Acuity Brands, Inc. (AYI) Q4 2017 Earnings Report, Transcript and Summary

Good morning, and welcome to Acuity Brands' Fiscal 2017 Fourth Quarter Financial Conference Call. After today's presentation, there will be a formal question-and-answer session. [Operator Instructions] Today's conference is being recorded. If you have any objections, you may disconnect at this time. Now, I would like to introduce Mr. Dan Smith, Senior Vice President, Treasurer and Secretary. Sir, you may begin.

Thank you, and good morning. With me today to discuss our fiscal 2017 fourth quarter and full-year results are Vern Nagel, our Chairman, President and Chief Executive Officer; and Ricky Reece, our Executive Vice President and Chief Financial Officer. We are webcasting today's conference call at 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 and today's press release, which identify important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements. Now, let me turn this call over to Vern Nagel.

Thank you, Dan. Good morning everyone. First of all, I apologize, I'm fighting a little bit of a cold here, but we will work through this. Ricky and I would like to make a few comments, and then we will be happy to answer your questions. While our results for the fourth quarter and the full-year were records, we had higher expectations coming into 2017. Market conditions were far more subdued from a growth perspective than most had originally expected, as demand remained flat throughout much of the year. Our results for the quarter and the full-year reflected solid performance given these market conditions, while our strategic accomplishments this year were very significant as I'll describe later in the call. I know many of you have already seen our results, and Ricky will provide more detail later in the call, but I would like to make a few comments on the key highlights, first for the fourth quarter. Net sales for the fourth quarter were a record $958 million, an increase of almost 4% compared with the year-ago period. Reported operating profit was $153 million compared with the $135 million in the year-ago period. Reported diluted earnings per share was $2.15 compared with the $1.89 in the year-ago period. There were adjustments in both quarters for certain special items as well as certain other add-backs necessary for our results to be comparable between periods, as Ricky will explain later in the call. And adding back these items, one can see adjusted operating profit for the fourth quarter of 2017 was $176 million, a quarterly record, compared with adjusted operating profit of $157 million in the year-ago period, an increase of 13%. Adjusted operating profit margin was 18.4%, an increase of 150 basis points compared with the margin reported in the prior year. Adjusted diluted earnings per share was a quarterly record of $2.55, up 15% from the year-ago period. For the full-year, Acuity's net sales were a record $3.5 billion, up almost 7% from 2016. Reported operating profit was $519 million compared with $475 million in the year-ago period, while diluted earnings per share was $7.43, up 12% from a year-ago. Adjusted operating profit was $592 million, up 7% from a year-ago. Adjusted operating profit margin in 2017 was 16.9%, the same as the year earlier. Our adjusted variable contribution margin was about 17% for the full-year, not bad after a weak first half. Adjusted diluted EPS was $8.45, up 8% from 2016. In addition, we'd generated a solid $316 million in net cash provided from operating activities this year. We closed the year with $311 million in cash on hand even after repurchasing $358 million of the company shares, investing $67 million for capital expenditures and funding $23 million in dividends this year, leaving us with plenty of financial firepower to execute our growth strategies. Lastly, I'm pleased to report that we once again earned much more than our cost of capital. Our adjusted cash flow return on investment for 2017 was almost 35%, a record, and up about a point from that earned in 2016. We believe this level of return is far greater than others in the electrical industry. For those who follow EVA, we generated over $170 million in positive EVA, an astounding achievement. Looking at the key highlights for the fourth quarter, net sales in the quarter were up almost 4% over the year-ago period, overall sales volume grew approximately 5%. This was offset by approximately one point for changes in the price mix of products sold. While it's not possible to precisely determine separate impacted changes in the price and the mix of products sold, we estimate impact of price mix was primarily due to changes in product price, primarily for more basic lesser-featured LED luminaires sold in certain channels. Overall, the increase in net sales was reasonably broad based, some of our key product lines and sales channels in the U.S. and Canada with normal variability within each grouping. Additionally, we believe overall market demand remain soft during the quarter. To add a bit more color on this, while available market data does not line up perfectly with our quarters, initial information from various organization, while varied suggest shipments of lighting fixtures in the United States was flat to slightly down when compared with the year-ago period, and consistent with the level of demand sequentially from the third quarter. Nonetheless, we were still able to grow our net sales in U.S. and Canada by approximately 5% this quarter far outpacing the growth rate of the overall lighting industry allowing us to continue to gain market share. I will comment more on our expectations for 2018 later in the call. Sales of LED products grew robustly again this quarter, and now account for more than two-thirds of our total net sales, which as you know includes the sale of non-fixture related products and solutions as well. Lastly, we believe our channel and product diversification as well as our strategies to better serve customers with new, more innovative, and holistic lighting and building management solutions, and the strength of our many sales forces have allowed us to yet again achieve solid sales growth and market share gain this quarter, particularly against the backdrop of a soft market environment. Our profitability measures for the fourth quarter were solid, but impacted by current tepid market conditions. Our adjusted operating profit for the fourth quarter was a quarterly record of $163 million, up almost $20 million compared with the year-ago period, while adjusted operating profit margin for the quarter was 18.4%, up 150 basis points from the adjusted margin in the year-ago period. The increase in the adjusted operating profit margin was primarily due to lower operating expenses as a percentage of net sales, partially offset by