Masco Corporation MAS CEO Keith Allman on Q4 2019 Results

Good morning ladies and gentlemen, welcome to Masco Corporation's 2019 fourth quarter and full year conference call. My name is Regina and I will be your operator for today's call. As a reminder, today's conference call is being recorded for replay purposes. To ask a question, please press star then the number one on your telephone keypad. To withdraw your question, please press the pound key. I will now turn the call over to David Tyka, vice president, treasurer and investor relations. You may begin.

Thank you, Regina, and good morning. Welcome to Masco Corporation's 2019 fourth quarter and full year conference call. With me today are Keith Allman, President and CEO of Masco, and John Sznewajs, President and Chief Financial Officer. Our fourth quarter earnings release and the presentation slides that we will refer to today are available on our website under Investor Relations. Following our remarks, we'll open the call for analyst questions. Please limit yourself to one question with one follow-up. If we can't take your question now, please call me directly at 313-792-5500. Our statements today will include our views about our future performance, which constitute forward-looking statements. These statements are subject to risks and uncertainties that could cause our actual results to differ materially from the forward-looking statements. We describe these risks and uncertainties in our risk factors and other disclosures in the Form 10-K and our Form 10-Q that we filed with the Securities and Exchange Commission. Our statements will also include non-GAAP financial metrics. Our references to operating profit and earnings per share will be as adjusted unless otherwise noted. We reconcile these adjusted metrics to GAAP in our earnings release and presentation slides, which are available on our website under Investor Relations. Finally, please note that we have accounted for our windows and cabinetry businesses as discontinued operations for all periods presented. With that, I'll turn the call over to Keith.

Good morning everyone. If they've mentioned, most of my comments will focus on adjusted performance from continuing operations, excluding the impact of rationalization and other one-time items. Turning to Slide 7, we finished the year on plan. Fourth-quarter sales matched prior year and increased 1% in local currency. Currency translation unfavorably impacted sales in the quarter by approximately $7 million. In local currency, North American sales increased 1% in the quarter, driven by pricing actions and volume growth in our plumbing and paint businesses. This was partially offset by lower volumes in our lighting business. In local currency, international sales decreased 1% in the quarter, driven by unfavorable mix partially offset by pricing actions. We reported operating income of $257 million with operating margins of 15.7%. Operating profit was impacted by mix, an unfavorable price/cost relationship, and higher variable costs. For the fourth quarter, our EPS matched the prior year at 54 cents per share. Please note that this performance is based on a normalized tax rate of 26% versus the previous 25% tax rate prior to discontinued operations. Due to the move of cabinetry and window segments to discontinued operations and the change in the tax rate, we have provided restated adjusted EPS numbers for 2018 and the first three quarters of 2019 in the appendix on Slide 22.

Turning to the full year 2019, sales increased 1% including 2% in local currency. Currency translation unfavorably impacted the full year by $77 million. In local currency, North American sales increased 2%. This performance was driven by disciplined pricing actions across both segments, partially offset by lower volumes. Local currency international sales matched the prior year. While we experienced some international market softness in 2019, Hansgrohe continued to drive share gains in its home market of Germany, India, and China. Our SG&A as a percent of sales increased 10 basis points to 18.9% for the full year. For the full year, operating income decreased $16 million or 1% with operating margins of 16.5%. Lastly, our EPS increased 6% to $2.25 for the full year.

