Greetings, and welcome to SiteOne Landscape Supply third quarter 2017 earnings call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero from your telephone keypad. As a reminder, this conference is being recorded. I'd now like to turn the conference over to Pascal Convers, Executive Vice President of Strategy and Development and Investor Relations. Please go ahead.
Thank you. Good morning, everyone. We issued our earnings press release this morning and posted a slide presentation to the investor relations portion of our website at investors.siteone.com. I'm joined today by Doug Black, our Chairman and Chief Executive Officer, and John Guthrie, our Chief Financial Officer. Before we begin, I would like to remind everyone that today's press release and the presentations made during this call include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our expectations and projections. Such risks and uncertainties include the factors set forth in the earnings release and in our filings with the Securities and Exchange Commission.
Additionally, during today's call, the company will discuss non-GAAP measures, which we believe can be useful in evaluating our performance. A reconciliation of these measures can be found in our earnings release and in our Form 10-Q, which we filed with the SEC today. I would now like to turn the call over to our Chairman and CEO, Doug Black.
Thank you, Pascal. Good morning. Thank you for taking time to join us today. We continue to make progress in the third quarter, growing our sales and profit both organically and through acquisition, while expanding our gross margin and making important investments to build our capabilities for the future. Even though we were negatively impacted by Hurricanes Harvey and Irma, we were able to achieve solid results during the quarter. I would like to start today's call by discussing SiteOne's unique market position and our strategy to deliver superior long-term performance and growth. I'll also provide some highlights from the third quarter and progress on initiatives so far this year. John Guthrie will then walk you through our Q3 financial results in more detail.
Pascal Convers will provide an update on our acquisition strategy. Finally, I will come back to discuss our outlook for the year before taking your questions. I'll start on slide four of the earnings presentation. SiteOne is the largest and only national industry leader with approximately 10% market share of the $17 billion wholesale landscape distribution market. We have grown our footprint to 481 branches across the U.S. and Canada. The landscape distribution market remains highly fragmented. We see a long runway to continue to expand our share, both organically and through acquisitions, for many years to come. Our business is well-balanced between maintenance, new construction, and repair and upgrading. These end markets are all healthy and growing. Each of them has unique demand drivers, which will provide us with a good level of diversification and balance through the construction cycle.
The breadth of our product offering. The depth of our value-added services further set us apart in the industry and provide significant competitive advantage and growth opportunities. Turning to slide five, our strategy leverages the advantage of being both large and local. As a large world-class company, we can leverage economies of scale, resources, functional talent, and operating capabilities that are difficult for our competitors to replicate. At the same time, our entrepreneurial local teams leverage their deep market knowledge and strong customer relationships along with these large company capabilities to deliver superior value to both our customers and our suppliers. We remain highly focused on executing our five commercial and operational initiatives, covering category management, pricing, supply chain, sales force performance, and marketing.
These initiatives have contributed to our strong performance in recent years and provide the foundation to expand margins and accelerate organic growth over the next several years. Finally, we have built a tremendous acquisition capability. You are seeing our momentum build. Acquisitions provide SiteOne with an additional avenue for revenue and profit growth as we expand our geographic reach and the breadth of our product offering for our customers while bringing on tremendous new talent and new best practices. I remain excited about the opportunity ahead of us and believe that we are still in the early stages of building our company and executing our strategy. Turning to slide six, I am pleased with the 13% overall growth that we achieved during the third quarter of 2017, especially considering the headwinds created by Hurricane Harvey and Hurricane Irma.
To give you a feel for those headwinds, I would like to highlight that we achieved organic daily sales growth of over 7% in both July and August before the hurricanes dampened our growth to just under 2% for September. We achieved organic daily sales growth of 5% for the quarter overall. We have seen organic growth rebound back to normal levels so far in the fourth quarter. In total, we are happy with our organic growth, which reflects further implementation of our sales force performance and marketing initiatives. We expanded gross margin by 80 basis points to 31.9% in the third quarter as we continued to benefit from our category management initiative. We remain excited about our ability to expand gross margin going forward as we move volume to our preferred suppliers and ultimately benefit from the major investments that we are making in our supply chain.
