Masonite International Corporation
Q4 2017 Earnings Call Transcript

Published: 22 Feb 2018

[Operator:]

Welcome to Masonite's Fourth Quarter and Year End 2017 Earnings Conference 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 this conference call is being recorded. I would now like to turn the call over to Joanne Freiberger, Vice President and Treasurer.

[Joanne Freiberger:]

Thank you Bob, 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. The information for the webcast presentation 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 the earnings presentation and press release and in 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 are 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 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 an overview of 2017, Russ will discuss our 2017 financial performance, and our 2018 outlook. Fred will then summarize before opening the call up to a question-and-answer session. And with that, let me turn the call over to Fred.

[Fred Lynch:]

Thanks Joanne. Good morning, and welcome everyone. 2017 was an important year for Masonite as we started the year with an exciting relaunch of the Masonite brand; changing the conversation around doors and making the deck door category more relevant. We achieved our highest new product vitality index in over a decade and it was our seventh consecutive year of average unit price. The architectural business segment reset is on tract and is demonstrated by double digit adjusted EBITDA margin, with adjusted EBITDA growth nearing 20%, despite lower net sales experienced during the year. We are encouraged by the transformation of this segment and look forward to its increased potential as the team focuses on delivering net sales growth in 2018. We re-energized and refocused our MVantage Lean operating system, making solid progress in the second half of the year, and in September we welcomed Randy White as Senior Vice President, Global Operations and Supply Chain with a 25-plus year track record of implementing lean operating systems and driving growth and profitability through operational excellence. We also demonstrated strong execution on our capital deployment initiatives, designs to increase shareholder value. During 2017 we purchased another $120 million of shares at an average price of $66.82 and to-date we have bought back over $247 million worth of our shares, representing over 12% of the shares that are outstanding when the Board approved our initial repurchase program in February of 2016. In September we took advantage of what we viewed as favorable high yield market conditions and issued a $150 million bond add on priced at 104%, and we recently completed two strategic tuck-in acquisitions, both of which are expected to margin accretive in 2018. We purchased A&F Wood Products in early October and just a few weeks to go we acquired DW3, which we will provide more color on shortly. And lastly I want to thank all of the employees at Masonite for putting safety first. We completed this year with a total incident rate or TIR of 1.47, a huge improvement from the six plus TIR we were demonstrating when I joined the company 11 years ago. While these are all notable accomplishments made possible through the hard work and dedication of Masonite team of 10,000 employees, we also faced headwinds during the year, some of which were self inflected. The tightening labor market has led to a higher wage inflation, while escalation in commodity prices are putting upward pressure on materials, both impacting our gross profits. The very act of hurricane season disrupted distribution in the South East and Texas, which also resulted in higher freight rates and fuel costs across the country, which had continued beyond those storms. We tightened our efforts on optimizing freight lane changes, maximizing full truck loads and capturing savings on packaging and supply through a combination of measured focus and process improvement projects. In our Q3 call we indicated that we believe the operational inefficiencies we were experiencing were temporary and not structural. To that end, we focus on improving operational performance in the second half of the year. We reduced headcount in the North American plants by over 400 during the year and optimized our shift schedules to take out less productive weekend shifts in several locations. As a result of projects led by our operations team and supported by outside consultants, we have initiated additional plant layout changes designed to increase efficiency via improved material flow throughout the manufacturing process. In some case this is aided by new investments in automation and robotics, which improved quality and increased capacity with less labor requirements. While we have made good progress, we have more to do and sustainable operational excellence remains our highest priority going into 2018. Meanwhile we’ve also taken pricing actions at all channels across all major geographies to mitigate the inflationary environment and obtain fair value for our products and our services. So let’s turn to slide seven, which illustrates the progress made in the second half of the year. Despite increasing inflationary pressures as the year progressed, we tightly controlled costs and improved labor productivity in the second half. As a result, adjusted EBITDA grew 7% in the second half of 2017 compared with the year-over-year decline of 4% in the first half. With our continued focus on driving operational improvements, as well as getting paid for the value for our products and services, we are encouraged by the additional opportunities that still exist to resume margin growth in 2018 and beyond. Turning to slide eight, expanding and optimizing our business portfolio have also been an emphasis over the last several years to positively impact both top and bottom line growth. By focusing on and adhering to our disciplined acquisition criteria, we’ve acquired 16 businesses since 2010 at attractive valuations, which we believe have improved operating capabilities, created leadership positions in our targeted product categories, while also expanding our channel reach in important geographies both in and outside of North American. One of our most important geographies for Masonite outside of North America is the United Kingdom. While there has been some Brexit related softness in general, in the general U.K. economy that has impacted the housing market, we believe there is good growth potential over the longer term given the housing demographics. Similar to our view as North American has emerged from the housing downturn, we believe it’s not a matter of ‘if’ housing growth will occur, but rather of ‘when.’ We believe that enhancing our footprint in this geography with expanded products, channel penetration and roots to the market is a strategic enabler to leverage this market growth when it returns. DW3, our most recent acquisition and the fourth in the U.K. in the past four years is a great example of this. DW3 is a leading – a market leading tech enable manufacture of premium composite doors and window components. It is a similar business to DSI, selling directly to installers and home improvement fabricators via a web enabled product configurator. DW3’s brands such as Solidor and Residence are well known in the market. Their wide brand recognition, aided by a strong online marketing presence and end user focused digital marketing were some of the many things that made this strategic acquisition a priority for us. DW3 bolts as Masonite U.K.’s product offering with timber core entry doors and extends our portfolio to include new PVC doors as well. DW3 is the high teen’s adjusted EBITDA margin business that is growing share faster than the market by utilizing an innovative ordering processing and route to market. Acquired at approximately 8.5 times pre-synergy adjusted EBITDA, we are understandably excited about its prospects going forward. We believe DW3 is a perfect fit in our strategy and continues to innovate with products and new services that unleash latent demand and grow the entire door category. So with that opening, I’ll turn the call over to Russ to discuss our financial performance and our 2018 outlook. Russ.

