Acuity Brands F4Q07 (Qtr End 8/31/07) Earnings Call Transcript

by: SA Transcripts

Acuity Brands (NYSE:AYI)

F4Q07 Earnings Call

October 4, 2007 10:00 am ET

Executives

Dan Smith - Treasurer

Vernon Nagel - CEO

Richard Reece - CFO

Analysts

Peter Lisnic - Robert W. Baird

Robert McCarthy - Banc of America Securities

Christopher Glynn - CIBC World Markets

Matt McCall - BB&T Capital Markets

Operator

Welcome to the Acuity Brands 2007 fourth quarter and full year results conference call. (Operator Instructions) Now I would like to introduce Mr. Dan Smith, Vice President and Treasurer of Acuity Brands. Sir, you may begin.

Dan Smith

Thank you. Good morning. With me today to discuss our fourth quarter and full year results are Vern Nagel, our Chairman, President and Chief Executive Officer; Ricky Reece, our Executive Vice President and Chief Financial Officer; and other selected members of our executive team.

We are webcasting today's conference call at www.AcuityBrands.com.

I would like to remind everyone that during this call we may make projections or forward-looking statements regarding future events or future financial performance of the company. Such statements involve 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 the 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. I would like to make a few comments and then Ricky and I will be happy to answer any of our questions. On behalf of our 10,000 associates worldwide, I'm again pleased to announce record results both for the fourth quarter and for the full year in 2007.

2007 was an outstanding year for Acuity Brands. We sold more products and earned more income for the fourth quarter and for the full year than in any other respective periods in our history. In fact, we exceeded all of our longer term financial targets in 2007. Also, this is our tenth quarter in a row of quarter-over-quarter record earnings as we again overcame a number of challenges.

I know many of you have already seen our results and Ricky will provide more detail in our financials a bit later in the call, but the following are a few of the key financial highlights.

First for the quarter. Consolidated net sales for the quarter were $693 million, up almost 3% compared with the year-ago period. This increase was due primarily to benefits from the successful implementation of our company-wide pricing strategies and the introduction of new products over the last few years. Gross profit margin was 43%, up 140 basis points over the year-ago period. Consolidated operating profit margin exceeded 12% for the first time ever, reaching 12.1%; an increase of 130 basis points.

Included in the quarter was approximately $800,000 of non-tax deductible expenses for the spin-off of Acuity Specialty Products. This reduced margins by 10 basis points and diluted EPS by $0.02 per share. Diluted earnings per share were a $1.16, up 25% from the year-ago period. Net income of $51.5 million topped the $50 million threshold in the quarter for the first time ever.

Now, for the full year. Net sales at Acuity Brands exceeded $2.5 billion, up almost 6% from 2006. Consolidated operating profit margins were 10.2%, exceeding 10% for the first time ever for a full year. Net income was $148 million, up almost 39% from 2006, while diluted earnings per share were $3.37, up 44%.

We are pleased to report that we generated over $241 million in cash flow from operations in 2007; a record. This was up almost 55% over 2006. Our free cash flow exceeded net income for the fifth time in the last six years, a key metric for us. Our cash balance exceeded $222 million at the end of August, up more than $134 million from the end of August last year. This significant increase in cash is after we invested $80 million to purchase new machinery, equipment and tooling, as well as funding the purchase of Mark Architectural Lighting acquired during the fourth quarter.

We generated positive EVA of more than $86 million in 2007 and our consolidated cash flow return on investment expanded 530 basis points to almost 21%. These exceptional results are the byproduct of the commitment and focus we have as an organization to provide our customers with superior value, our associates with great opportunity, and our shareholders with upper quartile performance.

As we look at the performance of each business unit, we made progress on a number of fronts. First at ABL. Our net sales grew more than 3% in the fourth quarter and almost 7% for the full year. Looking more closely at both the fourth quarter and the full year, much of the top line growth at ABL came from the execution of our full capture pricing strategies, a better mix of products sold, benefits from new products introduced over the last 24 months and to a lesser degree, unit volume growth.

This was particularly true for a number of our specialty brands which make up about one-third of ABL. They did well throughout the year, because of favorable construction activity for medium to larger size building projects -- a key sector for us -- continued improvements in service and the introduction of new products.

In addition, investments to enhance our market presents in key channels as well as significant improvements in our levels of service to customers, coupled with our various new product introductions allowed us to participate aggressively in the expansion of the lighting fixture market in North America, where we believe the market grew in mid single-digits on an inflation adjusted basis in our fiscal 2007.

While it is impossible to quantify the precise impact on our net sales of the decline in new construction in the residential housing market, I would not be surprised if our net sales at ABL were negatively impacted by more than 1% of total net sales in 2007 compared with 2006.

In addition, our sales growth in the fourth quarter was modest, while the expansion in our profitability was excellent. This was due in part to our strategy to focus more aggressively on higher value-added portions of the lighting market where way have a strong, competitive advantage and margins are more robust. My belief is that we gave up 2 to 3 percentage points of sales growth in the quarter because of our strategy not to devalue the feature and benefits of certain products to chase volume on low margins in this portion of the market known as stock and flow. This has been and continues to be an important portion of the market for us. We are implementing strategies which we expect to grow our position in this portion of the market while maintaining our margin expectations.

Looking at orders, our order rates in the fourth quarter as well in September were favorable, though somewhat inconsistent on a day-to-day basis. We believe this was due in part to the timing of release on medium to large-size commercial and industrial projects and some fall off caused by the slowdown in new construction in the residential housing market.

