Fortune Brands Innovations Q3 2023 Earnings Call Transcript

Quartr
Provided by Quartr
October 25, 2023

There are 10 speakers on the call.

Operator

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.

Operator

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

Speaker 1

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. I want to remind everyone that the forward looking statements we make on the call today, either in our prepared remarks or in the associated question and answer session are based on current expectations and market outlook and are subject to certain risks and uncertainties that may cause actual results to differ materially from those currently anticipated. These risks are detailed in our various filings with the SEC.

Speaker 1

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 Games basis unless otherwise specified. Please visit our website for reconciliations. 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.

Speaker 1

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

Speaker 2

Thank you, Lee, and thank you to everyone for joining us today. On this call, I will walk through the highlights of our Q3 performance and offer some thoughts on the macro environment. I will also give an update and our ongoing evolution into a tightly aligned company focused on brands, innovation and channel. I will then turn the call over to Dave for discussion of our financial results, our updates to our guidance for the remainder of 2023, as well as some thoughts our emerging expectations for 2024. Turning to our Q3 performance.

Speaker 2

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 Q2 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 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.

Speaker 2

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 advantage channel relationships helped drive our results and give me confidence in our strong future. Our Fortune Brands advantage capabilities We'll 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 standalone 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 $1,300,000,000 in the quarter versus $1,200,000,000 the prior year, up 5%. Organic net sales were down 4% versus the prior year.

Speaker 2

Our operating margin was 17.4 percent, up 40 basis points versus the Q2 of 2023. Our sales and margin performance together with exceptional cash generation resulted in earnings per share of $1.19 A 3% increase over the Q3 of 2022 and gives us confidence in delivering our revised EPS range of $3.80 to $3.90 As we discussed on our lost 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. It 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.

Speaker 2

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.

Speaker 2

A recent third party survey indicated that over a third 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.

Speaker 2

Builders, particularly the large production homebuilders with whom Fortune Brands enjoys strong relationships, Continue to respond to affordability challenges in the 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 and R. R and R market remains dynamic. There are many variables that are impacting the repair and remodel space, including consumer savings and confidence, employment levels, existing home turnover and home equity levels.

Speaker 2

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 and because they are smaller ticket, 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 name and aesthetics were by far the most important factors consumers considered during their purchase journey, more so than price. Our brands perfectly aligned with those criteria.

Speaker 2

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.

Speaker 2

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're actively scenario planning for a variety of outcomes in 2024. Turning now to an update on our organizational transformation.

Speaker 2

As we approach the 1 year anniversary of the Cabinets 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 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.

Speaker 2

A more efficient structure has allowed us to remove 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 and 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.

Speaker 2

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. 1 of the key areas that we have identified as a growth catalyst is Connected Products.

Speaker 2

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 product space. Our recently aligned organization is helping us fully unlock our potential across the full company. The addition of Yale in August enhances our capabilities and product set, giving us the scale and talent to lead in connected products. Now with our strengths combined, We are further on the path to becoming a digital innovative disruptor.

Speaker 2

From 2020 to 2022, Fortune Brands Connected Product sales nearly tripled, and this is 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 $250,000,000 Today, we have 4,500,000 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 Luxe The peace of mind has been freed from using keys.

Speaker 2

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. I 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 1,000,000,000 of dollars in preventable water damage claims and 1,000,000,000,000 of gallons of water. While our connected product journey is well on its way, we have much more runway ahead, including our ability to deliver 1st 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.

Speaker 2

Before I turn to the individual businesses 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 Q3, water innovation sales were $688,000,000 an increase of 8% compared to the prior year quarter.

Speaker 2

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. Amaron North America's business was down low single digits versus last year's Q3 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.

Speaker 2

We've been highly strategic about our promotional activity to ensure our promos are targeted and tailored to drive the best results. Organic household sales were down low single digits in the quarter. The U. S. Luxury consumer continues to remain relatively resilient and our high quality where Tisnel Crafted Products Resonate.

Speaker 2

Our recently acquired Emtek Business performed above our expectations To 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. I look forward to a bright future as we bring all of the brands together under the House of Roll 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.

Speaker 2

However, our non developer channels that focus on the emerging R and R market, which includes 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, 3rd quarter sales were up mid single digits versus prior year as we gain share in the key wholesale channel.

