Acuity Brands, Inc.

Acuity Brands, Inc.

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Electrical Equipment & Parts

Acuity Brands, Inc. (AYI) Q3 2008 Earnings Call Transcript

Published at 2008-07-03 10:00:00
Executives
Dan Smith – Treasurer and Secretary Vernon J. Nagel - Chairman, President, and Chief Executive Officer Richard K. Reece - Executive Vice President and Chief Financial Officer
Analysts
Chris Glynn - Oppenheimer Matt McCall - BB&T Markets [Glen inaudible] - Sidoti Peter Lisnic - Robert W. Baird Ted Crawford - Maple Leaf Partners
Operator
Welcome to the Acuity Brands 2008 third quarter financial conference call. (Operator Instructions) I would now like to introduce Dan Smith, Vice President, Treasurer and Secretary, Acuity Brands.
Dan Smith
With me today to discuss our third quarter results are Vern Nagel, our Chairman, President and Chief Executive Officer; and Ricky Reece, our Executive Vice President and Chief Financial Officer. We are webcasting today’s conference call at www.acuitybrands.com. I would like to remind everyone that during this call, we may make projections or forward-looking statements regarding future events or future financial performance of the company. Such statements involve risk and uncertainties, such that actual results may differ materially. Please refer to our most recent 10-Q and today’s press release, which identify important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements. Now, let me turn the call over to Vern Nagel. Vernon J. Nagel: Ricky and I would like to make a few comments, and then we will be happy to answer your questions. First, on behalf of our 7,000 associates worldwide, I am again pleased to announce record quarterly results for net sales, net income, and diluted earnings per share from continuing operations for the third quarter of 2008. This is our 13th quarter in a row of quarter-over-quarter record results. I know many of you have already seen our results, but I would like to make a few comments on the key highlights for the quarter. Our diluted earnings per share from continuing operations were $1.01, up over 29% from the year ago period. Results in the year ago period included a gain of $6.6 million or $0.10 per share for a favorable legal settlement. Excluding this settlement gain in order to make the current quarter’s results comparable with the year ago period, diluted EPS from continuing operations this quarter was up 49%, an extraordinary achievement given the current challenging economic environment. Net sales for the quarter were $512 million, up 2% compared with the year ago period. The growth in net sales and continued robust increase in earnings reflect benefits from the implementation of our strategies to be the innovative leader in new energy efficient lighting fixture products, expand our market presence in key channels and new markets, improve our service, drive productivity gains, and maintain our disciplined approach to pricing. The growth in our net sales in the quarter was even more notable given the continued decline in construction activity in the residential housing market along with a slowdown in new store construction in the retail sector due to curtailed consumer spending. While it is impossible for us to know the precise impact that declining demand in these two important sectors had on our net sales, we believe this weakness reduced our total net sales by almost 4% this quarter compared with the year ago period. Also, we continued to enhance the mix of our sales to higher more value-added products, while creating additional products that have features and benefits at price points to better address the more price sensitive portion of the market, in market where we have been losing share. While this transition has benefited our profitability, it will continue to affect our top line growth rate until those actions to stop our share erosion in that portion of the market take hold. The acquisition of Mark Architectural Lighting and the favorable impact of foreign currency exchange rate changes contributed about two percentage points of the increase in net sales in the quarter. Excluding the impact of these two items and the decline in both the residential housing market and new store construction for retail, we believe our net sales grew about 4% in other areas of the non-residential market. While it is impossible again to calculate precisely the impact of our pricing actions, product mix and unit volume, we believe this increase in net sales was split relatively equally among pricing and product mix, while unit volume was essentially flat. In addition to our positive top line performance we were particularly pleased with our operating performance, especially regarding productivity and customer service. Improvement in these key areas along with favorable pricing and the better mix of products sold contributed to the 310 basis point expansion in gross profit margin over the year ago period to 40.6%.This is the first time our gross profit margin has ever exceeded 40%. Consolidated operating profit margin was 14%, an increase of 340 basis points over the year ago period after excluding the settlement gain recorded in the year ago period. This too is the first time we have achieved a consolidated operating profit margin of 14% for any period. Consolidated operating profit was $71.7 million, an increase of 35% over the year ago period, excluding the impact of the settlement gain. This was extraordinary performance by our team, especially given the sales weakness in two importance sectors of our business. Looking at our results from another perspective, we generated $18.6 million of incremental operating profit excluding the settlement gain in the year ago period, and an increase of $10 million in net sales. Profitability and margins in the quarter grew significantly in spite of rising costs for certain raw materials such as steel, component parts and certain employee related costs. And while continuing to make investments to further improve productivity and for projects to expand our presence in key markets like New York City and lighting-related adjacencies, particularly the lighting relight market, where we see significant growth opportunities. Lastly on the strategic front, we accomplished a great deal in the quarter. For example, we grew our presence in key markets like New York City, introducing a wide range of Lithonia Lighting products to complement our specialty brands designed for major projects as well as distributor stock business. We invested heavily in our new Technology Services companies, including expanding our emerging relight programs through our SAERIS organization, and