Fortune Brands Home & Security, Inc.
Q3 2013 Earnings Call Transcript

Published: 24 Oct 2013

[Operator:]

Good afternoon. My name is Rob and I will be your conference operator today. At this time, I would like to welcome everyone to the Fortune Brands Home & Security Third Quarter 2013 Earnings Call. [Operator Instructions] Thank you. Mr. Brian Lantz, Vice President of Investor Relations and Corporate Communications, you may begin your call.

[Brian Lantz:]

Good afternoon, everyone, and welcome to the Fortune Brands Home & Security quarterly investor conference call and webcast. We are pleased to be here today to provide an update on our progress during the third quarter of 2013. Hopefully, everyone has had a chance to review the news release issued earlier. The news release and the audio replay of the webcast of this call can be found in the Investors section of our fbhs.com website. I want to remind everyone that the forward-looking statements we make on the call today, either on our prepared remarks or in the associated question-and-answer session, are based on current expectations and the market outlook, and are subject to certain risks and uncertainties that may cause actual results to differ materially from those currently anticipated. These risks are detailed in our various filings with the SEC, such as our annual report on 10-K. The company does not undertake to update or revise any forward-looking statements, which speak only to the time at which they are made. Also, any references to operating profit, earnings per share or cash flow on today's call will focus on our results on a before charges/gains basis as described in today's news release unless otherwise specified. With me on the call today are Chris Klein, our Chief Executive Officer; and Lee Wyatt, our Chief Financial Officer. Following our prepared remarks, we have allowed ample time to address any questions that you may have. I'll now turn the call over to Chris.

[Christopher J. Klein:]

Thank you, Brian, and thanks to everyone for joining us today. We delivered strong third quarter sales and profit. We continue to leverage our structural competitive advantages and build on our momentum as the market for our products expands in both the new construction and Repair & Remodel markets. Importantly, based on our momentum and strong performance, we are again increasing our 2013 annual outlook. Let me first spend some time on the quarter highlights and then I'll discuss our increased annual outlook. For the quarter, sales were up 24% and EPS was $0.46, up 59% from a year ago. Notably, sales for each of our segments were up double digits and our 3 housing-related segments saw total sales increased 26% as we continue to gain share in our categories and benefited from the WoodCrafters acquisition. Now let me give you some highlights by segment. Sales for our Cabinets business were up 36% for the quarter. Importantly, even excluding WoodCrafters sales, Cabinets sales were up 18%, well ahead of the market for our products as we grew market share in this segment. We exceeded our expectations as we benefited from a growing new construction market and a cabinet remodel market that continues to build momentum. The stronger pace of R&R spending in Cabinets was a continuation of the momentum we saw in the second quarter and mix continued to improve as we saw growth across a full range of semi-custom and custom product lines resulting in a better mix with higher price points. We gained share in both the dealer channel where we are the clear market leader and in home centers where we saw strength in our semi-custom and in-stock Cabinets, as well as our bath vanity programs. We are leveraging our structural competitive advantages, including our portfolio of brands, our leading position in the dealer channel, a continuous stream of innovation and our service-oriented operating platform to generate sustainable momentum. Also, the WoodCrafters integration is fully underway and right on track. This acquisition further builds on our competitive advantage in Cabinets, particularly as the Repair & Remodel market gains momentum. WoodCrafters also establishes a leadership position for us in vanities and further strengthens our efficient and responsive North American supply chain. Notably, we grew our Cabinet profits by $24 million in the quarter, nearly tripling last year's third quarter profit. This performance again reflects our ability to successfully target profitable growth and leverage our efficient operating platform. Plumbing sales were up 22% in the quarter. Moen saw broad sales gains in both wholesale and retail in the U.S. and in China. Gains were again strongest in our U.S. wholesale business driven primarily by the pace of new construction. Our leading market share with the top builders and wholesalers and our strategy over the past several years to expand in the multifamily segment are yielding share gains and solid profit growth. We also benefited from consumers choosing to upgrade faucet packages for their new homes, as well as sell-through on our new premium products, including our MotionSense hands-free, electronic kitchen faucet, which is now available in our traditional Brantford line, contemporary kitchen pull down styles and the align and stove collections and our Aris [ph] modern suite. Moen also saw double-digit gains at retail with their steady pace of consumer-driven innovations. At MotionSense, our Microban antimicrobial finishes and new traditional styles in our Ashville collection and more contemporary styles in our Gibson line. Internationally, sales in China, where there are now more than 875 Moen branded stores, were again up strong double digits over the prior year driven by the expansion of our store network, improved performance of the existing Moen stores and the expansion of our direct-to-builder effort. The team in China continues to build our business with a wider range of price points and with products uniquely tailored to the Chinese market and the Chinese consumer continues to spend in our category. Windows & Doors sales were up 14% for the quarter. Door products saw sales growth of 14% driven by gains in new construction and our ongoing distribution expansion. Windows sales grew 15% as the window Repair & Remodel market began to grow and as we gain share in our dealer West operation. In the Security & Storage segment, our sales were up 10% to the prior-year quarter with strong profit growth. Security sales were up 7% to the prior-year quarter with strength in U.S. retail and international. Master Lock U.S. retail sales grew with program expansions at large customers in spite of a relatively weak overall back-to-school period for retailers. Our rollout of a new line of commercial electronic access control solutions designed to secure high-value sites such as cellular telephone towers and other storage facilities also contributed to our sales gains. Tool storage sales were up double digits in the quarter as we continue to reposition the product line, but also benefited as the largest customer pulled forward some shipments into the third quarter, ahead of the fourth quarter holiday season. So to sum up the third quarter performance, I'm excited about our performance versus our market which continues to be led by significantly stronger new construction and an improving Repair & Remodel market. This performance demonstrates the strength of our operating model and our ability to generate profitable growth as volume returns and we leverage our competitive advantages to gain share. Let me now turn to our full year outlook for 2013. Lee will then take you through our outlook in more detail in a few moments. From a market perspective, while higher home prices and mortgage rates appeared to have slowed order rates, the new construction market is still on track to grow at 20% this year. And looking forward into 2014, most analysts are projecting growth as demand for new construction outstrips supply in many markets across the country. More importantly, given that Repair & Remodel is nearly 70% of our mix, it is particularly encouraging to see the improved pace of Repair & Remodel activity continuing into the fall remodel season. Notably, we're seeing strength in some areas that had been lagging such as bigger ticket semi-custom and custom cabinets and replacement windows. We're also seeing increased project size and stronger demand for more premium faucets in our Moen wholesale showrooms. These trends give us reason to be optimistic as we close out 2013 and prepare for 2014. Therefore, our revised full year 2013 outlook is built on a fundamental assumption that the U.S. home products market grows at a combined 9% to 10% annual rate. Based on our market assumption and continued share gains, we now expect our 2013 full year sales to increase at a 15% to 16% rate over 2012 with our home products businesses growing faster. We expect our 2013 EPS before charges and gains to be in the range of $1.47 to $1.49. So to sum up to sum up, we delivered strong third quarter sales and profit growth that built on our first half momentum. We remain confident in our ability to continue to outperform our market and we have again raised our outlook for 2013. Importantly, our strong brands, management teams and capital structure provide flexibility to both focus on profitable organic growth and drive incremental shareholder value with our strong free cash flow by investing in our businesses, pursuing accretive strategic acquisitions and returning cash to shareholders. Now I'd like to turn the call over to Lee who will review our financial performance and provide more details on our revised 2013 outlook.

