Good afternoon. My name is Donna, and I will be your conference operator today. At this time, I would like to welcome everyone to the Fortune Brands Third Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be question-and-answer session. [Operator Instructions].

I will now turn the conference over to Mr. Dave Barry, Senior Vice President of Finance and Investor Relations. Thank you, sir. Please go ahead..

Good afternoon, everyone, and welcome to the Fortune Brands Home & Security third quarter 2022 earnings call and webcast. Hopefully, everyone has had a chance to review the earnings release issued earlier. The earnings release and audio replay of the webcast of this call can be found in the Investors section of our fbhs.com website.

I want to remind everyone that the forward-looking statements we make on the call today either 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 required by law.

Any references to operating income or margin, earnings per share or cash flow on today's call will focus on our results on a before-charges-and-gains basis unless otherwise specified.

Joining me on the call today are Nick Fink, our Chief Executive Officer; Pat Hallinan, our Chief Financial Officer; and Dave Banyard, President of our Cabinets business. Following our prepared remarks, we have allowed time to address some questions. I will now turn the call over to Nick..

Thank you, Dave, and thank you to everyone for joining us on the call today. Our teams delivered a very strong third quarter with 20% EPS growth and improved margins across all segments in a shifting demand landscape. During the quarter, we saw a softening in U.S.

single-family new construction and R&R as the Federal Reserve's continued action on interest rates started to have its intended effect on housing demand. We remain strong believers in the medium to long-term market opportunity, underpinned by attractive demographics and a significant shortage of U.S. housing.

Our third quarter results demonstrate both the strength of our portfolio and the team's ability to deliver results regardless of the environment. Despite these increasing challenges, we once again made operating margin progress in each segment versus last year.

We expect second half margin expansion versus the first half of the year inclusive of our digital investment. Our strong performance demonstrates our ability to outgrow the market, increase margins, and make focused strategic investments in the challenging macro environment.

We are expecting a soft start to 2023 and are focused on driving out performance, while executing a tight set of strategic priorities. We remain strongly positioned and are well ahead of schedule in executing our planned separation into two world-class companies. Our teams are working hard towards finalizing the separation before the end of this year.

I've invited Dave Banyard, who will continue to lead the Cabinets business following the separation, to join the call today. Dave will provide an update on the progress of the separation and give his perspective on his team's transformational work as well as the exciting potential for the Cabinets business as a stand-alone company.

Dave, thanks for joining the call today. Turning to our third quarter performance. Our teams delivered impressive results in a shifting macro environment, including 20% EPS growth versus the prior year.

Sales grew 3%, reflecting strong price realization offset by the continued normalization of channel inventory, coupled with comping against an exceptional third quarter of 2021.

As the unprecedented supply chain and demand environment of the COVID years begins to dissipate on a trailing basis, our three-year organic sales and operating income CAGRs up 10% and 17% respectively, are proof points of the sustainable long-term value created over this period.

Importantly, our consolidated operating margin was up 150 basis points over last year, with each segment making year-over-year operating margin improvement. Price and continuous improvement outpaced inflation in the quarter, and we continue to invest in key strategic priorities, such as our digital transformation.

Our digital initiatives are already yielding tangible results including increased e-commerce sales, improved app ratings and accelerated procurement savings. Our results are a further testament to the strength of our brands, the hard work of our teams driving transformation and the power of our Fortune Brands Advantage capabilities.

While our third quarter results were impressive, we are facing increasing headwinds from shifting consumer behavior in response to housing affordability and macroeconomic uncertainty. The Fed's tightening monetary policy is having the intended impact on capital goods, including housing.

Rising interest rates are impacting single-family new construction permits and starts activity, and our wholesale and retail channel partners are destocking inventory as customer traffic slows and lead times normalize. The pace of impact is accelerating, and we are revising our full-year guidance to reflect the current environment.

We have managed through similar headwinds before and are taking thoughtful yet decisive action to protect our business are prioritizing investment in a tighter set of key strategic priorities to win for the long-term.

Pat will provide more detail later in the call on how we intend to manage the P&L and balance sheet through the anticipated period of softness, while protecting our long-term growth and market leadership positions. We constantly challenge ourselves to do better regardless of the macro environment.

We recently announced a redesign of the new Fortune Brands organization, which will better position us to realize the many opportunities to drive growth and margin progression at an accelerated pace.

At the center of this exciting evolution, we are transitioning from a decentralized structure with separate businesses to a more aligned operating model that prioritizes activities that are core to brand, innovation, and channel under Cheri Phyfer.

