Fortune Brands Q3 2007 Earnings Call Transcript

Fortune Brands (FO)

Q3 2007 Earnings Call

October 26, 2007 5:00 pm ET

Executives

Norman Wesley - Chairman, CEO

Bruce Carbonari - President, COO

Craig Omtvedt - CFO

Analysts

Todd Duvick - Banc of America Securities

Peter Lisnic - Robert W. Baird

Bryan Spillane - Banc of America Securities

Robert van Brugge - Sanford Bernstein

Andrew Sawyer - Goldman Sachs

Omar Al-Midani- FTN Midwest Research

Presentation

Operator

I would like to welcome everyone to the third quarter Fortune Brands earnings conference call. (Operator Instructions) Thank you, Mr. Wesley, you may again your conference.

Norman Wesley

Good morning. Thanks for joining us to review Fortune Brands third quarter results. Before I begin, let me note that our presentation includes forward-looking statements that are subject to risks and uncertainties, including those listed in the cautionary language at the end of the news release; and, that our actual results could differ materially from those targeted.

This presentation also includes certain non-GAAP measures that are reconciled for the most closely comparable GAAP measure in our news release or on the supplemental information page linked to the webcast page on our web site.

Fortune Brands delivered solid third quarter results that comfortably achieved our earnings target. This was a quarter that once again demonstrated the benefits of Fortune Brands unique breadth and balance, as profit growth for our spirits and wine brands helped to offset the impact of the U.S. Housing correction.

Our spirits and wine brands delivered record third quarter operating income, even with a strong double-digit increase in brand-building investment to support new marketing programs. We're benefiting from higher prices on certain premium spirits brands, the favorable trend of consumers trading up to higher end brands, and further synergies from our acquisition of Allied Domecq brands.

We're pleased that despite the challenges presented by the housing downturn in the U.S., we're continuing to significantly outperform the home products market. We limited our sales decline in Home and Hardware to just 4%, which underscores how we're gaining share in a home products market that is down double-digits.

That outperformance reflects the success of innovative new products, growth with key customers, extension into adjacent product categories and expansion in international markets. With successful new products and double-digit sales increases in golf balls and golf footwear, Titleist and FootJoy lead our golf brands to a third quarter sales record and gained share in key product categories.

Now, looking closer at the numbers. Reported net income was $209 million, or $1.33 per diluted share. That compares to $0.98 in the year ago quarter. It's important to remember that last year's number reflects a net charge amounting to $0.32 per share. That charge principally related to the required accounting for the increased value of V&S minority interest in our spirits and wine business.

Excluding one-time items in both the currents and the prior year periods, diluted earnings per share before charges and gains was $1.35, up 4% from $1.30 last year. These results were comfortably within the target range we announced three months ago, which was for diluted earnings per share before charges and gains to be in the range of mid single-digits, up mid single-digits to down mid single-digits. They were also $0.06 ahead of the First Call consensus estimate of Wall Street analysts.

Net sales for the third quarter were $2.2 billion, off 1%. On a comparable basis, excluding excise taxes, we estimate sales would have been off 2% in constant currency. Operating income for the quarter came in at $376 million, off 1%. We are particularly pleased with our margin performance in the quarter, as operating margins expanded in spirits and wine, and we limited margin erosion in home and hardware to just 50 basis points in a challenging market. Fortune Brands overall operating margins were even with a year ago.

Looking at our asset and investment return measures, return on equity before charges and gains was 16%. After-tax return on net tangible assets before charges and gains was 23%; working capital efficiency came in at 34%, and return on invested capital before charges and gains was 9%.

Fortune Brands strength, stability and success are both served not only by our breadth and balance, but also by our adherence to a simple and effective four-point strategy. Investing first is to invest to grow our leading consumer brands, improving operations to continuously enhance productivity and cost structures, positioning our business for stronger growth and higher returns, and leveraging the strength of our financial resources to drive shareholder value even higher.

That last point includes a commitment to returning immediate value to shareholders by paying attractive dividends. In the quarter, we boosted the dividend another 8% to an annual rate of $1.68 per share. We've increased the dividend in each of the 11 years since the company began trading as Fortune Brands, a reflection of our confidence in the long-term strength of our business.

In the quarter, we also announced the beginning of a smooth transition of executive leadership that will provide continuity for Fortune Brands. As we announced in August, our President and Chief Operating Officer, Bruce Carbonari will succeed me as CEO in January and I will remain Chairman of the Board.

