Fortune Brands Innovations : Q3 2023 Fortune Brands Earnings Call Transcript

Fortune Brands Innovations, Inc.

Third Quarter 2023 Earnings Conference Call

October 25, 2023

Presenters

Leigh Avsec, Vice President of Investor Relations and Corporate Affairs

Nicholas Fink, Chief Executive Officer

Dave Barry, Chief Financial Officer

Q&A Participants

Matthew Bouley - Barclays

John Lovallo - UBS

Stephen Kim - Evercore ISI

Michael Rehaut - J.P. Morgan

Adam Baumgarten - Zelman & Associates

Phil Ng - Jefferies

Operator

Good afternoon. My name is Camilla and I will be your conference operator today. At this time, I would like to welcome everyone to the Fortune Brands Third Quarter 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks, there will be a question and answer session.

I would like to turn the call over to Leigh Avsec, Vice President of Investor Relations and Corporate Affairs. You may begin the conference call.

Leigh Avsec

Good afternoon, everyone, and welcome to the Fortune Brands Innovations Third Quarter 2023 Earnings Call. Hopefully, everyone has had a chance to review our earnings release and supplemental financials. The earnings release and the audio replay of this call can be found in the Investors Section of our website.

1. want to remind everyone that the forward-looking statements we make on the call today, either in our prepared remarks or in the associated question-and-answer session, are based on current expectations and market outlook and are subject to certain risks and uncertainties that may cause actual results to differ materially from those currently anticipated. These risks are detailed in our various filings with the SEC. The company does not undertake any obligation to update or revise any forward-looking statements, except as required by law. Any references to operating profit or margin, earnings per share, or free cash flow in today's call will focus on our results on a before charges and gains basis, unless otherwise specified. Please visit our website for a reconciliation.

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With me today on the call are Nick Fink, our Chief Executive Officer, and Dave Barry, our Chief Financial Officer. Following our prepared remarks, we have allowed time to address some questions.

I will now turn the call over to Nick. Nick?

Nick Fink

Thank you, Leigh, and thank you to everyone for joining us today. On this call, I will walk through the highlights of our third quarter performance and offer some thoughts on the macro environment. I will also give an update on our ongoing evolution into a tightly aligned company, focused on brands, innovation, and channel. I will then turn the call over to Dave for a discussion of our financial results, our updates to our guidance for the remainder of 2023, as well as some thoughts on our emerging expectations for 2024.

Turning to our third quarter performance. Our teams executed well and delivered solid top and bottom line results in a macro environment that remains challenging. Our net sales growth outperformed the market for our products and our margin results sequentially improved over the second quarter of 2023.

We delivered above-market POS results across most of our businesses. Our recently acquired assets are performing better than we expected and our balance sheet remains very healthy as we continue to generate strong operating and free cash flow.

Our results this quarter demonstrate the potential and power of our aligned organizational structure and our Fortune Brands Advantage capabilities as well as our unwavering focus on outgrowing the market, preserving margins, and generating cash, all while continuing to prioritize key investments, including brand building, thoughtful capacity additions, and our digital transformation.

The actions we took over the past year to better leverage the strength of our organization and sharpen our focus on our leading brands, meaningful innovation, and our advantaged channel relationships, helped drive our results and give me confidence in our strong future.

Our Fortune Brands Advantage capabilities will continue to advance our growth and margin journey by reducing cost, informing our strategic pricing strategies, and enabling our high-growth focus areas like connected products.

Finally, I'm pleased to report that our integration of the Emtek, Schaub, and Yale and August assets is going extremely well, and we are even more optimistic about the growth potential that these businesses have, both regarding their stand-alone performance as well as the potential they have to accelerate our transformation into a digital disruptive company and a luxury goods powerhouse.

Net sales were $1.3 billion in the quarter versus $1.2 billion in the prior year, up 5%. Organic net sales were down 4% versus the prior year. Our operating margin was 17.4%, up 40 basis points versus the second quarter of 2023.

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Our sales and margin performance, together with exceptional cash generation, resulted in earnings per share of $1.19, a 3% increase over the third quarter of 2022 and gives us confidence in delivering our revised EPS range of $3.80 to $3.90.

As we discussed on our last earnings call, we continue to expect some headwinds from lower point-of-sale performance as consumer softness continues and as we further digest the impact from the slowdown in the new construction market through the first half of 2023.

As has been widely reported, while single-family new construction permits and starts continue to improve off of cycle lows, based on where our products are installed in the production of a home, we do not expect to see the benefit until the end of 2023 and into 2024.

