Fortune Brands Home & Security Inc. (NYSE:FBHS) Q4 2016 Earnings Conference Call January 31, 2017 4:30 PM ET
Brian Lantz - SVP, IR
Chris Klein - CEO
Lee Wyatt - SVP and CFO
Philip Ng - Jefferies
Tim Wojs - Baird
Bob Wetenhall - RBC Capital Markets
Michael Rehaut - JPMorgan
Scott Rednor - Zelman & Associates
John Lovallo - Bank of America Merrill Lynch
Stephen Kim - Evercore ISI
Good afternoon. My name is Mike and I will be your conference operator today. At this time, I would like to welcome everyone to the Fortune Brand's Fourth Quarter and Year End Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a Question-and-Answer Session. [Operator Instructions].
Thank you. I would like to turn the call over to Mr. Brian Lantz, Senior Vice President of Investor Relations and corporate Communications. You may begin your conference.
Good afternoon everyone and welcome to the Fortune Brands Home and Security quarterly investor conference call and webcast. We are pleased to be here today to provide an update on our progress during the fourth quarter of 2016 and provide our 2017 guidance. Hopefully everyone has had a chance to review the news release issued earlier. The news release and the audio replay of the webcast of this call can be found in the Investor section of our fbhs.com website.
I want to remind everyone that the forward-looking statements we make on the call today either in our prepared remarks or in the associated question-and-answer session are based on current expectations and a market outlook, and are subject to certain risks and uncertainties that may cause actual results to differ materially from those currently anticipated. These risks are detailed in our various filings with the SEC such as our Annual Report on 10-K. The Company does not undertake to update or revise any forward-looking statements which speak only to the time at which they are make. Any references to operating income, earnings per share or cash flow in today's call will focus on our results on a before charges and gains basis for continuing operations with the exception of cash flow unless otherwise specified.
With me on the call today are Chris Klein our CEO and Lee Wyatt our Chief Financial Officer. Following our prepared remarks, we've allowed ample time to address questions that you may have.
I will now turn the call over to Chris.
Thank you, Brian, and thanks to everyone for joining us today. In the fourth quarter, overall sales growth accelerated, led by plumbing, and our teams again delivered strong operating margin growth across all segments, driven by a continued focus on growing in the most attractive parts of our market.
For the full year, we continue to execute our strategy of disciplined profitable growth as we increased earnings per share at 33%, with sales growing 9% and our operating margin exceeding our plan for the year, rising 140 basis points to 13.2%. We also saw early benefits from a recent formation of our global plumbing group, and the strategy is to grow sales faster than the market while maintaining margin. In addition, we delivered incremental growth during the year as we completed the acquisitions of ROHL and Riobel. We purchased $424 million of our shares and again increased our quarterly dividend. Our teams have continued to execute at a high level against our strategy and the momentum we have built positions us well for continued strong performance heading into 2017.
Let me first take you through some of the fourth quarter highlights and my thoughts on our full year performance in 2016. Then I’ll discuss our view of the U.S. home products market and our 2017 outlook for sales and EPS growth. And finally, I will discuss our upcoming CFO transition. Beginning with the quarter, overall sales increased 6% versus the prior year and 10% when we adjust for the negative impact of calendar shift in our Cabinet segment. Operating margin performance was strong, increasing 130 basis points to 13.3% with solid performance across all operating segments.
Turning first to the Plumbing segment. Plumbing sales were up broadly in the quarter, increasing 19% overall and low-double-digits excluding our recent acquisitions. Growth in the quarter was driven by a number of changes we made to drive growth in the Plumbing business starting in the fourth quarter of 2015. Specifically, we began focusing and growing sales in segments of the wholesale market with targeted customers, developing and accelerating the launch of new products at retail, employing more sophisticated online marketing tactics, bringing out a new ad agency and reinvigorating our brand positioning and marketing programs, investing in digital marketing capabilities and deepening our pool of talent as we formed the new Global Plumbing Group and focused on the high impact areas.
Together these changes helped strong sales performance in the fourth quarter and should continue to benefit us going forward. We continue to emphasize product innovation and are becoming more sophisticated in our marketing approach by focusing on digital content and mix across spreads. Overall for plumbing in the fourth quarter, we experienced strong sales and profit growth across our channels. U.S. wholesale and Canada sales were up double-digits while U.S. retail and China sales increased high-single-digits.
Going forward, our strategy will continue to focus on growing sales above market, while maintaining our operating margin and on making accretive acquisitions under our newly formed Global Plumbing Group. We have seen early benefits as we accelerated organic growth in the quarter and again to realize some of the potential from our acquisitions. We continue to believe that we have the ability to reach $2.5 billion in Plumbing sales by 2020.
For our Cabinet segment reported sales were down 1% in the quarter, but grew 7% excluding the impact of the Cabinet division calendar shift, which Lee will detail in a minute. Excluding this impact, sales growth was strong in our core markets, with the exception of some continued softness at the luxury end of the market. Importantly, due to our disciplined focus on profitable growth, we delivered strong operating margin improvement.
Let me cover our Cabinet's highlights, excluding the calendar shift, to give you a sense of our core performance, which accelerated nicely from the third quarter. Sales in our dealer channel trended up, growing mid-single-digits overall. Sales of our core stock and semi-custom dealer lines grew high-single-digits, driven by strength across the Board in our Aristokraft, Homecrest, Schroc, Diamond, Kemper and Mid Continent lines. Sales at the luxury customer end of the market where we saw our Omega, Decora and Ultracraft lines were down modestly in the low-single-digits.
