Fortune Brands Innovations, Inc. Q4 FY2022 Earnings Call

Greetings. I would like to welcome everyone to the Fortune Brands Fourth Quarter 2022 Earnings Conference Call. All lines have been muted to avoid any background noise. I will now turn the conference over to Leigh Avsec, Vice President, Investor Relations and Corporate Affairs. You may begin our conference call.

Good afternoon, everyone, and welcome to the Fortune Brands Innovations' fourth quarter and full year 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 website, fbin.com. 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 may be required by law. Any references to operating income, margin, EBITDA, earnings per share, or cash flow on today's call will focus on our results on a non-GAAP before charges and gains basis unless otherwise specified. Please visit our website for a full reconciliation. Joining me on the call today are Nick Fink, our Chief Executive Officer; Pat Hallinan, our Chief Financial Officer; and Dave Barry who, as we recently announced, will be succeeding Pat as our next Chief Financial Officer in early March. Following our prepared remarks, we have allowed time to address some questions. I will now turn the call over to Nick.

Thank you, Leigh, and thank you to everyone for joining us today for our first earnings call as Fortune Brands Innovations. As we detailed during our recent Investor Day, Fortune Brands Innovations is a growth company powered by secular tailwinds, underpinned by leading brands, innovation and channel management and supported by our Fortune Brands Advantage. Before we begin, I want to thank the thousands of Fortune Brands Innovations team members across the globe for your continued dedication and commitment to excellence. Our people are the foundation upon which our business is built, and you are the drivers of our next phase of growth. Additionally, I would like to recognize the MasterBrand associates who contributed so much to Fortune Brands. We wish you well on your exciting journey ahead. I also want to take a moment to congratulate Dave on becoming our next Chief Financial Officer. As part of our well-established succession planning process, Dave has gained finance leadership experiences throughout the company and has distinguished himself as a true partner to me and our teams. I'm excited for us to be working closely together. Finally, I want to sincerely thank Pat for his leadership and friendship over the last six years as CFO. Pat, while you will be missed, I know that we are in great hands with Dave. Our teams delivered an impressive year in the face of a challenging environment while also executing several key initiatives. The actions we took, including the separation of our Cabinets business and our reorganization into a highly aligned operating model, will enable Fortune Brands Innovations' continued long-term growth and sustained value creation. Let me speak for a moment about the 2022 results of Fortune Brands Home & Security, inclusive of Cabinets results through the full fiscal year. Our teams delivered net sales of approximately $8 billion, a 4% increase over 2021, as well as 20 basis points of margin improvement amid a softening demand environment and channel inventory reductions. Full-year EPS was $6.32, an increase of 10% versus 2021. As we previously said, following Labor Day, there was a significant slowdown in U.S. single-family, new construction and R&R demand as higher interest rates and inflation impacted affordability and typical seasonality returned to the businesses. In response to the slowdown, our teams took decisive actions to reduce our fixed cost base and to preserve our margins. However, we also maintained investments in our key strategic initiatives, including our digital transformation, brand building, and incremental capacity, critical to our long-term growth. While our full-year margin expansion was not at the levels we initially targeted at the start of 2022, our margin results are impressive in light of the abrupt shift in the marketplace dynamics as a result of the Fed's rate actions. Focusing now on the 2022 performance of Fortune Brands Innovations' continuing businesses, the company generated sales of $4.7 billion for the full year, down 2% from 2021. Importantly, the company's performance over the last three years demonstrates our team's commitment and ability to create long-term value during both growth periods as well as through near-term disruptions. Since 2019, Fortune Brands Innovations has grown net sales at a three-year CAGR of 11.8%. Our organic sales CAGR during this time was 8% against an estimated market CAGR of 6%. Notably, we also expanded our operating margin 130 basis points to 17.1%. Even as we face an expected down market in 2023, our guidance reflects our commitment to continued outperformance and long-term growth. I'm confident in our ability to drive value for our shareholders regardless of the external environment, and I am excited for the future. Going into 2023, we are fully aware of the challenges we face ahead, particularly in the first half of the year. We will remain proactive in our response to any short-term headwinds while continuing to focus on outgrowing the market, preserving margins, generating cash, and prioritizing strategic investments. We remain excited about the medium to long-term potential of the housing market and are confident in our ability to deliver outsized results, as we focus on the supercharged growth opportunities within our categories. Our Fortune Brands Advantage capabilities will continue to advance our growth and margin journey by reducing costs, informing our strategic and pricing strategies, and enabling our higher growth focus areas like connected products. Our newly aligned and more efficient structure is intended to remove unnecessary duplication, accelerate our leadership in brands, innovation, and channel, and will allow us to more quickly deploy our Fortune Brands Advantage capabilities across the portfolio. Importantly, we also continue to be driven by our culture of doing the right thing, as evidenced by industry-leading safety records, leading ESG programs, and our focus on innovative products that help address some of the world's most pressing sustainability and safety issues. Turning to our fourth-quarter performance, consistent with what we signaled last quarter, our businesses saw demand levels decline abruptly following Labor Day. Fortune Brands Innovations' net sales declined 7%, while operating margin improved 110 basis points to 17.3%. These sales results were driven by the slowing macro environment and channel inventory reductions, coupled with strong prior year comparables driven by industry-leading 2021 service level performance. Given these challenges, our teams continued to focus on rightsizing