lower adjusted gross profit margin. Gross profit margin for the fourth quarter was 42.5%, a decrease of 100 basis points compared with the year-ago period. Gross profit and gross profit margin were negatively impacted by higher cost for certain items including product warranty and commodities, particularly steel and to a lesser degree the impact of price mix changes. This was partially offset by lower cost for certain components and productivity improvements primarily from previously announced streamlining actions. We continue to aggressively address these issues by accelerating programs to reduce cost, particularly for certain basic less differentiated product families and to expand our overall competitiveness and to improve our profitability. Next, adjusted SDA expenses were down $15.2 million compared to the year-ago period. Adjusted SDA expense as a percentage of net sells was 24.1% in the fourth quarter, a decrease of 250 basis points from the year-ago period. The decrease in adjusted SDA expense was primarily due to lower incentive compensation expense, partially offset by greater salary and healthcare cost due to continued investment in additional head count that support and drive our tiered solution strategy. Our incentive compensation program is based on period-over-period improvement for our key financial metrics, which are an integral part of our pay-for-performance culture. Our performance this year has resulted in a much lower earned payout than in the year-ago period. Our adjusted diluted EPS was $2.55. A quarterly record compared with $2.21 reported in the year-ago period. The increase was primarily due to a 12% increase in pretax income and lower shares outstanding, partially offset by a higher tax rate in the quarter. The lower average shares outstanding was due to the stock repurchases in the third quarter. Before I turn the call over to Ricky, I would like to comment on a few important accomplishments this year. On the strategic and technology front, we continue to make great strides setting the stage for what we believe will be strong revenue growth and profitability over the long term. We continued our rapid pace of introducing new products and solutions along the entire value chain, expanding our industry leading portfolio of cost effective, innovative, energy-efficient luminaires and lighting control solutions as well as our building management capabilities. Many of these solutions are connected to our IoT software platform as innovation continues to be at the forefront of our tiered solution strategy. While sales data for our tiered solutions is still imprecise and expanding off a small base, we believe sales in our Tier 3 category encompassing our holistic integrated solutions were up almost 30% this quarter and now represent 15% of our total sales. In May, we announced our Atrius brand, encompassing our portfolio of IoT business solutions and our Atrius software platform, which as you know has been developed over the last few years. This software platform is a robust, scalable, and secure platform that enables an array of capabilities including indoor positioning, asset tracking, space utilization, spatial analytics, and energy management. For example, the Atrius solution builder provides a comprehensive development environment for customers and partners to build IoT solutions that consume data from our vast sensory network and from other third-party sensors. In fact, since the introduction of this incredible platform a growing number of some of the industry's leading technology of software providers are utilizing data from our Atrius IoT platform and using our software solutions to deliver their own unique and valuable capabilities and solutions to their customers. Interest in our Atrius platform is significant and we expect to continue to add additional user partners. Through our Atrius platform, we will continue to provide and expand our comprehensive set of IoT business solutions built on our unique capability to collect extensive and valuable sensory data through intelligent luminaires, lighting and building management controls, software platform services and development, developmental tools. These solutions deliver connectivity and intelligence to a space be an expansive network of smart LED lighting and controls and a software platform that gathers, unlocks and transforms large data to enable a broad range of software solutions addressing critical business challenges all while delivering a superior visual environment and significant energy savings. Atrius solutions have already - has already been deployed across nearly 90 million square feet of indoor spaces leveraging more than 1.7 million network sensors. Additionally, the installed base of Acuity Brands network lighting systems encompassing more than a billion square feet can now be upgraded to a more multi-functional Atrius sensory network that can supply IOT data to this robust platform. From a commercial perspective, we have deployment and active pilot with several of the largest U.S. base and certain European retailers as well as other key vertical applications including certain airports. These commitments and orders from both customers accelerating the expansion of their current platforms as well as customers moving beyond pilot programs to implementation deploying the Atrius IoT Platform, including our comprehensive lighting and building management solutions look for unique and value added capabilities and solutions to enhance their businesses and potentially allowing us the opportunity to meaningfully expand our installed base of Atrius enabled systems over the next 12 to 18 months. And this does not include the potential growth opportunities for new customers and partners again from which, there is great interest in deploying our Atrius platform and solutions. Importantly, we have added and will continue to add new technologies, capabilities and analytical features to our Atrius Solution platform creating a more comprehensive full suite of IoT solutions that are well beyond proof of concept stage that we believe will continue to contribute to accelerate growth in our Tier 3 and 4 solutions. Lastly, we continue to expand our industry leadership position in our Tier 1 and Tier 2 products and solutions particularly for lesser featured entry level products, we have been able to create these capabilities while providing industry leading results because of the dedication we resolve for more than 12,000 associates who are maniacally focused on serving, solving and supporting the needs of our customers. I'll talk more about our future growth strategies and our expectations for the construction markets later in the call. I would like to now turn the call over to Ricky before I make a few comments regarding our focus for fiscal 2018. Ricky?

