James Hardie Industries - Q2 2018

Transcript

Louis Gries (CEO)

Good morning, everyone in Australia, and everyone on the phone. Thanks for joining. Normally, we have the same agenda. In fact, since I've started at Hardie in nineteen ninety-one, today is the first day we're gonna announce -- we announced it yesterday, actually, a relatively large acquisition. So we've slotted that on the agenda. It'll be up front. When we get to Q&A, I think we should do the Fermacell questions first, just to make sure we get them all in, in case the normal business questions kind of run on. So, we'll... And as far as the business itself, I'll cover, as I always do, the kind of overview of the operations. Matt will take care of the financials, and then we'll move to Q&A. Okay, so Fermacell.

I guess first, it's a business we've, we've known of for a lot of years. It's very, very much set up like Hardie. They started investing in the technology about the same time Hardie started investing in fiber cement technology. So it's been almost forty years. This, this is more the financial overview of the, of the transaction, which, when we get to questions, Matt might fill in a few blanks if you need them filled then. But the headline numbers are here, EUR 473. It's roughly nine times to be debt financed, and we'll own it sometime in the fourth quarter. So a binding offer was signed yesterday by both parties. Get to the next slide, which, which talks about it a little bit.

Like I said, it's very much set up like Hardie, category leader. It's a differentiated business sitting on top of a commodity industry, basically, in their case, gypsum. In our case, we normally sit on top of either basic cement boards, things like cardboard, OSB, and vinyl, which are all basic commodities. The business has a strong brand, and they developed their brand the same way Hardie did, and that's through pull-through selling, so trying to get to the decision makers, what your decision, rather than push your product through the channel. So they use more technical sales approach than we do, and you'll see in a slide coming, they participate more in non-res than we do. So the technical sales is pretty critical for a couple of the segments they participate in.

They have a good track record. Like I say, over that period of time, they didn't grow to the same scale as Hardie did with fiber cement, but certainly, when you look around the world, they're the company that did the job, growing the category for fiber gypsum. And they do have a strong management team, which was critical for us, because, as most of you know, our capabilities are either in North America or Asia Pac as far as management. So it was important to get a strong management team that goes with the business. And again, those of you that follow the company know that, we anticipated launching an international growth strategy, and we started to rebuild the GMT with that in mind.

Jack Truong, who joined us in April on the senior team, does have a lot of international experience. And obviously, he'll be responsible for the business. Now, on its own, it's a good business, well set up, has organic growth opportunities, not to the same upside as Hardie would have in the U.S., but more similar to what we have in Australia. There's still market share gains for the Fermacell business available. The second part of the equation for Hardie investors is we've been in Europe for 10-plus years trying to grow organic fiber cement business, and we just haven't gotten there. We're roughly 30-40 million EUR without much cash flow that goes along with that.

It's a different market than what we participate in, either in Asia Pac or in the U.S., but it is a market that we see a lot of potential. It has a lot of the macro drivers that we look for that we think are important to value creation for fiber cement. We just never got the scale to have much influence in the market. So we sell basically U.S. products that are exported from U.S. plants, and it becomes very nichey and very, you know, very kind of scattered geographically.

So what we think Fermacell does is it gives us that regional capability and regional perspective and regional influence that I think will be important to launch a much higher growth fiber cement strategy in Europe. So that is the second part of the equation. Obviously, those regular cash flows out of Europe, I think are important to us because we do need product development, market development, and a regional plan in fiber cement. And our current business doesn't yield any real cash flow in Europe, and that was always kind of an obstacle for us to make the big bet in Europe.

We didn't think our capability was right, and we didn't have any, you know, kind of regional cash flows to work with. So, going forward, we just feel like we've solved that problem. Now there's a lot of work to be done. In the short term, our focus will be on bringing Fermacell into the corporation and making sure we don't go backwards with their business, and, you know, in other words, do a good job with the integration. And then sometime in the next twelve months or so, we'll start thinking about resetting the fiber cement strategy. So right now, we're gonna close the business.

Once we close the business, we'll start the integration process, and I would say sometime, you know, in the next, like I say, twelve months, we'll really get serious about what the, what the fiber cement strategy for Europe looks like, you know, gen two, basically. Next slide, the bullet points on the left are kind of a bit of a repeat, sort of a category scale, you know, European capability and perspective, a strong management team. On the right, where we list out the countries, it's interesting, the U.K. is not up there, and that's kind of fine with us.

The U.K. is actually the geography we have the strongest position with our current fiber cement, and it is a target market for them, but they've they haven't gotten good traction in that U.K. market. So the fact that U.K.'s not there is probably fine with us. The other. They're biased toward Germany. Frame construction is growing in Germany. Modular construction is growing in Germany. So Germany is a target market even for our current product line in fiber cement, so that that works well for us. Like I said, their split commercial you know residential and repair model looks to be pretty even. I didn't even actually look at the exact numbers. And I think what you're gonna see in the fiber cement business in Europe is gonna be very similar.

It won't be like the U.S., where we're mainly an exterior company, 80% exterior. Be more like Australia, where we're 50-50. About half our business down here is interior, and half is exterior. Just gives you some of the details on this slide. So 270, and this is basically, they're on a calendar year, so EUR 270 is where they expect to end up. They have about 800 employees, six manufacturing plants. There are a lot of similarities between their manufacturing plants and our manufacturing plants, so I think that's gonna work well for us. One area they're out ahead, and hopefully, maybe we can accelerate our progress, is they're basically zero process waste leaving the site.

So those of you that follow the company would've heard we have a kind of objective in Hardie to beat zero to the landfill, and this business has already gotten there, and it'll be I think we'll get some good transfer there. They got a sales force spread across Western Europe, headquartered in Germany. This is kind of our summary slide. So this is, you know, why Hardie wants this business. Obviously, there were other bidders for the business. A lot of companies recognized it as a good business. We were more interested in and have been actually for several years because of what we think it can do for us with fiber cement. So this kind of just ticks off the main points.

When we get to routes to market, channel, and customer, it's really way more about customers, end customers, and specifiers than it is channel. Now, there'll be some channel benefit, but the main benefit will be end customer and specifier. Strong brand, so we haven't obviously taken over the business, so we haven't worked out our branding strategy. But we will not be moving away from the Fermacell brand, and we may even use the Fermacell brand on some of our fiber cement products. The middle column basically says you just can't. You don't get there because you bought Fermacell. Fermacell's a gate that we go through, and it kind of enables it. But we need product development, market development specific for Europe, and we need regional supply in Europe.

So those will all be future investments. I think product development and market development will start earlier. Product development, almost immediately. Market development, when we start seeing that we have some products to bring to market, that have a different value proposition than our current products. And then, regional capacity is probably something like three to five years. It's not, not something we'll be announcing real quick. And then the other thing is, these technologies do sit side by side. They're very close technologies. There's some significant differences and significant similarities, so we do expect some crossover. We expect some of what we do to kind of push their capability forward a bit, and vice versa. Some of what they do will help us in fiber cement.

