience. If the market declines are within mid-single digits or better in 2023, we expect to achieve decremental margins between 20% and 30%, depending on the severity of market changes and the quarterly pace of inventory reduction. Our business model improvements and ongoing efficiency initiatives position us to demonstrate our strong margin performance next year. In summary, our solid quarterly and year-to-date results reflect the strengths of what will become two robust companies, each leveraging unique advantages driven by brand, innovation, and channel for New Fortune Brands, and sustained transformation as well as operational excellence for Master Brand, both benefiting from a strong global supply chain and focused organizational realignment. Each company will have a robust balance sheet and the capacity to enhance returns through capital allocation, alongside strong cultures and commitments to strategic priorities that are primed to unlock new earnings potential. I will now hand the call back to Dave Barry to conclude our prepared remarks and open the lines for questions.

Thanks, Pat. That concludes our prepared remarks on the third quarter. We will now begin taking a limited number of questions. Since there may be a number of you who would like to ask a question, I will ask that you limit your initial questions to two, and then re-enter the queue to ask additional questions. I will now turn the call back over to the operator to begin the question-and-answer session. Operator, can you please open the line for questions? Thank you.

Thank you. The floor is now open for questions. The first question today is coming from Adam Baumgarten of Zelman & Associates. Please go ahead.

Hey, good afternoon everyone. My first question is for Nick. Could you provide some insights on the current demand environment and share how the business performed during the quarter? That would be really helpful.

Sure, happy to, Adam. In looking at the demand environment this quarter, we certainly saw a turning point in the macro housing data during the third quarter. As you're aware, building orders declined significantly, and permits and starts have been trending downwards. For the rest of the year, we expect single-family new construction to remain roughly flat, with a likely decline in the first half of next year and also in the second half of this year. It's interesting to note our retail POS data has remained surprisingly strong throughout the year, despite some significant laps. After Labor Day, we observed a noticeable decrease, raising questions about whether consumers have pulled back or if this is simply a return to typical seasonal patterns. Compared to last year and looking back to 2020, the back office still appears to be solid. We'll see how this develops, but as mentioned in my and Pat's comments, we anticipate challenges as we enter the first half of this year. There was a marked step down post-Labor Day. Nonetheless, we know the long-term outlook for housing is very positive, and we’re well-versed in the underlying fundamentals. Our focus is on managing the business to ensure we are positioned for growth, taking market share, and building strong brands despite these short-term challenges. We'll operate with a very streamlined P&L management approach without neglecting essential strategic investments, such as in digital capabilities, to remain healthy and competitive in the long run. We believe we have the necessary tools to achieve this, and our margin performance this quarter reflects that capability. We've successfully navigated this in the past and will do so again, aiming for above-market top-line growth and industry-leading margin increases. This is our guiding principle as we analyze the data and formulate plans to overcome short-term challenges and capitalize on the positive developments ahead.

Great, thanks. And then maybe on Water Innovations margins really quite strong in the quarter. Maybe some more color would be helpful on how you were able to keep margins so elevated in the face of volume deleverage, input cost headwinds. And if the incremental or I should say, decremental margin profile in that business is maybe different than what you outlined for next year because of some of the actions you've taken.

Yes, I'll start, and then Pat will provide some specifics. Philosophically, we will discuss some of the transformational changes we've made in our operations. We are increasingly relying on our scale and our ability to achieve excellence across the organization, enhancing our capabilities. With this scale, we gain more flexibility and options throughout the business. Thus, we are dealing with a business that has faced challenges, particularly from China. I believe that eventually, those circumstances will improve since housing is a critical part of the Chinese economy. We've experienced significant inventory destocking, and unexpectedly, some inventory has been situated in production rather than at traditional locations. However, we've been able to adapt to that environment, continue to grow our point of sale, and invest strategically while also managing our cost structure. We have tightened our strategic priorities but are still investing for the future. Additionally, with less dependence on China—still maintaining a double-digit operating income margin but lower than in the U.S.—we're seeing some impact from the mix. Overall, we are focusing on leveraging our strategies and managing the business effectively, which is contributing to our margin performance. Pat, would you like to add more details?

