David Chaika - Vice President, Treasurer and Investor Relations Keith J. Allman - President, CEO & Class II Director John G. Sznewajs - Vice President and Chief Financial Officer.

Dennis Patrick McGill - Zelman Partners LLC Robert Wetenhall - RBC Capital Markets LLC Eric Bosshard - Cleveland Research Co. LLC Michael Jason Rehaut - JPMorgan Securities LLC Samuel H. Eisner - Goldman Sachs & Co. Tim R. Wojs - Robert W. Baird & Co., Inc. (Broker) Mike Wood - Macquarie Capital (USA), Inc. Nishu Sood - Deutsche Bank Securities, Inc.

Susan Marie Maklari - UBS Securities LLC Michael G. Dahl - Credit Suisse Securities (USA) LLC (Broker).

Good morning, ladies and gentlemen. Welcome to Masco Corporation's Second Quarter 2016 Results Conference Call. My name is Jonathan and I will be your operator for today's call. As a reminder, today's conference call is being recorded for replay purposes. [Operation Instructions] I will now turn the call over to Mr.

Dave Chaika, Vice President, Treasurer and Investor Relations. Mr. Chaika, you may begin..

Thank you, Jonathan, and good morning, everyone. Welcome to Masco Corporation's 2016 second quarter earnings conference call. Joining me today are Keith Allman, President and CEO of Masco; and John Sznewajs, Masco's Vice President and Chief Financial Officer.

Our second quarter earnings release and the presentation slides that we will refer to during the call are available on the Investor Relations portion of our website. Following our prepared remarks, the call will be open for analyst questions. As a reminder, we would appreciate it if you'd limit yourself to one question with one follow up.

If we are unable to take your question during the call, please feel free to call me directly at 313-792-5500. I'd like to remind you that statements in today's presentation will include our views about Masco's future performance, which constitute forward-looking statements.

These statements are subject to risks and uncertainties that could cause our actual results to differ materially from the forward-looking statements. We've described these risks and uncertainties in our risk factors and other disclosures in our Form 10-K and our Form 10-Q that we filed with the Securities and Exchange Commission.

Today's presentation also includes non-GAAP financial measures.

Any references to operating profit, earnings per share or cash flow on today's call will be as adjusted unless otherwise noted, with a reconciliation of these adjusted measurements to GAAP in our quarterly press release and presentation slides, which can be found in the Investor Relations section of our website, www.masco.com.

With that, I'll now turn the call over to our President and Chief Executive Officer, Keith Allman..

Thank you, Dave, and good morning, everyone. Before we get started, I'd like to welcome Dave Chaika to his new role as Masco's Treasurer and Vice President of Investor Relations. And I'd like to congratulate Irene Tasi on her promotion to Vice President of Retail Sales at Masco Cabinetry.

These changes are another example of Masco's people development strategy at work. Turning to slide four. I'm pleased to report that the momentum we built in 2015 and carried forward into the first quarter of 2016 has continued year-to-date.

We had a great second quarter, as strength in our underlying markets, combined with solid execution, translated into excellent financial results. Looking specifically at the quarter, our top-line increased by 4%.

Notably, our adjusted operating margin increased 260 basis points to 17.1%, reflecting our portfolio's strong operating leverage, a favorable price commodity environment, and our culture of continuous cost improvement. This represents our best second-quarter operating margin since 2002.

Our adjusted EPS grew 21% to $0.46 per share, which includes the $40 million additional interest expense we incurred during the quarter due to the early retirement of a portion of our debt.

These results reflect our ability to capitalize on improving end-market dynamics and our ability to generate robust consumer demand from our industry-leading brands. I'd like to provide you with some additional insight into the drivers behind each of our segments' performance. Let's begin with Plumbing.

Our portfolio of plumbing businesses continued its strong performance and grew sales in North America by 9%, and grew sales internationally by 11% in local currency.

This segment's strong growth was broad-based, with Delta, Hansgrohe and BrassCraft Manufacturing, our rough plumbing business, each having record quarters for both sales and operating profit.

The Delta and Brizo brands continue to resonate with the consumer, and drive sales growth in both the retail and wholesale channels in North America, while the Hansgrohe and Axor brands continue to gain share internationally.

Watkins Manufacturing, our premier wellness and spa business within our Plumbing segment, also achieved a record sales quarter, a good sign that consumer confidence continues to build, as exemplified by these big-ticket purchases.

Our Decorative Architectural segment delivered a solid quarter, despite being up against a tough comp, as we pointed out on our last quarterly earnings call. We continued our strong Pro paint sales growth, as a result of our mutual efforts with The Home Depot to grow and capture share in this channel.

And BEHR MARQUEE, a high-price-point DIY product, continued to post exceptional year-over-year comps. BEHR was once again acknowledged as the quality leader by achieving a number one ranking from a leading consumer testing organization for its BEHR PREMIUM PLUS ULTRA Exterior paint.

Our BEHR products have now held the number one ranking for interior and exterior paint, as well as exterior stains, for four years running, demonstrating our commitment to customer-focused, award-winning, high-quality products.

Our investments in paint are paying off, and we intend to continue to reinvest in this segment to drive profitable volume growth along with our partner.