Additionally, we have aligned all of our global supply chain resources under Ron Wilson as our Chief Supply Chain Officer, to fully leverage the scale and execution excellence of our total business. This new operational focus structure will better align the company's resources with our growth and productivity priorities following the separation.

This organizational redesign increases our ability to leverage best practices across the whole organization. We will be able to further leverage the Fortune Brands Advantage to drive increased productivity and capture additional growth at higher margins.

We look forward to unveiling more of this advantage strategy at our highly anticipated Investor Day expected to take place on December 6 at the New York Stock Exchange. We hope that you can all join us. As is well documented, there's a fundamental long-term need for housing in the U.S.

as a deficit of millions of homes exist and the current age of homes today remain at or near multi-decade highs. We believe the importance of the home remains as strong as ever as consumers continue to invest in priority areas of the home, including the kitchen, bathroom, and the outdoors.

Our portfolio is targeted at the heart of the market and is exceptionally well positioned to navigate the challenges ahead and capitalize on consumers' continued desire to upgrade their homes. Our brand power, innovation and best-in-class service provides a unique value proposition that greatly resonates with the consumer and our channel partners.

These attractive attributes, coupled with market leadership positions and advantaged channel exposure will provide stability and opportunity as we proactively manage the business through the near-term macro environment. Now I will turn to each of our segments to provide some color on what we are seeing.

Beginning with Water Innovations, sales were down 14% in the quarter as channel inventory reductions and a soft China market more than offset mid single-digit POS growth in the U.S.

Upgraded Moen and House of ROHL showroom displays are driving double-digit POS lift and our investments in brand and innovation continue to resonate with consumers and customers. In our core U.S. market, channel destocking accelerated ahead of our expectations during the quarter and is continuing into the fourth quarter.

In addition to continued destocking at our major customers, down channel inventory held their production plumbers, builders and smaller wholesalers grew as lead times extended.

As our service levels recovered and construction and consumer activity slowed, this additional inventory has started to work its way out of the channels at an accelerated pace. In China, economic and pandemic headwinds continue with new construction activity done almost 40% year-to-date.

Our team is doing an outstanding job rightsizing our cost structure relative to the demand environment in China, and we remain positive on the opportunities for further innovation and long-term growth in this market.

It is important to note that while the Water Innovations top-line has been impacted by inventory destocking in China over the last two quarters, U.S. POS has maintained mid single-digit growth throughout the period.

Additionally, the segment has delivered a three-year organic sales CAGR in the high single-digits, while expanding year-to-date operating margins by nearly 300 basis points over 2019. We expect the destocking dynamic to normalize in early 2023, and our sell-in should approximately equal our sellout.

Notwithstanding the top-line challenges, our water innovations team took action in the quarter to preserve operating margin and delivered 10% decremental margins, resulting in third quarter operating margins of nearly 25%.

We continue to prioritize strategic investments, including the purchase of Aqualisa and its leading smart water in valve technology. The business remains well positioned to outperform over the long-term through strong brands, innovation and industry-leading service. Turning to Outdoors & Security business.

Sales grew 6% driven by our POWERHOUSE Therma-Tru brand, which grew at strong double-digits. As one of the most recognized builder brands in housing, Therma-Tru continues to convert homeowners to advanced material fiberglass door systems from traditional wood and steel alternatives.

LARSON sales grew mid-single digits as we continue to capture synergies as we integrate LARSON offerings with the rest of our outdoor portfolio. Security sales were down mid-single digits, driven by retail inventory reductions, partially offset by commercial sales growth.

Decking sales were down low double-digits as destocking continues in the wholesale channel, while retail POS remained positive during the quarter. We continue to believe the value proposition of material conversion will drive long-term secular growth in composite decade.

Outdoors and Security operating margin was 16.1% and improved 70 basis points sequentially and 50 basis points versus prior year as price and cost actions continue to more than offset inflation.

Finally, our Cabinets business delivered another exceptional quarter with sales growth of 20% as our transformational efforts continue to deliver and pricing actions become more fully realized in the P&L. Our service levels and product offerings have enabled continued share gains across the channels.

The business will continue to work down excess backlogs through the fourth quarter and expect to end the year at normal levels. Cabinet's operating margin was up over 400 basis points versus prior year.

Price and cost actions more than offset inflation and our team is strategically positioning the business to enter 2023 as a stand-alone public company with a cost structure that reflects the macro environment. The transformational work continues as Master Brand drives its lean culture through its operational and supply chain strategy.