Turning to Slide 8, our plumbing segment grew 3% in the quarter excluding the impact of currency, driven by strong growth in North America. Foreign currency unfavorably impacted sales by approximately $9 million in the quarter. North American sales increased 5% in local currency, reflecting improved demand from our wholesale, retail, dealer, and e-commerce customers. This growth was against an 8% comp in the fourth quarter of 2018. Growth was led by Delta as they achieved another record sales quarter through increased volumes across their product categories. Additionally, Watkins, our spa business, continued to outperform by also achieving another record quarter with its innovative new products and industry-leading brands. Our international sales in the fourth quarter decreased 1% in local currency due to lower sales in Germany as Hansgrohe faced a difficult comp with sales growth of 7% in Germany in the fourth quarter of 2018. This was partially offset by strong growth in China. Operating profit in the quarter decreased $5 million due to higher variable costs partially offset by incremental volume. Turning to the full year 2019, sales increased 2% in local currency. This solid growth was driven by record years at Delta and Watkins. North American sales grew 2% in local currency as a result of early and aggressive pricing actions taken to mitigate the impact of tariffs, offsetting lower volumes. Our international plumbing sales matched prior year in local currency as Hansgrohe's solid growth in Germany and China was offset by softness in other regions. Full-year operating profit matched prior year due to a favorable price/cost relationship as we priced ahead of feeling the impact of tariffs costs in certain market instances, partially offset by higher spending, unfavorable currency translation, and mix. For 2020, we expect the plumbing segment sales growth to be in the 2 to 4% range excluding currency, principally due to our low growth expectations for the European plumbing market. As a reminder, 35% of the plumbing segment sales are outside of North America. We anticipate full-year margins will be similar to 2019 as we experience the full impact of the List 3 and List 4 tariffs in 2020. The expected tariff impact will be the greatest in the first half of the year, and we are estimating operating margins will be down roughly 100 basis points in the first half of 2020 before recovering in the second half of the year. Also, given current exchange rates, we do not expect currency to materially impact our 2020 revenue.

Turning to Slide 9, the decorative architectural segment declined 3% in the fourth quarter. This performance was driven by strong paint sales which were more than offset by lower sales in our lighting business due to the loss of a portion of a private label business and inventory rebalancing with a key customer, which impacted volumes in the quarter by approximately $20 million. Behr's solid mid-single digit growth in pro and low single-digit growth in DIY products was aided by approximately $20 million of sales pulled forward from Q1 2020, similar to the pull forward we experienced in the fourth quarter of 2018. Operating income declined due to lower volumes in lighting and an unfavorable price/cost relationship driven by the impact of tariff costs and higher incentives, partially offset by lower spending. Turning to the full year 2019, sales grew 3% driven by our pro paint initiative as we achieved high single-digit growth and continued to grow share with our pro growth. This was also aided by the acquisition of Kichler in March of 2018. This performance was partially offset by lower volumes in our lighting and builders hardware businesses as a result of our disciplined pricing actions in 2019. Full-year operating income decreased 1% principally due to lower volumes and increased commodity costs, partially offset by selling price increases and lower spending. In 2020, we expect low single-digit growth in DIY paint and mid-single digit growth in pro paint. We also expect revenue in this segment will be impacted by the loss of a portion of a private-label program and inventory rebalancing at a key customer. The revenue impact of these items will be approximately $15 million each in Q1 and Q2, and approximately $5 million in Q3. This volume loss and the full impact of tariffs will depress the segment's operating margin by approximately 300 basis points in Q1 before recovering in the balance of the year. For full year 2020, we expect sales growth in the segment to be in the 0 to 2% range with operating margins between 17 and 17.5%.

Turning to Slide 10, our year-end balance sheet was strong with net debt to EBITDA of 1.7 times, and we ended the year with approximately $1.7 billion of balance sheet liquidity. Working capital as a percent of sales finished the year at 15.7%, an improvement of 10 basis points over prior year. During 2019, we repurchased 7% of our outstanding shares for approximately $900 million, and we increased our annual dividend by 13% to 54 cents per share. We took further action in 2019 to strengthen our balance sheet by reducing our debt by approximately $200 million, and we initiated a plan to terminate and annuitize our U.S. qualified defined benefit pension plans. We should complete this plan by the end of 2021. This will reduce our ongoing pension expense and contributions once completed. Lastly, we expect the sale of our cabinetry business to close in February, and we expect net proceeds from the sale of approximately $645 million after taxes and expenses. Going into 2020, our disciplined capital allocation strategy is unchanged. We will continue to prioritize investment in our businesses to drive organic growth, we will balance acquisitions with the right strategic fits and returns with share repurchases, and we will maintain an appropriate dividend. Including the expected net proceeds from the sale of our cabinetry business, we expect to deploy up to $1.2 billion for share repurchases in 2020, subject to market conditions. This activity would bring our expected 2020 average share count to between 265 and 270 million shares. We generated $660 million of free cash flow in 2019, and we expect a 100% free cash flow conversion rate in 2020. Lastly, for the full year 2020, we expect revenue growth of 2 to 3% with operating margins of approximately 16% and, as Keith mentioned earlier, our 2020 EPS estimate is $2.35 to $2.55, which represents 9% EPS growth at the midpoint of that range. With that, we'll call back over to Keith.

