Core & Main Inc

NYSE:CNM

Earnings Call Transcript 2022-Q4

[Operator]

Welcome to the Core & Main Fourth Quarter 2022 Earnings Call. My name is Harry, and I'll be coordinating your call today. [Operator Instructions]

And I would now like to hand over to Robyn Bradbury to begin the presentation.

[Robyn Bradbury, Vice President, Finance, and Investor Relations]

Thank you. Good morning, everyone. This is Robyn Bradbury, Vice President of Finance and Investor Relations for Core & Main. Core & Main is a leader in advancing reliable infrastructure with local service nationwide. We are thrilled to have you join us this morning for our fourth quarter earnings call.

I am joined today by Steve LeClair, our Chief Executive Officer and Mark Witkowski, our Chief Financial Officer. Steve will lead today's call with a review of our fiscal 2022 execution highlights followed by a discussion on our growth strategy. Mark will then discuss our financial results and fiscal 2023 outlook followed by a Q&A. We will conclude the call with Steve's closing remarks.

We issued our fourth quarter and full-year earnings press release this morning and posted a presentation to the Investor Relations section of our website. As a reminder, our press release, presentation, and the statements made during this call include forward-looking statements. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our expectations and projections. Such risks and uncertainties include the factors set forth in our earnings press release and in our filings with the Securities and Exchange Commission.

Additionally, we will discuss certain non-GAAP financial measures, which we believe are useful to assess the operating results of our business. A reconciliation of these measures can be found in our earnings press release and in the appendix of our investor presentation.

Thank you for your interest in Core & Main. I will now turn the call over to Chief Executive Officer, Steve LeClair.

[Steve LeClair, Chief Executive Officer]

Thanks, Robyn. Good morning, everyone. Thank you for joining us today, we're excited to share our results with you. Starting on page five of the presentation, fiscal 2022 was an impressive year for Core & Main. We achieved a record $6.7 billion of net sales, which was 33% higher than last year and 83% higher than fiscal 2020. Our ability to grow the business over the last several years is a testament to the investments we've made, our ability to execute with agility, and our associates relentless focus on our customers. Our teams executed at a high level to deliver these results, while improving our operating capabilities and solidifying our platform for growth.

We made tremendous progress on our organic growth strategy and margin initiatives in fiscal 2022. Our product and customer initiatives produced solid results throughout the year. We continue to accelerate the adoption of new products in our industry, like fusible HDPE solutions to our waterworks customers, fabrication, and kitting assemblies for fire protection contractors and advanced storm water management and erosion control systems. We've also increased our share with strategic accounts to typically lead large projects that require greater technical expertise and specialized procurement needs. The combination of these products and customer initiatives delivered consistent above market growth and share gains during the year.

We are an industry leader yet we estimate we have only 17% share of a very fragmented $40 billion addressable market. Accordingly, our future growth opportunity remains significant and we have identified several priority markets where we believe we are under penetrated. We have been successful expanding in various markets by having the ability to pursue greenfield expansion or M&A opportunities. We opened three new locations in underserved markets in fiscal 2022, growing our footprint to approximately only 320 branches across the United States and building on our commitment to make our products and expertise more accessible nationwide. Over the last five years, we've opened 15 new locations, all of which continue to mature and offer additional growth opportunities. We have the ability to efficiently open new branches in attractive markets, due to our size and scale, talent pool, and advanced training program.

In addition to our organic growth, we also welcomed eight new companies to Core & Main during and subsequent to the year. With approximately $175 million of historical annualized net sales. These businesses have talented teams, strong customer relationships, and in certain cases they brought us new capabilities or provided opportunities for growth in adjacent markets. With a strong balance sheet and experience integration team and the reputation of the acquirer of choice in our industry, we remain well positioned to grow sustainably through acquisitions. We have deployed over $800 million of capital through M&A since 2016 to enhance our geographic footprint, bolster our product lines, enter adjacent markets and acquire key talent. While these businesses are highly integrated into our business model, we estimate that this group of acquisitions generated over $1 billion of sales in 2022 and over $200 million of adjusted EBITDA.

This is a testament to the significant value we gained from M&A and it reflects tremendous synergy improvement. We generate synergistic value from the business we acquired through our favorable purchasing advantages, fixed cost leverage, facility optimization, preferred and often restrictive access to products, regional and national sales initiative resources, and a scalable [IQ] (ph) platform. We have completed several acquisitions where we extended our product lines into their offerings, thereby expanding our overall sales opportunity.

We've also acquired businesses that provided access to new products and technologies and we were able to pull those products through to our nationwide branch network. Over the past several years, these synergies have been a key driver of our growth and profitability. As we look ahead, our M&A pipeline remains very active, we expect to continue adding strong businesses to the Core & Main family throughout 2023 and beyond.

On the gross margin side, we continue to build out a highly scalable assortment of private label brands and products used throughout the water, wastewater, geosynthetics and fire protection industries. These products typically yield gross margins that exceed our core products by 1.5 times to 2 times. We ended the year with private label representing approximately 2% of our total COGS with opportunity for it to grow to 10% to 15% over the several years. We believe our direct sourcing capabilities, brand recognition and diversified domestic and international supplier relationships will continue to create cost advantages and improve product availability in the future.

Our private label efforts are focused on a wide array of spend on ancillary products that support our customers' projects, but not the highly specified products from our key supplier partners. We've also made great progress in optimizing system-wide pricing through IT enhancements and data-driven analysis, which enables us to identify pricing opportunities, and mitigate the impact from rapid cost changes. We expect these initiatives and others to contribute positively to our gross margin in the years to come.

Turning to our productivity initiatives. We made strategic investments during the year aimed at improving our customer experience, while making our teams more efficient, thereby driving organic growth and improving SG&A leverage. In addition to our technology-driven initiative, we now have a dedicated strategic operations team, who partners with our field to develop and implement operational best practices across the company. Not only do these solutions improve our efficiency to help drive EBITDA growth and EBITDA margin expansion, they also improved customer service through better communication responsiveness with our customers. We are excited about increasing the capacity and efficiency of our branches and we see continued improvement ahead.

