SiteOne Landscape Supply, Inc. Q2 FY2022 Earnings Call

Greetings, and welcome to the SiteOne Landscape Supply Second Quarter 2022 Earnings Call. I would now like to turn the call over to Mr. John Guthrie, Executive Vice President and Chief Financial Officer for SiteOne Landscape Supply. Thank you. You may begin.

Thank you, and good morning, everyone. We issued our second quarter 2022 earnings press release this morning and posted a slide presentation to the Investor Relations portion of our website at investors.siteone.com. I'm joined today by Doug Black, our Chairman and Chief Executive Officer; and Scott Salmon, Executive Vice President, Strategy and Development. Before we begin, I would like to remind everyone that today's press release, slide presentation and the statements made during the call include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our expectations and projections. Such risks and uncertainties include the factors set forth in the earnings release and in our filings with the Securities and Exchange Commission. Additionally, during today's call, we will discuss non-GAAP measures, which we believe can be useful in evaluating our performance. A reconciliation of these measures can be found in our earnings release and in the slide presentation. I would now like to turn the call over to Doug Black.

Thanks, John. Good morning, and thank you for joining us today. We were pleased to continue our positive momentum during the second quarter with solid growth in sales and profits, despite strong comparable growth from last year and spring weather headwinds in our northern markets. Weaker volume in these markets was more than offset by stronger price realization across all markets, coupled with a good contribution from acquisitions. We are also very pleased to add 7 new high-performing companies to SiteOne over the last 4 months through acquisition, building our foundation for future performance and growth. As we enter the second half of the year, we expect prices to contribute less to organic daily sales growth and volume to improve versus the first half of the year against weaker comparisons. Taken all together, with our strong teams, improved capabilities and robust acquisition pipeline, we expect to continue gaining market share and achieve another very good year of performance and growth in 2022 while building our company for the future. I will start today's call with a brief overview of our unique market position and our strategy for long-term performance and growth, followed by some highlights from the quarter. John Guthrie will then walk you through our second quarter financial results in more detail and provide an update on our balance sheet and liquidity position. Scott Salmon will discuss our acquisition strategy, and then I will come back to address our latest outlook before taking your questions. As shown on Slide 4 of the earnings presentation, we have grown our footprint to more than 620 branches and 4 distribution centers across 45 U.S. states and 6 Canadian provinces. We are the clear industry leader over 5 times the size of our nearest competitor, yet we estimate that we only have about a 15% share of the very fragmented $23 billion wholesale landscaping products distribution market. Accordingly, our future growth opportunity is significant. We have a balanced mix of business with 64% focused on maintenance, repair and upgrade, 21% focused on new residential construction and 15% on new commercial and recreational construction. As the only national full product line wholesale distributor in the market, we also have an excellent balance across our product lines as well as geographically. Our strategy to fill in our product lines across the U.S. and Canada, both organically and through acquisitions, strengthens and reinforces this balance over time. Overall, our balanced end market mix, broad product portfolio and good geographic coverage offer us multiple avenues to grow and more ways to create value for our customers and suppliers while providing important resiliency in softer markets. Turning to Slide 5. Our strategy is to leverage the scale, resources, functional talent and capabilities that we have as the largest company in our industry, all in support of our talented, experienced and entrepreneurial local teams, to consistently deliver more value than our competitors to our customers and suppliers. We've come a long way in building SiteOne and executing our strategy over the last 6 years, but we are still in the third or fourth inning of our overall development as a truly world-class company. Accordingly, we remain highly focused on our commercial and operational initiatives to further build our capabilities and improve the value that we deliver to customers and suppliers. These initiatives are complemented by our acquisition strategy, which builds in our product portfolio, moves us into new geographic markets and adds terrific new talent to SiteOne. Taken all together, our strategy creates superior value for our shareholders through organic growth, acquisition growth and EBITDA margin expansion. If you turn to Slide 6, you can see that we have built a strong track record of performance and growth over the last 6 years with consistent, organic and acquisition growth and good EBITDA margin expansion. Note that we have done this while investing heavily in our teams and in new systems and technologies to build the foundation for SiteOne and to create superior capabilities for our customers and suppliers. We are still building and investing, and we remain confident in our ability to gain market share and continue driving all 3 of our value creation levers going forward. You will also note that we have now completed 72 acquisitions across the irrigation, lighting, agronomics, nursery, hardscapes and landscape supplies product lines during the last 8 years, with 8 completed so far in 2022. We only acquire well-run companies, and so all these acquisitions were already high-performing companies before joining SiteOne. After they join us, we together enjoy the benefits of our combined commercial and operational capabilities. Acquisitions are also a key source of new talent and ideas, and therefore, they enhance our competitive advantage as we grow. We're off to a strong start to the year, and our acquisition pipeline remains robust with significant potential to continue growing through acquisition for many years to come. Slide 7 shows the long runway that we have ahead in filling in our product portfolio, which we aim to do primarily through acquisition, especially in the nursery, hardscapes and