As we noted in our third quarter conference call, we continue to benefit from previous actions to fully capture our announced price increases as part of our annual price review process and other price increases driven by the need to cover rising costs. Additionally, we were able to maintain our selling prices in a challenging pricing market because of our much improved service capabilities and the desirability of our energy efficient and innovative products.

Profitability and margins in the fourth quarter at ABL grew significantly in spite of rising costs for performance-based compensation and certain raw materials and component parts, and while continuing to make significant investments to further improve productivity and for projects to expand our presence in key markets like New York City in lighting-related adjacencies.

Our performance in the quarter was due to our successful efforts to enhance customer service, the introduction of new products, improved pricing and productivity and to a lesser degree, the overall growth of the nonresidential construction market; again, partially offset by the decline in residential construction.

Operating profit at ABL for the full year grew more than 38% while margins expanded 290 basis points to a record 12.8%, reflecting both the leverage and success in or execution over strategies to improve pricing, product mix, productivity and to a lesser degree, volume. Ricky will provide some more insight into ABL's financial performance in a moment.

All in all, ABL had a great year in 2007. I compliment the leadership team and all associates at ABL for their dedication, outstanding execution and intense focus on the pursuit of operational excellence.

Now looking at ASP, our net sales grew by approximately 2% in the quarter and about 3% for the full year. Overall, sales gains made in Europe and certain markets in North America, plus the benefit of higher selling prices in the industrial/institutional channel were partially offset by lower shipments in certain markets in the United States and the retail channel. Volume in the I&I channel varied by region with certain markets continuing to report solid unit growth while other areas such as the Midwest continue to struggle due to difficult economic conditions.

In the fourth quarter, ASP reported operating profit of $16.2 million, or 10.6% of net sales. This was up from the year-ago period by $600,000 an improvement of 30 basis points on margin, as higher selling prices more than offset rising costs. For the full year, operating profit at ASP declined by $9.2 million. The decline was due entirely to environmental and insurance-related expenses as noted in our third quarter conference call.

Lastly, with regard to the results posted by ASP for the fourth quarter and the full year, I believe the senior leadership at ASP did a marvelous job of managing the business and delivering results for key stakeholders, while dealing with the significant distraction of preparing the company to be spun off to our shareholders. For those of you who are familiar with spin-offs, you know just how distracting they can be to a management team, particularly when managing in a volatile market. The team at ASP is very excited by the prospects of having the spin-off behind them so that they can get back to doing what they do best: profitably growing their company.

I would now like to turn the call over to Ricky to make a few brief comments on our overall financial performance in 2007 before I make some concluding remarks.

Richard Reece

Thank you, Vern and good morning, everyone. Vern previously discussed our consolidated operating results for the quarter and full year so I will not repeat this information. However, I would like to discuss and provide more detail around our segment results for the quarter and full year. Next, I'll provide some information regarding our outstanding performance for the quarter and the year in cash flow generation, including some metrics regarding working capital management and our investing activities, as well as our healthy financial condition as of the end of the fiscal year. Then I would like to conclude with an update on the planned spin-off of ASP, including updating previously disclosed information regarding planned capital structure and certain financial characteristics of each business post-spin.

Let's start by looking more deeply at the results of the lighting segment. Sales for ABL for the fourth quarter increased 3.1% compared with the year-ago period. As Vern said previously, this increase was primarily due to increased pricing and the contribution of new products introduced over the last few years. Also contributing about two-thirds of a percent to this revenue increase was the acquisition of Mark Architectural Lighting, which we completed in mid-July so its results were included for six weeks of the quarter; and a modest boost from a favorable impact from foreign currency translation which added about 0.5% to the favorable comparison.

The favorable impact of our full capture pricing strategy, a better mix of products sold and the above-average profit margin contribution at Mark Lighting contributed to our $11.4 million, or 17.3% increase in operating profit at ABL for the fourth quarter compared with the year-ago period. In addition, these factors further supported the 170 basis points improvement in ABL's operating profit for the quarter. This improvement in profit margin was achieved after covering increased cost for freight due to higher fuel costs, greater commission and incentive compensation costs resulting from increased revenues and the improved performance, as well as certain investments we are making to expand our products and market presence.

Sales at ABL of almost $2 billion increased 6.7% compared with fiscal year 2006. Again, this year-over-year improvement is largely due to the increased pricing and favorable product mix. We also enjoyed increased unit volume, especially earlier in the fiscal year, resulted both from a stronger nonresidential U.S. construction market, strong international markets in which we participate and the added contribution from our new product introductions. Favorable foreign currency translation added about 0.4% to the increased revenues.

Partially offsetting some of these revenue gains for the year was the negative impact of the sharp decline in residential construction. While we are not a major player in this market, as Vern said earlier, it could have negatively impacted our sales at ABL by about 1%.

Operating profit at ABL for the fiscal year was $251.1 million, or 12.8% of revenue. Included in these results was the favorable settlement of a commercial dispute totaling $6.6 million.

Backlog at ABL as of August 31, 2007 was $174 million, essentially flat with the end of last year. I would add that our improved service capability has resulted in our late backlog being at a record low and a continued reduction in our cycle times, all contributing to a much better backlog situation. I would further add that incoming orders continue at a favorable pace.

Now let's look at ASP's results. Sales at ASP for the quarter were $152.6 million, up 1.6% compared with the fourth quarter of last year. Foreign currency translation increased sales 1.1% compared with the fourth quarter of 2006. The remainder of the increase reflects the benefits from higher pricing and volume growth in international markets.

Sales in the quarter were negatively impacted by both inventory reductions and timing of promotional activities at a major retail customer. Additionally, volume in the U.S. institutional and industrial channel in total was down compared with last year; however, it varied by region. We believe the market for specialty chemicals continues to be solid during the quarter.

