Good morning and welcome to Acuity Brands' Fiscal 2018 Second 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. And I would like to introduce Mr. Dan Smith, Senior Vice President, Treasurer and Secretary. Thank you. Sir, you may begin.

Good morning. With me today to discuss our fiscal 2018 second quarter results are Vern Nagel, our Chairman, President and Chief Executive Officer; and Ricky Reece, our Executive Vice President and Chief Financial Officer. We are webcasting today's conference call on our web site 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 in today's press release, which identify important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements. Now, let me turn this call over to Vern Nagel.

Thank you, Dan. Good morning everyone. Ricky and I would like to make a few comments, and then we will answer your questions. While we made progress on improving our top line growth in the second quarter, particularly against the backdrop of a continued weak non-residential construction market, our profitability performance was below our expectations. 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 few comments on the key highlights for the second quarter of 2018. Net sales for the second quarter were $832 million, an increase of over 3% compared with the year ago period. Reported operating profit was $88 million compared with $108 million in the year ago period. Reported diluted earnings per share was $2.33 compared with $1.53 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. In adding back these items, one can see adjusted operating profit for the second quarter of 2018 was $103.8 million compared to adjusted operating profit of $123.9 million in the year ago period, a decrease of 16%. Adjusted operating profit margin was 12.5%, a decrease of 290 basis points compared with the margin reported in the prior year. Adjusted diluted earnings per share was $1.89, up 7% from the year-ago period. For the first six months of fiscal 2018, net cash provided by operating activities was $178 million compared with $90 million provided in the year ago period. During the quarter, we spent $194 million to repurchase 1.2 million shares of our stock. Nonetheless, we closed the quarter with $230 million in cash…

Thank you, Vern, and good morning everyone. As Vern mentioned earlier, we had some adjustments to the GAAP results in fiscal 2018 and 2017, which we find useful to add back, in order for the results to be comparable. In our earnings release, we provide a detailed reconciliation of non-GAAP measures for the second quarter of both fiscal year 2018 and 2017. Adjusted results exclude the impact of amortization expense for acquired intangible assets, share based payments expense, acquisition related items, special charges for streamlining activities, and an income tax net benefit for discrete items associated with the Tax Cut and Jobs Act of 2017. 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 will 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 it will help, as you compare our performance to other public companies in our industry. The effective tax rate for the second quarter was a benefit of 23.1%. This benefit included $31.2 million or $0.75 per diluted EPS of net discrete items associated with the U.S. Income Tax Cuts. Primarily, due to an income tax benefit from the remeasurement of the company's net U.S. deferred tax liabilities to a reduced federal rate, partially offset by an unfavorable impact related to the taxation of the company's accumulated unremitted foreign earnings. Excluding this discrete benefit, the adjusted effective tax rate was 16.9% compared with 32.6% in the second quarter of last year. We currently estimate that our blended effective income tax rate, before discrete items, were approximately 26% to 28% for the remainder of fiscal 2018, and 23% to 25%…

Thank you, Ricky. The current weakness in the lighting industry has created a challenging environment for management to drive short term financial performance, while continuing to invest in attractive long term opportunities. Nonetheless, we are optimistic regarding our long term future, despite this persistent market softness, which has impacted our short term financial performance. We are often asked about the vitality and conditions of the key end markets we serve. On one hand, market data suggests that the overall growth rate of the U.S. lighting market over the last three quarters was down low single digits compared with the year ago periods. Many reasons have been cited for this softness, including among others, weak non-residential construction activity, lack of skilled labor, previous concerns over tax regulations, and current uncertainty regarding trade policies, substitutions to lower priced alternative products, and pricing pressures in some end markets for certain less featured products. On the other hand, while we believe all of this is true to varying degrees, we continue to pull our vast customer base and channel partners, and from the majority, we continue to hear guarded optimism regarding the prospects for future growth. Generally speaking, the trades are busy, the backlogs are favorable. As for our market expectations for the balance of 2018, we continue to see favorable trends in certain leading indicators, continue to hear from customers that large projects are set to release, and see some encouraging reports from third party forecasting organizations. Nonetheless, we continue to be cautious and believe overall market conditions could continue to be challenging for the near future, suggesting growth in the lighting fixture market may remain sluggish for the balance of fiscal 2018. However, most importantly, we expect to continue to outperform the overall growth rate of the markets we serve, primarily in…

[Operator Instructions]. Matt McCall with Seaport Global Securities. Your line is open.