That's hard to, you know, clearly identify right now, but I think intuitively, you know it's there, 'cause what we're trying to do is so similar. Okay, we'll go into U.S. business. Like I said, you'll have a chance to ask plenty of questions on Fermacell. First slide on the US, this is the group overview. You see a lot of red arrows pointing down. Basically, you know, that's all driven by the North American business, so when we get into that, we'll show you where. We're basically tracking the way we set out, the way we thought we would for the year. We're resolving so many issues that were triggered when we ran out of capacity or the capacity planning for fiscal year 2016.

Wasn't right, and we ran out of capacity in fiscal year 2017. So, I guess there's a couple bullet points here about manufacturing. International is running well, and obviously we declared a dividend. Go to the next slide, which would be on the U.S. business. Basically, revenue is up on flat volume, so the price is strong, but the volume is flat below the market index, obviously. So, a little bit of negative market share there. The volume in this second quarter, it's unusual because it's negative, I understand, a bit of a surprise. The last two times we've done results, I've told you the order file's been soft. It was soft in May, and it was soft again in August.

There's a few things that probably drove that to be flat. I mean, drove that to be negative rather than flat last quarter, or at least helped drive it, and that was. I think I talked in September about a product line we exited in the interiors business, which is four by th- G2 product, which is an interior product. And then we had the two storms, and the temporary disruption in the markets kind of affected the order file for a period of time with both storms. So we think the half year's, you know, about 20-25 million ft short for those two reasons. But believe me, that's not the main story.

The main story is, we're still coming out of a period of allocation where we lost traction in the market. We got to get that traction back in order to start growing above the, the market index. I guess the bullet points on the right, you know, we're below the market index. It's basically still coming out of that period where we were short board and customers were forced to go to other products. Price is good. Manufacturing is tracking the way we thought it would. I think we told you in February it was gonna get better every quarter, and it's been on that trend line. And the EBIT in the first half, obviously not what we'd expect for our business, but we'll talk about it a little bit further.

Next slide does cover the unit costs in manufacturing. You can see we're still above some kind of low lows we had in the early part of 2017. We've obviously taken, we got more headwind on price this year than we've had, you know, in most years. So our input costs would be quite a bit higher than that period in 2016, but our 2017. But our performance isn't quite back either. So it's not all price that's left. We've got some performance opportunities that are still there, and I believe we'll get more out in this quarter and then again next quarter as well. Next slide is our EBIT margin slide, which everyone knows was at the wrong end of the range for three quarters in a row.

Actually, that number in second quarter still below what I'd expect for a second quarter in a good market. So it's not fully backed. The efficiency in the business model is not fully back to where it needs to be. But obviously, we've made a lot of progress. Most of that progress, I mean, we have price helping us this year. You can't, you know... But that was helping us in the first quarter as well. So the big difference between last quarter and this quarter is just the manufacturing and some organizational efficiencies that we've been able to start realizing. Next slide shows the price. Yeah, price has been tracking as planned, so that's been zero issue this year.

You go to the next slide on the right, top-line growth, we've talked about it. We're not growing above the index the way we want, so till we start doing that, that slide really doesn't become a positive story, even though the market's gotten, you know, incrementally better every year. International, fiber cement or Asia Pac, for the most part, it's been a really positive story the first half of the year, largely driven by Australia, but New Zealand's running fine, and Philippines business is in a bit of a winback from a position they lost short term against imports.

And that's what's really driving the two, two red arrows there, is, relatively more, volume from the Philippines and, reset pricing in, in a segment in the Philippines. So the, so the story on, you'll see at the next page, the story on, Asia Pac business is pretty much good across the board. Everything pointing up in ANZ. Philippines, you got that one, you got that, EBIT, slightly off, but, getting going in the direction that we want. So, we're, we're pretty-- we're very happy, actually, with the, Asia Pac, business. We think they're, they're doing a good job running the business. The growth rate in Australia is very good in a market that's coming off. So, it's all good. All right, I'll hand it over to Matt.

Matt Milliken (CFO)

Okay. Good morning, everybody in Sydney, and thanks for everybody on the phone for joining us. I'm on slide 21. I'll go through the financials. For the second quarter, we reported net sales of $525 million, which was up 6% for the group, with EBIT of $97 million in the quarter, up 10%, and net operating profit of $66 million, up 16%. The net sales increase of 6% was driven by price, as Louis talked about already in the North America segment, and good volume performance in the international segment. Gross profit increased 3%. Gross margin rate is down 110 basis points year over year. I'll step through that a bit more later. SG&A expenses are up 9%.

We're continuing to invest in organizational capability, and you're seeing that reflected in the SG&A, and then adjusted net operating profit was down 1%, for the most part, on the heels of the North America business. For the half, we had reported sales. I'm gonna do the rest of the presentation as Darth Vader. For the first half, we had reported sales of $1.034 billion, which is up 6%. A similar story to the quarter. Gross profits of $356 million, and EBIT dollars of $181 million, down 12%, and net operating profit of $123.8 million, down 14%.

With very similar drivers, as you can see noted on the right, for the business performance. Price performance in North America drove top line, with volume being favorable in international. SG&A expenses increased 5% for the first half compared to the same period a year ago, and net operating profit down 4%, for the most part, driven by the North America segment EBIT down 8% for the half, while international fiber cement EBITs were up 15% for the half. Foreign exchange, as you can see, this is a chart we've used now for some time, didn't really have a material impact on the quarter, on the reported comps.

You can see really no change on net sales, gross profit, or adjusted EBIT, and only a point on adjusted net operating profit, excluding the impact of translation. Louis mentioned earlier that input costs have been a headwind for the year, and they continue to be so. You can see, you know, pulp, cement, freight, gas are all up, so all important inputs for us. Pulp continues to climb in the market. It's up 11% compared to the same six months a year ago, and we're continuing to see that market move up. Cement is up 5%. That's pretty consistent with where we've seen it the last several times we've talked and in prior years. But cement, the cement market continues to be strong.

You know, one change since we've talked in August and then in May, you know, freight market prices are up about 16%. We're continuing to see driver shortages and truck shortages, as well as market and fuel increases. That's on top of you know, our own inefficiencies that we're still working out of from the capacity constraint. But nonetheless, the actual market prices are up quite a bit. You can see gas up 13%, electricity down 5%, but input costs for the year are certainly a headwind on the North America results. This slide looks at our second quarter versus our first quarter.

You can see that, quarter over quarter, our gross margins in the segment improved about 270 basis points, and that's almost entirely all the production cost increase. You get a little bit of price favorability quarter to quarter, getting a full quarter of the price increase and some mix. Startups are a little bit lower as we're coming out of some of the startups, and we've got Plant City more or less fully started up now, and the Summerville startup is stabilizing. So the performance of manufacturing each quarter is starting to, you know, demonstrate an impact on gross margins and therefore EBIT margins.

So EBIT margins in the segment in the second quarter were up about 420 basis points to 24.5% in comparison to where they were in the first quarter of the fiscal year. I'll zip through the segment results. You can see North America EBIT was flat in the quarter and down 8% in the first half, and that's a combination of... In comparison to a year ago, production costs were higher in the first half of this fiscal year than they were in the first half of last fiscal year.