the cost structure of the business as evidenced by our margin performance in the quarter. Our sound balance sheet and advantaged capital structure enabled us to strategically deploy capital both organically and inorganically. In 2022, we repurchased $580 million of shares and completed three strategic acquisitions, namely Flo, Solar Innovations, and Aqualisa. Also, as we announced at the end of last year, we have signed a purchase agreement to acquire two world-class businesses from ASSA ABLOY, the Emtek premium and luxury door and hardware business and the U.S. and Canadian Yale and August residential smart locks business. This disciplined acquisition, which we continue to expect to close around midyear, would be a strong accelerant to our connected product and luxury portfolio strategies. Turning to the remainder of our remarks today, first, I will share what we are seeing in our end markets. Then I will highlight key takeaways from our fourth-quarter and full-year results. Finally, Pat will provide highlights on our financial results, and Dave will share our thoughts around our future financial performance expectations for 2023, including how we intend to manage the P&L and balance sheet through the anticipated period of softness while advancing our previously communicated long-term goal of achieving a net sales growth CAGR of 6% to 9%, operating margins of 20% to 22%, and EBITDA margins of 23% to 25%. Now turning to some thoughts on the market for our products. As anticipated, our fourth quarter was marked by accelerated reductions in demand and continued inventory destocking across the channel, as well as a return to typical seasonality of demand patterns. Orders for new single-family homes dropped precipitously versus the prior year as consumers have paused on new home purchases. As a reminder, in previous periods of mortgage rate increases, consumers and builders typically take two to four quarters to adjust to the new levels of affordability, and we believe this adjustment is currently underway. In repair and remodel, activity slowed following Labor Day and continued at a depressed pace through the fourth quarter as normal seasonal demand patterns returned to the industry. Finally, in China, the housing market continued to be soft as Chinese consumer confidence and continued COVID mitigation strategies weighed on investment. We expect these macro challenges to continue into 2023 driven by temporarily depressed new construction starts and housing turnover, reduced consumer spending, and continued channel partner inventory normalization in select parts of the business. However, as we've consistently stated, we have confidence in the underlying fundamentals of the housing market and believe our products and brands are uniquely positioned to outperform. As the Fortune Brands Innovations portfolio is now more heavily weighted towards smaller ticket repair and remodel items or, in the case of our Security business, are more market-agnostic, our products are less exposed to market cyclicality. Additionally, as we have previously discussed, Fortune Brands Innovations' product portfolio is increasingly focused on our supercharged categories, those parts of the market with the highest potential for growth due to their secular tailwinds. Our leading brands and quality products inspire loyalty and confidence in categories where brands matter, especially in challenging environments. Our brand power, innovation, and best-in-class service provide a unique value proposition. Our focus on innovative products and operations are drivers of growth, productivity enhancement, and margin expansion. And finally, our category management expertise and strong customer relationships give us insights into consumer and customer behaviors and trends that enable greater consistency and pricing discipline. Let me be clear, we are well aware of the challenges that we are facing in 2023, and we have already taken significant and meaningful action in anticipation of the environment. Importantly, we are doing so in a thoughtful and disciplined way. Our experienced management team has successfully navigated through similar headwinds before. We will continue to protect our business while prioritizing investment in a tight set of key strategic priorities to win for the long term. Now let me turn to our fourth quarter and full year performance. Total company sales were down 7% in the fourth quarter, with full year sales down 2%. Operating margins were 17.3% for the fourth quarter and 17.1% for the full year, an improvement of 110 basis points and a decline of 20 basis points, respectively. These results reflect a recalibration of many aspects of the macro environment, including a slowing market for our products, continued channel inventory reductions, a return to normal seasonality as well as sales declines in China due to the continued COVID mitigation efforts. Looking forward, we believe that these headwinds will dissipate as the housing market stabilizes, inventory levels normalize, and inflation continues to decline to more manageable levels. While we still expect additional challenges, we believe we are prepared for the disruptions to come and are optimistic in our ability to outperform the market as it normalizes and returns to growth. Now turning to our individual businesses, beginning with Water Innovations, sales declined 9% in the quarter and 7% for the year driven by lower-than-expected volumes, including lower sales in China and inventory destocking throughout the channel, following our industry-leading 2021 service level performance. Fourth quarter declines were partially offset by the impact of the extra fiscal week and the Aqualisa acquisition, which is being rapidly integrated. Fourth quarter Moen U.S. POS was only down low single digits, and we saw continued POS growth in the U.S. for House of ROHL. Water Innovations' operating margins were an impressive 24% for the quarter and 24.2% for the year, driven by continuous operating improvement, fixed cost reduction initiatives, and price realization. While we focus on preserving our margins and returning to above-market growth across this segment, we continue to make critical investments in our key priorities. These investments in branding and innovation resonate with consumers and help highlight our value proposition during a time in which consumers may be more selective about their product choices. Additional investments in capacity and distribution, including our recently announced West Coast distribution center, will allow us to better serve our customers and improve our already best-in-class service experience. Despite the headwinds experienced by Water Innovations in 2022, our results over the last three years give us confidence in the segment's ability to outperform the market. Our three-year