Thanks. Good morning. It's actually Reuben on for Matt. So a lot of moving parts with the margins right now. Can you kind of update us, I guess, if the current environment continues? I know you have got inflation and freight and steel and employee costs. Can you help us with maybe where you are expecting contribution margins to be over the next year or two with the current environment?

Well, as we have pointed out in the prepared remarks, our focus is to really adjust the portfolio through new product introductions, both at the, if you will, lesser featured end of the market, as well as to continue to bring out solution sets that support the higher end of the market. Our Atrius-based solutions are in high demand. We are seeing very significant growth for these types of products. So we are looking to manage, if you will, the business in this, if you will, challenging environment. And so, I think you will see our margins, and as we said again in our prepared remarks, probably not change a great deal, unless we do see a pickup in some of the portions of the market, particularly for larger projects, where we typically enjoy higher margins, because of the differentiated nature of those products. So we are expecting that, by the way, to happen. From an SDA perspective, I'd like to just make sure everyone understands that. While our costs are up, we have added headcount over the year ago period. The increase in our headcount over the last few quarters has really flattened out as we continue to leverage our structure. So we are seeing a period-over-period improvement. But SDA, as a percentage of sale on an adjusted basis were at 27.8%. Typically, we are in the upper 26s, call it say, 27%, but the second quarter is typically our lowest volume quarter, our lowest sales volume quarter. So as a percentage, the numbers are a bit higher. As we look out into the third quarter and the fourth quarter, our expectation that SDA as a percentage of sales will come down more into the range that we typically have operated, which is in that, call it 26% to low 27% range. I would also caution folks that our third quarter is typically our highest expense quarter because we have certain events where we have like our national sales conference and we have light fair. These are expensive activities, and they typically occur in our third quarter.

Okay. And Vern, just to clarify, when you say you don't expect margins to change much unless you have an acceleration, is that from the Q2 levels or are you talking about on a year-over-year basis?

I think we are looking more on a year-over-year basis. Though our Q2 margins, obviously pressured compared to the year ago basis, were driven primarily by -- difficult for us to precisely gauge price versus mix, but we think in this particular quarter, it was about half and half. If you go back and look at it historically, we have typically experienced price mix in the 1% to 2% range. We have gone above that, but typically, that has been price related, and so this quarter, we saw again compared to the year ago period, a channel mix and a product mix movement that was in addition to, if you will, price. And that channel mix has to do again with the larger project portion of the world, and we hear from lots of people, that backlogs are strong, activity is good, and that these projects will release. It just hasn't released. We have great market share there, we have great value propositions, but we are just not seeing the release. And so, while again, people are encouraged, until we actually get the order and then shipment, that's when we will declare that the markets are moving back in a more favorable way.

Okay. Great. Very helpful. And then, on the share repurchase program, can you help us with -- you kind of touched on a little bit in your prepared remarks, how you view share repurchase versus M&A today, and maybe do you have an updated leverage target, given the extent of the potential share repurchase program?