[Russ Tiejema:]

Alright, thanks Fred. Good morning everyone. On slide 10 we summarized our consolidated financial results for the fourth quarter 2017 versus of fourth quarter of 2016. Net sales of $509 million represented an increase of 6% with volume average unit price and foreign exchange each contributing approximately 2%. Gross profit increased 4% to $100 million, while gross margin declined 40 basis points to 19.7% of net sales, due primarily to material cost inflation and higher distribution expenses. Adjusted EBITDA increased 6% and adjusted EBITDA margin expanded 10 basis points. Within material cost, we continue to experience commodities inflation primarily in wood, resins and steel and we introduced market price increases in all channels across all major geographies that were designed to mitigate this. As Fred shared earlier, we continue to make solid progress with the improvements in direct labor and factory overhead. In the fourth quarter our labor productivity continued to improve sequentially, offsetting wage inflation with slightly higher factory costs due primarily to higher benefit expense versus the prior year. Continuing to drive additional labor productivity is a top priority for our operations team going into 2018. In distribution we again incurred higher cost in the fourth quarter, primary in outbound freight expense. Logistics inflation in the form of higher fuel costs and higher carrier rates remained in place subsequent to the hurricanes. We expect inflationary pressure on carrier rates to continue due to tightening capacity caused by the mandatory adoption of electronic logging devices or ELDs and driver shortages in the face of stronger economic conditions. Net income for the quarter was approximately $72 million, an increase of $56 million over Q4 last year. However income tax benefits in two areas made up approximately $51 million of this improvement. First, as a result of recently announced U.S. tax reform, we recognize the $27 million income tax benefit from the lower tax rate applied to net differed tax liabilities held in the U.S. Second, in the quarter we determined that we should no longer carry certain valuation allowances against net differed tax assets held in Canada. The elimination of those allowances resulted in a $24 million tax benefit in the period. Adjusted earnings per share for Q4, 2017 was $0.71 or 29% higher than the same period last year and excludes $1.77 of tax benefits related to the two items I just mentioned. Let’s turn to a review of each of our reportable segments beginning with North American residential. Net sales increased 7% in the fourth quarter and 6% for the full year. While adjusted EBITDA increased 1% in the fourth quarter and decreased 6% for the full year. In the fourth quarter volume increased 4% over the fourth quarter of 2016, aided by new retail business in Florida, and we continue to see steady improvement in average unit prices as price increases more than offset some unfavorable mix due to the larger percentage of interior doors related to that new retail business. Net sales also included about 1% of benefit from foreign exchange, primarily due to strengthening of the Canadian dollar. Much of the material and distribution cost headwind discussed on the prior slide was related to the North America residential business, offsetting the positive impact of volume and higher pricing. In addition, there were higher corporate allocations as compared to the fourth quarter of 2016. Turning to slide 12 in our Europe segment, we continue to experience the positive momentum in our Europe business that began last quarter. Net sales in the fourth quarter were up 7% when compared to the fourth quarter of 2016, due primarily to the increase in value of the pound sterling. This is a market reversal from the first half of the year when the pound sterling was down over 10% as compared to the first half of 2016 prior to the Brexit vote. Excluding foreign exchange tailwinds, net sales were flat in the fourth quarter compared to the prior year quarter, and up 1% for the full year as compared to full year 2016. Strong average unit price growth in the fourth quarter was driven by pricing actions, which more than offset lower volume. Higher volumes from the merchant and contractor remodel channels were offset by softness in the builder channel, due in part to continued general weakness amongst the top U.K. builders, which comprised the majorities of our revenues in this channel. Adjusted EBITDA in the Europe segment increased 10% in the fourth quarter and decreased 13% for the full year. The adjusted EBITDA margin for the segment was 30 basis points higher in the quarter, driven by pricing and improved distribution cost performance. Continued material inflation was partially mitigated by favorable transactional currency impacts as the pound sterling appreciated against the euro in the fourth quarter. Turning to slide 13, this illustrates the significantly improved results we are now seeing from our architectural business. Adjusted EBITDA in the segment increased 48% and adjusted EBITDA margin increased 410 basis points as compared to the fourth quarter of 2016, despite a net sales decline of 1%. For the full year adjusted EBITDA increased over 19% compared to 2016 and adjusted EBITDA margin was up 200 basis points. Transformation projects executed in the architectural business throughout 2017 have helped streamline operations and driven this improved profitability. Adjusted EBITDA margin in this business has grown for six consecutive quarters with a quickening trend in the second half of 2017, as pricing actions and cost savings from the closure of the Algoma plant took hold. Our quick shift channel also continues to deliver strong results. USA Wood Door had a record net sales year in 2017 and A&F Wood Products which was acquired in the beginning of the fourth quarter is contributing stronger sales and margins than we originally anticipated. Net sales volume declined approximately 1% in the fourth quarter and 3% for the year. Fourth quarter average unit price growth of approximately 3% partially offsets some continued softness from lower order intake. Our strategy for the architectural business was to treat 2017 as a transition year, resetting our planned footprints, reconfiguring our product portfolio and harmonizing product specifications. And with these important