[E. Lee Wyatt:]

Thanks, Chris. As Brian mentioned, the majority of my comments will focus on income before charges/gains, which best reflects ongoing business performance. Let me start with our third quarter results. Sales were $1.125 billion, up 24% from a year ago, with our home product sales growing 26%. Consolidated operating income for the quarter was $122 million, up 67% or $49 million compared to the same quarter last year. EPS were $0.46 for the quarter, up 59% or $0.17 versus the same quarter last year. Now let me provide more color on segment results. Our Cabinet sales were $449 million, up $119 million or 36% over the prior-year quarter, led by growth in dealers and home centers. Operating income for this segment almost tripled to $37 million, up $24 million as we benefited from higher sales volume running through our improving supply chain. And operating margin was 8.2%, 420 basis points higher than the same quarter last year. Our strategy of disciplined sales growth is working as planned as we continue to exceed the overall Cabinet market growth while improving profitability. We are seeing broader growth in our semi-custom and custom Cabinet lines, as R&R spending improved over last year. Excluding WoodCrafters, sales grew 18% and operating income increased $19 million to $32 million, more than doubling. Plumbing sales for the third quarter were $338 million, up $60 million or 22% versus the prior-year quarter. All channels, again, performed well, with U.S. wholesale and retail and the China business all experiencing double-digit sales growth. Operating income was $66 million, up 36%, even as we made incremental brand investments in the U.S. And importantly, operating margin was 19.5%, 210 basis points higher than the same quarter last year. Windows & Doors sales were $181 million, up $23 million or 14% from the prior-year quarter. Within this segment, the Door business experienced 14% sales growth, while the Window business grew 15%. Operating profit for this segment increased to $9 million, $2 million better than last year. Third quarter Security & Storage sales were $157 million, up 10% to the prior-year quarter. Security sales increased 7% and sales of tool storage products were up 21%. However, approximately $5 million of the $7 million sales growth for storage in the quarter was the result of our largest customer pulling forward some fourth quarter orders, ahead of the holiday promotional period. Segment operating income increased 42% to $30 million driven by a combination of sales gains and changes to our benefit structure as we align all of our benefit programs ahead of implementation of the new health care law. So to sum up the third quarter performance, we continue to leverage our structural competitive advantages to drive share gains and we're beginning to see better mix driven by the improving R&R market. During the quarter, we also took steps to better align the systems strategy in our Cabinets segment with its business strategy, focusing on more flexible systems that provide industry-leading content for consumers and superior tools for designers to deliver the best purchase experience in the industry. As a result of this shift in systems strategy, we recognize net charges of $0.09, primarily noncash charges related to abandonment of previously developed software. Turning to the balance sheet. Our September 30 balance sheet remained solid, and our cash position increased in the quarter to $157 million even as we opportunistically repurchased $30 million of shares in the quarter. Debt decreased to $356 million. As we previously stated, over an assumed 5-year time horizon beginning in 2012, to the housing market to return to a steady-state, our strong free cash flow combined with our flexible balance sheet, should provide over $2 billion of cash to drive incremental shareholder value. Let me now provide further details on our revised outlook for 2013. As discussed previously, our approach to the annual outlook begins with a market assumption but also includes continued share gains in addition to the overall market growth. So based on our market assumption and our performance through the third quarter, we now expect our full year 2013 sales to increase 15% to 16% compared to 2012. Our expectation for full year EPS are now in the range of $1.47 to $1.49. The midpoint of our guidance represents an increase of 66% over 2012 EPS of $0.89. It is important to note that within our EPS guidance, we intend to continue to make strategic investments across our businesses in the fourth quarter in order to prepare for significant growth opportunities in 2014 and beyond. We expect 2013 free cash flow to be approximately $300 million for the full year after CapEx of approximately $90 million and we should end the year with net debt-to-EBITDA around 0. In summary, our business model's performing well and we are pleased with our strong third quarter and year-to-date performance. This momentum should position us well for 2014 as we continue to benefit from our structural competitive advantages in the recovering market for our products. Importantly, this sustainable momentum in both the housing market and in our business performance should allow us to create incremental shareholder value by making select acquisitions and returning cash to shareholders through our dividend and share repurchase. I will now turn the call back to Brian.