Bruce has been a big part of Fortune Brands' success over the past 17 years, and he brings a wealth of experience, a unique blend of strategic and operating expertise, and a continued sharp focus on shareholder value.

On the subject of the sale process involving Vin & Sprit and the Absolute vodka brand, there's nothing new to report. The Swedish government has not yet announced the details or the timing or how it plans to proceed with the privatization of V&S. We look forward to participating in the process once it's established.

Now, before Craig walks us through the segment results, here is Bruce to discuss our major operating initiatives.

Bruce Carbonari

Thanks, Norm. As we have discussed in previous quarters, we are sharply focused on two major initiatives that are critical to our success in 2007. First, continuing to build our major premium spirits brands; and second, to navigate the downturn in the housing market. We continue to make progress in both of these areas and at the same time, we're delivering strong operating margin performance in both businesses.

In spirits and wine we're continuing to expand margins. That reflect or focus on the premium end of the category, favorable mix shifts, higher pricing for certain premium brands, and synergies from the successful integration of the Allied Domecq brands.

In home and hardware, as Norm indicated, we have limited margin declines to just 50 basis points in the quarter. That's due to the success of our share gains, productivity and cost initiatives, as well as the targeted price increases we've implemented. These price increasing are offsetting the high commodity costs that adversely impacted margins in the first quarter.

Regarding brand-building for our major spirits brand, we discussed last quarter that we would be ramping up new marketing activities and boosting brands spin in the second half. As the world's fourth largest premium spirits company and the largest base in the United States, we have an excellent foundation on which to build, with powerful positions in key categories.

For example, we have the world's #1 position in bourbons at all premium levels; the world’s #2 tequila, the #2 Canadian whiskey in the world, one of the world's leading cognac, and the leading cordial line in the United States, as well as the #2 super premium U.S. wine brand.

As we've successfully integrated the brands we acquired from Allied Domecq, we now see opportunities to boost brand investment and build brands people want to talk about. Our brand-building activity accelerated in the quarter to a strong double-digit increase and will continue into the fourth quarter.

A lot of what we're doing is centered around connecting with consumers in non-traditional ways and building word of mouth buzz so consumers call for our brands. In fact, we are launching new advertising marketing, and positioning campaigns to build equity for three major brands. That includes a relaunch of our super premium Suaza Hornitos tequila line, featuring new advertising, new packaging and two new product extensions. We're backing the Hornitos relaunch and the Fine Line of Tequila campaign with significant new brand spend, with much of that going to non-traditional mediums and online advertising.

Just last week, we launched Courvoisier's Find Greatness Within campaign, an integral part of our long-term brand-building plans for this iconic cognac brand. On the heels of Dario Franchetti's championship season in the Canadian Club Indy Car, we this month launched a brand new campaign for Canadian Club, the world's #2 whiskey.

In addition, the United States Senate declared September National Bourbon Heritage Month, and we supported the world's greatest bourbon portfolio with significant promotional activity at the point of purchase and online, including the world's biggest distilled spirits ad that provided high visibility in Las Vegas.

We also launched new spirits product in the quarter, including Jim Beam’s Beam and Cola in Australia, Courvoisier Exclusive, an ultra-premium cognac designed for mixed drinks; and Dekuyper Red Apple Liqueur, which should be a special addition to the fall and winter cocktails.

Brands are built over time, and we are confident in the programs we've developed and pleased with the progress we have made in the quarter.

Lastly, as has been previously announced, in the quarter we sold the William Hill and Canyon Road brands and related assets to Gallo. That is a move that enables our Vin and Beam Wine Estates to focus resources where they can most impact profitable growth.

When it comes to home products, it's clear that the housing downturn will last longer than just about anyone predicted. Even so, we are determined not to be a victim to the challenging market. We're pleased with how we're executing our plan to outperform the home products market and to position ourselves to capitalize when the market recovers.

As Craig will detail in a moment, our third quarter sales in our home product segment were down just 4%, that's in a market that is down double-digits. Year-to-date, we have managed to limit our decline in home product sales, excluding acquisitions and divestitures, to just 7%.

We are outperforming the market by continuing to focus on the fundamental strategies that have served us so well. It starts with consumer insights to better understand how consumers make purchase decisions; that's helping us develop and launch new products and expand relationships with key customers.

