SiteOne Landscape Supply Inc

NYSE:SITE

Earnings Call Transcript 2018-Q3

[Operator]

Greetings and welcome to the SiteOne Landscape Supply Third Quarter 2018 Earnings Call. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Pascal Convers, Executive Vice President of Strategy and Development for SiteOne Landscape Supply. Thank you. You may begin.

[Pascal Convers, EVP, Strategy, Development & IR]

Thank you, and good morning, everyone. We issued our third quarter earnings press release this morning and posted a slide presentation to the Investor Relations portion of our website at investors.siteone.com. We will be referencing the slides during this call. I'm joined today by Doug Black, our Chairman and Chief Executive Officer; and John Guthrie, our Chief Financial Officer.

Before we begin, I would like to remind everyone that today's press release, the slide presentation and 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 uncertainty 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, the company will discuss non-GAAP measures, which 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 our Chairman and CEO, Doug Black.

[Doug Black, Chairman & CEO]

Thank you, Pascal. Good morning and thank you for taking the time to join us today. During the third quarter we delivered solid organic sales growth, double-digit growth in overall revenue, strong gross margin and adjusted EBITDA margin expansion and excellent cash flow, all despite some tough weather-related and inflationary headwinds. We also added five more terrific companies to SiteOne during the quarter and in October, bringing the total number of acquisitions to 12 for the year. Lastly, we made further progress on our investments for the future by completing the rollout of our new e-Commerce platform during the quarter.

I will start today's call with a review of our unique market position, our strategy to deliver long-term performance and growth and our progress over the past four months. John Guthrie will then walk you through our third quarter financial results in more detail, and Pascal will address our acquisition strategy. Finally, I will discuss the trends that we see in our markets, as well as our outlook for the balance of 2018 and how we are generally thinking about 2019, before taking your questions.

I'll start on Slide 4 of the earnings presentation. As the largest and only national wholesale distributor of landscaping products, we have grown our footprint to 552 branches and 3 major distribution centers in the United States and Canada. By the end of 2018 we will have approximately 11% share of the wholesale landscaping products distribution market. We are 4x larger than our nearest competitor and larger than 2 through 10 combined. Our size and scale, our agile and customer-focused culture and our full-line product capability give us competitive advantage and provide increased value to our customers and suppliers.

Additionally, we have a very balanced mix of business, with 60% focused on maintenance and repair and upgrade, 25% focused on new residential construction and 15% on new commercial construction. This balanced mix and broad product portfolio give us important resiliency in softer markets.

Turning to Slide 5, as we progress through the cycle our large and local strategy provides us with advantages over many of our competitors and should allow us to gain market share organically. We further drive the strategy by acquiring leading local and regional companies that fill in our product portfolio, add terrific talent to our teams and expand our branch network across the U.S. and Canada. Our commercial and operational initiatives help to improve our value to customers and suppliers, expand our margins and accelerate organic growth throughout the cycle. We are still in the early innings of implementing our strategy and we believe that we can create significant value through organic growth, margin expansion and acquisition growth for many years to come.

Slide 6 illustrates SiteOne's history and our strategy in action. We've built a great track record of performance and execution, with good organic and inorganic sales growth over the past three years, and solid operating leverage. Let me remind you that we've been building the company during the last four years, which involves heavy SG&A investment to establish our IT, category, marketing, supply chain, finance and acquisition teams, as well as our underlying systems infrastructure to improve e-Commerce. With the teams and the infrastructure largely in place, we expect to benefit by leveraging these investments going into 2019 and over the next several years. Accordingly, we remain well positioned to achieve our stated mid-term adjusted EBITDA margin goal of 10%-plus.

Turning to Slide 7, it's important to remain focused on the large opportunity that we have to fill in our full product line capability in every major U.S. and Canadian market through acquisitions. As the graph shows, we have the full line and product capability today in only approximately 45 of our targeted 225 major markets, primarily due to the lack of nursery and/or hardscape branches. We will continue to fill these in while also penetrating new markets and improving our market position in existing markets through the acquisition of well-run irrigation and agronomic distributors.

I will now discuss some highlights from our third quarter performance on Slide 8. We achieved 15% overall sales growth, with contribution from both acquisitions and organic sales. Organic sales growth was 5%, which included 4% price inflation and 1% volume growth. After the delayed spring we expected the construction volume to remain strong in the third quarter, especially in the fall season, which begins in September. However, organic sales growth in September was only 3%, given the effects of Hurricane Florence and wetter than usual weather in the Northeast, Mid-Atlantic and Midwest. In October we saw organic volumes return strongly in the first week, then decline with Hurricane Michael and the very wet weather in Texas, and then return again recently in the second half of the month.

All these trends lead us to believe that the underlying work is there to be done when the weather cooperates. In the markets that are experiencing normal weather patterns we do see strong organic sales coming through. Customer backlogs remain strong and the underlying market is very solid.

