Beacon Roofing Supply, Inc.

to the Beacon Fourth Quarter and Fiscal Year 2020 Earnings Call. My name is Gabriel, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be conducting a question and answer session towards the end of the conference, and at that time, I will give you instructions on how to ask a question. If at any time during the call you require assistance, please press star followed by zero, and a coordinator will be happy to assist you. As a reminder, this conference call is being recorded for replay purposes. This call will contain forward-looking statements, including statements about its plans and objectives and future economic performance. Forward-looking statements are only predictions and are subject to a number of risks and uncertainties. Therefore, actual results may differ materially from those indicated by such forward-looking statements. as a result of various important factors, including but not limited to those set forth in the risk factors section of the company's latest Form 10-K and Form 10-Q for the quarter-ended June 30, 2020. These forward-looking statements fall within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 regarding future events and the future financial performance of the company, including the company's financial outlook. forward-looking statements contained in this call are based on information as of today november 19 2020 and except as required by law the company undertakes no obligation to update or revise the any of these forward-looking statements finally this call will contain references to certain non-gap measures the quick conciliation of these non-gap measures is set forth in today's press release the company has posted a summary financial slide presentation on the investor section of its website under events and presentations that will be referenced during management's review of the financial results. On today's call for Beacon will be Mr. Julian Francis, President and CEO, and Mr. Frank Lonegro, Executive Vice President and CFO. I would now like to turn the call over to Mr. Julian Francis, President and CEO. Please proceed.

