Acuity Brands Inc

NYSE:AYI

Earnings Call Transcript 2018-Q4

[Operator]

Good morning and welcome to the Acuity Brands' Fiscal 2018 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.

[Dan Smith, Senior Vice President, Treasurer & Secretary]

Thank you and good morning. With me today to discuss our fiscal 2018 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.

[Vern Nagel, Chairman, President & CEO]

Thank you, Dan. Good morning, everyone. Ricky and I would like to make a few comments and then we will answer your questions. While our results for the fourth quarter and the full year were records, we had higher expectations coming into 2018. Market conditions for growth were far more subdued than most had originally anticipated, especially for larger commercial projects and deflationary pricing persisted throughout the year, while cost pressures were far more significant than most had forecast, particularly in the fourth quarter.

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 will 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 of almost $1.1 billion for the fourth quarter were a record increasing approximately 11%, compared with a year ago period. Reported operating profit was $142 million, compared with $153 million in the year ago period. Reported diluted earnings per share was $2.70 compared with $2.15 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, our adjusted operating profit for the fourth quarter of 2018 was $154 million, compared with adjusted operating profit of $176 million in the year ago period. Adjusted operating profit margin was 14.5%, a decrease of 390 basis points, compared with the prior year. We will provide important detail on the change in operating profit and margin in a moment. Adjusted diluted earnings per share was a quarterly record of $2.68, up 5% from the year ago period.

For the full year, net sales in 2018 were a record $3.7 billion, up 5% from 2017. Reported operating profit was $455 million, compared with $519 million in the year ago period, while diluted earnings per share was $8.52, up 15% from a year ago. Adjusted operating profit was $528 million, down 11% from the year ago period. Adjusted operating profit margin in 2018 was 14.3%, down 260 basis points from a year earlier. Adjusted diluted EPS of $8.84 was a record, up 5% from 2017.

In addition, we regenerated a record of $353 million in net cash provided from operating activities this year. We closed the year with $129 million in cash on hand even after repurchasing $298 million of the company shares, investing $163 million to acquire two great businesses, spending $44 million for capital expenditures and funding $21 million in dividends this year.

In addition, we entered a new five year $800 million credit facility, leaving us with plenty of financial firepower.

Lastly, I am pleased to report that we once again earned much more than our cost of capital. Our adjusted cash flow return on investment for 2018 was over 33%. We believe this level of return is far greater than others in the electrical industry.

For those who follow EVA, we generated over $168 million in positive EVA, a great accomplishment.

Looking at the key highlights for the fourth quarter, net sales for the quarter exceeded $1 billion for the first time ever and were up approximately 11% over the year ago period. Overall, net sales volume grew approximately 13%. This was offset by approximately 3 points for changes in the price and mix of products sold, acquisitions and changes in foreign currency added another 1 point growth. Our significant sales growth was due in large part because of our continued efforts to expand our customer base and the introduction of new products and solutions, which allowed us to gain overall market share.

Overall, we experienced solid growth in net sales in most channels and geographies. The largest contributors to the increase in net sales volume were greater shipments of certain high volume, more basic, lesser-featured LED fixtures, primarily for applications on smaller commercial and residential projects, greater demand for our Atrius-based luminaires and growth in our infrastructure and utility channel primarily through our Holophane team. The increase in sales of more basic, lesser-featured products was driven in large part by the success of re-launch of our Contractor Select portfolio as well as gains in certain other brands sold through numerous channels including home centers and electrical distributors where we posted strong sales growth.

Sales through our C&I channel which have historically made up more than 60% of our total sales were down slightly again this quarter in dollar terms as well as a percentage of our total net sales compared with the year ago period primarily as demand for larger non-residential projects remained soft.

Further, overall net sales were impacted by changes in the price and mix of products sold primarily due to lower pricing on certain luminaires reflecting increased competition primarily for more basic, less-featured products and changes in both product mix which included substitutions to lower priced alternatives and channel mix which includes declines in shipments for larger commercial projects noted a few moments ago.

While it’s not possible to precisely determine the separate impact of changes in the mix -- in the price and mix of products sold, we estimate the impact of price mix was more due to changes in product pricing and to a lesser degree mix, primarily due to product substitution.

Based on the information from various data collection and forecasting organizations, we believe the overall growth rate for the fourth quarter as measured in dollars for lighting in North America was flat to slightly down, continuing the sluggish trend over the last several quarters.

Our net sales growth rate of approximately 11% stands in stark contrast to the overall growth rate of the luminaire market in North America. We believe our channel and product diversification as well as our strategies to better serve customers with new or innovative and holistic lighting and building management solutions and the strength of our many sales forces have allowed us to continue to gain overall share in the North American market this quarter.

Our profitability measures for the fourth quarter while solid given overall market conditions were below our expectations and prior year performance. They were impacted by changes in the price and mix of products sold noted earlier and significantly higher cost particularly for certain commodities and components as well as freight and wages which I will address in a moment.

Our adjusted operating profit for the quarter was a $154 million, down approximately 12% compared with the year ago period, while adjusted operating profit margin for the quarter was 14.5%, down 390 basis points from the adjusted margin in the year ago period. The decrease in adjusted operating profit margin was primarily due to the decline in adjusted gross profit margin.