Thank you, Vern and good morning everyone. As Vern noted, we had a record fourth quarter and full-year results, however I had some further insights to our financial performance for the fourth quarter and year ended August 31, 2017. As Vern mentioned earlier, we had some adjustments to the GAAP results in fiscal 2017 and 2016 which we find useful to add back and order for the results to be comparable. In our earnings release, we provide a detailed reconciliation of non-GAAP measures for both the fourth quarter and full fiscal year. Primarily, due to the impact of the four acquisitions completed in fiscal year 2016, we experienced noticeable increases in amortization of acquired intangible assets, share based compensation expense since we used restricted stock as a tool to improve retention and to align the interest of key leaders of acquired businesses with those of shareholders, special charges as we streamline and integrated recent acquisitions, other acquisition related items including acquire profit in inventory, professional fees and certain contract termination cost and impairment of intangible assets as we rationalized acquire trade names. Additionally, fiscal 2017 adjusted results exclude a gain associated with the sale of an investment in an unconsolidated affiliate. We believe adjusting for these items and providing these non-GAAP measures provide greater comparability and enhanced visibility into our results of operations. We think you'll find this transparency very helpful in your analysis of our performance. In addition, many of our peer companies especially as we become more of a technology company make similar adjustments so will help as you compare our performance to other public companies in our industry. During the fourth quarter and full-year of fiscal 2017, the company recorded a pretax special charge of $9.6 million and $11.3 million respectively, the fourth quarter charge consists primarily of severance and employee related benefit costs for the elimination of certain operations and positions following a realignment of our operating structure including positions within various SD&A departments. We expect to realize annualized savings well in excess of the fourth quarter charge, we intend to reinvest these savings in our business primarily an additional headcount to support and drive our Tiered solution strategy. During the fourth quarter and full-year of fiscal 2016, the company recorded a pretax special charge of $4.9 million and $15 million respectively for actions initiated to streamline the organization including the integration of recent acquisitions. We had miscellaneous expense of $2.2 million or $0.03 per diluted earnings per share reported in the fourth quarter of fiscal year 2017 was comprised primarily of losses associated with changes in foreign currency exchange rates. In the fourth quarter of last year, we reported net miscellaneous income of $0.1 million. The effective tax rate for the fourth quarter was 36.4% compared with 34.8% in the fourth quarter of last year, we expect the effective tax rate for fiscal year 2018 to once again be 35.5% before any discrete items and if the rates in our taxing jurisdictions remain generally consistent throughout the year. Net cash provided by operating activities total $316.2 million for fiscal year 2017 compared with $345.7 million for the year-ago period. At August 31, 2017 operating working capital defined as receivables plus inventory less payables was $40 million higher than the prior year and equaled 44 days compared with 38 days a year-ago, most of this increase was in inventory due to a build up early in the fiscal year to support increased sales volumes and improved service to customers. We were able to reduce inventories by approximately $25 million in the second half of fiscal year 2017 while improving our service levels which exhibits the power of our supply chain using Acuity Business Systems and the application of lean principles. In fiscal year 2017, we spent $67.3 million on capital expenditures which is a reduction of 20% compared to the prior year. This decline in capital spending was primarily due to reduced spending associated with facility enhancements compared to the year-ago period. Capital spending as a percentage of sales was 1.9% in fiscal 2017 and we currently expect to spend approximately 2% of sales in fiscal year 2018. In fiscal 2017, we repurchased 2 million shares of our common stock for $357.9 million and paid dividends of $22.7 million. We returned to our shareholders in the form of stock repurchases and cash dividends over $318 million which is significantly more than the $316 million of cash we generated from operations in this year. At August 31, 2017, we had a cash and cash equivalent balance of $311.1 million a decrease of $102.1 million since August 31, 2016, the decrease was due primarily to cash used to repurchase stock, invest in capital expenditures and paid dividends. Our total debt outstanding was $356.9 million at August 31, 2017. Our debt to total capitalization at fiscal 2017 year-end was 17.7% and net debt to capital was 2.7%. We had additional borrowing capacity of $244.7 million at August 31, 2017 under our credit facility, which does not expire until August 2019. We clearly enjoy significant financial strength and flexibility and we will continue to seek the best use of our strong cash generation to enhance shareholder value. Thank you. And I'll now turn it back over to Vern.