However, our results reflect the impact of fewer sales representatives this year compared with last year, as we slowed our hiring of new reps while we developed enhanced recruiting, retention and training programs. We believe these new programs will increase our retention rate and accelerate the sales growth of newly-hired sales representatives.

Operating profit at ASP for the fourth quarter increased 4.1% to $16.2 million. Operating profit as a percent of sales was 10.6%, up 20 basis points compared with prior year. Increased price was a primary reason for this improvement. We also benefited from productivity improvements in our manufacturing operation. Partially offsetting these benefits were increased costs for raw materials, primarily chemicals.

For the full year, ASP had revenues of $565.9 million, up $13.8 million or 2.5% compared with last year. Foreign currency contributed slightly less than 1% of the increase. Price and international unit growth contributed the remainder of the increase, partially offset by volume declines in the U.S. I&I and retail channels.

Operating earnings for the fiscal year at ASP was $39.6 million. The annual results include a special environmental charge of $7.3 million pretax. Excluding this charge, operating profit for the year declined $1.9 million compared with last year. Benefits from increased pricing were more than offset by higher raw material and freight costs, increased compensation expense related to inflationary wage adjustments and severance and increased insurance costs due to higher claim experience.

Now let's turn to consolidated cash flow. We continued our long history of strong cash flow. Cash flow from operations for the fourth quarter alone was over $117 million, bringing the full year amount to just over $241 million. Our net trade cycle days improved 11% compared with the year-ago period and now stands at 39 days. This while funding a $138 million increase in our revenue base 2007.

Days in inventory ended the year at 45 days, an improvement of four days compared to last year end and compares very favorably to all our major competitors. We invested $36.9 million in capital expenditures for the year; ABL spent $31.5 million, and ASP spent $5.4 million.

In addition, we repurchased over 1 million shares of our common stock in the open market in fiscal year 2007 at an average price of around $49 per share. Largely offsetting the costs for these repurchases were proceeds from the exercise of 1.3 million of stock options from employees and retirees and the related tax benefits. Overall, our diluted shares outstanding have decreased by 1.7 million shares compared with last year end.

I will now provide an update on the planned spin-off of ASP, or Zep Inc., as the new company will be called. We are still on track for a distribution of Zep shares in the fall, hopefully during our fiscal first quarter. Form 10 as amended has been filed and we are awaiting final regulatory approval. As we disclosed previously, the spin-off will be accomplished by issuing to shareholders at the distribution record date one share for every two shares of Acuity Brands Inc., they own. With approximately 44 million AYI shares outstanding, that would mean an initial share count for Zep of approximately 22 million shares. Zep is expected to be listed on the New York Stock Exchange with a ticker symbol ZEP.

We expect the capital structure of Zep to be around $70 million of debt with a leverage ratio of under 1.7 times EBITDA, adjusted for special environmental costs incurred in fiscal year 2007. We are in the process of finalizing Zep's financing which is planned to include $100 million unsecured bank facility and a $40 million account receivable securitization facility.

Proceeds of the additional borrowings by Zep of approximately $62 million will be paid to Acuity Brands. AYI intends to use the proceeds to repurchase shares or pay off outstanding debt. We intend to maintain the combined dividend of Acuity Brands in Zep equal to the $0.60 per share AYI is paying today. The plan is for Zep to pay a dividend of $0.16 per share, which would equate to $0.08 per share on an unadjusted one for two share distribution basis. This would result in Acuity Brands paying an annual dividend of $0.52 per share after the spin.

I will now conclude my prepared remarks with a brief summary of the financial characteristics of each of the businesses post spin. First I'll address Zep. We estimate that the allocation of fiscal year 2007 corporate and stock-based incentive compensation costs necessary to a approximate the cost that may be required for Zep to operate as a standalone public company would be around $13 million, which would include approximately $4 million for stock-based incentive compensation expense which currently is not allocated by AYI to the segments. We expect Zep's effective tax rate to approximate 37%. As I said earlier, Zep's initially will be modestly leveraged at under 1.7 turns of adjusted EBITDA.

The resulting Acuity Brands Inc. will remain a holding company, wholly-owning Acuity Brands Lighting. While we expect to maintain the holding company structure of Acuity Brands, we believe we can meaningfully simplify its operations and costs. Therefore, we believe the annual run rate for operating costs of the holding company that will be necessary to operate Acuity Brands post spin will be approximately $20 million, including stock-based incentive compensation of around $12 million, which again since AYI has not historically allocated these costs to its segments, covers about 250 plan participants. We will likely see corporate cost higher than this annual run rate in fiscal year 2008, due to only benefiting from a partial year of savings resulting from simplification of our structure due to the timing of the spin-off and the transition of personnel. Acuity Brands effective tax rate is expected to be approximately 35% after the spin.

In conclusion, as previously disclosed, we estimate incurring approximately $7 million in non-tax deductible transaction costs in order to affect the spin-off which includes about $2.1 million we've expensed in fiscal year 2007. All of these transaction costs will be recorded by AYI.

In addition, as a result of simplifying AYI's corporate structure, a restructuring charge is expected to be incurred primarily to vacate the corporate facilities and for the reduction of certain personnel. While the amount of this charge is not determinable at this time, we do not currently believe that it will have a material impact on AYI's financial position. Zep will also potentially undertake various restructuring initiatives post spin-off in order to streamline and improve the effectiveness of its operations. While the exact cost of these actions is not known at this time, we disclosed in the Form 10 that we anticipate related expense could range from $5 million to $8 million.

Thank you and I'll now turn it back to Vern.

