Earnings Call
Toro Co (TTC)
Earnings Call Transcript - TTC Q3 2020
Operator, Operator
Ladies and gentlemen, thank you for standing by and welcome to The Toro Company’s Third Quarter 2020 Earnings Conference Call. At this time, all participant lines are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Nicholas Rhoads, Managing Director of Investor Relations. Please go ahead.
Nicholas Rhoads, Managing Director of Investor Relations
Thank you and good morning. Our earnings release was issued this morning, and a copy can be found in the Investor Information section of our corporate website thetorocompany.com. On our call today are Rick Olson, Chairman and Chief Executive Officer; and Renee Peterson, Vice President, Treasurer and Chief Financial Officer. We begin with our customary forward-looking statement policy. During this call, we will make forward-looking statements regarding our business and future financial and operating results. You all are aware of the inherent difficulties, risks, and uncertainties in making predictive statements. Our earnings release as well as our SEC filings detail some of the important risk factors, including those related to COVID-19, that may cause our actual results to differ materially from those in our predictions. Please note that we do not have a duty to update our forward-looking statements. In addition, during this call, we will reference certain non-GAAP financial measures. Reconciliations of historical non-GAAP financial measures to reported GAAP financial measures can be found in our earnings release or on our website. The company believes these measures may be useful in performing meaningful comparisons of past and present operating results to understand the performance of its ongoing operations and how management views the business. Such non-GAAP financial measures should not be considered superior to, as a substitute for, or as an alternative to, and should be considered in conjunction with the GAAP financial measures presented in our earnings release in this call. With that, I will now turn the call over to Rick.
Rick Olson, CEO
Thanks Nick, and good morning. Our third quarter was a strong and dynamic one given the circumstances. Since COVID-19 began to spread across the globe, the macroeconomic environment went from robust growth to recession almost overnight. Now, we are seeing more positive economic and market trends, but the rate of the recovery and the status of the virus remain highly variable. In short, the environment in which we conduct business remains uncertain. For the third quarter, we were pleased to have achieved topline growth on the strength of our residential segments as favorable weather, our new product lineup, and stay-at-home trends drove robust demand in the mass and dealer channels. Incremental sales from our successful Venture Products acquisition also contributed to third quarter growth. I am deeply grateful for the extraordinary efforts and the commitments of our team during these challenging times. The health and safety of our people remains our top priority, as we support and deliver value to our customers. Our talented global team of more than 9,000 remained resilient and solution-oriented. Among other things, we modified production lines and workflow to accommodate social distancing, continued to work effectively while adhering to local safety guidelines, developed methods to move production and inventories to meet customer requirements, and managed the demands of home, childcare, and personal wellness. Our teams did all this while delivering a solid quarter of financial results. Turning to the demand environment during the quarter. In May, as the residential segment remained strong, we saw an improvement in our professional segment, and those trends continued throughout the quarter and into the month of August. As customers gained more confidence, demand started to return. The market continues to be dynamic given the variability of the economic recovery and the status of the virus around the world. We are fully prepared to respond to potential market changes. Our long-standing ability to adapt to different business environments was evident in the quarter, and our team is well-positioned to continue to succeed even in challenging market conditions. Looking at the results for the quarter, our residential segment continued to excel with a 38% year-over-year net sales growth and strong margins. The movement outdoors we've seen during the past several months contributed to record sales of zero-turn mowers, which doubled in the quarter. We also saw strong contributions from walk power mower sales. Professional segment net sales for the quarter declined 80% year-over-year, which was better than expected. Sales included incremental revenue from the Venture Products acquisition. We're encouraged by improved demand for our professional segment products, particularly in the landscape contractor, rental, specialty construction, and irrigation markets. We're seeing demand driven by greater business confidence and increased home investments. Improved retail demand within the quarter reduced field inventory, which is in good shape and more than prior year, setting us up well for preseason shipments. With robust performance in our residential segments and improved demand in our professional segment, we demonstrated the strength of our diverse portfolio of businesses and our ability to be agile while focusing on customer needs. This positions us to drive growth forward as our end markets normalize. There are two additional highlights in the quarter that I would like to recognize. First, we launched our Sustainability Endures platform, which furthers and enhances our longstanding dedication to make a positive global impact socially, environmentally, and financially. And second, we were named Innovative Partner of the Year by the Tractor Supply Company. This reflects our commitment to innovation as well as the effectiveness of our partnership to deliver great products during these difficult times. The successes we experienced this quarter were due to the dedication of our team, our innovative product lineup, strong demand through mass and dealer channels, and the contribution from our first full quarter of the Venture Products acquisition. We're enthusiastic about our future given our balanced and flexible business model that allows us to adapt quickly to change, enduring values that focus on the success of customers, innovative new products aligned to customer trends, a strong financial position, and the proven ability of our people to adapt and perform successfully in these dynamic times. With that, I will turn the call over to Renee for a more detailed discussion of our financial results.