Turning to Cabinets, the team delivered yet another strong quarter, growing our leadership position at retail and continuing to optimize sales mix by exiting low-margin, direct-to-builder business, as we described on our first quarter earnings call.

Moving to Windows and Other Specialty Products, our sales grew by 3%, but we did not meet our operating profit expectations. We're working diligently to address this underperformance and remain confident in our long-term operating margin expectations of 10% to 13% for this segment that we outlined in our Investor Day.

Overall, we are very pleased with our second quarter operating performance.

Additionally, we continued progress against our key capital allocation initiatives, including finalizing our debt transactions and paying down $400 million in debt; repurchasing approximately 2.8 million shares, bringing our total shares repurchase to-date to 28 million against our 50 million repurchase authorization.

And lastly, our board of directors announcing its intention to increase our annual dividend by $0.02 per share beginning in the fourth quarter, expressing confidence in our future outlook. With that, I'd like to turn the call over to John, who will go over our operational and financial performance in detail.

John?.

Thank you, Keith, and good morning, everyone. As Dave mentioned, most of my comments will focus on adjusted performance, excluding the impact of rationalization and other one-time charges. Our focused execution continued as we delivered strong top and bottom line growth in North America and internationally.

The second quarter of 2016 was our 19th consecutive quarter of year-over-year sales and operating profit growth. Sales increased 4% for the quarter. The impact of foreign currency translation softened in the second quarter, and negatively impacted our revenue by approximately $6 million. North American sales were up 3% in the quarter.

We continued to experience strong demand for our repair and remodeling products in all channels of distribution and across the price continuum, as consumers are trading up to our better and best product offerings. As a reminder, repair and remodel activity accounts for approximately 83% of our total sales.

International sales increased 9% in local currency in the quarter, driven by the continued strength in our international plumbing and window businesses. Gross margins expanded 220 basis points compared to the second quarter of last year to 35.2%.

And our track record of SG&A improvement continued in the second quarter, as SG&A as a percent of sales improved 40 basis points, driven by focused cost control and productivity improvement throughout the organization.

We delivered very strong bottom line performances, as operating profit increased 22% to $342 million, with operating margins expanding 260 basis points to 17.1%, our highest second quarter margin in 14 years. Our EPS was $0.46 in the quarter, an improvement of $0.08 or 21% compared to the second quarter of 2015.

These results include the $40 million of one-time interest payment we noted in last quarter's earnings call to complete the retirement of debt maturities. This negatively impacted our EPS. Turning to slide seven, our Plumbing segment had a terrific second quarter.

Segment sales increased 10%, excluding the impact of currency, driven by growth in our faucets, showers, spas and rough plumbing products. Foreign currency translation negatively impacted this segment's sales by approximately $5 million in the quarter. Our North American sales grew 9% in the second quarter.

We experienced strong demand for our innovative Delta and Brizo brands with both our wholesale and large retail customers as we gained share in the quarter. Our second quarter sales also benefited by approximately $10 million due to loan-in sales associated with a recent retail program win.

Our international Plumbing sales increased 11% in local currency. Hansgrohe continues to outperform, as it delivered its highest quarterly sales and operating profit in the company's history, breaking the record they set last quarter.

We experienced sales growth around the globe, with particular strength in Central and Northern Europe, the Americas, and Asia. Additionally, our mix improved as our premium price point Axor brand grew double-digits in the quarter.

Operating profit for this segment increased 39% in the quarter, driven by incremental volume, productivity improvements and a favorable price-commodity relationship, particularly in Europe. This segment also benefited from a positive year-over-year commodity hedge impact of approximately $5 million.

The second half of 2016, we anticipate investing approximately $10 million in advertising and displays to support new product launches at both Delta and Brizo.

Given this segment's sustained performance improvement, but also taking into account further investments to grow the business, we are raising our long-term operating margin expectations for the segment from 16% to 17% to the high teens. Turning to slide eight, the Decorative Architectural segment sales matched the second quarter of 2015.

We experienced solid performance of our BEHR MARQUEE Interior product and continued strong growth across our BEHR PRO business. However, as I mentioned on the first quarter call, this segment faced a difficult comp in Q2, as the second quarter of 2015 was a record sales quarter for BEHR.

In the second quarter of 2016, the timing and amount of incremental promotional expense for the Memorial Day and July 4th promotional events negatively impacted our revenues. You may recall last year's July 4th event was entirely in Q3, while this year's event straddled Q2 and Q3.

Additionally, sales were negatively impacted by an in-store inventory draw-down late in the second quarter of 2016. Liberty Hardware had another solid quarter due to the continued share gains from successful new product introductions and program wins in the retail channel.

We are also pleased that Liberty was recently awarded the final portion of a nationwide shower door program at The Home Depot. We will be resetting the remaining 800-plus stores with this innovative program in the fourth quarter.

Operating profit increased $6 million in the second quarter, principally due to operating leverage on higher volume at BEHR and Liberty. While we have experienced solid margins in the first half of the year, we will invest to grow gallons in the second half of 2016.

At this time, we expect the amount of this investment to be approximately $30 million, the majority of which will be spent in the third quarter. Turning to slide nine, we are extremely pleased with our Cabinet segment's improved performance in Q2.

Segment sales declined 3% due to the deliberate exit of certain lower-margin business within the builder direct channel in the United States and at select low-margin accounts in our UK cabinet business.