Thank you, Ricky. At Acuity, we remain very bullish regarding our future, despite recent market softness. We continue to see significant long-term growth opportunities that are ever changing and evolving in a positive direction for our company. We are often asked about the vitality and conditions of the key end markets we serve. We now know that the overall growth rate of the lighting market over the last two quarters was essentially flat and even slightly down compared with a year-ago periods. This was considerably different from the growth rate anticipated by various forecasting organizations at the start of the year. Many reasons have been cited for this softness including among others, lack of skill labor, uncertainty over tax regulations and pricing pressures in certain end markets for certain less feature products. While all of this is true to varying degrees, we continue to pull our vast customer base and excuse me and from the majority we hear optimism regarding the prospects for future growth. Generally speaking, the trades are busy and backlogs are favorable. Having said that, well forecast from various data sources we collected very widely, the consensus estimate suggest that growth through the lighting fixture market, could remain sluggish for the next few quarters especially giving the devastating impact of recent hurricanes in certain areas and then rebounding in the second half of our fiscal 2018. Therefore, we remain bullish regarding the company's long-term prospects for continued profitable growth particularly as we bring more value-added solutions the market for both new constructions and a conversion of the installed base. While this tamped market conditions may be with us in the short-term, we continue to see science that give us optimism regarding the future growth of the markets we serve. Leading indicators for the North American market such as architecture billing index, vacancy rates, office absorption, lending availability and favorable employment cost continue to improve at varying paces, which gives us optimism for growth beyond the current market as dealers for 2018. So, following few of our key assumptions for our fiscal 2018, given the information I just noted. We expect the lighting market North America are largest market to experience low single-digit growth for a full fiscal 2018, reflecting the expected rebound in the second half for the year. Additionally and most importantly, we expect the continued outperform the overall growth rate of the markets we serve. Next we expect the price of certain LED components to continue to decline go at a decelerating pace. While certain other costs including certain components and commodity cost are specially steel prices as well as certain employee-related costs primarily due to further investments in associate headcount, wage inflation and healthcare cost will increase somewhat. We expect to mitigate some of the impact of these rising costs through certain pricing initiatives, productivity improvements and product cost reductions, while the timing of these initiatives might lack the timing of these increased costs. Next, we continue to be leery of the impact of foreign currency exchange rate fluctuations, which are always unpredictable. Additionally while our gross profit margin is influenced by several factors, including sales volume, innovation, components and commodity cost, market level pricing, and changes in the mix of products and sales channels, we expect our annual gross profit margin to improve over time as volumes grow or mix evolves and we execute our tiered solutions strategies and as we realize typical gains in manufacturing efficiencies. Expansion of our gross profit margin is a key focus for us in 2018. Further, we continue to target a current variable contribution margin on an incremental dollar basis in the mid to upper 20% range over a full-year period knowing that is not possible to predict with precision what the rate will be by quarter. I would point out that our variable contribution margin in the second half of 2017 was 30% over the second half of 2016. Next, our adjusted SDA expense as a percentage of sales was approximately 25.4% in 2017. This is below our recent annual trend, primarily due to much lower incentive compensation expense. Trust me, we are motivated to drive strong period-over-period growth, which is at the core of our pay-for-performance culture. This would result in much higher incentive compensation expense in 2018 compared with 2017. So as you consider your financial models, we would expect our adjusted SDA expense as a percentage of net sales to be closer to our historical trend, assuming will continue to meaningfully outpace the growth rates of the markets we serve and we enhance our company wide productivity, helping us to expand our gross margins towards historical trend. So to be very clear, our focus is to garner additional top line growth, driven primarily by our ability to outperform the growth rates of the markets we serve, continue to move the mix of products and solutions as we execute our tiered solutions strategy, and to leverage our infrastructure achieving targeted incremental margins to improve our overall profitability. Looking more specifically at our company, we are very excited by and focused on the many opportunities to enhance our already strong platform, including the expansion of our tier 3 and tier 4 holistic lighting, building management, and Atrius IoT platform and software solutions. As I noted earlier, we are now converting certain customers to implementation from pilot programs. And we continue to expand the number of pilot programs with customers for these smart platforms and continue to experience strong interest for many other key customers and potential partners in multiple verticals to deploy our holistic solutions with these unique capabilities and more. As we have noted in our last several conference calls, the implementation of our integrated tiered solution strategy and our opportunities to meaningfully participate in interconnected world is an integral part of our overall growth strategy to meaningfully expand our addressable market by adding significantly greater broad-based holistic solutions that will allow our customers to optimize the performance of their facilities. As we noted earlier, while we are in very early stage of the game, we are seeing positive results in our growth rates for our tier 3 and 4 categories as well as the acceptance of our IoT enabled smart platform solutions, particularly with the launch of our Atrius platform. Our company wide strategy is straightforward. Expand and leverage our industry leading product and solutions portfolio coupled with our extensive market presence and our considerable financial strength to capitalize on market growth opportunities that will provide our customers with unmatched value and our shareholders with superior returns. This all takes focus and resources. We are investing today to enhance and expand our core competencies, affording us the opportunity to excel in our fast changing industry because we see great future opportunity. Through these investments, we are significantly expanding our addressable market. Our strong growth record supports this view. As I said before, we believe the lighting and lighting related industry as well as the building management systems market will experience significant growth over the next decade because of continued opportunities for new construction, more importantly, the conversion of the installed base, which is enormous in size, to more efficient and effective solutions. As the market leader in lighting solutions and a technology leader in building automation along with our Atrius platform, we are positioned well to fully participate in these exciting and growing industries. Thank you. And with that, we will entertain any questions that you have.

Thank you. [Operator Instructions] Our first question is coming from Ryan Merkel with William Blair. Your line is open.

Hi, thanks. Good morning everyone.

Good morning.

So first, I wanted to ask about Chinese competition at the low end of the market, and I am wondering what percent of sales would this impact and is lower pricing impacting the stock in flow business?

It's apparent there are all sorts of different information; I get emails probably like many of you do with china.com. It is becoming more and more clear that the folks there and some of these manufacturers are being subsidized, if you will, to come into these markets. We actually have seen some data around that. I believe that at the margin, it's probably impacting some of the pricing for certain channels for certain of these lower de-featured products. But I would say that, overall, when we look at our price mix and I talk to our customer base, they are seeing some impact but I would not say it's a material impact, whether the product has the quality and the features that they are after, too often to the untrained eyes, someone says, "I have this product at this price." But for most folks who are purchasing these kinds of products, they actually have a level of knowledge of what they are putting in. And so, they understand that potential price is not really indicative of the value that they are after. I can't give you a percentage of -- I actually don't know, of what some of these products' price point would be. We see them being fairly narrow in what they are targeting. And so, I don't consider this to be a meaningful impact on some of the things that we are doing. Price competition in the marketplace in general, I think continues to be probably at a bit more of an aggressive level overall as demand has slowed down a little bit. But for us, overall price mix, and we think that price mix it was a point was mostly priced mostly LED luminaires and mostly due to the -- if you will, decline in component level pricing, which we feel is decelerating. So, I know I am not giving you a specific answer to your question, but I see that the china.com sort of syndrome is in a very, very small select group of products.