Let me take a quick answer, and then Ricky, please chime in. If I look back over the last decade or so, Acuity has really done, I think an excellent job of returning capital to shareholders in very shareholder friendly ways. We have purchased over $1 billion worth of shares, almost 15 million shares over the last decade plus. We have done acquisitions totaling about $1.1 billion, $1.2 billion. We have returned dividends of probably north of $300 million and CapEx of about $700 million. So Acuity is always looking over the longer term for ways to optimize its return to shareholders. We are very optimistic about our long term growth opportunities. We see the technology side of our business really being in its nascent beginning. But yet, the optimism and the utilization is now starting to ramp up. We are very excited about that. So we are going to continue to invest in that, because we see it as a huge potential for us. So we want to make sure that we are balancing off, how do we invest in our business with the opportunity to take advantage of situations, where the marketplace in our view is misjudging, really the long term opportunities of this company. And so, this is why we are saying that it is -- we will continue to look to do share repurchases, because we see that as a long term valuation creating opportunity for our shareholders. We are -- Ricky, if you look at our balance sheet, we have historically been underlevered relative to sort of our industry norms, and so this share repurchase really gives us the opportunity to have a capital structure that may be more consistent with industry norms.

Yeah, I would add on to that; on the leverage side, we clearly want to maintain our investment grade rating. We have had some preliminary discussions with the rating agencies and so forth around that. So leverage would still be in line with what you would expect for an investment grade company. But as Vern said, higher than the very low leverage we have had in the past. So probably under two times leverage would be what you would expect versus us being more close to half turn of leverage in the past. So -- or willing to leverage up, I would say on the M&A, the pipeline continues to look good. We do have capability and the desire to continue to be active in M&A. We will be likely accessing additional capital, to make sure that we have the firepower, should we purchase the entire $6 million that we still have the firepower to be active in the M&A area. So I don't think our long term allocation of capital will change dramatically in terms of M&A and buying back shares, but as Vern said right now, the share repurchase looks like an attractive way to enhance shareholder value, and we believe we can do that, while continuing to be in the M&A market and seeking opportunities to increase value through M&A as well.

And let me just add one more comment, Ricky's intent would be to be opportunistic in the marketplace, to acquire shares, and do that over time.

Great. Thanks guys.

Your next question comes from Rick Kwas, Wells Fargo Securities. Your line is open.

Hi. Good morning. Just a question on price mix Vern. So should we think about mix being the sort of headwind going forward, and in combination with price, the down three to four is the way to think about it, or at least over the next few quarters? It just seems to me that, from a mix standpoint, it's going to be a little bit of a struggle to lessen that burden over the next few quarters, given the comps you face, and given the import competition out there? So I think, considering that it's pretty important to gross margin and hence how the stock is going to behave over the next several quarters, how should we think about this to right size our thought process when I am trying to model this?

We believe that the pricing environment has for -- that certain portion of the market that, we will call it a lesser featured sort of lower valued market, pricing competition there has remained fairly consistent, it has been aggressive. And so, that is primarily where we are seeing, if you will, price -- we have price in some other areas. There is a little bit of product substitution that's also influencing that. But I would say that it's more the channel mix side of it. We are guessing. I mean, it's really difficult for us to precisely pin down the difference between price changes, as well as channel and product mix. Now channel and product mix, which we guess to be approximately half of the 3.5%, so you can do the math around that. We think it's really the larger project side of the world, just continuing to be soft. When I look at our projects and our shipments in the projects, on Q2 over Q2, I mean, it represents the primary reason that we were down, if you will, in that area. So I see us competing very effectively, if you will, in the world of those lesser featured, lower value type products. Yeah, we have to tweak our portfolio, but we are pretty good at that. When I look at our -- when we said that our volume was up about a little over 6%, and we look at our contribution margin off of that, it was consistent with what we see throughout our entire portfolio. So that's not the issue, it's that -- it's in price mix, half of it price, half of it mix, and the mix piece is really more -- we are just not seeing the uptick yet in larger projects. We believe that it will happen, but when will it happen, we are just being cautiously optimistic about it. We are very excited about the growth rates that we are experiencing for our Atrius-enabled luminaires. But a lot of those products are finding their way into very large, if you will, buildings, whether its commercial retailers or whether it's large public facilities, airports, convention centers. So what happens typically, is that you are focused on shipping a lot of very similar type fixture. So the margin profile, the cost to serve that piece of business by the way, is just less. It's not that it's bad, it's just less. Its less than these larger projects that we see in the commercial world, where they are very complex. They are incorporating a great deal of different luminaires, control platforms, and they are easy to manage, and we are really good at it. And so that's just not happening. So that's the mix piece. On the price piece, Ricky, we are seeing kind of the same.