net sales growth CAGR is 8%, both organically and inorganically, which compares to market performance of around 6% during the same time. During this three-year period, we also saw 270 basis points of margin expansion. We remain confident that the business will maintain its market-leading top line performance with margin appreciation over time. In addition to consistently producing excellent products backed by a brand people trust, Moen is well positioned to capture the outsized growth associated with the secular tailwinds of connected products and ESG. At the recent CES show, we introduced the newest member of our integrated smart water network, the Moen Smart Sprinkler Controller and Smart Wireless Soil Sensors. This product has incredible water conservation potential and is already receiving a lot of positive attention and external recognition and awards. Importantly, it adds another node to our Moen smart water ecosystem, which continues to deliver increasing value to consumers. I encourage everyone to visit their website to learn more about how we are revolutionizing the way people connect with water. Our House of ROHL portfolio is performing very well as our brand, product, and showroom strategy increasingly resonates with luxury consumers. The House of ROHL generated mid-teens sales growth for the year and remains well-positioned to capture increasing share of the luxury plumbing market in 2023 and beyond. Finally, in China, sales declined approximately 30% as COVID mitigation efforts impacted new construction activity and consumer confidence. Due to the quick and decisive actions of our team, the business remained profitable. Despite the external challenges, the team continued to execute their strategy of pivoting towards growth from R&R and category expansion, which will deliver for us as the market stabilizes. Turning to Outdoors & Security, sales were down 5% for the fourth quarter and increased 6% for the full year. Operating margin for the segment was 14.8% in the fourth quarter and 14.5% for the full year driven by pricing. Our results reflected a soft market for decking and inventory destocking across the segment as more typical seasonality returns. Our decking business is increasingly optimized for operational and sales outperformance as we accelerate our journey to refine the Fiberon brand. Our POS indicates that we have maintained our overall share of the market that we continue to believe we will gain in popularity as consumers increasingly understand the value proposition of our advanced material decking products. Our Therma-Tru and LARSON brands continue to remain the brand of choice for consumers and professionals, and our recently acquired Solar Innovations brand is integrating well, finishing the year with very strong performance. Consumers and customers gravitate towards the value proposition that these brands bring, including innovative features, dependability, and attractive designs. We're exploring new synergistic product offerings between these brands, which we expect to drive incremental future growth. Finally, our sales for our overall Security business were down low-single digits due to destocking of locks and safes. Our commercial Security business remains strong, with low double-digit growth in the fourth quarter. As expected, our Outdoors & Security brands faced significantly softened demand this past quarter. We've already taken actions to streamline the businesses, positioning us well for the future. Longer term, we continue to be confident in the secular tailwinds driving outdoor living and the conversion to advanced materials as well as the inherent ESG talents and growth in the commercial security space as safety continues to remain a critical topic for employers across the world. We will be focused on expanding our presence in these highly attractive categories. The segment's long-term performance is impressive and demonstrates our ability to outperform even in the face of challenging environments. Our three-year net sales growth CAGR for the segment is 17% or 9% on an organic basis compared to market performance of around 6% during the same time. During the same period, we also saw 140 basis points of margin expansion. We remain confident that over time, the business will produce above-market sales and margin appreciation. To reiterate, 2022 was a year of transformation for Fortune Brands. We took steps to reshape the business while also preparing for an expected downturn. I'm immensely proud of everything our teams achieved this past year while also delivering impressive results in an increasingly challenging macro environment. We successfully executed the spin-off of our Cabinets business well ahead of our timing expectations, which we expect will unlock greater shareholder value for both companies by allowing us to focus on and invest in our unique growth opportunities. We rebranded our entire company with our new identity, reflecting our evolution as a business focused on driving accelerated growth in our categories through brand and innovation. To enable this focus and better leverage the Fortune Brands Advantage capabilities, we reorganized the company from a decentralized structure of separate businesses to a more aligned and efficient operating model. These transformative changes will enable us to deliver on the long-term growth and margin targets we set forth during our Investor Day and will also help us navigate the short-term challenges that we will face in the year ahead. In 2023, which Dave will speak to in greater detail, we expect to successfully navigate the challenges ahead while focusing on driving above-market growth, preserving margin, and generating cash. We will proactively manage through the short term while actively positioning Fortune Brands Innovations for the future and expect to be an even stronger, more efficient business when the markets return to strength. I'm confident in our ability to perform because we have already proven our ability to perform through all cycles, including over the last three years. Our team has executed exceptionally well, including growing the company above market through a monumentally disruptive period. We believe that we have already digested a great deal of the impact from these disruptions. As we begin 2023, we're seeing supply chains and customer inventories starting to return to more normalized levels. In short, we expect a challenging external environment in 2023. However, we are facing into it with focus, alignment, and ambition. We're confident in both the long-term fundamentals of the housing market and Fortune Brands Innovations' potential for accelerated outperformance when the market returns to growth. I will now turn the call over to Pat to summarize our 2022 results, and then Dave will talk about our 2023 outlook.