The repair and remodel market remains soft, although the Pro was relatively stronger than pure DIY categories and our strength with the Pros worked to our advantage.

We will remain proactive in our response to any short-term external headwinds, while continuing to focus on outgrowing the market, preserving margins, generating cash, and prioritizing strategic investments in the key growth priorities that we expect to pay outsized dividends when the market rebounds.

Now turning to some thoughts on the current U.S. housing market and the market for our products. The need for housing remains incredibly strong, although it is being constrained by current affordability challenges. In fact, we believe the recent slowdown has only added to the pent-up need for housing.

1. recent third-party survey indicated that over 1/3 of respondents reported plans to purchase a residential property within the next 12 months. This remains well above the pre-pandemic average and the longer- term average dating back to 2014 of 29%, demonstrating significant supply and demand imbalance in the larger housing space.

While we cannot predict when the Fed will signal the end of the current cycle of rate increases and quantitative tightening, once it does so, we would expect interest rates to return to more normal levels and the corresponding significant return to growth in the housing market. We continue to believe this fundamental demand, together with our strong and optimally positioned brands, will result in medium- to long-term tailwinds for our business in both new construction and repair and remodel.

Starting with new construction, as has been widely reported, the single-family new construction market continued to improve versus what was initially anticipated at the beginning of 2023, despite higher-than- expected interest rates. Builders, particularly the large production homebuilders with whom Fortune Brands enjoys strong relationships, continue to respond to affordability challenges in a dynamic marketplace.

As we have previously stated, while the positive impact on our business will not be immediately apparent due to the timing of when our products are installed in a newly constructed home, this should be a growth tailwind in 2024.

Turning to R&R. R&R market remains dynamic, and there are many variables that are impacting the repair and remodel space, including consumer savings and confidence, employment levels, existing home

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turnover, and home equity levels. We believe that we are well prepared for any external headwinds and remain confident that our products are increasingly well positioned to outperform in any market.

First, as mortgage rates rise to the highest levels in many years, homeowners are increasingly viewing their current homes as a longer-term investment and are interested in improving them to match their tastes and needs. We continue to believe our products are relatively more insulated than other R&R items because they're smaller ticket, are less disruptive to install, and because they offer immediate aesthetic improvement or meaningful innovation and functionality to a home.

A recent study indicated that for building products, performance, trusted brand names, and aesthetics were by far the most important factors consumers considered during their purchase journey, more so than price. Our brands perfectly align with those criteria.

As we continue to evolve our portfolio and focus on supercharged categories, which are categories that we have identified with high growth potential due to the exposure to secular tailwinds separate from the housing market, and as we continue to build upon our already strong brands and introduce meaningful innovations, we expect that our products will further distinguish themselves.

Consumers continue to have high confidence in their homes as an asset. This has resulted in an environment where the home space is still viewed positively and consumers are willing to invest in making their spaces reflect their lifestyles and needs. That said, we are watching macroeconomic trends closely, including consumer confidence levels, consumer spending habits, and employment levels, all of which impact repair and remodel trends.

While we are confident in the mid- to long-term trends for our products, we are anticipating an environment that continues to be challenging and uncertain. As we have in times before, we will respond quickly and decisively in any environment.

As Dave will detail more completely in his section, we are actively scenario-planning for a variety of outcomes in 2024.

Turning now to an update on our organizational transformation. As we approach the one-year anniversary of the Cabinet spin-off and reorganization of our business, I wanted to reflect on the many transformational activities we undertook over the past year. These activities are driving our future as an exceptional company, focused on growing our core, while also accelerating our emerging connected products business.

As we noted at the time, the separation represented a chance for Fortune Brands to evolve into an entirely new company, one marked by excellence in brands, innovation, and channel. And while we are proud of the amount of value creation the separation has generated for our shareholders, we're even more excited about the growth potential that we unlocked.

We've now had nearly a year operating as a more fully aligned company with an organization that is designed around accelerating growth. While it will take more time to realize the full impact of our new structure, we are already seeing tangible results. Our more efficient structure has allowed us to remove

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unnecessary duplication, make strategic decisions faster and with more precision, and deploy our Fortune Brands Advantage capabilities across the portfolio.

By removing those activities that do not create value, we create space for those that do. This is a multiyear journey that has already begun to pay dividends. Our new structure has allowed us to invest additional capital and talent in those projects with the greatest opportunity to drive growth, including our digital transformation and connected products, which we believe have the potential to transform our entire space.

