Hello. My name is Shamali, and I will be your conference operator today. At this time, I would like to welcome everyone to the Fortune Brands Second Quarter 2023 Earnings Conference Call. [Operator Instructions] I would like to turn the call over to Leigh Avsec, Vice President of Investor Relations and Corporate Affairs. You may begin the conference call.

Good afternoon, everyone, and welcome to the Fortune Brands Innovations Second Quarter Earnings Call. Hopefully, everyone has had a chance to review the earnings release and our web posting for additional information on our most recent acquisition as well as our supplemental financials. The earnings release and our audio replay of this call can be found in the Investors section of our fbin.com website. I want to remind everyone that our forward-looking statements we make on the call today, either in our prepared remarks or in the associated question-and-answer session, are based on current expectations and market outlook and are subject to certain risks and uncertainties that may cause actual results to differ materially from those currently anticipated. These risks are detailed in our various filings with the SEC. The company does not undertake any obligation to update or revise any forward-looking statements, except as may be required by law. Any references to operating profit or margin, earnings per share or free cash flow in today's call will focus on our results on a before charges and gains basis unless otherwise specified. Please visit our website for our reconciliations. With me on the call today are Nick Fink, our Chief Executive Officer; and Dave Barry, our Chief Financial Officer. Following our prepared remarks, we have allowed time to address some questions. I will now turn the call over to Nick. Nick?

Thank you, Leigh, and thank you to everyone for joining us today. On this call, I will walk through the highlights of our second quarter performance and offer some thoughts on the macro environment. I will also discuss our recent acquisition and how we expect these leading brands to accelerate key strategic initiatives and contribute meaningfully to our performance. I'll then turn the call over to Dave for a discussion of our financial results and how we are thinking about the remainder of 2023, including the upward revisions to our market forecasts, and increase to our full year 2023 sales and EPS guidance. Turning to our second quarter performance. Our results and the actions we took this quarter demonstrate the resilience and strength of Fortune Brands Innovations. Our teams delivered solid sales and strong margin results amidst an external environment that remains dynamic. Our leading brands are focused on meaningful innovation and our advantaged channel relationships positioned us well in the current environment and drove our results. I want to thank all of our associates for your dedication and pursuit of excellence, and again, welcome our newest associates to Fortune Brands Innovations. Together, we are going to continue to build an exceptional company. Net sales of $1.2 billion in the quarter were down 7% versus the prior year, and our operating margin was 17%. Our top line results were 50 basis points above our estimates for our market. These results demonstrate our ability to grow above the market, protect margins and invest in key strategic growth initiatives, even in the challenging environment. Our sales and margin performance generated earnings per share of $1.07. As we discussed on our last earnings call, heading into the second quarter, we knew that we were coming up against uniquely challenging year-over-year comparisons. As we…

Thanks, Nick. As a reminder, my comments will focus on income before charges and gains to best reflect ongoing business performance. Additionally, comparisons will be made against the same period last year, unless otherwise noted. Let me start with our second quarter results. As Nick highlighted, our teams executed well this quarter amid challenging comparables and the impact of last year's abrupt slowdown in single-family new construction. Our results reflected their dedication. Sales were $1.2 billion, down 7% and consolidated operating income was $198 million, down 11%. Total company operating margin was 17%, and earnings per share were $1.07. Our sales in the second quarter largely tracked our POS. Volume was down high single digits, which was partially offset by low single-digit price. Changes in channel inventories did not impact consolidated results. As we discussed previously, we expected operating margin in the first half of 2023 to be heavily impacted by production inefficiencies and stranded fixed costs related to our inventory reduction efforts. We continue to make excellent progress against our near-term inventory reduction target and our organic second quarter inventory finished at $845 million, down roughly $240 million from our third quarter 2022 peak. Our second quarter operating margin of 17% included a roughly $20 million impact from these efforts, bringing the total P&L impact in the first half to more than $50 million. Going forward, healthier supply chains and our more aligned organizational structure should improve our ability to accurately forecast with continued focus on service levels and inventory mix. While we are pleased with our second quarter results, our teams remain focused on driving outperformance, including above-market growth, preserving and enhancing margins and generating cash. Our continued focus on these performance metrics has enabled the team to drive both key strategic growth investments and strong cash flow.…

Thanks, Dave. That concludes our prepared remarks. We will now begin taking a limited number of questions. Since there may be a number of you who would like to ask a question, I will ask that you limit your initial questions to 2, and then reenter the queue to ask additional questions. I will now turn the call back over to the operator to begin the question-and-answer session. Operator, can you open the line for questions? Thank you.