Thanks, Nick. I'm immensely proud of what Fortune Brands has accomplished over the last decade, and I am confident in the team's ability to continue to outperform the market and accelerate value creation. As a reminder, my comments will focus on results before charges and gains in order to best reflect ongoing business performance. Additionally, unless otherwise noted, the financial results presented will reflect Fortune Brands Innovations' performance from continuing operations. Finally, all comparisons will be made against the same period last year, unless noted otherwise. For the fourth quarter, sales were $1.1 billion, down 7% or down 9%, adjusting for FX and the impact of the 53rd fiscal week. Consolidated operating income was $196 million, down 1%. Total company operating margin was 17.3%, an improvement of 110 basis points. EPS were $1.07. For the full year, sales were $4.7 billion, also down 2%, adjusting for FX and the impact of the 53rd week. Consolidated operating income was $809.7 million, down 2%. Total company operating margin declined 20 basis points to 17.1%, with the second half operating margin improving 80 basis points. Our EPS were $4.24. As a reminder, the company did not allocate any 2022 interest expense to Cabinets as part of the separation. To reflect, the year began with 10-year treasury rates below 2% and 30-year mortgage rates below 3.5%. Persistent inflation resulted in an unusual pace of interest rate increases from the Fed which sent treasury rates upwards, decreased housing affordability, and slowed demand for housing following Labor Day. In the face of this rapidly changing environment, our teams took actions to protect the business while preserving investment in key strategic priorities. We remain highly focused on driving outperformance over time, including above-market growth and margin progression. I am confident the company will achieve the long-term targets set forth in our recent Investor Day. Now let me provide more color on our segment results, beginning with Water Innovations. Sales for the fourth quarter were $641 million, down 9%, or 11% excluding the impact of the 53rd week and FX. Fourth quarter results reflect the impact of the slowing global market, continued inventory destocking, and strong prior year comparables from our leading service levels, partially offset by price. For the year, sales were down 7%. Looking forward, we believe we will have worked through the remaining channel inventory reductions and unfavorable prior year service level comp dynamics by the end of the first quarter. Water Innovations operating income was $154 million in the fourth quarter, up 5%. Operating income for the full year was $623 million, down 2%. Operating margin was 24% for the quarter and 24.2% for the full year, reflecting cost reduction actions and price realization. Despite the real challenges we faced this year, our Water Innovations brands are still effectively competing in their markets. Our POS data for this segment is solid compared to the overall market as our total brand proposition continues to resonate with customers and consumers. Turning to Outdoors & Security, sales for the fourth quarter were $490 million, down 5%, or down 7% excluding the 53rd week and FX, driven by channel inventory reductions, the softer market environment, and strong prior year comparables, partially offset by acquisitions. For the full year, sales were $2.2 billion, an increase of 6%, or an increase of 5% excluding the impact of the 53rd week and FX. For Doors, which includes our Therma-Tru, LARSON, and Solar Innovations brands, sales were flat in the quarter as price offset the slowing housing market. Therma-Tru delivered an exceptional 2022 driven by innovation and strong customer service. We remain excited about the future of our Doors businesses as we work to bring additional innovative solutions to consumers as we integrate these brands to accelerate value creation. Decking sales were down over 30% in the quarter as wholesale channel inventory reductions more than offset high single-digit retail POS. We believe channel inventory reductions will be finished by the end of the first quarter and sales growth will track POS beyond that point. Security sales were down low single digits in the quarter as retail destocking of locks and safes more than offset low double-digit growth in our commercial products. We will continue to invest behind our brands and innovation to align the portfolio with the secular growth tailwinds of commercial and connected security and safety. Outdoors & Security segment operating income was $73 million during the quarter, down 11%, reflecting operating inefficiencies from volume declines associated with the channel destocking. Operating income for the full year was $312 million, up 2%. Segment operating margin for Outdoors & Security was 14.8% in the quarter and 14.5% for the full year. Turning to the balance sheet, our balance sheet remains strong with cash of $643 million, net debt of $2.0 billion, and our net debt-to-EBITDA leverage is 2.1 times. A portion of the proceeds from the dividend from Cabinets was used to pay down our variable rate debt. We finished the year with the full $1.25 billion available on our revolver. Our 2022 free cash flow of $330 million was lower than our expectations. Our lower free cash flow was driven by higher working capital due to sales reductions within supplier lead times and inventory investments to mitigate supplier risk due to COVID, lower operating income, and the payment of spin-related transaction fees during the quarter as a result of the accelerated spin timeline. For 2023, we have initiated actions to reduce our working capital balances, primarily via inventory reductions, and are targeting a higher cash conversion ratio for 2023. In summary, our teams delivered strong 2022 results in the face of a challenging environment. We transformed the business for long-term value creation, and we also positioned the company for an uncertain 2023 by altering our cost structure and prioritizing cash generation. We will continue to strategically invest in those priorities we believe will generate the highest returns and will best position the company for long-term growth. I will now turn the call over to Dave to discuss our 2023 outlook.