Speaker 2

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, 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 flow through in late 2023 and early 2024, we expect to see improving results from Outdoor Brands. Lastly, in Security, 3rd quarter sales increased 32% year over year and grew 6% organically. Operating margins for the segment were 16.8%.

Speaker 2

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 startup 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.

Speaker 2

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.

Speaker 2

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.

Speaker 2

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 a 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 commitment to above market sales growth and margin performance. With that, I'll turn it over to Dave.

Speaker 3

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 Q3 results. As Nick highlighted, our teams executed well and delivered solid sales, margin and free cash flow performance.

Speaker 3

Sales were $1,300,000,000 up 5% and consolidated operating income was 220,000,000 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 $269,000,000 which brings our year to date free cash flow generation to $660,000,000 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.

Speaker 3

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 Now let me provide more color on our segment results.

Speaker 3

Beginning with Water Innovations, sales were $688,000,000 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 $166,000,000 and operating margin remained strong at 24.2%, reflecting lower volumes, partially offset by continuous improvement initiatives. While U.

Speaker 3

S. House of Roll 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.

Speaker 3

That said, we continue to see growth in the emerging R and 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 Remarkable, and we are confident we will lead as that market continues to evolve. Turning to Outdoors, Sales were $366,000,000 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 comparable. Segment operating income was 54 300,000 down 18%.

Speaker 3

Operating margins for the Q3 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 increase mid single digits in the quarter driven by mid single digit POS growth in the wholesale channel.

Speaker 3

Finally, in Security, sales increased 32% to $207,000,000 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 $35,000,000 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 in August. Turning to the balance sheet and our cash flow performance.

Speaker 3

Our balance sheet remains strong with cash of 453,000,000 net debt of $2,400,000,000 and net debt to EBITDA leverage at 2.6 times. Our working capital reduction efforts continue to shrink our balance sheet and generate cash. We continue to make progress against our near term inventory reduction targets and our organic third quarter inventory finished at $829,000,000 down roughly $260,000,000 from our peak in 2022. Our impressive free cash flow of $269,000,000 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 $30,000,000 of shares in the quarter.

Speaker 3

And as of today, Our total 2023 share repurchases are $150,000,000 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 EPS guidance reflects a $0.15 increase over the midpoint of our initial guidance earlier this year.

Speaker 3

As a reminder, our 4th quarter EPS will be unfavorably impacted by 0 point week in the Q4 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 and R market, which is predominantly impacting sales in our Outdoor segment. 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.

Speaker 3

Our base planning assumptions currently include a low single digit market decline, with U. S. R and R also down low single digits. Our U. S.

Speaker 3

Single family new construction market is up low single digits Based on the impact of second half twenty twenty three 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.

Speaker 3

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?

Speaker 1

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 2 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.

Speaker 1

Operator?

Operator

Thank you. A confirmation call will indicate that your line is in the question Thank you. Our first question comes from the line of Matthew Bouley with Barclays. Please proceed with your question.

Speaker 4

Hey, good evening, everyone. Thanks for taking the questions. Maybe just start off on the guide and Kind of how you're looking at the Q4 here. Clearly, a lot of crosscurrents in the market. I think you just mentioned Deceleration on the DIY side, sort of looking at the guide, it looks like you're implying some sequential deceleration in the top line.

Speaker 4

So just I know we kind of back into what you gave given with the full year guide, but just sort of any puts and takes, upside, downside to how you're thinking about the Q4? Thank you.

Speaker 2

Yes, Matt, why don't I give you some kind of high level thoughts on that and then Dave can take you through some of the puts and takes. But a couple of things. I mean, certainly just from perspective, as we said in the prepared remarks, the market Has been more or less as we've expected, I think with some of the point of sale DIY, maybe some of the retail stuff being a bit softer, single family new construction Being a bit stronger and as we see how it plays through the year, the top line performance of every quarter has been improving. And so as we look to the Q4 on an organic basis, now that the 3rd week, we'd expect that to be flat, which is a sequential improvement. And so good to see the business kind of coming back to flat, in particular with the market Outperformance.

