Acuity Brands' (AYI) CEO Vernon Nagel on Q3 2016 Results - Earnings Call Transcript

| About: Acuity Brands, (AYI)

Acuity Brands, Inc. (Holding Company) (NYSE:AYI)

Q3 2016 Results Earnings Conference Call

June 29, 2016, 10:00 AM ET


Dan Smith - SVP, Treasurer and Secretary

Vernon Nagel - Chairman, President and CEO

Richard Reece - EVP and CFO


John Walsh - Vertical Research.

Tim Weiss - Baird

Sven Eenmaa - Stifel

Jeff Osborne - Cowen & Company

Brian Lee - Goldman Sachs


Good morning, and welcome to Acuity Brands Fiscal 2016 Third Quarter Financial Conference Call. After today's presentation, there will be a formal question-and-answer session. [Operator Instructions] Today's conference is being recorded. If you have any objections, you may disconnect at this time.

Now, I would like to introduce Mr. Dan Smith, Senior Vice President, Treasurer and Secretary. Sir, you may begin.

Dan Smith

Hello, good morning. With me today to discuss our third quarter results are Vern Nagel, our Chairman, President and Chief Executive Officer; and Ricky Reece, our Executive Vice President and Chief Financial Officer.

We are webcasting today's conference call at I would like to remind everyone that during this call, we may make projections or forward-looking statements regarding future events or future financial performance of the Company. Such statements involve risks and uncertainties such that actual results may differ materially. Please refer to our most recent 10-K and 10-Q SEC filings in today's press release, which identify important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements.

Now let me turn this call over to Vern Nagel.

Vernon Nagel

Thank you, Dan. Good morning, everyone. Ricky and I would like to make a few comments and then we will be happy to answer your questions.

First off, our results for the third quarter of 2016 were outstanding. Our net sales grew 25% while our adjusted diluted earnings per share grew 40%. We achieved record quarterly results for a number of key financial metrics including net sales and gross profit margin and on an adjusted basis operating profit and diluted earnings per share. In fact this was our 13th quarter in a row where we achieved double digit volume growth, a remarkable achievement.

We believe these results are yet again strong evidence of our strategies to provide our customers with differentiated value-added solutions and to diversify the end-markets we serve are succeeding, allowing us to extend our leadership position. These strategies include accretive acquisitions, the continued aggressive introduction of innovative, energy-efficient lighting and building automation solutions, expansion in key channels and geographies, improvements in customer service and company-wide productivity gains.

Our results for the third quarter set records for Acuity even as we continue to invest in our strong sales growth in the areas with significant growth potential including the expansion of our solid state luminaire and lighting controls portfolio, as well as our building automation and Internet-of-Things solution. I know many of you have already seen our results and Ricky will provide more details later in the call but I would like to make a few comments on the key highlights for the quarter.

Net sales for the third quarter were $852 million, an increase of 25% compared with a year ago period, and the highest quarterly sales in our history. Reported operating profit for the third quarter of 2016 was $121 million compared with reported operating profit of $99.2 million in the year ago period. There were adjustments in both quarters for a certain special charges which Ricky will describe later in the call.

Also our reported operating profit included items such as share based compensation expense, costs associated with the acquisition, and certain purchase accounting adjustments including profit in inventory and amortization expense for acquired intangible.

In order to make our quarter results comparable between periods we find it helpful to add back these items to our reported results. In doing so one can see adjusted operating profit for the third quarter of 2016 with a quarterly record of $146.1 million compared with an adjusted operating profit of $108.1 million in the year ago period, an increase of 35%. Adjusted operating profit margin was 17.2% up 140 basis points from the adjusted margins in the year ago period.

Adjusted diluted earnings per share was a quarterly record of $2.06 compared with adjusted diluted EPS of $1.47 in the year ago period up 40%. This is compelling performance. We closed the quarter with $337 million of cash on hand after investing $614 million for acquisitions this year leaving us with plenty of financial fire power to execute our growth strategies. Further we generated a record of $244 million from net cash provided by operations in the first three quarters of 2016 up $86 million or 54% from the year ago period.

Our record results for the quarter were significant improvements over the year ago period. We believe you will find our results for the quarter even more impressive upon further analysis. Net sales for the third quarter grew 25% compared with the year ago period. We estimate our sales volume grew by an impressive 16%. The additions of Distech and Juno increased net sales another 12 points while changes in price mix and foreign currency reduced net sales by approximately 2 points and 1 point respectively.

While it is not possible to precisely determine the separate impact of price and mix changes on net sales, we believe the difference was primarily due to lower pricing on like kind LED luminaires between periods reflecting the decline in certain component cost and to a lesser degree changes in the mix of products sold.

The increase in net sales was broad based along most product lines and sales channels. Sales of LED products at Acuity now account for approximately 60% of our total net sales, which as you know, includes the sale of non-fixture related products and solutions as well.

Lastly, we believe our channel and product diversification, as well as our strategies to better serve customers with new, more innovative and holistic lighting and building automation solutions and the strength of our many sales forces have allowed us to yet again achieve meaningful sales growth this quarter.

Before I turn the call over to Ricky, I would like to comment on our profitability and strategic accomplishments for the quarter. As we noted earlier, our adjusted third quarter operating profit was $146.1 million, the most in our history and adjusted operating profit margin for the quarter was a quarterly record of 17.2% up 140 basis points from the adjusted margin in the year ago period.