Renee Peterson, CFO
Thank you, Rick, and good morning everyone. During the third quarter, we once again demonstrated the ability of our adaptable business model and resilient culture to manage near-term headwinds and position us for long-term growth. We continued to capitalize on our strong balance sheet to invest in growth while executing well operationally. We remain flexible in order to drive financial results, while keeping our people safe and delivering on our brand promise to our customers. In this environment, we grew third quarter net sales by 0.3% to $841 million. Reported and adjusted EPS was $0.82 for the quarter, compared to reported EPS of $0.56 and adjusted EPS of $0.83 last year. For the first nine months, net sales increased 5.6% to $2.54 billion. Diluted EPS was $2.37 compared to $2.18 in the first nine months of fiscal 2019. Year-to-date adjusted diluted EPS was $2.38 compared to $2.52 a year ago. Before I review segment results, I'll cover liquidity. At the end of the third quarter, our liquidity was $992 million. This included cash and cash equivalents of $394 million and availability under our revolving credit facility of $598 million. We have no significant debt maturities until April 2022. We are in a strong position today in the event of an extended period of macroeconomic uncertainty. Now, to the segment results. Residential segment net sales for the third quarter were up 38.3% to $205 million, mainly driven by strong retail demand for zero-turn riding and walk power mowers and our expanded mass channel. Year-to-date fiscal 2020 net sales increased 20.4% compared to the same period of fiscal 2019. Residential segment operating earnings for the quarter were up 76.7% to $28.5 million. This reflects a 300 basis point year-over-year increase to 13.9% when expressed as a percent of net sales. This improvement was largely driven by productivity and synergy initiatives and SG&A expense reduction and leverage on higher sales volume. This was partially offset by COVID-related manufacturing inefficiencies and unfavorable product mix. Year-to-date, residential segment operating earnings increased 70.2% to $87.2 million. On a percent of sales basis, segment operating earnings increased 400 basis points to 13.8%. For the third quarter, professional segment net sales decreased 7.9% to $623.6 million. This was due to reduced channel demand as a result of COVID-19-related impacts. This included fewer shipments of golf and grounds equipment, reduced sales of rental, specialty, and underground construction equipment and fewer shipments of landscape contractors zero-turn riding mowers. This was partially offset by incremental Venture Products sales. For the year-to-date period, professional segment net sales increased 1.3% compared to the same period of fiscal 2019. Professional segment operating earnings for the third quarter were up 39.3% to $113.7 million and when expressed as a percentage of net sales increased 610 basis points to 18.2%. This increase was primarily due to lower non-recurring acquisition-related expenses versus the prior year period, favorable net price realization, and decreased commodity costs. This increase was partially offset by unfavorable product mix and COVID-related manufacturing inefficiencies. Year-to-date, professional segment operating earnings increased 0.8% compared to the same period in the prior fiscal year. When expressed as a percentage of net sales, operating earnings remained constant at 17.2% year-over-year for both fiscal periods. Moving to our operating results, we reported a gross margin for the third quarter of 35%, an increase of 330 basis points over the prior year period. Excluding acquisition-related costs, adjusted gross margin decreased 70 basis points to 35.2%. The decrease in adjusted gross margin was primarily driven by COVID-19-related manufacturing inefficiencies, unfavorable mix due to the higher sales of residential products, and increased inventory reserved in one of our professional businesses. This was partially offset by favorable net price realization in the professional segment and productivity and synergy initiatives. For the first nine months, reported gross margin was 35%, up 160 basis points compared with 33.4% in the prior year period. Adjusted gross margin was 35.2% compared with 35.3% in the first nine months of fiscal 2019. SG&A expense as a percent of sales decreased 170 basis points to 21.2% for the quarter, primarily due to lower travel and meeting expenses, acquisition-related charges, and employee salaries. For the first nine months of fiscal 2020, SG&A expense as a percent of sales was 21.9%, up 20 basis points from the prior year period. Operating earnings as a percent of net sales increased 500 basis points to 13.8% for the third quarter. Adjusted operating earnings as a percent of net sales increased 50 basis points to 13.9%. For the first nine months of fiscal 2020, operating earnings as a percent of net sales were 13.1% compared with 11.7% a year ago. Adjusted operating earnings as a percent of net sales for the first nine months were 13.4% compared with 14.2% a year ago. Interest expense decreased $700,000 for the third quarter compared to a year ago, due to lower interest rates. Interest expense increased $4.7 million for the year-to-date period compared to a year ago. This was due to increased borrowings as a result of our professional segment acquisitions. For the full year, we continue to expect interest expense of about $33 million. The effective tax rate was 19.8% for the third quarter and the adjusted effective tax rate was 20.9%. For the first nine months of fiscal 2020, the effective tax rate was 19.2% and the adjusted effective tax rate was 20.6%. For the full year, we continue to expect an adjusted effective tax rate of about 20.5%. Turning to the balance sheet and cash flow. Accounts receivable totaled $294.7 million, down 5.6% from a year ago. Inventory was up 5.7% to $656.2 million and accounts payable decreased 11.8% to $268.7 million. Year-to-date free cash flow was $259.3 million with a net income