Our first question will come from the line of Steven Kim with Evercore.

Yeah, thanks very much guys and appreciate all the detail here. I guess the first question really relates to the margin guidance that you've given. I'm curious, for the decorative architectural segment, can you get a sense for what kind of a margin impact you think the private label program being discontinued at your retail partner is representing, and how much of the margin guidance you're looking for particularly here in the first quarter is being driven by other impacts? And then I guess might as well stay on the decorative segment and particularly Kichler. I'm curious as you look at that business opportunity, a lot has happened. The tariffs coming in shortly after the acquisition was an unfortunate event, and there's continuing to be issues in China due to the coronavirus, one can imagine affecting your supply chain. I'm curious, number one, you didn't mention anything to that effect. Could you maybe talk about how that might be factoring into your outlook at all? And then, if you believe that there has been any adjustment in your improvement plan in Kichler in light of what's happened, as you've watched things develop over the last three quarters, has there been any change in your strategic thinking around how to approach improving the results in that business given the changing world?

Great, thanks very much.

Your next question comes from the line of Matthew Bowie with Barclays.

Good morning, thank you for taking the questions. I wanted to follow up on the decorative side just around that Q1 guidance for the 300 basis point decline. It sounded like you're saying that's largely reflective of the tariffs flowing through, and obviously your full-year guidance suggests that the margins will recover through the balance of the year. So I guess my question is more cadence-wise: are you expecting kind of a steady improvement sequentially through the year, or is that margin improvement kind of more weighted to the end of the year as you anniversary those tariffs?

Sure, even though Matthew, let me give you a little bit of color here. So if you think about how the tariffs impacted us starting in 2019 and how they phased through our P&L through the course of

The tail end of 2019 and going into 2020, we had about $60 million of incremental tariff cost in the P&L. In 2019, we expect another incremental $90 million to impact the P&L in 2020, and most of that $90 million should be in the first half of the year. Really, if you consider that $60 million started to flow through our P&L kind of the middle of the third quarter and really hit us the full effect, that is to note in the fourth quarter of 2020. So we should experience the full impact in the first two quarters of the year, and then it continued a little bit in the third quarter, and this should dissipate as we get into the fourth quarter of this year. So we've implemented the pricing tool to mitigate up to $450 million of tariffs, but we're also continuing to work on margin recovery efforts through cost out opportunities, apply our negotiations, and looking at other resourcing opportunities that we may have. But one thing that I should point out is we might face a little bit of margin compression because what we are experiencing is cost recovery on these tariffs, so we don't necessarily have margin dropping to the bottom line. That said, we should expect to resume some margin expansion in the back half of the year once these tariffs work their way through the P&L. So I hope that's helpful to you.

It is. Thank you, thank you for that. And then secondly, just kind of bigger picture around Kichler. You know, just hoping you could elaborate a bit around kind of longer-term growth plans. I mean, you know, kind of how you envision this business positioned from a channel perspective, or what I guess needs to change that you think would allow this business to kind of return to growth after you've moved past some of these near-term losses. Thank you.

Appreciate the detail. Thank you.

Your next question comes from the line of Michael Wood with Nomura.

Hi, good morning. I wanted to see if you can elaborate a bit more on the incentives that you called out impacting paint processor ability in the presentation, and what are you seeing in terms of consumer reaction to these incentives? And if you could just talk about, you know, maybe what's changing the industry in terms of how competitors are behaving with pricing incentives in paint?

I think there might be a slight misinterpretation. It's incentives between ourselves and our retail partners. It's not a consumer-based incentive. So just to clarify, you're saying that the actual price and incentives offered at the store have not necessarily changed? This is between — that's correct. Largely due to volume rebates that we have with our major customers.

Great. And in terms of the market share gains that we should expect going forward for the business overall, if I do just rough back-of-the-envelope math for the end market assumptions overlaid to your business, I get a roughly 2% growth rate, and you're calling for 2% to 3%. Is that the typical share gain that you'd expect, or is there something impacting that that's preventing it from being larger?