Cost inflation remained elevated in the quarter, with the largest increase in agronomics products. Additionally, our national irrigation suppliers have announced further price increases, ranging from 4% to 6%, which are going into effect in October through December. We continue to see widespread increases from our vendors and now expect our inflation for the year to approach 4%.

We also expect this higher inflation to carry into 2019. Given this inflationary trend, we were particularly pleased with our 110-basis-point improvement in gross margin to 33%. Our teams worked diligently with our suppliers and our customers to manage and mitigate cost increases in material, freight and labor in order to pass them through to the end user in a responsible manner. With the benefit of our category management and supply chain initiatives we remain well positioned to achieve good gross margin improvement in 2019.

Our adjusted EBITDA grew 24% in the quarter, which reflects growth in our base business, our ability to expand gross margin and good contribution from acquisitions. Adjusted EBITDA was slightly dampened by lower than expected sales volume and by planned investments in our strategic initiatives during the quarter. Adjusted EBITDA margin improved by 80 basis points during the quarter and we are pleased to be moving forward again toward our 10% milestone.

In September we completed the rollout of our new e-Commerce platform, the new siteone.com. Our customers can now see our products and their specific pricing online, and can order from us 24/7 to pick up product or have it delivered. The new tool will make both our customers and SiteOne more efficient, saving them and us time and money. We are seeing good early adoption of the new siteone.com and now have over 6,000 customers signed up on the new site. Our customers are providing great feedback that we are using to make adjustments and improvements. We're also working on a multiyear roadmap to make siteone.com a full-service, industry-leading portal with information, products and tools to assist landscapers on any project or task. We are very excited about this new capability at SiteOne.

In summary, we are building an infrastructure at SiteOne that will enable us to perform at world-class levels for our customers, suppliers and shareholders for many years to come. Our acquisition strategy continues to be successful and complement our organic growth. We have completed 12 acquisitions year to date, four of these in the third quarter and one more in October. Combined, these acquisitions comprise approximately $220 million of trailing-12 month revenue, which is approximately 12% of our 2017 revenue. More importantly, all of these companies are high performers and bring outstanding talent and terrific customer relationships to SiteOne, while filling a strategically important part of our product portfolio in their respective markets.

Having now acquired 34 companies since the beginning of 2014, we have developed a strong culture and capability that has become of the SiteOne DNA. Our acquisition strategy continues to ramp up nicely and you can expect to see continued deal activity as we move into 2019.

When taken altogether, I am very pleased with our progress in building the foundation for SiteOne, as well as with our team's ability to navigate through the various challenges in the third quarter and post a record result.

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

[John Guthrie, EVP, CFO & Assistant Secretary]

Thanks, Doug. I'll begin on Slide 9 with the income statement for our third quarter results. We reported a net sales increase of 15% to $579 million in the third quarter. During the quarter we had 63 selling days, which was unchanged compared to the prior year. Organic daily sales grew 5% in the third quarter and 4% for the first 9 months. Organic daily sales for landscaping products, which includes irrigation, nursery, hardscapes, outdoor lighting and landscape accessories, grew 4% for the quarter and 5% for the first 9 months. We saw a deceleration in sales growth in September, due to a combination of the impact of Hurricane Florence and generally wet weather. As Doug mentioned, our customers indicate that they still have good backlogs of work and typically cite weather, labor constraints and project timing as their primary reasons for order delay.

Organic daily sales for agronomic products, which includes fertilizer, control products, seed, ice melt and equipment, grew 6% for the quarter and 5% for the first 9 months. Organic daily sales for agronomic products for both the quarter and the year benefited from a stronger economy and price increases in response to cost inflation.

Pricing increased 4% for the quarter and 3% for the first 9 months of the year. This is a measurable acceleration over the 1% increase in 2016, no increase in 2017, and even the 1% we saw in the first quarter of this year. The price inflation is being driven by increases in materials and freight costs. We expect this trend to continue and are already seeing additional price increases from manufacturers in the fourth quarter. For the full year we expect price inflation will be between 3% and 4%.

We are not factoring tariffs into our price inflation forecast for 2018, as they will not have a meaningful impact this year. We do think products like lighting, control products, tools and equipment will be impacted to some degree by the tariffs in 2019. We are also hearing from suppliers that increased freight costs and higher labor costs will lead to increased prices in 2019 as well. As a result, we are expecting price inflation in 2019 to be similar to 2018.

Acquired sales growth was $54 million in the third quarter and 11% of our overall growth rate. For the first 9 months acquired sales growth was approximately $130 million, or 9% of our overall growth rate.