steps now largely behind us, our focus turns to improving the customer experience and resuming volume growth in 2018. Turning to slide 14, we summarize our full year financial results. In 2017 net sales increased 3%. While SG&A expenses declined 5%, our adjusted EBITDA only increased 1% as a result of the cost increases and operational inefficiencies previous discussed. For the full year net income was $152 million as compared to $99 million in 2016, with the improvement explained principally by the income tax benefits related to the valuation allowance and U.S. Tax Reform that were realized in the fourth quarter. We delivered $3.33 per share of adjusted EPS, which excluded $1.76 of tax benefits. Turning to slide 15, total available liquidity including unrestricted cash and accounts receivable purchase agreement and our undrawn ABL facility was $339 million or approximately 16% of our trailing 12 months net sales at December 31, 2017. Subsequent to year end we did use approximately $96 million of cash to fund the acquisition of DW3 in January and our pro forma liquidity was approximately 12%. At the end of the fourth quarter total debt and net debt to trailing 12 months adjusted EBITDA were 2.4 times and 1.8 times respectively. Pro forma taking the DW3 acquisition into account, total debt and net debt ratios would be 2.3 times and 2.0 times respectively. We achieved free cash flow to adjusted net income conversion of 100% in 2017. For the full year we repurchased $120 million of our stock and we have purchased an additional $18 million since year end, which leaves us with approximately $103 million of remaining availability under our share repurchase authorization. With a strong balance sheet and healthy liquidity along slide our further growth prospects; we are pleased to see that S&P operated our corporate credit rate last week to BB-plus. Given the investor queries on the impacts of recently announced U.S. Tax Reform, we thought it would be appropriate to explain how we see anticipated changes impacting Masonite. First, it’s important to recognize that as a Canadian company certain aspects of the U.S. reform such as the transition period and taxes accumulative to foreign earnings do not apply to us. The benefits we expect to see from tax reform are largely associated with the lower U.S. corporate rate and immediate expensing of capital expenditures through 2022 as a majority of our earnings in capital investments are associated with the U.S. An area of uncertainly is new limitations under deductions or deductibility of interest expense. Until regulations are published it is unclear how these limitations may apply to internal debt structures. One area we know will be slightly unfavorable is more limited deductibility of incentive compensation expense, since performance base compensation and a majority of our executive compensation plans are performance based, it’s now considered in deduction limitation. On balance, we anticipate that U.S. reform could be favorable to our book tax rate by anywhere from one to five percentage points, depending on the final regulations related to interest deductibility. However given the loss carry forwards we have available to us, we anticipate little impact on our cash tax payments in the near term. On slide 17, we frame up our outlook for 2018 by starting with the key headwinds and tailwinds we believe could affect our businesses. Starting with key macro factors, we anticipate a continued slow and steady recovery in the U.S. housing market, with mid single digit growth in U.S. new home starts and completions and low single digit growth in the RRR market. We also expect the recently implemented price increases across all channels and all major geographies and the growth in higher value products and services to drive higher average unit price and adjusted EBITDA margins. There are also factors that we believe could counter balance these tailwinds to some degree. For several quarters now we’ve discussed the tightening labor market with increasing labor costs, which is a headwind to our ability to reduce manufacturing costs. This further heightens the importance of continuing to improve labor productivity to offset higher wages and allow us to respond to higher demand with less incremental headcounts. We also recently announced to our employees that we are establishing a starting minimum wage of $12 per hour for all positions in the United Sates, recognizing the need to attract and retain talented employees. Adding to this inflationary pressure is our expectation that commodity prices will continue to escalate and driven material costs higher. For perspective, we entered 2017 with an outlook for net commodity inflation of 1% to 2% and by the time we exited the third quarter, our view point was that we would likely be at the top end of this range and this is what ultimately transpired. Looking ahead into 2018 we think this trend continues and that we’ll likely see net commodity inflation in excess of 3% particularly in steep, wood and resins. Logistics inflation is also expected to continue as I mentioned previously. From a customer and end market perspective, the regional retail loss that we announced last quarter is expected to reduce our 2018 net sales by approximately 2%. Also there is a continued level of general uncertainly in the UK economy, which may impact the timing of new housing growth. Taking all of these factors into consideration, as we look into 2019 and including our recently closed acquisition of DW3, we expect to achieve net sales growth between 6% and 8% and adjusted EBITDA between $280 million and $300 million. We believe this translates to a range for adjusted EPS of between $3.70 and $4.20 per share. We believe our effective tax rate will be between 23% and 27% in 2018, excluding any benefits or changes related to the exercise of share based compensation. This is higher than our actual rate in 2017, since the elimination of valuation allowances in Canada will result in us recording book tax expenses in that jurisdiction more than offsetting any benefit we see from U.S. Tax Reform. However, we expect cash taxes to remain largely consistent between $9 million and $12 million in 2018. Lastly, we believe our capital expenditures will be between $75 million and $80 million for the year. With that, I’ll turn the call back to Fred to summarize our discussion today.