Thank you, Gabriel. Good evening and welcome to our fourth quarter 2020 earnings call. Let's get real set on the call. With me today is Franklin Agro, our Chief Financial Officer. Our prepared remarks will correspond with the slide deck, which is posted to the investor relations section of Beacon's website, and I'll begin on page four of our slide materials. 2020 was not the year we expected, but Beacon exits the year a significantly stronger company. Our 7,500 employees worked incredibly hard to provide strong service levels to customers while keeping those customers and themselves and their colleagues safe during an unprecedented environment, a pandemic, wildfires, hurricanes, and social unrest. I could not be prouder of the business results we delivered given the circumstances. As a company, we have successfully transitioned to new leadership and embraced a new strategy. We have implemented four key strategic initiatives, generating meaningful contributions to our results. And I see the mindset and processes behind these initiatives becoming quickly ingrained in the company's leadership at all levels. Kept up by a record fourth quarter, full-year adjusted EBITDA margins exceeded 2019 despite COVID, and our 2020 operating cash flow was the second highest in company history. We've used the cash to pay down our ABL and materially improve our balance sheet. We are delivering the type of results you should expect from Beacon, and we will continue to improve and grow. There are several important takeaways from the quarter that I want to emphasize. First is that we have a resilient business mix. After state government restrictions negatively impacted March and April, we quickly recovered and delivered five consecutive months of stable year-to-year daily sales rates. This is an important characteristic of our underlying markets, driven by the less cyclical repair and replacement cycle and our balanced exposure to both residential and commercial constructions. Second, price execution is a critical focus for my leadership team. Fourth quarter gross margins improved more than 100 basis points, both sequentially and year over year. We have been intensely focused on making positive strides to improve our gross margin the past year after a couple of years in a challenging environment. We are pleased to report traction on price increases we implemented during the quarter. While some of this Q4 gross margin benefit reflects favorable timing, we expect our price initiatives to be accretive to margins going forward. Third, our operating expense discipline continues. As Frank will discuss later, we are extremely pleased to report a sequentially flat adjusted OPEX to sales percentage. That's as we have previously guided, despite higher incentive compensation. We continue to do an excellent job of managing headcount while posting a second consecutive quarter with significant year-over-year employee productivity. Fourth, we deliver a strong cash flow year. Fiscal 2020 operating cash flow at $479 million demonstrates really solid operating performance in a difficult environment. We reduced net debt leverage to 4.7 times as we continue to move towards our leverage goal of about three times. Our strategic initiatives meaningfully contributed to results. I'll touch on each of the four initiatives in more detail in a minute, but I wanted to quickly highlight the success of our digital platform and underperforming branch initiatives. Our industry-leading digital platform achieved the aggressive exit run rate goal of 10% of sales that I set for fiscal 2020. We continue to emphasize our e-commerce platform as a key differentiator beacon and will invest to maintain our leadership position. As for our lowest quick file branches, they produced more than $20 million of operating margin improvement for the fiscal year. While it's been difficult to separate branch-specific performance relative to the impact of our swift reaction to COVID, it is clear we are well on our way to delivering the targeted 30 to 60 million of margin benefit. Moving to page five of our slide materials, I want to highlight a couple of items related to our fourth quarter results. In August, we provided you with a framework outlining our expectations for the fourth quarter. Our sales outlook called for a low single-digit revenue decline year over year with increasingly difficult comparisons as the quarter progressed and limited incremental price contribution. For margins, we provided expectations for a slight sequential improvement in gross margins and a modest increase in adjusted off-ex to sales with temporary costs returning. Fourth quarter sales modestly exceeded our expectations, as August and September month sales were both slightly stronger than anticipated. Both margin lines outperformed our public outlook, with gross margins up 140 basis points sequentially and adjusted operating costs of a percent of sales flat with the third quarter. Actual EBITDA margins finished at 9.5%, up substantially both sequentially and year-on-year. There were several moving parts within our Q4 gross margin performance, and Frank will speak to those in more detail. At the completion of our prepared comments, I will address our future margin expectations. Next, I'll provide an update on our key initiatives. Please turn to page six of the slide deck. These four initiatives have become significant drivers of our sales and margins. These initiatives create multiple paths to add value for customers and differentiate us from our competitors, raise the quality and consistency of our customer service, increase communications and interactions with customers, and provide clear focus areas for our employees. The successful implementation and execution of these initiatives generate top-line, gross margin, op-ex, and cash flow benefits. Our strong performance of the initial COVID lockdowns in late March and April illustrates the benefits of our strategic direction, and now I'd like to provide more detail on each. Let me begin with our focus on organic growth. Our sales team, branch leadership, and marketing organizations are in lockstep driving sales growth. We have placed the customer at the center of our business and are resourcing our inside and outside sales teams to support contractors who want to save time, be more efficient, and grow their businesses. We are helping our sales representatives by providing training, development, developing productivity tools, and supporting them with expanded lines of private label and branded products, as well as a cooperative e-commerce platform and call center personnel. We believe the number and quality of calls we have with customers has a direct correlation to our sales performance. We have an established set of goals for our sales team for the number of interactions daily. As we move towards this optimal level, we believe the increased activity will drive sales growth with both new and existing customers. Next is our industry-leading digital platform. As I said, I'm pleased to report that Breakin's digital platform exceeded 10% of company sales during September. As you may remember, this was an aggressive goal that I set shortly after joining the company a year ago. We have a first mover advantage, significant breadth of digital solutions in our offering, a sales and marketing organization committed to enhancing the platform, and increasing buy-in from vendors and customers who recognize us as the industry leader. Customers have been particularly enthusiastic about the benefits of online ordering and estimating tools during the pandemic. Our customer service continues to reveal contractors' high marks for the platform's user-friendly order processing, tracking, and payment features. Additionally, digital works in conjunction with other strategic objectives at Beacon and is particularly effective at driving growth in our private label offering. As an example, online order templates for contractors give us the ability to orient customers to our private line of private label products. This has provided a significant boost for tribal sales, which increased 50% year-over-year in 2020 and has a positive impact on our gross margins. Next, moving to our on-time and complete network. Our OTC strategy is another significant differentiator relative to our competitors. We believe it provides four key benefits to our business. First, It enables us to improve our service platform, shortening delivery cycles and enhancing product availability, which contributes to our top-line growth. Second, by optimizing our network and delivery routing, we see expense reductions such as fleet and employee productivity. Third, we can optimize our inventory position across multiple locations, driving a permanent reduction in working capital. And fourth, it significantly enhances our talent development pipeline, giving us the opportunity to develop early career talent in significant roles. Currently, we operate OTCs in 58 markets, each having market-based P&Ls, and the majority operating centralized dispatch, a key element in optimizing delivery performance for our customers. In total, these markets contain 260 branches, representing more than half of our exterior locations. We opened our first new hub location earlier this year in Denver, which follows three legacy hubs in operation, as well as two specialty siding hubs. Lastly, I want to highlight our branch operating performance. Earlier this year, we introduced a new program focused on raising the operating performance and profitability of our lowest quintile branches. We have publicly disclosed a $30 to $60 million bottom line improvement goal for this initiative. As I mentioned earlier, I'm pleased to report that our initial group delivered more than $20 million of operating income improvements during fiscal 2020. This is a tremendous accomplishment given significant market challenges tied to COVID, and with these locations having only a couple of quarters of operations with action plans fully implemented. I'll now pass the call over to Frank, who will discuss full quarter results in more detail. Thanks, Julian, and good evening, everyone. Before getting into the details of the quarter, I thought it would be helpful to provide some perspective on the last seven months since joining Beacon. In mid-April, we were in the depths of COVID, and the future was uncertain at best. Julian, the board, the executive committee, and the division presidents were already fully engaged in cost reduction, cash preservation, and trade working capital management. It's a pleasure to work with a team that can think clearly in a crisis, execute the necessary actions rapidly, and leverage those actions as sales improve. There is no doubt in my mind that our experience in navigating the COVID environment has accelerated our performance and increased our potential. To that point, our second half operating expense performance demonstrates our ability to deliver efficiencies regardless of whether sales are declining or improving. Turning to page eight, we'll review our quarterly sales