Speaker 2

And then as I look at some of the actual dollar point of sale that we get, which is more Retail base, it's actually held remarkably steady for the last, call it, 10 to 12 weeks on a dollar basis. So obviously, We'll both move around in terms of percentages versus last year, but just what are consumers doing when they go into stores? What are the dollars they're spending? That's been very steady. While we'd like it to be higher, the predictability of seeing that kind of steady line sort of feeds into degree of confidence around the Q4.

Speaker 2

Terry, do you want to give

Speaker 3

a little more color? Yes, Matt, I'm happy to provide a bit more color. I think starting with sales, If you look at our organic performance throughout the year each quarter, as Nick mentioned, we've gotten better versus prior year. So it started down 10 in the Q1 then down 8%, now down 5%. And we'd expect the Q4 to be flat, Excluding that extra fiscal week comp or likely down 3% to 4% reported organically when you factor in that comp.

Speaker 3

So nice The sequential improvement versus the prior year on the sales line. And then on margin, we still see the second half operating margin around 15.5% or better, which would imply kind of a Q4 of 15.5% or better, Which is I think expected in the Q4 to see a bit of a sequential pullback from the Q3 just given volumes are down, but still well ahead of where we were in the first quarter, which is our other low volume quarter. So feel good about how the business is managing, I think, both the top line and the margin opportunity. And then if you think about this EPS, I'd remind people that our prior year had 2 favorable impact that won't repeat, one being the flow through from that extra fiscal week and the other being some favorable tax outcomes as we spun cabinets that were one time in nature. So as we look at EPS in the quarter, we see something normalized that's down low single digits or better versus the prior year.

Speaker 3

I know our teams are still working hard to capitalize on opportunities in the quarter, but still feel like we're managing the business well given the environment.

Speaker 4

Got it. Okay. Thank you for that. Thanks for buttoning that up for us. Second one, a little higher level.

Speaker 4

Now that you've had the assets on your team for another quarter and been able to dig in and get integration underway. I'm curious, you had some comments at the top alluding to this, but sort of what have you learned incrementally as you've been able to dig into the assets. And specifically, the comments you made around the help with how Yale in August could benefit your Connected Products portfolio. Curious, number 1, is Do your synergy targets include benefits to the Connected Products portfolio? And then just number 2, more broadly, As you've looked into this further, what areas of upside could you see in those synergy targets?

Speaker 4

Thank you.

Speaker 2

Yes. I'd be happy to take that question. We were as you heard in the prepared remarks, we're just delighted with the acquisition. Even putting aside the fantastic value that I came across that, just the quality of assets themselves are Really phenomenal. The quality of the teams that support those assets have been fantastic.

Speaker 2

And the performance Since we've owned them, has even exceeded our expectations on the top line. And on the bottom, you'll see We've actually been able to accelerate some of our investments in the integration just because the integration is going really well. And so that's kind of The big picture message. Now, you asked a great question, sort of, what have we learned? I take the niche of it separately.

Speaker 2

But certainly, it's fair to Emtek Business. I mean, they're just really remarkable, continue to gain share, Really, really outperformed the market. We were just recently on a market visit and one of our customers pointed to displays in a relatively small footprint of the store and said this is 50% of the sales in the category Just from this little area and I think it just speaks to how powerful the brand is. What we've really learned is What is the formula that supports that and the business model and how does that work as profitably Yes, it does. And so a lot of learnings coming from that that are starting to be integrated into the whole house of roll strategy.

Speaker 2

And so just last week, we were going over Annual operating plans and as those teams are coming together, not just thinking about how do we offer these as an entire suite of product, which was part of our initial thesis, but really thinking how do we Elevate the best of the best in the business models to be an even better solution for and Designers. And so we think there's a lot of potential and a lot we can learn there. And then on the Yale and August side, Look, we're very proud of the Connected Products progress that we've made and the digital initiatives that we've made Up to this point, but getting to know those teams, I mean, they really are a mid cycle operate, like a mid cycle startup. And a lot of that team is the original August team, which if you spend some time and Speaking to people in that part of the world, there are some of the most highly respected connected engineers around. And so we're really looking to them Help lead us as we think about how to bring these teams together and how do we take what we've already created, which we're really proud of, investment that we're already making, which is not insignificant and then combine it with what we just acquired.