Further, our adjusted gross profit margin for the quarter was a record 44.5% up 130 basis points compared with the year ago period. The expansion of our adjusted gross profit margin was primarily due to the benefits of higher net sales volume, productivity improvements throughout the supply chain and lower input costs, partially offset by the addition of Juno which in its recent past has had a lower gross profit margin than Acuity.

Next, total selling, distribution and administrative expenses excluding the adjustments – the adjustment items noted earlier for each quarter were up $45.2 million or 24%. Adjusted SD&A expenses as a percentage of net sales were 27.3% in the current quarter, a decrease of 10 basis points from the year-ago period. The increase in adjusted SD&A expense was primarily due to higher freight and commission costs to support the increase in net sales, the impact of acquisitions and to a lesser degree higher compensation costs. The increase in compensation costs was primarily due to additional headcount to support and drive our tiered solutions strategy.

Next point is very important. Another way to view just how robust our third quarter results were is to examine our variable contribution margin excluding the impact of acquisition. On a comparable basis our variable contribution margin as a percentage of net sales was approximately 30%, well above our current target of mid to upper 20s. All-in-all, we had another great quarter.

On the strategic front, we continue to make great strides, setting the stage for what we believe will be strong growth and profitability in 2016 and beyond. Internally, we continue to accelerate the deployment of our lean business processes, driving greater productivity and enhanced customer service. We continued our rapid pace of introducing new products and solutions, expanding our industry-leading portfolio of innovative, energy-efficient luminaires and lighting-controls as well as our building automation platform.

With the addition of Juno we now offer customers more than 1.8 million lighting SKUs to choose from, more than three times as many as we had in 2008. To our knowledge, no other lighting company provides customers with more choices and solutions than Acuity Brands. Much of this growth in our portfolio has been driven by the expansion of our Digital Lighting Solutions portfolio, including controls and now building automation systems and IoT applications.

The innovation continues to be at the forefront of our strategy. For example our Innovative LED Solutions earned multiple awards from the industry’s most prestigious programs during LIGHTFAIR International including the 2016 LFI Innovation Awards and the Next Generation Luminaires Solid-State Lighting Design Indoor Competition. Additionally we continue to invest in and expand our capabilities to drive our integrated, tiered solutions strategy which consists of four tiers.

The purpose of this strategy is to lever our incredibly diverse and growing portfolio by offering customers solutions that best meet their needs, whether it would be a single device which we categorize as Tier 1 or a complete holistic integrated lighting and building automation solutions, which we refer to as Tier 3 for the indoor and outdoor needs, and everything in between.

We deliver this comprehensive portfolio all with the promise and security from Acuity that these solutions are smart and simple, both to install and to use. These are compelling and powerful value propositions for our customers and a competitive advantage for Acuity. And the additions of Distech, Geometri and Juno has meaningfully enhanced our industry leading capabilities and solutions portfolio.

While sales stated for our tiered solutions is still imprecise and expanding off a small base, we believe sales of our Tier 3 category, encompassing our holistic integrated solutions were up approximately 40% through the first three quarters of this year over the year-ago period and now represent almost 10% of our total sales. Furthermore, our Tier 3 solutions can be enabled to collect data and to support our connectivity to the Internet of Things, affording Acuity additional revenue streams which we identify as Tier 4 solution.

To fully execute our holistic tiered solution strategy, we have continued to hone our organization structure to be more customer-centric, leveraging our industry-leading access to market and to better allocate resources among each of our tiers, creating the best solutions for our customers’ applications. We have added enormous capabilities over the last year including our recent acquisitions as well as increased salary headcount to support the growth as part of this overall tiered solutions strategy.

Additionally, now that LED is widely accepted, the attention of customers is focused on how they can best control and utilize this light source to optimize their visual environment, while realizing additional benefits including energy savings and the opportunity to have a smart connected platform to enable the Internet of Things. Because Acuity truly understands how best to fully utilize the unique capabilities of digital lighting through our smart and simple solutions for virtually any application, and with the addition of Distech Controls we believe we are uniquely positioned to grow much faster than the markets we serve.

At Acuity, we are not just talking Internet of Things, we are doing it. Over the last 12 months we have converted over 12 million square feet of space for customers, including Target and two other global leading retailers to Smart Lighting Solution. As part of the Smart Lighting Solution, we currently have almost 200,000 maintenance free Beacon enabled LED lighting fixtures that are performing superbly collecting data and enabling applications to provide users with superior lighting and energy performance as well as useful actionable information.

We believe this level of capability and deployment is unmatched in our industry. Importantly, we expect this installed base to quadruple by the end of 2016. Further target selected Acuity as its exclusive Smart Lighting Solutions provider. The integration of Distech which operates into its historical markets as more of a standalone company is moving along very well.

We expect the combination of Acuity with its broad industry leading solid-state lighting portfolio, innovative control technologies and integrated digital solution and Distech to contribute to our tiered solutions strategy are offering holistic unified solutions that deliver true end-to-end optimization of all aspects of the building.

These solutions are designed to enhance the occupant experience, improve the quality of the visual environment and provide seamless operational energy efficiency and cost reductions as well as increase digital functionality due to a unique capability to collect vast amounts of data that can better enable the Internet of Things for building owners.

In fact we just introduced [nLight Eclipse] [ph] a powerful cost effective capability that enhances our industry leading lighting controls by making them far simpler to deploy and more impactful at delivering total Smart Building Solution that unifies lighting HVAC, power metering and security. This solution set streamlines building programming, facilitates our smart multi-zone daylight harvesting and color turning capabilities and enhances IoT access.

