Beacon Roofing Supply (BECN) Q3 2016 Results - Earnings Call Transcript

| About: Beacon Roofing (BECN)

Beacon Roofing Supply, Inc. (NASDAQ:BECN)

Q3 2016 Earnings Call

August 02, 2016 5:00 pm ET

Executives

Paul M. Isabella - Beacon Roofing Supply, Inc.

Joseph M. Nowicki - Beacon Roofing Supply, Inc.

Analysts

Kenneth R. Zener - KeyBanc Capital Markets, Inc.

Jason A. Marcus - JPMorgan Securities LLC

Kevin Hocevar - Northcoast Research Partners LLC

Philip Ng - Jefferies LLC

David J. Manthey - Robert W. Baird & Co., Inc. (Broker)

Jim Barrett - C.L. King & Associates, Inc.

Operator

Good afternoon, ladies and gentlemen, and welcome to the Beacon Roofing Supply's Fiscal Year 2016 Third Quarter Earnings Conference Call. My name is Mariana, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be conducting a question-and-answer session toward the end of this conference. At that time, I will give you instructions on how to ask a question. As a reminder, this conference call is being recorded for replay purposes.

This call will contain forward-looking statements including statements about its plans and objectives and future economic performance. Forward-looking statements are only predictions and are subject to a number of risks and uncertainties. Therefore, actual results may differ materially from those indicated by such forward-looking statements as a result of various important factors, including but not limited to, those set forth in the risk factors section of the company's latest Form 10-K.

These forward-looking statements fall within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 regarding future events and the future financial performance of the company, including the company's financial outlook. The forward-looking statements contained in this call are based on information as of today, August 2, 2016, and except as required by law the company undertakes no obligation to update or revise any of these forward-looking statements.

Finally, this call will contain references to certain non-GAAP measures. The reconciliation of those non-GAAP measures is set forth in today's press release. The company has posted a summary financial slide presentation on the investor's section of its website under events and presentations that will be referenced during management's review of the financial results.

On the call for today Beacon Roofing Supply will be Mr. Paul Isabella, President and CEO; and Mr. Joe Nowicki, Executive Vice President and Chief Financial Officer.

I would now like to turn the call over to Mr. Paul Isabella, President and CEO. Please proceed, Mr. Isabella.

Paul M. Isabella - Beacon Roofing Supply, Inc.

Thank you. Good afternoon and welcome to our 2016 third quarter earnings call. Similar to last quarter, the 10-Q will be filed later this week, and as such Joe and I will spend slightly more time on our prepared remarks to ensure we provide enough detail for the quarter.

As you can see from our press release, we continued the momentum established in the second quarter and delivered very strong results in the third quarter.

Aided by the acquisitions made this year, most notably the RSG acquisition, good organic growth, and benefit from increased storm activity, we achieved record sales in the quarter of over $1.15 billion. This is quite an accomplishment as this quarter represents the first time we crossed over $1 billion of sales in a quarter. This represents over 60% growth over the prior year with existing same days growth of nearly 9%.

We delivered record EPS of $0.68. That's $0.77 adjusted representing a $0.12 improvement versus last year. Our team did an excellent job of delivering strong results, integrating our eight acquisitions made this year, and as always staying extremely focused on servicing our loyal customer base.

And now a little more color on the quarter before I provide updates on some of our strategic initiatives and what we're seeing in the industry.

Five of our seven reported regions reported positive growth. Our Southwest region led the way with very strong double-digit growth fueled by storm demand in North Texas and San Antonio markets. In addition, the Southeast and West regions saw strong double-digit sales growth as a result of strong demand. The Mid-Atlantic and Midwest grew single digits, while the Northeast and Canada declined single digits.

On an existing same day basis, sales were up for all three product lines as well, demonstrating the strength of our diverse product lineup.

Residential existing sales were up over 13% in the quarter. This was mostly driven by storm activity, same-store sales, and greenfield growth. Our complementary sales grew almost 7% on an existing same days basis. Growth in the quarter was driven from our existing business across most of our footprint. This product line continues its steady increase and has seen positive existing sales growth in 12 quarters of the last 13 quarters.

We will continue to focus on growing this product line across our footprint through strategic acquisitions and via legacy RSG branches with sales personnel adding this product to the sales offering. Economic indicators related to this product line are positive and should mean solid demand for the foreseeable future.

Our commercial product line registered 3% sales growth for existing same days in the quarter. Five of our reported regions grew in the quarter, and two of them experienced double-digit growth.

It's worth noting that commercial sales have grown in 10 quarters of the 12 prior quarters on an existing basis. This product line has been steady and we expect that will continue.

Along with the solid sales growth, gross margins increased nicely over the prior year. This is the seventh consecutive quarter in which the gross margin percent increased over the prior year. We're very pleased with this. We've seen steady progress with gross margins and as such we'll continue focusing on the levers of mix, product cost, and pricing. Joe will provide more detail during his prepared remarks.