Speaker 2

And we really think that could be a huge growth unlock. And so you asked about synergies. I think we went in with a Pretty good synergy case of some, I won't call them easy because they take a lot of work, but some lower hanging fruit like distribution overlaps And those sorts of things, what we're coming away is with some transformational ideas around both the House of Roll and the Connected business that the teams are leaning into, right? It's not me saying you got to deliver more. I mean, they sort of took the case and they said, we think we can do far more than this because we really think that this unlocks pretty significant growth for both portfolios.

Speaker 2

And so Those are being refined now, but we're really, really excited. As you heard in the comments, I mean, the Connected business now approximating and approaching $250,000,000 on an annualized basis, but Over 4,000,000 activations and compounding at a really, really fast growth rate now feels like a scale Connected Business and Connected Platform and having one technological backbone to which we can continue to refine the products we have, but also add more to the ecosystem over time It's really, really exciting. So I could go on for a while. I'll stop for some further questions, but you can tell we're pretty excited about it.

Speaker 4

Great. Well, thanks Nick. Thanks Dave. Good luck guys.

Speaker 2

Thanks Matt.

Operator

Thank you. Our next question comes from the line of John Lovallo with UBS. Please proceed with your question.

Speaker 5

Good evening, guys, and thanks for taking my questions. Nick, I actually did want to follow-up on what Matt just asked to some extent on the connected product portfolio. Very interesting opportunity goes beyond SmartLocks, obviously, with Smartwater. I think you guys I think you mentioned you've tripled the sales over the past few years. So question is, I mean, where do you go from here?

Speaker 5

What's sort of the expected growth trajectory? And what are the potential product expansion opportunities?

Speaker 2

Yes. Well, John, thanks for that question. I mean, we've really taken a big step forward, I think, through the strat plan cycle And really also solves that question that you just laid out. So instead of sort of just thinking about it incrementally, we're really like what is the addressable market here And what do we expect that we could gain in terms of ownership of that market? And you touched on Smartwater.

Speaker 2

I mean, when you look at The smart water opportunity from a number of different lenses, it is pretty staggering, right? Just to start with just For Pure, how much preventable water damage is there today? We think that's $15,000,000,000 of claims a year. It's greater than fire and burglary combined, right? So $15,000,000 of preventable water damage.

Speaker 2

I actually believe we're going to grow that addressable market because we're going to come up with more products that can address more types of preventable water damage. We can take that pretty much to 0. I mean, we did a study with LexisNexis in 10,000 homes. We reduced 96% of the claims to 0 And the other 44% of claims, I believe we reduced by over 70%. So pretty much going to 0.

Speaker 2

There's an ESG lens to it, right? In addition to saving, we take potentially trillions of gallons of water. There's a huge energy component to processing and cleaning water. And so you take Mission Mullen, which is really based on what we have in the market today, our commitment to save 1,000,000,000,000 gallons by 2,000 and thirty. That according to the math available in the EPA website, the equivalent of us taking 1,000,000 cars off the road for a year, And so you can start to see now from municipalities, right, it has a huge dollar value impact.

Speaker 2

And so the opportunity is huge. We're Really not thinking of it as a multibillion dollar opportunity. We're building teams around really addressing not just Our core product, making it better and better all the time. We're building an ecosystem around it. So when it connects to your Moen Irrigation, smart irrigation system or your Moen Smart Faucette or Yermone Smart Sump Pump Monitor and I could go on and on.

Speaker 2

It really gets better and better and smarter and smarter Speak to all these nodes in the home, understand what's going on and really do things like protect you from freezes because it can Pulse water out of your kitchen faucet or help protect you if you're on vacation from bacterial buildup and things like that. And so we're really Now leaning into this, I think in a much more serious way. And as I just said in response to Matt's question, if you then add on the scale of having the Yale August team come on board and think about what it is to be able to think about cloud as a single team or Wi Fi as a single team or AI, right? The Smartwater Network is AI powered. So our AI team becomes sort of a single team that dedicates people to different projects and products, It's still functioning as a scale team.

Speaker 2

We think the opportunity is really, really significant and we look forward to speaking about it more in the future.