We're also extending brands into adjacent product categories and we're capitalizing on international growth opportunities. All of these initiatives are adding up to tangible share gains.

We are also being proactive on the productivity and cost side to promote efficiency, protect operating margins, and better align our global supply chains to navigate the housing downturn and optimize process for long-term growth. That includes increased use of lean manufacturing, a sharp focus on inventory management, and reducing component and material costs through targeted global sourcing initiatives.

Additionally, since our last conference call, we've initiated the consolidation of an additional facility that results in a relocation of certain window manufacturing. That is on top of the facility consolidations we discussed in previous quarters.

We believe these proactive steps are optimizing our supply chain for the future, at the same time they're providing near-term benefits by appropriately aligning our costs and capacity as we navigate the challenges of a housing correction that will, by all accounts, last into 2008.

Many economists now suggest that the housing products market could be off by double-digit rates again in 2008. Regardless of the length of the downturn, we strive to continue to outperform the market and we continue to focus sharply on both the growth and cost side of the business.

We are currently putting together next year’s business plan and as we customarily do, we will provide 2008 growth targets for home and hardware and all of our segments in our January conference call.

Now, with a closer look at our third quarter performance, here is Craig.

Craig Omtvedt

Thanks, Bruce. Starting with spirits and wine, the third quarter sales increased 2% to a record $665 million. Revenues were impacted by second quarter distributor buy-in ahead of the SAP conversion we discussed last quarter, as well as soft revenue performance for select regional brands.

Operating incomes moved 5% to $179 million, that's also a third quarter record. OI benefited from our focus on higher pricing on certain premium brands, favorable mix shift to higher end brands, and acquisition synergies. Even with a double-digit increase in brand spend in the quarter, OI margins before charges for the quarter expanded to 27%.

Drilling down, our worldwide spirits and wine case volumes are up low single-digits year-to-date. Volumes are up in the low single-digit range in both the U.S. and in non-U.S. markets. Again, I remind everybody one that our volume numbers are based on depletions.

Our major premium bands continue to outperform our national and regional brands. Looking first at our two biggest spirits bands, case volume for our flagship Jim Beam brand are up low single-digits year-to-date. Underscoring how we're building the kind of brand equity that supports higher pricing, revenues for Jim Beam are up high single-digits for the year.

Suaza tequila volumes are up low single-digits year-to-date, while revenues are up in the mid single-digit range. As Bruce indicated earlier, we are excited about new programming we've developed to further build Suaza, including the just announced relaunch of the Suaza family super premium Hornitos.

Looking at other key brands, case volumes for Maker's Mark and Courvoisier, are up in the high single-digit range while Teacher's Scotch is up double-digits. Dekuyper volumes are off slightly while Canadian Club is flat. Volumes for our wine brands are up in the high single-digit range, led by very strong performance for Clos du Bois, Geyser Peak and Wild Horse.

As we enter the largest quarter of the year for our spirits business, we feel good about the health of our brands, and about our growth prospects. As previously discussed, we're further accelerating brand spend here in the fourth quarter to continue building our brands and to drive momentum behind them. For the full year, we are continuing to target operating income before charges in spirits and wine to be up in the mid to high single-digit range.

Now, turning to home and hardware. Sales in home and hardware came in at $1.2 billion off 4%. Again, that's in a market that's down double-digits. Revenues benefited from our share gains in a challenging market as well as easier comparisons.

Operating income in home and hardware was $184 million, down 7%. On the operating margin front, we're still targeting to limit full year margin erosion to the range of around 150 basis points. Breaking that down, that's around 1 point on our base business, and about 0.5 point related to the addition of Simonton.

Each of our product lines showed progress in the quarter. Once again, our strength in the replace and remodel market, which drives the majority of our home product sales, continued to serve us well. We also continued to benefit from successful new products, expansion with key customers, extension into adjacent product categories, and growth in international markets.

Sales for our cabinetry brands were off at a mid- ingle-digit range. We benefited from favorable shift to higher end brands including Omega, Kitchen Craft, Diamond and Schrock. At Moen, sales were flat. The #1 faucet brand in North America benefited from extra selling days, solid growth with U.S. retailers and double-digit gains in international markets, all of which offset lower sales to wholesale distributors, who largely serve the new construction segment.

A similar story at Therma Tru, where our door sales were also flat. The #1 brand of residential entry doors benefited from sales growth in the home center channel and also outperformed the market with wholesale customers. Sales at Simonton Windows continued to be off with the market. Sales of storage and security products were up low single-digits, as strong gains for Master Lock more than offset modestly lower sales for Waterloo tool storage products.