performance. During our past two earnings calls, we provided details on the disparate impact of COVID on our business. While there continue to be geographic performance gaps due to COVID, the economic impacts from COVID are also evident in our product and end market categories. Residential roofing delivered 6% sales growth during the fourth quarter, evidence of a rapid recovery following the initial COVID lockdowns. County market indicators for both new construction and repair and remodel activity remain quite positive as the consumer continues to concentrate discretionary spending on their homes. Our contractors remain busy, and we see the potential for an extended roofing season. But as always, this will be dictated as much by weather as by underlying demand. We are well positioned to capitalize on this favorable residential backdrop, and our single purchases in the quarter were slightly above the year-over-year growth from the arm of data you've seen. Commercial roofing sales declined 12% in the quarter, with declines similar to what we experienced in Q3. Continued uncertainty in the office and retail sectors have created select deferrals and re-roofing, while new commercial construction has also experienced a slowdown. Certain categories, including schools, which traditionally complete re-roofing projects during the summer months, were pulled forward due to COVID-related building closures We have recently seen some leading indicators improve, and bidding has also stabilized, but visibility remains limited going into the slower winter period. Complimentary products were down 1.5% year-over-year, but improved significantly on a sequential basis. As a reminder, the complimentary category is split relatively equally between exteriors and interiors and between residential and commercial. Not surprisingly, in Q4, complimentary sales in residential markets outperformed complimentary sales in commercial markets. Turning to slide nine, we'll review gross margin. We were delighted with our gross margin performance in Q4. Four-quarter gross margin of 25.5% improved 140 basis points sequentially and 120 basis points year over year. Getting into the details, there were a number of items that favorably impacted gross margin performance. In the quarter, on a year-over-year basis, price cost was positive by approximately 75 basis points, driven by three primary factors. One, our continued successful implementation of recent price increases. Two, a timing benefit related to our pricing increases relative to the corresponding increase in our cost of goods sold. And three, stronger residential sales incentives based on increased shipments to our customers. We also benefited from favorable product mix in the core as we experienced stronger sales from our higher margin residential roofing category. Going forward, we should continue to experience favorable mix as residential roofing is expected to see continued outperformance. We also expect to benefit from the recently announced price increases. Given our high level of execution in implementing these increases across the network, The timing benefit we experienced in the fourth quarter is likely to be smaller in the first quarter, and we do not expect any meaningful timing benefits beyond fiscal Q1. Finally, our vendor incentives in Q1 should reflect seasonally lower quarterly sales activity. Julian will provide further details regarding our gross margin outlook in his wrap-up comments. As I mentioned in my opening comments, we are proud of our Q4 operating cost performance and appreciate the tremendous efforts of the entire Beacon team in managing costs tightly. Adjusted OpEx was $346 million unchanged from last year. Strong labor and fleet productivity efforts were largely offset by higher incentive compensation as we finished fiscal 2020 with significantly stronger bottom line results than we anticipated in the prior quarter. As a percentage of sales, expenses were largely unchanged, both sequentially and year-over-year, at 17% of sales. During our Q3 call, I highlighted three buckets of cost savings enacted during COVID, temporary, continuing temporary, and permanent savings. On a sequential basis, four and a quarter operating costs reflect the return of the temporary cost actions we took during Q3. A portion of the continuing temporary costs also returned, That said, travel and entertainment expenditures remain below historic levels and will provide year-over-year cost benefits in the first half of fiscal 2021. In our third quarter release, we also introduced a new measure, sales per hour work. We believe this metric provides useful insights into our efficiency efforts. And with labor being the most significant cost for any distributor, driving efficiency in this area remains a central focus. Following an incredible third quarter performance, we are very pleased that we produced a 15% year-over-year improvement with 7% fewer employees in the fourth quarter. We will continue to leverage this important efficiency metric going forward, but it is only one measure of what we're trying to accomplish more broadly with our operating expenses. We are focused on improving the efficiency and effectiveness of our sales personnel, their driving asset utilization gains, and our truck fleet. And we are working hard to offset inflation with productivity in each of our operating divisions, functional departments, and corporate teams. The impact of COVID has certainly created greater urgency and beef and has helped us accelerate the pace of continuous improvement evident in our results. Turning to slide 10, we'll review our cash flow and balance sheet. We finished 2020 with a very strong Q4 cash flow, raising the full-year operating cash flow to $479 million, illustrating the benefits of favorable earnings and strong trade working capital management. Quarterly cash flow was again driven by strong operating results from sequentially improving sales, strong gross margin performance, and continued cost discipline. And while we had previously anticipated working capital would be relatively neutral in Q4, we ended the period with a positive contribution from trade working capital, primarily due to higher AP at the end of the quarter. AR was slightly higher sequentially, given higher sales in the fourth quarter, and inventory levels were better by 7% year-over-year, stable sequentially, as we continued to leverage the aggressive actions we undertook in Q3. Importantly, our strong second half cash generation produced significant debt reductions. During Q4, we reduced total debt by $600 million. And Beacon now has repaid the entire $725 million March PBL drawdown. As a reminder, we drew down the ABL as a proactive measure given the economic uncertainty from COVID. Currently, we have approximately $250 million outstanding on our ABL and would expect to pay that off during the first half of fiscal 2021. Our management team continues to view debt reduction and balance sheet strength as high priorities. To that end, we are pleased to report that our net leverage declined to 4.7 times trailing 12-month EBITDA, reaching the lowest leverage level since the Ally transaction. We are making good progress in operating performance, cash generation, and debt reduction, and are continuing to target net leverage of approximately three times EBITDA. With that, I'll turn the call back to Julian for his closing remarks. Thanks, Frank. I'll be providing a brief wrap-up to fiscal 2020 before sending to 2021 Outlook on page 12 of the slide materials. Fiscal 2020 represented a transition year for Beacon with new leadership and the implementation of a new strategic direction. This evident strategy signals Beacon's move from a predominantly growth by acquisition company to one with renewed focus on organic sales growth and industry-leading operational execution. As part of this shift, our leadership team established four major strategic goals to guide us going forward. Fiscal 2020 also presented Beacon with our greatest challenge since the financial crisis more than a decade ago. The COVID pandemic caused demand to crater. Our company's response to this unprecedented environment has been incredible. The third quarter highlighted our ability to control costs and improve productivity. In the fourth quarter, we demonstrated strong pricing execution, resulting in a significant increase in gross margins. Internally, we are focused on building our company's culture around continuous improvement and operational excellence, and we hope this is becoming increasingly clear to the investment community. We made significant progress here in 2020, but as I've repeated since joining Beacon, we want this company and its employees to realize their full potential. We continue to pursue a path to do both. Now let me provide some details that should help you frame Q1 and the 2021 fiscal year. Our October sales improved approximately 6.5% year-over-year, reflecting the combination of strong residential volumes and higher pricing, partially offset by weaker commercial sales. We have continued to see heightened demand within residential and markets, particularly residential roofing and insulation, and are confident this strength will continue in fiscal 2021. In our first quarter, we are expecting overall net sales to increase low to mid single digits, largely dependent on the number of available grouping days before winter weather impacts our customers. For gross margin, we expect a first quarter year-over-year improvement tied to solid pricing execution and favorable next benefits versus the prior year. We anticipate a portion of the favorable Q4 timing benefits to continue into Q1, but it will have a smaller impact than prior quarter. The combination of these factors are expected to result in first quarter margins of approximately 25%. We will continue to actively manage operating costs while improving employee and peak productivity. During these past seven to eight months, we have gained valuable insights into our capacity for variabilizing certain expenses, which should be most evident as we winterize during December, January, and February. For the 2021 fiscal year, COVID creates uncertainty, particularly for non-residential end markets. While we have seen some signals that non-red bidding activity may be blossoming, it remains appropriate to keep a cautious outlook and manage our business accordingly. With this relative lack of visibility, we are focused on what we control, executing on our strategic initiatives, driving sales growth above market, instilling pricing discipline, and driving productivity gains throughout the organization's patience. Each of these represent key elements we put in motion during 2020 and expect further gains within the new year. As a result, we currently expect to do a sales growth at the upper end of a low single-digit range, combined with gross margin expansion, yielding adjusted EBITDA in the range of $500 to $525 million. We're excited about 2021 and are off to a good start. And getting over that, We're ready to open the line for questions.

