SiteOne Landscape Supply Inc

NYSE:SITE

Earnings Call Transcript 2023-Q2

[Operator]

Good day, and welcome to the SiteOne Landscape Supply Inc Conference Call. All participants are in a listen-only mode. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to John Guthrie. Please go ahead.

[John Guthrie, Executive VP, CFO and Assistant Secretary]

Thank you, and good morning, everyone. We issued our second quarter 2023 earnings press release this morning and posted a slide presentation to the Investor Relations portion of our website at investors.siteone.com. I'm joined today by Doug Black, our Chairman and Chief Executive Officer; and Scott Salmon, Executive Vice President, Strategy and Development.

Before we begin, I would like to remind everyone that today's press release, slide presentation and the statements made during this call include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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 the earnings release and in our filings with the Securities and Exchange Commission.

Additionally, during today's call, we will discuss non-GAAP measures. We believe can be useful in evaluating our performance. A reconciliation of these measures can be found in our earnings release and in the slide presentation.

I would now like to turn the call over to Doug Black.

[Doug Black, Chairman of the Board and CEO]

Thanks, John. Good morning, and thank you for joining us today. We're pleased to see end market demand remain resilient in the second quarter, which allowed us to achieve solid organic daily sales growth and record operating cash flow despite the continued normalization of our gross margin and EBITDA margin.

Our strong teams executed well in gaining market share, driving positive organic sales volume growth and managing through price deflation and select products. We were also pleased to add 3 new high-performing companies to SiteOne during the quarter and in July, bringing terrific talent to our team and expanding our customer relationships and our full product line capability in their respective markets. Through the execution of our commercial and operational initiatives and our acquisition strategy, we continue to build SiteOne as a world-class market leader for the long term while delivering consistent performance and growth in the near term.

As we move into the second half of the year, we remain confident that our well-balanced business, strong balance sheet, exceptional teams, improved capabilities and robust acquisition pipeline, position us well to navigate the current environment and achieve continued success.

I will start today's call with a brief overview of our unique market position and our strategy for long-term performance and growth, followed by some highlights from the quarter.

John Guthrie will then walk you through our second quarter financial results in more detail and provide an update on our balance sheet and liquidity position. Scott Salmon will discuss our acquisition strategy, and then I will come back to address our current outlook for 2023 before taking your questions.

As shown on Slide 4 of the earnings presentation, we have grown our footprint to more than 650 branches and 4 distribution centers across 45 U.S. states and 6 Canadian provinces. We are the clear industry leader over 4 times the size of our nearest competitor. Yet we estimate that we only have about a 16% share of the very fragmented $25 billion wholesale landscaping products distribution market.

Accordingly, our future growth opportunity remains significant. We have a balanced mix of business with 65% focused on Maintenance, Repair & Upgrade, 21% focused on New Residential Construction and 14% on focused on New Commercial & Recreational Construction. As the only national full product line wholesale distributor in the market, we also have an excellent balance across our product lines as well as geographically. Our strategy to fill in our product lines across the U.S. and Canada, both organically and through acquisition, strengthens and reinforces this balance over time.

Overall, our balanced end market mix, broad product portfolio and good geographic coverage offer us multiple avenues to grow and create value for our customers and suppliers while providing important resiliency in softer markets.

Turning to Slide 5. Our strategy is to leverage the scale, resources, functional talent and capabilities that we have as the largest company in our industry, all in support of our talented, experienced and entrepreneurial local teams to consistently deliver superior value to our customers and suppliers. We have come a long way in building SiteOne and executing our strategy, but we are relatively early in our development as a true world-class company.

Accordingly, we remain highly focused on our commercial and operational initiatives to further build our capability to create value for all stakeholders. These initiatives are complemented by our acquisition strategy, which fills in our product portfolio, moves us into new geographic markets, and adds terrific new talent to SiteOne. Taken all together, our strategy creates superior value for our shareholders through organic growth, acquisition growth and EBITDA margin expansion.

If you turn to Slide 6, you can see our strong track record of performance and growth over the last 7 years with consistent organic and acquisition growth and EBITDA margin expansion. We have done this while investing heavily in our teams and in new systems and technologies to build the foundation for SiteOne and create superior capabilities for our customers and suppliers. We are still building and investing and we remain confident in our ability to gain market share and continue driving all 3 of our value creation levers going forward.

We have now completed 85 acquisitions across all key product lines since 2014. We expanded our development team in 2021 and then leverage them to increase acquisition activity in 2022, resulting in a record 16 acquisitions last year. Our pipeline of potential deals remains robust, and we expect to continue adding and integrating an increased number of new companies to support our growth. All of these companies are high performers. And so they strengthened our company with excellent talent and new ideas for performance and growth. Given the fragmented nature of our industry and our modest market share, we have a significant opportunity to continue growing through acquisition for many years to come.