landscape supplies categories. We are well networked with the best companies in our industry and expect to continue filling in these markets systematically over the next decade. I will now discuss some of our second quarter performance highlights as shown on Slide 8. We achieved 12% net sales growth in the second quarter with 8% organic daily sales growth and 4% net sales growth added through acquisitions. The organic daily sales growth was driven by 19% price realization, partially offset by an 11% volume decline. With 26% organic daily sales growth in the first half of last year, driven primarily by volume, we expected volume growth to be negative for the first half of this year. In addition, we had less favorable weather in our northern markets this year than last year, which significantly affected our growth in those markets. Accordingly, organic daily sales growth were flat during the quarter in our northern markets, stretching from the Northeast across to the Pacific Northwest, including Canada. Gross margin improved 210 basis points to 37.9% for the quarter, as we continue to benefit from proactive inventory management during this high inflation period. For the first half, gross margin is also up 210 basis points to 36.1%. As a reminder, we had previously thought that gross margin would decline this year without the benefits of price realization that we achieved primarily in the third and fourth quarters of last year. We still expect gross margin to be lower in the second half than last year, but given our strong start and the persistent inflation, we now expect modest improvement in gross margin for the full year 2022. On the SG&A side, our operational initiatives and disciplined cost management were offset by lower volumes, higher-than-expected fuel and wage expense and our continued investments in marketing, digital and operational excellence. Our recent acquisitions of hardscapes and landscape supply companies also contributed to the SG&A increase as a percent of sales, as these businesses operate with a higher gross margin and a higher SG&A percentage. Accordingly, SG&A as a percentage of net sales increased by 160 basis points to 22.4%. We expect SG&A leverage to improve in the second half. The combination of good organic sales growth, gross margin improvement and solid contribution from acquisitions allowed us to deliver adjusted EBITDA growth of 16% for the quarter and expand adjusted EBITDA margin by 60 basis points to 18.2%. Overall, we remain focused on improving our adjusted EBITDA margin as we grow by executing our commercial and operational initiatives and capturing synergies with acquisitions. In terms of our initiatives, we have continued to make good progress this year. On the gross margin side, we continue to grow with small customers, drive private label growth and improve our inbound freight costs through our Transportation Management System or TMS initiative. As price realization runs its course this year, we expect these initiatives to allow us to continue driving steady gross margin improvement in the years to come. We also have several initiatives aimed at improving our customer experience while making our teams more efficient, thereby increasing organic growth and improving our SG&A leverage. MobilePro helps automate branch transactions while allowing our associates to serve customers from anywhere on the branch site. We can serve customers quicker and more accurately, especially at our larger nursery and hardscapes sites, and our branch associates are more efficient—a win-win. We have recently enhanced the functionality of MobilePro and solved some of the connectivity problems. So our progress in rolling this out across SiteOne has accelerated. By mid-2023, MobilePro should be broadly deployed across SiteOne. We also are currently rolling out DispatchTrack, which allows us to manage our outbound deliveries to customers and proactively update customers on their delivery status by text. DispatchTrack is a terrific improvement to our customer experience and has set us up to start managing our outbound fleet more efficiently within each MSA. We expect to benefit from these efficiencies in 2023 and beyond. Additionally, we continue to make great progress with siteone.com as we have added substantial new functionality and capabilities to the site. With these improvements, we are seeing improved customer adoption and increased activity as we move into the second half of the year. Finally, we are executing numerous other operational excellence initiatives that are focused on enhancing our customer experience and improving our associate efficiency. These projects range from how we answer our phones during the busy parts of the day to how we organize and staff our branches, to how we bid and quote commercial projects. We now have a full-time team in each major line of business, working with the field to isolate pain points and then develop and implement solutions across the company. In total, we have ample opportunity to improve our customer experience and increase our operating effectiveness and efficiencies while expanding gross margin in the years to come. On the acquisition front, we added a record 6 high-performing companies to our family during the quarter and 1 more since the quarter closed, bringing the total to 8 so far this year. These companies provide us with excellent new talent and capabilities for growth in their respective markets, while adding approximately $125 million in trailing 12-month sales to SiteOne. Our development teams remain very active in 2022, and we expect to continue adding strong companies to SiteOne in the coming months. With an experienced and recently expanded team, broad and deep relationships with the best companies, a strong balance sheet and an excellent reputation as the acquirer of choice, we remain well-positioned to grow consistently through acquisition this year and for many years in the future. In summary, we are executing strongly in the current environment to build our teams, execute our initiatives, deliver value to our customers and suppliers, add new companies and achieve excellent performance and growth. As we look ahead to the second half, we are confident in our ability to deliver another strong year in 2022. More broadly, as we look ahead to 2023, which will likely be a tougher year, we remain very confident in our capability to navigate through any market conditions and expect to both outperform the market and with our strong balance sheet, continue to build our company for the future. Now John will walk you through the quarter in more detail.