acquiring Guardian to enhance our ROAM services businesses directed at enabling utilities and municipalities to more effectively manage their remote assets, including lighting fixtures. Lastly, we continued to enhance our product offering by introducing new and innovative products, including those incorporating LED technology and products directed at the relight market, as well as entering into alliances with strategic partners to open new markets. These strategic accomplishments, as well as our exceptional results are the by-product of the commitment and focus we have as an organization to provide our customers with superior value, our associates with great opportunity, and our shareholders with upper quartile performance. All-in-all, ABL had a great third quarter, particularly given the challenges of a changing landscape in the economic environment throughout the world. I complement the leadership team and all associates at ABL for their dedication, outstanding execution, and intense focus in the pursuit of operational excellence. I would like to now turn the call over to Ricky to make a few brief comments on our overall financial performance, before I make some concluding remarks. Richard K. Reece: Vern has previously discussed key highlights of our revenues and operating results for the quarter. So I will not repeat this information. However, I will touch on a few additional items regarding our third quarter results. Selling, distribution and administrative costs were $136.5 million in the quarter ended May 31, 2008 compared with $129 million in the prior year period, which benefited from a pre-tax gain of $6.6 million for a favorable legal settlement. As a percent of sales, operating expense for the quarter was 26.6% compared to 25.7% in the prior year. Excluding the favorable legal settlement in the prior year, SD&A expense increased less than $1 million, and actually declined 40 basis points as a percent of net sales. This improvement reflects our efforts to manage our indirect cost, including benefits from simplification of our administrative structure as a result of the spin-off of Zep, while continuing to invest in new products and services, as well as new markets. During the quarter, net interest expense was essentially flat. We enjoyed strong cash flow generation in the quarter with cash flow from operations of $55 million, up almost 11% compared with the prior year period. During the third quarter, our effective tax rate related to continuing operations was 33.9% versus 34.9% in the prior year. The current year third quarter benefited from a large deduction representing a benefit from increased exports of goods manufactured in the U.S. compared with the prior year’s third quarter. We still estimate that for the full year the tax rate will be approximately 35.5%. We reported a $0.01 loss from discontinued operations during the third quarter, due to revisions in estimates for tax reserves related to activities of the Zep business, which occurred prior to the spin-off. Let’s now turn our attention to the results for the first nine months. Sales for the nine months ended May 31, 2008 were $1.504 billion, up 5.6% compared with the prior year period. The factors affecting this comparison are very similar to the factors discussed previously for the quarter. Operating profit for the first nine months of fiscal 2008 was $187.3 million. This reflects an increase of $34.5 million or 22.5% compared with the prior year period. The operating profit margin increased to 12.5% from 10.7% in the prior year. Excluding the impact of the first quarter special charge of $14.6 million and the prior year’s favorable legal settlement of $6.6 million, which will make the results more comparable, the operating margins increased 310 basis points to 13.4% for the nine months. Diluted EPS from continuing operations was $2.55 for the nine months ended May 31, 2008 compared with $1.96 in the same period last year. Excluding the items that affect comparability, diluted EPS from continuing operations for the nine months increased 48% compared with last year. The loss from discontinued operations for the first nine months of fiscal 2008 was $0.01 per diluted EPS, or $0.4 million, a decrease of $11.2 million from the prior year period. This decrease was due primarily to the contribution of only two months of operating results in the first nine months of fiscal 2008, rather than a full nine months results in fiscal 2007. In addition, discontinued operations were negatively impacted by approximately $5.5 million in cost related to the spin-off during the first quarter of fiscal 2008. These non-tax deductible costs consist primarily of legal, accounting, financial advice and other professional fees to complete the spin-off. My concluding comments will address our cash flow and financial position. During the first nine months, we generated cash flow from operations of approximately $111 million versus $114 million in the prior year. This slight decline was due largely to the timing of tax payments and payments made against the special charge in the first nine months of fiscal 2008 compared with last year’s, partially offset by the improved net income. Our overall trade cycle days remained flat compared with the prior year at 41 days. We invested $21.4 million in capital expenditures during the first nine months, roughly the same amount as in the prior year. We estimate that full year capital expenditures will approximate $35 million. Additionally during the quarter, we acquired the assets of Guardian Networks for approximately $3.5 million in an effort to enhance the operating platform of our ROAM business. During the first nine months, we repurchased approximately three million shares of our common stock at a cost of $131 million. There are currently one million shares remaining under our existing share buyback program. As a result of the spin-off and our recent share repurchases, our shareholders’ equity declined to $565 million at May 31, 2008 compared with $672 million as of August 31, 2007. We continue to maintain strong financial flexibility as reflected by our net debt-to-cap ratio, which was 21% at the end of the quarter. From a liquidity standpoint, we have cash of $216.3 million and availability under our revolving credit facility of $241.3 million as of May 31, 2008. In addition, we continue to generate strong cash flow from operations. Due to the strong financial position we intend to terminate our $75 million receivable securitization line, as we do not see a current need for this additional source of capital. We have not used this facility in almost two years, disruptions in the credit market