Thanks, Pat. Before turning to the details of our outlook for 2023, let me first provide some thoughts on the market backdrop and our approach to creating value regardless of the environment. We believe that strong demand fundamentals in our core markets support a multiyear housing expansion. However, we expect near-term housing affordability issues will result in a challenging 2023. If history is any indication, it is during challenging periods that Fortune Brands distinguishes itself through exceptional performance. We will confront such instances in 2023, as we have in the past, by appropriately managing our P&L and balance sheet while preserving strategic growth investments. Our focus for 2023 will be on delivering market-beating sales performance, preserving margins, and generating cash. By executing against these priorities, Fortune Brands Innovations will be well positioned to reaccelerate our growth and margin improvement journey when the housing market normalizes. With that backdrop, let me discuss the specifics of our 2023 outlook. We expect the global market for our products to be down between 6.5% and 8.5%, with the U.S. housing market also declining 6.5% to 8.5%. Within this market forecast, we expect U.S. R&R declining between 4% and 6%, U.S. single-family new construction declining between 18% and 22% with starts down around 25%, and the China market for our products to be down between 15% and 20%. Based on these assumptions, we expect full-year net sales to be down 5% to 7% with operating margins between 16% and 17%, implying decremental operating leverage of between 25% and 30%. We also expect EBITDA margins of between 19% and 20%. We expect decremental leverage in the first half of the year to be higher than the full-year target as one-time production inefficiencies and stranded costs from our inventory reduction efforts impact the P&L disproportionately relative to the full-year result. The first quarter will be impacted most acutely. Based on these assumptions, we expect full-year EPS within the range of $3.60 to $3.80. This outlook assumes volumes continue to decline as the housing market and overall global economy cools. If these challenges abate more quickly, this may create upside to our forecast. We should have better insight into these potential upside opportunities by the middle of 2023. As the macro environment evolves, we may revisit our guidance as merited. Now let me speak to our outlook for each segment as it relates to our overall guidance. Beginning in the first quarter of 2023, we will report Outdoors & Security as separate segments. We expect Water net sales down 5% to 7%, with segment operating margins around 23% to 24%. Outdoors net sales down 6% to 8%, with segment operating margins around 13.5% to 14.5% and Security net sales down 2% to 4%, with operating margins around 14% to 15%. We expect 2023 free cash flow of approximately $475 million and anticipate a cash conversion rate of around 100%. Our free cash flow forecast includes capital expenditures of $250 million to $300 million, inclusive of growth investments in Water and Outdoors that are expected to meaningfully enhance our operations and productivity. Additionally, we are executing plans to reduce our inventory by $175 million to $200 million and made meaningful progress against this target in the fourth quarter of 2022. Our balance sheet remains sound, and we expect to return to strong cash flow generation in 2023. Further capital deployment will be a function of the timing around the closure of the pending acquisition of the ASSA ABLOY assets, our overall leverage ratio in the context of the macro environment and business performance, and the availability of value-creating alternatives. Consistent with our track record, following organic investment and paying an attractive dividend, M&A and opportunistic share repurchases remain our top allocation priorities. The annual EPS outlook includes the following assumptions: corporate expenses, including investments in our ongoing digital transformation, of about $110 million to $120 million. Note, we continue to optimize our total SG&A to align to the new structure and size of the business and have made meaningful progress against our SG&A improvement targets outlined during Investor Day. Interest expense of approximately $110 million to $115 million. A tax rate around 23.5% to 24%. And average fully diluted shares of approximately 128 million to 129 million. As discussed, we are going into 2023 fully aware of the challenges we face. And while we have already taken meaningful actions, we are prepared to take further actions if necessary. However, we also believe that much of the external disruption stemming from the entirely unique COVID era is behind us, allowing us to focus on growing above market and generating cash. We remain confident in both the long-term fundamentals of our market and our ability to reach the targets we have set forth. I will now pass the call back to the operator for questions. Thank you.