[Brian Lantz:]

Thanks, Lee. That concludes our prepared remarks for the third quarter. We will now begin taking your questions and will continue as time allows. [Operator Instructions] I will now turn the call back over to the operator to begin the question-and-answer session. Operator?

[Operator:]

[Operator Instructions] Your first question comes from the line of Dennis McGill from Zelman & Associates.

[Dennis McGill:]

Chris, I was just thinking on the first question, can you maybe dig a little bit further on Windows? It seemed -- the acceleration there 2Q to 3Q and knowing that, that business is both Repair & Remodel and then custom new construction. Any more color you can give as far as what's driving that and what you're kind of hearing from customers?

[Christopher J. Klein:]

Thanks, Dennis. It's really more R&R and what we saw was, I guess, finally a bit of momentum coming back on the R&R side of Windows. I'd say that in general. I guess, the big theme here in the third quarter for us is really a strong R&R demand coming back into our businesses, and I think the Windows side saw that. We also picked up a little business out West through our dealer network out there, so that contributed as well. So I'd say we talked before about Windows and that it's lagged. The energy tax credit over a couple of years ago kind of sucked up some demand and eventually we'd see some more demand coming through Windows. And I think we're pleased that we're finally seeing a little bit of demand flow through that business.

[Dennis McGill:]

So if you exclude the business that you picked up out West, if you were to look at constant customer business, is that still seeing acceleration?

[Christopher J. Klein:]

Yes, yes, absolutely. Now it's primarily through short line distribution and it was kind of across the board, across markets, and so that was pretty good. And I say it was a steady building really from June onward. So we only saw a little bit of it in the second quarter but then it kind of continued through the whole third quarter.

[Dennis McGill:]

Okay. And then separately, back to the new construction commentary. You mentioned earlier that people like us in the public markets are talking about the order slowdown that some of the publics are seeing. If you just look at some of your leading indicators, are you seeing any signs either from wholesale inventories or orders that you would see more on the front side of that type of slowing?

[Christopher J. Klein:]

Yes, I think the third quarter across the board was strong, strong in new construction. September was a strong month, so we saw good activity in September. October is only a couple of weeks so it's hard to tell. I would expect eventually we'll see a little bit of that flow through. But the inventory levels are kind of -- they're whirring to POS, so we don't see a lot of accumulation of inventory, but it's been like that really since May, June. So we haven't seen a lot of that impact flow through the business.

[Operator:]

Your next question comes from the line of Robert Wetenhall, RBC Capital Markets.

[Desi DiPierro:]

This is Desi filling in for Bob. When you look at the -- at your portfolio, you're starting to see improvement in product mix across the businesses as the outlook for the Repair & Remodel spending improves?