[Operator Instructions] Our first question comes from the line of Phil Ng with Jefferies.

Appreciate the great investor deck. It's got some good insights on the asset deal. It looks like you're anticipating pretty strong growth with sales stepping up from $400 million to $525 million 2026. Can you provide some color on the growth drivers? And Nick, I think you don't typically bake in much cross-selling in past deals, what's giving you the confidence on the cross-selling synergies you're calling out? I think it's about $65 million to $85 million. How do you see that kind of ramping up? And what are some of the big opportunities?

Phil, thanks for the question. Happy to elaborate a little bit. We've obviously seen a variety of deals and done a variety of deals over time. This one really sits at a wonderful crossroads of being fantastic brands backed by an excellent team; a great price pay through some really disciplined approach to the asset itself; but then thirdly, the third part of the intersection is really the opportunity to come and unlock growth by putting these things together in our portfolio. And we try to be really disciplined around value, but then also really disciplined around the other 2 items, which is looking for great brands and teams, but asking where we can add value with the Fortune Brands portfolio. And I'd say this is one of the more exceptional deals that we've seen. And so I'll give you a couple kind of key foundational pillars and then happy to elaborate if it's helpful. But one, I'd just start actually with the Emtek business. So Emtek and Schuab, leader in the luxury hardware category, very design-led, a lot of colors and choices for designers, incredible supply chain and service, really a concierge approach and doing that at really, really fantastic margins. Not something that you see very often bringing all of those things together. And when we look at the House of Rohl platform, which you can see in the organic results here, continues to take share and outperform the market and is really, really resonating with consumers and designers. By putting those 2 things together over time, we'll now have a platform that's north of $0.5 billion, outgrowing the market and has global reach, right? And the elements really work together, whether it be in the channel where we have overlap in types of distribution channels, but not…

That's super. That's great color, Nick. Glad to see you're really excited about this transaction. You bumped your organic sales guide. Give us some color on any intra-quarter trends you saw, early read into July. You've expressed a more upbeat outlook on new construction. How do you see that inflection in the orders the builders have called out in your business, particularly Plumbing and Doors?

Yes. Sure. I'll start, and then I'll hand it over to Dave, and he can give a bit more detail about it. But I'd say at the highest level, if you think about it, it's actually been fairly consistent thematically with what we saw in the second quarter. And so what did you see? Saw relative strength in both builder, I think relative to expectations, in their order books and what was being reported. Now obviously, in Q2 of '23, we're digesting the slowdown from last summer, right? And so the uptick is yet to come through the P&L. And then on the R&R side, I'd say relative strength in everything that was more project or pro related and relative weakness in things that were more kind of DIY or weekend warrior related. And so as you then look into July, I'd say thematically that continues to be true. And we're going to see more uptick around the large production builders. We're seeing their value chain and supply chain start to strengthen as people prepare for those orders to come through. We've seen continued strength in our pro-related channels where the projects continue to be strong. And it's more around the very discretionary DIY products that you continue to see some weakness. But as Dave alluded to in his remarks, even there, in the last few weeks, there are some encouraging signs of certain product groups where you're seeing at retail a little bit more life than we've seen in that DIY stuff. So Dave, I don't know if you have a...

Yes. So I'd add some color around just the second half sales cadence. And so our prior organic guidance was down 3% to 5%. I'd remind people that includes the extra nonrepeating fiscal week from last year, that for the second half is roughly 2 percentage points all in the fourth quarter or 4 percentage points overall. So that organic guidance then, call it, down 2 percentage points, excluding that comp. We're moving it at the midpoint of our current guidance now to flat in the second half of the year. And I think simply, you think about it, it's POS down low single digits, offset by a favorable inventory comp of low single digits. That gets you roughly to the flat. And then the nonrepeating fiscal week is a 2 percentage point headwind, and that gets you to the midpoint of the guidance. So to Nick's point, as we -- here at the end of July, we look at our POS data, we see it trending in the right direction to support this forecast. And then if you layer on top of that the single-family new construction improvement that will really start to benefit us in the fourth quarter, that gives us confidence to believe in our second half outlook.