Thank you. We will now begin taking a limited number of questions. Our first question is from Susan Maklari from Goldman Sachs. Your line is now live.

Thank you. Good afternoon, everyone. My first question is a bit higher level. Obviously, 2022 was a very big year for the business. You did a lot around the reorganization, the Cabinets spin. Can you just give us an update, as we come into the first couple of weeks of this year, how things are progressing with that? And I guess, how are the changes that you've made impacting how you're thinking about the forward trajectory of the business and the ability to continue to outperform?

Susan, great questions. So why don't I take that from the top? Certainly, you saw challenges emerging in the second half of last year while we were doing an enormous amount of work around both the portfolio and then the go-forward structure of the business. And so while our work is really long term in nature, we also sort of leaned into what we saw was going to be a very tough environment to allow us to streamline, take cost out and really make the business faster, more agile, and even more responsive than it has been historically. And so certainly saw that slowdown, as Pat referred to, even more so across the Labor Day period. And we're very, very clear, 2023 is going to be a challenging year. Then you saw our view about what we expect the market to do. But that said, we've got the team, and we've got the experience to manage challenging times. With our new aligned structure, we've now got tools than ever. And what I mean by that is you've seen what we've been able to do with the Fortune Brands Advantage, right, since 2020, which is deliver market-leading growth and offset headwinds all through the COVID period while driving margins up. This new structure allows us to take those capabilities and play them across the entire portfolio with far greater speed than we had when those capabilities were purely siloed inside of different businesses. And so it is an efficiency play, for sure, but it's far more than that. It's an effectiveness plan; it's a growth play because we know that we have very, very strong world-class capabilities in different pockets of the business, and now we're going to drive them with absolute speed. So as we come out of this, ergo, it's going to be a tough market. But I look back at the last three years, and the CAGR of the business is north of 8%, margins have grown 270 basis points over that period. And we've had to digest so much in terms of a slowdown and an acceleration and supply chain challenges and inventory piling up at our customers' customers that was even hard to see, and then taking that out. Now as you look into 2023, it's going to be a tough market. But I think we're going to have to digest a lot of that noise, and we can phase into a tough market just clear-eyed, knowing exactly what we need to do. And as Dave said in his remarks, it's during times of challenge that this company truly distinguishes itself. And I think with this new structure, we're going to be able to get after that even faster and then come out of this period with truly accelerated growth going forward. So sobering about the market but excited about what this company can do.

Okay. That's very helpful color. And then I guess, digging a bit more specifically about 2023, can you talk to the expectations around input costs? What are you seeing from an inflationary perspective? And the ability to hold price against that, you obviously made a lot of progress on the price side in 2022, how are you expecting that will come together this year?

Hey, Sue, this is Dave. I can handle that one. So I'll start with your inflation/deflation question and then get to price. We're expecting, I'd say, modest deflation but not banking on deflation by any means to deliver the margin targets both this year and long term. So if you think about our COGS base for Fortune Brands Innovations, which is roughly $2.8 billion, we see freight and material deflation of roughly one percentage point of that at the high end, though this is offset by continued inflation elsewhere in the business. So labor inflation has been pretty sticky; some indirect items that we purchased, inflation has been pretty sticky. And I think it's important to note that our key metals, such as copper and zinc, have given back a lot of their declines from the middle part of 2022. And so we're not seeing a significant benefit at this point in the metals side, maybe a bit in freight, but kind of coming in, I'd say, second quarter into the second half of the year. So kind of modest deflation and not banking on a big tailwind. And then on the price side, as we've taken price to cover inflation, I think we've also taken price based on the strength of our brands and innovation. And consumers, we've talked about in prior calls, consumers have been willing to continue to purchase our products, and we see our sales rates at the POS perform ahead of market. So the consumer is getting value as well with our price increases. And so as we look at the year, we expect low single-digit growth from price, and about half of that is going to be carryover price, and about half of that is new price. And most of the new price is coming in the Water segment as we see the world right now.

Okay.

I'll offer some insights on our pricing strategy, as it's a key component of your inquiry. In recent years, we've invested in enhancing our pricing capabilities within the business, utilizing data, tools, and analytics. This has enabled us to determine the best pricing approach that benefits not only us but also our channel partners. One of our objectives is to improve margins for our partners while ensuring that consumers see value through our brand and innovation efforts. We have outperformed the market by around 200 to 250 basis points over the past three years while also increasing our margins. Consumers are responding positively to our pricing strategy. As long as we maintain our focus on brand development and innovation, it continues to favor us. As we anticipate more challenging market conditions, we will remain focused on securing appropriate compensation for the value we provide in brand and innovation. If it requires adjusting our pricing for certain quarters to gain market share and stimulate long-term consumer demand, we are prepared to do that.

Great. That's very helpful. And I just finally want to congratulate Pat and wish him best wishes in his new role. It's been great working with you, and best of luck.

Thank you, Sue.

Thank you. Next question is coming from Matthew Bouley from Barclays. Your line is now live.

Hey, good evening, everyone. Thanks for taking the question and I want to pass along my best wishes to Pat as well. So a question on how you're seeing the year play out, 2023, in terms of cadence. You've got the 6.5% to 8.5% market decline for the full year, and then you also made the comment that you see decrementals as kind of less favorable in the first half than in the full year with those inefficiencies in Q1. So I guess it would be helpful if you could put some color specifically on that Q1 outlook and then kind of outline how you're thinking about sort of top line cadence and the resulting margin progression through the year. Thanks.