[Christopher J. Klein:]

Yes, absolutely. I think that is -- I think the thing that moved the needle the most here was product mix within R&R. We started talking last quarter about the fact that you look at Cabinets business, the heart of market semi-custom, not the value end but really more the traditional semi-custom Cabinet business, we were seeing strong momentum and that definitely continued through the third quarter. Our strength in the dealer side of that business was really good. And in the faucet side, we saw a shift in mix up to really more premium product. And I'd say that was in new construction, as well as R&R. So mix was -- there was plenty of volume but mix was quite good. And I think that drove part of the profitability that you see as well.

[Desi DiPierro:]

Okay. And then from a manufacturing, logistics perspective, how do you think about balancing price increases for your products versus volume growth given the surge in demand that you've experienced here to date?

[Christopher J. Klein:]

I think we're pretty disciplined. We've been focused for a while now on profitable growth. And the reality is, yes, we could probably see even more top line growth, but we won't call it a growth. And so I think if you look at the results, you see a good balance between top line and strong leverage profit coming through that's a little bit unique relative to some of our competitors. And so I think we balanced that appropriately. I'd say it's not so much as getting price but there's quality business out there and the quality business is the business that we're really working hard against.

[Operator:]

Your next question comes from the line of Stephen East from ISI Group.

[Stephen F. East:]

Chris, you mentioned that in construction you never saw any slowdown. I guess, in our world, there's a lot of concern that the slowdown over the last 5 months and the government shutdown affecting consumer confidence, et cetera, also weighed on the remodel market or would start weighing on it. If I listen to you, it sounds like you all are not seeing any of that. What would you see initially if you started to see a wobble from the consumer in the remodel business?

[Christopher J. Klein:]

I think you'd see a slowdown in showroom traffic, you'd see a slowdown of consumers coming in with ideas on projects. And the reality is that, that is -- that's a multiple month cycle. Meaning if they're going to do a big kitchen remodel, bathroom remodel, replacement project on their windows, they think about months ahead, they start working on it. And so the good news is all that is still flowing. And to the extent you'd see a slowdown, it wouldn't be until I don't think the next real remodel cycle we should be into next year. So right now, folks aren't stopping, the volume continues to flow on the R&R side and we haven't seen that falloff that folks are looking for.

[Stephen F. East:]

Okay. And then if you look at your strong revenue growth and what you're projecting for the fourth quarter, I guess 2 different questions here. One, how do you split apart at least directionally price, mix and volume? And then your fourth quarter, the implied incremental op margin is lower than what we've seen in any other quarters so far. And I guess it doesn't really match up with, at least the way I'm thinking about it, with what you've been talking about with mix moving up. So maybe you can reconcile those 2 things.

[E. Lee Wyatt:]

I think -- This is Lee. When we think of price, historically, price makes up of -- on an annual basis, about 1% of our sales growth and I think that's consistent for this year. And everything else is mix and units and I think both are growing nicely, especially driven by this increased Repair & Remodel market and specifically with big ticket items. So we don't break that out but both are very favorable. And in terms of operating margins, I think if you take kind of the midpoint of our guidance for the fourth quarter, you see some are 8.5% to 9% and that's higher than the first quarter and that's higher than prior year significantly. So fourth quarter is actually always a little bit lower margin quarter for us than the second and third, so we don't see that as being unusual at all.

[Stephen F. East:]

Okay. That's very helpful. And then one -- just one quick other question. Your dealer in retail, you said both are growing. Which one are you seeing the faster growth in?

[Christopher J. Klein:]

Yes, I'd say dealer is very strong. We're strong across both and it's quite encouraging to us that we've been so disciplined in terms of the promotional activity on the retail side and home centers and yet we continue to grow share there. And then on the dealer side of the market, we're a leader in that market. We've continued to pick up dealerships. We're going deeper into the dealers, meaning they're carrying multiple lines. And we're just seeing great order patterns. And I think it's a multi-year investment and really the service around that channel. So we're pleased with both. I think they're really unique in terms of behavior, but they've both been very strong to this quarter.

[Operator:]

Your next question comes from the line of Ken Zener from KeyBanc Capital Markets.

[Kenneth R. Zener:]

Chris or Lee, I wonder if I could just -- the question Steve just asked around volume for Cabinets, I think it was generally for the company, but could you kind of break out the 18% organic, how much of that was volume and then price mix? Because I think there's some widening dispersion we're seeing and -- what was the industry growth rate do you think for Cabinets in the quarter?

[Christopher J. Klein:]

We don't really break that out. I think it was a combination of both for us. There was healthy volume coming through, but we did see a movement upward in mix going from our value lines more into the heart of the market, stronger kind of per box priced semi-custom lines and even a pickup on the custom side of the market. So I think it was a combination of both as you look at it to get to that kind of growth. Then -- and that will then reflect through on the margin side as well, right?

[Kenneth R. Zener:]

Okay. And then, I think, Lee, when you're making the comments around Cabinet organic, you said that obviously up 18% and then it was a $32 million organic number kind of implies an 8% margin. Which would have -- when you back out kind of looks like the WoodCrafters is kind of in that 8% margin range. Is that -- I thought that was going to be a higher margin business? Or can you talk about the margins implied in that acquisition and how long they'll kind of stay at that lower rate than it had been running historically?