Gross profit increased 19% to $191 million in the third quarter, while gross margin expanded 110 basis points to 33%. The improvement in gross margin was due to increased pricing and contributions from acquisitions, partially offset by higher material and freight costs. Product mix did not have a significant impact on gross margin in either the quarter or the first 9 months of the year.

Selling, general and administrative expenses, or SG&A, increased by 19% to $152 million in the third quarter, and SG&A as a percentage of sales increased 70 basis points to 26.2%. The increase in SG&A as a percentage of sales was primarily attributable to our growth from acquisitions and planned investments in critical strategic initiatives like e-Commerce. On an adjusted basis, excluding the acquisitions, SG&A as a percentage of sales was down slightly.

We have recorded income tax expense of $2.4 million in the third quarter of 2018 compared to $10.7 million in the third quarter of 2017. The effective tax rate was 7.4% and 38.8% for the third quarter of 2018 and 2017, respectively. The decrease in the effective tax rate was attributable to the reduction of the U.S. corporate income tax rate from 35% to 21% as a result of the 2017 tax act and an increase in the excess tax benefit pursuant to ASU 2016-09. For the third quarter we recognized $6.3 million in excess tax benefits compared to $0.4 million last year. For the first 9 months we recognized $15.3 million in excess tax benefits compared to $2.5 million in the prior year. We continue to expect our 2018 effective tax rate will be between 26% and 27%, excluding the impact of the excess tax benefit associated with ASU 2016-09 and other discrete items.

Net income increased 77% to $29.9 million for the third quarter compared to $16.9 million for the prior year period. The increase in net income for the quarter is attributable to higher organic sales, contributions from acquisitions and our lower tax rate. Our weighted average diluted share count was 42.7 million for the third quarter of 2018 compared to 42.5 million for the fourth quarter of 2017. The increase reflects both option-exercise activity during 2018 and an increase in the average stock price for the third quarter of 2018 compared to the fourth quarter of 2017.

Adjusted EBITDA increased 24% to $60 million for the third quarter compared to $48 million for the same period in the prior year. Now I'd like to provide a brief update on our balance sheet and cash flow statement, as shown on Slide 10.

Net working capital increased approximately 20% from the third quarter of 2017 to $514 million as of September 30, 2018. The growth in net working capital primarily reflects the increase in inventory and receivables attributable to our acquisitions. Cash flows from operations was approximately $70 million in the third quarter compared to $17 million in the prior year period. The improvement in cash flow relative to the prior year is primarily attributable to increased earnings and improved working capital management.

With regards to working capital, we are now starting to see some of the expected benefits of our strategic supply chain initiative. We made cash investments of $62 million for the quarter compared to $12 million for the prior year period, primarily reflecting our increased acquisition activity during the quarter. Net debt at the end of the quarter was $566 million and leverage was 3.3x our trailing-12-month adjusted EBITDA, which is up from 3.1x last year. The modest increase in leverage primarily reflects increased borrowing to fund our acquisition strategy. Our long-term year-end leverage target is 2x to 3x net debt to adjusted EBITDA. We are tracking toward the high end of that goal by the end of this year.

In summary, our capital structure continues to provide us with the flexibility to execute our growth strategy, including the funding of our acquisitions.

I will now turn the call over to Pascal for an update on SiteOne's acquisition strategy.

[Pascal Convers, EVP, Strategy, Development & IR]

Thank you, John. As Doug mentioned earlier, acquisitions play a key role within our overall growth strategy as we continue to fill a significant white space. As shown on Slide 11, we have now acquired 34 companies since the beginning of 2014. They added 197 branches to SiteOne and contributed $770 million in sales on a trailing-12-months basis. We're having a strong year and have made good progress accelerating our pace of acquisitions from 4 in 2015 to 6 in 2016 to 8 in 2017 and now 12 more through the first 10 months of 2018, representing $220 million in last-12-month sales.

Now as we turn to Slide 12 through 14, you will be able to find information on the five acquisitions we completed in the last four months. On July 2 we completed the acquisition of Landscape Express, which is a leading distributor of hardscapes and landscape supplies, with four locations in the Boston, Massachusetts metropolitan area. The Landscape Express acquisition complements our existing operations with a full range of irrigation, agronomics and nursery products and allows SiteOne to offer a full product line to our Boston customers.

On July 25 we acquired Kirkwood Material Supply, which is a leading supplier of hardscapes, nursery and related landscape supplies, with eight locations in the greater St. Louis market. Through Kirkwood, SiteOne adds products which we did not have to existing irrigation, agronomics and landscape lighting product lines and allows SiteOne to offer a full product line to our customers in St. Louis. On July 27 we completed the acquisition of Stone Center of Virginia, which is a leading distributor of hardscapes, landscape supplies and outdoor lighting in the Washington, D.C. Metro. Stone Center's Manassas, Virginia location is a perfect complement to our current irrigation, agronomics and nursery product businesses and allows us to provide a full product line to our customers in northern Virginia and southern Maryland.