As a leading specialty distributor that provides products, services and solutions with the national footprint, we also have an excellent balance across our offering in geographies. Our strategy to fill in existing product lines and geography, both organically and through acquisitions, reinforces this balance over time. Our end market mix, broad product portfolio and vast geographic footprint offers us multiple avenues to grow in more ways to create value for our customers and suppliers, while providing resiliency in softer markets.

I have great confidence in our ability to operate this business and outperform in any economic environment. The resilience of our municipal end market, including the non-discretionary repair and replacement nature of our business and our ability to generate strong cash flow even in weaker economic environment sets us apart. While we expect a more challenging residential end market, compared to where it has been performing in recent years, we have multiple levers to pull for continued growth.

We have seen pricing stabilize and remain elevated for several months across our municipal pipe products. We expect to see continued inflation in other product categories. Overall, we don't expect a notable impact from pricing in fiscal 2023, either positive or negative. As we move into fiscal 2023, we'll continue executing on our growth and margin expansion strategies.

Turning to page six, you can see our strong track record of performance over the last five years, with annual sales growth averaging approximately 20%, including 300 basis points above market growth and 600 basis points of EBITDA margin expansion. We've done this well investing heavily in our teams and in new systems and technologies to develop the foundation for Core & Main. We remain confident in our ability to gain market share and drive profitable growth over the long-term.

On page seven, we've outlined our value creation targets. Historically, our end market volumes have grown the low-to-mid-single-digit range annually and we have grown in excess of the market by at least 2 percentage points to 3 percentage points. We drive above market growth through the execution of our products and customer initiatives, growth in underpenetrated geographies, the addition of key sales talent and local share gains.

M&A is also central to our growth strategy. We have a robust pipeline and a proven playbook we utilize in pursuing and executing acquisitions. Our acquisitions have historically delivered 2 percentage points to 5 percentage points of sales growth annually and we are confident in our ability to deliver similar results over the long-term. We complement our sales growth with margin expansion initiatives, fixed cost leverage, and productivity gains, which has allowed us to grow our profitability 1.3 times to 1.5 times faster than our sales. Because of our fixed cost structure, we naturally gain operating leverage as we grow, often having significant capacity to expand within our existing buildings, yards and delivery fleet.

Our margin expansion initiatives include private label, category management, pricing analytics and productivity and innovation in addition to margin enhancement from accretive M&A are expected to continue driving sustainable margin improvement in the years to come. Lastly, we have a track record of strong operating cash flow, due to the low capital requirements of our business and our effective working capital management. We expect and convert between 55% and 65% of our adjusted EBITDA into operating cash flow, providing ample liquidity to fund our growth strategies for returning capital to shareholders.

On page eight, we outlined the secular growth trends that underpin each of our end markets. Municipal demand has exhibited steady growth over the long-term, due to the critical and immediate need to replace aged water infrastructure. However, due to limited available funding over the last decade, the pace of investment has significantly lagged the need for investment. In recent years, access to capital, increased water utility rate and necessity of increased municipal investments in water and we expect these trends to continue for the foreseeable future. Each year, billions of gallons of treated water is lost through the United States, due to our aging water infrastructure.

Our secular focus on water, coupled with the commitment from our associates to advance reliable infrastructure helps mitigate these challenges over time. Our exposure to the resilient municipal end market positions us well to outperform the broader market in the event of a deeper short-term decline in residential lot development. We also believe we can capitalize on the anticipated long-term growth in residential and non-residential development, both of which remain below long-term historical averages and are expected to benefit from population growth. The historical under build of housing versus household formations, demographic populations, the need for commercial, institutional, industrial and other non-residential development to support population growth.

Our non-residential end market consists of a balanced mix of project types, including commercial buildings, healthcare facility, schools, industrial complexes, and less cyclical road and bridge rehabilitation projects, which provide stability through the ups and downs of economic cycles. Our broad exposure to the non-residential end market generally provides stability as demand for these projects can happen on different cycles. Our residential exposure, which is just over 20% of net sales is nearly all new land development. And supply developed lots is at historically low level. As such, we believe that continued lot development will be critical to support long-term housing supply needs.

Turning to page nine, our end markets are backed by critical investment in the U.S. Infrastructure from the Infrastructure Investment and Jobs Act, which we estimate to be an addressable product sales opportunity exceeding $15 billion. In the coming years, we expect funding associated with the bill to have a core focus on the upgrade, repair and replacement of municipal water systems, we are positioned to capitalize on this significant opportunity. We also anticipate that the $110 billion of funding earmarked for road and bridge work will be a tailwind for our non-residential end market as we will have opportunity to sell our storm drainage products on these projects, including geosynthetics and erosion control.

The first wave of funding has been allocated to state revolving funds or municipalities can apply for the grants or loans. We are also seeing some allocation of funds and while not material at this point, it is encouraging to see. Over 55,000 municipalities across the U.S. some of which lack the knowledge and resources to apply for the funding, which could delay the process in getting into the hands of the municipalities. We expect to play a key role in assisting municipalities to obtain this funding to help advance reliable infrastructure in the communities we serve. Once funds are awarded and allocated, municipalities will build them into their fiscal budgets. At that point, we'll begin to see it flow into our end markets likely in the second-half of 2023.

As I wrap up my prepared remarks, I want to share that I'm extremely proud to see our vision of advancing reliable infrastructure realized through the achievement of our growth strategies. Our teams have worked diligently to transform Core & Main into an industry leader that can be relied on to consistently deliver local knowledge, local experience, and local service nationwide. We remain confident in our ability to navigate challenging market conditions, outperform the market, and continue to grow the business both organically and through M&A.

Now I'll turn the call over to our Chief Financial Officer, Mark Witkowski to discuss our financial results and fiscal 2023 outlook. Go ahead, Mark.