This decline was partially offset by KraftMaid's strong performance in the retail channel, resulting in double-digit growth in year-over-year share gains.

In the dealers' channel, we drove single-digit growth through increased volume and favorable mix with both our Merillat offerings and our dealer-exclusive KraftMaid Vantage program continued to resonate with our dealer base and consumers. Segment profitability in the second quarter improved $22 million or 147% over 2015.

Our strong second quarter margin of 14.2% was driven by cost-savings initiatives as well as an improved mix as we reduced our exposure to lower-margin builder direct business and enjoyed (15:41) continued growth of our higher price point semi-custom KraftMaid offering.

For the balance of 2016, we believe the revenue impact of our decision to exit select builder direct business and our retail kitchen countertop business will negatively impact sales by approximately $15 million in both Q3 and Q4.

In addition, during the second half of 2016, we will be launching new products under the KraftMaid and Quality brands, and anticipate approximately $10 million of expense associated with these new product introductions.

Finally, given this segment's sustained performance improvement, we are raising our long-term expectations for operating margins from 8% to 9% to low to mid-teens. Turning to slide 10, our Windows segment sales increased 3%, driven by growth in Milgard, our leading Western U.S. window business.

Milgard's continued growth was driven by a positive mix shift toward our premium window and door product lines and favorable pricing. Excluding the negative impact of stronger U.S.

dollars, our European window sales increased 10%, as this segment continues to benefit from share gains through the strong performance of our premium price point window and door offerings.

This segment's operating profit declined was due to ERP expenses in Milgard of approximately $6 million, which we previously disclosed, and an adjustment to Milgard's warranty reserve of approximately $10 million. In addition, we experienced approximately $8 million of incremental labor costs and inefficiencies as Milgard continues to grow.

Despite this quarter's results, we continue to believe this segment will achieve 10% to 13% operating margins long-term. Turning to slide 11, during the quarter, we took additional action to further strengthen our balance sheet and unlock shareholder value. We ended the quarter with approximately $1.1 billion of balance sheet liquidity.

As we mentioned last quarter, in March, we issued $900 million of new notes, then in mid-April we used the proceeds from these debt issuances, together with cash on hand, to repay and also (18:04) retire all of our $1 billion notes due in October 2016 and all of our $300 million notes, which were due in March of 2017.

To complete the retirement of these two debt maturities, we incurred approximately $40 million in a one-time interest payment during the quarter, which increased our interest expense to $87 million for the second quarter. However, the results of these transactions will generate an annual interest expense savings of nearly $45 million.

Starting with our third quarter of 2016, our quarterly interest expense will be approximately $44 million. With these refinancing transactions, we have delivered on our long-term commitment to strengthen our balance sheet.

Due to our strong cash flow and this recent debt retirement, we have greatly enhanced our financial flexibility, as our net debt to EBITDA now stands at approximately 1.6 times.

From a working capital perspective, we delivered another strong quarter of performance with working capital as a percent of sales improving 70 basis points versus the prior year to 13.3%.

Finally, as Keith mentioned, we continued our share repurchase activities and during the quarter, we repurchased 2.8 million shares valued at approximately $88 million. So with that, I'll now turn the call back over to Keith..

Thank you, John. I'm pleased with our team's continued strong execution. Our results reflect the strength of our powerful brands, and our rigorous focus on operational excellence.

Due to our continued success in these areas, we are raising our long-term margin expectations for our Plumbing segment to the high teens and for our Cabinet segment to the low- to mid-teens. The fundamentals driving our business continue to accelerate.

Home prices continue to appreciate, which is a driver for larger ticket items such as cabinets and windows. Housing turnover continues to increase, which is a leading indicator of repair and remodel spend. And as you recall, repair and remodel is 83% of our business.

And homes remain affordable, with improving access to credit, as well as lower mortgage rates, stimulating housing and home improvement activity. Consumers continue to gain confidence to reinvest in their homes, and we are well-positioned to benefit from those positive trends. The strategies that we laid out last year are working.

Going forward, we remain committed to investing behind our brands for growth; developing innovative, award-winning products to ensure we maintain our must-have position with our customers; focusing on operational excellence through our continued deployment of the Masco Operating System; and finally, balancing our capital allocation between investing for growth, acquisitions with the right strategic fit and returns, and returning cash to shareholders through share buybacks and dividends.

We remain very confident in achieving our 2017 earnings per share target of $1.80 that we set at our Investor Day last year. Our operational execution, coupled with our strength in balance sheet and strong liquidity position, provides us with multiple levers to continue to drive shareholder value. With that, I'd like to open up the call for questions.

So I'll throw it back to you, Jonathan..

Your first question comes from Dennis McGill with Zelman & Associates. Please go ahead..

Hi, good morning. Thank you. First question just relates to the push in margin for the two segments.

When you guys are talking about long-term, is that a year-dependent measure, or are you thinking about that as a certain amount of revenue in each segment or a certain macro backdrop? Can you just maybe update us on how that ties in to the prior 2017 outlook and timing?.

Dennis, I would say that it's consistent with the macroeconomic outlook that we had in 2017, so I would frame it in that manner. And in terms of the timing of it, we're looking at that as a multiyear, more longer-term outlook on what we expect from a run-rate out of these businesses..