Keep in mind that the real cost of the capacity constraint and the stress on the network wasn't really felt until the second half of last fiscal year, so we get a bit of a comp this year, a tougher comp, if you will. Then obviously, we're continuing to invest in SG&A. So both of those are negative dynamics on the EBIT for the North America segment. Internationally, you know, the market index is about flat. We got dwellings in Australia that's, you know, call it down, high single digits. The R&R market is down, you know, 2%-3%, and then you get non-residential that's up.

We're up on a market index that's flat, and volume comps that are obviously above that. The team's done a good job on category share and a focus and a drive this year on executing certain strategies to drive category share gains, and that's what you're seeing come through in the strong volume performance. That combined in Australia with the stabilization of the Philippines sales strategy and the performance of that business has helped the international business, you know, report a second quarter EBIT increase of 20%, a first half EBIT increase of 15%. Our other segment, you know, has continued to perform more or less where we thought it would perform for the year.

You'll see that EBITs are gonna be a little bit more of a loss this year. We're continuing to invest in product manufacturing capabilities in the windows business. We like kind of what that team's doing, and so we're investing a comparatively small amount of money into the business in order to enable them to deliver on their strategy. You can see the R&D, no real significant change in our R&D spend from quarter to quarter, half to half, so that continues on a pretty consistent trajectory. General corporate costs for the half, they obviously look flattened, and that's what they are on a reported basis.

Keep in mind that, the first half also includes the gain on sale that we took when we sold a building next to our Fontana manufacturing plant. We reported that in the first quarter. That was about $3.4 million. So, general corporate costs are up $3 million-$4 million in total. And that for the most part is on organizational capability and some discretionary spending. Income tax, we're estimating a 23.8% estimated adjusted effective tax rate for the year. Our adjusted income tax expense decreased, you know, due to where our earnings moved from period to period, and a lower adjusted operating profit before income taxes.

Income taxes are paid and payable in Ireland, the U.S., Canada, New Zealand, and the Philippines, and, I think as many of you know, income taxes are not paid or payable in Europe or Australia. Due to tax losses in Australia, that's primarily because of our contributions to the fund. On 29, cash flow, we reported cash flow from operations for the first half of $98 million, down 25% from $131 million that we reported in the first half of the prior corresponding period. We're rebuilding inventory levels, so working capital is a use for the first half and will likely be in the second half as we get inventory levels, you know, back to where we want them.

There was also an increase in the payment to AICF this year in comparison to a year ago. As many of you that are familiar with how that payment works, it tends to fluctuate year to year, and this year was higher. We're continuing to invest in capacity-related projects. I'll go through those in a moment. So we had higher investing activities, and those were the main drivers of our cash flow for the first half. We've spent through the first six months of the year $83.6 million on CapEx, and that's an increase of $48 million compared to a year ago.

During the quarter, we completed the commissioning of the fourth line in Plant City, so PC4 has been fully commissioned, and we're continuing to start up the Summerville facility. That startup is where we thought it would be at this stage, from the last time that we talked. We're continuing the construction of our Tacoma, our second plant, that's adjacent to our current plant in Tacoma, and that's scheduled to commission and open in the first quarter of next fiscal year, so next spring. We're continuing to do planning on our Prattville, Alabama, facility. We expect that to commission in the first half of fiscal twenty. I'd expect that the February result that we'll take you through some numbers on, on Alabama.

And then we're continuing to expand capacity to our Philippines facility. That project was announced quite a while ago, and we expect that to be complete during the second half of this fiscal year. On financial management and capital management, you know, so strong margins and operating cash flows, governance and transparency and overall an approach on our balance sheet as though we're an investment-grade financial management approach. Our capital allocation, you know, remains the same, so our first interest is to fund the fiber cement business and ensure that we've got the necessary tools in place and teams in place to support organic growth in that business. We remain committed to the ordinary dividend.

You saw that today with the announcement of a first half dividend. And then, as we've said, we always wanna have the flexibility both for changes in the market and fluctuations that are out of our control, as well as to be strategic, and certainly the Fermacell acquisition presented an opportunity for us to do that. We are gonna maintain our leveraging target between one to two times adjusted EBITDA. You will see that for a short period of time, we will be above that range. I'd expect us to come back within the range over a one-to-two-year period. As of September, we had $500 million of unsecured credit facilities.

We had the existing $400 million unsecured, senior unsecured note. You can see the average maturity there of three years, 3.2 years, and from a liquidity standpoint, we shape up pretty well. A bit more on the balance sheet. You can see the debt profile on the left. You know, overall, very strong balance sheet. $79 million of cash, $602 million of net debt, and 42% liquidity. You see the debt structure. Our net debt leverage at the end of September was 1, just shy of 1.4 times.

And as I said, we remain committed to the one to two, despite the Fermacell acquisition that for some time will put us up above two. In terms of guidance, we've narrowed the range, 245-275. You know, we think that that's a good representation of the likely outcomes for the year. Obviously, that's still subject to how the housing market in the U.S. finishes out for the year, as well as our own performance, as well as some factors that are outside of our control, like foreign exchange and the like. So with that, I'll open it up to questions.

As Louis said at the top of the call, we're gonna start with Fermacell-related and acquisition-related questions, and then we'll come back to the core business.

Emily Smith (Director)

... Hi, it's Emily Smith from Deutsche Bank. [Foreign language] Just I guess firstly, on Fermacell, I guess just trying to understand if this is part of a strategy where you're going to grow, in, I guess, through further acquisitions, we should think about. It's been a long time since you've made an acquisition, as you said, Louis. So I guess trying to understand what this means, if there are further acquisitions in the pipeline and if you intend to continue to grow through acquisition. I think secondly, just wondering, I think if you look at the numbers we have, I think the EBITDA margin comes in around 19.5%. Just wondering if that, you know, if you guys see some upside to that, as you get

Louis Gries (CEO)

Okay, the first question on our bias toward growth. So that really hasn't changed. We kind of built ourselves to be an organic growth strategy, organic growth company, and we'll continue to be that, I think, in the foreseeable future. We don't have any work going on in Europe for further acquisitions. We've had a scan in the U.S. for several years now, but we expect anything when you do in the U.S. to be more about the technology than the market position. So we don't expect a big acquisition or an acquisition this size in the U.S. So we are an organic growth company. We feel like, you know, it's obviously harder to grow organically, but we think it's way more valuable revenue growth.

The acquisition of Fermacell was really partly because it is a big business, but if we weren't interested in fiber cement growth strategy in Europe, we wouldn't have bought Fermacell, so it is there to kind of provide that gate or that enabler for where we think we need to be in order to fully commit to Europe as a fiber cement market for Hardie. As far as the EBIT margin, this is a good business. It returns much better than most building materials business, especially through a cycle, and we do see opportunity for you know further improvement in both on the top line and the bottom line.

Our main focus, like I said early on, would be this is a well-run business, so as we bring it into Hardie, we wanna make sure we don't knock it off in any way. So, we're not really looking to change the EBITDA margin or the basic growth rate they've been tracking down the last three to five years. We're hoping to maintain that and bring this into our company in a very, you know, kind of . . . in a way that, you know, gives us that platform we're looking for, rather than have to try to fix things up. So it's not broken, so we're hoping not to break it. All right.