[Mark Witkowski, Chief Financial Officer]

Thanks, Steve. I'll begin on pages 11 and 12 with highlights of our fourth quarter and full-year results. For the fourth quarter, we reported net sales of nearly $1.4 billion, an increase of 10%, compared with the prior year period with approximately 3 points of growth from acquisitions. Our organic growth was due to higher selling prices as we passed along rising material costs, partially offset by mid-single-digit volume decline.

During the quarter, we benefited from higher selling prices, compared with the prior year. Sequentially, we saw prices stabilize even as supply chains continue to improve, while prices have remained at elevated levels to-date, we are beginning to see the price contribution moderate as we anniversary the increases from a year ago. Organic volume declined by approximately 5% in the fourth quarter due to strong multiyear comps. We anticipated and were impacted by normal seasonality this year and we also experienced more typical weather conditions, compared with the prior year.

Our results in the quarter were also impacted by a softening residential end market as land and lot developments slowed in response to higher interest rates with developers continuing to scale down projects. Considering the strong volumes we have experienced in the past two years, both non-residential and municipal markets continue to show strength.

We delivered gross margins of 27.1% for the quarter, which were up 90 basis points from the prior year period. Our gross margin performance was driven by utilization of low cost inventory, the execution of our margin enhancement initiatives, accretive acquisitions, and a favorable mix benefit. SG&A as a percentage of net sales in the fourth quarter increased 80 basis points to 15.5%. The increase primarily reflects the impact of higher variable compensation, acquisitions, cost inflation and increased operating expenses to support our growth.

Our SG&A as a percent of net sales is typically higher in the first and fourth quarters, due to the seasonality of our sales and fixed cost structure. We recorded $84 million of net income in the fourth quarter, compared with $79 million in the prior year period. The increase was primarily due to higher operating income, partially offset by higher interest expense and the provision for income taxes.

Adjusted EBITDA increased approximately 9% to $164 million, compared with $151 million in the prior year. Adjusted EBITDA margin decreased 20 basis points to 11.9%, due to cost inflation, higher operating expenses to support our growth and lower sales volume.

Turning to the full-year performance on page 12. Net sales grew 33% to $6.7 billion for fiscal 2022. The increase was due to higher selling prices from passing along rising material costs, mid-single-digit volume growth, driven by market share gains and approximately 3 percentage points of contribution from acquisitions. We estimate that end market volumes were broadly flat for the year underpinned by low-single-digit volume growth in our municipal end market, mid-single-digit volume growth in our non-residential end market offset by low-double-digit volume declines in residential lot development.

We have performed our end markets and achieved share gains from the execution of our product, customer and geographic expansion initiatives, the addition of key sales talent and strong operating performance during a period of supply chain challenges. We continue to accelerate the adoption of new products in our industry such as smart meter solutions, fusible HDPE products and services, fire protection, fabrication and kitting assemblies, and stormwater management systems. We've also increased our share with strategic accounts, who typically pursued large projects that require greater technical expertise and specialized procurement needs like the new construction and rehabilitation of water and wastewater treatment facilities.

We estimate that these initiatives drove over 300 basis points of above market growth in fiscal ‘22, despite the considerable share gains we achieved and have maintained since last year. Gross profit for fiscal ‘22 increased 40% to approximately $1.8 billion and gross profit margin increased 140 basis points to 27%. The increase was primarily driven by utilization of low cost inventory, the execution of our margin enhancement initiatives, accretive acquisitions and a favorable mix benefit.

Given the benefit from our inventory investments and the favorable pricing environment, we estimate that roughly 100 basis points to 150 basis points of our 2022 gross margins may be temporary in nature and could reset once supply chains and costs fully normalized. However, we expect continued improvement from our gross margin initiatives, which will help reduce the potential reset in gross margin rate.

Selling, general and administrative expenses for fiscal ‘22 increased 23% to $880 million, while SG&A as a percentage of net sales improved 110 basis points to 13.2%. The improvement in SG&A as a percentage of net sales was due to fixed cost leverage on the increase in net sales partially offset by $127 million increase in personnel expenses, which was primarily driven by higher variable compensation costs and increased headcount.

In addition, distribution facility and other operating costs increased due to higher volume and inflation. Interest expense for fiscal 2022 was $66 million, compared with $98 million in the prior year. The decrease was due to lower debt levels, compared with the prior year, partially offset by higher interest rates on the unhedged portion of our senior term loan.

Income tax expense for fiscal 2022 was $128 million, compared with $51 million in the prior year, reflecting effective tax rates of 18.1% and 18.5% respectively. The increase in taxes was a result of higher pretax income. Net income for fiscal 2022 increased 158% to $581 million. The increase was primarily due to higher operating income, lower interest expense, in the absence of two IPO related charges in the prior year, partially offset by the increase in income taxes.

Adjusted EBITDA for fiscal ‘22 increased 55% to $935 million and adjusted EBITDA margin improved 200 basis points, due to our strong net sales growth, gross margin expansion and leveraging our cost structure and the increase in net sales.

Turning to our cash flow and balance sheet performance on page 13. We delivered $307 million of operating cash flow in the fourth quarter. We take a disciplined approach to cash generation and it is important quality of our business model. As we've discussed over the last several quarters, we continued to invest in inventory to ensure we had the best levels of availability for our customers during a period of supply chain challenges.

Additionally, our receivables have grown as a result of our strong sales growth. This working capital investment has supported our growth over the last year and has generated record returns. We generated over $400 million of operating cash flow in fiscal 2022, which reflects a 43% conversion from adjusted EBITDA. We expect continued improvements in operating cash flow as we work to optimize our inventory levels. At the end of the year, we had over $1.4 billion of liquidity consisting of $177 million of cash and cash equivalents and $1.2 billion of excess availability under our senior ABL credit facility.