Our next question comes from the line of Stephen Kim with Evercore ISI.

Yes, a lot to ask about. Let's start with the acquisition. I think that you had indicated that there was going to be a little purchase accounting impact in the back half. Any reason why we should expect for that to continue into fiscal '24? And as you look across the sales synergies and cost synergies, do you think we could see some of the cost synergies by the end of the year start to trickle in? Just give us a little color on, I guess, timing in 3Q, 4Q and maybe a look into 1Q?

Steve, this is Dave. I'll talk to that. On the synergies side, I think maybe some of the sales synergies trickle in by the end of the year. On the cost side because of their inventory positions, while the teams will be doing the work, we won't see that in our P&L until next year just given the balance sheet. And then to your question on purchase price amortization. So remember, these are trade names that are amortized over a long period of time. So it is roughly $0.08 in the back half of this year. It will be $0.16 full year next year impact. And then going forward beyond that, pretty consistent for the next 10 or so years until that trade name is fully amortized and off the balance sheet. So hopefully, that helps to answer your question. I don't know, Nick, if there's anything you'd…

No. No.

Yes, absolutely. Okay. Great. That's very helpful. Now I know that your guide, you mentioned your guide, the improvement sort of reflects, to some degree, and I think a large degree, the -- an enhanced view of single-family activity. And I'm assuming there's basically the lagged starts effect. Are there any mix or margin implications from the rebound that we've been seeing in housing starts start to emerge as well? At least if you could talk to that, that would be helpful.

So the mix impact on us?

Yes. Benefit to you. You talked about the top line, but I'm wondering if there might be margin implications that would come from that. And if you could describe what those might be.

Yes. So I'll just give you some thoughts around it thematically and Dave can give more color. I would say bottom line is we are -- and we really work to keep the portfolio margin-agnostic, whether it be around product price point -- [ I'm sorry ], margin percentage around product price point or around channel. And so if you look -- you think about it, we might have -- if we see a lot more production builder business, that may come in at a lower contribution margin, for example, but it takes a lot less to serve that business because they're big customers, you can call on them. It's more standardized than say, showroom business, which you need big sales forces out in the market serving that; maybe higher contribution margin, but larger SG&A supporting it. And at the end of the day, that sort of balances out. And so it moves around the P&L as the P&L geography, but I would think about it as we're fairly agnostic, no matter kind of the channel or where we sort of set price points in the continuum from premium to ultra-luxury in our portfolio.

Yes. And I would just add. And Steve, I'd point you to our full year guidance for operating margins for Water, which prior was 23% to 24% and updated is around 23.5%. So at that midpoint, inclusive of the change in single-family new construction and the headwind from the purchase price amortization from the ASSA deal that's now rolling into that segment. So pretty consistent from a margin standpoint within Water.

Our next question comes from the line of Michael Rehaut with JPMorgan.

First, I just wanted to dial in a little bit on some of the puts and takes on the updated margin guidance for the year. I guess, on a segment level, you had Security nick down at the high end of the prior guidance. I just wanted to confirm that that's, I assume, largely just driven by the acquisition accounting? And if there are any other puts and takes into the back half outlook, particularly I'm thinking about to the extent that you have a little bit better top line outlook, organically at least. Were there any additional leverage that you were thinking of? And was that offset by anything else? And then I just had a follow-up.

Mike, this is Dave. On the Security question, you are correct. That's predominantly just impact from accounting from the acquisition and the base business is performing well, as evidenced by their margin results in the second quarter. And then in the back half, we have said on our initial call this year that we expected back half operating margin to be between 17% and 18%. We still think that's the right range for the back half, between 17% and 18%. Now there are some puts and takes in there. We are making some incremental investment, investing in digital, investing in brand and R&D in the second half, and we're controlling that tightly. But we see some areas that we want to accelerate as we head into 2024. And then interestingly, if you look at our first half margin performance of 15.2% and normalized for the inventory reduction overhead of $50 million that we called out, you're right at about that 17.5%. So the business is demonstrating pretty consistent margin performance and trajectory while digesting some of the implications of reducing our balance sheet and the market volatility, but we feel good about the outlook going forward.