Thanks, Doug. I'll begin on Slide 9 with some highlights from our second quarter results. We reported a net sales increase of 12% to $1.22 billion in the quarter. There were 64 selling days in the second quarter, which is consistent with the prior year period. Organic daily sales increased by 8% in the quarter, driven by price inflation in response to rising product costs, partially offset by dampened volumes resulting from higher prices, moderating economic conditions and unfavorable weather in our northern markets. Acquisitions continued to perform well, contributing approximately $45 million or 4% to our second quarter net sales growth. Scott will provide more details regarding our acquisition strategy later in the call. Geographically, we saw a wide variation in organic sales growth in the second quarter. In the Sun Belt market, we saw solid organic daily sales growth of 17%, but in northern markets, stretching from the Pacific Northwest to the East Coast, we saw no organic daily sales growth. These markets, which faced a tough 24% comp from last year, were negatively impacted by the slow start to the spring and unfavorable weather compared to the prior year. Overall, 7 out of our 9 regions, including all northern markets, had more rain in Q2 2022 compared to a very dry Q2 2021. Organic daily sales for agronomic products, which include fertilizer, control products, ice melt and equipment, increased 7% for the second quarter due to strong price inflation resulting from rising product costs, partially offset by reduced volumes from unfavorable weather and higher prices. Prices for agronomic products like fertilizer and grass seed have risen dramatically over the past year. And while price inflation has been an overall net positive to sales growth, we believe the higher prices for products like fertilizer have reduced the short-term demand as our customers grapple with constrained maintenance budgets. In addition, some of our largest agronomic markets are in the north, and the combination of the wet weather and a late spring resulted in some lawn care operators reducing rounds of agronomic product applications. Organic daily sales for landscaping products, which include irrigation, nursery, hardscapes, outdoor lighting and landscape accessories, increased 9% for the second quarter due primarily to price inflation as prices for products like PVC pipes and drainage remain elevated compared to the prior year. Price inflation continues to play a major role in the organic daily sales growth for both landscaping products and agronomic products. We estimate price inflation contributed 19% to our organic daily sales growth for the quarter. While we have started to see signs of relief in some of our most volatile products like fertilizer and copper wire, price inflation has been greater and more persistent than we originally expected. We still expect price inflation to moderate in the second half of 2022 as we start to compare last year's price increases, but we expect the magnitude of the reduction to be less than we originally forecasted. Conversely, we expect volume, while still healthy, to be less than we originally expected as it appears we have come off peak levels due to the combination of weather, higher prices and general economic uncertainty. As we look out to the rest of the year, we expect these trends to continue. Gross profit increased 19% to $461 million for the second quarter, and gross margin increased 210 basis points to 37.9%. Gross margin during the quarter was positively impacted by supply chain initiatives, price realization and contributions from acquisitions. We continue to expect a gross margin decline in the second half of 2022, as our gross margin improvement initiatives such as private label and small customer growth are more than offset by the loss of the price realization benefit that we experienced last year. However, the amount of the reduction will be less than our original expectations due to the persistent price inflation. Selling, general and administrative expense, or SG&A, increased 21% to $273 million for the second quarter. SG&A as a percentage of net sales increased 160 basis points to 22.4% due to increased operating expenses supporting our growth, cost inflation and the impacts of acquisitions. We continue to make investments in our initiatives, including marketing, digital and MobilePro, which we believe will enhance the customer experience and improve the efficiency of our operations. We are also seeing the impact of inflation in SG&A as costs for salaries, fuel, travel and general branch operations have all increased this year. Finally, our most recent acquisitions have positively impacted our gross margin but also negatively impacted SG&A due to their higher operating cost structure. For the second quarter, we recorded income tax expense of $44.8 million compared to $36.8 million in the prior year period. The effective tax rate was 24.2% compared to 23% for the 3 months ended July 4, 2021. The increase in the effective tax rate was due primarily to a decrease in the amount of excess tax benefits from stock-based compensation. We realized $2.4 million in excess tax benefits for the 3 months ended July 3, 2022, compared to $4.8 million for the 3 months ended July 4, 2021. We recorded net income for the second quarter of $140.7 million compared to $123.5 million for the prior year period. The improvement was primarily driven by our strong sales growth and gross margin improvement. Our weighted average diluted share count for the second quarter was 45.8 million, which is comparable to the prior year period. Adjusted EBITDA increased by 16% to $222 million for the second quarter compared to $191 million for the same period in the prior year. Adjusted EBITDA margin, reflecting our gross margin improvement, increased by 60 basis points to 18.2%. Now I'd like to provide a brief update on our balance sheet and cash flow statement, as shown on Slide 10. Net working capital at the end of the second quarter was at $885 million compared to $624 million at the end of the same period in the prior year. The increase in net working capital is primarily attributable to higher receivables resulting from our strong sales growth and an increase in inventory, reflecting supply chain uncertainty, cost inflations and strategic purchases ahead of cost increases from our suppliers. Net cash provided by operating activities during the second quarter was $95 million compared to $138 million for the prior year period. The decrease is primarily due to the increase in working capital to support our growth. We made cash investments of $104 million for the quarter compared to $36 million for the same quarter last year. The increase in cash investments reflects our increased acquisition activity during the quarter. Net debt at the end of the quarter was approximately $436 million compared to $257 million at the end of the prior year period. The increase in net debt reflects higher borrowings to fund the increase in working capital and our acquisition investments. Leverage at the end of the second quarter increased to 0.9x our trailing 12-month adjusted EBITDA compared to 0.7x at the end of the second quarter of 2021. The higher leverage reflects the increased net debt. Our target net debt to adjusted EBITDA leverage range at the end of the year is 1x to 2x. At the end of the quarter, we had liquidity of $228 million, which consisted of $50 million of cash and approximately $178 million in available capacity under our asset-based loan or ABL facility. On July 22, after the close of our second quarter, we amended our ABL facility increasing the size to $600 million from $375 million and extended maturity to July 2027 from February 2024. With this amendment, we increased liquidity by an additional $225 million. In summary, our priority from a balance sheet perspective is to maintain our financial strength and flexibility without sacrificing long-term growth or market opportunities. I will now turn the call over to Scott for an update on our acquisition strategy.