Prior to the second half of 2016, we experienced a two-year run of solid double-digit growth at this very high end of the market, which tends to be more discretionary, cyclical, and tied to certain geographic markets. The softness in the second half of 2016 was focused in the higher income geographic markets including South Florida, the Mid-Atlantic and the Northeast.
Our home center in-stock cabinets and vanity sales, which represent over 20% of our total Cabinet sales increased at a mid-teens rate due largely to strong sell through of new programs and product upgrades that launched earlier in the year. The balance of our Cabinet business, which includes builder direct home center special order in Canada grew 3%. Sales in the builder direct channel were up double-digits driven by new construction activity and operating margin improved meaningfully as we focused on the regions where we can achieve profitable growth.
In the home center, special order channel, where our competitors were very aggressive on promotions, sales were down slightly. The volume in this part of our business represented only 13% of fourth quarter CapEx revenue and we remain focused on our strategy of disciplined profitable growth. We are committed to growing profitably with our home center customers in this segment, by partnering with them in areas where we can leverage our sustainable competitive advantages, including product innovation, new styles and designer focused tools and customer service enhancements. Lastly, sales were down in Canada, where the economy in the central provinces continue to be challenged by the earlier downturn in the energy market.
So overall for Cabinets, momentum picked up again fourth quarter. Our teams continue to execute well and build on our structural competitive advantages. As the largest Cabinet company in the industry, with the broadest portfolio of brands, price points, products and channels, we have the ability to target and consistently win in attractive segments of the market without resorting to excessive promotions. Our consistent results reflect this focus and I’m pleased by our ability to simultaneously grow and increase operating margin consistently over the last eight years.
Door's reported sales were up 6% for the quarter. Door products saw sales growth driven by gains in both wholesale and retail. The Therma-Tru brand continued strong performance across both channels, with mix and efficiency driving 170 basis points of operating margin improvement. New products continued to be important to this business, and we had success with our new door styles as well as decorative glass. Our team has been able to build momentum by enhancing the capabilities of our wholesale fabricated network and by building successful programs in retail. In the security segment, sales increased 6% for the quarter. High single-digit increases in Master Lock US retail, commercial and international throughout the growth.
Safe sales were limited in the quarter as we worked to ramp up our new facility. The recent integration of Sentry safe and Master Lock continue to drive profit improvement and we remain excited about the top line opportunities we see in these two brands over the next few years.
So to recap the quarter, we executed our strategy very well in improving U.S. home products market, delivering solid sales growth and exceptional profit growth. Reflecting on the full year we delivered a very strong performance on multiple dimensions in 2016. Against the backdrop of a steadily improving housing market, coupled with the stronger business model we have created, we just achieved one of our best years ever, capping an impressive five year run of consistently increasing sales, earnings and operating margin.
While our teams have executed extremely well and delivered outstanding results in 2016, and even we're excited about the foundation that we have built to drive both organic and incremental growth over the next five years. Housing market demand drivers continue to be solid, and with the highly capable management team and strategy we have in place, we are extremely well positioned, not just for 2017 but for the next several years.
Switching back to 2016, in the full year we grew sales by 9%, earnings by 33% and increased total company operating margin by 140 basis points, which exceeded our plan. Importantly, inside of each business we made a number of significant changes to enable us to continue to deliver profitable growth. In Plumbing, we created the new Global Plumbing Group, a key platform that will enable accelerated organic and incremental growth for years to come, while maintaining the strong operating margins for the segment.
In Cabinets, we grew at above market rates in the parts of the market that we targeted for profitable growth and continue to improve mix of efficiency, which increased segment operating margin by 180 basis points. In Doors, our full year operating margin rose by 320 basis points, and we reached record levels of working capital efficiency. We launched new products in wholesale and that retail and drove continued sales in operating income growth. And in security, we completed the integration of the SentrySafe supply chain into our operating platform and have already begun to realize profitability improvement with full year operating margin up 160 basis points.
Beyond these strategic actions, we also deployed capital in value creating ways as we completed two plumbing acquisitions, re-purchased shares and again increased our quarterly dividend. Moving forward we will continue to focus on creating meaningful incremental shareholder value by using our strong cash flow and balance sheet to make strategic acquisitions and return capital to shareholders.
Our acquisition pipeline continues to be active, and I'm encouraged by the number of things we are working on and the potential we have to create incremental shareholder value over time. We are closely monitoring potential changes to regulatory trade and other governmental policies, as it may make some opportunities we are working on more attractive and others less attractive. Over the next two to three years, we believe we'll continue to have the potential to deploy more than $2 billion to drive this incremental growth in shareholder value.
Now let me turn to our full year outlook for 2017, starting with our of the U.S. home products market. Our 2017 annual outlook is built on an assumption that the U.S. home products market, which impacts over 70% of our sales grows at a 6% to 7% rate which is slightly less than last year's market growth due to the challenging comps in the first quarter. Within that overall assumption, we anticipate that the pace of repair and remodel demand in 2017 grows at a rate of 4.5% to 5%. We see consumers continue to demonstrate an appetite for stronger styling, product differentiation and project complexity, which will continue to improve mix across our categories.