Slide 7 shows the long runway that we have ahead in filling in our product portfolio, which we aim to do primarily through acquisition, especially in the Nursery, Hardscapes and Landscape Supplies categories. We are well networked with the best companies in our industry and expect to continue filling in these markets systematically over the next decade.

I will now discuss some of our second quarter performance highlights as shown on Slide 8. We achieved 11% net sales growth, 4% organic daily sales growth and 7% growth added through acquisition. Price inflation continuing to moderate, we are very pleased to achieve 3% organic daily sales volume growth during the second quarter. Furthermore, organic sales growth was more balanced in the second quarter across our product lines and regions than in the first quarter. As expected, price inflation continued to decline and was negative in June, driven by deflation in select products like fertilizer, grass seed and PVC pipe. Price inflation was 1% during the quarter compared to 6% in the first quarter and 19% in the second quarter of last year. We expect prices to be down in the second half and inflation for the full year 2023 to be roughly flat.

Gross profit increased 6%, while gross margin contracted by 170 basis points to 36.2% as we expected. The loss of the extraordinary price realization benefit achieved during the second quarter of 2022 was partially offset by our Hardscapes and Landscape Supplies acquisitions, which carry a higher gross margin and also by lower freight cost. Our teams continue to maintain competitive pricing while managing price versus cost well despite the challenges of commodity-related deflation. We have now fully lapped the extraordinary price realization achieved during 2021 and 2022, and we expect gross margin in the second half of 2023 to be similar to the second half of 2022.

SG&A as a percent of net sales increased by 130 basis points year-over-year to 23.7%. Acquisitions had the largest effect on SG&A as a percent of net sales as the same Hardscapes and Landscape Supplies acquisitions that benefited gross margin also increased our SG&A. Inflation across all categories, except for freight, also contributed to the higher SG&A as a percent of net sales. We are highly focused on operating leverage and expect to see benefits from our productivity initiatives as inflation normalizes and as we return to positive organic daily sales growth.

Adjusted EBITDA for the quarter declined 5% to $211.2 million, and adjusted EBITDA margin declined by 260 basis points to 15.6%, at the normalized price realization benefit combined with higher SG&A yielded lower adjusted EBITDA. Adjusted EBITDA and adjusted EBITDA margin are on track with our expectations so far this year and we expect the decreases in both to moderate significantly in the second half.

In terms of initiatives, we continue to grow with our small customers significantly higher than our average while also driving growth in our private label brands and improving our inbound freight costs through our transportation management system, all helping us to expand gross margin. Year-to-date, we have increased our partners program members by approximately 50% to 36,000 members. Most of the new members are small to midsized customers. We have increased our percentage of bilingual branches from 56% to 59% this year and are continuing to focus on Hispanic marketing to create awareness among this important customer segment.

Lastly, we are making great progress in our sales force productivity as we leverage our CRM and establish more disciplined revenue-generating habits among our over 900 inside and outside sales associates. The continued rollout of MobilePro and dispatch track allow us to offer better customer service while also increasing the productivity of our branch staff and delivery fleet. Both of these capabilities are now deployed company-wide, and we continue to see usage and benefit increase across the company.

We made good progress in growing our digital sales and customer activity on siteone.com during the second quarter, which helps us increase market share while allowing our associates to focus more on creating value for our customers and less on transactional activity.

And finally, we are seeing some of the early benefits from our operational excellence teams who are systematically spreading best practices in each line of business across SiteOne to drive value for our customers, suppliers and company. As an example, over the past year, we have driven changes in key aspects of our nursery business in terms of staffing, sales, assortment and procurement. As a result, our Nursery product line has outperformed all other lines of business this year in organic growth, profit improvement and improved inventory turns.

Taken all together, we are continuing to improve our capability to drive organic growth and achieve operating leverage even as we fight through the challenges in 2023.

On the acquisition front, we have added 5 high-performing companies to our family so far this year, with approximately $75 million and trailing 12-month sales added to SiteOne. Following a record number of acquisitions in 2022, our expanded development team remains very active and engaged with a robust pipeline of targets, and we expect to have another good acquisition year in 2023. With an experienced team, broad and deep relationships with the best companies, strong balance sheet and an exceptional reputation, we remain well positioned to grow consistently through acquisition this year and for many years to come.

In summary, we are pleased with our progress at the halfway mark and navigating through the challenging market conditions in 2023. While end market demand remains resilient, we will continue to be challenged with commodity product deflation, cost inflation and overall economic uncertainty in the second half. In the face of these headwinds, we have solid momentum with our key commercial and operational initiatives and remain confident in our ability to deliver increased value to our customers and suppliers while outperforming the market.

Now John will walk you through the quarter in more detail. John?

[John Guthrie, Executive VP, CFO and Assistant Secretary]

Thanks, Doug. I'll begin on Slide 9 with some highlights from our second quarter results.