[Fred Lynch:]

Thank you, Russ. So looking forward, we are encouraged by a number of factors. While we had a rocky start to 2017, we believe our performance momentum in the second half of the year is reflective of the mindful actions taken by our teams to get us back on track. Our focus on continuing the improvement in factory productivity and distribution are our top operational priorities for 2018. We are continuing to invest capital in the business to improve both our operational performance and efficiency. Price increases that are designed to overcome the inflationary headwinds related to material labor and distribution costs have been taken across all channels and all major geographies and we continue to focus on obtaining fair value for the products and services that we provide. Our priority is to resume margin growth in 2018 and achieve mid to high teen adjusted EBITDA margins over the longer term. Our balance capital allocation is focused on improving returns. DW3 was our 16th acquisition completed since 2010. DW3 further expands our residential door business in the United Kingdom and significantly strengthens our overall leadership position in an important and strategic market. Our architectural business segment profitability has continued to improve and we are now positioned to focus on top line growth in 2018. Macroeconomic factors remain favorable, and we are encouraged by the longer term outlook for new housing starts, home improvement spending and non-residential construction in our principal market in the United Sates. I’d like to take a moment to recognize the hard work that the Masonite team of 10,000 employees put into achieving the accomplishments delivered in 2017, as we continue to help people walk through walls. Thanks to each and every one of you. And finally, before we turn the call over to the operator for Q&A, as a reminder we will be holding our 2018 Investor Day at the New York Stock Exchange net week on Friday, March 2. Several members of our senior management team including our business unit leaders and our leader of operations in global supply chain will be presenting and we hope that you will join us there. With that, I’d like to open the call to questions. Operator?

[Operator:]

Thank you, Mr. Lynch. [Operator Instructions]. Our first question comes from the line of Mike Wood with Nomura Instinet. Please proceed with your question.

[Mike Wood:]

Hi, good morning. Thanks for talking my question. First question just on the timing of the price increase in the fourth quarter. How much of it did you actually recognize in the fourth quarter and are there any additional price actions attempted here in early ’18?

[Fred Lynch:]

So we have put price increases in place throughout the fourth quarter. A portion of that was seen towards the second, I would say the latter half of the fourth quarter, but we expect the full impact of that to occur in the first quarter. And then I will tell you that by this point in time we have now increased prices which some included in the first quarter to all channels and all geographies.

[Mike Wood:]

Understood, thanks. And how much of – well the distribution headwind, the $6 million you bridged, it seems slightly worse than last quarter. I think you disclosed five. I guess how much of your initiatives to ship the full truck, the lean optimization is already reflected in the fourth quarter. Does that headwind continue at this level into the beginning of 2018?

[Fred Lynch:]

I’ll start it off. So when you look across that distribution logistics fees, there is a portion of that that we will be able to drive efficiencies in our operations to recovery some of that, but frankly a significant portion of that is still being driven by inflation and higher lane rates. We anticipate at this point in time that those higher inflationary costs in the distribution channel will continue to hit us throughout 2018. We see no reason right now to believe that truck rates or that changes in freight lanes is going to occur given the current shortage of drivers, the current shortage of trucks, the regulations that are being put in place and our teams are working every day to negotiate the best rates possible.

[Mike Wood:]

Okay, and finally can you just give us an update on kind of near term trends in the U.K. market given your growing presence there? I understand you made some prepared remarks about the longer term optimism. But just, you know where you see the health of the starts business, the remodeling business there in the U.K.?

[Fred Lynch:]

You know I would say that the remodeling business has been steady. We have a unique position we believe in the remodeling business, in the renovation business because of our business models. So and we think we further enhanced that with the acquisition of DW3. In that case, we believe we grow faster than the nominal growth in the market place, because we are unleashing the latent demand and taking share because of our unique way that we address those markets. With regard to the home builders, 2017 was a rough year. Brexit definitely led some uncertainty into the marketplace. But the U.K. government has made housing a very focused effort in order to drive additional housing starts in the U.K. We expect to start to see some of that in 2018, but we really do need to see I think the U.K. get past this Brexit uncertainly for that to fully take hold. Demographically speaking, there is a big need for shelter in the U.K. and so we are encouraged by that. Now whether, we see a lot of that in 2018 or we see it more flat pushing at 2019 I think is yet to be determined.