New home construction is assumed to grow at high single digits in 2017. Single family is expected to continue to grow faster than multifamily, and single family entry level activity is expected to continue to accelerate.
Our total global market, which includes assumptions for the U.S. market as well as our other international home securities markets is expected to grow at a combined 5% to 6% for 2017. Based on that total global market assumption, continued share gains, plus the ROHL and Riobel acquisitions, we expect solid top line growth for 2017, with our full year sales increasing 6% to 8% over 2016. With this market and sales growth, our teams are focused on delivering full year EPS in the range of $2.95 to $3.05.
So overall, our 2017 outlook is based on reasonable market growth assumptions, based on the basket of indicators that we monitor. We'll continue to execute on our growth strategy and I feel good about the winning momentum that our teams are carrying into the year. Before I turn the call over to Lee, I wanted to talk about his transition to retirement at the end of the year and some of the things that we've been able to establish in the time he's been here.
Over the last 5.5 years, we have significantly strengthened our management team, including all areas of finance function. We've added stronger functional leaders and created a more robust set of processes across all areas. Lee's successor, Pat Hallinan, will step into a strong finance team. He is deeply familiar with our approach and strategy, having worked in our two largest businesses, Cabinets and most recently Plumbing. He is a proven leader that fits in well with our high-performance culture that is focused on creating shareholder value through a focus on profitable growth.
Because of the strong leadership and processes we've been able to establish, I see the eventual transition from Lee to Pat as seamless. Additionally, Lee will be with us throughout the year to ensure a smooth handout. At the right time, I will thank Lee for his many contributions to our company and will wish him the best as he prepares for retirement. However, we have a strong 2017 ahead of us with plenty of exciting opportunities unfolding. So I'll hold off on those comments until later in the year when he steps away.
With that, I will now turn the call over to Lee who will review our financial performance and provide more details on our guidance.
Thanks Chris and good afternoon. As Brian mentioned, to best reflect ongoing business performance, the majority of my comments will focus on income before charges and gains from continuing operations.
Let me start with our fourth quarter results. Sales were $1.3 billion, up 6% from a year ago, in spite of challenging comps from the prior year. Excluding the negative impact of a calendar shift in our Cabinet segment, total company sales increased 10%. Consolidated operating income for the quarter was $173 million, up 18% or $26 million compared to the same quarter last year. Consolidated operating margin improved 130 basis points to 13.3%. EPS was $0.71 for the quarter versus $0.56 for the same quarter last year, increasing 27% and were at the high end of our guidance range.
Now let me provide more color on segment results. Our Plumbing sales for the fourth quarter were $426 million, up $68 million or 19%, led by U.S. retail, U.S. wholesale, Canada and China. Sales excluding acquisitions increased low-double digits. Our new global plumbing group is executing our strategy, and in 2017 we expect plumbing sales to grow by double digits for the full year, including the recent acquisitions. Operating income increased $17 million to $88 million, up 23%. Operating margin for the segment was 20.6%, up 80 basis points from the prior year quarter. For the full year, plumbing sales increased to 8.5%, operating income was up 14% over the prior year and operating margin increased 100 basis points to 21.7%.
Turning to Cabinets. Our Cabinet business had a favorable calendar shift in the fourth quarter of 2015 that increased sales for all channels. More specifically, the fourth quarter of 2015 included nine shipping weeks prior to the Thanksgiving week, while the fourth quarter of 2016 had only eight weeks. These are the highest volume weeks of the season.
Additionally, the fourth quarter of 2015 included three more regular shipping days. The full impact of this calendar shift was an additional $45 million in sales in 2015. To best understand year-over-year business trends in the segment, it’s necessary to exclude this impact. Reported sales were $601 million, down $7 million or 1% versus the prior year quarter. However, sales increased 7% for the Cabinet segment when you adjust for the calendar shift. Reported dealer sales of $300 million were down 3% from the prior year, but were up 5% excluding the calendar shift, which strength across core product lines.
Reported sales in-stock cabinets and vanities of $130 million increased 7%, but 15% excluding the calendar shift, driven by strong sell through of new products. Reported sales in the home center semi-custom, builder direct and Canada of $171 million were down 4%, but increased 3% excluding the calendar shift. With builder, direct up strong double-digits and home center and semi-custom in Canada down for the reasons Chris described earlier. Importantly, margin improved in all of our channels. Even in home center semi-custom, where sales decline modestly as competitors drove elevated promotional activity, we remain disciplined and chose to grow operating margin. This improvement in margin across our channels is a sign that our strategy, which remains focus on disciplined, profitable growth is the right one for our business.
Operating income for the Cabinet segment increased 4% over the prior year quarter, with operating margin increasing 60 basis points to 10.6%. Operating margin increased 110 basis points to 11.1%, excluding an increase in bad debt reserve related to the direct bankruptcy filing during the quarter. For the full year reported Cabinet sales increased 10% over the prior year and operating income grew 33% to $260 million, with the operating margin increasing 180 basis points to 10.8%. This significant increase in profitability was driven by our team's discipline focused on growing in the most attractive parts in to the market and not chasing lower margin sales.
Overall, we remain pleased with the underlying strength in our Cabinet business and by our ability to drive margin improvement; and expect Cabinet sales to grow by high-single-digits in 2017 with continued operating margin improvement. Door sales were $122 million, up $7 million or 6% from the prior year quarter. Sales were up in all channels and operating income increased $3 million to $16 million, up 22%. Operating margin was 13.3% for the quarter, up 170 basis points. For the full year, Door sales increased 8%, operating income grew 42% and operating margin increased 320 basis points to 15.2%. We expect 2017 operating margin in the Door business to be over 14%.