On July 30 we made the strategic acquisition of CentralPro, which is a leading supplier of irrigation and related products with 10 locations and one distribution center in central and eastern Florida. CentralPro brings a talented team to SiteOne with an excellent reputation and a strong history of customer focus and growth. The combination of our two companies makes us the clear irrigation leader in the State of Florida and provides good purchasing synergies as well as cross-selling opportunities.

On October 19 we completed the acquisition of C&C Sand and Stone. C&C served the Colorado market with four wholesale centers and two showrooms focused on the distribution of hardscape and landscape supply products to landscape professionals. C&C is a great with SiteOne as it expands our geographical presence and hardscapes capability in Colorado, allowing us to provide a full line of landscaping products to our customers.

As we turn to Slide 15, we continue to see a significant opportunity to grow profitably through acquisitions, which allows us to move into new markets, expand our presence in existing ones, broaden the product offering and also, very importantly, add outstanding talent to our team. Our pipeline remains robust and with 12 acquisitions year-to-date, our M&A strategy is gaining momentum and we continue to build a reputation as the buyer of choice in the industry. We'd like to thank all the leaders of SiteOne, who are great ambassadors working hand in hand with our development team to help SiteOne attract the best companies to join us in the future.

While the timing of acquisitions cannot be fully predicted, we have strong momentum and expect to close additional acquisitions in the next few months, which should contribute nicely to our growth in 2019 and beyond.

And with that, I'd like to turn the call back over to Doug to discuss our outlook.

[Doug Black, Chairman & CEO]

Thanks, Pascal. I'll wrap up on Slide 16. We are proud of the results that we delivered in the third quarter, given some of the challenges that we faced. Having passed through the significant inflation in the spring and this fall, we are well positioned for performance and growth in the remainder of the fourth quarter and on into 2019. Our foundation is stronger and we are bringing on new capabilities which will further enhance organic sales growth and EBITDA margin expansion. Finally, our acquisition pipeline is robust and we will continue to see growth through acquisitions as an important contributor to our overall performance.

In terms of markets, I would like to spend a little time on the trends that we are seeing across our end markets and how those trends impact our organic sales growth prospects for 2019. The maintenance end market represents 40% of our business and we are seeing very good growth in this segment, due to a strong economy and significant price inflation. As John mentioned, our agronomics business, which is primarily maintenance, grew 6% this past quarter, which is the strongest third quarter that we have seen in several years. We expect the current trends in maintenance products of steady volume growth and significant inflation to continue into 2019.

Similarly, the repair and remodel end market, which comprises approximately 20% of our business, is benefiting from the strong economy, low unemployment and good consumer spending. We're also benefiting from two major trends in repair and remodel. First, there is the ongoing focus on outdoor living, which involves making the backyard a living space, particularly with hardscapes and lighting. Second, there is increased scrutiny of stormwater management, which his driving double-digit growth in our drainage and stormwater categories. We expect these two trends to continue for many years. Accordingly, we would expect growth in repair and remodel to remain healthy in the mid-single digits in 2019.

The new commercial construction end market, which is approximately 15% of our business, also looks strong going into 2019, based on our customers' current robust backlog of projects.

Lastly, the new residential construction end market accounts for approximately 25% of our business. There's been a lot of discussion about housing starts and the publicly available data would indicate a recent slowdown, as potential homeowners adjust to higher home prices and higher interest rates. We have not seen the effects of this slowdown in terms of landscaping product demand, but we are prepared for this end market to soften next year. Fortunately, we are well diversified across end markets and, taking all of the markets together we expect to see steady organic sales growth in 2019, even if new residential demand softens.

Further, we are working on initiatives and capabilities which should enable SiteOne to more consistently gain organic market share. In terms of 2018, though we see current positive momentum on many fronts, there is now not enough year left to make up the spring and fall weather-related shortfalls in our organic sales, while also overcoming the significant inflation which has dampened our gross margin improvement. Accordingly, we are lowering our guidance for 2018 adjusted EBITDA to be in the range of $175 million to $180 million. As mentioned, we feel very good about our momentum going into 2019 as we realize the benefits from our initiatives and acquisitions, and further drive organic growth and gross margin improvement, while beginning to benefit from SG&A leverage.

In closing, I would like to acknowledge all of the SiteOne associates who continue to create significant value for our customers and suppliers. We have a tremendous team and it is an honor to be joined with them as we build a company of excellence for all of our stakeholders.

Operator, please open the line for questions.

[Operator]

[Operator Instructions]. Our first question comes from the line of David Manthey with Robert W. Baird.

[Christopher Belfiore, UBS Investment Bank]

The first question is organic daily sales growth rates. Could you talk about your experience through the month? I think last quarter you gave us kind of what the trends were in April, May and June. And then you said it continued into July. Could you just talk about what those growth rates were?