conversion of 100.7%. This positive performance was due to the increase in net earnings, favorable net working capital change, and reduced capital expenditures. Our disciplined capital allocation strategy includes investing in organic and M&A growth opportunities, maintaining an effective capital structure, and returning cash to shareholders. Our sharp focus on near-term liquidity has reaffirmed our capital allocation priorities for the year. These include prioritizing debt repayment to maintain our leverage targets, curtailing share repurchases, and considering strategically compelling acquisitions. We increased our cash dividend for the third quarter of fiscal 2020 by 11.1% to $0.25 per share as compared to the prior year period. Based on our current outlook and strong financial position, we expect to maintain our dividend. As Rick discussed, there remains uncertainty as a result of COVID-19-related factors. We withdrew our guidance in March and we will not be providing specific full-year guidance on this. Similar to past practice, we will provide full-year fiscal 2021 guidance on our fourth quarter call if we have sufficient visibility and confidence to do so. However, based on current visibility and with an understanding of the uncertain nature of the economic environment, we would like to provide you with our current thinking about the fourth quarter. We anticipate continued year-over-year growth in the residential market. Professional markets should benefit from the gradual return to more normal buying patterns as customer's confidence in the economy increases. These positive trends will likely be somewhat offset by remaining COVID-19 headwinds, such as budget constraints, the effect of social distancing restrictions, and regional variations in economic recovery. As you know, precision is difficult in this environment. But if these assumptions hold true, we anticipate that fiscal 2020 fourth quarter net sales will be higher than that of the prior year quarter and adjusted EPS will be similar to that of the fiscal 2019 fourth quarter. We expect that other income to be lower in the fourth quarter of fiscal 2020 than in the prior year period as a result of a favorable pension and post-retirement plan benefit in fiscal 2019 that will not be repeated. We continue to expect total net other income for fiscal 2020 to be about $13 million. We continue to expect depreciation and amortization for fiscal 2020 of above $95 million and capital expenditures of about $80 million. We anticipate that fiscal 2020 free cash flow conversion rate will be similar to fiscal 2019. We plan to build inventory in the fourth quarter to mitigate any potential supply chain and manufacturing constraints due to social distancing restrictions. In summary, we executed well in the third fiscal quarter in a challenging environment as our team demonstrated their resiliency, commitment, and determination. We are in a strong financial position and continue to invest in technology and innovation to drive long-term growth. As a result, we are confident in our ability to navigate through any near-term challenges and capitalize on growth opportunities. I will now turn the call back to Rick.
Rick Olson, CEO
Thanks, Renee. We're optimistic about our future. Our diverse portfolio of businesses and strong customer relationships position us to drive growth as our end markets normalize. Our productivity initiatives continue to enable operational improvements, and our focus on innovative products and our recent acquisitions are aligned with changing global market dynamics. We had several new products introduced during the year that demonstrate our ability to innovate and satisfy our customers' evolving needs. For example, the new chainsaw and power shovel that are part of the Toro 60-Volt Lithium-Ion Flex-Force platform. The e-Dingo Compact Utility loader, electric and hybrid greens mowers, the Ditch Witch JT24 Horizontal Drill, SK3000 Stand-on Skid Steer, and Aqua-Traxx Azul Drip Tape. Our recent acquisitions also continued to deliver. With both Charles Machine Works and Venture Products aligned with key market trends, such as 5G and broadband build-out, infrastructure improvements, and product versatility for our professional and homeowners with acreage customers. We are encouraged by the continued strong residential demand and the improvement in our professional markets. As we look forward, we'll be watching a number of macro trends such as the trajectory and duration of COVID-related impacts including social distancing restrictions and global supply chain disruptions, global economic recovery factors driving general consumer and business confidence, and commodity trends, and weather patterns for the fall and winter seasons. More specifically, we're tracking certain key factors for individual markets as we end the year and look ahead to fiscal 2021. For the residential segment and certain professional segment businesses, continued customer interest in home investments driven by stay-at-home trends. For golf, continued strength in rounds played coupled with improved food and beverage revenue. For ground equipment, the health of municipal and other tax-supported budgets constrained by COVID-related factors. For landscape contractors, business confidence and favorable mowing conditions. For underground, 5G and broadband build-out, critical need infrastructure rehab and replacements, and increased oil and gas projects. For rental and specialty construction, homeowner-related projects, and the resumption of our construction activity. And for snow and ice management, the timing of the winter season and continued demand within our new product categories. In closing, we are enthusiastic about our future, given our new product pipeline and the proven ability of our people to drive growth and productivity in these dynamic times. I'd like to again recognize the dedication and resilience of our employees and channel partners and offer my sincere thanks to our customers and shareholders for your continued support. With that, Renee and I will take your questions.