As we look to the balance of the year, we continue to feel well-positioned in a challenging market. We will benefit from the share gains, productivity and cost initiatives Bruce discussed earlier, as well as our focus on the replace and remodel segments of the market, which continues to perform better than new construction. Additionally, our comparisons ease in the four quarter.

While we expect to continue to outperform the market, we've revised our full year target in home and hardware to reflect the sustained nature of the housing downturn. We are now targeting operating income before charges in home and hardware to be down at a low double-digit break for 2007.

Turning to golf, sales for our golf brands reached the third quarter record $319 million, that's up 7%. Operating income of $30 million was flat, adversely impacted by expenses for new product launches, patent litigation and related costs. In golf balls, sales grew at a double-digit rate as we continue to gain market share and benefit from favorable mix shift.

In addition to continued growth for the Titleist ProV1 family, the new Titleist NXT Tour and NXT Extreme are off to excellent starts as are new Pinnacle models introduced in the quarter. Sales of golf clubs were off modestly against a strong double-digit increase in the year-ago quarter when sales benefited from the timing of new product introductions.

FootJoy golf shoes drove a double-digit increase in sales on the success of new models in the eComfort, Contour and Real Fit lines. We just relaunched the DryJoy line with new advanced features in styles and initial marketplace acceptance is excellent. Sales of golf clubs grew double-digits, and accessories saw go strong growth as well.

As we look to the balance of the year in golf, our intensive new product development initiatives continue. Also, keep in mind that the fourth quarter is the seasonally smallest and historic smallest quarter and historically generates a small profit or loss in our Golf segment. For the full year, we are now targeting operating income before charges in Golf to be relatively flat, impacted by the cost factors I just mentioned.

Now, before turning things back to Norm, a few additional items. First, reported third quarter results reflect a $2.2 million in after-tax restructuring charges, amounting to $0.02 a share, and that's related primarily to supply chain initiatives in home products.

Looking to the fourth quarter, regarding credits, I'm pleased to report that we've reached closure with the IRS regarding select matters associated with our 2001 and 2002 tax returns. Pending congressional joint committee approval here in the fourth quarter, we will return approximately 85 million in tax provisions to income.

Regarding charges, as Bruce indicated, we are actively working to optimize our cost structure and we expect to incur additional fourth quarter pretax charges in the range of $15 million to $20 million associated with the supply chain initiatives we've already discussed.

Second, stemming from our routine true-up of our effective tax rate, we are now targeting a before charge as gains rate 32.2% for 2007, and that's versus our prior rate of 33%. About 50 to 60 bips of the reduction results from the true-up of taxes against our global profit mix and the remaining 20 to 30 basis points relates to general tax initiatives.

Lastly, fine-tuning our estimated free cash flow for the year, we are targeting free cash flow in the range of $500 million to $550 million; again, that's after dividends and capital expenditures.

Now back to Norm.

Norman Wesley

Thanks, Craig. For the remainder of the year, we expect Fortune Brands to continue benefiting from global growth of our premium and super premium spirits brands, plus sustained market share gains in the challenging home products market. We believe Fortune Brands is on track to deliver solid fourth quarter performance as well as full year results within the target range we established at the beginning of the year.

For the fourth quarter, we are targeting diluted earnings per share before charges gains to be in the range of up low single-digits to down mid single-digits, and that's against the $1.42 we delivered in the fourth quarter of 2006.

With three quarters now behind us, we are in a position to further refine our target range for the year. For 2007, we currently expect diluted earnings per share before charges gained to be down in the range of low to mid single-digits, and that's against $5.33 in 2006.

Now Bruce, Craig and I will be happy to take your questions.

Question-and-Answer Session

Operator

Your first question comes from Todd Duvick - Banc of America Securities.

Todd Duvick - Banc of America Securities

I'm just wondering what your tightening up of free cash flow target for the year is? If you can tell us what you expect for the fourth quarter and if you can tell us what the free cash flow priorities are in the near term?

Craig Omtvedt

Well, as you can see in the press release that we put out, our year-to-date free cash flow for the nine months is at the $225 million range, and so looking at the fourth quarter, we are currently targeting something in the range of up to 275 to 325, so that would be comparable to the approximately $300 million that we generated here in the third quarter.

