Masonite International Corporation
Q2 2017 Earnings Call Transcript

Published: 10 Aug 2017

[Operator:]

Welcome to Masonite's Second Quarter 2017 Earnings Call. During the presentation, all participants will be in a listen-only mode. After management's prepared remarks, investors are invited to participate in a question-and-answer session. Please note that this conference call is being recorded. I would now like to turn the call over to Joanne Freiberger, Vice President and Treasurer.

[Joanne M. Freiberger:]

Thank you, Diego, and good morning, everyone. I'm joined in our Tampa office today by Fred Lynch, our President and Chief Executive Officer, and Russ Tiejema, our Executive Vice President and Chief Financial Officer. Also in the room with us today to participate in the Q&A session is Tony Hair, the President of our Global Residential Business. The information for the webcast presentation that will accompany today's call is available on our website at www.masonite.com. During this call, we will be making forward-looking statements that are subject to risks and uncertainties, which are described in greater detail in our earnings presentation, our press release and our 2016 Annual Report on Form 10-K, all of which are available on our website. Actual results may differ materially from those expected or implied. Forward-looking statements are as of the date they're made. And we undertake no obligation to update any forward-looking statement beyond what is required by applicable securities law. Our discussion of operating performance will include non-GAAP financial measures within the meaning of SEC Regulation G. A reconciliation of these measures with the most directly comparable GAAP measures is included in the press release and in the appendix of today's presentation. On today's call, Fred will begin with a company overview. Russ will discuss financial performance. And then Fred will summarize before opening the call to a question-and-answer session. And, with that, let me turn the call over to Fred.

[Frederick J. Lynch:]

Great. Thanks, Joanne. Good morning and welcome, everyone. Softer than expected demand primarily in the North American residential market, foreign exchange headwinds and certain plant consolidations resulted in modest net sales growth in the quarter. The modest sales growth combined with operational inefficiencies and higher costs overshadowed previous price increases executed across all three of the business segments and resultant performance that was below our expectation in the second quarter of 2017. Net sales increased 1% to $520 million led primarily by the new business with Home Depot in Florida as well as average unit price increases. While we believe we made progress on productivity issues in our North American residential business that negatively impacted our first half financial results, we clearly have more work to do. And although directly overstaffing in our manufacturing plants have been flexed down to reflect lower demand and shift schedules in the plants have been adjusted, further steps are needed in light of the softer than expected demand we experienced. Initiatives to reduce manufacturing overhead costs continue and are ongoing. Higher distribution costs were more pronounced in the second quarter resulting from higher freight costs due to temporary actions taken to maintain customer service levels in the face of certain constraints at certain plants as well as the accelerated ramp up of the Home Depot Florida business and Florida stores. As the labor market remains tight, wage inflation has increased importantly. Given the general scarcity of labor, we expect this trend to only continue which will require further actions and programs to offset the additional expense. Addressing these constraints and improving our operational efficiency is the key focus area for us in the second half of 2017. We continued to manage other costs very tightly, particularly in light of our operational performance resulting in SG&A savings of $5 million compared with the second quarter of last year. To note, there are also approximately $4 million of discrete cost related to legal reserves, the resolution of customer claims in the UK and plant transitions that negatively impacted adjusted EBITDA in the quarter. Bottom line, we're not at all satisfied with our operational performance in the first half of this year and given softer demand and competitive pressures in certain U.S. geographies, we no longer expect our net sales growth rate, adjusted EBITDA and adjusted EPS to be within the ranges provided in our original 2017 outlook. We'll continue to take actions that we believe are necessary to improve our manufacturing and distribution performance. But at the same time, we remain committed to our strategic initiatives and are optimistic that the construction markets in which we operate, while lumpy at times, provide long-term growth opportunities for Masonite. So, let's turn to slide 6 for a quick update on the various transformational initiatives underway in the Architectural business. Recall that our objective is to integrate the network of architectural manufacturing plants into a single cohesive business unit. And the various work streams that support that goal remain on track. We believe that goal of a unified business platform will provide us with the significant competitive advantage in the future with production flexibility, simplified ordering and superior customer service. The transformation streamlines our brand by transitioning from six separate brands to a single brand known as Masonite Architectural. We're executing this in phases, an approach we believe can help insure a smooth transition with architectural specifications as well as brand recognition and awareness, given the individual strength of our legacy brands. Another part of the simplification of the business includes reducing the number of SKUs by transitioning from 125 fire listings that were brand and location dependent down to just 25 fire listings. We're also transitioning from 29 overlapping product lines to just 8. Our SKU rationalization plan will reduce the number products, but not the breadth of our product range. We believe our ability to serve the market will only improve with these changes. We've spoken in the past about the benefit of moving all of our manufacturing sites on to a common ERP system. Our plan is to have all of our architectural door plants on one ERP platform and one front-end door configurator by the end of 2018. We believe that the combination of a common ERP system and a simplified product family will allow us to increase overall plant flexibility and reap the benefits of our Mvantage lean operating system. As recently as 2016, we had almost no flexibility, meaning an order for a specific door could only be made at one plant, creating additional added operational challenges and limiting our ability to flex our production footprint. Through our efforts to optimize the manufacturing chassis, reduce the number of products offered, and integrate the IP systems, we're increasing the number of products that can be made at multiple plants. We're transforming from isolated plants to a fully integrated plant network. Again, we believe these efforts will provide a more reliable service platform for our customers and unlock the underlying benefits of being the largest and the only vertically integrated architectural wood door manufacturer in North America. Turning to slide 7, we want to provide a quick update on the Home Depot Florida business. We began shipping product to new stores in the latter part of the first quarter. The initial stage of the transition included rolling store changes and refilling inventory levels at stores where the need was most immediate. In the second quarter, we expanded the store count, shipping new product and completing store resets within the 150 stores in the Florida Home Depot market. We've been encouraged by the early point of sale results and consumer reception to the upgraded product offerings, particularly the VistaGrande and Everland exterior doors and the Heritage interior doors. In the quarter, this new business contributed over $13 million of incremental net sales for the North American Residential segment. As both the new housing and remodeling construction markets continue to grow, we believe there is a significant opportunity to increase the relevance of doors in the minds of designers, contractors, builders, and consumers. This has been a key element of our new brand introduction, website re-launch and our marketing strategy. We're working with our channel partners to drive engagement, customer interactions, and ultimately higher sales. We're doing this by highlighting whole home door solutions as a way to transform the look and feel of your home at a relatively economic price. We're investing in the industry and the success of our channel partners by being more present in the market within the homebuilding and renovating conversation and creating innovative new product consumers are searching for. We held our first Trend Live event in Chicago during the second quarter, and have more events scheduled for our East Coast partners in the second half of the year. Trend Live is really all about helping our channel partners grow their business through the power of trend and industry insights. We're being the thought leader in this space and Trend Live is just another example of how we're supporting our goal to unlock the potential of doors as a defining element in the design of a home. We'll be tracking success, to not only engagement at events, but also lead generation and conversions coming from those events using our new CRM and our new marketing automation tools. We continue to invest in digital initiatives also across the business segments and customer channels, which again we believe will benefit all of our channel partners. Our current digital initiatives include our updated websites, better online door builders, our MAX configurator, and our ADVISAR test program in Florida, which is testing commercialization strategies to improve the customer experience and unleash latent demand. We're also working with our channel partners to provide digital solutions for tech savvy members of the Pro segment. We believe that by making doors more relevant to the consumers, and making it significantly easier for consumers to shop for, select, purchase and have contractors install their doors, we can unleash latent demand and grow the entire door category. So with that said, I'll turn the call over to Russ to discuss our second quarter financial performance. Russ?