Thank you.

Your next question comes from the line of Mike Dahl with RBC Capital Markets.

Good morning, thanks for taking my questions, John. Just to pick up on that last question, if we think about the paint business, think that pull forward into Q4 looks like it was probably a couple cents, and maybe that's borrowing from 2020 by the same amount in terms of top-line in that segment. I think so. If you think about paint specifically, when you have DIY as a market flat, Pro low single digits, that single flat, you've got that one point headwind. Do you expect to perform in line with the broader paint market, even with that comp headwind, or do you still think you can outperform those overall numbers?

Yeah, yeah. So to react to your comments, you have one. I think your math is largely right on the pull forward and the bottom line impact. As we think about the growth in both DIY and Pro, we do think we can outpace the market in both instances. Even though we're a half a billion dollar business now, we still have a relatively light market share, still further share to be gained in the Pro. And as we look at our performance on the DIY portion of the business, again because of our alignment with our key channel partner, Home Depot, and the growth rates that they're experiencing and the folks that they draw to their stores, we think we can outpace the DIY market growth as well here in 2020.

Okay, that's helpful. Second question, also following up on another question earlier about the kind of price tariff march and impact. I think you were answering the question, getting in agreement on plumbing and lighting, talking about that piece of margin and the recovery on tariffs. But just to clarify, is that also specifically true for plumbing? And it looks like within plumbing, your second half margins have to be up to get to that flat full year if you're down 100 bps. So is that incremental actions around price, supply chain, raw materials benefiting you, or is that just pure volume leverage to get it to that?

Yeah, Mike, so again you're right. My prior comments were about the enterprise-wide. And specifically with respect to any single segments, if you break down the plumbing segment, you're right, those are the margin expansions that we expect in the second half of the year, required given the margin headwinds in the first half of the year due to the impact of the tariffs. We expect the back half of the year that's largely volume driven. We don't expect any further pricing actions or anything else incremental outside of volume to drive that margin expansion in the back half here.

Your next question comes from the line of Selden Clark with Deutsche Bank.

Hey, thanks for the question. I just continued on the last question. How do we think about volume and price within your revenue guidance for plumbing and decorative? So you think volume on...

I would consider most of the volume — you know, we indicated earlier with the impact of the tariffs flowing through, we kind of laid out our top-line estimates. I expect modest pricing, very low impact at all on pricing because of the pricing we've put through on the tariffs back in 2019, early in 2019 I should say. And so most of that is all — most of the goals that we have outlined for you today, both with the decorative architectural segment as well as the plumbing segment, and therefore the company in total, are volume driven.

Okay. And then just kind of continuing on the 2021, you reiterated the expectation for $2.80 or $3.00 of earnings, but I think you got it to something like a 16.8% underlying margin, which obviously implies another 80 basis points improvement on top of this year. What's the right bridge to think about on how to get there? Is that still going to be volume driven, or are there some cost actions that you can see down the line, or pricing actions that you see down the line a little bit longer term?

Okay, so 16.8% is still kind of the right number to think about roughly? Yeah. Okay, appreciate the time. Thanks.

Your next question comes from the line of Michael Wehunt with JP Morgan.

All right, thanks. Good morning, everyone. The first question I just had, I just wanted to break down the tariff impact. And I guess, John, you said earlier that you estimated about a $60 million impact in 2019, incremental $90 million in 2020. I was just trying to get a sense for the offsetting actions to those headwinds through price, supply chain, etc. Specifically, if you want to throw that in there, if you feel that that was either supply chain or other things that you did specifically to offset. And trying to get a sense of the offsetting actions there to get to a net headwind or such. How do you see that flow through in 2019 and how do you expect the 2020 to shake out when these offsetting actions actually kick in?