We reported a net sales increase of 11% to $1.35 billion for the quarter. There were 64 selling days in the second quarter, which is the same as the prior year period. Organic daily sales increased 4% compared to the prior year period primarily due to volume growth on solid end market demand. Price inflation contributed approximately 1% to organic daily sales growth during the period. As Doug mentioned, we are seeing less pricing inflation as we comp the large price increases of the last year and the cost for products like fertilizer, grass seed and PVC pipe decrease. We now expect price inflation to be roughly flat for the full year, which comprise price deflation in low single digits in the second half of this year.

Organic daily sales volume increased 3% for the second quarter as we experienced solid demand from our end markets. In addition, in comparison to both the second quarter of 2022 in the first quarter of 2023, weather had a much smaller impact on sales.

Organic daily sales for Landscaping products, which includes Irrigation, Nursery, Hardscapes, Outdoor Lighting and Landscape Accessories, grew 5% for the second quarter, primarily due to price inflation resulting from rising product costs. Organic daily sales for Agronomic products, which includes Fertilizer, Control Products, Ice Melt and Equipment, grew 2% due to volume growth resulting from solid demand and improved weather in key northern markets. The strong volume growth was partially offset by lower prices for products like fertilizer and grass feed.

We were pleased with the performance of our acquisitions in the second quarter, acquisition sales, which reflects sales attributable to acquisitions completed in both 2022 and 2023 contributed approximately $86 million or 7% in net sales growth. Scott will provide more details regarding our acquisition strategy later in the call.

Gross profit increased 6% to $489 million for the second quarter compared to $461 million for the prior year period. Gross margin decreased 170 basis points to 36.2% as lower freight costs and contributions from acquisitions with higher gross margin were more than offset by the loss of the price realization benefit realized in the second quarter of 2022. As we have discussed in prior quarters, we are expecting gross margin to normalize in 2023 as we transition to a more traditional pricing environment.

Selling, general and administrative expense or SG&A, increased 18% to $321 million for the second quarter. The increase in SG&A primarily reflects the impact of acquisitions. SG&A as a percentage of net sales increased 130 basis points in the quarter to 23.7%. The increase in SG&A as a percentage of net sales is primarily due to the impact of acquisitions, continued cost inflation and incremental investments to support our growth.

For the second quarter, we recorded an income tax expense of $40 million compared to $45 million in the prior year period. The effective tax rate was 24.4% for the second quarter of 2023 compared to 24.2% in the prior year period. The increase in the effective tax rate was primarily due to a decrease in the amount of excess tax benefit from stock-based compensation. We expect the 2023 fiscal year effective tax rate will be between 25% and 26%, excluding discrete items such as excess tax benefits.

Net income for the second quarter of 2023 decreased 12% to $124 million compared to $141 million for the same period in the prior year, as higher net sales were more than offset by our lower gross margin and increased SG&A expense. Our weighted average diluted share count was $45.7 million compared to $45.8 million for the prior year period.

Adjusted EBITDA decreased by 5% to $211.2 million for the second quarter compared to $222 million for the same period in the prior year. Adjusted EBITDA margin, reflecting the lower gross margin decreased 260 basis points to 15.6%.

I would like to provide a brief update on our balance sheet and cash flow statement as shown on Slide 10. Net working capital at the end of the second quarter was $903 million compared to $885 million at the end of the prior year period. The increase in net working capital is primarily attributable to an increase in accounts receivable resulting from our sales growth. While total inventory was flat compared to the same period last year, inventory turns increased as we reduced our stocking levels with improved product supply.

Net cash provided by operating activities increased to $254 million for the second quarter compared to approximately $95 million for the prior year period. The record operating cash flow reflects our progress in reducing inventory levels that we increased in prior periods in response to supply chain uncertainty. We made cash investments of approximately $35 million for the second quarter compared to approximately $104 million for the same quarter in 2022. The decrease reflects a decline in acquisition investments made during the quarter. Scott will provide additional details on our acquisition pipeline later in the call.

Capital expenditures were $9 million for the quarter, which was flat with the prior year period. Net debt at the end of the quarter was approximately $385 million compared to approximately $436 million at the end of the second quarter of 2022. The lower net debt reflects our strong operating cash flow and lower acquisition investments.

Leverage at the end of the second quarter was 0.9x our trailing 12-month adjusted EBITDA is the same as the prior year period. As a reminder, our target year-end net debt to adjusted EBITDA leverage range is 1 times to 2 times.

At the end of the quarter, we had liquidity of approximately $524 million, which consisted of approximately $70 million cash on hand and approximately $454 million in available capacity under our ABL facility. On July 12, 2023, we further increased our liquidity by borrowing an additional $120 million on our term loan and using the net proceeds to increase ABL availability. Our priority from a balance sheet and funding perspective is to maintain our financial strength and flexibility so we can execute our growth strategy in all market environments.