Speaker 5

That's helpful color. Thank you. And then the next question is on water specifically. The sales outlook was raised from, I think, flat to down 2% and now flat to down 1%. U.

Speaker 5

S. New construction a little better, China a little worse. So I guess, how are you thinking about House of Roll and Moen in this equation, which I think were both down organically in the quarter? And also what's driving the decrease in margin outlook from, I think, 23.5% to 23% on an improved sales outlook? Thank you.

Speaker 3

Hey, John, this is Dave. I'll handle the margin one first. I think it's more around some of the accelerated investments that we're making, as Nick mentioned, some with the Emtek acquisition and then some in the base. And so as we've talked about in the past, our margin quarter to quarter Days in that kind of low to mid-20s and you may see some fluctuations. It was 24.2% in the Q3 and we'll step back a little bit in the 4th, but More around investment timing than anything else.

Speaker 3

And then on the sales line, the team really continues to perform well And drive out performance. And so House of Roll, as we've mentioned, down low single digit organically in the 3rd quarter, Probably at similar levels in the Q4. And then for Moa and Americas in a similar performance we see that down low single digits in the 4th quarter, which really implies that our POS run rate stays at mid single digits or better and We have some favorable inventory tailwinds from last year that we've discussed. So I think it's more as we have line of sight at the end of the year, just tightening that range around the performance that we're seeing out of the business.

Speaker 5

Thank you, guys.

Operator

Thank you. Our next question comes from the line of Stephen Kim with Evercore Core ISI. Please proceed with your question.

Speaker 6

Yes, thanks guys. Appreciate all the color. Wanted to Ask a little bit on the U. S. Residential side.

Speaker 6

You, I think, Increase the U. S. The single family new construction component of your guide, but multifamily has been looking weaker and The, what with the increase in rates and so forth, I think, the concerns exist about how things might look, over the next Few months. So I know that you have a fairly constructive view of that given the undersupplied state of the industry. Obviously, I share that view as well.

Speaker 6

But I was curious if you could talk specifically about the multifamily side, to the degree to which that may be weighing on the overall outlook, because I didn't hear you call that out. And then Similar to this, in your outdoors division, your doors business has a lot of starts exposure, I guess. Your sales guy you said it was kind of as expected, The starts effect, but the sales guide came down a bunch. And so just curious if you could just sort of maybe tie that in there as well.

Speaker 2

Sure. Why don't I I'll start and just give you some perspectives and Dave will add some more color around it. I'll just start more on your question about The starts in multifamily. And multifamily is actually a pretty small part of our business. And so I don't disagree with you.

Speaker 2

I do think it's challenged. I mean it's going to be challenged, but it's a pretty smart small part of our business. And then within that, the part of multifamily that we serve tends to be the higher end of multifamily. So I think where a lot of the customers are calling is probably in places where we don't have a ton of exposure because we're more if you think about Multifamily for sale, large concept buildings, those are the type of things that we tend to be calling on versus the I think we're seeing a lot of pressure in the rental market, which tends to gear more towards The price competitive stuff. So why not pause there, Damien, ask him, Paula, and then we can talk about the outdoors piece.

Speaker 3

Yes. Steve, so multifamily in total is about 7% of the portfolio, so pretty small. And recall, our products go in towards the end. So our multifamily estimate for this year is actually up high single digits. And so we're not feeling much headwind in the macro this year based on when our products are consumed on multifamily.

Speaker 3

I'd say what's a little bit softer is probably the overall U. S. R and R, right? If we're still down 4% to 6%, we're at the midpoint of that, Maybe a bit below the midpoint and that's offsetting the single family new construction benefit in the overall macro.

Speaker 4

Yes. Okay.

Speaker 2

On your outdoors question, you're right, more single family new construction exposure there. What's been interesting We kind of haven't yet seen the benefit of the search acceleration pull through our products. We think that's probably just got to do with when our products are installed and that varies. I mean, not the point of installation doesn't vary, but The lag between starts and completes tends to vary. And so it's kind of an inexact science.

Speaker 2

And so We've not seen a pull through very strongly in doors or valves, which for us is a great indicator given our exposure To large production builders, we get a great sense given the valve install is fairly early on, when that's pulling through. And so we think that's probably most likely to be a end of 'twenty three and into 'twenty four tailwind.