Yes, Adam, I've got to put into perspective how we got from the high teens, low 20s to the mid-20s. And that is twofold. A lot of the Fortune Brands capabilities around procurement leverage design for manufacturability and design for value and revenue growth management, along with SG&A leverage have been in combination, the key from taking that business from a high-teens margin business to a mid-20s margin business. And then to your question of how in a time of toughness are we able to preserve the decremental margins. And that's just people being very perceptive of what's happening in the demand stream and being very quick to react on discretionary SG&A without compromising the key priorities and key among that has been our business in China staying profitable despite a couple of quarters where they're down around 25%. So that's been the key to that. I think longer term as we look into next year, why we have a broader range is as we do right size inventory, which we haven't done enough of yet, we're going to have a different overhead absorption dynamic go through the system as we right size inventory. And so when we get towards the end of the year and we're providing the detailed guidance for '22, we can narrow that range a bit. But that's the difference between what you're seeing in the current quarter and what you would see on a full-year basis for '23.

Got it, thanks. Best of luck.

Thank you. The next question is coming from Phil Ng of Jefferies. Please go ahead.

Hi guys. Congrats on good results in a choppy backdrop. My question for you, Nick. I've always thought Fortune as a decentralized model, and it's obviously worked for you guys quite well. The results speak for themselves. The news on the realignment on the org structure, help us understand the thought process on why now, what that unlocks. And also any color on the cap structure anticipated dividend from the spend?

Okay. I'll take the first part and sure Pat may weigh in a little bit on the second part. So why now, and I appreciate the comments on the quarter. We pride ourselves in acting with urgency. It's a big part of our ethos. Agility is one of our three key values. And as you look actually at data around companies that have gone through separations and spins, there's actually some fascinating data like companies that move to reorganize themselves well ahead of the separation date outperform the market over time. And I think it sort of speaks partly to the culture, but also to getting that flying formation into place early and then out of the gates as you go. And so that was for the timing then the overall structure. And you're right, the decentralized structure has served very well over time. Over the last few years, you've seen us introduce Fortune Brands Advantage across the portfolio. We've been able to get a lot of value out of that, right, taking sort of key areas that could really drive incremental value and then leveraging across the portfolio. And as we saw that work, we could see the fact that you could get value out of doing things across the portfolio. But we could also see that we could go faster and harder on some of these initiatives if we didn't have the structural impediments that we had. And so as early September, we announced this move from a decentralized or to a more closely aligned operating model. And what do we expect, they'll do two things to drive growth, right? Because you're going to have our best-in-class capabilities across the whole portfolio. We could see pockets of things we're doing really well all over the portfolio, but being able to do them everywhere is going to drive growth, and it's going to drive productivity because you're going to have better capabilities and less duplication, right? So you should get greater productivity, and it should help us drive incremental fuel for investment as well as our margin journey. So that's the idea behind it. We'll share quite a bit more at the Investor Day, but we're really excited. We really excited the organization is energized and you can already see some of it just taking hold as people grab on to some of these opportunities. And the last thing I'll note about it, and I think this is a little bit different to the people thinking we move just purely to a centralized organizational full matrix organization. A lot of these high-performing functional areas will not report to me. They're going to report closest to the market, which kind of stays true to that decentralized ethos, right? So Cheri Phyfer is going to have our global marketing function. She's going to have a global innovation function, a global engineering function because they're not needed across kind of the corporate level, supply chain, everywhere, HR, everywhere, right? So those they're reporting to me. But we really wanted to drive these as close to the market as possible to retain the agility that you've seen from a decentralized structure. So hopefully, we're going to get the best above out of this. But as you can hear, I'm pretty excited about it.

