TTC - NYSE

Good day ladies and gentlemen, and welcome to The Toro Company's Second Quarter Earnings Conference Call. My name is Tanya, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of today's conference. As a reminder, this conference call is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's conference, Julie Kerekes, Treasurer and Senior Managing Director of Global Tax and Investor Relations. Please proceed Ms. Kerekes.

Thank you and good morning everyone. Our earnings release was issued this morning, and a copy can be found in the Investor Information’s section of our corporate website, thetorocompany.com. We have also posted our second quarter earnings presentation to supplement our earnings release and general investor presentation. On our call today are Rick Olson, Chairman and Chief Executive Officer; Angie Drake, Vice President and Chief Financial Officer; and Jeremy Steffan, Director of Investor Relations. We begin with our customary forward-looking statement policy. During this call, we will make forward-looking statements regarding our plans and projections for the future. This includes estimates and assumptions regarding financial and operating results, as well as economic, technological, weather, market acceptance, acquisition-related and other factors that may impact our business and customers. You are all aware of the inherent difficulties, risks and uncertainties in making predictive statements. Our earnings release, as well as our SEC filings, detail some of the important risk factors that may cause our actual results to differ materially from those in our predictions. Please note that we do not have a duty to update our forward-looking statements. In addition, during this call we will reference certain non-GAAP financial measures. Reconciliations of historical non-GAAP financial measures to reported GAAP financial measures can be found in our earnings release and on our website in our investor presentations, as well as in our applicable SEC filings. We believe these measures may be useful in performing meaningful comparisons of past and present operating results and cash flows to understand the performance of our ongoing operations and how management views the business. Non-GAAP financial measures should not be considered superior to or a substitute for the GAAP financial measures presented in our earnings release and this call. With that, I will now turn the call over to Rick.