I will now turn the call over to Scott for an update on our acquisition strategy.

[Scott Salmon]

Thanks, John. As shown on Slide 11, we acquired 2 companies in the second quarter and 1 in July with a combined trailing 12-month net sales of approximately $35 million. Since 2014, we have acquired 85 companies with approximately $1.5 billion in trailing 12-month net sales added to SiteOne.

Turning to Slides 12 through 14, you will find information on our most recent acquisitions. On May 8, we acquired Adams Wholesale Supply with 3 locations focused on providing Agronomics and Landscape Supplies with San Antonio, Dallas/Fort Worth and Houston, Texas markets. On May 26, we acquired Link Outdoor Lighting with 4 locations providing Landscape Lighting, the Landscape Contractors in the Orlando and Naples, Florida markets as well as in Houston, Texas and Nashville, Tennessee. On July 3, we acquired Hickory Hill Farm & Garden, single-location wholesale distributor of Irrigation, Nursery and Landscape Supplies. The acquisition of Hickory Hill complements our existing business in the Lake Oconee Georgia area, allowing us to provide the full line of landscaping products and supplies to landscape professionals in this high-growth local market.

Our acquisitions continue to add terrific talent to SiteOne and move us forward toward our goal of providing a full line of landscape products and services to our customers in all major U.S. and Canadian markets.

Summarizing on Slide 15, our acquisition strategy continues to create significant value for SiteOne. With a strong balance sheet and a robust pipeline across all lines of business and geographies, we are confident that we will be able to add many more outstanding companies to SiteOne during the year.

I want to thank the entire SiteOne team for their passion and commitment to making SiteOne a great place to work and for welcoming the newly acquired teams when they joined the SiteOne family. I am confident in our ability to keep adding more outstanding new companies through acquisition as we move through 2023, creating excellent value for all our stakeholders.

I will now turn the call back to Doug.

[Doug Black, Chairman of the Board and CEO]

Thanks, Scott. I'll wrap up on Slide 16. As mentioned, we are pleased to have achieved 2% organic daily sales growth in the first half of 2023. So far, the year is playing out as we had expected, with durable demand and moderating price growth due to commodity price deflation. As we look forward to the second half, as John mentioned, we expect price inflation to be negative, resulting in flat pricing for the year.

In terms of volume growth, we remain optimistic that end market demand will remain durable as we continue to execute our commercial and operational initiatives to grow faster than the market. In terms of end markets, we expect the decline in new residential construction, which comprises 21% of our sales to continue during the second half. Note that builders have become more bullish in terms of housing starts in the second half, which could lead to sales growth for landscaping products in the new residential construction market late in the year or in 2024.

New commercial construction, which represents 14% of our sales, has remained solid and based on our current bidding and customer backlogs, we expect continued growth in this market throughout 2023. The repair and upgrade market, which represents 29% of our sales, has been mixed so far this year across geographic markets and we now expect this market to be flat.

Lastly, we expect sales volume in the maintenance category, which represents 36% of our sales to remain steady with modest growth. With this backdrop, we expect our organic daily sales to be down slightly in the second half, driven by a decline in prices.

For the full year 2023, we expect organic daily sales to be approximately flat. We expect gross margin in the second half to be similar to the prior year period and adjusted EBITDA margin to be slightly lower on a year-over-year basis. Given reasonable demand, we would expect to resume expanding adjusted EBITDA margin in 2024 and beyond.

In terms of acquisitions, as Scott mentioned, we have a strong pipeline of high-quality companies and look forward to adding more of these to the SiteOne family in the remainder of 2023. Our acquisitions are performing well, and we continue to improve our ability to integrate them into our company. Accordingly, we expect acquisitions to contribute strongly to our performance and growth during the year.

With all these factors in mind, we are raising the bottom end of our guidance range slightly and now expect our fiscal 2023 adjusted EBITDA to be in the range of $400 million to $425 million. This range does not factor any contribution from unannounced acquisitions.

In closing, I would like to sincerely thank all our SiteOne associates who continue to amaze me with their passion, commitment, teamwork and selfless service. We have a tremendous team, and it's an honor to be joined with them as we deliver increasing value for all our stakeholders.

I would also like to thank our suppliers for supporting us so strongly and our customers for allowing us to be their partner.

Operator, please open the line for questions.

[Operator]

[Operator Instructions] The first question comes from Ryan Merkel with William Blair.

[Ryan Merkel, William Blair]

Thanks for all the help on guidance for the year. My first question is on the price deflation that you mentioned, and it's a 2-parter. I'm curious, what is the source of the deflation? Is it simply just passing through lower costs? Or is there also excess supply of some of these items?