[Mike Wood:]

Thank you.

[Operator:]

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

[Michael Rehaut:]

Hi thanks, good morning everyone. First question I had was just maybe – actually both of my questions I guess we’re just trying to drive a little more detail around the guidance, which I think overall is very encouraging and just looking at the top line, the sales guidance of 5% to 7% ex-FX, I was hoping to get a sense of what – given all the moving pieces with the recent acquisitions, how much of that 5% to 7% is being contributed by the acquisitions and across your different regions if you expect, or sorry segments, if you expect that growth to be greater or less across the different segments?

[Russ Tiejema:]

Its Russ, Michael. If you take a look at what we’ve disclosed about our two most recently acquisitions, that being in A&F Wood Products at the beginning of Q4 last year and now the most recently disclosures on DW3, you can see where it’s about 3% revenue growth that we anticipate in 2018 associated with those newly acquired companies. Now on the flip side, recall we got the retail business loss that we announced last quarter; that’s an offsetting headwind to the extent of about 2%. Clearly we are going to see the revenue lift particularly from DW3 in the U.K. business into 2018 and we are going to see the revenue headwind from the loss of that lowest retail business in our North America residential segment.

[Michael Rehaut:]

So, if you kind of strip those out then you are talking about – if you exclude both of those items, I think you are still getting to like a mid-single digit core sales growth and just want to make sure I’m thinking about that right then. Within North American, you know I assume obviously with that being the predominate share of your revenue breakdowns, how much of that four to seven roughly mid single digit, I assume there is point or two from price and if you could maybe talk about what’s driven that by channel or end market.

[Fred Lynch:]

I think you are generally unpacking the numbers in the correct way. I’ll go back to our comments earlier about the U.S. market in particular. This slow and steady trajectory that we’ve seen over the last year, at this point we believe likely continues into 2018. And so if you look just at the U.S. Housing Market, which is about 75% of our total revenue in the North American residential segment, you could expect that mid single digit growth rate in the new housing side and then a low single digit growth rate on the RRR side; Canada and Mexico not significant contributors to growth in 2018. So all told, if you wrap those together and that would indicate you know a low single digit growth rate.

[Michael Rehaut:]

Okay, no that’s helpful. And I guess turning to margins and the EBITDA guidance, you know implies if I take the midpoint of sales and EBITDA, a nice return to EBITDA margin expansion in contrast to the contraction last year. I’m getting about 70 bps at the midpoint. Working off of that, assuming that 70 bps is right, which you know I’m pretty – you know just taking the midpoint of sales growth and EBITDA, it looks like it’s right around there. How should we think about again the different segments that you have in terms of being above or below that 70 bps? In other words, would you expect to see that roughly 70 bps somewhat equally or are there still perhaps headwinds in one region versus another. Obviously North American was a big headwind in 2017, but you had a nice moderation in decline in this most recent quarter. So any help there in terms of how to think about the margin expansion by segment relative to the overall corporate average would be very helpful?

[Russ Tiejema:]

Sure. Well we don’t get into specific guidance for any one of our particular segments, but I’ll offer a little bit of color, just at the high level about the puts and takes of the business. You know it is clearly going to be an inflationary environment for us in 2018 and that inflationary environment really cuts across all of our businesses. If you look at the commodities picture in particular, we’ve indicated at least 3% across the various commodity baskets and that’s going to impact us on a global basis. There are different commodity baskets that impact greater in certain regions than others. For example, the increases in steel have a bit more of an outsized impact in North American than in global. On the other hand in our Europe segment, which is principally our U.K. business we anticipate higher inflation rates on wood, since a lot of the wood basket comes in from outside the U.K. and is euro denominated and we are seeing a lot of suppliers still looking to try to claw back losses they’ve seen with transactional FX incurred over the last 10 months. The other fact that we see is wage inflation. We talked about that in the middle of 2017, the fact that we were seeing higher rates of wage increases in many of plants, migrating more from a single digit inflation rate to more than to more than mid-single digit inflation rate in order to procure the right talent and retain people in our plant. That’s going to continue and that’s probably a headwind that’s a bit more pronounced in North American than other places, just given the tightening labor environment that we are seeing there. And then the other aspect that we can’t ignore in inflation and Fred talked about this in some length and I mentioned as well, the fact that in the U.S., the resurgence of economic growth and some of the regulatory environment is driving logistics inflation specific to this market. Those are how I would think about the general inflationary pressures we see and where they might play out in the different segments that we report.

[Michael Rehaut:]

I mean I appreciate that, but I guess at the same time you are expecting other items such as price, overall top line gross productivity to more than offset that inflation and on a combined basis you are looking for 70 bps of, roughly 70 bps of EBITDA, adjusted EBITDA margin expansion. So, can you give us any color in terms of how that falls out across the segments? I mean again, you’ve had tremendous improvement in architectural in the past year. North American has kind of been the flip side; you’ve had a challenging year there. Any thoughts around how that 70 bps plays out across the segments. Again if there is anything additional you can add.