have made this source of financing less competitive, and our current provider of this credit is getting out of this line of business. These factors caused us to decide to save the fees and terminate this facility early. In addition, barring any significant cash requirements for possible acquisitions, we currently intend to use cash on hand to pay off the $160 million in publicly traded notes that are scheduled to mature during the second quarter of fiscal 2009. And I will now turn the call back to Vern to discuss our outlook. Vernon J. Nagel: As we look at the fourth quarter of 2008 and into 2009, we continue to see challenges, but more importantly opportunities. Just to note a few of these challenges, all the data we see shows the economy in the United States and in many other parts of the world experiencing a slowdown due to political uncertainties, the disruption in the housing and financial markets, and higher commodity costs. Clearly, it is impossible to know the effect these items could have on the future growth rate of the construction markets or for how long into the future these conditions may prevail. But it is clear that those factors which influence the future growth rate of new construction, including the future vitality of the economy, job creation, consumer sentiment, occupancy rates, and the availability of capital all are in the state of current flux, are signaling slower growth ahead or in some markets continuing declines in demand. Our backlog at the end of May was $182 million, down approximately 4% compared with the year ago period. The decline was due primarily to improved cycle times, and the timing of certain orders, and the reduction in past-due backlog. However, our daily incoming orders rates in June have been soft compared with those reported in the year ago period. This softness is due in large part to the steep declines in the residential home sector, including its effect on new store construction in the retail industry. In addition, the weaker U.S. economy over the past few quarters is now starting to negatively influence demand in certain commercial and industrial markets. Nonetheless, we continue to enjoy positive growth in key sectors and geographies of the non-residential market where we have particular strength. We expect other factors to also influence our fourth quarter of 2008 and into 2009, including continued cost pressures for certain raw materials, particularly steel, component parts, fuel and other employee related items. To help offset some of these recent spikes in costs, we announced a price increase on most products ranging between 3% and 10%, effective early May. While we expect to announce another price increase shortly given the dramatic and rapid rise in certain raw materials, particularly steel, we will likely not be able to recover all of the increases in cost at least in the short-term, putting pressure on gross margin. While we monitor these challenges closely, we so far have demonstrated a strong capability to deal effectively with these issues, while delivering upper quartile results for our shareholders. We continue to find ways to offset costs associated with investments and programs to drive future profitable growth, including those that enhance customer service, improve productivity, expand our access to market, and develop new innovative products. In addition, we continue to aggressively make investments to accelerate our product pipeline, including LED-based products as well as fund our expansion in the relight market, where again we see significant growth opportunities. However, we are not immune to the turbulent economic conditions that prevail throughout the world. In spite of our many proactive actions to drive superior performance in the fourth quarter, we expect these conditions to influence demand making significant improvement in period-over-period results challenging. To be clear, in spite of any challenges we may face in the fourth quarter, we expect to exceed all of our long-term financial goals, including margin expansion, earnings growth, and cash generation in fiscal 2008. As we look beyond the current environment, because this too shall pass, we believe the lighting industry will experience solid growth over the next decade, particularly as energy and environmental concerns come to the forefront. For Acuity Brands, we feel we are positioned uniquely to not only participate in this evolving industry, but to accelerate that change in growth by providing unique and innovative solutions to meet the needs of our growing customer base. Even in the current environment, there are solid opportunities for us to continue to prosper, particularly as we introduced new innovative products and further expand our access to new markets, including the relight market. We are encouraged by our traction in the relight market as commercial, industrial and retail customers take advantage of our broad array of efficient lighting fixtures designed to reduce energy consumption, while creating a much better lighting environment. We believe this market which some estimate to be in excess of $70 billion in size represents a significant growth opportunity for us. Also we continue to position ABL to better leverage its market presence by continuing to make investments which enhance our go-to-market programs and strengthen our geographic footprint, as well as expanding our product offering with new innovative products to provide superior value to customers from an energy and lighting performance perspective. We have created one of the broadest, most efficient energy and cost-effective product portfolios available in the industry to allow our customers reduce their energy consumption, while providing a better lighting experience for their customers and associates, as well as contributing to their own sustainability goals. We believe this will continue to be an opportunity for growth in 2009 and beyond. In addition, we continue to make investments in programs to train and develop our associates to enhance their ability to service customers and improve productivity. We continue to demonstrate that by investing in these programs we can profitably grow our business, better serve our customers, and improve our margins, while at the same time making investments for future profitable growth. Our record results over the last 13 quarters support the investment in these programs. Lastly, we will continue to be relentless in our mission to excel in providing our customers with superior value, our associates with great opportunities and our stockholders with consistent upper quartile performance. With that, we will entertain any questions that you have.