Security sales were $153 million in the fourth quarter, up 6% for the prior year. Segment operating income increased to $24 million, up 28% and the segment operating margin was 260 basis points higher at 15.6%. The improved operating margin reflects the benefit of the Sentry Safe integration. For the full year, security sales increased 5%, operating income increased 18% from the prior year and operating margin was 14.1%. We expect to increase operating margin in the security business to around 15% for the full year 2017.
To sum up consolidated fourth quarter performance, sales increased 6% and EPS were at the high end of our range at $0.71. Our total company operating margin increased 130 basis points to 13.3%, with an incremental margin of 45%, excluding acquisitions. For the full year 2016, sales increased 9% and EPS grew 33% to $2.75 including $0.16 of tax benefit related to the accounting change for equity compensation. Total company operating margin was 13.2%, a 140-basis point improvement. We are well on track to reach our long-term goal of approaching 15% operating margin when the housing market returns to steady state levels.
Turning now to capital deployment. During 2016, we repurchased $424 million in shares, including $61 million in the fourth quarter and we bought an additional $27 million in January of this year. We spent $260 million on plumbing acquisitions and approximately $100 million on dividends and increased the 2017 dividend rate.
2016, free cash flow was $531 million and reflects the benefit of over $80 million of reduced working capital. Even after the significant level of capital deployment in 2016, our December 31 balance sheet remains solid. Cash was $251 million, debt was $1.4 billion and our net debt to EBITDA leverage was 1.5 times. Additionally, we had significant capacity under our revolving credit facility to continue to deploy capital to drive incremental growth.
Turning last to the details of our outlook for 2017. Based on our projected 6% to 7% U.S. home products markets growth and our total global market growth of 5% to 6%, as well as continued share gains in our areas of strategic focus, we expect full year 2017 sales to increase 6% to 8% compared to 2016. Our resulting outlook for 2017 EPS are in the range of $2.95 and $3.05. The midpoint of our EPS outlook reflects an increase of 14% when you exclude the benefit of the accounting change for equity compensation on our tax rate of $0.16 in 2016 and $0.05 in 2017. The annual EPS outlook includes the following assumptions. Interest expense of around $50 million, a tax rate of around 32.5% and average fully diluted shares of approximately $157 million.
In summary, the fourth quarter and full year EPS had strong growth. The solid performance of our business through the year, the platform we have created with the global plumbing group and the expected continued market recovery give us confidence in continued solid growth in the coming years. Importantly, the 140 basis point operating margin increase in 2016 and continued increase in our 2017 outlook places on track, is not ahead of our timeline for achieving our long term operating margin targets.
Also, as demonstrated by the Riobel and ROHL acquisitions, share re-purchases and the dividend rate increase, we remain focused on using our balance sheet and cash flow to drive incremental shareholder value. And our credit facility agreement provides significant flexibility to continue to drive incremental shareholder value.
I will now pass the call back to Brian.
Thanks Lee. That concludes our prepared remarks on the fourth quarter of 2016 and our full year 2017 outlook. We will now begin taking a limited number of questions. And since there may be a number of you who would like to ask a question, I will ask that you limit your initial questions to two, and then reenter the queue to ask additional questions.
I'll now turn the call back over to the operator to begin the question-and-answer session. Operator?
[Operator Instructions] The first question is from Philip Ng from Jefferies.
I guess the first question for me, as you pointed out in the release, the uncertainty will add a little noise to the recovery and with interest rates going up, just wanted to get your view on where are we in the cycle, the shape of the recovery as we look at 2017, because the last time I think rates did go up off a very low base. There seem to be some pre-buy ahead of that and demand kind of faded. Just want to get your thoughts on how you guys are positioned this year?
If we look across a whole number of drivers that we follow, I'd say interest rates is really important, but everything else we're looking at continues to point up. Consumer confidence is up. Household formations continue to expand beyond where we're building to. So if you look at assessments of household formations around 1.4 million in 2016 plus 200,000 demolitions, we are not building at a level of 1.6 million at this point in the cycle. Unemployment is down, purchase loan activity is up, variability credit is good, household debt levels are low. So assume there was a tick up in rates but all the other things that we follow look quite positive.
Fourth quarter, definitely saw an increase in starts to attract the public builders. Looked like order rates continued to be strong coming out fourth quarter end of the first quarter. So on the new construction side we are actually looking at '17 as being a good year. We think it will be in aggregate like '16 but the weighting will be a little bit different. By the time, it starts to kick in, it will be later in the first quarter and then second quarter, third quarter we should see some very strong performance coming through on that side. On the R&R side, I think we're looking at R&R growth for the year around 5%, first quarter probably a little soft. We had such strong comps last year and then probably a little better than 5% quarters two, three, four. So I think the market is setting up to be okay. I think obviously, it will pick up an interest rates. But we don’t think it's going to suck the area out of the marketplace.
Okay very helpful. And I guess switching gears to Cabinets, constructive, encouraging hear you say high-single digit growth for the full year. But can you provide a little more color on just the competitive activity called out in the home center channel. I think you did call out a little weakness in luxury as well. Do you expect that to have any impact as we think about this year? And is there anything we need to be mindful in terms of the calendar shifts that you saw in '16? What the impact would be this year? Thanks and good luck in the quarter.