Okay. No, that's helpful. I mean that's kind of what I was looking for, at least some direction there, and my thought process was that it was a smaller piece of what you do. And then secondly, when is the supply chain disruption going to be behind us? And when do you see gross margins rising year-over-year again?

Sure. So, I believe that the gross margin -- excuse me; the supply chain issues are behind us. We've actually seen great stability and improvement in our productivity. Some of the year-over-year cost that we had in increasing certain benefits to stabilize the workforce, we're now starting to annualize those, but when I -- when we look at our productivity within the supply chain, they are in a very favorable trend. A couple of other things that have impacted us, when we talk about price mix being about a point with most of it being priced, that's flowing through. It's being offset to a large degree by component cost savings, but when we look at steel, steel has definitely been eating into the margin capability. So, we are now looking to, if you will, cost out. As an example, redesign certain products that contain more steel than what we can design, if you will too. And we are also looking at certain pricing opportunities to evolve that. I am actually bullish, the long-term prospects for our gross profit margin because of our ability to leverage. Some of the margin issue just to also talk a little bit about warranty, you know, we've expanded and we've been growing in our outdoor and our utility space, and part of the warranty cost have been the event of extended warranties. So it's really just Acuity, if you will, meeting market conditions, but yet we recognize that if you will, warranty cost when we make that sale, and it's a higher portion of the expense than what it has been historically, where warranties have been in the more normal range of a year or so. So, I think that you are going to see gross profit margins improve for the full-year 2018. It's always impossible for us to predict. I know you all want us see it predicted to the tenth of a basis point each quarter, but I feel that the trends that we have and what we are focusing on will be favorable for us in 2018 and beyond. As I said in my prepared remarks, gross profit margin is -- and improvement there is an intense focus for us.

Okay. Thank you very much.

Our next question will come from Rich Kwas with Wells Fargo Securities. Your line is now open.

Hi, good morning everyone. Just a couple of questions; one on the market, Vern, can you give us some clarity on what's happening between renovation, retrofit, and new construction? Earlier in the year project activity is pretty robust and would seem like new construction on the non-res side is picking up some steam. What are the implications given the overall growth rate for the retrofit renovation market that seems that slowdown a bit here over the course of last few quarters, just an update there and your thoughts and the outlook for fiscal '18?

Rich, it's interesting to us. I have in front of me just some data that Dan provided to me, and when we look at, you know, this is -- excuse me, this is construction spent, it's for August, right. So, this not the lighting market, but it's just interesting, non-residential both private and public down in the month of August. July was not terribly dissimilar, but yet when we talk to the trades, when we talk to architects, engineers, contractors, people generally speaking are busy and backlogs are building. So, the release of some of these things are just taking a bit longer. It's all over the board, frankly. Again, in one market, folks will say, "Well, it's because we are having difficulty finding labor," and in other market they say, "No, that's not the issue, it's people waiting to see whether they are going to be able to get a pull right off of their renovation or the upgrading of their facility." So, all of this to us suggest that there is still pent-up demand. We believe that the smaller short cycle project has slowed down a little bit. Some folks have tried to guess, well, how much pricing as a part of that. There is probably a little bit of that, but generally speaking, the markets that we see and the markets that we serve and we seem them all by the way, have favorability, and yet the words in the music don't seem to quite match. And so, we sit back and say, "Okay, our customer base is telling us that they have these things, we can see this project cancellations don't seem to be happening. It seems that things are getting pushed out a little bit." So, at Acuity, we remain favorable on what the market trend is going to be, not in the very, very short-term but overall both for full '18 and going into '19, because of just again more of the macro type trends. And then we will get into specific aspects of the business. We see opportunities; I mean, look at our Tier 3 solutions there. That is project-based business typically, and it continues to grow at a favorable rate, people are interested in adding luminaires with technology. So, we are seeing growth there. It's on that smaller project side that we seem to be experiencing more of the slowdown. I just -- I see as we add more value into that chain or into the channel, I see growth continuing.

Okay. And then, just a follow-up, your comments around SD&A as a percent of sale, so this is a near-term trough this year, meaning fiscal '17, how should we think about the expected increase for 2018? Because you have some bogies for earnings growth, EPS growth, operating margins et cetera that you target to get paid, and I'm just curious, you know, do we think that the -- the SD&A as a percent of sale goes back that 27% range, or is that more subdued than that as we think about the next year?