I'd just add, Mike, if you think back to our Investor Day in December when we presented that longer-term margin walk and all the activities that we had planned to start to drive those, feeling very good that that is now coming through in both the Security and the Outdoors business. And notwithstanding the fact that was a pretty choppy external environment out there. You can see the businesses making the progression that we want them to make. And we're doing that by taking this newly aligned structure and the Fortune Brands' advantaged playbook and applying it and the teams are feeling very good about their ability to execute well against that over time.

Right. And appreciate that. And I guess, secondly, maybe just go back to the slide on the deck around the synergy opportunities on the top line, which very detailed and obviously, very well thought out. I think back to the acquisition of Fiberon and I believe you had, correct me if I'm wrong, I want to say, a 50% growth over 3 years. And a lot of that due to some really nice additions on the distribution side that you were able to secure new customers, et cetera, added distribution for the Fiberon product. We see a lot of expansion of channel in both the Yale and August and Emtek and Schuab. And so I guess the question is, maybe just to push, obviously, these are really good numbers in terms of the synergies on the sales side, but I would have actually thought perhaps there would have been room for some -- for slightly higher numbers. And maybe I'm just being a little too aggressive, but -- or maybe you're perhaps being conservative. I just wanted your take on that. Particularly over a 3-year period, it does seem like there's a lot of cross-selling opportunities too, to the point on the slide. And just curious if I'm thinking about things maybe a little too aggressively in terms of even greater upside potential.

Yes. So well, firstly, thanks for calling out that Fiberon analogy because I think it's really good. And I think what's particularly interesting about that example that you called out is that is still ongoing. Like those gains at the higher margin part of that business and those distribution gains are still unfolding. Obviously, the market's been a little bit tougher this year, as we just track that conversion rate, so that bounces between 1% to 2%, you see it sort of move back up, you'll see those play through. And during that whole time, though, we're preparing that business to then build on, right, with brand and innovation. And so very dramatically I think. Somewhat what I'd say specific to August, Emtek and Schaub is firstly I'd just call out, we closed June 30. So we've only had the teams together for a short amount of time. And they've identified a series of synergies that we put here, particularly around channel. And what we'll do is we'll be very respectful of what these businesses do better than the legacy Fortune Brands Innovations business. And so they have channel strength in certain areas that is better, and we will look to learn from that and build it into the legacy business. And then conversely, there are, of course, places where the legacy business has a strength that these businesses don't, where we construct to expand through distribution and access in our channel, strengthen relationships. And so will there be more upside over time for that? Possibly. But I think the real big unlock comes from really sort of the 1 plus 1 equals 5 strategy, which is as you put these things together, can we unlock new innovation, new approach, whether it be on the luxury side, where we really are going to have a lot more scale to go after the business on a global business and on a global basis with that luxury consumer who cares about brand and cares about the artisanal stories behind it, or on the technology enabled side where just our connected business is going to be that much bigger and the infrastructure and backbone on which it now all sits is going to allow us to unlock innovation at a faster pace. And I think that's where the real upside may exist, but that's going to take us a little time to work through those innovation opportunities and bring them to market.

Our next question comes from the line of Susan Maklari with Goldman Sachs.

Can you talk a little bit about how you're positioned from an inventory perspective across the different channels and the different segments? It sounds like you got a nice lift in the quarter from the volumes that did flow through there. As you think about the back half, what's the ability to capture any further upside to demand and perhaps see those volumes continue to move a bit further?

Yes. So it's Dave. I'd say looking at Water and Security, relatively balanced from an inventory perspective, relative to the rate of sales. But I'd say we're still a little bit light in Outdoors in the channel, primarily around wholesale decking at the end of the quarter. We do expect and really have started to see some of those orders that we expected to come through in July for decking. And so we're seeing that inventory fill back up. But I think if the market were to accelerate beyond our expectations in the second half, there would be some inventory upside opportunities as we would expect customers to put some inventory ahead of those sales. But where we sit right now, it's pretty well balanced, and we've kind of gotten through a lot of the prior year challenges from inventory builds and depletes that was really noisy on the sales line.