In round numbers, Mike, I'd say let's call it 90% of our mitigation actions were through price. That was the biggest lever that we pulled in 2019. That leaves about 10% in terms of the cost of the tariffs mitigated through supply chain resourcing, negotiations with suppliers, and that sort of thing. We'll continue to do that. The majority of our movement out of China is our existing suppliers that have established production in other low-cost countries, and we'll be ramping that up. We'll be moving some, in some limited cases, to some new suppliers, but that's a longer-term play for us and it's going to take a while to do that. So fundamentally, when you think about the mitigation, it was mostly price, and we put that through aggressively and early in 2019. And hence now, with the combination of the timing of the tariffs when they hit and more importantly the flow of inventory through our system into the P&L, that's why we have that overhang and that $90 million headwind heading into 2020. But, Mike, as we exit 2020, we don't think there's going to be a net headwind. We think we've got between the pricing actions and the supply chain actions that Keith mentioned, we think we've got the impact of tariffs fully covered.

Alright, that's helpful. Thank you. Secondly, I just wanted to circle back to Kichler for a moment. You answered a bunch of questions, but I'm just trying to make sure I have some of the numbers right and how to think about the business as it is by the end of this year. John, I think you said that private label and inventory balancing with each team $15 million in the first couple of quarters, going to $5 in the third quarter. Was that right? Maybe just be clear: collectively, the private label and inventory rebalancing will be $15 million in each of Q1 and Q2, so total impact in the year of $35 million from both of those actions. Okay, so I was just trying to get a sense of, as the business has, I assume you had maybe a $15 million hit in Q4, so you're talking somewhere in the range of $50 to $75 depending on how things traversed in 2019 in terms of revenue from the original purchase. You've also talked a lot about the different types of cost actions that you've done to improve the business. I was just trying to get a sense of, with all the moving pieces, how you would characterize the margins today or by the end of 2020 rather, I think more importantly for that business relative to where you purchased it. Are you kind of in line, still a little bit behind, or even ahead given some of the company-specific actions? And how do you think about any potential further improvement in 2021?

Yeah, Mike, so with respect to the margins, we don't break out margin by individual company. You can appreciate the question. You mentioned in his comments a couple minutes ago, we continue to work and successfully work on the supply chain and cost-out initiatives. In Kichler, the volume has been a little bit more of a headwind than we had anticipated when we bought the company. But that's about as much as we can say on that topic.

Your next question comes from the line of John Laval with Bank of America.

Hey guys, I thank you for taking my questions as well. Just sticking with lighting here, and I don't mean to beat a dead horse, but just from a broader industry perspective, I'm curious: there's been a number of headwinds obviously, and you guys have handled them fairly well. The question is, is there any concern that there's something structurally changing in the lighting industry, similar to maybe what we're seeing in cabinets and flooring as it pertains to consumer preference? Right, it is creating a headwind here.

Okay, thanks Keith. And then John, just on the SG&A front, $310 million in the quarter, that was up fairly meaningfully on a dollar basis, also as a percentage of sales. Can you just help us understand maybe some of the key drivers under that, please?

Yeah, sure, John. As you may recall, last fourth quarter was actually one of the lightest quarters we had in SG&A in a long time. So it was more of a low base that we were up against. The one thing that you may recall that we called out in the fourth quarter last year, we did have a $4 million gain on the sale of a building, which did not occur this year, which would be a headwind against that comp. But it was more just extremely tight or low SG&A last year on a one-off basis as opposed to anything else.

Your next question comes from the line of Justin Sphere with Gentlemen and Associates.

Good morning, guys. Appreciate it. I just wanted to unpack some of your margin forecast. You mentioned the 300 basis point headwind in the first quarter being worked out of the decorative architectural segment being more tariff affected. But I'm trying to reconcile that with the fact that you obtained price. So are you just saying that it's volume deleverage or something else? Is there a lag in your pricing relative to the cost rolling through? Help me understand that. And then also on top of that, just any tailwind from lower raw material costs across your business, lower inbound transport cost, or any other factors that are offsets that we need to be aware of?

Yeah, so just a couple questions in there. Let me try to address those. So in terms of the margin degradation from the fourth quarter to Q1, there's a couple things going on there. One is lower volumes. We referenced the fact that we lost a portion of private label business. Also with the pull forward in paint, that $20 million obviously comes out, which should indicate we have lower volumes in Q1. We're anticipating lower volumes in Q1 in the decorative architectural segment, and that would help drive that operating profit margin lower. In terms of raw material costs, and the third thing I should say is on the margin side, it's tariffs because it's cost recovery that will drive your margins lower as well. On the offset side, obviously we always work on cost productivity. In terms of commodity costs specifically, the input costs into paint have moderated here since a year ago. But recall the way things work, particularly with our paint business, is that we intend to be price-cost neutral over time. So that may have an impact on margins over this period. As prices moderate, input costs moderate, there may be some impact on pricing as well. So I think that puts it all together to hit all your questions.

