Ferguson Enterprises - Q2 2024

Transcript

Operator (participant)

Hello, and welcome to Ferguson's second quarter results conference call. My name is Adam, and I'll be coordinating your call today. I'd now like to turn the call over to Brian Lantz, Vice President of Investor Relations and Communications. The floor is yours. Please go ahead.

Brian Lantz (VP of Investor Relations and Communications)

Good morning, everyone, and welcome to Ferguson's second quarter earnings conference call and webcast. Hopefully, you've had a chance to review the earnings announcement we issued this morning. The announcement is available in the investor section of our corporate website and on our SEC filings webpage. A recording of this call will be made available later today. I want to remind everyone that some of our statements today may be forward-looking and are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected, including the various risks and uncertainties discussed in our Form 10-K, available on the SEC's website. Also, any forward-looking statements represent the company's expectation only as of today, and we disclaim any obligation to update these statements. In addition, on today's call, we will also discuss certain non-GAAP financial measures.

Please refer to our earnings presentation and announcement on our website for additional information regarding those non-GAAP measures, including reconciliations to the most directly comparable GAAP financial measures. With me on the call today are Kevin Murphy, our CEO, and Bill Brundage, our CFO. I will now turn the call over to Kevin.

Kevin Murphy (President and CEO)

Thank you, Brian, and welcome everyone to Ferguson's second quarter results conference call. On the call today, I'll cover highlights from our second quarter performance. I'll also provide a more detailed view of our performance by end market and by customer group before turning the call over to Bill for the financials. Then come back at the end and give some closing comments before Bill and I take your questions. Our associates have continued to execute well, going above and beyond to serve our customers, helping to make their projects more simple, successful, and sustainable. In the quarter, we saw a modest revenue decline of 2.2%, largely driven by 2% deflation in a challenging market. We delivered solid gross margins and appropriately managed costs while preparing for our seasonally stronger second half.

Adjusted operating profit came in at $520 million, with adjusted diluted earnings per share of $1.74, down 8.9% against last year. Over the three years since fiscal 2021, this represents sales growth of 35%, adjusted operating profit growth of nearly 50%, and adjusted diluted earnings per share growth of nearly 60% for the second quarter. Looking forward, open orders and sales per day trends support our expectation of improvement through the balance of the fiscal year against easing comparables. Our views on fiscal 2024 guidance are unchanged. Bill will walk you through this in more detail shortly. Turning to our performance by end markets in the United States. Net sales were down 2.2% as end markets remained challenged.

Trends in new residential housing starts and permit activity improved slightly in the quarter, while repair, maintenance, and improvement work remained soft. Our residential revenues, which comprise just over half of U.S. revenue, declined 4% during the second quarter, representing a sequential improvement from Q1. Non-residential markets showed comparative resilience. Commercial and civil infrastructure activity held flat in the quarter against strong comparables, with industrial down 6% against an outstanding 24% comparable. Overall, net sales in non-residential declined by 1% during the quarter. See good levels of non-residential bidding activity and expect improvement through the second half. While we expect growth rates will fluctuate over time, our intentional, balanced end market exposure positions us well. Moving to our customer groups in the United States.

Residential trade plumbing declined by 2%, an improvement from double-digit declines over the last three quarters as we begin to lap easier comparables and new residential markets begin to stabilize. Leading indicators such as new residential permits and starts have recently seen modest improvement, and we expect further improvement in future quarters. HVAC growth continued, rising 1% against a 10% prior year comparable. We will continue to build on the strengths of our residential trade plumbing and HVAC customer groups in service of the growing dual-trade contractor. Residential building and remodel revenues declined 4%, similar levels to the first quarter, with continued pressure on repair, maintenance, and improvement. Residential digital commerce declined by 13%, with consumer demand remaining weaker. Waterworks revenues were flat.

Bidding activity is healthy across our broadly diversified business mix, including residential, commercial, public works, municipal, meters and metering technology, and wastewater treatment plant, soil stabilization, and urban green infrastructure. The commercial mechanical customer group grew 1% as we continued to see our customers pivot towards work such as data centers and major capital projects. Our industrial, fire and fabrication, and facility supply businesses delivered a combined net sales decline of 3% against a strong 17% growth comparable. Our breadth of customer groups allows us to bring value to the total project while also maintaining a broad and balanced end-market exposure. Now let me pass to Bill to cover the financial results in a bit more detail.

Bill Brundage (CFO)

Thank you, Kevin, and good morning, everyone. Second quarter net sales were 2.2% below last year. Organic revenue declined 3.7%, partially offset by acquisition revenue of 1.5%. Pricing environment was similar to the first quarter, with approximately 2% deflation, driven by weakness in certain commodity categories as we lap strong comparables, while finished goods pricing has remained slightly positive. Gross margin of 30.4% was up 20 basis points over the prior year, driven by strong pricing and product strategy execution from our associates. We are appropriately managing the cost base, with SG&A stepping down more than $40 million from Q1. We're balancing targeted cost control actions and productivity initiatives with continued investment in core capabilities for future growth.