Vernon Nagel

Thank you, Ricky. As we look at Acuity Brands in total, we were very pleased with the performance and progress we made in 2007 on our key annual improvement priorities, including to better serve our customers, improve productivity, enhance profit margins and drive strong cash flow. We expect this momentum to carry into 2008. As we look forward to 2008 for Acuity Brands with the lighting company as its lone subsidiary, we do have our challenges and our opportunities.

Just to note a few of the challenges. First, we expect to continue to experience cost pressures for certain raw materials, component products, fuel and employee-related items such as healthcare.

Second, we continue to find ways to make up for costs associated with investments in programs to drive future profitable growth including those that enhance customer service, improve productivity, expand our access to market and innovate new products.

Third, as the markets continue to grapple with issues associated with the fallout of the sub-prime lending market, there is the potential this could lead to rising interest rates or a tightening of lending practices for commercial projects. This of course could have a disruptive influence on the broader economy which could dampen demand in both the nonresidential construction market and the residential market.

Fourth, we expect the residential market to be somewhat softer for the foreseeable future, somewhat impacting our shipments through the home improvement channel and for other infrastructure-related products that are tied to new construction for the residential housing market.

Lastly, there always exists the potential for irrational pricing tactics by undisciplined competitors.

While we monitor these issues closely, we continue to be very vigilant on our pricing and quotation posture and continue to drive programs throughout the company to enhance our competitive position. Overall, we continue to be cautiously optimistic about the growth prospects of the nonresidential lighting market where we expect to see unit volume growth in the low single-digits in our fiscal 2008.

We see a number of influences that we believe are working in our favor for positive unit volume growth. For example, based on the recent rebound in nonresidential building awards and other indicators such as the architecture building index, we expect demand for lighting fixtures will continue to be positive in our fiscal 2008, though quarter-to-quarter order rates may be inconsistent. We believe other factors that influence the nonresidential construction market continue to show positive signs including vacancy rates and rising rents for commercial space, the outlook for employment which continues to be favorable, increased spending by governments on infrastructure projects like roads and highways, strong growth demographics for school-aged children fueling a boom in school construction and continued attractive long-term interest rate environment. We are also encouraged by traction in the retrofit market as commercial, retail and industrial customers take advantage of more efficient lighting fixtures to reduce energy consumption while creating a better lighting environment. We believe these factors and the general positive economic outlook for North America continue to support a positive longer term growth trend in the nonresidential construction market.

Also, we continue to position ABL proactively to better leverage its market presence through investments that enhance our go-to-market programs and strengthen our geographic footprint as well as expanding our product offering with new and innovative products that provide superior value to customers from an energy and lighting performance perspective.

For example, we've have created one of the broadest, most energy efficient and cost-effective product lines available in the industry, to allow our customers to benefit from the Energy Policy Act of 2005, which positively impacted our sales in 2007 and we believe will continue to be an opportunity for growth in 2008.

In addition, we continue to make investments in programs to better train and develop our associates that further enhance their ability to service customers and improve our productivity. We continue to demonstrate that by investing in these programs we can profitably grow our business, better serve our customers and improve our margins while investing for future profitable growth.

Lastly, we announced in July our intention to spin-off the specialty chemical business to our shareholders. We expect the spin-off to be completed shortly. I believe this will enhance long-term shareholder value as both businesses will more narrowly focus on executing their strategic plans.

Overall, we expect that after excluding the activities and costs associated with the spin-off, Acuity Brands with ABL as its lone subsidiary will again meet or exceed our long-term financial goals of generating consolidating operating profit margins in excess of 10%, growing diluted earnings per share in excess of 15%, providing a return on shareholders equity of 20% or better and generating cash flow from operations less capital expenditures that is in excess of net income.

Lastly, we will continue to be relentless in our mission to excel in providing our customers with a superior value, our associates with great opportunities and our stockholders with consistent upper quartile performance.

Thank you and with that we will entertain any questions that you have.

Question-and-Answer Session

Operator

Our first question comes from Peter Lisnic - Robert W. Baird.

Peter Lisnic - Robert W. Baird

If I could just ask you a quick question on the stock and flow business, it sounds like there is some pricing pressure that perhaps has gotten worse there. Can you maybe give us a sense as to what exactly is going on in stock and flow and how the demand environment there looks?

Vernon Nagel

I don't know that the pricing pressures there have necessarily gotten worse. They have been very, very competitive. We participate in that market in a significant way but we pick and choose how and where we will participate. As I said in my prepared remarks, we have focused very aggressively on the larger project business where we have, again, a very significant competitive advantage. As we have done that, we have chosen not to participate at some of the price points in certain portions of that stock and flow business. As I said, I believe that's probably impacted our top line growth right by probably 2 to 3 points. But as you can see from growing our operating profit dollars as well as improving our margins, we continue to drive very substantial growth.

It's my expectation that in the early part of 2008 we will begin to address the lost stock and flow business in a way with products that have features and benefits at competitive price points that will allow us to maintain our margin expectation.

So again, Peter, I'm not going to say that the stock and flow business has materially changed. We've see this really throughout the year. I would say that in our fourth quarter it was a bit of a tough comp because in last year's fourth quarter, as you'll recall, the industry had a price increase and so there was a stimulation, if you will, of or an acceleration of volume in fourth quarter of last year that I think drove a little bit of an uptick in last year's numbers that was not repeated in this year's fourth quarter.

Peter Lisnic - Robert W. Baird

Your last comment there sort of hints upon my next question which is, it sounds like the order picture seems pretty solid. You're looking for volume growth to be up low single-digits in '08. Can you give us a sense as to what's going on with order patterns? The thing that drew my attention in the press release was that you had some delays in orders being released from your agents. I'm just wondering if that's an ancillary impact of the global credit issues that we're working our way through now?