Speaker 3

Yes. And Steve, just some color on that. So our Moen valve POS in the Q3, so The component of the product that goes behind the wall in new construction was still down mid single digit. And then our doors wholesale POS, which predominantly serves new construction was down low double digits. So we're not seeing that new construction pull through yet.

Speaker 3

It's a Nick's point, probably late Q4, early 2024. The other piece on the outdoors guide is driving it down a little bit. Channel inventories are still lean across that segment. And we expected A bit more inventory to come in, in the quarter than we saw. And as we exited the quarter, it's still pretty lean both on the decking and door side.

Speaker 5

Okay. Okay. That's helpful.

Speaker 6

Yes, I appreciate that. That info on the valves is interesting because we have seen that pull through come Happened in some other segments, so another product. So that's interesting, that it should come soon.

Speaker 2

Given that we're pretty much locked into I mean, not for experience, but locked into that portion of the bullish is very high. It's a pretty good news for us.

Speaker 6

Yes, clearly. Okay. Second question relates to just Kind of generally, if you could talk about the dynamic between price cost, if there was anything sort of to call out there that we should be thinking about Across your the various segments.

Speaker 3

Yes, Steve. Nothing material to update really from where we've been in the past few quarters. So still See price as a low single digit contributor to sales, started to see some deflation, metals deflation in the P and L In the Q3 as we expected, but I'd say overall deflation still less than 1% of COGS given offsets to labor. Some of the freight lanes have increased and then around indirect spending. And so tracking to where we thought we'd be at the beginning of the year And no material update or change.

Speaker 2

And I'll just add for some color. We talked about this previously, but one of our key Fortune Brands advantage Capabilities is category management. And so what are the these are the things that we decided to invest in to get really, really good at. Things like next generation sourcing capabilities, global supply chain, category management, complexity reduction in digital. And We're finding that having that capability, which is really data and analytics driven and understanding of the shelf, The consumer and shopper behaviors, the elasticities, having that tool now has been very powerful because it's allowed us to have Very constructive conversations with our trade partners and allows us to be very precise and targeted in how we manage price and therefore continues to be a contributor while keeping us competitive in the marketplace.

Speaker 6

Okay, great. Thanks very much guys.

Operator

Thank you. Our next question comes from the line of Michael Rehaut with JPMorgan. Please proceed with your question.

Speaker 7

Great. Thanks very much. Good afternoon, everyone. Just wanted to for my first question, make sure I'm getting some of the nuances of the change in guidance here. And I guess just on a basic level, it seems like the slight reduction in Operating margin is predominantly driven by the slight change in sales.

Speaker 7

So just want to make sure I'm thinking about that right. It just appears like it's more just a function of the sales leverage. And when you think about From a top down perspective, you have a couple of the segments, a slight tick down in the sales guidance. What's really driving that from an end market perspective? And it also appears, if I'm looking at it right, that You were a little better than our outlook on 3Q and a little worse than what we were thinking about 4Q.

Speaker 7

So if there's any type of shift between timing here or if things are a little better, things are a little worse in the last 3 months of the year. Just wanted to appreciate any of those differences as well.

Speaker 3

Yes. Hey, Mike, it's Dave. I'd say your first question That's accurate. It's really sales slight reduction in our sales guidance flowing through to operating margins is based on the volume leverage. Well, that's really coming in outdoors.

Speaker 3

I mean, if you look at the segment changes, water segment guidance overall up Slightly, so from minus 2 to flat to minus 1 to flat and then security same, up slightly 13 to 15, up to 14 to 15. And so it's really outdoors, as we mentioned earlier on the call, slightly lower R and R, POS and then channel inventories that are leaner. So I think that's a simple way to think about the change in guidance. 3rd quarter, 4th There are always some timing benefits across the quarter or challenges across the quarter. As I mentioned earlier, teams are working hard to Get the best result out of the Q4 that we can given the market environment.

Speaker 7

Right. No, no, I appreciate that. I guess I was focusing A touch more on the organic change. I mean, it brings me really to the second question, which is that You've mentioned both acquisitions are doing better than you expected. And so I was hoping to get a sense, number 1 of I know it's just 1 quarter perhaps that's under your belt here, but any kind of updated thoughts about How to think about an annualized revenue run rate for these two businesses.