We are not seeing lots of difference, we are seeing a little bit more substitution going on. But even in that substitution, while the price points may be lower, our gross margin profile, as a percentage, is still attractive, we are selling more of them. And we saw that in our world.

So I hope I am giving you some guidance that, for us, the opportunity to leverage our platform, is really built around two things; one, continuing to move our product portfolio to be competitive in that lower, less featured product portion of the market. But being ready to serve large jobs, and these jobs would be $50,000 and above kind of jobs, that are important to us.

I would just add to Vern's comment, that it's -- the price portion hasn't changed as much as I think it's the channel and product mix that got it to go up from one to two to the three to four. It's hard to predict, is that channel mix going to continue to be where it was this quarter or are we going to see the improvement which Vern highlighted in these major projects, that would better forecast where that price mix may go.

And then, do you feel you are losing share on the larger more specified projects?

No, not at all. We do not. Solution set [ph] portfolio is robust. Our access to that market through our agency partners is strong. It's interesting to us, when we specifically look at geographies and markets. I mean, it's a handful of markets also, that are experiencing fairly significant decline, and we know these markets. The Dodge data supports declines so on and so forth, and a lot of our agents in those key markets are -- they are the 900 pound gorillas. And so they are saying, we are busy, but there is just nothing that's releasing right now.

Okay. And then just a real quick one on tariffs; I know it's early days, but what are your thoughts around tariffs, the impact, as it relates to competition, as well as on margins in your business? I don't know what percentage of your LED kit you source in China appears to be on the list in terms of being affected by tariffs and then, that would affect import players as well. So just curious on how -- I know it's early, but just any broad thoughts on how you think the impact could shake out over the next few quarters?

So Ricky, what is known, right, is the fact of steel and aluminum, and we know that that has not really had an impact on any of us. When it comes to the specific componentry, I think that we are evaluating some of those things. But again, we have the robust supply chain. What we are seeing from the administration are still positive signs. I know there is a lot of rhetoric around the relationship between Canada, the U.S. and Mexico. We produce roughly 80% of what we sell. 20% we import, probably a little more than half of that. So that would be subject potentially to some opportunities of price increases. But we believe that our competition for those types of products, are doing exactly the same. So the marketplace would be impacted almost equally. I would be encouraged by our supply chain in North America, to fully leverage our capabilities, should there be some differences that occur in how they interpret what components are. Yes, we purchase LED chips, but we purchase them from around the globe, not just, if you will, Chinese based suppliers. So we have other suppliers that we are -- that we consider partners, that are in different parts of the globe, than what is being discussed as potential targets for import duties.

Thank you. I am passing on.

Our next question comes from Ryan Merkel, William Blair. Your line is open.

Thanks. So first question I had was on launching the value lines to win back share and the stock and flow. On average, how much lower are the ASPs relative to the product you are selling before? And then, are the gross margin rates similar or lower than before?

Yeah. So the opportunity of relaunching Contractor Select. I mean, the portfolio is roughly in place, and some of those products are being sold today. So we don't see, a meaningful if you will, change in price. But what we do see, is on the products that we are adding, what we are doing is, those products are more appropriately featured. Though there will be some points of differentiation, that will make them more appropriately featured for the market, and our cost structure will be more attractive for us. So really, it has more to do with us, not if you will, gaining share. We are not losing share. Yeah, we could gain share. We expect to continue to grow in those areas. But it's really about attacking some of our profitability around those, and to improve that price mix, if you will, relationship.

So, the gross margin has been similar to before?