And Phil, in terms of the Cabinets capital structure and related dividend. We're well underway with that. As we said in the script and with the press release, we're ahead of schedule and working hard to get everything done this year, including the capital structure and related dividend. We're working with our existing Fortune Brands Bank Group. They've been great and very supportive of this transaction, and we're appreciative of that. It's obviously been a very tumultuous time in the credit markets. As we've expressed in prior calls, we're expecting to pursue all bank financing, a mix of a revolver and a Term Loan A. And we would still expect the dividend to come out of that to be in the range that we've communicated previously of $500 million to $1 billion, likely towards the higher side of that range. We still expect to get that done and get that done this year and to leave cabinets with an appropriate amount of financial flexibility to navigate 2023, which you heard us express. We certainly expect some challenges at least the first half of the year, if not the full-year. And then the Cabinets business has been exceptional at doing their part to drive profit growth and margin, they're likely to finish this year with pretax operating income in that $390 million to $400-ish million range and then depreciation and amortization, that's probably about $60 million on top of that. So their drop to drive the profit that supports that capital structure, and they're doing a great job of it. And so I think it will be coming across the finish line much as we expected when we talked in the second quarter.

That's great color. And just one last one for me. On the decremental margin guidance you called out for 2023, it sounds like the front half is going to be probably closer to the top end as you kind of work through inventory destocking and maybe as you kind of fine-tune your fixed cost profile, I guess? And then the back half, maybe on the lower end, are we thinking about that right? And then certainly, you're starting to see your ROHLs fall like metal, PBC, and hardwood. Is that something you guys have accounted for? Is that a potential upside from a margin standpoint? Thanks a lot, guys.

Yes, I would say you're thinking about it correctly. And I think the ROHLs are contemplated within that. The challenge for us will be as we position ourselves for the longer-term market and given the labor market dynamics, how much capacity do we hold on to thoughtfully and how quickly do we unwind that inventory while potentially leaving some capacity less utilized than it might otherwise be. And so that's why we have that range. And then when those ROHLs flow off our balance sheet and into our income statement, we'll have a better line of sight to what not a perfect line of sight, but a better line of sight three months from now. So we'll provide an appropriate update when we provide official guidance, but I think that range is appropriate for now, and I think you're thinking of it correctly with it being a bit higher in the first part of the year and a bit tighter in the back part of the year.

Thanks a lot for the comment.

Thank you. The next question is coming from Michael Rehaut of JPMorgan. Please go ahead.

Thank you. Good afternoon everyone. I appreciate your time for my questions. I wanted to focus on a couple of areas. First, I’d like to discuss water innovations related to the top-line and touch on destocking in China. It seems there has been a noticeable contrast between your top-line results and those of your biggest competitor who reported this morning. You mentioned that point-of-sale data is still trending positively, suggesting you may not have lost market share. However, we haven't observed the same signs of inventory destocking or declines in China that you’ve indicated. Can you elaborate on the reasons for these differences? Additionally, you anticipate a moderation of these trends in the fourth quarter. If you're projecting a full-year sales decline of 4% to 5%, that would suggest the fourth quarter might be closer to flat.

Mike, it's Pat. I'll begin and maybe Nick will provide additional details. It's indeed unusual for us to report a sales decline in our Water Innovations business. However, it's crucial to consider that the brand remains healthy and competitive in the marketplace, as evidenced by a mid single-digit positive point of sale this quarter. Overall, when analyzing the business over the past three years, using 2019 as a reference point, we anticipate a compound annual growth rate of about 9% in sales and approximately 14% in profits by the end of this year, which will be consistent by the end of the fourth quarter. The long-term performance of the business is solid. The results reported this quarter and last are primarily attributed to the strength of our supply chain in the latter half of 2020 and throughout 2021, alongside unique dynamics affecting our business mix. In North America, we hold a strong share in new construction, and the supply chain challenges faced over the past two years contributed to notable wholesale inventory buildup, even at lower levels outside our main wholesalers and production plumbers. We're currently seeing that inventory being reduced. In China, our focus is mainly on residential new construction, not hospitality, and the government’s pressure on the construction sector is primarily directed at residential projects, which reflects some unique aspects of our business. The supply chain advantages we experienced in 2021 and the latter half of 2020 are influencing the results we see in the second and third quarters of this year. Notably, in this quarter, 12 out of the 14 points of decline were due to North American destocking. While this quarter shows a downturn, the brand continues to perform, as illustrated by the point of sale data. Regarding the fourth quarter expectations, they are approximately correct; although, keep in mind that our Water Innovations and O&S businesses have a 53rd week included in that period. So while it appears to be flat to down 1% on a reported basis, we adjust for the 53rd week, which indicates a decline of about three to four percent on a like-for-like basis and reflects a deceleration in destocking activity. There are many factors at play here, but overall, the brand is performing well, demonstrated by the point of sale figures and the outstanding three-year growth rates in both sales and profits. Much of what we are witnessing this year is the result of last year’s supply chain strength.