Operator (participant)

There's Peter Steyn from Macquarie. Just gonna talk.

Peter Steyn (Managing Director)

But, sorry, Peter Steyn from Macquarie. Just, in terms of the channel, could you give us a sense of how Fermacell are going to the market at this point in time? And then, the sense is that this is largely an interiors business as it stands, you're trying to bring exteriors to that. Is there a very clear commonality in the channel opportunity? Do you see it a relatively easy sell into those existing channels?

Louis Gries (CEO)

Okay, yeah, good question. We're not near as much about the channel as we are to market position. So we think the end users and the specifiers involved are key enablers for Hardie fiber cement. And I think the channel basically both companies feel the same. Okay, we're pull-through companies. We create demand for products in a market with the decision makers, and then once you create that demand, normally the channel will support you. So both companies starts with that view, and certainly we'd have that view at Hardie in Europe. So it will help that you know they're fairly big with DIY in Germany, and they have you know dealers established mainly for interior products, but some of those dealers do have both exterior and interior.

That'll be a small help, but that's not the big enabler. The big enabler is kind of that European capability and end customer specifier. And, you know, I don't know if I've been thinking wrong all these years or not, but I think having regular cash flows in the region will encourage us to, you know, really make the investments in product development, market development, and capacity that we needed to. You know, we just can't get this thing going, the way we've been investing in the market to date. So, we think this, obviously, we haven't invested to a greater degree because we weren't very certain of our returns. And we feel way more certain with Fermacell as part of the company.

Andrew Scott (Head of Industrials Research)

Louis, Andrew Scott from Morgan Stanley. Can you just talk a little bit about what you see as the addressable market? You referenced wood-frame construction in Germany growing. I think that's from a pretty low base. Historically, that's been something you've said you thought was key for a Hardie's platform. What do you view as the addressable market, and what does it require from a product perspective?

Louis Gries (CEO)

Yeah, that's a good question. I wanna go back, because over the years, I have talked about what we think the macro drivers are for our current fiber cement business model. And that's, we like being in regions where there's no asbestos. So, we don't want, we don't want, quote, "cheap, cheap cement boards in a market." We like frame construction. Our value proposition on our current product line, especially in the U.S., is basically high durability, low maintenance, and it looks like wood. We like high GDP per capita, not because we wanna sell to the most wealthy people in the country, but we want a big middle class, and big middle class seems to be highly correlated to high GDP per capita.

We want a large population because, basically, we're a fiber cement company that has technology that allows much higher throughput and lower unit cost on a machine. And then, we want an open business system. So we don't wanna have to have a JV to be successful in a market. JVs, besides splitting the profits, you gotta take a risk on technology and IP that we've never been comfortable with. So when you look at Europe, they have all but the frame construction. They're on a long-term trend of kind of moving toward frame construction. You know, currently, the U.K. is about twenty-five, coming off of twenty in two thousand and four. They're forecasted to be thirty-one in the next nine or ten years.

Germany, thirteen, currently sixteen, coming off of thirteen, forecast to be twenty. And then France, ten, coming off of five, forecast to be thirteen. So as Andrew says, we have our eyes open, okay? We're going into a masonry construction market. Now, that trend line on frame construction will help our current product lines, okay? Which are built for frame construction. But we have to come out with product lines that have a value proposition in masonry construction markets, 'cause that's the standard in the market, and it's anticipated to be a standard for a long time.

That's why I was talking about commitment, product development, and once we get that product, get that value proposition clearly, you know, described, then we'll start the market development, depending on if it's commercial or residential product line.

Andrew Scott (Head of Industrials Research)

And what does that mean, Lou? Does that mean more panel, less plank?

Louis Gries (CEO)

Yeah, certainly, panels are used in masonry construction, especially high density. Yeah, definitely less plank. Planks are frame construction markets. So you won't see a product mix in Europe reflecting our product mix in the U.S. And remember, our product mix in the U.S. is very different than our product mix in Australia and New Zealand. So you will definitely see a different product line in Europe.

Andrew Scott (Head of Industrials Research)

The last one for me, this might be more for Matt, but can you just talk to us about what that revenue trajectory and maybe the share position has looked like over the last few years for Fermacell's core business?

Matt Milliken (CFO)

Yeah. They've got a very good market share position in their core markets. Strong in Germany and German-speaking countries. You know, as Louis said, we like that they're underpenetrated in countries like the U.K. and France, where we've got a strong position in France and in the U.K. So we've been on a good trajectory the last several years, four, five years of growing market share. But where they've been focused, that's where they've been growing market share. They've not been focused on a broader Scandinavia or U.K. or France, and that's where we see good market opportunity to go over their market share.

Andrew Johnston (Head of Basic Industrials and Services)

Lou, quick around the interiors market and the exterior market in Europe. So if you look at the interiors, it would seem that the easy sell for fiber cement is to use their existing channel in the interiors to pull back backer board. But then if you look at their range of products, they seem to have interest to know what their what percentage of their sales is essentially used in the same application. So how do you get your board into the interiors market without cannibalizing existing product?

Louis Gries (CEO)

They... Thanks, Andrew. They do have small cement board. One of their plants is actually a cement board plant. They make two product lines. One would be very, very similar to what I think most of you would be familiar with, a Durock, a PermaBase, Aquapanel in Europe, actually. The difference is they put a very smooth face on it, 'cause it's a board that's sometimes finished. It always-- it doesn't always have backer. I mean, it doesn't always have tile over it, so it's not exclusively a backer board, but it is a cement board for wet areas. And then, the other half of that business is for kind of niche applications. It's a super high-performing fire board for tunnel lining and stuff like that.

So, that's one of their facilities. It's a relatively small part of their revenue and profitability, but it's not something we'd walk away from. We think they're pretty good positions in the market that we could continue to grow. Our backer board product is more designed to be a high-volume product. Now, Europe hasn't gotten to high-volume use of backer boards, but the trend line's been okay, and it's better in the U.K. than it is continental Europe. But yeah, I mean, now that we own both, I mean, basically, we're gonna go to customer with the technology that gives them the best value proposition. So I can't tell how much it would be cannibalizing, but 270, we talked about, revenue isn't much at risk.

through Hardie product substitution. That's not really in our, especially since their product is produced locally and ours is produced in the US. There's not much motivation in our mind to get there.

Andrew Scott (Head of Industrials Research)

Does that mean part of the strategy at this stage is to put your backer board through that channel?

Louis Gries (CEO)

Yeah, well, if they can carry our backer board to market better than we do, we'll certainly want them to do that.

Andrew Scott (Head of Industrials Research)

On the exteriors, to what extent does the whole insulation, exterior insulation that they're retrofitting to buildings in Europe, to what extent does that represent a significant opportunity for you?

Louis Gries (CEO)

When you think about it, significant in the region, yes. For Hardie, you know, it would be one of our product lines, but I don't think it'll be our biggest product line, even if you look ten years down the road. It kinda relates to an earlier Andrew question, which was, you know, what about panels? And panels, the insulation systems have, you know, they're competing with stucco. The panels are competing with stucco over insulation on reskinning a building in Europe. So we think it's a good market. We need to do product development for that. So it, it's a higher density color through standard right now, which currently, Hardie doesn't have. So we'd have to do that product development to participate.