Thank you. So I'll start with the last piece, the calendar shift beyond us. So we should have comparable calendars this year. We can talk about that and give you a little more detail on that. But I think as we look at a comparable apples-to-apples, quarter was up 7% for cabinets, strong growth in dealer, semi-custom, harder market, we're up high single, low-double there, in stock vanities, mid-teens, builder direct.
And you mentioned that the home center promotional activity. That's about 13% of our sales for the quarter. And I guess, if I look back over the last eight years, from time-to-time one of our competitors or the other of our large competitors will go very aggressive on promotions. We've been disciplined and we've been focused on taking the business that is at a good margin. And so we haven't chasing down the rabbit hole and just throwing money after it. We'd rather invest our money in products and service and training for the designers. So it hurts a little bit, but the reality is once they came off-promotion, volume came back to us. So I'd rather do that and take the business that I got at good profit margins and let the other guys chase -- throw money at promotions and chase it.
On the very high end in custom, which is about 10% of our Cabinet business, there we saw softness the whole second half, we as a industry did. If you looked at TCMA [ph] data that that was reported, a lot of TCMA [ph] these are smaller regional guys reporting in, that in parts of the market South Florida, the Northeast and Atlantic we saw some weakness in that very high end of the market. That's off of two really strong years. So we had kind of a two year surge in that part of market. A lot of that R&R activity coming out of savings, equity market, not a lot of borrowing in that part. And there seemed to be a pause. Based on the traffic that we're seeing in the showrooms and talking with our dealers, it appears to be coming back but it's early. It's January. So we'll see how it unfolds. So I'd say little soft but given how small it is for our total business, didn't hurt too bad. And clearly, we were able to continue to drive margin improvement in the core of the business because the mix held up throughout.
The next question is from Tim Wojs from Baird.
Good. I guess just maybe first question. As you look at kind of the cadence through the year, could we just kind of -- maybe as a percentage of full year EPS or something like that, can we just, is there a way to think about what Q1 should look like relative to maybe historical patterns as a percentage of the full year? EPS, or revenue or margins?
Yes, I think if you -- you'd start with first quarter of '17. It's growing against the tough comp obviously with the market being up with the additional good weather days we had in the first quarter of ’16. So when you think about our full year sales, a range of 6% to 8%. I’d say the first quarter probably is at the low end of that. I think as you get into the second half, you are at the high end of that. So kind of a natural progression in terms of sales.
In terms of EPS, if you back out this impact of the accounting change on the tax rate, which was $0.16 in 2016 and will be $0.05 in 2017, if you back that out, and you should have that by quarter, what you see is a pretty consistent EPS growth quarter-over-quarter. So somewhere from -- on average for the year it’s 14% up. So I think you’ll see anywhere from 10% to 15% on a quarterly basis throughout the year, with the first half being at the lower end of that and the second half being at the higher end.
Okay, okay. And then just, when you think about incremental, so I think just kind of back of the envelope, I get about 25% or some incremental margin on sales. So one is my math right there? And then two, how are you guys thinking about just price cost and maybe some of the mix impact? I know Chris you mentioned entry levels picking up a little bit on the new construction side. How we should about price cost and mix in 2017 on margins?
So incremental, I think if you -- we’re still annualizing the two acquisitions on the Global Plumbing Group. Think if you back that out, incremental margins are a little over 30% at the midpoint of our guidance. So we think that’s good. It reflects this disciplined process of growth. I think at the midpoint of the guidance you’d see an operating margin approaching 14%. We were 13.2% this year, a little bit ahead of our sales, because annually we went about 100 basis points. So we were 140 basis points growth company-wide in ’16, maybe it’s 80 or 90 in ’17, but gets us around that 14%, which says we’re right on track.
A lot of that is coming out of price mix. We see that across all the businesses, looking across Plumbing, continue to improving mix there. Within Cabinets, even as he said, if we're going more entry level, we continue to drive mix-up in that part of the market. So seeing doors, continued attachment rate on glass, decorative glasses, into there. So we’ve been able to achieve that mix improvement across the whole board.
The next question is from Bob Wetenhall from RBC Capital Markets.
So when I look back in 2016, I think the highlight for me is the margin expansion that you guys continued to deliver, irrespective of the operating environment. It’s 130 basis points year-over-year, speaks to strong execution and having a very attractive portfolio. What are we, Chris or Lee to jump off going into next year, can we still expect 100 basis points of operating margin expansion? What should expectations to be after a very strong 2016 on the margin side?
Yes. I think if you look again at the mid-point of our guidance, that’s around 14% operating margins. So you take the two years ’16 and ’17, that would be 240 basis points improvement. So we're right on track in terms of margins. We're right on track, probably a little bit head of our long term perspective of 14% to 15% operating margins at steady state. And it all comes back Bob, and Chris can elaborate on this focus on profitable growth on improving mix and efficiencies across all of our business.
And it’s really, it’s going to -- within -- if you think about it for a second, it’s within the businesses and then it’s across the portfolio. So within the businesses, if I look at Cabinets, we continue to drive that margin improvement by improving the mix and the proportion of business that’s coming through more attractive parts of the market. So we're kind of managing that within the portfolio. So it gets too skinny on margin, we're not too aggressive on that, and that is part of the reason why we're not going to be too aggressive on some of this promotional activity you see.