Our net debt leverage at the end of the year was 1.4 times, representing an improvement of 1.1 times from the end of fiscal 2021. We maintain our cash and cash equivalents according to a conservative banking policy that requires diversification across a variety of highly rated financial institutions. Our ABL credit facility is also diversified across various financial institutions with no individual bank making up more than 10% of our available credit line. While we don't anticipate any significant impacts from the recent events in the banking sector, we will continue to monitor the situation closely.

Now I'll cover our outlook for fiscal 2023 on page 14. As you know, we are operating in a more challenging and economic environment as we head into fiscal 2023. Accordingly, we anticipate softer demand, compared to last year, which is reflected in our guidance. We expect net sales to range from $6.5 billion to $6.9 billion, representing year-over-year growth ranging from up 3% to down 3%. This assumes soft market volumes due to anticipated double-digit volume decline in residential lot development, partially offset by strength in municipal repair and replacement activity and a stable non-residential end market.

Our value creation formula remains firmly intact. We expect to achieve 2 points to 3 points of sales growth from the execution of our product and customer initiatives growth in underpenetrated geographies, the addition of key sales talent and share gains. We're also in a position to maintain, if not accelerate our pace of M&A activity. We have significant balance sheet flexibility supported by strong cash flows, a robust pipeline of opportunities and a proven integration playbook. We expect 2 points of sales growth in fiscal 2023 from acquisitions that have already closed.

Regarding material costs, there are reasons to believe that pricing from our products may staying at higher levels due to the long-term demand characteristics of our end markets and the restricted supply of many of the products we distribute. As such, we expect contribution from higher selling prices to be roughly flat for the full-year. Roughly two-thirds of our sales are from products that are highly specified at the local level. The cost of these products have historically been very sticky and we have been successful in passing along the rising material costs through higher prices.

We expect to hold on to the recent price increases from these products and we may even experience additional price increases through 2023 as suppliers continue to catch up with their rising costs. The remainder of our sales primarily include municipal pipe products, many of which are specific to our industry with limited alternatives thereby likely providing more stability versus pipe products that can be utilized across multiple industries. We will continue to monitor the cost of our municipal pipe products closely, but we have been pleased to see the cost of these products remain firm at higher levels over the past few quarters.

We expect our gross margin to normalize in fiscal 2023 by 100 basis points to 150 basis points without the benefit from inventory investments ahead of rapid inflation. However, we will mitigate the impact of this through our margin expansion initiatives and productivity gains, which has allowed us to consistently grow profitability 30% to 50% faster than our sales.

Taken altogether, we expect fiscal 2023 adjusted EBITDA to be in the range of $785 million to $865 million providing a new foundation for continued EBITDA margin improvement over the long-term. We anticipate an effective tax rate of 18% to 20% in fiscal 2023. Keep in mind that our effective tax rate will increase if our continuing limited partners exit their position over time since more income will be allocated to Core & Main, Inc. However, we expect our total cash tax distributions to reduce over the same time frame as we shift partnership distributions to corporate taxes and realize additional favorable tax attributes.

Regarding cash flow, we expect to convert 80% to 100% of our adjusted EBITDA into operating cash flow in fiscal 2023 as we optimize our inventory balances throughout the year. If our supply chains continue to improve, we intend to reduce inventory to the extent we can maintain service levels with our customers.

I'll wrap up on page 15 with a discussion of our capital allocation priorities. We expect to generate significant cash flow in 2023 and beyond given the tremendous growth and profitability we have achieved. Our primary capital allocation priority remains to invest in the growth of the business, both organically and through acquisition, but we expect to have excess capital available to deploy, which we intend to return to shareholders.

We are adding dividends as a potential future form of capital return alongside share repurchases as we consider the strength of our cash flows and our desire for a balanced approach. We will continue to evaluate these priorities, while maintaining our financial strength and flexibility.

In closing, we have a resilient business model and a leadership team capable of quickly adjusting the changes in the market. We are strategically positioned with multiple paths of sustainable growth. We remain focused on executing at a high level to deliver value to our customers, suppliers, communities, and shareholders.

At this time, I'd like to open it up for questions.

[Operator]

Thank you. [Operator Instructions] Our first question today is from the line of Jamie Cook of Credit Suisse. Jamie, your line is open. Please go ahead now.

[Jamie Cook, Credit Suisse]

Hi, good morning. I guess two questions. Understanding in your guide you're talking about sort of a stable non-res market. Can you sort of talk to risk that you see in terms of the non-res sector and what's happening on the local banking side, just like the risk there and where the offsets would be if non-res starts to deteriorate?

And then my second question, you're sitting with a very strong balance sheet potentially going into a downturn. Can you speak to your appetite for the size of the acquisitions and how much you'd be willing to lever up? I'm just wondering if there's an opportunity to do sort of a larger deal versus the mortgage acquisition you've done more recently? Thank you.

[Steve LeClair, Chief Executive Officer]

Okay. Thanks, Jamie. Yes, regarding non-residential, I'd share with you a couple of things. Number one, we deal with this a lot on the upfront when it comes to land development for commercial construction. So we have a pretty good line of sight into our bidding activity and the starts activity on that side. And then as the buildings progress, we have a good line of sight into the finish phase of that and we get into fire protection products installed. So as we look through our backlog and we look through our bidding activity, we're really comfortable with what we're seeing in terms of the strength of the bidding activity and the strength of the backlog to really remain firm through ‘23.

When you look at the M&A piece, we really believe we're in a spot right now. The ability to accelerate some of the M&A activity, we're obviously very prudent about what we do and we look at a lot of deals out there. The pipeline is as strong as it's ever been, and we continue to see opportunity there as we look at not only the product expansion opportunities that we've had with geosynthetics, but also the bolt-on activities. As far as levering up, we've been able to really utilize a lot of our own operating cash flow at this point to do so. So as Mark shared with you, in terms of our capital allocation priorities, we believe we can really sustain a lot of the organic growth, the M&A and we do have options for excess cash as well and different allocation opportunities there.

[Jamie Cook, Credit Suisse]

Thank you.