In terms of pricing, we saw a slight decline in the quarter much as we had the last few quarters. We were able to offset this entirely with reduced material costs. I'm not surprised that pricing was slightly down. Our announced price increases were effective early to mid-June. We wouldn't expect to see price realization in such a short window between that time and the end of the quarter. Historically, there has always been a gap between distributor announced price increases and realization and this has ranged from 30 days to 60 days. The exception as you can imagine is in the North Texas market, where demand is extremely strong. We are seeing sequential gains Q2 to Q3 across this region, and a few others which is a very encouraging sign.

As a reminder, two of our primary goals are to grow sales and gross margin. We were able to do both in the quarter. We will be smart about our approach to pricing given our growth plans and balance that with our solid management of material input costs. We believe we can keep gross margins in our stated range and will work to maintain the balance between strong growth, solid gross margins, and the resulting price movement. We did this in Q3. Pricing is an important element of our P&L, but staying focused on both strategic growth plans and gross margin consistency is critical for our financial performance.

Related to working capital, as has been the case historically, the third quarter is a peak working capital quarter, and our team managed it very effectively. Inventory and payable performance was very good. Inventory turns continue to improve, and we're 12% better than the prior year and 17% better than the second quarter.

This resulted in strong cash flow from operations of nearly $74 million on a year-to-date basis.

From an operating expense standpoint, we experienced leverage as we grew sales. When excluding one-time costs related to the RSG acquisition, our operating expense as a percentage of revenue declined nearly 30 basis points for the quarter compared to last year. As we've added over $1 billion of acquired revenue, we are intensely focused on minimizing cost increases as we grow the top line, while still modestly reinvesting as needed across the company.

The operating expense leverage should increase in the fourth quarter as the synergies continue to ramp to full run rate and sales increase.

And now I'd like to provide an update on the RSG integration and synergy plans. As I explained on our second quarter call, we made excellent progress on the initial phase of the integration and our cost synergies. To-date, we are now tracking ahead of plan. The primary focus since deal close has been to fully execute on our synergy strategy, drive maximum efficiencies and cost savings in the business, and ensure positive customer impact.

Our estimate for 2016 synergy savings is on track to outpace our original target of $30 million. Joe will provide a breakout on where we are to-date and the areas of improvement we're seeing.

Overall, our field and headquarters team is handling the eight acquisitions we have executed on this year very well. We could not have achieved the excellent results for 2016 without the dedicated hard work of our team.

In addition to executing on the synergies and leveraging our existing infrastructure, our number one focus, as I've said in the past, continues to be on providing value-added customer service. And in total, our acquired markets generated approximately 9% EBITDA in the quarter. Very good performance.

Related to growth, we have for the last several months stepped up our efforts related to sales synergies and initiatives in regards to the RSG acquisition. We have a dedicated 600 plus person outside selling team, which is one of the largest in the industry, and they're very focused on growth and customer value-add.

These, in addition to our 350 plus branch managers, and a 500 plus person inside sales team greatly enhances our ability to service customers and grow. We have a very diverse mix of business with our three product lines, and our team is focused on expanding these across our footprint. As part of that effort, we have launched several growth initiatives and related follow-up tracking. We believe this and our combined sales force are differentiators in the marketplace.

And now, a little information on greenfields and acquired growth. As you know, greenfield branches have been and will remain a key part of our growth strategy for many years, as have acquisitions. From fiscal 2012 to the current year, legacy Beacon and RSG has opened up 62 greenfield branches.

As these mature, they will continue to contribute to the top line as they gain market share and the bottom line as the cost base is leveraged from the higher revenue. Legacy Beacon greenfields contributed approximately 24% of our existing growth in the quarter.

Our strategy to pursue opening more greenfield locations three years ago and RSG's similar strategy continues to drive growth as they grow to maturity and contribute to our sales gains.

So far this year, we have opened one branch which has been our plan. We will most likely end this year with one opening given the amount of acquisition activity we have been involved in. As of now for 2017, we're planning 1 to 2 openings based on our current strong acquisition volume and pipeline.

As we've said in the past, this number will vary year to year based on our acquired business load and business conditions. There are many markets we want to expand in, and we will continue to evaluate these.

The other seven acquisitions we closed on this fiscal year are going extremely well. As a reminder, we closed RCI of Omaha, Nebraska; Roofing & Insulation Supply of Dallas, Texas; and Statewide Wholesale of Denver, Colorado in December. In April, we acquired Atlantic Building Products of Eastern Pennsylvania; and Lyf-Tym of North Carolina. In May, we announced the acquisition of Fox Brothers Company of Central Michigan. And in June, we announced our most recent acquisition of Woodfeathers of Portland, Oregon. Woodfeathers has three locations in Oregon and one in Washington, selling mostly residential roofing products.

Beyond purchasing a well-established solidly run business, Woodfeathers gives us presence in Oregon, which expands Beacon's U.S. coverage to 46 states – a great fit and a great opportunity to expand further in the Pacific Northwest.

The seven acquisitions are all great companies that also give us the opportunity to expand all of our lines of business within their footprint. This will act as another growth lever for us in the markets they serve in the future.

To summarize acquisitions, I've – as I have said in the past, it's difficult to predict the timing. The pipeline remains very full, and since we announced the RSG acquisition, we have seen a noticeable increase in the level of acquisition-related activity.