Operator, Operator
Thank you. Our first question comes from the line of Mike Shlisky with Colliers Securities. Your line is now open.
Mike Shlisky, Analyst
Good morning, everybody.
Rick Olson, CEO
Good morning.
Mike Shlisky, Analyst
So, I want to start-off maybe asking a question or two about Tractor Supply. Can you give us an update on your level of satisfaction on that new initiative this year? It sounds like they're certainly satisfied with you given the awards you've won. But I'm curious how things went according to your expectations now that we're past the spring and summer and whether you have any major additions or improvements for next year plan at this point?
Rick Olson, CEO
It was a great first year with Tractor Supply, and although there were some concerns as we began the spring season due to the lockdowns, it turned out to be an outstanding year. We are continually exploring ways to strengthen our partnerships and identify opportunities that benefit both parties moving forward. The positive news is that residential growth has been broad-based this year. We've experienced growth not just with mass retailers and new channel partners but also in our dealer channel and with our long-standing mass partners. Overall, it has been successful across the board. Tractor Supply has been a fantastic addition, complementing our other channels, and it has resulted in very positive outcomes. We feel very optimistic about it.
Mike Shlisky, Analyst
I also wanted to ask about your dealerships in the professional sector. Do you feel any of them are experiencing financial difficulties during the quarter? And do you believe that most of them will be able to manage through this COVID situation well, given that they have so far?
Rick Olson, CEO
I didn't hear the first part of the question about the area where the dealer is located.
Mike Shlisky, Analyst
I was curious, kind of broadly speaking across professional, whether you're seeing any dealers who have had some volume challenges that they faced any financial strain recently and do you think most of them will get through it given that some of the demand environment is improving so far?
Rick Olson, CEO
Yes, the professional businesses experienced a decline, but they responded as businesses typically do. They took early actions and many utilized the CARES Act to help manage the situation. They are appreciative to see their customers returning and entering buying cycles again. We did not observe any significant financial threats impacting that channel overall.
Mike Shlisky, Analyst
Okay. And perhaps lastly for me, it looks like one of the major engine suppliers out there is facing some financial difficulties and has filed for Chapter 11. Can you tell us if there's any issues in your supply chain on engines and whether you might see as any engines get changed or stopped going forward, if this company changes its own product offerings?
Rick Olson, CEO
Yes, Briggs & Stratton has been a good supplier to us, although they are also our competitor, which creates an interesting dynamic. The sale process is ongoing, and while there are some procedural aspects to consider, it's likely that it will go to the stalking horse at this stage. From our standpoint, we are consistently revising our engine strategies, and we have multiple engine suppliers, which has been something we've anticipated for a while. Due to the long lead times associated with engines, we need to have our strategies established well in advance of the season, and we already have our plan in place for 2021, which is being executed.
Mike Shlisky, Analyst
Okay. Thanks so much. I'll leave it there. Appreciate it.
Rick Olson, CEO
Thank you.
Renee Peterson, CFO
Thank you.
Operator, Operator
Thank you. Our next question comes from the line of David MacGregor with Longbow Research. Your line is now open.
David MacGregor, Analyst
Yes, good morning everyone.
Rick Olson, CEO
Good morning.
David MacGregor, Analyst
Pretty solid quarter under the circumstances. So, congratulations on that. I guess I'd just start off with Tractor Supply, just because it's been discussed so far. Is there any way to kind of parse out sort of the growth in residential from Tractor Supply versus that core growth, that core underlying growth and give us some sense of proportion?
Rick Olson, CEO
Yes, while we won't provide a detailed breakdown, we can discuss the internal and external factors influencing our performance. As mentioned in previous quarters, we've refreshed our residential business with new innovative products that have generated interest, coupled with enhanced marketing and a shift in brand messaging that has been well received across all our channels. Adding a significant new mass partner has also contributed positively. We anticipate these factors will persist. While channel fill had some unique elements that may not recur, we're exploring ways to expand partnerships, understanding that most mass partners typically don't carry inventory. Thus, we expect continued opportunities, with growth across all residential channels. On the external side, key factors include a favorable growing season, which historically supported our residential business even during economic downturns. Additionally, the stay-at-home initiatives have increased interest in home and yard investments, leading to upgrades in equipment. While we expect this trend to taper as restrictions lift, we believe the underlying growth drivers for residential will sustain our growth, although it may not reach the same levels as this quarter but will still show growth with various opportunities ahead.