We also have opportunities to further improve our gross margin as we expand our private label product offerings. In terms of SG&A, the quarter reflects our heavy investments in our IT systems, supply chain, sales force, and our new e-commerce platform as we continue to build key capabilities to accelerate organic growth and expand EBITDA margins in the future. On the IT side, we continue to upgrade our infrastructure to ensure a solid foundation for our company. In September, we moved our data center to a world-class facility, which reduces our risk and sets us up for the next five to 10 years of growth. For supply chain, we're installing our second and third distribution centers in Southern California and in Pennsylvania to complement our existing DC in Georgia.
All three distribution centers are on track to be fully operational for the spring of 2018, which will allow us to reduce transportation costs, improve customer service, improve our stock turns, and facilitate the expansion of our private label brands. With our sales force, we continue to invest in new talent, training, and development. Here, we are systematically upgrading our sales force to drive acceleration in our organic growth while also moving to a more efficient structure where our outside sellers are supported by dedicated inside sales and service associates. We believe these moves, while slightly dilutive near term, will accelerate our organic growth and improve our go-forward SG&A leverage. We have seen this benefit from pilots that we ran earlier in the year.
On the e-commerce front, we are building a world-class and fully mobile SiteOne portal that will provide our customers with industry-leading capability to quote work and efficiently order product from us, while also having access to terrific content on new products, technologies, and ideas to grow their business. We are very excited about the productivity benefits that we can bring to our customers and ourselves through this new SiteOne mobile app and e-commerce platform. In total, we believe that these investments and many others that we are making today to build our company will deliver tremendous benefit in creating a competitive advantage in our fragmented market and supporting accelerated performance and growth for many years to come. We also continue to execute our acquisition strategy, completing two acquisitions during the quarter and one more recently in October.
In total, we have now completed eight acquisitions in 2017, with approximately $130 million in annual revenues. On the corporate governance side, I'm very pleased that we were able to have Fred Diaz join our board in August. Fred is currently the general manager in charge of performance optimization for the global marketing and sales division of Mitsubishi Motors. He previously served in senior management roles at Nissan and Chrysler and brings deep experience in leading teams, building strong brands, serving professional customers, and achieving exceptional performance and growth. Following Fred's appointment to our board, we have nine directors, six of whom are independent. In summary, despite the hurricane headwinds and our significant SG&A investments, we were able to grow EBITDA by 11% and net income by 13% during the quarter, a solid overall outcome.
Our end markets remain healthy. We continue to build our company and execute our successful strategy. Now, I will let John Guthrie walk you through the quarter in more detail. John?
Thanks, Doug. I'll begin on slide seven with the income statement for our third quarter results. We reported a net sales increase of 13% to $502 million in the third quarter. Organic daily sales grew 5% despite the negative impact of the hurricanes. We had 63 selling days in the quarter, which was unchanged compared to the third quarter of last year. Organic daily sales grew 7% for construction-related products like irrigation, nursery, and hardscapes, as we continue to benefit from strong demand in the construction and repair and upgrade end markets. Organic daily sales grew 2% for agronomic products as they continued their steady growth. Pricing for all products was down less than 1% for the quarter, reflecting a continued low inflation environment. Acquisitions in the third quarter contributed approximately $34 million of net sales growth, or an additional 8% to our growth rate.
Gross profit increased 16% to $160 million in the third quarter. Gross margin was 31.9% for the quarter, an improvement of 80 basis points over prior year. Our category management initiatives proved to be the primary driver of this improvement once again. Product mix had a slightly negative impact on margin of 20 basis points for the quarter. Selling, general, and administrative expenses, or SG&A, increased by 19% to $128.1 million in the third quarter. As Doug explained earlier, the increase in SG&A was primarily attributable to the investments we made in our sales force, e-commerce, and IT, in addition to higher operating costs associated with some of our acquisitions. SG&A as a percentage of sales increased to 25.5%, a 130 basis point increase for the quarter. We recorded net income of $16.9 million for the third quarter compared to net income of $14.9 million for the prior year period.