Okay and then maybe, so if we bridge from today to that longer-term view, are the incremental margins in the two businesses different than how you've talked about or similar, just from a stronger starting point today?.

No. I think incrementally, the margins are going to get a little bit better as we're going to maintain some of that gross margin improvement. Of course, there's some offsets to that, as we talked about with regards to investment.

John, maybe you want to add a little bit to that?.

Yeah, Dennis. I would say that our incremental margin outlook for the businesses hasn't changed significantly. I think we're still in that kind of 30% for Plumbing and that 30% to 35% for Cabinetry..

Okay and if I could just sneak it in, John, could you maybe elaborate a little bit more on the windows, the three different expenses or related expenses you mentioned? Are those intertwined, in that the ERP is causing the labor inefficiencies? And then also, on the warranty reserve, any color there would be great..

Yeah, I'll take a little bit of it, and I think Keith's going to want to talk just a bit about the operational aspect of it. So I think they're three very distinct items, Dennis. So, the ERP is separate and discrete from the other things. So that was about $6 million in the quarter.

We brought up our Portland facility on the system, and so we incurred a little bit more than we expected to incur by 1 million or so dollars, just given the way that went. But it's going well. We're shipping product out of Portland, and so we're pleased with that.

The second item relates to our warranty accrual adjustment, and what we do there is, on a very regular basis, we look at all of our accruals across the company.

And as we looked at some of our experience and some of our assumptions going forward, we thought it was appropriate to change the reserve, and so that's reflected in what – the adjustments that we took this quarter. Then I'll turn it over to Keith to talk about the operational aspect of things..

Dennis, I'd say that it's not uncommon for a business to hit some speed bumps along the way, especially when you're looking at the growth that Milgard has experienced. We've had mid-single to low-double digit growth for each of the past 14 quarters, so we've had a lot of growth there.

Individually or separately, these items really aren't a big issue, but collectively, they've got our attention. We have teams addressing these issues aggressively. And we're confident that we're going to get back and maintain and get to our margin expectations of that 10% to 13%..

Okay. Appreciate all the color. Good luck, guys..

Thanks..

Your next question comes from Bob Wetenhall with RBC Capital Markets. Please go ahead..

Hey. Good morning. And congrats on a very encouraging quarter and a positive outlook. Trying to understand, if you could help me frame it a little bit better in thinking about it. The results are really strong and you're taking up your long-term profitability and margin targets.

What's the mix here in the divisions where you're increasing the margin targets long-term, between self-help and strength of the cycle? What's giving you that confidence to say, hey, we've already gotten where we want to be faster, and here's what we're thinking about in the next couple years?.

Well, as you might expect, Bob, it is a mix between a strong market, which we expect to continue going forward, and our execution.

I look it at it – we as a team look at it from a number of ways, the nature of our cost out, how are we driving the productivity improvements that we're seeing and are they sustainable, are they systemic, are they based on the approaches that we're driving in the Masco operating system? And, quite frankly, we look at the people and we look at the teams, and we evaluate how those teams are successfully implementing our operating systems and the nature of the improvements that they're driving.

So when we look at sustained performance improvement, we look at how it's come to us and we looked at the people that are driving it and the confidence that we have in those teams.

Those things, all together, have said, you know, we're comfortable in taking our margins up to the high teens in Plumbing, which is very, very solid business, and taking them up in Cabinets as we've described..

Got it. And that's helpful. Thank you. Could you elaborate a little bit more on in the paint business the profitability was really good.

You guys had previously commented that there would be kind of a long-term multi-quarter glide path towards a normalized margin of 18%, and I was trying to understand the margin profile, the strength of it in this quarter, and any update you can give us on what's happening in do-it-yourself sales versus Pro channel. Thanks and good luck.

Very nice quarter..

Thanks, Bob. In terms of our performance in paint, I think there's a couple things to think about. As we talk about that glide path closer to the high teens, 18% range, we're very pleased with the performance of the segment this quarter and the progress that we've made.

But, as we've talked about historically, we'll be investing in this business over the long-term to help grow gallons. I think there's a couple, three things that may influence the margin pressure downward. First is commodities.

We have been experiencing some mild commodity cost inflation from our major suppliers of titanium dioxide, and as I think everyone's aware, they've announced further price increases for later this year. The second is investments.

As we've talked about historically, we are trying to grow this business and grow gallons in conjunction with our channel partner, The Home Depot. And so we're investing heavily to grow our Pro business.

In fact, we are investing here in the back half of 2015 (sic) [2016] (29:10) part of the $30 million investment that I outlined in my prepared remarks really goes to growing hub stores. We have 100 new hub stores where we'll be employing people to help grow our paint business in The Home Depot.

And finally, mix; I think we've mentioned very clearly over the course of the last couple quarters, our Pro business does not have or come at the same margin profile as our core DIY business.

So I think those are the three elements that, over time, will drive the margins closer to that high teens range from where we're at and from where we stand today in the 22% range..

Bob, in terms of your specific question on the Pro, our Pro business continues to do very well. We grew in that low double-digit range again in the quarter. Our investments and strategies that we are driving together with The Home Depot are paying off very well, and we're encouraged with the trajectory.