[Russell E. Tiejema:]

Thanks, Fred. Good morning, everyone. On slide 10 we summarize our consolidated financial results for the second quarter of 2017 versus the second quarter of 2016. Net sales of $520 million represent an increase of 1%, or 3% excluding foreign exchange. Gross profit decreased to $107 million and gross margin declined 100 basis points to 20.6% of net sales, due largely to the production and distribution inefficiencies that Fred mentioned earlier. These impacts were felt in direct labor, overhead and the distribution areas of our cost of goods sold. Also as mentioned earlier, we did incur a number of discrete costs that impacted adjusted EBITDA in the quarter, creating a combined headwind of approximately $4 million. These included manufacturing inefficiencies related to closing and relocating certain manufacturing operations, including the architectural door plants in Algoma, Wisconsin and our door plant in Chile, as well as legal reserves and the resolution of certain customer claims in the UK builder channel. SG&A was approximately $5 million lower, primarily as a result of tightly controlled personnel costs, which were down approximately $3 million and reduced professional fees. We also incurred lower non-cash expenses including reduced stock compensation expense. SG&A as a percent of net sales was down 120 basis points to 12.2%. Taken together, these factors all resulted in adjusted EBITDA of $69 million, flat compared to last year and adjusted EBITDA margin that was down slightly to 13.2%. Net income was approximately $27 million and adjusted earnings per share were $0.89. Recall that in the second quarter of 2016 we realized an income tax benefit of $6 million or $0.20 a share due to the change in accounting treatment for share based compensation. Normalizing for this prior year benefit, adjusted earnings per share increased $0.07. Let's turn to a review of each of our reportable segments beginning with North American Residential. Net sales increased 6% in the second quarter, while adjusted EBITDA decreased 2%. Volume increased almost 5% when compared to the second quarter of 2016, driven by strong retail demand including shipping products to Home Depot stores in Florida which Fred discussed earlier. As part of the business win in Florida, we incurred typical startup costs including training and higher staffing levels at a few of our Southeastern plants. In addition, we experienced higher than expected distribution costs as we responded to an accelerated rollout schedule which required shipping product from more distant sites as well as solid general demand trends in the new Home Depot Florida stores. Average unit price increased approximately 2%, the result of both like-for-like price increases and positive mix. Fiberglass doors in particular had a strong second quarter with double digit sales volume growth. The benefits from sales volume gains and improving average unit price were unfortunately offset by operational inefficiencies in both manufacturing and distribution. As we noted following Q1 results, staffing levels in our plants early in the year were elevated for the level of sales growth we expected. We began taking actions to reduce our direct labor head count late in the first quarter and into the second quarter. During the second quarter, we reduced manufacturing head count in our North American Residential plants by over a 140 people. As a result, we exited the second quarter with improved labor productivity but still not at satisfactory levels given that volume did not recover as much as anticipated as we progressed through the second quarter. Actions were also taken in the second quarter to evaluate and further reduce manufacturing overhead costs in a number of our North American plants. While as expected overhead personnel reductions could not be actioned as quickly as direct labor and remained elevated versus Q2 last year, we still achieved a reduction in overhead expense as a percentage of sales versus the first quarter. We plan to carefully monitor inbound demand and aggressively flex labors needed to continue improving productivity throughout the second half of the year. Despite managing head count, we're also experiencing labor cost pressure in the form of mid single-digit hourly wage inflation as the labor market for qualified and reliable employees remains tight. Distribution efficiencies were an increased headwind in the second quarter consisting of the combination of startup costs related to accelerating the ramp up of the new Home Depot business and temporary actions to protect delivery performance were necessary. These included modifying plant customer assignments in certain cases, where variations in regional demand or plant specific constraints would otherwise increase lead times. This resulted in longer shipping routes, and higher fuel costs, as well as reduced payload efficiency. As Fred noted, addressing plant constraints and returning to optimize customer plant assignment is a top priority for the operations team in the second half of the year. The softer than expected demand that contributed to these operational inefficiencies in the first half of 2017, as well as the prospect of continued labor constraints and responding to wage inflation further support our strategy to invest in capital projects designed to increase the productivity and throughout of our plants. Turning to slide 12, and our Europe segment. Net sales in the second quarter were down 10% when compared to the second quarter of 2016, due primarily to the decline in value of the pound sterling. Excluding foreign exchange headwinds, net sales were down less than 1%. Continued volume and average unit price growth in the merchant and contractor/remodel channels were offset by weaker results in the builder channel. As a result, adjusted EBITDA decreased $4 million. Approximately half of the decline was due to foreign exchange with the balance attributable to distribution costs, the resolution of customer claims and inventory reserves in the builder channel. In addition to the continued growth I mentioned in both the traditional merchant and contractor channels, we saw a healthy rebound in the builder channel in July. We believe the outlook for the housing market in the UK remains healthy and are optimistic about growth potential in the UK market over the long-term. Turning to slide 13. Net sales in our Architectural business segment were down 5% in the second quarter compared to the second quarter of 2016. Adjusted EBITDA decreased 2% while adjusted EBITDA margin expanded 30 basis points compared to the second quarter of last year. Sales volume declined approximately 7% in the second quarter primarily due to delayed shipments and extended lead times as we transition production from the Algoma, Wisconsin facility to other architectural plants. Average unit prices increased over 1%. Solid gains from price increases implemented last year were offset in part by a higher mix of lower-priced stock door business due largely to timing of projects in healthcare and education sectors that utilize higher value offerings. The execution of our architectural transformation is progressing well. Product line simplification, SKU rationalization and brand integration efforts are on track. All production at our Algoma, Wisconsin plant ceased by the end of June, and we have now shifted those orders to other plants in our network. Overall, the strong underlying demand trends in non-residential construction spending leaves us with an optimistic outlook for the long-term future growth potential of this business segment. Turning to slide 14. Total available liquidity at July 3, 2017, totaled $212 million, including unrestricted cash and accounts receivable purchase agreement and our ABL facility. Total debt and net debt to trailing 12 months adjusted EBITDA was 1.9 times and 1.8 times respectively. Through yesterday, we repurchased $46.3 million of our stock year-to-date, which leaves us with $195 million of remaining availability under our share repurchase authorizations. And with that, I will now turn the call back to Fred to summarize today's discussion.