The increase in net income was primarily caused by higher net sales and our gross margin improvement. The effective tax rate was 38.8% for the third quarter compared to 41.8% for the prior year period. The change in the effective tax rate was primarily due to the adoption of ASU 2016-09 in the first quarter of 2017. Adjusted EBITDA was $48 million in the third quarter compared to $44 million for the same period in the prior year. The improvement reflects our good top-line growth and our ability to expand gross margin. Now I'd like to provide a brief update on our balance sheet and the cash flow statement as shown on slide eight. Net working capital increased 12% year-over-year to $429 million at the end of the third quarter.
The increase in net working capital primarily reflects the increase in inventory from acquisitions, but we are also carrying more inventory due to product line expansions and our supply chain initiative. As we optimize the supply chain, we are making some progress on reducing working capital, but we do not expect to fully get back to more normalized levels until next year after we get all the new distribution centers in place. Longer term, we expect that both JDA and the DCs will be the building blocks which will enable us to generate efficiencies in our operations, including higher inventory turns, lower working capital, and improved customer service. Net debt at the end of the quarter was $468 million, and leverage was 3.1x our trailing 12 months adjusted EBITDA, which is consistent with the prior year period.
We expect our leverage to be under 3x by the end of 2017. We generated positive cash flow from operations of $17 million for the third quarter compared with negative $3 million in the prior year period. The change in operating cash flow reflected our increased earnings and improved contribution from working capital. We made cash investments of $12 million during the quarter, including $5 million for capital expenditures and $7 million for acquisitions. In summary, our capital structure continues to provide us with the flexibility to execute our growth strategy, including the funding of our acquisitions. I will now turn the call over to Pascal for an update on SiteOne's acquisition strategy.
Thank you, John. As Doug mentioned, acquisitions play a key role within our overall growth strategy. As shown on slide nine, over the last 12 months, we have acquired 10 companies that added 30 branches to SiteOne and contribute $150 million in sales on a trailing 12 months basis. As we turn to slide 10, you will be able to find information on the two acquisitions we completed in the third quarter. In August, we closed the acquisition of South Coast Supply, a leading Southern California hardscape company with two locations, which is another great example of our ability to identify and acquire local market leaders. South Coast Supply further expand the full line offering in Orange County, present significant cross-selling opportunities, and should also allow us to accelerate our hardscapes growth in the West.
In September, we acquired Marshall Stone, a leader in the distribution of natural stone and hardscape material with two locations in the greater Greensboro, North Carolina, and Roanoke, Virginia, markets. Marshall Stone dedicated hardscape centers complement our existing operations, allowing for a full range of product offering in the North Carolina and Virginia markets. As we turn to slide 11, you can see some details on the acquisition of Harmony Gardens, a leader in the distribution of nursery and related products to landscape professionals with two locations in the greater Denver and Fort Collins, Colorado, markets. Like Marshall Stone, Harmony Gardens bring a key product offering to an area where we didn't have it. Through Harmony Gardens, SiteOne add nursery products to our existing irrigation, agronomics, hardscapes, and landscape lighting product lines in Colorado.
Our acquisitions are contributing meaningfully to the performance of SiteOne, as many of these companies have been fully integrated into our organization and are delivering clear value as we realize our planned synergies. As we turn to slide twelve, we continue to see a significant opportunity to grow profitably through acquisitions which allow us to move into new markets, expand our presence in existing ones, broaden our product offering, and also very importantly, add outstanding talent to our team. Our pipeline remains robust and with eight acquisitions year to date, our M&A strategy is gaining momentum and we continue to build a reputation as the buyer of choice in the industry. We would also like to thank all the leaders of SiteOne who are great ambassadors, working hand in hand with our development team to help SiteOne select the best companies to join us in the future.
While the timing of acquisitions cannot be fully predicted, we have additional acquisitions that we expect to close in the next few months and will contribute nicely to our growth in 2018 and beyond. With that, I'd like to turn the call back over to Doug Black to discuss our outlook.
Thank you, Pascal. Overall, we are pleased with our progress during the quarter. With regard to the hurricanes, we do expect some positive incremental sales as the Texas and Florida markets benefit from rebuilding efforts.