[Fred Lynch:]

You know I do Mike. I think Russ did a great job of giving you great details around that. We want give guidance by segment, that’s not part of our practice. So I think if you take into consideration all of the things we just shared with you, that’s pretty helpful. And you’re right that we just look at the performance of our architectural and how its improved, just you can do the math and take them over the year-over-year basis you would expect to see that one to be able to deliver a little bit more.

[Michael Rehaut:]

Great, thank you.

[Operator:]

Thank you. Our next question comes from the line of Tim Wojs with R.W. Baird. Please proceed with your question.

[Tim Wojs:]

Hey everyone good morning.

[Fred Lynch:]

Good morning Tim.

[Russ Tiejema:]

Good morning Tim.

[Tim Wojs:]

I guess maybe just the cadence of margins, if you can help us a little bit through the year, and the reason I'm asking, just you know last – you first half, you had some of the higher costs around operating inefficacies, you know in kind of the first half of the year and then obviously improves in the back half. But then I imagine inflation is probably going to be a little bit more of a headwind in the first half, maybe in the second half of a price cost basis. So just trying to think, if you think about 70 basis points at the midpoint margin expansion for the year, any help you can offer, any color? Just how we should think about that, first half versus the second half, or something like that.

[Fred Lynch:]

Yeah I think just going back to what Russ had said earlier, if you think about the architectural business clearly we’ve had nice progress. So you should see the fact that that progress will help us automatically just because of where we have come to. We don’t want to get into, obviously given quarter-by-quarter outlooks at this point in time. I would say that we did not have the best first quarter last year, we know that, and when we come into this first quarter which I’m sure will be some of the next questions, so we’ll go ahead and anticipate that. January was – it has been a tough month. It was a tough month I think for the industry in general due to weather related issues. We experienced those same weather related issues. But if I take January and February combined, we saw what we thought was – February so far, the month is not over for us yet. But we feel like we’ve recovered some of that softness that occurred in January due to weather related issues and it recovered in February. So as you sit here today and we look through the full year, we think it’s going to be a balanced year recognizing that we are coming out of more of a hole in the first half of last year than the second half of last year.

[Tim Wojs:]

Okay, no, no that’s – go ahead.

[Russ Tiejema:]

I was just going to say Tim, its Russ. I would just you know emphasize. I think Fred seeded up well. We hesitate often to talk about weather, but given how severe conditions were in January, we can’t underestimate the impact that had on our business. And it wasn’t just from a demand perspective, which clearly was impacted; our operations struggled with it. We had unseasonably cold weather in markets that typically just don’t see that, and between winter weather conditions that impacted absenteeism in the plant and make it difficult to staff some of our shifts, we did see some production disruptions that we got to try to claw back a little bit from post January.

[Tim Wojs:]

Okay, no that’s helpful, I appreciate that. And then I guess maybe just specifically North America on the new construction challenge. Curious what you are seeing kind of heading into ’18 maybe versus what you saw heading into ’17. Just curious anything around kind of channel inventories and demand and any sort of view on what stock might look like at your bigger customers thank?

[Fred Lynch:]

Yeah Tim, I think that from an inventory perspective we have a clear view of that in the first half of ’18 than we had in the first half of ’17. Obviously we took more time and effort to make sure we understood that first half as we laid out our – we understood that inventory level as we laid out our outlook. So we think that the channels are setup to kind of mimic what the market growth will be in 2018.

[Tim Wojs:]

Okay, and then maybe just the last thing of DW3. Could you just remind us how you think about you know with an acquisition maybe this size. How you would think about synergy realization and maybe what that could like over the next couple of years?

[Russ Tiejema:]

Yes Tim, its Russ, I’ll take that one. What excited us a lot about DW3 is how effectively that business has been running. It’s been doing a nice job, it’s been growing well, it’s been outpacing what they call the RMI market or the equivalent of our RRR market here in the U.S. So I would say from a near term perspective the integration is largely around just bringing them into our systems and our environment administratively. The longer term is looking at are there ways that we can better leverage the operations of DW3 and DSI as an example, because the business is run very, very similarly. Our objective whenever we go in to tuck-in acquisition like this is to target at least a term worth of synergies and we don’t see any reason why that could be achieved longer term on this one as well.

[Tim Wojs:]

Great! Good luck on ’18. We’ll see you next week.

[Fred Lynch:]

Thanks Tim.

[Russ Tiejema:]

Thanks Tim.

[Operator:]

Thank you. Our next question comes from the line of Kathryn Thompson with Thompson Research Group. Please proceed with our questions.

[Steven Ramsey:]

Good morning this is Steven Ramsey on for Kathryn. I guess just in Q4, could you just talk about how demand was intra quarter? Was there a sequential pattern of improvement and any color by segment?

[Fred Lynch:]

You know, I would say that we don’t normally talk about it. It was a normalized quarter.

[Steven Ramsey:]

All right, and then thinking about guidance, is there any real concern? What are the main reasons that would concern you on sales or margin basis to go to the low end or the high end of guidance?