Thanks, John. As shown on Slide 11, we acquired 6 companies during the second quarter and 1 company since the end of the second quarter, bringing our total to 8 for 2022, with a combined trailing 12-month net sales of approximately $125 million. Since 2014, we have acquired 72 companies with approximately $1.35 billion in trailing 12-month net sales added to SiteOne. Turning to Slides 12 through 18, you will find information on our most recent acquisitions. On April 22, we acquired BellStone Masonry Supply with a single location serving the Fort Worth, Texas market. BellStone distributes hardscapes and bulk landscape supplies and builds upon our December 2020 acquisition of Alpine Materials, which also supplies hardscapes products. On April 28, we acquired Preferred Seed, a leading supplier of agronomics products to landscape contractors in Upstate New York with 1 location in Buffalo. On June 17, we completed our acquisition of Across the Pond, a wholesale distributor of hardscapes and bulk landscape materials with 1 location in Huntsville, Alabama. This acquisition expands our current presence in the market and our product offering to include hardscapes and bulk landscape supply. We completed our acquisition of Yard Works, an industry leader in the distribution of bulk mulch and soil on June 22. With 13 locations across Central Virginia, the addition of Yard Works extends the strong market position we established earlier this year in Northern Virginia with the acquisition of JK Enterprises. On June 30, we acquired Prescott Dirt, a distributor of landscape supplies and hardscapes with 2 locations in Prescott and Prescott Valley, Arizona. On July 1, we acquired A&A Stepping Stone, a leading wholesale distributor of hardscapes and landscape supplies with 4 locations in Sacramento, California. The addition of A&A establishes a leading hardscapes and landscape supplies platform in the growing Sacramento market. And lastly, on July 22, we acquired River Valley Horticultural, a wholesale distributor of nursery, hardscapes and irrigation products with a single location in Little Rock, Arkansas. River Valley establishes a nursery platform for SiteOne in Central Arkansas. These acquisitions add terrific talent to SiteOne and move us forward toward our goal of providing a full line of landscape products and services to our customers in all major U.S. and Canadian markets. Summarizing on Slide 19, our acquisition strategy continues to create significant value for SiteOne. The recent expansion of our team has both improved our capacity to source and complete acquisitions and also improved the quality and effectiveness of our integration of these new companies and teams. Our team of over 60 former owners, together with our experienced field leadership, creates an unrivaled, down to earth, and make it happen culture at SiteOne, which in turn makes us the acquirer of choice for family businesses. Our laser focus on landscape distribution gives these entrepreneurs tremendous confidence that when they join SiteOne, they are joining the long-term market leader who will provide their associates with strong support and nearly endless opportunities for career growth and success across North America. Heading into the second half of 2022, we are pleased with our M&A momentum and the ongoing strength of our pipeline. We have a highly capable team, an excellent reputation and a strong balance sheet to fund our acquisition strategy in both strong and challenging market conditions. Taken together, these elements give us confidence that we will add more outstanding companies to SiteOne across the U.S. and Canada throughout the rest of 2022 and for many years to come, as we build SiteOne's capability to provide more value to our customers and suppliers. I want to thank the entire SiteOne team for their passion and commitment in welcoming the newly acquired teams when they joined SiteOne. Their leadership and efforts are the key to our long-term success in building our company.