We would expect that benefit to be realized as we move into 2018. We continue to see positive underlying market trends with good growth in residential and commercial construction, solid demand in repair and upgrade, and steady demand in maintenance. We are modifying our guidance to reflect the impact of the hurricanes and our current forecast for slightly higher overall SG&A investment for the year. We now expect full year 2017 adjusted EBITDA to be in the range of $155 million-$160 million, representing growth of 15%-19% over 2016. As we look ahead to 2018, we feel good about the underlying market and very good about the momentum in our business and the new capabilities that we are creating. We expect to achieve further gross margin improvement and meaningful SG&A leverage in 2018, following a heavy year of investments in 2017.
In closing, I would like to acknowledge all the SiteOne associates who have worked tirelessly serving our customers, especially our great teams in Texas and in Florida that were affected by the hurricanes. We have a tremendous team, and it is an honor to be joined with them as we build a company of excellence for all of our stakeholders. Operator, please open the line for questions.
Thank you. At this time, we'll be conducting a question and answer session. If you'd like to ask a question, please press *1 on your telephone keypad, and a confirmation tone will indicate your line is in the question queue. You may press *2 if you would like to remove your question from the queue. Please ask one primary question and one follow-up question to allow as many as possible to ask questions. For participants that are using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we poll for questions. Thank you. Our first question is from the line of Nishu Sood with Deutsche Bank. Please proceed with your question.
Thank you. I wanted to start with the pickup in the sales after the hurricane impact in September. You'd mentioned that daily organic sales were, I think, 7% in July and August, then dropped to 2%, and were recovering. Are we back to that prior pace in October? How quickly did that happen or do you expect it in November? How has that progressed?
Right, Nishu. Thank you. We're seeing the markets come back in Florida. A little bit slower in Houston, where they were harder hit. We wouldn't be quite back to the pace, that July, August pace, but we kind of like the trajectory that we're heading in. We think we'll finish the year in a solid fashion. As you see, year to date, we're around 5%. Our expectation is we'll finish solidly around that number.
Got it. Okay. Relating that to the reduction in the EBITDA guidance, can you help us understand the impact of that downshifting from the 7% daily organic sales pace to the 2%? What kind of EBITDA impact and what percentage of the reduction or what portion of the reduction in guidance? Also, the other portion of the reduction in guidance, the SG&A. Just wanted to understand. You folks have obviously had a lot of investments in SG&A over the years. Clearly has built up your capacity to have the growth and be the business that you are today. You had earlier been talking about, Doug, that perhaps in the second half of 2017, we might start to see some SG&A leverage, it clearly seems that you pulled forward, perhaps, or accelerated or I guess this is my question: What led to the increment here?
Did you decide to step up your capabilities? Are you accelerating it? Are you pulling it forward? Is this a new initiative, what kind of dollar impact that also had on the guidance reduction?
Okay, terrific. I'll take the first part of your question. The EBITDA impact of the hurricane, we figure it's about $2 million-$3 million EBITDA. About 2% of our sales, 2%-3% of our sales in Houston, about 10% in Florida. When you take it all in, that's what we figure was the impact. Obviously that pulled us down into the bottom half of the range. Then the investments. This year was designed to be kind of our last heavy building year. As you know, we've been building in 2015, 2016, and 2017. We've added terrific capability. We had planned in 2017 to try to get a little bit of gearing flattish on the SG&A as a percent of sales. Then, all along our plan in 2018 was to get that more meaningful gear.
I think that what's happened is, well, first of all, we're on track with our major investments, supply chain, IT, e-com. Those investments are on track, we feel good about those. We're seeing a little bit slower organic growth than we had planned. Obviously, the hurricane's part of that. The other part of that is pricing. Last year, we got about a 1% pricing lift. It looks like this year we'll have somewhere between -1% and 0% in terms of pricing. Again, these aren't huge movements, but if you take the hurricane and that together, that clips a couple of percent off your overall growth rate. The investments that we had planned and that we are doing send us into a slightly greater SG&A as a percent of sales and slightly less.