Adjusted operating profit of $520 million was down $62 million or 10.7% lower compared to prior year. Adjusted diluted earnings per share of $1.74 was 8.9% lower than prior year, with the reduction due to lower adjusted operating profit, partially offset by the impact of our share repurchase program. Our balance sheet remains strong at 1.1x net debt to adjusted EBITDA. Moving to our segment results. Net sales in the U.S. declined by 2.2%, with an organic decline of 3.7%, partially offset by 1.5% contribution from acquisitions. Adjusted operating profit was $525 million, delivering an adjusted operating margin of 8.2%.

In Canada, net sales were down 3.7%, with an organic decline of 3.3% and a 0.4% adverse impact from foreign exchange rates. Markets have remained challenging, and we saw similar trends to that of the U.S. Adjusted operating profit came in at $9 million. Turning to our first half results, the year is progressing as expected. As we set out at the beginning of the year, we expected to operate against a challenging market backdrop, particularly in the first half of our fiscal year, against strong revenue and adjusted operating margin comparables. Net sales were 2.5% below last year, with an organic decline of 4.4%, partially offset by an acquisition contribution of 1.9%.

Gross margin was 30.3%, down 10 basis points, as our associates have been disciplined in managing prices through a period of commodity price deflation. We have managed labor and non-labor expenses throughout the year, balancing the near-term market demand environment against expected growth in upcoming quarters. Adjusted operating profit of $1.3 billion was down 10.6% compared to the prior year, delivering a 9.0% adjusted operating margin. Adjusted diluted EPS of $4.40 was down 9.7%. We believe the business is well positioned as we head into the second half, with improving market demand and the cost base in good shape. Next, the business continues to generate strong cash flows.

Inventory positions normalized as we exited last fiscal year, and we have returned to our normal historical seasonal working capital trends with a modest outflow in the first half of the year. Interest and tax outflows were slightly lower than last year due to the timing of tax payments, resulting in strong first half operating cash flow of $863 million. We continue to invest in organic growth through CapEx, investing $192 million in the first half. As a result, we generated free cash flow of approximately $700 million. Moving to capital allocation. Our balance sheet position is strong, with net debt to adjusted EBITDA of 1.1x.

We target a net leverage range of 1-2 times, and we intend to operate towards the low end of that range through cycle to ensure we have the capacity to take advantage of growth opportunities, as well as to maintain a resilient balance sheet. We allocate capital across four clear priorities. First, we're investing in the business to drive above-market organic growth. Previously mentioned, we invested $113 million in working capital and $192 million into CapEx during the first half, principally focused on our market distribution centers, branch network, and technology programs. Second, we continue to sustainably grow our ordinary dividend. The board declared a $0.79 per share quarterly dividend, a 5% increase over the prior year, reflecting our confidence in the business and cash generation. Third, we're consolidating our fragmented markets through bolt-on geographic and capability acquisitions.

We are pleased to welcome associates from SecureVision, Grove Supply, and Harway Appliances during the first half. Our deal pipeline remains healthy, allowing us to continue to execute our consolidation strategy. Finally, we are committed to returning surplus capital to shareholders when we are below the low end of our target leverage range. We returned $250 million to shareholders via share repurchases during the first half, reducing our share count by approximately $1.5 million, and ended the period with $285 million outstanding under the current share repurchase program. Now, let's turn our attention to the remainder of the fiscal year. As Kevin outlined earlier, current open orders and sales per day trends support our expectation of improvement through the balance of the fiscal year against easing comparables.

We believe we are well positioned for our upcoming seasonally stronger second half. As a result, our view of fiscal 2024 guidance remains unchanged. We believe revenue will be broadly flat for the year. Here, we assume end markets decline in the mid-single-digit range. Expect to outperform these markets by approximately 300-400 basis points. Sales from completed acquisitions, which we expect to generate just over $600 million in revenue, and the benefit of one additional sales day landing in the third quarter. Overall, while we saw modest deflation in the first half, we are assuming a broadly neutral pricing environment for the full year as a whole. We need to provide a range for adjusted operating margin between 9.2%-9.8%. Expect interest expense of approximately $190 million-$210 million.

Our adjusted effective tax rate is expected to be approximately 25% this year, and we expect to invest between $400 million-$450 million in CapEx, similar levels to last fiscal year. So to summarize, we had solid execution in the first half, and our views on fiscal 2024 guidance are unchanged. Remain focused on execution and believe the combination of our strong balance sheet, flexible business model, and balanced end market exposure positions us well. Thank you, and I'll now pass back to Kevin.