Operator
(Operator Instructions) Your first question comes from Chris Glynn - Oppenheimer. Chris Glynn - Oppenheimer: Fourth quarter cash flow is typically the strongest of the year. Any movement around that normal trend this year, should that be the typically expectation again? Richard K. Reece: Yes. I think, we will continue to see the strong cash flow generation as we come off of a very robust summer season. For certain of our product lines, we were able to bring inventories down a little bit, and we are hoping to do that again at the end of this fourth quarter, as well as the elevated sales we tend to have in the second half of the year as we collect on those receivables. Some of it of course would depend on the timing of sales throughout the quarter, but our expectation, Chris, is consistent with prior years that we would hope to have a good strong cash flow in the fourth quarter. Vernon J. Nagel: Chris, I would also comment that with a couple of vendors, we have been offered rather favorable cash discounts. We have taken advantage of those opportunities and those have pushed our days payable down a little bit. So where we have continued to trend favorably in terms of our working capital usage, we did take advantage of some opportunities there. So that has had some minor impact on overall cash flow. But again, we continue to generate favorable cash flow, as Ricky pointed out, we would expect to do that. Chris Glynn - Oppenheimer: Given the stock price reaction today, just wondering how much was left on the repurchase authorization? And then with the cash and the availability on the revolver would you lever up in this environment? It’s off $4 or $5. Richard K. Reece: Yes, we have got a million shares remaining under the authorization from our Board. And we will continue to look at stock repurchase as one opportunity to use cash. We haven’t contemplated at this point, Chris, to lever up, to recapitalize by repurchasing shares and using our line. But we do want to keep some dry powder, so that acquisition opportunities, which we think may become more plentiful in this less robust market or at least more favorably priced in this less robust market, and we want to be able to take advantage of that. Plus we are seeking to retain our investment grade rating as we all saw during this winter and into the spring and summer that non-investment markets have been shutout. And we have certainly appreciated having the flexibility of being investment grade should the right opportunity come up. So we are sensitive to that. Having said all of it, certainly if we see opportunities to create shareholder value by repurchasing stock, and if that’s the best use of cash and how to appropriately capitalize the company, then we certainly will evaluate that and take advantage of those opportunities. Chris Glynn - Oppenheimer: On the top line even excluding the new retail construction, it sounds like from unit volume perspective the rest of the non-res markets were flat. Now within that you do have some of the energy efficient retrofit. I am just wondering about the scale of the non-res markets decline versus what you are seeing on the retrofit? And would there be an expectation for some top line growth in ‘09? Vernon J. Nagel: The short answer on ‘09 is, yes, we are expecting top line growth. And that is against the backdrop of what arguably could be a declining market. If you look at contract awards from Dodge and from other folks who examine those types of things, they are trending down here in ‘08. There is a lag factor. So we would expect there to be some down in the market in our fiscal ‘09 and calendar year ‘09. Having said that, our growth objectives and our growth initiatives around key areas, relight being one of them, are we think, very real and we are pursuing those very aggressively. And we are seeing our relight opportunities start to ramp up. As you might imagine, there is a lag time as we energize, if you will, our sales force. And again, given the fact that we have by far and away the number one sales agency group in the industry, as well as our own direct sales force, we are ramping these folks up through training and development. And we are now starting to see those folks making calls and we are soliciting I think very attractive leads. A couple comments on our top line for this particular quarter, it’s very interesting when you look throughout North America, and you look at these various geographies. We have seen very attractive growth in a number of geographies where we continue to leverage our position both in terms of our access to market, our sales forces, as well as our new products, and new products not only for relight, but new products that have a energy efficiency story to them while providing a superior lighting environment. So we are getting very good traction. The problem that we see is that in other markets or in certain markets, pick the Midwest. The Midwest has really been a very difficult market in general. I think that our team and our folks have done well in those markets, but yet the market itself is down dramatically. It’s just general economic activity. And so when you look at markets, whether it’s Detroit or at Pittsburgh, or at Cleveland or some of these places, our teams there are very, very strong, and we are holding our own, but the problem is just that the overall economic environment is down. If you look at other geographies in the country, and we are seeing again very, very attractive growth because of our capabilities and our product offering. So when we look at all of the influences that came to bear in the third quarter, I am quite pleased that we were able to show top line growth. We have been moving aggressively to change the mix of our products. I made a comment earlier that we have by design, and this has been going on for the last several years moving our portfolio to higher value add, higher margin type products that more price-sensitive portion of the market we have been introducing products that have features and benefits at price points into those markets. We are gaining traction, but not as quickly as the market itself has been moving away from us. I would expect us to reverse that trend as we get into the ‘09 period. Chris Glynn - Oppenheimer: Reverse what trend exactly? Vernon J. Nagel: Reverse the trend where the lower, more price-sensitive portion of the market where we have been losing share, because you didn’t have products that had features and benefits at the price points that people were willing to pay. We have now introduced products that are targeted at those markets. Contractor Select is the name of the brand that we are taking through by Lithonia, targeted at those markets and we are starting to see traction. But it takes time to move and get back into some of those more price-sensitive portions of the market. So, that mix change has really benefited, if you will, our profitability. As I mentioned, this quarter was the first time that we had achieved a 40% gross profit margin ever in our history. The first time that we achieved a 14% operating profit margin ever in our history, but some of it comes at the expense of top line growth, because again that lower, that more price-sensitive portion of the market has been an area where we have been losing share. It’s my expectation for us to get back into that through Contractor Select, and regain some of that share that we have lost. Chris Glynn - Oppenheimer: You’ve basically guided to 15% plus EPS growth for the fourth quarter in terms of citing expecting to exceed your long-term targets. Just on the top line, the easier comp with last year’s quarter and then the pricing would seem to suggest a little stronger year-over-year top line than the third quarter? Vernon J. Nagel: I am not sure completely of all the things you just asked. So let me make a few comments. One, our pricing going into the fourth quarter, the price increase that we put in place in May really was effective for orders that were placed prior to June 27, so we are not really expecting a great deal of change or benefit from that price increase in our fourth quarter. Unit volumes were flat in the third quarter, again driven by the decline in resi and new store construction in retail. We would