Okay. That's helpful. And then you talked about Security and some of the company's specific efforts that are going on there to drive results, just sort of above and beyond the acquisitions that closed this quarter. Can you just talk a bit more about some of those initiatives? And how should we be thinking about them flowing through to the business and actually coming through in terms of the -- both the revenue and the margins over time?

Yes. I would -- a very simple way to think about it is if you sort of rewind the clock a little bit on the Water business and you just observe what sort of happened, let's say, starting in '15, '16 and the playbook that was applied there. It's the same playbook being applied to Security. And actually, they're very similar in sort of brand resonance, ability to put innovation behind it, connected product and even the supply chain has a lot of commonality. And so you can really sort of almost lift and shift a lot of that playbook. So starting from the top line down, far more emphasis on innovation. And so what we're seeing come through, we alluded to strength in commercial. We're really developing a leadership position in some of the safety work that we do in facilities. It's very sticky work. We go in and do consultative selling. We help make facilities safer, there's obviously a lot of emphasis on that right now. It's a great strength of ours. We're able to put the brand and innovation behind it. Eventually, that will be connected as well and will be a much more data-driven thing. And that's just an example of a vector that can drive top line. And then you sort of play it through like the supply chain improvements that we made in Water, whether it be in sourcing or footprint over time, allowed us to generate a lot of fuel that we then reinvested to drive the top line, some of which came into margin, and you saw the margin progress over the years, but a lot of which was invested in the top line. And so it really is those sorts of capabilities that we talk about the Fortune Brands' advantaged capabilities because it's taking that playbook, applying it and I think over time, and then particularly as we bring in these assets, these new assets into play and are able to accelerate some of the connected overlap, we'll not just see the top line accelerate but we'll see the margins go along with that. And in our philosophy, it's very much a virtuous cycle because as you develop those margins, you're able to invest in these businesses faster. As you invest in them, obviously, the top line grows even quicker.

Yes. And, Susan, just to put some numbers behind that, because we are starting to see it come through the results. And so if you look at Security's performance versus the second quarter of 2019, sales are up 15% or roughly a 4% CAGR, and their operating margin is up 390 basis points. And so you see the output of what Nick described is really taking that playbook from Water, embedding it at Security and getting that flywheel going around growth, reinvestment and margin enhancement.

Our next question comes from the line of Joe Ahlersmeyer with Deutsche Bank.

Just want to go into the Yale business a little bit deeper. If you could maybe quantify the amount of the business that's currently going through e-commerce? And any considerations there around key customer partnerships with the change of control, anything to consider there?

Yes. I'll give you some perspectives broadly and Dave can elaborate, although we usually don't break it down to that level of granularity, we've put some information in the deck here. But I would think that this business has historic strength in the integrated channel which we found very interesting. And so as people connect the products into homes, there there's still one at a time, which August is built on, but there's also sort of a multiple and this works on the system with an integrator. And what's really interesting about the Yale infrastructure backbone is how flexible it is on a variety of different systems. And so that's a real strength of theirs. It's something that we don't have elsewhere in the business, and so we really want to build upon and we could expand our portfolio even in our existing Master Lock business and portable Security business, right? I think there we have -- we're able to secure things that are affordable in a connected way. And so if we can leverage that backbone. But then, of course, we have a lot of strength in retail and e-commerce, which historically has been, let's say, weaker for Yale. And so we think that that's an opportunity where we can leverage our historic strength to build their business up.

Yes. And Joe, I'd say interestingly, like our connected product business, this business has been chip constrained, and they actually prioritize these third-party integrators over other channels over the past few years. So the amount of sales flowing through e-commerce or even brick-and-mortar retail are lower than the demand would be for this type of products. As we get this business integrated back in stock, that will be another growth avenue for us going forward.

Yes.

Yes. And that was actually my second question, was around those constraints you had mentioned earlier, I guess, late last year. So maybe for my second question, I'll just ask a clarifying question on the wholesale decking. Did you say that sellout improved high single digits? And was that [ versus ] before a specific amount of time?

Yes, we said at the end of July, we were in high single digits versus prior year sellout?