We believe the capabilities and ease of installation of this Tier 3 solution set is unmatched in the industry today. Through the deployment of solutions like these as part of our tiered solutions strategy Acuity Brands is driving the evolution to smart buildings in smart cities. We expect these recent strategic acquisitions coupled with our aggressive internal investments will allow us to continue diversify and strengthen our foundation as we further serve as a robust platform for our future growth that is less reliant on the new non-residential construction cycle.

We have been able to produce these results because we - of the dedication and resolve of our now 10,000 associates who are maniacally focused on serving, solving and supporting the needs of our customers. I will talk more about our future growth strategies and our expectations for the construction market later in the call.

I would like to now turn the call over to Ricky before I make a few comments regarding our focus for the balance of 2016. Ricky?

Richard Reece

Thank you, Vern and good morning everyone. As Vern noted we had a strong third quarter performance on virtually all metrics including sales and earnings growth, profitability and cash flow. I will provide a bit more color on our record third quarter results and our financial position. As Vern mentioned earlier we had some adjustments to the GAAP results in the third quarter of fiscal 2016 and 2015 which we find useful to add back in order for the quarterly results to be comparable.

In the third quarter of fiscal year 2016 we added back $1 million or $0.02 per diluted share for various acquisition related items. $7.5 million or $0.11 per diluted share for the amortization of acquired intangible assets. $6.9 million or $0.10 per diluted share for share based compensation expense and $9.7 million or $0.14 per diluted share for special charges related to streamlining activities including integration of recent acquisitions and consolidation of certain production activities.

We adjusted prior year results for amortizations for acquired intangible assets of $2.8 million of $0.04 per diluted share, share based compensation expense of $4.4 million or $0.06 per diluted share acquisition related items of $1.3 million or $0.03 per diluted share and special charge of $0.4 million or $0.01 per diluted share.

In addition we adjusted prior year’s results for the gain on financial instruments used to hedged the deistic Canadian dollar purchase price of $10.5 million or $0.15 per diluted share. These adjustments to our GAAP earnings resulted in an adjusted diluted EPS of $2.06 for the third quarter of fiscal year 2016 which is a 40% increase compared with the $1.47 adjusted diluted EPS in the year ago period.

We believe these non-GAAP measures provide greater comparability and enhanced visibility into our results of operations. We thank you for find this transparency very helpful in your analysis for our performance. In addition many of our –companies make the same adjustments that would help you as you compare our performance to other public companies in our industry.

In our earnings release and Form-10Q we provide a detailed reconciliation of non-GAAP measures. During the third quarter of fiscal 2016, the company recorded a pre-tax special charge of $9.7 million were actions initiated to streamline the organization including the integration of recent acquisitions.

These streamlining activities include the consolidations of selected production activities and realignment of certain responsibilities primarily within various selling, distribution and administrative departments. We expect to achieve net annual savings of at least twice the amount of the special charge commencing at the end of the first quarter of fiscal year 2017.

We anticipate incurring additional cost associated with these and potential future integration and streamlining activities in the fourth quarter of fiscal year 2016. The effective tax rate for the third quarter was 34.3% compared with 36% in the third quarter of last year. We expect the effective tax rate for the fourth quarter of fiscal year 2016 to be 35.5%.

Before any discreet items and in if the rates in our tax and jurisdictions remain generally consistent throughout the year. Cash flow generators from operations for the first nine months of fiscal year 2016 were an impressive $243.9 million and increase of $85.7 million or 54% compared with the prior year.

We did an excellent job this quarter of managing operating working capital defines as receivables plus inventories less payables. As our operating working capital net of the effect of acquisitions decreased by one day compared with last year as 41 days which we believe is industry leading.

In the first nine months of fiscal year 2016 we spent $61.8 million on capital expenditures compared with $42.3 million in the prior year. This uptake in capital expenditures is primarily due to investments necessary to support our growth including tooling for new products, expansion and our electronic capacity and building out of our innovation and technology center in Metro, Atlanta which we moved into earlier this fiscal year.

We currently expect to spend approximately 2.5% of revenues in capital expenditures in fiscal year 2016. At May 31, 2016 we had cash and cash equivalent balance of $337 million. A decrease of $419.8 million since August 31, 2015, this decrease was primarily to cash used to fund acquisitions of $613.7 million in capital expenditures to $61.8 million as well as to pay dividends to shareholders of $17.1 million.

Our total debt outstanding was $354.4 million at May 31, 2016. The ratio of debt net of cash to total capitalization net of cash was 1.1% at May 31, 2016. We had additional borrowing capacity of $243.9 million at May 31, 2016 under our credit facility which does not expire until August 2019. We clearly enjoy significant financial strength and flexibility and will continue to seek the best use of our strong cash generation to enhance shareholder value.

Thank you. And I will now turn the call back to Vern.

Vernon Nagel

Thank you, Ricky. As we look forward, we see significant long-term growth opportunities that are ever-changing and evolving in a positive direction for Acuity. Last week’s UK referendum with European Union has created a great deal of uncertainty and generated significant volatility in the global financial markets over concerns regarding the potential impact if any on the global economy.

This uncertainty and volatility have the potential to affect consumer and business sentiment which could negatively impact global economic activity. This notwithstanding we remain bullish regarding the company’s prospects for continued profitable growth.