expect those conditions to prevail as we go into the fourth quarter. Our fourth quarter is typically up relative to third quarter. And so last year in our fourth quarter, we had revenues of roughly $540 million. It would be our expectation to show some ability to grow on that. But we are still trying to catch this falling knife, if you will, in the residential market, and it has been subsequent fall out into other areas. On a year-over-year basis, new home construction is down over 40%, multi-home or multi-tenant construction is down more than 40%. Obviously, we are not down anywhere near that. So I believe that we are doing a excellent job there. Nonetheless, that isn’t impacting our overall volumes. So, while we saw all of this mix going on, it’s my expectation that the fourth quarter will be flattish to slightly up in terms of top line, when you look at it compared to the year ago period. Richard K. Reece: Another comment I would make is, Chris, we will have anniversaried the acquisition of Mark Architectural Lighting within the fourth quarter, which it has been contributing about a 1% improvement on the top line. We made that acquisition in our fourth quarter last year. So we are anniversarying that. So that benefit won’t be there either. Vernon J. Nagel: And let me also then comment on, I think, you had asked a question on margins. And I know folks will have questions on that as well. Again, I compliment the team at Acuity Brands Lighting that we have done just an excellent job in expanding our gross profit margins due to price and product mix, very difficult to tell the difference between the two. Though, of that 4% increase that we quoted in the portion that grew, we think that it was split relatively equally between price and mix with volume being flat. It’s our expectation that as we go into the fourth quarter we will continue to show that same favorability. The problem is that we are also expecting based on how rapidly steel costs and fuel costs, just to name two, have increased in the quarter, it’s unbelievable. Some of our competitors have announced additional price increases. I think that one came out today, the other one was a couple of days ago. We too will be coming out with a price increase, but we are not going to be able to make up for the dramatic increase in these two areas to really in the fourth quarter. I think we will catch up again back in the first quarter. So our expectation is that our margins, gross profit margin could be impacted by as much as a point in the fourth quarter due to those, the timing of those increases. So, while I am expecting us to continue to improve as we have, again if you look throughout the first three quarters of this year our gross profit margins have been up. Last quarter or in the third quarter, it was up 310 basis points, second quarter 270 basis points, first quarter 210 basis points. So we are demonstrating a track record of continued improvement. We will find some challenge because of these rising commodity costs and fuel costs.
Operator
Your next question comes from Matt McCall - BB&T Markets. Matt McCall - BB&T Markets: Vern, you talked a lot about pricing, and the use of pricing to offset some of the commodity pressures. I know a lot of the margin improvement that you just spoke about has come from other areas outside of pricing. Can you talk about maybe accelerated efforts on the manufacturing structure side? You talked about distribution structure in the past as a potential area of cost savings. Just talk about other ways that you are addressing this issue and the timing that those should show up as offsets to the cost issues? Vernon J. Nagel: In the quarter, our team from a supply chain perspective improved its productivity quarter-over-quarter by well more than 5%, this is while dealing with declines in unit volume in terms of how we serve the residential market. So our lean journey is really yielding benefits to improve our productivity and as importantly to improve our service. So we would expect those types of gains to continue. The lean journey, it has a beginning, but it should never have an end. It would be our expectation that you will continue to see those benefits as we go forward. As we enter 2009, we continue to look at ways to structure our business that allow us to redeploy, if you will, assets from lesser value-added areas to higher value-added areas. And it would be our expectation that we would continue down that path. We continue to look at our manufacturing footprint. We continue to look at ways to distribute our products better, more effectively to meet the needs of our customers. So I see continued opportunities in those areas to drive real value. Our commitment to add 70 basis points of improvement on our base top line continues to be a commitment that we have internally. And again, I am pleased to say that we have far outpaced that goal. And again, we expect to continue to achieve at least our goal, and hopefully continue to outpace it as we have. Matt McCall - BB&T Markets: I think in the prepared remarks, Ricky, you might have spoken about the Zep cost savings, the streamlining efforts. And initially, I think, you talked about $6 million of expected cost savings next year in addition to what you recognize this year? Is that still the bogie and is that in addition to the 70 basis points or is that just going to help you get there? Richard K. Reece: First off, we are looking at a total of $14 million of savings. And we think we will be at that run rate as we go into ‘09. Your estimate of how much we’ve achieved to date is probably in the ballpark, we haven’t said publicly exactly how much run rate we are at today. But we do still believe we are on track to be at that $14 million savings run rate as we enter into ‘09 or exit ‘08. And that will be incremental to what we think we can do through these productivity improvements and product mix and so forth that are causing the 70 basis point. Vernon J. Nagel: And Matt, to be clear, we did see contribution to our improved profitability from those actions in the third quarter. Matt McCall - BB&T Markets: I want to talk about the gross margin line, and specifically the cost issues. SG&A expectations, you referenced continued investment in some growth or, I think, last year, there was a pretty nice decline in the SG&A percent of sales, Q4 versus Q3. Is the 120 basis points last year, anything we should think about incremental spending that’s going to throw that off, as we look Q4 versus Q3 this year? Vernon J. Nagel: I am looking at our operating expenses as a percentage of our revenues. In the third quarter, we were at about 26.6%.It would seem to me that we would get a little bit of leverage off of that. But we are investing in a number of areas, LED, our entry into the ROAM. The ROAM business, which is again, a service business targeted at municipalities and utilities, which we think has tremendous growth potential, is still in an investment mode. And so we’re expensing the ramp up of those folks. We have some other businesses similarly that we’re doing. We’re adding to our engineering capabilities around the company, particularly as we drive LEDs, particularly as we enter into alliances, to help manage those alliances. So we’re investing in those areas, and you’re still seeing us generate increasing operating profit gross margin capability. Richard K. Reece: There is nothing significant in our fourth quarter beyond what you’ve been seeing Matt, here in the second and third we continue to invest as Vern said, but there is nothing significant planned that would materially effect the fourth quarter. Matt McCall - BB&T Markets: And those normal seasonal patterns seem to make some sense. Maybe not to the extreme that you saw last year, but still some seasonal benefit? Vernon J. Nagel: Matt, in the fourth quarter last year, the marketplace started to feel the impact of the decline in the residential market. That has now started and we anticipated this. This is not anything new to us that has started to spill over into some of the other areas such as the Small Project business. When you build a neighborhood, you generally build a strip mall. That strip mall is considered non-residential, but yet it’s influenced by the expansion