Gross margin, I am going to talk gross margin percentage. I think, that our gross margin percentages will continue to improve on that, if you will revamp product line. From a pricing perspective, we don't believe we have been losing any share in the marketplace. We think that there is actually opportunity to gain share. Data around that is hard to come by, but the data that we do have, suggests that we are maintaining our share, even in the face of, if you will, some price degradation and substitutions going on that end. We just want to improve our profitability margin percentages on those products that we sell. We are seeing nice volume growth, form factors are changing, and so we expect that. We are actually driving some of that. So while the top line dollars are being impacted in that substitution, we think that we are actually improving our margin percentages. So it'd be interesting to see. The installed base is massive, and that's where a lot of this stuff is going. So we believe, there could be an incremental opportunity for sales growth, even though units will be up higher than sales dollars. But we want to continue to drive our sales dollars up as well, as well as our margin percentage with these types of more competitive value propositions for that portion of the market.

Got it. That's helpful. Okay, and then secondly, why have you needed to substitute to lower priced products or large commercial jobs?

I am sorry, say that again?

You mentioned you needed to substitute to lower priced products for large commercial projects? I am wondering, what was the driver there, what's driving that decision?

Yeah, if I said that, I didn't mean that. So I apologize. I think that on the larger projects, the opportunity there is to sell value propositions that, where price -- price is always important. It's a competitive bid business. But it's not the same as, if you will, stock and flow, where there is not really a specifier involved. Our pricing and our opportunities in that, on those larger projects, is really brought to bear by [ph] -- we are having a much better mix of products typically, we are adding much more controls into it. And we are having the product or a project manage those capabilities with our channel partners, to bring value to that entire project. So I don't consider that to be a -- it's very different than what's happening, if you will, in that lesser featured individual single product flowing to non-specified jobs. So if I said that, somehow we are having to substitute product on larger projects, that's not what I meant. Ricky?

Got it, I think I -- got it Ricky.

I was just going to say, the substitution, we are seeing that as in moving from troughers to panels or some downlights to wafers, not in the major projects as mentioned.

Got it. I just misunderstood I think the press release, I read it wrong. Lastly, the price pressure you are seeing, is it still just impacting the 20% of sales that you have defined as less for future products?

Yeah again, as we have said, project business by its very nature, has always been a bid business. But typically, folks, when they are bidding, they are looking at the full value of their solution set. It's not just products, it's how well can they project manage it. How well can they tie in their more sophisticated control solutions, things of that nature. So again, while it's a competitive bid business, it's not someone coming in and saying, I sent something over the internet, and here is my price, do you want to buy it? It's very different than that. And on the 80-20, I would say, the 20% is more people who are interested in first cost. Price and availability more important than features and functionality, for people who are interested in the total cost of ownership, they do have an ear towards, how will this help me make my building smarter and more intelligent. How will it make my building do more things for me. So you have the opportunity to differentiate your value proposition. Sure, there is still substitution going on, as Ricky points out, for some of these products, just because, some of these new form factors are really cool and really interesting. Some of them are at lower price points and the brethren that they are potentially displacing, but then there are other products that are coming to the marketplace, that are higher priced than the products that they are displacing, because they do there, and they are better luminaires.

Understood. Thank you.

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

Hi. Good morning guys. Thank you for taking my question. I wanted to drill down a little more on the lack of large big jobs that you have been referencing. This is actually quite kind of interesting, because we don't see the same dynamic in other dynamics that are levered to the same construction cycles, and for example, we cover some HVAC names, and they have seen an increase in large jobs in the last quarter or two. So I am curious, if maybe -- are you seeing that, maybe the agents are being disintermediated somehow, because I am assuming if the building is being built, that means HVACs also needs light anyway. So why is that, that there is such discrepancy in this trend, around similarly the same markets? Maybe can you comment on that.