Adjusted gross profit margin for the fourth quarter was 39%, a decrease of approximately 350 basis points compared with the year ago period. It is critically important to understand the underlying factors that drove the decline in our margins this quarter and the actions we took to counter those factors as well as the timing of financial impact of those actions. Adjusted gross profit increased $7 million over the year ago period driven primarily by higher sales volume and productivity improvements, partially offset by changes in the price and mix of products sold and higher input costs. We estimate the impact of price mix reduced our adjusted gross profit margin by 280 basis points this quarter.

Another significant factor impacting our adjusted gross profit and margin was higher input cost for certain items, including electronic and certain oil-based components, freight and certain commodity-related items, particularly for steel. Many of these items experienced dramatic increases in price in the fourth quarter due to several economic factors including enacted tariffs and wage inflation due to the tight labor markets.

We estimate the inflationary impact of these items reduced our adjusted gross profit in the quarter by more than $20 million, lowering our adjusted gross profit margin by 200 basis points and reduced adjusted earnings per share this quarter by $0.38.

We took significant actions in the quarter that we believe will offset these and other cost increases, including wage inflation as well as the impact of currently enacted increases in tariffs. These actions included announced price increases and other measures to improve productivity and reduce other costs. We believe that the timing of the price increases and other actions implemented will begin to offset these and other cost pressures midway through our first quarter of 2019. Therefore, we expect to continue to experience some drag in margins in our first quarter of 2019.

Next, our adjusted SDA expenses were up approximately $29 million compared with the year ago period. Adjusted SDA expense as a percentage of net sales was 24.4% in the fourth quarter, a very slight increase over the year ago period, demonstrating the leverage of our SDA investment as net sales volumes grow.

The increase in adjusted SDA expense was primarily due to higher freight and commission costs to support the increase in net sales, greater employee-related costs and to a lesser degree, cost for marketing and outside services, partially offset by actions taken in prior periods to streamline the organization. Excluding the impact of higher freight and commission expense due to the increase in net sales volume, more than half of the increase in SDA expense compared with the prior year was due to greater employee-related costs. While our salary headcount remained flat year-over-year even after acquisitions, we expect employee-related costs will continue to rise as we enter fiscal 2019 as markets for certain skills remain tight contributing to a rise in wage inflation.

Our adjusted diluted earnings per share was $2.68 compared with $2.55 reported in the year ago period. The increase was primarily due to the favorable impact of the new tax law and the lower average shares outstanding due to the stock repurchases in the past year, partially offset by a decline in operating profit in the quarter. As I noted earlier, we believe the spike in certain input costs reduced our adjusted EPS this quarter by $0.38.

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 continued to make great strides setting the stage for what we believe will be strong revenue growth and profitability over the long-term. Let me briefly mention a few of our accomplishments in 2018.

We introduced almost 100 new product families this year, expanding our industry-leading portfolio. We gained market share in many important product categories and sales channels. Tier 3 and 4 solutions grew by 30% this year and now make up more than 15% of our total revenues. Our Atrius-based IoT luminaires and solutions are becoming the industry standard in the retail segment. Additionally, we are expanding these solutions in other channels as awareness by customers of our meaningful points of differentiation and the capabilities of IoT solutions increases significantly, providing customers with the opportunity to transform their spaces from expense items to strategic assets.

It is now evident that certain Chinese-based lighting companies, many clearly being subsidized in some form are influencing pricing for certain basic, lesser-featured fixtures sold in certain channels. We will not yield this space for many strategic reasons. As such, we aggressively will reintroduce our expanded Contractor Select portfolio to profitably compete in this portion of the market.

We acquired two excellent companies this year, Lucid and IOTA as part of our strategy to expand our portfolio and access to market. Also, we introduced in late 2018, the next generation of our industry-leading lighting control system nLight AIR, a wireless control system with a wide range of options and functionality for which there is strong customer interest. We believe Acuity has the most comprehensive and feature-rich wired and wireless lighting control systems available, and importantly, are now connected to our growing BMS solutions.

Lastly, we initiated many actions this year to further streamline our operations to reduce costs and improve our productivity. We believe these initiatives will enhance our operating and financial performance as well as allow us to accelerate investments in areas with higher growth opportunities. Ricky will have additional comments on this in a moment.

We have been able to create these capabilities while providing industry-leading results because of the dedication and resolve of our many associates who are maniacally focused on serving, solving and supporting the needs of our customers. I will talk more about our future growth strategies and expectations for 2019 later in the call.

I would like to now turn the call over to Ricky. Ricky?

[Ricky Reece]

Thank you, Vern. And good morning, everyone. As Vern mentioned earlier, we had some adjustments to the GAAP results in the fourth quarter of 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 fourth quarter and full year of both fiscal year 2018 and 2017.

Adjusted results exclude the impact of amortization expense for acquired intangible assets, share-based payment expense, acquisition-related items, special charges and credits for streamlining activities, manufacturing inefficiencies and excess inventory adjustments related to the closure of a facility, gain associated with the sale of the company's Spanish lighting business, gain associated with the sale of an investment in an unconsolidated affiliate and an income tax net benefit for discrete items associated with the US Tax Cuts and Jobs Act.

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 you as you compare our performance to other public companies in our industry.

During the fourth quarter of fiscal 2018, we reversed pre-tax special charges of $5 million, as certain previously planned streamlining activities were no longer expected to occur, primarily because we were successful in selling the Spanish lighting business for a gain during the quarter. We recorded a pre-tax charge of approximately $10 million in the prior year fourth quarter, which included planned streamlining activities associated with the Spanish business that were no longer necessary due to the successful sale of the business.