And then do you think prices are going to stabilize in the second half? Or could continue to go lower as we look into 2024?

[John Guthrie, Executive VP, CFO and Assistant Secretary]

We would -- we think it is primarily just reorienting the prices for lower cost is what's going on, were the market prices if you've seen some of the commodities like fertilizer have come down. It's not from an oversupply and increased competition for business. The demand is -- it's actually improved this year. We showed good volume growth in Agronomics and Agronomics is the primary area where we are seeing deflation.

I think our crystal ball isn't great, but I think we've seen -- we're aware with the pricing that's going to happen in the second half, and we've incorporated that into our guidance right now from that perspective. So we -- there were some price increases, grass seed and fertilizer that have gone in recently and feel pretty good about those holding on through the fall selling season.

[Ryan Merkel, William Blair]

And then maybe just a question on sales trends. What are you seeing in July? Is that consistent with organic sales down low single digits? And what is the feedback from contractors? Are they still quoting and booking new work? Or are they sort of bleeding backlog at this point?

[Doug Black, Chairman of the Board and CEO]

July has been a solid month in line with our guidance. And our customers are, I'd say, solid to maybe even a little optimistic. The builders have become more optimistic, which has some of our larger customers feeling -- kind of feeling better about spec data at the late part of the second half. And then the commercial market has remained strong. So backlogs have remained or bidding is still in a growth mode versus prior year.

And so I would call -- and so -- the backlog has got very long during COVID and those certainly have come down to normal. Contractors are certainly having to work harder to find work. But we don't see any kind of panic or customers that can't find the work. There's simply kind of normal backlogs to pre-pandemic levels, I guess, is how we would call it.

[Operator]

The next question comes from David Manthey with Baird. Please go ahead.

[David Manthey, Baird]

To build on that last question, last quarter, you were a little slow out of the gate on the year, and then April rebounded for you. Can you talk about the trends that you saw through the quarter, were they pretty stable? And related to that, this extreme heat situation, is that actually a negative for your business net?

[Doug Black, Chairman of the Board and CEO]

So we saw volume, as you mentioned, picking up through the quarter. Of course, price came down. And so those 2 factors have kind of worked in tandem. And so I'd say it's been pretty kind of consistent through the spring and the second quarter, though the total organic growth would have kind of dropped sequentially from April to June, though still positive in June.

In terms of the weather, we benefited this year from the weather in the northern kind of Great Plains across the top end of the U.S., which had very poor weather last year in the spring, had better weather this year. So that was a benefit to us. Obviously, it was weather in Texas and some of the Southern California, Arizona, Texas, Florida, which kind of worked against us. We would call that maybe a push in the second quarter in terms of weather.

And when you take the heat, the heat helps us to some degree in terms of they're going to have to treat the lawns, irrigation tends to do better in the hotter weather. However, in some of the extreme heat markets, we're seeing customers kind of cut their afternoon hours and do some things there that might clip demand.

So overall, I think it would be a fairly neutral effect. We haven't seen a large negative effect from the extreme heat at least to date. The summer months in June and August tend to be a bit of a low -- anyway as people are taking vacations before school, et cetera. And we certainly have seen that same trend, but nothing that's different from prior years.

[David Manthey, Baird]

And building on this pricing question, it sounds like pricing levels in your commodity products Agronomics from the start of the year, have declined slightly, but it also -- I believe, John, you said that there's a price increase, you feel like maybe those are stabilizing. Just correct me if I'm wrong on that.

And then second, any commentary on non-commodity products, pricing trends? Are they stable? I know there's a wraparound effect from last year, and there's obviously year-over-year comps. But as you look from the beginning of the year to today, if you could just talk about trends in those 2 categories.

[John Guthrie, Executive VP, CFO and Assistant Secretary]

Yes. I think what we've talked about at the beginning of the year is still holds. I look at our product lines, we're still showing increases in and almost every kind of -- for the quarter in almost every of our major product lines other than Agronomics, but Hardscapes, Nursery prices have held up very well. Irrigation other than PVC pipe and drip tubing has held up very well. So in general, I think our thesis with regards to pricing has come out that the 80% kind of our business that's non-commodity-related roughly has maintained pricing and then the commodities has come down.

Maybe some of the commodities have come down a little bit faster. We were probably low single digits, now we're roughly flat for the year. I would say that trend. But I think directionally and kind of the model we have continues to hold from what we've talked about in prior calls.

[Operator]

The next question comes from Damian Karas from UBS. Please go ahead.

[Damian Karas, UBS]

Nice to see you guys getting back to volume growth. Congrats on that. I had a question kind of specific to the maintenance side of your business because I recall from last year that, that was unexpectedly weak as a lot of your contractors were rationalizing supply because of inflation. I'm assuming that, that was a nice tailwind for you in the second quarter? And just curious what kind of customer behavior you're seeing now in the maintenance side? Are budgets sort of acclimated to today's pricing and you're getting back to kind of like normal quantity of product being applied?