[E. Lee Wyatt:]

Yes, just to quote the facts. The Cabinet margin was 8.2%. WoodCrafters was actually about the same margin, about 8% in the quarter. In the third quarter we had these accounting adjustments because this is the first quarter that we included them. We have to mark up inventory and so when you look at -- when you think about future quarters, historically, their operating margin is going to be 13% to 15%. So they're very profitable, it's just that they were depressed in the third, which, I think, we talked about last quarter.

[Kenneth R. Zener:]

Correct. So it'll be flowing through at that higher historical rate now that you've done the inventory adjustments in this first quarter?

[E. Lee Wyatt:]

Yes. So the good news is all this flushes out in the third quarter. So by the fourth, we're run rate margins.

[Kenneth R. Zener:]

Excellent. And could you -- now that we're seeing the strong Door and Window growth, can you kind of just talk to the margin spread, I guess, if you will, or how we should think about the profitability there as Doors is obviously more profitable. You guys are doing some OEM work. Windows get more supply in the channel but with this type of volume, how should we think about that kind of run rate?

[E. Lee Wyatt:]

I'd say it's still a case where the Door business is generating much of the segment profit because it's in kind of a steadier cadence, if you will. On the Windows side, we're just now starting to see the growth come through. Over time, that will convert better into profitability. So I think that's the balance between those 2 right now.

[Operator:]

Your next question comes from the line of Stephen Kim from Barclays.

[Stephen S. Kim:]

I wanted to ask you a little bit more about Cabinets, that information on WoodCrafters was very useful, but I wanted to ask you a little bit about what you -- what we saw in the quarter with respect to the Chinese plywood issue, and I know that you guys have been doing a pretty good job around that. But I was curious if you could comment on what impact you think that may have had in the third quarter or how that impact may play out for you at all in the fourth quarter or beyond?

[Christopher J. Klein:]

Sure. First of all, the issue has really been slow to develop over the last 18 months, so we saw this coming on the horizon all the way until it's about to have some impact. Didn't impact the third quarter. In the fourth quarter, we don't think it's going to have any material impact. What we're doing is working with different suppliers to try to mitigate some of that impact, and that's both across China, the rest of Asia, as well as North American suppliers. We've got a lot of scale, obviously, being a leader in the industry on the Cabinets side and in fact the WoodCrafter acquisition helped that as well. So we're doing all we can to try to mitigate it. I think to the extent that there is some pricing that then would need to come in, in addition, we'll be in a strong position to take the pricing that we need but we're not going to need to take all the pricing that perhaps may flow through the overall industry. So the good news is this wasn't a surprise. We've been active in working and talking with suppliers and I think we'll manage through it just fine.

[Stephen S. Kim:]

Well, that's -- yes, that's really encouraging. Also, if I could ask you a question about your overall incremental margin. One of the things that we focused on was, in the recent presentation, I guess, you had changed the disclosure on incremental margins as you get to a steady state. And at that time, I think you were basically implying an incremental margin that could be achieved of roughly 35%. And this quarter, and I know there were some issues but it looks like you are probably sort of in the low- to mid-20s. And I was curious if you could comment on whether you do -- just -- do you look for 35% incremental margin opportunity as you get back to a steady state? And if so, how do you envision that sort of growing from here up until up to that level? Like what do you see the flight path or the trajectory of that incremental margin looking like?

[E. Lee Wyatt:]

Let's -- we'll start with the third quarter. A strict calculation would be about 22% or 23% incremental margins, but WoodCrafters being in here for the first quarter will reduce your incremental margin. If you exclude the WoodCrafters impact, they carry a very good run rate operating margin but it does take down your incremental. So if you exclude WoodCrafters, we were 28% incremental margin for the quarter, which is right in the middle of our 25% to 30% annual growth. So we feel good about that and it kind of fits where we thought. In terms of longer term, we've talked about 25% to 30% as we get back to that 14% operating margin when we hit steady state, which is 1.5 million housing starts and 5% to 6% R&R and we're pacing nicely if you take the midpoint of our guidance on operating margin. This year, it's going to be 9%, 9.5%, so that's all good. But -- so we've really -- just to be clear, we've never said that incrementally we would move to 35% to get back to that steady state. 35% is a calculation and if you get to $800 million of EBITDA right at $5 billion, it might take us $5.1 billion, it may take us $4.9 billion or $5.2 billion. So 25% to 30% is where we see the incremental margins during this period of getting back to that steady state. So we feel very good about our margin in the quarter and we feel very good about where we're moving as we get back to steady state.

[Operator:]

And your next question comes from the line of Michael Rehaut from JPMorgan.