Andrew Scott (Head of Industrials Research)

Just finally, on the price differential between fiber cement in the U.S. and Europe, what's driving that? Is there significant extra marketing expense, or is there something about processes or something that's not obvious with why there's such a differential in price?

Louis Gries (CEO)

Did you pick this up through research that fiber cement sells at a higher price in Europe? I just wanna make sure I answer your question right.

Andrew Scott (Head of Industrials Research)

Uh, yes.

Louis Gries (CEO)

Yeah. It's ability to pay, to be quite honest with you. So U.S. is a very way more competitive market than Europe, so a lot more competition on price. The value proposition, you know, for the products are probably pretty much the same. But you know, Europe's ability to pay for building materials seems to be higher than the willingness to pay in the US. So we do sell at higher prices in Europe. It's not based on our cost, it's based on market pricing.

Andrew Scott (Head of Industrials Research)

Surely, there's no downtrend in,

Louis Gries (CEO)

No, no, everyone likes our prices.

Keith Chau (Analyst)

Well, Matt, Keith Chau from Evans...

Operator (participant)

Your mic is not working.

Keith Chau (Analyst)

Hello, Matt. Keith Chau from Evans and Partners. Just a couple of quick questions. The first one is just based on the historical ownership of the Fermacell business. Are you comfortable that you've acquired a business with the right capital structure and capital and assets employed, or is part of the integration costs associated with putting a little bit more meat behind the management and operational bone to run the business?

Matt Milliken (CFO)

Yeah, we're certainly very pleased with the management team. It's a very good team, and you know, we're optimistic that the entire team will, you know, come over and join us. So that was certainly one critical component to us proceeding with the acquisition. On the asset side, I mean, they've got good manufacturing, you know, facilities today. They're in good condition. They've been run well. The facility that we visited, Louis and I visited, was operating well, and the team is, you know, very knowledgeable, so that gave us some good reassurance. We've included in our business assumptions, you know, capacity expansion, CapEx over the next several years as we continue to grow the business.

And certainly, our objective is to continue to take the current market share growth that they've enjoyed over the last several years, and expand on that, which will obviously drive incremental volume, which will result in capacity above where it is today. So we've assumed some level of both, capacity CapEx, as well as, a recognition that we're likely to invest in the facilities at a slightly higher rate than probably where they've been invested at the last several years. We've got both of those assumptions included in our business case and business model.

Keith Chau (Analyst)

Matt, are you able to give us a bit of a steer on what those CapEx requirements will be beyond FY 2018 or in the next six to 12 months?

Yeah, I'd be happy to do that, Keith, but we'll have to wait till we close. You know, they've been privately held now for, you know, more than about ten years.

Sure.

Matt Milliken (CFO)

So just out of respect, out of our confidentiality agreement, we're gonna be a little limited today with kind of detailed information that we were able to share, but we'll certainly provide more once we close on it, and we'll give you some projections on what we expect CapEx to look like over a couple of years.

Keith Chau (Analyst)

Okay. And then in terms of the return hurdles for the acquisition, are you able to give us a steer on, you know, what those return hurdles are, when you may or when you consider those return hurdles achievable at the EBIT level?

Matt Milliken (CFO)

Yeah. You know, we've tried to be pretty transparent in the way that we disclose the acquisition, you know, it's and set the expectation. It's not gonna be accretive in the first year. We know we're gonna, or we're at least planning on putting some cost into the business above what its current rate is today, to ensure that it's got the right both organizational capability, operating and capital, you know, cost structures in the business. That, combined with some integration costs and the transaction costs, will, you know, prevent it most likely from being EPS accretive in the first year. When we exclude those, it's EPS accretive in the first year, but that seems a bit unfair to talk about it that way.

That's not what our shareholders get to enjoy. In the second year, it looks like, you know, based on our assumptions, it'll be EPS accretive. From an EBIT rate and an EBITDA rate, we're not gonna, you know, provide specific numbers on that today. They're good. They're very good in comparison to other building materials peers. You know, they're not gonna be quite as good as our EBIT margins that we enjoy in most of our segments, but they'll be quite healthy, and we would expect that once we get to the end of the year, you know, four quarters that you'd receive EBIT margin rates that, while a bit below what our team is out there, but better.

Louis Gries (CEO)

Thanks, Matt.

Yeah, thanks. Brooke from JPMorgan. Just a question on Europe again, with regard to fiber cement. Is it, is it more about participating in the shift towards frame construction, or is it really about taking share from products in the wood markets already in, in those countries?

Yeah, no, frame construction is the easier part of the equation, but it's also a much smaller part of the equation. So like I said earlier, I think, as we grow fiber cement in Europe over the years, you'll see us, offering value propositions for builders, that are building in a masonry standard. So, the frame construction trend is helpful, but it's not the main game.

And then the products that you're gonna be making, shipping over to Europe, I mean, which plants in the network in the U.S. do you think are producing those?

It can move around a bit. You have to get them certified, so you don't move them regularly. But, I think Peru and Pulaski are the current plants now, and probably continue to be the plants. Again, within five years, we expect to have capacity in Europe. So, that's been a long bridge. You know, the ten plus years we've been importing product, and part of our commitment to Europe is we need to move down that track, and as soon as we get our product lines figured out, commit the capacity in Europe. Okay, if there's no more... We got a mic that works, or? I'm gonna start putting you guys to work, Keith. You gotta pass your own baton.

Peter Steyn (Managing Director)

Thanks, Louis. Peter Steyn, from Macquarie again. Just, very quickly, if you could give us a sense of, any concerns you may have around conditions precedent being fulfilled, and then, perhaps, a perspective on the funding costs, both bridging and in your long-term, plans, and will that be funded in Europe?

Matt Milliken (CFO)

Yeah, both good questions. I'll take those. In terms of the closing conditions, I mean, obviously, the transaction is subject to the normal customary closing conditions. We're obviously not anticipating that we have, you know, any issues as we progress through that. But nonetheless, you know, we'll be diligent and rigorous in our approach and make sure that we can get an on-time closure. So we're not anticipating having any difficulties with that. But as I think many of you know, most of the problems that come in closing aren't anticipated. So on the funding, you know, we did announce it as a debt finance transaction.

Certainly, the debt markets are very favorable at the moment and are projected to be so for the next several months. We are considering a permanent replacement of the bridge financing that we've already got in place with a bond in Europe. We'll continue to evaluate that. The financing costs in the current bond market make it very attractive to fund the transaction long term at a relatively low cost of capital.

Peter Steyn (Managing Director)

Thanks.

Louis Gries (CEO)

Okay. Any, Fermacell questions on the phone? Sorry, I guess we have a few more in the room. You shouldn't have passed that mic over so fast.

Emily Smith (Director)

Sorry, Emily Smith from Deutsche. Just one more question for me. I'm just wondering if you can help me in terms of, like, how would you guys define success in Europe? Over the sort of medium term, what are your plans and aspirations there?