Yeah, hey, Matt, it's Dave. I'll take that one, and then Nick and Pat can add on. I'd say we typically don't give quarterly guidance, but there are some unique attributes in the first quarter that we alluded to that it's worth expanding upon. So let me start with the first quarter, and then I'll also provide some color on first half, second half cadence and how we're seeing the year progress per your question. So in the first quarter, we expect sales to decline low double digits, really driven by market softness and select channel inventory reductions primarily in Outdoors and Water. As we said on the call, we expect to be through most of the channel inventory declines by the end of the quarter but still will be a headwind in the first quarter. And then within each segment specifically, we'd expect low double-digit sales declines in Water and Outdoors and low single-digit at Security as they're less exposed to kind of the housing market as the channel inventory declines. On an operating margin standpoint, and this is where there's a bit of departure here from the full year, operating margin, we expect the first quarter to be at 12.5% to 13%. And that includes roughly $30 million of cost coming into the P&L from impacts of our production curtailments and stranded fixed costs related to our inventory reduction efforts. So we said on the call, what we said earlier, we're targeting inventory reduction of about $175 million to $200 million. About $65 million of that actually occurred in the fourth quarter, but we're hanging up some unfavorable costs from production curtailments that will come off the balance sheet into the P&L in the first quarter. So if I look at a normalized margin for us, excluding that $30 million, we'd be roughly flat to the prior year. It's about a 300 basis point impact. And then within each segment, we'd expect Water margins down in the low-20s, Outdoors in the high single digits and Security in the low double digits for the quarter. So with that said, with sales kind of down low double digits and the margin between 12.5% and 13%, we'd expect a first quarter EPS of $0.57 to $0.61. But now let me step back and just put the year in context a little bit. So looking at the first half, second half cadence, for the first half, inclusive of that first quarter that I just talked through, we see a first half sales decline between 7% and 9% and a first half operating margin between 15% and 15.5%. And that implies a first half decremental leverage of slightly greater than 30%. So as we mentioned earlier, we see the first half a bit higher than our full year average, and that's because of these stranded costs from our inventory reduction efforts. If we say the full year was about $50 million to $55 million, the first half is about $40 million, with $30 million of that in the first quarter, as I discussed. So that's going to be the headwind on the margin side in the first quarter and the first half. But then as we look to the second half, we see a sales decline between 3% and 5% and an operating margin between 17% and 18%, which implies a decremental margin better than 20%, which is more in line with our historical performance during a down market. So a lot to digest there, and the business is digesting a lot in the first half, in the first quarter. And we do expect the year to start off in a choppy manner just given the volatility of builder orders and starts. But as we look forward and look into the second half, we see the business performing kind of more indicative of how we would perform relative to market and with decrementals in a down market on the margin.

Got it. That's super helpful, Dave. I really appreciate that. Second one, just zooming into the very near term, you made those comments about kind of year-to-date trends. And you just mentioned at the top, in the response there, that you do expect some destocking in Water and Decking, I think, through Q1. I think I also heard you say in the prepared remarks that, in some cases, you're seeing customer inventories returning to a more normalized level. So I'm just curious, any more color on that kind of destocking outlook, how confident are you that it will be complete by Q1 across your businesses? And if you have any color on what you're seeing in POS year-to-date, that would be helpful as well. Thank you.

Hey, Matt, it's Nick. I'll start and then hand it over to Dave for more details. Regarding the inventory situation, a significant portion of that buildup is at our customers' customers, which is quite unusual, especially in Water, given our connection to production plumbers who experienced a surge in new construction. We believe most of that inventory was cleared in 2022, but there might be some remaining in early '23, possibly at retail and a bit more in decking, although we think that's mostly done. When it comes to decking, it's likely down in the mid- to high single digits in '22, and expected to be flat or slightly down in '23. Dave can provide additional insights on this. However, as you've pointed out, it's important to consider this in relation to point-of-sale growth. As we noted in our prepared remarks, we saw a significant drop after Labor Day. Interestingly, in January, as you've probably seen, the performance was slightly better than expected. Our POS retail data indicates that spending matched 2021 almost dollar for dollar, week for week, remaining flat for the month, which is more positive than our overall outlook for the year. We'll monitor how things develop, but we are preparing for a more challenging POS environment than what we're currently experiencing and will see how it plays out.

And Matt, this is Dave, I would just add. I think Nick did a good job of summarizing it. But as we move through the second half of last year, our teams got a lot closer to our customers with what's happening with their inventory and their customers' inventory. And so as we look going forward and continue to have those conversations, it's one of the things that gives us confidence that, hey, based on our market expectations for right now and our sales forecast for the year, there are some pockets of inventory in the channel that need to come out to normalize in the first quarter, as I mentioned, within Outdoors and Water. But otherwise, we feel like we are getting to normalized levels. And then as we progress from the second quarter on, our sell-in will more approximate our sell-out in the business.

Wonderful. Well, thank you, Dave, thanks Nick. Good luck guys.

Sure.

Thank you. Next question is coming from Adam Baumgarten from Zelman. Your line is now live.