During the fiscal year 2018 and 2017, we recorded net pre-tax special charges of $5.6 million and $11.3 million respectively related primarily to streamlining activities. We expect to incur additional costs in future periods associated with the closing of certain facilities primarily attributed to early lease terminations and moving costs. We expect the annual savings from the fiscal year 2018 streamlining actions once fully implemented to exceed the amount of the special charge. The savings will be reinvested in activities to support higher growth opportunities, as well as drive improved profitability.

We reported net miscellaneous income of $4 million in the fourth quarter of fiscal 2018, which reflected a $5 million gain associated with the previously mentioned sale of the Spanish lighting business. This gain was primarily due to the recognition of favorable accumulated foreign currency translation adjustments previously recorded in comprehensive income. The effective tax rate for the fourth quarter was 21.1%, compared with 36.4% in the prior year quarter.

The fourth quarter of 2018 tax expense included a one-time tax benefit of $3.9 million related to reduction in estimated taxes on undistributed foreign earnings. Excluding this one-time benefit, the effective tax rate on adjusted earnings in the fourth quarter of 2018 was 25.5%. The lower effective tax rate and total charge adjustments were primarily due to the US Tax Cuts and Jobs Act signed into law last December.

We currently estimate that our blended effective income tax rate before discrete items will approximate 25% for fiscal 2019. As these lower rates reflect the passage of the new US tax law, it will have a meaningfully positive impact on our future earnings and cash flow. The impact of the tax legislation may differ from current estimates, possibly materially due to among other things, changes in interpretation or assumptions the company has made, guidance that may be issued and actions the company may make as a result of the tax legislation.

We primarily manufacture our products in North America. However, we source certain components and approximately 15% of our finished goods from China that are subject to the recently enacted import tariffs. We are aggressively seeking to mitigate the impact on our profitability of these added costs. Our mitigation efforts included a variety of activities such as finding alternative of non-Chinese suppliers, in-sourcing the production of certain products; and as Vern mentioned earlier, raising prices.

Effective September 17, 2018, we raised prices up to 6% on the majority of our products to cover cost increases we had experienced that are not directly related to the tariffs. We have announced two additional price increases of 6% on the majority of our products and 10% on our China sourced finished goods, which are directly related to the increased tariffs and these price increases will be effective October 15, 2018.

Based on our mitigation activities, including the announced price increases once fully enacted, we believe we can offset the added costs and tariffs. There is a delay in when we see the benefits from our mitigation activities and our cost increases that can continue to negatively impact our margins in the first quarter of fiscal 2019. We generated $353.2 million of cash flow provided by operating activities during fiscal year 2018 compared to a $336.6 million for the year ago period. Operating working capital defined as receivables plus inventory less payables increased almost $92 million during fiscal 2018. This increase is largely due to higher inventory primarily due to the customer expansion in the home center, new product launches and a build up of finished goods to support committed projects in the corporate accounts channel.

Our operating working capital days increased six days to 50 days primarily due to higher inventory at August 31, 2018 compared to the prior year. At August 31, 2018, we had a cash and cash equivalent balance of a $129.1 million, a decrease of a $182 million since August 31, 2017. The decrease was primarily to cash used to repurchase common stock, to fund acquisitions, to invest in plant and equipment and to pay dividends partially offset by cash flow from operations. We’ve repurchased 2 million shares for $298.4 million during fiscal year 2018. We have 5.2 million shares remaining under our current share repurchase board authorization. Our investment in capital expenditures was $43.6 million for fiscal 2018, a decrease of $23.7 million compared with the prior year. We currently expect to invest approximately 1.5% of net sales and capital expenditures in fiscal year 2019.

On June 29, 2018, we entered into a new credit agreement with a syndicate of banks that provides us with a $400 million five year unsecured revolving credit facility and a $400 million unsecured delayed draw five year term loan facility. Our total debt outstanding was $356.4 million at August 31, 2018. Our debt-to-capitalization at August 31, 2018, was 17.2% and net debt-to-capital was 11.7%.

We had additional borrowing capacity of $794.7 million at August 31, 2018 under our new credit and term loan facilities which do not expire until June 2023. We clearly enjoy significant financial strength and flexibility to support our growth opportunities which may include acquisitions and we’ll continue to seek the best use of our strong cash generation to enhance shareholder value.

Thank you and I’ll turn it back to Vern.

[Vern Nagel, Chairman, President & CEO]

Thanks, Ricky. Current market conditions in the lighting industry continue to create challenges for management to drive improvements in short-term financial performance while continuing to invest in attractive long-term opportunities. Shorter term issues notwithstanding, we are optimistic regarding our long-term future. Our many actions taken in 2018 to improve market -- our market reach, enhance our customer solutions and capabilities and to drive company-wide productivity were done so we can optimize our financial performance while continuing to invest in areas we believe have high growth potential over the long-term.

The following are a few observations regarding our fiscal 2019. Many independent third-party forecasts continue to suggest the overall construction market as measured in dollars will grow in the low to mid-single digit range. We believe the lighting industry will continue to lag the overall growth rate of the construction market, primarily due to continued product substitution to lower priced alternatives for certain products sold through certain channels.