If you also look across the portfolio, as we're growing plumbing faster than the market and we’ve got very good margins in that other market and clearly demonstrating, we're putting that business on a higher growth trajectory, that shifts the overall balance of the margin within the portfolio a little bit more toward that part of the market and that benefits us. Inside of Doors, inside of Security, we continue to manage that. So it's kind of across the board inside the businesses as well as how we manage it across the businesses. So I would say we are on a good track. We've been executing on this strategy really four, five years. Once we got through the point where volume is going to cover fixed costs, we explicitly, we are driving profitable growth, we're driving it in every corner of the business and you can see quarter-over-quarter, year-over-year our performance shows that.
Yes, it was – it was a great quarter. You guys definitely to serve some serious recognition. Wanted to switch gears for a second. You guys did two M&A transactions on the plumbing side, following before that SentrySafe, but it seems like the emphasis on building out the Plumbing platform and where are you guys, what do you see in the pipeline? Do you think if you buy something it’s a public market or private market vehicle? There’s a lot of questions about taking the legacy businesses you have now and what can be done to get them to the GPG growth targets you talked about. And I’m just trying to understand is there enough opportunity, the opportunity set big enough on M&A that you guys are going to be able to achieve those GPG growth targets you laid out?
Yeah, I think we are very active, we are looking on a plumbing sector, we are looking on in some other sectors, but we are definitely focusing plumbing. If you look at the organic growth and growing faster than the market, a portion of that target is going to come, probably at least half of it is coming from organic growth and then a portion is going to come out of acquisitions. So there is not – there's not a huge hurdle to me on acquisitions. The reality is if we're successful, they could in excess. But I think we targeted a balance between those two and so if you look at the trajectory Plumbing's on, coming out of the fourth quarter and say okay, backing that into the next few years, I can see where a portion of that organically as well as we are looking at. Third part of your question was how much of this is private, how much is public? It’s a mix depending on sector. We are looking at a couple of public situations, but I can’t give any more detail on that and then a lot of assets around the world are still privately held and those are long lead times that we have been working for a long time and you just kind of see where our catalysts in the market that could make some of those things happen. So continue to work those situations.
And just to confirm, how do you feel about the pipeline, like is it full or do you guys feel like …
Yes, I feel good. I think one of my comments in my prepared remarks is that we are taking stock of any regulatory trade tax impacts. And some of those maybe quite positive, meaning that we are a large U.S. manufacturer with assembly operations, manufacturing operations in the U.S. Now 70% of our employees are in the U.S. and we are big U.S. tax payer, 32% type of tax rate. So that may change and make some things seem more attractive for us as we look at M&A. There are other things that by way of mix could be less attractive. So factoring that in, I wouldn’t say that’s slowing down. There are things that we're working on that work irrespective, but certain things that those changes could impact, we're taking stock of that.
The next question is from Michael Rehaut from JPMorgan.
First question, I just wanted to drill down a little bit on your comments on the first quarter and first half versus the second half. And Lee I think you alluded to first quarter sales growth potentially being at the lower end of the 6% to 8% range, which would be pretty impressive given the comp of 16% growth rate there. And likewise, in Cabinets, the lights out performance you had 30% plus there. So just trying to get a sense of, drilling down by segment, would you expect cabinet to be positive in the first quarter, because again also with the high single digit growth for the full year, which is a little more than we were expecting as well, just trying to get a sense of perhaps what's driving that high single digit growth number, because clearly it would seem that there is some nice market share gains built in there and how that fits into your first quarter outlook?
I think as you look at being at the low end of that range, could be five to six, it's in that range. I think Cabinets does have a challenging comp. I think they will be ok. Is that 4, 5, or 6 it's probably in that range. Keep in mind on the global Plumbing group, we're annualizing the acquisitions of ROHL and Riobel. So that will cause them to be probably double digit growth when you include that acquisition activity. And then in doors and security or at kind of that wall in. So I'm comfortable saying would be somewhere in that vicinity of the low end, is it 5% or 6%, it's all in there. But the global plumbing group will give you nice boost.
Yes, certainly. We are definitely counting on that. I guess just second question on capital allocation and in specifically share re-purchase. We were mainly expecting a little bit more share re-purchase, we were maybe expecting a little more share repurchase in the fourth quarter given the pull back in the stock and I think historically you've been pretty opportunistic. When you've had decent pull backs in the stock like you saw in the fourth quarter. At the same time you alluded a reference to your intent focus on growing out GPG and maybe being on the sideline or maybe being a little bit of a wait and see mode with regards to the regulatory environment. So just trying to -- in piecing it all together, how should we interpret I guess maybe more of a call it lighter share buyback relative to the pullback. Is there -- should we be thinking about it more that the acquisition pipeline like you said is still pretty active and there are things that may hit sooner than later? Or you're really just trying to maybe play it a little more conservative until some of the regulatory backdrop clears up.
So I think it's a combination of things. I think clearly we were active in the fourth quarter and in January and buying back shares and we'll continue to monitor kind of where the market is trading. And we think that as you see by our actions that at press levels a little bit later than where we are, those are good points for us. And we'll be opportunistic as we have been.
On the other hand, there I think we're looking at that we can deploy capital against on the acquisition side and we'll keep investing internally. If I look back really over the last five years, we've been pretty consistent in saying we're going to be very efficient with our cash flow and appropriately aggressive. So I think we've deployed quite a bit capital over the last five years, slightly more into acquisitions than on share repurchases with consistency on the dividends. And I think that’s our plan coming into the year.