[Frederick J. Lynch:]

Thank you, Russ. Performance in the first half of 2017 was below our expectations from a sales volume and operational efficiency standpoint. And sales growth remained modest in July. While, we believe that we've made progress addressing the operational issues in our business, we have more work to do, and that will be a key focus during the second half of the year. Results in our European segment are expected to improve as foreign exchange headwinds subside in the second half of the year and we leverage investments made in manufacturing and distribution in the UK to better service our channel partners. We continue to make progress with our Architectural business transformation to unlock the underlying benefits of being the largest and the only vertically integrated architectural wood door manufacturer in North America. But again, there's more work to do. Based on results in the first half of the year and in the absence of higher net sales growth in the second half, we would not expect to achieve 2017 adjusted EBITDA that is meaningfully higher than 2016 given softer demand, competitive pressures in certain U.S. geographies, as well as increased wage inflation and operating costs that are expected to continue. Although the first half of 2017 was disappointing, we remain optimistic about the long-term underlying fundamentals in our end markets. Demographic trends in North America and UK suggest that more homes need to be built to accommodate population changes, and we believe we're poised to take advantage of those needs. We continue to focus on key strategic initiatives that we've outlined, including advancing our Mvantage operating system, while simultaneously automating key functions of the manufacturing process. Driving engagement with the new Masonite brand and innovating with digital and marketing tools designed to change the conversation around doors, making them more relevant to consumers, designers, contractors and homebuilders. And with that, we'd like to open the call to questions. Operator?

[Operator:]

Thank you, Mr. Lynch. Our first question comes from Jason Marcus with JPMorgan. Please state your question.

[Jason A. Marcus:]

Good morning. So, it looks like the updated guidance now implies gross margins likely remaining down year over year in the back half of the year. I know you highlighted higher wage inflation and operating costs, but I think it would be helpful if you get a little more granular on the moving parts and what the biggest changes are relative to your previous outlook. And then based on what you're doing to mitigate the issues, are you expecting some of these issues to moderate as you go from 3Q to 4Q and as you think about where you will be from an operational perspective as you guys exit the year and enter 2018, any color on that would be helpful.