[Steve LeClair, Chief Executive Officer]

Thanks, Jamie.

[Operator]

Our next question is from the line of Kathryn Thompson of Thompson Research. Kathryn, please go ahead. Your line is open.

[Kathryn Thompson, Thompson Research]

Hi. Thank you for taking my questions today and appreciate the detail that you gave in the prepared commentary. Just a clarification on your EBITDA margin guidance and getting back to normalization. How much of that decline is really more related to volume versus price, you know, outsized pricing gains. Or other factors that we may not take to account for instance mix?

[Mark Witkowski, Chief Financial Officer]

Yes. Hey, Katherine. Thanks for the question. As you look at our guidance for the EBITDA margin at the midpoint, we're down about 170 basis points, off of where we finished in fiscal 2022. I would attribute most of that really to the gross margin normalization that we're anticipating to happen in 2023. I think from a pricing and a volume standpoint, we think those are ultimately going to hold fairly firm next year, so we'll see a little bit of cost inflation come through on the SG&A side. So there's a little bit pressure there, but it really -- we believe provide the new foundation for where we're going to grow off of and really get us back to that and kind of value creation target of 1.3 times to 1.5 times operating leverage that we've been able to deliver consistently historically.

[Kathryn Thompson, Thompson Research]

Okay. And then a consistent question we are getting from not just our public companies, but the many private companies that we speak to on a regular basis. Is that -- there's so much volatility in the market? And how do you -- how do you forecast? And I guess the question I posed you that is posed to me often, which was -- what are the metrics given the volatility in the market that you are relying on most and making that prediction? And how has that changed and really understanding the why behind these metrics?

[Steve LeClair, Chief Executive Officer]

You know, Kathryn, I shared with you a couple of things that we have internally that we evaluate as we have a number of indicators, including our backlog, the geographic location of where this backlog is and you follow that up with all the bidding activity that we see. And so we feel like we've got a really good line of sight into the different end market sectors, the geographies, and our ability to forecast as we go forward. The biggest unpredictability we had in the past has always been the pricing piece. Now as that is stabilizing, we believe that we're in a much better basis right now to forecast going forward.

[Kathryn Thompson, Thompson Research]

Okay, great. Thanks very much, and I'll hop back in the queue.

[Steve LeClair, Chief Executive Officer]

Thanks, Kathryn.

[Operator]

Our next question is from the line of Mike Dahl of RBC Capital Markets. Mike, please go ahead now.

[Mike Dahl, RBC Capital Markets]

Good morning. Thanks for taking my questions. Just a follow-up on the current dynamics around end markets and kind of the recent banking stress. I guess two-fold, we'll go on regional banks do play a large role in land development, as well as in the resi sector, as well as non-resi. So maybe could you articulate a bit more when you say double-digit declines in lot development, maybe quantify that a little?

Then on the non-resi piece, you know, appreciate the bidding is still healthy. Today, if, you know, historically, do you have a good way of tracking, I assume you track your win rate, but do you have a good way of tracking project fallout in terms of where, kind of, a bid ultimately doesn't even translate to a project moving forward? And how are you -- and how do you evaluate that looking forward?

[Steve LeClair, Chief Executive Officer]

Yes. I shared with you as we look at the bid activity, certainly we look at win rate, we look at the ability for open jobs, if you can imagine a lot of the -- these -- the work that we do is project related. And so the release of materials and the release of the credit lines that we have with the businesses are certainly tracked pretty closely as we go through here, it’s kind of a complex lien rights type situation and how we look at the credit piece. So we do follow that. We do have a good line of sight. We are pretty quick at being able to adjust down on that. And to be able to get real time information, as well as what we're seeing on the forward looking and then certainly in the backlog. So it's too early to tell exactly what type of indirect impact some of the banking failures are going to have and the crisis it's going to have with our customers go up to this point.

Certainly, we don't have any direct impact to our business, and as we look at the customer impact, that's kind of yet to be determined. But we do have pretty good indicators to start assessing that as it starts to play out, if it plays out.

[Mike Dahl, RBC Capital Markets]

Okay, that's helpful. And then secondly, on the, just on the pricing assumptions, it seems like you still exited the year and kind of a low to mid-double-digit range on price, which presumably given your comments so far about price remaining elevated, there's some carryover impact, yes, at least to start this year. So maybe help us understand, kind of, the trajectory of pricing as you go through the year to get to the flat estimate or is this just, kind, of being conservative on how the back half plays out, because it seems like you're flowing through the entire -- you're kind of thinking in your gross margin side that prices really normalize, but then there should be some tailwinds to start the year. So just the puts and takes around that?

[Mark Witkowski, Chief Financial Officer]

Yes, sure, Mike. Thanks for the question. Yes, you're right, as we wrapped up 2022, we did have some still year-over-year pricing benefit in there in the low-double-digit range. As we move into Q1 and certainly into Q2, you look back to last year, we really started to see some of that acceleration of price happen. So we do expect that price to moderate fairly quickly as we get into 2022 -- or sorry 2023 in particular in the first quarter we'll see a little price benefit and then that's going to stabilize pretty quickly as we get into Q2 and Q3 as we anniversary those increases from a year ago.

I'd say on the gross margin normalization is really more the cost side catching up more so than any, kind of, price declines or anything. Obviously, we could see some risk with certain product categories. But frankly on some of our non-pipe categories, we're still seeing some price increases come through, though not necessarily the same magnitude or frequency that we saw last year, so that's what gives us the confidence that we'll see that, kind of, price really stabilize as we get to, kind, of mid-year and that's kind of how we see it playing out at this point.

[Mike Dahl, RBC Capital Markets]

All right. Thanks, Mark. Thanks, Steve.

[Steve LeClair, Chief Executive Officer]

Thanks.

[Operator]

Our next question is from the line of Dave Manthey of Baird. David, please go ahead now. Your line is open.