I will now turn the call back to Doug. Thanks, Scott. I'll wrap up on Slide 20. Following our spring season, which, as we mentioned, was significantly weather-affected, we've developed solid momentum as we move through the summer and into our important fall season. Volume has been less negative in July than in the second quarter, and sales growth has remained in the double digits due to continued price realization. As we lap last year, as John mentioned, we expect price realization to moderate, but we also expect volume to strengthen versus easier comparisons from 2021. Our customers continue to have solid backlogs of work, and we expect them to remain busy through the end of the year. Overall, the market should provide a reasonable environment for us to execute our commercial and operational initiatives and drive further growth in sales and profits in the second half. In terms of end markets, we are beginning to see some slowdown in residential new construction, which comprises 21% of our sales. With home price inflation and higher interest rates, homebuilders are seeing less demand and are being more cautious in terms of new starts. We would expect this softness to continue with moderate declines versus the prior year. On the contrary, new commercial construction representing 15% of our sales has remained strong with healthy bidding activity and large backlogs. Note also that early phase material shortages in concrete and building components have delayed the landscaping phase of new commercial projects, which, in turn, has dampened near-term activity but increased the backlog of work for our customers. Major repair and remodel, which comprises 27% of our sales, has also remained strong with only a few parts of the country developing some softness. Typically, in a downturn, major repair and remodel has proven to be more durable than new construction, and we expect that to be the case both this year and in 2023. Note that low unemployment and high home values both support the major repair and remodel market. Finally, the maintenance end market, which comprises 37% of our sales, has remained steady. Again, as John mentioned, our end customers have somewhat fixed dollar budgets for maintenance. And so with the rapid price inflation in products like fertilizer and seed, maintenance customers tend to cut back wherever they can to get through the year. Looking forward, as prices in these products come down and budgets are adjusted, we should expect volume to recover as customers focus on the longer-term health of their landscaping. Overall, maintenance dollar demand has remained steady, and we expect that to continue. In total, we expect our end markets to provide a reasonable foundation for us to execute our strategy and gain market share, as we deliver higher value to our customers and suppliers. Accordingly, we continue to expect to achieve high single-digit organic daily sales growth for the full year of 2022, mostly driven by price inflation. As mentioned, we now expect our gross margin to be slightly higher than last year, offset by SG&A, which will also be slightly higher than last year as a percentage of sales. Accordingly, we expect our adjusted EBITDA margin to be similar to 2021. In terms of acquisitions, as Scott mentioned, we have a strong pipeline of high-quality companies and look forward to adding more of these to the SiteOne family during the year. Our acquisitions are performing very well, and we continue to improve our ability to integrate them into our company. Accordingly, we expect acquisitions to contribute strongly to our performance and growth in the remainder of 2022 and the years ahead. With all these factors in mind, we are increasing our expectations for fiscal 2022 adjusted EBITDA to be in the range of $440 million to $460 million, which represents year-over-year growth of 6% to 11%. This range does not factor any contribution from unannounced acquisitions. In closing, I would like to sincerely thank all our SiteOne associates who continue to amaze me with their passion, commitment, teamwork and selfless service. We have a tremendous team, and it is an honor to be joined with them as we deliver increasing value for all our stakeholders. I would also like to thank our suppliers for supporting us so strongly and our customers for allowing us to be their partner. Operator, please open the line for questions.

The first question comes from Ryan Merkel with William Blair.

I wanted to start with the comments that higher prices are hurting growth. Can you just unpack what you mean there?

Yes. I think there, Ryan, we're referring particularly to the maintenance piece of our business. As we described earlier, the maintenance budgets are fairly fixed, both maintaining facilities, et cetera. And when prices go up to the extent they have, they use some short-term tactics to get through and save here and pinch there, seed, fertilizer, et cetera. When prices revert back, they come back and go back to maintaining the long-term health of their properties, right? So there is some price elasticity in that market. And given the significant run-up in prices, we're seeing some of that softness. So that's what we're referring to in terms of kind of price-driven demand dynamics.

Okay. Saying that will correct itself as some of the commodity prices come down?

Right. That's traditionally what we see is that, prices come back down, they're able to spend and use the volume that they need to maintain what they're trying to maintain. So that tends to correct. So you could call that an upside for possibly for next year on the volume side.

Got it. And just to be clear, weather was the biggest impact to growth in the quarter or was it the higher prices because you listed that first in the press release, so I just wanted to clear that up?