[Doug Black, Chairman & CEO]

Yes. So we started the quarter strongly. And, again, July and August from last year were tougher comps, kind of 7% to 8% last year. As we developed what we expected to see was good solid growth in July and August, which we did see, and then really a very strong September, as the fall season starts in September and September and October are good months for us. And that's where we got the weather affecting us in September and the growth rate dropped to 3% overall average, the month at 5%. And just to describe September, we had Hurricane Florence that hit us but we also had wet weather really from Texas all the way up through to New Jersey for the month of September. If you look at the stats, Texas had 11 more rain days than last year; the Carolinas 12 more rain days; the Southeast, which would be Georgia, Tennessee, 12 more rain days. So it just - it was a very unusual month in September that brought the volume down. Overall we think that the September impact had about a 100 to 200 basis impact for the quarter in general, so 5% we felt on a volume basis would have been about 100 to 200 basis higher, had we had let's call it normal weather in September.

[Christopher Belfiore, UBS Investment Bank]

So I guess if July - last quarter you said you saw some of the same trends as you saw in May and June, which you cited as 8% to 9% growth. If July was 8.5% and September was 3%, I think that implies that August was 3% as well. Is that accurate? And then can you also give us any kind of indication of what October's growth rate might preliminarily look like?

[Doug Black, Chairman & CEO]

Right. No, July and August were more 5% to 6% and, again, on a comp of 7%. Right? And then it dampened to 3%. So that's how you get to 5%.

[Christopher Belfiore, UBS Investment Bank]

Okay. And then October?

[Doug Black, Chairman & CEO]

And October what we're seeing is better than September, but still weather dampened. Obviously we've had Michael. We still have the very wet weather in Texas. And so we would be doing better than September, but not at the pace, again, that we would expect for a normal October.

[Operator]

Our next question comes from the line of Ryan Merkel with William Blair.

[Ryan Merkel, William Blair & Company]

So first, cost inflation has impacted gross margin improvement this year. Was the third-quarter gross margin below your internal expectations? And then, is the issue just timing of when you pass along the price to cover the inflation?

[John Guthrie, EVP, CFO & Assistant Secretary]

Yes, I think that the latter is true. Really where we were hit - cost hit us was in the first half of the year. We felt as if actually we were very pleased with the gross margin improvement in the third quarter.

[Ryan Merkel, William Blair & Company]

Okay. That's kind of what I was getting at, because I thought it was a pretty good result.

[John Guthrie, EVP, CFO & Assistant Secretary]

Yes.

[Ryan Merkel, William Blair & Company]

So we shouldn't be worried about price/cost being an issue in fourth quarter. And more importantly, you don't think it's a risk as we go into 2019.

[Doug Black, Chairman & CEO]

Right, right. And when you look at the first half, the inflation that we saw kind of caught the market by surprise. And it was very freight related and very local in terms of it hit our fertilizer products and a lot of those products that don't go through our DC. So the nature of that inflation was just tougher to pass through. Obviously we had to work with our suppliers and our customers to [response] with that sector. And it took us a couple, three months to really drive that. What you see in the third quarter is we're continuing to see inflation and will continue to see it in the fourth and we think in 2019. But now it's much more planned and proactive all the way through the chain. And it also is affecting more the products that go through our distribution center. So as we protect certain jobs or certain commitments that we've made on the front end, we can buy forward and cover ourselves on the back end. So, yes, so we do feel great about the third quarter outcome on gross margin and we feel like we're going to be able to manage gross margin going forward in a much more successful fashion than we did in the first half of the year.

[Ryan Merkel, William Blair & Company]

Got it. And just a follow-up as we think about gross margin for 2019. Should we expect a pretty strong result, maybe improvement of 50-basis-points-plus, since you didn't get it this year? And I think this year you were expecting something in that range?

[Doug Black, Chairman & CEO]

Well, it's too early to call specifics on 2019. I mean, we're focused right now on finishing up the year and working our way through the fourth quarter. We'll have much better guidance when we report the fourth quarter results and the full year results on specifically what we can achieve in 2019. But we would in general see our EBITDA margin in 2019 being more balanced between gross margin and SG&A leverage than we have seen in the past. But too early to call any specific levels at this point.

[Ryan Merkel, William Blair & Company]

Fair enough. And then just lastly and I'll pass it on, so in a year like 2018 where weather was largely unfavorable, does some of the work carry over into the next season? Is it fair to think about pent-up demand as we enter 2019? Or is that not the way to think about your business?

[John Guthrie, EVP, CFO & Assistant Secretary]

We think that's a very fair way to think about weather, that - you know, if you were to try to get your yard redone here in Atlanta, which has had very wet weather this year, I mean, people are really telling you to wait till spring of next year for that. So we think especially if the impact in markets along the East Coast, the eastern, where we've really seen more of the weather events this year than in previously, we would expect a lot of that work to carry into 2019.