As John mentioned, we're adding 100 new hub stores, and that's on top of an install base of hub stores of 106. So this very productive for us. We like what we're seeing in the Pro and we're going to continue it..

Your next question comes from Eric Bosshard with Cleveland Research Company. Please go ahead..

Thanks. Two questions for you. First of all, curious in what you're observing in terms of remodel spending.

Obviously the Plumbing numbers look good in the quarter, but within the Cabinet business if you can exclude the business you walked away from, what you're seeing in terms of order rates and order patterns there? And then, secondly, would love you to elaborate a little bit further on the expected payback from the incremental investment that you're making in the paint business.

Obviously you're talking that that may normalize or dilute the margins, but should this also accelerate the top line growth?.

Eric, in terms of the remodeling side, we continue to see good demand. I think home price appreciation is a good driver for that. And there has been some deferral in investing in big-ticket items that folks have put into their homes for a number of years and that's coming off the sideline.

As we talk to the various dealer and constituents around our business, we're hearing about good foot traffic and continued good spend. In the Cabinet and Window business, which both of those have a very strong component of R&R in them, we are seeing improved mix as well.

Now, a part of that is driven by productive changes we've made to our assortment and how we're managing the business, but it's also a general uptick in mix in terms of the market. I think a great indicator is our Watkins spa business. As John said, we set another sales record there this quarter.

And when you consider the discretionary nature of this product and its high price point, it really reflects on the consumer's appetite to reinvest in their home. So we're seeing the consumers utilize credit more with larger ticket purchases, such as spas. So I think the consumer is feeling confident.

That's a direct reflection on demand in R&R, and then of course home price appreciation and new housing turnover, all which are continuing to grow, which continue to feed that. With regards to your second question, Eric, around the incremental payback on the Pro initiative, it's an outstanding payback for us. It's very profitable.

While it doesn't have necessarily the margin of our core DIY business, it has outstanding returns for us. And I think, importantly, the fact that we are so intertwined strategically with Home Depot that this is a very positive revenue source for us for quite a while. We're very confident in the Pro and paint..

Yes, and, Eric, can you just give a little bit more color. I think part of your question was how did our Cabinet business grow if you factor out the business that we walked away from. And if you just take a look at our core business that's excluding that builder walk away business that we did, our core business was up kind of 5%, 6% in the quarter..

And it looks like you're gaining market share.

How do you view that relative to the market and what was that number in the first quarter?.

Yes, that's right, Eric. I think your assessment is right. We feel like we're picking up a little bit of share. Particularly in retail, we know we're picking up share for certain there. The first quarter, if you strip everything out, I think we had very similar growth rates in the first quarter of the year.

And that business is a business that we did not walk away from..

Okay. Thank you..

Your next question comes from Michael Rehaut with JPMorgan. Please go ahead..

Thanks. Good morning, everyone, and nice quarter. First question I had was on the paint margins. Just want to make sure I'm thinking about it correctly, because I guess you highlighted $30 million of extra expense in the third quarter, which could be around 500 bps, 600 bps of a margin impact.

At the same time, you highlighted the promotional expense, which hits more the top line, and I'm sure that also contributed to the margin strength itself. So looking into 3Q, I know you don't get too granular here, but given that I wouldn't expect the full 500 bps, 600 bps to hit because of a lesser amount of promotional expense.

Should it kind of return to that high-teens type of number that you're looking at longer term, or could it still exceed 20%?.

Yes, Mike, first of all, the $30 million of expense will not be entirely in Q3. That's going to be split between Q3 and Q4, though the majority of which I would estimate will hit in the third quarter.

And so as you think about the margin degradation from where we stand today to future quarters, I think the scenario that you outlined, yes, I think we'll see consistent or steady margin degradation. I'm not expecting necessarily a clip (35:47) back to 18%, but I think over time we'll drive that way.

So I think high teens, low 20%s could be an opportunity for the third quarter. But as you referenced, we don't give out quarterly guidance..

Okay. No, thanks. But just again trying to think of it the right way. Switching back to Cabinet growth, if we can get a little more detail there if possible. I don't recall hearing the exact or estimated dollar amount of the impact of the exited businesses this quarter.

And then I guess maybe you can give some of the pluses and minuses, because if it's even $10 million, $15 million, that would imply kind of that best like a low single-digit sales growth rate. So just trying to think about how that might improve over time to like a mid-single-digit.

If there are other drags that are holding back that business as we'd expect some of the new product initiatives and share gains to take greater hold..

Yes, Mike, so we had about $10 million to $15 million of lost business this quarter from the exit of the direct-to-builder in the retail countertop business. I'm going to tell you that that our retail business grew in low-double digits and our dealer business grew at about single digits.

So you put all that together, if you factor out, again, the business that we walked away from, our core business grew about 5%, 6%..

And is that a good run rate for the back half as well, excluding the exit of the low-margin business?.

Yes, I think that's a good way to think about it. We've got good traffic that we're seeing in our dealer customers. We have good mix. We're excited about the product launches that we have coming in, in Q3 and Q4.

Now it's going to take some while for that to get traction as the designers start to get comfortable with it, but it's good stuff, and we like the prospects for the business, and nice steady growth rate, and continued execution, importantly..

Thanks. One last quick one, if I could. Just on the labor inefficiencies and ERP expense and other specialty, should that start to peel off in 3Q? And excluding you're about at 4% excluding the warranty hit this quarter.