Yes. Listen, for us to earn incentive compensation at Acuity, all salaried people are on some form of incentive compensation. It's all based on period-over-period improvement. So, just to make it easy for you, I will pick -- the three areas are operating profit dollars for most people, so growth in operating profit dollars, improvement in operating profit margin, and cash flow. And so, each of those things have to improve on a year-over-year basis, so there is a maniacal focus on driving solutions that's for the customers to make that happen. I think that as we think about where our business should be, we need to have top line growth and margin improvement to really earn, if you will, incentive comp. We are going to continue to invest in headcount along our tiered solutions strategy. This year, we added almost 400 folks to our salary headcount, almost 13%. I don't think it will be as much next year, that's why we are targeting our variable contribution margin to still be in that mid to upper 20s expecting to really leverage what we are doing. So, as I think about your models, I think that something north of 26% as a percentage of sales is probably in the range of reasonableness. I think 27 is probably a little too high. We are getting leverage as we grow our business on our SDA, but the key is how we continue to improve margins, we are seeing steel that kind of level off, which is favorable. I don't know if they will stay that way. We are driving productivity throughout our company, our supply chain is kicking along, I think that some of the warranty issues that we've had will still continue to pursue aggressively. The outdoor and the utility market, we are again - we are matching competitive, if you will, pressures around those things, but on a year-over-year basis as that basis grows, we will see additional warranty as a percentage of our sales. So, that will be a drag if you will on gross profit. So, your model, it's gross profit - it's top line growth, it's gross profit improvement because of the things that we are doing and it's leveraging our SDA, but leveraging at probably more in the 26-plus percent range.

Okay. Thank you for the color.

Our next question comes from Sophie Karp with Guggenheim Securities. Your line is open.

Hi, good morning, and thank you for taking my question. I have a question on your capital allocation strategy here, maybe have you guys considered raising your dividend or changing what you've been doing given that the cash flow is pretty healthy and the dividend yield is low, and it seems like the growth has been slow recently, so it that something that could be up for consideration?

So, each quarter, the board reviews our dividend policy, if you will. And so, we feel comfortable with where the dividend is. We continue to see really significant growth opportunities, I think if you look at over the last six years, seven years, we've deployed in acquisitions using both cash and our stock, but close to a billion or two, somewhere in that range, I think.

Right.

And so, the pipeline of opportunity, both for investment, partnership relationship, straight-out acquisitions, continues to be robust for us. But as you know, acquisitions are impossible to predict, and so they are lumpy. And we used almost $380 million in our third quarter to repurchase stock. So, our focus is how do we drive strategy of the business? So, it's acquisitions and commercial relationships first, stock repurchases second, and then lastly what is our dividend policy. I'm very proud of the organization in terms of what we delivered, our cash flow return on investment, and what was arguably a very tough market environment, we continue to manage our business very well, we paid for some of that through incentive compensation programs, but all of us believe strongly that the growth opportunities and the ability to drive superior returns on our invested capital are well-available to the organization. And so, most shareholders have encouraged us to deploy the capital back into the business, because we are generating such strong returns after that. But just to be clear, we look at that on a regular basis. Ricky, do you have any additional thoughts?

I will just reiterate that acquisitions is clearly been an area where we think we have created value over time, and is the highest priority. We see a lot of opportunities in the M&A space to continue to build out, whether it's filling product gaps, whether it's acquiring greater technology or access to market, and then geographic expansion is certainly an option, at one point today we are still 97%, North America focused as well. We are very strong here in North America. There is a huge growth opportunity for us geographically. So, we still see a lot of growth engines to use that cash flow in the M&A area.

Sophie, I would also add, we spent a lot of time talking with our shareholder base and both current shareholders as well as perspective shareholders and we talked a lot about this very topic, and given the growth potential that our industry has over the next decade given the significant position that we have in the broad industry, and it's being redefined by the way, and for the opportunities of the interconnected world coming to our space to add an investment into that, it's really a growth environment. So, the capital ebbs and flows a little bit, but we see the growth opportunity, that's really why we are, if you will, holding our powder dry…

All right, thank you, this is helpful. And then, my another question was, this environment where like you said the bookings seem to be strong, but they conversion to sales seems to be slow, I assume it's a little bit puzzling for I guess us, analysts and investors as well. Have you seen similar dynamic in prior cycles? And what could this be indicative of? And how in your experiences this could ultimately get resolved?

Yes. So, prior cycles have typically experienced a greater boom, if you will, then followed by a greater decline. This recovery, and I won't play economist here, you all know it better than me, but this recovery has been long and slow. And so, we do not necessarily see the speculative overbuild, I'm talking broadly, you can pick some market and say oh, no, residential is bubble again in this area. We just don't see the speculative overbuild broadly defined in both non-residential as well as residential. Obviously, some markets not withstanding. So, it feels to us like what is -- we've grown to a fairly high level in terms of dollar value, but why are we taking a breather right now? All of the indicators that we see the people that we talked to would suggest that this is a temporary law and I don't know that there is something historically that I can drawback on to say that ultimately this looks that way. In fact we have the opposite view. We see more and more people interested in writing solutions both new construction as well as if you will renovation of existing spaces to take advantage of energy savings, to take advantage of the IOT capabilities that Acuity is uniquely positioned to offer. We are just at a high level and we are kind of holding that pattern right and but we are not seeing the kind of growth that we think is pent up and available to us. The installed base is still significantly under converted. I think we are talking hundred millions of dollars of opportunity. Why is it not moving faster at this stage? I can give you all of the things I hear but it's impossible for me to say it's this specific reason.

Got it. Thank you. It's helpful. I will jump back on the queue.

Our next question comes from Matt McCall with Seaport Global Securities. Your line is now open.

Thank you. Good morning guys.

Good morning.