Cabinet's tremendous results this year are the product of several years' work to replatform the business into a world-class performer. The transformation is remarkable and yet we believe there are still plenty of opportunities to pursue further value creation following the separation.

Our stakeholders should be excited about the increased agility, resilience, growth and profit potential of this market leader in its future journey ahead. To summarize, it's been a strong quarter. and our value creation algorithm remains fully intact.

In 2022, we expect to deliver another year of above-market growth and margin progression even in the face of multiple headwinds. We are already taking action in anticipation of softening demand and are laser-focused on maintaining our margin journey and driving cash generation.

We will proactively manage through the short term and are actively positioning both new Fortune Brands and Master brand to win for the long-term with above-market growth and higher margins over time. We are well prepared to face any future challenges and we'll work to deliver on our commitments to all of our stakeholders.

Before Pat addresses our quarterly financial performance and financial guidance update in greater detail, I would first like to turn it over to Dave Banyard to give his perspective on Cabinet's progress towards the separation and provide some insight into the transformational journey he has led over the past three years.

Dave?.

Thanks, Nick. It's great to be joining you here on today's call. I appreciate the chance to provide you all with an update on the separation and highlight some of the exceptional work that the Cabinets business has accomplished. I trust you'll see why I'm proud of our current performance, but I'm equally as excited about Master brand's future.

As Nick said, we're progressing well ahead of schedule on the separation. The team has diligently worked to develop the infrastructure required to be an independent publicly traded company, which includes building on our current leadership team and adding key roles.

Our search for the best talent extends to Master Brand's future Board as we're finalizing a world-class independent and diverse Board of Directors. As we prepare for the separation, we continue to make progress on our strategic transformation, which began three years ago.

Master brand has a great history as a market leader, but there is an opportunity to improve. Our culture of continuous improvement part of what we call the Master Brand Way, focuses on efficiency and the best use of our scale, which has allowed us to both increase manufacturing flexibility and improve margins.

We continue to better align around customers and channels with products specifically tailored to the needs of each part of the market. This realignment has improved service levels, increased customer satisfaction and delivered stronger financial performance.

These improvements were made during times of immense disruption to global supply chains and labor markets. This demonstrated performance in challenging times gives us confidence in our ability to deliver as market conditions change.

Because of our strategic transformation, we've already aligned the Cabinets manufacturing network in anticipation of the future demand environment. and we have flexibility to adjust further as market conditions change.

This flexibility will help preserve financial performance and allow us to continue to invest in our strategic initiatives, including in areas such as digital and e-commerce, which will help drive incremental future growth.

I look forward to showcasing more operational success stories from our strategic transformation and details of our strategy at our upcoming Investor Day. I speak for the entire team when I say how excited we are knowing the best days of Master Brand are ahead of us. I'll now turn the call over to Pat..

Corporate expenses of about $130 million, including digital transformation investments of around $20 million and separation costs of up to $15 million, interest expense of $122 million to $124 million, a tax rate around 24.5% to 25% and average fully diluted shares of approximately $131 million.

As our sales forecast reductions have occurred within supplier lead times and transit times have shortened materially, our inventory levels remain higher than previously targeted. As a result, we expect 2022 free cash flow of approximately $400 million to $450 million.

Our free cash flow forecast includes capital expenditures of $250 million to $275 million as we adjust the rate of investment to reflect current market conditions, while continuing to enable future growth. As we look to 2023, we acknowledge the impact housing affordability and macroeconomic uncertainty is having on the consumer.

It is not prudent to provide 2023 guidance today. However, today, we can share -- we are preparing for a 2023 characterized by a global market decline of low to mid single-digits with the first half more challenged than the second half.

Our teams are preparing to drive industry-leading margin performance including decremental margins should a global market decline occur. Also, our teams are focused on converting inventory to cash rapidly without compromising supply chain resiliency.

If 2023 market declines are mid single-digit or better, we expect to deliver decremental margins between 20% and 30%, depending on the magnitude of market change and pace of inventory reduction by quarter.

Given our business model improvements and recent and pending efficiency actions, we expect 2023 to be another proof point, demonstrating our margin performance strength.

In summary, our strong quarterly and year-to-date results are reflective of what will be two strong companies focused on leveraging unique advantages powered by brand, innovation, and channel in the case of New Fortune Brands and continued transformation and operational excellence at Master Brand, with both companies driven by an advantage global supply chain, and a focused organizational realignment.

Both companies will have strong balance sheets and ability to enhance returns via capital allocation. Further, both companies have strong cultures and commitments to strategic priorities prime to unlock a new level of earnings potential. I will now pass the call back to Dave Barry to conclude our prepared remarks and open the line for questions.