Yes, the price was a relatively minor factor. The weather had a significant impact, particularly in April and May, which were challenging months. We finished the quarter with an 8% decrease in volume, which was down 11% overall. For July, we're experiencing a decline of about 5% to 6%, indicating some recovery. The situation in the northern markets, from the Northeast to the Pacific Northwest and including Canada, remained flat, despite a 17% growth in the Sun Belt. When I say flat, I mean flat overall, taking the price increase into account. It was a tough spring compared to last year, which had much better weather.

Okay. That's helpful. It seems that volumes will be down in the low single digits, possibly mid-single digits in the second half, which is an improvement from the second quarter. Is that simply due to easier comparisons and more typical weather?

If you look at last year, the first half was mainly driven by our growth volume. We achieved 22% growth for the full year, with 11% of that being volume growth, which occurred mostly in the first half. The second half was flat to slightly up last year, so there’s an easier comparison this time around. We expect volumes to continue to improve and be less negative in the second half as we progress through the third and fourth quarters.

Got it. Maybe just lastly on gross margin. The guidance implies a run rate of about 34% in the second half. I know you're not guiding to '23, but is 34% a fair run rate as we look forward? There are a lot of questions out there in distribution land about where gross margins will settle out in '23 and when inventory profits come out of the numbers? Any help there would be appreciated.

I think if you look at our guidance in the beginning of the year, it had kind of a baseline of 34%. I think that certainly will give more as we get closer, but that certainly was in our guidance at the beginning of the year from that standpoint.

And that was the low end. We guided for 34% to 34.5%, and that's where we thought it would reset this year. That's probably where we believe it will go when the price aspect is excluded. However, keep in mind that each year we make acquisitions, and we're actively pursuing a lot of hardscapes and landscape supplies acquisitions. These typically come with a higher gross margin and also higher selling, general, and administrative expenses, but remain in a similar EBITDA range. So that's an important factor. When you consider a couple of years of this, you have to anticipate some improvement in gross margin simply due to acquisitions.

The next question is from Stephen Volkmann with Jefferies.

My question is around your comment, Doug, that '23 is setting up to be a tougher year. So I guess maybe that's something around residential, but I don't want to put words in your mouth. So maybe just a little bit of detail about sort of big picture how you're thinking about '23? And then the follow-on there at the same time is what's the playbook for a tougher year? Is there work you can do on SG&A or do you think acquisition activity can accelerate? Is there inventory reduction? Just kind of what are the moving pieces in a 'tougher year?'

Thank you for the question. Looking at the context of a challenging year, I'll break it down by market. Starting with new residential, which accounts for 21% of our sales, it's likely to be softer than this year, presenting a headwind. In contrast, new commercial has been strong, with good backlogs and bidding activity, so we feel confident about new non-residential, which makes up 15% of our sales. We model 27% of our sales and have seen solid performance in that area, although growth might be less than this year. We expect it to be a bit softer. Maintenance tends to remain stable across various market conditions, and if commodity prices decrease, we could see some upside in volume, even with maintenance budgets remaining stable. Overall, we don't want to set expectations for 2023 just yet, but it doesn't appear to be a terrible year ahead, although it could be more challenging than this year. An important factor this year is our price realization, which we don't expect next year, meaning we'll need to adjust to the absence of that. We anticipated a gross margin reset this year, which is likely to happen next year instead. Factoring all this in, it may be a more difficult year compared to last year's exceptional performance. As we navigate through markets with declining volumes or headwinds, we'll implement our commercial operational initiatives to enhance our gross margin and improve our SG&A leverage. We'll approach specific soft markets prudently by potentially trimming our workforce and halting new hires if needed. Additionally, we plan to continue investing in acquisitions across various markets. Overall, we remain optimistic about our company's performance, regardless of how the market unfolds next year.

Got it. Okay. That's super helpful. Just a quick follow-on, on the pricing, since you mentioned it. Do we get positive impact of carryover pricing in '23 or do you think that sort of deflation in certain kinds of products might kind of offset that? Just how should we think about inflation in '23?

We'll have to see. It's been more persistent this year than last year. In our original guidance, we expected some commodities to decrease more dramatically in the second half of this year. Looking long-term, about 20% of our business tends to reprice frequently, and some of that may decrease in the future, particularly for fertilizer and PVC pipe. I believe fertilizer prices will come down from their peak in the second half of this year, but they will still be high compared to two years ago. We're noticing a decline in copper wire prices right now. However, how much they drop remains to be seen as we approach the end of the year. Some items peaked in the second quarter and are beginning to decline, which we have factored into our guidance.

We believe that the other 80% will remain solid and stable; there is a possibility for additional price increases there, and we feel optimistic about that segment continuing to hold steady. Manufacturers will keep an eye on costs, but the other 80% has been in catch-up mode, and we expect that trend to persist.

The next question comes from the line of David Manthey with Baird.

First off, John, I don't know if you gave it, but the price and volume breakdown across agronomics and landscape products, if you could provide that to us?