[Michael Jason Rehaut:]

First question, just to go back to the incremental margins for a moment. And appreciate the clarity that, I guess, you're reiterating that in fact it's still the 25% to 30% on a consolidated basis over the next couple of years or as we get back to normal. But the Cabinet margins this year went from 56% incremental in the first to 36% in the second. And I believe if you adjust for WoodCrafters, it's 32%? So just wanted to get a sense for that business overall. I believe you've talked about it in the past as being above average and even this quarter, it would -- that would be the case. But is something more in the low 30s kind of a reasonable way to think about that business going forward?

[E. Lee Wyatt:]

We've just again restate the facts. You're right on a calculation basis, incremental margins for Cabinets were about 20% in the quarter. Back out WoodCrafters, it's about 32% just as you state. As you think about the year, we will be in Cabinets above 30%. And a lot of that has to do as we -- in any given quarter, any given year, we talk about it could spike above the 25% to 30%. And you're seeing now and you're seeing it a lot around R&R as it comes back and you get the big ticket lags starts to stop or disappears. And so we're seeing that and that will cause it to spike a period of time. But over time, 25% to 30% makes sense for the total company and somewhere in that range over time for Cabinets but yes, you could see it spike above 30% and we will see it above 30% this year, we think.

[Michael Jason Rehaut:]

Okay. And just so I got the math right also on the inventory adjustment on WoodCrafters, that's a $3.6 million or so, that's about an 80 bps hit, that's more one-time, is that fair to say?

[E. Lee Wyatt:]

Fair to say. That's a little high. The inventory -- actual inventory adjustment is closer to about $2 million.

[Michael Jason Rehaut:]

Was that the entire adjustment or were there other adjustments because you said that normally, you would have been 13% to 15% and it was at 8%.

[E. Lee Wyatt:]

Yes, I think if you look on a run rate, just looking at a business that's $230-plus million, I think you'll see on average a 14% operating margin. There is also amortization of the goodwill associated with it, but I would plan around 14% operating margins in that business.

[Michael Jason Rehaut:]

Okay. And just one other technical question, if I could. The benefit -- change in benefit plans that affected the Security & Storage segment. Could you just break out what benefit that was exactly? And is this kind of a one-time positive impact or should we be modeling this higher, the benefit -- that the margin benefit from this change is an ongoing phenomenon?

[E. Lee Wyatt:]

Yes, that we are taking the cost down there on some of the benefit programs. It will be a multiyear benefit, so it will not be just this year. So you'll see it for several years. So you could continue to model that in. We'll build into our overall guidance when we give you guidance for '14.

[Operator:]

Your next question comes from the line of Dan Oppenheim from Credit Suisse.

[Daniel Oppenheim:]

I'm wondering if you can talk about your thoughts on terms of use of cash given the comments about the -- where the balance sheet will be at the end of this year. Certainly a good problem to have. How do you think about that in terms of the upside for acquisitions here? And desire for them and the opportunities that you're seeing available right now?

[Christopher J. Klein:]

Sure. We've been consistent in how we've thought about it and remained kind of the same place, which is first priority is to invest in the business, prepare for what we see as a multi-year expansion in both new construction but also R&R, make sure that we're investing in the business appropriately. We then would look out and say, to the extent we see accretive acquisitions that can build the business, we'll give those consideration. If not, we'll be in the market buying back shares or increasing our dividends. So our intention is not to stockpile cash. Obviously, we don't have a lot of debt, but we will over time here utilize the balance sheet efficiently to create the value that we can create. So we'll be looking at the situation as we come into the year. Right now, the M&A market isn't that active, but there are feelings out there. And so over time, we expect that will -- the pace of that will increase over the next 18, 24 months. And to the extent there are things that look like we want to do near term, then we'll be more aggressive in our dividend or share repurchase.

[Daniel Oppenheim:]

Great. In terms of the share repurchase, how should we think about that moving forward? Is that something based on sort of opportunistically during the third quarter based on dips in the stock? Or are you planning to put to work similar amounts in terms of dollars on a quarterly basis here? Any thoughts there?

[E. Lee Wyatt:]

Yes, in the short term, we'll use -- probably share repurchases more just on the opportunistic basis until we understand the broader market for M&A and where to really maximize our use of cash to drive shareholder value. So as we learn more about M&A, we may do more of that. At some point, if -- once we understand the M&A market over the next 6 to 18, 24 months, we may increase share repurchases. But that would just be as a way of maximizing shareholder value when we have more facts.

[Operator:]

Your next question comes from the line of Garik Shmois, Longbow Research.

[Garik S. Shmois:]

Just wondering first off if you could talk about the impact on Plumbing margins from the growth in China?

[E. Lee Wyatt:]

The Plumbing, as we've said, we're investing and growing. We have over 875 stores now, so we're growing that. The margins are lower than the Moen business in the States because we continue to invest, so it's lower, but it's still very positive. We like that business. It's a great growth opportunity. And when we stop opening as many stores, then obviously the margins will pop back up. So a little dilutive on margins but still very positive. But it's hard to criticize anybody who doesn't have the margins of our Moen wholesale business, they're so strong.