We now also have a dedicated transformation and integration office reporting directly to me, which is responsible for driving progress on the key growth initiatives across the company, and we are now able to deploy our best talent and our Fortune Brands Advantage capabilities across the entire enterprise in a much more rapid, efficient, and holistic fashion.

There has been an enormous amount of change across the organization, but our 12,000 associates across the globe have leaned into the change and embraced our transformation in a way that is nothing short of exceptional. I'm so proud of our team. Fortune Brands Innovations is stronger, more agile, and more aligned than it has ever been.

One of the key areas that we have identified as a growth catalyst is connected products. Today, I want to help put this business in its proper context. Our leading brands advantage route to market and technology backbone makes us uniquely positioned to capture growth in the connected products space. A recently aligned organization is helping us fully unlock our potential across the full company.

The addition of Yale and August enhances our capabilities and product set, giving us the scale and talent to lead in connected products. Now that our strength's combined, we are further on the path to becoming a digital innovative disruptor.

From 2020 to 2022, Fortune Brands connected product sales nearly tripled and this was during a chip- constrained environment that limited us from reaching our full sales potential. Including our recent acquisitions, our annualized run rate of connected product sales approaches $250 million. Today, we have

4.5 million activations of our connected products, and we expect those numbers to grow exponentially as we continue to transform and disrupt the market.

Our connected product portfolio offers real solutions to real needs for making life easier and more secure for the individual to addressing some of the world's most pressing sustainability and safety issues.

Businesses are using our Master Lock connected access solutions to help them work more efficiently. Individuals with Yale and August Smart Residential Locks have peace of mind and have been freed from using keys. Homeowners with products from the Moen Smart Water Network, including our AI-enabled flow, Smart Water Monitor and Shutoff, can better protect against damaging and costly leaks in their homes.

1. cannot overstate the potential positive impact our Smart Water products can have on homeowners, insurance companies, and on the environment as we look to save billions of dollars in preventable water damage claims and trillions of gallons of water.

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While our connected product journey is well on its way, we have much more runway ahead, including our ability to deliver first-of-its-kind connected products and ecosystems. We will continue to innovate to make our homes, communities, and the planet smarter, safer, and more sustainable. Expect much more from us as we continue to evolve this growth engine for our business.

Before I turn to the individual business's performance, I would like to put our results in their proper context. We were well prepared for the challenges that we are currently facing and took meaningful action in anticipation of the environment. As a result of these actions, we were able to deliver solid top and bottom line results.

As the external market remains soft due to affordability concerns and macro uncertainty, we will continue to protect our business while prioritizing investment in a tight set of key strategic priorities, such as those just discussed, in order to win for the long term.

In the third quarter, Water Innovation sales were $688 million, an increase of 8% compared to the prior year quarter. Our margins for the segment were 24.2%. On an organic basis and excluding FX, sales decreased 3% due to market-driven volume declines, partially offset by price.

Our Moen North Americas business was down low single digits versus last year's third quarter due to lower volumes as a result of market softness, particularly in retail. However, our POS data showed that we gained share in the market, driven by our strong outperformance in the key wholesale channel.

Retail promotional activity increased in the quarter. And we've been highly strategic about our promotional activity to ensure our promos are targeted and tailored to drive the best results.

Organic House of ROHL sales were down low single digits in the quarter. The U.S. luxury consumer continues to remain relatively resilient and our high-quality artisanal crafted products resonate.

Our recently acquired Emtek business performed above our expectations in the quarter. We are extremely pleased by the progress of the integration of Emtek. The more I learn about this business and their commitment to the consumer and the customer, the more impressed I am.

1. look forward to a bright future as we bring all of the brands together under the House of ROHL platform, which is now a uniquely positioned global luxury powerhouse with exceptional growth potential.

In China, sales were down low teens year-over-year or mid-single digits, excluding FX. While we saw higher- than-expected project completions as the government is increasingly incentivizing developers to deliver finished projects, the overall market remains soft and the Chinese consumer remains cautious.

However, on non-developer channels that focus on the emerging R&R market, which include showroom, home decorator, and e-commerce, all saw growth, and our business is well positioned to capture the market evolution away from new construction.

Turning to our Outdoor segment. Sales declined 9% in the quarter, reflecting market softness, particularly in the doors business. Our margins were 14.8%. In decking, third quarter sales were up mid-single digits

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versus prior year as we gained share in the key wholesale channel. Looking forward, we are focused on driving meaningful innovation in this space and have the resources and talent to innovate for the future in this growth category.