Thank you, Rick, and good morning everyone. As Rick said, we delivered strong performance in the second quarter achieving record net sales and diluted EPS amid a backdrop of unfavorable weather patterns and very dynamic operating environment. This performance highlights the benefits of our attractive and broad portfolio with the large majority of our solutions geared to professional end markets. We grew overall consolidated net sales for the quarter to $1.34 billion an increase of 7.2% compared to last year. Reported EPS was $1.59 per diluted share, up 28.2% from $1.24. Adjusted EPS was $1.58 per diluted share, up 26.4% from $1.25. Professional segment net sales for the second quarter were $1.07 billion, up 15.4% year-over-year. This increase was primarily driven by higher shipments of products broadly across the segment with notable strengths for construction and golf and grounds products and net price realization. Professional segment earnings for the second quarter were up 37.6% to $227.5 million. When expressed as a percentage of net sales, earnings for the segment were 21.3%, up from 17.9%. The year-over-year increase was primarily due to net price realization, favorable product mix, productivity improvements, and net sales leverage. This was partially offset by higher material and manufacturing costs. Residential segment net sales for the second quarter were $265.8 million, down 16.8% compared to last year. The decrease was primarily driven by lower shipments of products broadly across the segment, partially offset by net price realizations. Residential segment earnings for the quarter were down 38.7% to $22.7 million. When expressed as a percentage of net sales earnings for the segment were 8.6%, down from 11.6%. The year-over-year decrease was primarily driven by lower sales volumes, higher marketing expense, and higher manufacturing costs. This was partially offset by net price realization and lower freight costs. Turning to our operating results, our reported and adjusted gross margins were both 35.8% for the quarter, up from 32.4% and 32.5% respectively. The year-over-year improvement was primarily due to net price realization, favorable product mix and productivity improvements partially offset by higher material and manufacturing costs. SG&A expense as a percentage of net sales for the quarter was 19.5% compared to 18.8% in the same period last year. This increase was primarily driven by higher marketing expense, partially offset by net sales leverage. Operating earnings as a percentage of net sales for the second quarter were 16.3% on both a reported and adjusted basis. This compares to 13.7% and 13.8% respectively in the same period last year. Interest expense for the quarter was $14.7 million, up $6.7 million from the same period last year. This increase was primarily due to higher average interest rates. The reported and adjusted effective tax rates for the second quarter were 20.6% and 21.1% respectively compared to 20.6% and 20.8%. Turning to our balance sheet as of the end of the second quarter, accounts receivable were $462 million, up 5% from a year ago, primarily driven by higher international net sales and partially offset by lower Residential segment net sales. Inventory was $1.1 billion, up 26% compared to last year. This increase was primarily due to higher finished goods, work in process and service parts, largely driven by inflation and component supply constraints, so essentially from the end of the first quarter of fiscal 2023, inventory was relatively flat, but our composition improved with work in process slightly lower. Accounts payable were $515 million, down 9% compared to a year ago, primarily driven by a reduction in inventory purchases. Year-to-date free cash flow was a $1.3 million use of cash. This was primarily driven by seasonal working capital needs, including higher work in process and service parts levels as we continued to navigate current supply chain dynamics and better serve our customers. It also reflects the timing of capital expenditures with $63 million spend year-to-date compared to $36 million in the same period last year. We've remained well within our one to two times target gross debt-to-EBITDA leverage ratio and are committed to maintaining our investment grade credit rate. This supports our strong balance sheet, which in turn provides the financial flexibility to fund investments that drive long-term sustainable growth. Our disciplined approach to capital allocation remains unchanged with priorities that include making strategic investments in our business, both organically and through acquisitions, returning cash to shareholders through dividends and share repurchases and maintaining our leverage goals. These priorities are highlighted by our recent actions, including our plan to deploy $150 million in capital expenditures this year to fund new product investments, advanced manufacturing technologies and capacity for growth. Our dividend payout increase of 13% over last year and our return of nearly $25 million to shareholders year-to-date through share repurchases. As we look ahead to the second half of the fiscal year, we expect continued strong demand for our innovative products in key professional segment markets. We are also encouraged by the incremental supply chain improvements that we expect will continue to enable increased production for our construction and golfing grounds products. At the same time, we will continue to closely monitor macro-economic dynamics and we'll be prepared to remain agile through a range of possible outcomes in the near-term. With this backdrop and based on our current visibility, we are narrowing our full year fiscal 2023 net sales and adjusted diluted earnings per share guidance ranges. For fiscal 2023, we now expect net sales growth in the range of 7% to 8% compared to 7% to 10% previously. This reflects expectations for a continuation of improved production rates for construction and golf and grounds products. This also includes anticipated volume reductions for our Residential segment as well as for professional products sold to homeowners due to unfavorable weather patterns experienced year-to-date and macroeconomic trends. This also assumes more normal weather patterns in the second half of the year. We continue to expect Professional segment net sales to grow at a rate higher than the total company average for the full year. For the Residential segment we now expect fiscal 2023 net sales to be down mid-teens as a percentage compared to fiscal 2022. We continue to anticipate a more typical quarterly sales cadence with Q2 and Q3 being our larger quarters. Looking at profitability, we continue to expect gross margin improvement in fiscal 2023 compared to fiscal 2022. With the revision to our net sales guidance, we now expect our gross margin in the second half of the year to be lower than the first half of the year. This is primarily driven by anticipated manufacturing inefficiencies as we adjust production volumes to demand for products geared to homeowners and work to improve our inventory position as we close out the year. We expect these manufacturing inefficiencies to be partially offset by productivity gains and net price realization. In addition, for the full year, we continue to expect improvement in total company and Professional segment adjusted operating earnings as a percentage of net sales compared to last year. We now expect a lower earnings margin for the Residential segment for the full year as compared to last year. This is a reflection of the expected reduction in volume. For our other activities categories, we expect the third quarter and the fourth quarter of fiscal 2023 to be similar to the average quarterly run rate of the first half of the year. In line with our revised net sales expectations, we are narrowing our full year adjusted EPS guidance range to $4.70 to $4.80 per diluted share from the previous range of $4.70 to $4.90. This adjusted diluted EPS estimate excludes the benefit of the excess tax deduction for share-based compensation. Additionally, for the full year, we now expect depreciation and amortization of about $125 million to $130 million, interest expense of about $57 million and free cash flow conversions of approximately 90% to 100% of reported net earnings. We continue to expect an adjusted effective tax rate of about 21%. Turning to the third quarter of fiscal 2023, we expect total company net sales to grow at a rate slightly below the low end of our full year guidance range. For the Professional segment, we expect a net sales growth rate similar to the second quarter growth rate for that segment. For the Residential segment, we expect a meaningful reduction in the third quarter net sales year-over-year given the dynamics we mentioned. From a profitability perspective for the third quarter, we expect gross margins and adjusted operating earnings margins on a total company basis to be similar to the same period last year. For the Professional segment, we expect the third quarter earnings margin to be similar to slightly higher than the same period last year. For the Residential segment, we expect the third quarter earnings margin to be lower than the same period last year, driven by expected lower volume and associated manufacturing inefficiencies as we adjust production to demand. We expect our third quarter adjusted diluted earnings per share to be slightly higher than they were for the same period last year. We believe we will continue to realize the benefits of a diversified portfolio of products that address attractive end markets bolstered by our extensive distribution and support network. Even with the current and expected future macro and weather dynamics, we expect to deliver 12% to 14% growth year-over-year in our full year adjusted diluted EPS, a testament to these benefits and our engaged team. We are building our business for long-term profitable growth and remain confident in our ability to drive the same value for all stakeholders. With that, I'll turn the call back to Rick.