Speaker 7

I think a quarter ago, you're talking about, I believe $240,000,000 for Emtek Schaub and 170 for Yale August. If there's any changes to how we should think about those numbers on an annualized run rate. And from an again, from an end market perspective, if you think about those 2 different businesses, Where is that upside coming from, if it's again a certain channel or end market or if there's even any initial Benefits from some of the sales synergies, we try to expect would be more in 2024, but just any thoughts in terms of the drivers there?

Speaker 2

I'll start with the drivers and then I'll give it to David. He can talk you through the rest of it. But I'd say the drivers Our A, on the and again, you have 2 different, this is Emtek and Schott's. I think they we, I guess now, have just built A fantastic business model and mousetrap that really, really works for the high end designer consumer and that continues to take share. And so it is Outperforming some market in a very healthy way.

Speaker 2

But I think the real opportunity will be to take What's really working in that model and leverage it across the rest of the luxury portfolio. And then on the Yes, on August side, just a really fantastic product set that had been growing really nicely, but have been chip constrained for a while. And as that's starting to flow now, And I think also we're giving the team their sort of the privilege of focus on really working on a number of things that they Had on their place that they wanted to do, but they were also working on other priorities for their predecessor organization. They told us to Give us a privilege to focus for a while and let us get some things done next quarter or 2. And we're seeing some of that come to fruition.

Speaker 2

I think it's early days To say does that change our view on the run rate? I mean, we've sort of owned it since late June. But what it's allowing us to do is lean into the synergies with a lot of confidence and also invest ahead of plan on bringing some of those synergies to life.

Speaker 3

Yes. I think Nick said it well, Mike. I mean, we'll provide a more detailed view of 2024 on our next call for those businesses. But it is going well. It is early days, And the team is capitalizing a lot of opportunities.

Speaker 7

Great. Thank you.

Operator

Thank you. Our next question comes from the line of Adam Baumgarten with Zelman. Please proceed with your question.

Speaker 4

Hey, guys. Good evening.

Speaker 8

Just curious on some of the benefits you've been seeing from the leadership reorganization and kind of how that's playing out. And I know there's been some savings you've called out in the past year, in the 1st year or so, but just kind of how to think about it going forward and then I'll stop there.

Speaker 2

That work and it was a lot of work and it's still a lot of work because we're really in the 1st cycle of the new operating structure, right. So we just saw the 1st integrated annual plans a week ago. Next month, we'll see the 1st integrated brand plans, product plans, innovation plans. But in short, it is actually going ahead of schedule and better than we expected. And I said that with a lot of Credit to our teams because I think it's really their sort of trust and enthusiasm of leaning into it that's delivering.

Speaker 2

But it was designed to unlock growth and productivity. And Dave can talk a bit to the numbers, but economic the immediate cost out benefit Is a really nice byproduct of not wasting energy on things that weren't creating value and allowing the organization to spend their time on things that will. And so we're seeing

Speaker 3

a lot more of that.

Speaker 2

We're seeing us be able to move through initiatives a lot quicker. And a simple example, again, I talked about Fortune Brands Advantage, you have these capabilities and we were getting much better at deploying them across the organization. But now it's not a question of is it a good idea, not a good idea, is the beta. Those leaders, Sherry Pfeiffer leading our commercial organization, Ron Wilson leading our supply chain organization. If they want to go execute on something across the entire portfolio, They agree with their teams and they go execute.

Speaker 2

And so we're seeing a much faster execution of our key initiatives. And I think that will be the real unlock over time, and where I expect to show up more than anywhere else is growth. Now you asked where are we in that? I think We've taken out kind of like the bite out of the easy third. Now again, I caution myself Using the word easy, because I think our team would say nothing was easy about it, but it's the obvious lower hanging fruit opportunities.

Speaker 2

The next 2 thirds will really come from things like Simplifying our systems, being able to work more easily across the business, taking out more duplication as we have more efficient systems in place and we see that as a multiyear growth and productivity journey for the company.