Dave?.

Thanks, Pat. That concludes our prepared remarks on the third quarter. 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 two, 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 please open the line for questions. Thank you..

Thank you. The floor is now open for questions. [Operator Instructions]. The first question today is coming from Adam Baumgarten of Zelman & Associates. Please go ahead..

Hey, good afternoon everyone.

I guess my first question is about -- maybe, Nick, if you could touch on the current demand environment out there and maybe some color on how the business performed throughout the quarter, that would be really helpful?.

Sure. Happy to, Adam. Yes, I'd say if you looked at the demand environment in the quarter, you certainly saw an inflection point inside of the third quarter inside of the macro housing data. So as you well know, building orders turned sharply negative. Permits and starts have been on a downward trend.

And so as we look out for the year, we'd expect single-family new construction to be roughly flat. And second half -- sorry, first half, probably first half of next year down and second half of this year down.

It's very interesting to look then at the -- on our retail POS data, which have been remarkably resilient through the course of the year, I think, notwithstanding some pretty big laps inside of that. And post Labor Day, we saw that come off quite a bit. So I think question remains to be seen how much of that is consumers pulling back.

How much of that is a return to regular seasonality. It's come off versus last year if you track it against 2020 where the back office still pretty strong, it's kind of hanging in there. So, we'll see as that unfolds, as you heard in my comments and Pat's comments, we'll plan for it to be challenged as we go into the first half of this year.

But you could definitely see that step off as you got into the kind of post-Labor Day environment. And so, as we think about that, the question then for us is really we know the long-term backdrop is excellent for housing, right? And we know all the fundamentals, you're well versed in them.

And so how do we manage the business to continue to be set up to grow and take share and build incredible brands over the long run to take it through this short-term headwind. You love our mark around that.

We will operate in a very lean, very tight P&L management way, but we will not compromise on the key strategic investments we need to make, things like digital in order to continue to be healthy and win in the long run. And we believe we've got the levers to do that. I think the margin performance this quarter demonstrates that.

You've seen us do it in the past, and we'll do it in the future, and we'll continue to drive above market top line performance and industry-leading margin appreciation.

And so that's really a flying formation as we look at this data we look forward and build a plan to kind of get through the shorter-term headwinds and into all the good stuff that's coming in the long run..

Great, thanks. And then maybe on Water Innovations margins really quite strong in the quarter. Maybe some more color would be helpful on how you were able to keep margins so elevated in the face of volume deleverage, input cost headwinds.

And if the incremental or I should say, decremental margin profile in that business is maybe different than what you outlined for next year because of some of the actions you've taken..

Yes, I'll kick off and then Pat will give us some specifics. I mean I'd just say philosophically, we'll touch on some of the -- as you think about some of the transformational changes, we've made to the way we operate the business.

We're really meaning more and more on our scale and our ability to drive excellence throughout the organization and take our capabilities and drive them. And as you get that scale play, you get a lot more flexibility and levers throughout the business. And so, you're seeing a business there that has had headwinds, obviously, from China.

I think eventually, those will come around housing it's too important part of the Chinese economy over time.

And a lot of inventory destocking and frankly, some which we hadn't seen was sitting at the production plumber, not just where it traditionally had set, but has been able to respond to that environment, continue to grow POS and invest behind that, but act very rapidly to manage its cost basis.

With a tighter set of strategic priorities, I'd say, but still investing and then managing for the future. And so with that and partially mix, as you got a bit less China, which is still just as a reminder, still double-digit operating income margin, but less than the U.S., you got some mix effect in there.

But really pulling on these leverage now how to manage the business, types of strategic priorities and that's what's leading to this kind of margin performance.

So Pat, do you want to give any more color?.

Yes, Adam, I've got to put into perspective how we got from the high teens, low 20s to the mid-20s. And that is twofold.

A lot of the Fortune Brands capabilities around procurement leverage design for manufacturability and design for value and revenue growth management, along with SG&A leverage have been in combination, the key from taking that business from a high-teens margin business to a mid-20s margin business.

And then to your question of how in a time of toughness are we able to preserve the decremental margins.

And that's just people being very perceptive of what's happening in the demand stream and being very quick to react on discretionary SG&A without compromising the key priorities and key among that has been our business in China staying profitable despite a couple of quarters where they're down around 25%. So that's been the key to that.

I think longer term as we look into next year, why we have a broader range is as we do right size inventory, which we haven't done enough of yet, we're going to have a different overhead absorption dynamic go through the system as we right size inventory.