Thank you. Ladies and gentlemen, if you wish to ask a question, press star followed by one on your touch-tone telephone. If your question has been answered or you wish to withdraw your question, press the pound key. Each caller is limited to one question. Your first question will come from the line with Michael Reho of J.P. Morgan. Please go ahead.

Hi. Good afternoon, everyone. Congrats on the results. I wanted to first kind of delve in a little bit to the guidance for first quarter and the upcoming fiscal year. You know, more focused on, I guess, how you're thinking about gross margins. Obviously, you kind of gave a guidance of roughly 25% down from 25.5 in the first, in the fourth quarter of 20. And it would, seem, if I'm trying to make some proper assumptions about the full-year guidance, that perhaps you're looking for gross margins more in the high 24% range. So I was hoping to get just that break, if I'm thinking about that correctly, how to bridge the gap between 4Q and 1Q and also kind of, let's say, 1Q in the overall fiscal year if it's primarily due to some of the timing benefits, maybe some positive mix reverting, just trying to get the different drivers and buckets in terms of what's driving those changes.

Sure, Michael. It's Frank. Thanks for the question and congratulations. So you're thinking about it the way that we're thinking about it. Your math makes sense to me. When I look at the Q1 guidance relative to Q4 performance, obviously there's a couple of moving parts there. The continuing pricing execution is going which is going to be helpful from a year-over-year perspective. There is a temporary benefit that we mentioned that will impact Q1, maybe slightly smaller than it was in Q4, but will certainly have some benefit there in Q1 for us. And then continued mix. Obviously, the residential markets continue to be strong for us, and that carries with it some margin lift associated with that. When we think about the full year, you know, obviously the year is one month or one and a half months into it. So, you know, we're trying to figure out how long does the ready strength go? Will this commercial come back? What does COVID do? What does the weather look like? So there's a lot of things that go into handicapping gross margin for the full year. Clearly we're off to a good start and look forward to updating you as the year goes on.