[Frederick J. Lynch:]

Okay. There's lot of questions in those questions. I think at a high level as we clearly walked away from our initial outlook given the fact that many things have changed since we'd given that. As we look into the second half of the year, the assumption at this point of time is that this flat volume environment will continue. And given the fact that our current cost, in particular wage inflation, is overcoming the current prices we have in place, given those three components, it's simply just math that says if nothing else changes that's where we'll end up at the end of the year. So that's how we're progressing it. Obviously, we're working on all of those components so that we can have a different outcome. But that's what that outcome would suggest. With regards to the operational efficiency, I'd say that as we dove into it we made some changes in 2016 and changed some – change of directions in how we were running our plant operations and how we were staffing and preparing for growth. In retrospect, we made some wrong decisions. We've now gone back and redirected back and refocused our operating system and manage operating system back to the protocols we had in place. Simply the practices that were being put in place did not fit our business model. And we've now made those corrections. It's a big shift, takes a little bit of time to turn. We feel that we're turning the ship well into that turn and moving in the right direction. However, we are faced with the reality of and are continuing to see a much higher level of required wage inflation in order to be able to attract and retain hourly employees. And as Russ mentioned, not only in the first half of this year but as we – our typical raise period is July and so we just went through our adjustments for hourly wages in all of our plants in July and that was a mid-single-digit increase. So not only do we have to continue to work on the productivity, but we have to overcome that as well.

[Jason A. Marcus:]

Okay, thanks. And then just on the demand environment, it looks like in North America volume growth was up about 1% excluding the new Home Depot business. Just wanted to see if you can characterize the overall demand environment by channel as you look at new residential construction relative to repair/remodel and then where maybe you've seen changes over the last quarter or two and why you think underlying demand isn't stronger relative to the broader housing recovery.

[Frederick J. Lynch:]

Yeah. So at first I'd say that the unit volume was down excluding the Florida bases in North America, not sales volume. As we look at the market, housing is at about half the level we anticipated coming into the year. Our customers continue to be bullish and I'll let Tony talk a little bit about that. So we're a little surprised, to be honest, about the general industry slowness that we're seeing right now in the door category. And hence our hesitation to be aggressive on the outlook providing the second half. Tony, I don't know if you want to give more color on that?

[Tony Hair:]

Yeah. I think our customers do continue to be bullish on that. Certainly in the retail environment we saw in the first half some inventory modifications, but customers are positive. And we certainly hope that that brings through as we go through the remainder of the year. And our focus is on getting seeding on the new products that we've got out there to continue to generate interest and enthusiasm in those, and take advantage of that when the market does come back.

[Jason A. Marcus:]

Okay. Thanks.

[Operator:]

Thanks. Your next question comes from Bob Wetenhall with RBC Capital Markets. Please state your question.

[Robert Wetenhall:]

Hey, good morning. And thanks for all the details. Super helpful. I don't know who the question is for, but I just wanted some clarity around the press release, because you noted that in the absence of higher sales in the second half, you would not expect to achieve EBITDA growth that is higher than 2016. And when we're looking at the second half on a relative basis, it looks like you had some headwinds in the first part of the year that become tailwinds in the second half, including a better FX environment and easier comps. So when I'm looking at it, it sounds like the setup is actually rather favorable going into the second half of the year from a revenue standpoint in spite of maybe a pause in industry demand. Am I understanding this correctly or is there any way you could kind of clarify how we should be thinking about top line performance in 2H?

[Frederick J. Lynch:]

Yeah. Bob, as we look at it, our performance top line in the first half of the year was flat. While, again, there's lots of indicators, as you say, for us to be potentially optimistic about, we're not going to be – we're going to assume at this point in time that the second half for the year appears to be flat. We'll be prepared for a better growth than that, but our statement was, in the event that we have a flat environment in the second of the year, our costs are overcoming our current price. And, therefore, given those three pieces of data, we would assume we would not expect our EBITDA to be significantly higher than prior year.

[Robert Wetenhall:]

Right. I was just – you're saying in the absence of higher net sales. And my question was more about given the fact you have FX tailwinds and easier comparisons, doesn't that create a better opportunity for stronger sales growth, not really asking about EBITDA, I was just trying to understand some of the demand drivers.

[Frederick J. Lynch:]

Yeah. And I think the answer is, if that happens, that will be a positive.

[Robert Wetenhall:]

Got it. And you'd also referenced the long-term growth framework that you laid out about six months ago, calling for revenue growth of 7% to 9% and EBITDA margin in the range of 16% to 17%. And I just wanted to understand, do you still view that as an appropriate earnings framework for the company on a kind of mid-cycle earnings basis. How should we be thinking about that? I'm not really asking about the quarter, I'm really trying to understand long term about how you feel about Masonite's growth potential. And should we take the events in the first half and what we've seen in this year with the operational challenges and view that as kind of transitory difficulties that any manufacturer encounters or is there something that is more systemic in the environment which is impacting the earnings power?

[Russell E. Tiejema:]

Hey, Bob, it's Russ, I'll take that. The way we think about it, first and foremost I would say that the long-range outlook that's a process that we refresh each year as part of our annual planning cycle that starts in the fall. So, we'll be looking closely at that here in the next month or two months. But how we think about it is as we believe the long-term growth prospects for all the markets we served really are unchanged, and that the long-term growth initiatives that we're putting in place, the investments we're putting into new product, the digital capabilities that we're developing, we think those all remain pretty important drivers of our revenue growth. And we're also focused on not only fixing the operational performance issues that we have here in the near term, but we're going to continue investing to improve throughput efficiency in the plant. That should position us to be able to more economically or cost effectively respond to that industry growth that we do still anticipate to happen. So, boiling all that down, we believe the potential for continued margin expansion in the business remains intact. But as part of the upcoming cycle, we're going to evaluate whether the lower than anticipated volume growth that we've seen this year impacts either the pace or the trajectory of the long-term revenue growth framework.