Vernon Nagel

It's very interesting to us and so I'll give you just my own personal view. I don't know that there's a lot of fact base around this. The words and the music don't seem to quite match. So everyone reads the newspapers, but yet we look at quotation activity, we look at the architectural building index, we talk to customers. There is still a great deal of activity out there but yet everyone talks about what they read in the newspaper while they're going to work every day and are very busy.

July construction starts were down considerably but then August was up about 6%. I think what you're seeing is just some of the dislocation that is being caused by what's happening and people are again, waiting and watching a little bit. Our August order rates were spotty but yet then September, we have come back to be really quite favorable. So the quarter was favorable and September actually reflects I think a continuation of a favorable trend.

The only thing I can say is that the leading indicators of positive unit volume growth for lighting fixtures continues, in our view, to be in place and we think that our order book reflects that, though I do thing that some of that day-to-day inconsistency probably will linger due to that uncertainty that is in the marketplace for the reasons that you articulated.

Operator

Your next question comes from Robert McCarthy – Banc of America Securities.

Robert McCarthy - Banc of America Securities

To talk about this 2% to 3% volume you think you basically ceded, primarily in stock and flow, in quarters past you referred to a couple competitors or one competitor being a little soft on price, almost to the point of being a little irrational. Are you still seeing that phenomenon?

Vernon Nagel

We believe that the pricing environment has really not changed significantly. We still see it's regional, it's pockets, it's in different pieces of the business where folks execute over pricing strategies that we don't quite understand.

But having said that, I don't think anything has materially changed. We continue to be very aggressive in our full capture pricing strategy. As we said, really over the last couple of years, we have taken that increase in price and we have reinvested it back into the business in terms of new products. We're bringing out new products at a very rapid rate and those are being received in the marketplace very positively. These are lighting fixtures that provide superior lighting characteristics, while providing our customers with tremendous energy savings and so there's a great deal of value that's being provided there and that's what you're seeing as our mix changes.

But on the flow side, on the stock and flow side, again, it's a very important part of our business.

Robert McCarthy - Banc of America Securities

How big a part of your business?

Vernon Nagel

It varies but I think we have said in our 10-K that the project side is roughly 75% of our business while the non-project side, and this would include things like our home improvement capabilities, our national accounts represent about 25% of the business.

Robert McCarthy - Banc of America Securities

Stock and flow would be within that 25%?

Vernon Nagel

Correct.

Robert McCarthy - Banc of America Securities

Perhaps you could talk a little bit about the energy efficiency theme and the new product introductions. Has your product fatality index gone up recently if you look at the back half of the year or any kind of run rate you can give us there? How much of your overall portfolio now do you think is levered towards more energy efficient fixtures?

Vernon Nagel

I would say that I don't have an exact percentage of our portfolio but we have been aggressive over the last 24 months of migrating from different types of lamp and ballast configurations to far more energy efficient configurations and so I would say a very significant portion of our portfolio is now what we would call energy efficient and we continue to drive that portion of our business as our engineers and our product market development folks continue to really look for new ways to enhance that.

Again, what you're seeing quite frankly for us, we're seeing nice growth in various sectors of our business whether it's national accounts, whether it's on the project side, folks looking to develop certified buildings. We're very proactive in that and again, that's where you're seeing the benefit of our product mix continuing to improve.

Robert McCarthy - Banc of America Securities

So we should expect to see these kind of price and mix attributes impacting your core results going forward? You would be in a positive price environment over the next couple years, given the fact that you have overhauled your portfolio of products?

Vernon Nagel

I would expect us to continue to improve our operating profit. We are, as you know Rob, our focus is to improve on our base business, our operating profit margins by 70 basis points or better while pulling through the variable contribution that we get on unit volume growth. So it is my expectation as we will ultimately conclude 2008 that we will have improved our margins in a very positive way.

Robert McCarthy - Banc of America Securities

On non-res for 2008, you did talk about some key sub segments in non-residential that you expect to grow and your overall outlook suggests low single-digit volumes. Could you talk about those key segments or drivers?

The second question with respective to non-res is, I understand that all the indicators right now remain relatively healthy but some of the indicators that build up into the leading indicators could be degrading over time. What milestones should investors look for, for a softening non-res market at the margin from your standpoint? What will you be looking for to get a better sense of the tail for 2008 as we head toward the end of 2007 on a calendar year basis?

Vernon Nagel

Well, I believe that the fundamentals are in place for the balance of calendar 2007, which is the first third, if you will, of our fiscal 2008. Again, what are those things? Employment factors, interest rate environment. While the spreads have tightened up a tad here, with the fed lowering rates, I mean, the ten-year treasury is now at what? 454 or something? It's down 60 to 70 basis points from its 52-week high. While spreads have tightened up, I think overall interest rates remain very, very favorable for this type of activity.

You look at vacancy rates, both city as well as suburban environments, favorable. If you look at rising rents in these markets, favorable. You're not seeing a lot of over building around the country so absorption continues to be favorable. The backlog, the construction backlog continues to be favorable. So those are the types of things that we continue to look at on a macro basis. Obviously we are very in touch with our customer base and looking at the activities, what's on their drawing board, and how can we help facilitate that.

The architectural building index continues to be very favorable. As I talk to folks in that portion of the industry, they're actually finding it difficult to find people because of all the projects that they have, or inquiries. So I believe all of those things that you follow, Rob, and investors follow are good indicators of where we're going.

Operator

Your next question comes from Christopher Glynn - CIBC World Markets.

Christopher Glynn - CIBC World Markets

On ROAM, how are you seeing the uptick and the adoption and the rollout and any kind of competitive presence there and maybe just some metrics around what you think that can do over the next couple years.