We'll continue to make acquisitions where it makes economic sense, knowing at the same time we have to drive our debt leverage lower. Since the close of RSG on October 1, we have been able to reduce our debt leverage, and it remains at 3.6 times for the third quarter.

This is a great accomplishment as we purchased nearly $80 million of acquired businesses in Q3 and we're in the peak of working capital needs. We're very focused on our commitment of getting below two times in three years and we're confident we can accomplish this while still being active in the acquisition market.

And before I get to our updated guidance, I would like to talk about – a little bit about the significant storm activity in a few of our key markets.

As you know in the early spring, there were major hail events in the North Texas and San Antonio markets, as well as to a smaller extent in the Southeast, parts of the Midwest, and Mid-Atlantic.

Most of the spring storm activity should run through the fiscal year with the North Texas, San Antonio storms most likely running into next calendar year.

We are seeing the benefits of great timing of the RSG and Wholesale Roofing Supply deals. Wholesale Roofing is also located in the Dallas area. Our market presence and capacity in this storm impacted area has been greatly increased post acquisitions. As we head in for the fourth quarter this storm activity could potentially help us achieve the top end of our guidance, which I'll now update.

With an additional quarter of visibility and coming off another solid quarter, I'm very optimistic about the fourth quarter and anticipate earnings slightly above our prior estimates. Before I get to some of the specifics, I'll set the table by saying that for July we had existing same days growth of approximately 7% over the prior year. We view this as very strong performance considering the intense heat most of the country saw in July.

We should see our growth rate accelerate through the quarter.

Based on what we've seen for the first three quarters and current trends, I expect full year revenue to be in the range of $4.2 billion to $4.3 billion for 2016. And in terms of gross margin, I expect us to be in the range of 24% for the full year.

We should see the benefits from product cost and mix to achieve our gross margin range. Related to mix, residential roofing will continue to be positive – a positive impact on GM as the hail damage will drive higher levels of shingle repair. As I shared earlier a key focus for us is gross margin consistency, as well as strong sales growth. Working all the levers of gross margins is key and as I said I believe we're accomplishing this.

Regarding our SG&A expenses excluding one-time costs and new purchase accounting related to the RSG transaction, we expect to be in the range of 17.9% to 18.1% of revenue for the full year. This is a solid improvement from the prior year. And related to EPS, I'm increasing the guidance I gave during our last earnings call which was $2 to $2.10 to the new estimate of $2.05 to $2.15.

With three quarters complete, market conditions appear favorable and storm demand should continue fully into the quarter, synergies are tracking better than plan, and we are now on track to outpace our original estimate.

We are optimistic about the fourth quarter. We will continue executing the fundamentals of customer service, gross margin discipline, cash generation, cost control, and continued synergy attainment with RSG in all of our acquisitions in order to finish the year as strong as possible.

And now, I'm going to turn the call over to Joe to provide further details on the financial highlights of the quarter. Joe?

Joseph M. Nowicki - Beacon Roofing Supply, Inc.

Thanks, Paul, and good afternoon, everyone. Now I'll highlight a little more detail on a few key financial results and metrics that are contained in our earnings press release and also the third quarter slides that were posted to our website. Similar to last quarter we've included a few extra slides to help explain the results in more detail. In my prepared comments I'll also go into more depth on a few of the key areas this quarter like gross margins, operating expense, inventory and synergies.

Overall, as Paul said, it was a very solid quarter producing several new records for the company. Slide 3 provides an income statement for the quarter, and slide 4 provides an adjusted income statement which excludes the one-time costs primarily associated with the RSG acquisition as we've highlighted in our press release.

We had strong top line growth of over 60% for record third quarter sales of $1.15 billion. As Paul mentioned this was a first quarter of over $1 billion in sales, great achievement.

The growth is primarily driven by the nine acquisitions we've made since Q3 of last year. In addition we saw good growth in our existing markets of 8.7%. Gross margin increased over the prior year by 90 basis points. Operating expenses were up in total, mainly due to higher volumes and costs related to the RSG acquisition. The operating expenses in our existing markets declined 30 basis points as a percentage of sales. As a result, for the quarter we achieved record EPS of $0.68, $0.77 on an adjusted basis.

For comparison purposes, there were 64 days in both Q3 of fiscal 2015 as in Q3 of 2016. Paul already went through our Q3 sales results as shown on slide five, so I'll not repeat any of that information here but I will go through our monthly sales trending. As compared to the prior year, our average sales per day on an existing branch basis were up in each of the three months of the quarter.

April sales were up approximately 15%. May sales were up only 3% as they were impacted by record wet weather in many of our regions. And we finished the quarter strong with June sales up 9%, driven by a 16% increase in residential sales.

On a very positive note, our total gross margin rate was 24.5% for the quarter which is up 90 basis points from a year ago and on an existing market basis it's up 80 basis points. It's also the seventh quarter in a row that we've seen year-over-year improvement in gross margin and it represents the highest gross margin rate we have seen since December of 2012. Overall, we're very pleased with the improvements in our gross margin.

Most of the change was driven by a product cost decline of 280 basis points, primarily a result of the purchasing synergies from our acquisitions. Pricing declined in the quarter roughly 215 basis points from the prior year, although we're seeing improvement as it's up sequentially from Q2. Paul mentioned, our price changes vary greatly by region depending on competitive factors, demand and storm volume. We're optimistic that we'll see continued favorable movement as our price increases that just became effective in June start to have an impact.