[Operator]

Our next question comes from the line of Michael Eisen with RBC Capital Markets.

[Michael Eisen, RBC Capital Markets]

Just wanted to start off, been thinking about where we are in the season and some of the delays we've seen. I think in the past you've talked to October as being kind of an ending point for the season. And so I was really trying to think of what the impact of weather delays being offset somewhat by the benefits of the distribution centers, how we should think about free cash flow into the end of the year and kind of what you can generate from this point going forward.

[John Guthrie, EVP, CFO & Assistant Secretary]

Yes. From a cash flow standpoint we do generate positive cash flow in the third quarter - I mean, in the fourth quarter. So we would expect just looking at our - what we talked about with regards to leverage ratio, that we would be coming down to more the 3x within our range. And that's really being driven by free cash flow in the fourth quarter. We will expect to see similar to what we saw last year, just slightly better in the fourth quarter on free cash flow because of the seasonality. What you saw really this quarter was really improvement as a result of our distribution center. But we will be buying a little bit of inventory forward in the fourth quarter in preparation for setting ourselves up for 2019. But we still expect in the fourth quarter of next - in the fourth quarter to outperform last year in free cash flow.

[Doug Black, Chairman & CEO]

And overall we're expecting free cash flow to be in and around net income, kind of at or maybe slightly above our net income level for the year 2018.

[Michael Eisen, RBC Capital Markets]

Perfect. That's really helpful. And then just changing gears a little, thinking of SG&A and some of the spend you guys have been doing on the growth initiatives. You talked a little bit about being first half weighted earlier in the year and we continue to see some pressure on the SG&A line. Is now the right time to think about an inflection point and you guys really leveraging the platform? Or are there still incremental costs associated with growth that will limit expansion for the next couple of quarters?

[Doug Black, Chairman & CEO]

Yes. So that's a great question. It was more front half loaded. We did in the third quarter spend roughly $1 million more than we did last year in the quarter on our initiatives. In the fourth quarter we would look to be flat in our spending versus last year. So we are starting now and going forward to spread it out as a comparable versus the prior year.

[Operator]

Our next question comes from the line of Nishu Sood with Deutsche Bank.

[Nishu Sood, Deutsche Bank]

I wanted to ask about the reduction in the EBITDA outlook for '18. If I look at the reduction it seems to be greater for 4Q than for 3Q. I just wanted to understand the drivers of that. The two issues that we're talking about today are the weather effect and the price/cost issues. But both of those, from what we've discussed so far, it sounds like they were worse in 3Q and would stabilize heading into 4Q. Your October organic sales trends improved slightly from September into October. And the adjustment in terms of pricing would have had a few months more in 4Q versus 3Q. So why is 4Q more affected by these issues than 3Q as reflected in your guidance adjustment?

[Doug Black, Chairman & CEO]

Well, one of the factors you have to keep in mind is we're heading into a tougher comp in Q4 from last year than in Q3. Last year we had 7% . . .

[John Guthrie, EVP, CFO & Assistant Secretary]

7% organic growth in Q4. And we had very robust gross margin improvement in Q4. So I think what you're seeing there, Nishu, is we still expect good progress. We think organic growth actually will end up being roughly similar to the third quarter. When you take what we've seen so far in October, which is the biggest month, and we project outward against a tougher comp. And then on the gross margin side, again, we've got a tougher comp on that side as well going into the fourth quarter. So that's really more comp related than anything, any kind of progress or lack of progress that we're achieving on our key metrics.

[Nishu Sood, Deutsche Bank]

Got it. And then on pricing, so we went from kind of flat to 1% 1Q to 2 Q and then 1% to roughly 3% in 2Q and then kind of 3% to 4% as we looked into 3Q. So the greater acceleration in pricing - I'm sorry - in input cost inflation was arguably in 2Q versus 3Q. In 2Q you were able to turn it around fairly quickly with - kind of intra-quarter. And this quarter it seems like it taking a little bit longer. Since more of the acceleration was in 2Q, what has changed since then? Why does it seem to be taking a little bit longer now? Why is it tougher to pass the inflation on this quarter versus last quarter?

[Doug Black, Chairman & CEO]

No, I think we're actually seeing just the opposite, Nishu. When you look at the second quarter, we only had 10 basis of gross margin improvement. And that reflected the fact that it took us pretty much the whole quarter to pass through those input cost inflation that we saw starting in the beginning of the quarter. In the third quarter we've continued to see price inflation ramp up, although obviously not the dramatic ramp-up that we saw in second quarter. And from our gross margin outcome we were able to more quickly and, as I mentioned before, in a more planned and proactive way, pass that through. So we do feel good that we're now - we and our customers and our suppliers are a little bit ahead of the curve. We're anticipating the inflation. We're planning it. We're working together. And therefore we're passing it through quicker.