[Dave Manthey, Baird]

Thank you. Good morning, everyone. The waterworks segment of [H2] (ph) supply obviously had a pretty rough period of time from the peak in ’06 through ‘09. I was just wondering, Steve, if you could just compare and contrast the company then versus now and give us some comfort around cyclicality? And what we might expect the -- during the -- whatever is to come here?

[Steve LeClair, Chief Executive Officer]

Yes, sure, David. If you go back to that time period back in ’08 and ‘09, the business end market exposure was significantly different at that point. It was roughly about 50% residential. So a lot of the lot development and everything else that happened back then, that's where this business was exposed to fairly significantly. A lot less exposure in municipal and certainly in non-residential. We tried to -- and have diversified the business significantly since then.

The other thing I'd share with you is back then the reason the recovery took so long, particularly in the residential piece for us when we get into land development was there were a number in a big -- in a significant amount of I'd say developed property that was not built on. And so that lasted for years before any new land development happened and new infrastructure was put in the ground. As residential started to improve in 2010, ‘11 and ‘12, they were utilizing a lot of the predeveloped lots that were out there. So we're certainly not experiencing that now. The exposure we have is significantly less, it’s about 22% today is residential in terms of land development.

And if you look at kind of the available lots that are out there, land development is still a key shortage item. And these builders are still working on land development, still working on acquiring land as we get through this period here with the interest rates and everything else. So the business has diversified into municipal much more heavily, we've been able to add a lot more adjacent products into there. We talked about some of our meter business that we have grown significantly in this space and become a leader in that, also with high density polyethylene infusible HDPE, some of those areas have helped us to diversify the business and bring in other product alternatives into that industry. So we're in a much different spot right now, many more levers to grow, much more diversified in terms of our end markets since then.

[Dave Manthey, Baird]

Thank you for that. And second on this landscape and construction acquisition, just two locations in Chicago, I think what serves 15 States and it sounds like they manufacture soap fence and geosynthetics. I'm wondering this is some kind of backward integration product access type acquisition. And I think we can back into $60 million in revs, is there something different about that profit model we should know about? Just more detail on that deal in particular would be helpful?

[Mark Witkowski, Chief Financial Officer]

Sure, you know, it’s two locations up there, but I'd almost consider it, if you're trying to estimate relative size about one location would be equivalent of what we typically would do. And then we have gotten into geosynthetics and light fabrication, and we've been able to utilize that. If you look at some of the acquisitions we've done in the last few years, we started with a small geosynthetics branch in Indiana. We have since built our presence with a number of acquisitions up and down the eastern seaboard out into the West Coast with California and then have organically opened a few other locations, as well as we utilize those products be able to pull through our branches and continue to serve existing customers through their other channels. So we see it as a margin accretive opportunity to continue to add value into our existing customer base and that [Technical Difficulty]

[Dave Manthey, Baird]

Well, thank you.

[Steve LeClair, Chief Executive Officer]

Thanks, David.

[Operator]

Our next question is from the line of Nigel Coe of Wolfe Research. Nigel, your line is now open.

[Nigel Coe, Wolfe Research]

Thanks. Good morning, everyone. Just want to go back to the margin guidance for 2023, and I think, Mark, you might have mentioned that most of the price cost, sort of, normalization occurs in the next 12 months. So just wondering if the 12.4% midpoint guide, is that a good base for 2024? And are we now at a normal base that's open [Indiscernible]?

[Steve LeClair, Chief Executive Officer]

Yes, Nigel, that's how we're thinking about it right now. We expect some of that normalization to start happening as we get into Q1 and Q2 and probably the biggest headwind in Q3 going into 2023. But really feel like at that midpoint, we'll be able to get back to our typical, kind of, value creation growth off of that 12.4% EBITDA margin at the midpoint.

[Nigel Coe, Wolfe Research]

Okay, that's great. And then, obviously, a lot of free cash flow in your guide for next year, roughly several [$7 million] (ph) of free cash flow. You mentioned the dividends, I'm just wondering what we're thinking is around the potential dividends next year, would that be a relatively modest dividend? I mean, any thoughts around that? And then just to understand your thought process on deployments, would you expect to deploy the bulk of that $7 million in either M&A buybacks and dividends?

[Steve LeClair, Chief Executive Officer]

Yes. Thanks, Nigel. The capital allocation is really a function of the cash flow, as you mentioned, we've been able to generate and really our confidence in it going forward for the long haul. So we’ll still have organic growth in M&A is our key growth priorities. And as we mentioned, we think we can continue to do those at least at the level that we've done historically. But given the cash flow that we expect to generate, we really feel like we can balance that and return some capital to shareholders through either share repurchases, which could take various forms and potentially a modest dividend. So that's how we're thinking about it right now. We'll go through and assess those alternatives and try to optimize those returns to the shareholder base.

[Nigel Coe, Wolfe Research]

But right now, debt reduction is the priority.

[Steve LeClair, Chief Executive Officer]

Not currently given where our leverage is. We're pretty comfortable where we are at 1.4 times, we'd be comfortable going up to 2 times to 3 times depending on what opportunities they're available for us. But right now, I think the opportunities we have for growth and return of capital present better return capabilities.

[Nigel Coe, Wolfe Research]

Great. Thanks. Yes, thanks very much.

[Steve LeClair, Chief Executive Officer]

Yes. Thank you.

[Operator]

The next question today is from the line of Joe Ritchie of Goldman Sachs. Joe, your line is now open.

[Vivek Srivastava, Goldman Sachs]

Hi. Good morning. This is Vivek Srivastava on for Joe. My question -- my first question is on the total addressable market, it was interesting to see your TAM from the point of IPO, which was around $27 million is now around $40 million. Can you talk about what are the factors driving the increased TAM? How much of it is due to pricing? And where have you gained market share? Because even your market share is higher now in this market and if you are number one in the market share now?