From a pricing perspective, we expect the market to be competitive, though announced price increases by many in the industry should abate some of these pressures. Additionally, labor shortages in certain markets will continue to impact growth rates for both construction and lighting. We believe the outcome of the tariff situation could have a dampening effect on overall demand due to higher component costs and finished good prices, particularly at the proposed increase in tariffs to 25% from 10% on finished goods made in China takes effect on January 1, 2019. It is not possible for us to precisely determine what the potential impact tariffs will have on demand as it is a very complex situation impacted by numerous factors including currency fluctuations and political outcomes.

Excluding the potential impact of future tariffs and other changes in the economic or political environment, we expect the overall growth rate of the lighting market as measured in dollars should be up low-single digits in 2019 which is a departure from the negative growth over the last year and a half.

As previously mentioned, we believe the announced price increases and other actions taken will in time offset the spike we experienced in current costs for various items noted earlier. However, we believe costs for many inputs could continue to rise due to the inflationary impacts on certain commodities, particularly steel and oil, the impact of tariffs on imported electrical components and finished goods, freight and wages primarily due to tight labor markets. These potential cost increases could have a negative impact on our financial results due to the timing and nature of any mitigation efforts, including future price increases and other actions to reduce costs. Further, we believe that product substitutions to lower priced alternatives for certain products and portions of the lighting market will continue, particularly for more basic, lesser-featured products sold through certain channels potentially pressuring both top-line growth and profitability. The re-launch of our Contractor Select portfolio and other actions taken were done to enhance our opportunities for profitable growth in this portion of the market.

Foreign currency exchange rates will continue to be volatile. Excluding the impact of any of those factors just noted, we remain cautiously optimistic for fiscal 2019. Our wide and varied customer base generally remains positive about their growth prospects; many have record backlogs, though they too are concerned about the timing of releases, particularly for larger projects and the potential impact of tariffs and inflation on overall demand. However, and most importantly, we expect to continue to outperform the overall growth rate of the markets we serve, primarily in North America. Further, we believe the sales of our Atrius-based luminaires within our Tier 3 and 4 categories will continue to expand. Though, I would like to emphasize there will be lumpier times because of the unpredictability and timing of customers' renovation and new construction cycles.

As we have noted before, our gross profit margin is influenced by several factors including sales volume, innovation, components and commodity costs, market pricing dynamics and changes in product and sales channel mix. Additionally, we are always striving to improve our profitability through our continuous improvement efforts.

However, we believe for any meaningful gross profit margin improvement to occur, we will need to experience an acceleration in market demand in the C&I channel, particularly for larger commercial projects where contribution margins are more favorable due to the complex nature of these types of projects. This illustrates the influence of product and sales channel mix on our margin profile.

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 improve the mix of products and solutions sold as we execute our tiered solution strategy and to leverage our fixed cost infrastructure to achieve targeted incremental margins to improve our overall bottom-line profitability.

Lastly, we are focused on and very excited by the long-term potential of the many opportunities to enhance our already strong platform including the expansion of our Tier 3 and 4 holistic lighting, building management in our Atrius IoT platform and software solutions.

The world of data optimization targeted by our Atrius platform is still in the early stages of development and we believe Acuity is uniquely positioned to take full advantage of these profitable growth opportunities.

As we have noted in our last several conference calls, the implementation of our integrated tiered solution strategy and opportunities to meaningfully participate in the interconnected world is an integral part of our overall long-term profitable growth strategy to meaningfully expand our addressable market by adding significantly greater broad-based holistic solutions that will allow our customers to transform their connected intelligent buildings and campuses from cost centers to strategic assets.

This all takes focus, resources and time. We're investing today to enhance and expand our core competencies, affording us the opportunity to excel over the longer term in our fast changing industry because we see great future opportunity.

As I have said before, we believe the lighting and lighting-related industry as well as the building management systems market have the potential to experience significant growth over the next decade because of continued opportunities for new construction, and 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 and lead these exciting and growing industries.

Thank you. And with that, we will entertain any questions that you have.

[Operator]

Thank you. [Operator Instructions]. Our first question comes from Ryan Merkel with William Blair. You may go ahead.

[Ryan Merkel]

Thanks. A couple questions from me. First, I wanted to ask about pricing. How much price did you capture in the quarter from the summer price increases? And then now that we're approaching the middle of your fiscal first quarter, can you comment on whether you're starting to recover the 200 basis points of gross margin that you lost this quarter?

[Vern Nagel, Chairman, President & CEO]

Sure. Ricky, why don't you start?

[Ricky Reece]

Yes. The price increase that we did earlier in the summer was on selected items. It was not across the entire product family. The broader ones didn't come effective until after the end of the quarter. So, we got pretty good capture on that, but I want to stress that it was largely on the legacy, non-LED products, and therefore that's a minimal amount of what we're selling today, and therefore didn't have as big of an impact as the price increases that became effective middle of September and then other two that'll become effective here in the middle of October.

[Vern Nagel, Chairman, President & CEO]

And Ricky, I would also say that as we see our order rates, they continue to be robust. And so those orders that are being placed have in effect the price increase that was announced on August 9th. So, I would say that we are seeing capture in a robust way on that price increase. And we expect to have the same type of capture on the other price increases as well.

[Ryan Merkle, William Blair]

Okay, very good. And then secondly on gross margins. I think your view has been that we should be finding a bottom soon and you've got pricing, new product introductions, and cost takeout, so I guess I'm just trying to gauge your confidence, Vern. How confident are you that the fiscal fourth quarter could be the bottom for gross margins?