As you can appreciate, that's going to come from just a myriad of factors that affect the free cash flow. Obviously at this point, we're continuing to pay down debt.

Todd Duvick - Banc of America Securities

Given Norm's comments about the Vin and Sprit situation, given that there really is no firm timetable in place right now, paying down debt in the near term is definitely positive from a bondholder perspective. At what point do you maybe shift over to share repurchase or just accumulate cash on the balance sheet?

Craig Omtvedt

Well, that's clearly not something we would speculate on. As we indicated a year or so ago, or two years ago when we did the Allied deal, we said that in the near term, our priority was going to be to pay down debt and that wasn't just to achieve credit ratios, that was just to position us for optimal flexibility.

I think we're at a point now where pay down debt is a default position, not an absolute priority, but it continues to be our focus at the present time. We've always said that as you think about our longer term focus on cash flow, our first priority has always been internal CapEx just because of its returns. Second has been acquisitions or share repurchase as appropriate, and third has been the dividend.

So the longer term priorities and focus hasn't changed, but in terms of optimizing our flexibility, debt paydown is where we want to be right now.

Operator

Your next question comes from Peter Lisnic - Robert Baird

Peter Lisnic - Robert W. Baird

In terms of the commercial paper markets, any material impact on your ability to access those markets or any balance sheet risk along those lines?

Craig Omtvedt

No. Just to step back a little bit, when we hit the height of the frenzy, on what I'll call the credit crunch, we obviously ended up with shorter durations of issuance in order to protect as a much as we could rates, but we had no problem with issuance. We definitely saw a blip up in rates for a period of time, but that's been settling back. So at this point, things look pretty comfortable in term of commercial paper market.

Peter Lisnic - Robert W. Baird

So no real change to the cost of credit either then?

Craig Omtvedt

Well as I said, it was higher during the height of the frenzy there. I mean, we saw rates on commercial paper jump up to north of 6%, but our run rate had been more along the line of 540 and so at this point, we are trending back towards that level, so we're trying at this point.

Peter Lisnic - Robert W. Baird

And if I could on the spirits business, plus 2%, can you break that out between price and volume?

Norman Wesley

First off, are you talking about for the quarter?

Peter Lisnic - Robert W. Baird

Yes.

Norman Wesley

We are looking at the quarter. But we really look at the year-to-date numbers. We have, if you recall like the last quarter, we had a lot of volatility in the second and third quarter because of the SAP implementations. As you look at year-to-date, we still see a growth level between 2% and 4% for the spirits business.

Craig Omtvedt

There's been some contribution of price, but you also then have to look at mix. There are mix shifts going on as well, so it's not so simple as to just break it down as far as price and volume.

Peter Lisnic - Robert W. Baird

If you wouldn't mind expanding then on some of the softness that you've seen in your regional brands. I assume part of that, to some extent, has been by choice but the other part has just been people are just trading up like you said in your opening comments, Norm.

Norman Wesley

They are. We see and continue to see this trend that premium is growing much faster than the regional brands, and this is basically the consumer driving that decision and calling out for brands rather than just taking what's off the shelf. It's a good trend, it's a positive trend. We have a mix of 70% premium versus 30% regional.

Craig Omtvedt

Let me jump in with just maybe one other comment here just coming back to the sales, because we said we were up 2%, but year over year, pricing had minimal impact here in the third quarter.

The other thing I would highlight is that we've had transitional things going on year over year, we had the Pernod bottling contracts last year, we have got FX, and then we had some issues with just the way accounting is required on what were intra-company sales year over year. If I take all that noise out, what we could have been talking about here is sales on an underlying basis, that would have been up in the 3% range.

Norman Wesley

Both of the premium and regional mix that we're seeing, the premium is still pretty much a 2X a sales per case value, and the margins are at the premium level.

Operator

Your next question comes from Bryan Spillane – Banc of America Securities.

Bryan Spillane - Banc of America Securities

First for you, Craig, looks like you've brought down your expectations on cash flow from operations or operating cash flow. Can you just talk through what is driving that? Is it working capital or is there some other dynamic that is driving that?

Craig Omtvedt

Actually, we really haven't brought down our expectations. At the beginning of the year just because of the variables, as you can appreciate we start with a bit of a broader view of what cash flow can be. But just as we've done with dialing in on where we think our operating income performance is going to be and other factors, diluted earnings per share, we've just simply done the same thing with free cash flow.