or contraction in the residential market. The bottom line is that as the economy continues to move it will influence obviously non-residential as well as residential construction. We think that the fall off, and if you look at Dodge and you look at some of these others, it’s nowhere near as significant as if you go back and look at 2001 and 2002, primarily because the overbuild in a lot of these areas just did not occur. The ramp up from the trough of the last decline was really not very significant compared to historical patterns. So our view of the future is that the decline that we are experiencing, or that the industry is experiencing, probably will not be as dramatic either. We think that the ability to offset that is very real for us because of our market presence, new products. But as well as entering into some of these new markets, whether it be relight or New York City or expansion into some other more direct opportunities, we think that there is growth in ‘09 for us that looks very favorable. Matt McCall - BB&T Markets: You talked about the lag factor with construction overall. Most of the data we are seeing from a non-res construction standpoint, I agree that some of the leading indicators are starting to show a little reason for concern. But most of the coincident indicators, just the spending data in general, is still showing some strength. So that’s why I was a bit surprised to hear the comments about orders being down and you said in certain commercial and industrial environments, maybe that was what you were referencing, some of the strip malls. But I was anticipated a little bit more of a lag and you would see a little bit more growth post the construction stream? Vernon J. Nagel: So let me be clear on a couple of points just for clarification. We are seeing continued strength in a number of geographies. We are also seeing weakness in certain geographies, for example, the Midwest, South Florida. Those areas are being impacted by either general economic activities or more directly, resi. We also believe that in the more price sensitive portion of the market, I think I commented on this last quarter, we are seeing, again, erosion in our share because we have opted to not play in that market at those price points with the products that we have. So we’ve introduced new products targeted at that portion of the market. Those products are starting to have traction, but they are not having traction at the rate of where previous share erosion had occurred. So for us, it’s now this trade-off as we ramp that business back up. I am expecting the fourth quarter to be favorable, vis-à-vis that particular product line, but not enough to offset what is occurring in that portion of the market. So it’s just simply, for us, more of a timing issue, I believe, in terms of what overall orders look like. Resi, as well as how it impacts retail construction where we have strength, clearly is an impact. Like I said earlier, we believe that in the third quarter it was down for 4%. That is a direct impact. There is no leading lag indicator. A lot of those are national account type pieces of business.
Operator
Your next question comes from [Glen inaudible] - Sidoti. [Glen inaudible] - Sidoti: Just a clarification on the 100 basis point negative effect from the rising commodity costs you expect in the fourth quarter. You still expect the margins to be up sequentially though over the third quarter just due to your traditionally higher volume in the fourth quarter, right? Vernon J. Nagel: Again, third quarter, first time we had ever achieved a 14% operating profit margin. First time our gross profit margins have exceeded 40%. It would be our expectation that we could build on that, but when it comes down to how impactful will these commodity costs be, we are still trying to assess that. That’s why we are putting out, we think it could impact our gross profit by about a point, or up to a point, I should say. [Glen inaudible] - Sidoti: Looking forward with respect to your SG&A costs in a sluggish growth environment you’ve touched upon this a little bit already but, would you expect to see just the SG&A to increase or decrease? I am just trying to get a sense of how much of those expenses are tied to sales commissions and a sense of base compensation? Vernon J. Nagel: Well, again, I think on a period-over-period basis, Ricky, we are looking at probably a 3% to 4% increase in actual spending in some of those key areas, if you are talking about an ‘09 period. But we would also look at opportunities within our continuous improvement efforts to offset those costs. Now having said that, I still believe that we will have some now year-over-year increases in our SG&A because we continue to invest in some of these specialty businesses. Particularly ROAM, which is a business, again, that we think has tremendous potential, but it is people intensive. So I would see next year us still having some burn rate, if you will, there. We continue to expand our engineering capability to really help facilitate and accelerate our growth in new products, so there are some adds that are going on there. How it is all going to play out, I still believe that we will be able to, on a period-over-period basis, generate north of 70 basis points of improvement. And that is really our target, whether it comes from our ability to drive supply chain benefits that come through gross profit or it’s service and we are able to take cost out of up and down the line. We are just looking at adding to that 70 basis points or better to our operating profit line on a go-forward basis here. [Glen inaudible] - Sidoti: With respect to the May price increases, was the market receptive to those increases? Were you able to fully realize? Vernon J. Nagel: Yes, we have a very disciplined approach to pricing. In some instances, we actually have lost share because we have held our pricing discipline. The May price increases were effect for orders that were put in place prior to June 27. I don’t remember the exact date, something like that. So our ability to capture the full price or have it impact significantly the fourth quarter, I just don’t see it. Our backlog, roughly $180 million, so it is really not going to start kicking in until late August and then really into the first quarter. Then the next price increase, which should be coming out here very shortly, won’t really impact us until we get into the middle, if you will, of our first quarter. So these commodity increases are going to be impactful. And just to put those in perspective, steel, from the end of the second quarter, for us that’s the end of February to the end of May, went up about $0.20 a pound, and we say in our 10-K that we use about 120 million, or 120,000 tons of steel and aluminum a year, so that is to 240 million pounds. That is 60 million pounds a quarter and, at a $0.20 increase, that is $12 million. So you can, just from that alone, get a sense of just how significant this increase has been. It’s unprecedented, frankly. And if you look at diesel fuel, we consume, in total, probably a million gallons of diesel fuel a quarter, and on a year-over-year basis it’s up $1.60. So these cost increases, again, have been unprecedented and are significant. So we have been very diligent. We have demonstrated, I think, a strong track record of being able to increase our prices, take out costs in our business to improve our profitability, and we expect that on a go-forward basis. [Glen inaudible] - Sidoti: With respect to the retrofit market, I know in the past you have said you had trouble to figure it out how significant of a market that is for you. On the third quarter basis, have you made any progress on that front figuring out the impact? Vernon J. Nagel: We have, and I believe that as we talk about what ‘09 brings for us in a more specific and direct way at the end of next quarter, we will really bring greater clarity to that. Because, again, we are getting traction in the marketplace, and we would rather really bring more fact-base to the conversation. And we will have another quarter now of aggressive selling efforts and I think we will be able to bring greater clarity to all shareholders in that regard. So that’s really a next quarter opportunity for us.