David MacGregor, Analyst
Rick, building on your last point, many investors are grappling with the extent of pull-forward that might be happening, not just with Toro but across the board in this sector. While it's clear that some pull-forward exists, the main question is how significant it is. I'm assuming you have models to help gauge this. Can you provide insights into the extent of the pull-forward demand contributing to current growth as opposed to what might be a more sustainable growth level?
Rick Olson, CEO
Yes, I think you've noticed the catch-up happening this quarter, and there will likely be a bit more of that, but we see customer buying patterns returning to normal as we look ahead to the fourth quarter. While it was a noticeable factor this quarter, it's not the main driver going forward. Professional customers are resuming their usual buying patterns. As we've mentioned before, turf-related products are used while grass is growing, so they remain in demand and need to get back on their regular buying cycle. The positive news is that field inventory is in excellent shape, lower than last year. In fact, we would prefer it to be slightly higher in some cases. We are working to ensure inventory is positioned correctly moving forward. Overall, we are entering the fourth quarter and looking ahead to 2021 with strong inventory conditions, which should enable us to capitalize on ongoing growth.
David MacGregor, Analyst
That's good to hear. But just one more question on that pull-forward is, given the strength we're seeing right now and you're talking about the expectation that we return back to a more normalized pace of growth, I guess the bigger question is the extent to which you perceive risk of us falling below that normalized growth and potentially into a negative growth period just because of the volume that's been pulled forward. How would you assess that risk to your business?
Rick Olson, CEO
Most of what I was discussing was about catching up. These were purchases that had been delayed because all businesses, especially on the professional side, took similar precautions. They paused their spending, held off on capital purchases, and once they began to understand the economic trajectory, the status of the virus, and when their customers started making purchases that they likely would have made earlier in the year. On the residential side, with potential pull-forward, we see a significant base and most of the sales are for replacements. This is influenced by factors like home ownership and new home ownership. Weather also plays a positive role; during a good growing season, some people will replace their equipment each year.
David MacGregor, Analyst
Do you think...
Rick Olson, CEO
Go ahead.
David MacGregor, Analyst
I was just going to say, do you think in the residential business, it was catch-up as well as opposed to pull-forward?
Rick Olson, CEO
Yes, it was catch-up. I think in your definition, there might be a slight increase included, but as we look ahead, we continue to anticipate growth based on our modeling.
Operator, Operator
Thank you. Our next question comes from the line of Joe Mondillo with Sidoti & Company. Your line is now open.
Joe Mondillo, Analyst
Hi, good morning everyone.
Renee Peterson, CFO
Good morning.
Rick Olson, CEO
Good morning, Joe.
Joe Mondillo, Analyst
So, in the press release and your prepared commentary, you mentioned a potential offset to some of the growth dynamics in 4Q being budget constraints. I'm just wondering what part of your business would be most affected to that. And are you actually starting to see effects of that or is that just something you're sort of cautious of?
Rick Olson, CEO
There are likely several factors at play, but the one we are specifically discussing relates to the municipal side. A part of our business is connected to tax-supported entities, and it remains unclear what municipal budgets will look like in the upcoming budget cycle and how maintaining parks and municipal golf courses will be prioritized. While one could argue that it will remain a focus, it's uncertain how this will unfold. Additionally, there are other budget constraints to consider. Golf has received very positive news recently, with rounds played in July increasing by nearly 20%, a record high. However, some revenue streams from golf have not yet fully recovered; our food and beverage sales and events revenue are still lagging. As restrictions ease and these activities are able to resume, budgets should return to a healthier state, although they are currently somewhat constrained. Furthermore, aspects of golf related to resorts represent a small portion of the overall market. Destination golf that involves traveling to a resort-oriented city continues to face constraints, adding pressure to budgets. These are the budget factors we are referencing.
Joe Mondillo, Analyst
Okay. And just I guess broadly looking at the two segments, you commented a little bit about channel inventories, but parsing through the two segments, would you describe inventories as below normal at this point?