Hey, everyone. Thanks for taking my question. Just curious on the acquisition front, sort of what you're seeing out there, if you're seeing any multiples come down, if the pipeline is pretty full. Also just your general kind of appetite for M&A in this type of environment as we look forward.

Yes, I'd say certainly, multiples have compressed from where they were kind of '21 and even part of '22. I think you saw that a lot more risk-off environment in the later part of last year, and I expect it will be the same this year. Although, as we pointed out and we got three smaller deals done over the course of last year. We feel very good about those and integrations are going really well. And I think kind of have a prudent capacity to take good assets and put them on the platform continues to deliver for us. And I'll add that this new structure really creates a much stronger acquisition platform because now we can play all of our capabilities across acquisitions, which is exciting. And so there are some things out there, but we've also got this pending transaction for the Emtek and the U.S. and Canadian Yale smart lock business, which we're really excited about because they are very supportive of our existing connected home strategy and our existing luxury strategy, and so they'll be great strategic accelerants. And so we're continuing to move towards what we hope will be a midyear closing date. We're kind of deep into integration planning, cooperating with the Department of Justice as they work through their case and anticipate that that will close midyear. So I think we're probably going to be watching that closely and, of course, watching the balance sheet closely in a tough environment to make sure that we keep the strength of our balance sheet intact as we move towards hopefully closing that. And if that goes as planned, it would be great. If not, there are other opportunities that are very interesting out there.

Thanks for clarifying. Regarding your forecast of a 15% to 20% decline in revenue from China for the year, do you anticipate that this will follow a trend similar to the overall business, where there might be a more challenging first half followed by improvement as the year progresses? Or do you expect it to remain relatively stable throughout the year?

Adam, it's Dave. I'll take that question. Let me provide some context regarding China before addressing your specific inquiry. The market there remains challenging, particularly in new construction, with new starts decreasing by 40% and new sales falling by 30% in 2022. This has created a difficult environment. Our team has effectively managed costs to maintain profitability and adjust the business and investment levels for the current situation. We anticipate that the market conditions will continue to impact sales growth in 2023, as the lag time for new construction projects in China tends to be around 12 to 18 months, compared to three to six months in the U.S. Consequently, the issues we faced in 2022 will carry over into 2023. The team has strategies in place to outperform the market, which is a consistent approach as we head into 2023. In the long term, we expect the Chinese market to transition more towards a repair and renovation focus, similar to the U.S. We believe our business is making the necessary preparations to position ourselves for growth through our brands, innovation, and channel relationships. However, it may be premature to conclude that conditions in China will improve as the year advances, given the aftermath of last year's decline in new construction.

Hey, guys. That's helpful. Thank you.

Thank you. Next question is coming from Stephen Kim from Evercore ISI. Your line is now live.

Yeah, thanks a lot guys. Just a housekeeping point, when you talk about POS, are those numbers adjusted for the extra week? Or are they inclusive for the extra week? And then when you talk about the U.S. new construction market, I think you said down 18% to 22%, single-fam starts, down 25%. This might be a tough question, but I'm wondering what kind of mortgage rate assumption you're sort of embedding in that outlook. And yeah, then I have a follow-up.

Steve, this is Dave. I'll address both questions. For POS, there is no impact from the 53rd week, so it's a straightforward comparison year over year. Regarding housing starts, we aren't expecting much relief in mortgage rates. If the Fed continues its course this year and mortgages remain around 6% or higher, our forecast is a 25% decrease in starts, which shows some improvement from recent builder order trends. We anticipate that builders either need to adjust their pricing or consumers are changing their expectations, leading us toward an equilibrium. To achieve that 25% decrease in starts this year, we need to see improvement, but we're not counting on significant changes in mortgage rates for this assumption.

Got you. Yes. And that was kind of where I was going. I think you mentioned that POS in January was actually flat year-over-year. So it sounded like it was better than, obviously, the outlook that you're laying out here. And so I guess, if you see, the industries see, let's say, better results in 1Q and 2Q, would that be a benefit to you as soon as the back half of the year or even sooner? I was a little surprised to hear that POS improved in January because that was really just when we started to see housing doing a little bit better there, and you saw it like almost immediately. So I'm just kind of curious, what kind of a lag do you think we're thinking about or we should be thinking about if housing does better than you think?

Yes. Regarding our market forecast, we're currently seeing a decline in single-family demand as we progress through the year. There tends to be a three to six month lag, possibly longer, due to the backlog of completions affecting our product demand based on the declines we experienced last year. I believe that the R&R sector will remain somewhat unpredictable. While our market assumption is that R&R will finish the year down in low single digits, there could be potential upside if consumer confidence remains strong and the economy manages a soft landing. However, we're not observing that trend at the moment. We had a decent point of sale in January, but one month’s performance won't define the quarter or the year, and we still face some challenges ahead.

No doubt. Yes, okay. Great. That's really helpful. Appreciate all the color here. Thanks guys.

Thank you. We reached the end of our question-and-answer session. And ladies and gentlemen, that does conclude today's teleconference. You may now disconnect. We do thank you for your participation today.