Kevin Murphy (President and CEO)

Thank you, Bill. Let me again thank our associates for their unwavering dedication to serving our customers, helping to make their projects more simple, successful, and sustainable. We are pleased with our execution in the first half. Business is well positioned as we anticipate firming demand, and as Bill set out, our fiscal 2024 guidance is unchanged. We look forward, we are well-positioned with a balanced business mix between residential and non-residential, new construction, and repair, maintenance, and improvement. We have an agile business model and flexible cost base that allows us to adapt to changing market conditions. Our cash generative model allows us to continue to invest for organic growth, consolidate our fragmented markets through acquisitions, and return capital to shareholders. To do this while maintaining a strong balance sheet, operating at the low end of our target leverage range.

We have consistently executed on these priorities, and this supported a long-term track record of outperformance and disciplined deployment of capital. Scale and breadth allows us to leverage our competitive position across our customer groups in order to benefit from emerging multi-year tailwinds in our end markets. Remain confident in the strength of our markets over the medium and longer term, and expect to capitalize on these growth opportunities. Thank you for your time today. Bill and I are now happy to take your questions. Operator, I'll hand the call back over to you.

Operator (participant)

Thank you. For our Q&A, if you would like to ask a question, please press star one on your telephone keypad now. If you change your mind, please press star followed by two. When preparing to ask your question, please ensure your device is unmuted locally. Now, our first question comes from Matthew Bouley from Barclays. Matthew, your line is open. Please go ahead.

Matthew Bouley (Senior Equity Research Analyst)

Hey, morning, everyone. Thank you for taking the questions. You all mentioned current open orders and sales per day supporting second half improvement. I guess, what exactly are you seeing around orders and daily sales? And, you know, maybe it would help if you can kinda help us with the cadence of growth through fiscal Q2. How did January trend with weather and all that, and kind of what are you seeing quarter to date? Thank you.

Kevin Murphy (President and CEO)

Good morning, Matt. Yeah, thank you for the question. This is Kevin. I'll take the beginning portion, maybe then Bill can sprinkle in some detail around what we're experiencing. As we said previously, the second quarter is always our seasonally weakest quarter from a revenue perspective. And if you look at how we progressed through the second quarter, the top line was a bit more pressured than what we would have expected, really, given what was an extended holiday season for the trade professional and some January weather impact that was a bit more challenging than, say, years past. But generally speaking, the year is progressing as we expected, and that second quarter progressed largely as we expected.

If we look forward, the bidding activity that we've got out there from our waterworks group all the way up through residential trade, plumbing, and the like, and the open order volume that we have, sales per day trends against what are some easing comparables, really do support what we think is gonna be improvement throughout the balance of the year.

Bill Brundage (CFO)

Yeah, Matt, and we've seen that improvement start to play through in the early part of the second quarter. So in February, organic growth was about flat, which, when you add in the acquisition impact, that would lead to slightly positive total growth for the month. So again, supporting our confidence level that growth is improving and will improve as we move through the second half.

Matthew Bouley (Senior Equity Research Analyst)

Perfect. Thanks for that, guys. Very helpful. Second one, the deflation of 2% in the quarter sounded like that was all commodity. I think you said finished goods was slightly positive. And so, to get to your full year guide of broadly neutral inflation, are you starting to see any kind of incremental finished goods inflation and price increases to support that? Or is it really just kind of the year-over-year comps as you get to the second half? Kind of what takes inflation positive in the second half to get to your guide? Thank you.

Bill Brundage (CFO)

Yeah, so back to your point, about 2% deflation, both in Q1 and Q2, largely driven by commodity deflation. Commodities were down, call it low-to-mid-teens in the quarter. And those finished goods, as we expected, are still, slightly positive in terms of year-over-year inflation. I think a couple things as we roll through the second half leads us to believe that that deflation will improve. First and foremost, we are continuing to roll over, not just easing revenue comparables, but easing inflation comparables. And in fact, we'll start to roll over our first months of commodity deflation as we step out of the third quarter and into the fourth quarter. We've seen some stability, broadly in those commodity prices over the first half of the year.

So assuming that that stability continues, that commodity deflation should lessen as we move throughout the second half. And again, we would expect finished goods inflation to be in that more traditional low single-digit range. So that leads us to believe that we'll have improving deflation moving back towards inflation in the second half. But of course, predicting commodities is difficult, so as we're guiding broadly neutral pricing for the full year, you know, there's some range of possible outcomes around that around that full year guide.

Kevin Murphy (President and CEO)

Yeah, Matt, as we've discussed in the past, the commodity-based product basket that we have is going to and has moved at different rates and has had some, you know, puts and as well inside of that. And so, as we're sat here today, we've seen some signs of stabilization. We've seen some resin price increases playing through inside the marketplace, and then we've seen some stabilization from a steel pipe perspective. So we feel more confident about that. And as it relates to finished goods, we've talked traditionally about the annual spring price increase season, and although it hasn't been as ubiquitous as the past, we have seen major product categories announcing price increases that give us some degree of confidence as we go into that second half.