Rick Olson, CEO
They are field inventories are lower than last year at this time. We consider this a success given the decline in several of our businesses, as our operations team responded effectively by producing the right products at the right moment and adjusting production as needed to seize opportunities. There are a few areas where we would like to see increased inventory as we approach the next season, particularly because our output rates have been impacted in some instances due to COVID-related restrictions we implemented. Therefore, it's essential to have sufficient inventory in place as we begin the season, since our plant's output will not be at the same level. As a result, we have had to arrange for extra hours and shifts, which means we need to adjust the schedule moving forward.
Renee Peterson, CFO
And in my prepared remarks, I mentioned that we would be building some inventory in fourth quarter to help to address those. So, we want to make sure that we can mitigate any supply chain challenges that may occur as well as be ready for the season and ready to deliver to our customers' needs.
Joe Mondillo, Analyst
Okay. And just a follow-up as far as field inventories, is that sort of below average? Is that across the board or I mean certain areas, maybe like in golf, are you seeing flat to maybe a little above inventory or sort of broadly speaking, are you seeing just field inventory is pretty low?
Rick Olson, CEO
It's broadly based across all of our businesses, and to provide some insight into those, we sell our products through another party. They are all businesses looking to preserve liquidity and have been more conservative about inventory, and we see that in the overall numbers. However, as we gain confidence and they recognize the opportunities ahead, just like our residential dealers did in the spring, they will need products and will re-enter the buying cycle as well.
Joe Mondillo, Analyst
All right. And then last question, just as far as CapEx, just curious what you're investing in for CapEx? Anything interesting that's going to maybe help profitability going forward? Anything that you could highlight?
Renee Peterson, CFO
Yes, I would say our CapEx is really a combination of investing in productivity and cost reduction efforts. We're always looking for those opportunities. New products are another key area for us. And there is an element of maintenance capital as well. So, we try to balance it across those three. And I think, in particular, some of the new products are really exciting, and we'll see those come out in the next number of years.
Rick Olson, CEO
I think especially if you go back to our technology priorities, a lot of our investments in new products were going very much on target with those priorities, alternative energy, smart connected products, longer-term robotics, and autonomous.
Joe Mondillo, Analyst
Okay, great. Thanks for taking my questions.
Renee Peterson, CFO
Thank you.
Rick Olson, CEO
Thank you.
Operator, Operator
Thank you. Our next question comes from the line of Tim Wojs with Robert W Baird. Your line is now open.
Tim Wojs, Analyst
Hey, good morning everybody. Nice job on the results.
Rick Olson, CEO
Good morning.
Renee Peterson, CFO
Thank you.
Tim Wojs, Analyst
How do you feel about your internal capabilities to ensure there aren't any constraints on the component side? Did you face any supply chain challenges in the quarter, or were you aware of any supply chain issues in the industry during that time?
Rick Olson, CEO
We did not experience significant disruptions during this period. Our operations team performed exceptionally well. When I summarize this, it does not fully convey the process we went through, especially regarding the supply chain. My notes from the first quarter reflect our worries about the supply chain as the virus spread worldwide. Fortunately, we have not faced major stoppages due to supply shortages. Our plants adjusted remarkably quickly to maintain operations and support our customers. For example, on a 100-foot assembly line with 50 employees, implementing social distancing requires them to spread out, which might necessitate extending the line or reducing the number of workers. This could mean needing an additional shift or extra production time to meet our production goals. Our operations team has effectively managed these challenges, helping us gain market share, particularly in the residential sector as availability became a concern.
Tim Wojs, Analyst
It's reassuring to hear that. Based on your comments, it seems that pro is likely to return to a more normalized growth situation in the fourth quarter. I just wanted to confirm that and ask which product end markets you anticipate will contribute the most to that growth.
Rick Olson, CEO
We do expect pro to grow. I think we've talked about a couple of areas that are more constrained, the portion of our business particularly with Charles Machine Works that are tied to oil and gas, the rate at which some of those golf factors come back into play. So, municipal budgets being related to that as well. But on the driver side, the grounds business continues to be very positive for us, our landscape contractor business, the construction, and underground business. The snow business continues to grow professional and residential, and rental has been very positive. If you go back the underground business, the telecommunications is very strong right now. As we expected, the 5G major players have come back into their buying cycles, and they paused as well, but they can really afford to pause too long because they are in a race to build out the 5G network. And then, just one other comment about telecommunications, fiber for improved broadband, especially for home, has been a factor that's especially come into light and the whole concept of the digital divide of some parts of our population that don't have adequate broadband in order to do the things expected to learn from home, work from home. So, that's a good driver for our business and appropriate emphasis.
Tim Wojs, Analyst
Thank you for the information. I wanted to ask about the tariffs that are being introduced on imported engines from China. Could you discuss the potential impact of that on Toro and whether there are ways to mitigate it as we look ahead to next year?