[Nishu Sood, Deutsche Bank]

Got it. Okay. And the price inflation as we kind of disaggregate it, is it mainly to do with transportation? I mean, is it transportation on your folks side? Or is it more on your supplier side? Just wanted to understand the drivers a little bit better, please.

[John Guthrie, EVP, CFO & Assistant Secretary]

When we're talking about price inflation, it is almost all on our suppliers' side, is what we're passing on to the customers. And we're hearing a number of different components on what's driving that from their side - increased raw materials, freight, increased labor costs. We've heard all of those, and a robust market, to be honest with you. So it's coming from the supplier's side, in addition to just like third-party freight costs that we internally bear. But it is very little to none of our own - our costs.

[Operator]

Our next question comes from the line of Keith Hughes with SunTrust Robinson Humphrey.

[Keith Hughes, SunTrust Robinson Humphrey]

If you look at the guidance for the fourth quarter, I don't have all the numbers here but it appears kind of a flattish EBITDA margin in the fourth. Is that just the influence of the new price increases you talked about in the prepared segment as you kind of flushed those through, particularly in the off season, kind of prevents any further gain?

[Doug Black, Chairman & CEO]

Yes, I think it's a combination of price and the tougher comp. If you remember, last year we finished very strongly, 7% organic growth. And that impacts some of our rebates and outcomes there, which all are accretive to gross margin. This year we're looking at a more conservative finish on the sales side in the fourth quarter. And when you take all those things together we're only going to see a more modest improvement on the - flat to modest improvement on the gross margin metric in the fourth quarter. We will get some SG&A leverage in the fourth quarter. As we mentioned, the planned investments are flat and we have good line of sight on what we're spending SG&A-wise. And when you put those together, in the fourth quarter we're expecting some EBITDA margin expansion as a combination of those factors. But the fourth quarter is a small - it's a small quarter. The profits are lower and the numbers can be swung one way or another with very small movements in either sales or margin.

[Keith Hughes, SunTrust Robinson Humphrey]

Okay. And you talked about finishing your new technology initiative. Are you currently set up where customers can do app-based ordering? Or is it just web site basically at this point?

[Doug Black, Chairman & CEO]

Could you repeat the question?

[John Guthrie, EVP, CFO & Assistant Secretary]

We have an app for our website.

[Doug Black, Chairman & CEO]

Yes.

[Keith Hughes, SunTrust Robinson Humphrey]

So the app is fully functional in terms of ordering and order tracking for customers. Is that correct?

[Doug Black, Chairman & CEO]

Yes. Yes, so we now have an app. We were running two websites, the new one and our old one, side by side. And they're now merged. And we're fully functional, both with the app or website, to order product for pickup or delivery 24/7.

[Keith Hughes, SunTrust Robinson Humphrey]

All right. Are you guys the only one in your market that can do this?

[Doug Black, Chairman & CEO]

There's regional players here and there. And if you look at Ewing and Horizon, they would have websites. But in terms of being mobile, phone, app, et cetera, our website is superior to anything that's out there in the industry.

[Operator]

Our next question comes from the line of Matthew Bouley with Barclays.

[Marshall Mentz, Barclays Bank]

This is actually Marshall Mentz on for Matt. I just wanted to ask one, actually, and on pricing power again. Specifically, just given how you're positioned in your markets, a lot of times is a one-stop shop maybe a better offering than a lot of your competitors? What about the way that you're situated gives you confidence that you're going to continue to maybe get ahead of the inflation that you expect into next year?

[Doug Black, Chairman & CEO]

Well, I mean first and foremost we have to be competitive in the market and we have to cause our customers to be successful. So that's our primary objective. But you are right. We offer a lot of value to our customers. And we also have tremendous and strong relationship with our suppliers. We're the number one purchaser of all landscaping products in the market, when it comes to the wholesale market and supplying contractors. So we use our strong customer relationships, our strong relationships with our suppliers, to work tougher to pass these price increases through. And as the leader in the industry, we do feel very confident that we can do that successfully. I think we've shown this year that we've been very successful. As I mentioned, going into 2019 we're now all planning the input cost inflation and how to get that through to the market together. So we feel good about our position and our ability to continue to work with our customers and suppliers to pass these costs along.

[John Guthrie, EVP, CFO & Assistant Secretary]

I would add I think that's also a market dynamic. Been in this industry for a long time and when we've seen similar action before we're not isolated in going up with the market because the industry seems to be responding to those price increases also.

[Operator]

Our next question comes from the line of Doug Clark with Goldman Sachs.