So while we don’t give earnings guidance, I would like to provide a few observations. First the consensus estimate from independent third-party forecasters calls for the broad lighting market in North America which represents 97% of our total net sales to grow to mid to upper single digit range through fiscal 2016 reflecting the benefits of both new construction and renovation activity. Again the favorable trend in our June order rate seems to support this continued levels of improvement, further we continue to see signs that give us optimism regarding the future growth of the markets we serve in our business.

Leading indicators for the North American markets such as architecture billing index, vacancy rates, office absorption, lending availability and favorable employment trends continue to improve at varying paces, while residential construction continues to grow nicely.

Excluding the price of certain LED components which are expected to continue to decline and steel costs, which have risen recently, we do not anticipate significant changes in most input costs over the next 12 months. We expect to offset the impact of rising steel prices through certain pricing initiatives and product cost reductions further we expect employee related cost to continue to rise primarily due to increases in associate headcount, wage inflation and the negative impact of rising healthcare cost.

Next, we continue to be leery of foreign currency exchange rate fluctuations particularly during this period of uncertainty caused by the U.K. announcement last week. Another observation, while our gross profit margin is influenced by a number of factors including sales volume, innovation, price product and sales channel mix as well as current dilutive impact of Juno, we expect our annual gross profit margin to continue to improve over time as volumes grow and as we continue to realize typical gains in manufacturing efficiencies including cost savings related to the integration of recent acquisition.

Our record adjusted gross profit margin for the first nine months of fiscal 2016 is a good example of our potential, it is a positive picture. Additionally, while we always experience some isolated pricing pressures in various markets and sales channels, we will continue to be vigilant on pricing. As we have said before, we will defend our market position vigorously from competitors, should they attempt to use price as their only point of differentiation.

Lastly and most importantly, we expect our growth rates to continue to meaningfully outperform the markets we serve. Looking more specifically at our company, we’re very excited by the many opportunities to enhance our already strong platform including the expansion of our Tier 3 and 4 holistic lighting and building automation solutions that for example connect smart lighting with smart phones for retailers, as well as our growing electronic component software capabilities.

We are experiencing strong interest from many of our key customers for our holistic solutions with these capabilities and more. And as I noted earlier, we expect to quadruple our installed base by the end of 2016.

As we have noted in last several conference calls, the implementation of our integrated tier solution strategy and our opportunities to meaningfully participate in the interconnected world is really a continuation in the advancement of our overall growth strategy, which has been in place for some time. This includes expected benefits from the acquisition of Distech, which we believe will meaningfully expand our addressable market and add much greater opportunities to offer our customers even more broad-based holistic solutions to optimize the performance of their facilities.

While we are very early in this game, we are seeing positive results in our growth rates for Tier 3, and the implementation of our IoT solutions. Further, we expect the addition of Juno to meaningfully expand and strengthen our lighting solutions portfolio, including both down and track lighting as well as enhance our presence in the residential and corporate account sales channels.

As we noted in our last earnings call, while we are extremely bullish on the long-term growth potential of the Juno Lighting Group, we experienced some modest short-term impact on their net sales, as we integrated certain overlapping sales forces. We are pleased to report the integration of those sales forces has been substantially completed and early indicators such as quote rates for Juno products are up significantly over the year ago period. This gives us optimism that much of the negative impact of the sales force integration is behind us.

Lastly, the addition of Geometri, a small yet fast growing business intelligence company, will enhance our expanding business analytics capabilities as part of our software solutions portfolio to support retailers and other building users need for actionable data. The addition of Geometri will meaningfully enhance our Tier 4 solutions offering and is already paying dividends through greater customer connectivity.

Our company-wide strategy is straight forward, expand and leverage our industry-leading product and solutions portfolio coupled with our extensive market presence and our considerable financial strength to capitalize on market growth opportunities that will provide our customers with unmatched value and our shareholders with superior returns.

This all takes focus and resources. We're investing to enhance and expand our core competencies to excel in our fast changing industry because we see great future opportunity. Through these investments, we have significantly expanded our addressable market; our record growth supports this view.

As I’ve said before, we believe the lighting and lighting related industry as well as the building automation systems market will experience significant growth over the next decade because of continued opportunities for new construction and more importantly the conversion of the installed base which is enormous in size to more efficient solutions particularly as energy and environmental concerns come to the forefront along with emerging opportunities for digital lighting to play a key role in the Internet-of-Things.

We continue to believe the many markets we serve as part of the broader lighting and building automation industries, some of which could grow by 50% over the next few years will provide us with significant growth potential. As a North American market leader in lighting solutions and a technology leader in building automation, we are positioned well to fully participate in these exciting and growing industries.

Thank you. And with that, we will entertain any questions that you have.

Question-and-Answer Session


[Operator Instructions] The first question is from John Walsh with Vertical Research.

John Walsh

Hi, good morning. I was wondering if you could talk a little bit about the acquisition pipeline and then kind of wondering also about some of the volatility we are seeing in Europe, if that kind of opens an opportunity to do something there or if you feel you need to wait for the market to normalize a bit before you would do anything in that market?

Vernon Nagel

So Ricky why don't I take the second part first and then you comment on acquisition. Our strategy in broad Europe is really two-fold. We have a very strong brand in both industrial and Roadway, as well as other types of indoor capabilities.

So we will continue to drive our productivity, our focus in those markets with those products. We focus on U.K., we focus on Germany, Northern Europe. We have our capability in Spain and my senses is that, while there is great deal of uncertainty going on right on, which could have some impact on our order rate, we still think it’s a bullish opportunity because of what certain markets and certain countries are doing in terms of their industrial output.