[Doug Black, Chairman of the Board and CEO]

Yes. In general, that's what we're seeing. We're seeing strong volumes and Agronomics. And the prices are down, obviously, which mitigates that. But that's played out as we expected. We didn't expect customers to kind of come back to normal application rates. In terms of like the golf industry, they've got nice revenues. And so their budgets are fairly fixed or increased. Prices are coming down. They're able to use more product. So yes, we're pleased that, that trend in Agronomics has played through, and we expect that to continue to play through into the second half.

[Damian Karas, UBS]

And would you be able to give us a sense for what -- how you think you're performing year-to-date in terms of share gains or losses? Any perspective on kind of what the industry performance has been?

[Doug Black, Chairman of the Board and CEO]

We do feel like we're gaining share consistently. And each market has the puts and takes, but across the country, we're gaining market share in really all of our product lines. And so we feel good about that. We stay -- there's not a lot of good industry data, but we stay in close contact with our suppliers. And so we know what's going on with ourselves relative to our competitors, et cetera. We're very pleased with our small customer efforts, as we have stated before. We've got less share with smaller customers than we do with the larger customers. It's just the way that we were -- we developed early on in our history. And so that's a big target for us. And we see that small customer growth that is far ahead of the industry, if you will. And so we feel like we're making particular progress there with the smaller customer segments, which is great to round us out as a company.

We already have significant share with the larger customers, we've been holding on to that. Obviously, that's a lot of where the fighting is in these types of markets is for that large customer business. We're holding our own there, but we're picking up kind of significant share in the small -- medium to small customer segment, which is part of our strategy.

[Operator]

The next question comes from Mike Dahl with RBC Capital Markets. Please go ahead.

[Mike Dahl, RBC Capital Markets]

And just a follow-up, one more kind of clarification or quantification on the pricing side. So it sounds like pretty stable on non-commodity. Can you just help us understand kind of in terms of quantifying then how much commodity prices are down?

And then when you think about if commodity prices are stabilizing here or whatever your market's kind of telling you for the second half, how that would impact the beginning of 2024 as well? I know it's early, but just if commodities continue to track here, what would that mean for net pricing in '24?

[John Guthrie, Executive VP, CFO and Assistant Secretary]

I don't have exact numbers on 2024 yet. We'll have to see -- see how that plays out. But I think it would be fair to say, at least in Q1, we probably face a little bit of a headwind because of commodities since we did -- if we look at the quarters, we had 6% in Q1, and that will be the tough comp from that standpoint. We'll have to see that kind of the rest of 80% of the business, if that offsets that 6% number from that standpoint.

Percent of commodity? Yes. I mean we have some commodities that are, I would say, kind of -- of fertility, which is primarily fertilizer. Quantifying that, probably we're about -- at our current run rate, low double digits in the low teens at a combined basis, down year-over-year on pricing. I would expect piping would be similar. Those are the ones that we've called out and grass seed, and we have a pretty big grass seed season in Q3 would be the 3 that will probably be down low double digits. So that blends together. And as we alluded to on the call, we've got that -- the rest of the business that's out there and much more modest or price increases, and that gives us the low single-digit headwind on the second half.

[Mike Dahl, RBC Capital Markets]

And then my second question is on [Indiscernible]. Last quarter, you outlined the continued expectation for gross margins to normalize down to 34.5 to 35. If we look at the 2Q upside and then kind of put in flat year-on-year in the second half, it seems like you get to a little north of 35. So I'm wondering just how much of that is still kind of timing related versus the internal initiatives or M&A potentially driving kind of some structural uplift to how you're now viewing gross margins?

[John Guthrie, Executive VP, CFO and Assistant Secretary]

Yes. I think we talked about [34.5] to [35], as you say, kind of our guidance, what we talked about on the call is going to put us at the high end of that number. A lot of that will be -- will be kind of, I think, some freight and the acquisitions will be positive with regard to that, though, year-over-year, some of the kind of the larger high gross margin acquisitions we're starting to comp those also from that standpoint. So -- so rest of the year, we are at the high end, more 35-ish for that, if you do the math. And then -- and a lot of that due to kind of as we work through all these kind of onetime kind of benefits kind of rolling off and then -- and then kind of structurally, we think this is kind of where we start as our baseline for future years.

[Operator]

Next question comes from Keith Hughes with Truist. Please go ahead.

[Keith Hughes, Truist]

The unit growth in the quarter and the projection here is, I mean, a good bit better than must every one of your peers on both the manufacturer and distribution side. So I guess my question, is there any one market that's outperformed even your expectations as we come through this kind of turbulent period?