Rick Olson, CEO
Yes, we are closely monitoring this situation along with many others in our industry, as it significantly impacts the overall market. As mentioned earlier, engines generally have a long lead-time, so we are continually refining our engine strategy based on current developments. The plan for 2021 was set some time ago, and we are now focused on executing that plan. We are confident in our 2021 strategy and do not anticipate any significant impact this year based on what we know so far. The situation is still evolving, with many variables at play. We are engaged in long-term planning and have carefully considered the dynamics with our various engine suppliers to ensure we deliver the best value to our customers. We remain vigilant about how this unfolds, recognizing that historically, these situations can fluctuate significantly and sometimes resolve more favorably than anticipated.
Tim Wojs, Analyst
Okay, I appreciate that. Appreciate the thoughts. And congratulations for you guys.
Rick Olson, CEO
Thank you.
Renee Peterson, CFO
Thank you.
Operator, Operator
Thank you. Our next question comes from the line of Sam Darkatsh with Raymond James. Your line is now open.
Sam Darkatsh, Analyst
Good morning Rick, Renee. How are you?
Renee Peterson, CFO
Very well. Thanks. How are you?
Rick Olson, CEO
Very well.
Sam Darkatsh, Analyst
I wanted to clarify the previous question regarding the engines sourced from China. I'm trying to understand how much of the cost will be passed on to consumers in the residential sector next year, whether through Toro products or across the industry, considering there is usually some elasticity in demand. What do you estimate will be passed on, and how much do you think will be absorbed by channel partners?
Rick Olson, CEO
Yes, I think you understand that the pressures on the residential side from a pricing perspective are significant due to the existing standard price points. What’s interesting is that this is an industrywide concern. If there ends up being a long-term impact or a transitional period until the supply chain adjusts, unfortunately, that will affect our customers and will fundamentally change market pricing at some point. We will have no choice but to pass it through. However, as we have indicated, we have our plan in place for 2021, so we don’t foresee any significant issues for this year.
Sam Darkatsh, Analyst
And remind us in fiscal 2020, what your exposure was to those Chinese-sourced engines that are now subjected to the tariffs?
Rick Olson, CEO
I don't have a specific number in front of me. They would be certainly in our top several engine suppliers.
Renee Peterson, CFO
Limited to the residential.
Sam Darkatsh, Analyst
Okay. I would like to ask a few directional questions about 2021. Clearly, we understand that providing detailed guidance is almost impossible given the many variables that remain uncertain, but I’m just trying to gain some insight. First, regarding incremental margins. You've previously mentioned that a normal incremental margin is around 25%. I know this was also suggested in the Vision 2020 outlook. There are both positive and negative influences to consider. It seems likely that the professional mix will improve next year compared to this year, although I suspect some discretionary spending may also come back. What are the reasons we might not expect a 'normal-ish' incremental margin for next year?
Renee Peterson, CFO
Yes, Sam, this is Renee. Let me answer that question. I think we would say planning a normal-ish type of incremental margin would be reasonable. To your point, we do recognize there will be some cost actions that we took this year that will come back into the equation as we go into FY 2021. There are also some costs that we're incurring this year that at some point in time, we think will go away. Some of that still impacts of social distancing and some of those inefficiencies that we talked about will also go away. And we keep in mind; we always focused on productivity and synergy to reduce our cost structure. So, that remains the same. So, I would think kind of a normal level would be reasonable.
Sam Darkatsh, Analyst
My final question is about free cash flow conversion for next year. You're estimating a conversion rate of around 90% this year, similar to last year. As you increase inventory, I assume capital expenditures will normalize next year. How do you expect cash flow conversion to compare next year to the 90% range you've experienced in the past few years?
Renee Peterson, CFO
Yes, I would say, we're building the inventory for a specific reason. At this point in time, it's to mitigate some of the concerns around the supply chain, which again, the team has done a great job doing today and then, making sure that we're available to meet customer needs. Assuming that social distancing impacts go away, we would then intend to normalize our inventory levels throughout the year. So, we would expect to be in a normal level or a bit better.
Sam Darkatsh, Analyst
So, normal, better than the 90%. So, maybe closer to a 100% that you originally were targeting for this year, sort of, thing?
Renee Peterson, CFO
Absolutely, by normal, more historically.
Sam Darkatsh, Analyst
Okay, terrific. Thank you very much and be well.
Renee Peterson, CFO
Thank you.
Rick Olson, CEO
Thank you.
Operator, Operator
Thank you. Our next question comes from the line of Tom Mahoney with Cleveland Research. Your line is now open.
Tom Mahoney, Analyst
Hello. Good morning. I wanted to ask about the normal cadence around price increases. I guess they're specifically focused on the pro as you look into the next three to six months and into fiscal 2021. What are the things you'd evaluate as to whether you could move forward with those annual increases in the pro segment like you typically do?