you know getting through the next few months of winter i think will give us a lot better insight into what the full year looks like uh but your numbers make sense from our perspective at this point in time great uh great thank you frank um i guess secondly um love to get your thoughts also uh from guidance perspective on the uh the top line uh guidance and you know talking about first quarter sales up low to mid single digits And then the full year being up towards the upper end of low single digits, which to me sounds like 4%. I guess that would imply maybe the rest of the year being at the middle or slightly less, I guess depending on how the math works out. But the assumptions behind that, I'd love to get your sense if you're thinking continued you know, relative strength or growth in the residential roofing side, maybe non-res continuing to be weak, as we've indicated for the first quarter. And, you know, if I could just layer in a second question or an element to this, I'd love to hear your thoughts also on, you had mentioned that the shingle purchases slightly exceeded the armor shipments. um and i was just curious on how that kind of flows through the numbers and if there was any type of inventory rebuild and you know how that might you know how you're thinking about that impacting the first half of the year gotcha well if uh if i missed any of the questions that were embedded in there julian will help me out but let me uh let me take it from what i think was the top of the question set in terms of q1 and the revenue piece

We gave you a fairly wide range, as you can tell. We said those single digits to mid-single digits, and a lot of that just depends on how the weather plays out in the second half of November and into December. There's always a month-to-month decline as we go through the fiscal Q1, which is really good to see is that so far throughout the first six weeks of the quarter, we look like we're in good shape. I mean, October came in, as you can see there, at 6.5%. If that continues, obviously we'll be more toward the mid-single digits rather than the low-single digits. If we end up with a bunch of weather that hits us in the next six weeks, then I take the under. So that's kind of the way that Q1 wraps up. We'll know a lot more here in the next couple of weeks as we get through Thanksgiving and the end of November, and we'll close that up and have a better view of exactly where the first quarter is going to shape up for us. In terms of the full year, just to... you know, give you where our head was when we put the guidance out there. We've got low single digits as kind of one, two, three. So when we say the upper end of that, we're talking about within that, not above that. And your point around non-res is really the qualifier. You know, how deep is non-res going to, you know, going to impact us in 2021? Right now, to Julian's point in his remarks, we do feel like there's some bottoming there. With the COVID vaccine, it's possible that we could actually see some second-half help on the commercial side, but it's just too early to call that one right now. In terms of ARMA, what we were trying to explain to you is that our year-over-year purchases – We're slightly above the ARMA data. So the ARMA data said that the year-over-year selling by the manufacturers was in the 25% range. We purchased about 26%. So we were just a little bit ahead of that from a purchasing perspective year-over-year. Hopefully that's helpful. Julian, fill in any gaps I left. Yeah, I think as we're thinking about sales, when you think about where we are today, it's a strong fourth quarter. Obviously, we know that industry shipments in the fourth quarter were actually slightly above the maximum production capacity. So you can't actually sell more than that if we were going to complete our inventory. So part of this is the strength of In the back half of the year that we saw, excluding to April and May timeframe, it's going to be difficult to beat from a top line perspective, just in terms of number of shipments. And then the drag, as Frank indicated, there's a lot of uncertainty about commercial still. We do think that it's been bottoming. But as we look year over year, we just want to sum that up. And Michael, last point you asked about the inventory level. We essentially sold everything we bought in the quarter, so we didn't build any. any shingle inventory in accordance.

Next question will come from the line of Mike Dahl of RBC. Please go ahead.

Hi, thanks for getting my questions. I just wanted to follow up on that with my question in terms of the inventory and understanding those dynamics. If you purchased above at 26% but your sale out was 6%, just help us understand the dynamics Yeah, the lack of build. And is there any difference when you're talking about inventory with respect to, are you saying specifically to residential single inventory still is flat? And then part, or was it like kind of resi up and non-res down? Part two of this. was then going to be, as you think about the first part of the year, how are you planning your kind of inventory position for the first half? Thanks.

No, good questions, Mike. So remember that ARMA is talking about the manufacturers selling and our buying. which is relative to where we both were a year ago. So it's year over year buying for us. And then obviously the sale is a year over year sale. So a lot of it depends on what the benchmarks were a year ago. You know, we did have strong shingle sales Asphalt shingle sales, which is what the ARMA data collects, we were at about 8% asphalt shingle sales. In terms of inventory, what you saw was we were flat on a sequential basis, quarter over quarter. From a year-over-year perspective, we were down about $100 billion of inventory, down about 7% year-over-year overall. The commercial inventory on a sequential basis was down about 10%, so we did see a reduction in there that I think was important for us to capitalize on given the end market demand also was down pretty significantly in the second half of the year.

Our next question will come from the line of David McGregor of Longbow. Please go ahead.

Yes, good afternoon. You called out the price increase. You said you were particularly pleased with the execution on the price increase, which seems to be maybe a little more focused around that than might have typically been part of your narrative. So I just wondered if there was something different about the way you went about securing the price increase this time that may have made a difference.