And so when we get towards the end of the year and we're providing the detailed guidance for '22, we can narrow that range a bit. But that's the difference between what you're seeing in the current quarter and what you would see on a full-year basis for '23..

Got it, thanks. Best of luck..

Thank you..

Thank you. The next question is coming from Phil Ng of Jefferies. Please go ahead..

Hi guys. Congrats on good results in a choppy backdrop. My question for you, Nick. I've always thought Fortune as a decentralized model, and it's obviously worked for you guys quite well. The results speaks for themselves. The news on the realignment on the org structure, help us understand the thought process on why now, what that unlocks.

And also any color on the cap structure anticipated dividend from the spend?.

Okay. I'll take the first part and sure Pat may weigh in a little bit on the second part. And I'll take the first part, first. So why now, and then I'll talk a little bit about what we're doing. I'd say why now, and I appreciate the comments on the quarter. We pride ourselves in acting with urgency. It's a big part of our ethos.

Agility is one of our three key values. And as you look actually at data around companies that have gone through separations and spins, there's actually some fascinating data like companies that move to reorganize themselves well ahead of the separation date, outperform the market over time.

And I think it sort of speaks partly to the culture, but also to getting that flying formation into place early and then out of the gates as you go. And so that was for the timing then the overall structure. And you're right, the decentralized structure service very well over time.

Over the last few years, you've seen us introduce Fortune Brands Advantage across the portfolio. we've been able to get a lot of value out of that, right, taking sort of key areas that could really drive incremental value and then leveraging across the portfolio.

And as we saw that work, we could see the fact that you could get value out of doing things across the portfolio. But we could also see that we could go faster and harder on some of these initiatives if we didn't have the structural impediments that we had.

And so as early September, we announced this move from a decentralized or to a more closely aligned operating model. And what do we expect, they'll do two things to drive growth, right? Because you're going to have our best-in-class capabilities across the whole portfolio.

We could see pockets of things we're doing really well all over the portfolio, but being able to do them everywhere is going to drive growth, and it's going to drive productivity because you're going to have better capabilities and less duplication, right? So you should get greater productivity, and it should help us drive incremental fuel for investment as well as our margin journey.

So that's the idea behind it. We'll share quite a bit more at the Investor Day, but we're really excited. We really excited the organization is energized and you can already see some of it just taking hold as people grab on to some of these opportunities.

And the last thing I'll note about it, and I think this is a little bit different to the people thinking we move just purely to a centralized organizational full matrix organization. A lot of these high-performing functional areas will not report to me.

They're going to report closest to the market, which kind of stays true to that decentralized ethos, right? So Cheri Phyfer is going to have our global marketing function.

She's going to have a global innovation function, a global engineering function because they're not needed across kind of the corporate level, supply chain, everywhere, HR, everywhere, right? So those they're reporting to me.

But we really wanted to drive these as close to the market as possible to retain the agility that you've seen from a decentralized structure. So hopefully, we're going to get the best above out of this. But as you can hear, I'm pretty excited about it..

And Phil, in terms of the Cabinets capital structure and related dividend. We're well underway with that. As we said in the script and with the press release, we're ahead of schedule and working hard to get everything done this year, including the capital structure and related dividend. We're working with our existing Fortune Brands Bank Group.

They've been great and very supportive of this transaction, and we're appreciative of that. It's obviously been a very tumultuous time in the credit markets. As we've expressed in prior calls, we're expecting to pursue all bank financing, a mix of a revolver and a Term Loan A.

And we would still expect the dividend to come out of that to be in the range that we've communicated previously of $500 million to $1 billion, likely towards the higher side of that range.

We still expect to get that done and get that done this year and to leave cabinets with an appropriate amount of financial flexibility to navigate 2023, which you heard us express. We certainly expect some challenges at least the first half of the year, if not the full-year.

And then the Cabinets business has been exceptional at doing their part to drive profit growth and margin, they're likely to finish this year with pretax operating income in that $390 million to $400-ish million range and then depreciation and amortization, that's probably about $60 million on top of that.

So their drop to drive the profit that supports that capital structure, and they're doing a great job of it. And so I think it will be coming across the finish line much as we expected when we talked in the second quarter..

That's great color. And just one last one for me.

On the decremental margin guidance you called out for 2023, Pat, it sounds like the front half is going to be probably closer to the top end as you kind of work through inventory destocking and maybe as you kind of fine-tune your fixed cost profile, I guess? And then the back half, maybe on the lower end, are we thinking about that right? And then certainly, you're starting to see your ROHLs fall like metal, PBC and hardwood.