Matthew Bouley (Senior Equity Research Analyst)

Great. Thanks, Kevin. Thanks, Bill. Good luck, guys.

Kevin Murphy (President and CEO)

Thanks, Matt.

Bill Brundage (CFO)

Thanks, Matt.

Operator (participant)

The next question is from John Lovallo from UBS. John, your line is open. Please go ahead.

John Lovallo (Analyst)

Good morning, guys, and thank you for taking my questions as well. The first one is, you know, you guys do have a pretty agile cost structure. I think it's highly variable, around 80%-90%. Incrementals are generally kind of 10%-13-ish%. Now, recognizing pricing was a bit of a headwind in the quarter, why were decremental margins so high at close to 40%?

Bill Brundage (CFO)

Yeah, John, thanks for the question. If you think about the second quarter, again, in our seasonally lightest quarter, and as Kevin mentioned, there was a bit more pressure on the top line. So that has a bit of an outsized impact on the bottom line operating leverage when you get a bit more pressure from a top-line perspective. The fixed cost nature of our business, even though we have a good variable cost structure in that seasonally lighter quarter, plays down a little bit more from a decremental perspective. But as we take a step back and think about the overall cost structure, we are pleased that the cost did step down from Q1 into Q2.

As we think about labor costs, which is certainly our largest component of our cost base, you know, we manage very closely full-time equivalents and headcount as the primary input to that labor cost. If I look at where full-time equivalents are, as we exited Q2, we're down slightly still year-over-year on volumes that were effectively flat for the quarter. So the teams are doing a really nice job managing those input costs, and we've really positioned that cost base for what we expect to play through in the second half and into next fiscal year, which is an improving growth environment. So given the fact that, you know, our associate base is the intellectual capacity and capability of the organization, we wanna make sure we have the right associate base to take care of that future growth.

So feel good about where the cost base is. Yes, it put a little bit more OpEx pressure in Q2, but as we look forward, we believe we're in the right place.

Kevin Murphy (President and CEO)

John, just to reiterate a little bit of what Bill said, we do feel good about where the cost base is as we prepare for what we believe to be an improvement through the balance of the year. If you think about what the volume outlook looks like, you know, inside of our residential trade plumbing business, which has been a pressured part of the business, both new construction as well as repair, maintenance, and improvement. They've done a great job of going out and taking market share. They've grown in volume and pounds for PVC pipe, even though the pricing environment has been down in the mid-20% range, while at the same time holding gross margin. And so keeping those teams engaged and prepared for what we think is an improving outlook in the second half is quite important.

So we're pretty positive about what the team has done in terms of expense management.

John Lovallo (Analyst)

That's helpful. Thank you. And then, you know, on the industrial segment, in particular, down 6% year-over-year, understanding the comp was tough at around 24%. Just curious, I mean, the first quarter faced a similar comp and was actually up, I think, you know, 3% year-over-year in the quarter. So was there anything, you know, particular in the quarter, you know, outside of the tough comps that challenged industrial?

Kevin Murphy (President and CEO)

Yeah, John, there's nothing that we would point to right now. You've got some timing issues that are out there. I talked about a little bit of an extended holiday season. I talked about a little bit of weather. We typically don't like to talk about weather, but it did have an outsized impact with branch closures. But if I look at what's building behind that industrial environment, the backlog is solid, especially in that major capital projects area. We've talked historically about that mega project trend. When you look at together, our industrial, our waterworks, commercial, fire and fabrication, and HVAC business coming together, that's where we're seeing a good tailwind from an open order perspective and are positive about what's coming in the second half.

John Lovallo (Analyst)

Great. Thank you, guys.

Kevin Murphy (President and CEO)

Thank you.

Operator (participant)

The next question comes from Philip Ng from Jefferies. Philip, your line is open. Please go ahead.

Philip Ng (Managing Director)

Hey, Kevin. You know, looking at your non-res business, certainly some puts and takes on the heavy side. Clearly, you're upbeat about that. Light commercial could be a little softer, but just kinda help us unpack in the back half. Do you expect growth? And the bidding activity you're seeing in some of these mega projects, do you expect that to kinda ripple through in the second half? And conversely, have you seen light commercial bottom out here?