So while Europe represents or sales outside of North America represent really only 3% of our total we continue to like the strategy that we have in Europe and that is to focus on key customer sets, key channels with key products that we have and maintain our capability there.

If there are opportunities that come up we’ll look at them but they have to be very consistent with our strategy. In terms of acquisitions overall, we continue to see a very interesting pipeline and Ricky why don't I ask you to comment on that.

Richard Reece

Yes, we continue as Vern said to see a very robust opportunity for acquisitions. Our focus is in two primary areas technology and there we continue to see opportunities not only to acquire but to make investments in minority or larger investments in or to partner or lastly to just have a commercial relationship to share technology on a licensing type arrangements. So we do see a lot of opportunities there and continue to be very active in pursuing opportunities to expand our capability and technology.

The other areas in bolt-on tuck-in type acquisitions both for our luminaire business as well as our Control Building Management business. There too we’re seeing a robust pipeline obviously Juno is a great example of bolt-on, tuck-in type acquisition that fills gaps that we have. There we are more likely obviously look to acquire as opposed to invest in but we do see a robust pipeline and I think it’s likely in both of those areas to continue to see SP active where it supports our strategic focus and creates a value at a reasonable price.

Vernon Nagel

And as everyone knows, we are very disciplined in terms of the acquisitions that we make. Transactions have to be both desirable as well as doable from a financial perspective. So it’s difficult to precisely determine the exact timing of acquisitions. But suffice it to say that it’s part of our strategy for growth. We will continue to look for these types of opportunities as Ricky described.

John Walsh

Okay. And then just on the second question, are there any metric that you can share about driving the Tier 3, Tier 4 solutions growth either the amount of headcount that has been added to sales and engineering this year and kind of expectations in the next year, how you’re going to drive that initiative?

Vernon Nagel

Sure. In my prepared remarks I said that Tier 3 solutions through the first three months and again it’s coming off of a smaller base and our measuring capabilities in the prior periods weren’t as robust as they are today but we guesstimate that Tier 3 portion of our business which now represents almost 10% of our business grew at approximately 40% growth rate.

When we think about how we have invested in our tiered solutions strategy in our headcount including acquisitions this year is probably up and their salaried headcount area close to 30%. And while we don’t specifically allocate all capabilities by tiers because of the way products can work and migrate through the tiers and support the tiers it’s not really an effective use to allocate.

But what I can say is that when we look at things specific to our tiered solutions strategy like our ability to develop software whether it’d be firmware that makes our entire Tier 3 solutions work well between various control components Distech of course and in our lighting business that group has expanded by a factor of four.

We probably had 18 months ago less than 20 folks in this group today we have over while we are approaching 80 folks. And by the end of the year we will probably have close to 100 on our way probably to 150 people. And it’s really because of the opportunities that we see in supporting the Tier 3, Tier 4 solution set.

We are very pleased to announce that Target selected us as their exclusive Smart Lighting Solutions provider. The opportunity to provide them not only with lighting solutions that enhance energy efficiency but provide them with other opportunities to do things is really – I think it’s the ample of how we’re moving but investing in and growing our Tier 3 solution strategy.

So more to come there into very early innings of this game and we are very excited about the potential of what this tiered solutions strategy will afford for U.S. shareholders and for our customers as solutions.

John Walsh

Great, thank you for the color.


Thank you. The next question is from Tim Weiss with Baird.

Tim Weiss

Hi guys, good morning, nice job. I guess just going back to Target, is there any way to maybe kind of put some numbers around just the revenue opportunity? I think you said that the number of beacon enabled light fixtures is going to quadruple by the end of the year and just maybe some rough math, that could add a couple of points to revenue growth. So just want to make sure that maybe I'm in the ballpark in terms of how we should think about the Target win financially?

Vernon Nagel

Well, I mean as you might imagine the opportunity of Target, the initial opportunity is somewhat I mean interesting in that they will build out, I think the number is probably north of 300 stores over the next three or four months.

I think what's more interesting in trying to put a numerical number around it, and it's not just target, it's the whole notion of how the installed base not just in retail, but when you think about other very large building owners whether it's campuses or universities or research centers, these large installed base is the opportunity to convert them from traditional lighting to smart lighting solutions really is not only for energy savings, but daylight harvesting, the ability to make the visual space better more effective, the opportunity to participate in the Internet of Things as data collection points that's what we find really fascinating.

So, our relationship with Target is a decades or long relationship. There are great customer and we dedicate significant resources to making sure that we are meeting their needs at every step. So it's an example of our access to market and then bringing these solutions that to the market that are allowing us to drive two or three.

So when I think about the total market, DOE says that there's 100 billion square feet of building space that is in U.S. 70% of which was put in place before 1990. Few years ago, we estimated that to convert that installed base might have been about $3 a square foot for lighting and controls.

Today we believe that number is much higher, because of the true value add that can be brought through the smart life and the target situation is just an example. And there are many, many, many more.

So without focusing too much on target but focusing more on what target represents as a leader in the retail space and taking a leadership position to make the conversion to smart lighting. I think that's what's really interesting. And then how that expands and extends to other folks that are different subsets of the retail market, which as you know is huge, so that they can take advantage of smart lighting. That's the potential. I think that the market that’s out there that installed base is enormous in size and represents an enormous opportunity for Acuity as we go forward.