[Douglas Clark, Goldman Sachs Group]

My first one is also on inflation and pricing. I just want to clarify, first of all, that you mentioned 3% to 4%-type price inflation that you expect to pass through in 2019. Does that include the tariff component or no?

[John Guthrie, EVP, CFO & Assistant Secretary]

We are estimating that that includes the tariff component. That's what we're hearing from our suppliers. We have nursery - a lot of our products are not on a Chinese-base or Chinese-sourced. So there is a component in there. Obviously we'll have greater clarity around the beginning of the year. But we have factored that into our estimates.

[Douglas Clark, Goldman Sachs Group]

Okay, great. And then, between the price inflation that you're seeing and also just the tight labor market overall, which is obviously pretty important to your industry and landscaping in general, is there any demand elasticity or sensitivity as prices rise, let's call it, a net 8-plus-percent in 2019 versus '17?

[Doug Black, Chairman & CEO]

There's always - when prices rise at this rate there's always a little bit of effect on volume, especially in, say, the maintenance category and fertilizer or seed or other products where the contractors or the landscapers can value-engineer and still come in and deliver the project and still keep their selves whole. So we do feel like there's a modest effect. But we don't think it's a dramatic effect on volume. As prices come up we do expect volume to come through. Weather allowing, we have seen the volume come through this year in markets that have had more normal weather. We have seen good volumes with the inflation being additive to that.

[Douglas Clark, Goldman Sachs Group]

Okay, great. And then a quick follow-up is on M&A. I was curious. It sounds like there is kind of a pipeline for the next several months or heading into kind of the slower season. I was wondering if there was any seasonality to M&A ability to get deals done in kind of the winter months.

[Pascal Convers, EVP, Strategy, Development & IR]

They come when they come. Right? We can't really call when sellers will sell. Obviously we had a very great start of the good third quarter, with four deals closing in July. Actually, we had three deals close in a matter of five days. But if you look at 2018 [Technical Difficulty] whole, right, versus 2017, we've closed 12 deals in just 10 months versus eight deals during 2016, two years ago. So within two years. No, there's no seasonality. We've got [Technical Difficulty] lines and some will come in the next few months [Technical Difficulty] in the end of 2019. But the M&A pace and activities are accelerating as expected.

[Operator]

[Operator Instructions]. Our next question comes from the line of Steve Volkmann with Jefferies.

[Stephen Volkmann, Jefferies]

Just back to the inflationary environment. It would seem logical that you'd see kind of a meaningful step-up I guess on January 1 as we get the next layer of tariffs and I assume some annual price increases and so forth. So I'm just curious how I should think about the cadence of price increases in 2019 and whether there might be some timing mismatch around sort of how you respond to that.

[John Guthrie, EVP, CFO & Assistant Secretary]

Yes, we might expect that year-over-year price increases in Q1 would be higher than the rest of the year, just because we did see a large increase in Q2, and to a certain extent that we'll start lapping ourselves from Q2. So Q1 will be probably a little bit higher I would expect than the rest of the year just from that lapping effect, from a timing. Having said that, there's a lot of seasonality that goes into our business. So January and February aren't huge sales months for us anyway. But on Q2 it should be kind of - we should be at a regular run rate.

[Stephen Volkmann, Jefferies]

Okay, great. And does it make sense for you guys to try to get ahead of some of these January 1 increases> If that's the biggest increase do you - it doesn't sound like you're going to be adding a lot of inventory. But just talk me through how you think about hat.

[John Guthrie, EVP, CFO & Assistant Secretary]

We are going to be adding some inventory in Q4 in preparation for that. And so we have planned in Q4 to try to buy ahead where we can.

[Stephen Volkmann, Jefferies]

But you're still going to generate free cash about at net income levels.

[John Guthrie, EVP, CFO & Assistant Secretary]

Yes, for the full year, I would say that's still our plan, to be around that ballpark.

[Doug Black, Chairman & CEO]

Right. So we have planned - we're going to see our inventory stock turns go up versus last year. And that does factor in that buy-forward. So one of the strategic investments we made were putting in our three distribution centers. Those distribution centers allow us to be more efficient with our inventory in the branches. And they also allow us to kind of buy forward in a smart fashion. So the combination of those two, the efficiencies obviously less the inventory that we're going to buy up, still give us good improvement in the cash flow outcome that we described earlier.

[Operator]

Thank you. Ladies and gentlemen, there are no further questions at this time. I'll turn the floor back to Mr. Black for any final comments.

[Doug Black, Chairman & CEO]

Okay. Well, thank you for joining us today. We appreciate your interest in SiteOne and we're excited about the future. I would like to take one more opportunity to thank all of our associates who have worked so hard to help us build a great company. At the end of the day, we are as good as our people and we have a fantastic team. And that gives us good confidence that we can build a great company in the years to come. Thank you very much.

[Operator]

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.