Like a trailing 4 weeks or some -- like what's the period?

Yes, yes. That's how we'd look at it.

And our next question comes from the line of John Lovallo, UBS.

I guess first question would be on Water volume in the U.S. I mean, can you just help us with what that was down in the second quarter and maybe what the positive impact from pricing was? And then more broadly, where are you seeing potential opportunities for incremental pricing across your broader portfolio as we move into the back half of the year?

Yes, I'll start, and then Nick can comment. Just to decompose Water sales. Well, reported sales, down 5%. Strong sales growth from China given the prior year comp and the acceleration of some previously started development. So if you pull that out, organic, excluding China, it'd be down about 9%. And we see POS down low double digits. And so within that then, John, it's volume, down low double digits, offset by price up low single, which is consistent with what we've been saying all along. We took a low single-digit price increase in Water at the beginning of the year and that stuck and remains in market. And then there's a small low single-digit benefit on sales from product load-in timing around Amazon Prime Day, which was just different weeks last year versus this year and it fell into the second quarter. But the cleanest way to think about it is POS, down low double digits; volume down low double; offset by low single price.

And then the second part of your question on pricing opportunity, what I'd say is part of these Fortune Brands' advantaged capabilities, I was just talking about, one of the things that we've invested in is category management skills and capabilities, particularly in Water and Security and now turning them over to the Outdoors business. And what that does is really gives us the ability to understand what is happening with the consumer, what is happening with the pro at the shelf using data and analytics and then to work with our customers and wholesale partners to optimize pricing. And so we're constantly -- we try to avoid doing massive or shocking price increases. Now, obviously, between 2020 and today, there was some of that in certain categories, but we really seek to do smaller, more incremental regular price that the market expects, that our customers are used to, that are easily digestible. And even at the peak in Water, I think you never saw us move beyond mid-single digits. And if you do that consistently and you do it all the time, you're able to create value for the entire value chain, for all of our partners, and do it in a way that you're bringing the consumer along and I think that's reflected in the fact that we've been able to do it consistently but still gain share as we were doing it.

That's helpful. And Nick, one of the comments that you made, and it's not unique to your business, but I would love to get your thoughts on it. DIY being a little bit softer than pro in an environment where there's a little bit more challenge from an economic standpoint. I mean, intuitively, you would think it could be the opposite where the consumer is trying to save some money by perhaps doing things a little bit more themselves. I mean why do you -- what do you think is driving this dynamic where the pro is holding up better?

Yes, I'll give you my hypothesis for what it's worth, which a, I think we go back to sort of the fundamentals, right? You have a very, very underbuilt housing market. And so you're going to see new construction. You're seeing that come through and the production builders have the systems and the processes and they're excellent doing what they're doing. So you've seen them take share. And then you have a very aged housing stock. And so I think you see consumers prioritize their homes and go after projects where they really need to bring their homes into a more modern era and you've seen that hold up. And I think where you've seen what I'd say is relative weakness is in the huge growth that we saw in kind of retail POS in 2021 and 2022 that we've called out pretty consistently, saying coming into that spring selling period, you really saw people go out and spend a lot in retail for kind of the spring into early summer months. My belief is a lot of that was stimulus driven. They had money and were probably doing projects that they wouldn't have otherwise done. And as we anticipated, if you now look at the POS data, sequentially, the numbers improved week on week on week as you sort of went through the late winter into the spring, as we would expect them to with normal seasonality, but they did not comp the huge hill that was built the prior year when people went out and did a lot. And interestingly, and consistent with that, as we've now gotten into kind of mid-summer and you get past that hump, you can see those POS dollars come back into line and closer to flat, I would say, consistent with -- and flat versus last year, consistent with what we'd expect a normal season to look like. And so I guess to sum it up, I think new construction, bigger projects, modernizing homes or building new homes continues to be driven. I think what we are digesting is a stimulus-driven lap that was pretty tough. I was surprised actually that we pretty much lapped '21 and '22. And then in '23, I think you did see sequential growth, there was just too big a lap without the support of those stimulus dollars.

And we have reached the end of the Q&A session and also this does conclude today's conference. We do thank you for joining today's conference call. You may now disconnect.