Is that something you guys have accounted for? Is that a potential upside from a margin standpoint? Thanks a lot guys..

Yes, I would say you're thinking about it correctly. And I think the ROHLs are contemplated within that.

The challenge for us will be as we position ourselves for the longer-term market and given the labor market dynamics, how much capacity do we hold on to thoughtfully and how quickly do we unwind that inventory while potentially leaving some capacity less utilized than it might otherwise be. And so that's why we have that range.

And then when those ROHLs flow off our balance sheet and into our income statement, we'll have a better line of sight to what not a perfect line of sight, but a better line of sight three months from now.

So we'll provide an appropriate update when we provide official guidance, but I think that range is appropriate for now, and I think you're thinking of it correctly with it being a bit higher in the first part of the year and a bit tighter in the back part of the year..

Thanks a lot for the comment..

And Phil, I'd just add, a lot of the cost actions to which you referred, we will have taken this year, right? And so really in the same print you're really trying to get off to as quickly as possible and move on a number of things this year.

And our aim is to get as much of that into good shape as we round out the year and kind of start next year in a good spot..

Got it. Got you. Very helpful. Thanks a lot..

Thank you. The next question is coming from Michael Rehaut of JPMorgan. Please go ahead..

Thanks. Good afternoon everyone. Thanks for taking my questions. I wanted to zero in on a couple of areas. First, just on the water innovations on the top-line and talk about destocking in China.

It's now a quarter or two, maybe even where there's a decent amount of contrast between the top -- your top-line results and your largest competitor that reported this morning. And it sounds like -- I think you had mentioned that POS was still trending positive. So perhaps you haven't lost market share.

But certainly, we didn't see or hear of inventory destocking as well as the declines in China that you're reporting from across the aisle, I guess, if you want to say. So I was hoping if you could just kind of drive down in a little bit of perhaps what those differences are, why they're occurring.

And I think you're also expecting quite a moderation of those trends in the fourth quarter.

If you're talking about full-year sales down 4% to 5%, I believe you said that would imply something in the fourth quarter closer to flat?.

Mike, it's Pat. I'll start and then maybe Nick will add to the color. So it is certainly unusual for us to report a sales decline in our Water Innovations business. But I think the important thing is, first, is the brand healthy and competing in the marketplace. So we saw that with mid single-digit positive POS in the quarter.

But even -- I would step back from that and say, as a business over the three years using 2019 as a basis, you're talking about a business that has -- by the end of this year, even if you cut it off in the third quarter, but it will be about the same at the end of the fourth quarter, a three-year sales growth CAGR of about 9% and a profit CAGR of about 14%.

So the business is performing over the long-term. I think what you're seeing in the results that are reported in this quarter and in the previous quarter is really more to do with the strength of our supply chain over the back half of '20 and '21 and some of the unique mix dynamics of our business. In the U.S.

and North America broadly, we have really strong share in new construction.

And so that business those lots and lots of angst around supply chain hassles and new construction over the last two plus years, and that drove a lot of wholesale inventory buildup, even in lower levels of the value chain outside of our main wholesalers, production plumbers and so forth. And so you're seeing that come out of the system now.

And then in China, we're mostly a residential new construction business. We're not a hospitality, new construction business in China. And you're seeing most of the pressure the government is putting on the construction in China is in residential new construction. So I think those are some unique mix elements of our business.

And I think the unique supply chain strength we had in 2021 and the second half of 2022 or rather 2020, are what's driving what you're seeing in the second and third quarter of this year. So for example, in this quarter alone, of our 14 points down 12 points was North American destocking.

So it's mostly about in this quarter, North American destocking but the brand is performing. You're seeing that in the POS. And then your comments to the fourth quarter, roughly correct, though, recall our Water Innovations business and our O&S businesses have a 53rd week in there.

So it's roughly flat to down 1% on a reported basis, but you have about two points in the quarter that that's the 53rd week. So it's more like on a like-for-like basis, about three or four down in the quarter and that's a deceleration of the destocking you're seeing. So lots of moving parts there.

I'd step back and say the brand is performing as you see in the POS, the three-year CAGR of sales growth and profit is outstanding. And a lot of what you're seeing in these quarters in the middle of this year is really the strength of the supply chain last year..

Well, I think, Pat, nailed that -- I mean, I'd say, Mike, just we've stayed focused on the long-term net market outperformance we are on the nine on the top, 14 on the bottom that Pat referenced the almost 300 basis points of operating margin improvement over that time that the business has been able to deliver.