Tim Weiss

That is great. Would you say that over the last maybe even year to date that the number of conversations that you are having with retailers is starting to accelerate?

Vernon Nagel

Absolutely, and it's not just retailers, it's users of space that are looking to optimize how they use based, not just from an energy saving standpoint, but how can quality of life enhance what they're doing. How can these luminaries that can be enabled in a much more effective way.

Today and you still have technologies that are out there that are using battery powered beacons and somehow they're trying to say that that is the equivalent. It's really a shame because those that that old technology those old solutions that people are saying well I have that too. It's really not the same. And as people become more comfortable and I understand the solutions that what Acuity offers is really huge, the introduction of nLight Eclipse for example.

But just another example of a Tier 3 solutions that allows us to get after building owners not just retailers but all building owners in a way that allows us to optimize their lighting while driving great unification between the HVAC systems, sub-metering, security and lighting and allowing us to do this in a very, very clever and simple way. It doesn’t exist in the marketplace so we’re excited about that whole approach to the installed base because of its size and scale.

Tim Weiss

Okay. And then just my second question, just on the restructuring and the streamlining expenses that you called out, should we think of that as incremental to the mid to high 20% incremental margin target that you have out there or is it kind of included in that target over the next year?

Vernon Nagel

The opportunities that we have to continue to direct investment in our business we're looking for ways to continue to own how we approach the market. The investments that we make and some of those are difficult decisions of what we are not going to because they are still some market but we see so much potential and again Tier 3 and Tier 4 it what can mean for that install base.

We will continue to direct investment and continue to drive productivity in our business and I’ll consider this productivity opportunity where we can continue to invest. This quarter we delivered on the legacy business about 30% variable contribution. So its higher than what we kind of have been targeting into that mid to upper 20s, so, we’re always looking to optimize in the short term what we are doing in terms of variable contribution margin so, we can drive our results but we are doing that against the back drop of long term investment opportunities.

And for us mostly that's human capital. We’re spending right now on CapEx about 2.5% of sales little bit higher than what we normally do but we're still investing at a very rapid pace in our human talent as I mentioned earlier in putting acquisitions or salary headcounts up about 30% but interestingly our SD&A as a percentage of total sales we picked up about 10 bips. So we’re looking to leverage our base while investing, so to say precisely that all of those savings are going to enhance variable contribution we're looking at balancing of investing for the short term as well as driving - investing for the longer term while investing our delivery shorter term as well

Tim Weiss

Great, keep up the good work and good luck.


Thank you. The next question is from Sven Eenmaa with Stifel.

Sven Eenmaa

Thanks for taking my questions. First I wanted to ask in terms of your sales in today new construction and renovation market. What kind of growth rates are you seeing in new construction versus renovation side and are there any verticals in the market which you see accelerating or decelerating currently?

Vernon Nagel

Sure. Overall we believe that our mix of business is tilted - we have estimated 50% renovation, 50% new construction, it’s probably tilting a little bit more towards renovation and I would see that over time, it may even tilt more because the installed base is so enormous and the opportunity there is to provide value solution sets and customers where there is no alternative, they’re not building something they’re not renovating, we call that unplanned renovation but it’s because the payback and the opportunity of the new solution set is so compelling that they want to make that unplanned renovation.

I would say new construction continues to move along at a solid but yet somewhat of almost schizophrenic pace. We see spurts and then we see declines, we see spurts and declines and that has to do with the entire geography because we served so many different markets, it’s difficult to discern an absolute trend. There is no doubt that when we went through here over the last 18 months changes in oil prices that's some of the activities and those oil patch areas slowed down a little bit but yet in other areas of technology, we see those markets continuing to expand.

So I feel generally speaking that as employment continues to improve, we’re seeing broad based improvement in commercial office buildings, we're seeing improvements in healthcare as budgets of states continue to improve, we are seeing spending on education both K through 12 as well as higher education, the industrial segment continues to move along nicely, roadway seems to be moving along quite nicely.

So I think all in all, we are continuing to see improvement on a gradual basis but it’s the - it’s the renovation market that allows us to continue to drive our growth in a solid way.

Europe, we will wait and see what happens there. Obviously that uncertainty is out there but I don’t feel like that contagion of anything that may go on there will spill over here. And just to reiterate, 97% of our revenues are generated here. We have a great business in the U.K. and in Spain. Obviously U.K.'s products just got a heck of a lot cheaper for people to now acquire them and mainly in Europe. So we continue to be bullish on the overall opportunities for Acuity.

Sven Eenmaa

Great to hear. The second question I wanted to ask was regarding your integrated solution which now you can provide both the Distech acquisition including lighting controls and HVAC and obviously you mentioned security as well. There are obviously already established competitors in those markets but curious to understand like which verticals or which market segments do you see for US, kind of the lowest hanging fruit or where do you expect to make the fastest headway there?

Vernon Nagel

Sure. So if you look at Distech, and Distech is a technology control company and so it’s not really selling hardware components. So when you move or remove that and you look at people who are selling software control solutions Distech has while it’s a smaller business it has a very strong reputation for being innovative using technology and it has a reasonable market share.

And so the opportunity for us to work with and have two channels, there are traditional channel system integrators and our traditional channel of local agents work together to sell these solution set that really provide a great deal of value for really buildings of all types. And really explain why using our now Unified system which we’re very excited about. It’s software it took a lot of time to develop a lot of hard work but the nLight Eclipse System will be the backbone in terms of creating a very, very simple piece of glass for building users to now manage the affairs of their building in a much more simple and effective way.