[Mark Witkowski, Chief Financial Officer]

Yes, thanks for the question. Yes, if you look at the addressable market, I'd say the primary factor for that growth over that period has been the increase in prices that we've seen. As we talked about the end market for 2022 was relatively flat given the softer residential environment we experienced in particular in the back half of the ‘22. And we've continued to take share gains while we've seen that market expand and that's come through various forms. Obviously, the acquisitions that we've done, expansion into the erosion control geosynthetic space. The local share gains, we believe we've taken a lot of share primarily in these local markets by having access to products and then expanding the products that we've got available for our customers.

And then our sales initiatives with our strategic accounts in particular has allowed us to take some nice share gains over this period. So those are the main factors and continue to strive towards being the primary leader in the space.

[Vivek Srivastava, Goldman Sachs]

Thanks, that's helpful. And maybe just jumping on to your non-residential exposure. Can you share how much of your non-res, I think 39% of your sales is non-res? How much of it is more institution exposed versus more commercial exposed? Because, really, what we're trying to size is their lending risk is probably more on the commercial side suggest. Any color on how much of that is -- that's strictly commercial?

[Mark Witkowski, Chief Financial Officer]

Yes, we've got a pretty balanced mix in the non-residential end market. Some area obviously commercial is part of it, institutional spend is in there, some industrial that we've seen a lot of good growth as well with warehouse data centers. Also in non-resi, we have some multifamily exposure we put in there, as well as some very, I'd say, non-cyclical road and bridge work. So a lot of our storm drainage product that goes into road construction sits in our non-residential end markets. So it's pretty well diversified across the board, which is one of the primary reasons why we think that market is going to hold and be pretty stable into ‘23 despite some of the headwinds that we know are out there.

[Vivek Srivastava, Goldman Sachs]

[Indiscernible] Thank you.

[Mark Witkowski, Chief Financial Officer]

Yes, thanks.

[Operator]

Thank you. And the next question is from the line of Anthony Pettinari of Citi. Anthony, your line is now open.

[Asher Sohnen, Citi]

Hi. This is Asher Sohnen on for Anthony. Thanks for taking my questions. I wanted to just clarify, what I think, I heard respond to another question just in terms of the cadence of sort of EBITDA margin if you're guiding from maybe 150 basis points to 200 basis points decline? On the full-year, I think, I heard maybe 3Q is where the year-over-year decline start to really pick up. Is that correct?

[Mark Witkowski, Chief Financial Officer]

Well, I think as you look at the comps related to 2022, that was one of our higher EBITDA margin quarters was Q3. But I think as you think about the cadence of that reset really starting in Q1, into Q2. And then the bigger headwind just given the comp is Q3. So if that helps a little just kind of think about the cadences that plays out in ’23.

[Asher Sohnen, Citi]

No, that's really helpful. And my second question, so you got it, so I think 80% to 100%, sort of, operating cash flow conversion in ‘23, which is obviously higher than your long-term 55% to 65% target. So I'm just wondering what's driving that delta? Is it just the reversal and some inventory investments you made? And then longer term, is there any opportunity to kind of maybe sustain new tie levels of cash conversion?

[Mark Witkowski, Chief Financial Officer]

Yes, you're right on the operating cash flow relative to our long-term target, we do expect that to be higher in ‘23 and that's primarily due to the inventory optimization that we expect to occur beginning in Q1 and into the selling season. So inventory is the biggest part of it receivables have been in good shape, good quality, receivable base. And that's really the main factor there. I'd say the longer term is there opportunity that's something that we'll continue to evaluate as we get our inventory rightsized and optimizing 23%, but I'd say that 55% to 65% is still a good target to think about long-term.

[Asher Sohnen, Citi]

Great. Thank you so much. I'll turn it over.

[Mark Witkowski, Chief Financial Officer]

Yes. Thanks.

[Operator]

The next question today is from the line of Matthew Bouley of Barclays. Matthew, please go ahead.

[Elizabeth Langan, Barclays]

Good morning. You have Elizabeth Langan on for Matt today. Just kind of looking at your guide of fiscal 2023, the commentary around pricing was really helpful, but I was wondering if you could speak to maybe like your embedded expectations for like the path of demand through the year and maybe like how that plays with volume. Like, the implications for volume. And, you know, if you could break that out maybe first-half, second-half, that'd be helpful?

[Mark Witkowski, Chief Financial Officer]

Yes. I would say in terms of the cadence for volume, again, just kind of looking back to 2022 in terms of where we had really difficult comps, meaning really strong performance last year, Q1 was probably one of our stronger year-over-year volume quarters. So comping against that this year, I think it's going to be a difficult hurdle to hit. So as you just think about kind of year-over-year cadence, I'd say Q1 expecting a little softer relative to where we've been in ‘22. And then kind of getting back on to normal kind of seasonal increases into Q2 and Q3 like we've had in the past and then Q4 again will be a typical seasonal quarter sequentially from Q3 to Q4. I would typically expect that to ramp down.

[Elizabeth Langan, Barclays]

Okay. Thank you. And then on non-res as we're kind of seeing like larger projects roll through the channel and onshoring trends, how are you thinking about those opportunities? And could you maybe touch on your ability to work with contractors and provide value-added services? And if there are any verticals that are -- you think that you're specifically advantaged to serve within those?

[Steve LeClair, Chief Executive Officer]

Sure, Elizabeth, I think when you look at some of the trends that have been happening here with onshoring, certainly industrial and manufacturing growth has been really strong for us, and when we look at our -- particularly our fire protection products, one of the value-add we do there is really working with the designers and the engineers on prefabbing and kitting a lot of the fire protection assemblies, so that they can be put on -- on-site and assembled on-site rather than fabricated on-site. And so our ability to be able to do that and respond quickly for construction needs has been really second to none. And we've handled projects as large as full stadiums down to smaller warehouses, et cetera. So I think that's an area where we feel really well positioned to be able to capitalize that over the medium and long-term for sure.

[Elizabeth Langan, Barclays]

Thank you. That's all for me.

[Steve LeClair, Chief Executive Officer]

Thanks, Elizabeth.