Thank you, Angie. As we enter the second half of the fiscal year, we are encouraged by the expected continuation of strong demand across key professional segment markets, in an improving supply chain situation, and the arrival of seasonably warmer weather. We believe we are well positioned in each of the attractive end markets we serve with our innovative product lineup supported by the best team of employees and channel partners. I would like to share some additional color on order backlog as this has been a topic of interest. Traditionally, order backlog has not been a meaningful metric for our company, given typically shorter lead times for our products. As previously reported, our order backlog was $2.3 billion at the end of fiscal 2022. For historical perspective, our order backlog at the end of fiscal 2020 was $370 million. While some of the increase can be attributed to the growth of our business and overall inflation and seasonal variation can also be a factor, the current balance remains significantly elevated over what we would consider normal. The majority of our backlog continues to be for construction and golf and grounds products in our Professional segment. This is a result of the robust demand we've experienced for these products, coupled with a high level of supply chain disruption that has contributed to extended order fulfillment and influenced customer order patterns. Importantly, we achieved volume growth across these categories during the second quarter with disciplined execution supported by an improving supply chain. At the same time, we continue to experience significant demand for these products. With this pace of new orders, our open order book at the end of the second quarter increased slightly compared to the end of the first quarter, remains higher than the balance at the end of fiscal 2022. Given this dynamic, we expect backlog to remain elevated throughout and beyond this fiscal year. Our team remains focused on optimizing output and reducing lead times to support our customers and return backlogs to a more normal level as soon as possible. Turning to the broader economy, we continue to keep an eye on monetary policy actions, the geopolitical environment and inflation. We're also monitoring overall business and consumer confidence and spending patterns. In addition, we're watching developments in the banking sector including any tightening of credit conditions. As part of our normal business practice, we leverage our scale and banking relationships to offer access to attractive financing options for our channel and end customers. We expect this funding will continue to operate smoothly and believe the credit quality of our customers remain strong. We're keeping in close contact with our banking partners as we continue to monitor developments. I'll now comment on the macro factors we are seeing in our end markets, which could impact future results, starting with our Professional segment. For underground and specialty construction, we expect robust demand to continue supported by multi-year public and private infrastructure investments. These investments include broadband and alternative power buildouts, as well as solutions to address the aging infrastructure. We believe we are in a strong position to capitalize on this demand, with the most comprehensive product lineup in the industry. For golf, we expect a continuing strength in rounds played and overall interest in the game to support healthy course budgets and drive strong demand. We remain extremely well positioned in this attractive market as the only company to offer both equipment and irrigation solutions, and as the longstanding market leader in both. For municipalities and grounds, we anticipate continuing prioritization of green spaces and interest in zero exhaust emission products supported by healthy budgets. Our deep relationships and growing suite of no compromise of sustainable solutions position us well to serve this market. For snow and ice management we expect a more subdued pre-season selling-in as lack of late season snowfall has left channel inventories at higher levels relative to last year. Having said that, our strong presence in the Midwest where snowfalls were better is expected to provide some offset.