We don't split it out completely like that. I think it would be fair to say based upon what Doug mentioned, what we're seeing with regards to agronomic products that it's greater in that line than it is in the landscape products and what I mentioned is kind of the fixed volume component.

Okay. Yes, fair enough. And then definitionally here, when you talk about the 27% that's major repair and remodel, what do you think in terms of discretionary versus nondiscretionary in that business? How much of that is sort of responding to something? And how much of it is just deciding you want to do a project? And related, when you talk about new construction specifically, are you talking about selling into a structure that was just built or could that also be someone who's putting in a new outdoor kitchen that never had one before? Just definitionally, if you could help us with those?

New construction refers to a home that has just been built. A new kitchen in the backyard would be considered a major repair and upgrade. When discussing major repairs and upgrades, there are frequent questions about what is discretionary versus nondiscretionary. While it's a topic that could lead to extensive debate, what truly matters are the underlying factors that influence these decisions. Typically, those factors include job availability and home equity. There's also a level of housing turnover; when new homes are sold, the new owners often want to make changes. These factors are significant drivers. It’s an unusual situation right now, especially considering the potential for a recession and a decrease in new residential construction alongside low unemployment rates. I haven’t experienced many recessions characterized by low unemployment. We have a lot of white-collar workers who remain employed and are spending more time at home, often looking to improve their living spaces. Since home values have risen, owners have substantial home equity, which usually leads to an increase in strong repair and remodeling activity. We cautiously remain optimistic that repair and remodeling will continue to be robust due to these factors. We’ll need to monitor how this develops, but the foundational elements supporting this market are there.

The next question is from Matthew Bouley with Barclays.

Can I ask on the SG&A side? Yes, I know you mentioned several factors that drove sort of the deleveraging in the quarter despite the strong, I guess, price inflation you had. I'm curious, I guess, number one, if you sort of quantify those pieces that drove the deleverage and maybe if there's anything additional perhaps on the weather and staffing and incentive side that plays into that? And obviously, what I'm really getting at is sort of your view to the second half of the year and the ability to sort of improve the leverage side with SG&A?

Yes. Regarding the increase in SG&A, I believe the acquisitions contributed approximately 40 to 60 basis points of that rise. These are businesses that come with a higher cost basis. About 20 basis points should be removed on an adjusted basis due to some one-time costs associated with those acquisitions. So, roughly 40 basis points were linked to ongoing acquisition activity, while 20 was due to the adjusted costs. The remaining increase, about 90 to 100 basis points, can be attributed to wages, which accounted for about half of that. We're also seeing higher fuel costs in our delivery fleet. We've continued to invest in IT and have increased our travel budgets. Those factors—fuel, investments in initiatives, and overall wage inflation—have contributed to the rise in SG&A. Looking ahead to the second half, while we do anticipate some ongoing impact, we expect it to be less significant than what we experienced in the first half; however, the acquisition-related costs may continue or even increase due to our recent activities.

Got it. That's great color. And then just a second quick one, just on customers and inventories. I guess this is kind of skewing to the medium-sized and larger-sized customers. But I guess, to what degree are your customers able to hold sort of excess inventory? And do you suspect over these past few months that there was any overordering going on at customers that could now result in some destocking?

No. I mean the capacity for them to hold inventory is not great. You do get some buying. We have EOP programs and stuff that were combined, can move around, but that's particularly in the early part of the year. So at this point, we wouldn't have a sense that there's significant inventory that our customers are holding or are sitting on. So yes, they're going to continue to buy kind of hand to mouth as they go through the rest of the year.

The next question is from the line of Keith Hughes with Truist.

Yes, I just wanted to go back to some of the pricing questions. You talked about declines coming in some of the agronomic products. Are you starting to see prices in sprinkler pipe? Is it starting to come off and how quickly is...

We're not seeing any significant reduction in our costs in irrigation or hardscape, nor are we observing anything being passed through to the industry at this time.

Okay. Would that also apply to hardscapes?

That would imply hardscapes as well. Almost all of our product lines other than the specifics on copper wire, I know is one that we've seen, and I think for fertilizer will be less of those two.

The next question comes from the line of Mike Dahl with RBC.

Doug, just wanted to ask on the second half volumes a little bit more. So less negative in the second half. It sounded like 2Q is the biggest issues were in the northern markets, but as you've gotten into July and then your expectations were still negative volume in the second half, has that broadened out across your markets in terms of volumes turning negative? Or is that still a broad comment around just not seeing the recovery in those northern markets?