The mix impact in our business drove 20 basis points of improvement as a result of the shift to more residential product sales. There was a slight decrease in direct sales in the quarter compared to the prior year, and that had a positive impact on gross margin as well. The percentage of direct sales decreased to 16% from 17% in the prior year. As we've mentioned previously, our direct sales have lower gross margins and also operating expenses as compared to our warehouse sales.

Commercial and residential prices both declined approximately 2% to 2.5% compared to the prior year. Complementary prices were down approximately 1%. Our product mix had a favorable impact on existing gross margins as volume shifted to more residential products. Residential roofing increased to 52.4% of our sales versus 50.3% in the prior year. Commercial products declined to 32.7% from 34.5% in the prior year, and complementary decreased to 14.9% from 15.2% in the prior year.

Now moving on to operating expenses, total operating expenses were $203.7 million or 17.7% of sales. This represents a year-over-year increase of $82.3 million, but let me walk you through now how this builds up.

This includes $7.9 million of nonrecurring costs from the 2016 acquisitions. Excluding these amounts, our adjusted operating expenses are 17% of sales. These adjusted operating expenses include $75.5 million of new cost related to the acquisitions. Excluding these, our existing market operating expenses are $120.3 million or 16.6% of sales. This represents a 30 basis point decline from the prior years.

We're definitely getting some leverage with the incremental volume, and we believe there's opportunity to improve even more.

As seen on slide six, there was an increase in volume-related payroll, benefit and stock compensation cost of $7.5 million. Bad debt expense increased in the quarter by $1.9 million. These costs were partially offset by lower depreciation and amortization of $700,000 and lower selling expense of $1.2 million.

It should also be noted that we're seeing the benefit of our synergies take place. As Paul mentioned, as you can see on slide seven, the integration of the RSG business has gone very well and we've recognized approximately $25 million in synergies year-to-date. We worked aggressively to integrate the two companies quickly and as a result, we were able to accelerate the timing of the savings we initially estimated.

The three areas of synergies, as you recall, are branch consolidations, procurement and other SG&A savings. To-date, we've consolidated 29 branches, 26 branches in December and another three branches in the third quarter, and we're starting to see the benefit of it this quarter. Potentially there are a few more branches that could be closed if the economics are right.

Within a branch consolidation, savings come from lower head count, lower fleet expense, lower rent expense and other efficiencies that occur when combining two branches. More than a quarter of the year-to-date savings came from branch consolidations.

Regarding procurement, we've made great progress there as well. As we purchase material on the new contracts and sell through inventory, we realize the purchasing savings. We saw some benefits start in the first half of this year, but this increased in Q3 where we saw almost half of the savings coming from procurement.

And finally, we've captured significant savings related to duplicate head count. We've been able to realize efficiencies through the combining of the two organizations.

As we look to the full year 2016, we see synergies of approximately $35 million. This is an increase from our previous estimate of $30 million due primarily to the timing of our implementation of the integration. This allowed us to achieve more of the synergies in 2016 than we had initially anticipated, and this progress that we've made so far has really given us confidence to raise our fiscal year 2017 target to $55 million.

We continue to look for ways to leverage our cost structure. Cost control is a historic strength for Beacon. With the acquisition of RSG, we're already seeing a significant improvement in our operating cost leverage.

Interest expense and other financing costs were up $10 million versus the prior year. This increase is primarily from our debt balances increasing over $900 million in conjunction with the RSG acquisition. We're managing this very closely making every effort to delever and reduce this cost. I'll talk more about that when I review the balance sheet.

Our effective tax rate for the quarter was 37.8% compared to 37.7% last year. This change was driven primarily by the treatment of one-time RSG acquisition costs and other discrete items. Adjusting for these, our effective tax rate would be approximately 39%, which is consistent with the prior year.

On a related note, it's important to also make you aware that our cash tax rate was approximately 10%. This includes the impact of the RSG NOLs and the other tax attributes that we acquired. This was a significant part of our acquisition strategy, and they're a great benefit to our cash flow which allows us to continue to pay down our debt.

Our net earnings were $41.1 million for the quarter, $46.6 million on an adjusted basis, compared to $28.3 million last year. Diluted net earnings per share were $0.68. That is $0.77 on an adjusted basis compared to $0.56 for the same period last year.

Our adjusted EBITDA for the quarter was $109.6 million, 9.5% of sales compared to $60 million in the prior year, 8.3% of sales. Outstanding year-over-year improvement driven by our strong sales and operating results.

Now I want to provide some clarity on the one-time expenses that we show on the earnings-per-share and EBITDA tables that are included in the press release and also on slide eight. We incurred a total of $8.3 million of one-time costs in the quarter and $50.2 million year-to-date. $1.5 million of the costs are related to the integration including severance and retention costs, and also some lease termination costs. $0.6 million is related to the transaction costs such as legal and accounting, and $0.5 million is related to the cost of the new debt issuance. Those are expenses that are amortized over the life of the debt agreements. And $5.7 million is related to the step up in amortization with the increased customer intangible assets from the RSG acquisition. For the full year, we expect these to be approximately $23 million. Slide nine provides a more detailed breakdown of our total amortization costs, including and excluding this incremental amortization cost.