Could we see that improve into mid-single digit somewhere in the like mid-single digit margin? I know, again, maybe not giving the guidance for that, but some of the ERP or labor, would that kind of be lesser of a headwind in the back half?.

We have an ongoing roll out of ERP, Mike, at Milgard, and so I would anticipate $4 million to $5 million of ERP expense each of the next several quarters and that will probably go into the first part of 2015 – 2017, I should say, as we continue to roll it out across all of Milgard's manufacturing locations. So that will continue..

In terms of the labor, let me take that one, John. The nature of the issue that we're having here is really about supporting the high growth with additional labor, and labor turnover. So this is probably our toughest business when it comes to being in the northwest and getting our labor and keeping our labor.

With this growth, we drive hard with respect to getting as much as we can out of our existing shifts. And when you put in new second shifts, there's always a learning curve for that, bringing in some new supervision.

So I think we'll probably see some labor inefficiencies bleed into next quarter a little bit, but we're on this and we're going to get it taken care of quickly..

Great. Thanks, guys..

Your next question comes from Samuel Eisner with Goldman Sachs. Please go ahead..

Yes, good morning, everyone..

Good morning, Sam..

On the Plumbing segment, I just want to make sure I got the moving pieces correctly here. You commented that there was about $10 million of revenue load-in, assumed that's 20% margin, so about $2 million of EBIT, and you had a $5 million hedging benefit as well.

Are those the only two major items in a bridge that we should be modeling, or thinking about for this quarter? Just because obviously, the profitability in this quarter was pretty substantial..

Yes, no, Sam, I think you're thinking about it exactly right..

Got it. That's helpful there.

The $10 million for next quarter, is that essentially offsetting some of the walk savings for the hedging losses that you had in the third quarter as well?.

No, the $10 million really is, for next quarter, the second half of the year, really. It really is some product launches that we're doing. Now I would tell you, the other thing that probably impacts the second quarter, Sam, that I forgot to mention probably is, we're (40:48) on marketing spend in the second quarter.

So I think you'll see that grow as we go into the third and fourth quarter, and then there's $10 million of expense related to these product launches, if the collateral material displays and the like gets the products into our, either our channel partners or the wholesale showrooms where we're launching these products..

Got it. Maybe transitioning over to the paint segment, you commented that you're starting to see some price increases by your TiO2 suppliers.

When do you anticipate some of that to start to impact your P&L, and how are you guys going to go about offsetting that? Do we expect that, back half of the year, that you'd start to see a raw material headwind? How do you think about the whole price-cost relationship going forward?.

In terms of that, generally we have a 60-to-90 day lag before raw material price increases flow through and hit our financial statements. So I think you'll start seeing the impact of the second quarter increase really hit our third quarter.

And then, to the extent that there are further increases later in the year, you can again calibrate those on those 60-to-90 day timeframe where it flows through. In terms of, how do we offset, obviously we work with our suppliers very closely on that. We're working on cost productivity within our own operations to try to offset some of that.

That said, I think we've got a good thing going right now with our Pro business and our MARQUEE business, that seems like it's heading in the right direction. So hopefully, as consumers mix up a little bit, that will help offset some of that pricing pressure..

All right. And if I can just sneak one more in here. Keith, you made the comment about, we're talking about R&R spending, how consumers are utilizing a bit more credit these days. I was wondering if you could expand on that a little bit more.

Are you seeing that in the forms of people starting to use HELOCs and home equity loans again? Just curious if you can expand on that comment. Thanks..

Sure. I'll point you to our use of credit and our – just a direct little statistic here, in terms of third-party consumer financing program that we have in our Watkins spa business. Year-to-date, that volume is up 60%. Our in-store approval rates are up nearly 80%, and applications are up 30%.

So that's one example there, and certainly, HELOCs is another one where people are starting to pull that value out of their home. But very much close to home is that credit financing that we see in Watkins, which is for a big-ticket item.

So we think that's a great sign for consumer confidence, and it shows a willingness to invest in that bigger-ticket item for the home..

Your next question comes from Tim Wojs with Baird. Please go ahead..

Yes, hey, guys. Good morning. Nice job..

Thanks, Tim..

I guess, just on Decorative, you had made the comment that BEHR was up year over year from a volume basis.

Could you expand a little bit, maybe what gallon growth was in BEHR for Q2? And then the inventory reduction you that cited, is that over, or is there some residual impact to think about for Q3?.

So gallon growth is up low-single digits in the second quarter. In terms of the inventory reduction, we think it's largely behind us, though we continue to monitor that. I would tell you, though, that our sell-through with our channel partner was better than our sell-in to the channel partner in the quarter..

Okay. Okay. And then maybe just a bigger-picture question. You guys have done a really nice job deleveraging the balance sheet.

And so I know you're paying more dividends and you're still buying back stock, but how do you think about the aggression or the intensity within the M&A program, particularly in Decorative and Plumbing going forward?.

Tim, we laid out a balanced approach to capital allocation last year at the Investor Day. It's working for us, and we plan to continue to do that. As we talked about, we've repurchased 28 million shares against our 50 million share authorization. We paid down debt of $40 million – $400 million, excuse me, lots of zero. Increased our dividend twice.