Operator
Your next question comes from Peter Lisnic - Robert W. Baird. Peter Lisnic - Robert W. Baird: Vern, I was wondering if you could give us a little color commentary on the actual June order number, what it looked like. Vernon J. Nagel: We haven’t provided that data, but I would say that to say that we were down it would be in the middle single-digit range. But I wouldn’t read too much into that, Peter. There is a lot of noise in that number and so for us, again, fourth quarter from a volume perspective we still have time to go here. And we are seeing activities. Our daily order rate is starting to, if you will, improve. And some of the actions that we have around how to stimulate that, again whether it’s relight or whether it’s continuing to drive new products, we see that as an opportunity. So that is why we tried to give a bit of clarity around third quarter period-over-period volume was flat once you exclude resi and new store construction. Our expectation is that we will probably be somewhere in that range again. But comparing fourth quarter to fourth quarter, just to be clear on that. Peter Lisnic - Robert W. Baird: Was there anything in the month that you saw that was, disconcerting or any new pockets of weakness? Or is it just similar geographic issues in the Midwest and maybe the Southeast, and then the light retail also being under pressure? Vernon J. Nagel: Well, I actually think that there has been some good news that has popped out and that is you get a number of markets, which were devastated by the change in the resi market, you are actually seeing flatness and in some markets improvement. So if that is an indicator that resi is now hitting bottom, which I don’t know if it is or it isn’t. But you look at these trends I believe that is a very favorable trend. Because, again, that then influences a lot of small float type projects and so that to me is an area where, again, we have lost share, but would be an opportunity for us and for the industry at-large. Peter Lisnic - Robert W. Baird: As you look out to fiscal ‘09, and it sounds like you are looking for positive top line growth on an organic basis, can you maybe help us build a bridge as to how you get there? If you assume that the Dodge numbers are right and the end markets are down whatever percent, how you go from that down number to a plus comparison in your top line? In other words, what portion of that might be new products or share gains from Contractor Select, energy efficiency related products, price, those sorts of things? I’m just wondering how we get there. Vernon J. Nagel: That’s a very good question and we would intend to help you build that bridge as we finish ‘08 and really comment on that more specifically in the next conference call after fourth quarter. But to provide some insight there, we are expecting and we are just using publicly available data, there is no information that we have necessarily that is different than what is available to all of you. That the market could be down in low single-digits next year and I am talking about the non-residential construction market. We believe our opportunity, through a combination of new products, products that, again, have an energy and better lighting story, not for the retrofit market but for the market in general, will allow us to continue to expand and do well in those sectors where we have very strong market presence and strong market share. You know what they are. They would be the commercial buildings, they would be institutional type buildings, they would be manufacturing installations, they would be warehouses, those kinds of things is where we play well. Healthcare, as an example. So new products driven towards that and those products we have actually introduced some and we are seeing traction. But it’s small when you start. We are a very large company, but the way those products are introduced and how they are being received and accepted is very exciting to us. Relight market, we are definitely ramping up our capabilities there, not only from a product offering perspective, but through SAERIS, which is our turnkey solutions provider. Today that business is very small, but when you have the sales force that we have and they are now being trained and we’re in the marketplace with people who have the skill to help sell this type of differentiated service. My expectation is that you will see nice growth from that. Our expansion into new markets, and I’ll just pick one specifically, New York City. We opened up our Light and Space office there. That agency, which is a company representative, our business on a year-over-year basis is up about 100%. And so while the numbers are very small relative to the size of our company, it’s very important. That market is a $250 million market, just the installed base. We believe specifications coming out of New York City are another $250 million. So traditionally, we have had very, very little share in that market. On May 1, we introduced about 70 of the more popular SKUs of Lithonia Lighting that are New York compliant into that marketplace to help complement our specialty brands. That is a huge, huge deal. Again, Lithonia Lighting and ABL enjoy roughly a 20% share in the non-residential market and yet we were just a fraction there. So if you imagine our ability to ramp up in that market place, it’s pretty exciting. So we see pockets of opportunities like that to help us drive incremental growth offsetting any potential decline in the marketplace.