So just try to understand it, because I know there's a lot of unevenness with the paint. Because last year, I guess in the first quarter of 2019, your comps were down 7%. I know some of that was Kichler, but it was because you had pull forward the prior year. So I would have thought that those would have kind of evened out such that you wouldn't have as much of an impact there from the comp side. And obviously you have Kichler business. But I'm just trying to reconcile your comment that it's mostly tariffs that are hitting you. Is it not the tariff cost that you're trying to get price for, and you've lost share as a result of that or losing business, and that's affecting your margin profile on the decorative architectural segment?

You know, if I maybe didn't communicate right, but I think you only — you know, I think the main driver is going to be lost volume. We talked about the lost programs, and so that's going to be the main contributor to the margin degradation, followed by the tariff impact. Of the two, volume is a much greater impact than the tariffs on the margins. And that makes up.

And then lastly for me is just, who are you losing share to in the lighting business? Is there perhaps another player that doesn't source from China that's advantaged post tariffs? Because I was under the impression that everyone was kind of in the same sandbox, so to speak, in terms of supply chain. Is it or is it something else?

Your next question comes from the line of [unclear] with SunTrust.

Yes, thank you. Can you give us in 2019 what was North American plumbing growth? North American plumbing growth was 2% I think for the full year. Was that all volume or was there pricing in there? There was a little bit of pricing in there. Well, yeah, I mean if you consider the tariffs, actually a fair amount of pricing in there. You put in price to offset the tariff impact, especially in Q1 and Q2 of last year. Okay. And so you're not expecting any price coming in 2020 in plumbing? Not much.

There might be a little bit that we put in, but not a ton though. Okay, that's all. Thank you.

Your next question comes from the line of Phil English with Jefferies.

Hey guys, can you give us a sense how we should think about the share buyback as you've layered it in in 2020, and then any update on the M&A pipeline?

In terms of the way we're thinking about it, I think we mentioned we'll probably use a large portion, maybe a good chunk of the proceeds from the chemistry transaction shortly after the proceeds are received. And then through the balance of the year, we look at the balance of the $500 to $600 million that we discussed in our Investor Day, being more opportunistic depending on how the market plays out. In terms of the M&A pipeline, it remains solid. We continue to drive it. Overall, I would say that M&A activity was a little bit slower in 2019 than I expected, with the global trade uncertainty and some of the business valuations being in flux because of that. But it seems to have picked up lately. We like some of the things that we're looking at. Most of them are fairly small. I would say that seller expectations still remain high, so we're going to be patient, but solid pipeline.

Got it. And just one last one for me on the lighting stuff. I mean, obviously there's some tariff headwinds and share loss as we think about 2021. When you work through some of these issues, and you mentioned you expect to return to growth, so we expect margins in that segment, decorative architectural, to get back to that 18% to 19% range?

Phil, you mean our call? We laid out 17% to 18% margins in that segment in our Investor Day in September, and our thought process around that has not changed since September.

Got it. Next one.

Our final question will come from the line of Truman Patterson with Wells Fargo.

Good morning, guys. Thanks for taking my question. The first one to touch on the coronavirus again. Could you dig into that a little bit more? What portion of plumbing products have component pieces sourced from China? And Keith, I believe you mentioned contingency plans as well. I'm just trying to understand what's going on there. It does seem like it's intensifying. Could you discuss your current inventory balances and maybe an update of your supply chain? If plants actually remain shut for another week or two, will that actually impact the product that you can get on shelves?

Okay, okay. Thanks for that. On the R&R side, you know, pretty slow in 2019. It looks like your guidance has R&R picking up a little bit here. Or are you actually seeing activity start to recover early in 2020? And if so, do you think weather has had any impact on that? I'm just trying to understand how sustainable these near-term green shoots are.

Ladies and gentlemen, that will conclude today's conference call. Thank you all for joining, and you may now disconnect.