Regarding the status of our balance sheet, as noted on slide 10, cash flow from operations year-to-date was a positive $74.4 million compared to $11.2 million last year. Slide 11 provides more detail on our inventory. Total inventory turns were 4.8 in the quarter versus 4.3 last year. We demonstrated improvement in our legacy Beacon branches, the new RSG branches, and in the branches we combined as part of the integration. We're very pleased with the increase in velocity of inventory through our branches. We view turns as a more relevant metric for us to use as a measure of inventory efficiency and ultimately our ROIC performance.

In addition, our accounts receivable days sales outstanding, DSO, was 36.1 days for Q3, an improvement from 39 days in Q2. It's also consistent with our prior year performance as a pro forma company. The third key element of our working capital is accounts payable. Here, we were able to maintain our days payable outstanding at approximately 42 days, similar to Q3, and make solid improvement over the prior year.

Capital expenditures excluding acquisitions in Q3 were $11.9 million compared to $8.4 million in Q3 of 2015. We've been carefully evaluating our fleet with the addition of RSG. For fiscal year 2016 we still expect capital expenditures to be slightly less than 1% of sales which is a nice improvement over prior years.

Net cash used for investments was slightly over $1 billion, reflecting not only RSG, but also the additional seven acquisitions we made this year. Keep in mind that $307 million in the RSG acquisition was funded through the issuance of common stock and is not reflected on the cash flow statement.

As shown in slide 12, we are able to maintain our net debt leverage ratio from the second quarter at 3.6 times in what has traditionally been a peak use of working capital. We also purchased almost $80 million of acquired businesses during the quarter. We should see this ratio improve into next quarter as we generate strong cash flows and EBITDA.

We are well on track to meet our commitment of reducing our leverage to under 2 by 2018. Our current ratio was a strong 1.92 to 1 versus 1.97 to 1 at Q3 2015.

Now I'd like to just quickly highlight some of the year-to-date results as shown on slides 13 and 14. For the first half of the year we had strong top line growth of 70.9% for record sales of nearly $3 billion. This was driven primarily by the acquisitions we have made over the last year but in addition, we saw significant growth in our existing markets of 13.9%. Gross margin increased over the prior year by 70 basis points. Operating expenses while up in total were mainly due to higher volumes and costs related to the RSG acquisition. Excluding the RSG transaction costs, our existing market operating expense as a percentage of sales declined 140 basis points, demonstrating great leverage. As a result, we achieved EPS of $0.71, adjusted EPS of $1.21 compared to $0.63 in the prior year. Great performance through nine months.

Now before we move on to Q&A, I'd like to provide a little more detail on how we did in Q3 compared to the Street estimates and also discuss our current guidance going forward. We exceeded the average Street estimates for the quarter by a penny. The variance was mostly driven from our gross margins, which were up significantly over the prior year and more than we had expected. Our team has done an outstanding job of executing on the plan synergies as part of the acquisitions and we've benefited overall from an increased mix into our residential product line.

The gross margin gain was partially offset by higher operating expenses. We did achieve operating expense leverage over the prior year, but not as great as in Q2. Some of it was specific to an increase in AR reserves for identified accounts related to our acquisitions, which should not recur going forward. Some of this is weather related as our teams ramped up for the spring selling season and were met with a very wet May in some regions. This is temporary and we're confident we'll see additional operating expense leverage as we move forward as a result of our synergies and integration efforts.

As Paul mentioned given our performance in Q3, we're raising both our revenue and our EPS guidance. We expect revenues be in the range of $4.2 billion to $4.3 billion and adjusted EPS to be in the range of $2.05 to $2.15.

Slide 15 provides more detail on the key assumptions underlying our sales guidance. Achieving the low end of the range of $4.2 billion assumes Q4 sales will be approximately 5% greater in sales per day than Q3. This was driven in large part by the seasonality of our business. It also assumes a low to mid-single-digit existing market growth in the second half that results in full-year existing market growth of approximately double digits.

In the low case, we do not assume any price increase will stick. We've also included about $50 million in additional revenue due to acquisitions we completed so far this year.

Achieving the high end of the range assumes mid to high single-digit existing market growth in the fourth quarter which results in mid-teens for the full year. It also includes an assumption that we'll be able to pass along some price increases in selected storm markets. And a little higher volume from the acquisitions that we completed.

Slide 16 goes on to list some of the key assumptions for our adjusted EPS guidance. You'll notice due to the seasonality in our business, we count on driving almost 40% of our EPS in Q4. To hit the low end of the range, we need approximately – sales of approximately $1.2 billion in Q4. This case also assumes the product mix is consistent with the year-to-date results and also assumes that gross margin will be consistent with Q3. And that's primarily a result of the continued impact of the RSG purchasing synergies. The low end also assumes we get back to our traditional operating expense leverage of 50% variable cost and that the total RSG synergy improvements continue at the same level as Q3.