[Garik S. Shmois:]

Yes. I guess, a natural follow-up to that would be when would you anticipate the cadence for the sales growth from new store openings to slow? And in turn, margins to trend up closer? And why with the legacy business?

[Christopher J. Klein:]

Yes, it's something we look at quarterly. And this year, we were very disciplined in terms of both opening stores, as well as closing stores that weren't performing up to our standard. And so I'd say we slowed the pace of net expansion in doing that to make sure we're getting the right throughput in each location. But having said that, we did obviously continue to increase. At some point, it will really be determined by the market. And if the market slows down in terms of where the opportunity is or if we feel like we've saturated the markets that we're focused on, then we'll back that off and the natural consequence of that will be higher profit levels but probably not as robust a growth trajectory although we expect to continue to be positive. It's kind of the nature of -- we've built this business from scratch over the last 17 years and kind of came in and built it one at a time. And so I think that's the characteristic of developing an organic market is it has that kind of a pattern. But at some point, we want to turn it into more of a strong profit contributor, as well as a growth contributor.

[Garik S. Shmois:]

Okay. And just a follow-up on Cabinets and raw material costs. Was there any impact of raws on Cabinets in the third quarter?

[E. Lee Wyatt:]

Yes. And I'd say generally in terms of inflation across Cabinets and the business, very modest overall inflation in the quarter. We did see in terms of the wood and the plywood and particleboard, we did see some inflation more in that kind of mid-single digits, but very manageable. So very manageable on the Cabinets side all around.

[Operator:]

Your next question comes from the line of Peter Lisnic from Robert W. Baird.

[Peter Lisnic:]

On the Cabinet business, as you look at the mix moving to semi-custom and custom a little bit of that needle moving, can you give us a sense to how far off we are from normal in that mix? And then what that might mean as you kind of move more towards on more normal semi-custom and custom mix, what that might mean from a margin perspective?

[Christopher J. Klein:]

Yes, I'd say in general terms, we're not there yet, and we're probably not even halfway there yet. The market, I would characterize over the last 3, 4 years has been very value-focused. The price points around, I'd say, value semi-custom significantly less than where the market's starting to shape up right now. And consumers are now focused more on quality, durability, getting the right look that they want and that moves them up into the kind of the heart of the market, semi-custom market. So I'd say we're not even halfway there. As it moves forward, yes, you will see improved mix and improved profitability as we come through there. I wouldn't -- I'd just characterize it as being within the movement of the 8% margin we're seeing today up to that 14%. A lot of that improvement is driven by this part of the market. We're primarily an R&R-focused Cabinet company in the dealer network, home center market. And that really is what drives us from that 8% to that 14%.

[Peter Lisnic:]

Okay, perfect. And just one quick one. The asset impairment charge that you recorded in the quarter, can you just a little bit of detail on what that was?

[E. Lee Wyatt:]

Yes, it's just part of our normal process of kind of aligning our IT strategies with our business strategies and adjusting business strategies. So we basically looked at the -- it's in Cabinets basically and we said we need more flexible systems, that's what where we're going to invest. We've got some systems developed over the last several years that we don't really -- we won't use because they're not as flexible to really drive the good customer experience that we need. And so we're always going to keep our balance sheets clean. So we took a charge about $0.09, it's all noncash for things developed over several years. So it's just a matter of just continuing positioning ourselves for growth and being the #1 in the industry.

[Operator:]

Your next question comes from the line of Keith Hughes from SunTrust.

[Keith B. Hughes:]

My question has been answered.

[Operator:]

Your next question comes from the line of Nick Coppola from Thompson Research Group.

[Nicholas A. Coppola:]

Yes. A lot of my questions have been answered, too, but just thinking at a high level, thinking about your leadership in the dealer space in Cabinets, obviously, it's a high-margin, desirable channel, there are a lot of competitors kind of jockeying for that position. I guess, how do you think about -- or what are you seeing competitively? And what kind of moats do you have there in the dealer space?

[Christopher J. Klein:]

The dealer market is a long-term game. And as we sit here today, we've got real structural competitive advantage in that market. We've built that business over many, many years. We've got deep relationships with the individual dealers. We work hard to bring them across multiple lines. We support them. These are literally thousands of customers across the country. There's small business owners. And we've done a lot to help them survive and we've done a lot to help them grow, and there's really great relationships through the whole system. And so, we do that. And then on top of that, bring in new products, great customer service, terrific quality. We're close to market in terms of manufacturing, got semi-custom plants throughout North America, close to the end market. So they've got great service from that. So we think we're really well positioned in that market and our results continue to show that. We're obviously concerned about any competitor who shows up and we'll keep executing and do what we do well every day and I think the results will continue to be positive for us. So yes, I'd agree. You expect others would continue to focus on the market, but I like where we are, and I'd expect we're going to continue to see success.