[Vern Nagel, Chairman, President & CEO]

Ryan, while we don't prognosticate going forward, as I look at the fourth quarter, the spike increases of cost were a little north of $20 million. These are very discrete items that we track. And we just didn't see those increases really in Q3 anywhere near to the extent that we did. So, when I look at our business and really try to understand the very elements of your question, I believe that 200 bps of margin degradation, because of these spiked costs, we will recapture these.

If I look at the price mix, which was probably a 280 bps drag on margins compared to the year ago period. Again, we’re seeing -- we continue to see that, if you will, price degradation, but we also see a shift in products to, if you will, lower-priced substitutions. And it doesn't mean that they're less effective. It doesn't mean that we make less margin. It just may mean that we make less margin dollars around that.

Having said all of that, I believe that the price increases will have an influence on that price mix as well, as we go into the market. So confidence level of trying to understand where we are and then the base going forward, our view is that 2019 will see growth in dollar terms, driven by, again, price increases. We're assuming that the economic environment continues to be favorable. Again, our customer base gives us pretty solid input that while they have record backlogs, yes, they're a little concerned about releases of larger products, they still see the notion of stock and flow in those types of projects being favorable.

So, we have a positive, yet cautiously optimistic view coming into 2019. And we're pretty good at extracting margin as volumes improve. So as I mentioned, mix does have an impact on our business. Mix did have an impact this quarter. When we look at our C&I business, we don't look at it as a business, but we look at the C&I channel. Typically, that's north of 60% of our total revenues. Well, it declined this quarter because the revenue growth in other aspects of our business, whether it be electrical distribution channel, the home center channel, the infrastructure and utility channel, our enterprise solutions, which are really selling our Atrius-based luminaires, those are the folks that brought us the lift and larger projects were left behind, if you will.

So, we are optimistic that these larger projects will continue to come back, and that adds spice to our margin stew, if you will, because the variable contribution off of those more complicated projects are favorable to us.

[Ryan Merkle, William Blair]

Very helpful. Thank you.

[Operator]

Thank you. The next question comes from Tim Wojs with Baird. You may go ahead.

[Tim Wojs, Robert W. Baird]

Yes. Hey. Good morning, guys. I guess maybe first just on inflation. You talked a little bit about beginning to offset the inflationary pressures kind of midway through to Q1, which I guess where we're kind of at today. So I mean are you starting to see that pricing start to recapture the inflation? And then second I guess, is your message that kind of by the time you get into the second quarter that you should kind of be fully offsetting inflation? Just some color on those two questions would be helpful.

[Vern Nagel, Chairman, President & CEO]

Sure. We do believe that the price increase that was effective for 9/17 on those inflationary items, as Ricky had described earlier, that we are seeing full capture and we are starting to see the offset to that. But again, as you know, we have costs in our inventory that need to roll through and the way that inventory turns in less than a quarter, it will influence Q1.

Our expectation is that as we get into our full Q2, we will have full capture of both price increases that will offset the inflationary effects of costs that we saw earlier, as well as the significant tariffs increases on component parts that are rolling through, and then to a lesser degree on finished goods. So, our expectation is that we will cover these costs.

I do believe that we are experiencing continued wage inflation because of tight labor markets. Our expectation is that that will continue. We do hope to offset some of those with productivity improvements, and then to a lesser degree, the price increases that we have put in place.

[Tim Wojs, Robert W. Baird]

Okay, that's helpful. And then just on the large project side, I mean any change you've seen kind of sequentially as you kind of talk to your agent base or talk to your customers just about the release of some of those large projects?

[Vern Nagel, Chairman, President & CEO]

Yes. Again, I believe that folks continue -- and when I say folks, I'm talking about contractors, electrical distributors, if you look at people who are in the specification world, architects, engineers, lighting designers, people continue to be busy. Contractors and electrical distributors, many of them are operating with record backlogs. So the question is, how and when do these release? I do believe in certain markets that labor shortages continue to be a problem, and so people are picking and choosing which jobs they release. I do think that some of those labor shortages will continue to influence our industry.

But I also believe that some of these larger projects that people had on the books are starting to release. And so, our expectation is that as we get into 2019, some of these more interesting projects will release and we're starting to see that. We've had some really nice releases of both commercial spaces, as well as street and roadway things starting to release. For all of those of you who come through Atlanta, when you walk outside, you'll see a fantastic overhang or a bridge, if you will, between parking structure and the terminals, and that all looks just outstanding.

So, we're starting to see these types of projects release. So again, cautiously optimistic around that, and our market channel partners have a similar view.

[Tim Wojs, Robert W. Baird]

Great. Thanks. Good luck on this year.

[Operator]

Thank you. The next question comes from Rich Kwas with Wells Fargo Securities. You may go ahead.

[Rich Kwas, Wells Fargo Securities]

Hi. Good morning, everyone. On the price increases, have you seen any pre-buy, noticeable pre-buy? I imagine that wasn't all that substantial maybe in the quarter that just got reported, but so far as you're seeing into F Q1, any significance on the volume side that you're seeing?

[Vern Nagel, Chairman, President & CEO]

So Rich, we saw some uptick in volume prior to, if you will, the 9/17 effective date. And then post the 9/17 date, we've continued to see strong demand. I think some of that may have to do with the effective -- the price increase effective 10/15, because I think for all folks, from the things I've read everyone's saying that you have to take delivery on that. So, I suspect that there is some of that. But that doesn't necessarily influence medium to larger sized projects as much. So -- and we're seeing some of that, but I don't think that is really at the core of the overall growth that we're seeing in our order rate. It's a factor, but it's not the overall factor.