Kevin Murphy (President and CEO)

Yeah. Well, thank you for the question. And we do see growth in the second half. Again, we do see open order volumes picking up across that non-residential space, from waterworks through commercial, through industrial, and through fire. When you look at what's out there, we've said that those major capital projects, specifically those like on-shoring and reshoring, sustainability trends, fiscal stimulus, you know, aided, they're gonna take a bit longer. We're seeing that play out. I mean, much like we saw with the Infrastructure Act and how that plays through our waterworks business, it's just taking more time, both in terms of release as well as in, you know, project delays that we may see during the normal course of construction. There are also some tailwinds that we're really starting to capitalize that are in the current market.

If you think about AI and what the data center impact is, those are very good projects for us across multiple customer groups, and we're seeing it play out very similarly to the way in which we're seeing mega projects play out. And that is across customer group collaboration with the owner, the general contractor, to make sure that Ferguson is a valuable partner on the job for the contractor as well as the owner. And so, we're bullish on what that looks like in the second half, and that's starting to play in today.

Philip Ng (Managing Director)

Kevin, you beat me to the punch. I was gonna ask you what percentage of your business on data centers is your non-res business, just because it's very much in vogue for with that AI dynamic. But any color on the the data center portion of your business for non-res?

Kevin Murphy (President and CEO)

Yeah. For me, the color is that it's very much like that mega project or major capital project landscape. Number one, they're good profit pools that are growing, and it's a unique time in the construction environment, you know, for our country. But maybe more importantly, it offers us up that unique opportunity to come together as multiple customer groups for the owner, the general contractor, as well as for the contractor that's actually doing the install. And so coming together on water, commercial, industrial, fire, HVAC is proving valuable. We're seeing that play out. In fact, we've made some good investments in how we can approach that part of the construction environment uniquely as to where we used to just bid that work as individual customer groups, really coming together and offering a total package.

Philip Ng (Managing Director)

Okay. Appreciate all the great color. Thank you.

Operator (participant)

The next question comes from David Mantey from Baird. David, your line is open. Please go ahead.

David Mantey (Analyst)

Thank you. Good morning, everyone. First question for Kevin, maybe. On slide five, when you look at your U.S. end markets, in the second quarter, they're mostly flattish year-over-year, give or take. After this quarter, which of these end markets leave you more encouraged for the second half of the year, and on which ones are you more cautious following recent results?

Kevin Murphy (President and CEO)

Yeah. Thanks, Dave, for the question. If I start at the residential side, as we're sat here today, we're looking at an RMI or repair, maintenance, and improvement residential market that is a touch softer than what we would have expected at the beginning of the year. LIRA is calling for a down market, call it in that mid to high single digit area for the calendar year. But the residential new construction market we see as a bit more positive, especially in the single-family side of the world. We think that multifamily, although it's been supportive for the business as we've delivered product to the market, it now starts to get a bit more challenged because there's been a lot of product that has entered the market from a multifamily perspective. But single-family starts and permit activities give us a more bullish tone.

On the non-res side, as I talked earlier on the call, the major capital project work and the data center work gives us some really good outlook for the second half. And so, I'd say there's some balanced optimism as we go into the second half. There's balance in terms of how we're lapping comparables from prior year, and so it plays to that, again, balanced business mix. On one note on that multifamily side, we are seeing good activity levels in high-rise multifamily, especially down in your neck of the woods, down in Florida. And so, we're bullish on that multifamily high-rise work, but maybe a bit more pressured on the core multifamily side.

David Mantey (Analyst)

Yeah. Thanks for that detail. Quick one for Bill. Mathematically, if we think about the new M&A deals that you've announced and the roll-off of prior acquisitions, what percentage contribution to growth should we expect in the third and fourth quarters?

Bill Brundage (CFO)

Yeah, Dave, if you look at the first half, we delivered, you know, just under, just under 2%, just under $300 million worth of acquisition contribution. And given the deals we've recently announced, we'd expect a similar dollar amount in the second half. So somewhere just south of that 2% range, roughly $600 million of full year revenue contribution would be our expectation at this point.

Kevin Murphy (President and CEO)

Got it. Thanks, guys.

Bill Brundage (CFO)

Thanks, Dave.

Operator (participant)

The next question comes from Ryan Merkel, from William Blair. Ryan, your line is open. Please go ahead.

Ryan Merkel (Co-Group Head of Industrials and Technology Research Analyst)

Hey, good morning. Thank you. I wanted to ask on gross margins, really solid result this quarter. Can you remind us of gross margin seasonality as we think about modeling 3Q and any reason not to use normal seasonality?

Bill Brundage (CFO)

Yeah, Ryan, I mean, seasonality, you know, really doesn't play a large factor or doesn't have a large impact on gross margin swings. I mean, it's sometimes as we approach the larger seasonal months in the summer calendar, we'll get a, actually a touch of pressure there, just given the HVAC growth in our business and the waterworks growth in our business in those seasonal months, which tends to have slightly lower gross margins. Again, similar operating margins. But in general, in that low 30%-35% range is kind of our expectation and where we've, where we've delivered over the last several quarters.