I believe Pat summarized that well. Mike, we have remained dedicated to our long-term goal of surpassing market performance, with a 9% growth at the top and 14% at the bottom, as Pat mentioned. We've achieved nearly 300 basis points of improvement in our operating margins over this period, and we have always maintained that we will outperform the market and increase our margins. We have done so in the past and will continue to do so moving forward. To elaborate on the supply chain aspect that Pat mentioned, our service levels have significantly improved, and we're quite proud of that. Last year, we were operating at about a 70% fulfillment rate, while our largest customers indicated that the industry average was around 40%. This discrepancy enabled us to better serve our customers and consumers, which remains a top priority. They have also been building inventory to support builders and ensure that plumbing issues do not delay home construction. As demand slows, we will see that inventory decrease, but we are confident, as Pat noted, that the healthy point of sale figures indicate strong growth potential in this business, which is generating substantial value. Regarding China, our operations there are extensive and diverse, meaning we are well-exposed to the Chinese economy. However, as Pat pointed out, our teams have managed to maintain profitability and they are among our most adaptable teams. They will quickly reposition resources to seize growth opportunities as the market stabilizes and begins to recover, and we will be ready to capitalize on that growth.

That's great. I appreciate the detailed answer, as it really helps in understanding the situation. I would also like to dive deeper into the comments regarding 2023 and the decrementals, building off of Phil’s previous question. I was a bit surprised to learn that the 20% to 25% decrementals include any potential raw material benefits that you might see next year. Are those decrementals actually better than you would typically expect? If I remember correctly, you've previously estimated the decrementals closer to 25% to 30%. Could you clarify this a bit for me? If you are projecting full-year decrementals in the 20% to 25% range without the benefit from raw materials, it suggests that there may be margin contractions next year unless other factors might offset that.

Yes. In a stable environment with fewer market fluctuations and inventory changes, our target range would typically be around 20% to 25%. For next year, we aren't providing precise guidance, and we’re allowing ourselves some flexibility for inventory destocking. Since the pandemic began, we've added approximately $500 million to $600 million in working capital to our balance sheet, which is significant given our initial base was around $900 million to $1 billion. The reason I mention that raw material deflation is factored in is that it will take time to reduce the inventories before we see the impact of that deflation. It won’t happen immediately. So far this year, while there has been some deflation, it has primarily affected ocean freight and certain ground freight costs, with everything else remaining relatively stable. We are not experiencing what I would term a significant deflationary trend, particularly in how it is impacting our profit and loss statement, as we still hold substantial inventory. Looking ahead, we estimate that we will work off about $200 million to $400 million in inventory next year, depending on how the year progresses and the best strategies for managing our capacity and relationships with vendors, which will influence how any raw material changes affect our income statement.

I want to emphasize that we are not relying on deflation for our business. Given the current situation, I feel optimistic about our prospects. If the global economy were to slow down, it’s possible that deflation could increase. If that happens, it may positively influence our performance in the latter half of next year as we address the inventory that Pat mentioned. However, we need to focus on the facts at hand, especially considering the volatility we’ve faced over the past couple of years. We cannot base our business on uncertain factors and must work within our capabilities and the resources available to us to achieve the best outcomes. These are the assumptions guiding our strategy. If economic conditions improve quicker and deflation rises, that could positively affect our profit and loss statement.

Thank you. The next question is coming from Stephen Kim of Evercore ISI. Please go ahead.

Yes, thanks very much guys. I appreciate all the color so far. Just on the destocking issue, I was wondering if there was any impact from the effect from the new distribution center that you opened up. And then also, when you talk about the decremental margins, I was wondering whether there'd be any meaningful difference or variability across the segments in terms of that 20% to 30% range you gave?