[Rich Kwas, Wells Fargo Securities]

And then Vern, on your comment about going -- if the rate goes to 25% effective 1/1, which is the plan, it seems like whatever price increases you've put through, you'd have to put through an incremental price increase to cover the move from 10% to 25%. Is that the right way to think about it?

[Vern Nagel, Chairman, President & CEO]

Rich, it is. I mean, yes that is exactly the right way to think about it from Acuity's perspective. I think even from a market competitive standpoint, a 25 point increase in just cost because of tariff, the -- few would have the ability to absorb that. So, the question for us is how much does that influence demand? And you know it gets really complicated when you start to bring in changes in foreign currency and what offsets what, but our expectation -- our strong expectation in our price increase in the release that we had, we identified that should the tariff increase on 1/1 go to 25%, that the price increases that we would put in place would be effective immediately on that date. So, we didn't announce what that price increase would be, but we said it would be effective that date. So, we gave our many, many channels way advance warning on this.

[Rich Kwas, Wells Fargo Securities]

And then you're seeing good follow-through from your competitors? And it seems like imports are even raising pricing, so I mean what's your thoughts around just realization?

[Vern Nagel, Chairman, President & CEO]

We think overall -- folks -- it's too much for someone to absorb for too long. I think that there will be some gamesmanship a little bit on the fringe around how much inventory do I have at lower prices, and how long can I last, and what's going to happen there. But on the other hand, you should have folks saying well the industry is going to put through the price increase, it's going to go all the way to the end consumer. So, do I use that as an opportunity to optimize my margin? So all -- that's all the noise out there. Our view is that the industry follows through on these price increases.

[Rich Kwas, Wells Fargo Securities]

Okay. And then last one from me, just this is a shorter-term question. But since the margin dropped as much as it did here this quarter, typically you go from F Q4 to F Q1 and it tends to vary, but it seems to be up a little bit, at least sequentially in terms of gross margin. Is there any thoughts, any color you can provide us on how we think about the near-term in terms of going back to one of the other questions around the bottoming here on gross margin? Is there any thoughts on the near-term? Anything that you'd point out that we should really think about as we think about the November quarter?

[Vern Nagel, Chairman, President & CEO]

Rich, we have -- as an industry, really we've experienced over the last, I'm going to say handful of years, deflationary environment. This quarter was really the first quarter where inflation reared its head in an aggressive way. Truthfully, I would say that Acuity, I'll put us into the big bucket, and the industry caught a little bit off-guard on the significance. And some of it had to do with the tariffs. We just didn't know how those things were going to roll through but that’s a piece. We were experiencing inflation in other areas as well. And so, I think the timing of how we put through our price increases, we were probably a little late. And so that's why I'm calling out, if you will, the spike increase in these costs, because typically we catch up, we understand how to do it and boom, we're now putting this in place.

We're also looking at other measures to reduce our costs, but we always are doing that. So, that's why I'm calling out this north of $20 million spike increase that impacted our margins a couple of 100 bps. We knew that we were going to have some mix changes, particularly as we introduce Contractor Select into several different channels. The margin profile on Contractor Select is solid. But when I look at the overall average or compare it to larger projects, it's not there and it never will be, but our cost-to-serve is also a lot less.

So, we like the dynamics. But I would just tell you that we missed the spike increase, as did most of the industry. We caught up pretty quickly. So, I think as you think about your margin sequentially going forward, we're still down year-over-year, even if I add that back. And that had to do again more with mix and some of these product price substitutions and price. I think that will still -- the product substitution will still be with us. I think that the price increases are going to be addressing some of the price degradation that we've seen over the last probably five or six quarters.

[Rich Kwas, Wells Fargo Securities]

So, to simplify it, if you think about the 200 basis points impact sticking here at least for the November quarter on a year-over-year basis, and then anything above that you'd have to just think about overall volume assumptions and then go forward from there? Is that right -- just if I simplify it?

[Vern Nagel, Chairman, President & CEO]

It is, that is. And the fact that the price increases are going to kick in as well, not just to cover costs but also how will it influence different positions that people have. Acuity does have a strong position because of our North American manufacturing footprint, but we import a lot of components that we convert, if you will, in the process. So, we're going to look to see how we can drive our productivity and our improvements to capture margin there as well.

[Ricky Reece]

I would just like to make sure that you remember that the price increase will be only for half of the first quarter. We'll get the full impact of that in the second quarter of course. But the price increases related to tariff aren't effective until the 15th of this month, October 15th, which obviously is halfway through the quarter. So as you're doing your math there, Rich, I just want to make sure that you factor in that we won't have the full quarter benefit of the price increases.

[Vern Nagel, Chairman, President & CEO]

That's a good point. Unfortunately, there's noise around that.

[Operator]

Thank you. The next question comes from Joseph Osha with JMP Securities. You may go ahead.

[Joseph Osha, JMP Securities]

Yes, well. Hello, good morning.

[Vern Nagel, Chairman, President & CEO]

Good morning.

[Joseph Osha, JMP Securities]

Two questions for you. First, given the extent to which you've been willing to lever the business and buy back stock, work with the balance sheet, I'm wondering at this point, would you be willing to go out and explore the idea of acquiring smaller competitors, and exploiting additional efficiencies there in an effort to maintain market share? I'm wondering what your thoughts are about that.