So we’re very excited about the possibilities and the opportunities of that because it’s applicability again think of education campuses of any type, commercial office buildings, healthcare facilities and you can just keep going on buildings of any type are really the opportunity here.

And given the connectivity that we have through contractors, engineers, lighting designers and they through system integrators and then their own form of contractors this will allow us to sell those value proposition. And the ease of installation, the ease of programming is really going to be a point of key differentiation and then the end user has again very, very simple tools or simple to use but massive tools that are available to help drive the effectiveness of their building.

Sven Eenmaa

Great, thank you.


Thank you. And the next question is from Jeff Osborne with Cowen & Company.

Jeff Osborne

Hi, good morning and congratulations on the results. I just had two quick questions. One, on the 2% price mix; that is a little higher than recent quarters. You had alluded to on the call that the driver of that was the LED component and other component price declines, but I just wanted to get a sense of was there a pickup there or was your reductions in price somewhat of a catch-up or where there competitive aspects at play? Any color would be helpful.

Richard Reece

Yes, I would say it’s a slight pick-up we’ve been saying 1% so it’s a slight pick-up with around – we have seen kind of a trough in not just LED components which is the primary driver of that but still in other areas that kind of hit a trough and there’s a little bit of lag and when that gets in pricing that I think impacted that. It’s those kinds of cost reductions in commodity such as steel, aluminum. Copper do get past on pretty quickly in our industry.

Now as many of you know steel has taken a quick V turn not even a U turn, the V turn based on the tariffs that have been imposed on steel to where we’ve seen steel rise 35 something percent here in the last few months.

So I - it will be interesting to see how quick the market reacts to passing that on. Historically they have been -- the industry has passed that on. But I would say it’s still predominantly due to passing on reduction in our input cost predominantly LED but we have seen some reduction in others that it cause that number to round to 2% instead of the 1%.

Jeff Osborne

Got it. Thanks for that, Ricky. Then, Vern, for you. You mentioned target over the next three to four months roughly 300 stores. I think you also in your prepared remarks alluded to two other retailers, which I imagine you are limited in what you can -- at least naming them, but can you just give us a sense of scope? Is the timeframe for rollout a similar timeframe, as well as scope and size of the number of stores?

Vernon Nagel

Again we are working with multiple end customers and multiple different verticals and we don’t have specific date. But my too sense is that based on the question that we had earlier the activity in the interest level is increasing at a very high rate. And our ability to position ourselves and to have dialogue with these various end customers is robust. And you know, retailers are very, very focused on the quality of lighting their store. They are very focused on energy savings. They are very focused on these types of things.

So the transition from conventional for us in lighting into LED while it’s very interesting they are doing it because they see multiple opportunities around it. I mentioned target only by way of example and when you think about the installed base and I want to keep bringing this back to that. It is so be enormous in terms of the potential for conversion that this was where our excitement is. It’s not - for the investing public you guys the several give us some evidence that the Tier 3 solutions that their strategy can work.

Our growth there is being quite significant as a percentage of our sales. It’s now becoming significant. This was a customer that made a move. It’s just a – it’s a continuation of the margin towards the huge opportunities that’s out there. So you are right. I’m not going to mention other names but I want to make sure investors understand is that the opportunity through all of these verticals is quite enormous.

And so we are looking at all those verticals and we’re attacking them as we have with bigger and we are selling the solutions as we believe that we have great sales forces that know how to sell these types of solution set.

So it gives us a leg up in making sure that we’re first. And I would expect us to continue to outperform the growth rates of the markets we serve because of these types of opportunities. Again, the installed base is enormous and it’s much larger could be a substantially larger than what new construction represents for a long time to come because of its size and its scale.

So that’s why I’d like to direct your attention and your focus. If you look at what our growth rates have been over the last 13 quarters double digit growth rates have outperformed the growth rates of the markets we serve. We are doing a good job bringing the margin to bear people they’ve asked us about margins you have in Tier 3.

You know just a quick comment, if I look back over the last three years where we’ve been implementing this tiered strategy approach, you know, we’ve picked up close to 400 basis points on a gross profit margin and almost 500 basis points on our operating profit margin during that time period.

So while lots of things are happening to improve our business as we migrate and as we expand it’s probably a better word in our Tier 3 solution strategy. You’re seeing how it’s influencing in a favorable way our margin impact. And while we’re investing I mean this has been a continuous comment that we’ve made. We are investing today because we see the opportunity of tomorrow. We started that a while back and you’re seeing the return and the benefit off of that.

Our cash flow return on investments still is in the low 30 percentile which is you know puts us in the 95 percentile in terms of performance capabilities there. But I think we’re doing all this right.

Jeff Osborne

Perfect. Thanks so much.


Thank you. The next question is from Brian Lee with Goldman Sachs.

Brian Lee

Hi, guys. Thanks for taking the questions. First one was on pricing, it does seem like ASP declines have been more moderate than a lot of people have been expecting particularly on the LED side given the component declines we have seen.

So just wondering does this have to do with your product mix simply getting better as part of the tiered strategy and masking the blended ASP declines or are there some other drivers behind this? And can you also comment on what the sustainability of the trend is medium and longer-term in your view?

Vernon Nagel

I think Acuity has done a very good job for a long time of really focusing on continuous improvement driving productivity gains throughout the business. We just simply because pricing of componentry comes down as Ricky pointed out earlier, it can find its way back into the market.