I think that to say that for the year, we are targeting the 500 to 550 versus approximately the 575 last year is not an extreme adjustment. The other thing I would remind you of is that this year, we're dealing with $100 million more of interest payments than we had last year with the payment that was made this year. I think as you are aware, our interest payments on our euro debt are made on an annual basis, so we didn't have any interest or cash outflow in 2006, and we obviously do here in 2007. So I think overall, as you look at the numbers, we are in reasonably good shape.

Bryan Spillane - Banc of America Securities

So there's no change in your expectations? Because I thought that the range that you had for cash from operations, so before free cash flow, now it's 900 to 975, and for some reason, I thought you had a wider range previously.

Craig Omtvedt

When you look at that in some ways, that just becomes a function of mechanics, but in terms of how I think about the free cash flow and how we forecast it, it's really at the free cash flow level that really matters to us.

Bryan Spillane - Banc of America Securities

Cap Ex, it looks like you are bringing your CapEx expectation down for the year? Is that true?

Craig Omtvedt

A little bit, obviously we have got the benefit of the asset sales here for the vineyards and a couple of brands that Bruce mentioned before. As we look at where we are going to be with the underlying spend, right now with where we are with all the challenges people have and other initiatives, I think that is coming down a bit.

Norman Wesley

In the home side especially.

Bryan Spillane - Banc of America Securities

Bruce, if you could just give us some color on the spirits business? It's great to get the color by brand, but just regionally or geographically, if you can give us some color what geographies performed well relative to others?

Bruce Carbonari

We continue to see the U.S. market to be solid; good, strong growth, a real strong mix of the premium versus the regional, as I suggested. For Australia, it's a very strong market for us, and continues to be a very excellent reception to our new product that I mentioned, the Beam with the Sugar Zero product.

India continues to be a growth emerging market for us, and we're doing well with Teachers' there and some of our other brown liquors. Europe is solid, UK and Spain a little bit more challenging than other parts of Europe. I would say China, we're very, very young and maybe a little behind in China. Brazil is doing very well with Teacher's as well, but we have a small entry level into the Brazilian market.

But again, Europe is solid, U.S. is solid, and I would say India and Australia are probably the two fastest growing markets right now.

Bryan Spillane - Banc of America Securities

In terms of where you are putting the marking investment now, is most of that stepped up investment happening in the U.S. market or is it spread more evenly?

Bruce Carbonari

It's spread. I think I mentioned this last call, that we went and spent some time since the acquisition really defining our priorities as far as we call brand market contributions, BMC, so we prioritize the brand and then we prioritize the market which we believe that brand will work best in. Then we are supporting that with the brand advertising, so it's global. It's not widespread across the board, it's very selected and very targeted to an audience, and to a geographic market for a specific brand.

Operator

Your next question comes from the line of Robert van Brugge - Sanford Bernstein.

Robert van Brugge - Sanford Bernstein

A question about the spirits category in the U.S. We've recently seen some renewed strength in the beer category. Are you seeing any slowdown in the shift out of beer into spirits or possibly some trading down from the spirits category into beer?

Bruce Carbonari

We have not. When we look at the monthly numbers you see volatility all the time, but as we look over the year, we have not. We continue to see in the trends that we've seen all year, and that's what I mentioned earlier is the premium brands doing very well, the regionals not doing as well. So the cocktail culture is alive. I think the innovation that all of us have brought to that culture continues to be motivating the consumer to continue to purchase a premium level of spirits, so we don't see that trend, no.

Norman Wesley

I would just add, it's kind of hard to pinpoint that in a short period of time. I have seen in the last couple of quarters that the beer companies have done a bit better. I'm not sure if that's hard to pinpoint that to say that we really see that as any kind of a trend.

Robert van Brugge - Sanford Bernstein

Also, a question about the home and hardware business. Do you have any view of how the repair and remodel market spending is trending in the back half of this year? Your view of next year versus the new construction market? Not necessarily for your brands, but for the market overall?

Bruce Carbonari

Yes, this will be more of a market comment. We entered the year thinking that the new construction market was going to be better than actually it has turned out, and we thought the R&R market was going to be a little worse than it's turned out. The remodel market has been basically flat to slightly down. We've seen that continue now through the second and third quarter. So it's been very positive from our standpoint. We have a mix of two-thirds, one-third to repair and remodel versus new construction, so it bodes well for us.