Vernon Nagel

Why don't I ask Ricky to address that? Ricky leads a small team that really acts as the board of directors for that business. We're quite excited about ROAM and its prospects.

Richard Reece

Thank you, first, for those who may not be familiar on the call, ROAM is our remote monitoring and management of lighting fixtures primarily for utility and municipal applications using the lighting along the roadway and in the subdivisions and so forth. We are pretty much complete with a major installation that we're putting in outside Phoenix, Arizona in Glendale and are very excited about that application, as is more importantly the customer. We are continuing to fill the funnel on prospects and opportunities there, calling primarily on the larger cities and municipalities and investor-owned utilities and we believe we have a differentiability product out there.

There are some competitors that we are having to compete against, but we believe not only the product but equally important, the features around how we manage the information for the municipality or the utility for them to use that and push the information out to the maintenance workers and so forth differentiates us. So we continue to be excited.

As far as exactly what kind of potential do we see as you can appreciate, there are millions and millions of light poles out there and our objective is to see how many of those we can put our ROAM fixture on. And then you've got opportunity beyond to use that technology for other types of near adjacencies to utilize than bandwidth. So were excited not only about the ability of that, but the sustainability of the growth of that and the consistency of it, reducing our dependence on new construction cycles.

Christopher Glynn - CIBC World Markets

Generally positive commentary on the sustainability of the pricing environment is what I heard. It looks like pricing did have a lesser contribution than it has had in some time in the quarter. Correct me if I'm wrong. Just wondering about your comments on those areas, as well as the current commodity cost inflation environment and outlook relative to what you've seen in general over the past couple of years?

Vernon Nagel

Chris, when you look and analyze the quarter, what you're going to see at Acuity Brands Lighting is that our pull-through on the incremental $16 million of revenue was about 70% at the operating profit level. So our ability to drive price and mix and differentiate our service capabilities is alive and well in the marketplace.

Again, if you take the impact of residential of 2 to 3 points on the stock and flow side, you see a very favorable picture in our business in terms of growth. That's pretty exciting. Our operating profit at ABL grew in the quarter 17%. So I believe that on a go-forward basis, the things that we are focusing on, we will continue to see favorability in '08.

We have our challenges. The chop is out there in the marketplace, people are reading newspapers, but we believe between new product introductions, particularly directed at this potential of the flow business as well as introduction of products in our specialty business as well as productivity improvements, we see a favorable picture for 2008. So again, we remain cautiously optimistic that we will be able either to meet or exceed many of our longer-term financial goals. That to me is very positive.

On the material and component side, we're kind of speculating 2 to 3 points.

Richard Reece

We're seeing moderation there, certainly not the rapid increase; we're expecting moderation there and not the rapid increase we've had over the last 18 months. The major inputs we look at still are aluminum, copper. Most of the folks that forecast that are looking at moderate, very low single-digit if not flat to maybe even declines as you go out further. Fuel of course is a bit of a challenge. We're continuing to see oil prices at very high historical levels. But that has a double edge for us. Positive in one way because question earlier was asked by Rob on what do we see in regards to the retrofit activity as you see fuel cost and all go up. That makes the trade-off much more positive to re-fixture a facility to take advantage of these energy savings. Fuel is not a big input to our raw materials but obviously is a factor in our freight. That one we are forecasting that we will continue to see increases year-over-year, but more in the low to mid single-digit level.

Operator

Your next question comes from Matt McCall - BB&T Capital Markets.

Matt McCall - BB&T Capital Markets

Vern, you gave some interesting breakdown of the lighting business. You talked about the 75% project, 25% non-project and I think you broke out some specialty brands that represent one-third of the lighting business. I don't think I heard it referenced that way. Maybe can you explain how those products are different and maybe is there a difference in, the growth rate or the profitability of what you would term specialty products?

Vernon Nagel

Our specialty brands include Holophane, include Gotham, include Mark Architectural Lighting, which we just acquired, include Hydrel, include Peerless. These are all very, very well-known brands in the industry. They're known for their specialty nature and those businesses comprise in total about one-third of our total revenues and of course are very important on various types of projects.

As you know, the Holophane brand goes to market through its own direct sales force while the other brands participate with our package agency folks and participate in what we call our volume-based business. I would say that the margin characteristics are slightly higher on the specialty products but yet when I look at our volume-based businesses, there our cash flow return on investment is extremely attractive.

This is why when folks examine our business and try and compare them to our competitors, we like to ask them to look at our cash flow return on investment. We are so dominant in the volume side of the marketplace, the margins there may not be as high as some of these smaller specialty brands but the cash flow return on investment and how we lever that asset base is very attractive for our shareholders. Those businesses are growing both the volume and the specialty businesses are growing at a nice clip.

So I will try to give a little bit of insight into how we manage that. We are continuing to focus on rounding out our portfolio in terms of specialty type of products and brands but we are investing very heavily in our volume-based brands because this is where there is tremendous mass appeal in terms of the market size. The energy story around those is huge. It's really both sides of the business that you're seeing margin expansion and contribution to our cash flow return on investment.

Matt McCall - BB&T Capital Markets

That's helpful and leads into my next question. You stole my point. I think the point about the 70% incremental margin is a big one. That was eye-popping. But that's obviously a great story and the first question is, if we look into '08 I know you mentioned the 70 basis points of incremental margin plus a contribution margin on top of that. As you talk about the separate businesses now, maybe could you address what lighting looks like, versus what ASP looks like? ASP's incremental margin is obviously a very different story. Where would you expect most of the margin improvement in each one of those business to come? Would it be gross margin, would it be SG&A, a mix for each business?