Operator
Your next question comes from Ted Crawford - Maple Leaf Partners. Ted Crawford - Maple Leaf Partners: On inventory, can you tell me what your cost of goods sold would have been in the quarter if you had used LIFO, and I wonder if you have that for ‘07 too for the year, fiscal year? Vernon J. Nagel: We really expense our purchase price variances, we capitalize a little bit coming back, but our inventories turn pretty quickly. So you’re seeing the blood, the guts, and the glory in our numbers. Unfortunately, these cost increases are coming at us fast and furious and we’ve been able to offset generally those things through pricing. The impact is going to be pretty significant here in the fourth quarter, that’s why we estimate up to a point of margin potential degradation. I believe that in the third quarter, when you look at the inflationary factors that influenced our quarter, they were almost 2% of revenues. So we were able to still generate the kinds of gross profit and profitability while absorbing some of those through our other productivity gains. Richard K. Reece: We have seen, obviously, inflation in raw material cost and component costs. But if we had been on LIFO instead of capitalizing those into inventory, we would have been expensing that. Fortunately, we do a pretty good job, best in the industry, of managing our inventory so we don’t have quite as much inventory. It would have some of an impact of increasing our cost of goods sold, but I think just given a guess, based on what I’ve seen in cost increases for raw material and all, it’s in the single-digit range, mid-single digit type of range now. Ted Crawford - Maple Leaf Partners: Single-digit as a percent of COGS? Richard K. Reece: As a percent of COGS, mid-single digits year-over-year if you look at all of the areas, and then we’ve got some productivity gains that have offset some of that as well, that if we’d have been on LIFO we wouldn’t have gotten those benefits. Vernon J. Nagel: But be clear, Ricky. I think the question is how much is still sitting in our inventory. I don’t think that it’s mid-single digits in COGS. Richard K. Reece: No, it would be mid single-digits of inventory. Vernon J. Nagel: You are asking a question that we haven’t really swaggered at but to me, if I had to look at it as a percentage of sales, it would not reach anywhere near a point. I don’t have the exact number off the top of my head but, as a percentage of sales, it would be substantially less than a point. That’s remaining in inventory yet to rollout. Richard K. Reece: I thought the question was how much have the material costs gone up year-over-year as a percent of COGS. Now, again, our inventory is a lot less than COGS because we turn our inventory eight times or so a year. Ted Crawford - Maple Leaf Partners: What percent of your COGS is aluminum and steel combined, roughly? Vernon J. Nagel: Well, just a number that we provide in our 10-K, we use roughly 120,000 tons. So call it to 240 million pounds of steel and aluminum per year. Call it roughly, though it doesn’t play out exactly this way, or 60 million pounds of steel and aluminum per quarter. And if you just make it easy on yourself and say that in this quarter it’s $0.20 on 60 million, that’s $12 million. And by the way, again, let’s be clear to everybody, when we procure steel, we procure out but not out terribly because we move prices, in terms of price increases, fairly rapidly. And our inventory turns, particularly on our raw materials is very, very rapid. So it would be our expectation that it gives you a sense of magnitude of just in that one component of what it’s going to look like for next year and what we have to do to offset that.
Operator
Your last question is a follow-up from Chris Glynn - Oppenheimer. Chris Glynn - Oppenheimer: Yes, just trying to front run your fourth quarter ‘09 outlook just a little bit more from a qualitative standpoint. You talked about one of the drivers being the new products. Now, right now with the 2% we have flat non-res, you are talking low singles next year. So from the 2%, that would seem to be a net drag relative to new products, because that has been there in a driver for quite a while, hasn’t it? Vernon J. Nagel: It’s been a driver of our mix change and so we’ve benefited from that because those products generally carry higher profit margins. It is also gone to offset some of the dollar erosion in the more price sensitive portion of the market. And just by way of example, imagine that we are selling a unit that today, it’s a new product, we’re charging $100 for it and we’re losing share in a unit where we will sell for $50. So while I’m losing units in that more price sensitive portion of the market, my top line is being benefited because I’m selling a higher value-added products. On a go-forward basis, and again in ‘09, we’re still working through some of the more tactical aspects of our ‘09 plan. We see the opportunity to drive growth in a down market. Whether that growth is going to be a particular number and it’s my view that, that we will show positive growth, that positive growth will be in the lower single-digits. We’re still trying to understand the impact of pricing on that. We are talking about how we offset this decline in unit volume. We have not completely gone through and understood exactly what is going to happen from a price perspective because of rising commodity costs. So we still have to factor that in, Chris.
Operator
At this time, I would like to conclude the question-and-answer session. Vernon J. Nagel: Thank you everyone, for your time this morning. Again, we continue to believe we are focusing on the right objectives, deploying the proper strategies and driving the organization to succeed in critical areas that deliver on the expectations of our key stakeholders. I strongly believe that our future is bright. We’ve had 13 quarters in a row of record results, while the fourth quarter will provide us a bit of a challenge. I am extremely optimistic about the opportunities that we have before us and so from that perspective I believe that our future is very bright. Thank you for your support, and we’ll talk to you next quarter.