So we like the balance that this has given us, with specific regard to acquisition. We're focused on bolt-on acquisitions. As we've said, we're not changing our strategy, and specifically on paint and plumbing. We would look, and are looking in other areas, but our focus is on paint and plumbing.

Our pipeline is growing in terms of absolute size, and we're seeing accelerated movement of targets through our pipeline as we develop them, develop relationships, and start to understand better how we could add value.

We're being prudent, I would say careful, in making sure that our acquisition targets, and a deal, should we do it, would bring good value. We're very disciplined in looking for the appropriate return on our investment, and the ability for us to bring synergies to it.

So no real change to our capital allocation or our M&A strategy, anything that's significantly different from what we've talked about for the better part of a year-and-a-half or so. I would tell you that I like our balanced approach because it gives us flexibility, but our strategy is unchanged in this area..

Great. Keep up the good work..

Thank you..

Will do..

Your next question comes from Mike Wood with Macquarie. Please go ahead..

Hi. Congratulations.

On Cabinets, can you talk about the rate of margin improvement by channel between retail and dealer, where it's happening faster or beating your expectations, particularly on price? And in that same vein, if you could talk about the impact the common ERP system is having in terms of price and service?.

In terms of where the improvements of margin are coming, a channel-by-channel basis, the lion's share of our margin improvements is operationally based, and it's very hard to detangle that. It's reflected in both channels of distribution. So the biggest change in margin from a cost-out perspective is really shared between the channels.

When you look at where we're having the most margin productivity in terms of price, if you will, I'd point to the dealer side, where we're getting mix, and that's been very helpful.

We've come out now some time ago with the KraftMaid vantage program, which really gives some differentiation to the dealers, and we're seeing that be very productive and that continues to raise in terms of the percentage of mix of our overall sell. And so I'd look at our margin as a combination.

Of course, there's factory and shop floor improvements that are shared by both segments. And then particularly in dealer, the mix-up is helping us. And I'll tell you, we're excited about the new products.

We've got – John talked about and I summarized about the investments that we have in the back half around new products for both KraftMaid as well as our Quality brands. So from my perspective, that pipeline for continuing our improvement in this segment is important and we're hitting it..

Great.

And also as a follow up, what feedback are you getting from the builders with the product exits that you're seeing? Are they shifting to lower-end cabinets from other manufacturers? Are you getting any builders coming back to the large manufacturers such as yourself?.

I haven't really seen the price point of the replacement for the work that we're walking away from and how that's being replaced. I suspect it's at a relatively consistent level of pricing and et cetera. In terms of who's getting that business, it's really not the big nationals.

What we're seeing more often than that – substantially more often than that is the regional players..

Thank you..

Your next question comes from Nishu Sood with Deutsche Bank. Please go ahead..

Thank you. First question I wanted to ask was in the Plumbing category, specifically digging into the North American business. Terrific sales performance there. There's already been some discussion of big ticket and in the spa business.

Across the kind of main Delta portfolio, what were you seeing in terms of what sorts of products were driving that very strong sales gains? Obviously, we saw a lot of design improvements at the trade shows early this year.

So what are you seeing there, and what has been driving that very strong sales growth?.

It's really broad based. In our core business and through both wholesale distribution and repair and remodeling, we're seeing nice unit volume, and that Delta brand is very well known for those customers that are in that price point. And we're very pleased with the performance of our showroom brands, which would be that higher end.

We mentioned our Brizo brand, which is the high-end brand underneath Delta Faucet company. That's double-digit growth and running very well. You look at our Axor brand, which is a high-end brand within the Hansgrohe organization that had double-digit growth. And then within the Hansgrohe continuum of product, the higher end is continuing to drive.

So I'm happy with our channel focus and the work that our sales folks are doing in the showroom. That's very productive for us. But the bread and butter of the core is doing as well in terms of unit volume..

Nishu, what I would add to that is you may recall we had a very strong fourth quarter with our wholesale customers. And therefore, that led to a pretty soft Q1 with those same customers because they had pulled forward some orders out of Q1 into Q4.

As we look at the numbers, I would tell you that we think that there was some replenishment going on, particularly in the first part of the second quarter as they continued to fill lower inventories. That helped made the second quarter top line..

Got it. Got it. No, that's very helpful. And price commodity wise, you mentioned in Plumbing that that was a tailwind. And obviously, you talked a little bit about in paint, the headwinds there. As you look across just the kind of market pricing, some of the metals prices are rising, wood products as well, the energy chain.

So I was just wondering if you could talk about how that might flow through across the separate divisions in the next couple of quarters and what your outlook is there, please..

Yeah, so I think there's a couple things there, Nishu, to talk to you about. Brass, which is the main component of our Plumbing products, is made of copper and zinc. And zinc actually has risen pretty nicely over the course of the last couple of quarters. It's been up off its bottoms consistently.

If you take a look at copper, copper really fell pretty dramatically in the November timeframe last year and really stayed low through kind of mid-January, and then it started to tick up from there.

And as we've said in the past, it takes about two quarters for those impacts to flow through and hit our P&L, which is about the second quarter when that would – when we feel a lot of that impact. So feel good about that. Looking around to our other product categories, though, not seeing a ton of inflation in our wood products at all.