As we've always said, we'll outperform the market. We'll grow margin. We've done it, and we'll continue to do it. And then just to give you a bit more color, that supply chain difference that Pat referenced the service levels, which we're pretty proud.

We're beating ourselves up a lot of last year because we were hitting like a 70% full rate and towards the end of the year, our biggest customers were telling us the industry average is closer to 40.

So you have a huge dichotomy there that allowed us to serve customers and consumers, which is one of the top focus areas, and they were building some inventory downstream to serve builders and make sure that a house never got held up because of plumbing, right? And as that slow, you see that inventory come out. It will correct.

But as Pat said, we keep looking to that healthy POS and know that over time, this is a very, very strong growth business with a lot of value generation and its somewhat is done. We'll continue to do that. And then China, our businesses is large and broad, right? And so it's going to have broad exposure to the Chinese economy.

But as Pat said, the teams kept it profitable and they are amongst the most agile teams we have. And so they will quickly put it to where the growth is going to come as that market starts to settle down now and return to growth, and we'll be there to capture that..

That's great. Appreciate the detailed answer that definitely helps a lot in piecing it together or deconstructing. Secondly, I just want to drill down also on the comments around 2023 in decrementals and kind of working off of Phil's question before.

I was a little surprised to hear that the 20% to 25% decrementals are inclusive of any likely raw material tailwind that I think you'd likely experience next year. Are those decrementals, therefore, a little better -- excuse me, than you would normally see? In other words, I think maybe you've already typically framed the decrementals.

I want to say closer to 25% to 30%.

So maybe if you could just kind of guide me there a little bit because if you're talking about full-year decrementals in the 20%, 25% range and you don't have that raw material lift, it would seem like, obviously, you're talking about margin contraction next year unless there are other factors that would prevent that?.

one, we're not giving tight guidance today; and second, we're giving ourselves some room to maneuver for the inventory destocking.

We put, since the pandemic broke, somewhere on the order of $500 million to $600 million of working capital investment onto our balance sheet, which is pretty considerable, considering we started with a base that was around $900 million to $1 billion in total.

And so the reason I'm saying that there's some raw material deflation held within that is it will take us a while to bleed off the inventories and get to that raw material deflation. It won't be hitting us right away. And then when you look at what's really come through the system in terms of deflation year-to-date.

While there's been some deflation, it's been mostly around ocean freight and parts of ground freight. Everything else has been pretty modest to date. So we're not yet in a, what I would call, a significant deflationary wave, especially at the rate it's flowing through our P&L because we have quite a bit of inventory still on our balance sheet.

So all you're picking up there is -- we have a meaningful amount of inventory to work off the balance sheet next year, probably in the $200 million to $400 million range, somewhere in there, depending on how the year unfolds and what's the most appropriate way to manage our capacity and our vendor relationships, and that will affect the rate at which any kind of raw material change impacts our income statement..

I'd just add, we don't bank our business on deflation. If -- we see what we see today, and I can sense we can go. If the global economy slows, could there be more expected deflation, I think they probably could.

And if that comes, that will be a positive impact probably in the later half of next year as we work through the inventory that Pat referred to.

But we've got to deal with a set of facts that we've got, particularly in the environment that we've experienced, which has been incredibly volatile over the last couple of years where we wouldn't bank the business on anything and work within what's within our own gift really and the levers that we have to deliver the best result.

And so those are the assumptions under which we run. If things end up being a bit better because the economy slows faster and you see increased deflation come through, then that won't be a bad thing for the P&L..

Okay, thank you..

Thank you. The next question is coming from Stephen King sorry -- Stephen Kim of Evercore ISI. Please go ahead..

Yes, thanks very much guys. I appreciate all the color so far. Just on the destocking issue, I was wondering if there was any impact from the effect from the new distribution center that you opened up.

And then also, when you talk about the decremental margins, I was wondering whether there'd be any meaningful difference or variability across the segments in terms of that 20% to 30% range you gave?.

I'll take the first one, and Pat can touch on the second one. And so you're pretty astute to remember that distribution center. So good for you. I guess, yes, in the sense that, that distribution center absolutely allowed us to keep service levels very, very high last year.

That -- I mean when things were just getting crushed, we opened that thing at performed right off the bat at really high levels of both moving service levels as well as efficiency. And it's a known factor.

We've experienced in the past where we are able to provide really high service levels, we tend to be the first place that our customers will go when they need to manage inventory. And so it's sort of the no good deed goes unpunished, in our things that's fine, you digest it and you move through it.