[Fred Lynch:]

Well, I guess from my perspective Steven, it’s largely macro factors. You know if we were to see a significant backup in economic conditions particularly in the U.S. that really stalled housing growth and impacted residential remodeling investment that could be a headwind to us on the revenue line.

[Steven Ramsey:]

Great, thanks.

[Operator:]

Thank you. Our next question comes from the line of Jay McCanless with Wedbush Securities. Please proceed with your question.

[Jay McCanless:]

Hey, good morning everyone. Thanks for taking my questions. The first one I had, could you talk about the gross margin impact from raising the minimum wage to the $4 to $12?

[Russ Tiejema:]

Yes, so we did a thorough study around our wage rates across the businesses. I think we talked in the past that when we asset turnover in our organization and with the advent of putting in a more sophisticated HRS system, we are able to really see where that’s occurring over time and our highest turnover levels we are occurring in the very early days of hiring folks. So we were looking in the first 30 to 60 days, whereas once we have employees that are there for a year or more and as they start to move up the pay progression, we tend to have a much higher retention level. And so going through that analysis, we found that, less than 5% of our employees were still being, coming in at starting wagers that were under $12 an hour and given that that was where we were having the high turnover and through the discussions we were having, we were finding that we were losing some of those employees because they were able to find that higher wage rate in a relatively quick time given the market conditions that it would make more sense for us to take it to that level.’ So again, it was less that 5% of our employee base, but it was an important 5% of our employee base that was turning over too quickly.

[Jay McCanless:]

My second question, when I look at the commercial construction forecast for ’18 it seems like low single digit growth is consensus. Can you guys talk about some of the changes you made in the architectural segment and how you guys view growth there relative to what seems to be this low single digit consensus?

[Fred Lynch:]

Yeah, I think you know if we look at that market and believe we should be able to growth at least, with or better than that market or that industry. We have not over the last two years, largely did not in 2017, because we made a thoughtful and determine decision to reset that business and make changes including shutting down plants, pulmonizing product offerings, reducing product line offerings, etc, etc. Those are the right decisions to get that business to the profitability level that we saw in the fourth quarter and for us to able to continue to build upon that. We did cause customer, I would say a lack of customer experience, positive experience during 2017, because we made those decisions and we made them thoughtfully and we communicated them with our customer base and they understand that. We have the opportunity now. We are performing well right now across that business from a delivery perspective. We are performing well right now across that business from a profitability perspective and we see 2018 as being an opportunity for us to begin to recovery some of that share loss that we saw in 2017.

[Jay McCanless:]

Great, and then the last question I had, some of your larger customers are ramping up their spending on technology and some other initiatives. Are you guys seeing any pushback from the larger customers in terms of either the stocking levels that they are willing to accept for in terms of pushing back on price above normal levels?

[Fred Lynch:]

No.

[Jay McCanless:]

Okay, great. Thank you.

[Fred Lynch:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Trey Grooms with Stephens. Please proceed with your question.

[Trey Grooms:]

Hey, good morning. Thanks for sneaking me in here. Last one for me really I guess around the guidance that I was still kind of wondering about, was on the mix. What are your expectations there in the guide? I mean should you or should we be expecting any kind of impact from mix in especially North American?

[Fred Lynch:]

One of the things we continue to do as a company is to drive new products and I think it’s one of the things we are proud of, that has occurred over the last several years as we’ve taken our vitality index, which measures new product sales over the last five years, and from a very, very low single digit perspective to a high single digit perspective. And so you should expect that we’ll continue to see mix being an important part of our average unit price improvement as we continue to provide higher end, more fully finished products to the market place and that’s part of our strategic focus.

[Trey Grooms:]

Right, I understand. I know it was a little bit of a headwind in 4Q that you point out, but just with some of the transition you know with some of the business that transitioned away and then taking into account new products and all of that; just wondering if mix would be kind of a neutral or a positive or a negative as we look into ’18?

[Fred Lynch:]

Again, I think we also want to be careful about how we describe mix, because sometime it’s inter-channel mix that you see. So in this case, what we are talking about in the fourth quarter it was because we were selling a higher amount of interior doors, but that grew faster than our entry doors. So entry doors come in at a much, much higher price point than interior doors and therefore what looks like a negative mix shift really isn’t necessarily a negative mix shift. It’s just the different shift between different product lines and price. I don’t know if that helps explain that. But our goal is for that mix to be positive with each of the product lines, whether it be interior which is lower price or entry which is higher price or architecture which is even higher price.

[Trey Grooms:]

Okay, thank you. That’s helpful, and then I know you guys kind of simplified your product lines over the last few quarters. Just wondering how that’s gone, the traction you’ve gotten there and the benefit you’ve seen, just any details or update around that?