Moving to the Residential segment, we are watching weather patterns along with consumer confidence and spending preferences. We're also watching how the current environment affects channel inventory levels. While the accelerated demand of the pandemic has normalized, we expect this segment to continue to benefit from regular replacement cycles driven by the non-discretionary nature of our products. Importantly, we also expect the benefits from our refresh product lineup, expanded channel and strong brands remain a competitive advantage for the long-term. While we anticipate and plan for a range of macroeconomic outcomes in the near-term, we believe our organization is well equipped to deliver positive results in this environment. We have a long track record of managing through economic cycles and weather patterns with agility and resiliency and expect continued benefits from our growing scale and broad portfolio. Our record performance here today demonstrates these benefits and our adaptability. We offer inbuilt solutions that perform necessary work with regular replacement cycles in attractive end markets. These factors, along with our talented team and best-in-class distribution and service networks, give us confidence in our ability to grow our market leadership over the long-term. We believe we remain well positioned to drive value for all stakeholders in both the near and long-term guided by our enterprise strategic priorities of accelerating profitable growth, driving productivity and operational excellence and empowering people. On that note, I would like to thank our employees and channel partners for going above and beyond every day to support our customers and deliver great results. You are the key to The Toro Company's success. I would also like to extend my gratitude to our customers and shareholders for your continued support. With that, we will open up the call for questions.

Good morning, Rick. Good morning, Angie. How are you?

Good morning, Sam. Good. Well, how are you?

I'm well. Thank you for asking. A couple, two, three quick questions if I could. First off the sequential commentary around backlog obviously is very encouraging. Could you talk about what you're seeing with respect to cancellation rates, both in absolute terms as well as relative to 1Q and year end if you could, Rick?

Yes, good question. I did have a chance in factious within the last 24 hours to circle back through and check on cancellation rates. We're seeing an extremely low level of cancellation rates. That's really not been a factor and really, I mean, the great news is we are seeing additional output from our factories, and perhaps maybe the better news is the demand is coming in even more strongly, so we're, we're exceeding in some respects our output from our factories. But the demand coming from the professional businesses, underground, specialty construction, golf and grounds has been outstanding. So it's done more than we expected,

So even though it's an a absolute terms extremely low no take higher in cancellation rates sequentially from last quarter?

No, no.

Okay, terrific. And then my other question as it relates to the residential business, I think if my math holds at least, your guidance now suggests maybe, I don't know, about $150 million or so in lower sales residential than you had previously contemplated, but your guidance at least at the midpoint is only down about a nickel which is much less than the normal residential decrimental margin might suggest. So is the offset better than expected Pro volumes and margins, or is the offset where the lower residential sales that you're expecting are coming at lower ticket or lower margin type of products?

The offset is the strength of the Pro business with those higher margins that you that you refer to and the ability to get more product produced to fulfill the demand. So it's really, that's really the offset for the lower numbers that we're projecting for residential.

If I could sneak one more in, I apologize, it's quick. Talk about your resi, talk about your residential market share, Rick. I'm -- obviously, virtually everybody is seeing the same sorts of trends, but the sell-through trends and product placement trends at retail. Can you talk about what -- to the extent you have visibility, what you're seeing versus peers?

We feel very positive about our market share position. It's really reflecting the work that we've done over the last number of years to have a very strong portfolio to have a very relevant technology portfolio. We've seen the strength across our channels, so in addition to the mass partners that are very important to us, we've also seen the strength in our dealer network. In fact, exceptional strength in the first quarter -- or excuse me, second quarter, first half of the year with our dealer business, it's done very well.

Thank you, thank you both.

Thank you.

And one moment for our next question. Our next question will come from Tim Wojs of Baird. Your line is open Tim.

Hey good morning everybody.