But those service levels in that distribution center have been part of those service levels, I think certainly allowed our customers more flexibility..

Yes. And I'd say on decrementals, all businesses will be working towards similar objectives. I think what will differ is how each of them is experiencing demand relative to capacity relative to inventory rightsizing quarter-by-quarter.

I think that if you see a difference, it's because of the circumstances that the businesses face are unique to the business as opposed to they're inherently structurally different or pursuing different objectives..

Okay. Yes. That makes sense.

Talking about the circumstances and the set up next year, I believe you kind of gave some commentary about single-family resi, was wondering whether you had a handy way of describing your outlook in terms of single-family starts, let's say, and existing home sales as you look into fiscal '23, what kind of ranges or levels are you kind of thinking about as you contemplate your guidance?.

Yes. And so Steve, I'll kind of remind you and others, we always, on the new construction side of things, just lag starts three or four months. But for the last three or four years, it's kind of been using an average of a lag starts plus completion. So take -- think of it simply as starts lag three months plus completions divided by two.

It's kind of like that our simple algorithm because builders, to us, appear to be swinging labor between starts and completions. What our expectation is, this is early days. So we reserve the right to update this as we get towards the end of the year as starts next year, single-family starts in the U.S., likely down in that 15% to 20% range.

But the completions because of the backlog somewhere closer to flat. I mean, could they be down a bit, maybe but closer to flat. You kind of put those two things together and you're down like minus 10-ish, new construction. And then R&R somewhere from flat to down low single digits, may be mid-single digits, but low single-digits.

And if you think of just the simple algorithm of our business of a quarter to a third new construction and the balance R&R, that kind of gets you to about mid-single-digits. I wouldn't tie a specific existing home sales into that where, existing home sales is one of many variables we look at for R&R.

But that's the simple high-level math we're using right now that kind of gets us around that mid-single-digits or better because a full year with R&R down three would be pretty will be a pretty significant development. I certainly think starts will contract pretty significantly in the first half of the year.

Just by the order rate, we're seeing today is kind of directionally in that same order of magnitude..

Yes. That's very helpful, Pat. I just -- if I could just follow-up on that specifically though on the existing home sales or the EHS across the marketplace, so it seems like there's -- I'd say, across the investing landscape.

There's a lot of folks who are focused on the fact that mortgages that are in the installed base, the average rate that homeowners have is much lower than the prevailing rate. And so therefore, you're going to have a bit of a locked-in effect. That's something that I know folks are very focused on.

And so that has led people some people to think that existing home sales could be down very dramatically, sort of plunging to levels that we have not seen really in the last 20 years. And I'm curious if you are sympathetic to that idea or if you believe that we should not be too extreme in our views around how low EHS can go.

And so that was really kind of a -- one of the things I was hoping you can maybe touch on in your comments. I just noticed that 40% of homeowners don't have a mortgage at all, another 10% probably don't have very much that they're borrowing on their balance. And so I'm sort of thinking that existing home sales may do a little better than folks think.

But I just wanted to get your sense on that..

Yes, I don't know that I have a specific number in mind like relative to 5.5-ish million that would normally transact. What I would say is we would agree that because of the near-term effect of mortgages locked in many well below 4%, that, that friction is going to exist for part, if not all of next year.

How low it will plunge that level? I don't know. But I would -- that, to us, has often resulted in if people are more committed to the homes that are already in because of their mortgages could translate into reasonable set of R&R activity and two-thirds of our businesses are in R&R activity. So I don't want to say we're indifferent.

It's one of the many variables that's swirling out there. People staying in their homes is not, per se, bad for our product demand. The confidence they have in their homes and how important their homes are in their life, which in a hybrid work environment, has certainly changed. So it's a variable we have our eye on.

But -- and it will play out, but it could end up playing out to be favorable to R&R. So I don't think we sit here and say it's definitively a bad thing no matter what, that's not something where we are..

Yes. And I'd just add to. One of the things that we look at is we pulse consumer interest by Google Search of home renovation. That activity is still 25% higher than it was pre-COVID on our latest release. So you still got 25% more -- just activity. There's not dollars, activity around home renovation searches, people doing work.

And so where if that goes between existing home sales, people are in homes need to renovate those homes, looking at the $29 trillion of homeowner equity and how that might be deployed, I think would be some of the fascinating stuff that we've learned next year, but that consumer interest to us is still very, very important as you plan into next year and see how this all unfolds..

Yes, thanks very much guys. That's really helpful..

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