Vern, I just want to clarify, you hit the margin question a few times, but just making sure I have all the puts in the undertakes. So you talk about the 25% to 30% I understand it's on a full-year basis. But and you gave some insight into the SD&A while we expect that to be - talk a little bit about gross margin and the expectation I know you say is going to show some improvement next year, but maybe one or some of the components of that improvement, some of the offsets of headcount additions or if there are headcount additions there, just I know you are going to eliminate some issues this year that will help next year. I'm just trying to understand, what kind of visibility you have in that gross margin number. What kind of assumptions you having to make to get us into that 25% or 30% contribution margin for the full-year?

So historically over the last couple of years been able to reasonably be in that mid to upper 20 variable contributions. 2017, it was a rough start. So if you all remember coming out of the fourth quarter of 2016, the disruption at that point in time to the supply chain was heavy turnover particularly at a couple of our facilities in Mexico, where there are fantastic facilities. But other competitor, excuse me other companies were coming in there and competing for labor to look forward as an example was one of those folks, so they started to ram up then they pullback. So we've been able to significantly stabilize our workforce, we provided some additional benefits to be competitive, we have now in the second half of our fiscal 2017 addressed those issues and actually were driving productivity gains again. So we have offset some of those costs. I think the headwinds on the gross profit margin were mix, right. So, mix has a bit of an issue that flows through dollar-for-dollar at the gross profit level actually flows Q2 operating profit. Number two, we experienced, if you will, cost declines in certain LEDs, but those things are offset a little bit by the pricing in products, steel costs rose reasonably significantly in 2017, you guys could see the trend there you know how much steel we use. So, pricing in some of those markets for some of those products we're able to do some pricing, some price increases, in other areas we're offsetting that or looking to offset that through cost outs, through engineering redesign. So, our feeling is that steel prices maybe level off a little bit given overall market demand plus our ability to price, take pricing actions as well as our ability to cost out certain things, we see improvements there, traditional productivity improvements we'll continue to do that and some of the warranty costs while I would expect them because some of that has to do with us simply meeting market competitive levels around extended warranties is that portion of the business expands we'll still see a little bit of an uptick there. But I'm expecting that we will have improvements in our overall product quality that will help us drive improvements in our margin there as well. And then lastly, our expectation is that along our entire Tier solution strategy, we're continuing to make design changes, we're continuing to enhance the mix to more featured and more capable products and even in those areas where you have a feature Tier 1 solution set, our team is robustly focused on driving opportunities there to be extremely competitive with anyone who enters the market not just pricing those markets people care about quality, they care about delivery, they care about innovation, they care about training. So Acuity doesn't always need to absolutely be the lowest price to really be the best value for people and lot of our customer sets understand how to merchandize that the right way.

Okay. All right, that's helpful. And the other question I had, you mentioned the hurricane kind of the near term drag, any estimate of what the pressure is going to be, I think you said over the next couple of few quarters you could see some pressure if I heard you correctly any estimates on what the near term drag could be and is there a longer term opportunity at all, I wouldn't think there's much but…

You know Matt, at the end of the day I don't know what the end of the day will be all the stuff will level itself out but if you look at the port folks in Houston, you look at the port folks in Florida, Puerto Rico, our agents and their customers were out of business for a while. And now best business is starting to come back, it's coming back at a measured pace eventually all of that is stuff that was damaged there is going to need to be replaced and so that will be an accelerant ultimately. I just think that in the shorter term, I don't know is that a quarter, is that two quarters, I just think it will have some drag on the broad opportunity of those markets than converting to an accelerant as people start to repair out. I would also say labor in those markets is going to be a serious issue.

Ricky, you -- I've been in the hurricane tracker here lately you think like I was in Houston when Harvey hit and I was in Florida when Irma hit, so don't ask me to come to your city.

Okay, you're doing it wrong. And I'm sorry, Dan, for one more, I just want to make sure I understood some of these about the incremental margin, so the mid to high 20 that you're targeting that's an all-in number for the next year's expectation that is with the return of bonuses, that's an all-in expectation.

Correct.

Okay. All right, thank you guys.

Yes, we have to pay for our incentive compensation, it's not period over period results and in those results of improvement, you have to pay for your own incentive compensation. So that's correct, it's inclusive.

Okay, okay. Just clarified, thank you, Vern.

Thanks.

Our next question will come from John Quealy with Canaccord. Your line is open.

Hey, good morning, folks. First question please just big picture as we think about the investments that we're doing in people and process in '18 to support a number of different things, just big picture as we get into '19 does that cadence slowdown, revenue being put aside for this question but this investment period do we see a year type track or we're just going to keep doing it as long as the market is there?

Well, with that last caveat we will always invest as long as we see the market potential but our current expectation is that 2018 is still, if you will, a year of investing, I think that as you get into '19 and '20 we continue to invest that we start to harvest some of that investment, so our expectation is that, our variable contribution margins in that '19, '20 and beyond period start to expand fairly meaningfully. That does not mean by the way that we won't continue to invest in our business, it just means that we will be leveraging more and more of the phase that we have established. And this is throughout our business, it's interesting to me when I think about our company over the last just four years the non-residential market which is a benchmark that most of you use to gauge Acuity success on an inflation adjusted basis, it still hasn't come back to 2008 levels but yet in the last four years, we've grown our top line by two-thirds, we've improved our gross profit margin by 250 basis points, we've improved our operating profit margin by 400 basis points and our operating profit dollars are two and half times as high as they were. So, you think about the formidable base that Acuity has been able to create in a marketplace that began the way you measuring it under inflation adjusted basis, it's still not back to its historical high, I think that's a testament to the investments and the returns that we're getting off of our investments to expand our portfolio, to expand our access to market and to really drive our capabilities in this technology market. I mean, the fact of the matter is that Tier 3 sales today represent probably 15% or a little bit more of our business and yet those things didn't exist four years ago. So, we're getting to returns that are there and we want to continue to drive that in a robust way but the short answer to your question is we would expect as we get into 2019 and 2020 to start to see the variable contribution margin half of our business and half of the sales dollar improved.