In Doors, sales declined low double digits as the slowdown from the 2022 single-family new construction market continues to impact Therma-Tru and general market softness remains in the space.

Looking forward, as the impact of the recent improvement in the single-family new construction market begins to float through in late 2023 and early 2024, we expect to see improving results from Outdoor brands.

Lastly, in Security, third quarter sales increased 32% year-over-year and grew 6% organically. Operating margins for the segment were 16.8%. Our organic results were driven by price and continued growth in commercial and international markets. Importantly, improvement in our operating margin is a true testament to the power of the new organizational structure and our Fortune Brands Advantage capabilities. We expect we will continue to see even more impressive margin results in Security as we continue to deploy these capabilities.

As we integrate Yale and August, we continue to be extremely impressed by their innovative focus and start-up mentality. There's clearly deep talent and passion, and I look forward to seeing their knowledge and insights contribute to the entire Fortune Brands connected product portfolio.

Importantly, Yale and August exceeded our expectations as they recover from the impact of chip shortages and are working to develop new customers and channels. As with Emtek, the more I learn about these incredible brands and the teams who support them, the more enthusiastic I am.

Before I turn the call to Dave, let me share a few final thoughts. Our reorganization into a more efficient, centralized company, focusing on brands, innovation, and channel has progressed faster than we anticipated thanks to the strong engagement and trust from our teams. We continue to invest in our key strategic priorities, including our iconic brands, digital transformation, and meaningful innovation. We are growing our connected products portfolio. And finally, we made meaningful progress in the integration of our transformative acquisition.

We are transforming Fortune Brands into an even more growth-focused, highly innovative company in spite of continued external and macro headwinds. I'm encouraged by all that we have accomplished and excited about what we will achieve next.

We're constantly monitoring and are well prepared to respond to uncertain end markets in the short term, while we position ourselves for accelerating long-term outperformance in the market supported by fundamental growth characteristics. As we head into the last part of 2023 and as we set our sights on 2024, we are focused on execution and delivering on our commitments to above-market sales growth and margin performance.

With that, I'll turn it over to Dave.

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Dave Barry

Thanks, Nick. As a reminder, my comments will focus on income before charges and gains to best reflect ongoing business performance. Additionally, comparisons will be made against the same period last year, unless otherwise noted. Let me start with our third quarter results.

As Nick highlighted, our teams executed well and delivered solid sales, margin, and free cash flow performance. Sales were $1.3 billion, up 5%, and consolidated operating income was $220 million, up 2%. Total company operating margin improved sequentially to 17.4% and earnings per share were $1.19, up 3%. Free cash flow in the quarter was $269 million, which brings our year-to-date free cash flow generation to $660 million.

Turning to sales. On an organic basis, net sales were down 4%, driven by volume declines. Overall, volume was down mid-single digits driven by high single-digit POS volume declines, partially offset by low single- digit favorable channel inventory comparables. Price contributed a low single-digit benefit in the quarter.

Through the quarter, our POS volume softened sequentially in line with normal seasonal trends and DIY channels continue to remain softer than Pro channels. Our operating margin of 17.4% reflects our team's continued ability to drive continuous improvement savings and fund key strategic priorities, while remaining agile in the face of challenging end markets.

Our teams remain focused on driving above-market growth, preserving and enhancing margins, and generating cash. As I will detail later, our balance sheet remains strong and we have the flexibility to manage through various economic outcomes, while deploying additional capital to drive shareholder value.

Now let me provide more color on our segment results. Beginning with Water Innovations, sales were $688 million, up 8%. Organic sales were down 4% or down 3% excluding the impact of FX. The organic net sales results reflect the impact of lower volumes, partially offset by price. Water Innovations operating income was $166 million and operating margin remained strong at 24.2%, reflecting lower volumes, partially offset by continuous improvement initiatives.

U.S. Moen point of sale was down mid-single digits while U.S. House of ROHL point of sale was down low single digits. The luxury consumer continues to outperform the broader market.

China sales declined low teens or down mid-single digits when adjusting for the impact of FX. The Chinese market remains soft and though the completion of delayed projects accelerated as a result of government programs, new home sales and starts are moderating as the Chinese consumer remains cautious.

That said, we continue to see growth in the emerging R&R channels, including at brick-and-mortar locations and online. As we have stated, our performance in the face of challenging external conditions has been nothing short of remarkable, and we are confident we will lead as that market continues to evolve.