[Robert Wetenhall:]

Okay. And just, Fred, you had written an article in ProSales talking about the ADVISAR unit. Can you just recap some of the highlights of the article for people who aren't familiar with it? I thought it was an interesting way to approach the market.

[Frederick J. Lynch:]

Yeah. As you said, at a high level, we are doing a beta test in the Florida market on a digital approach to the marketplace. We're working with dealers, dealer installers, contractors with a new brand of product that's a much higher end brand. And that is only available through a digital interface. We're pretty excited about what basically we can learn from this, and then be able to take that across the broader customer base that we have and start to figure out how do we deploy digital to help them be more effective, whether it's in the retail channel, the Pro channel, the two-step channel. We believe the learnings from this test will allow us to just be a better supplier and simplify the process, as we've talked about before, of shopping for, selecting, purchasing and having contractor install your door.

[Robert Wetenhall:]

Got it. Thanks, and good luck.

[Frederick J. Lynch:]

Thank you.

[Russell E. Tiejema:]

Thanks, Bob.

[Operator:]

Our next question comes from Mike Wood with Nomura Instinet. Please state your question.

[Michael Wood:]

Hi, good morning. First question, just wanted to ask about wage inflation that you called out. Is this specific to where your plants are located or is it industry wide? And in response to that, I mean, are you able to take steps on the pricing to recoup that on a go forward basis?

[Russell E. Tiejema:]

Hey, Mike, it's Russ, maybe I'll respond certainly the first part of that around wage inflation. We've been hearing for a while that across the industry labor inflation has been a concern. I can't speak for where others are seeing it specific regions. I would tell you that on an annual basis, we look at the overall markets in the regions that our plants operate and evaluate where we need to be competitively on a wage rate basis. And as Fred mentioned earlier, we have been seeing the steady pace of mid single-digit wage inflation really over the course of 2015 to 2016 and now in the first half of 2016 to 2017. And we're seeing that continue into the back half of the year. Again, as Fred noted, we review those wages and put changes in place in the July timeframe each year and we're seeing that continued pace of mid single-digit wage inflation. Some plants less, some plants more depending on the competitive position in that particular community they operate. So it's something we're going to have to continue managing through and it certainly only enhances our focus on the need to return direct labor productivity to levels that we would expect, particularly in light of the softer than anticipated demand recovery.

[Frederick J. Lynch:]

Just to put it in perspectives, you look at our total payroll across the company is in excess of $500 million, about – nearly 80% or probably 75% of that is related to our plant labor. And you're talking in the high $300 million level, a 5% increase on that level, you could tell it is a pretty significant impact to our P&L. So, again, ultimately this is something that isn't in our equation when we think about the value that we need to get for our products. At the same time, we'd like to be also able to make sure that we're putting productivity actions in place again to our Mvantage lean operating approach, as well as where it makes sense to invest in capital that makes us less reliant on that labor. We are seeing, I would say, clearly, compression. So at the lower end of the labor scale, we're having higher wages or wage increases versus general. So on the general level, at the salaried level, we're probably closer to 3% on an annualized basis, whereas we're above 5% at the entry levels in the plants. In fact, in some plants we had to make entry level changes in the range of 10% just because of competitive businesses coming into the market that where our plants are served. So, it is a challenge. I don't think it's a challenge that's any different than anyone else in the industry is faced with.

[Michael Wood:]

Okay. And then just a follow up on, you elaborated on – you mentioned competitive pressures in certain geographies. Can you just elaborate on that? Are you actually seeing price declines in some markets and any color you can provide on where that competitive pressure is coming from?

[Frederick J. Lynch:]

Yeah. It's very localized. We're in the Southeast, particularly in Florida we're seeing some rebates – very high rebates being offered to builders but we don't see it as a general issue. But it is the same issue on a regional basis.

[Michael Wood:]

Thank you.

[Operator:]

Thank you. Our next question comes from Tim Wojs with Baird. Please state your question.

[Timothy Ronald Wojs:]

Hey, everybody. Good morning. I guess my question just maybe back to the volume picture. I mean what are you hearing from, I guess, the internal kind of assessment you've done and basically what you've heard from your customers? I mean, why is volume flattish if you're looking at single family housing starts that are up nearly double digits and remodel market that's up kind of mid single? I mean, anything you can point to, to kind of give us some confidence that something is not going to structurally changing in the industry?

[Frederick J. Lynch:]

You know Tim, I think the – I will start off – this has not been – this isn't something that we faced before, that this industry tends to lumpy in the volume, particularly in the wholesale market. We think the new housing starts for the first half of the year were more in the 3.8% to 4% range or 3.8% in the second quarter. So new housing has not been as robust as we anticipated. Clearly, from a retail perspective, we had a very strong first four months of 2016. And so on a year-over-year basis we did not see that repeat itself. But I think the combination of those two are leading to that. Again, when we look at what we've heard from other folks in the industry who have already shared their results, I don't think that were any different from an overall demand perspective.

[Timothy Ronald Wojs:]

Okay. Okay. And then just maybe in looking at the Architectural business, just some of the work you're doing there to combine the plants, I mean should we expect more of a subdued EBITDA kind of improvement level in 2018 as well as you kind of integrate the ERP and the front-end configures?