[Nicholas A. Coppola:]

Yes, I think that makes sense. And the results speak for themselves.

[Christopher J. Klein:]

Yes.

[Nicholas A. Coppola:]

But -- so just one more question, also kind of high level, but how do you think about the impact of kind of the modestly higher interest rates we've seen for your business? And kind of interplay with new construction activity?

[Christopher J. Klein:]

I guess, I look at it -- obviously, you're going to have short-term shocks to any business. But I'd look at it over the medium term and just say, I like the overall picture of the market. And keeping in mind, we underbuilt on the new construction side for many years. And so the market is kind of building to satisfy that demand, interest rates are still historically very low. And affordability is very good. And so you look at those fundamentals and say, if I look out to '14, if I look out to '15, my expectation is you'll continue to see healthy growth rate in new construction. On the other side of the business, on the R&R side, a lot of the renovation is being driven really by people investing in their homes. Not a lot of borrowing as far as we can see. I think there is some borrowing against it. And as people's equity in their homes improve, they'll have more to draw upon, which will probably be more powerful than a 75-basis point movement in interest rates. So I think the availability of credit is important. And I just look at rates and say, historically, mortgage rates are still pretty good, 4.25, 4.5, relative to historically where they've been. So that's the way we run our business, that's how we plan. We look at the macros, we look at the longer run and play it out over the next year and 3 years. And we see good growth ahead of us. And frankly, we're planning for how we're going to fulfill against all that terrific growth.

[Operator:]

Your next question comes from the line of Mike Wood from Macquarie.

[Mike Wood:]

Could you frame for us the growth that you saw in the semi-custom Cabinet markets and whether or not there is any deceleration or acceleration in the stock Cabinets?

[Christopher J. Klein:]

Yes. Semi-custom was strong and kind of consistent throughout the quarter and remains strong on the stock side, there's a couple of categories here. There's stock cabinets that go into new construction on our Aristokraft line. And then there's in-stock cabinets that we sell into home centers. I'm not sure which one of those you're questioning.

[Mike Wood:]

Yes, I guess, first is more curious because you saw that kind of mid- to high-teens growth, the segments are organically in the semi-custom side.

[E. Lee Wyatt:]

I'd say just from the data, we saw strong double-digits across the board in all those categories and did not see deceleration. We had seen early growth in the year in the stock. And now we're just in this quarter seeing really the strong growth in the semi-custom and custom. So they were all strong double-digit growth.

[Mike Wood:]

Okay. And the faucet shift to the premium products, would you characterize that as being market-driven or was it specific to product launches or shelf space that you gained?

[Christopher J. Klein:]

It's both. I think it's both new products we brought out that are selling through strongly. And then I also think that if you're looking at a better mix, both on the R&R side, bigger projects, more and we saw that on the Cabinets side, too. That translates into a more premium faucet package, more premium bathroom, showering. So I think it's both of those things flowing through. And we're fortunate to have continued to invest in new products and new innovations. So when a consumer shows up in our showroom, our stuff looks great and when they want to move up into a higher price point, we can meet that need because we've got new finishes, new features, styling that appeals to their demand. So I'd say those 2 things are working hand-in-hand and we're capturing that benefit.

[Operator:]

And your final question comes from the line of Jim Barrett from CL King.

[James Barrett:]

Chris, could you discuss the level of promotional activity year-over-year in the quarter among the home centers, in dealers? And what is your outlook for '14 in that regard?

[Christopher J. Klein:]

I'd say we're very pleased that, that level of promotional activity has come down. I think it's down to a level that -- well, I don't think it's as low as it might have been in 2006, it's come significantly down to a point where it's sustainable where it's at. I don't think it's going to increase going into next year. Frankly, I think there's enough fundamental consumer demand that folks don't need to be doing it. There's also pretty good capacity utilization through the industry. So if those were the drivers over the past couple of years, those drivers aren't there anymore. So I'd say it's a pretty good environment just in terms of the level of promotion and the overall level of pricing in the market.

[James Barrett:]

Okay. And did I hear you correctly that the rate of sales growth in Cabinets was higher among dealers and home centers than among homebuilders?

[Christopher J. Klein:]

I think what we were saying was it ticked up. So they're now at about an equal level but accelerated as R&R picked up really over the last 4 months. The homebuilders were on a separate track, obviously, throughout the first half of the year of strong growth. R&R was lagging there, especially big ticket was lagging. But over the last 3 or 4 months, we've seen that pick up and -- so now they're running at about the same level.

[Operator:]

And I will now turn the call back to Brian Lantz.

[Brian Lantz:]

We'd like to thank everybody for joining us today, and we look forward to speaking with all of you very soon. Thank you.

[Operator:]

Ladies and gentlemen, thank you for your participation. This concludes today's conference call, you may now disconnect.