Okay, thank you. My last piece on Atrius, so that 350 million square feet type number that we've talked about the last year, do you need other technologies to get there as you know building based locational services technologies pretty dynamic, what else can you put into that Atrius toolbox and does that expand the opportunity longer term? Thanks guys.

Yes, there are other technologies that we will continue to add, I prefer not to talk about that until we actually introduce those capabilities but I believe that what Atrius is really a quilt of capabilities, there will be no one particular silver bullet that says this is why you buy Atrius, you're buying Atrius because it can take advantage of a mass of sensory network ubiquitous nature of lighting and the fact that lighting will convert from conventional lighting to LED lighting because of the energy savings to pay for really that conversion and with the Atrius or with Acuity and Atrius enabled solution set, you get all these features and benefits that will continue to expand the features and benefits that users will have, again between building management and lighting and lighting control, we believe that's north of 85% of all the data that's being generated and building can be collected off of those systems and the Atrius platform allows us to enhance that using third-party sensors as well. So, our belief is that the Atrius platform literally will be able to collect 100% of the information being generated inside of building and then use at to build, help the building due to things that needs to do efficiency wise and then business solution wise, and now we're tying at into our outdoor capability so, we see this as a robust platform that will always be adding new technologies and new capability.

And I would add while we will be adding capabilities in all of this sensory platform. We were also be working with other technology partners to bring in some of their capabilities to enhance the overall solution capability that we can deliver using that sensory network of Atrius so, it's not all that we're going to need to do ourselves. We can partner with it and are partnering with other very formidable technology companies to help build out the full solutions suite and capability that we believe Atrius can provide.

Our next question will come from Vishal Shah with Deutsche Bank. Your line is open.

Yes, hi. Thanks for taking my question. I wanted to just better understand your Tier 2, Tier 4 pilot projects can you expand on and what you seeing there and when you can expect to convert some of those pilot projects into in your awards and then secondly on going back to question, the point of margins, you mentioned that you're going to have some pricing initiatives as part of the margin expansion strategy in 2018. Can you talk about what your feedback has been so far from the customers? And do we see the margin expansion more of towards second half 2018 story or do you see some of that playing out even before that? Thank you.

Yes. So, on the margin question, I'll address that first. Our expectations that all of the things that we're doing we'll continue to see margin improvement. I don't want to go on quarter-by-quarter and I think that's a very difficult challenge because mix place a big part in that but if I think about the full-year and the activities that we have going on we see favorable trends as I mentioned. Our productivity in our supply chain robustly positive, I think will start to anniversary some of these steel increases so, that should be less of a drag we're working hard as we create new products to think about how do we position that features and benefits but we have a cost process that allows us to improve our margins we're very focused on how do we cost out existing designs where these products still have a lot of life left in them, if you will, from a lifecycle perspective. So I think you're going to see an improvement that kind of fairly consistent basis I just Ricky would be reluctant to try and say what does that look like by quarter. You will see improvement. It's a maniacal focus that we have this year. And then the first question was…

Tier 3, Tier 4 and movement from pilots and…

So, it's interesting the discussions that we are having with many, many customers have expanded quite significantly the interest level, and if you will, technology-based lighting solutions where these things can be that sensory network is really had a frenzy peak there's, there are people that now the lean goes in the marketplace. So we're no longer having to it in July's when we walk into customers with our solutions that we're able to show them if you will very specifically how we're doing these things. So, the dialog now is how can this help me and so the pilot, the number of pilots are expanding and we are now having folks that are moving from pilot to actual implementation and it's very exciting I mean as we pointed out the number of square foot that we improved in just a quarter it was like a 30 some percent increase we went from 60 to 90 million square feet, 50% improvement so and no one else is anywhere even close to that just to be extremely clear so, we are excited that the growth rates and the acceptance of what is happening and again we're so early in this game that it's, it's very opportunistic for Acuity and our customer sets are responding more and more to it and I'm really excited about the number of partnerships that our team has expanded with, you'll continue to see us make announcements on these types of partners, which really expands our access to market, but more importantly, it really puts a sense of approval on what we are doing. And it's just not easy, I mean, unfortunately you saw that Equifax had an issue with people hacking; security on our systems and the things that we are doing here are truly industry-leading to be sensitive to these kinds of issues, and that's how we are differentiating -- one of the ways we are differentiating ourselves with our solutions.

Great, thank you.

Thank you.

I would like to turn the call back over to Mr. Vern Nagel for closing remarks.

Thank you everyone for your time this morning, and again, we strongly believe we are focusing on the right objectives deploying the proper strategies and driving the organization to succeed in critical areas that will over the long-term continues to deliver strong returns to our key stakeholders. Our future is very, very bright. Thank you for your support.

And with that, we will conclude today's conference. Thank you for participating. You may disconnect your lines at this time.