We probably have added more sellers, because we're excited about what we see as we add sellers. We're doing two things with the sales force. One is we're adding talented sellers, and two, we're moving to an inside/outside sales structure. The inside/outside part of that gives us good gearing, because the inside sellers are net lower cost than outside sellers, and you get some good efficiencies there. We've made some pilots this year, and we're going to continue to move stronger toward that in the second half. We are adding sellers where we see the need, and to some extent, you'll see the benefit of that more next year than this year.
When you take that all together, the hurricane, pricing, our major investments on targets, maybe a little bit more investment in our sales force, anticipating some terrific productivity out of them in 2018, that adds up to a slightly dilutive 2017, but we feel very good about our trajectory toward next year.
Okay, thanks for the details.
Thanks, Nishu.
Our next question is from the line of Robert Wetenhall with RBC Capital Markets. Please proceed with your question.
Hey, congrats on navigating a pretty tough operational environment and getting back to business quickly.
Thanks, Bob.
Wanted to ask about your M&A program. You're tracking in excess of $215 million already this year, which means that Pascal's actually working really hard. Your original guidance for M&A activity was about $100 million annually. I just wanted to see if you're revising your expectations in terms of how we should think about the pace of M&A activity. You've really outpaced your initial $100 million target. Is there a new run rate that the investment community should think about? Is it going to be like 150 or 200, just based on the fact that you've done such a good job at it for the last two years?
Thanks, Bob. I appreciate the support on this one. You're right. We have exceeded, actually, our target of $100 million over the last three years. We did 190 in 2015 after acquiring Shemin. We did 150 last year. Year to date, after doing eight acquisitions, we're at 130. We tend to exceed. However, you want to be conservative. You never know when those deals are going to close. For now, we still like to keep the conservative guidance of $100 million. However, Bob, we would anticipate to beat that guidance this year, of course, and going into next year. We've got a very nice outlook. We've closed eight deals this year versus six last year and four deals two years ago, there's an acceleration. Our pipeline is much bigger. We have identified 250 strategic targets, we're going to continue to mine that.
It's not a sprint. It's a long journey of buying year in, year out for the next 10-15 years, all those nursery hardscapes, irrigation and agronomics companies, we feel very good about the momentum and the pace of acceleration. If you look back, by the way, over the last three plus years, we have acquired 22 companies, those 22 companies have added $550 million of revenues to the company. We're satisfied with the pace, we'll continue to accelerate going forward.
Got it. That's helpful and encouraging. Doug, could you give me a little way to think about the margin walk towards like a low teens or maybe mid-teens adjusted EBITDA margin? Since going public, you guys have convincingly demonstrated incremental margin expansion, both gross margin and SG&A leverage. Third quarter is 9.6%. What should we be thinking of, both in the context of incremental SG&A spending and some of the initiatives on procurement and category management that you previously outlined? I'm not talking about the quarter. I'm asking more for like a one to two-year view on the margin walk going forward. What's the opportunity set look like? What are the levers you can pull? Is it going to be gross margin? Is it going to be SG&A? How much benefit? How should we think about that walk? Thanks and good luck, guys. Nice quarter.
All right. Thanks, Bob. Yes, we stated that our milestone that we wanted to get to in the midterm was 10%. We feel like we can go further than that's the target for now. We really see line of sight of getting there in a couple of years, 2019 to be specifically. We're on pace to do that. We're going to make progress this year. On the gross margin side, we've seen steady progress all along, we think that progress will continue. We still have a lot of opportunity in category management to move volume to our preferred suppliers. We've got now private label brands coming online that are helping our margin. We still have a lot of juice left in the category management initiative to get us good gross margin. We have supply chain coming on.
We're going to get our 2nd and 3rd D.C. on, get those settled before the season. We're going to see meaningful contribution from supply chain to gross margin. We're excited about that. The gross margin walk will continue. We started a couple of years ago at 27%. We're now up around 32%, heading toward that this year, and we see line of sight for improved gross margin going forward. On the SG&A side, we're all excited to go into 2018. We've made heavy investments. They've been intentional investments. They're all designed to fortify our value proposition and give us competitive advantage. We've talked about those, e-commerce, IT, our sales force, our category management team, pricing, all the teams that we've put together.