So I don't know that you should expect that much difference from the way we've been playing it out. But if I look over the last three years it's probably a good template for how we're going to play out over the next couple of years in terms of combination of things. And that obviously tilts it more aggressively towards acquisitions. We're busy at looking at a lot of different things, but I never force it there. So to the extent that we're successful on a number of the things that we're working on, titled more so on the acquisition side. So I guess that's about as much specificity as I can provide.
The next question is from Scott Rednor from Zelman & Associates.
Hey good afternoon. Chris I was just hoping if you could just talk about how quickly you could move or adjust your capacity in two scenarios? One would be if interest rates did cause new residential construction as well as materially, how quick could you adjust the plans and how quick could the business respond? And then similarly if there were some kind of border tax adjustment, just how much of the footprint is in Mexico or abroad and could you change the sourcing model in that scenario?
Yes, we've got a lot of flexibility in what we've built. If I go probably back to the downturn, we've restructured and made decisions around what hubs we were going to build as we came back up again. And so within that footprint we can staff up and staff down. And we've had to do that throughout. The last eight years of recovery hasn't been a straight line. So there are quarters or parts of the year where we've have to pull back and then we've have to surge and staff. so we're good at that. And so I'd say on that we watch it very closely, we watch a lot of the macro factors and then we also watch inside of our own business and adjust staffing appropriately. And to the extent we need to move aggressively, we move aggressively. We are on the side of moving harder and stressing the system as opposed to waiting patiently and that's kind of been the way we've run the business. So I feel really good about that. We've got a great team, and we're on it.
In terms of kind of the outcome of any of the proposals being talked about, we're looking at all of that very carefully, we're not making any decisions until things get sorted out and I think there’s some continued proposals on the table. I’d start with we are a big U.S. manufacturer. We’ve got about 70% of our people in the U.S. We’ve got another 10% in Canada. So if I look outside U.S. and Canada, you’re talking about kind of roughly 20% between China, Mexico and Europe. And so we’ve got flexibility in those operations and we just have to see how the impact of any of these changes are going to collectively hit us in terms of obviously reduction in tax rate.
If you are paying in the 30s, anything anybody is talking about and take it down, and we're also looking at the strength of the currency one way or the other and looking at any other taxes or tariffs. And so we’ll be pretty deliberate about make any changes, but we’ve got flexibility in the system, we can repurpose facilities, where we can ship things and will react accordingly. That’s a good about where we see competitively. I think it actually could present some interesting opportunities for us. Again starting with the fact that we're a big U.S. employer with a big U.S. -- fat [ph] tax rate, and so while that hasn’t been competitively a great advantage, it looks like that maybe going forward. So we’re again, just looking at things from a fact-base way, waiting for things to unfold, and as they unfold, we’re going to be taking some pretty deliberate actions around it as you could imagine.
I appreciate the lengthy response. Lee, did you make any comments around plumbing margins in ’17 and then just quickly, if there is still benefit on the tax line, sounds like still nickel. Why with the full year tax rate go all the way back to 32.5?
Couple of things on the operating margins at the midpoint of the guidance. I think going up, let’s call it 14%, you’d see all the operating companies improve their margin. The one that might be flattish or slightly down potentially could be the Global Plumbing Group, because remember our strategy there is to grow faster than the market and maintain operating margin. So anything around 21% operating margins for Global Plumbing Group if we were driving sales above market would be very successful.
So that’s the one you could see flat to maybe even slightly down, if we're growing above market nicely. So that is the strategy, but overall going to 13.2% operating margin to around ’14 is a pretty strong year. And on the tax rate. So remember that we had $0.16 benefit in ’16, basically driven around, and that’s all in that equity comp accounting change. And looking at what we think might get -- what options might get exercised, it’s really hard to estimate that obviously. We think that’s about $0.05. So that benefit in ’16 was about 400 basis points on our tax rate. So you think about a tax rate that was 28.7%, in ’16, you add 420 basis points back for the impact of that accounting change and you get to 32,933. So that was the rate without that. You do the same thing in ’17, we talk about 32.5% tax rate at the midpoint of the guidance, you had back impact of $0.05, it'd get you to around 33 or so, 33.5. So slightly up, but very consistent in terms of our base tax rate.
The next question is from John Lovallo from Bank of America Merrill Lynch.
Hi guys. Thanks for taking my call. The first question just following up on the border tax question, more specifically just on the Plumbing business where a lot of manufacturing is done overseas. If there was a border taxing, are there strategies that could you have to kind of mitigate the impact? And then ultimately do you think that the cost is going to be passed on to consumers?
Yes, it’s probably just to say cost is going to go over there. I think if you look at our plumbing business, we’ve got a global supply chain that feeds components into our assembly operation, which is based in North Carolina. And so that model sources from around the world. Who knows how uniform tariffs are going to be, or the application if taxes are going to be. But as an industry, we’ll all be sourcing components similarly. I think proportionally we're advantaged, because we are doing assembly for the U.S. market in the U.S. and I'd say there is a lot of finished goods that are coming into the Plumbing market that are actually assembled overseas. And so our proportion of that tariff or tax would be lower than our competitors.