Vernon Nagel

That's a good question. Let me do ASP first and then we'll do ABL. I think ASP really has a unique opportunity for future growth. The management team and many of the leaders of that business have had a significant distraction put upon them by virtue of the spin-off. It takes a lot of time and effort and it's taken a lot of their time and effort to prepare for the spin-off. I think some of the opportunities that are in the marketplace for them, they have not been able to fully realize those because of the diversion of their attention.

I believe that in their business, you will see opportunities to both improve margin as they lean out their supply chain. I also believe that you will see opportunities to improve their operating structure as they continue to lean out their whole distribution and go-to-market system. John Morgan and the team will be articulating that on a road show here shortly. I think that shareholders will really get an opportunity to see the power and the opportunity of that business.

So I see top line growth, I see margin improvement at gross profit and I see operating expense opportunities or operating opportunities to improve over the next 12 to 24 months.

When I look at Acuity Brands Lighting, I see our opportunities to continue to enhance our top line growth. It's our expectation that we will grow at above market rates in 2008 and beyond, primarily because of the introduction of new products and services into the business. Many of these products and services also bring with them enhanced margins because of the value proposition that they bring.

I believe that in terms of our supply chain at ABL, there continues to be significant opportunity for improvement and our folks are very focused on those internal capabilities. From a shareholders' perspective, we probably didn't fully lever, if you will, our operating expenses as well as we could have in 2008, primarily because what you're not seeing is employee-related costs, whether it's performance-based incentive compensation or healthcare costs. If you exclude that, it's my expectation that we would continue to make good progress on improving our productivity in that area in 2008. It's a focus for us.

So I would see, again, top line growth opportunity at the gross profit level due to the supply chain improvements and then levering our fixed overheads, if you will, from an operating expense point of view.

By the way, all of this I believe will continue to drive a greater improvement in our cash flow return on investment. That's a big deal. We generated as a company positive EVA of over $86 million in 2007 so I believe we're focused on the right things to drive shareholder value.

Matt McCall - BB&T Capital Markets

That is also helpful. Just to jump back to the metrics you've given us in the past, the 20% to 25% incremental margin, 70 basis points. That was for the company as a whole. How should we look at those specific metrics as we break the company apart?

Vernon Nagel

I believe what I have said is that from a variable contribution perspective, ASP is probably a little bit higher than ABL. But we're probably not materially different than other, if you will, product manufacturing type companies and so the number is somewhere in the 25 point range on a variable contribution basis, that is probably not a bad number to use for your models.

Matt McCall - BB&T Capital Markets

For ABL?

Vernon Nagel

For ABL, probably a little bit higher than that.

Matt McCall - BB&T Capital Markets

Margin opportunities, 70 basis points is mostly for ABL, is that correct?

Vernon Nagel

Yes. I mean, that's the challenge. We of course have put that challenge out to our self and I think we started that three or four years ago, and we've been good so far on that and there's no reason for us to back down now.

Matt McCall - BB&T Capital Markets

You delivered. That's why I keep asking the question, because I want to see how long it can last. Last question, you mentioned some lumpy order patterns, I think it was with ASP from one of your consumer channel customers. Any update there? Is that lumpiness going to improve next quarter?

Vernon Nagel

The comment that I made in this conference call around the lumpiness of orders was directed at ABL, really from the project side. I feel like that lumpiness has a lot more to do with people reading the newspapers than the real activity that out there.

When it comes to our consumer products group on the lighting side, our folks there continue to do just an outstanding job of serving the home improvement channel. We believe that the POS sales through that channel actually for our products the decline has been dramatically less than the overall decline that folks have seen in that space, due to the residential downtick. I think that has a lot to do with new products that we've brought out; it has a lot to do with our merchandising capability, it has a lot to do with just how we access those customers through that channel, so very favorable there.

What that means is that year-over-year we did not see a significant diminution in sales in the lighting side. Going forward, we still expect that channel to be challenging by virtue of the end customer base. I think people, you read this just as I do, but I think people are expecting calendar year 2008 to still be a very challenging year for the housing market.

On ASP's side of the world, the opportunity and the challenge that they have there is while they still are a very significant player in the home improvement channel, some of the changes in strategy or the evolving strategy that some of the major customers have limits some of the shelf space that is available to ASP. So their challenge is how do they extend their access to market, how do they increase their shelf space? Their SKU count isn't going down, it's just simply that the shelf space available to them is, so that's had some impact in terms of incoming orders, but POS still continues to be positive for them.

Richard Reece

Matt, I would add, because I did make a comment on ASP or Zep, they did experience in the fourth quarter some reduction in inventory held by a major retailer in the home improvement channel and then fewer promotional activities. The promotional activities can be a bit lumpy, these are the near the checkout counter or the half pallet type sales that you might see or promotional activities and it just so happened in the fourth quarter that Zep didn't experience as much of that that obviously can drive volume. As Vern said, the POS was stronger than what our sales to this channel reflected so we would hope that might get back to a more normal pace and that choppiness or air bubble will come on through.

Operator

Your next question comes from Robert McCarthy - Banc of America Securities.

Robert McCarthy - Banc of America Securities

If you just think about your residential exposure, it's relatively minimal but it must have had a pretty significant decline if it was only 1% on a consolidated basis. Are you seeing declines in concert with new home starts on the order south of 20%?

Vernon Nagel

Rob, a couple of things. First of all, we were very clear that it is virtually impossible for us to have exact data. It's our belief that overall that was the impact. The impact came in a couple of areas. It came in what we believe would be direct shipments of product that would find its way, but also some of the ancillary products. We've seen in some markets which had fairly robust residential growth where that has slowed down. Products that we would sell into infrastructure-related, you know, lighting roadways, strip malls, some of these things that are the output or the follow-on to residential construction, we've seen some impact there.