We're at the end of that build. In 2018, we start a very deliberate and long march downward in terms of SG&A as a % of sales. Of course, that will add to our EBITDA. Next year, we have two major levers that will be contributing. Gross margin continues, SG&A leverage kicks in. We have good progression toward that 10% and beyond in the next couple of years.
If you got to that 32% number for the gross margin already, which is great accomplishment, is there really more runway on the gross margin side? Can that be a 33% or 34% number in a couple of years?
Yes, we believe so. Yes. With the supply chain and the category, again, private label brands. We brought on a new private label lighting brand a couple of months ago. We just introduced it in September. We're already up to kind of a $5 million annual run rate on that. Pro-Trade is the brand name. It's a terrific line. We have it now supplied through our D.C.s. We've got a lot of things going that's going to help that gross margin going forward.
Terrific work. Good luck, gentlemen. Thank you.
Thanks, Bob.
Thank you, Bob.
Our next question is from the line of Keith Hughes with SunTrust Robinson Humphrey. Please proceed with your question.
Thank you. In the guidance page, you talk about SG&A's % of sales being up. For 2017, if I do just rough math, that would imply that you would actually see some leverage in the fourth quarter. I guess my question is that really the beginning of where we see the leverage, or is there a possibility that could actually come in a little bit higher than expected as the spending continues?
Yeah. On the fourth quarter, we would see it more flattening. We don't expect a big leverage in the fourth quarter, but it will kind of come back and flatten out. Then you'll start to see the leverage. The first quarter in any year is tough to call because the sales can move around. I wouldn't be too caught up in what the first quarter of next year shows us, but definitely in next year, meaningful march downward to contribute to our EBITDA expansion. Yeah, the fourth quarter, you'll see it settle down from the third to a flattish metric.
Okay. In terms of the sales pace in the quarter, in terms of the Florida market, will that come back faster than Houston, given it's more just a cleanup versus a repair?
Yes, Keith. We would expect Florida to kind of get what we've seen, it's really got to where it was before the hurricane hit. We haven't seen that, what I would call a rebound, where it yet, with a recovery well above where it was tracking, but it is back in tracking. Houston, since it wasn't so much more severe, we really haven't seen a pickup there. I think, in general, with hurricanes, that's not the number one priority for those people who are affected. The timing is somewhat delayed and pushed out to the next year, after they get the basic necessities. Certainly, for the people in Houston, it was a pretty serious event.
Okay. Thank you.
Thank you.
Our next question is from the line of Ryan Merkel with William Blair. Please proceed with your question.
Hey, thanks. Good morning, everyone.
Good morning, Ryan.
Morning, Ryan.
I want to go back to the investment spending for just a minute. Can you tell us how much investment doesn't repeat in 2018?
In terms of the e-commerce, that's heavy this year. That will go down next year. Our IT is heavy this year. That would go down. Salesforce investments, we would expect that to go down as well. Relative, we're investing heavily in that supply chain. That'll settle down a bit as well. We're still investing heavy in those. Again, the reason we have confidence in our gearing is those major investments that we're making settle down. Of course, you've got normal inflation on the base and other things. Those investments would be less next year than this year.
They'll be less, but it's still going to be a gearing issue. It's not like there was a couple of one-time items. It's more of what I would call normal incrementals will take place next year rather than what you would expect as if a one-time, big spend. Though there is, obviously, with e-commerce putting up a site, there is some one-time spend there.
Right. Just to put in, we think our normal gearing is 15-
Yep
16% to the bottom line of an incremental sales dollar. We should see more of that normal gearing next year.
Okay. That's really what I was getting at. You don't have a number at your fingertips as to how much SG&A wouldn't repeat, because I think e-com was $4 million.
Right. Yeah, no, the e-com, like John said, it was $4 million to $5 million investment. Of course, we built a team too, to operate that. Ongoing, you're always going to be investing in a new system, but we wouldn't expect it to be as heavy as this year.
Got it. Okay. Just moving to pricing. You mentioned that price, I think for the year, is going to be flat to maybe down a little bit. I'm just wondering, why isn't there more inflation, just given the end markets are fairly healthy? Can you just dive into that a little bit? Secondly, do you think that that can improve in 2018, that we can get back to some inflation, or is there something going on that we should be aware of?