David, thanks for the question. Yeah, I think that we did focus on this price increase. Obviously, we've seen price increases over the last several years due to asphalt inflation. I think this was a slightly different type of price increase than we've seen historically the last few years. have been sort of inflation asphalt driven into a declining market environment. This time I think we saw pricing increases into what was clearly a good market. I do think that we executed on that very, very well. We set targets for each of our divisions. We got a lot of buy-in across the organization for how we were going to implement. We put tracking in place. to ensure that we were doing the right things. And we had daily updates on how we were executing to make sure that we were following up on the opportunities that were presenting themselves.

Next question will come from the line of Kevin Hausbar of North Coast. Please go ahead.

Hey, everybody. I wanted to I wanted to come back to the gross margin outlook for the fiscal first quarter. I guess I just wanted to make sure I understood it right. Because if I look at normal, it looks like, you know, 25.5% gross margins in the fourth quarter got into around 25 in the first. So decline of 50-ish basis points quarter over quarter. It looks like, you know, normal seasonality dictates. That's usually pretty similar, it looks like. If I go back, sometimes it's a little above, sometimes it's a little below. 1Q versus 4Q. And it seems like maybe one of the big drivers was the positive price cost, which I would have thought would have only benefited a small part of the quarter in the back half of this most recent quarter. So I would think that that would be a tailwind sequentially into the first quarter as you get the full quarter's benefits from that versus what you saw in the fourth quarter. So it's Is the normal seasonality, is it reasonable to think that normally it's flatter sequentially and then it would sound like then these other one-time items that go away, some of the timing benefits might be more than offsetting, you know, having a full quarter of price cost. So I'm curious, I just wanted to get your thoughts on, make sure I'm understanding all the moving pieces right as we think of gross margins.

So thanks, Kevin. So think about it like this. The price increase went into effect in mid-August. And so obviously as we start selling out our inventory at that point, we're getting a full benefit before all of that cost comes in and we reweight all of our inventory as it goes out. So that is where the big benefit comes from in Q2. we continue to see some of that benefits in Q1 as we continue to work through the inventory that we had pre-price increase. But that obviously diminishes as the full inventory cost starts to catch up a little bit. So that's really where the compression comes from. Yeah, typically, as you look at fourth quarter, I think you're right that it's about flat sequentially. I mean, what really happens is that as we get into kind of a late November, post-Thanksgiving, December timeframe, the residential mix tends to drop off pretty quickly. And so we see that material, obviously that's a high-margin component of our business, generally we see towards the end of the quarter that drop off. So that combined with the timing of our inventory kind of leads to us saying sequentially down because the timing benefit primarily goes away.

Our next question will come from the line of Selden Clark of Deutsche Bank. Please go ahead.

Hey, thanks. Could you just help us think through the impact on working capital next year and maybe how we should think about free cash flow for 2021?

Yeah, I think on the free cash flow side, it might be sort of easier to just think about conversion rates. I think if you were in the 60% range next year in terms of free cash flow conversion, you'd probably get to the right neighborhood. Obviously, interest costs, you know what that's going to be just based on what you've seen. We're probably going to be a... a bit of a higher taxpayer next year. And I think you'll see a little bit more CapEx. This one was a bit artificially low on CapEx, given that we really curtailed CapEx spending in Q3 and Q4 a little bit. So CapEx is going to be a little bit higher year over year. And then I think the conversion of about 60, and I'm really talking about EBITDA to free cash flow, should be in that 60% range.

The next question comes from the line of David Manthe of Baird. Please go ahead.

Thank you. Good evening, everyone. Two questions. First off, could you give us price realization year-over-year, res, non-res, complementary? And then second, on the gross margin, Can you tell us approximately what was the gross margin benefit from rebates? And then also, Frank, when you gave the list of positive margin factors, you did not mention private label. And I'm just wondering, why not? Was it too small or what?

Yeah, I think on the private label piece, you know, any time our private label sales increase, which they clearly did, as Julian mentioned, We do get some margin lift that's clearly embedded within that. Apologies for not breaking that one out separately, but digital is helpful there. Private label is helpful there. Mix is helpful there. There's a lot of different factors. We were trying to give you some of the major moving parts there, especially the ones that may be unique to the quarter and not repetitive. In terms of the vendor incentives, as you know, vendor incentives are largely derivative of what we sell in the quarter as compared to what we buy in the quarter. So in this particular quarter, given the fact that we had significant year-over-year sales, we did have higher vendor incentives from those sales. There may also have been a little bit of catch-up from Q3 just based on the outlook that we had for sales at that point in time. But largely, it was because we had such a significant sell-through of asphalt shingles in the core.

Our next question will come from the line of Catherine Thompson of TRG. Please go ahead.

Hi. Thank you for taking my questions today. The first is just really on logistics. Could you give the status of trucking constraints and how this has impacted your interiors business versus your exterior products. And then could you clarify differences really in transportation as to getting products from your suppliers and how you're doing in terms of just getting product to your end customers? Thank you.