Good morning Tim.

Maybe just to start, Rick, could you maybe just give us a little bit of color or context in terms of just how much improved the production rates are in construction and kind of golf and grounds and what's really driving that? Is that just some of the supply chain kind of easing in some of the bottleneck areas? Is it just better productivity? I mean can you just maybe add a little bit of context of kind of where it is today versus where it was six months ago and kind of what you're expecting for the back half?

I think it's actually one of the big stories for us in this quarter is the amount of growth that's coming from actual unit volume. I know with inflation and so forth over the last number of years, there's been a lot of price that's gone into the revenue line. In this case, it's significantly driven by volume that reflects the success within our production facilities. Our own production facilities had gotten better some time ago, but it's really been the supply chain, the suppliers specifically. And we've mentioned over the last couple of quarters, it's narrowed down to some key categories, that's still true. So the availability of those components is still pacing our production output at this point, but it's getting steadily better and volume was the driver of our revenue growth this quarter, which is pretty significant relative to the last number of quarters.

Okay. And do you expect incremental improvements in the back half of the year or are you kind of expecting that the back half looks more like the second quarter?

I mean, all of our -- we look at all the factors up and down and all that's included within our guidance, but we do expect steady improvement in our operations as our suppliers are getting healthier.

Okay. Okay. Good. And then maybe just on the Pro landscape business, just kind of, I guess, two questions there. How would you kind of characterize the field inventory levels within the kind of Pro part of that business, I guess, is the first question. And then I guess the second question, just when you think about the overall kind of Pro landscape business, how much of that would you assign to the homeowner versus the actual professional?

Yes. If you -- first of all, on the inventory question, we for the last number of years have struggled with enough inventory in the field. That's a category where we have now at least normal, in some cases, higher inventory than is probably optimum in the field for the landscape contractor business. Keep in mind this is across three brands, the Toro brands, Exmark and Spartan. And the homeowner is -- I don't have a specific number for you, but the homeowner is an appreciable portion of that business. And this would be a homeowner that has a large acreage or the land to justify a more professional product and so that's kind of the situation there. So homeowners is an element of that. They would be the less demand coming from homeowners. The Pro demand continues to be very strong for LTE landscape contractors and the professional products. So -- and that would correlate to the field inventory as well, which is higher field inventories, so lower end of that range, lower inventory of the more professional grade.

Okay. That's helpful. And then maybe just a last question. Is there -- within the Residential business, is there any way to kind of think about how much the -- your 60V products now are as a percentage of that overall business?

We -- I don't have a specific number of the 60V reflects. But if you just think about if the Residential business is 20% to 25% of our overall business, that's one of the smaller categories overall.

Okay. Okay. Good. I appreciate the color and the time. Good luck at the back half of the year, guys. Thanks.

Okay, thank you. I appreciate the questions.

One moment for our next question. And our next question will come from David MacGregor of Longbow Research. Your line is open.

Yes. Good morning everyone. Congratulations on getting the golf and the special construction velocity, but I think that's a good sign. Yes. I mean that's got to be a weight off your mind. I wanted to just maybe pick up on Tim's question on landscape contractor. Can you just talk about what you're seeing in terms of retail demand patterns? I mean it looks like you've set a back-to-back sales events and landscape contractor to extend now through July 31 or pretty late into the season, which just suggests the majority of that business in this category this year is going to be incentivized. Is the demand elasticity increasing in that category? And if so, do you make any adjustments for that in your revisions you made to guidance?

We -- as a normal process of creating our guidance, we would build in our best thinking with regard to any programs, et cetera, and programs have come back into the picture. They haven't been much of a factor for the last number of years. But especially, as you can imagine until later spring, we're really counting on more of that normal retail to shift into the later part of the year. So that's probably what you're seeing, if you're looking at some -- looking at some programs. I would just -- there was an earlier question about field inventory, I would just say, in general, for all professional products, field inventory is very low at this point, much lower than we'd like to see certainly, for the half of the LTE that we were talking about is the true professional products. Some of the entry-level portions of that are a little different story that are more commonly purchased by homeowners that prefer professional products.