To hit the high end of the adjusted EPS range, we'll require sales of $1.3 billion in Q4 along with the ability to pass through some of the price increase in selected markets as previously noted. Gross margin is assumed to be up slightly over the prior year to improve pricing. The high end also assumes we get back to our traditional operating expense leverage of 50% variable cost and also the RSG synergy improvements continue at the same level as Q3.

I know I've spent a lot of time unpacking the current quarter and the forecast. As I mentioned last quarter, there's a lot of complexity in our financials right now, with many moving parts as a result of the acquisitions. I wanted this year to spend as much time as possible providing clarity to the quarter's results so that all the investors will be as excited in our future as we are. We'll now respond to and take any questions you may have.

As Paul mentioned in his opening, due to time constraints, we're limiting questions to one per caller, please.

Question-and-Answer Session

Operator

Each caller is limited to one question. Your first question comes from the line of Keith Hughes with SunTrust. Your line is open.

Joseph M. Nowicki - Beacon Roofing Supply, Inc.

Good afternoon, Keith.

Paul M. Isabella - Beacon Roofing Supply, Inc.

Looks like we lost Keith.

Operator

Your next question comes from the line of Ken Zener with KeyBanc. Your line is open.

Kenneth R. Zener - KeyBanc Capital Markets, Inc.

Hello, gentlemen. Can you hear me?

Joseph M. Nowicki - Beacon Roofing Supply, Inc.

Yes, we can.

Paul M. Isabella - Beacon Roofing Supply, Inc.

We can hear you, Ken. How are you?

Joseph M. Nowicki - Beacon Roofing Supply, Inc.

Yes, we can, Ken.

Kenneth R. Zener - KeyBanc Capital Markets, Inc.

Okay. Good. I wasn't sure if it was me. The – thank you very much for breaking out the guidance as well as the detailed working capital. Obviously with some manufacturers reporting, it's well known that there's been a lot of volatility certainly on the residential side. So, the assumptions, if I could just delve a little bit, I mean, I think operationally you're obviously – you've been working on these branch savings for the integration, you're moving on to procurement. Is that procurement in terms of rewriting contracts, or is it just, you know, the more generic stuff? Because it seems like you've gotten ahead of the integration costs, so if you could just go into a little of the detail there. Like, what surprised you? Where do you think some of those risks still are?

Joseph M. Nowicki - Beacon Roofing Supply, Inc.

Sure, Ken, I'll take a first pass at it and then I'm sure Paul will add some color as well too. Yeah, the synergies or savings we're seeing on the procurement side are really from two areas. Yes, it's the contract switching, as we talked about, moving everybody onto the lowest price contract, right, our contract or RSG, whoever was the lowest.

But in addition to that, we're also seeing benefit from the scale buying as well too. We talked about that early on that we mentioned we'd see some scale buying savings as well too, and that's also beginning to roll into it. And I think both of those have been positive from what we had expected through the initial work.

Paul M. Isabella - Beacon Roofing Supply, Inc.

Yeah, and I would add that I think, you know, as we look at – I wouldn't say there's been any issues at all. If anything, I think we're still early in the process because the other big element for us, quite frankly, is to look at vendor consolidation. We still – not even necessarily at the larger vendors, but we have so many other vendors below that where we have multiples by region, and we're working on that and we've made progress, but it still will be a good funnel because RSG had a list, we had a list, and we're working very hard to consolidate that. So we've made good progress, and I think there's more as we continue – our supply chain team continues to dig deep for us to become as efficient as we can on the material side.

Joseph M. Nowicki - Beacon Roofing Supply, Inc.

Yeah, and not to mention, even besides material, Ken, there – we're also doing some work on the indirect contracts as well which is adding to our synergies. So as we look across the indirect contracts outside of materials that the company has, we're consolidating those and driving some benefit there as well too. So, it's been going very well.

Operator

Your next question comes from the line of Jason Marcus with JPMorgan. Your line is open.

Jason A. Marcus - JPMorgan Securities LLC

Hi. My question is on the inventory levels that you had at the end of the quarter. Just wanted to get a sense of how much inventory was up on a per branch basis when you look at legacy Beacon versus RSG. And then I guess just more generally, how you're thinking about inventory levels right now I guess both at your company and what you're seeing in the overall channel?

Joseph M. Nowicki - Beacon Roofing Supply, Inc.

Yeah, we feel – I'll start out with how we feel. We believe and we feel our inventory is in very good shape; well-positioned. We also believe a key measure for us and for us going forward is turnover because it really speaks to velocity, and that's what we want. So we showed great progress year-over-year and sequentially from a velocity standpoint.

Per branch to us, really as we looked at it, doesn't really mean a lot. We have so many different diverse branches, so many different diverse product lines, and now with RSG having much larger branches, that tends to skew things. And it even would skew it more as we have stocked up in our storm-related markets. So I think if you see the increase of our inventory sequentially or year-over-year, I think, it's very logical and it supports higher sales volume. A lot of that driven by storms in Texas, but we have also seen storm activity in the Southeast and the Midwest.