[Doug Black, Chairman of the Board and CEO]

Well, the strength of our has been in the South Florida, the Southeast, it's kind of been -- has been very strong. It's been traditionally strong for us. But if you want to -- if you're asking where our strongest area would be that it would be kind of Florida and the Southeast. Obviously, our weakest area would have been California and where we had really, really poor weather. Texas has had poor weather. So those have been markets that are traditionally strong that have been a little weaker, and it all kind of blends out. But that's been our strength. We've been very pleased with kind of the Southeast U.S. performance so far this year.

[Keith Hughes, Truist]

And from an end-user market perspective, is there any one of those that have just -- not going to hit as much as you would have anticipated?

[Doug Black, Chairman of the Board and CEO]

That's not going to hit as much?

[Keith Hughes, Truist]

That has not been so far as weak as maybe you would have thought at the beginning of the year?

[Doug Black, Chairman of the Board and CEO]

Well, we're a little bit surprised that the residential market is -- seems to be more -- the builders are more bullish for the second half. Now we kind of haven't seen it yet, but we were thinking there would be a longer negative trend in new residential construction. And it just seems like the builders are more optimistic than we would have thought that would have been.

Commercial has held up well. We thought commercial was going to be solid. It's probably been a little better than we thought. The model has been kind of as expected and maintenance really has been as expected. So I'd say the new residential construction but we haven't seen it. The future looks better there later in the second half and in '24 than we would have thought coming into 2023.

[Operator]

The next question comes from Joe Ahlersmeyer with Deutsche Bank. Please go ahead.

[Joe Ahlersmeyer, Deutsche Bank]

Just wanted to follow up on that last point about New Residential. Can you clarify if that late second half benefit that you think you may get this year versus next year, is that included even at the high end of your guidance? Or are you still sort of pushing that out to next year?

[John Guthrie, Executive VP, CFO and Assistant Secretary]

We haven't included anything with regards to that into our guidance at all from that standpoint. I mean that would be kind of more of a '24 [indiscernible], is what we think. And our guidance is based on conversations and what we're seeing with contractors today in the marketplace.

[Joe Ahlersmeyer, Deutsche Bank]

And then the comment about returning to margin expansion next year. I assume that's more on the volume leverage and the cost side and less so from the gross margin if we're stabilizing there. Could you maybe just talk about the sort of expectation of what drives the margin expansion from here? If it is more volume or if it's further productivity on the cost side? And then if I could just sneak another one in, just any plans on how to trend the inventory into next year?

[Doug Black, Chairman of the Board and CEO]

I'll take the first one. I'll let John take the second one. So no, we feel like it will still be the balanced going forward. Once we -- this is a reset year, when we finished the year in kind of a stable situation, we see reasonable demand going forward. We do expect continued gross margin improvement both organically through our initiatives with small customers, our private label brand initiatives and then or just operating freight and some of our initiatives there. We also will get mix benefits from acquisitions going forward in terms of gross margin.

But then on the SG&A side that you mentioned, we do expect to get operating leverage and we have a lot of initiatives focused on productivity that we expect to pay off. So we see both of those contributing to our EBITDA margin expansion as we head toward our range of 13% to 15% adjusted EBITDA margin. We expect that improvement to come from both SG&A as a percent of sales and also gross margin.

And then, John, you talked to inventory?

[John Guthrie, Executive VP, CFO and Assistant Secretary]

Yes. We would expect inventory turns to continue to improve next year. I mean I don't know if Q2 especially was obviously very strong. This would be kind of more of a normal from a standpoint. We hope to go into next year with less inventory and then kind of be more specific on the build in the first quarter. That will still be there kind of, I would say, more flattish in the second half before they kind of trend down at the end of the year. So I think kind of this quarter, because we -- over the -- really the last 12 months have been working off some of the excess inventory that we brought in to kind of address the supply chain challenges during the COVID period. So this was an especially strong quarter for that. I would say we're going to go back to more historical quarters. But we do expect kind of next year and go forward to continue to improve our inventory turns. We're still not -- if -- where we project at the end of this year, we're still not where we completely were right before COVID and there's still opportunities going forward.

[Operator]

The next question comes from Jeffrey Stevenson with Loop Capital.

[Jeffrey Stevenson, Loop Capital]

Congrats on the nice quarter. I just wanted to first comment on Repair & Upgrade, where you're expecting demand to be flattish this year. Doug, you mentioned that demand is mixed by region. And you called out the Southeast as being one of the stronger markets, but could you provide any more color on some of the areas that maybe are a little more challenged than other?

[Doug Black, Chairman of the Board and CEO]

Well, we've been a little more challenged in the West in general than the East. And part of that is we -- it's kind of hard to tell how much of that is weather and market but that's where we would have seen -- where we think that the market maybe is not as strong as we mentioned the Southeast and the East in general.