Turning to outdoors. Sales were $366 million, down 9%. POS for the segment was down low double digits, which was partially offset by mid-single-digit favorable channel inventory benefit from the prior year

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comparable. Segment operating income was $54.3 million, down 18%. Operating margins for the third quarter were 14.8%, driven by reduced volumes.

Door sales were down low double digits. As expected, sales were impacted by lower volumes from single- family new construction and market softness. However, these brands should be positively impacted by the recently improved new construction environment as we look toward 2024.

In Decking, we saw sales increased mid-single digits in the quarter driven by mid-single-digit POS growth in the wholesale channel.

Finally, in Security, sales increased 32% to $207 million or 6% on an organic basis, reflecting the impact of the acquisition, increased distribution, price, and continued strength in Master Lock's commercial and international channels.

Total Security segment operating income was $35 million, up 46%, and operating margin was 16.8%, an increase of 170 basis points. Utilizing the playbook first deployed in our Water Innovations business, our team continues to work to transform our security business into a higher-growth,higher-margin business focused on attractive categories where our brands and innovations can drive consumer and customer share gains over time. This strategy will be accelerated by the continued integration of Yale and August.

Turning to the balance sheet and our cash flow performance. Our balance sheet remains strong with cash of $453 million, net debt of $2.4 billion, and net debt-to-EBITDA leverage at 2.6x. Our working capital reduction efforts continue to shrink our balance sheet and generate cash. We continue to make excellent progress against our near-term inventory reduction targets and our organic third quarter inventory finished at $829 million, down roughly $260 million from our peak in 2022.

Our impressive free cash flow of $269 million in the quarter allowed us to make significant progress in deleveraging following our recent acquisition. In addition, our cash generation enabled us to opportunistically repurchase $30 million of shares in the quarter. And as of today, our total 2023 share repurchases are $150 million.

To summarize the quarter, we delivered solid sales and margin results in a soft environment, while further reducing inventory levels and generating significant cash flow.

With that in mind, I'll now provide an update to our 2023 guidance. As today's press release indicates, we are updating our full year 2023 guidance to reflect our current expectations and market conditions. Due to our continued strong execution and agility in this dynamic environment, we are increasing the midpoint of our EPS guidance by $0.02 and narrowing the overall range to $3.80 to $3.90. In total, our updated EPS guidance reflects a $0.15 increase over the midpoint of our initial guidance earlier this year.

As a reminder, our fourth quarter EPS will be unfavorably impacted by $0.05 as a result of a nonrecurring extra fiscal week in the fourth quarter of last year.

We are also updating our sales and margin guidance to reflect current market conditions, including a softer-than-anticipated second half R&R market, which is predominantly impacting sales in our Outdoor segment.

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The full details of our updated guidance can be found in our press release.

As we head into 2024, we are actively planning for a variety of scenarios. While it would not be prudent for us to provide a full set of guidance assumptions for 2024 at this point, we are able to share some initial thoughts.

Our base planning assumptions currently include a low single-digit market decline, with U.S. R&R also down low single digits. Our U.S. single-family new construction market is up low single digits based on the impact of second half 2023 starts growth and a 2024 starts and completion forecast of up 3% to 5% and roughly flat, respectively.

We expect China and Canada markets to be more challenged than the U.S., both down high single digits. We would expect our organic sales to beat this market estimate and given the work we continue to do to replatform the business and drive efficiencies, we see a path to operating margin improvement and earnings growth if the market is down low single digits or better.

Our teams have done a fantastic job navigating the uncertainty of the past few years. And as we approach the end of 2023, we remain confident about the future of the business and our team's ability to create value regardless of the macro environment.

I will now pass the call back to Leigh for question and answer. Leigh?

Leigh Avsec

Thanks, Dave. That concludes our prepared remarks. We will now begin taking a limited number of questions. Since there may be a number of you who would like to ask a question, I will ask that you limit your initial questions to two and then reenter the queue to ask additional questions.

I will now turn the call back to the operator to begin the question and answer session. Operator?

Operator

Thank you. If you would like to ask a question, please press star one on your telephone keypad at this time. A confirmation tone will indicate that your line is in the question queue. You may press star two if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please while we pull for questions.

Thank you. Our first question comes from the line of Matthew Bouley with Barclays. Please proceed with your question.

Matthew Bouley

Hey, good evening, everyone. Thanks for taking the questions. Maybe to start off on the guide and kind of how you're looking at the fourth quarter here. Clearly, a lot of crosscurrents in the market. I think you just mentioned some deceleration on the DIY side, sort of looking at the guide, it looks like you're implying some sequential deceleration in the top line. So just -- I know we can kind of back into what you gave,

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