So this is why I made a comment earlier that there are things that could actually benefit us, because we’ve got this base in the case of plumbing assembly operation. In Cabinets, we are actually building Cabinets here in the U.S. quite significantly. We’ve got a huge employee base and a big manufacturing operation. And so again maybe sourcing some components or raw materials globally, a huge proportion the value-add that we’re bringing into that product is here in the U.S. So you got to look at I guess, you look at it competitively and say where are we relative to who we're competing against by segment and then where is the impact. And not much of that gets back to the system. I guess we’ll see what form it takes as its coming at us.
Okay. Yeah, that’s helpful. And then I think last year you may have given a free cash flow and CapEx outlook. Just wondering if you guys might provide that?
Yes, we -- this year net CapEx in ’16 was $145 million. I think we'll probably be in that $140 million range this year. Free cash flow, very strong obviously in ’16, $531 million and we actually had a couple of things that really drove improvements in working capital. Actually in ’16 working capital improved to a positive for the year of $80 million as we did a couple of things we -- we cleared some inventory that we had built during our transition of the Global Plumbing Group, some of the Asia manufacturing and then for the security, the transition of the SentrySafe. So we build safety stock there. We’ve now kind of taken that down. We also looked at just the need to focus on working capital. Our WCE is down to about 15% right now. So we had some good onetime benefits in ’16 that won’t repeat for the same level. I would say probably and we're still kind of working to be honest on that free cash flow plan. I think you could see $425 million, $450 million of free cash flow next year and that’s assuming we go back to kind of a normal growth in the working capital. So still very, very strong growth and strong free cash flow.
The next question is from Stephen Kim from Evercore ISI.
Good job on the quarter. Just a quick -- the first question is talking about the political environment and the regulatory environment. You had mentioned a very sensible sort of approach to how you might handle any kind of border tax issues or domestic tax policy and you sort of said that you’d move fast, hard and fast but you’d also wait for some certainty and I guess I was thinking that probably that same kind of balance would inform the way you would approach acquisitions perhaps, which would perhaps adjust that we might be sort of for installing any actual direct action there until maybe the back half of the year. But I wanted to see if I have that wrong and if you could correct me on whether that's the right or wrong way that to be thinking about your M&A strategy this year?
Yes, there are things we're working on right now that work irrespective of changes that are going to be made. So there are things that are maybe more domestic which we're taking domestic and adding into domestic. We're operating in the country and we're going to add to that country within the parameters of that country. I think anything that had got a cross-border component, we want make sure kind of where things are tracking and whether we're bringing things in here to benefit from our manufacturing or whether they've got a global supply chain that would have to be reoriented around my earlier comments.
So those are things that there is certainty, and it looks like it could be significant that you might wait on. But it doesn't mean that our M&A strategy is wait and see. We're active on some things right now that could materialize in the first half of the year if things line up okay. It's just, clearly we're not going to jump into something that might be subject to changes in trade policy or changes in tax policy until that could sort it out. And I don't know how quicker that will get sorted out. So we're not going to -- we'll just be aggressive in watching that and understanding how it impacts both our current business as well as anything we're looking at.
Yeah that makes a lot of sense. Okay, thanks very much for that. And I'm sorry I forgot to mention that Lee we will definitely miss you, but glad you're sticking around for a while so we can continue to pass through you. So we appreciate you giving us a chance.
I'll get a few more shots Adam. --.
Great. Second question I had related to your special-order business in cabinets. I guess could you just help us on the big picture try to contrast the situation that you see in the home center special order cabinet business too. Sort of what was emerging or what evolved in the builder direct business which obviously you took a step out of couple of regions and things like that. Can you just sort of contrast the situation the way you see it between these two businesses?
Home center special order is an important business to us. It's just in proportion to the total. We've got very strong programs at all three home centers. We invest a lot in product development, in innovation, in training. And so there is a consistency to that business that we approach it with. We take a very straightforward, profitable growth type mindset to it and we try to partner with each of the home centers and say we'd like to expand your offering, we'd like to introduce new product extensions, and we want to provide a lot of service and reliability to you. It's a really good partnership with all three of them and we like that business. That's just running as a constant through the system.
From time-to-time one of the other of our competitors will for a short period of time surge on promotions. Our consistency and the way we're approaching this says we're not going to follow them on that. We'll let it return back to normal and so therefore there is a proportion there is a share, there is a market share of that that we like to have. And that's a good profitable attractive business. And those home center partners enjoy having us in there as well.
So I contrast that with on the builder side of the market and builder direct, there was a lot of cost over the years that had been added to that segment because of the level support that we needed to provide to builders to be able to support them with direct programs, which is designer services, which is installation services, and it spread across the entire country, which meant we had a lot of infrastructure required to support that business, dedicated specifically to that channel. We took a step back three years ago, even longer, really, just imagine three years ago, say we can’t really support on the margin structure of that business, all that infrastructure. And so we simultaneously took out some infrastructure as well as then we couldn’t support that business and so exited. It kept infrastructure in place, margin structure was better and since restructuring that business we’ve been growing in the east. It's East of the Mississippi, so it isn’t just East Coast and that’s very nice profitable business. So it has to do with the composition of how you service that business and the competitive environment around that. And so that’s the difference between those two.
I will now turn the call over to Brian Lantz for closing remarks.
Thank you, everybody. I just want to thank everyone for attending the call today and we look forward to speaking with you all again very soon.
This concludes today’s conference call. You may now disconnect.
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