So we typically in Q4 reduce – Q4 reduce inventory, which we will do, and we should see continued turns improvement year-over-year and sequentially. So all in all, we feel great about our inventory level and we believe we're doing the right thing, whether it's stocking up for service for our contractors or buying a tad more due to price increases that the manufacturers have pushed through and supporting that that into the end market. The key metric to really watch on inventory is the turns. And 4.3 to 4.8, great progress, great improvement we've made. And as Paul said, in fourth quarter you'll see us continue to work down the inventory levels as we always do. And we'll make even better – even more improvement on the inventory turns in the fourth quarter as well too. Feeling really good about our inventory.

Operator

Your next question comes from the line of Kevin Hocevar with Northcoast Research. Your line is open.

Kevin Hocevar - Northcoast Research Partners LLC

Hey. Good afternoon, everybody.

Unknown Speaker

Good afternoon. (43:32)

Kevin Hocevar - Northcoast Research Partners LLC

It sounded like you – in terms of pricing, it sounded like had some optimism about the price increases you had in place kind of throughout June. And it sounded like maybe they're getting some traction here so far into this quarter. So wondering if you could give me a sense for how those are going, kind of your price increases to your customers as well as the price increases that the manufacturers have into distribution.

Paul M. Isabella - Beacon Roofing Supply, Inc.

Yeah, Kevin, pertinent topic. Again I'll go back a little higher level because we think it's so critical for us, and that's to manage gross margin. And within that of course, we're going to continue to take advantage of our material cost strength, the continued mix we should see.

And then the balancing effect with that is price. And as we've said before, price is very, very specific to specific regions around the country based on competitive factors, amount of distribution and the economic health of that region. So we support the price increases from the manufacturers. They push them through. They're going through in June, and we'll continue to support those. We've raised price. We issued the price increases. I alluded to in my prepared remarks, whether it was launching early June, mid-June, there's typically that gap. So we wouldn't expect to see any major year-over-year change when you really think about it, just given the fact that there is inventory in the channel priced lower.

That being said, we've been measuring very, very tight our operating units on a sequential basis and by customer because obviously, as the manufacturers push price to us, we need to offset it, right? And that's the whole theory behind this, and that's what we want to do. So as you look sequentially, not necessarily our reporting units, but if you go across our discrete regions, about a half of those saw sequential gains Q2 to Q3, albeit a point that's very encouraging for us. And then I think as we dig a little deeper into July, we see the Texas market making even greater gains.

So there's even more optimism there, as you can imagine, given the amount of homes that are being re-roofed, given just the amount of the magnitude of the volume there in North Texas and San Antonio. We should expect to see price increases – one, because the manufacturers have pushed those through; and two, we are spending a tad more on the expense side bringing in equipment, people, the OT we're working, things like that.

So we feel pretty good. Summary, sequentially, we're seeing an uptick. We hope and believe it will continue. But again I think the fallback is always, we're not going to lose share. We're going to continue to protect that, and the offset and balance is mix and the material cost out to get us to the gross margin level we talk about for the fourth quarter, which is at 24.5%-ish range, as Joe alluded to, and that's our focus.

Operator

Your next question comes from Philip Ng with Jefferies. Your line is open.

Philip Ng - Jefferies LLC

Hey, guys.

Paul M. Isabella - Beacon Roofing Supply, Inc.

Hey, Philip.

Philip Ng - Jefferies LLC

I guess on the OpEx side – hey – strong quarter. On the OpEx leverage side of things, I think you guys called out I think AR receivables being a bigger outlier this quarter. Can you kind of parse out how much of the hit was that to the quarter? And how should we think about OpEx leverage in the back half and go into 2017? Is that going to look more like the first half of this year? Thanks.

Joseph M. Nowicki - Beacon Roofing Supply, Inc.

Good question. Thanks for asking. To give you a little better feel for that, we've traditionally talked about the operating expenses being roughly 50% fixed, 50% variable in there, right? And this quarter didn't quite get to the level that we wanted to. We had roughly – we made good leverage on it. If you look at our operating expenses from an existing market perspective, we moved from 16.9% down to 16.6%. So, which was great, but if you do the math, if we wanted to try to get to our 50% variable, we probably were about $3 million high. That's what it would have taken to get to our 50% fixed and variable rate, and it really results from two things. One of them was with receivables, which were running about $2 million over where we had expected they would be, this is the bad debt expense number.

All of that was driven primarily by specific receivables or accounts, and it was all tied to some of the acquisitions that we have done and just getting the initial reserves set up and established. That was the biggest driver of it. Besides that, solid (8:39) as I mentioned earlier, a little bit had to do with just the timing of when we brought people on board, and then some of the wetter weather in May that caused an impact to it. Overall, good performance, still got good leverage out of it. I think our improvement next quarter could be getting to that 50% variable rate as we've talked about.

Operator

Your next question comes from David Manthey with Robert Baird. Your line is open.

David J. Manthey - Robert W. Baird & Co., Inc. (Broker)

Hey, guys. Good afternoon.

Paul M. Isabella - Beacon Roofing Supply, Inc.

Hey, David.

David J. Manthey - Robert W. Baird & Co., Inc. (Broker)

First off, I don't know if you can quantify or estimate the impact of the Dallas, Fort Worth and San Antonio storms in the quarter. And then secondarily, Paul, I think you said that you expected that to stretch into 2017.

Paul M. Isabella - Beacon Roofing Supply, Inc.

Yeah.