Louis Gries (CEO)

Yeah, I think I kind of framed it up a bit. You're probably looking for a revenue number ten years out, which I'm not gonna give you. We'll be working on our kind of organic strategy for fiber cement in Europe very seriously over the next year or two. But I've already given you product development, market development, and regional capacity. So you know, we're willing to invest quite significantly, and we wouldn't do that unless we saw, you know, a pretty good upside, a scale of a business outside of fiber gypsum that, you know, is really material for the company.

So, some of you I've talked to over the years, and, you know, we've been kind of dissatisfied with just sitting there with a toe in the water in Europe, and we really had to make a decision whether we're gonna, you know, kind of invest in that geography or not, or we're gonna pull back from it. We obviously went ahead with the investment route. And, you know, a lot of our emphasis, as we kind of built up the capability on the GMT, was around growth outside of the US. So we feel like this is a decision we made about a year ago, and we were fortunate to have Fermacell come onto the market.

It came on pretty quickly after Jack joined, so it was a little hard to get our arms around it right away, but it took about six months to get to the binding offer, which I think was good for us. We know a lot about this business. We knew a lot about it when it was on the market as part of Xella. Back in 2008, we looked at it. We didn't, we weren't interested in anything other than Fermacell at the time, and the sellers weren't interested in breaking it up. We didn't get a chance at it then, but, so our knowledge going in was pretty good, but we also had the five plus months with a full-time team working on this.

So we definitely know what we got, and we're definitely comfortable with the commitment we're making to Europe.

Lou, you mentioned, in the release, I think, fiber gypsum or gypsum fiber has 70% category share. Can you give us a sense of what proportion of the interior linings market or the addressable interior linings market, gypsum fiber has at this point in time, how that's developed over time, and what the goal is for the future?

Yeah, that's a good test for me, which I think I'm gonna fail. So just generally, it's if you look at the broad market, Western Europe, it's probably in the 6%-8%. And then in some markets, it can be higher than that. Germany and Switzerland, it would be higher, but you know, it's not gonna. It's not a substitute for gypsum board. It's a value-add alternative to gypsum board. When you're really looking for high performance, either around sound, mainly around sound, fire, or strength. When you're looking for that high performance, you wanna move away from gypsum board, so it's in no way a substitute for gypsum board.

Matt, just a question, whether you're willing to disclose what the total cost of the transaction will be? So if we add in the initial cost plus the year one costs, you know, transaction costs, integration costs, et cetera, are you willing to give us a guide on where you think that number's gonna come out?

Matt Milliken (CFO)

We will on closing.

Okay.

But I'd be hesitant to do that just yet. For one, we haven't obviously incurred a lot of the, some of the closing costs and the integration costs just yet. We've obviously got estimates, but I'd be a bit more comfortable once we move through the next several months and we get the transaction closed.

Okay. And then, Lou, just a question around potential market opportunities. You said you're expecting the European business to look more fifty-fifty, so fifty interiors and fifty exteriors. So I assume fifty interiors is really just your backer board product, or are there other opportunities in Europe?

Louis Gries (CEO)

You can use backer boards behind stucco systems, but currently, we don't market that in the U.S. or Europe. So what I meant to say is, it won't look like the U.S. You know, Australia is 50-50, in the U.S., we're 80-20 exterior, and I expect Europe will be a much more balanced kind of product line, meaning we'd have. We have almost no sales in commercial in the U.S., so I would expect commercial's a target market in Europe. I'd expect exteriors obviously to be the target market, but I also think we'll do more interiors business with fiber cement in Europe than we do in the U.S. But it's way too early to call. I just kind of framed that up.

Don't, don't think we're taking a U.S. business model to Europe, 'cause we're not. It's not frame construction. You know, it's a different value proposition for most decision-makers in Europe. Hey, I know you're gonna wanna have a few questions on the business, so let me just check real quick. Are there any Fermacell questions on the phone?

Operator (participant)

Thank you. If you wish to ask a question, please press star, then one on your telephone and wait for your name to be announced. Your first question comes from Simon Thackray from Citi. Please go ahead.

Simon Thackray (Director)

Thanks, guys. Simon Thackray from Citi. Just a quick couple of questions, Lou and Matt. You made the point that the business came to you fairly quickly after Jack, you know, came on board. It's been in two lots of private equity hands. Can you explain how it came to you? Obviously, Lone Star bought off PAI and Goldman Sachs in December 2016. Did they approach Hardie? How come they're bringing the... Why are they wanting to exit this business?

Louis Gries (CEO)

We knew the people at Fermacell, so we did get a call from Fermacell, but I think the bank that was working for Lone Star used a pretty normal process in marketing the business, but we just happened to know the people from Fermacell, so we did get a call from them.

Simon Thackray (Director)

Right. And so just when I look at that business, and I think you made the point, you know, they've been in business for, well, marketing this gypsum, you know, fiber gypsum for about 40 years, but the revenues are EUR 270 million, and you're saying it's got 70% plus category share. So the category itself is only, what, about EUR 375 million?

Louis Gries (CEO)

Yeah, whatever those numbers divide out to, that's right, and it'd be smaller than that. It'd be smaller than that in the U.S. and Asia. I think it may be, you know, a little bit bigger than U.S. So, it's not that different than, you know, Hardie. Obviously, they haven't gotten the same scale, but when we were investing in fiber cement in the early nineties, when Keith Barton was running the company, certainly we were counterintuitive with our investments.

Most people saw fiber cement at the time as a declining industry rather than a growth industry, and we were able to invest in the technology, push it into some other places, get it to a cost point that enabled certain market positions, and we've grown it, and we've grown it to whatever it is, two billion or something. But so they've got the two seventy, but I tell you, it's a very similar story. They're more niche-y than we are. We hit some volume markets in the US, and they wouldn't have volume markets like we have in siding in the US. But they have a lot of specific you know value propositions for certain niches.

Whether you're in commercial or frame construction, residential, where you're either looking for strength, fire or sound. They have a very strong value proposition to those buyers. Whether that can be expanded over time, I'm not sure. I don't know enough about the business itself and the technology itself, but I know their incremental growth rate is fairly good, and as Matt mentioned, in Germany, they're way ahead of other parts of Western Europe, so we think there's opportunities to maybe not pull that market share up to where it is in Germany, but we do feel we can pull it up in countries like the U.K. and France and Scandinavia.

Simon Thackray (Director)

Got it. So what has been, just as a reference point, what has been the sort of rate of growth? I mean, I know you're guiding EUR 270 million to calendar year 2017, but what sort of growth rate has that been seeing, say, the last three years?

Louis Gries (CEO)

Yeah, as Matt said, I mean, we're not gonna disclose information till we own the business, but we will give investors a good update. Here's what we have. Here's how we look at it.

Simon Thackray (Director)

Sure.

Louis Gries (CEO)

Here's what we're gonna do with it.

Simon Thackray (Director)

But it's grown above its index, is the point you're making?

Louis Gries (CEO)

Yep, it is. Definitely is.