That's a nice question. Yes I can. It is very encouraging to us that the HVAC and other folks like that are seeing pickups in their business, because the last people into larger projects are the lighting people, the furniture people, the carpet people. So we are the last 20% of any project. So this is why I said in my prepared remarks, and why we feel that, there is going to be this uptick, because we are seeing improvement in the steel people, in the HVAC people, in some of these things. But I would tell you that, we are not forecasters, so I want to be really clear about that. We use data that you all see. If I look at the census bureau, private non-residential spend, which is a key market for us, it has been down low single digits or flat for nine months in a row. That's not our data, that's census data. Private resi, has been -- it went from being kind of low double digit, now it's kind of flat -- excuse me, down middle single digit. And then when we look at lighting equipment, also from a U.S. census bureau, it has been down five of the last six quarters, and in the most quarter, it was down 3.5%. So I don't think that the channel is being disintermediated, particularly for larger projects, the channel may be under or channels, I should say, may be under pressure for different ways of conducting business over the internet, things of that nature, on those low end lesser feature type products. But I think on the larger project side, I think we're positioned incredibly well for that uptick. So I would submit to you that the positiveness that you are seeing in some other folks who are earlier in the construction cycle, should bode well for the overall lighting industry for larger projects.

Got it. Thank you. I will jump back in the queue.

Our next question comes from Tim Wojs with Baird. Your line is open.

Hey, good morning everybody. Maybe just -- I just had a couple of cost questions; so I guess on the SD&A line, I think absolute SG&A might have been up about $20 million year-on-year in the second quarter, and I know it's a weaker quarter from a percentage basis. But on an absolute basis in the back half of the year, would you expect SD&A to continue to be up in dollar values? And I guess, what's the flexibility that you have internally to take cost actions to maybe reduce that SD&A line if you have to?

We would expect dollars to be higher in the back half, and understand why. So a portion of our SDA is truly variable, freight and commissions. It's roughly between 11.5%, 12% of sales, and so as sales in the back half of those, everyone knows, we are more of the back half oriented company. Third quarter, fourth quarter sales are typically higher than first and second quarter, with second quarter typically being our lowest sales quarter. So that variable dollar is going to take it up. Number two, the headcount; while it has been fairly stable for the last few quarters, on a period-over-period basis, it's still going to increase. Wage inflation is alive and well. We provided the merit increases effective November 1st Ricky, I think it was? And so, the range there. So we have added wage increases headcount to a degree, we are enhancing the incentive compensation based on full year opportunity. Cash flow has been very robust, which is one of our elements, and we have been incurring some additional costs, because we are expanding access into a couple of different channels, that are requiring incremental investment. The third quarter is typically always higher, because we have light fair, and we have our national sales meeting, which are millions of dollars to pull these things off, those are period expenses. But yet, we expect our revenues to increase even in this, if you will, somewhat tepid environment. So as a percentage of sales, we would expect our adjusted SDA to come back down. It's interesting, when I look back over the last handful of years, we have had SDA in the second quarter of 27.8% before. I mean, I am not saying that it's a good or bad thing, but these are investments. Now in answer…

Okay. Great. That's very helpful. I appreciate all the color. And then, I guess relative to pricing and maybe managing some of the commodity increases that you might be seeing in raw materials and freight, would you -- are you comfortable getting like-for-like pricing increases, just given maybe some of the competitiveness in the market? Or do you -- would that come through new product introductions, that might have a higher ASP or a despec product? Thanks.

Yeah, we are looking to -- we have increased prices on certain fixtures and solution sets that are directly impacted by some of these increases in raw material costs. But we are also looking to continue to drive costs out through new product designs, that allow us to maintain the margin percentages, and even grow the margin percentages, off of those products, as new form factors come into the marketplace. So I think it's a combination of both. And Ricky, we are also looking at just our overall, if you will, total business structure. Can we do things in our business and be more efficient, and that's part of what our ABS process is, how do we continue to use Kaizen events to take costs out of our business, so that we can reinvest it in other areas. Ricky?

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

Everyone, thanks for your time this morning. We strongly believe we are focusing on the right objectives, deploying the proper strategies, and driving the organization to succeed in critical areas, to have the potential over the longer term to deliver strong returns to our key stakeholders. We believe strongly our future is bright. Thank you for your support.

That concludes today's conference call. Thank you for participating. You may disconnect at this time.