Ryan Merkel (Co-Group Head of Industrials and Technology Research Analyst)

Just to follow up there, if, you know, inflation turns positive, is that a helper to your gross margins as we think about the second half?

Bill Brundage (CFO)

We don't expect inflation to move at a pace that would have a big impact on gross margins. Certainly, as we lap those comparables and as we've talked about, we still expect low single digit inflation on finished goods. That would be helpful from a revenue perspective, but I wouldn't expect a large gross margin impact, without some significant, you know, short-term moves in commodity prices, which we don't expect sitting here today. But again, that's a little bit difficult to predict and call.

Kevin Murphy (President and CEO)

Ryan, what we are pleased with is, as we've been going through this period of commodity-based product deflation, to hold and to achieve the kind of gross margin levels that we have is very encouraging. Especially as, as I've indicated earlier, we've taken market share and actually grown volume inside of some of those commodity-based products, held in, produced good gross margins, even in a falling price environment. As we look forward to what we should experience this year, we start to get back to, again, a more normalized pricing environment, where you see annual price increases playing through on finished goods.

This year may be a bit more choppy than years past, but generally speaking, that's where we get back to utilizing our product strategy and charging for the value that we provide to get long-term sustainable gross margin expansion, and call it that 10-20 basis points environment.

Ryan Merkel (Co-Group Head of Industrials and Technology Research Analyst)

Got it. That's helpful. And just for my follow-up, anything to think about for March and April when we think about last year in terms of modeling? I know there was some weather last March. Just curious what if the comparisons get a little bit easier, and if there's anything to think about.

Bill Brundage (CFO)

Yeah, it's difficult to predict what the weather impact would be, Ryan, but certainly the comparables continue to ease as we step through Q3 into Q4. You know, we had our first negative organic growth or organic decline of about 2.4% last year, Q3, and then that went down to about 5%, organic decline in Q4. So the comparables do continue to ease a bit as we march through kinda month-by-month through the end of the fiscal year.

Ryan Merkel (Co-Group Head of Industrials and Technology Research Analyst)

Perfect. Thank you.

Bill Brundage (CFO)

Thanks, Ryan.

Operator (participant)

The next question comes from Mike Dahl, from RBC Capital Markets. Mike, your line is open. Please go ahead.

Mike Dahl (Managing Director and Senior Analyst)

Morning. Thanks for taking my questions. First question, just looking at kind of category performance. Digital has been soft, even as we've gotten against easier comps, I think double digits off of, you know, comping off a double-digit decline, and you're now down to about 8% of sales from 10%. You know, obviously, that ties at least partially with your comments around RMI, but just wondering if you can give a little more color there and give us an update on, you know, how you're planning to invest and expand the digital effort here.

Kevin Murphy (President and CEO)

Thanks, Mike, for the question. Good morning. When you look at that digital piece, it was the most affected in terms of a pull forward of demand during that COVID lockdown period. And you're right, the RMI side of the world is a bit more challenged on the residential portion of the business. And so the customers that that is really going after and targeting is that light decorative pro and that project-minded consumer. And so they're probably the most pressured when we look at that residential space. You know, if you think about consumer balance sheets, and again, where they are spending their money on experiences versus, say, some light renovation on the home, that's where we're seeing the pressure.

If I look at where we're going to take this business going forward, where we get really energized is how we pair what we think are really unique assets together for an omni-channel experience. Because if you look at the digital business, especially Build with Ferguson, that's a unique digital experience for that project-minded consumer and that light decorative pro. And the tools that are there from a technology perspective are starting to really enable that building and remodel business through the showroom, bringing together a best-in-class experience for bricks and mortar, with a consultative experience in person, together with a best-in-class experience digitally and a great project tool. So as we look forward, that's really where you're gonna see those businesses come together and where we should see that growth.

Mike Dahl (Managing Director and Senior Analyst)

Thanks, Kevin. That's helpful. And then shifting gears, back onto kind of capital allocation, M&A, it seems like there's been a significant uptick in broader M&A activity across virtually everything: distribution, manufacturing, a lot of things, housing-related, industrial-related. You know, can you talk to, obviously, you closed the three acquisitions, but just the pipeline you're seeing, kind of composition, has that changed at all as you've gone through the past few months? And, you know, any kind of medium to larger size things taking a boost or are you still, or would you still expect kind of similar cadences we've seen?

Kevin Murphy (President and CEO)

Yeah, Mike, I would say no significant change. Pleased with the four deals we've now completed year to date. In fact, we closed on our Yorkwest deal that we announced previously. Signing on, we closed on that late yesterday. So pleased to have those four deals this year. The pipeline is pretty healthy right now. Still full of those sized deals that you would expect, just given the nature of our industry. So, as we've talked about a lot in the past, you know, 10,000+ small to medium-sized competitors out there that make a good, robust, and healthy pipeline for us for what we believe will be years to come. So I'd expect a similar cadence. Nothing very large in the pipeline, just given the nature of what our industry is.