Simon Thackray (Director)

Okay. So if I... And I know there'll be more detail, if I just do this math fairly simply and say that based on the transaction multiple, it's about EUR 52 million EBITDA, and you're going to, you said you're gonna put incremental CapEx into the business. Is that to... Has the business been somewhat, I'm gonna use the word rather carelessly, starved of CapEx under PE? Is there an opportunity to grow the core business with incremental CapEx, or is the CapEx you're referring to really more about growing your capability for fiber cement?

Louis Gries (CEO)

Yeah, those are all good questions. So the first, you know, everyone, I guess, everybody in the room's between the lines, you're saying, "Hey, you bought it from a PE firm. Did they starve the business of capital?" And the answer to that is no. We like how the business has been run during the period of time that Lone Star owned it, or still owns it, I guess. But these plants are a little bit older than Hardie plants, but they're well-kept.

They're well-maintained plants, but they're, you know, I mean, they haven't, as we talked about, their scale of the business wasn't growing at the rate like it was fiber cement, where we were building a plant, you know, every two, three years for a period of time, and we're kind of getting back into that window building capacity regularly. So what that means is most of your capacity is relatively new rather than relatively older. They have a new plant in Spain that is relatively new and won't need much CapEx, normal maintenance type CapEx that Matt and I are referring to. But some of their older plants have a few sections that need some maintenance CapEx, which we will address.

Simon Thackray (Director)

So in summary then, if I can try and conclude this properly, the existing business will grow at the rate that it has been growing, that it hasn't been staffed, that it's actually a good business. There's nothing incremental you bring to the existing business. Is that my understanding? More you will learn more about the market for fiber cement, how you're going to put your product portfolio together for Europe, but the existing management will stay and drive the existing business. Is that right?

Louis Gries (CEO)

Yeah, that's right. It's a good way to term that. Basically, what they're bringing to us is the story, not what we're bringing to them, okay? So, it's a very similar continuous process plants to what we have. So we're not gonna get in a room with them and kind of lose each other on how we think about how you run these plants. And they're not gonna have any trouble figuring out our plants, 'cause they are very similar processes. Now, the forming section's different, and a few other things are different, but it's similarity. It's not like we just bought an assembly plant, and we're gonna have to learn how to do assembly.

We're not gonna have any problem in that respect. The opportunity is what they bring to us. They bring the European capability. They bring the European access to customers, and that's what's gonna help us in fiber cement. Now, I kind of indicated on, I think it was the last slide I had, there's gonna be crossover in the technology. We're gonna learn from them. They're gonna learn for us. I don't know how to quantify that. I don't know exactly where those areas would be right now, but I'll guarantee it'll happen in the next five to seven years. There's just absolutely too many similarities to not learn from each other.

Simon Thackray (Director)

And we've got similarities with-

Louis Gries (CEO)

Okay, hey, Simon, I'm gonna have to cut you off. I know there's a few questions on the business, and we're two minutes from quit time, so we'll extend our quit time to 11:30 A.M. and take care of business questions.

Andrew Johnston (Head of Basic Industrials and Services)

Andrew Johnston, CLSA. Just a question around volumes in the U.S. Can you talk about what the trajectory is like for recovering lost customers? Because it sort of feels like it might have got a bit worse this quarter, the volume-

Yeah, it didn't. That's the first thing. I agree with you. There's no question, you know, the negative numbers are hard to swallow, so it feels like it got worse, but it didn't get worse. You know, when we were sitting here in August and even in May, I commented we have a soft order file. Believe me, I'd like to have a firm better order file than we have now, but I don't consider it soft, based on where we're living. So, I think we're starting that win-back process. It's starting to show up in our order file. I think the third quarter will be better than the second, and I think the fourth quarter will be better than the third. So I think we have momentum on the market side.

Louis Gries (CEO)

It's slow, it's a slow go. I think it was maybe in August, I said, "Hey, I thought the year would kind of end up at market index," and if you just take out your adjustments, you know, we exited a product line, and if that storm, you know, kind of doesn't, if the storm demand doesn't swing the other way, there's a little bit there, but not enough to worry about. I think there's a possibility we could end up flat to market index, but I think right now it's more likely we'll be a couple points below market index.

Andrew Johnston (Head of Basic Industrials and Services)

Okay, and on the tactical pricing, 6% is pretty impressive for the quarter, but how do we how should we think about the overall pricing for the rest of the year? Does that tactical pricing, is it such that, you know, we should be seeing 6% in the subsequent quarters, or is it just a, like, some short one-off stuff?

Louis Gries (CEO)

Yeah, so, our we commented on the price increase we took effective April 1, plus the tactical pricing kind of tune-up we did, and that product line we exited would've helped our overall pricing as well. So there's stuff like that that's going on. But I think we're now back to normal on pricing. You know, we skipped a year, and we didn't have much the year before. So when you look at our chart, it's flat, flat, and then it's up quite a bit this year. You know, we're back to regular reviews. You know, we're, we got a pricing framework we're gonna work with this year, and we'll be announcing a price increase, probably right around the first of the calendar year for April 1 implementation.

It won't be a super aggressive price increase like some of the other commodity businesses are taking right now because of the demand due to storm and stuff like that. But you know it'll be a normal Hardie increase that fits well with our 35-90 growth objectives and return objectives.

Andrew Johnston (Head of Basic Industrials and Services)

Okay, thanks.

Louis Gries (CEO)

Yeah, I didn't answer your specific question. I think Q3 and Q4 will look very much like Q1, Q2 on pricing, but then you'll have a new price coming in starting next year.

Andrew Johnston (Head of Basic Industrials and Services)

Great. Thanks.

Peter Steyn (Managing Director)

Lou, sorry, I think, did I just lose... No, I didn't lose it. Just in the context of what you've seen from a price point of view, if that continues, it does suggest that your guidance range, certainly as your margin performance stands right now, at the very least, outcomes could be fairly high at the top end of that range. How do you sort of think about the progression? What concerns have you built into how you think about the outcomes for the full year?

Louis Gries (CEO)

Yeah, I mean, our guidance is our guidance for a reason. We think there's things that could pull us up and things that could pull us down, but we think we'll be in the range. We don't know if we're gonna be likely to be in the top end of the range or bottom end of the range, so I mean, I don't have any guidance on our guidance. Okay? Our guidance is our guidance is my guidance. Any other questions on the business? Yep.

Andrew Johnston (Head of Basic Industrials and Services)

Lou, just on the cost side, I think in the first quarter result, you mentioned that manufacturing or unit manufacturing costs had fallen five in the last six months. That's certainly come to fruition. How are they tracking now?

Louis Gries (CEO)

Yeah, it's tracking, it's tracking well. I think, you know, like I said, early in the year, we said we think it gets better every quarter through the year, and we still feel the same way. Yeah.

Andrew Johnston (Head of Basic Industrials and Services)

Thanks.

Emily Smith (Director)

Hi, Louis, I'm out again. Emily Smith. Just on the, I know everyone's sort of talking about the margins. So you talked about Q3 volumes are gonna be better than Q2, Q4 better than Q3.

Louis Gries (CEO)

Relative to the comps from last year.

Emily Smith (Director)

Yeah, relative to the PCP.

Louis Gries (CEO)

Yeah.