We've seen a little bit of inflation, but not much, TiO2, we've already spoken about. Petroleum has been up and down a little bit.

The one area that we did see a little bit of inflation, and we called this out in our first quarter call was glass out in the western United States where a glass factory had gone down and so we had implemented price to offset that price increase that we incurred.

That said, we're working hard on our continuous improvement through our Masco operating system to try to offset any of this inflation that we are incurring to continue to drive our margins even higher..

Great. Thank you..

Your next question comes from Susan Maklari with UBS. Please go ahead..

Thank you. Good morning..

Good morning..

Good morning..

It seems like, doing some quick math here, you did make some improvements in your working capital this quarter.

Can you just talk a little bit about what's been going on there, and are there further efforts that we can expect to see as you continue to maybe drive some efficiencies?.

Let's talk about inventory first, Susan. We really look at inventory as an indicator of how well our supply chain is doing, we look at working capital as an indicator of how well our supply chain is doing.

So when we look at these improvements, I think it's really a reflection of the work that the teams have been doing in the factories and in our supply chain organizations to drive down and drive out waste in the shop floor through things like setup reduction and focused on one-piece flow and all of those fundamentals that we have as part of our operating system.

In terms of inventory from a supply chain perspective, we look at and are constantly developing and improving our methodologies for identifying minimum order quantities and working with our suppliers so that we can get shorter supply chains. So it's a combination of a lot of work that we're doing.

Quite frankly, Susan, I didn't expect us to be able to continue to improve to this degree. If you look at where we are, it's pretty darn good. I don't know if we're best in breed in our peer group, but I know we're very close. And the better you get, the harder it is to get better. We're not going to stop.

But I wouldn't look for any material real improvements here. But don't tell my guys that..

Okay. All right. Sounds good. And then in terms of the free cash generation, I mean, you've obviously done an amazing job there as well.

But as we think about your ability to perhaps drive some even more-improved operating margins in these businesses, is there any change to how you're thinking about your ability to generate free cash and how that could possibly trend looking out?.

No, I don't think so, Susan. As you cite, as our free cash flow – as our profits continue to grow, I think a couple of good things. As Keith just mentioned, we've got working capital locked down pretty tight so as that continues to grow, that should help our free cash flow. Our capital expense, our CapEx is a relatively light touch.

We've been averaging around 2%, just under 2% of sales for the last several years, a little bit more than that this year as we completed a couple of investments that we're making, but after this year, we do expect that to migrate that back down to kind of to that 2% of sales range.

So don't feel like there's significant investment to be poured back into the business as we continue to grow, so that should really enhance our free cash flow in the next several years..

Okay. Great. Thank you..

And ladies and gentlemen, we have time for one additional question. Mr. Mike Dahl with Credit Suisse. Please go ahead..

Hi. Thanks for taking my questions. A couple of questions around paint. First, obviously a lot of initiatives around kind of the Pro and building that business, I think interesting with the hub store roll out and doubling there.

Could you just talk a little bit more about beyond this next 100 stores what the opportunity is and I guess as part of this, is this really the most-successful initiative that you've seen as far as what it actually takes to crack the code with the Pro, just any color around there?.

Well, this is a $6 billion market when you look at it and we look at where we are, I'm happy with our growth rate certainly, but I think there's a substantial runway for us to continue in working with The Home Depot to do better and better here. The additional hub stores, obviously we're making that investment because it works.

But we still have a lot of value to generate here, no question, given the size of the market, and given our relative newness. We're continuing to learn. We have an outstanding team in paint, and we have an outstanding partner in Home Depot.

And as I've talked about on several occasions, to me, it's the interwoven strategy that we have with these guys and our cooperation and our relationship that's really driving a good chunk of this value. And that's continuing to increase. So I'm very positive on the outlook in Pro.

And we're going to continue to deploy our operating system against this initiative. Our people are developing. We're learning more. We're servicing the Pro better. We're getting faster. There's a lot of room for upside here..

And, Keith, how much of the business is still going through a Home Depot store versus some of your direct-to-customer initiatives?.

Oh, goodness. Most of it. Almost all of it..

Over 99%, Mike, is going to the Depot store. Very – almost nothing's going direct-to-customer..

Okay. Thanks. And then second question is around the Liberty program wins, John. Just wondering if you could give us a little color on just how to think about any potential load-in factor.

How much of the investments that you highlighted are related to this Liberty program? And how to think about kind of then an ongoing run rate for kind of sales there..

Yeah, so this program is something that Liberty launched a couple of years ago, and they won the West Coast and then subsequently won the Midwest region. And now they've won the balance of the United States with these 800-plus stores that we'll be bidding in Q4.

In terms of the investment that's going to go – and it should be kind of in the order of magnitude of $5 million, mostly in Q4, Mike, when we set those stores. There will be a bit of a load-in on that. Don't have a good estimate for you.

I'll probably give you some greater clarity in Q3 as we get closer to the launch of those – on the Q3 call when we get to the launch of those stores.

But I got to tell you that the Liberty team has just done a terrific job of coming up with new programs consistently, new merchandising concepts which this really is, and really enhancing their business with their channel partners. So hats off to Mark and the Liberty team. They've done a great job of building that business..

Great. Thank you..

And, ladies and gentlemen, this concludes today's conference. You may now disconnect..