Going out as far as there's a lot of forecasting out there. We are working on our plans right now and we will present our view of the market in the next call, but obviously the new construction will continue to be challenged, and obviously the R&R side is one that there's a lot of varied views out there, so it's hard to call right now.

Operator

Your next question comes from the line of Andrew Sawyer - Goldman Sachs.

Andrew Sawyer - Goldman Sachs

I was wondering if you could you talk a little bit about as we think into 2008, and if the market remains difficult from a home and hardware perspective, this year you did a lot with productivity; you took some pricing, but how should we think about the leverage you guys can pull to help manage through the environment if it does remain challenging?

Bruce Carbonari

In general, obviously 2008 is going to be more difficult than we thought when we first walked into 2007. This market has a lot of inventory in both the new construction side and the existing home side. We as an industry are going to have to figure out how we rebalance that.

Obviously the new construction side, we've seen the builders be much more proactive than they can be by reducing production and so forth, and we've seen a little bit of stabilization now between probably seven to eight months of inventory out there on the new construction side, whereas the existing home inventory continues to keep on increasing and I think it's across ten months now.

We are in this phase of the cycle here where consumers are in a freeze. What I mean by that is they still have the passion to move or upgrade their home. Mortgages are still relatively affordable, but the problem is they want to buy cheap but get full price on what they are trying to sell. That's pretty typical in a market that's in decline. So in general, we are in this consumer freeze period right now.

Craig, I think what I'll start with as far as Fortune Brands go, our focus here is not really to predict the market but outperform the market. Well before any of this began, the structure of the businesses that we have, the balance of the businesses that we have and the balance between repair and remodel and new, the balance between traditional channels and home centers, and the way we have developed our cost structure to being maybe more variable than fixed. That's allowed us to have the flexibility during this market that is critical when you have a market that can be cyclical.

Craig Omtvedt

I think the only thing I would add to that is, fundamentally nothing has changed in terms of our view of the overall home category. I mean, we continue to see the long term demographics as very positive. So clearly, what we are dealing with right now is a correction. Candidly, we think a long overdue correction to take some of the excesses out.

We'll speak more definitively to what our plans are for next year in January, after we conclude the whole budgetary process that we are going through right now. But the real challenge right now is one of balancing what we want to do to take costs out, to support the profit performance in '08 but at the same time, be sure that we are doing things that keep us positioned for the long haul.

I mean, the last thing we want to do is take a $1 out in '08 and find that it's going to cost us $2 to put it back in, in '09. So, that's just kind of philosophically what we're going through right now, but as I indicated for this year, I think that we've done a pretty strong job of minimizing or holding to as low as possible the margin deterioration position for the year.

We'll just have to get through the budgetary process and we'll give you a better view in January.

Andrew Sawyer - Goldman Sachs

Craig, should we use a 32% to 33% tax rate for '08?

Craig Omtvedt

Actually, we'll see how that plays out but I think with where we're at right now with mix of business, early days, I would say next year is 32% or better. So I think if you want something for just now, use the 32%.

Andrew Sawyer - Goldman Sachs

On this patent litigation regarding the Pro V1, what is the risk here, and can you guys put some context around that?

Craig Omtvedt

At this point, I mean there is no risk. We've settled on that, obviously the terms are confidential, so that's not something that we can speak to. But obviously, when you look at the results here in the third quarter, we were down a little bit because of the patent litigation and related expenses; but when you consider that volume was up and when you consider that basically, what we're talking about in terms of if OI had been relative to the sale, we are only talking about $2 million here, and part of that was launch expense. So the bottom line is it's a manageable issue.

Operator

Your next question comes from the line of Omar Al-Madani.

Omar Al-Midani - FTN Midwest Research

The core home demand, I know you mentioned repair and remodel was flat to slightly down. Is it fair to assume 3Q was similar to 2Q in terms of was there any delta either way?

Bruce Carbonari

Between the second quarter and the third on R&R?

Omar Al-Midani - FTN Midwest Research

Yes.

Craig Omtvedt

Basically they were the same.

Omar Al-Midani - FTN Midwest Research

And your expectations for the fourth quarter? Obviously, this is the market.

Norman Wesley

Yes again, we don't talk about forward views, the market the last couple of quarters has been very stable.

Craig Omtvedt

We read pretty much what you do, and there's lots of people who have estimated no appreciable change in the trend in repair and remodel in the fourth quarter of '07.