David J. Manthey - Robert W. Baird & Co., Inc. (Broker)

Is it your belief that because of the labor constraints that we're seeing on the contracting side, that this could stretch on longer, and maybe it doesn't have as much of an acute impact in a given quarter, but it stretches on longer than even historical experience?

Paul M. Isabella - Beacon Roofing Supply, Inc.

Yeah, Dave, I'll start with the duration. Although very hard to predict the future, there are some factors at play here. One is, for sure, may tamp things down a bit with a bit of rain. All right, so that pushes things out and that's why you saw our number being a little down, but we recovered some of that in June and then July. And then of course the heat, you talked about labor. I think also for sure our belief is the San Antonio storm, just because of activity and some of the other reasons you talked about, will extend. And given the overall size, the data we have is about 300,000 homes. I mean, this could at first blush go into our Q3 of next year, and we'll have to continue to assess that. Again, David, it'll be based on how fast things are re-roofed, et cetera. And it's difficult to influence that, so what it is what it is.

The good news for us, the first part of your question, is we have great presence and density in Texas in general. We have close to 40 branches, so we have a tremendous ability to serve the contractor base. We've nearly tripled our capacity in North Texas post-acquisition, that's adding Wholesale Roofing Supply, Grand Prairie and RSG, so that all bodes well from an existing sales at 9%. And there's no exact science but as we try to eyeball it, we think three points of that came from that North Texas and to a lesser extent San Antonio, because it hasn't fully aired out yet in San Antonio. So overall, I think if you look at that existing sales, three points on storms, a couple points on greenfields, and then the rest four points or so normal market growth, which would be share gain and just penetration in each of those legacy markets.

So all in all, I think pretty good performance. And if anything, that quarter, I don't think from a storm standpoint has reached its peak. I think it will in Q4. Depending on the weather in Q1, we could also see very strong sales that could be equal or greater than this quarter. So we feel pretty good about what's happening, again given our – whether it's Beacon legacy or RSG, branch size, we're in great position to take care of our contractors that are servicing the storm.

Operator

Your next question comes from the line of Jim Barrett with C.L. King & Associates. Your line is open.

Jim Barrett - C.L. King & Associates, Inc.

Hi, Paul and Joe.

Joseph M. Nowicki - Beacon Roofing Supply, Inc.

Hi.

Paul M. Isabella - Beacon Roofing Supply, Inc.

Hey, Jim.

Jim Barrett - C.L. King & Associates, Inc.

Paul, you touched upon this briefly. But if we exclude the market growth from storm activities and Beacon's own market share gains from greenfields and other market share initiatives, what is your sense as to the underlying growth volumetrically within the residential market across the U.S.?

Paul M. Isabella - Beacon Roofing Supply, Inc.

Within res? Well, again, we had in the...

Jim Barrett - C.L. King & Associates, Inc.

Yeah.

Paul M. Isabella - Beacon Roofing Supply, Inc.

...quarter the 13%. We didn't break it down to that level. I alluded to the bigger piece of 4% total market. So if you took half it, it's probably still in that 7% to 8%, which is healthy. We think most markets still have strong re-roof demand, even outside of storm. And again, Jim, this gets mixed, right, because as you look at the Southeast there's a storm in South Carolina area; then Nebraska had some healthy activity and that tends to get mixed up a bit. But I'd say of the 13%, close to three quarters of it was normal growth and then the balance, the storm and greenfields hit roughly.

Operator

That concludes the questions. Now I would like to turn the call back over to Mr. Isabella for his closing comments.

Paul M. Isabella - Beacon Roofing Supply, Inc.

Thank you. So all-in-all, an excellent quarter by our team. And let me just run through quickly some of the highlights again. Our third quarter sales were a record $1.15 billion, up 60% from the prior year. Existing growth was 8.7%, as we said, fueled by storm repair, greenfield growth and existing branch sales. And as Joe talked through, once again we managed working capital very effectively.

Our balance sheet is healthy and will allow us to deliver on our near and long-term growth goals. We feel good about our capital structure and the cost of capital. And as I said earlier, in the quarter we funded almost $80 million in acquisitions and we were still able to maintain our net debt leverage ratio of 3.6 times. And we're very fixated on getting it down to 2 times in the coming years.

As we said, we've made excellent progress on the integration and we're ahead of the original synergy targets and we won't stop. I also talked about raising our EPS estimate to the range of $2.05 to $2.15. And as I've said multiple times in the past, we're in great markets that will continue to grow. We're well-positioned to capitalize on this growth with our enhanced branch count, product placement and density in many of these markets.

We are executing the elements of our strategic plan and we'll continue to focus on our customers, employees and our financial results. Our overall integration efforts and actions are on track related to RSG. We are very focused on this and are following a detailed planning process to ensure customer satisfaction and sales growth is the focus as we execute this synergy attainment plan.

As I said earlier, the organization is primed for continued growth. They are proving extremely resilient in the face of multifaceted change and are responding very well. Our future is very bright as our team continues to grow and deliver on our commitments. And our customers have also responded very positively to the combined company as we work to provide as much value for them as possible.

I want to thank all of our investors for their interest in our company as well as our customers and our employees for their loyalty. This concludes our earnings call. Have a great day.

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