Rick Olson, CEO
Yes, we always discuss how we price according to the market. Our first step is to assess the value of our product offerings in comparison to the value perceived by the customer. Historically, we've noted that we achieve 1% to 2% of the realized price. We aim to deliver a value package that maintains that level, utilizing innovation which includes desirable features for homeowners on the residential side as well as products that provide returns on investment for businesses. This way, if there is an increase in costs from other areas of their budget, such as fuel, labor, or chemicals, they can justify a rise in equipment expenses.
Tom Mahoney, Analyst
Understood. In terms of the inventory build in the fourth quarter, can you provide specifics on which segments the incremental build is focused on?
Renee Peterson, CFO
We would look at it more generally. Certainly, we don't expect to see the same type of growth, as Rick mentioned, in residential, but we know there is some probably variability in that marketplace, and we do expect professional will continue through the recovery. So, I think it would be overall not specific to one particular segment.
Tom Mahoney, Analyst
Thank you very much.
Renee Peterson, CFO
Thank you.
Rick Olson, CEO
Thank you.
Operator, Operator
Thank you. We do have a follow-up question from the line of David MacGregor with Longbow Research. Your line is now open.
David MacGregor, Analyst
Yes, thanks for taking the follow-up. I guess just to follow up on Sam's question, Renee, you said eventually the social distancing cost and the impact on the business will go away. You talk for a couple of quarters now about COVID-19-related manufacturing inefficiencies. I'm just interested in your thoughts, just how much longer do they last? And I'm not necessarily asking you how much longer COVID-19 is an issue, but we do seem to be on some kind of a recovery trajectory here. And I'm assuming that for the purpose of this question, that trajectory continues. How much longer? Is this something that dissipates and goes away by the sort of the first calendar quarter and second calendar quarter next year, or how should we think about this?
Renee Peterson, CFO
Our plan is not to expand capacity but to use what we have more effectively. That's why we're considering building some inventory to manage costs better. As long as social distancing measures are necessary, there will be an impact on how our factories operate. We are always focused on improving synergy and productivity, and our operations team is dedicated to finding ways to offset those costs. We expect to comply with the social distancing guidelines, which will affect how we run our plants. At some point, we anticipate these measures will change, and costs will decrease, allowing us to reconfigure the plants for more efficient operation.
David MacGregor, Analyst
But in the meantime, these are just higher costs. They're kind of structural, and you just need volume to leverage them? Is that the idea?
Renee Peterson, CFO
Yes, it is.
David MacGregor, Analyst
Okay. The second question is about the favorable pricing situation mentioned in the pro segment. You did well with pricing and mentioned improved costs. Can you provide any quantification of that? Additionally, how sustainable is this through the fourth quarter, and how far ahead should we be considering this favorable pricing scenario?
Renee Peterson, CFO
Yes, I think that relationship would certainly hold all things being equal through the remainder of the year. As we look into next year, I think it goes to the pricing, and that Rick just talked about, we always price to market, not to costs. So, we'll see. We have to remain competitive. We do think from a cost standpoint, continue our focus on productivity. As the economy improves, there'll probably be some headwinds related to some material input costs. So, lots to see as that unfolds. If we're able to hold that or some of the dynamics change, then it will be driven more by the macroeconomics than anything we're doing.
David MacGregor, Analyst
Okay. Thanks very much.
Operator, Operator
Thank you. We do have a follow-up question from the line of Joe Mondillo with Sidoti & Company. Your line is now open.
Joe Mondillo, Analyst
Hi everyone, just one follow-up question. At the residential segment, obviously very strong demand this year and you're probably benefiting I would assume from some temporary cost reductions. Just wondering how sustainable you think the 13% to 14% margins are if we return to a normalized environment?
Renee Peterson, CFO
Yes, we believe the residential segment has made significant progress. We are pleased with their performance. Moving forward, we will focus on managing new products and improving productivity. Our increased scale and broader distribution should provide us with cost advantages. All of these factors are definitely positive. However, we might face some challenges; only time will tell. If the overall market improves, there may be increased pressure on commodities, and weather conditions can also play a role, particularly affecting the residential segment more than the professional segment. This could impact our margins.
Joe Mondillo, Analyst
Okay, all right. Thank you.
Renee Peterson, CFO
Thank you.
Operator, Operator
Thank you. This concludes today's question-and-answer session. I would now like to turn the call back to Nicholas Rhoads for closing remarks.
Nicholas Rhoads, Managing Director of Investor Relations
Great. Thanks for your questions and interest in The Toro Company. We look forward to talking again in December to discuss our fourth quarter and full year results. Thanks everybody.
Operator, Operator
Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.