[Frederick J. Lynch:]

Our expectation for that business is that the inflection point comes after 2017. I think we have been pretty consistent with that. Many of the changes that we're putting in place particularly with the shut down in the Algoma plant, the conversion of that plant to our Jefferson City plant, which is a much lower cost plant, which will be helpful to us, but the real benefit I think is this rationalization of the product offerings, which we anticipate will complete in the second half of 2017 and we should able to take full advantage that as we move into 2018.

[Timothy Ronald Wojs:]

Okay. Great. Thanks.

[Frederick J. Lynch:]

Thank you.

[Operator:]

Our next question comes from Trey Grooms with Stephens, Inc. Please state your question.

[Trey H. Grooms:]

Hey, good morning. I had a follow-up on the competitive pressure comment as well, Fred, I think it was mentioned a couple of times in the prepared remarks. You said in some U.S. geographies, you noted Florida, is that pretty isolated to that Florida market? And then also where is it in the – I guess in the product line, are you seeing that? Is it more on the low end like what we saw, I guess it was a few years ago or maybe last year, there was a little bit of very temporary pressure on some of the very low end products? Just any color would be good.

[Tony Hair:]

Trey, this is Tony. Yeah, we – the competitive pressures we mentioned have really been very geographically centered, Southeastern Florida has been the primary area that we've seen those and I guess the builder market and they have been focused primarily at interior doors, that's been the – that's been the big focus on those. So, that's what we're referring to when we talked about the competitor price pressure.

[Trey H. Grooms:]

Okay. And with that – did that – did those pressures impact your volume in that market more or was it price, I mean do you feel like – I mean did you have to adjust the price down to kind of go along with some of that stuff or do you feel like you maybe gave up a little bit of volume holding on in that market, I mean because your pricing was up...

[Frederick J. Lynch:]

We're not going to give specific on how we respond to competitive pressures.

[Trey H. Grooms:]

Okay. But I mean I guess it's fair to say that that's an ongoing thing and that's not – that wasn't something that's now behind you.

[Frederick J. Lynch:]

That's correct.

[Trey H. Grooms:]

Okay. And then next question would be on some of the operational and distribution inefficiency, I mean, it sounds like some of that was – as you mentioned, some – making the wrong decision on hiring or whatever and execution maybe was a little bit of an issue there, but that sounds like that's pretty much behind you and that corrections have been made, you are well into the turn. I guess I'm just scratching my head, I understand wage inflation is what it is and that's going to continue to be an issue, but just around the operational and distribution inefficiencies that you call out, is that – is there additional kind of growing pains that could be associated with that there going forward? Is that just part of business? I'm just trying to get my hands around how that's going to impact us going forward and when we should see or impact you guys going forward, and when we should see some change there and have that behind us.

[Russell E. Tiejema:]

Hey, it's Russ. How I think about it is on the direct labor side, we made a lot of progress. And if you look at our direct labor cost as a percentage of sales, it was within about 20 basis points of what it was in the second quarter last year. So we feel like we've gotten the most traction there because those are the head count actions you can typically action most quickly. We also made some progress on overhead but not enough in light of the volume that has not come back as quickly as we had anticipated in the second quarter. And so, if you look at our overhead cost as a percentage of sales, year-on-year, they're still up about 90 basis points in the second quarter. We're continuing to focus very aggressively on that evaluating what our overhead templates look like, our head count or footprint looks like in each of our plants. The area where we saw an increased headwind in Q2 as opposed to Q1 was on the distribution side. And so a combination of this accelerated ramp-up on the Home Depot Florida business. And then frankly the fact that in certain cases we had a throughput constraints in certain plants that was leading us to remap some of our plant assignments for certain customers to maintain service levels. And so you saw higher freight costs, lower efficiency and how we're shipping products longer distances in some cases to support certain customers. And that's an area that we're revisiting and we'll be managing very aggressively in Q2. So, when I step back from all that, what that suggests to me is for the second half of the year we will continue to manage direct labor in line with volume, overhead a lot of progress, some yet to do, distribution number one priority.

[Trey H. Grooms:]

All right. Thanks for the color, Russ. I appreciate it.

[Operator:]

Our next question comes from Alex Rygiel with FBR. Please state your question.

[Alex J. Rygiel:]

Thank you and good morning. Firstly, your stock is down pretty hard this morning. Russ, can you update us on when you can be in the market buying back stock?

[Russell E. Tiejema:]

Well, you know we don't talk prospectively about what we will do relative to our share repurchase program. We obviously operate under blackout programs, blackout time periods, like ahead of and immediately following our earnings releases, but we do have 10b5-1 plans in place that allow us to be in the market throughout those periods and then when they open, we'll reevaluate the situation and how we want to deploy capital in that way.

[Alex J. Rygiel:]

And then Fred, I'm still having a little bit difficultly understanding the flat market demand. Do you think this is being caused by the increase in price over the last few years? Is it purely driven by kind of consumer demand, unrelated to price? Is there some channel inventory reductions that are occurring out there? If you could just expand upon that, please?

[Frederick J. Lynch:]

Yeah. I'd say if you look at it from a retail perspective, from a POS perspective, we think that the market is in that low to mid single-digit level, and we think that will continue. So, consumer preference in remodeling is continuing, I think as expected. In the housing, new housing market, that continues again to be lumpy. It continues to depend on when completions occur. Again, I think we've been consistent in saying that at this point in time our customer base is bullish, but we haven't seen it, we didn't see it in July. And so we're being appropriately conservative as we look into the second half of the year, given our experience in the first half of the year.