And that pipeline is still solid. We still focus on both geographic bolt-on and capability M&A. You see us focusing on new capabilities inside of our Waterworks business, especially in areas like meters and metering technology, stormwater management, soil stabilization, and urban green infrastructure. And then you also see us focusing on expanding our HVAC capabilities so that we can best serve that dual trade, HVAC and residential plumbing repair trade professional. We see that market growing, we see that contractor base growing, and we'd like to be uniquely positioned to take care of that customer as we go forward. And M&A is a big part of that landscape as we look to fill out our HVAC capabilities across the United States.

Mike Dahl (Managing Director and Senior Analyst)

Thank you.

Operator (participant)

The next question comes from Kathryn Thompson from Thompson Research Group. Kathryn, your line is open. Please go ahead.

Kathryn Thompson (Founding Partner and CEO)

Hi, thanks. Just a clarification from earlier in the Q&A. Could you remind us what percentage of cost of goods sold are commodity products? And, how has this balance changed, today versus, say, three to four years ago?

Bill Brundage (CFO)

Yeah, Kathryn, today, commodities are roughly just under 14% of our revenue. If you went back, pre-pandemic, we were, we were more like 10%, 11% of revenue. With rapid commodity inflation, that increased as a percentage of our sales to up over 16% at one point. So we've started to normalize back, kind of midway back, closer to where we were pre-pandemic. And given where commodity prices are today, probably expect a similar, similar range, in terms of total percentage of revenue as we step through the second half.

Kevin Murphy (President and CEO)

And that'll all depend, Kathryn, on how we progress through the next, call it, four or five quarters, as we start to see good non-residential activity continue to play through. That'll play through beginning with our Waterworks business, roll into, you know, heavy steel pipe usage inside of our commercial mechanical business, some heavy steel pipe usage inside of our industrial business, as well as iron fabrication. So you may see that volume begin to increase, even though price deflation is already largely set in through the group.

Kathryn Thompson (Founding Partner and CEO)

And we find that there's some building product categories with other companies that where you're able—you're better able to pass through pricing on commercial projects than on residential. How does that play through for you in terms of pricing power, particularly take into account larger scale projects that are a greater relative mix versus historic levels?

Kevin Murphy (President and CEO)

Kathryn, I wouldn't say that our ability to pass through pricing is very different between residential and non-residential inside of our business mix. Certainly, you have different pressure points that happen for long gestation period projects, but we generally play that through in conjunction with the contractor and the manufacturer as we're going through those projects. So there isn't a whole lot of difference as we go through there. As we've said, we don't expect to have massive price inflation or abnormal price inflation as we move into the second half. We do see finished goods having some positive movements from a pricing perspective and stabilization on the commodity side of the world.

Kathryn Thompson (Founding Partner and CEO)

Okay. And, finally, last week, the largest annual residential construction and end market trade show, the International Builders' Show, wrapped up. What, if any, trends can you share with us that could give just some additional broader color into that important residential end market for you?

Kevin Murphy (President and CEO)

.Yeah, so if you think at the highest level, as we've talked, Kathryn, and by the way, that just ended, so I haven't gotten a complete download in terms of what the epiphanies were coming out of the show from our associates. But at the highest level for us, in terms of market, again, we think that we're gonna see good movement from a single-family residential start perspective, as we're underbuilt inside of this country, and existing home turnover is still pressured. We think that multifamily starts to tail off. And on the remodel side of the world, we still believe that the high-end remodel side of the world is going to be a bit more resilient than, say, your core RMI portion of the business. We're seeing that play out.

If you look at the real core customer for our showroom business, that local high-end builder remodeler, what we've seen is, you know, if they're doing, call it six-12 projects annually, and they're high-end projects, we're seeing them flip from new residential construction to more high-end total remodels. But their book of business is still pretty solid, and they feel pretty good about the marketplace. So generally, from a market perspective, that's what we're seeing. In terms of trends that are happening inside the product set, you know, I'll defer to a bit later in the year as to what the takeaways were from KBIS IBS.

Kathryn Thompson (Founding Partner and CEO)

Okay, great. Thanks very much.

Kevin Murphy (President and CEO)

Thanks, Catherine.

Operator (participant)

Our final question today comes from Patrick Baumann from J.P. Morgan. Patrick, your line is open. Please go ahead.

Patrick Baumann (Analyst)

Oh, hi, good morning. Thanks for taking my questions. Just wanted to jump back to gross margins. You mentioned, I think, in the commentary, that pricing and product strategy are drivers of expansion in the quarter. Can you just flesh out what you mean by that? Because on pricing, you know, you're seeing deflation, so are you getting some price cost benefit? I think you said, like, discipline from your associates from a price perspective. And then on product strategy, is this own brand contribution, is this, or something else, you know, from a services perspective?