I'll take the first question, and Pat can address the second one. You're quite perceptive to recall the distribution center. It certainly played a crucial role in maintaining our high service levels last year. When demand was extremely high, we launched that facility, and it immediately performed exceptionally well in both service levels and efficiency. In our experience, when we can ensure high service levels, we become the preferred choice for customers managing their inventory. While it can feel like no good deed goes unpunished at times, we take it in stride and move forward. The service levels at that distribution center have definitely provided our customers with greater flexibility.

Yes. And I'd say on decrementals, all businesses will be working towards similar objectives. I think what will differ is how each of them is experiencing demand relative to capacity relative to inventory rightsizing quarter-by-quarter. I think that if you see a difference, it's because of the circumstances that the businesses face are unique to the business as opposed to they're inherently structurally different or pursuing different objectives.

Okay. Yes, that makes sense. Talking about the circumstances and the set up next year, I believe you kind of gave some commentary about single-family resi, was wondering whether you had a handy way of describing your outlook in terms of single-family starts, let's say, and existing home sales as you look into fiscal '23, what kind of ranges or levels are you kind of thinking about as you contemplate your guidance?

Yes. And so Steve, I'll kind of remind you and others, we always, on the new construction side of things, just lag starts three or four months. But for the last three or four years, it's kind of been using an average of a lag starts plus completion. So take, think of it simply as starts lag three months plus completions divided by two. It's kind of like that our simple algorithm because builders, to us, appear to be swinging labor between starts and completions. What our expectation is, this is early days. So we reserve the right to update this as we get towards the end of the year as starts next year, single-family starts in the U.S., likely down in that 15% to 20% range. But the completions because of the backlog are somewhere closer to flat. I mean, could they be down a bit, maybe but closer to flat. You kind of put those two things together and you're down like minus 10-ish, new construction. And then R&R somewhere from flat to down low single digits, maybe mid-single digits, but low single-digits. And if you think of just the simple algorithm of our business of a quarter to a third new construction and the balance R&R, that kind of gets you to about mid-single-digits. I wouldn't tie a specific existing home sales into that where, existing home sales is one of many variables we look at for R&R. But that's the simple high-level math we're using right now that kind of gets us around that mid-single-digits or better because a full year with R&R down three would be pretty will be a pretty significant development. I certainly think starts will contract pretty significantly in the first half of the year. Just by the order rate, we're seeing today is kind of directionally in that same order of magnitude.

Yes, that's very helpful, Pat. I wanted to follow up specifically on existing home sales across the marketplace. It seems that many in the investment landscape are noting that the average mortgage rate for homeowners is significantly lower than the current prevailing rate. This creates a locked-in effect, which many are focusing on. As a result, some believe that existing home sales could drop dramatically, reaching levels we haven't seen in the last 20 years. I’m curious if you share that perspective or if you think we should moderate our views on how low existing home sales might go. I also noticed that 40% of homeowners don't have a mortgage, and another 10% probably don’t have much debt. This leads me to think that existing home sales might perform better than expected. I’d like to hear your thoughts on that.

I don't have a specific number in mind regarding the typical transactions of around 5.5 million. However, I believe we can agree that due to the impact of many mortgages being locked in at rates well below 4%, there will be some friction that may last for part or all of next year. I'm uncertain about how low that number will drop. However, having people more committed to their current homes due to their mortgages could lead to a reasonable level of repair and remodel activity, as two-thirds of our business comes from that area. I don't want to imply we're indifferent to this situation; it's just one of many factors at play. Homeowners staying in their homes isn’t necessarily negative for our product demand. Their confidence in their homes and the importance of those homes in their lives, which has certainly shifted in a hybrid work environment, is a key factor for us to monitor. This situation could ultimately be advantageous for repair and remodel activity. So, we don’t view it as definitively negative.

Yes. One of the things we examine is consumer interest in home renovation through Google Search. This activity is currently 25% higher than it was before COVID based on our latest data. There is clearly 25% more activity related to home renovation searches and people undertaking renovation work. If this trend affects existing home sales, as individuals in homes look to renovate, we should consider the $29 trillion in homeowner equity and how it might be utilized. I believe this will reveal interesting insights for next year. Consumer interest remains very important as we plan for the coming year and anticipate how everything will develop.

Yes, thanks very much guys. That's really helpful.

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