[Alex J. Rygiel:]

And then as it relates to market share shifts, did Masonite lose any market share in the first six months?

[Frederick J. Lynch:]

Given on an overall basis, given what we've seen with the public information supplied by the competitors to do so, we don't believe so.

[Alex J. Rygiel:]

Thank you very much.

[Frederick J. Lynch:]

Thank you.

[Operator:]

Our next question comes from Nick Coppola with Thompson Research Group. Please state your question.

[Nicholas Andrew Coppola:]

Hey, good morning.

[Frederick J. Lynch:]

Good morning.

[Nicholas Andrew Coppola:]

Yeah. So I wanted to follow up on the question about the timeline for operational improvements. And do you think we get back to a more normalized flow through by 2018?

[Russell E. Tiejema:]

We better. That's clearly the objective. Again, I would go back to what I said earlier about direct labor, pretty aggressively managed. After the first quarter call, we acknowledged that that was an area that we had already started working on and that we thought we would have corrected largely in Q2. And on the direct labor front, that is indeed where we made the most progress. Again, overhead, still some work to do. Good progress in the second quarter. We would expect that we're going to see continued improvement into the second half. But, in large part, it's going to depend on what kind of volume recovery we actually see in the second half of the year as opposed to what we've seen in the first six months. And, as Fred just mentioned, we've seen just this modest growth in July also. So it's going to continue to require a very steady hand on overhead and distribution in particular to drive margin improvement for the second half.

[Frederick J. Lynch:]

As a follow up to that, we have had a very strong operating program in place at Masonite over the last number of years. Again, we did – I think we steered in the wrong direction as we came to the end of 2016 and ended up overstaffing and putting some additional costs in that that we thought would help drive hourly productivity that did not. And so we've reversed a lot of those already and have those eliminated. Again, it's a big shift. It's taking longer to turn than we would like. As Russ mentioned, if you look at the head count from a head count perspective, I think we're back in relatively good shape as we sit here going into the second half. We now have the additional challenge of the wages, and we'd like to be able to offset those through other programs.

[Nicholas Andrew Coppola:]

Yeah. Related to that, with the wage inflation, is there any rethinking about automation initiatives?

[Frederick J. Lynch:]

Yeah. That's been part of our strategy. We've had a number of automation initiatives that are underway this year that are ongoing as we speak. We've done a number of automations in the past. So we have a belief that at least for the foreseeable future that we will continue to have a scarcity of labor. And it's not so much the concern about the hourly wages because at the end of the day, the market is going to determine that and we're going to respond by paying what a fair wage is for employees that we want to bring in reliable and capable employees. And that's just – it is what it is. But we're going to look at certain roles and say can we more efficiently – given the scarce market for labor, are there areas in our plants where we can actually add automation to reduce that. That's been part of our strategy in the last several years. We have a number of products that have driven automation. If you look back from the last peak and where we are today, our revenue per employee is up quite substantially because of some of the automation that we put in place already. So that will continue.

[Nicholas Andrew Coppola:]

Okay. And then I wanted to ask about architectural volumes. Clearly, you had delays with closures there. But what are you seeing in terms of the core demand, what are you seeing in backlog growth? I think we talked about resi demand quite a bit already, but what's going on the non-res side of things?

[Frederick J. Lynch:]

Yeah. I mean, core demand is actually good. We have more demand than we sold in the second quarter. And so we're continuing to be in that phase. We're continuing to ramp up. As I mentioned, our plant in Jefferson City, that plant is operating about double of where it was a year ago. So, our focus right now is not only on providing core capability in demand, but there has also been a big shift towards more finished products. So, machining of the doors had become a greater need, as well as finishing. We've just done a multimillion-dollar installation of a flat paint line in one of our plants to offset a manual booth process. So, it's going to give us way more capacity with a lot less labor associated with it. We see an increasing demand for that product going forward. So that's an example of what's going to happen. We like this market because we believe we should be able to grow this faster as we finalize this footprint and this rationalization to be able to shift volume between our multiple plants.

[Nicholas Andrew Coppola:]

Okay. Thanks for answering my questions.

[Frederick J. Lynch:]

Thank you.

[Operator:]

Thank you. Our next question comes from John Baugh with Stifel. Please state your question.

[John Baugh:]

Thank you. Good morning. I guess two questions. First, on the UK side, and I understand there were certain costs you've called out there. Is there some though degradation in the margin to get the volume you've gotten in the builder channel going on as well? And if so, where does that sort of sit sequentially or year-over-year?

[Tony Hair:]

Yeah. This is Tony. Good question. We've not seen degradation our issues there. The volume has been very robust in the merchant channel; the builder channel has been a little bit slower. And our impact there were really some customer adjustments from poor service, and some incremental distribution costs.

[John Baugh:]

Okay. And then...

[Frederick J. Lynch:]

But the builder channel looks relatively healthy in the UK. We think they've kind of recovered from the Brexit scare. And again, the underlying fundamentals are very positive for that business. And as such, we have been investing again in automation, so that's another plant where we just made a major investment in automated paint line to be able to service that marketplace. We've also made an investment and adding additional automated presses in for being able to manufacture more doors from our facility in Barnsley. So, both of those not only have the investments in capacity, but there are also investments in lower labor requirement versus what we traditionally did.