Okay. And you talked in your prepared remarks about increased marketing expense. Is this really where you're seeing it is just trying to support the residential and the landscape contractor business, some of these more consumer-facing businesses?

Yes. We've seen those marketing expenses normalize, but we have had kind of a targeted marketing campaign in our residential group, which is really for kind of the long-term benefits of our premium brand and that was planful. But yes, we are beginning to see some of those more normal targeted promotions too for the sales side of things.

Okay. And I want to ask about inventories. Your April 30 inventory levels remained pretty much in line with the previous quarter. I noticed in your guidance, you're sort of thinking 90% to 100% conversion now. I guess from a timing standpoint, how are you thinking about sort of the timing? And maybe we're talking about extending into 2024, but how are you thinking about the timing of liquidation of the excesses getting back down to more sort of typical turns.

Yes. I'll first start with probably saying that our inventory is really not where we want it to be. We have a very sharp focus on that this year to really reduce the amount of inventory that we have. We did see some improvement in our composition over the quarter where our WIP actually went down a bit. The majority of our inventory now is sitting in finished goods. And as we think about the cash flow, we do expect to see stronger cash flow based on all of our working capital factors in the second half.

Okay terrific, thanks very much.

Thank you.

One moment for our next question. And our next question will come from Tom Hayes of CL King. Your line is open.

Thank you, and good morning and I appreciate you taking my questions. First on the golf segment, Rick, just wondering, are you seeing any difference in the demand across the spectrum, of course, is it whether municipal semiprivate private?

Yes. First of all, welcome back. Good to hear from you again. And the golf as you can imagine, just from looking at the end demand, the interest in what's happening with professional golf situation right now, the demand for golf continues to be very strong, and we see that across the spectrum of types of golf courses. When you get into the municipal courses, municipal budgets for parks and those outdoor parts of their budgets have been prioritized and are in very healthy conditions. So even when you get to a municipal and small private level, they're still seeing very strong demand for golfers and that just feeds the funding available to upgrade equipment and do the replacements that they would normally do. So we're not seeing a difference really top to bottom. They buy different suites of equipment. But other than that, the demand is strong across the spectrum.

Okay. May be just shifting gears a little bit to the rental equipment market. I know some of the public companies in the space have talked about the continued strong demand and I was just wondering how you guys are seeing it?

We see the same. In fact, we are just having a conversation. I asked the leader of our area responsible for rental to go back and look at the numbers again, he came back and confirmed really the strength of all of our industry sources, which says rental continues, and we're seeing that strength ourselves in the near-term and it's reflected in the orders that are out there for the future as well. So a lot of drivers of the rental business, but they are very positive about the future.

Okay, I appreciate it. Thank you very much for the time.

Thank you, Tom.

One moment for our next question. Our next question is coming from Eric Bosshard of Cleveland Research Company. Your line is open.

Thanks. Two things, if I could. First of all, in Residential, I'd just love some clarity on what's different now versus 90 days ago? What again, just to summarize what played out differently than expected?

Yes, the -- if you think about when we had our last earnings call, I think we were -- we said Residential would be down a little bit from the year relative to what we were -- what we had talked about previously. At that time, we tracked things like the green out in North America and other key markets and it was actually ahead of pace for the spring to arrive early. And shortly after that call, that shifted in the opposite direction. So the biggest factor and the one that can trump other factors, including the economy, et cetera, is weather and seasonal timing. So that's what shifted shortly after our last call. We try to reflect our best commentary about where we think things are going. And then the maybe second factor that we think is -- are the keys for the residential businesses, consumer confidence and the economy, the banking situation that happened shortly thereafter. So the two biggest factors we think are driving mower demand within residential. Weather and the economy happened shortly after we had our last commentary. And a positive news is Pro is better than we expected at that time. So that's a substantial offset to what we're seeing on the Residential business and that accounts for 75% to 80% of our business that is looking very, very strong.

Okay. And then within the timing, the there's a lot of discussion about an extended season. Is it not something -- this is not a business that can be made up? Is there a different appetite from retailers to bring in inventory? Just curious in terms of that point.