In terms of what's going on in the remodel market, obviously, the headwind would be the low housing turnover. Existing home sales are down and existing home sales always drive good remodel activity, including kind of professional remodel. And then we have seen some -- as the uncertainty in the economy has kind of set in, some, I'd call it, not kind of middle range projects that are just a little slower than they were, right? I mean keep in mind that we are coming off of a kind of a [Indiscernible] pace before. And so maybe we got spoiled, but we're certainly seeing those backlogs come down. That being said, we're still -- good business out there, which is still a big market for us. We feel good about it. We just think it's a bit softer than it was. It was in the high-growth mode. It went to a reasonable growth mode. Now it's, call it, flat to slightly up. And we think -- we'll see how it goes.

But the puts and takes of the economy, we like the fact that we see consumer confidence coming up because certainly, consumer confidence impacts remodel. We think that the sticker shock and the -- and the headwind of existing home sales has kind of already been played in. And so we would look for that to be solid, perhaps improving as we look into '24 and beyond. Right now, we're calling it flat.

[Jeffrey Stevenson, Loop Capital]

And then in commercial, it seems like you got really good visibility through the remainder of the year. But just on bidding activity, have you seen any impact from whether it be the regional banking crisis or higher interest rates? And at a high level, kind of how you're thinking of that end market as we kind of head into '24?

[Doug Black, Chairman of the Board and CEO]

Right. Yes, there was -- I guess, worry in general that, that would have it happening. And in fact, the banking price is on commercial. We haven't seen it. The bidding has been solid. It's been consistent. Our customers are busy. So it looks like that that's not going to affect that market, given what we see with our customers and the activity that we're seeing. We really have seen no slowdown there at all. So we're encouraged by that.

[Operator]

The next question comes from Matthew Bouley with Barclays. Please go ahead.

[Matthew Bouley, Barclays]

I'll ask on SG&A. I think you called out acquisitions and cost inflation and growth investments is impacting that. It looks like on a per branch basis, SG&A might have been up roughly 15% in the first half of the year. And I think the guide is implying it gets a lot closer to flat year-over-year. So just kind of any color on what you're doing to sort of manage down SG&A here in the second half.

[John Guthrie, Executive VP, CFO and Assistant Secretary]

Well, I think 2 things. One is we -- a lot of the increase came in at -- during the second half of the last year. So we are in the comp -- higher numbers. But in addition, we're looking closely and managing all SG&A expense. We're looking at our staffing models to make sure that they're following along with demand from that standpoint and keeping a close eye on continuing to kind of watch on -- focus -- spend on the things that are going to drive volume growth this year and next, but also taking a keen eye to the items that won't have that benefit from that standpoint.

[Doug Black, Chairman of the Board and CEO]

And just to build on that, we respond as the market -- as the market plays out. And so in markets that have a tougher headwinds, either in terms of market or weather, we pulled back significantly on labor appropriately, right, to serve the lower demand in other markets, we would be in a growth mode because of a stronger market. So one of the -- one of the benefits of our -- the way we run our company and in a very decentralized way that we're flexible for each market to kind of match what's going on in that market. So we're certainly working at hard this year because demand is -- it's different across the country. And so that's how we're managing.

And as John mentioned, we're lapping kind of increases from last year. So we feel good that will -- as the growth comes back, as we move into next year, that we've got opportunities to get good operating leverage across the company.

[Matthew Bouley, Barclays]

And then secondly, on the gross margin, obviously, you had the inflation benefit previously and now that's rolling off. Think you mentioned earlier that you're kind of managing price versus cost in spite of this commodity deflation. So my question is, are you actually benefiting at all from that spread with commodities coming down? Or do you sort of have to pass through that deflation immediately? And what does deflation actually end up doing to the gross margin?

[John Guthrie, Executive VP, CFO and Assistant Secretary]

We're fortunate that the -- in general, the industry, both on the good side and bad side follows the cost of the supplier. So in general, as raw material costs come through kind of the market will go with it. And we won't be able to, especially for commodity products where we're bidding on PVC pipe jobs or for fertilizer application. Our while the percentage of margin will hold, our kind of -- the dollar of gross profit dollars will decrease with that. And that's kind of the headwind we've talked about with regards to the sales side. But the market is relatively rational as far as from that standpoint and kind of prices up of a margin basis rather than -- and so, as we go down, I guess, in general, what we're thinking is we're going to be able to maintain the margin, but the price will come down with it.

[Operator]

Thank you. This concludes our question-and-answer session. I would like to turn the conference back over to Doug Black for closing remarks.

[Doug Black, Chairman of the Board and CEO]

Okay. Thank you all for joining us today. We very much appreciate your interest in SiteOne. We're excited about our company and strategy, and we look forward to speaking to you again on our next earnings call.

Thank you to our terrific associates, also our suppliers and customers. Thank you, and have a great day.

[Operator]

Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.