Right. Well, the main part of the deflation, if you will, is our agronomics products, which again, came down last year. You lapped those prices, that's been down all year. We've seen the other product lines just kind of flattish with some of them having some small amount of inflation. You end up between negative 1% and 0.
I think what we're seeing, the preliminary indications in the marketplace, what we're hearing from our category teams is there will be some price inflation next year. I don't think we're going to see the rapid inflation you see in kind of, let's say, lumber. It'll swing more from being flat to down slightly to more GDP type of inflation, the normal CPI type inflation, which would be a positive for the business next year.
Okay. Then, just lastly, if I could, just stepping back, looking at new construction, what's sort of your early read on 2018, just looking at customer bidding activity? It sounds like you're pretty optimistic and you expect mid-single digit growth, but maybe just clarify that for us, if you would. Thank you.
Yes, we really just see next year developing similar to this year. Commercial is still strong. We still see good backlogs with our customers. Residential still seems to be pacing along, and then the repair/remodel is at healthy levels with unemployment low and with income high on the consumer side. We're seeing consumers continue to install products and continue to use professionals to do those major rebuilds. We would be optimistic. We certainly don't think it'll be stronger than this year, but we really don't see any difference heading into next year than we saw heading into this year.
Perfect. Thank you.
Thank you, Ryan.
Our next question is from the line of Mike Dahl with Barclays. Please proceed with your question.
Hi. Thanks for taking my questions.
Thanks.
I wanted to follow up on some of the comments that both prepared remarks and in Q&A, you've mentioned private label, and I know these are some initiatives you've been working on for some time, but sounds like some of them are potentially set to ramp as we head into 2018. Just first, can you remind us, as a percentage of your overall sales right now, what are your private label sales and how do you see that shaping up as you look out to your 2018 mix?
Right. Our current private label mix is in around 20%. Of course, the big brand we have there is LESCO, which is a well-known 60-year-old brand in our agronomics business. It's a terrific brand. We also have GreenTech as our high-end irrigation system brand. We do aspire to significantly increase our private label brands. We've really needed the DCs to be able to do that so we can source into the DCs and have the product available. Having our first DC up and running this year, we're able to start our first additional major private label brand, which is Pro-Trade, and the lighting space offered a good opportunity to do that. We're starting with Pro-Trade. We're rolling that out across the country.
As I mentioned, we're two months into it and we're up to a $5 million annual run rate, so we're really happy with how that's ramping up. Then we plan to bring on additional products, both under the Pro-Trade line and under other private label lines. We'd like our private label to be 30-plus% in the future, potentially 40%. So we're ramping up toward that, and you will see that increase in 2018. Of course, that helps on the gross margin side. That helps expand our gross margins further.
Got it. Right, which leads me to my second question, which is, if we think about your margin trajectory over the next couple of years, I know that's going to be a component of it, but can you give us any more quantification of how much of a benefit the shift towards private label alone could be? What's the relative margin profile today on private label versus your other products?
Right. It'd be hard to pin a number. We're still learning and we're still in the early days of pushing that out and rolling that out. I think we'll be able to, with more confidence, talk about that as we get into next year or later part of next year. For the near term, meaning 2018, while private label will start to help us, the majority of our gross margin improvement is still going to come from our Category Management initiative in total, which is really continuing to move our volume to preferred suppliers and get much better deals from them. Then the supply chain rollout is going to significantly reduce our logistics cost. Those are the major drivers for next year.
Private label, while it will be positive, kind of slight contributor to next year, we think is more meaningful in 2019 and 2020, as we really gain momentum there. Hard to pin a number at this point.
Fair enough. The last question I had is just going back to the prior question around thinking about more the new construction side as we look into 2018. One of the trends being observed with the builders is an incremental push towards the low end, and that's really where a lot of the incremental growth is coming from, which I think traditionally would have a different type of landscaping content. Is there any insight you can give us as to how you see that affecting you, if there's a take-per-home metric that you've looked at in the past where you've looked at entry-level homes versus move up or high end?