[Russ Tiejema:]

Yeah Trey, its Russ. I can speak to that. So that was specifically in our architectural business and we’ve been really pleased what how that’s gone. It was not a small effort, because you had product families and product configurations that were largely independent and different from one and other across all of the companies within the architectural segment that we had acquired over the last few years, and it took a pretty concentrated effort on the part of the team over several months to really get down to one set of harmonized product specifications. But we are really pleased with how that ultimately came together late last year and what that’s going to allow us to do now is much more efficiently flex production of similar door types across multiple plants in North American. So we are pleased with how that’s turned out and we think that will help us unlock additional operational efficiencies in the architectural business looking ahead.

[Trey Grooms:]

Great. Last one from me and I noticed in the slides for, you guys reiterated the longer term guidance for margins expectations that on last quarter you guys were kind of readdressing or kind of rethinking the longer term expectations around the top line growth. Just any update you could give us around that on longer term.

[Fred Lynch:]

That will be a key feature of our conversation at our Analyst Day, a week from tomorrow. So, we look forward to taking everyone though that at that time.

[Trey Grooms:]

Okay, didn’t mean to try to steal any thunder there. Just noticed the one in the slide deck and thought I would ask.

[Fred Lynch:]

That’s all right.

[Trey Grooms:]

All right, thanks a lot and good luck.

[Fred Lynch:]

Thank you.

[Russ Tiejema:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Kevin Hocevar with Northcoast Research. Please proceed with your question.

[Kevin Hocevar:]

Hey, good morning everybody. I’m probably treading on thin ice here with this question because I know you don’t like to talk about future pricing actions. But a lot of conversations on inflation throughout the call and it sounds like there is an expectation that you can offset that with pricing actions. So I was wondering if the actions you took in the fourth quarter you know are enough at this point to offset that or would we need to see further pricing actions throughout the year to fully offset and/or more than offset the inflation you expect to see in 2018.

[Russ Tiejema:]

Yeah Kevin, its Russ. You are right, we don’t prospectively talk about price but I’m comfortable saying at this point that we think the pricing actions that we’ve taken put us in pretty good stead relative to our current viewpoint on inflationary pressures in 2018. We’ll just have to see how the inflationary market continues to play-out over the next 12 months.

[Kevin Hocevar:]

Okay, got you. And then on slide 14, a really nice EBITDA bridge you have there for the full year in 2017. You know obviously the three headwinds there, the big ones where the materials factory and distribution, and I was wondering if you could comment a little bit on how to think of each of those buckets in 2018. I think to an earlier question we talked about distribution continuing to be a headwind, but it sounds like there are some mitigating factors you can take, so maybe not as big of a headwind but still a headwind. Materials I think you said was a 2% headwind this year. Material inflection you said 3% next year, so maybe instead of $10 million or should we be thinking $15 million and then with the factory I guess maybe you could help us think about that. But you know each of those three buckets; I guess how should we think about the impacts in 2018?

[Fred Lynch:]

Well, you know when you look at our material costs footprint, you know first of all between 50% and 55% of our cost of goods sold is material cost. So pretty soon you’ll look at how significant a portion of our cost of goods solid is and you put three plus percent inflation rate against it and you can see that’s probably a significant headwind as we look ahead into 2018. You know across the rest of the business we are real pleased with the efforts that we have made on improving productivity, particularly in our factories. Our direct labor and overhead costs have continued to improve, our labor productivity is improving, but frankly it’s a big headwind on the inflation front within our factory platform to deal with. You consider the fact that we’ve got about $400 million worth of total labor cost in our manufacturing plants. You apply a low to mid single digit inflation rate against that, it turns into some real money. So we are going to be looking to aggressively offset that inflation wherever possible with productivity, but it’s clearly a headwind. And then on a distribution side, as we’ve mentioned before, we knew that it would take us through the end of 2017 to address a lot of the inefficacies that had piled up a bit throughout the course of last year. We’ve made some good progress there, but once again inflationary environment in North America in particular. So I look at all of these categories as being significant inflationary features this year. It’s down to the work that our sourcing and operations team are doing to find productivity to offset them as much as possible.

[Kevin Hocevar:]

Got you. Okay very, very helpful and then on the – last question from me, on the corporate expense, I’m just curious how to think of that, because it went from $24 million in ’16 to $8 million in ’17 and I’m assuming incentive come was a good chunk of that reduction. So how should we think about the corporate expense in 2018, especially as we kind of normalize that incentive comp number?

[Fred Lynch:]

Incentive compensation was clearly a significant feature. We had slightly higher accruals in 2016 as we slightly over performed and we clearly underperformed expectations in 2017 and we brought those down pretty significantly. You will see a reset on the incentive compensation accruals as we go into ‘18 here. So you will see an increase in corporate expenses associated with that.

[Kevin Hocevar:]

Okay, got it. Thank you very much.

[Fred Lynch:]

Thank you.

[Operator:]

Thank you. There are no further questions at this time.

[Fred Lynch:]

Well great. Well, we appreciate everyone joining us on the call today and we look forward to seeing you next week at the Investor Day. Thank you very much.

[Operator:]

Thank you for joining the Masonite International Fourth Quarter Earnings Call. This conference call has been recorded. The replay may be accessed until March 8. To access the replay, please dial 877-660-6853 in the U.S. or 201-612-7415 outside the U.S and enter conference ID 13675896.