Thanks for the question, Catherine. And to be quite frank with you, we're not experiencing a lot of inbound freight challenges today. Primarily on the exterior side, it's more related to available supply from the manufacturers in terms of their production capacity. Obviously, all of the manufacturers, not just in the exterior, but also our interiors business, cut their production in the April, May timeframe. As the market rebounded, particularly in the residential space, obviously the market got tight and there's been some disruption in that. But it's more related to supply from the manufacturers than it is directly to trucking. And we're not having any problems once we get the inbound trucks into our facilities on getting them out. Well, we are having a few issues. It's just around that supply is getting the inventory balance right across the country. And that's probably a little bit related to, again, the supply situation, not so much the inbound freight challenges. We were very happy with our ability to service all the customer demand with actually fewer trucks and fewer truck miles for the fleet that we own and lease. We actually delivered some pretty nice productivity in the last couple of quarters, operating fewer trucks, fewer miles for essentially the same delivery. So pretty good all around.

Next question will come from the line of Ryan McHale of William Blair. Please go ahead.

Hey, thanks. Two questions from me. First, I realize the commercial outlook is murky, but as things normalize, is there a meaningful pent-up demand opportunity in your view? And then second, how much is price adding to resi sales in October?

So I'll address the commercial question. Like you said, we're paying for NOx. Do you think that we're seeing that outlook stabilize? What we're seeing on a market basis is really a lot of job deals. When a job is cleared to ship, it tends to go very quickly right now. I do think we've seen some of the statistics that we follow. The architectural billing index, for example, that's bounced back. That's starting to head back to kind of what we see as some more normal levels, I think. I think we're just going to see perhaps not the steep double-digit declines that we had seen for the last couple of quarters. But I still think we're going to see it down for the next several quarters looking forward. I think partly because a lot of that new construction that would normally flow through just got pushed up. So I just think we're going to see an air bucket in the near term. In the longer term, I think it bounces back. I don't think there's anything about this pandemic that's going to fundamentally alter how people sort of work ultimately. I think there might be some delayed investment, particularly in roofing. that might be pushed off for the next quarter. So it is okay. It's certainly not going to be off as much as it has been. We think that's coming back a little bit, but certainly a little bit of weight. And on your October question around residency in general, as Julian mentioned, you know, sales up double digits. I'd say, you know, kind of a one-third, two-third would be the right way to look at it, kind of one-third price, two-third volume.

Your next question will come from the line of Keith Hughes of Trist. Please go ahead. Keith Hughes of Trist, please go ahead.

Yes, you had referred in the prepared comments on realizing $20 million of savings on the low-performing branch initiative, I think 30 to 60 was the goal. Whatever you end up in that range, do you think you can get the majority of it in the next fiscal year?

Thanks for the question, Keith. If I heard you right, you just asked about our performing branches, and we said we got 20 of the sort of 30 to 60 that we'd forecast for our target. I don't think we'll get all of that, the remainder. in the next year. I mean, obviously, we're bouncing back a little bit from the COVID situation, so I think there's a little bit of a challenge. I do think we can see continued progress amongst some of those branches. We're also going to make sure that we expand the group that we're working with to have make sure that we're releasing this as quickly as possible. I think we can certainly see something similar, but I don't see us getting all 60, as you indicated, within the next fiscal year now.

Our next question will come from the line of Philip Ng of Jefferies.

Please go ahead. Good evening, everyone. Congrats on the very strong quarter. The single manufacturers have a 46% price increase for February. I'm just curious, Do you have increases yourself? Do you see that as an opportunity to continue to drive further growth margin expansion? And when we think about some of your other businesses, whether it's commercial or your interior exterior business via drywall, ceiling, non-res, do you see an opportunity to kind of replicate some of that success you've had on pricing and gross margins as we look at 2021?

Thanks for the question, Bud. So let me start with shingles and I'll broaden it out. Yes, we have got one or two manufacturers who have announced a February price increase. Quite honestly, sitting here in mid-November, I think it's a little early for me to prognosticate on how that will be. As I said in prepared remarks, as well as the increase, we did show good execution. i don't see any reason why if that increase goes into place and if the market's uh conducive why we shouldn't execute very well but it's a little early to know that that's going to go in place and february isn't uh isn't the strongest month of the year from a demand perspective so uh i'll play a little bit of a wait and see attitude on where that goes with regards to the rest of the the product lines and we have seen price increase announcements It's still early in terms of execution. Obviously the market and the residential side of things is still reasonably good. So obviously price increases into a reasonably good market always have more chance of success. I think we're going to continue to emphasize that. As I said in my prepared remarks, our leadership team is very focused on that and very focused on the execution and driving that through the organization. So certainly if we do see price increases and we get them from our manufacturers, we would intend to push those price increases through into the marketplace to make sure that we can recover our costs and get paid fair value for what we do. I think on the commercial side, again, I really do feel today that it's pretty murky. I keep saying that because it is. So I think that we've got some opportunities in markets, but I think there's also some opportunities for leakage in that as well.

My next question will come from the line of Truman Patterson of Wells Fargo. Please go ahead.