We don't have any good rules of thumb there. Obviously, the mid-high end has more landscaping than the lower end, and they tend to put in irrigation, whereas the lower end doesn't. Certainly we're helped as there's a nice healthy top end and mid end market. I would just say that our business is pretty balanced across commercial, across residential. Maintenance is 45% of our business, so that's a good steady component. Repair and remodel is a big component. Whether the trend is slightly to more low-end homes or slightly higher, et cetera, in the big scheme of things, at the rate that we're growing and our ability to gain market share, et cetera, we wouldn't be worried about that as a meaningful factor for our growth over the next couple of years.
Okay, thanks a lot.
Thank you.
Thank you. As a reminder, to ask a question today, press *1. The next question is from the line of Samuel Eisner with Goldman Sachs. Please proceed with your questions.
Yeah, thanks. Good morning, everyone.
Good morning.
On gross margins this year, I think you're going to be about 60 basis points of expansion, a little bit under 40% incremental gross margins. That includes negative pricing. I want to better understand how much the negative pricing is impacting the gross margins or gross margin expansion or in dollar terms for this year. If that's expected to be flat next year, do we then expect incremental gross margins to be higher than the roughly 36%, 37% that you guys are going to do this year?
What we're seeing with regards to pricing is primarily that is a reflection of cost also. I wouldn't say specifically that all the decrease in pricing this year is a negative headwind to the gross margin percentage. Obviously, it is a headwind to gross margin dollars, but a lot of that is corresponding with reductions in the cost of materials also.
Right. Sam, we follow costs up and down pretty closely. Since we don't have huge movements up or down, we are able to track there. Our gross margin improvement really is just relative in terms of moving volume to preferred suppliers, gives us a relative better cost of goods sold than prior year. That's really what we're doing. In general, in terms of prices to customers, we're following costs up and down.
Got it. The way that I should think about that comment is that if pricing is flat or even positive in 2018, that doesn't really affect your gross margin profile next year or beyond.
Right. No, it would help our organic growth, right? Obviously it's a headwind to organic growth, which makes things tougher on the SG&A side, et cetera. We do expect that to be a benefit next year, where it was a headwind this year, which is positive. For gross margin percentage specifically, wouldn't be a big impact.
Got it. That's helpful. You made a couple comments, Doug, regarding the SG&A improvements going forward. I think you said meaningful two or three times into 2018. I think the quote was very deliberate, long downward march. I'm curious, what is the framework to think about SG&A growth going forward relative to sales? Does it grow at half of the rate of sales? Does it grow at three quarters of the rate of sales? When your M&A cadence, or at least the number of transactions, is increasing over that same time period, how do we think about the change in SG&A and that kind of ultimate equation going forward? Thanks.
Right. No, great question. Again, I would go back to the natural gearing in our business. As we grow incrementally on sales, we expect to get about, let's say 15%-16% of that to the bottom line. That's with no improvement in gross margin. That implies the level of gearing that we can get on our SG&A. In terms of acquisitions, it really depends on which type they are. The nursery and the hardscapes tend to have a little higher cost to serve, but they have a little higher margin to match. That impacts SG&A negatively or makes the rate higher. If we buy some good agronomic companies, that hub type operators like a Green Resource, they have a lower SG&A than we have as a percent of sales, that would bring it down. It really depends on the mix of acquisitions.
This year where we're heavy on nursery and hardscapes, we're getting a little bit more SG&A with the acquisitions. In the future, if we're buying a normal irrigation or an agronomic player, we tend to bring that down. We expect the mix to be kind of even overall, we don't expect it to be a huge variance one way or the other. In any one year, it could swing it a bit.
Yeah. Specifically this quarter, because we have had a significant number of hardscapes acquisitions, it was a mix issue that negatively contributed to our SG&A percentage.
Got it. That's very helpful. Thanks, guys. Appreciate it.
Thank you, Sam.
Thank you. I will now turn the floor back to Doug Black for closing remarks.
Okay, great. Thank you for your interest in us. Thanks for joining us today. We appreciate your interest in SiteOne, and we're very excited about our long-term growth and profitability potential for the company going forward. Again, I'd like to thank all our terrific associates for making our company great, and especially those in the hurricane-affected areas that have really worked tirelessly to dig their way out of those situations. Thank you very much.
Thank you.
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