We deal on a bid world but we’re all trying to or at least Acuity is trying to differentiate its features and benefits relative to the price and I think we have been successful in convincing our customers of the true value of the solution set that we bring.

Again when we are up against competitors that are bringing battery powered beacons to the marketplace that's old news, people who are installing that type of technology are making a huge mistake, it's almost irresponsible for them to do that. The fact of the matter is that Acuity continues to drive that productivity, drive the change in its value proposition so that it can continue to extract the value of our gross profit margin if you will for that value.

I expect that the trend to continue. We tend to look at gross profit over a annual period, not quarterly period, I know that you all have to look at everything on a quarterly basis but I think if you look at that type of thing over an annual basis, you’ll see that continuous improvement in our business is allowing us to improve margins volume as that increases we’re able to extract that variable contribution mix as we continue to grow Tier 3.

But let’s be clear Tier 1 and Tier 2 are critically important and we do well there as well in terms of margin profile but there is no doubt that Tier 3 and Tier 4 have gross profit margin dynamics that are accretive to what we’re doing today.

So we would expect to see that trend continue. Even the pricing as Ricky pointed out earlier on component cost, that's ebbing and flowing, it's something that we’ve always had to manage. What’s more important about it is you can continue to have improvements even incremental improvements in technology and that goes back into the florescent world. Just imagine when it went from T12 to T08 to T05 same scenario.

So simply because it’s an LED light source, it hasn’t really changed how we think about the internal workings of our business and how we compete in the marketplace, we are always trying to sell value, the new technology, LED is an enabler for us to selling more value, i.e. Internet of Things, combined solutions stats for energy savings, that's how we are driving the value and I expect the trend to continue.

Brian Lee

Great, that is super helpful. Second question was just on the market itself. Recently the DOE released some LED penetration statistics for the U.S. lighting market for 2015. If you look at the data it looks like resi has been slower than expected, both commercial and industrial has been tracking better and then outdoor was most penetrated at I think a bit over 20%.

So wondering how do those trends compare to what you are seeing in your business? And then on outdoor specifically, I know there has been a lot of talk about the retail channel and building automation but can you give us some sense of whether the higher penetration in that particular vertical is expected to lead to more moderate growth and then what your exposure is there specifically versus some of the other end market categories? Thank you.

Vernon Nagel

Sure. I can only comment on our outdoor business and that continues to grow at a very nice pace. So we are actually gaining share nicely there, our growth rates are exceeding the overall growth rates of the market. The reason for the penetration in outdoor it's a total cost of ownership type thing, the whole notion of whether it’s an industrial outdoor or whether it’s a street or roadway, these luminaires are very expensive to have to change light bulbs and maintain. So LED is a perfect opportunity to bring value there.

So the penetration rate of outdoor makes complete sense to me and I expect that to continue but let me remind everyone, it’s still only 20%, there is another 80% that is out there and that 80% market continues to by itself just an outdoor to be an enormous market by itself.

In other areas of the business, we are very excited about the introduction of nLight Eclipse and other components off of that, the ability to we will have some more comments on this later for the ability to separate meter. We believe it's going to allow Acuity with this lighting solutions, building automation solutions that get after that commercial office market, the installed base which is converted very, very slowly.

Primarily because most commercial buildings are socialized utilities, so it's hard to actually get down to what are you consuming in terms of energy, you just pay it based on square footage. So we're very excited about the potential of converting to that type of market as we go forward.

Ricky, other end markets I would say, we see again continued opportunities for further penetration, I think that the notion of what retail is doing, retail is looking at not just energy savings, but what more can occur there that's a big space.

Richard Reece

And I would just acknowledge the obvious that it's wherever it was more an incandescent light source in the commercial world that it's converting much more quickly than the fluorescent when you get in and as you mention indoors converting slower offices that have fluorescent, if you've upgraded to high upper T8 or T5 that's still a very energy efficient light source, so their conversion is slower, but you are now seeing LED pulling away from the lumens per watt and the capability of fluorescent.

So I do think it will accelerate there, we're very well penetrated in that indoor space, and would expect fully participate is that conversion accelerates about where it's been the fastest today is more where you've had energy sources that were less energy efficient incandescent and high pressure sodium HID that had issues not just energy, but slow to come on hard to control, those type of things that are driving this conversion.

Vernon Nagel

And lastly in the retail side I believe that folks early on found replacements to be expensive. I think that their level of satisfaction with them was not as robust, I think more and more folks are finding that replacement kits are a more effective way to do things within their home, they work better, they meet the specifications of long life that they're supposed to. If you put a bulb in a can that wasn't made to handle that kind of bulb, chances are you're going to get significantly less life then what the manufacturer may advertise. So we don't sell bulbs, but we obviously create kits that are very cost effective, and very, very efficient, that portion of our business continues to grow very nicely.

So, I believe this conversion whether it happens 5 years, 10 years, 15 years or 20 years, is just a huge, huge market and an opportunity for significant growth overtime.

Brian Lee

Great, thanks guys.


Thank you. I would like to turn the call back over to Mr. Vernon Nagel for closing remarks.

Vernon Nagel

Thank you for your time this morning. We strongly believe we are focusing on the right objective deploying the proper strategies and driving the organization to succeed in critical areas that will over the longer term continue to deliver strong returns to our key stakeholders. Our future is very bright and we thank you for your support. Thank you.


And that concludes today's call. Thank you for your participation. You may now disconnect.

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