Robert McCarthy - Banc of America Securities

Would you characterize that as your light commercial exposure then, too?

Vernon Nagel

I would say that there is exposure there in that regard.

Robert McCarthy - Banc of America Securities

That number you highlighted to us, does that take into account strictly residential or your light commercial number as well? Or is it also impacting your volumes in light commercial as well?

Vernon Nagel

I'm including the impact of our light commercial activity.

Robert McCarthy - Banc of America Securities

So the 1% would be light commercial and res consolidated?

Vernon Nagel

Yes.

Robert McCarthy - Banc of America Securities

Maybe longer-term since we can talk about LED and the overall regulatory environment just for energy efficiency, what kind of milestones could we look for? There's been talk of legislation basically to ban going forward incandescent light bulbs in Federal facilities. That might cause a migration to more energy efficient lamp sources and lighting fixtures.. Could you talk about any kind of regulatory or legislative milestones that could be coming up over time?

Additionally, given the fact that Phillips has the stated goal of improving it's overall presence in North America and are really attacking the market from new, more energy efficient lamps, whatever technology that would be -- florescent or LED -- could you talk about from that standpoint any kind of comment on their strategy and will they need to get market access to exploit that strategy going forward?

Vernon Nagel

Well, I'll try and answer your 15 questions.

Robert McCarthy - Banc of America Securities

Yes, and then I just have a couple more follow-ups.

Vernon Nagel

First of all with regard to legislation and the incandescent bulbs and stuff, we know that there is legislation that is either out there or is being proposed whether it's California or New York; actually the opportunity, our folks internally believe that raising the energy standards with which products need to perform at is probably the best way to do that. Because there's always evolving technologies even in the incandescent side.

Having said that, we believe that there is still a great deal of opportunity in the traditional fluorescent lamp, current ballast configuration to really drive greater energy opportunities as well as improve the lighting output. So LED is a growing and important portion of the market but the largest portion and it will be for quite some time continues to be the more traditional ballast lamp configuration and we believe that the partners that we are working with there will be, again, continued advancements there that will be very exciting and we'll continue to push the cost benefit profile of LED.

Again, unique opportunities. When it comes to LED, I believe that we are very, very strongly and positively situated to bring LED products to market because again, LED is really simply a light source and it needs to have a fixture that creates the proper environment so it can do what it's supposed to do. Our folks really are all over this.

Robert McCarthy - Banc of America Securities

Do you think you have a competitive advantage versus your competitors in that space?

Vernon Nagel

I don't know that we have necessarily a competitive advantage or not. There are folks that are attempting to bring out new types of white LED and put those into fixtures that are different than color. When it comes to color, we have many products today, Hydrel, Peerless, Gotham, many products that use LED today and are available to our customers, so very exciting opportunities that fit particular applications. It's the white light opportunity that is now evolving into the market. Still very cost prohibitive, very expensive for mass appeal but nonetheless, we continue to introduce and examine opportunities to find the right applications for these types of fixtures. I believe you'll see them evolve over the next handful of years in a positive way.

Phillips, coming into the market they acquired Color Kinetics. Color Kinetics has a very niche position in the market place and so we would expect that Color Kinetics, we work very closely with them, we will continue to have that relationship. Phillips is one of our largest suppliers. We have a very strong relationship with them and so our expectation is that relationship will continue to evolve in a positive way.

Operator

Your final question comes from Christopher Glynn - CIBC World Markets.

Christopher Glynn - CIBC World Markets

Going a little deeper into some of the puts and takes on the volume outlook, I just wonder if the delays in project orders released from sales agents, if that effectively is push out to the fiscal first quarter or the first half and if there is also a prebuy impact expected in the next quarter or two relative to the most recent price increases?

Vernon Nagel

It's hard to say, but it's our sense that as people realize that the sky is not going to fall -- and I do realize that folks, some of Wall Street is looking into their portfolios and trying to understand what did they buy when they bought some of these sub-prime products -- but I believe on the commercial side, most of what we have seen has not been speculative. It's been for projects that really do have good economics. Can't say that in every specific project, but in general. So I have a favorable view around what that environment looks like.

So whether it's pushed out, yes it probably has. Again, September is just a month. We've got a long way to go but September's orders I think were favorable, making up for what we saw as choppiness in August, which probably was driven by very weak stuff in July. July is when sub-prime hit and I think everyone just stopped. They were like deer in the headlights, so to speak.

So it's our view that we will see favorability, though, again, with choppiness in 2008.

Christopher Glynn - CIBC World Markets

Finally, comments on the interplay of maybe light commercial falling off further as the residential environment deepens versus seems like maybe there's a bit of a pickup in the heavy project environment.

Vernon Nagel

Well again, there are certain markets on the resi side that are being pounded worse than others, it's where they have had a great deal of speculative build. I think that those few markets will continue to experience a rather negative fallout. The demographics continue to be strong. We still have population growth, the age of kids, schools need to be built so we continue to see favorable trends in those things.

I think while we may have seen a temporary lull in some of the smaller projects that are ancillary to residential build, I think on a longer-term basis it is still favorable due to those, again, interest rate environment, demographics, job creation. Those are the key indicators on the longer-term basis.

Operator

I will now turn the call back over to Mr. Vernon Nagel for closing remarks.

Vernon Nagel

Thank you for your time this morning, everyone. We believe that we are focusing on the right objectives, deploying proper strategies and driving the organization to succeed in critical areas that deliver on the expectations of our key stakeholders. We believe our future is bright and we thank you for your continued support.

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