Kevin Murphy (President and CEO)

Yeah. Thank you, Patrick. And if we think about the pricing side of the world, one of the things that is most important from a customer service and a customer engagement perspective is consistent pricing across our network and across time. And so making sure that we have good, solid matrix utilization, as well as doing the right thing from a specials pricing. As you know, we're a value-added and service-driven company, and so in some cases, upwards of 20% of our revenue can be non-stock specials. And so making sure that we're pricing appropriately for the project has an impact on our gross margin and that gross margin expansion. Additionally, from a product strategy perspective, we think that's probably our best avenue for overall gross margin.

And yes, own brand is probably the highest expression of what that product strategy looks like, because you have a product that's unique to Ferguson and one in which we are promoters of the brand and, and have a higher overall gross margin profile. But it's not just own brand. It's also the partner vendors that we have, that we can grow faster than market for them, that we can offer unique cost savings, and we can drive value for them and have a higher overall gross margin profile. So it's really our sales associates, both inside and out, driving the right product for the job and the application for the customer, and then secondarily, those that have the highest gross margin profile for Ferguson as a company. And that's the way we look at expanding gross margin over time.

Patrick Baumann (Analyst)

Makes sense. Helpful. And then on the, my follow-up is on the commodity product pricing side. You, you mentioned some increase in resin as a good sign for PVC pipe, I suppose. I'm wondering if you could comment on any differences you're seeing in the smaller diameter, like plastic water pipe for, resi trade versus, like, the bigger diameter stuff for the waterworks business. You said, you said something about, like, a 20% decline overall, I think. I'm just wondering if you could give any color on differences between, you know, the types of, PVC pipe.

Kevin Murphy (President and CEO)

Yeah. And if you look at the commodity-based basket of products that we have, again, it's PVC pipe, steel pipe, cast iron, ductile iron, copper tube. And so inside of that basket, we've said that they're gonna move at different paces and potentially move quite differently. PVC is one of those. We've seen a bit more movement on the small diameter and plumbing PVC pipe than we have on large diameter and waterworks PVC pipe. We've seen more stability. That said, resin price increases are gonna affect both sides of that. And so although we've seen a bit more pricing pressure or deflation in plumbing, we do see that moving in a different direction as we're sat here today. So it really has had different movements across, call it, the first two quarters, especially this year.

Patrick Baumann (Analyst)

Helpful. And then if I could fit one more in here. I know I'm the last question, so I'm just gonna fit one more in if I can. On your MDC rollout, any update kind of on, on, you know, how that's going relative to your expectations? Like, what are kind of the plans for this year from an MDC perspective and any kind of financial metrics you could share with us on, you know, how it's impacting the business?

Kevin Murphy (President and CEO)

Yeah, Pat, we're pretty pleased with our rollout to date. To date, we have three MDCs that are open, Denver, Phoenix, and Houston. Houston being our most recent MDC that we've opened. And as we look at this year, from a calendar year perspective, we'll open our first MDC in Canada, in Toronto. We'll have Nashville come online later this calendar year, and then as we roll into next calendar year, Dallas and Washington, D.C. So the rollout strategy of, call it, two to three per year over the next several years, is very much on track. Early reads on productivity levels are quite good and positive. As you know, we've got a lot of investment in automation within those warehouses.

You know, just from a pure labor standpoint, you know, we're getting 20%-30% productivity out of those components of the warehouses. Good productivity, but maybe more importantly, from a strategic standpoint, you know, what we're bringing is best same-day availability of inventory into these major metropolitan markets. That's really improving customer service scores and product availability, fill rates, and in-stocks in those markets. We think this is a real core component of our continued organic growth strategy over the next several years. So very pleased with the rollout to date, and we'll continue to march down that path.

Patrick Baumann (Analyst)

Great. Thanks a lot for the update. Best of luck.

Kevin Murphy (President and CEO)

Thanks, Pat.

Operator (participant)

This concludes today's Q&A session. I'll now hand over to Kevin Murphy for closing remarks.

Kevin Murphy (President and CEO)

Thank you, operator. Thank you all for your time with us today. We appreciate it more than you know. Again, I'll end where we started, and that's a thank you to our associates. Their tireless efforts to really make our customers' projects better because we were on the job with them. As I take a step back, we are pleased with how the year is progressing. It's generally progressing as we expected. As we look forward to the second half, our seasonally stronger second half, we look forward to continued improvement as we lap some easing comparables. Again, thank you very much for your time. We look forward to seeing and talking with you soon.

Operator (participant)

That concludes the Ferguson second quarter results conference call. I'd like to thank you for your participation. You may now disconnect your lines.