The dynamics -- dynamics are what you would expect if you're in the place of a dealer. We always work, and I think it was previously mentioned, there are promotions out there to drive sales during the more middle portion of the season. The early portion of the spring is where the natural demand and interest is usually there. So if that gets muted it ships out. People still need to replace their equipment, but they're not -- there's not the same sort of momentum about doing that. That's where we come in with promotions and so forth. But -- so that's kind of the psychology of the end retail customers. From a dealer standpoint, they're just being logical about managing their inventory. If they didn't sell as many in the spring, they're going to be more hesitant about medium reorders when they do get some retail in the mid-summer. And all of these are factored into our guidance that we go through all of those plus [indiscernible]. We love to say we can make up for what happened in the spring, but we know realistically that there's lost opportunity in the spring that we can't completely make up.

Okay. And then the second -- and I assume this is an apples and oranges question, but the backlog increased and the finished goods inventory increased and again, you made a comment that the desire to work down the finished good inventory. Feels like finished good inventory solves backlog, except if we're back to the apples and oranges concept. Can you just help expand a little bit on the logic that I'm presenting here?

Yes. You've got the logic figured out of the increase in our finished goods inventory that we -- that Angie talked about is on the Residential side and the backlog is the Professional side.

Perfect.

Thank you.

One moment for our next question. And our next question will come from Edward Jackson of Northland Securities. Your line is open.

Good morning, thanks for taking my questions. I'm just going to ask really quick ones. First, just to kind of beat the inventory horse. If I listened to all the commentary from all the questions that have been asked so far, is it fair to assume is that we look into the back half of 2023 and going into 2024 that we should see kind of turns or days improve and at an absolute level, the inventory number go down and free up some of your inventory and drive some free cash flow?

Yes. Our expectation is that we will continue to see inventory improve and that those terms will increase. As we -- today, we still have -- as we just heard on the question before that our finished goods inventory is largely in the residential area, but that's where the improved -- the increase came from. We still have a big need in our Professional segment to move finished goods inventory into our channels to field inventory, so an opportunity to move that WIP into finished goods. We did make good progress in WIP and we expect to really enter F 2024 in a better position and overall, that's how it looks.

Okay. No, I mean, I care a lot about free cash flow, so it's a pretty important question. Secondly, on the gross margin, I mean you've really seen some improvement within margins and obviously, the revenue mix is helpful. But the price realization clearly is having an impact as well. When we think through this year and kind of positioning out into 2024, do we -- are those trends to continue? I mean, is there a likelihood that we will see your margins come back to, for lack of a better term, more historic, maybe like in the 34 -- more between 34% and 35% just because you're catching up with regards to inflation, and you see what I'm saying and then perhaps maybe the mix between Professional and Residential?

We haven't guided for F '24 yet, but if we look back at our F '23 guidance, we do expect gross margin improvement, although initially, we talked about our second half going to be -- our first half is going to be higher than our second half. Now we're looking at -- sorry, opposite way. Now looking at our first half being higher than our second half really due to the manufacturing adjustments that we'll see based on reduced volume. But our gross margin for Q3 will be similar year-over-year to what we saw in Q2. And we continue to see really overall productivity improvements throughout our plants as we continue to see those modest supply chain improvements and are continuing to improve our output.

So without putting words in your mouth, but putting words in your mouth, just sort of generically as we kind of roll through the things, improving supply chain, catching up with regards to cost inflation, et cetera, et cetera, that it's fair to assume not like on a quarter-by-quarter basis, but just generally speaking, just a better margin environment for Toro as we kind of roll through the next year or two.

We do expect F '23 margin improvement, and we'll continue to focus on long-term margin improvement as we go forward.

Okay. And now a real deep in the weeds question for you. In the cash flow statement on your distribution and contributions to the finance affiliate, you've been -- it's been a use of cash to the tune of about $2.5 million per quarter. And can you just provide some kind of color on how we should think about that line item in your cash flow statement as we go forward? I mean, it's just something I really need a little guidance for and is important as it relates to cash flow.