[Operator]

Our next question is from the line of Pat Baumann of JPMorgan. Pat, please go ahead now.

[Pat Baumann, JPMorgan]

Well, thank you. Good morning. Just had a couple here. On slide nine, can we walk through how you went about building up the TAMs for these different buckets? And then how that translates to your company, I guess, it should be assumed share that's in line with that 15% to 20%, that you’ve -- I think you said 17% on one of an earlier slide and then spread that out over five or so years? Or is there a reason to believe it'll be kind of above or below that type of share? And I know this is a long question, but I think you said none of this is assumed yet for ’23, maybe just kind of flush out what's holding it up.

[Mark Witkowski, Chief Financial Officer]

Yes. Hey, good morning, Pat. Thanks for the question. Yes, as you look at the infrastructure build, we basically look at that spend and how much that as material component that we would distribute. And then obviously, as you mentioned, then applying our share to that, I would say the one difference is, as you think about some of these projects, they tend to be fairly large scale and we're one of the best position to capture those benefits. So we do feel like there's opportunity to get more than our fair share of those types of projects.

As you think about it and then as it relates to timing, as Steve mentioned, we have seen some beginnings to that -- those funds starting to flow, which has been encouraging to see, we wish we had seen more, I'd say, at this stage, so that's what's pushed us more maybe towards the back half of ‘23 before we really start seeing the incremental benefit here. I'd say we are feeling better about the supply chain and starting to free up, so that could be an opportunity to potentially accelerate some of this, if we see more of those funds starting to get applied for.

And then, yes, I think over a period of five to seven years as those projects depending on the size and the scale actually get deployed as a reasonable time frame to think about that opportunity.

[Pat Baumann, JPMorgan]

How much is incremental do you think in terms of versus like current market? Like is some of this just kind of funding from different sources as opposed to like incremental projects? Or is there a way to think about the incremental nature of this stuff coming through?

[Mark Witkowski, Chief Financial Officer]

Yes, we still believe it's incremental. We've indicated in the past we do think it could accelerate our municipal end market by 1 points to 2 points of growth over this period. So there is incremental funding here. There is through a lot of either state revolving funds or specific grants for this type of work. So we're still confident that we could see an acceleration of that municipal end market due to this funding.

[Pat Baumann, JPMorgan]

Great. And then on pricing, last year I think you pointed to 32% of your sales were commodity priced product, I think you called it? Can you remind us what that is now, kind of, what's embedded in those numbers? Like what type of product is in there? And how much price did that see in ’22 and kind of what gives you confidence that this bucket of products will be able to, kind of, sustain pricing if commodity costs come down?

[Mark Witkowski, Chief Financial Officer]

Yes, Pat. So what I would say is we've got about two-thirds of our revenue is based on products that are highly specified at the local level and price is very sticky and that's a element of this business that gives us a lot of confidence about the stability of pricing. Then I'd say there's less than 5% or so of our product that really tracks more towards underlying commodities. And those would be things like copper pipe, steel pipe, that's used in our fire protection product line. And those pipe products are widely distributed to various industries. So they tend to be much more cyclical.

The balance of it then, so call it 25% to 30% is our municipal pipe products, which include PVC pipe, municipal ductile iron pipe, is in that category. Those types of pipe products are very specific to this sector and don't tend to move as cyclical as those copper and steel pipe. And we've been very encouraged to see the pricing on those products be fairly stable here over the last few quarters even despite the supply chains improving in those categories. So those are areas that do have some risk. So we'll watch them closely. But that's how we're thinking about it and the stability that we've seen recently is really what's driving that confidence going into ’23.

[Pat Baumann, JPMorgan]

And as you think about those buckets and thanks for the color, are you expecting like flattish pricing in all those buckets? Are you expecting maybe the more specified bucket that's two-thirds of sales to be up a little bit? And the rest to be down a little bit. Any color on that?

[Mark Witkowski, Chief Financial Officer]

Yes. The way we think about it is these non-pipe products, we're typically supplying a solution to our customers, so we're typically not just providing PVC pipe or ductile iron pipe, it's part of a package where we're selling valves, fittings, hydrants, really a full solution and we're anticipating that project that we're selling, the pricing is going to be stable overall for 2023. There could be some puts and takes in certain product categories, but overall, we think that pricing is going to be stable as we sell projects.

[Pat Baumann, JPMorgan]

Okay, great. And then one last one for me. Any kind of parameters that you could provide given that we're almost through March in terms of like first quarter sales or margins? Any color would be helpful. I think, in modeling for everybody?

[Mark Witkowski, Chief Financial Officer]

Yes, sure. I think as we've anticipated, the first quarter is going to coming in as expected with some of the softness and the residential end market in particular. So I think from a volume standpoint, there's going to be some pressure in Q1. We did see some sequential gross margin reduction from Q3 to Q4 of ‘22, I expect we'll continue to see that into Q1 and Q2 of 2023 as that kind of gross margin normalizes as we've talked about. So those are probably the key pieces to think about as we get into the first quarter of 2023.

[Pat Baumann, JPMorgan]

Okay. Thanks so much for the color. Appreciate it.

[Mark Witkowski, Chief Financial Officer]

All right. Thank you.

[Steve LeClair, Chief Executive Officer]

Thank you.

[Operator]

[Indiscernible] we have no time left for any further questions. So it would be my pleasure to hand back to Steve LeClair for his closing remarks.

[Steve LeClair, Chief Executive Officer]

Thank you all again for joining us today. It was a pleasure to have you on the call. Fiscal 2022 was an outstanding year for Core & Main. We are well positioned to build on our positive momentum and we have a strong outlook for fiscal 2023. We are confident that our strategy will drive further value creation as we continue to execute on our growth strategies and deliver on our capital deployment model. We have a tremendous amount of opportunity ahead of us and we are well positioned to execute on those opportunities. Thank you for your interest in Core & Main. Operator, that concludes our call.

[Operator]

Thank you everyone for joining. This concludes the call, and you may now disconnect your lines.