Speaker 3

And Adam, just to put some financials behind it. So as we've mentioned, No, that first third or so was $55,000,000 of gross SG and A out that we have invested some back into the business to drive some key priorities. And the teams have been busy working this year on the next phase of that organization of the future. And as we look to design it, It's going to come with process improvement system simplification to really get more lean operating environment relative to where we've been.

Speaker 8

Okay, great. Yes. I guess the other switching gears question I would have is just on the decking business, it seems like that's a Yes, pretty meaningful positive standout, you guys, your peers, competitors in terms of versus the broader backdrop. I guess, Maybe if you have any color on what's driving that, how sustainable it is, anything you're seeing there just because of the broader, I'd say home improvement market is kind of soft at this point.

Speaker 2

Yes. I would start out a couple of things. I mean, firstly, again, as you know really well, just The underlying value prop of composite and PVC Materials continues To really be healthy and particularly in the end and all the other costs of installing a deck. And so that will take share against wood and we'll continue to do so For a very, very long time. And in our own capacity modeling, we will play with that conversion ratio.

Speaker 2

We think it's somewhere between 1% and 2% of which, so in a really hot year, it might be a 2% and a slower year like this year, we think it might be closer to 1%, but it's still happening. And so I think that It does continue to drive the top line. The next piece I think is really important that you mentioned was sustainability, right? And We've tried to be very thoughtful and very judicious about how we go to market to do it in a sustainable way for us and all of our route to market partners. And so be thoughtful about pricing, be thoughtful about our product offerings and therefore be thoughtful about where we go across the portfolio.

Speaker 2

And I think what you see in these latest results is we've been willing to give up a little bit of Lower margin business where we think it's not going to be healthy or sustainable to go focus on areas that are And more up the price spectrum and then that's where we ended up taking share and I think that's what read through these results. We'll continue to to that strategy because we think that's the most sustainable way to build this business out for the long term.

Speaker 8

Great. Thanks. Best of luck.

Operator

Thank you. Our next question comes from the line of Phil Ng with Jefferies. Please proceed with your question.

Speaker 9

Hey, guys. Thanks for squeezing me on the call. And Dave, really appreciate you giving us Early look on 2024 in terms of the market. You're calling for a low single digit decline in 2024, but you're expecting margin expansion and earnings growth. So can you help us unpack what are the key drivers in terms of growing earnings?

Speaker 9

And any color on ranges because the Street is certainly modeling pretty robust earnings growth next year. So maybe we'll off the level set a little bit, but really appreciate you giving us an early look on 2024.

Speaker 3

Yes. Hey, Phil. Happy to I think our confidence in margin expansion and earnings growth really stems from the work that we talked about on call. So replatforming the business, getting after some synergy opportunities. We've mentioned some changes in the security business that we've made.

Speaker 3

So there's a lot of, I'd say, internal activities that we see coming through the P and L next year. We have we will be comping that inventory reduction headwind in the Q1. Given where production is likely going to be planned, I wouldn't expect to get all of that back because We'll still be producing at a level lower than we were in 2021 and 2022. And then we still see price cost As a benefit and our teams are still working through their strategic recommendations to our customers around pricing, but Looking to have price contribute again positively to net sales growth next year, as we really think about taking price using our category management capabilities and based The strength of our brands and innovation in a way that both maximizes our share, but also profit for us and our customers. And we've demonstrated our ability to do that over the past couple of years.

Speaker 3

So I think it's really those three levers, the internal actions we've taken, some favorable comps on our cost bar and then some price cost favorability.

Speaker 9

Is there any way to size up those buckets for us that we Have a better handle. And should we assume flattish market if you're outpacing the market and you're taking Price again to maybe flat tails or you could actually you got some top line growth?

Speaker 3

Yes. I think Phil, our teams are still working through all the details. We've seen enough To be able to give this confidence now, we'll provide more in January. And then yes, I think depending on where the market settles, You would expect us to beat the market and typically organically we're targeting 150 to 200 basis points above The market. And so that would imply organic growth in that flat to down low single digits depending on how the market settles down.

Speaker 9

Okay. Appreciate the color.

Operator

Thank you. We have reached the end of our question and answer session. And with that, thank you for joining today's conference call. You may now disconnect.

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Earnings Conference Call
Fortune Brands Innovations Q3 2023
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