Hi, good afternoon, everyone. Thanks for taking my question. Just wanted to touch on your adjusted OPEX, you know, POS. It was essentially flattish year over year on very similar revenues. You all mentioned that your lower quintile branches, underperforming branches, I think you were able to drive $20 million in EBITDA improvements. uh for the entire year but you know i guess where i would have expected you know opex leverage in the fourth quarter if that were the case where were the real offsets and how can we really think about this going forward as we move through 21 um really thinking of some of those covid costs coming back online yeah that's right good question um

A lot of moving parts in Q4, let me walk you through those. We were really happy with the labor productivity and the fleet productivity. You know, fewer people, lower overtime, better sales per hour, all the things that you've heard us talk about, lower fuel costs, lower TV costs. Felt really good about the things we were doing on the productivity side. And then when you look at the primary offset to that, it was really higher incentive compensation. If you put yourself back three or four months ago and we were in the depths of COVID, incentive comp wasn't one of the things we were worried about at the time and didn't have a real good prognosis for the rest of the year. So obviously on a sequential basis, we were in a very different place on incentive comp. and the same holds true on a year-over-year basis. When I look at 21, certainly the first quarter, I would estimate for you that OPEX should be lower year-over-year, both from a dollar perspective and an OPEX-to-sales perspective, and I would tell you the same on a quarter-over-quarter basis. From the year-over-year perspective, You're going to continue to see the labor and the fleet productivity. You're going to see us deploy the lessons learned from COVID as we winterize, especially in the northern half of the country. And you're going to see continued lower travel and entertainment costs. If I looked at it on a quarter-over-quarter basis, so how do we do sequentially, you know, the incentive cost is going to reset to targets, and we're going to have more variable costs just given the fact that you have lower seasonal sales in Q1 versus Q4.

Your next question will come from the line of Trey Grims of Stevens. Please go ahead.

Hey, thanks for taking my question. So I just wanted to touch on the supply situation. You've referred to it several times, of course, and just more color, if you could, on that. And are you expecting this to impact or put a governor on your sails at all as maybe new revs starts, you know, the ramp we've seen there really start flowing through to you guys? Or should that kind of normalize as we get into the seasonally slower demand periods?

Thanks, Craig. So certainly at the moment, I think, as Frank said, we sold everything we bought in the fourth quarter, and we've seen a pretty strong start to Q1 in the same vein. It's sales up 6.5% in October. So obviously, as we start to see winter impact the overall market, sales side of things, inevitably we're going to be able to get four shingles and there is demand in the marketplace. I think that's going to happen. So I think that both the manufacturers and the distribution channel is going to be able to replenish some of it. Now, I think we're at very low levels. I think the manufacturers are at very low levels today. I think the distribution channel is at very low levels today. And so, you know, there's some work to do to replenish. And then I think it's a big question is, as you emerge from... the February time frame into March, we see sales tick up quite sharply between February and March and then March and April. Given the outlook for new housing and given the outlook for repair and replacement markets, I think we could be looking at some level of continued growth supply challenges over the early part of the year. Now, that's all assuming that those sales do actually come to pass and the housing market continues to be as strong as it is today. I think we'll wait and see on that. I think there'll be some replenishment over the next couple of months, the sales decline, and then it'll really be a tale of how the spring selling season really starts to break out after winter.

And your next question will come from the line of Garik Shmury of Loop Capital. Please go ahead.

Hi, thanks. Congratulations. I'm just wondering if you could talk about if there's any carryover of storm demand impacting your guidance and how to think about geographic mix in fiscal 21, just given, you know, especially the shock decline in the spring and some of the northern and west coast markets due to COVID.

Thank you, Garik. Certainly, we saw, obviously, the storms that hit Louisiana, particularly towards the middle to the back half of... Q4 creates some demand in those markets. We would expect, as all hurricane-related demand, that tends to drag out. So we would expect to see that continue, given that it's in the southern part of the U.S. and less impacted by weather. We would expect to see some of that come through in this quarter, for sure, and we're certainly anticipating that. Part of it is going to be the availability of supply as well, and making sure that we can get product into that region. Obviously, the heavy building materials we deal with don't travel too fast, cost-effectively, so we want to make sure that that's positioned appropriately. As we look out, we thought that throughout the year, the storms were about average. I think that we would probably say given the hurricane towards the end of our fiscal year, it might have been a stronger calendar year than a normal year. But I think that, you know, so far we saw within our fiscal year, a pretty normal storm year. Obviously, it's starting out a little bit stronger, but it's a long time. We've still got a lot of the hailstorms in the spring to work through to decide if it's going to have a meaningful impact on our outlook. I would tell you, coming into the planning process in this, we always go back to an average storm year. and base our plan based on what we think a normal storm year is.

That concludes the question. I would now like to turn the call back over to Mr. Francis for his closing comments.

Thank you, Gabriel, and thanks to everyone for joining our call. I want to especially thank our customers who have endured a very challenging environment and faced uncertainty with courage. and also our supplier partners who faced whipsawing demands and did their utmost to ensure our partnership navigated the past few months successfully. To our employees, I'm incredibly grateful for your commitment to help our company thrive, and we hope all of you on the call and all our employees, customers, and suppliers are staying healthy. Thanks very much.