[John Baugh:]

Okay. And then I guess it'll be the tenth question on the North American volume. Just want to maybe understand clearly what you said about results in Q2 first half and then said in July and we'll just stick to residential and we will stick to volume. So, you're saying that volumes ex the Home Depot win are relatively flat or actually slightly down year-to-date, and then a similar result in July? And then I have a follow-up question.

[Frederick J. Lynch:]

Yeah, that's correct. We said excluding the Depot transition in Florida, we were slightly down in unit volume in the second quarter. And then...

[John Baugh:]

Okay.

[Frederick J. Lynch:]

Go ahead.

[John Baugh:]

No, okay, so slightly down and then similar in July, okay. And so I guess the question in my mind and seemingly others is, if we do, and I understand the housing may not be as robust as you forecasted at the beginning of year, but it's still up and repair/remodel still up. So here you're left to ponder either for building smaller homes or people aren't using as many doors or just both are kind of hard to believe. So there has to be something going on in either positioning of inventory with your various customers or share loss. And I guess I'm just trying to get a sense of when you would anticipate getting more clarity, what you're looking for to get more clarity on why volumes are flat to slightly down in a tailwind backdrop.

[Frederick J. Lynch:]

Yeah, we spend obviously a lot of time with our channel partners to understand that. I would say that as we went through that process this year, we were probably – we were a little bit premature in responding to their – to the expectations that our channel partners were sharing with us with regards to housing. And so that's why we are being a little bit – obviously being thoughtful in making sure we understand the data on a fundamental basis. So we agree with you on all parts. We do anticipate that the market will come back. It has been lumpy in the past and it's been harder to gauge in the past than we would like. And we'll see how that progresses in the second quarter – in the second half, sorry.

[John Baugh:]

Great. Thank you. Good luck.

[Frederick J. Lynch:]

Thank you.

[Operator:]

Thank you. Our next question...

[Frederick J. Lynch:]

We'll take one more question, I think, just based on timing.

[Operator:]

Okay. We have one last question and that comes from Jay McCanless with Wedbush Securities. Please state your question.

[Jay McCanless:]

Hi, good morning. So the first question I have, can you talk about capacity utilization across your plant base because I'm still having a tough time reconciling. In one breath you have wage pressure and tin the next breath you've got excess labor. What percentage of your plants are performing in line with your expectations for capacity utilization? I'm guessing that's the best way to kind of think about this.

[Frederick J. Lynch:]

So, we're going to talk about two things. So, one, Russ will talk in a moment about what our capacity looks like in our door facings which is our large heavily capital-intensive operations, which are much more automated and less people-intensive, then you have our assembly plants. And so with the assembly plants, it's often the issue is how do you run shifts, right? Do you run two shifts? Do you run two shifts and then a weekend shift? And a lot of the work that we have done actually over the last two quarters in many cases is eliminating that weekend shift that we stepped up in preparation for the – a stronger market, and then had to then dial that back off. And often times when you do that, you actually have to change the actual people that you hire because you have a different group of people that want to work a weekend shift, they want to work the other shift. So, that also led to some of the issues we have with regards to having to move things around plants because when you pull a whole shift off, it takes a while to staff up the two shifts and so therefore you have to start shipping product in between. So it's a little bit more complex in the assembly operations with regards to how we manage shifts because they're very much more labor-intensive than it is with the large continuous plants. And I'll turn to Russ to talk about the large continuous plants.

[Russell E. Tiejema:]

Yeah. Goof morning, Jay. On the component side or the facing side of the business, you look at our global facings capacity over the last trailing 12 months, been running at about 80% now. That's five plants globally. If you look just at the plants that are servicing primarily the North American market, they are running closer to the 90% range, 92%, even slightly higher. It's really our plant in Ireland that is the lowest capacity utilization plant in our network right now. That could be used to supply additional volume into North America in the future. At present, not necessarily required. But to Fred's point earlier, really the capacity utilization that we focused on from an installed base or an equipment perspective is the facings plants. Because they are very capital-intensive, very process oriented. On the assembly side of the operation, it's much more of a people-metered business as opposed to a process and capacity-metered business.

[Frederick J. Lynch:]

Now with that said, without – if volume does remain flat in the second half of the year, you'll probably notice as you go through that we have higher inventory than we would like to have. So part of that would be in our overall raw material basis and we will potentially reduce that utilization a little bit in the second half.

[Jay McCanless:]

Okay. Very helpful. The second question I had on the Home Depot business, it sounds like Depot may have accelerated this rollout, maybe changed what they had in the planogram in terms of SKUs and things of that nature. Is that what this comes down to is that Depot wanted you guys to roll into more stores faster than you had to change the distribution, the manufacturer to keep up or did you guys run into personal issues that kept you from meeting the business that Home Depot was requesting?

[Frederick J. Lynch:]

Jay, it's more of the former, it was an accelerated transition out of their previous supplier and investment we had originally planned. And so we had to reach to other facilities in our network to be able to meet the accelerated demands and there were distribution costs associated, etc., with that.

[Jay McCanless:]

Okay. And then the third question I have ...

[Frederick J. Lynch:]

Okay. We're going to have to go because it's – I apologize, but it's over time. But I want to thank everyone again for joining the call today. We look forward to speaking to you soon. And operator, if you could please provide replay instructions.

[Operator:]

Thank you. Thank you for joining the Masonite International second quarter earnings call. This conference call has been recorded. The replay may be accessed until August 24. To access the replay, please dial 877-660-6853 in the U.S. or 201-612-7415 outside the U.S. Please enter conference ID 13666258. Thank you. You may disconnect your lines at this time.