Yes, Ted, this is Julie. That relates to our Red Iron joint venture, and that will just kind of move up and down as our balances with them move up and down throughout the year. So we can discuss that further when we talk. I think we're talking several but yes, yes.

Okay, well thank you for taking my questions.

Thank you.

Yes, thanks.

One moment for our next question. And our next question seems to be a follow-up from David MacGregor of Longbow Capital Research. Your lines is open.

Yes, thanks for taking the follow-up. Rick, just sort of backing away from the quarter and looking at some longer-term drivers here, could you just give us an update on where you are with the autonomous offering in Residential? And I guess two things, what are the opportunities here to expand distribution and put the product in front of more consumers? And secondly, I guess based on kind of the early feedback you're getting, what are the consumers focusing on with your product as the sources of competitive differentiation?

Sure. I think one thing I would just say is, keeping the Residential offering in the context of the other products that we've already talked about and those that are in process, we really see a suite of robotic solutions going forward, of which that particular platform and configuration would be one of them, but we've also shown what we're doing on the golf side, we've shown through our industry trade shows, what we're doing on the landscape contractor side. And as these needs converge, they will -- they may have a combination of solutions. The specific residential solution that you're talking about, we have operating in limited volume out in the field right now, and we'll be expanding that availability of that product through this year and into the first part of next year as well. So what they see really as the differentiated piece that's desirable is ability to operate in all conditions with less impact from things like tree canopies and access to GPS. So it uses fairly advanced optical systems to be able to create an understanding of its environment, and we think that, that will -- although it's a very challenging technical issue we believe that provides a lot of value to our customers, ultimately and better satisfaction rate.

Interesting. And I guess, battery and hybrid products overall, you're targeting 20% of motorized product sales by 2025. Where is that percentage today?

I think the exact percentage is somewhere a little bit north of 6% at this point. We did publish and have been public about our goal to be 20% by 2025. And we have -- as you've seen, we have been on a steady path releasing electrical battery solutions across all of our markets. We are challenged to keep up with the demand for golf, fully battery zero emission products in golf. Including green mowers, walk and rides, the utility vehicles with -- and people movers, with lithium-ion solutions on the -- we just introduced the revolution and the landscape contractor side, Exmark will be coming with a similar products. We've had our residential products, the 60V Flex-Force platform, just a steady introduction of those products, even in the construction side, the eDingo, the Ultra mud buggy that's electric battery have opened up new opportunities for us to operate indoors. So we are extremely excited about the progress with electric and battery -- electric battery products. One element to getting to that percentage is the consumer or the end customer uptake and their acceptance of electric as a solution. We will continue to offer both electric and battery solutions and in some categories, when you get into a more economically challenged time, it's a bigger upfront purchase. So we know that there are factors going into the decision. We are absolutely committed to our path to our goal, and we are doing our part to make sure we've got the solutions in place to be able to achieve that.

Right, right, thank you for that. Last question from me is just on the acquisition pipeline. You've done fairly significant transactions in 2019, 2020, 2021, 2022, nothing so far in 2023. I know that window kind of opens and closes over time based on a number of factors. Just wondering how you're thinking about the acquisition opportunity right now within the bigger capital allocation thought process and what the pipeline looks like right now in terms of the next maybe three to four quarters?

We are -- we've talked about it a number of times, we're very disciplined about our capital allocation process, and those priorities remain the same. Acquisition opportunities and M&A are part of those priorities and the process never ends. So even after a significant acquisition we are talking the next day to the -- to another set of people that might be of interest. I would say there's no significant difference in the amount of opportunities that might be out there. And that process continues. And again, the most important thing for us is not the opportunities. It's the discipline to make sure we have acquisitions that we don't regret in the future. We don't regret the acquisitions that we've made. We are delighted with what we've done in the last few years.

Thanks very much, and good luck.

Okay. Thank you.

Thank you.

This concludes the Q&A session. Ms. Kerekes, please proceed with the closing remarks.

Thank you, Tanya, and thank you all for your questions and interest in The Toro Company. We look forward to talking with everyone again in September to discuss our fiscal 2023 third quarter results.