[Vern Nagel, Chairman, President & CEO]

So, three elements of our overall, if you will, shareholder value creation strategy is to continue to drive the financial performance of our business, acquisitions, and return of capital through stock repurchases. I thought that 2018 was a pretty solid reflection of that balanced strategy. We picked up almost $300 million or invested almost $300 million in share repurchases. We spent about $160 million, slightly more, in acquiring two small businesses. And dividends and CapEx were probably another $60 million or $70 million on top of that.

So, the answer to that is yes. We continue to explore different opportunities that are both share expansion opportunities, the ability to expand into our -- expand our access to market, to expand our technology capabilities. I think Lucid and IOTA were two good examples. IOTA expanding our SaaS model around bringing more Tier 4 type solutions to Acuity. And I thought that the acquisition of IOTA was just as you described, a beautiful business that expands both our access to market and our product portfolio.

So Ricky and team have a pretty active pipeline of acquisitions that they're looking at.

And so I would expect us to continue to do the things that we demonstrated that we've done in the past around these types of acquisitions.

[Joseph Osha, JMP Securities]

Okay. Thank you. And second question, it's interesting, operating expense is 25.5% of revenue. That's as low as it's ever been. Your comments about wage pressure notwithstanding, might we be seeing that OpEx line perhaps sort of in the mid-20s percentage of revenue going forward? Some commentary there would be helpful.

[Vern Nagel, Chairman, President & CEO]

So when I look at the dollars and put freight and commissions aside, which are pretty truly variable, based on the type of revenue that we have, our fixed investment in our SDA, our salaried headcount was stable year-over-year at about 3,100 folks, 3,200 folks. But that was also -- we did acquisitions where we brought in salaried headcount, but we also took some streamlining actions. My expectation is that we will see wage inflation more than we have say over the last handful of years. But generally speaking, we feel that the investments that we have in our human capital are pretty solid right now.

So, we would expect as our volumes grow in dollar terms, because the price increase will impact dollar terms, that we will see some leverage on our SDA expense. It's interesting. Our unit volumes continue to expand at a more rapid rate than our dollar volume. And so that has an influence on many things. We measure everything in terms of dollars as a percentage of sales. So, when we see our freight costs going up, when you have product substitutions that are putting lesser valued items on a truck, it doesn't necessarily mean that the box is any different. So, you're experiencing freight -- more freight cost as a percentage of sales, and then you add on top of that the fact that oil's going up, you can't find enough truck drivers. And so freight rates are going through the roof right now.

So anyway, a long way around the barn to answer your question. Yes, we would expect leverage on our SDA line going forward.

[Joseph Osha, JMP Securities]

Thank you very much.

[Vern Nagel, Chairman, President & CEO]

And then just to finish off real quickly on that, everyone looks at a quarter-to-quarter. We look at it on a full year basis because a lot of that SDA is fixed. And it goes -- if volume changes as we have seasonality in our business, for example, our second quarter is typically our lowest seasonal quarter, you would expect SDA as a percentage of those sales to be higher. So, you have to just look at it over the course of a full year.

[Joseph Osha, JMP Securities]

Thank you.

[Operator]

Thank you. The next question comes from Christopher Glynn with Oppenheimer. You may go ahead.

[Christopher Glynn, Oppenheimer]

Yes. Thanks. So just want to look at the gross margin volatility here. Moving away from the year-over-year frameworks, I think it was down about 260 basis points sequentially. Putting aside inflation and the timing of price, you did say price mix was a 280 basis point drag, but price mix was better than it was in the third quarter. You moved from a minus 5 to a minus 3. So, that 280 magnitude seems a little surprising. Maybe you could help clarify why or why not that's sort of incongruous kind of number? That magnitude of 280 given that the minus 3 improved from the third quarter?

[Vern Nagel, Chairman, President & CEO]

Sure. So Chris, I just did a little math and maybe my math is wrong, but our adjusted gross profit was about $414 million. So, if I add the 30 back to that and compare it to the $1.61 billion sales, I get a 41% -- excuse me, I get a 43.8% margin. So, well, I get a 41.8% margin, sorry. So, that's the 280 bps if I exclude the spike cost in that. It's just math.

[Christopher Glynn, Oppenheimer]

Well, we didn't have such gross margin impact called out from price mix in the third quarter, but you had in fact a minus 5 price mix on the top-line that quarter.

[Vern Nagel, Chairman, President & CEO]

I just -- I guess I looked at it just a little bit differently this time. We felt as we were looking at and then analyzing our business, the price mix, primarily price, but with product substitution a little bit and mix going in there, that’s -- that was the number. That's about a 280 bps impact if I look at it on this quarter's results. I don't have third quarter in front of me, so I'm a little bit at a loss. I can get back to you.

[Christopher Glynn, Oppenheimer]

Okay. On a separate tack, inventory spiked last quarter for purpose-built finished goods. We certainly saw that in the volume this quarter. Inventory still remains up here at year end. Is that still a story of kind of purpose-built finished goods, kind of a bullish kind of positioning for the channel volume throughput you're seeing?

[Vern Nagel, Chairman, President & CEO]

Yes. We're seeing our inventory investment in a couple of different areas to support growth, growth through if you will our electrical distribution channel, our home center channel, our enterprise solution folks. These are all investments that we're making because we expect to see increases in revenues through those channels. I would also say that we've had some component issues, so we've wanted to make sure -- if you recall, a couple of quarters ago we mentioned MOSFETs and other types of resistors, and other types of electronic components that were just a challenge to get. So, we pulled those in, probably have converted some of those, but I think that our inventory levels are reflective of what we expect in future sales.