Omar Al-Midani - FTN Midwest Research

In terms of the share gains is 3Q accelerated from the second quarter? Is that right?

Bruce Carbonari

Yes, they continue. We are getting them in different areas, but yes, they continue pretty much across the board. It isn't one company-specific, we are seeing it in the door business, in the faucet business, the cabinets. It is right across the board, and in different channels and different markets.

Omar Al-Midani - FTN Midwest Research

Turning to spirits for a second, the SAP timing on revenue growth, what was the SAP timing in 3Q? The shift there?

Bruce Carbonari

We launched the piece of SAP on August 1st of this past quarter. With that, there was some volume in Q2 as our distributors in our three-tier system, our distributors loaded up just to make sure that we didn't have a hiccup, which we didn't have as we launched this. What has happened since then is just flushing and getting the inventory rebalanced.

Norman Wesley

It's difficult when you are talking about a broad base of distributors and product lines, it's difficult to pinpoint exactly how much the buy ahead was versus how much of it we gave back.

Omar Al-Midani - FTN Midwest Research

In terms of your spirit spending, I know you talked about double-digits here in the third quarter versus probably down a bit in the first half, if I recall correctly. When you think about the fourth quarter, is the spending a similar year over year increase as 3Q saw or will there be an acceleration?

Bruce Carbonari

Well first off, the fourth quarter is the biggest quarter in the spirits business as the holiday season approaches. What we had said was it is a continuation of the increased brand spend that we had in the third quarter to the fourth quarter.

Craig Omtvedt

But it will be, the fourth quarter from just kind of a perspective, quarter-over-quarter standpoint, year over year, the fourth quarter numbers for brand spend will be significantly higher than they were in the third quarter.

Omar Al-Midani - FTN Midwest Research

Year over year?

Craig Omtvedt

I'm saying fourth quarter year over year will be significantly higher than the same comparable third quarter year over year.

Omar Al-Midani - FTN Midwest Research

Your full year EPS guidance, a little bit lower than prior. Anything in September? What was the delta that has caused you to change that as a margin?

Norman Wesley

It was really fine tuning; I mean, we had three quarters behind us so a little bit more fine tuning, that's all.

Operator

Your next question comes from Peter Lisnic - Robert Baird

Peter Lisnic - Robert W. Baird

Do you guys mind talking a bit about commodity costs? I think there was mention that it was essentially offset in the quarter, but what the outlook might be like for fourth quarter? Really more specifically maybe for '08, I know you don't want to give a forecast for '08, but just where the trend might be would be helpful.

Craig Omtvedt

Well let’s go in reverse order and let's just talk about trends, at least at the moment, looking into next year. As you look at the metals market, we'll look at copper, zinc, related commodities. We are seeing what I would describe at relative stability, at the moment/ I mean, we are seeing it blip up a bit and down back and forth, but relative stability. So as we look at next year right now, I think basically we would describe that as manageable.

Then you start to look at plywood, and you look at lumber and other items that are really important to us. We view those as manageable as well. So early days, I mean we are still sorting ourselves out, but we don't see anything that's presenting what we think is going to be a huge challenge at least for next year at the present time.

Now, coming back into the fourth quarter you are right; what we've done is offset the price increases, but the year over year has some moving parts in terms of last year. We had mark-to-market in it for our faucet business. As it stands right now, I think we are in a somewhat better position fourth quarter this year than we were last year, but at this point, it would be hard to put a real tight number on that.

Peter Lisnic - Robert W. Baird

Going back to the question about margins in '08 in home and hardware, you frequently talked about your ability to extract 300 to 400 basis points from productivity in home and hardware, and I would imagine with Simonton being relatively early days in the grand scheme of things, that, that sort of target, you are still relatively comfortable with?

Is that another way of looking at how you can protect the downside in '08 if the market becomes markedly worse?

Craig Omtvedt

Yes, I think it is. We continue to run with the target of taking out 3% to 5% of costs of sales through productivity every year, and that hasn't changed.

Norman Wesley

Good times or bad, that's our targets.

Operator

There are no further questions at this time.

Craig Omtvedt

Thanks again for listening today. As we approach the end of the year, we will continue building our brands and executing what we believe are the strategies that have helped us succeed in our markets. Fortune Brands is on track to deliver full year results within the target range we established at the beginning of the year and we will review 2007 results and our outlook for 2008 during our conference call in January.

Thanks again for joining us.

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