Emily Smith (Director)

I think in at previous results, you've also talked, you know, you kind of expected to exit the year at close to the top end of your EBIT margin guidance range, the 20%-25%, and you've done that earlier than perhaps some, many would have expected. So, I mean, is there upside from here going into the end of the year as these manufacturing costs continue to come down, and how should we be thinking about the margin aspect?

Louis Gries (CEO)

It'd be the same question as Andrew's, just phrased differently, right? Yes, there is upside, but certainly not guaranteed, so we gotta see what we can deliver. There's potential upside. We got a good trend line in manufacturing.

Emily Smith (Director)

Mm-hmm.

Louis Gries (CEO)

We're very early on the market win back. It's really hard to call that right now, you know. So it's really hard to call that right now. But if we get both volume and manufacturing, yeah, I mean, we're a manufacturing business. We got prices set.

Emily Smith (Director)

Mm-hmm.

Louis Gries (CEO)

We get volume and manufacturing, we're gonna end up pretty strong, but that's not what we're forecasting. We're forecasting kind of how we did. I mean, we haven't changed at all. We just checked the box for you rather than changed our thinking about the business. Our thinking is still the same. It's, you know, we're working out of the funk we got in because we ran out of capacity. It showed up first in manufacturing costs, and now it's showing up in growth above the index. We think we have game plans in place to fix both, and when we fix both, you're gonna like our results a lot better than you do today.

Emily Smith (Director)

And so just looking at the manufacturing costs that you call out, as in terms of how much it's impacted margin, I think in the Q1, it was close to nine hundred points, and this quarter it was maybe, I don't have the numbers in front of me, but four point seven or four point nine points. I mean, how long is it going to take, in your view, for that, for us not to be talking about it anymore and it to be back to normal?

Louis Gries (CEO)

I mean, normal with some variance, you know, probably not more than a couple quarters, you know? There's variance in a business, and we got a little bit outside of our normal variance. When we ran out of capacity, we kind of shocked the business model a bit and got outside of our normal variance. And we expect to be back in that certainly first quarter of fiscal year 2019.

Emily Smith (Director)

Thank you.

Louis Gries (CEO)

Any questions on the phone?

Operator (participant)

Thank you. Your next question comes from George Clapham from Arnhem Investment Management. Please go ahead.

Louis Gries (CEO)

Okay, it looks like George might have moved on. Is there any question beyond his?

George Clapham (Chairman)

Hello?

Louis Gries (CEO)

Oh, yeah. Sorry.

George Clapham (Chairman)

Sorry.

Louis Gries (CEO)

Yep.

George Clapham (Chairman)

Hello?

Louis Gries (CEO)

Yeah, George, this is Louis. We got a telephone problem? He can't hear us.

George Clapham (Chairman)

Can you hear me? Hello?

Louis Gries (CEO)

Yep, we can hear you.

George Clapham (Chairman)

Yeah, sorry. Yeah, Louis, a couple of developments in the U.S. home builder market, Lennar and CalAtlantic getting together. Do you guys have much exposure to those builders? I understand they're gonna be about the second-largest home builder by volume. Is that an opportunity? And just, you mentioned the market index. I'm not too sure what the market index is growing at in terms of your benchmark for this year. So if you could just let me know what-

Louis Gries (CEO)

Yeah

George Clapham (Chairman)

You're expecting the market index to grow at.

Louis Gries (CEO)

Yeah, on Lennar, CalAtlantic, they are merging. I think they're gonna be about the same size as Horton. We already have their business, both builders, so we're very confident we'll have the combined companies, or combined builders company business as well. So probably not much of an opportunity, but not much of a risk for us either. On the market index, I think we're tracking somewhere approaching five, somewhere between a four and five, approaching five on our market index calculation.

George Clapham (Chairman)

Okay. Thanks, Louis. Yeah.

Louis Gries (CEO)

Yep.

Operator (participant)

Thank you. Your next question is a follow-up question from Simon Thackray from Citi. Please go ahead.

Simon Thackray (Director)

Thanks. Just, just one on the volume again, and I'm sorry if it's been answered. It's been very hard to hear on the line here. The cash flows in the first quarter showed $11 million sort of drag from a buildup in inventory. The second quarter, which shows $16 million drag, so sort of a total of $27 million. I thought the whole point about building the inventory was so that you could meet the market for customers who were on allocation, and you made some comments, obviously, from Dallas, that you had been winning back some of those larger customers. So does—how does volume end up being flat quarter on quarter, when your... In those circumstances, when you had inventory to meet demand?

Louis Gries (CEO)

Oh, yeah. There, yeah, we have the material. We don't have the demand. So that's how it ends up being flat in the quarter. If we had more orders, obviously, we have the ability to ship it. So, yeah, I mean, it's just market traction. Now, the question. I think that was the question, but I think I should comment on why we're building inventory. Basically, this year is gonna be much more of a level load approach to our manufacturing plant. So, we normally build inventory in the first or in the winter months. This year we started to build it earlier because we had been working hard on getting our throughputs up in the plant.

When the sales order file was coming in softer than forecast, so we didn't want to pull the plants back. We wanted to continue on with the manufacturing, and that's kind of how we're looking at the year as well. So we'll distribute inventory closer to the customer this year than we ever have in the past. It's kind of a new program that we're evaluating, whether it should be a long-term program for the business.

But, so we'll build inventory more this winter than previous winters, partly because we think we have kind of a supply chain game plan that might be beneficial for both us and for our customers, but also because we wanna continue on with our manufacturing kind of initiative to increase throughputs per hour in the plant or net hours per week. Having said that, we have pulled some of the plants back, so we're not running all plants 24/7. We have two plants running about half the time, so two shifts running four. And then we have a few other plants where we've taken some shifts off some of their lines, but not all of their lines.

Simon Thackray (Director)

Right. I think so, I'm a bit confused. September, when we were there in Dallas, there was commentary about sort of stratifying the different types of customers, and the big builders had never missed a stick of volume, because you, you're contracted to them. And then there was a series of sort of mid-sized builders that some had been on allocation, but you were getting those back. I'm trying to understand, did that not happen, or did you lose share elsewhere?

Louis Gries (CEO)

No. We're getting back. I mean, I don't know specifically what your interpretation of the presentation was, but, you know, I think, you know, we've talked about... We're talking about not all customers, but some customers that have had to had to go on to different products when we were, short product, have not come back. And, you know, that's, you know, that's a win-back type, game plan, which the guys have in place, but it's, we're certainly not through it yet. So, we've won, say, you said the September quarter. We've definitely won more customers back, since September, but we haven't won all those customers back.

Simon Thackray (Director)

Right, but that means you're getting positive traction on volume now?

Louis Gries (CEO)

Yeah, we're. Like I said, I think Q3 will be better than Q2, and Q4 will be better than Q3, indicating I think we have some traction or momentum, whatever you wanna call it, but we're nowhere near where we wanna be on our growth against the market index. We've still got a lot of work to do.

Simon Thackray (Director)

Got it. Got it. Okay, thank you.

Louis Gries (CEO)

Yeah.

Operator (participant)

Thank you. There are no further questions at this time. I'll now hand back for closing remarks.

Louis Gries (CEO)

All right. Thank you very much. I appreciate everyone's interest in the company.