[Christopher Glynn, Oppenheimer]

Okay, thanks.

[Operator]

Thank you. Our last question comes from Brian Lee with Goldman Sachs. You may go ahead.

[Brian Lee, Goldman Sachs]

Hey, guys. Thanks for taking the questions and squeezing me in here. I just had maybe a couple of housekeeping ones. I think you might have alluded to this, Vern, but can you update us to what percent of sales Tier 3 and Tier 4 were in the quarter and then what the growth rate was? I think it was 40% year-on-year last year, so just trying to get a sense for what the trend line is looking like? And then similarly on LED as a percent of sales, roughly two-thirds is what you've been tracking at. If there's an update on that number you could provide as well?

[Vern Nagel, Chairman, President & CEO]

Sure. I think that LED relative to our total percentage of sales, we're probably going to stop reporting that because as a percentage of our luminaires, it's just such a significant portion, that just assume that it's all LED. It would be the exception when it's not LED. And we do sell non-LED products but that's not really the focus. So we've really stopped, actually even internally accumulating that data because it doesn't mean anything to us anymore. So, relative to our lighting business and lighting in general, as you know, we sell many other products beyond just lighting. The predominant share is now LED.

As to Tier 3 and Tier 4, so for the full year, sales of Tier 4 and Tier 4 were up 30%. And if I look at our fourth quarter, we're up about 25%. Again, a little bit of lumpiness, that's why I'm talking to make sure people understand that we will have continued lumpiness as we deliver those solution sets, particularly with our Atrius-based luminaires. So, we're up about 25 points. And if I did that based on the quarter, we would probably be a 17% or 18% of total sales would be in that 3 and 4. But understand also that mix influences that.

So as we introduce -- and in our Contractor Select portfolio the introduction was received very well in numerous channels. Well, those aren't Tier 3 and Tier 4 solutions. So, don't be concerned about percentage wise. We feel robustly strong that our investments in the things that we're doing in 3 and 4 are paying off.

When I look at our enterprise solutions business, which is really what we're selling our Atrius-based luminaires through, that business was up huge on a year-over-year basis. And we're now introducing our nLight AIR solution set, which is really Tier 3 enabled capabilities. And we're seeing really strong interest there. So our expectation is that Tier 3 and Tier 4 in 2019 will continue to grow at really quite a significant rate, and improve our capabilities as we go forward.

[Brian Lee, Goldman Sachs]

Okay, great. And appreciate that color. Just a second question on margins here. The $20 million and 200 basis point impact from wage inflation and also costs and tariffs I know may be difficult, but is there any rough ballpark delineation you can provide as to how much was wage-related, and how much was other cost-related? And then I know there's been a few questions around the gross margin trajectory. I just want to clarify, are you inferring that gross margins in fiscal Q1 will be up versus fiscal Q4, i.e., Q4 is the trough or are we to assume that things are relatively flattish and then you get an up quarter where you get the full capture in fiscal Q2? Thank you.

[Vern Nagel, Chairman, President & CEO]

Sure. So let me be clear on the slightly more than $20 million of spike increases. Those spike increases were for various types of material, whether it's commodities like steel, component parts, electronic component parts. We also experienced an increase in freight. What we -- and they’re round items, but when we say wages, what we're really meaning, wages are in the SDA area for us, so that in fact $20 million is not including wages.

But what is important in the $20 million is if you look at freight and some of these other things, freight is a meaningful part of our business, whether we're shipping product to our customers or people are shipping components to us, these folks are having a difficult time finding enough truck drivers. And so wage inflation is driving up their rates to us. It's because of the tight labor markets that we're experiencing some of these inflationary items that are coming through. So at the gross profit level, I'm not calling out our wages, I'm calling out the tight labor market that's driving other costs -- other input costs for us to be higher.

So, that $20 million doesn't include our SDA wages. Our SDA wages, as I said, while headcount is flat, if I look at the increase on a year-over-year basis of our SDA, excluding freight and commissions, a little bit more than half was due to employee-related costs. And that's the wage inflation item that we see there. So I hope that adds a little bit of clarity to the point.

[Brian Lee, Goldman Sachs]

Yes, that's helpful. And just on the gross margin trajectory?

[Vern Nagel, Chairman, President & CEO]

Sorry, I forgot that one. I think on the gross margin trajectory, as Ricky described, our expectation is that the price increase that is effective 9/17 or a portion of what we have will have a positive impact. And then the price increase that is effective 10/15, we will absorb some costs prior to that. So our expectation is that we will claw back at a portion of this 20 plus million. Our expectation is that we'll see some positive price in some of the other areas. So, we're hopeful that we will see a lift from the fourth quarter in terms of margins. But it's a fluid situation, as you might imagine.

[Brian Lee, Goldman Sachs]

Okay. Thanks, guys.

[Vern Nagel, Chairman, President & CEO]

Thank you.

[Operator]

Thank you. And I would like to turn the call back over to Mr. Vernon Nagle for closing remarks.

[Vern Nagel, Chairman, President & CEO]

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 that have the potential over the long-term to deliver strong returns to our key stakeholders. Our future is bright. Thank you for your support.

[Operator]

And that does conclude today's conference. All participants may disconnect.