Yes. I think the northern markets have come back some, but they certainly aren't matching the strength we see in the Sun Belt. So we're just being cautious. Now it could be more positive, right, as things continue to develop because as I mentioned before, volumes last year were kind of flat to slightly up. And we'll see how we do, right? We like the trends we see so far, as I mentioned, through June to July. We'll see how that continues. But the trend of the kind of the northern markets being softer than the south of the Sun Belt have continued, though we've seen some recovery in the northern markets. The southern markets have remained pretty steady in that kind of strong mode.

Okay. And my second question, just a follow-up on Matt's question around inventories. It seems like there's some destocking going on in the retail channel around certain products; obviously, retail would carry — you carry a lot more in different products, but when you're looking at your inventory balances up a bit, some of that's M&A, some of that's inflation, but how are you thinking about managing your inventory as you go into year-end against what you've characterized us and discussed about potentially seeing a tougher 2023 trends?

We expect our inventories to decrease, which is typical for this season. It's important to understand that due to uncertainties in the supply chains and the lead times from our suppliers, every distributor, including us, had to stock more inventory to mitigate the unpredictability of when we could restock. This is not a product-specific issue; we simply needed to carry more stock because we were unsure about the timing of shipments or deliveries from our suppliers. Therefore, we wanted to have sufficient inventory in our distribution centers and stores. Recently, we've noticed that the requirements and lead times from suppliers are improving significantly, even though not all supply chain issues have been resolved. We usually undergo a seasonal inventory reduction, and in addition, we are removing the extra lead times that required safety stock. This will help us lower our inventories to what I would consider a normal level needed to replenish our stores and meet customer demand.

The next question is from Jeff Stevenson with Loop Capital.

Congrats on the nice quarter.

Thank you.

So with eight acquisitions year-to-date, that's in line with the total number you did last year. And I'm just wondering what's driving the increased pace of acquisitions? Is there more motivated sellers in the market or is it some of the internal initiatives you guys have been doing?

Yes. Good question, Jeff. I don't think there's been any specific macro drivers that are pushing sellers to the exits. I think it has more to do, as we mentioned a few quarters ago, we intentionally strengthened our team to both increase our capacity to source and close deals. But equally as importantly, to improve our focus and execution of integrating companies after closing. Those actions have played out very well for us on both fronts. Acquisitions, by their nature, can't be neatly forecasted, and so you can get some, call it, hot streaks and dry spells. But I think the bottom line for SiteOne is we have better capacity than we've ever had, and we feel really good about our strong momentum going into the second half and moving into 2023.

Yes. And it is amazing how as we've added capacity of our quarters that go out and kind of find and talk to companies that, that we're still discovering as big we are and as ubiquitous as we are, we're still discovering great companies that kind of hidden gems, if you will. And it's just when you've got more folks out there, you tend to turn up more activity, and so we're seeing some of that as well, as Scott mentioned.

The next question is from the line of Andrew Carter with Stifel.

One thing I wanted to ask about is you kind of, over time, mentioned that the hardscape locations nursery, the higher SG&A, but they're also higher margin. How do those items kind of index towards the more discretionary aspects of new construction? And from a mix perspective, if you had some weakness in new construction, would that be difficult to overcome at the EBITDA level?

No, great question. I'll start with hardscapes. Most of our acquisitions focus on hardscapes and landscape supplies, which are aimed at the major repair and remodel market. The landscape supplies aspect is primarily related to maintenance, like molds and soil. We're pleased to see growth in these areas because they target the more durable segments of the market. Nursery relates more to new construction, so that's where the distinction lies. This is how these product lines are positioned.

The next question is from Damian Karas with UBS.

Lot of ground covered. I appreciate all the details. Just a few follow-ups. Doug, you mentioned earlier, major remodels have been more stable in past market downturns compared to new construction. I guess just thinking about trends from the last few years, hasn't repair and upgrade actually been a bit more of a growth driver than new construction for you? And I would think that, maybe just opposed to what you've seen in prior cycles?

Right. No, I mean the professional repair and remodel market has been very strong, right? I mean there's no doubt about it. It's been a big driver of growth. My comment was on a traditional market and a traditional downturn. So if you go back to the great downturn or typical downturns, repair and remodel is going to come down roughly half of new construction. But I don't think we're in a typical market, right? As I mentioned, we're in a low unemployment market and with high home values. And so those typically drive repair and remodel. So we'll have to see, but it certainly is a market that we embrace. The outdoor living trend is real. COVID put real emphasis on that, but it's going to continue long term; stay-at-home lends itself to repair and remodel. So a lot of things pointed at that sector that caused it to drive long-term growth. And so we like it, and we're going to continue to build that as a part of our end market portfolio.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Doug Black for any closing remarks.

Okay. Great. I know we're running over, but thank you all for joining us today. We really appreciate your interest in SiteOne. We're excited about our company, and we look forward to building it and working with you as we go forward. And we look forward to speaking with you again next quarter. A final thank you to our great associates for doing such a great job of helping us build SiteOne. Thank you very much.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.